Personal Accounting Essay

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Personal accounting is the counterpart of business accounting and represents  the set of behaviors needed to manage the financial processes of an individual or household so that income is sufficient to cover expenses and leave a remainder for investment.  While the two worlds  of business and personal  accounting will inevitably  intersect,  with business owners responsible for both, it is generally preferable   to  keep  the  two   separate   whenever possible  to avoid  conflicts  of interest  and potentially  illegal commingling  of funds.

Process

The acquisition of financial  resources  for personal use is, ironically, perhaps  the most straightforward task  associated  with  personal  accounting. All of the other steps in the process require careful attention to detail and monitoring to make sure that the estimates  one makes about  the future  are accurate or, if they are not, that  one’s financial plans can be adjusted  to accommodate the variance.

Financial planning is used in personal accounting just as it is in the world  of business  and  likewise involves  a  cyclical  series  of  steps.  The  first  such step  is  to  take  stock  of  one’s  current   financial position.  This requires  one to review all available financial statements and any other documents pertaining to income, investment, debt, and expenditure  in   order   to   ascertain   how   much money  is owed,  how  much  has  been  saved,  and how  much  comes  in  on  a  regular   basis.  Some people use a personal  balance sheet to record all of this information in one place, making  it easier to refer to multiple categories.

Once the current state of one’s personal  finances has been established,  the next step is to make a list of goals one would  like to accomplish  pertaining to  money.  Short-term financial  planning   of  this sort may have only one goal, such as saving money for a new car, but in most cases people find it necessary to work toward multiple personal  financial goals at the same time. Typical  goals include saving for retirement, setting aside funds for children’s  education, saving  for  a  vacation,   and paying off student  loans or credit card debt.

After taking stock and establishing goals, and before   any   further   action   can   be  taken,   it  is necessary to identify ways to accomplish  the goals. While this can seem like an overwhelming  task, in many  cases it comes  down  to  reducing  expenses, increasing  income,  or  using  the  current   level  of income  in  a  different   way.  A  family  saving  to install  a  swimming  pool  might  choose  to  cancel their  cable television  subscription and  instead  use that  money  to  save up  for  the  pool.  Or  a young woman   who   wants   to   purchase   a  motorcycle might take a second job to increase her income sufficiently to afford  the payments.

Once a plan has been developed, it must be implemented. Often  the most difficult part  of achieving a financial  goal is sticking with the plan one has developed. Much like dieting, sticking to a budget   to   reach   a  financial   objective   requires delaying gratification, and this is a skill that  many struggle with, since our natural tendency  seems to be   to   live   for   today    instead    of   saving   for tomorrow.

Finally, as the plan  proceeds,  it is important to stop   periodically   and   evaluate   how   things   are going.  This  is especially  true  of  long-term   plans because each day that  passes brings the possibility of changes to life circumstances that  could have a major  impact  on  how  well  the  plan  aligns  with one’s needs. A couple  that  has  been  saving  every penny for 3 years for a trip around the world may very well decide to cancel their travel plans if they find  out  that  they  are  going  to  have  a baby,  for example.  Even  in  less extreme  situations, it  is a good idea to occasionally take stock of the financial plan’s progress  and think  about  any modifications that  might  be  necessary.  It  is quite  common  for people  to invest a part  of their  retirement savings account  in instruments such as stocks  and  bonds only to decide several years later  that  the rate  of return   on  those   instruments  is  not   what   they would  like  it  to  be.  One  of  the  basic  tenets  of personal   accounting is that,  despite  all  the  time and   efforts   taken   to   create   a   financial   plan, the  plan  is not  set in stone.  Needs  and  priorities change as time passes, and financial  plans need to change   as  well.  For   this   reason,   the   financial planning  process is best understood as an ongoing cycle rather than a finite task with a clear beginning and ending. Personal  accounting works  best when it is followed  like a fitness routine, with  continuous  attention  to  goals,  performance  evaluation, and periodic reassessment  of the original  goals.

