Friday, September 08, 2006

Question from a Reader: How to Track Expenses

Here's a question from a reader that I have been meaning to answer for ages:

I have a basic budget drawn up in Excel with Budgeted and Actuals columns for my expenditures, which I am refining as the months (3 so far) go by. I use my credit card for almost everything so I know where it's all going, and I pay the balance off in full every month.

My question is, I'm not sure whether I should chalk up my Actuals in the month in which they are incurred, or in the following month, when they are paid. The one creates an accurate record for me of how much I spend in a month, while the other gives a picture of my current cash flow.

Which is the usual way of tracking this? Thanks in advance for your thoughts.

Here's some info from an article I found that explains the issue a bit:
Cash vs. Accrual Accounting

There are two basic accounting methods available to most small businesses: cash or accrual.

Cash method.
If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.

Accrual method.
With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.

Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.

This article targets a business user, but you can see what the issues are for personal finance as well. Do you want to have to enter everything twice, and maintain payables and receivables accounts? Sounds like a nuisance to me. But if your cash is tight enough that you want to monitor cash flow very carefully, maybe the accrual method is the way to go. I would recommend using the cash method, and recording your expenses as they occur, and just stay aware of what the running balance is on a credit card so you'll know how much cash you'll actually be paying out when the bill comes due the following month.

Anyone else have any thoughts on this? I never took Accounting 101 so there may be some points I'm missing...


Anonymous said...

For my budget, I like to record expenditures as I make the purchase, even if I'm not actually paying for them until later. What I'm actually tracking is my behavior, measured in dollars, rather than cash flow, because that's what I'm interested in. That sounds like the accrual method.

But then I record income only as I actually get it. This is due to not wanting to count my chickens before they hatch, which is a useful conservative philosophy. But this sounds like the cash method.

I'm sure an accountant would freak out at using one method for expenditures and the other for income, but it's the only thing that makes sense to me--my spent money is already spent even if it's not yet due, and my earned money may already be earned, but something could still happen to prevent my getting it.

If I were running a business, I'd want to be consistent, but both ways would be useful. The accrual method would help me evaluate my behavior--am I charging enough for the jobs I am doing to make a profit? But the cash method would help me evaluate my methods--do I need to give people different deadlines, start charging more money up front, refuse to accept checks from certain clients, etc.

I don't have a business, though. I do mostly the same mixed-strategy thing with my checkbook as I do with my budget. As soon as I write a check or approve a payment, I subtract it from my balance, even if it hasn't cleared yet and even if it's not even scheduled to go through until much later in the month. I only get paid once a month, and it will all be gone before my next paycheck.

One difference is that if I withdraw money from my checking account so that I can use it to buy things with cash, I record that right away in my checkbook, but I don't record it in my budget until I actually make purchases with that money.

(Another difference is that I record mortgage payments by the month even though I promised to pay all that money a long time ago when I bought my house. Same thing for cyclical expenditures--I may have a contract to pay something each month, but I don't record infinite payments, just one at a time.)

Adam Nash said...

I agree with the other poster here. I use basically a cash method for tracking expenses, but I don't try to "ride the float" in my tracking. If I write a check, or schedule an online bill payment, I record the expense in Quicken right away.

As a result, the cash in my bank accounts is always higher than what I have totalled in Quicken. This allows me the benefit of "free money" in terms of interest on the float, without the risk of overspending the account.

mapgirl said...

I also follow a bit of what Debbie does. Mostly I book my planned expenses for the month because frankly my credit card bill is due every month at the same time and really it doesn't matter since I don't put it on my income-expense statement/net worth update till the end of the month. And in that case, I am cash method since I don't plan next month's expenses when I run those numbers (though strictly speaking an income-expense statement is NOT a balance sheet where you'd 'accrue' your income or expenses).

And even if you did 'accrue' your income, you'd only do it monthly, meaning that you would only book a portion of your revenue for the year each month. If you really want to know about this kind of accounting practice shadiness, read up on MicroStrategy. For example, they booked 3-yr $36million sales contracts all in the month the contract was signed instead of $1 million per month over the entire 3 yr period of the contract, thereby inflating their growth rate. Crazy stuff.

Sorry to wander off, but does that help illustrate the point of accruals vs cash? It's been a long time since I took Accounting 101 so I might also be off a bit.