Читать книгу CFP Board Financial Planning Competency Handbook - Board CFP - Страница 46

Thomas Warschauer, PhD, CFP^®

San Diego State University

CONNECTIONS DIAGRAM

Many topics use financial statements as a basis for their analyses. For example, cash flow statements are necessary for insurance needs and retirement planning computations. Virtually all accumulation goals depend on funding based on either appropriating investment assets or allocating cash flow. An understanding of these funding sources is based on an analysis of these financial statements. Statements of financial position are necessary for investment analysis and determining appropriate financing strategies. Tax and estate evaluation also begin with an evaluation of the client’s financial statements. Evaluation of financial statements results in observed strengths and weaknesses of the client’s fiscal situation, which is discussed in Chapter 77.

INTRODUCTION

Finance professionals agree that financial analysis virtually always begins with the construction and evaluation of financial statements. The construction of financial statements is an ancient art, although statements for business analysis are much more developed than those for individual or family analysis.

Financial planners need to be familiar with both corporate/business accounting techniques and individual financial statements. Given that the purpose of financial statements prepared by a financial planner is different than that of corporate financial accounting, standardization of statements is less important than it is for public reporting of business entities. Thus, financial-planner-produced statements need not be compliant with generally accepted accounting principles (GAAP) unless they are also to be used in public reports or are being prepared by certified public accountants based on the Financial Accounting Standards Board rules and U.S. Securities and Exchange Commission policy.

The basis of a sound financial statement is grounded upon an understanding of basic accounting principles. Underlying accounting principles that are important to individual and family accounting statements include the following:

■ Objectivity principle – quantities must be verifiable.

■ Materiality principle – the amount of detail depends on its cost to collect and its relative importance.

■ Consistency principle – similar situations call for similar treatment.

■ Conservatism principle – reporting revenues or assets only when they are assured.

■ Full disclosure principle – all material facts are disclosed.

Some accounting principles are of less importance in individual accounting, but essential to business reporting. These include:

■ Historical cost principle.

■ Revenue recognition principle requiring accrual basis accounting.

■ Matching principle (expenses have to be matched with revenues).

The key statements in business accounting are the income statement (also called the profit and loss statement), the statement of financial position (often called the balance sheet), and the statement of cash flows. In addition, firms sometimes present statements explaining changes in equity or net worth. In general, planners should be familiar with business statements because sometimes their clients own businesses. Also when planners recommend the purchase or sale of individual securities, they must analyze and interpret GAAP-prepared statements of the prospective investments they are considering. An individual company security analysis recommendation is based on intimate and detailed knowledge of these statements and their associated accounting footnotes. For a planner who is not dealing with these situations, only a very general understanding of business accounting is necessary.

The key statements for individual or family accounting are different. Whereas the income statement is generally considered to be the most important statement for businesses, it does not exist in individual accounting. The statement of financial position and cash flow statements are the most important statements in family finance. Budgets are actually pro-forma or forecasted cash-flow statements that are used for the purpose of tracking actual expenses relative to the amount budgeted for them.

The importance of financial statements to the financial planning process may be, to some, a bit debatable. It would be possible to complete even a comprehensive financial plan without ever creating or analyzing a financial statement. However, most finance professionals agree financial statement analysis is the normal starting point for the evaluation of a company’s or individual’s financial condition, and is thus an excellent source of evaluating a client’s strengths and vulnerabilities of their current condition. Although it is not a clear practice standard that financial statements always be generated and evaluated, it is clearly a useful practice.

The learning objectives reflect the needs of all planners to generate and analyze their clients’ financial positions and for planners who engage in specific areas to fully understand business accounting techniques.

LEARNING OBJECTIVES

The student will be able to:

a. Construct statements of financial position and cash-flow statements as applied to clients consistent with sound personal accounting standards.

Certain common conventions are widely practiced within financial planning. First, assets listed on balance sheets are properly listed with the safest and most liquid types first and the riskiest and least marketable last. Although grouping of assets into categories varies, at least three groups are common: safe (sometime called liquid or cash assets) are usually listed together, as are all investment assets and all personal (or use) assets. There is no agreement on whether business ownership (partnerships or proprietorships) should be listed separately, with investments, or with use assets. Another important tool is the use of footnotes to the statements a planner creates. Footnotes may list contingent assets (e.g., an expected year-end bonus or inheritance) or contingent liabilities. In fact, footnotes should list or explain any item whose omission would cause a material misunderstanding of the client’s financial position.

The AICPA Personal Financial Statements Guide provides specific instructions for the construction of financial statements for individuals. Probably the most important innovation is the computation of taxes due on the liquidation of assets as a reserve liability account that results in an after-tax and more meaningful valuation measure of an individual’s net worth. Although most planners do not show this figure, its use would improve the usefulness of the net worth figure.

