Module 3

Question 1

If the partnership interest has been held for quite a while and is considered an income-producing asset, the planner might use the present value of future income streams.

Answer 1

On the other hand, there may be situations in which determining the value is difficult; in such cases, a zero amount can be used.

Question 2

In the case of assets subject to penalty for early withdrawal, the fair market value is still presented on the statement of financial position, unaffected by potential penalties. If there is a known sum of money or asset that is to be received by the client (such as proceeds of a life insurance policy or the sale proceeds of an asset),

Answer 2

you will have to make a decision concerning its inclusion on the statement as a receivable, footnoting as needed.

Question 3

One item often ignored, because it isn’t actually an asset, is an inheritance. With some clients, an inheritance of a known amount may be quite certain. It may be that the death has occurred, but the distribution of the estate assets hasn’t taken place. T

Answer 3

The circumstances may be such that there is no concern about whether the inheritance will take place—only when it will occur. In this case, some note of it is appropriate, especially when you are providing estate planning

Question 4

Common abbreviations for property ownership = S1. = spouse

Answer 4

Individual ownership of the named spouse (or, in a community property state, the spouse’s separate property); the name of the S1 spouse appears in the statement of financial position footnotes.

Question 5

Common abbreviations for property ownership = S2. spouse 2

Answer 5

Individual ownership of the other named spouse (or, in a community property state, the other spouse’s separate property); the name of the S2 spouse appears in the statement of financial position footnotes

Question 6

Common abbreviations for property ownership = JT. jointly

Answer 6

Property that is held jointly with rights of survivorship (note that the respective joint tenants are usually, but not always, married spouses; if the joint tenants are nonspouses, it will be reflected as such in the footnotes to the statement).

Question 7

Assets may be titled as tenants in common (TIC)

Answer 7

tenant

Question 8

Common abbreviations for property ownership = CP = community

Answer 8

Community property of the spouses

Question 9

Liabilities can be listed in several different ways.

Answer 9

They could be listed in descending order based on the account balance, to reflect either the order in which payments are due or in the order of shorter-term to longer-term obligations.

Question 10

(TE)

Answer 10

tenants by the entirety

Question 11

Current (short-term) liabilities

Answer 11

are those due within one year from the statement date, such as a promissory note.

Question 12

Long-term liabilities

Answer 12

are those due more than one year from the statement date.

Question 13

Another style is to list liabilities related to

Answer 13

depreciating assets separate from those for appreciating assets. If the client is delinquent in payments, then the amount overdue, along with accrued interest, should be added to the outstanding principal balance. The financial planner will have to make decisions about including contingent liabilities, footnoting as needed.

Question 14

Net worth

Answer 14

1. is the difference between assets and liabilities.
2. It fluctuates from statement to statement, depending on the financial transactions that take place between the dates of statement preparation.
3. Comparison of net worth values over time can reveal how well the client is doing in achieving financial goals that involve a permanent increase in net worth.

Question 15

Footnotes

Answer 15

1. are an integral part of all personal financial statements and should be taken into consideration when the financial planner evaluates the client’s situation.
2. Footnotes clarify items in the statement or indicate values or circumstances not disclosed in the body of the statement.
3. They can also indicate relevant contingencies, such as an inheritance or a pending lawsuit that may affect future assets or liabilities.

Question 16

TEST TIP

Answer 16

Pay attention to footnotes in practice questions and exam questions. Often, the information in the footnotes is needed to answer correctly. For instance, if a question were asked based on information in Figure 3.1 about the terms of the Smith’s mortgage loan, you would need to reference the footnotes to answer the question correctly.

Question 17

the cash flow statement = Also known as the statement of cash flows,

Answer 17

1. reveals the client’s cash receipts and disbursements over a specific period of time—monthly, quarterly, and often over one year.
2. it summarizes the inflows and outflows of cash and reveals a client’s pattern of spending, saving, and investing.

