Beyond Balance Sheet – A Wealth Maximiser approach for Chartered Accountants
Recording Other People’s Money V/s Managing Other People’s Money
The profession of Chartered Accountancy is known for their financial acumen and knowledge about taxation and accountancy. It is their ability to apply knowledge to real-time that sets them apart. They are known as taxation and financial experts and it’s time that profession should think about value creation by applying these skills in the emerging field of wealth creation.
As a student of commerce in high school, my favourite subject was Accountancy (no doubt it is today too!) and nothing other than the CA course was my dream. Because if you love accounting, you ought to be a Chartered Accountant! When we look at a Balance Sheet or a Profit and Loss account there are three aspects: one from the perspective of the preparer, second from the perspective of the user and, third from the perspective of an auditor or a regulator. All of them use the same terminologies: Assets, liabilities etc., but in a different manner. In the course of time, I became a portfolio manager and I am still using the same accounting training but in a different way.
The Mindset Shift: From Historical Numbers to Future Value
While we prepare the balance sheet, we have to record all assets, cash flows, expenses and income of our client. As auditors, we dig deeper into those numbers just to find out if some errors of omission or some real mismatches that must be reported to the shareholders. For us as Chartered Accountants, they are numbers, and we never try to think beyond because that is what our job is. We cannot believe in any future projections and are trained to always be conservative and ethical in our approach. This is a typical concept of recording another’s money.
Times are changing and so are we. A Chartered Accountant now has to look beyond only the balance sheet and start thinking of managing money as well. The client’s and Balance Sheets will be same but our solutions will be way forward and more future oriented.
A Client’s Life Balance Sheet Approach: Human Capital & Core Capital
To better comprehend the financial position of an individual and to manage the associated risks by that individual—an economic balance sheet (or holistic balance sheet) can be used. A wealth manager will always see an individual’s assets that are made up of mainly two components - human capital and financial capital, which has its own risks to manage.
Human capital is the net present value of an investor’s future expected income weighted by the probability of surviving to each future age. For young professionals, human capital is vastly larger than all other balance sheet assets combined.
Financial capital includes tangible and intangible assets owned by an individual or household—such as residential property, vehicles, equities, fixed income investments, and bank deposits.
The Wilcox, Horvitz and Di Bartolomeo Model (2006)
In 2006, famous authors Wilcox, Horvitz and Di Bartolomeo developed the notion of a life balance sheet, which is a comprehensive accounting of an investor’s assets and liabilities, both explicit and implied:
- Explicit Assets: Readily marketable financial assets (stocks, bonds, liquid funds) and real estate.
- Implied Assets: Present value of employment earnings (human capital or net employment capital) and expected guaranteed pension benefits which provide distinct economic value.
- Explicit Liabilities: Readily identifiable debt obligations, mortgages, and personal loans.
- Implied Liabilities & Core Capital: Capitalised value of desired future life goals—funding children’s college education, funding a secure retirement, emergency safety reserves, and seed capital for business ventures. The capital required to maintain a given lifestyle, fund these goals, and provide reserves is designated as Core Capital.
- Excess Capital: An investor with more assets than liabilities on the life balance sheet has more capital than necessary to fund lifestyle and reserves; this surplus is Excess Capital that can be safely transferred to others or invested aggressively without jeopardising lifestyle. That is where accounting ends and wealth maximisation starts!
Exhibit 1: Structure of a Hypothetical Life Balance Sheet
| Assets (Portion % in Total) | Liabilities & Equities (Portion % in Total) |
|---|---|
|
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Let’s take the example of an individual who has just joined a large MNC firm after completing MBA from IIM and looking for advice about his taxation and current level of savings. The person should be guided to have a goal-driven approach rather than a consumption-driven approach, and informed about the life balance sheet approach and how his present level of assets and liabilities will keep evolving further with time. This enlightenment will encourage him to talk more about savings and investments rather than only focusing on his current level of taxation and earnings.
A traditional Balance Sheet approach enables us to understand marketable assets that exist today; however, it offers limited insights on how to optimally utilize these assets to maximise the expected lifetime value of the individual (a concept economists call “utility”). An accountant with a wealth maximisation objective can use the economic balance sheet approach to support his clients to comprehend how available resources can be put to use in funding life goals over the remaining lifetime. When we actually showcase the significance of human capital and other assets through the balance sheet approach, the attitude of the client shifts towards considering the Chartered Accountant as their primary guide for managing wealth.
