This Document Contains Chapters 1 to 3 Chapter 1 Understanding the Financial Planning Process Chapter Outline Learning Goals I. The Rewards of Sound Financial Planning Improving Your Standard of Living Spending Money Wisely Current Needs Future Needs Accumulating Wealth II. The Personal Financial Planning Process Steps in the Financial Planning Process Defining Your Financial Goals The Role of Money The Psychology of Money Money and Relationships D. Types of Financial Goals E. Putting Target Dates on Financial Goals Long-term Goals Short-term Goals and Intermediate Goals III. From Goals to Plans: A Lifetime of Planning The Life Cycle of Financial Plans Plans to Achieve Your Financial Goals Asset Acquisition Planning Liability and Insurance Planning Savings and Investment Planning Employee Benefit Planning Tax Planning Retirement and Estate Planning Special Planning Concerns Managing Two Incomes Managing Employee Benefits Managing Your Finances in Tough Economic Times Using Professional Financial Planners IV. The Planning Environment The Players Government Business Consumers The Economy Economic Cycles Inflation, Prices, and Planning V. What Determines Your Personal Income? Where You Live Your Career Planning Your Career Major Topics Personal financial planning provides major benefits that help us to more effectively marshal and control our financial resources and thus gain an improved standard of living. Because the emphasis in this text is on planning—looking at the future—we must examine many areas to set and implement plans aimed at achieving financial goals. These areas are introduced in this chapter and examined in detail in later chapters. The major topics covered in this chapter include: The benefits of personal financial planning techniques in managing finances, improving one’s standard of living, controlling consumption, and accumulating wealth. Defining financial goals and understanding the personal financial planning process necessary to achieve them. Financial planning as a lifetime activity that includes asset acquisition plans, liability and insurance plans, savings and investment plans, employee benefit plans, tax plans, and retirement and estate plans. Special financial planning concerns with an emphasis on the economic environment’s influence, including managing two incomes, planning employee benefits, and adapting to other major life changes. The use of professional financial planners in the financial planning process, the various types of financial planners, and choosing a financial planner. The influence of government, business, and consumer actions and changing economic conditions on personal financial planning. Age, marital status, education, geographic location, and career as important determinants of personal income levels. The important relationship between career planning and personal financial planning. Key Concepts To begin developing a personal financial plan, one must understand basic financial planning terminology, principles, and environmental factors. The following phrases/terms represent the key concepts stressed in the chapter. Standard of living Consumption patterns Wealth accumulation The personal financial planning process Financial goals The role of money The psychology of money Money and relationships Types of financial goals The life cycle of financial plans Plans to achieve financial goals Technology in financial planning The planning environment—players, economy, and price levels Special planning concerns Financial planners Determinants of personal income Career planning Average propensity to consume Financial assets, Tangible assets, and Liquid assets Utility Liability Flexible benefit (cafeteria) plans Commission-based versus fee-only planners Factors of production Fiscal policy Monetary policy Economic cycles (business cycles) Expansion versus Contraction Peak versus Trough Inflation Consumer price index and Purchasing power Financial Planning Exercises The following are solutions to problems at the end of the PFIN 4 textbook chapter. Student answers will vary. In general, using personal financial planning tools helps individuals to organize their finances, evaluate their current financial condition, and track changes in their financial condition through time to see if they are making progress toward their financial goals. Student answers will vary depending on their personal situation. The purpose of this exercise is to encourage students to focus on how their personal goals and plans will change over their financial planning life cycle and also to help them be specific in setting their goals by designating dollar amounts and dates. Student answers will vary. Suggestions may include the following: Junior in college—pay off all credit card debt by graduation; pay off all student loans within 10 years of graduation; save $2,000 for a down payment on another vehicle during the next two years. 30-year old computer programmer who plans to earn an MBA—pay off auto loan before beginning degree; find a cheaper place to live; set aside $5,000 for emergency use during school. Couple in their 30s with two children, ages five and nine—begin college fund for each child; fund Roth IRAs for both parents; max out employer-sponsored retirement plan, such as 401k, each year. Divorced 42-year old man with a 16-year old child and a 72-year old father who is ill—engage the help of friends or family in carpooling teenager to school and activities; explore community or church programs which might provide assistance for the father, such as Meals on Wheels or a visitation program; help father with estate planning needs, hiring an attorney if needed. As you move through life and your income patterns change, you’ll typically have to pursue a variety of financial plans. As we pass from one stage of maturation to the next, this life cycle of financial plans reflects our patterns of income, home ownership, and debt changes. The role of these plans is important in achieving our financial goals which can range from short-term goals, such as saving for a new sound system, to long-term goals, such as saving enough to start your own business. Reaching your particular goals requires different types of financial planning. Answers on economic trends will depend on current economic conditions. If the GDP is growing, the economy is expanding and general economic conditions are considered favorable. Unemployment is probably low, and jobs are available. If the GDP is slowing, the economy may not be doing well, and jobs may be scarce. Changes in the CPI indicate the level of inflation. If inflation is rising, purchasing power is declining, and you will need more money to achieve your financial goals. In periods of high inflation, interest rates rise making it more difficult to afford big-ticket items. Age, education, and geographic location all impact personal income. For example, the amount of money you earn is closely tied to your age and education. Generally, the closer you are to middle age (45–65) and the more education you have, the greater your income will be. Heads of households who have more formal education earn higher annual incomes than do those with lesser degrees. Geographic factors can also affect your earning power. Salaries vary regionally, tending to be higher in the Northeast and West than in the South. Typically, salaries will also be higher if you live in a large metropolitan area rather than a small town or rural area. Possible steps to “repackage” yourself might include: Analyzing skills and experience to identify transferable skills Looking for companies in related fields and industries Considering your own interests to see if other career paths make sense Networking extensively Researching fields that use your skills Developing functional resume focusing on skills rather than job titles Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 1-1. Standard of living, which varies from person to person, represents the necessities, comforts, and luxuries enjoyed by a person. It is reflected in the material items a person owns, as well as the costs and types of expenditures normally made for goods and services. Although many factors such as geographic location, public facilities, local costs of living, pollution, traffic, and population density affect one’s quality of life, the main determinant of quality of life is believed to be wealth. 1-2. Generally, consumption patterns are related to quality of life, which depends on a person’s socioeconomic strata. This implies that wealthy persons, who are likely to consume non-necessity items, quite often live higher quality lives than persons whose wealth permits only consumption of necessities. 1-3. The average propensity to consume is the percentage of each dollar of a person’s income that is spent (rather than saved), on average, for current needs rather than savings. Yes, it is quite possible to find two persons with significantly different incomes with the same average propensity to consume. Many people will increase their level of consumption as their incomes rise, i.e., buy a nicer home or a newer car. Thus, even though they may have more money, they may still consume the same percentage (or more) of their incomes as before. 1-4. An individual’s wealth is the accumulated value of all items he or she owns. People accumulate wealth as either financial assets or tangible assets. Financial assets are intangible assets such as savings accounts or securities, such as stocks, bonds and mutual funds. Financial assets are expected to provide the investor with interest, dividends, or appreciated value. Tangible assets are physical items, such as real estate, automobiles, artwork, and jewelry. Such items can be held for either consumption or investment purposes or both. 1-5. Money is the exchange medium used as the measure of value in our economy. Money provides the standard unit of exchange (in the case of the U.S., the dollar) by which specific personal financial plans—and progress with respect to these plans—can be measured. Money is therefore the key consideration in establishing financial plans. Utility refers to the amount of satisfaction derived from purchasing certain types or quantities of goods and services. Since money is used to purchase these goods and services, it is generally believed that greater wealth (money) permits the purchase of more and better goods and services that in turn result in greater utility (satisfaction). 1-6. Money is not only an economic concept; it is also a psychological one that is linked through emotion and personality. Each person has a unique personality and emotional makeup that determines the importance and role of money in his or her life, as well as one’s particular money management style. Personal values also affect one’s attitudes to money. Money is a primary motivator of personal behavior and has a strong impact on self-image. To some, money is of primary importance, and accumulation of wealth is a dominant goal. For others, money may be less important than lifestyle considerations. Therefore, every financial plan must be developed with a view towards the wants, needs, and financial resources of the individual and must also realistically consider his or her personality, values, and money emotions. Money is frequently a source of conflict in relationships, often because the persons involved aren’t comfortable discussing this emotion-laden topic. Each person may have different financial goals and personal values, leading to different opinions on how to spend/save/invest the family’s money. To avoid arguments and resolve conflicts, it is essential to first become aware of each person’s attitude toward money and his or her money management style, keep the lines of communication open, and be willing to listen and to compromise. It is possible to accommodate various money management styles within a relationship or family by establishing personal financial plans that take individual needs into account. Some families are able to avoid conflict by establishing separate accounts, such as yours, mine and household, with a set amount allocated to each account each pay period. This way, no one feels deprived, and enough has been set aside to pay the bills and to meet common financial goals. 