Question 18

PROFESSOR’S NOTE

Answer 18

A cash flow statement is not technically the same as an income statement. An income statement is most often used in a business context and focuses on a company’s financial performance. Revenue is recognized as income, but may not immediately result in a cash flow (think accrual accounting). Income statements are seldom, if ever, used in a personal financial planning context, except where personally owned businesses are involved

Question 19

cash flow ~ is not the same as

Answer 19

an income statement

Question 20

cash flow is used

Answer 20

in personal and business situations

Question 21

cash flow statement and the statement of financial position are the two primary financial statements used

Answer 21

to evaluate an individual client’s financial situations.

Question 22

Cash Inflows and Reinvestment in Financial Planning

Answer 22

1. Cash Inflows: Include gross salaries, wages, interest, dividends, rental income, tax refunds, and other amounts received.
2. Special Inflow Category: Funds withdrawn from savings or liquidated investments should be categorized separately as “savings and investments” to clarify the cash source.
3. Dividends & Interest:
   3.1. Reinvestment Reporting: Practitioners may either exclude reinvested dividends/interest from financial statements or show them as both an inflow and an outflow.
   3.2. Net Effect: The financial impact remains the same, but some lenders and planners prefer the transparency of showing both inflows and outflows, allowing flexibility in financial decisions.

Question 23

1. Cash Inflows:

Answer 23

Include gross salaries, wages, interest, dividends, rental income, tax refunds, and other amounts received.

Question 24

2. Special Inflow Category:

Answer 24

Funds withdrawn from savings or liquidated investments should be categorized separately as “savings and investments” to clarify the cash source.

Question 25

3. Dividends & Interest:

Answer 25

3.1. Reinvestment Reporting: Practitioners may either exclude reinvested dividends/interest from financial statements or show them as both an inflow and an outflow.
3.2. Net Effect: The financial impact remains the same, but some lenders and planners prefer the transparency of showing both inflows and outflows, allowing flexibility in financial decisions.

Question 26

Outflows in Financial Planning

Answer 26

Outflows Categories:
1. Savings and Investments: Money set aside for future financial goals.
2. Fixed Outflows: Predictable, recurring expenses with little client control (e.g., mortgage payments, insurance premiums).
3. Variable Outflows: Expenses that vary and can be controlled (e.g., food, transportation, entertainment).

RECOMMENDATION: Challenge: Clients often struggle to track all expenses, especially variable outflows.
Solution: Use financial software or apps to track spending, combining credit card statements and checking accounts into a cohesive cash flow tool.

Question 27

PROFESSOR’S NOTE

Answer 27

Although not categorized as such in Figure 3.2, taxes and FICA are sometimes listed as variable outflows on the cash flow statements. The ability to affect income taxes through various investment options and income planning is the rationale for this position. Further, if a client loses his job or is disabled, both the income and the taxes would be reduced.
When an individua

Question 28

Taxes, Liabilities, and Cash Flow Statements

Answer 28

Taxes as Variable Outflows:
- Rationale: Income taxes can be influenced by investment choices and income planning.
- Example: If income decreases (e.g., job loss), taxes would also decrease.
Credit Card Charges: VARIABLE
- Cash Flow Impact: Credit card charges should be categorized appropriately on the cash flow statement.
- Debt Reduction: Payments made to reduce credit card balances can be listed as a separate variable outflow.
Customizing Outflows: VARIABLE
-Subcategories: Additional fixed and variable expense categories can be created as needed.
-Savings Priority: Savings and investments should be listed first to emphasize the “pay yourself first” approach.
Net Cash Flow:
-Definition: The difference between inflows and outflows (surplus or deficit).
-Balancing: Adjustments can be made by increasing savings or miscellaneous expenses.

Question 29

Debt can function as either an important tool for clients to acquire

Answer 29

items and manage outflows, or as a drain on resources.

Question 30

Debt is best used for large purchases, especially those that normally create equity, such as a

Answer 30

mortgage for home ownership, where it would be difficult for clients to acquire the item for cash.

Question 31

consumer debt (e.g., credit cards, automobile loans) should be avoided as much as possible.

Answer 31

This is particularly true for clients who are unable to control spending when consumer debt is readily available. I

Question 32

Debt-to-income (DTI)

Answer 32

Ratios are financial metrics used to assess a client’s financial situation by comparing their debt payments to their income. These ratios are compared to industry benchmarks, particularly in mortgage lending, to determine financial stability.

