Corporate Rights, Responsibilities, and Authority

SOX: Audit committee:

Independent directors, choose, compensate, oversee, and terminate outside auditors

Whistleblower coverage

Certification of CEO and CFO:

review of annual reports, not materially misstated annual reports, fairly stated annual
reports

ICFR, design of control, evaluated effectiveness of control, conclusions, SD and MW in

controls, any fraud, significant post-evaluation changes in controls

Don't mislead auditor

Disclosure of Pro Forma and reconciliation

Code of ethics for financial officers or why they don't have one

Cannot loan money to top officers

Can claw-back wrong doing bonuses

Dodd-Frank Act

Extended the time to file a complaint with OSHA from 90 days to 180 days.

Extended the right to sue to whistleblowing employees of private subsidiaries controlled by public
companies.

Granted whistleblowers the right to a jury trial in retaliation cases that are properly filed in federal
court.

"Financial expert" (which the SEC has done in detail), the Commission shall consider whether a person
has through education and experience acquired: (1) an understanding of GAAP and financial statements;
(2) experience in (a) preparation of financial statements and (b) application of such principles in
connection with the accounting for estimates, accruals, and reserves; (3) experience with internal
accounting controls; and (4) an understanding of audit committee functions.

SOX requires that every audit committee of a public company have at least one "financial expert" with
(a) an understanding of GAAP and financial statements; (b) experience in preparing or auditing F/S; (c)
experience with internal auditing controls; and (d) an understanding of audit committee functions.
Mandatory awards, between 10% and 30% of sanctions imposed.

Under SOX, it is a crime to punish a public company whistleblower who provides truthful information
relating to any federal offense.

Types and Principles of Accounting Controls

Internal Control: To provide reasonable assurance, done by mgmt BOD and personnel, achieve
objectives on effectiveness and efficiency, reliability, and compliance

Types:

Preventive Controls (cheapest): general controls, segregation of duties, passwords

Detective Controls: after controls, detect error after occurrence. also have preventive benefits

Corrective Controls: reversing controls. backups

Feedback Controls: evaluate and respond to results of a process (closely relate to prevent, detect and
correct controls) fixing something

Feedforward Controls: project future results and alter inputs in response. projecting

General controls: restricting access, backups, background checks, etc

Application controls: focus on accounting applications, data entry, updates and reporting. Data input,
processing and output activities.

Types and Principles of Accounting Controls: DEEP DIVE

Often paired with detective controls: corrective controls

They move together, if something is wrong we want to correct

Passwords are general controls

Data inputs, outputs and processing: usually application controls

Introduction to COSO and the COSO Cube

5 dimensions in original cube: Monitoring, control activities, risk assessment, control environment

4 types of reporting:

Financial/Non financial

Internal/External

17 Principles of Internal Control

Control Environment:

Organization demonstrates integrity and ethical values. Set and Demonstrate. Tone at Top

BOD demonstrates independence of management, oversee development and monitoring of

internal control

Management establish structures, reporting lines, and appropriate authorities and

responsibilities to achieve objectives (with BOD oversight)

Competence: demonstrate commitment to attract, develop, and retain competent people to

achieve objectives
 Accountability: Hold individuals accountable for their internal control responsibilities.
Enforcement through authority, establish and evaluate performance measures, monitor and
consider performance pressures

Risk Assessment

Objectives: have sufficient clarity to enable ID and assessment of risks to achieving objectives

Assessment: ID risks to achieving objectives and analyze risks to guide a strategy for managing

Fraud: consider fraud risk in assessing risks to achieving objectives

Change Management: ID and assesses change in external and internal enviornment that could
impact system of internal control

Control Activities

Risk Reduction: reduce risk to acceptable levels

Technology Control: select and implement general controls over technology

Policies: establish stakeholder expectations and procedures to ensure implementation

Information and Communication

Quality: relevant, high quality information to support internal control (ID, capture courses of
data, turn data into info., consider costs and benefits)

Internal: Internal communication supports internal control process (whistle-blower,

communication through chain of command, sensitive to audience)

External: communication with outsiders supports internal control processes

Monitoring

Should be ongoing and periodic: benchmarking and providing feedback, consider other factors
in environment

Address Deficiencies: parties charged with taking corrective action receive timely
communication of internal control deficiencies (including senior mgmt and BOD, at least 1 level
above)
17 Principles of Internal Control (DEEP DIVE)

The COSO ERM Model

Enterprise Risk Management (ERM) proposes portfolio level view and is a process

effected by BOD, MGMT, and personnel. applied in strategy setting

designed to identify potential events that might affect the entity

manage risks

provide reasonable assurance regarding achievement of objectives

Management: considers risk interrelations, unit level and Entity level

Objective (4): Strategic, Operational, Reporting, and Compliance

Organizational Levels of Activity (4): Subsidiary, Business Unit, Division, Entity Level

Control Components: Internal Environment, Objective Setting, Event Identification, Risk Assessment,
Risk Response, Control Activities, Information and Communication, Monitoring

(Testing of the original model is usually focused on the Elements of Control (Control Environment, Risk
Assessment, Information & Communication, Monitoring, & Control Activities))
The COSO ERM Model- DEEP DIVE

BOD: big picture risks, overall strategy and environment, financial results, relations with audit

Internal Audit: evaluation and assessment. build activities into plans: risk tolerance, risk ID and ranking

Chief Risk Officer: oversee and manage process

New Product Development Manager: risk management procedures: risk tolerance, risk ID and ranking

External Auditors: control and risk assessment, evaluate FS assertions, control system & risks

Risk Management Policies and Procedures

Goals of ERM:

Align risk appetite and strategy

Improve risk responses

Reduce operational surprises and losses

ID and Manage multiple cross-enterprise risk

Seizing Opportunities

Improving Capital Deployment and HR

Analyze and Decompose Risk

Expected value of loss = likelihood (probability) of loss x amount of loss

Understand Control Environment

Tone at Top

Policies and Standards

Segregate Critical Accounting Functions (ARSR)

Authorizing Events

Recording Events

Safeguarding resources

Reconciling, oversight and auditing

Managing Internal Control Change

Change Agents: to facilitate change, ensure they are understood and embraced

Impediments to System User and Designer Communication

Management Commitment and Support

Internal Control Monitoring Purpose and Terminology

Whey monitor controls: they deteriorate over time (entropy), technology improvements, changes in
mgmt techniques, etc

Monitor to: lessen effects of entropy and to ensure more timely accurate and reliable information,
maximize efficiency and reduce costs

Evaluators: Primary attributes are competency & objectivity. have skills, knowledge, and authority to

understand risks that can affect objectives

ID critical controls to manage or mitigate risks

conduct/oversee monitoring of information on effectiveness of IC

Competence: knowledge of controls and related processes and what constitutes a deficiency

Board Monitoring: evaluating mgmt's monitoring process and assessment of risk of mgmt override
controls

Self-assessment:

By unit of function: people responsible determine effectiveness. by personnel who operate

control of peer or supervisory review within same unit

Self-review

review of one's own work. least objective type.

Least -> Most: Self, Peer, Supervisor, Impartial

Control objectives: targets to assess effectiveness of IC. State risk that they should manage or mitigate

Compensating Controls: accomplish same objectives as another control for deficiencies

Deficiency or IC Deficiency: IC requiring attention. Could be perceived, potential or shortcoming,

opportunity to strengthen IC to increase achieving objective
Key Controls: most important to assessing ability to manage or mitigate meaningful risks.

Failure might materially affect objectives, yet might not reasonably be detected by other
controls

Effective Operation might prevent other control failures or detect failures before they become
material

Key Performance indicators: assess critical success factors. measure progress toward goals

Key Risk indicators: forward-looking metrics to ID problems

Direct Information:

Directly substantiates operation of control. Highly persuasive.

Obtained by: observation, re-performance, directly evaluating operation

Can be ongoing or separate evaluations

Indirect Information:

Relevant to assessing controls are operating and underlying risk mitigated

No explicit evidence if controls are operating effectively

Persuasiveness of Information

Degree that information supports relevant conclusions

Derives for suitability and sufficiency

Relevant Information: assessing operation of underlying controls or component

Reliable information: accurate, verifiable and from objective source

Sufficient Information: gathered enough to for reasonable conclusion. must be suitable

Suitable Information: relevant, reliable, accurate, verifiable and timely

Timely: makes it possible to prevent or detect control deficiencies before material

Verifiable: can be established, confirmed or substantiated as true/accurate

Internal Control Monitoring Purpose and Terminology: Deep DIVE

Technology changes increase need of IC monitoring (changes, etc)

BOD is more concerned with big picture objectives

Higher level of review is more objective

Preventative is preferred to detective

Reliable information is objective

Persuasiveness is the degree that information provides support for conclusions regarding effectiveness
of IC

Processes of Monitoring Internal Control

Reviewing process: review of flowcharts, risk and control documentation

Benchmark Assessments: comparing controls and processes with best practices in comparable functions

Questionnaires: indirect evidence on extent controls are operating as stipulated

Focus groups and Interviews: ID concerns and surprises related to changes in IC

Assessing Changes in IC Effectiveness (Monitoring-for-change continuum)

Establish a control baseline

Change identification: change in operations, design, or risk

Control Revalidation: periodically revalidate controls remain effective, continuous control

baseline

Change management: when changes occur, verify they remain effective. establish new control
baseline for modifications

Introduction to International Professional Practices Framework

Institute of Internal Auditors (IIA)

Sets standards applicable to Internal auditing, Administers Several Certification

IIA Guidance:

Strongly Recommended Guidance (3 P's)

Position Papers: significant governance, control or risk issues in relation to internal audit

Practice Advisories: general approach, methodologies and consideration of internal audit (no
processes/procedures)

Practice Guides: detailed guidance of internal audit- procedures, tools, programs, sample
deliverables

Mandatory Guidance

Definition of Internal Auditing: independent, objective, assurance and consulting activity

IIA Code of Ethics: for internal auditors and units executing

4 Principles

Integrity:

Objectivity:

Confidentiality

Competency
 International Standards for the Professional Practice of Internal Auditing & Glossary

Statements: basic requirements

Interpretations: clarify concepts in statements with glossary

IIA's Standard Categories

Attribute Standards: involve characteristics of entities and individuals performing internal audit

Performance Standards: involve criteria to evaluate quality of internal audit services

Assurance is between: 1. process owner 2. the user 3. internal auditor

Consulting is between: 1. client 2. internal auditor

Attribute Standards

Implementation standards designations: Assurance "A", Consulting "C"

Chief Audit Executive: SR. person to effectively manage internal audit in accordance with charter and the
definition of Internal Auditing , The Code of Ethics, and the Standards.

Attributes focus on characteristics of individuals and internal audit activities

Attribute Themes (4):

1. Purpose, Authority, Responsibility

- STD 1000: must be defined in internal audit charter. CAE periodically reviews charter and submits for
approval

recognition of definition of internal auditing. code of ethics, standards in the internal audit
charter

2. Independence and Objectivity

- STD 1100: internal audit activity must be independent and auditors must be objective in work

organizational independence, direct interaction with board, individual objectivity, impairment to

independence or objectivity
3. Proficiency and Due Care

-STD 1200: engagements must be performed with proficiency and due professional care

Proficiency, Due professional care, Continuing Professional Development

4. Quality Assurance and Improvement Program

-STD 1300: CAE develop and maintain quality assurance and improvement program that covers all
aspects of internal audit activity

requirement of quality assurance and improvement program

Internal assessments (ongoing, monitoring, periodic assessment)

External assessments (at least every 5 yrs)

Reporting on quality assurance and improvement program

Use of "conforms with international standards for the professional practice of internal auditing"

Disclosure of nonconformance

Performance Standards

Evaluate the performance of internal audit

7 Themes

1. Managing the internal audit activity: CAE effectively manage internal audit activity to ensure it adds
value

Planning, Communication and approval, resource management, policies and procedures,

coordination, reporting to senior management and board, external service provider and
organizational responsibility

2. Nature of Work: evaluate and contribute to improvement of governance, risk mgmt, and control
processes using systematic and disciplined approach

governance, risk management, control

3. Engagement Planning: internal auditors must develop and document plan for each engagement
including objectives, scope, timing, and resource allocations

planning considerations, engagement objectives, engagement scope, engagement resource

allocation, engagement work program
4. Performance of Engagement: ID, analyze, evaluate, and document sufficient information to achieve
engagement objectives

ID info, Analysis and Evaluation, Documenting Info, Engagement Supervision

5. Communicating Results: communicate results of engagements

criteria, quality, errors and omissions, use of "conducted in conformance with the international
standards", disclosure and nonconformance, disseminating results, overall opinions

6. Monitoring Progress: CAE establish and maintain system to monitor the disposition of results
communicated to mgmt

7. Communication the Acceptance of Risks: CAE concludes that mgmt accepted and unacceptable level
of risk, must discuss with senior mgmt, if not resolved communicate with BOARD

Introduction to Economic Concepts

Economics: allocation of resources to alternative uses

In Economics:

Price is Y axis and is independent

Quantity on X axis and is dependent

Neutral relationship would be straight across or straight up and down

Introduction and Free-Market Model

Microeconomics is a study of individual decision making units

Command Economic System: Government determines production, distribution and consumption of

goods and services

Market Economic System: individuals, businesses and other entities determine production, distribution
and consumption of goods and services

Demand

Demand schedule shows quantity at certain prices

Quantity and price are inversely related

Demand = negatively sloped line (demand : downward)

Income effect: buy more at lower price

Substitution effect: lower price items replace higher priced items

Sum of demand curves = individual demand curves

Movements on demand curve are only based on price

Change in demand is a shift in demand curve: caused by factors other than price

Influence in demand:

Change in price of substitute of commodity (demand of substitute moves with price of

commodity)

Change in price of complementary commodity: (price of main commodity moves in opposite

direction of demand of complimentary)

Change in quantity demanded: move on demand curve (price only, all other factors the same)

Change in demand: shift in demand curve (all other factors besides price. Decrease= curve to the left.
Increase: curve to the right)

Supply

Supply: quantity of good or service that will be provided at different prices

Increasing output = higher per unit cost: more goods will be provided only at higher prices

Supply curve has positive slope

Only price changes along supply curve change quantity supplied

Sum of supply curves = market supply curve

Change in supply shifts supply curve (left is a decrease in supply, right is an increase in supply)

Shifts in supply curve are for factors other than price

number of providers, costs of inputs, technology, etc

Change in quantity supplied: movement along given supply curve as a result of change in price only

Change in supply: shift in supply curve from factors other than price (supply decreases= left, supply
increases= right)
Market Equilibrium

Market demand intersects market supply

Demand in market just takes supply provided and supply just meets demand

Equilibrium price and equilibrium demand are established

Equilibrium price: neither shortage nor surplus

Market Shortage = actual price charged is less than equilibrium price: demand will exceed supply

Market Surplus: actual price charged is more than equilibrium price: supply will exceed demand

Causes of changes in market equilibrium:

IF demand only changes: equilibrium quantity and price will change in same direction

IF supply only changes: equilibrium quantity will change in same direction as supply but
equilibrium price will change in opposite direction

IF supply and demand changes: new equilibrium quantity and price will depend on direction and
magnitude of each change

Price ceiling: cant go above that price (really the lowest level)

Price floor: cant go below that price (really the highest level)

Elasticity

Elasticity of Demand: quantity demanded as a result of change in price

Elasticity of Demand = (% change in quantity) / (% change in price)

% change =(New- old)/old

Outcome of elasticity:

>1 Elastic % change in Q Demand > % change in Price

=1 Unitary % change in Q Demand = % change in Price

<1 Inelastic % change in Q Demand < % change in Price

Elasticity of supply: measure the effect of a change in price on quantity supplied

Cross elasticity of demand: measure the effect of a change in price on one commodity on the quantity
demanded for another

Elasticity of demand: most common. most likely on exam

Inelastic basically means price has minimal effect

Consumer Demand and Utility Theory

Utility theory: measure of satisfaction from good or service

Total utility: increases as quantity acquired increases

Marginal utility: decreases with quantity acquired (utility acquired from the last required unit)

Maximize total utility where last dollar spent on every commodity acquired gives same marginal utility

Indifference curve: 2 quantities of 2 commodities that give the same overall satisfaction

When total utility is maximized, the marginal utility (MU) of the last dollar spent on each and every item
acquired must be the same. Thus, total utility is maximized when:

(MU of item 1/price of item 1) = (MU of item 2/price of item 2)

Inputs and the Cost of Production

Periods of Analysis (time horizons)

Short run analysis= period during which at least 1 input into production can't be changed
(size/capacity of production line)

Long run analysis= period during which all inputs into production can be changed
(size/number of plants)

More concerned with short-run costs analysis

Total Fixed cost: doesn't changed with level of output (property taxes, rent, etc)

Total Variable cost: varies directly with level of output (raw materials, labor, etc)

Total cost = total fixed cost + total variable cost

Average fixed cost: per unit fixed costs ( AFC = Total fixed cost / units produced)

Continuously downward sloping

Average variable cost: per unit variable cost ( AVC= Total Variable Cost / Units produced)

U shaped. law of diminishing returns. at some point additional units only serve to increase AVC

Average total cost: average fixed cost + average variable cost

U shaped but not as drastic as AVC

Marginal Cost: cost of last acquired unit of input

U shaped. includes variable costs. will cross ATC and AVC at their lowest point

Law of diminishing returns( short term concept): in a system with fixed and variable costs, adding more
variable inputs will eventually result in less and less output per unit of input. Variable inputs overwhelm
fixed factors, inefficiencies result, average variable cost begins to increase

Long-run Cost Concepts

all costs are variable. U shaped due to economy of scales (efficiency).

