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Chapter
Using Financial
Statements and Budgets
Chapter 2
How Will This Affect Me?
A recent survey shows that more than half of adult Americans could not cover six months of living expenses or
the cost of medical emergencies. And younger millennials between the ages of 18 to 24 are the least prepared.
This is scary . . . and this chapter explains what you can do to avoid being part of that alarming statistic.
Everyone knows it’s hard to get where you need to go if you don’t know where you are. Financial goals
describe your destination, and financial statements and budgets are the tools that help you determine exactly
where you are in the journey. This chapter helps you define your financial goals and explains how to gauge your
progress carefully over time.
Hopefully most of your students have had a semester of financial accounting. If so, while this chapter will be a
review for them, they may need help understanding the differences between cash and accrual accounting. The
chapter deals with cash accounting; the previous accounting course dealt with accrual accounting. If they have
not had an accounting course, the students may have a hard time. If this material is new to them, it will be
helpful if you go over worksheets (2.1 and 2.2) and then discuss the Financial Planning Exercises 3 (preparing a
personal balance sheet) and 4 (preparing a personal income and expense statement).
The Facts or Fantasies are true false questions designed to create interest in the chapter. They are below and in
the power points for the chapter.
Learning Goals
LG 2-1 Understand the relationship between financial plans and statements.
The statement above “it’s hard to get where you need to go if you don’t know where you are” is very true. The
LG 2-2 Prepare a personal balance sheet.
The Balance Sheet computes the net worth as of a given date. The Balance sheet formula [Total Assets = Total
not. While liquid assets and investments may look the same, their purpose is very different. The liquid assets
LG 2-3 Generate a personal income and expense statement.
While the balance sheet reports financial position as of a given day, the income statement covers a stated period,
typically a month, quarter, or year. A useful exercise is to ask the class “is income gross pay or net pay?” If
LG 2-4 Develop a good record-keeping system and use ratios to evaluate personal financial statements.
Without records, you are flying blind. It like the person who says they can spend money as long as they have a
LG 2-5 Construct a cash budget and use it to monitor and control spending.
The income statement reports the cash surplus or deficit for the period. But is the surplus of $2,000 good or not.
LG 2-6 Apply time value of money concepts to put a monetary value on financial goals.
Financial plans are concerned with what future amounts you will need to be able to provide for your desired
LG 2-7 Understand the relationship between inflation and nominal interest rates and calculate the real interest
rate.
Inflation is arguably the most prominent source of investment risk and is a key driver of interest rates. It is
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be used as
quizzes after you covered the material or as “pre-test questions” to get their attention.
• Because financial statements are used to record actual results, they’re really not that important in personal
financial planning.
• A leased car should be listed as an asset on your personal balance sheet.
• Only the principal portion of a loan should be recorded on the liability side of a balance sheet.
• Generating a cash surplus is desirable, because it adds to your net worth.
Fact: You can only increase your net worth by generating a cash surplus, someone giving you additional
assets, or through increases in market values. The only one of the three you control is generating cash surplus.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
1. True False Whereas the balance sheet summarizes your financial condition at a given point in time, the
income and expense statement reports on your financial performance over time.
2. True False Because financial statements are used to record actual results, they’re really not that important in
personal financial planning.
3. True False A leased car should be listed as an asset on your personal balance sheet.
4. True False Only the principal portion of a loan should be recorded on the liability side of a balance sheet.
5. True False Generating a cash surplus is desirable, because it adds to your net worth.
6. True False When evaluating your income and expenses statement, primary attention should be given to the
top line: income received.
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help
make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do,
that is, until the student starts looking around at the web site. But they will learn by doing so.
Track Your Expenses
It's easy for spending to become so automatic that we're not aware we're doing it. So where does your money
go? The only way to find out is to keep track of it. Writing down what you spend in a paper journal or using an
app like Expensify (www.expensify.com) is simple and will make you more aware of where your money goes.
Knowing where you are will probably make you feel better too - so do it now.
Save Automatically
We all know we should save regularly. One way to create a savings "habit" is to literally make it automatic.
Open a savings account apart from your checking account. This will separate your savings from what you have
available to spend. And then set up an automatic deposit or transfer from your checking account to your savings
account each month. This sets your "habit." You can do it now.
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices
being made.
No Budget, No Plan: Tyler Bought a Boat!
Tyler is 28 and has a good job as a sales rep. He's always found budgeting boring and has been intending to start
a financial plan for years.
Recently Tyler went out with some friends on a rented boat to fish. He had a great time and saw a boat for sale
on his way home. Before he knew it, the salesman convinced Tyler that the deal was just too good to pass up.
So Tyler bought a $10,000 boat and financed 80 percent of the cost for the next 5 years. Sean now finds himself
relying more on his credit card to get by each month.
What if Tyler had kept track of his money, used a budget, and had a set of financial goals? Knowing where his
money went and having a financial plan would have increased the chance that Tyler would make more
deliberate, informed financial decisions.
