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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.
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.
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.
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.
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.
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