Products

There  are many  different  financial  instruments to choose from when approaching personal  accounting. Each such tool  has strengths  and  weaknesses that  make it more suitable for some purposes  than for  others.  The  most  complex  category  for  most people to understand contains  the investment products: stocks, bonds, and mutual  funds. Each of these allows an investor  to purchase  an asset that will (hopefully)  appreciate in value  over  time, so that  the investor  earns  money  on the investment. In   the   context   of   personal   accounting,  these earnings then become available for whatever  goals one has established.

Stocks, also known  as securities, are portions of ownership  in  a  corporation.  Stocks  permit   the owner  to  participate in  the  management of  the corporation  and   to   share   in  the   corporation’s profits,  if there  are  any.  Stocks  produce  income either  through dividends,  which  are  divisions  of overall  profit  distributed according  to how  many shares of stock  one owns, or by manipulating the stock market  to buy a stock at a low price and sell it  later  at  a  higher  price.  Bonds  are  somewhat different from stocks. Bonds are issued by a government body or a corporation to raise capital that  must  eventually  be repaid  with  interest.  For example,   a  city  desiring   to  upgrade   its  library might pass a bond issue to raise the money; the city would  issue and  sell bonds  at a specified interest rate and payment  schedule. These bonds  would  be purchased by investors  seeking a safe, guaranteed return   on  their   money.  Mutual  funds   combine features  of stocks  and  bonds;  they are essentially bundles  of stocks,  bonds,  and  similar  investments that are professionally managed on behalf of investors. The fund  managers  aggregate  various  stocks and  bonds  into  one fund  so that  investors  do not have to purchase  each of the stocks and bonds  in the bundle  individually—they can simply invest in the fund.

Another type of investment product widely used in  personal   accounting  is  insurance.   There   are many  types  of  insurance  available  for  purchase: car insurance, health insurance, unemployment insurance, renter’s insurance, medical insurance  for pets, and so on. Each of these is both an investment and an attempt at managing  risk. Part of personal accounting  involves   determining  whether   it  is better,  for example,  to not  carry  health  insurance and use the money that  would  have been spent on premiums  for other  goals or to reduce  the risk of catastrophically  expensive   illness  or   injury   by paying for insurance. There are also some life insurance  policies that  bear  similarities  to savings accounts. Term life insurance  is in effect for a fixed period provided that the premiums  are paid during that  period,  but when the period  ends so does the policy.  Whole  life insurance,  on  the  other  hand, includes  a  cash  account   that  accumulates   like  a savings account  and even pays dividends.

Finally,  personal  accounting also  relies on  the financial  tools with  which most of us are already familiar.  These  tools  are  bank  products such  as loans,  checking  accounts,   savings  accounts,   and credit cards. Most  people find that  it is necessary to use a combination of these tools, since no single one offers all of the options  necessary to conduct financial  transactions and monitor one’s position. The typical  person  will have loans  for his or her home   and   car,  a  savings  account   to  set  aside money for the future,  and a checking account  for making  payments.  Even though  credit cards come with  steep  interest   rates  attached, most  people find it convenient  to have at least a few of these also.

Planning

Personal accounting uses the tools described above in several different types of organization and planning.  One such area is estate planning,  though it is one that  many  people  prefer  not  to contemplate.   Estate   planning   involves   deciding   how one’s property will be distributed on one’s death. This property can include real estate, personal possessions,   cash,  and,  in  some  cases,  rights  to receive future benefits. These assets can be distributed to friends and relatives, donated to charitable organizations, or otherwise  disposed of. It is also not uncommon for people to revise their estate  plans  from  time  to  time.  Sometimes  this happens  because the person designated  to receive a certain  property dies  before  the  planner  or  they become estranged  and the planner  decides to leave the  property to  someone  else. Regardless  of who receives property from  the  estate,  it is crucial  to factor in the tax consequences of bequests (property distributed on death) so that the recipient does not receive a tax bill along with the property.

