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Preparing personal financial statements.

Accountants are often engaged to prepare financial statements for an individual or related individuals such as a husband and wife as a family unit. These statements are commonly referred to as Personal Financial Statements (PFS). PFS may be needed for obtaining credit, estate planning, filings by public officials or candidates for public office and, more recently, for general financial planning. Although there are some similarities between PFS and the statements prepared for business enterprises, there are many differences.

This article reviews the major provisions of authoritative Statement of Position (SOP) 82-1, Accounting and Financial Reporting for Personal Financial Statements.(1) This pronouncement is reproduced in an appendix to a recently revised Personal Financial Statements Guide.(2) The guide expands on the material in SOP 82-1 by addressing the procedures that accountants should follow when engaged to compile, review, or audit PFS, and it also addresses the accountant reports which should be issued with the various PFS engagements.

Accounting Basis and the Reporting Entity

Whenever accountants are associated with financial statements that purport to be in conformity with generally accepted accounting principles, there must be a clear indication of (1) the basis of accounting used, and (2) the entity covered. SOP 82-1 indicates PFS should be prepared on the accrual basis of accounting, not the cash basis.(3) Thus, PFS should reflect the financial effects of transactions and events having cash consequences for the individual covered in the periods in which those transactions and events occurred rather than only in the period in which cash is received or paid by the individual. Concerning an appropriate entity for PFS, an individual, a husband and wife, or family unit may serve as the reporting entity.(4) Since identification of the specific individual(s) covered is very important to any interpretation of the statements, the notes to the statements should contain a clear indication of who is covered.(5)

The Statements-Formats and Elements

SOP 82-1 identified two personal financial statements: (1) A Statement of Financial Condition (SFC), and (2) A Statement of Changes in Net Worth (SCNW). The statement recommends, but does not require, that PFS for the current period be presented with PFS for one or more prior periods as such a presentation is more informative than a single period.(6)

Statement of Financial Condition. The SFC is the only required PFS. An illustrated statement for Robert H. and Vicki Brock is presented in Exhibit 1. Although the format of the statement is similar to a business balance sheet, there are some major differences.

First of all, SOP 82-1 requires that assets be presented by order of liquidity and liability by order of maturity in the SFC. The current versus noncurrent classification scheme used in business balance sheets to focus on working capital is not used when preparing PFS.(7) Also, in PFS assets are presented at their estimated current values, and liabilities are presented at their estimated current amounts. The current value of an asset should be determined in the context of a likely transaction between a willing and well informed buyer and seller, neither of whom is forced to buy or sell. Current value is defined as the dollar amount at which an asset could be exchanged between such a buyer and seller, taking into consideration any cost of disposal if applicable (for example a commission to sell the family residence). The current amount of a liability is defined as the discounted amount of the future cash payment(s) needed to settle no obligation. Discounting should be done using the interest rate implicit in the transaction in which the liability originated. If, however, the debt can be settled currently at an amount lower than the discounted amount, the lower amount should be used for the current amount.(8) The use of current values and current amounts in PFS is a major deviation from the historical cost measurement focus of business financial statements. To make sure users of PFS are aware of this measurement focus, the notes to the financial statements should disclose that current values and current amounts are being used, and indicate how the amounts were determined.(9)
Exhibit 1
Robert H. and Vicki Brock
Illustrative Statement of Financial Condition
December 31, 1993
Assets
Cash $ 1,000
Commissions Receivable 4,500
Investment in certificate of deposit, 8%,
matures in 1996 25,000
Investment in marketable securities 70,000(*)
Vested interest in AB Corporation retirement fund 55,500
Residence 80,000
Personal effects 14,000
Total assets $250,000
Liabilities
Income taxes payable, current year 5,000
Mortgage payable 70,000(*)
Total liabilities $ 75,000
Estimated income taxes on the difference between
the estimated current values of assets and the
estimated current amounts of liabilities and
their tax bases $ 25,000(*)
Net worth $150,000
The notes to financial statements are an integral part of these
statements
* Additional explanation or description likely needed in the
notes to financial statements. If so used, the note should be
referred to in the body of the statement.


Another item in the SFC presented in Exhibit 1 that makes this statement somewhat different from a business balance sheet is the presence of "estimated income taxes on the differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases" ("estimated income taxes" hereafter). This account is similar to the deferred income tax account which may appear in a business balance sheet because of temporary differences between the tax bases of assets and liabilities and their reported book amounts. Estimated income taxes are presented in the SFC because tax consequences may result from liquidating an asset at current value or settling a liability at current amount when such amount differs from the tax basis of the item. Thus taxes may have an impact on the amount that an asset or liability contribute to an individual's net worth. For example, assume the "investment in marketable securities" reported the SFC in Exhibit 1 were purchased by the Brocks for only $55,000. Their current value of $70,000 exceeds their tax basis by $15,000. If one assumes $5,000 in taxes would have to be paid on the gain if the securities are sold, the marketable securities are only worth $65,000 net to the Brocks ($70,000 less $5,000 in taxes). SOP 82-1 indicates a provision must be made in the SFC for such estimated tax consequences.(10) Observe that the estimated $5,000 in taxes are not shown as a direct adjustment to the current value of the securities, but are included in the single amount of $25,000 for all differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases. In the illustration, it is also assumed that two additional differences exist. "Commissions receivable" (1) and "vested interest in AB Corporation retirement fund" (2) are assumed to have tax bases of $0. If received, it is estimated that one-third of the receipts would have to be paid in taxes. This accounts for the additional $20,000 in estimated income taxes ($4,500 + $55,500 = $60,000 * 1/3 = $20,000). Professional judgement must be exercised in deriving the estimated income taxes figure. Major differences that exist between the tax bases of assets and liabilities and their respective current values and current amounts should be disclosed in the notes to the financial statements. Also, the assumptions used in estimating the income taxes on the differences should be disclosed.(11)

A final point readers should note regarding the SFC is that "net worth" is the term used to identify the difference between total assets and total liabilities after deducting the estimated income taxes discussed earlier.(12)

Statement of Changes in Net Worth. The SCNW is an option PFS. This statement is most useful when comparative statements of net worth are issued since the SCNW presents transactions and events which change net worth from one period to another period.

