How Mental Accounting differs from Financial Accounting
 
Developed by economist Richard H. Thaler, mental accounting describes how people place the face value of money based on the budgets or categories they make up in their minds(food budget, entertainment budget,etc.). People treat money differently, depending on factors such as the money’s origin and intended use, rather than thinking of it in terms of their formal accounting. People make up different budgets in their minds. Budgets exist for sensible, understandable reasons but they violate the principle of economics that money is fungible. To say money is fungible means that, regardless of its origins or intended use, all money is the same and should be used in whatever way best serves the interest. Despite the irrationality of mental accounting, many of us are bias and these habits often leave us less financially stable.
 
Individuals are prone to irrational decision-making in their spending and investment behavior. People separate their money sitting into a savings jar and another portion with debt at some interest rate payment. This goes against logic as the person can pay off the loan amount from his savings without accumulating interest payments. He just separates money in his head whereas money should be fungible according to the principle of Economics and should be used in the best way to optimize. 
 
When an amount of money has been spent and cannot be retrieved, it is said to be sunk. Individuals incur sunk cost fallacy when they behave as a result of a previously invested resource. Individuals sometimes order too much food and then over-eat just to get their money’s worth. As it makes us feel better about the transaction. Similarly, a person may have bought a $20 ticket to a concert and then drive for hours through a storm, just because he feels that he has to attend due to having made the initial investment. With ex-ante cost-benefit analysis, he decided to drive through the storm so that he can put the game into his made-up category of normal transactions and not into a loss even though the cost of driving through the storm is dangerous. After the ex post-cost-benefit analysis the evaluation might not be included in the account which here are the extra costs incurred - time, inconvenience.
 
Investors and Gamblers are often affected by mental accounting biases. Lottery winners are inclined to engage in more impulse spending because they mentally account for the gains as ‘unexpected profits’ whereas, had they earned their profits from their job, they would be less inclined to spend wildly. Money obtained from earning a salary and money associated with capital gains are treated differently. Capital gains make investors willing to risk an affordable loss. Mental accounting also concerns the frequency with which accounts are evaluated and ‘choice bracketing’. Accounts can be balanced daily, weekly, yearly, and so on in different time frames according to the choice of the individual. Investors prefer to have the losses as a whole and the gains separately. These Mental biases are inconsistent and irrational when compared with Financial values.