Question 33

The two main debt to income DTI ratios discussed are:

Answer 33

Consumer Debt Ratio
Housing Cost and Total Debt Ratio

Question 34

Consumer Debt Ratio:

Answer 34

This ratio compares monthly consumer debt payments (excluding mortgages) to monthly net income, such as service automobile purchases and credit card purchases. A generally accepted rule is that this ratio should not exceed 20% of net monthly income.

Question 35

Consumer Debt Ratio FORMULA ( not exceeding 20% of net monthly income)

Answer 35

consumer debt ratio = monthly consumer debt payment / monthly
net income

Question 36

Housing Cost and Total Debt Ratios

Answer 36

These ratios compare housing costs such as rent or mortgage, including interest payments on the mortgage, property taxes, association fees homeowners insurance premiums [PITI], and total debt payments to gross monthly income. They provide insights into how clients manage their overall debt.

Question 37

Housing Cost Ratio FORMULA ( not exceeding 28% of gross monthly income)

Answer 37

housing cost ratio = monthly housing cost / monthly gross income

Question 38

Total Debt Ratio FORMULA ( not exceeding 36% of gross monthly income

Answer 38

total debt ratio = total monthly debt / monthly gross income

Question 39

Total Debt includes

Answer 39

monthly housing costs, consumer debt payments, monthly alimony, child support, and maintenance payment

Question 40

Debt Management Rules of Thumb

Answer 40

Consumer Debt = 20% or less of net monthly income
Housing costs = 28% or less of gross monthly income
Total debt = 36% or less of gross monthly income

Question 41

How is the Total Debt (Back-End) Ratio calculated, and why are minimum payments used?

Answer 41

The Total Debt (Back-End) Ratio is calculated using the minimum required debt payments rather than the actual amount paid. This ensures the ratio reflects the mandatory obligations the client must meet. Housing costs in this ratio include PITI and association fees.
For example, if your clients are paying $500 to their credit card debt but the minimum payment is $150, then $150 would be used in this ratio.

Question 42

What is one purpose of debt-to-income ratio benchmarks?

Answer 42

To assess a loan applicant’s ability to assume additional debt.

Question 43

How can financial planners use debt-to-income benchmarks?

Answer 43

Financial planners can use them to determine if a client’s current debt level appears excessive based on their resources.

Question 44

What should be done if a benchmark percentage is surpassed?

Answer 44

The client’s financial situation should be evaluated to help manage and potentially reduce their debt.

Question 45

Are all debt-to-income benchmarks mutually exclusive?

Answer 45

Yes, they are mutually exclusive. If one benchmark is surpassed, the client’s situation should be reassessed.

Question 46

How can different levels of property taxes affect debt assessment?

Answer 46

Clients with the same debt level but different property tax obligations may be in vastly different financial situations, impacting debt assessment.

Question 47

What does the Current Ratio measure? = LIQUIDITY MEASURE

Answer 47

The Current Ratio measures an individual’s ability to service short-term liabilities by dividing current assets by current liabilities. A ratio greater than 1.0 is preferable.

Question 48

How is the Current Ratio calculated?

Answer 48

The Current Ratio = current assets / current (short-term) liabilities.

Question 49

What does a Current Ratio greater than 1.0 indicate?

Answer 49

It indicates that the client can pay off existing short-term liabilities with readily available, liquid assets.

Question 50

What is the Net-Investment-Assets-to-Net-Worth Ratio?

Answer 50

This ratio compares the value of investment assets (excluding home equity) to net worth, indicating progress toward capital accumulation goals.

Question 51

What is a recommended Net-Investment-Assets-to-Net-Worth Ratio as retirement approaches?

Answer 51

A recommended ratio is at least 50%, with the percentage increasing as retirement nears.

Question 52

Why might younger individuals have a lower Net-Investment-Assets-to-Net-Worth Ratio?

Answer 52

Younger individuals may have a lower ratio, around 20% or less, because they have not yet had time to build a substantial investment portfolio.

Question 53

How is the net-investment-assets-to net-worth-ratio calculated?