1-7. Realistic goals are set with a specific focus and a reasonable time frame to achieve results. It is important to set realistically attainable financial goals because they form the basis upon which our financial plans are established. If goals are little more than “pipe dreams,” then the integrity of the financial plans would be suspect as well Students’ descriptions of the steps to achieve a specific goal will, of course, vary. They should follow the general guidelines in the chapter: define financial goals, develop financial plans and strategies to achieve goals, implement financial plans and strategies, periodically develop and implement budgets to monitor and control progress toward goals, use financial statements to evaluate results of plans and budgets, and redefine goals and revise plans as personal circumstances change. 1-8. Individual time horizons can vary, but in general individuals would expect to achieve their short-term financial goals in a year or less, intermediate-term goals in the next 2-5 years, and long-term financial goals in more than five years. Refer to Worksheet 1.1 on p. 14 of the text for examples of financial goals. In making personal financial goals, individuals must first carefully consider their current financial situation and then give themselves a pathway to reach their future goals. People in the early stages of their financial planning life cycle may need more time to accomplish long-term goals than those who are already established in their careers and may also need to give themselves more flexibility with their goal dates. 1-9. Financial plans provide the roadmap for achieving your financial goals. The six-step financial planning process (introduced in Exhibit 1.3) results in separate yet interrelated components covering all the important financial elements in your life. Some elements deal with the more immediate aspects of money management, such as preparing a budget to help manage spending. Others focus on acquiring major assets, controlling borrowing, reducing financial risk, providing for emergency funds and future wealth accumulation, taking advantage of and managing employer-sponsored benefits, deferring and minimizing taxes, providing for financial security when you stop working, and ensuring an orderly and cost effective transfer of assets to your heirs. 1-10. Personal needs and goals change as you move through different stages of your life. So, too, do financial goals and plans, because they are directly influenced by personal needs. When your personal circumstances change, your goals must reflect the new situation. Factors such as job changes, a car accident, marriage, divorce, birth of children or the need to care for elderly relatives must be considered in revising financial plans. 1-11. The loss of two percentage points on investment returns is anything but inconsequential, particularly if the loss occurs annually over a period of several years. For example, if Chad had invested $1,000 at an 8% return and subsequently had invested all earnings from the initial investment at 8%, in 40 years he would have accumulated $21,725 from the initial $1,000 investment. If, on the other hand, he had earned a 10 %return on the same investment, he would have accumulated $45,259 in 40 years—more than double his return at 8%! Clearly, two percentage points over time can make a significant difference! Calculate various rates of return on a $1,000 investment to see that for every 2 %increase in return, your investment results will more than double over a 40-year period. By carefully considering his investment and banking choices, it is likely that Chad would be able to get a 2% greater rate of return without taking on additional risk. This can be done both by choosing investments and bank accounts that hold down expenses, as well as by finding investments of the same type that have performed better. 1-12. Employee benefits, such as insurance (life, health, and disability) and pension and other types of retirement plans, will affect your personal financial planning. You must evaluate these benefits so that you have the necessary insurance protection and retirement funds. If your employer’s benefits fall short of your needs, you must supplement them. Therefore, employee benefits must be coordinated with and integrated into other insurance and retirement plans. Tax planning involves looking at an individual’s current and projected earnings and developing strategies that will defer and/or minimize taxes. For income tax purposes, income may be classified as active income, passive income, or portfolio income. While most income is currently subject to income taxes, some may be tax free or tax deferred. Tax planning considers all these dimensions and more. Tax planning is an important element of financial planning because it guides the selection of investment vehicles and the form in which returns are to be received. This means that it is closely tied to investment plans and often dictates certain investment strategies. 1-13. This statement reflects a very short-sighted and too often expressed point of view. Due to the inconsistencies and unexpected changes of our economic system—and of life itself— the goals of and plans for retirement should be established early in life. If retirement goals are incorporated into an individual’s financial planning objectives, short- and longterm financial plans can be coordinated. Thus, financial plans can guide present actions not only to maximize current wealth and/or utility, but also to provide for the successful fulfillment of retirement goals. Furthermore, if retirement is desired earlier than anticipated, the plans may still permit the fulfillment of retirement goals. 1-14. Just like you, financial plans go through stages. Being part of a dual income couple: Couples should discuss their money attitudes and financial goals and decide how to manage joint financial affairs before they get married. Take an inventory of your financial assets and liabilities, including savings and checking accounts; credit card accounts and outstanding bills; auto, health, and life insurance policies; and investment portfolios. You may want to eliminate some credit cards. Too many cards can hurt your credit rating, and most people need only one or two. Each partner should have a card in his or her name to establish a credit record. Compare employee benefit plans to figure out the lowest-cost source of health insurance coverage, and coordinate other benefits. Change the beneficiary on your life insurance policies as desired. Adjust withholding amounts as necessary based on your new filing category. Major life changes such as marriage and divorce: Marriage. Finances must be merged and there may be a need for life insurance. Divorce. Financial plans based on two incomes are no longer applicable. Revised plans must reflect any property settlements, alimony, and/or child support. Death of a spouse: The surviving spouse is typically faced with decisions on how to receive and invest life insurance proceeds and manage other assets. In families where the deceased made most of the financial decisions with little or no involvement of the surviving spouse, the survivor may be overwhelmed by the need to take on financial responsibilities. Advance planning can minimize many of these problems. Unlike accounting and law, the field professional financial planning field is largely unregulated, and almost anyone can call themselves a professional financial planner. Most financial planners are honest and reputable, but there have been cases of fraudulent practice. So, it’s critical to thoroughly check out a potential financial advisor – preferably interview two or three. Most financial planners fall into one of two categories based on how they are paid: commissions or fees. Commission-based planners earn commissions on the financial products they sell, whereas fee-only planners charge fees based on the complexity of the plan they prepare. Many financial planners take a hybrid approach and charge fees and collect commissions on products they sell, offering lower fees if you make product transactions through them. The way a planner is paid—commissions, fees, or both—should be one of your major concerns. Obviously, you need to be aware of potential conflicts of interest when using a planner with ties to a brokerage firm, insurance company, or bank. Many planners now provide clients with disclosure forms outlining fees and commissions or various transaction costs. Government, businesses, and consumers are the three major participants in the economic system. Government provides the structure within which businesses and consumers function. In addition, it provides a number of essential services that generally improve the quality of the society in which we live. To create this structure, various regulations are set forth, and to support its activities and provision of essential services, taxes are levied. These activities tend to constrain businesses and consumers. Businesses provide goods and services for consumers and receive money payments in return. They also employ certain inputs in producing and selling goods and services. In exchange they pay wages, rents, interest, and profit. Businesses are a key component in the circular flow of income that sustains our economy. They create the competitive environment in which consumers select from many different types of goods and services. By understanding the role and actions of businesses on the cost and availability of goods and services, consumers can better function in the economic environment and, in turn, implement more efficient personal wealth maximizing financial plans. Consumers are the focal point of the personal finance environment. Their choices ultimately determine the kinds of goods and services that businesses will provide. Also, consumer spending and saving decisions directly affect the present and future circular flows of income. Consumers must; however, operate in the financial environment created by the actions of government and business. Consumers may affect change in this environment through their elected officials, purchasing decisions and/or advocacy groups. Yet, basically, change occurs slowly and tediously, often with less than favorable results. Thus, consumers should attempt to optimize their financial plans within the existing financial environment. The stages of the economic cycles are expansion, peak, contraction, and trough. Each of these stages relates to real gross domestic product (GDP), which is an important indicator of economic activity. The stronger the economy, the higher the levels of real GDP and employment. During an expansion, employment is high, the economy is active and growing, and prices tend to rise. During an expansion, real GDP increases until it hits a peak, which usually signals the end of the expansion and the beginning of a contraction. During a contraction, real GDP falls into a trough, which is the end of a contraction and the beginning of an expansion. An understanding of these four basic stages, coupled with knowledge of the stage in which the economy is presently operating, should permit individuals to adjust and implement financial actions in order to efficiently and successfully achieve their personal financial goals. Inflation is a state of the economy in which the general price level is rising. It is important in financial planning because it affects what we pay for goods and services; it impacts how much we earn on our jobs; it directly affects interest rates and, therefore, it affects such things as mortgage and car loan payments. The most common measure of inflation is the consumer price index, which is based on the changes in the cost of a typical “market basket” of consumer goods and services. This can be used to compare changes in the cost of living over time for the typical family. Inflation is measured by the percentage change in the consumer price index from one time period to another, so that as the CPI rises, the cost of living also increases. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1.1 Tom’s Need to Know: Personal Finance or Golf? Personal financial planning is a process through which financial plans are developed and implemented to achieve personal financial goals. An individual can develop these goals in a fashion consistent with his or her emotional needs and preferences. As a process, personal financial planning is dynamic and prospective as well as immediate and retrospective. Furthermore, it can be adjusted to changes in goals, emotional orientation, available resources, and the economic environment. Personal financial planning covers the key elements of one’s financial affairs and provides a plan to achieve financial goals. Income level is one input in the process but does not dictate its importance. An efficient, well-developed personal financial plan can help to maximize an individual’s wealth and quality of life given his or her income and goals. If desired goals cannot be met with a given level of income, financial planning will help evaluate what is really important and establish realistic and attainable goals. Thus, financial planning is important regardless of one’s income. The personal financial planning environment is made up of three key groups, all of which Tom will contact directly or indirectly. Government establishes an intangible structure in which an economy or society must function. It levies taxes to fund its operations and institutes regulations which direct and control the actions of the participants in the economic environment. Businesses produce goods and services, employ labor, and use land and capital. They receive money as payment for their goods and services and pay wages, rents, interest, and profit. Businesses are a key part of the circular flow of income supporting our economy. Businesses establish the price and availability of goods and services in our economy through competitive interaction with each other and interfacing with government and consumers. Finally, the consumer is the focal point of the financial planning environment. Consumer choices determine the types of products and services businesses provide. Because consumers are net providers of funds to government and businesses, their decisions to spend or save have a major effect on the planning environment. However, government and businesses place a number of constraints on the environment, and consumers must therefore function within those limits. The economy is a dynamic mechanism that reacts to numerous inputs. Economic fluctuations can cause significant changes in one’s wealth, thereby affecting financial plans. Changes in price levels result from increases in inflation, which can directly affect an individual’s present and future consumption patterns, level of wealth, standard of living, and quality of life. Changes in economic conditions also affect nearly all aspects of one’s financial life, from career choices to retirement. Thus, the state of the economy and its fluctuations are important factors defining the financial planning environment and affecting how one implements a financial plan. Although beginning golf would probably provide a great deal of personal satisfaction, personal finance would, in the long run, provide more benefits. The personal finance course will help Tom better understand the financial environment, thereby allowing him to establish a realistic quality of life and personal financial goals. He could then develop a plan to achieve his goals and a methodology for monitoring the ongoing effectiveness of that plan. With an understanding of the personal finance environment, the financial planning process, and goal setting techniques, Tom can optimize the use of his assets, provide for a secure financial future, and acquire the resources to realize his quality of life goals. Finally, the rewards achieved from using these financial planning techniques could, in the future, allow Tom to take not only beginning golf but also intermediate golf and possibly join a golf club. 1.2 Zack’s Dilemma: Finding a New Job This case asks students to consider the long-range implications of career and financial planning. In today’s business world, changes in the economy and in corporate strategies often result in workforce downsizing. Many students may be faced with the loss of a job during their working years. They may find themselves in Zack’s position, overqualified for some jobs and underqualified for others. Knowing what steps to take to avoid this situation is an important aspect of career and financial planning. There are many correct answers to these questions; some possibilities are given below. Important career factors for Zack to consider when looking for a new job include salary, opportunity for advancement, his transferable skills that could apply to a field other than retailing, availability of benefits, available training programs, types of industries and companies (size, work environment, etc.) that interest him, and tuition reimbursement policies so he can finish his degree. Personal factors that Zack should take into account as he investigates job opportunities include location/need to relocate (his children live in the area), personal lifestyle needs (is he willing to travel, work overtime, commute further?), type of work situation most suitable for him (managing others, part of a team, level of public contact, etc.), and any personal interests that could open doors to a new career. (There is some overlap between career and personal factors.) Zack should consider a lower-paying job on a short-term basis and at the same time look for a managerial job in another field. He cannot afford to wait out the recession; his funds will run out in a few months. This two-pronged approach is therefore preferable to one or the other. A job at a lower salary, particularly one with good benefits and a tuition reimbursement policy, would allow him to finish his degree or obtain other job training to qualify for a better position. Because he has no dependents, he should be able to cover his living expenses, although he may have to cut back on some discretionary expenses. He should look in several fields and not limit himself to retailing, particularly if he does not wish to relocate to another area of the country away from his grown children. If he is committed to staying in retailing, he probably will have to move. He needs to determine his personal priorities to make these decisions. We do not have enough information to know what they would be. He may want to participate in some career workshops or get some career counseling to work out some of these issues. There are many strategies today’s workers can employ to avoid being placed in Zack’s position. Staying with one employer and one basic type of work for 28 years, as Zack did, will be the exception rather than the rule. Job changes, whether voluntary or involuntary, should be made with certain objectives in mind, such as broadening your base of experience and learning new skills—for example, computer skills and management responsibility. Keeping up with industry trends and overall economic conditions is very important. This can alert you to the skills needed for future success and provide advance warning of possible downsizings. Don’t allow yourself to be “pigeonholed” into one very specific type of job for too long; look for opportunities to transfer within your company or to another firm to get more diverse experience. Think of your capabilities in terms of general skills that can be applied to other jobs, companies, and industries. Develop and maintain a network of professional contacts in firms and industries that appeal to you, and be willing to share your knowledge with others who need your help. Chapter 2 Using Financial Statements and Budgets Chapter Outline Learning Goals I. Mapping Out Your Financial Future A. The Role of Financial Statements in Financial Planning II. The Balance Sheet: How Much Are You Worth Today? Assets: The Things You Own Liabilities: The Money You Owe Net Worth: A Measure of Your Financial Worth Balance Sheet Format and Preparation A Balance Sheet for Jeremy and Elisha McPherson III. The Income and Expense Statement: What We Earn and Where It Goes Income: Cash In Expenses: Cash Out Cash Surplus (or Deficit) Preparing the Income and Expense Statement An Income and Expense Statement for Jeremy and Elisha McPherson IV. Using Your Personal Financial Statements Keeping Good Records Managing Your Financial Records Tracking Financial Progress: Ratio Analysis Balance Sheet Ratios Income and Expense Statement Ratios V. Cash In and Cash Out: Preparing and Using Budgets The Budgeting Process Estimating Income Estimating Expenses Finalizing the Cash Budget Dealing with Deficits A Cash Budget for Jeremy and Elisha McPherson Using Your Budgets VI. The Time Value of Money: Putting a Dollar Value on Financial Goals Future Value Future Value of a Single Amount Future Value of an Annuity Present Value Present Value of a Single Amount Present Value of an Annuity Other Applications of Present Value Major Topics We can achieve greater wealth and financial security through the systematic development and implementation of well-defined financial plans and strategies. Certain life situations require special consideration in our financial planning. Financial planners can help us attain our financial goals, but should be chosen with care. Personal financial statements work together to help us monitor and control our finances in order that we may attain our future financial goals by revealing our current situation, showing us how we used our money over the past time period, and providing a plan for expected future expenses. Time value of money calculations allow us to put a dollar value on these future financial goals and thereby plan more effectively. The major topics covered in this chapter include: The importance of financial statements in the creation and evaluation of financial plans. Preparing and using the personal balance sheet to assess your current financial situation. The concept of solvency and personal net worth. Preparing and using the personal income and expense statement to measure your financial performance over a given time period. The importance of keeping and organizing your records. The use of financial ratios to track financial progress. Developing a personal budget and using it to monitor and control progress toward future financial goals. How to deal with cash deficits. The use of time value of money concepts in putting a dollar value on financial goals. Key Concepts Personal financial statements play an extremely important role in the financial planning process. They can help in both setting goals and in monitoring progress toward goal achievement to determine whether one is "on track." Budgeting and financial planning guide future outlays. As such, they require projections of future needs, desires, and costs. Setting up a specific set of forecasts is the basis for future success. The following phrases represent the key concepts discussed in the chapter. Personal financial statements Balance sheet equation Types of assets, including liquid assets, investments, and personal and real property Fair market value Liabilities, including current liabilities, open account credit obligations, and long-term liabilities Net worth and equity Insolvency Income Expenses, including fixed and variable expenses Cash basis Cash surplus or deficit Record keeping Liquidity, solvency, savings, and debt service ratios Ratio analysis of financial statements Cash budgets Estimating income Estimating expenses Monitoring and controlling actual expenses Time value of money concepts and calculations Income and expense statement Budget control schedule Future value Compounding Annuity Present value Discounting Financial Planning Exercises The following are solutions to problems at the end of the PFIN4 textbook chapter. 