The Importance of Accounting in Our Daily Life

Accounting is one of the most essential disciplines for daily life. Not so long ago, people used physical checkbooks to track their spending and income. While these checkbooks have mostly been replaced with apps and digital tracking software, balancing a checkbook utilizes several of accounting’s core elements.

The importance of accounting in our daily life shows up everywhere, from tracking our spending to shopping for groceries to paying bills. Chances are, you've used some basic accounting principles already today.

In this article, you'll learn about the importance of accounting and see how some of its core elements can be applied in your daily life. By discovering the ways that accounting impacts you, you may even see how an online accounting degree may help prepare you to better manage your own personal finances.

Why Is Accounting Important in My Life?

When you hear the term “accounting,” you may think of offices full of certified public accountants (CPAs) preparing and filing tax returns. That’s understandable, but it’s actually a very general term that describes many different aspects of how we budget, spend, save and invest money.

Accounting plays an important role in your life, and, whether you’ve realized it or not, you’re most likely already applying accounting principles in several ways. For example, many of us have experienced having “too much month left at the end of the money.” If you manage a monthly household budget, you already know how to predict your income and expenses for the month, and must endeavor to budget carefully to be sure you can meet all of your financial obligations and have something to put into savings.

You also might use simple accounting procedures when working out a budget for a home improvement project, vacation or other occasional expenditure where you want to be careful not to overspend. Without basic accounting it would be almost impossible to keep track of our financial lives.

Let’s take a closer look at a few different aspects of accounting.

Budgeting

Setting a budget is one of the first and most important steps that any accountant does for a client or for themselves. To set a budget properly, you need to carefully analyze your income, fixed expenses and existing liquid assets. Once you've done that, you can see how those numbers line up with your financial goals. For instance, if you make $2000 a month and want to save $500 per month, you need to have less than $1500 per month in fixed expenses.

Spending

Budgeting well means balancing spending with income and making sure to leave money left over in case of an emergency or for savings should no unexpected emergencies occur.

Investments

The concept of appreciation is essential for investing money. Concepts like the time value of money (TVM), and a decent grasp of accounting principles can set you up to make wise investments for your future.

Taxes

A common interaction that most people have with accounting is during tax season. If you've kept up with tracking your expenses and income throughout the year, tax season will be easier.

Saving Money

Saving money is essential for building a budget that enables you to hit your goals and supplement spending, saving and investing.

PROJECT SELECTION UNDER RISK

Once information about expected and variability of return has been gathered, the next question is should the project be accepted or rejected?. There are several ways of incorporating risk in the decision process. Judgmental evaluation, payback period requirement, risk adjusted discount rate, and certainty equivalent.

Judgmental Evaluation

Often managers look at the risk and return characteristics of a project and decide judgmentally whether the project should be accepted or rejected, without using any formal method for incorporating risk in the decision making process. The decision may be based on the collective view of  some group like the capital budgeting committee or executive committee or the boar of directors. If judgmental decision making appears highly subjective or haphazard, consider how most of us make important decision in our personal life. We rarely use formal selection methods or quantitative techniques for choosing a career or spouse or an employer. Instead we rely on our judgement.

Payback Period Requirement

In many situations companies use NPV or IRR as the principal selection criterion, but apply a payback period requirement to control for risk. Typically if an investment is considered more risky, a shorter payback period is required even if the NPV is positive or IRR exceeds the hurdle rate. This approach assumed that risk is a function of time 

Ordinarily it is true that father a benefit lies in future the more uncertain it is likely to. E because economic and competitive conditions tend to change over time. However risk is influenced by things other than the mere passage of time. Hence the payback period requirement may not be an adequate method for risk adjustment or control.

Risk adjusted discount rate

The risk adjusted discount rate method calls for adjusting the discount rate to reflect project risk. If the risk of the project is equal to the risk of the existing investments of the firm, the discount rate used is the average cost of capital of the firm, I f the risk of the project is greater than the risk of the existing investments of the firm, the discount rate used is higher than the average cost of capital of the firm. If the risk of the project is less than the risk of the existing investments of the firm the discount rate used is less than the average cost of capital of the firm.

PAYBACK PERIOD

The payback period is the length required to recover the initial cash outlay on the project. For example if a project involves a cash outlay of Rs600000 and generates cash inflows of Rs 100000, Rs 150000 Rs 150000 and Rs 200000, in the first, second, third, and fourth years, respectively, its payback period is 4 years because the sum of cash inflows during 4 years is equal to the initial outlay divided by the annual cash inflows. For example a project which has an initial cash outlay of Rs 1000000/300000=3 1/3 years.
According to the payback criterion, the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period. If this is n years, projects with a payback period of n years or less are deemed worthwhile and projects with a payback period exceeding n years are considered unworthy.

Evaluation

A widely used investment criterion, the payback period seems to offer the following advantages.

1. It is simple, both in concept and application. It does not use involved concepts and tedious calculations and has few hidden assumptions.

2. It is a rough and ready method for dealing with risk. It favours projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years but not in earlier years. Now if risk tends to increase with futurity in general, this may be true the payback criterion may be helpful in weeding out risky projects.

3. Since it emphasises earlier cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.

PROJECT CLASSIFICATION

Project analysis  entails time and effort. The costs incurred in this exercise must be justified by the benefits from it. Certain projects, given their complexity and magnitude may warrant a detailed analysis other may call for a relatively simple analysis. Hence firms normally classify projects into different categories
 Each category is then analysed somewhat differently.
While the system of classification may vary from one firm to another, the following categories are found in most classifications.

