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.

LEVERAGES

Leverage arises from the presence of fixed costs in a firm's cost structure. It is useful to classify leverage as operating and financial leverage.

Operating Leverage

Operating leverage stems from the presence of fixed costs. When a firm has fixed operating costs, a change in 1 percent in sales results in a change of more than 1 percent in PBIT.

Financial leverage

Financial leverage arises from the use of fixed cost financing. When a firm has fixed cost financing a change in 1 percent in PBIT  results in a change of more than 1 percent in earnings per share.

Total leverage

Total leverage refers to the combination of operating leverage and financial leverage. Thanks to the presence of fixed operating costs and fixed financing costs, a given change in sales is translated into a larger relative change in earnings pet share through  a two step magnification process.

BREAK EVEN ANALYSIS

Like ratio analysis, break even analysis also called cost volume profit analysis, is a tool for financial analysis. It is primarily concerned with the following issues.
1. How profit varies with changes in output?
2. How profit varies with changes in costs prices?

Basic Assumptions

A simple tool for profit planning and analysis,break even analysis is based on several assumptions

Cost classification

The break even model assumes that the costs of the firm can be divided into two components.

A. Fixed costs

B. Variable costs.

Fixed costs remain constant irrespective of the changes in output. They include items such as managerial and supervisory salaries, depreciation charges, property tax, rent, interest on term loans, insurance and so on. Variable costs vary proportionately with output. They include items like material cost, power cost, and selling commission.

Constancy of unit selling price

This implies that the total revenue of the firm is a linear functions of the output. For firms which have a strong market for their products, this Assumptions is quote valid. For other firms, however it may not be so. Price reduction might assumption and not unrealistic enough to impair the validity of the cost volume profit model, particularly in the relevant range of output.

Stability of product mix

In the case of a multi product firm, the cost volume profit model assumes that the product mix of the firm remains stable. Without this premise, it is not possible to define the average variable profit ratio when different products have different variable profit ratios. While it is necessary to make this assumption, it must be borne in mind that the actual mix of products may differ from the planned one. Where this discrepancy is likely to be significant, cost volume profit model has limited applicability.

No change in inventory

A final assumption underlying the conventional cost volume profit model is that the volume of sales is equal ti the volume of production during an accounting period. Put differently inventory changes are assumed to be nil. This is required because in cost volume profit analysis, we match total costs and total revenues for a particular period

CLASSIFIED CASH FLOW STATEMENT

The statement presented above lumped together all sources of cash and uses of cash. To understand better how cash flows have been influenced by various decision, it is helpful to classify cash flows into three classes.

Operating activities

Operating activities involve producing and selling goods and services. Cash inflows from operating activities include monies received from customers for sales of goods and services. Cash outflows from operating activities include payments to suppliers for materials to employees for services, and to the government for taxes.

Investing activities

Investing activities involve acquiring and disposing fixed assets,buying and selling financial securities and disbursing and collecting loans. Cash inflows from investing activities include receipts from the sale of assets recovery of loans and collection of dividend and interest. Cash outflows from investing activities include payments for the purchase of assets and disbursement of loans.

Financing activities

Financing activities involve raising money from lenders and shareholders, paying interest and dividend, and redeeming loans and share capital. Cash inflows from financing activities include receipts from issue of securities and from loans and deposits. Cash outflows from financing activities include payment of interest on various forms of borrowings, payment of dividend, retirement of borrowings and redemption of capital.

GUIDELINES FOR FINANCIAL STATEMENT ANALYSIS

From the foregoing discussion, it is clear financial statement analysis can not be treated as a simple, structured exercise. When you analyse financial statement bear in mind the following guidelines.

1. Use ratios to get clues to ask the right questions.

By themselves ratios rarely provide answers, but they definitely help you to raise the right questions.

2. Be selective in the choice of ratios

You can compute scores of different ratios and easily drown yourself into confusion, for most purpose a small set of ratios three to seven would suffice. Few ratios aptly chosen, would capture most of the information that you can derive from financial statements.

3. Employ proper benchmarks

It is a common practice to compare the ratios against some benchmarks. These benchmarks may be the average ratios of the industry or the ratios of the industry leaders or the historic ratios of the firm itself.