1. In this exercise, we assume that the individual uses the cash basis of accounting rather than the accrual basis for reporting on the financial statements. Rent paid is listed as an expense. For the year, his rent expense would be $16,200 ($1,350 x 12) unless he has rent due, the amount of which would show up as a current liability on his balance sheet. The earrings should be shown on the balance sheet as an asset—personal property. Although the earrings have not been paid for, by definition they are an asset owned by Ralph. However, they should be listed at fair market value, which is probably less than the price paid due to the high markup on jewelry. The $900 bill outstanding is listed as a current liability on the balance sheet. Since no loan payments were made during the period, a corresponding expense would not appear, but the obligation to repay the $3,500 would be shown as a liability on the balance sheet. Assuming he made 12 payments during the year, Ralph would list loan payments as an expense of $2,700. Of the 20 remaining payments, only about half are for principal. Therefore, on the balance sheet he should show the unpaid principal of about $2,250 (20 x $225/2) as a liability. The balance of the future payments is interest not yet due and therefore should not appear on the balance sheet. If the loan was used to purchase something of value, he would list the fair market value of the item as an asset on his balance sheet. The $3,800 of taxes paid should appear as an expense on the income and expense statement for the period, but because the tax refund was not received during the year it would not be included as income on the statement. The investment in common stock would appear on balance sheet as a reduction in cash (an asset) and an increase in "investments” (an asset) at the current fair market value of the stock. 4. a. Hugo is correct in suggesting that only take-home pay be shown as income if the $1,083 ($5,000 – $3,917) in taxes is not shown as an expense. If they choose to show the tax expense, Johanna would be correct. Expressing income on an aftertax basis would probably be simpler and makes sense from a cash basis accounting standpoint. b. By having an allowance for "fun money," the Espinozas have specifically set aside a certain portion of their income for a little self-indulgence. This will serve three basic purposes: (1) it will give a little financial independence to each member of the family; (2) to a certain extent it allows for a little impulse buying which might further the enjoyment of life. However, it allows for this luxury under a budget control and diminishes the possibility of it occurring with an allocation from another account; and (3) it generally promotes a higher quality of life. Thus, the inclusion of "fun money" is probably justified. PLEASE NOTE: The following problems deal with time value of money, and solutions using both the tables and the financial calculator will be presented. The factors are taken from the tables as follows: future value–Appendix A; future value annuity–Appendix B; present value–Appendix C; present value annuity–Appendix D. If using the financial calculator, set on End Mode and 1 Payment/Year. The +/- indicates the key to change the sign of the entry, in these instances from positive to negative. This keystroke is required on some financial calculators in order to make the programmed equation work. Other calculators require that a "Compute" key be pressed to attain the answer. 5. At the end of 25 years, your $45,000 investment would grow to $244,215 at a 7% return. $244,234.47 FV = PV x FV factor 7%, 25 yrs. 45000 +/- PV = $45,000 x 5.427 7 I = $244,215 25 N FV At the end of 10 years the average new home, which costs $275,000 today, will cost $447,975 if prices go up at 5% per year. $447,946.02 FV = PV x FV factor 5%, 10 yrs. 275000 +/- PV = $275,000 x 1.629 5 I = $447,975 10 N FV No, you will have approximately $78,925 less than your estimate of $214,000 (or 214,000 - $135,075). FV = PV x FV factor 4%, 15 yrs. 75000 +/- PV = $75,000 x 1.801 4 I $135,070.76 = $135,075 15 N FV You will need to deposit $10,687.18 at the end of each year for 15 years in order to reach the $214,000 goal. $10,687.40 PMT = FV FVA factor 4%, 15 yrs. 214000 +/- FV = $214,000 20.024 4 I = $10,687.18 15 N PMT You will need to invest $13,577.55 at the end of each year at a rate of 4% for the next 35 years in order to retire with $1 million. $13,577.32 PMT = FV FVA factor 4%, 35 yrs. 1000000 +/- FV = $1,000,000 73.651 4 I = $13,577.55 35 N PMT 6. a. Bob can withdraw $71,955.39 at the end of every year for 15 years. $71,952.88 PV = PMT x PVA factor 4%, 15 yrs. 800000 +/- PV PMT = PV PVA factor 4%, 15 yrs. 4 I = $800,000 11.118 15 N = $71,955.39 PMT To withdraw $35,000 at the end of every year for 15 years, Bob would need a retirement fund of $389,130. PV = PMT x PVA factor 4%, 15 yrs. 35000 +/- PMT = $35,000 x 11.118 4 I = $389,130 15 N PV $389,143.56 Bob will not need to invest any additional funds because the original investment will meet his retirement needs. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 2-1. Personal financial statements provide important information needed in the personal financial planning process. The balance sheet describes your financial condition at one point in time, while the income and expense statement measures financial performance over a given time period. Budgets help you plan your future spending. These statements allow you to track and monitor your financial progress so you can set realistic goals and meet them. 2-2. The balance sheet summarizes your financial position by showing your assets (what you own listed at fair market value), your liabilities (what you owe), and your net worth (the difference between assets and liabilities) at a given point in time. With a balance sheet, you know whether your assets are greater than your liabilities, and, by comparing balance sheets for different time periods, you can see whether your net worth is growing. Investments are assets that are acquired to earn a return; they may consist of either real or personal property or financial assets. Real property is immovable: for example, land and anything fixed to it, like a building. Personal property is movable property—cars, furniture, jewelry, clothing, etc. Whether real or personal property is an investment depends on the character of the property: some you acquire with the expectation that the property will go up in value while other property may be expected to go down in value. 2-3. The balance sheet equation is: Total Assets − Total Liabilities = Net Worth A family is technically insolvent when their net worth is less than zero. This indicates that the amount of their total liabilities is greater than the fair market value of their total assets. 2-4. 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 paying down debts. This is accomplished by planning and requires strict control of income and expenses. A second approach would be to forecast expected increases in the market value of certain assets— primarily investment and tangible property assets. If the market value of the assets increased as expected and liabilities remained constant or decreased, an increase in net worth would result. (Note: Decreases in net worth would result from the opposite strategies/occurrences.) 2-5. The income and expense statement captures the various financial activities that have occurred over time, normally over the course of a month or a year. In personal financial planning, the statement permits comparison of actual results to the budgeted values. 2-6. The term cash basis indicates that only items of actual cash income and cash expense within the given period are included on the statement. For example, if you are due to receive a payment for work you have done, you do not count that amount as income until you actually receive it. A credit purchase becomes a liability on the balance sheet as soon as the debt is incurred. However, credit purchases are shown on the income statement only when payments on these liabilities are actually made. (Also, if a payment-in-full was not made, only that amount actually paid to reduce the liability is shown on the statement.) These cash payments would be treated as expenses because they represent disbursements of cash. 2-7. Fixed expenses are contractual, predetermined expenses that are made each period, such as rent, mortgage and loan payments, or insurance premiums. Variable expenses change each period. These include food, utilities, charge card bills, and entertainment. 2-8. Yes, a cash deficit appears on an income and expense statement whenever the period's expenses exceed income. Deficit spending is made possible by using up an asset, such as taking money out of savings, or incurring more debt, such as charging a purchase on a credit card. 2-9. Accurate records are important in the personal financial planning process. Such records help you manage and control your financial affairs, including controlling income and spending, preparing financial statements, filing tax returns, and planning future spending. A sophisticated financial record keeping and control system includes: (1) setting up a record book, (2) recording actual income and expenses, (3) balancing accounts periodically, (4) controlling budget expenses, and (5) balancing the books and preparing year-end financial statements. 2-10. When evaluating one's balance sheet, primary concern should be devoted to the net worth figure since it represents a person's wealth at a given point in time. Attention should also be given to the level of various assets and liabilities to determine whether their level and mix is consistent with one's financial goals. In evaluating one's income and expense statement, the primary concern should be whether there is a cash surplus or deficit. Consistently having a cash surplus on the income statement means that one's net worth is growing on the balance sheet, because the surplus remaining from one period will then be available to either increase one's assets or decrease one's liabilities. It is possible to use a number of ratios to evaluate a balance sheet. However, the solvency ratio and the liquidity ratio are most frequently used. The solvency ratio relates total net worth to total assets. It shows, in percentage terms, the degree of market value decline in total assets, which a family could absorb before becoming technically insolvent. This ratio is a good indicator of one's exposure to potential financial problems. The liquidity ratio relates liquid assets to total current debts. It measures a family's ability to pay current debts and provides an estimate of their ability to meet obligations in the event their income is curtailed. 