An illustrated statement for Robert H. and Vicki Brock is presented in Exhibit 2. This statement presents four elements to capture changes in net worth for a period of time: (1) realized increases in net worth, (2) realized decreases in net worth, (3) unrealized increases in net worth, and (4) unrealized decreases in net worth.(13) Elements (1) and (2) are comparable to most of the revenues and expenses to which appear on a business income statement. Elements (3) and (4) appear primarily as a result of SOP 82-1 mandate that assets and liabilities must be reported in PFS at current values and current amounts respectively.

In the illustration, it is assumed the marketable securities and the vested interest in the retirement fund increased in value by $4,500 and $1,500 respectively during 1993. It is also assumed the total increase of $6,000 was not accompanied by any increase in the tax bases of the items. If the two assets are liquidated, it is assumed one-third of the $6,000 increase ($2,000) would have to be paid in taxes. Thus, the estimated income taxes account increases by $2,000 for the year.

Handling Business Interest in the SFC

Although there are many special issues that accountants may face when engaged to prepare PFS, one major issue is how to present an individual's business interest in the SFC. None is presented in Exhibit 1. However, if the Brocks had such interest, a major decision to be made is whether to present an investment account in the statement or present the assets and liabilities of the business enterprise. SOP 82-1 indicates under most circumstances only an investment account should be shown. When the business interest is operated as a separate entity, be it a proprietorship or closely held corporation, only the current value of the investment as a going concern is shown in the SFC. The individual assets and liabilities of the separate entity are not presented in the SFC with similar personal items, but should be disclosed in summary format in the notes to the statements. If, however, an individual has "limited" business activities that are not operated via a separate entity it would be appropriate to show both the current value of the asset and the current amount of any related liability, in the SFC. An investment in real estate that is financed by a personal loan is the example presented in SOP 82-1 to illustrate when both the asset and liability should be reported in the SFC.(14)
Exhibit 2
Robert H. and Vicki Brock
Illustrative Statement of Changes in Net Worth
For The Year Ended December 31, 1993
Realized increases in net worth
Commissions and salaries $ 81,000
Interest earned 2,500
Dividends earned 6,500
Total realized increases $ 90,000
Realized decreases in net worth
Federal and state income taxes $ 21,000
Interest expense 1,000
Real estate taxes 3,000
Personal Expenditures 35,000
Total realized decreases $ 60,000
Net realized increase $ 30,000
Unrealized increases in net worth
Marketable securities $ 4,500
Vested interest in AB Corporation
retirement fund 1,500
Total unrealized increase $ 6,000
Unrealized decreases in net worth
Estimated income taxes on the difference
between the estimated current values
of assets and the estimated current
amounts of liabilities and their tax
bases $ 2,000
Net unrealized increase $ 4,000
Net increase in net worth $ 34,000
Net worth at beginning of year $116,000 (assumed)
Net worth at end of year $150,000
The notes to financial statements are an integral part of these
statements.


Conclusion

The ongoing emphasis on financial planning and reporting by individuals is generating an increasing demand for PFS. Accountants must know that GAAP, as defined for PFS, is in many respects different from GAAP as defined for business enterprises. Since the preparation of PFS requires a working knowledge of details not covered here (for example, how best to determine current values and current amounts for specific assets and liabilities), accountants engaged to compile, review or audit PFS are urged to study carefully the authoritative pronouncements dealing with PFS: (1) Statement of Position 82-1, Accounting and Financial Reporting for Personal Financial Statements, and (2) Personal Financial Statements Guide.(15)

Footnotes

1 American Institute of Certified Public Accountants, "Accounting and Financial Reporting for Personal Financial Statements," Statement of Position 82-1, (AICPA, October 1982).

2 American Institute of Certified Public Accountants, Personal Financial Statements Guide (AICPA, 1991).

3 SOP 82-1, paragraph 7.

4 SOP 82-1, paragraph 5.

5 SOP 82-1, paragraph 31a.

6 SOP 82-1, paragraph 6c.

7 SOP 82-1, paragraph 8.

8 SOP 82-1, paragraphs 12, and 27.

9 SOP 82-1, paragraphs 31 b and c.

10 SOP 82-1, paragraph 30.

11 SOP 82-1, paragraph 31j.

12 SOP 82-1, paragraph 6a.

13 SOP 82-1, paragraph 6b.

14 SOP 82-1, paragraphs 10, 11 and 31f.

15 As indicated earlier, accountants who secure The Guide need not secure a separate copy of SOP 82-1 since it is reproduced in an appendix to The Guide.

Quinton Booker is Professor of Accounting in Jackson State University's School of Business. He holds a BS in accounting, Master of Professional Accountancy and Doctor of Business Administration from Mississippi State University. He is a certified public accountant (Mississippi).
COPYRIGHT 1993 National Society of Public Accountants
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Booker, Quinton
Publication:The National Public Accountant
Date:Jan 1, 1993
Words:2204
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