Cash flow statements show revenues first and expenses later, sometimes in the following manner:

Alternatively, instead of “fixed” and “variable” expenses, planners sometimes list categories of expenses, such as home ownership costs, food and restaurants, automobile expenses, and so on.

b. Evaluate client financial statements using ratios and growth rates and by comparing them to relevant norms.

Analysis of corporate statements usually begins with the computation of standard ratios and growth rates and the comparison of those ratios and rates with industry norms, usually adjusted for the size of the firm.

Common ratios used in corporate analysis include liquidity ratios, profitability ratios, debt ratios, activity ratios, and investment valuation ratios. There are dozens of commonly measured ratios used to analyze a business’s financial condition.

DuPont analysis is a common analyst’s tool. It decomposes return on equity into several components such as profit margin and asset turnover.

DuPont System 46

Once ratios are computed, they are compared with those of similar companies. That means companies of comparable size and in the same or a similar industry. A common source of comparison ratios is Risk Management Associates (RMA).47 It is important to note that, apart from profitability measures, there is no such thing as a “good” ratio. The purpose of computing ratios is to better understand the nature of the firm. For example, a high liquidity ratio may be desired by a lender, but if it is too high it may indicate a lack of investment prowess by the firm’s management.

Whereas ratios make comparisons among accounts in a business’s or client’s financial statement, growth rates review changes over time. The two most important growth rates are growth in gross income over time compared with growth of net worth over time. The computation of ratios for individuals is a newer and less developed science than for businesses. Bankers have used debt ratios to determine whether it is a good idea to lend to a family. But just because a family is able to borrow does not mean it should borrow. There are several good sources of ratios for use in evaluating family statements; some even contain norms for purposes of comparison.48 They divide ratios into various types: liquidity, savings, asset allocation, inflation protection, tax burden, housing, and solvency.

In the introductory section, we mentioned some key differences in accounting principles for individual financial statements and corporate statements. However, probably the biggest difference is the use of market valuation of investment assets and replacement cost for individuals’ personal assets. This would be problematic for businesses because it would enable managers to easily manipulate earnings. Further, most business assets are not valued by the market directly.

Whereas the single most important number in corporate accounting is net income, probably the most important number in individual statements is net worth. However, net worth is commonly overstated for individuals who own appreciated assets or tax-deferred assets (individual retirement accounts [IRAs], for example). The solution to this problem, employed by the American Institute of CPAs (AICPA), is to reduce net worth by taxes that would be paid if all investments were shown after tax. The AICPA calls this amount the estimated income tax on unrealized appreciation, but we could simply call it a tax reserve.

It is important to remember that the sole purpose of planner-prepared statements is a better understanding of a client’s financial position.

IN CLASS

**Appropriate for both on-campus and distance courses.

PROFESSIONAL PRACTICE CAPABILITIES

Entry-Level: An entry-level personal financial planner can prepare and evaluate financial statements for a family.

Competent: A competent personal financial planner can compute growth in earnings and net worth to determine if the client is making good progress toward stated goals.

Expert: An expert personal financial planner can evaluate a firm’s financial condition given its 10-K and 10-Q reports and determine for whom, if anyone, it would make a good investment.

IN PRACTICE

Patricia

After establishing the client–planner relationship, Patricia Planner starts into the data-gathering phase of planning. She has asked a client couple to bring in a list of assets, debts, and cash flow items. The clients provided the following list:

Patricia now sets out to create and evaluate a statement of financial position and a cash flow statement. The first step would be to separate assets, liabilities, cash inflows, and cash outflows. The second step would be to categorize assets into safe, investment, or use assets, and to categorize expenses into taxes, fixed, or variable, or by use categories (auto, home, etc.). After creating the statements, Patricia could evaluate the financial condition of the clients by computing ratios and comparing them with norms, by evaluating the changes in net worth, and by observing the clients’ financial condition relative to their situation. This leads to observing a series of strengths and weaknesses regarding their current situation. Although practice standards do not permit giving advice until Patricia’s analysis is complete, she can see some obvious recommendations right away. She might begin with the evaluation of the investment assets relative to the clients’ income, ages, and goals. Are the investments diversified? Do they provide inflation protection? Does the income statement indicate past savings or the potential for savings?

For example, Patricia might use the financial statements to explain to her clients that using the $10,00 °CD, which is earning 1 percent per annum, to pay off most of the credit card balance on which they are being charged 12.8 percent per annum, would result in no change in net worth, while it would improve annual cash flow by $1,180.

NOTES

Visit www.wiley.com/go/wileycfpboard2e to access nearly 400 practice questions. Your access code is at the back of this book. CFP^® professionals in the United States can also choose to obtain the full 28 credit hours by taking and passing the test.

46

Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 9th ed. (New York: McGraw-Hill Irwin, 2011), 635.

47

www.rmahq.org.

48

Sue Greniger, Vickie Hampton, Karrol Kitt, and Joseph Achacoso, “Ratios and Benchmarks for Measuring the Financial Well-Being of Families and Individuals,” Financial Services Review 5, no. 1 (1996): 57–70.