2-11. A cash budget is a summary of estimated cash income and cash expenses for a specific time period, typically a year. The three parts of the cash budget include: the income section where all expected income is listed; the expense section where expected expenses are listed by category; and the surplus or deficit section where the cash surplus or deficit is determined both on a month-by-month basis and on a cumulative basis throughout the year. A budget deficit occurs when the planned expenses for a period exceed the anticipated income in that same period. A budget surplus occurs when the income for the period exceeds its planned expenses. 2-12. Two remedies are available for the Gonzales family. They may be able to transfer expenses from months in which budget deficits occur to the month in which the budget surplus exists, or conversely, to transfer income from the month with a surplus to the months with deficits. Another alternative is to use savings, investments, or borrowing to cover temporary deficits. The Gonzales family might also want to consider increasing their income, at least temporarily, by getting a “moonlighting” job. 2-13. By examining end-of-month budget balances, and the associated surpluses or deficits for all accounts, a person can initiate any required corrective actions to assure a balanced budget for the year. Surpluses are not problematic. Deficits normally require spending adjustments during subsequent months to bring the budget into balance by year end. 2-14. A dollar today and a dollar in the future will be able to purchase different amounts of goods and services, because if you have a dollar today, you can invest it and it will grow to more than a dollar in the future. At the same time, inflation works against the dollar, because rising prices erode its purchasing power. Time value of money concepts help us quantify these changes in dollar values so that we can plan the amount of money needed at certain points in time in order to fulfill our personal financial goals. 2-15. Interest is earned over a given period of time. When interest is compounded, this given period of time is broken into segments, such as months. Interest is then calculated one segment at a time, with the interest earned in one segment added back to become part of the principal for the next time segment. Thus, in compounding, your money earns interest on interest. The rule of 72 is a quick way to approximate how long it will take for an investment to double in value. Divide 72 by the percentage rate you are earning on your investment, and the answer will be approximately how many years it will take for your money to double. For example, if your investment is earning 8%, divide 72 by 8 to see that in approximately 9 years your money will double. 2-16. Future value calculations show how much an amount will grow over a given time period. Future value is used to evaluate investments and to determine how much to save each year to accumulate a given future amount, such as the down payment on a house or for a child's college education. Present value concepts, the value today of an amount that will be received in the future, help you calculate how much to deposit today in order to have enough money to retire comfortably, analyze investments, and determine loan payments. Solutions to Online Bonus Personal Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. While everyone's financial statements will differ based on their own expectation of the future, each should have similar elements such as: assets like a home, automobiles and investments; liabilities like a mortgage, an auto loan, and consumer debt; and a positive net worth. The statement of income and expense should reflect income from a job or business, investment income, and expenses for items such as home repair and operation, debt payments, savings, taxes, and insurance. See the following page for Teresa Blankenship’s balance sheet. Solvency: This term refers to having a positive net worth. The calculation for her solvency ratio is as follows: Solvency Ratio = Total Net Worth = $27,325 = 32.48% Total Assets $84,125 This indicates that Ms. Blankenship could withstand about a 33% decline in the market value of her assets before she would be insolvent. Although this is not too low a value, some thought might be given to increasing her net worth. Liquidity: A simple analysis of Ms. Blankenship’s balance sheet reveals that she's not very liquid. In comparing current liquid assets ($900) with current bills outstanding ($1,300), it is obvious that she cannot cover her bills and is, in fact, $400 short (i.e., $1,300 current debt – $900 current assets). Her liquidity ratio is: Liquidity ratio = Liquid Assets = $ 900 = 69.2% Total Current Debts $1,300 This means she can cover only about 69% of her current debt with her liquid assets. 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 this level of liquid assets is: Liquidity ratio = Liquid assets = $ 900 = 27.3% Total Current Debts $3,300 This indicates that should her income be curtailed, she could cover only about 27% of her existing one-year debt obligations with her liquid assets—and this does not include her mortgage payment! This is clearly not a favorable liquidity position. c. Equity in her Dominant Asset: Her dominant asset is her condo and property, which is currently valued at $68,000. Since the loan outstanding on this asset is $52,000, the equity is $16,000 (i.e., $68,000 – $52,000). This amount indicates about a 24% equity interest (i.e., $16,000/$68,000) in the market value of her real estate. This appears to be a favorable equity position. Problem 2—Worksheet 2.1 3. Ross and Cindy’s income and expense statement follows. Note that for the purchase of the photographic equipment and the car, only the amounts actually paid during the period are listed as expenses on the income and expenses statement. (We are not told the amount of the car loan payments, so the $2,450 listed does not reflect interest charges.) The outstanding balances will appear as liabilities on the balance sheet. The fair market value of the items purchased will appear as assets on the balance sheet. Problem 3—Worksheet 2.2 4. Monthly Cumulative Item Amount Amount Beginning Surplus Surplus No. Item Budgeted Spent Balance (Deficit) (Deficit) (1) (2) (3) (4) (5) (6) 1 Rent $550 $575 $50 $(25) $25 2 Utilities 150 145 15 5 20 3 Food 510 475 (45) 45 0 4 Auto 75 95 (25) (20) (45) 5 Recr. & enter. 100 110 (50) (10) (60) This question requires a personal response that will differ for each student. Therefore, a specific example has not been provided. However, the cases below provide several examples of possible answers to this question; it is recommended that the cases be examined in conjunction with this question. The question provides an effective means to involve the student in the budgeting process. Most students are somewhat amazed when they find out how they have actually been spending their money. Before assigning this question, it is interesting to ask the students to estimate how they actually spend their money. A comparison of their estimates with the actual spending records typically reflects the unconscious manner in which they may be spending. Most students will find that the use of a budget to control and regulate expenses allows them to make more meaningful and satisfying expenses. PLEASE NOTE: Problem 6 deals with time value of money, and solutions using both the tables and the financial calculator will be presented. The factors are taken from the tables as follows: future value–Appendix A; future value annuity–Appendix B; present value– Appendix C; present value annuity–Appendix D. If using the financial calculator, set on End Mode and 1 Payment/Year. The +/- indicates the key to change the sign of the entry, in these instances from positive to negative. This keystroke is required on some financial calculators in order to make the programmed equation work. Other calculators require that a "Compute" key be pressed to attain the answer. a. If Gwen can earn 4% on her money, $54,188 will be worth about $65,947 in 5 years: $65,927.99 FV = PV x FV factor 4%, 5 yrs. 54188 +/- PV = $54,188 x 1.217 4 I = $65,946.80 5 N FV No, she will fall short by about $34,053. Assuming that Gwen adds a payment to her savings at the end of each year for the next five years so that the fifth payment comes at the end of the time period, she would have to save $5,077.55 per year. This calculation is as follows: $6,290.62 FV = PMT x FVA factor 4%, 5 yrs. 34072 +/- FV PMT = FV FVA factor 4%, 5 yrs. 4 I = $34,053 5.416 5 N = $6,287.52 PMT If Gwen saves only $4,000 per year she would have an additional $21,664 for a total of $87,611 ($65,947 + $21,664) and will fall $12,389 short of her $100,000 goal. $21,665.29 FV = PMT x FVA factor 4%, 5 yrs. 4000 +/- PMT = $4,000 x 5.416 4 I = $21,664 5 N FV 7. Steve needs $81,459.60 today to fund college. PV = FV x PV factor 4%, 4 yrs. = $23,000 x 0.855 = $19,665 PV = FV x PV factor 4%, 5 yrs. = $24,300 x 0.822 = $19,974.60 PV = FV x PV factor 4%, 6 yrs. = $26,000 x 0.790 = $20,540 PV = FV x PV factor 4%, 7 yrs. = $28,000 x 0.760 = $21,280 Add $19,665 + $19,974.60 + $20,540 + $21,280 = $81,459.60 This problem in a TI BAII+ CFO = 0 C01 = 0, F01 = 3 C02 = 23000, F02 = 1 C03 = 24300, F03 = 1 C04 = 26000, F04 = C05 = 28000, F05 = 1 I = 4 CPT NPV = $81,459.21 8. It should be noted, that you are calculating this amount using an expected rate of return. Should the return be higher any given years, the value will be more. Should the return be lower any given years, the value will be less. $73,571.18 FV = PMT x FVA factor 6%, 20 yrs. 2000 +/- PMT = $2,000 x 36.786 6 I = $73,572 20 N FV Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 2.1 The Lawrences’ Version Of Financial Planning The Lawrences’ personal financial statements are on the following page. a. Solvency = Total Net Worth = $ 67,745 = .30 Total Assets $223,070 The Lawrences could withstand about a 30% decline in the market value of their assets before they would be insolvent. The solvency ratio also indicates percent ownership: the Lawrences own free and clear about 30% of their total assets. While this ratio is acceptable, they should seek to improve it. Liquidity = Liquid Assets = $3,570 = 1.33 Total Current Liabilities $2,675 The Lawrences can cover their current liabilities with their liquid assets and have a little to spare. However, they still have to make mortgage and auto loan payments each month and probably would not want to use up their money market funds to do so. Savings = Cash Surplus = $31,261 = 39.05% Income after Taxes $80,061 At about 39.05%, the Lawrences' current saving rate is above that of the average American family. However, if they were to live off only Rob’s income, their savings rate would probably fall considerably. Debt Service = Total Debt Payments Gross Income = Mortgage + car loan + credit card payments Gross Income = $11,028 + $2,150 + $2,210 = $15,388 = 13.04% $118,000 $118,000 The Lawrences are okay for now. However, with only his salary, the debt service ratio becomes higher: $15,388 = 20.2% $76,000 With more unexpected debt straining the one-income family, it could quickly spiral out of control. That said, the rule of thumb is to try to keep your debt service ratio somewhere under 35% or so, because that’s generally viewed as a manageable level; both ratios are below this guideline. Case 2.1, Problem 1 Balance Sheet Name(s): Rob & Lisa Lawrence Date: December 31, 2015 ASSETS LIABILITIES Liquid assets: Current liabilities: Cash $ 85 Bank credit card balances $ 675 Checking 485 Travel & entertainment card balances 2,000 Money Market 3,000 Investments: Long-term liabilities: Common Stocks 15,000 Mortgage on home—loan balance 148,000 Auto loan balance 4,650 Property: Home 185,000 TOTAL LIABILITIES $ 155,325 2009 Nissan 15,000 Household furnishings 4,500 NET WORTH (Assets - Liabilities) $ 67,745 TOTAL ASSETS $223,070 TOTAL LIAB. & NET WORTH $223,070 Income & Expense Statement Name(s): Rob & Lisa Lawrence For the Year Ending December 31, 2016 INCOME AMOUNT Rob $ 76,000 Lisa 42,000 TOTAL INCOME $ 118,000 EXPENSES Mortgage payments (includes property taxes) $ 11,028 Gas, electric, water 1,990 Phone 640 Cable TV 680 Food 5,902 Auto loan payments 2,150 Transportation expense 2,800 Medical expenses—unreimbursed 600 Clothing expense 2,300 Homeowner's insurance premiums 1,300 Auto insurance premiums 1,600 Income and Social Security taxes paid 36,539 Vacation (Trip to Europe) 5,000 Recreation and entertainment 4,000 Credit card loan payments 2,210 Purchase of common stock 7,500 Addition to money market account 500 TOTAL EXPENSES $ 86,739 CASH SURPLUS (DEFICIT) $ 31,261 [Note: $1,400 of the $11,028 in house payments was for property taxes—only $9,628 was for the mortgage. The homeowner’s insurance was listed separately.] 