Solutions to Financial Planning Exercises
1. Financial plans v statements: Describe and distinguish financial plans and statements.
2. Preparing Financial Statements: Hugo Garcia is preparing his balance sheet and income and
expense statement for the year ending December 31, 2020. He is having difficulty classifying seven
items and asks for your help. Which, if any, of the following transactions are assets, liabilities,
income, or expense items?
a. Hugo rents a house for $1,350 a month.
b. On June 21, 2020, Hugo bought diamond earrings for his wife and charged them using his Visa
card. The earrings cost $900, but he hasn’t yet received the bill.
c. Hugo borrowed $3,500 from his parents last fall, but so far, he has made no payments to them.
d. Hugo makes monthly payments of $225 on an installment loan; about half of it is interest, and the
balance is repayment of principal. He has 20 payments left, totaling $4,500.
e. Hugo paid $3,800 in taxes during the year and is due a tax refund of $650, which he hasn’t yet
received.
f. Hugo invested $2,300 in a mutual fund.
g. Hugo’s Aunt Lydia gave him a birthday gift of $300.
The gift increases his cash account and he has no obligation to repay. So, the amount is reported on his
3. Preparing Personal Balance Sheet: Use Worksheet 2.1 Katie Wright’s banker has asked her to submit
a personal balance sheet as of June 30, 2020, in support of an application for a $6,000 home improvement
loan. She comes to you for help in preparing it. So far, she has made the following list of her assets and
liabilities as of June 30, 2016:
Cash on hand $ 70
Balance in checking account 180
Balance in money market deposit account with
Southwest Savings 650
Bills outstanding:
Telephone $ 20
Electricity 70
Charge account balance 190
Visa 180
MasterCard 220
Taxes 400
Insurance 220 1,300
Condo and property 68,000
Condo mortgage loan 52,000
Automobile: 2016 Honda Civic 14,400
Installment loan balances:
Auto loans 3,000
Furniture loan 500 3,500
Personal property:
Furniture 1,050
Clothing 900 1,950
Investments:
U.S. government savings bonds 500
Apple Stock 3,000 3,500
From the data given, prepare Katie Wright’s balance sheet, dated June 30, 2020 (follow the balance sheet
form shown in Worksheet 2.1). Then evaluate her balance sheet relative to the following factors: (a)
solvency, (b) liquidity, and (c) equity in her dominant asset.
See following page for Worksheet 2.1 for Denise Fisher.
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except
3-a. Solvency Ratio: This term refers to having a positive net worth. The calculation for her solvency
ratio is as follows:
Total Current Debts $1,700
This means she can cover only about 53% of her current debt with her liquid assets. Rule of thumb, the
liquidity ration should be at least 1.
If we assume that her installment loan payments for the year are about $2,000 (half the auto loan
balance and all of the furniture loan balance) and add them to the bills outstanding, the liquidity ratio at
4. Preparing Income and Expense Statement: Use Worksheet 2.2. Robyn and Matthew Scott are about to
construct their income and expense statement for the year ending December 31, 2020. They have put
together the following income and expense information for 2020:
Robyn’s salary $57,000
Reimbursement for travel expenses 1,950
Interest on:
Savings account 110
Bonds of Alpha Corporation 70
Groceries 4,150
Rent 9,600
Utilities 960
Gas and auto expenses 650
Matthew’s tuition, books, and supplies 13,300
Books, magazines, and periodicals 280
Clothing and other miscellaneous expenses 2,700
Cost of photographic equipment
purchased with charge card 2,200
Amount paid to date on photographic equipment 1,600
Robyn’s travel expenses 1,950
Purchase of a used car (cost) 9,750
Outstanding loan balance on car 7,300
Purchase of bonds in Verizon Communication Inc 4,900
Using the information provided, prepare an income and expense statement for the Scotts for the year
ending December 31, 2020 (follow the form shown in Worksheet 2.2).
See worksheet on following page.
Issues: Purchase of bonds is a balance sheet transaction, a non-recurring conversion of cash to investment in
bonds. There is no expense; there is no impact on net worth. The payment of the auto loan could be left off the
expense statement since it is a reduction of an asset and a liability. However, the loan payment is a recurring
item and reporting it as an expense helps explain the change in cash. The determining factor is the recurring
nature and impact on net worth. The goal of all financial statements is to provide information. If the reader of
the statement needs to know about a transaction, that transaction should be on the financial statement.
Robyn’s travel expenses are off set by the reimbursement. There is no impact on net worth. However, it is a
recurring transaction and reporting it helps explain the change in the cash account. Reporting the expense may
also remind Robyn of an item that has not been reimbursed.
