People have to take a variety of economic decisions concerning earning, spending, and saving money. These decisions are based on their own judgment, study and perception. Initially, experts in the area of finance were reluctant to accept the views of psychologists. Gradually, the influence of emotion and psychology on economic decision-making got greater attention. Traditional finance theory holds that every economic decision should be based on rational calculation of its effect on wealth position. Generally, people don't have computation skills and the willpower to evaluate such decision, in terms of their impact on wealth. People have the tendency to separate their money into different mental accounts, leading to the development of mental accounting. This article aims at understanding the role played by behavioral biases and mental accounting done by people while taking economic decisions.

In many cases, economic decisions are interrelated or dependent on each other. For instance, a decision to buy a new asset may make it necessary to postpone repairing the washing machine, or spending an enjoyable evening at a restaurant tonight may mean that there is less money to spend on the holiday in the coming month. In this way, people may see decisions as related. Dependencies are not restricted to simultaneous decisions. Both previous decisions or outcomes and future decisions or outcomes may be seen as related. Such relationships of decision and outcomes can be understood through the study of mental accounting. Mental accounting is that branch of Behavioral Finance, which can be better understood by observing the behavior of people. There is no well developed convention for this area.

Mental accounting has emerged as a new area of behavioral finance, which attempts to study the division of money that people make, while taking an economic decision. It describes the process, whereby people code, categorize, and evaluate economic outcomes on the basis of certain subjective criteria. Mental accounting is a type of framing, where people mentally divide their assets and income into buckets called mental accounts. Different decisions are made regarding money depending on the mental account, even though the value of money is the same in all the accounts created mentally. According to the theory, individuals assign different functions to each asset group, which often has an irrational effect on their decisions.

Richard Thaler is considered as the pioneer, who coined the term "mental accounting", which refers to the inclination to categorize and treat money differently, depending on where it comes from, where it is kept and how it is spent. In the minds of most people, value of money varies with circumstances. For instance, people will go out of their way to achieve a savings of Rs. 5 on purchase of goods worth Rs. 25, but won't go to the same trouble to save Rs. 5 on purchase of a CD worth Rs. 500. Let us consider some interesting situations, where mental accounting plays an important role. The value of money is treated differently for gift or found money and earned money, even when the amount and the value are equal in both the cases.

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