4. Know the tricks used by accountants

Since firms tend to manipulate the reported income, you should learn about the devices employed by them.

5. Read the footnotes.

Footnotes sometimes contain valuable information. They may reveal things that management may try to hide. The more difficult it is to read a footnote, the more information laden it may be.

6. Remember that financial statement analysis is an odd mixture of art and science

Financial statement analysis can not be regarded as a simple, structured exercise. It is a process requiring care, thought,common sense, and business judgement a process for which there are no mechanical substitutes.

FINANCIAL MARKETS AND FUNCTIONS

A financial market is a market for creation and exchange of financial assets. If you buy or sell financial assets, you will participate in financial markets in some way or the others

Functions of Financial Markets

Financial markets play a pivotal role in allocating resources in an economy by performing three important functions.

1. Financial markets facilitate price discovery

The continual interaction among numerous buyers and sellers who throng financial markets helps in establishing the prices of financial assets. Well organised financial markets seem to be remarkably efficient in price discovery. That is why financial economists say. If you want to know what is value of financial assets simply look at its price in the financial market.

2. Financial markets provide liquidity to financial assets.

Investors can readily sell their financial assets through the mechanism of financial markets. In the absence of financial markets which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished. Thanks to negotiability and transferability of securities through the financial markets, it is possible for companies to raise long term funds from investors with short term and medium term horizons. While one investor is substituted by another when a security is transacted, the company is assured of long term availability of funds.

3. Financial markets considerably reduce the cost of transacting

The two major costs associated with transacting are search costs and information cost. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the effort and time one has to put in to locate a customer. Information costs refer to costs incurred in evaluating the investment merits of financial assets.

FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system performs the following interrelated functions that are essential to a modern economy.
A. It provides a payment system for the exchange of goods and services.
B. It enables the pooling of funds for undertaking large scale enterprises.
C. It provides a mechanism for spatial and temporal transfer of resources.
D. It provides mechanisms for managing uncertainty and controlling risk.
E. It generates information that helps in coordinating decentralised decision making.
F. It helps in dealing with the incentive problem when one party has an informational advantage.

FINANCIAL DECISIONS IN A FIRM

There are three broad areas of financial decision making viz. Capital budgeting, capital structure, and working capital management.

Capital Budgeting

The first and perhaps the most important decision that any firm has to make is to define the business or businesses that it want to be this decision has a significant bearing on how capital is allocated in the firm.

Once the managers of a firm choose the business or businesses they want to be in, they have to develop a plan to invest in building, machineries, equipments, research and brands, and other long lived assets. This is the capital budgeting process.

Capital structure

Once a firm has decided on the investment projects it wants to undertake, it has to figure out way and means of financing them.

The key issues in capital structure decision are.

A. What is the optimal debit-equity ratio for the firm?

B. Which specific instruments of equity and debit finance should the firm employ?

C. Which capital markets should the firm access?

D. When should the firm raise finance?

E. At what price should the firm offer it's securities?

Capital structure and dividends decisions should be guided by considerations of cost and flexibility, in the main. The objective should be to minimise the cost of financing without impairing the ability of the firm to raise finance required for value creating investment projects.

Working capital management

Working capital management also referred to as short term financial management refers to the day to day financial activities that deal with current assets and current liabilities.

BILL OF EXCHANGE

An instrument in writing containing an unconditional order. Signed by the maker, directing a certain person. To pay a certain sum of money only to or to the order of a certain person or the the bearer of the instrument. It means that if an order is made in writing by one person on another directing him to pay a certain sum of money unconditionally to a certain person or according to his instruction or to the bearer, and if that order is accepted by the person on whom the order was make, the documents is a bill of exchange.

Essentials of a bill of exchange

1. It should be in writing.

2. It should contain an order by the seller to the purchaser to make the payment in future does not amount to a bill of exchange.

3. The order contained in the biol should be unconditional. A bill of exchange with a conditional order can not be made payable.

4. The maker of the bill or the seller is known as drawer and the bill must be signed by him otherwisee. It will be invalided.