"Decreasing returns to scale" is long term form of law of diminishing returns

Long run cost curve is developed as minimum points on a series of short-run average cost curves
for different size or number of plant facilities
Introduction to Market Structure

Economic environment

Market Factors: Number of sellers and buyers, nature of commodity, difficulty of entry

Perfect competition - Perfect monopoly

Perfect Competition

Large number of buyers and sellers, each too small to effect price

Sell a homogeneous product

Entry and exit is easy

Buyer and seller have all information

In perfect competition, demand is constant for individual firm.

Marginal revenue and demand and price are the same

Profit is maximized where marginal revenue = marginal cost

Profit is the shaded area

Only at MR = MC is output at the best level for the firm. Provided the price (which also is MR)
at which each unit sells is greater than average total cost (ATC), this quantity also will result in
maximum profit. However, if price (MR) is not greater than ATC, the results for the firm would
be:

1. MR = ATC: Firm will break even.

2. MR is less than ATC, but greater than AVC (average variable cost): Firm is covering
variable cost and contributing to fixed cost, but not making a profit.
3. MR is less than AVC: Firm is not covering variable cost; the loss increases with every
unit produced. Firm should shut down.

Perfect Monopoly

Single seller, no substitutes, market entry is restricted

Monopolies exist because: Economy of scale (produce at a lower cost), Legal authority or control
(patent)

Marginal revenue below demand curve

Produce at marginal revenue meets marginal cost

Price is then determined where the quantity intersects demand curve

Short-run : ATC < Market Price = Profit

ATC = Market Price = breakeven

ATC > Market Price = Loss

Long-run: will continue to produce at MC=MR

Monopoly= higher price and inefficient use of resources because Price at optimum output> MC

Natural Monopoly= increasing returns to scale

Monopolistic Competition

Large number of sellers, firms sell differentiated products (similiar but not identical), close substitutes,
entry and exit are easy

Produce at MR=MC

Short run= ATC<MP=Profit, ATC>MP=Loss

Long-Run: as more firms enter, less demand for each

Equilibrium will happen in long run, all breakeven

Oligopoly

Few sellers, firms sell homogeneous or differentiated product, entry is restricted.

Interdependence among sellers

Change in slope of demand curve at market price

Above kink = more elastic

Below kink= less elastic

Kink because: May reduce price to meet competition

Short-run: ATC vs market price

Long-run: profits can continue due to entry to market being restricted

Price tends not to change due to possible price war

May seek to cooperate to benefit (tacit collusion is not illegal. follow leader)

Oligopoly is a market structure characterized by a few selling firms, each of which is large enough to
influence market price
Summary of Market Structure

Introduction to Macroeconomics

Government, financial sector, foreign, firms, individuals

Flow of funds between these

Leakages: individuals income not spent on domestic consumption (taxes, savings, imports)

Injections: additions to domestic production not from individuals expenditures (investment, government
spending, exports)

Elasticity of demand is the issue that is least likely to be studied in macroeconomics, as it is concerned
with the effects of a change in price on the demand for an individual good or service

Gross Measures—Economic Activity

Nominal GDP: measures the total output of final goods and services produced for exchange in the
domestic market during a period. not adjusted for changes in prices

Doesn't include: things that need additional processing, illegal acts, activities with no market,
goods produced in foreign countries by US owned company
Expenditures approach: measures GDP using final sales/purchases, the sum of spending by

Individuals, governments, businesses, foreign buyers (exports)

Income approach: measures GDP as value of incomes and resource costs, the sum of:

compensation, rental income, net interest, taxes on production and inputs, proprietor and
corporate income, depreciation

Real GDP: measures total output of final goods and services produced for exchange in the domestic
market during a period at constant prices

Nominal GDP adjusted for changing prices

Real GDP per capita = Real GDP per individual

Real GDP / Population

Net GDP: measures GDP less capital consumption during a period

(GDP-Depreciation)

Potential GDP: measures maximum output that can occur in domestic economy at a point in time
without creating upwards pressure on general level of prices. theoretical. take out adverse effects

GDP Gap: Real GDP and Potential GDP

Real GDP < Potential = Positive GDP Gap. inefficiencies in economy

Real GDP>Potential = Negative Gap. creates upwards pressure on prices

Gross National Product (GNP): measures total output of all goods and services would wide using US
resources. includes produced in foreign countries by US owned entities

Net National Product (NNP): measures total output of all goods and services would wide using US
resources but doesn't include depreciation

NNP = GNP - Depreciation Factor

National Income: measures total payments for economic resources included in production of all goods
and services, includes payments for:

Wages, rents, interest, and profits

Personal Income: total payments for economic resources received by individuals

PI = NI - corporate profits - social security-+ dividends and interest received by individuals +

government transfer payments to individual
Personal Disposable Income (PDI): amount of income individuals have to spend

PDI = PI - Income taxes

Potential GDP is a measure of the maximum amount of goods and services an economy can produce at a
given time, assuming available technology and full utilization of available economic resources, including
labor

A productive-possibility curve measures the maximum amount of various goods and services an
economy can produce at a given time with available technology and efficient use of all available
resources

Gross Measures—Employment/Unemployment

BLS collects employment data

Monthly survey of businesses and governments, measures employment, includes industry and
geographical data

Current population survey of households, measures employment and unemployment, includes

demographics

Frictional: in transition between jobs, or don't have info to get matched with employer

Structural: need for their prior types of jobs reduced or eliminated, or lack skills for current jobs

Seasonal: jobs regularly and predictably vary by season

Cyclical: downturn in business cycle, economic downturn reduced demand. greatest concern
Unemployment rate: percentage of labor force not employed

Natural unemployment rate: frictional, structural and seasonal reasons. there regardless of state of
economy

Full employment: only when there is no cyclical unemployment. Frictional, structural, and seasonal not
counted as unemployed in measuring full employment

Aggregate Demand

Aggregate demand: total spending in economy (expenditure approach). Sum of all market demand
curves (consumption, investment, government, net exports)

Consumption spending: spending by individuals on goods and services (no new housing, that's
investment), 70% of aggregate spending, primarily determined by PDI

Measures:

Consumption function: relationship between disposable income and consumption

spending. CS>PDI = Borrowing or spending savings. CS<PDI = Savings

Average Propensity to Consume: percent of disposable income spent on consumption

Average propensity to save = reciprocal of APC. APS + APC=100%

Marginal propensity to consume: change in consumption spending as a percent of change in

disposable income: $1 additional disposable income and .90 is spent, MPC=.90

Marginal propensity to save: reciprocal of MPC. MPC + MPS = 100%

Investment Spending: spending on capital items (construction, business PPE, business inventory).
fluctuates more that consumption spending

Interest rate (most significant), demographics, confidence, income/wealth, capacity utilization,

technological advances, vacancy rates, sales levels

Government Spending: purchases of goods and service by all levels of government (excludes transfers
payments). typically impact taxes and effects personal disposable income and personal consumption

Discretionary Fiscal Policy: Level of spending and taxation to impact aggregate demand
Exports: Amount of foreign spending on US Goods

Imports: Amount of US spending on foreign goods

Net exports = Exports - Imports

Positive = increase aggregate demand

Negative= decrease aggregate demand

US has been a net import country (worlds largest)

Imports/Exports influencing factors: exchange rate, relative price level, relative inflationary rates,
relative income and wealth, import/export restrictions and tariffs

Change in aggregate demand = shift in demand curve (factor other than price changes)

outward: reduction in taxes, confidence, new technology, interest lower, increase in wealth, etc

inward: increase in taxes, decline in confidence, (opposite of above)

Multiplier Effect: increase demand has ripple effect on total change in demand
(investment=consumption, etc)

multiplier = change is spending * (1/(1-MPC)) MPC=Marginal propensity to consume

Comparing 2 years Marginal Propensity to consume: change in MPC / change in DI

Aggregate Supply

Total output of goods and services produced in the economy at different price levels

Aggregate supply curve slope depends on theory followed:

Classical aggregate supply curve: vertical line. no change in output as price changes. very short
term

Keynesian aggregate supply curve: horizontal up to output at full employment, then slope
upward. then quantity will only increase if price increases

Conventional aggregate supply curve: continuous positive slope. steeper for output after full
employment

Changes in aggregate supply: shift in supply curve. factors other than price (resources, costs, technology)

Exports impact demand. Increase exports increases demand

A reduction in aggregate supply will shift the supply curve to the left, resulting in a lower
quantity of output at a higher price.

An increase in the minimum wage rate would be an increase in the cost of economic resources (labor),
which would shift the aggregate supply curve inward--a reduction in supply.

Since labor is an economic resource, a decrease in labor would shift the aggregate supply curve
inward (i.e., reduce aggregate supply)

A higher level of output reflects a shift in the supply curve to the right. Even with a vertical classical
supply curve, this would result in an increase in output and a decrease in price.

A higher level of output reflects a shift in the supply curve to the right. If a Keynesian supply curve is
assumed and demand is at full employment, this would result in an increase in quantity of output and a
decrease in price.

Aggregate (Economy) Equilibrium

Aggregate demand intersects aggregate supply

New equilibrium depends on whether demand or supply is increased/decreased, extent of change,

which theoretical supply curve is used

Conventional supply curve: demand only changes: equilibrium quantity and price will change in the
same direction as demand

Business Cycles
fluctuations in aggregate Real GDP (constant price level)

Expansion: business activity increasing

Peak

Recessionary: business activity decreasing.

Unofficial quantitative= 2 or more qtrs negative Real GDP. GDP down 10% or less (yrs and more
for depression)

Trough

Long term will still be an upward trend

Indicators for cycles:

Leading: consumer expectations, initial unemployment, stock prices, real money supply, etc

Lagging: changes in labor costs, inventory v sales, length of unemployment, comm loans, credit
and income

Price Levels and Inflation/Deflation

Changes in prices themselves create changes in measures of economic activity and outcome

Price indexes convert to base period

Base Period = 100% , each period is measured as a percent of base period

Consumer Price Index (CPI): price of basket of goods and services vs base period

CPI-U: urban consumers, base period is 1982-1984

Measuring Inflation/Deflation

(CPI-U - Prior CPI-U)/ Prior CPI-U = Inflation Rate

Wholesale Price Index (WPI): basket of raw materials, intermediate materials, and finished good @
wholesale level. may trickle down to affect CPI

GDP Deflator: relates Nominal GDP to Real GDP

Attempts to include all spending in GDP, More comprehensive, "basket" changes more frequent

GDP Deflator= (Nominal GDP / Real GDP) x 100

Inflation/deflation: rate of change in price level

Inflation Causes:

Demand induced (cost pull): spending > productive capacity at full employment

Supply induced (cost push): increases in cost of inputs raises prices (when pushed to consumer)

Inflation: lower wealth and real income, reduces aggregate demand, higher interest rates (lender keep
up with inflation), postpone commitments. primary focus of policy

To get real GDP, nominal GDP is divided by the GDP deflator

Money, Banking and Monetary Policy

Functions of money: common means of exchange, measure of value, store of value

FED's measures of money

M1: narrowest- based on instruments- paper and coin outside bank, checking in banks

M2: includes all M1 plus savings, money market, CD less than 100K, individual owned money
market mutual funds

M3: includes all M2, CD more than 100K, institutional owned money market mutual funds

FED board of governors: 7 members make policy, appointed by president with senate approval

FED open market committee: 12 members implement policy to effect money supply through open-
market operations

FED reserve banks: 12 responsible for geographical area, owned by member institutions for individuals
(commercial banks, savings and loan associations, mutual saving banks, credit unions), operate under
FED policy

Monetary Policy: managing money supply to achieve national economic objectives (growth, price
stability)

methods: Reserve requirements: % of loans made by banks to hold in reserve

Open market operations: FED buy and selling US treasury debt from member
banks. increase supply: buy decrease supply: sell

Discount rate: rate member banks pay when borrowing from FED
Monetary: primarily used because its quicker, less political, and doesn't redistribute output and income
as much

Fiscal Policy is from law makers, Monetary Policy if from FED

Introduction and Reasons for International Activity

Reasons: increase market, get commodities, lower cost commodities

Absolute Advantage: ability to produce good or provide service more efficiently

Comparative Advantage: ability to produce a good or provide service with lower opportunity cost
(resources, technology)

Maximize output: should specialize in things with least opportunity cost, should trade for other
things (principle of comparative advantage)

To provide 1 of x would cost _ of y

Porter's 4 Attributes:

Factor Endowment: advantage in factors of production

Demand conditions: nature of domestic demand

Relating and supporting industries: extent of internationally competitiveness

Firm Strategy, Structure and Rivalry

Porter 4 Outcomes:

Availability of resources and skills

Information used to determine which opportunities to pursue

Goals of individuals within entities

Pressures on entities to innovate and invest

Issues at National Level

Socio-political: increased unemployment, loss of domestic manufacturing, loss of defense industries,

lack of protection for domestic start-ups.

Import quotas: limit amount

Import tariffs: increase costs in domestic market

Better activities: training, r&d, etc...