Setting and  achieving  investment  goals is what most people think  of when they think  of personal accounting. As discussed  in the  section  above  on goal setting, this involves deciding what one wishes to  achieve,  determining what  types  of  saving  or investments  are necessary  to reach  that  goal, and then implementing the plan. An important consideration  in this  process  is the  need  to  balance  the two forces of interest and inflation as one considers how  much  to  invest  and  in  what  instrument to invest.  These  forces  affect  what   an  investment made  today  will be worth  in the  future.  Interest has the effect of increasing  the value of the investment, because the interest rate is the percentage  of the invested principal that will be added to the principal  during each investment  period; for example, $20,000 invested at an annual  interest  rate of 5 percent  will mean  a return  of $1,000 per year. This sounds enticing—until one recalls that money decreases in value with the passage of time because of the effects of inflation.  So in the previous example, if the economy  experiences 3-percent  inflation during  the  year  that  the  $20,000 is in the  bank, then even though  the investment  at the end of the year will have a dollar value of $21,000, the effects of inflation will mean that the purchasing power of this  money  is about  $20,630 ($21,000 minus  3 percent). Some money has still been earned but not as much as first estimated. Thus, personal  accounting  requires   one  to  select  investments   that   are likely to achieve growth  in value while remaining relatively  unaffected  by  inflation  or,  if not  unaffected,   at   least   able   to   significantly   outpace inflation.

One  of  the  goals  most  personal   accountants work  toward is saving for retirement. This can be a very complex matter  because it involves making predictions  about   many  different   contingencies, such as the state of one’s health and that of family members, the value of one’s home, the future costs of  necessities  like  food  and  utilities,  and  so  on. There are a wide array  of options  for setting aside money  for  retirement, from  the  Social  Security system,  administered by the  government, to  privately held pension plans and retirement accounts. One must also factor in the stability of the organization  one  relies on  for  retirement benefits,  particularly in the case of pensions from private companies. There have been a number  of instances in which companies  have filed for bankruptcy and only then  has it been discovered  that  the company’s pension funds are insolvent, meaning that  the retirement accounts   past  and  present  employees had been depending  on were no more.

Planning  for  taxes  is another major  factor  in personal  accountancy. Just as one does not wish to pass  on  a tax  burden  along  with  a gift to  one’s heirs, no one wants  to spend the energy needed to manage    one’s   finances   carefully   only   to   be surprised  at  the  end of the  year with  a huge tax bill from  the government. Each step that  is taken in creating  a financial plan must include an analysis of the tax implications  of that  step. As was the case with inflation,  many investments  seem promising at first, until  one remembers  that  taxes  will have  to  be  paid  on  whatever  amount is earned. This is not to say that the picture is hopeless; there are many deductions available that allow investors to either pay a lower rate or avoid being taxed  on a given investment  at all. The government permits these  deductions to  encourage   various  types  of activity,  such  as having  children,  starting  a business, or  buying  one’s first  home.  The  trick  is to remember  to work out the tax details at the outset and  thus   avoid  unpleasant  surprises   down   the road.

Such unpleasant surprises  can appear  in forms other than unanticipated taxation. Protection against  risks like death  or disability,  liability,  and long-term   medical  care  is  an  important part  of personal  accounting. The main  tool  used to mitigate such risks is insurance.  This involves the purchase  of an insurance  policy targeted  toward the specific risk anticipated or self-insuring  by setting aside money to be used if the need arises. In most cases, purchasing insurance  is the preferred  option because  of  the  amount  of  money  that   may  be needed; long-term  medical care can cost hundreds of thousands of dollars or even millions of dollars, and most people do not have that much money available to set aside for something  that may never be needed. Purchasing  insurance  allows one to pay a  small  amount regularly  to  make  sure  that  the insurance  company  will pay if the triggering event (death,  disability,  etc.) occurs.

