In an earlier post on accounting, I described one of the four basic accounting statements, the balance sheet, and the terminology of an asset, a liability, and owner’s equity. I also included an example of buying a car (well not just buying any car, but a 2010 Lamborghini Gallardo LP560-4 Coupe!!) to illustrate the difference between an asset and owner’s equity. This time I want to expand on that example a bit to help illustrate how accounting can help one make smarter financial decisions. These decisions might not be what the heart wants, but it will be what the pocketbook can afford!!
First a quick recap: the actual goal of accounting is to help you realize and correctly determine out of the many things and claims you have for and against you what is an asset, what is a liability, and what is owner’s equity. You’re using the accounting statement to help clearly visualize each category and to help quickly determine the best financial option given your current financial situation. This is the balance sheet’s primary purpose. There are three other accounting statements- the income statement, the cash flow statement, and the statement of owner’s equity that comprise current accounting principles.
We will still concern ourselves mainly with the balance sheet, but we’ll talk briefly about the income statement in this post. So what is an income statement? Wikipedia has a great article on the specifics of what an income statement is which goes into far greater detail than we’re currently interested in, but it’s worth a look if your curious. If you only want the quick bare bones summary, an income statement is a statement generated to help an individual determine his top line revenue, all associated costs incurred to earn that revenue, and the final residual income (or loss!!) associated with the aforementioned revenue activity. For individuals, the income statement is pretty straight forward. You have your job’s earnings at the top, you then subtract of all mandatory expenses needed to perform the aforementioned job (i.e. taxes, gasoline costs required to get to and from work, car maintenance, etc.), and then you’re left with the residual income which you can then use at your discretion (hopefully, though, food, clothing, and shelter are at the top of that discretionary budget). For our purpose we’re not really going to explore the ins and outs of the income statement; we’re only going to borrow a single line item from it- the expense line. We’ll need this to help track our overall expenses we incur from buying that Lamborghini with a loan.
We’ll also be making some assumptions that we’ll try and hold throughout the example- car loans are financed at 4.67% new, 5.02% used for a 60 month loan, which was found from Bankrate.com, you can invest money in a 5 yr CD at 1.55%, and that a cars’ intrinsic value is fairly constant over a five year time span. This would mean that five years from now that 2010 Lamborghini should be priced in equivalent dollars to a 2005 (or currently 5 year old) used Lamborghini would be priced right now. While we are playing a little fast and loose with model changes and possible issues with inflation (or deflation), hopefully they’re relatively static across all cars and these issues represent only a small amount of error in the calculations. We could try and find sales data for the same model over five years, but that would be a lot of work that probably isn’t worth the effort. With these assumptions out of the way, let’s look at our car example again. Using a new car loan to purchase our Lamborghini we can see that the monthly car payments would be $3,706.64.
At the start of the purchase our Balance Sheet would look like:
We’ve just bought our care signed up for a car loan and added the car to our balance sheet. We’ll be paying $3706.64 per month and track the value of the Gallardo on the balance sheet. Let’s assume that we make our payments diligently for three years. We’d like to see how we’re doing at this point. Our total expenses (for three years of payments) is $133,439.04. We also want to know how much the car is currently worth. To figure this out we’ll estimate the value of our Lamborghini Gallardo by seeing how much 3 year old Gallardo’s go for. Using AutoTrader.com I found a used 2008 Gallardo with 4,700 miles on it selling for $155,000. Assuming we actually drive our car a bit, we’ll conservatively assume that our Lamborghini will sell for $145,000. So our new Balance Sheet would look like this:
On the left side, the asset side, we have the market value of the Lamborghini Gallardo ($150,000.00). On the left side we’ve estimated the remainder of the car loan on a linear scale (which is 2/5 of the original balance). We’ve done this because we’re assuming we’ll pay of the entire car loan on time without missing a payment or refinancing. In reality it’s a bit more, since interest is paid upfront and not principal.
On the bottom right side (liabilities) you’ll see that we have a value of $150,000 also. This has to equal the value of the asset (Gallardo). To figure out the owner’s equity we just subtract the loan amount from the liability balance; our current equity in the car is $70,800. That’s not too bad. The last item we need to remember is our expense line item, which is $133,439.04. This just reminds us that we’ve paid approximately $133k to have a car worth $70k. Owning a Lamborghini for three years has reduced our net worth by $63k. This happened even though we only “lost” $48k on the face value of the Gallardo (from $198k brand new to $150k used). Loan expenses ate away another $15k. This is important to calculate and remind ourselves.
Hopefully this example helps show the usefulness of basic account (which isn’t too involved). I know I didn’t explain how I came up with the monthly payment for the Lamborghini, but I don’t know if that’s overtly necessary to know. Bankrate.com has a great free calculator that you could use at anytime to find that number and maybe, if there’s interest, I’ll show the formula I used (which gives the same result). Next time I’ll expand this example by showing an alternative investment option.