Currency Exchange Rate: directly affect imports/exports. stronger=closer to 1:1. stronger=more imports,
less exports

Balance of trade: difference between money value of imports/exports

Exports > Imports = Surplus

Exports < Imports = Deficit

Balance of Payments: summary accounting of US to other country transactions

Current Account: net amount for imports/exports, income from foreign investments (dividends
and interest), foreign aid and grants

Capital Account: net amount of investments and loans, outflows of investment and loans

Financial Account: net amount of US assets abroad, foreign assets in US. includes government
and private, monetary and non-monetary (PPE)

Deficit balance of payments consequence: greater demand for foreign currency vs dollar, will eventually
reverse. balance of trade equilibrium
Role of Exchange Rates

Direct: domestic price of one unit of foreign currency (ex. 1 euro = $1.10) *Dollar is last*

Indirect: foreign price of one unit of a domestic currency (ex. $1 = .909 euro)

Exchange rates determined by:

Free-floating currency: exchange rate by market forces of supply and demand for currency
(most countries)

Pegged or Movable currency: fixed by government with frequent revisions

Changes in demand for currency:

Political and economic environment

Relative interest rates (higher increases investment and demand)

Relative inflation rates

Level of public debt (higher = lowers demand)

Current account balance

Other: consumer preferences, relative incomes, speculation

Currency supply factors:

Determined by central bank

Supply side: buying dollars in open market using foreign currency reserves to reduce supply of
dollars, selling dollars would increase supply of dollars

Demand side: increase or decrease interest rates to increase of decrease demand for domestic
investments, which will increase or decrease demand for dollars

Changes affects:

Currency appreciation: less domestic dollars to buy foreign

foreign goods cheaper

encourages domestic efficiencies

puts downward pressure on domestic inflation

difficult for domestic producers to compete

 Currency depreciation: more domestic dollars to buy foreign

domestic goods cheaper, increases exports

increase exports, increase employment

import goods more expensive

drives up cost of foreign inputs

If you are importing a lot: your currency will decline in respect to others because you will need to spend
more of your currency to buy others because you have a greater demand for foreign currency vs foreign
for your currency

Currency Exchange Rate Issue (entity level)

Types of foreign currency exchange risk:

Transaction risk: possible unfavorable impact on transactions denominated in foreign currency.

receivable or payables in foreign currency (convert to dollars or convert to foreign).

mitigate by: matching, leading or lagging payments and collections, hedging

Hedging: sell receivable at a price set now (future contract)

Translation risk: unfavorable impact of changes in currency exchange rates on FS of foreign

currency that are converted to domestic. domestic company has foreign operation. some use
spot rate at BS date.

mitigate by: reduce amount converted using spot rate, offsetting,

borrow in foreign currency in net asset exposure to offset

Economic risk: changes in rates will alter value of future revenues and costs
mitigate: distribute productive assets in different countries, shift sources to
different locations

Forward contracts:

buy or sell at specified date at specified rate (must exercise)

Option contract:

option to buy or sell at specified date at specified rate (discretionary)

Transfer Price Issue

Price transferred between affiliated entities

Will dictate the amount it will charge for transfer and can manipulate taxes and profits

Appropriate allocation of entities if provided by IRS in US

Income allocated by functions performed and risk associated

Transfer Price based on: cost of selling unit (variable or full cost), market price, negotiated price

Introduction to Globalization

Globalization: movement to integrated world economy

Driven by: global institutions (world bank, international monetary fund, multinational corporations, etc)

Reduction in trade and investment barriers

Technology

Bretton Woods Agreement (1944) increased commerce after WW2. Established World Bank and IMF.
IMF is used for countries in currency crisis, banking crisis, financial debt crisis

Reductions in Trade: General Agreement on Tariffs and Trade (GATT): multilateral, encourage trade,
eliminate tariffs, subsidies, import quotas, and other barriers, harmonize laws, reduce transportation

World Trade Organization (WTO) oversees GATT

Foreign Direct Investments (FDI) = investment in non-monetary assets in country by foreign investors

Must understand: Political, economic, legal system (property, contract, intellectual property, product
and safety)

GATT has as its primary purposes the liberalizing and encouraging international trade by eliminating
tariffs, subsidies, import quotas, and other trade barriers, to harmonize intellectual property laws and to
reduce transportation costs.

The objective of the World Bank is to promote general economic development, especially in developing
countries, primarily by leading for infrastructure, agricultural, education, and similar needs

Foreign direct investment involves investments in non-monetary assets (e.g., property, plant,
equipment, etc.) in a foreign location
Globalization of Trade

Exports: sold to buyer in foreign country

Imports: acquire from seller in foreign country

Reasons for trade growth: reduced barriers, increased economic integration, regional trade agreements,
technology, financial sector

US imports grown much more than exports. US world's leading import. China world's leading export

The long-term trend for the dollar value of both U.S exports and imports has been to increase (in
dollar value)

U.S. imports as a share of GDP and exports as a share of GDP have both increased.

Both a country's imports and exports enter into the determination of that country's gross
domestic product. Specifically, it is net exports (exports minus imports) that enter into the
determination of gross domestic product.

Globalization of Production

Sourcing goods from around the world

Outsourcing: good or service under contract terms

reasons: cost savings, quality, reduce delivery time, focus, scalability, leverage

risk: quality, security, export/import (restrictions), currency exchange, legal

mitigation: due process, foreign lawyers, legal requirements in both country, through contracts,
negotiate for home currency, strict policy for legal compliance

Foreign Direct Investments: owned or controlled facilities (PPE to carry out production or service)

Location based on country's advantages

objectives: lower costs, improve quality, expand markets, increase growth potential

Globalization of Capital Markets

Capital markets bring together providers (investors) and users (borrowers)

Domestic markets: limits size and wealth, supply increases cost, limited opportunities
Global Capital Market: interconnected institutions and national markets

Stock/bond and commodities

Eurodollar Market (Euromarket): short and intermediate term loans in US dollars

Eurobond Market (international Bond Market): long term loans outside home country, in most
major currencies, avoid most government regulations

Reasons for growth: government de-regulation and increased communications

Risk: exchange rates could negate possible benefits

Globalization and Power Shifts

US share of output is declining

China, Brazil and India are the only ones that have experienced growth

Reasons for movement:

Internet/global communication

relocation of services to support foreign trade and production

FDI: developing country share has increased significantly

The U.S. exports about 10% of worldwide exports.

China and Germany are the world's largest export countries, with China accounting for about 11% and
Germany accounting for about 10% of worldwide exports.

Europe has had the greatest decline in share of worldwide output over the last 40 years.

U.S. share (percentage) of worldwide GDP (output) is approximately 25%

Becoming Global

Export: increase domestic, avoid cost of foreign production, international business at low risk

Import: obtain otherwise not available, lower cost, better quality than in country

Licensing: right to use asset (patent, trademark, formula) increase revenue, security, standards, skills

Franchising: mandate operating procedures, increase revenue, quality concerns

Joint ventures: establish in foreign location and owned by 2 or more unrelated entities, local knowledge

Subsidiaries: acquires controlled but separately legal entity, quick entry, known stats, block competitors

Establishing subsidiary: "greenfield venture", built to desire, costs time and money, more risk

Important technology: avoid licensing and franchising

Franchisor sells intangible assets to a franchisee and mandates strict operating requirements of the
franchisee. Thus, franchising does typically provide greater quality control than simple licensing

Introduction to Business Strategy and Market Analysis

Mission stmt: purpose and range of activities

values: underlying beliefs to govern operations

goals: est general purpose toward endeavors (mid-long term, multiple objectives)

Strategy: assess external (macro and industry) and internal (SWOT, relations to environment)

objective: desire measureable results

strategies: Cost leadership, differentiation, focus

implement strategies and monitor and control

The five forces framework developed by Michael Porter is used for determining the nature, operating
attractiveness, and probable long-run profitability of a competitive industry.

Macro-Environmental Analysis

PEST analysis: macro assessment of

P olitical: stability, laws, taxes, etc

E conomic: growth, interest, inflation, exchange

S ocial: pop growth rate, age, education, health and safety

T echnological: R&D, infrastructure , rate of change

 Macro-environmental analysis is concerned with analysis of the characteristics of a country or a
region. Specifically, macro-environmental analysis considers the broad political, economic,
social, and technological characteristics of a country or a region.

Industry Analysis

Industry: group of entities that produce close substitutes

Porters Model: 5 Forces to assess competitive state of industry

Threat of new entrance into market

Threat of substitute goods or services

Bargaining power of buyers

Bargaining power of suppliers

Intensity of rivalry in market

The highest intensity of rivalry should be in an industry with a high fixed cost structure, in which
producers seek to operate at full capacity, and a low degree of product differentiation, which results in
products having many substitutes.

Entity/Environment Relationship Analysis

SWOT

Strengths (internal): resources and capabilities

Weakness (internal): shortcomings competitive disadvantage

Opportunities (external): benefit from new or unmet demand

Threats (external): chances of adverse consequences due to external forces

SWOT Matrix:

Strengths/Opp: utilize to take advantage

Weaknss/Opp: pursue to overcome weakness

Strengths/Threats: use strengths to reduce susceptibility

Weaknss/Threat: pursue ways to prevent weakness from being overcome by threats

Generic Strategies

Purpose: leverage strengths to achieve objectives

Porter 3 Generic Strategies:

Cost leadership: become low cost provider. at average price and earn profits higher than
competitors or below average market price and gain market share.

To achieve: minimize cost, invest in production and distribution, high expertise

Risks: others will displace you at same strategy, improved technology outs you, others
separately achieve lower costs

Differentiation: uniqueness or quality valued. permits premium price

To achieve: highly trained, leading R&D, marketing and sales, innovation quality service

Risks: change preferences, economic status changes, imitation, other separately achieve

Focus: either cost leadership or differentiation within niche market

To achieve: marketing and research, targeting group, high customer satisfaction and
loyalty

Risks: smaller and size and lower volume, less bargaining power, imitation, changes in
target preferences, adapt to compete, attack on target group from others

Summary and Extensions

Resource Base Model (RBM): alternative strategic planning model

 assess resources and capabilities of an entity

base strategy on collection of resources and capabilities to take advantage of opportunity

Cost Concepts

Cost: amount paid in cash for good or service

Expense: portion of cost to portion of good or service that has been "used up". ex depreciation

Sunk Cost: cost of resources that have happened in past but cant be change by current of future actions.
disregard in current decision

Opportunity Cost: discounted dollar value of benefits lost from an opportunity not taken as a result of
taking another opportunity. don't involve cash. relevant in current decisions

Differential/Incremental Cost: costs that are different between 2 or more alternatives. only different
costs are relevant in economic decisions. cost of financing is not different if discounting

Cost of Capital: cost of long-term funds used to finance operation. LT debt, preferred stock, common
stock

Cost of LT Debt: rate of return that must be paid to attract and retain funds. less risky than
equity: less return required

Cost of preferred stock: rate of return to attract and retain preferred investments.

Like debt: dividends expected and paid before common dividends

Like equity: possible claim to additional dividends and priority claim upon liquidation

Cost of Common Stock: rate of return to attract and retain common investment. most risky:
highest return required

Rate determined by: perceived risk, expected dividends, expected price appreciation

WACC: rate of return of each source of capital weighted by its share of total capital

Percent of total capital for each source

Multiply each source by cost of each source

Sum all together to get WACC

Only debt takes taxes into account when calculating WACC

 % Capital x (1-Tax Rate) x Cost of Capital

Incremental costs are those that are different between two or more alternatives under consideration.
Ignores fixed costs

Product cost is the cost assigned to goods that were either purchased or manufactured for resale.
Product cost also is often referred to as "inventoriable cost."

Time Value of Money Tools

Questions gives you tables and you need to select the appropriate table. Don't need equations

Present Value (PV) of single amount= Future Cash flow / (1+ Rate)^number of periods

Future Value (FV) of single amount= Present Cash Flow * (1+rate)^number of periods

When compounding for more than 1 yr: Interest Rate = Annual Rate / Periods per year

Periods = Years * periods per year

PV of Ordinary Annuity: (aka annuity arrears) received at end of equal intervals (Ordinary: END)

FV of Ordinary Annuity: end of the period collections (Ordinary: END). FV is greater than sum of events

PV of Annuity Due: (aka annuity in advance) to be paid at beginning of period

If given table for ordinary table: use the prior period (Period given - 1) line in table. Add 1 to that
value, then use that total as input in calculation

FV of Annuity Due: to be received at beginning of periods

If given different values for different periods of an annuity, break down into common values

An annuity is a series of equal payments. The given values are:

$30,000 for years 1 and 2, and $20,000 for year 3.

Those values are not equal for every year But, they can be converted into two series of equal payments
comprised of: $20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2.

Interest Rate Concepts and Calculations

Interest= Cost of using money. percentage almost always an annual rate.

Changing base interest: can shift from variable to fixed or fixed to variable

Stated Interest Rate (nominal rate): rate in the contract, bond coupon. Doesn't take compounding into
account

Ex. Semi-annual. Stated rate= 6%,

Real interest rate: is the stated (or nominal) rate of interest for a period less the rate of inflation for that
period

Simple Interest: computed on the original principle only. no interest on interes

Ex. 2 yr, 2,000 at 6% simple interest.

Interest = 2,000 x .06 x 2 = $240

Compound Interest: interest paid on interest

Ex. 2 yr, 2,000 at 6% compounded annually, paid at end of period

Interest Yr 1 = 2,000 x .06 x 1 = $120
Interest Yr 2 = 2000 + 120 = 2,120 x .06 x 1= 127.20 Total interest =
120+127.20 = $247.20

Effective Interest Rate: rate implicit in relationship between net proceeds of borrowing and dollar cost
of borrowing. Net Proceeds may be less due to:

1. discounting interest deducted in advance

Cost of borrowing = Principle x interest rate
Funds Available= Principle - cost of borrowing
Effective interest rate= cost of borrowing / funds available

Ex. 2 yr, 2,000 at 6% simple interest.

Interest = 2,000 x .06 x 2 = $240
Net Proceeds= 2000 - 240 = 1760
Effective interest: (240/1760) = 13.64 / 2 = 6.82%

2. Compensating balance requirement

Annual cost of borrowing = Principle x interest rate
Funds Available = Principle x (1-compensating balance %)
Effective interest rate= cost of borrowing / funds available
Annual Percentage Rate (APR): annualized effective interest rate without compounding that is for a
fraction of a year. legally required basis for disclosure

Ex. 90 Days, 2,000 at 6% simple interest.

Interest = 2,000 x .06 x (90/360) = $30
Net Proceeds= 2000 - 30 = 1970
Effective interest: (30/1970) = 1.52 x 4 = 6.08%

Credit terms of "2/10, net 30" mean that the debtor may take a 2% discount from the amount
owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30
days. The 2% discount is the interest rate for the period between the 10th day and the 30th day; it
is not the effective annual rate of interest. The computation of the annual rate of interest using
$1.00 would be:
Interest 1
APR
_______ x ________________
=
Principal Time fraction of year
.02 1
APR
___ x ______ = .0204 x (360/20) =
=
.98 20/360
APR = .0204 x 18 = 36.73%
Thus, the effective annual interest rate for not taking the 2% (.02) discount is 36.73%. The 20
days in the 360/20 fraction is (30 - 10), the period of time over which the discount was lost as a
result of not paying early.

Effective Annual Percentage Rate (EAPR); annual percentage rate with compounding on borrowings for
fraction of a year. AKA: annual percentage yield. NOT LIKELY ON EXAM

EAPR = ( 1 + (Annual Stated Rate / periods in a year))^ periods in a year - 1

Ex. 90 Days, 2,000 at 6% simple interest.