3. If the Lawrences continue to manage their finances as described in the case, there is no question that, in the long-run, they are headed for financial disaster. Because the Lawrences have become accustomed to living with a double income, it will be extremely difficult to change their overall way of life or standard of living. The Lawrences must realize that the bottom line of the income statement is the most important, and given their present level of expenses, their contribution to savings or investment will change from an annual surplus—and it's already very small—to an annual deficit. As a result, their net worth will decline, and the long-run consequence of these events will be financially quite detrimental to the Lawrences. Rob must understand that the family will incur additional living expenses when the child is born, that inflation will continue, and that the cost of home ownership and everyday living will more than offset his expected 10 percent increase in pay. At the present time, Rob’s take-home income of $52,500 covers necessities, which are approximately $30,000; perhaps Rob considers cable TV a luxury and expects to reduce some of their dining out and clothing purchases next year. A 10 percent (takehome) pay increase of $5,250 will increase his take-home pay to $57,750 and will help the Lawrence family pay for the increased family size (based on Rob’s estimate of necessities), inflation, and numerous other costs. If one conservatively estimates a 3 percent rate of inflation in the cost of necessities, the resulting total cost would increase to $30,900. This results in a surplus from which to cover the added expenses for a child as well as other unforeseen costs. Furthermore, the inflation rate could be even higher. The long-run consequences of Rob’s strategy could prove very harmful. Although the Lawrences’ net worth is now positive, any future annual expenses exceeding income (take-home pay) will slowly erode their savings, investments, and net worth. They do not have much excess to cover any emergency expenses. If the Lawrences wish to maintain or increase their net worth and to achieve their financial goals, they must take immediate action to find ways to either increase revenue or decrease expenses. The logical solution at this time is for Rob and Lisa to prepare a budget and follow it to live within the constraints of their expected income and expenses. They should immediately look at all expenses, past, present, and future, to develop financial plans so they can live within their means. They should review their balance sheet and income statement and then prepare projected monthly and annual budgets. The couple should record planned income and expenses month by month, monitoring monthly surpluses and deficits so they can quickly correct them. It won't be too long before they realize that maintaining their present standard of living will seriously erode their overall net worth. Rob and Lisa should develop objectives or goals for both the long- and short-run. By correlating budget control with expected future goals, a realistic plan of action can be developed that allows them to achieve their financial goals and continue to increase their net worth. 2.2 Alex Mikhailov Learns To Budget a. In order to get the big picture of Alex’s expected income and expenses, it may be more useful to simply use a modified Worksheet 2.2, the Income and Expense Statement, to project his expected position for the coming year. [Note to Instructors: you may want to have students submit two separate Worksheets 2.2 using the template, rather than having them customize a combined answer as we have included in this manual.] When doing this problem together in class, work through the given setup using a blank Income and Expense Statement on the overhead projector. Then have the class decide which items need to be slashed. (See the example which follows.) After these decisions have been made, divide the expenses into months and fill out Worksheet 2.3 as indicated in part 2 which follows. b. For 2016, Alex’s total expenses of $35,979 are less than his expected total income; he has a deficit. The mentioned adjustments were incorporated into making Alex’s annual cash budget summary for 2016 shown on Worksheet 2.3 which follows. Please note that some of the monthly budgeted items vary by small amounts in order to make the totals correct. (Students' answers will vary depending on the adjustments chosen.) Case 2.2, Problem 1a Income and Expense Statement Name: Alex Mikhailov For the Year Ending December 31, 2016 Income 2015 2016 Salary Alex’s take-home pay of $2,893/mo in 2015 and $3,200/mo in 2016 . $ 34,716 $ 38,400 Other income (I) Total Income Expenses $ 34,716 $ 38,400 Housing Rent $12,000 $12,000 Repairs Utilities Gas, electric, water 1,080 1,134 Phone 600 660 Cable TV and other 440 500 Food Groceries 2,500 2,625 Dining out 2,600 2,600 Transportation Auto loan payments 3,840 3,840 Auto related expenses 1,560 1,638 Other transportation expenses Medical Health-related insurance Doctor, dentist, hospital, medicines 190 190 Clothing Clothes, shoes, accessories 3,200 2,250 Insurance Homeowner's Life Auto 1,855 1,948 Taxes Income and social security Property (if not included in mortgage) Appliances, furniture & other major purchases Loan payments 540 540 Purchases and repairs 1,200 660 Personal care Laundry, cosmetics, hair care 424 424 Recreation & entertainment Vacations 2,100 Other recreation and entertainment 2,900 2,900 Other items Misc. 600 600 Credit card pmts: 6 mo.@$75/mo. 450 450 Other expenses (II) Total Expenses CASH SURPLUS (OR DEFICIT) [(I) – (II)] $ 35,979 $ 37,059 $ (1,263) $ 1,341 Chapter 3 Preparing Your Taxes Chapter Outline Learning Goals I. Understanding Federal Income Tax Principles The Economics of Income Taxes Your Filing Status Your Take-Home Pay Federal Withholding Taxes FICA and Other Withholding Taxes II. It's Taxable Income That Matters Gross Income Three Kinds of Income Capital Gains a. Selling Your Home: A Special Case Adjustments to (Gross) Income Deductions: Standard or Itemized? Standard Deduction Itemized Deductions Choosing the Best Option Exemptions III. Calculating and Filing Your Taxes Tax Rates Tax Credits Tax Forms and Schedules Variations of Form 1040 The 2013 Tax Return of Jacob and Suzanne Robinson Finding the Robinsons’ Tax Liability: Form 1040 Gross Income Adjustments to Gross Income Adjusted Gross Income Itemized Deductions or Standard Deduction? The Robinsons’ Taxable Income and Tax Liability Do They Get a Tax Refund? IV. Other Filing Considerations Estimates, Extensions, and Amendments Estimated Taxes April 15: Usual Filing Deadline Filing Extensions and Amended Returns Audited Returns Tax Preparation Services: Getting Help on Your Returns Help from the IRS Private Tax Preparers Computer-based Tax Returns V. Effective Tax Planning Fundamental Objectives of Tax Planning Some Popular Tax Strategies Maximizing Deductions Income Shifting Tax-Free and Tax-Deferred Income Major Topics The average American family pays about one-third of its gross income in taxes. Therefore, tax planning is a very important element of a personal financial plan. The first objective of tax planning is to maximize the amount of money available for non-tax outlays by minimizing taxes. This is done honestly by understanding the tax laws and taking advantage of favorable provisions. The major topics covered in this chapter include: The economics of income taxes and their effect on take-home pay. Filing status, types of income, and the adjustments and deductions available when determining the amount of taxable income and the associated tax liability. Types of tax returns and a detailed explanation of how to determine taxable income and tax liability using IRS Forms 1040 and 1040EZ. Estimated taxes, procedures for filing taxes, and sources of tax preparation assistance. The role of effective tax planning in reducing taxes by maximizing deductions, shifting, sheltering, avoiding, and deferring taxable income. Key Concepts Because nearly everyone must pay taxes, an understanding of the basic terminology of taxes and tax planning is fundamental to effective personal financial planning. Clearly, everyone who pays taxes needs to know their method of calculation, allowable deductions, and payment timing and procedures. The following phrases represent the key concepts stressed in this chapter. Progressive tax structure Marginal tax rate Average tax rate Filing status Federal withholding taxes FICA Gross income and adjusted gross income (AGI) Taxable income Capital gains and losses Deductions and exemptions Joint returns and individual returns Tax calculation procedures Tax credits Estimated taxes Filing your return Tax audits Tax preparation services Good tax planning Standard deduction and Itemized deduction Filing extensions Tax evasion Tax avoidance Income shifting Tax deferred income Financial Planning Exercises The following are solutions to some of the exercises at the end of the PFIN 4 textbook chapter. 