Each  of  the  above  planning   activities  is  premised on  an  awareness  of one’s current  financial position—how much money is coming in and how much  is expected  to  go out.  This  means  that  the most basic task for personal  accounting is to continuously  monitor one’s financial  resources,  making adjustments as needed to address shortfalls and allocating  the occasional  surplus  in ways that  will pay off in the future. The clear perspective on one’s financial  position  that  this provides  makes it possible to engage in the other  planning  activities  of tax preparation, estate planning,  risk management and insurance  purchasing, goal setting, and saving for retirement.

Tools

There  are  many  options   from  which  to  choose when  selecting  a  personal   accounting approach; the determinative factor is usually personal preference.   Some  people   are   most   comfortable with traditional paper-and-pencil tracking  of income and  expenses,  but  many  prefer  the convenience and relative sophistication of computer software.  At the  most  basic  end  of the  software spectrum,  users  may  track  their  finances  with  a simple spreadsheet, which allows the user to enter formulas, perform  automated calculations, and generate visually appealing presentations that summarize  data  in the form of pie charts,  bar  graphs, and other  diagrams.

For  those  with  more  sophisticated needs,  particularly  those  involving  investment   instruments such as stocks,  bonds,  and  mutual  funds,  there  is also  the  option  of money  management software, sometimes called personal  accounting or home accounting  software.   These   applications  offer much more than simply adding up columns of numbers;  they can also be of assistance  with  goal setting.   The   user   can   define   a  goal,   such   as purchasing a sailboat, and the software will analyze the financial history of the user and make recommendations  as  to   how   the   goal   can   be achieved,  be  it  through selling  stock,  creating  a savings account  for the boat, or requesting  a bank loan for the purchase  price. Some of these applications can also be configured  to use the Internet  to connect  directly  to  the  user’s  financial  accounts, from  which they can extract  information without the user having to manually enter all of the transactions—a huge time saver but also a potential security risk that  some prefer to avoid.

The explosion  of the mobile computing  market has added even more tools to the personal  accountant’s toolbox, in the form of applications (“apps”) that one can install on a smart phone or tablet computer. This allows users to track their expenses as  they  shop  and  spend,  rather   than  saving  the work to be performed in a (often dreaded) monthly or weekly accounting session. Some of these apps even  allow  one  to  take  a picture  of a receipt  in order to enter it into the mobile accounting system, eliminating  the need for typing at all. Clearly, such a system offers huge advantages because it allows one to have an accurate  picture  of one’s finances with  very little required  in the way of bookkeeping. The downside  is that  some of the technology is so easy to use that  it attracts the less technologically sophisticated, who  may encounter problems that  result in the loss of their data. The frustration that  this  entails  can  act  as an  added  disincentive for taking  an active role in financial  management, an already  stressful subject.

Bibliography:

  1. Bach, David. Debt-Free for Life: The Finish Rich Plan for Financial Freedom. New York: Crown Business, 2010.
  2. Kay, Ellie. Half-Price Living: Secrets to Living Well on One   Chicago:  Moody  Publishers, 2007.
  3. Quinn, Jane B. Smart and Simple Financial Strategies for Busy People. New York: Simon & Schuster, 2006.
  4. Riggs, Thomas and Mary  Everyday  Finance: Economics, Personal Money  Management, and Entrepreneurship. Detroit, MI: Gale Cengage Learning, 2008.
  5. Rosenberg, Sharon H. The Frugal Duchess: How  to Live Well and Save Money.  Los Angeles: DPL Press, 2008. Stouffer, Tere. The Everything Budgeting  Book:  Practical
  6. Advice for Spending  Less, Increasing Savings, and Having  More Money  for the Things You  Really Want. Avon, MA: Adams Media,
  7. Stouffer, Tere. The Only Budgeting  Book  You’ll Ever Need. Avon, MA: Adams Media, 2012.

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