EAPR= (1 + .06 /4)^4 - 1= 6.13%

U.S. Treasury bill would be the risk-free rate plus the inflation premium (for the expected rate of
inflation during the life of the security)
Introduction to Financial Valuation

Fair value is the price to sell asset or transfer liability in orderly transaction between market participants

Valuation process: must take condition and location into account. at point in time (measurement date)

Level 1: highest and best inputs. unadjusted quote prices at date in active markets. identical
items

Level 2: observable either directly or indirectly but not level 1.

similar item in active market

quoted prices in not active market,

Other than quoted prices that are observable: rates, yield curves, credit/default risks

From or corroborated by observable market data by correlation

Level 3: lowest and least desirable inputs, most assumptions. unobservable. only when others
not available

assumptions, internal data, etc

Market Approach: prices and other info for items identical or comparable (housing)

Income Approach: valuation to convert future amount to determine worth at valuation date

Cost Approach: valuation to determine amount to acquire or construct substitute. more limited than
market or income approach. for specialized items

Under U.S. GAAP, valuation should be based on an exit price and not on an entry price. An exit price is
the price that would be received to sell an asset or be paid to transfer a liability in an orderly transaction
between market participants as of the measurement date.

Valuation Techniques—General

Level 1: value is the market value

Level 2: Comps. Over the counter market is a market. market is not active when: few relevant
transactions, prices not current or vary substantially, little public info

Level 3: estimates and assumptions. tend more towards complex accounting issues
Valuation Techniques—CAPM

CAPM: determines measure of relationship between risk and return

Incorporates: Time value of money (risk free rate) and element of risk (beta)

RR = RFR + beta (ERR - RFR)

RR= return rate

RFR= risk free rate (US government bonds)

beta= measure of volatility of asset being measured when compared to benchmark

ERR= expected rate of return. benchmark for class of asset

Beta: systematic risk as reflected by volatility. beta = Assets std dev/ benchmark std dev x coefficient of
correlation between them

Beta = 1 moves with benchmark. same risk as whole class of assets

Beta > 1 moves more than benchmark, more volatile

Beta < 1 moves less than benchmark, less volatile

CAPM Assumptions and limitations:

there is an asset class and benchmark

all investors have equal access to all investments of the class and all use one-period time
horizon

Asset risk is measured solely by variance of asset from benchmark (solely explains difference in
risk)

No external costs involved (commissions, taxes, etc)

No restrictions on borrowing or lending at risk free rate

Uses historical data which may differ from future

Used in: securities analysis

Capital budgeting (company or industry beta instead of project beta)

setting fair compensation for regulated monopolies

Valuation Techniques—Option Pricing

Option: right to buy or sell at price within time period

American Style: up to maturity

European Style: only at maturity date

Value Pricing:

Current stock price, time to expiration (longer is more), risk free rate of return, risk of optioned
asset (standard deviation, larger is more), exercise price, dividend payment on option security
(smaller dividend, more)

Black Scholes: for European call options only, stocks pay no dividends, increase in small increment, risk
free rate is constant. Uses probability of price and probability of exercise, discounts exercise price

Know what it is: technique for valuing securities and uses probability and discount.

Binomial Model: uses tree diagram to estimate values at time points between valuation date and
expiration date

((Probability * high)+ (Probability * low))/ (1+ Rate)^number of periods

If multiple periods: outcome of 1 period would be the input to the prior period and work backwards

Valuation Techniques—Business Entity

Involves:

Establishing standards and premise of valuation: reasons, legality, circumstances, assumptions

Assessing economic environment of entity being valued: economic environment, operations,

industry, locations

Analyzing financial statements and related information: common size analysis, trend analysis,
ratios, adjustments to statements

Formulating value:

Market approach: compare to similar entities, may require adjustments (controlling

premium, discount for controlling, discount for marketability, Disadvantage:
comparable entities, liquidity
 Income Approach: NPV of benefit streams, discount rate based on ROR given risks.
Discounted CFs, Capitalization of earnings (capitalization or interest rate to
earning to get value), Earnings multiple, Free CF (variation of discounted CFs)

Asset Approach: determines value by adding assets that comprise entity being valued.
less appropriate for valuing going concern and non controlling interest, better
for liquidation or for little or no CF or earnings

Nonpublic entities are likely to be more difficult to value than publicly traded entities, the conditions in
the macroeconomic environment should be considered in valuing an entity and the status of the
industry should be considered in valuing an entity

In a common-size income statement, each item is measures as a percentage of total revenues

In a common-size balance sheet, each item is measured as a percentage of total assets (or total liabilities
plus equity)

Introduction to Forecasts and Trends

Forecast of Macro-economic factors, budgeting process, demand for products, investment decisions, etc

Qualitative Approach: Based on judgment and opinion, subjective, based on consensus, useful when no
quantitative data, when making long-range forecast

Executive opinion

Market Research: surveys

Delphi Method: consensus of expert group using multi-stage to converge on process. BEST

Quantitative approach: quantitative data and models, objective, base on mathematics

Time series models: use patterns in past data to predict future (extrapolation, only concerned
with patterns, not concerned with cause)

Causal Models: assume variable is related to other variables and projects based on assumptions

Short Term: up to 3 months. time series appropriate

Medium Term: from 3 months to 2 years. time series and causal methods

Long Term: longer than 2 yrs. causal and qualitative methods

Forecast Error: difference between actual and forecast

Mean Absolute Deviation (MAD): average absolute values of forecasts

Mean Squared Error (MSE): average of sum of forecast errors squared

Mean Average Percentage Error (MAPE): error divided by actual value

Quantitative Methods

Time series: based on patters from past will continue more or less unchanged into some future period

Naive: immediate past period's actual value as forecast

Simple mean: uses average past values as forecast for future

Simple moving average: uses average of specific number of most recent values as forecast

Weighted Moving average: uses average of specific numbers of most recent values, each
weighted differently

Exponential Smoothing: average of specific number of most recent values with weights which
decline exponentially as data becomes older

Trend-adjusted exponential smoothing: exponential smoothing that adjusts for strong trend
patterns

Seasonal indexes

Liner Trend line analysis: least squares to fit straight line

Data Patterns: Level or horizontal (relatively stable), Seasonal, cycles, trends, random

Decomposition is removal of each pattern from the data: 1st smooth, then remove trends, then remove
cyclical effects

Casual models:

Regression: dependent v independent, fits curve to minimize error, time is independent

input-output: one stage/sector impacts another

Economic: statistical relationship believed to exist between economic quantities (black scholes)
Introduction and Project Risk

Capital Budgeting: measuring, evaluating, and investing in long term

Capital project risks: incomplete/incorrect project analysis; unanticipated actions of customers, supplier
or competitors; unanticipated changes in laws, unanticipated macroeconomic changes

The risk-free rate of interest is required by lenders, not to cover risks, but to compensate the lender for
deferring use of the funds by making an investment.

Introduction and the Payback Period Approach

Payback Period: determines number of periods needed to recover initial cash investment and compares
that time with a pre-established maximum payback period

payback =< maximum period = accepted

Sum yearly CFs for maximum period and compare to cost of project

Advantages: easy, useful in evaluating liquidity, establish short maximum period reduces uncertainty

Disadvantages: no time value money, ignores CFs after payback period, doesn't measure total
profitability, maximum payback period may be arbitrary

The annual revenue less the annual cash expenses is used as the amount per period (depreciation
expense excluded since it is a non-cash expense)

The profitability index approach to capital project evaluation is primarily concerned with the relative
economic ranking of projects
Discounted Payback Period Approach

Number of years needed to recover initial cash investment using discounted CFs

Don't use annuity factors, Use present value of 1 factors in calculations

Sum discounted values for the maximum payback period and compare to cost of project

Advantages: easy to use and understand, useful in evaluating liquidity, short maximum period reduces
uncertainty, uses time value of money

Disadvantages: ignores CFs after payback period, doesn't measure total project profitability, maximum
payback period is arbitrary

Accounting Rate of Return Approach

Accounting Rate of Return (ARR): expected annual incremental accounting net income from a project as
a percent of initial (or average) investment. total and divide by years. amounts using accrual accounting.

ARR = (Average annual increment revenues - Average annual incremental expenses)

initial (or average) investment

Numerator is also equal to incremental net income. Assumes incremental net income is the same each
year

Advantages: easy to use and understand, consistent with FS values, considers entire life of project

Disadvantages: ignores time value of money, uses accrual accounting values and not CFs

Net Present Value Approach

PV of expected cash inflows vs present value of expected outflows. Most commonly used. uses discount
or "hurdle rate" based on cost of capital WACC. The discount rate is determined in advance. stated in
terms of cash flow. The use of present value provides for the compounding of amounts over time.

NPV= difference between PV of inflow and outflows

NPV>= 0 accept

Advantages: time value of money, relates rate of return to cost of capital, considers entire life, easier to
computer that IRR

Disadvantages: requires estimation of CF over entire life, assumes CFs are immediately reinvested at
discount (hurdle) rate
After-tax [net] cash inflow would be: ((Sales - Cash OPEX) x (1-Tax rate)) + (Depreciation x Tax Rate)

The amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of
taxes saved. The present value of that saving enters into the determination of present values for net
present value assessment purposes.

Internal Rate of Return Approach

Determines discount rate that equates present value of expected cash inflow with present value of
expected cash outflows. Discount rate is IRR. Computes rate that makes CF = 0

Equation for NPV=0

Future annual cash inflows x PV factor = investment cost

rearranged: PV factor = Investment Cost / Future annual cash inflows

Then find PV factor in the table for number of years column to find the % rate

Advantages: recognizes time value of money, considers entire life of project

Disadvantages: difficult to compute, requires estimation of CF over entire life, all CFs be positive or
negative, assumes CF are immediately reinvested at IRR

Depreciation expense is not a cash flow and does not affect cash flows when income taxes are ignored;
it should be excluded. The residual value of an asset at the end of a project is a cash flow, is discounted,
and affects the present value of net cash inflows; it should be included.

Profitability Index and Ranking

Determines ranking by taking into account NPV and cost of project

PI = NPV of inflows / PV of project cost

Capital Project Ranking Decisions

Payback Period & discounted Payback period: useful for ranking when liquidity is important

ARR, NPV, IRR, PI: higher is better.

IRR can differ from NPV due to : project investment costs, timing of CFs, project life span
Introduction and Financial/Capital Structure

Financial structures: mix of all liabilities and SE accounts

Capital structure: only long tern funding : LT debt and SE

Introduction to Short-Term Financing

Short term financing / working capital financing: due within 1 yr (short term liability)

Payables

Trade Account Payables: Discounts on trade accounts payable have favorable effective interest rates and
should be taken

Advantage: easy, little legal documentation, flexible, interest not charged, collateral is no
required, discount for early payment

Disadvantages: require payment in short term, effective cost higher if discounts not taken,
financing is use specific (only assets acquired)

Accrued Accounts Payable: acquiring cash and other by obligation to be satisfied in future.
Salaries/wages, taxes, unearned revenue. time between benefit and obligation is satisfied provide short
term financing.

Advantages: easy, normal course of business, flexible, collateral not required normally

Disadvantage: payment in short term, some is use specific

Short term notes payable: cash from borrowing due in 1 yr or less. promissory note required, rate based
on credit rating, compensating balance may be required (will increase effective cost of borrowing)

Advantages: commonly available, flexible with varied amounts and periods, collateral normally
not needed, provide cash for various purposes

Disadvantages: poor credit higher rate or collateral, repayment in short term, compensating
balance increase effective cost and reduce funds available, refinancing necessary if not paid
when due
Stand-by Credit and Commercial Paper

Arrangement to have financing available for specific purpose of period of time

Line of Credit: informal agreement, maximum amount of credit that will be extended at any
time. Not legally binding, provides reasonable assurance of funds, available funds generally used
for any purpose

Revolving Credit: formal agreement, lender agrees to maximum amount of credit that will be
extended. Line of credit but legally binding

Letter of Credit: conditional commitment by financial institution to pay third party in accordance
with specified terms and conditions. Ex. pay 3rd party upon proof of shipment. Provides third
party assurance of payment, often used in connection with foreign transactions

Advantages: commonly available for creditworthy, highly flexible, usually no collateral, both line of
credit and revolving credit provide cash for general use

Disadvantage: poor credit higher rate, involves fees, satisfied in short term, compensating balance
increases effective cost and reduces funds available

Commercial Paper: short term unsecured promissory notes sold by large highly creditworthy firms

At most 180 days, more than 270 days requires SEC registration.

Sold directly or through dealers

May be sold on discounted bases or with interest paid over short life of note

Advantages: interest rates are usually lower, large amount can be obtained, no compensating balances,
no collateral, provides cash for general use

Disadvantages: available only to most creditworthy, satisfaction in short term, lacks flexibility in
extensions

Receivables and Inventory

Pledging of AR: using as security for short term loans. level available depends on creditworthiness or AR,
level of lender's recourse. fee based on value of AR is generally charged

Advantages: commonly available, flexible, no compensating balances, general use cash, lender
may provide billing or collecting services.

Disadvantages: accounts committed to lender, cost of pledging may be greater than other
financing, repayment in short term
Factoring AR: sale of accounts receivable. buyer is called factor

Without recourse: factor bears risk associated with collectability, except in case of fraud

With recourse: factor has recourse against seller for some or all of risk of uncollectability

Factor charges a fee (factor fee). based on creditworthiness, length and recourse
1. Amount to factor x factor rate= factor fee
2. Amount to factor - compensating balance - factor fee= amount provided
3. Amount provided - (amount provided x rate) = amount received

Advantages: commonly available, flexible, no compensating balances, general cash, buy

generally assumes billing and collection responsibilities

Disadvantages: cost of factor may be greater than other financing, if recourse can have on-going
risk, may alienate customers

Inventory secured loans: pledges all of part of inventory as collateral for short-term loan. amount
depends on value and marketability of inventory

Floating lien agreement: borrower gives lien on all of its inventory but retains control over it and
continues to sell it

Chattel mortgage agreement: lender has lien against specifically identified inventory, borrow
retains control but cannot sell it without lender approval

Field warehouse agreement: inventory remains at borrower's warehouse but under control of
independent 3rd party

Terminal warehouse agreement: inventory is moved to public warehouse and place under the
control of independent 3rd party

Cost of inventory loan: nature of inventory, credit of borrower, specific type of agreement used

Advantages: commonly available for certain inventories, flexible, general use cash

Disadvantages: pledge inventory not available when needed, cost may be great than other
financing, may require short term repayment, not available for certain inventory

Introduction to Long-Term Financing

Provided by funding that is due beyond 1 yr

The weighted average cost of capital for a firm is determined by the cost of its long-term financing, not
by its short-term financing.
Long-Term Notes and Financial Leases

Long term notes: cash through borrowing due in more than 1 yr. promissory note required (often
contain restrictive covenants). commonly between 1-10 years but may be longer, repayment in period
installments, may be secured by mortgage on property or real estate

Restrictive covenants: maintain working capital condition, restriction on incurrence of additional

debt without lender approval, specification or required frequency and nature of FS,
management changes without approval

Cost of long term notes: interest in market (changes as benchmark changes), credit worthiness, nature
and value of collateral

Advantages: commonly available, long-term financing with periodic repayment

Disadvantages: bad credit is more costly, violation of covenants have consequences

Leasing: acquisition of assets should be evaluated under both purchase and lease options

Is proposed project economically feasible if assets are purchased?