1. Sarah Adams’ tax calculations are as follows (assuming a 2013 tax year). Look on page 2 of the sample Form 1040 shown in the text. The standard deduction amounts are shown in the top left margin, and the exemption amount is given on line 42. Sarah is single and will claim herself as an exemption. Use the tax rate schedules given in Exhibit 3.3 to determine her tax liability. . a. Gross Income: Salary $33,500 Dividends 800 Interest on savings account 250 Rental income 900 Total gross income $35,450 b. Tax-Exempt Income: Gift from Mother $ 500 Child support from ex-husband 3,600 Loan from bank 2,000 Interest on state government bonds 300 Total tax-exempt income $6,400 Cindy would pay the following capital gains taxes according to the regulations for capital gains in effect in 2013. Please note that no mention is made of interest or dividends earned during the time these securities were held, and we will disregard these items for this problem. Interest or dividends earned increase a security's basis, or the starting amount for the capital gains calculation. This would serve to lower the capital gains realized, and thus lower the capital gains taxes due on the security. Sale price $1,200 Purchase price 1,000 Capital gain $ 200 Tax due ($200 × .28) $ 56 (The stock was held for less than 12 months; therefore the gain is a short-term capital gain and taxed at ordinary income tax rates.) Sale price $4,000 Purchase price 3,000 Capital gain $1,000 Tax due ($1,000 × .15) $150 (The bonds were held longer than 12 months but less than 5 years. The gain is a longterm capital gain and is taxed at 15% for someone in her tax bracket.) Sale price $1,000 Purchase price 1,500 Capital loss ($ 500) Tax savings * ( - $500 × .28) ($140) *If the stock in part c was Amy’s only capital gain or loss for the year, this loss would reduce her active income by $500. At the 28% tax rate, she would pay $140 less in taxes than would have been the case without the $500 capital loss. If she has other capital gains or losses, the long-term capital gains would be netted with one another, the short-term capital gains would be netted with one another, and finally the overall short-term gain or loss netted with the overall long-term gain or loss. a. Alan can use Form 1040EZ because his income is only from eligible sources and he has less than $1,500 in interest income. (Generally, tuition scholarships and grants are generally considered tax exempt, while those that go for room and board are not.) b. In order to deduct his contribution for a traditional IRA, Alan would have to use Form 1040A or the standard 1040 long form. The Roth IRA (available beginning 1998) is not tax deductible, so the illustration for part b assumes a contribution to a traditional IRA. Assuming “pre-tax income” to mean “taxable income,” the impact of an extra $1,000 deduction vs. a $1,000 tax credit for a single taxpayer in the 25% tax bracket (as of 2011) is as follows: a. $1,000 b. $1,000 Deduction Credit (1) Taxable income $40,000.00 $40,000.00 Less: Deduction from income 1,000.00 0 Income before taxes Taxes for a: $39,000.00 $40,000.00 $4,750 + [.25($39,000 − $34,500)] Taxes for b: $5,875.00 $4,750 + [.25($40,000 – $34,500)] $6,125.00 Less: Tax credit 0 1,000.00 (2) Taxes due $5,875.00 $5,125.00 (3) After-tax income [(1) – (2)] $33,125.00 $34,875.00 As can be readily observed, a tax credit reduces the taxes due (line 2) more than does a deduction, thus causing the after-tax income (line 3) to be greater with the $1,000 credit than with the $1,000 deduction. A tax deduction reduces taxable income (a larger number) whereas a tax credit reduces the tax due (a much smaller number), so dollar for dollar, the tax credit has a greater impact. 6. Typically, tax audits question whether all income received has been properly reported and if the deductions claimed are legitimate and for the correct amounts. Therefore, in preparation for the audit Ralph and Diane should get all their documentation in order for these items, particularly those for cash receipts and cash payments. They should contact their CPA or other tax preparer if they have to seek both their advice and guidance through the audit. If they did not have a professional prepare their return, they would still do well to consult with one before the audit. In fact, they might want to seek the counsel of a tax attorney. If the Hearsts do not agree with the IRS examiner on disputed items, the taxpayer can meet with the examiner's supervisor to discuss the case further. If there is still disagreement, they can appeal through the IRS Appeals Office. If they do not wish to use the Appeals Office or if they disagree with its findings, they may be able to take their case to the U.S. Tax Court, U.S. Court of Federal Claims, or the U.S. District Court where they live. [For more information, IRS Publication 1 deals with "Your Rights as a Taxpayer" which can be printed off from the IRS Web site, www.irs.gov.] 7 Taxable income is calculated as follows: Gross wages and salaries $50,770 Dividends and interest $610 Capital gains realized $1,450 Less: Capital losses $3,475 Net capital gains ($2,025) Passive income—limited partnership 200 Gross income $49,555 Less: Adjustments to Gross Income IRA contributions $5,000 Alimony paid 6,000 Total Adjustments (11,000) Adjusted gross income (AGI) $38,555 Now total the itemized deductions and compare to the standard deduction. Subtract the larger of these two numbers from the AGI. Itemized deductions: Mortgage interest $5,200 Property taxes 700 State income taxes 1,700 Charitable contributions Job and other expenses 1,200 [875 – (38,555 × .02)] 104 Total itemized deductions (8,904) Standard deduction for married filing jointly (for 2013) (11,600) Less: Personal exemptions (3 × $3,700) (11,100) Taxable income $15,855 Exclusions: Medical expenses of $1,155 are less than the 7.5 % minimum of AGI ($38,555 × 0.075 = $2,892) allowed by law before deductions can be taken. Sales tax and personal interest expenses are not allowed. Social Security taxes are not deductible. Job and other qualified miscellaneous expenses are limited to the amount which is over 2% of AGI. Interest paid on car loans and credit cards are generally not tax deductible. The standard deduction of $11,600 was used because it was greater than this family's itemized deductions of $8,904. The IRA contribution was assumed to be to a traditional deductible IRA, as contributions to Roth IRAs are not deductible. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. PLEASE NOTE: Tax laws change rapidly. To keep current with tax laws, find more information, or download forms, try the IRS’s Web site at www.irs.gov 3-1. With a progressive tax structure, the larger the amount of taxable income, the higher the rate at which it is taxed. The economic rationale underlying the progressive income tax is that taxation should be based not only on income, but also on the ability to pay. In other words, persons who earn more money should be better able to pay taxes. Therefore, as a result of the progressive tax structure, they are required to pay a larger portion of their taxable income in taxes than those who earn less money. 3-2. The five filing categories and their definitions are: Single—an unmarried or legally separated person. Married filing jointly—married couples who file one tax return that combines their income and deductions. Married filing separately—each spouse files his or her own return, with only his or her own income, exemptions, and deductions. Head of household—a single person who provides at least 50% of the household support for him- or herself and a dependent child or relative. Qualifying widow or widower with dependent child—a person whose spouse has died within two years of the current tax year and who supports a dependent child. Although filing a joint return usually results in lower taxes for couples, under some circumstances separate returns are preferable. This may occur when one person earns much less than his/her spouse and has a large amount of deductions. Taxpayers have the right to minimize their tax burden as much as is legal, so married couples should figure their taxes both ways and choose the option with the lowest tax liability. All income (before any deductions) that is subject to federal taxes is considered gross earnings. Note that this amount is not necessarily every cent you bring in, as some types of income are tax exempt and are not included in gross income for federal income tax purposes. Take-home pay is found by deducting the total amount withheld from a person's gross earnings. The amount withheld may consist of the federal withholding tax, the Federal Insurance Contribution Act (FICA) tax (i.e., Social Security), state and local taxes, and other items such as insurance premiums. The employer retains these payments and periodically pays them to the Internal Revenue Service or some other appropriate agency. The amount of federal withholding taxes deducted from gross earnings each pay period depends on (a) the level of earnings and (b) the number of withholding allowances claimed. Because of the progressive nature of the tax structure, the more a person earns, the greater his or her expected tax liability and the higher the level of withholding. However, the greater the number of exemptions claimed, the lower the amount of taxes withheld. Each exemption claimed in 2010 reduced taxable income by $3,650. Gross income is all income (before any adjustments, deductions, and/or exemptions) that is subject to federal taxes. Adjusted gross income (AGI) is found by subtracting adjustments to (gross) income from gross income. Allowable adjustments to gross income (within applicable limits and restrictions) include certain types of employee and personal retirement contributions, interest on student loans, and alimony paid. Examples of tax-exempt income include child support payments, compensation from insurance policies, gifts, veterans’ benefits, etc. These items are not included in gross income. Passive income refers to income derived from certain investments, typically real estate partnerships and other tax shelters, where the investor's primary line of business is not real estate. Capital gains and capital losses are profits or losses made on the sale of an asset such as stocks, bonds, or real estate investments. The gain or loss is the difference between the sale price and the cost basis of the asset. (The cost basis is the purchase price plus income produced by the asset on which income taxes were paid year by year.) Long-term capital gains are taxed at lower rates than is active income, while short-term capital gains are taxed at one's ordinary tax rate. Capital losses are subtracted from gains, and if losses exceed gains, the net loss is deducted from active income up to a maximum of $3,000 for the year. Losses in excess of this amount may be carried forward on future years’ tax returns. Note than capital losses will be at the taxpayer’s regular income tax rate and not the lower capital gains rate, as capital losses are used to reduce active income. [For a schedule of capital gains tax categories, refer to Exhibit 3.2.] Major categories of deductions (students are to list five) include: Medical and dental expenses in excess of 7.5% of AGI State, local, and foreign income and property taxes Residential mortgage interest, subject to certain limitations Charitable contributions, up to a specified percentage of AGI Casualty and theft losses over 10% of AGI with a $100 deductible per loss Job and other expenses in excess of 2% of AGI Since 1991, the allowable amount of itemized deductions is reduced for taxpayers with AGI above certain levels. It would be well to refer to the 1040 instruction booklet (found at the IRS web site www.irs.gov) for a brief description of the 5 tests which must be met in order for a person to qualify as a dependent. If Jeff and Laura use the filing status “married filing jointly,” they will claim two exemptions. If Laura’s parents provided over half her support for the year, then it’s possible they could claim her for an exemption. If they do claim her, then she cannot be claimed as an exemption on a joint return with her husband. In fact, only if she is filing to get a refund and if no tax liability exists for either spouse would Laura be able to file a joint return with her husband and still be claimed as a dependent on her parents' return. To be eligible to claim Laura, her parents must meet all 5 tests: 1) relationship (yes, she’s their daughter); 2) joint return (already mentioned—she probably will not be able to file a joint return with her husband if her parents claim her); 3) U.S. citizen (assume yes); 4) support test (yes, parents provided over half her support for the year); and 5) income. The income test would limit Laura’s gross income to less than $3,700 (in 2011), so this test would not be met ($625/mo. x 12 months = $7,500). However, since she made more, they could still claim her if she was under 19 or if she was a student under age 24. So in this case, Laura’s parents may be able to claim her. If they do, then she cannot claim herself or be claimed on her husband’s return and probably cannot file a joint return with him. If this situation applies to you, you probably would want to call the IRS and ask them. The average tax rate is the rate at which each dollar of taxable income is taxed and is calculated by dividing the total tax liability by taxable income. The marginal tax rate is the rate applied to the next dollar of taxable income (the highest applicable tax bracket). It is applied only to the portion of taxable income which falls in the last applicable tax bracket. A tax credit directly reduces one's tax liability, while a deduction from income reduces one's taxable income before taxes are calculated. Dollar for dollar, a tax credit is more valuable than a deduction. 