Mandatory investment

These are expenditures required to comply with statutory requirement. Examples of such investment are pollution control equipment, medical dispensary, fire fighting equipment, creche in factory premises, and so on. These are often non revenue producing investments. In analysing such investments, the focus is mainly on finding the most cost effective way of fulfilling a given statutory need.

Replacement projects

Firms routinely invest in equipment meant to replace obsolete and inefficient is to reduce costs, increase yield and improve quality. Replacement projects can be evaluated in a fairly straightforward manner, though at times the analysis may be quite detailed.

Expansion projects

These investments are meant to increase capacity and/or widen the distribution network. Such investments call for an explicit forecast of growth. Since this can be risky and complex, expansion projects normally warrant more careful analysis than replacement projects. Decisions relating to such projects are taken by the top management.

Diversification projects

These investments are aimed at producing new products or services or entering into entirely new geographical areas. Often diversification projects entail substantial risks, involve large outlays, and require considerable managerial effort and attention. Given their strategic importance, such projects call for a very thorough evaluation, both quantitative and qualitative. Further they require a significant involvement of the board of directors.

Research and development projects

Traditionally, R&D projects absorbed a very small proportion of capital budget in most Indian companies. Things however are changing. Companies are now allocating more funds to R&D projects, more so in knowledge intensive industries.R&D projects are characterised by numerous uncertainties and typically involve sequential decision making. Hence the standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgement. Firms which rely more on quantitative methods use decision tree analysis and option analysis to evaluate R&D projects.

Miscellaneous projects

This is a catch all category that includes items like interior decoration, recreational facilities, executive, landscaped gardens, and so on. There is on personal preferences of top management.

DISTINCTION AMONG VALUATION CONCEPTS

The term value is used in different senses. Hence, let us briefly review the differences that exist among the major concepts of value.

Liquidation value versus going concern value

The liquidation value is amount that can realised when an asset or a group of assets representing a part or even the whole of a firm is sold separately from the operating organisation to which it belongs. In contrast the going concern value represents the amount that can be realised if the firm is sold as a continuing operating entity.

In general security valuation models assume a going concern an operating business entity that generates cash flows to its security holders. When the going concern assumption is not appropriate as in the cash of an impending bankruptcy, liquidation value of assets is more relevant in determining the worth of the firm's financial securities.

Book value versus market value

The book value of an asset is the accounting value of the asset, which is simply the historical cost of the asset less accumulated depreciation or amortisation as the case may be. The book value of a firm's equity is equal to the book value of its assets minus the book value of its liabilities. Because the book value reflects a historical accounting value it may diverge significantly from the market value.

The market value of an asset is simply the market price at which the asset trades in the market place. Often the market value is greater than the book value.

Market value versus intrinsic value

As the nomenclature suggests, the market value of a security is the price at which the security trades in the financial market.

The intrinsic value of a security is the present value of the cash flow stream expected from the security, discounted at a rate of return appropriate for the risk associated with the security. Put differently, intrinsic value is economic value. If the market is reasonably efficient, the market price of the security should hover around its intrinsic value. 

SALES FORECAST

The sales forecast is typically point of the financial forecasting exercise. Most of the financial variables are projected in relation to the estimated level of sales. Hence the accuracy of the financial forecast depends critically on the accuracy of the sales forecast.
Although the financial managers may participate in the process of developing the sales forecast, the primary responsibility for if typically vests with the marketing department or planning group.
Sales forecast may be prepared for varying planning horizons to serve different purposes. A sales forecast for a period of 3-5 years. Of for even longer durations, may be developed mainly to aid investment planning. A sales forecast for a period of one year is the primary basis for the financial forecasting exercise discussed in this chapter. Sales forecasts for shorter durations may be prepared for facilitating working capital planning and cash budgeting.
A wide range of sales forecasting techniques and methods are available. They may be divided into three broad categories.

* Qualitative Techniques

These techniques rely essentially on the judgement of experts to translate qualitative information into quantitative estimates.

* Time series projection methods

These methods generate forecasts on the basis of an analysis of the past behaviour of time series.

*  Causal models

These techniques seek to develop forecast based on cause effect relationship expressed in explicit quantitative manner.

WHAT AND WHY OF FINANCIAL PLANNING

A long term financial plan represents a blueprint of what a firm proposes to do in the future. Typically it covers a period of three to ten years most commonly it spans a period of five years. Naturally planning over such an extended time horizon tends to be in fairly aggregative terms. While there is considerable variation in the scope, degree of formality and level of sophistication in financial planning across firms, most corporate financial plans have certain common elements. These are.

1. Economic assumptions

The financial plan is based on certain assumptions about the economic environment.

2. Sales forecast

The sale forecast is typically the starting point of the financial forecasting exercise. Most financial variables are related to the sales figure.

3. Pro forma statements.

The heart of a financial plan are the pro forma profit  and loss account and balance sheet.

4. Asset requirements

Firms need to invest in plant and equipment and working capital. The financial plan spells out the projected capital investment and working capital requirements over time.

5. Financing plan

Suitable sources of financing have to be thought of for supporting the investment in capital expenditure and working capital. The financing plan delineates the proposed means of financing.

6. Cash budget

The cash budget shows the cash inflows and outflows expected in the budget period.