Is proposed project economically feasible is assets are leased?

Reject if both are not feasible, purchase only if only option or if higher return (same for leasing)

Reasons leasing is less than buying: lessor has Buying power or efficiencies, lower interest rates, tax
advantages.

Non cost reasons: flexibility and convenience

Lease terms:

Net lease: lessee assumes cost associated with ownership (maintenance, taxes, insurance)
Executory costs

Net-net lease: lessee assumes cost associate with ownership and responsible for residual value
at end of lease

Advantages: limited immediate cash, lower costs, obligation is specific to cost needed, scheduling lease
payments to patter cash inflows

Disadvantages: not all leasable, asset specific, terms may be different than asset usefulness, chosen for
non-economic reasons ) convenience

The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term
debt would be to reduce the risk, and therefore the interest rate, on debt being issued.
Bonds

Pay bondholder fixed amount of interest each period and repay face/principle at maturity

Indenture=contract. Par/face value = usually 1K. Coupon rate of interest= annual rate of interest

Debenture bonds = unsecured/no collateral. more risk. higher cost

Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a
higher coupon rate (interest rate) than comparable secured bonds.

Selling price: relationship between coupon rate and market rate.

Less than par/discount. More than par/premium. at par = rate

Price is the PV of cash flows: Periodic as annuity using current market rate + Face value at
current market rate

Current Yield: ratio of annual interest payments to current price of bond in market

Yield to maturity: rate of return required by investors as implied by current price in market (not likely on
CPA exam)

Market price of bonds change inversely with changes in market rate.

Bond would have to be discounted to earn current rate to be sold. Longer maturity, greater risk and
higher the required face interest rate

Advantages: large sums, doesn't dilute earnings, interest payments are deductible

Disadvantages: periodic interest payments, principle repayment, may have security or restrictive
covenants, not available for small companies

Floating-rate bonds are most likely to maintain a constant market value. The rate of interest paid
on floating-rate bonds (also called variable-rate bonds/debt) varies with the changes in some
underlying benchmark, usually a market interest rate benchmark

Preferred Stock

Like bonds: doesn't have voting rights, dividend are limited and expected

Like Common stock: ownership, no maturity, doesn't require dividends, dividends are not an expense
and are not tax deductible
Characteristics: possibility of having different classes or types, cumulative or noncumulative (for not paid
dividends), participating or nonparticipating (dividends in excess of preference claim can be paid),
protective provisions, convertible or nonconvertible (exchanged for common), callable (buyback at pre-
established price)

PS value is present value of expected cash flows (cash flows being preferred dividend)

Need: estimated future annual dividends, investors' required rate of return, perpetuity dividend
assumption

PSV= annual dividend / required rate of return

PSER (expected rate of return)= annual dividend/market price

Advantages: no legally required dividend or repayment, lower cost of capital b/c less risk, no voting, no
maturity, no security

Disadvantages: high dividend expectation, dividend payments not tax deductable, protective provisions
onerous, higher cost of capital than bonds

Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs
to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost

cost of preferred stock financing= annual dividend/(selling price - underwriter's fee)

Par value x the preferred rate = annual dividends

Common Stock

Regulatory requirements limit most companies to 1 class of common stock (some allow more)

Characteristics: limited liability, residual claim on earning and assets (after creditors and preferred), right
to vote on directors, auditors, and changes in charter (via proxy), preemptive right of new common
issued

Valuation: present value of expected cash flows both at common investors' required rate of return

Dividends and stock appreciation

CSV= PV of dividends expected + PV of expected market price

Held for multiple periods: less certain, assume dividends and market value grow at constant rate

CSV = 1st year dividend / (required rate of return - growth rate)

CSER: The firm's cost of common equity is the rate of return currently expected by potential investors

CSER: (1st yr dividend / market price)+ assumed growth rate

This gives marginal (new) investor required rate, also current cost of common stock capital

Advantages: no legally required payments, no maturity, no security

Disadvantages: higher cost of capital, dividends not tax deductible, additional shares dilute

Greater risk than PS, so cost is greater

Cost of capital for retained earnings is the cost of capital for common shareholders

Historic economic rate of return on common stock = (dividends paid + change in the stock
price)/beginning price

Cost of Capital and Financing Strategies

Cost of capital is the rate of return required by each source. Determined by other comparable
opportunities

Higher risk = higher return required

Macroeconomic, past performance, amount of financing, relative level of debt, debt maturity

Averages: LT corporate bonds = 5.9% Common Stock: 12.3% Small Cap Common: 12.7%
PS between 5.9 - 12.3%

Strategies: Hedging (self-liquidating debt)-matching cash flows from assets with financing needed to
finance (LT-LT, ST-ST)

Optimum capital structure objective: mix to achieve lowest composite cost of capital

Business risk constraint: variability of firms EBIT. higher variability = less debt than steady EBIT

Higher tax rate = greater amount of tax saved from debt

The cost of debt most frequently is measured as the actual interest rate minus the tax savings. The tax
savings result because the interest expense is deductible for tax purposes and the resulting tax savings
reduce the effective cost (and rate) of debt financing. For example, if the stated (actual) interest rate is
10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be
10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.
Introduction to Working Capital Management

Working capital = current assets - current liabilities

Objectives: maintain level of working capital to meet on-going operating and financial needs, not over
invest in working capital which provides low returns or increase cost

The production cycle is the time needed to convert raw materials into finished goods. The longer the
duration (time) of this cycle, the higher the level of working capital that would be expected

Cash Management

Cash: currency, demand instruments, demand deposits

Objective is to maintain minimum balance for operating needs

The longer a firm holds cash, the longer it provides financing

Accelerating cash inflows: prompt payment, efficient handling of cash after receipt

Float: time payment is initiated to a firm and when payment is received and available for use. Reduce
float by:

lock-box system: faster, more security, faster handling of bad checks

Pre-authorized checks: faster, highly predictable, automatic, handling of cash reduced

Concentration banking: regular/automatic transfer from multiple banks to primary bank.

Depository transfer checks (official bank checks): unsigned, non-negotiable and payable to an
account of the firm

Wire transfers: expensive method, speed and security

Deferring Cash Outflows:

Firms try to increase outgoing float

management of purchases and payment processes (charge accounts, payment terms, pay only
when due unless discounted, "stretch" by paying after due date but within acceptable time in
industry)

Remote banking: increases float on checks used to pay by establishing accounts in remote
locations (electronic advances have eliminated)
 Zero-balance account: Advantages: eliminates excess cash, reduces admin (monitor and recon)

By agreement- with bank to have an account with 0 balance. Checks are written against
that account which results in overdrawn, transfer from another account daily to
re-zero

By deposit-deposit exactly amount written against it so always 0

Payment Through draft: uses "draft" like a check but drawn on account that isn't the firm's
account. sold for a fee. guaranteed payment

Bank draft: bank on itself or corresponding bank. individual basis or automatic and
charged to customer account

Cashier check: 1 time order drawn on bank. customer pays fee and amount

Certified check: order drawn on depositor account, bank withholds amount. obligation
of bank

Money order: like certified check, sold by non-bank, limited in amount

Advantages: will be honored, don't require account, can be automated

Positive Pay system: entity send bank electronic file of check written, bank compares checks to file, if
match then paid, If doesn't match: firm decides on approval

advantages: detect unauthorized or altered check, prevent improper use of account

Electronic Funds Transfers (EFT): for single but most commonly for multiple. Automated clearing house
(ACH) routes payments after bank reduces account and forwards payments

advantages: reduces float, admin is automated and integrated with accounting system, low cost

The cash conversion cycle: period beginning with paying cash for inventory and ending with the
collection of cash from the sale of products made with that inventory

Short-Term Securities Management

Used for temporary excess cash. Safety of principal, price stability, liquidity/marketability, other

Traded in "money market"

T-Bills: risk free, 91,181 and 365 days, periodic from FED continuous in market,

Federal Agency Securities: Fannie Mae, Federal Home Loan Bank, slightly higher risk than Tbill
 Negotiable Certificates of Deposit (CDs): fixed time deposit, bought and sold in market, less
liquid than federal securities

Bankers' acceptances: draft drawn on bank. if bank accepts it becomes negotiable instrument
for investment

Commercial Paper: short term unsecured promissory notes from large, highly credit worthy Co.s

Repurchase agreements: securities issued for loans with commit from buyer to resell to issuer
plus agreed interest. large amounts, any length of time

Accounts Receivable Management

Conditions leading to 1. recognition of receivables 2. collection of receivables

Est. terms of credit: period, discounts, penalty, documentation

Creditworthiness: maximize profits, not minimize uncollectable

Credit limits: use service, conduct own analysis

Collection: keep post-sales loss to minimum

Monitor AR: aggregate (averages and ratios), individual (AR aging. past due billings, dunning letters,
collection)

The overall objective of accounts receivable management is to maximize profits

Inventory Management

Traditional Materials Requirement Planning (MRP): 1960s to JIT advent. focuses on a set of procedures
to determine inventory levels for demand-dependent inventory types such as work-in-process and raw
materials

Supply Push: produced in anticipation of sale

Inventory buffers at every level against unexpected demand

Production is base on long set up and long runs

Quality at "acceptable" level, impersonal relationships with suppliers, based on lowest bid

Uses traditional cost accounting: job order and processing cost approaches

Just in Time (JIT): from Toyota. Can't be used by all firms

 Based on obtaining and delivery inventory only when needed

Demand pull- goods produced only when needed

Reduces inventory or eliminates. reduces lead time in replenishing inputs

Production in work centers where workers operate multiple equipment

Close relationship to limited and nearby suppliers

Quality is important

Uses simplified accounting: more items considered direct cost

Inventory ordering v carrying cost: more ordered, less cost but more carrying cost

total inventory admin cost= total order costs + total carrying costs

Economic order quantity (EOQ) determines most effective inventory. Concerned with minimizing total
inventory cost by considering carrying cost and restocking cost (reordering costs)

T= total demand, O = per order cost, C= per unit carrying cost

Assumptions: demand, unit and carrying cost is constant, delivery is instantaneous

Inventory reorder point:

reorder point = delivery time stock + safety stock

A change in safety stock does not affect a firm's economic order quantity (but does affect its
reorder point). The calculation of economic order quantity (EOQ) is:
Current Liabilities Management

Should be used to finance assets that generate cash in short term (self liquidating debt), Some provide
permanent financing if recurring, don't require collateral or covenants, discount should be taken,
compensating balance raises effective cost, line of credit-revolving credit-letter credit are stand by
financing

Introduction to Ratio Analysis

Name given to ratio or other measures usually indicates elements used

Name give to ratio frequently indicates quantitative function to be performed

terms "to" and "on" indicate to dived first item by second

term "return" = income

When using a balance sheet value with an income statement value, you have to use the average for the
balance sheet value

Liquidity Measures

ability to pay obligations as they come due. good for working capital management

working Capital= current assets - current liabilities

working capital ratio= current assets / current liabilities

Acid Test/Quick Ratio (no inventory): (Cash + AR + Marketable Securities)/current liabilities

Defensive interval ratio: number of times highly liquid assets cover average daily use of cash

(Cash + AR + Marketable Securities)/average daily cash payments

Times interest earned:

Net income + interest expense + income tax related to interest expense (or EBIT)
interest expense

Time preferred dividends earned: Net income / annual preferred dividend obligation
Income before taxes is computed as solving for y: Tax Rate x Y = Income after taxes

Operational Activity Measures

AR turnover: number of times AR incurred and collected during a period

Net Credit sales / Average AR

Number Days' Sales in Average Receivables

360 / AR Turnover

Inventory Turnover: I.D over or under stocking and obsolete inventory

COGS / Average Inventory

Number Days' supply in inventory: efficiency of general inventory management

360/ Inventory Turnover

Operating Cycle Length: average time from cash out to cash in

Number of days supply in inventory + number of days sales in AR

Cash cycle = (inventory conversion cycle + accounts receivable conversion cycle) - accounts payable
conversion cycle

Operating cycle = inventory conversion cycle + the accounts receivable conversion cycle

The cash discount period is not included when computing a firm's target cash conversion cycle. The cash
discount period is the period of time during which a debtor is offered a discount for early payments of
an account and does not establish when cash is actually received. The actual collection of cash could be
any time during or after the discount period and it is that actual date of collection that enters into the
measurement of the cash conversion cycle.

Profitability Measures

Gross profit: sales after cogs

Sales - COGS = gross profit

Gross profit margin: how much of each sales dollar is available to cover operating expenses and provide
profit

Gross Profit/ Net Sales or (Sales - COGS) / Net Sales

Net profit margin: how much of each sales dollar ends up as net income

Net income / Net Sales

Return on assets ( Return on investment): rate of return on total assets and indicates efficiency on
investments

(Net income + Interest Expense + Interest Tax Savings) / Average Total Assets

Return on Owners Equity: rate of return on all shareholders investment

Net Income / Average Stockholders' Equity

Return on Common Equity: only subtract current period dividends, even if in arrears

Net Income - Preferred Dividends / Average CS equity

Residual Income: excess of net income over the dollar amount of required rate of return on average
investment. Using company's rate of return (hurdle rate)

Required dollar return= average invested capital x hurdle rate

Residual income = Net income - required dollar return

Economic value added (EVA): measure economic profit. deducts opportunity cost from earning before
deducting interest. Cost associated with capital financing is LT debt and shareholders equity

EVA = Earnings before interest - (Rate of return x (LT Debt + SE))

EPS:

(Net Income - Preferred dividends (current)) / Weighted average number of CS outstanding

Price-Earnings (P/E or Multiple)

Market Price of share / Earnings per common share

Equity/Investment Leverage Measures

Debt to Equity Ratio

Total liabilities / Total Shareholders' equity

Owner's Equity Ratio

Shareholders' equity / total assets

Debt Ratio: debt leverage in funding entity

Total Liabilities / Total Assets

Book Value per Common Share

Common Stock Equity / Number of common shares outstanding

Book Value per preferred stock

Preferred stock equity + dividends in arrear / number of preferred shares outstanding

Risk Concepts—Summary

Risk: possibility of loss or unfavorable outcome that results from inherent uncertainties

Business Risk: macro risk between nature of firm and nature of environment

Diversifiable risk (unsystematic / firm specific): elements of risk that can be eliminated through
diversification of investments

Non-diversifiable risk (systematic / market-related): elements of risk that cannot be eliminated through
diversification of investments. general economic and political factors

General business risk is measured by variability of EBIT

Financial risk: common shareholders' risk of return as a result of debt financing and preferred stock

Interest Risk: increase market rate of interest will decrease value of outstanding debt

Inflationary risk (purchasing power risk): rise in general price levels reduce purchasing power of fixed
sum of money

Liquidity risk (marketability risk): assets cannot be readily sold at fair value for cash

Currency exchange risk:

foreign currency transactions: transactions settled in foreign currency will lose dollar value

foreign currency translations: dollar value of translated FS of direct foreign investment will lose
value
 foreign currency economic risk: changes in exchange rates will make future transactions less
viable

Risks and Controls in Computer-Based Accounting Information Systems

Weakest control element in most accounting systems: People

People, procedures, hardware, software, data

Manual v Computer System control: segregation of duties, audit trail, transaction processing, computer
initiated transactions, risk of errors and defalcations, management review

Increased management review for computer based

Risks in computer based systems (FUNI)

F aulty systems and reliance on them

U nauthorized changes in master files, systems, programs

N eeded changes are not made

I ntervention by people is inappropriate

Data Risks (DUL)

D ata

U nauthroized access

L oss of data

It is common for computerized systems to combine functions that would be considered

incompatible in a manual system (for example, in computerized systems, a single employee is
often responsible for creating the deposit and posting the transactions to the cash receipts
journal, the accounts receivable subledger, and the general ledger).