3-10. a. Form 1040 is the main form used in filing federal income taxes. All individuals filing the long form use Form 1040 accompanied by appropriate schedules as needed to file their tax return. The form's two pages summarize all items of income, the deductions detailed on the accompanying schedules, and note the taxable income and associated tax liability. A variety of schedules may accompany Form 1040, with Schedules A, B, C and D being the most frequently used. The schedules provide detailed guidelines for calculating certain entries on the first two pages of Form 1040, and their use varies among taxpayers, depending upon the relevance of these entries to their individual financial situations. Tax rate schedules provide the information for calculating the tax due after all deductions and exemptions have been taken to arrive at taxable income. The tables cover tax rates for the various filing categories. Estimated taxes are tax payments that must be made by persons earning income from sources that are not subject to withholding taxes. In order to assure that taxes are received on a "pay-as-you-go" basis, the IRS requires that taxpayers who earn income against which taxes are not withheld make quarterly estimated tax payments. The taxes are based upon the amount of this type of income expected during the year. IRS Form 1040ES is used to declare this income and tax estimate. Taxpayers with AGI over certain amounts are subject to additional estimated tax rules. Refer to Form 1040ES for a worksheet which will help you determine if you need to make estimated tax payments. For more details, see Publication 505. A tax audit is a review of a tax return to prove its accuracy with regard to proper reporting of income and deductions. Some taxpayers are chosen randomly for audits, while others are audited because certain income or deduction items fall outside of normal ranges. The best way to be prepared for an audit is to keep thorough records of cash receipts and expenditures and receipts from other deductible items. Especially when you have deductions that fall outside the IRS norms, be sure to have proper documentation and attach an explanation of such deductions to your return. The IRS provides various types of assistance to taxpayers. The agency makes available forms and publications which can be accessed by going online, by requesting a fax, by requesting a printed copy, or by picking them up at numerous locations around town. The IRS also provides direct assistance to taxpayers through a toll-free telephone number. In certain instances, the IRS will even figure your income tax liability for you. Refer to Publication No. 967. Tax preparation computer software, such as TaxACT, TurboTax, CompleteTax, and similar programs, allows those with PCs to do their own tax returns. Such programs can save hours of figuring and refiguring the many forms and schedules involved in filing tax returns. However, they are not a substitute for personal knowledge of tax laws and the skill and expertise of a tax accountant or attorney, especially when the tax return is complex. Tax avoidance is the practice of using various legal strategies to reduce one's tax liability. Tax evasion, on the other hand, refers to illegal means of reducing taxes, such as underreporting income or overstating deductions. a. Taxpayers can maximize deductions by accelerating or bunching their deductions into one tax year. Examples include paying next year's property taxes early in order to be able to count both this year's and next year's taxes on this year's return, and bunching nonreimbursable elective medical procedures into one year. Such actions may make it advantageous for a taxpayer to itemize deductions for at least one year versus having to take the standard each year. Income shifting is a technique for reducing taxes by shifting some income to a family member in a lower tax bracket. This is done by creating trusts or custodial accounts or making outright gifts of income-producing property to family members. (Note: The age of the family member will affect the tax benefits of this strategy.) Tax-free income is income which is free from federal income taxation. Qualified municipal bonds pay interest income which is free from federal income taxes. However, if you live where there is a state and/or local income tax, qualified municipal bonds from other states will be subject to your state and local income taxes. Be aware that not all municipal bonds qualify for the tax-exempt status and that capital gains on the sale of municipal bonds are not tax free! Tax-deferred income allows you to reduce or eliminate taxes today by postponing them to sometime into the future after retirement. The appeal of tax-deferred vehicles, such as IRAs and 401(k) plans, is their ability to allow the investor to accumulate earnings in a tax-free fashion. This will allow the investment to grow to a larger amount before it is subject to taxation, and the idea with this is that many people will be in a lower income tax bracket after retirement. Then, when income is taxed after retirement, not as much will be lost to taxes. However, many retired people are in the same or sometimes higher tax bracket than they were before retirement. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 3.1 The Kapoors Tackle Their Tax Return Other forms would have to be filed with this family's tax return for credit for qualified retirement savings contributions, additional child tax credit, and earned income credit. This family's itemized deductions total $6,339 ($831 + $4,148 + $1,360), which is less than the standard deduction. Therefore, they will take the standard deduction, because it will lower their taxable income and hence their tax liability more than would itemizing deductions. Note that their $200 of unreimbursed medical and dental expenses is less than 7.5% of their adjusted gross income, so this amount would not be considered toward their itemized deductions. Murali’s $366 in unreimbursed job expenses are too low to have any effect on their itemized deductions, as these expenses do not exceed 2% of their AGI. Also, medical and dental expenses are far below the 7.5% of AGI required for deductibility. The Kapoors would have to pay additional tax of $916.65 if they itemize deductions versus pay only additional tax of $127.50 if they take the standard deduction, a difference of $789.15. They would definitely choose to take the standard. Their son's income of $200 from dividends is considered unearned income and is below the minimum for which a single return has to be filed ($950 in unearned income). The only reason why they would file with income below this level is to receive a refund of any taxes withheld, which is not necessary in this case. Due to current tax laws, the Kapoors’ refund was greater than the amount of taxes they owed. However, if they make more money in the future and actually owe taxes, some possible tax planning strategies for them might include: Purchase Series EE savings bonds to use for Nalin’s education (interest is not taxed so long as the parents' taxable income falls within specified limits when redeemed for Nalin’s education). However, since Nalin is very young, the family might better provide for his education with more aggressive taxable investments than with savings bonds. Also, the family's income might be above the allowable limits for tax exemption when it is time to cash in the bonds. Shift some interest-earning investments into tax-free municipal bonds or bond funds. Caution: since this family is only in the 15% tax bracket, the yield on municipals may be lower than the after-tax yield on comparable corporate bonds. If this were the case, then municipals would not be a good choice for this family. In fact, this family needs to examine their investment objectives and time horizon to determine if bonds are an appropriate investment for them. Start a Coverdell Education Savings Account for Nalin. These accounts are allowed to grow tax-free, and the distributions are not taxed if Nalin’s higher education expenses in the year of withdrawal are at least as much as the withdrawal. If Nalin doesn't use all the money in the account for his higher education, this money can be passed on to other family members for their higher education expenses. The family might also want to consider a Section 529 Plan for Nalin’s education. See IRS Publication 970, Tax Benefits for Education. Continue to fund an IRA and add the allowed spousal contribution. As long as the family’s income is below the phase-out level, they can continue to make contributions to a traditional IRA even with a company-sponsored retirement plan. However, they may decide to go with Roth IRAs in the future, as withdrawals from Roths in retirement are not subject to taxes (if all conditions have been met). Even though taxes will have to be paid now on any money contributed to a Roth IRA, this family is in the lowest tax bracket, so taxes paid now on this amount would be small. The family’s earnings can rise much higher before reaching the phase-out level for a Roth IRA than for a traditional IRA. Investigate whether his company offers a flexible spending account for medical expenses that would reduce taxable income. Watch the timing of medical and miscellaneous expenses to see if they can be grouped in the same tax year to qualify to be deducted. If their taxable income rises enough to move them into a higher bracket, consider shifting some investments to their son (but keep the income within the required limits) so that more income is taxed at his lower level. 3.2 Cheryl Stern: Waitress or Tax Expert? Gross income: wages $10,500 tips 8,200 Adjusted gross income $18,700 Less: Standard deduction (for 2011) − 5,800 $12,900 Less: Exemption (for 2011) − 3,700 Taxable income $ 9,200 Cheryl is incorrect in her assumption that she is allowed to both itemize deductions and take the standard deduction if her income is below a certain level. She appears to be confusing the standard deduction with the personal exemption, which she did not include in her calculations. Itemized deductions are allowable personal and job-related expenses that can be used to reduce adjusted gross income in order to arrive at taxable income. The standard deduction is a blanket deduction that serves as an alternative to itemizing deductions. Those who itemize cannot take the standard deduction as well, and vice versa. At a taxable income of $9,200, Cheryl and John would each pay $955 in taxes filing as single taxpayers [$850 + .15($9,200 – $8,500)]. That totals $1,910 for the two of them. The taxes they would pay if married filing jointly are as follows: Adjusted gross income (2 × $18,700) $37,400 Less: Standard deduction (for 2011 for married filing jointly) − 11,600 $25,800 Less: Exemptions (2 × $3,700 for 2011) − 7,400 Taxable income $18,400 Their tax would be $1,910, the same as it would be for two single people filing individually [$1,700 + .15($18,400 − $17,000)]. Solution Manual for PFIN Personal Finance Michael D. Joehnk, Randall S. Billingsley, Lawrence J. 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