Think Future: The Investment Policy Statement (IPS)
A Chartered Accountant generally advises clients regarding investments with respect to tax planning under Chapter VIA (Sections 80C to 80U). Besides taxation, he needs to address short-term, medium-term, and long-term goals of the client and map financial instruments based on cash flows, risk, return, loan repayments, insurance, retirement, and different financial needs in sync with tax planning—i.e., through an Investment Policy Statement (IPS).
“Financial Planning and wealth creation starts with IPS. It’s a transcript guide prepared between an advisor and the client that defines general rules for investment goals which meets the goals of a client and describes the plans that should be engaged to meet these goals.”
As an adviser, they should counsel the client by addressing priorities of goals to generate wealth. This counselling and discussion must include (but is not limited to) three core factors:
Calculated based on time horizon, the target amount required for a goal, and its present value.
Determined objectively by client’s age, time horizon, financial resources, and balance sheet risk capacity.
Subjective risk preference and emotional perception of market fluctuations and drawdown pain.
Investor Risk Profiling: The Traffic Signal Approach
A wealth manager should describe and identify acceptance for risk while designing an investment policy statement. He must acknowledge that portfolios are subject to risk. A structured diagnostic questionnaire should be administered to identify client behaviour:
Diagnostic Questionnaire Dimensions:
- In case of investment erosion due to a stock market crash, what action will the investor take?
- What is the investor’s practical experience with investment products?
- What is the investor’s preference towards holding volatile/risky assets?
- What is the investor’s depth of knowledge about capital and stock markets?
Data is adequate to take decisive action. The advisor can recommend a highly volatile growth portfolio (equities) for clients who maintain both high risk-taking ability and high loss tolerance, even if their risk need is moderate or low. Conversely, a low volatile portfolio is allocated when both risk ability and behavioural tolerance are low.
Indicates that the investor’s financial risk-taking ability is greater than their behavioural loss tolerance. This means investor education is required. The advisor must guide and impart market knowledge so that discussions address the client’s emotional attitude to become consistent with their objective risk-taking capacity.
Triggered when the required rate of return to accomplish the desired goals exceeds the investor’s risk-taking ability. This situation requires revaluating goals and re-establishing realistic expectations. Actionable recommendations are only possible once target aspirations and return requirements are adjusted downwards.
Client Requirements & The Indispensable Portfolio Approach
A Wealth Manager must talk with his client about their financial planning, life goals and share insights about wealth creation to make them aware about managing their assets to live a financially independent life. The solution is investing early to create wealth across three fundamental pillars:
Investments in growing assets (equities, mutual funds, debt instruments) create alternate income through dividends and interest, securing financial independence.
Building an independent retirement corpus enables a stress-free, healthy retirement where past savings work tirelessly for the individual.
Establishing separate dedicated investment funds for specific future milestones ensures focused discipline and prevents goal cannibalisation.
“I can break a single pencil, but I cannot break 50 pencils tied together.”
A portfolio consists of many uncorrelated assets, like equities, bonds, real estate etc. Clients often arrive with strong behavioural biases tilted towards a single asset class like real estate or speculative equities. We must educate them on the grave risks of putting all their money in highly correlated assets.
One of my friends made good money in equities over the long term, but all his money invested in the crypto market plunged by 50%. When I showed him that his combined portfolio return (equities + crypto) failed to even match fixed deposit returns, he finally understood the essence of the portfolio approach and embraced structured advice.
Conclusion: A Triple Growth Opportunity for Chartered Accountants
Wealth creation is simple when done right and advised right. Behaviour control, discipline and commitment to investing is the key to create wealth. The power of compounding can help in multiplying returns if the time horizon is long term. With various investment opportunities available in the market, it is essential to pick the right one that helps in wealth creation. Moreover, wealth creation aligned with life goals or financial goals, will help investors stay motivated.
“As a wealth advisor to the client, a Chartered Accountant can act as a guide to wealth creation. Providing financial education to your clients will not only help their growth, but for a professional accountant, it represents an unparalleled opportunity for financial, professional, and intellectual growth.”