Name(s)
For the Ended December 31, 2020
Income
Name: $ 57,000.00
Name:
Name:
Self-employment income
Bonuses and commissions
180.00
960.00
4,150.00
Personal care
280.00
13,300.00
1,600.00
1,950.00
(II) Total Expenses
CASH SURPLUS (OR DEFICIT) [(I)-(II)]
Laundry, cosmetics, hair care
37,640.00$
21,490.00$
$
9,600.00
Appliances, furniture, and other
major purchases
Loan payments
Purchases and repairs
Other recreation and entertainment
Other items
Matthew's books, tuition, and supplies
Photographic equipment -- amount paid
Robyn's travel expenses
Life (not provided by employer)
Auto
Taxes
Income and social security
Property (if not included in mortgage)
Food
Groceries
Dining out
Utilities
Gas, electric, water
Phone
Cable TV and other
Rent/mortgage payment
(include insurance and taxes, if applicable)
Repairs, maintenance, improvements
Investment income
Interest received
Housing
INCOME AND EXPENSE STATEMENT
Robyn and Matthew Scott
Year
Wages and salaries
Robyn
5. Preparing Cash Budget: Theo and Sophia Martinez are preparing their 2021 cash budget. Help the
Martinez family reconcile the following differences, giving reasons to support your answers.
a. Their only source of income is Theo’s salary, which amounts to $5,000 a month before taxes.
Sophia wants to show the $5,000 as their monthly income, whereas Theo argues that his take-
home pay of $3,917 is the correct value to show.
Like many questions it depends. If the taxes and other payroll deductions are considered out of their
b. Sophia wants to make a provision for fun money, an idea that Theo cannot understand.
He asks, “Why do we need fun money when everything is provided for in the budget?”
By having an allowance for "fun money," the Martinez family have specifically set aside a certain
PLEASE NOTE: Problems 6 through 8 deal with time value of money, and solutions using both the tables and
6. Calculating present and future values: Use future or present value techniques to solve the following
problems.
a. If you inherited $45,000 today and invested all of it in a security that paid a 7 percent rate of
return, how much would you have in 25 years?
FV
=
PV x FV factor 7%, 25 yrs. (1+i)n
45000
+/-
PV
=
$45,000 x 5.427
7
I
=
$244,215
25
N
FV
$244,234.47
b. If the average new home costs $275,000 today, how much will it cost in 10 years if the price
increases by 5 percent each year?
FV
=
PV x FV factor 5%, 10 yrs. (1+.05)10
275000
+/-
PV
=
$275,000 x 1.629
5
I
=
$447,975
10
N
FV
$447,946.02
c. You forecast that in 15 years, it will cost $190,000 to provide your child with a 4-year college
education. Will you have enough if you take $75,000 today and invest it for the next 15 years at 4
percent?
No, you will have $135,071, which is less than your $190,000 goal.
FV
=
PV x FV factor 4%, 15 yrs.
75000
+/-
PV
=
$75,000 x 1.801
4
I
=
$135,071
15
N
FV
$135,070.76
d. If you can earn 4 percent, how much will you have to save each year if you want to retire in 35
years with $1 million?
c. To achieve his annual withdrawal goal of $35,000 calculated in part b., how much more than the
amount in part a. must Austin deposit today in an investment earning 4 percent annual interest.
8. Inflation and Interest Rates: Jessica Adams is 21 years old and has just graduated from college. In
considering the retirement investing options available at her new job, she is thinking about the long-term
effects of inflation. Help her by answering the following related questions.
a. Explain the effect of long-term inflation on meeting retirement financial planning goals.
b. If long-term inflation is expected to average 4 percent per year and you expect a long-term investment
return of 7 percent per year, what is your long-term expected real rate of return (adjusted for inflation)?
Be sure to consider the important impact of compounding.
2-1 What are the two types of personal financial statements? What is a budget, and how does it differ from
personal financial statements? What role do these reports play in a financial plan?
Personal financial statements provide important information needed in the personal financial planning process.
2-2 Describe the balance sheet, its components, and how you would use it in personal financial planning.
Differentiate between investments and real and personal property.
The balance sheet summarizes your financial position by showing your assets (what you own listed at fair
2-3 What is the balance sheet equation? Explain when a family may be viewed as technically insolvent.
2-4 Explain two ways in which net worth could increase (or decrease) from one period to the next.
There are basically two ways to achieve an increase in net worth. First, one could prepare a budget for
the pending period to specifically provide for an increase in net worth by acquiring more assets and/or
2-5 What is an income and expense statement? What role does it serve in personal financial planning?
2-6 Explain what cash basis means in this statement: “An income and expense statement
should be prepared on a cash basis.” How and where are credit purchases shown when statements are
prepared on a cash basis?
2-7 Distinguish between fixed and variable expenses, and give examples of each.
2-8 Is it possible to have a cash deficit on an income and expense statement? If so, how?
2-9 How can accurate records and control procedures be used to ensure the effectiveness of the personal
financial planning process?
2-10 Describe some of the areas or items you would consider when evaluating your balance sheet and
income and expense statement. Cite several ratios that could help in this effort.