The COBIT Model of IT Governance and Management

COBIT objectives: align IT and business goals / strategies. link business risks, control needs and IT.
common language. how much needs to be invested in IT and auditing oversight

Looks at business requirements, IT resources and IT processes and the relationships among them

Attributes of Information (7): effective, efficient, confidential, integrity, available, compliant, reliable
Activities: Business processes, Planning and organization, acquisition and implementation, delivery and
support, monitoring

IT resources: data, application systems, technology, facilities, people

COSO: organizational controls and processes

COBIT: focus on IT control and processes (Both are concerned with monitoring)

Monitoring in COBIT: monitor process, assess internal control adequacy, obtain independent assurance,
provide independent audit

Enterprise-Wide and Cloud-Based Systems

ERP integrates multiple systems: Management support, support of knowledge work, operational support

Goals:

Integrate: all data into 1 database

Cost Savings: lower maintenance costs

Employee empowerment: improves communication and decision making

Best Practices
2 or 3 tier architecture: 3 tier separates application and database functions (large and complex). 2 Tier
combines application and database into single tier

ERP system typically purchased in modules.

Online transaction processing system (OLTP): core business functions: sales, production ,purchasing,
payroll, financial

Online analytical processing system (OLAP): data warehouse and mining capabilities

Infrastructure as a service (IaaS): access to virtual hardware

Platform as a service (PaaS): access operating system and related services including development

Software as a service (SaaS): access to software

Community Clouds: available to member of a community (google apps for government)

Cloud based benefits: universal access, cost savings (pay for use), scalability (grow with organization),
outsourcing and economies of scale, enterprise wide integration

Cloud based risk: data loss, system penetration, linked to vendor

Primary objective of an enterprise resource planning system to integrate data from all aspects of an
organization's activities into a centralized data repository

Improving responsiveness and flexibility, and aiding the decision-making processes in an organization,
are important goals of an ERP system

Organizational Continuity Planning and Disaster Recovery

Organizational/ Business Continuity Planning (OCP or BCP)

Disruption: Based on criticality, application, cost, time to recover, securty

Recovery Point Objective: acceptable data loss recovery time

Recovery Time Objective: acceptable down time

Cold site: unimportant systems, off site location with electrical and other physical requirements for
processing. no equipment or files (added when needed), 1-3 days start up, cheaper

Warm site: off site location with similar computer hardware, does not include backed up data (delivered
when needed), more money

Hot site: completely equipped including data, near-immediate (within hours) operation, big costs
Mirrored site: running continually at multiple sites, fully staffed, fully equipped, real time replication of
mission critical systems, when one goes down the other picks up

OCP: plans for disruptions and disasters, integrate into culture, practice

BRM: business risk management

BIA: business impact analysis (risk portion of BCP)

Steps in OCP: create plan, determine critical functions and risks, determine continuity strategies,
develop and implement response, exercise maintain and update plan, embed plan into culture

Map level of incidents to events to responses 0 - 7

Task critical tasks are given the lowest priority in DRP. Mission critical tasks are given first priority in DRP

IT Functions and Controls Related to People

Risks associated with people: theft, destruction, alteration

Physical assets theft and destruction or intellectual property

IT responsibility: build applications, support delivery of IT services, manage data, manage networks and
communications

IT segregation of duties:

application development: safeguard assets in development. create and maintain in sandbox

system analysis: lead team of programmers, analyze and design

application programmers: write programs

systems admin and programming: granting authorization and access. maintain hardware and
software releases. no access to application programs or data files

computer operations: execute events, safeguard archived IP

data clerk: log and control document flows, batches, reconciling

computer operators: operate computer, load files, etc

file librarian: maintain files and data that are not online. no access to operating
equipment or data outside of library
 Most IT people controls are general and preventive

The "stakeholders" in an IT environment include both the IT personnel responsible for

developing and maintaining the system as well as the personnel from all areas of the
organization, who are the end users of the systems. In extranet environments, these end users
may also include customers and suppliers who access data relevant to their activities with the
organization online

System Development and Implementation

Purpose of system development: structured approach- ID roles, establish activities and critical path,
define project review and approval

Risks: does not work, cost overrun, behind schedule

Traditional system development lifecycle roles:

IT steering committee: review approve and prioritize development

lead system analyst: manages development teams, direct contact with end users, overall
programming logic and functionality

systems analyst and application programmers: design, create and test, work with users on
details

end users: identify problems and propose initial solutions

Waterfall:

planning/feasibility

Feasibility: possible, economic, meet user needs

Project plan: critical success factors, scope, major risks, milestones/responsibilities

analysis/requirements

understand business process and purpose

document system requirements (IT and end user collaboration- JAD)

design

technical architecture

model of the system

development

programmers design specifications and develop program and data. purchase hardware

testing

assessment of meeting design requirement (with both correct and incorrect data at operational
loads)

individual units, system testing, inter-system, user acceptance

implementation

Data conversion and user training

maintenance

monitor and update programs and systems

Pilot system: Users are divided into groups and are trained on the new system one group at a time.

Cold Turkey: Also called the plunge or big bang approach. The old system is dropped and the new
system is put in place all at once.
Program Library, Documentation and Record Management

SPLMS (source program library management system): software and instructions for people. managing
version numbers, validate changes

Store programs in source program library

retrieve programs for updating and maintenance

delete obsolete programs

audit trail

May be part of operating system or purchased separately

System documentation: greatest use for auditors, overviews, flow charts, processing logic

Program documentation: technical, description of inputs, logic, outputs program flow charts, source
code listing,

Operator documentation (run manual): how to load and execute programs and data

Documentation is general and preventative

Record retention and destruction: policy and plan should dictate, follow laws, can be held liable

Input and Origination Controls

Ensure reliability of data, enables auditor to assess risk

OLRT: online real-time: use entered data to display additional information

Batch control totals:

Financial total: add up some dollar amount

Hash total: add up something that is not normally summed

Record count: count the number of invoices

Key verification: re-enter and compare critical data (passwords)

Field check: data is the right kind (alpha or numeric, format)

Limit test: numeric fields within a range

Processing, File, and Output Controls

Application controls: Input, processing, file, output

processing: accuracy, validity, completeness, efficiency (detect unauthorized changes, maintain

integrity)

Run to run controls: batch totals form 2 runs agree

Transaction logs: OLRT systems, audit trail. data values, times, IP address, terminal, user name.
essential to backup and recovery points

file: Master files (have subsidiary files), standing files (rarely changed master files - fixed asset records),
transaction files, system control parameter files (inputs processing parameters)

Check digit (parity bit): 0 or 1 included in byte to indicate sum of bits (odd or even)

Read after write: confirms data was written correctly (burning to disk)

echo check: data has been transmitted correctly

boundary check: multiple or simultaneous users, prevents overwrite and access

Internal labels: read by system for removable storage

external labels: read by humans

version controls: protocols for ensuring correct file versions

file access and updating controls: restrict to authorized

output:

Transaction logs: log of printed output

access to sensitive reports through permissions and controls

spooling of print files: where data is sent and how its received

Primary objective of data security controls: Ensuring that accessing, changing, or destroying storage
media is subject to authorization

Introduction to E-Business and E-Commerce

E-commerce is sub category of E-business

E-business: process that relies on electronic dissemination of information (within or between

organizations)

E-commerce: transaction between organization and trading partners

Business to business: B2B, EDI, SCM, EFT

Business to customers: B2C

Business to employee: B2E sharing info and interacting with employees

Business to government:

Requisites: trust in partner and site or service

Risk: availability/downtime, security and confidentiality, authentication and non-repudiation, integrity

Models: electronic marketplace/exchanges, viral marketing, online direct marketing, electronic

tendering, social networking

E-Commerce Applications

Customer relationship management (CRM): managing client relationships based on customer data,
profitability and personalized marketing. e-business systems but not e-commerce systems

Electronic Data interchange (EDI): computer to computer exchange of business data, transaction
processing, structured data, facilitates JIT. Relies on service bureaus or VANs. Audit trails, controls and
security. Paperless, no data entry, reduce errors, required by some suppliers, real time, no delays
 Costs: infrastructure creation, application integration, new technology, business to business
linkages

E-banking: requires senior mgmt and BOD oversight, technology under senior IT leadership, operational
mgmt monitoring and measuring risk

Electronic funds transfer (EFT:) increase speed of transfer and reduce costs. usually 3rd party vendor
between company and banking systems, transactions through automated clearing house.

Supply chain mgmt (SCM): often includes EDI

The primary advantage of using a value-added network: It provides increased security for data
transmissions

System Types by Activity

Think in terms of capability when asked questions on systems

Operational systems: operational. support large volume day to day transactions. sometimes called TPS
(transaction processing systems).

Management information systems: lower mgmt. routine day to day lower level mgmt. internal data. for
structured problems. compare budgets v actual, reports. Accounting system is subset of this

Decision support systems: high level of mgmt. non routine problems and long range planning, significant
analytical and statistical capabilities. data or model driven. client risk assessment, acceptance and
retention

Executive Support System (ESS): support forecasting and long range strategic decisions. greater use of
external data. is a subset of DSS that are especially designed for forecasting and making long-range,
strategic decisions, and they place greater emphasis on external data. The need to consider a large
proportion of external information in the decision process makes an executive support system (ESS)

Knowledge Work systems: collect organize

System Types by Data Structure

Flat file:separate programs and data sets that each application manages. data sharing across
applications was a mess and required reformatting. high redundancy, bad type

Database systems: pool data into logically related files. good type
Knowledge management system: includes knowledge or knowledge database

Data warehousing and mining: collect, organize, integrate, and store entity wide data

Warehousing: archived operational transactions. can include external data. drill down / slice and
dice

Mining: exploration and extract needed info. pattern recognition

A data mart is focused on a particular market or purpose and contains only information specific to that
objective

Mobile Device, End-User, and Small Business Computing

Risks: user-installed applications can create security risks (spyware), loss and theft, access and
permissions

Challenges: redesigning displays, functionality across platforms, emerging technologies

End-User Systems development risks. no knowledge or application. inadequate testing, poor controls.

Small business: harder to control, higher risk of errors, defalcation, system failure. results from no
centralized IT, poor segregation of duties. Protect sites and data, logical electronic access

Combining the authorization and review/auditing functions, while not desirable, is the least risky option
and is recommended.

Authorization is most likely to be absent in a small business computing environment. There is a

great need for third-party review and testing within the small business computing environment.
Mobile computing increases, not decreases, usability issues

Data Structures, Software and Databases

Input: hardware, database system, software: output

Byte is logical grouping of bits (ex "R" could equal 1010010)

field: is a logical grouping of bytes, characteristic or attribute of entity. known as attributes in databases

Record: logical grouping of fields. describe an example of an entity (specific invoice)

file: collection of related records

Database: contains multiple files

System software: run computer and support system management (operating system)

Programming language: used to create applications. converted from source code to object code (what
its executed it.

Application software: general and specific. off shelf or develop internally

Database management system (DBMS): "middle-ware" between application software and operating
system. Data definition language (DDL): define and relations. Data manipulation (DML): add delete or
update. Data query language (DQL): extract data, SQL "text based" or query by example "drag and drop"

The database management system (DBMS) controls the storage and retrieval of the information
maintained in a database and is responsible for maintaining the referential integrity of the data.

Database management software is considered both software and middleware

Information Systems Hardware

Peripherals: input and output devices (keyboard, mouse, printers, etc)

CPU: control unit that interprets program instructions. ALU: performs arithmetic calculations

ALU, RAM, and the control unit are all considered part of the CPU

Primary Storage: main memory stores programs and data when in use. RAM for temporary, ROM
permanently memory

Magnetic tape: mostly for large archive storage for older less important storage, slow

Supercomputers: fastest available, calculation intensive, parallel processing and computer clusters
Mainframe computers: input / output systems, legacy and ERP, used with microcomputers in networked
systems with thousands of simultaneous users

thin clients: minimal capabilities that mostly uses resources on server

Transaction Processing

Manual processing: enter transaction on source doc, record in journal, copy to ledger, prepare report

Automated: data capture (bar codes), transaction file, master files, displays or reports

Batch: group transactions by type, sort into item number sequence (same as master file), process
sequentially, compute batch control totals. transaction and master files must be sorted on common key
"sequential-access files". use when sequential processing, low volume, periodic, independent
transactions or unimportant

On-line, Real time processing (OLRT): continuous, immediate transaction processing, near simultaneous
transaction entry and master file update. each transaction is captures, validated, and updated before
next one. Requires: random access storage devices (magnetic disks), networked computer or internet.
good for interdependent transactions. bad for cost and low priority systems

Point of Sale (POS): capture data from bar codes that connect with other data and integrated, systems
or terminals networked to central computer which maintains databases of products/prices/sales/etc

Online real-time processing is characterized by (1) the processing of one transaction at a time; 2) use of
random processing technology, and (3) processing of transactions immediately (as they occur)

In a computer-based system, the equivalent of a subsidiary ledger is a Master file

Multi-Location System Structure

Consolidate from multiple locations:

centralize: advantages: better security, consistency in processing disadvantages: high transmission

cost, bottlenecks, latency

decentralized: must do some, summarized sent to central. advantages: lower transmission costs, power
and storage at central, bottlenecks, improve latency disadvantages: redundancy, security, hardware
cost

distributed: distributed based on needs, increasingly common. reduce or eliminate need for expensive
central processing. disadvantage: consistencies, communication costs
Computer Networks and Data Communication

Network: 2 or more computing devices connected by communication channel

Node: network access point, a connected device

Each node is assigned DNS & IP address. network monitors display node activity

Switchs: allow traffic

Network interface card (NIC) or network access card (NAC): circuit board and software on each node,
matched to transmission media. computer speak to network speak

Client node: end user microcomputer. Server: provides services or resources to network

Local Area Networks (LANS or LANDS): dedicated lines, cover limited area

Wide area network (WANs): use shared lines

Storage area network (SANs): type of LAN, dedicated connect storage devices to servers, central storage

Personal area network (PAN): bluetooth, used by individuals

Wired communications: Twisted pair- slowest and least secure, low cost and in most buildings
coaxial cable: faster, more secure, moderate capacity, less subject to interference
fiber optic: fast and secure, light pulses through glass, more expensive.
Wired more reliable, secure, faster, can be lower costs if pre wired

Wireless communication: 1. microwave- primarily used in WANs 2. WiFi (spread spectrum radio
transmission) 3. Bluetooth. All are scalable, flexible, lower cost, mobility

The Internet—Structure and Protocols

Internet: largest client-server network. built on TCP/IP (transmission control protocol internet protocol).
means for assigning IP addresses

Packet/block: sent files are broken for efficiency.1. Header: routing info, length, protocol, originating
info 2. Data 3. Trailer: some systems use, error detection, end of message ID

Email: 1. Mail server: host email, deliver, forward and store 2. clients: link users to servers

TCP: breaks sent messages into IP packets, sent to routers and delivered

URL: uniform resource locator. Browser translates URL to IP address via HTTP request (hypertext
transfer protocol), HTTPS is for greater security