5. The purchaser upon whom the bill is drawn is known as drawee and he must be a certain person.

6. Amount ordered to be paid by the drawer in a bill must be certain and it should be in money alone and not in goods.

7. The person to whom payment of bill is to be made is known as payee and he must be a certain person or the bearer of the bill

MEANING, IMPORTANCE AND LIMITATIONS OF FINAL ACCOUNTS

Any business is started with an objective of earning profits. As such the business concerns are interested to know
A. Results of the business I.e. profit earned or loss incurred during the year will be calculated by preparing trading and profit and loss account which is also known as income statement.
B. Financial position of the business I.e. assets and liabilities at the year end will be calculated by preparing balance sheet.
The above two are Aldo called as financial statement since they show the financial results and financial position of the business. They are also called as final accounts as they are prepared at the end of the accounting cycle. I.e., transaction, journal/subsidiary books, ledger, trail balance and final accounts

Importance of final accounts.

1. Reveals financial results of the business i.e., profit or loss

2. Reveals financial position of the business I.e., assets and liabilities .

3. Liquidity and solvency of the business can be understood.

4. Helps in tax calculation.

Limitations of final accounts

1. Profit or loss true picture can not be calculated

2. Assets and liabilities values also not accurate

3. Window dressing is possible in preparing final accounts

4. Personal options of accountants/owners will influence final accounts to some extent.

PREPARATION OF TRIAL BALANCE- PRICEDURE

1. As the trial balance is prepared on particular date that particular date should be shown in the head of trial balance.
2. Trial balance is prepared in the form of statement containing so no, Name of the account, ledger Folio, debit balance and credit balance.
3. The debit balance of the accounts are to be written in debit column, where as credit balanced of the accounts to be written in the credit column of trial balance. The totals of both columns should be equal, it proves arithmetical accuracy.

Aspects to be considered while preparing trial balance

First prepare the format of trial balance showing heading with date on which it is prepared. Whenever the balance of ledger accounts are given based on the nature of the account decide whether the account us debit or credit.

Generally the accounts which show debit balance are the accounts of various assets, expenses and losses, debtors, drawings etc. The accounts which show credit balance are capital accounts, loan a/c, profit and gains a/c etc.

METHODS OF PREPARING TRIAL BALANCE

A trial balance can be prepared in the following two methods.

1. Totals method

Under this method, debit total and credit total of each accounts of ledger are recorded in trial balance. In this method, all accounts of ledger without balancing them will be totalled and recorded in trial balance in their respective rows.

2. Balances method

Under this method, only balance of each account in ledger is found out and recorded in trial balance. All the accounts at end of the year are balanced from the view point of trial balance. All the accounts may be grouped into the following three types.

A. Account showing debit balances.

B. Account showing credit balance

C. Account showing nil/ no balance

While preparing the trial balance all the accounts with debit balance are shown on the debit side of the where as all the accounts with credit balances are shown on the credit side of trial balance.

MERITS AND DEMERITS OF TRIAL BALANCE

Merits of trial balance

1.  It helping in finding out the arithmetical accuracy of the accounts in the ledger.

2. Trading, profit and loss account and balance sheet are prepared on the basis of trial balance.

3.it will help in detecting the errors in the books of accounts and in their rectification.

4. Trial balance enables us to know balance of all accounts in one place.

Demerits of Trial balance

1. Trial balance tallied even though errors are existing in the books of accounts.

2. It is only possible to prepare trial balance of an organization, if the double entry system is followed, which is costly and time consuming.

3. Even if some transactions are omitted the trial balance tallies

4. Trial balance us not prepared in a systematic method the final accounts prepared. On the basis of trial balance do not depict the actual financial position of the concern.

TRIAL BALANCE, FEATURES OF A TRAIL BALANCE

Trial balance is a statement in which debit and credit balances of all ledger accounts are shown to test the arithmetical accuracy of the books of account. Trial balance is ledger is not conclusive proof of accuracy of books of accounts.

Features of a trial balance

1. It is not an account, it is only a statement which is prepared to verify the arithmetical accuracy of ledger accounts.

2. It contains debit and credit balances of ledger account.

3. It is prepared on a particular date generally at the end of business year.

4. Trial balance helps in preparing final accounts.

5. As it is prepared by taking up the ledger account balance, both debit and credit side of a trial balance are always equal.

6. The preparation of trial balance is not compulsory. There is no hard and fast rule in this regard.