Answer 53

net-investment-assets-to net-worth-ratio = net investment assets / net worth

Question 54

Strengths
1. Adequate savings (particularly for retirement)
2. Appropriate emergency fund
3. Appropriate net worth, given client goals
4. Well-defined financial goals
5. Excellent cash flow management skills (including proper debt management)
6. Appropriate investments given client risk tolerance, time horizon, and goals
7. Appropriate insurance coverage
8. Valid and current estate planning documents
9. Stable or promising employment status

Answer 54

Weaknesses
1. Insufficient savings (particularly for retirement)
2. Inadequate emergency fund
3. Low net worth, given client goals
4. Financial goals that are not defined or unrealistic
5. Poor or improper cash flow management skills

6. Investments that are not aligned with risk tolerance, time horizon, and goals
7. Insufficient amount of or no insurance coverage
8. Lack of estate planning documents
9. Unfavorable employment status

Question 55

Which of the following can be monitored and evaluated through the use of a budget? Which of the following can be monitored and evaluated through the use of a budget?
I. Income
II. Net worth
III. Expenses
IV. Spending patterns

Answer 55

D. I, III, and IV

Question 56

Tim and Gina are working with you, their financial planner, to develop a budget. As part of the process, you ask them to list their discretionary and nondiscretionary expenses. Which of the following should Tim and Gina consider to be nondiscretionary cash outflows for planning purposes?
I. Utility bills
II. Loan payments
III. Travel and entertainment expenses
IV. Medical and dental insurance premiums

Answer 56

C. I, II, and IV

Question 57

After meeting with you, Janesh and Katie understand the need for an emergency fund. Janesh is a mechanic, and Katie volunteers at a local hospital. They ask you how much they should have in this fund. Which of the following is your best response?
A. An amount equal to 1 month of expenses
B. An amount equal to 3 months of expenses
C. An amount equal to 6 months of expenses
D. An amount equal to 12 months of expenses

Answer 57

C. An amount equal to 6 months of expenses

Question 58

16. Miguel and Michelle, both age 38, would like to create an emergency fund for major unexpected expenses. Which of the following accounts are appropriate for this fund?
    I. Stocks and bonds
    II. Savings account
    III. Traditional IRA account
    IV. Certificate of deposit (CD) with a three-month maturity

Answer 58

B. II and IV

Question 59

17. You have advised your client, Bette, that she needs to increase her savings. What might you recommend as good savings strategies? I. Plant a large vegetable and herb garden.
    II. Use an overdraft feature on her debit card.
    III. Consider a health insurance plan with a lower deductible.

Answer 59

B. I and II

Question 60

18. Athena would like to reduce her debts, which are listed as follows. She currently has $50 in excess monthly cash flow to start this process. Athena is currently making minimum payments to each account. Using the snowball technique, what would she be able to pay on Credit Card D once the smaller loans have been paid off?
    Debt

Credit Card A - 20 Minimum payment
Credit Card B - 30 Minimum payment
Credit Card C - 50 Minimum payment
Credit Card D - 125 - Minimum payment
Auto loan - 325 - Minimum payment

A. $100
B. $150
C. $225
D. $275

Answer 60

D. 275

Question 61

19. Over the years, Gabriel has made timely payments on three of his credit card accounts, all which have balances near the available credit limits. He also paid off a fourth credit card account, which he had for 20 years, and immediately closed it. Which of the following statements regarding Gabriel’s credit score is CORRECT?

I. By immediately closing his long-standing account when it was paid off, Gabriel likely increased his credit score.

II. Having three credit card account balances near their available credit limits adversely affects Gabriel’s credit score.

Answer 61

B. II only

Question 62

parties to a lease, the person or business that owns the asset and leases it to another is called

Answer 62

the lessor

Question 63

The person who leases, or rents, the asset is called

Answer 63

the lessee

Question 64

20. What is the best reason that your client, Jennie, should rent an apartment rather than purchase a home?
    A. She does not want to do yard work.
    B. She does not want to pay real property taxes.
    C. She expects to relocate within one to three years.
    D. She does not want to purchase homeowners insurance.

Answer 64

C. She expects to relocate within one to three years.

Question 65

the borrower

Answer 65

(mortgagor)

Question 66

the lender

Answer 66

mortgagee)