Simple mail transfer protocol- SMTP: protocol for email services

IMAP: internet message access protocol remote access to mailboxes as if they were local

FTP: file transfer services protocol for uploading and downloading files

Markup (or tagging) languages: codes that indicate how parts of file are processed and displayed (html:
text for display on web pages, XML: for tagging documents in machine-readable form, XBRL: extensible
business reporting language- xml based for encoding and tagging financial information)

Intranet and extranets: private networks with limited access built using internet protocols

XBRL is specifically designed to exchange financial information over the World Wide Web
Transmission control protocol/Internet protocol (TCP/IP) is the protocol used by the Internet

Backup and Restoration

Backup plans: recover from equipment, power, and errors. maintain at least 1 remote archive off site

Where it happened, reprocess first transaction before it, clean dataset now

Backup procedures: Grandfather, father, son (common in batch), checkpoint and restart (common in
batch), rollback and recovery (OLRT, same as checkpoint restart), fault tolerant systems (operate despite
component failure of redundancy and corrections for component failure. for high risk stuff), HACs
(computer clusters designed to improve availability, common in e-commerce), Remote (automated,
experts run), SANs (replicate data from multiple sites, immediately available, efficient storage for
servers), Mirroring (exact copy, stored in same format, expensive and large)

A fault tolerant system includes redundant components

Rollback and recovery procedures are common in online real-time systems
-Mirroring is a high-cost, high-reliability approach to backup that is common in e-commerce applications

Logical Access Controls

Software manages logical access control: read, write, copy, create, etc

Good password: more than 8 characters, upper and lower, number, special character

Security Token: one time password. Challenge should be safe, memorable, stable

Firewall: hardware and software combination that monitors network traffic

Network firewall: looks at header to allow, very fast

 Application firewall: inspect data packet contents, deep packet inspection, quickness varies

personal firewall: block unwanted traffic, childproofing

IDS: monitor network traffic for anomalies: signature based (stored/known), statistical based (unusual
levels), neural network (learn from created database and block)

IPS: honeypot / honeynet allow hackers access to a decoy system to identify and block

Physical Access Controls

IT facility controls: All are general controls

Some preventative: restricting access Some corrective: program and data backup, recovery

Power system risks: failure (blackout), reduced voltage (brownout), sags/spikes/surges, Electronic
interference (EMI)

Physical access: restrict access, ID badges, Labels, internal labels, attributes ,etc..

White Hacker: paid by organization Black Hacker: outside hacker not paid by company

Headers are used to identify data records in an accounting system file.

Encryption and Secure Exchanges

Encryption: converts plain text to secure coded ciphertext. Algorithm determines it. encryption key is a
device or code that makes message unique and is needed to decrypt

Key length: longer keys are slower and harder to crack

Symmetric Encryption (single key or private key): one algorithm to encrypt and decrypt. Sender creates
and send ciphertext and tells which algorithm key, receiver reverses. fast, simple, and easy

DES is old standard, AES is new standard

Asymmetric encryption (public/private encryption): uses paired algorithms. One to encrypt and one to
decrypt. safer but more complicated.

Digital Certificate: contains info for ID. uses asymmetric encryption, purpose is to provide identity and
create secure communication

Certificate or Certification authority (CA): to acquire key pair, user applies. registers public key on server
and sends private key to user
Digital Certificates: legally recognized identification using public/private key. added security of CA before
issuing certificate

Digital Signatures (e-commerce): uses public/private key. key pair can be acquired without verification

Secure internet transmissions protocols. all use some form of asymmetric encryption

SSL: secure socket layer.

S-HTTP: secure hypertext transport protocol

SET: secure electronic transactions protocol. internet consumer purchases

Both the public and private keys can be used to encrypt and decrypt messages, although the public key
can only decrypt messages encrypted using the private key and vice versa.

Digital certificate provides the most reliable form of electronic authentication

A virtual private network (VPN) is a secure way to create an encrypted communication tunnel to allow
remote users secure access to a network. The VPN uses authentication to identify users and encryption
to prevent unauthorized users from intercepting data.

A major disadvantage of using a private key to encrypt data is that both the sender and receiver must
have the private key before this encryption method will work.

A digital signature is used primarily to determine that a message is unaltered in transmission.

Computer Crime, Attack Methods, and Cyber-Incident Response

Backdoor: small amount of code to allow programmer to access

Denial of service attacks: floods server with incomplete access requests. often use botnets

Eavesdropping: unauthorized interception of private communication

Emailing bombing/spamming: sending millions of emails to address

Logic bomb: planted in system, dormant until event or time

Malware: exploit system and user vulnerabilities, ex. viruses, worms (copies across systems)

Trojan horse: hidden in file and will plant code on your system

Packet analyzers/network analyzers/sniffers: network control (legit) and data capture (nefarious)

Man in the middle attach: hacker impersonates sender and receiver

Password crackers: software to gain access.

Hijacking: take your IP address and use it to access network

Salami Fraud (slicing): transfer tiny amounts from large number of accounts

Phishing: spoof email and fraud websites

War chalking: draw symbols in public places to indicate available wifi network access

Cyber incident: violation of organization's security policy. response based on protocol

Manufacturing Costs

Direct Material: significant raw materials and components that make finished product

Direct Labor: wages for work that directly converts raw materials into finished products

Manufacturing Overhead: cost of labor and supplies that support production but are not easily traceable
to finished product

Prime Costs= direct material costs + direct labor costs

Conversion Costs= direct labor costs + factory overhead costs

Product costs are also known as "inventoriable costs" or "manufacturing costs". attach to goods and
expensed when sold (inventory: assets COGS: expense)

Period costs: cannot be matched with specific revenues and expensed in period

Actual costing: simplest, most accurate, waiting until all costs are known and then record (AQ x AP)

Normal costing: moderately simple and accurate, direct materials and labor traced to WIP when costs
are known ( Actual quantity x Pre-determined overhead rate) POR is estimated at beginning of yr and
reconciled at end of year

Standard costing: costing method that uses predetermined estimated rates and quantities to record
direct costs and overhead (SQA x SP) SP and POR are conceptually equivalent

Indirect materials flow into overhead. Left side of OH account is actual overhead or factory OH control.
Right side of OH account is applied overhead

Journal entries to record the manufacturing cost are similar for job-order and process costing. When
overhead is applied, it is debited to work in process. The credit is to factory overhead applied

Actual overhead is not debited to work in process. Rather, work in process is debited to factory
overhead applied
 Overhead is applied to jobs using a pre-determined overhead rate, which is calculated by
dividing estimated overhead costs (both variable and fixed) by a budgeted or estimated quantity
of a cost driver

Spoilage, Cost, and Inventory Flow

Spoilage:

Normal: uncontrollable and unavoidable as part of current manufacturing process. included in

COGS

Abnormal: controllable and avoidable. unexpected and due to exception. considered period cost

Scrap: material left over after production. money received from sale can be used to reduce factory
overhead and thereby reduce COGS. If significant can be treated as other sales revenue

Unless traceable to a job, spoilage spread equally across all jobs. caused by a customer charged as
additional revenue

Flow of costs through inventory:

Wholesale and retail: COGS = Goods available - Ending Inventory

Manufacturing have 3 inventories: Raw materials, work in process, finished goods

Schedule of COGS Sections: They build on each other 1-4

1. Direct Materials:

2. Total Manufacturing Costs: only section with "format" calculation change

 3. Cost of Good Manufactured

4. Cost of Goods Sold

The cost of units produced includes: Scrap and normal spoilage, but not abnormal spoilage.

Cost Behavior Patterns

High-Low method: provides rough estimate of fixed and variable cost that comprise total costs. calculate
change in costs from 2 production extremes. fixed costs are determined by removing variable cost
component

rise/run: (High cost - low cost) / (high units - low units) = variable cost per unit

TC = FC + VCU x Units High cost= FC + (VCU x high unit)

Always want variable cost per unit and fixed cost per total. High and low values are from the X axis

Variable cost per unit in the relevant range is defined to be a constant. This assumption enables
cost-volume-profit analysis and many other functions within cost accounting.

Total fixed cost is assumed to be constant in the relevant range. With declining production, fixed
costs per unit would increase because the number of units produced is decreasing.

Total costs decrease when production decreases. The decrease equals the decline in total variable costs
resulting from the production of fewer units. Fixed costs are assumed to be constant

Activity-Based Costing and Process Management

Purpose: assigning overhead costs to products. alternative to traditional methods. larger number of
smaller cost pools that more closely align to products

Cost Drivers: measures that are closely correlated with the way activity accumulates costs

Cost Center: where costs accumulated and then distributed to products

Cost Pools: group of costs that are associated with specific cost center

Value adding costs: costs that contribute to ultimate value: design, packing, etc

Non-value adding costs: do not contribute to value: storing of raw materials

Activity Cost Hierarchy:

Facility levels

Product sustaining level

Batch level

Unit level

Traditional systems tend to over cost high volume and under-cost low volume, ABC does the opposite

ABC: more precise measure of cost, more cost pools, more allocation bases
Process Management: increase manager understanding and promote elimination of waste

outsourcing: contracting to external provider

Shared services: provide essential business where previously provided by multiple parts or org

outsourcing: process is moved to foreign country

ABC systems identify more cost drivers (allocation bases) than traditional costing systems do.
Cost drivers are independent variables that help to explain the behavior of cost and are,
therefore, useful in providing cost allocations that more closely reflect the causal factors
affecting cost behavior. Costs are divided into a greater number of cost pools for this purpose, to
group together those costs that behave similarly and that may be related to smaller production
cells.

Off-shore operations are especially vulnerable to cultural/language issues and difficulty

protecting intellectual property rights.

Activity-based costing seeks multiple cost drivers to explain the behavior of cost. The technique
recognizes that there is no single independent variable to explain how a cost behaves. Breaking
down costs into lower levels of aggregation also helps to identify the factors that are relevant in
explaining cost, and to exclude other factors.

Absorption and Direct Costing

Only difference between variable and absorption costing is treatment of fixed manufacturing costs

Absorption is required for external reporting and that fixed cost be treated as product cost. Fixed
overhead costs assigned to inventoriable items.

Variable costing (aka direct costing) assigns only variable manufacturing costs to inventory: direct
material, direct labor and only variable manufacturing overhead. Fixed is a period cost and expensed as
incurred

Fixed admin and selling costs are the same for both methods. only difference is how fixed manufacturing
overhead is treated

In an income statement prepared as an internal report using the direct (variable) costing method, fixed
selling and administrative expenses would Be used in the computation of operating income, but not in
the computation of the contribution margin. The contribution margin equals sales minus variable costs.
Fixed costs are deducted from the contribution margin to calculate income.

Variable selling costs are period costs under both direct and absorption costing. Direct costing also
treats fixed manufacturing costs as period costs. Under direct costing, only variable manufacturing costs
are treated as product costs.

Sales
- Variable Manufacturing
- Variable Selling and Administrative
= Contribution Margin
- Fixed Manufacturing
- Fixed Selling and Administration
= Operating Income

Absorption and Direct Costing Effects

Question will focus on: Inventory evaluation, calculation of variable costing and absorption costing
income, reconciliation of VC and AC income

Absorption costing (gross margin format). if you produce more than sell, portion of fixed manufacturing
is capitalized as part of inventory and not expensed until sold
 Sales
- Variable Manufacturing for units sold
- Fixed Manufacturing for units sold
= Gross Margin
- Variable Selling and Admin
- Fixed Selling and Administration
= Operating Income

Variable costing uses contribution margin. classifies related to variable and fixed nature

Sales
- Variable Manufacturing
- Variable Selling and Administrative
= Contribution Margin
- Fixed Manufacturing
- Fixed Selling and Administration
= Operating Income

Variable selling and admin costs are not product costs. fixed manufacturing overhead is a product cost
for absorption. It is possible to produce the same income for both methods with no change in inventory

Reconcile the two methods by:

Difference = change in inventory X fixed manufacturing overhead per unit

Absorption costing includes fixed manufacturing costs as part of product costs; direct costing expenses
fixed manufacturing costs as a period expense. Because of this, inventory valuation under absorption
costing is more than inventory valuation under direct costing. When a firm sells more than it produces, it
must use some of its existing inventory. Since absorption costing has a higher inventory valuation, the
cost of goods sold under absorption costing will be higher (and income lower) than under direct costing.
Gross profit is a term taken from an absorption costing income statement. Gross profit is the difference
between sales and the cost of goods sold.

Job Costing and Overhead Allocation

Process costing: large volume Job Costing: unique items

Job Costing: accumulated by job, OVH applied based on predetermined rate. Grouping by customer.
follows sequential tracking

Process cost: will focus on calculation of equivalent units under difference assumptions, FIFO v weighted
average. accumulated by process by department or operation

OVH costs: 3 step process to memorize

1. Calculate predetermined OVH rate (POR):

Budgeted Factory OVH cost / Estimated Cost Driver Activity level

2. Allocate using actual units of allocation base

3. At end of year compare and over/under applied. Take difference between allocated OH and
actual OH to COGS

Process Costing
Used to accumulate costs for mass-produced, continuous homogeneous items that are small and
inexpensive

Manufacturing costs need to be allocated to COGTO and EI

3 Steps in process costing:

1. Determine equivalent Units (EU)

Compute for both direct materials and conversion costs. Equivalence is all about cost.
1 EU = 1 whole unit in terms of cost

2. Computer cost per EU

Divide cost for direct materials (DM) and conversion costs by equivalent units. Gets cost
per EU for both DM and conversion costs

3. Determine 1. COGTO of WIP and 2. Ending WIP Inventory

Appropriate EU multiplied by EU to WIP EI and COGTO

Cost Flow Assumptions: Only difference is treatment of beginning inventory. No BI = same result.

Weighted Avg: assumes prior period costs and current period costs are averaged together. BI
averaged with current period

FIFO: assumes prior period costs and current period costs are separate. BI treated as lump sum
and added to current period costs. consider current period only

All costs must be allocated to ending WIP or Finished goods

FIFO:

% Completed = amount done for the period towards completing

Units started and finished = Units completed - BI

 Nominal Units % Completed Equivalent Units
Beginning WIP 10,000 30% 3,000
Units started and finished 130,000 100% 130,000
Ending WIP 20,000 25% 5,000
Units to account for or Equivalent units 160,000 138,000

Weighted Average: Must include spoilage in your calculation with completed units and partial
completed EI

Units completed and transferred out, including normal spoilage 7,500

Ending inventory (% complete) *Units 2,000
Equals total equivalent units of work for conversion cost through the end of the current
9,500
period

Total conversion cost/equivalent unit for conversion cost = ($10,000 (BI conversion cost) +
$75,500 (units started in month))/9,500 = $9

Conversion cost of goods transferred out: $9(7,500 units including spoilage) = $67,500.

Joint and By-Product Costing

When multiple products result from single manufacturing process. When produced from same set of
raw materials and not separately identifiable until split-off point

Spilt-off pt: point when products are differentiated and processed separately

Joint Costs: costs incurred prior to split-off, must be allocated to joint products

Separable costs: additional processing costs beyond split off point

Cost Allocation methods:

Physical volume method: costs allocated based on quantity purchased. volume of all products is
established, each product's rate is determined, allocated based on that proportion
 Relative Sales Value Method: Costs allocated based on sales values of products either at split-off
or after additional processing. when market exists at split-off point, relative sales value of each
product is used to allocate costs. When no market at split-off, ratio of net realizable value to
total net realizable value (NRV) is used to allocate costs

NRV= final market price - additional separable processing costs of each product

By-Products: differ from joint, insignificant sales value when compared to main product, not
allocated share of joint costs, when processed after split off: additional processing costs to by
product. net sales used to reduce cost of main products, no revenue recognized from sale of by
products. misc income when insignificant

Scrap: some but little recovery value, seldom processed beyond split off, proceeds used to
reduce overhead costs (credit to factory overhead control), may be offset against specific
material

Where the net proceeds from the sale are used to reduce joint costs, no profit is recognized on sales of
by-products, even if 0 units of main product were produced and by-products were sold.

Budgeting

Questions difference between static and flex budgets, master budgets

Master Budget: comprehensive schedules

Budget process: begins with sales forecast (dollars and units), flow forward to cash budget and
production budget

Master budget: Static budget (AOP / BAC), flexible budget (IF / EAC), actual level deviates revenue and
VC changed. Rev (new quantity x sales price), VC (actual x VC per unit). total fixed cost remain same as
long as stay within relevant range

Production budgets:

BEG INV + Produced= Available - EI = Good Sold

With inventory declining, purchases must equal cost of sales less the decline in inventory. In other
words, purchases are less than cost of sales if inventory declines. Ex. If the gross margin is 40% of sales,
then cost of sales is 60% of sales

Purchases = cost of sales - inventory decline

If accounts payable (AP) is to decrease, payments on AP must exceed purchases. (Add decrease to AP for
total payment)

The cash budget is the last budget to be prepared and includes a plan for earning and financing all of the
strategic action plans of the enterprise and other incidental issues earning and requiring cash flow.

Desired Ending Inventory: (Desired Inventory - Beginning Inventory) + Projected output/sales

Forecasting Techniques

Expected value and joint responsibility and regression

Expected value: long run average outcome. sum of calculate weighted averages (value x probability,
then sum all)

Joint probability: probability given an event already occurred. multiply first prob. by second prob., then
sum event combinations, then divide each result by total

Variance analysis: dispersion of values around expected value, smaller is tighter group

Correlation analysis: coefficient (R) measures, -1 to 1

Coefficient of determination (R^2): degree that independent variable predicts dependent variable,
closer to 1 the more predictable. reflects the overall model's explanatory power of the independent
variables in predicting the dependent variable

Regression analysis: predicts dependent variable based on independent. does not reflect cause/effect-
just relationship

Cost-Volume-Profit Analysis Calculations

Determine breakeven point, income or effect on one or both. Before or after tax? CVP is before tax

Effect on income is almost always opposite of effect on breakeven. All changes except volume

Breakeven: CM = contribution margin (Price - variable cost per unit) P = price

Target Operating Income Units = (FC + TOI) / CM

Breakeven units = FC / CM Where CM = P - VC Unit

Breakeven Dollars = FC / CM % Where CM % = CM /P

Multi-Product Breakeven

Composite method: Take CM of both and multiply by selling mix. then add both results to get composite
CM. Then BE = FC / Composite CM, then take result and multiply by mix
At the breakeven point, the contribution margin equals total.

Contribution Margin - Fixed Costs = 0, and therefore

Contribution Margin = Fixed Costs.

Variable costs include Direct Materials, Direct Labor, Variable Factory OVH, Variable Selling/Admin

+Sales
- Variable Costs
=Contribution Margin
- Fixed Costs
=Operating Income
- % Income Tax
=Net Income

Dividing the total contribution margin by the unit contribution margin will yield the number of units
sold:

Cost-Volume-Profit Analysis Issues and Graphics

Income and breakeven typically move in opposite directions

No change in inventory, Applies to Operating Income (before tax).

Margin of safety: current sales vs breakeven. how much can it decrease before negative

When target profit beyond BE is specified:

Sales Units = (Fixed Costs + Targeted Profit) / Contribution Margin per Unit

For volume-profit chart: slope of line is contribution margin. Uses only 1 sloped line

Breakeven chart uses 2 sloped

breakeven sales = Fixed cost/contribution margin percentage

Breakeven Sales = Sales - Margin of Safety

Sales and Direct Cost Variance Analysis

Non-material variance- written off to COGS Material variances- allocate to ending WIP, FG, COGS
Variances due to quantity: Quantity or Efficiency Variances

Variances: Standard amount - actual amount

Standard amount: always the standard quantity allowed for actual production (SQA)

SQA = standard inputs per unit x actual finished good units produced

Quantity: multiplied by difference in price

Price: multiplied by actual quantity

Sum is flexible budget variance: sum of rate and efficiency variance

Rate = (Actual rate - standard rate) x Actual Units

Efficiency or quantity= (Actual quantity - standard quantity) x standard price

Overhead Variance Analysis

Separate variances for variable overhead and fixed overhead

Changes due to cost driver consumption, not true changes in overhead consumption

rate type variance = spending variance quantity type variance = efficiency variance

spending variance: price changes in indirect material and labor, poor budget. is influenced by managers,
controllable, due to both price and quantity

efficiency variance: the difference between actual direct labor hours worked, and the standard quantity
of hours allowed for actual production, times the variable overhead rate per hour. due to variations in
efficiency of base used to allocate overhead, often controllable if can control base, is influenced by
increasing or decreasing machine hours, all about machine hours

Volume variance: the difference between the master budget for fixed overhead and applied fixed
overhead.

(master budget production volume - actual production volume)(PF)(SQ)

where PF is the predetermined overhead rate for fixed overhead based on direct labor hours, and SQ is
the standard quantity of direct labor hours per unit.
Budget variance: difference between estimated total fixed overhead and actual total fixed overhead
cost, controllable

4-way analysis: variable overhead (spending and efficiency) and fixed overhead (volume and budget)

3-way analysis: combines variable spending and fixed budget into total variance

Relevant Costs 1

Relevant costs/benefits: future costs/benefits that differ among alternatives

Irrelevant costs: Sunk cost- cannot be changed, future costs/benefits that do not differ

Accounting costs: book values

Opportunity costs: forgone results from choosing one alternative

Incremental costs: difference between 2 decision alternatives

Sell now v process further:

only consider: incremental revenue - incremental costs

Keep or drop (discontinue): some of costs may not be eliminated, can impact other parts of org, will
eliminate contribution margin, allocated costs/fixed costs may continue

Incremental cost (also called differential cost) is the difference in total cost between two decision
alternatives

Joint costs are sunk costs that are unavoidable, regardless of whether the item is sold at split-off or
processed further

Relevant Costs 2

Special order decision: only relevant costs are associated with order and if applicable opportunity cost of
capacity cancelled to complete order

If can be produced with existing capacity, only consider: sales revenue and avoidable variable costs

All variable costs are avoidable and all fixed costs are not

Make or buy decision (outsourcing decision): same considerations as special order with added quality
concerns
Transfer Pricing

Determined by

Market based: price purchasing unit pays on open market

Cost Based: one variation on selling unit of cost of production (variable or full cost)

Negotiated: agreed upon by both. selling minimum price will be equal to direct costs if excess
capacity or market price if no excess capacity

Senior management ususally establishes rules on pricing for goals of organization as a whole

Transfer price per unit = additional cost per unit + opportunity cost per unit

(additional costs include incremental production costs incurred by selling unit)

Dual pricing: selling uses market buying uses costing

Taxes also considered in pricing (states and internationally)

Quality and Inventory Management

JIT is "pull" process: includes flexible environment, skilled/flexible workforce, workers organized in
teams or cells, worker perform many tasks, low or no defects

JIT typically takes costs directly to finished goods or COGS, if goods remaining in inventory- cost are flush
back to inventory

Quality of design: meeting/exceeding the needs/wants of customers

Quality of conformance: conforming to the design specifications

Appraisal costs: costs to I.D. defective products during manufacturing (inspection/test of functionality)

Internal Failure: I.D. before delivery External failure: failure in hands of consumer

Quality is low then more total cost of quality is related to cost of failure

Increases in cost of prevention and appraisal decrease cost of failure and increases quality of
conformance

JIT system seeks to reduce those activities that do not increase the value of the product to the customer

Safety stock is a buffer for variations in demand and lead-time for the delivery of material. Safety stock
affects the reorder point, but does not enter into the quantity to be ordered.
 Prevention costs are those that try to include proactive efforts to prevent defects before the
products are produced.

The formula for economic order quantity is the square root of the following expression:
2 X annual demand X cost to place an order
__________________________________
carrying cost per unit per year

Conformance costs: Prevention and appraisal

Non Conformance costs: Internal failure and External failure

JIT: Minimal inventories are maintained, and cellular production facilities are used. There is much
less need to maintain detailed records of cost by job. The job is simply costed at completion.
There is no need to know the cost until that time. Inspection costs are reduced because zero
defects is a goal. Production stops until the cause of the defect can be identified and fixed.

JIT: Cost per purchase order decreases, inventory unit carrying costs increases

Balanced Scorecard and Benchmarking

Balanced scorecard: Financial, customer, internal business processes, and learning/innovation/growth

within each: strategic goals, critical success factors, tactics, performance measures

Steps: ID strategic objectives, SWOT analysis, Develop operational tactics, develop performance
measures

Good scorecard: articulate strategy through cause and effect, communications, limit number of
measures used, highlight suboptimal trade offs

Don't: assuming cause and effect linkages are precise, seek to improve across all measures all the time,
use only objective measures on scorecard, fail to consider cost and benefits, ignore nonfinancial metrics

Benchmarking: against a leader in industry, best practices for efficiency and performance, ongoing
process, supports continuous learning and improvements

The customer perspective evaluates the organization's success in targeted customer and market
segments.

Measures of learning and growth are related to the quality, vitality, and productivity of the workforce
Throughput time is the total time required for an item to make its way through the manufacturing
system. The ratio of setup time to total production time reflects the adaptability of the system to
required changes in production capability. If this ratio is excessive, the firm is unable to alter its product
to meet changing customer demand. The ratio of rework to total units is a measure of quality. A lower
ratio indicates higher quality and less interruption to the production process.

Strategic Management

Org strategy: plan to achieve the mission

Porters 5 forces:

Bargaining power of customers: customer characteristics and product choice options

Bargaining power of suppliers: supplier characteristics that affect ability to negotiate

Threat of new entrance. new companies to enter market

Threat of substitute products

Intensity of competition. limits strategies

Strategies:

Product differentiation: competing on basis of being different. better quality of features

Cost leadership: high volume of low-cost products.

Environmental scanning: continuously gather and evaluate information that impact its ability to
compete

SWOT Analysis: analyzes internal factors in context of external factors to develop strategies

Competitive Analysis

ROI = NI / Total Assets

DuPont Approach to ROI:

Return on Sales x Asset turnover (ROS = NI/Sales Asset Turnover= Sales/Total Assets)

ROS aka profit margins Asset Turnover aka Capital turnover

Accrual Accounting can dilute economic substance and affect these measures (income measures,
FIFO/LIFO, depreciation, etc...)
Diluted hurdle rate: current average return on total is diluted based on a new investment that is greater
than hurdle rate but less than current average return. (Current avg total: 28%, hurdle rate: 20%, new
project: 25%. will not be accepted because dilutes current avg total)

Residual Income (RI)= Operating income - (Required Rate of Return x Invested Capital)

Required rate of return aka imputed interest rate

Value based management:

Economic Value Added (EVA) = Net Op. Profit After Tax - WACC(Total Assets - Current Liabilities)

Be prepared to calculate EVA on exam.

Cash Flow ROI = (Cash Flow from Operation - Economic Depreciation) / Cash Invested

The required annual cash investment needed to replace fixed assets is the definition of
economic depreciation.

Price Elasticity in demand= % change in quantity demanded / % change in price

Elastic if greater than 1, inelastic if less than 1

Substitute products: Increase in price of 1 increases demand in other

Complement products: increase in price of 1 decreases demand in other

Ratio Analysis

Profitability and Return Metrics

Gross Margin = Revenue - COGS required format by SEC

Contribution Margin = revenue - variable costs cost behavior

Operating profit margin = Operating Income / Sales Operating Income = EBIT

Profit Margin aka Return on Sales= Net income / Net sales

Return on Investment: all have net income divided by some sort of invested capital

Return on Investment = Net income / total assets

Return on Equity = Net income / common SE

 DuPont ROI formula = ROS x Asset Turnover analyzes income and assets

ROS=NI/Sales Capital/Asset Turnover= Sales/Total Assets

Residual Income= Operating Income - (Required Rate of Return x Invested Capital)

Asset Utilization Ratios:

Receivables turnover= sales on account / average accounts receivable

Days sales in receivables = average AR / average sales per day

Inventory turnover= COGS / Average Inventory

Fixed Asset turnover = sales / average fixed assets

Liquidity Ratios:

Current ratio: current assets / current liabilities

Quick/Acid Test= (Current Assets - Inventory) / current liabilities

Debt Utilization ratios:

debt to total assets= total debt / total assets

debt to equity = total debt / total owner equity

times interest earned = operating income / interest expense

Market Ratios

PE ratio= market price / EPS

market - to -book = market value per share / book value per share

book value per share = common SE / # common shares outstanding

Risk Management

Strategic risk: long-term broad-based exposure related to overall strategy of organization. controlled by
forecasting and planning

Operational risk aka Business risk: short-term and includes process risk, shared service risk,
foreign/off=shore risk, and credit/default risk. avoided by executing plan
Market risk: associated with economic events or natural disasters. avoided by sensitivity analysis and
insurance

Structuring operating leverage: more variable costs reduces breakeven risk, more FC increases CM

contingency planning: safeguarding, redundancy, backup, insurance

hedging and diversification: diversification responds to similar volatility but opposite direction

insurance: deals with pure risk- risk or loss with no gain. speculative risk involves possible gains

evaluating uncertainty: cost avoidance, increase revenue, strategies

Systematic risk is also known as market risk or nondiversifiable risk and is associated with large-scale
economic events or natural disasters and typically affects all companies to some degree.

Performance Improvement Tools

Constraints: determining bottlenecks to optimize output. product mix constraints should focus on
maximizing CM per unit of strained resource

Lean manufacturing: focus on continuous improvements. pull type. flexible equipment, low setup times,
highly skilled laborers. using small batches of a high variety of unique products with highly skilled, cross-
trained labor.

ID steps in value stream

Eliminate steps that do not increase customer value

Streamline process

Continuously evaluate to reach for perfection

Six Sigma: systematically reduce defects. reflects quality that is 99.99%. very similar to total quality
management (TQM) and uses TQM tools such as control charts, run charts, pareto histograms, and
Isikawa (fish-bone) diagrams.

Define process

Measure process

Analyze process

Improve process

Control process
Given that capacity cannot be increased in the short run, the product that produces the highest
contribution margin per hour should be produced

Project Management

Planning: WBS, network planning

PERT: program and evaluation and review technique. When using PERT, project completion
times are measured by a pessimistic, optimistic, and most probable estimate:

(O+P+( 4xM))/6

CPM: critical path method. Critical path is longest path.

Implementing: managing schedule and sequence

Monitoring: control implementation according to plan. time and cost

Planning risk: adequately planning, defining activities, organizing work, providing team members

Implementing risk: managing people, time and cost and interrelationships

Monitoring risks: controlling resources, quality, cost and timeliness

The process of adding resources to shorten selected activity times on the critical path is called
"crashing."