business environment and concepts - cpa exam review (21q4

CPA REVIEW TEXTBOOK

BEC Business Environment & Concepts

SECTIONS 5000–5500

2021 (EFFECTIVE OCTOBER 1)

© 2021 Surgent CPA Review, LLC

Surgent CPA Review: Editor‐in‐Chief: Liz Kolar, CPA, CGMA Director of Accounting and License Preparatory Content: John Castonguay, PhD, CPA This book contains material copyrighted © 1953 through 2021 by the American Institute of Certified Public Accountants, Inc., and is used or adapted with permission. Portions of various FASB and GASB documents, copyrighted by the Financial Accounting Foundation, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856‐5116, are reprinted with permission. Complete copies of these documents are available from the Financial Accounting Foundation. Material from Uniform CPA Examination Questions and Unofficial Answers, copyright © 1976 through 2021, American Institute of Certified Public Accountants, Inc., is used or adapted with permission. This book is written to provide accurate and authoritative information concerning the covered topics. It is not meant to take the place of professional advice. The content of this book has been updated to reflect relevant legislative and governing body modifications as of October 2021. Content and software copyright © 2021, Surgent CPA Review, LLC. No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, except as may be expressly permitted by the 1976 Copyright Act or in writing by the Publisher. Printed in the United States of America.


Acknowledgments

Surgent CPA Review was developed by a team of professionals who are experts in the fields of accounting, business law, and computer science, and are also experienced teachers in CPA Review programs and continuing professional education courses.

Surgent CPA Review expresses its sincere appreciation to the many individual candidates, as well as accounting instructors, who took time to write to us about previous editions. The improvements in this edition are attributable to all of these individuals. Of course, any deficiencies are the responsibilities of the editors and authors. We very much appreciate and solicit your comments and suggestions about this year’s edition.

The editors and authors are also indebted to the American Institute of Certified Public Accountants, the Financial Accounting Standards Board, and the Governmental Accounting Standards Board for permission to quote from their pronouncements. In addition, the AICPA granted us permission to use material from previous Uniform CPA Examination Questions and Answers. AICPA codification numbers are used throughout the Auditing portion of the Review to indicate the source of materials.

We recognize the work and dedication of our team of software designers and developers. Their vision has made this the best product possible. They contributed countless hours to deliver this package and are each fully dedicated to helping you pass the exam. Our thanks go out to the many individuals who have made contributions to both the software and textbook portions of the CPA Review. We extend our gratitude to our team of software testers who ensure that you receive only the highest quality product. Finally, we express appreciation to the editorial teams who have devoted their time to review this product. They have provided invaluable aid in the writing and production of the Surgent CPA Review.

Good luck on the exam!


Contributors

John “Jack” Castonguay, PhD, CPA, is an Assistant Professor of Accounting, Taxation, and Legal Studies in Business at Hofstra University in New York. He has taught financial accounting and auditing at the graduate and undergraduate levels and is currently focused on emerging technologies and data analytics. Jack holds a BBA in Accounting and a Master of Science in Accounting from James Madison University and received his PhD in Accounting from the University of Tennessee. He began his career at PricewaterhouseCoopers as an assurance associate, where his primary clients were financial service firms and manufacturing firms. Dr. Castonguay is a member of the American Accounting Association and a volunteer for Big Brothers Big Sisters of New York City.

Janel Greiman is an Assistant Professor at the Monfort College of Business at the University of Northern Colorado. She teaches tax at the undergraduate level as well as in the Master of Accountancy program. Ms. Greiman earned her Master of Taxation at the Sturm College of Law at the University of Denver. She is a CPA in Colorado with recent experience practicing in taxation. She is a member of the AICPA, the Colorado Society of Certified Public Accountants (CSCPA), the tax section of the CSCPA, and the American Accounting Association. Her research includes recent publication in Practical Tax Strategies and the American Journal of Business Education.

Jeff Helton, PhD, CMA, CFE, FHFMA, is an Assistant Professor of Health Care Management at Metropolitan State University of Denver, where he teaches courses in health care finance. He has over 25 years of financial management experience in hospitals, health plans, and government entities. Jeff is a Certified Management Accountant, Certified Fraud Examiner, Fellow of the Healthcare Financial Management Association, and a member of the Board of Examiners for the Healthcare Financial Management Association. He has published articles on health care accounting and budgeting in Strategic Finance, Healthcare Financial Management, and the American Journal of Management. Jeff has a PhD in Health Care Management from the University of Texas, an MS in Hospital Administration from the University of Alabama at Birmingham, and a BBA from Eastern Kentucky University.

Cynthia Hollenbach, BBA, MS, CPA, CGMA, has been teaching at the collegiate level for the last 10 years. She has also been and is currently a financial consultant to many corporate clients for over 25 years, involved with both private and public companies. She received her BBA from Baylor University and her MS in Taxation from the University of North Texas. Cynthia is licensed as a CPA in Texas and recently licensed as a CGMA, a new designation by the AICPA to recognize skills as a global management accountant.

Tracy Hunt, Esq., is a founding partner of Timby Hunt, LLC. He received his Bachelor of Arts from the University of North Carolina, Chapel Hill, and his law degree from Widener University School of Law in Wilmington, Delaware. For the past 15 years, Mr. Hunt has concentrated his legal practice in all areas of civil litigation, including business‐related contract issues, employment, land use, and personal injury. Mr. Hunt also heads up the Wills and Estates practice for the firm, and assists his business clients in incorporation, drafting of contracts, trademark infringement, and personnel matters.

Patricia Johnson, CPA, CFE, is a Visiting Assistant Professor at Daemen College in Buffalo, New York, and a sole practitioner working with small businesses and nonprofit organizations. She received her undergraduate degree in accounting from St. Bonaventure University and an MBA from SUNY Buffalo. Pat is a CPA licensed in New York State and a Certified Fraud Examiner. She is active in the New York State Society of CPAs (NYSSCPA) and the Association of Certified Fraud Examiners (ACFE). Pat is also a member of the AICPA, The Institute of Internal Auditors (IIA), and the Association of Government Accountants (AGA).


Liz Kolar, CPA, CGMA, has been teaching CPA Review for more than 25 years in the United States, has personally taught more than 2,500 live sessions, and has helped thousands of candidates pass the CPA Exam. She founded Pinnacle CPA Review and co‐founded Surgent Kolar CPA Review. She is a recipient of the ASWA Business Woman of the Year Northeast Region, Distinguished Faculty Member of the Year, and PICPA Outstanding Educator of the Year. Liz began her career in Public Accounting with a Big Four accounting firm auditing financial service clients after graduating from Pace University with an MBA in Public Accounting. Liz’s teaching career spans almost 30 years. She has taught at the undergraduate and graduate levels at Pace University and Seton Hall University, and is currently a professor at Delaware Valley University.

John Lauck, CPA, CFE, PhD, is the Chase Bank Endowed Assistant Professor of Accountancy at Louisiana Tech University. His research interests include judgment and decision making in auditing and accounting, particularly as it relates to auditor professional skepticism, auditor detection of fraud and deception in financial reporting, and managerial ethics. John’s teaching interests include auditing, forensic accounting, and managerial accounting. Before receiving his PhD in accounting from Virginia Tech, John worked as an auditor in public accounting where he specialized in the nonprofit and construction industries. John received his Bachelor’s and Master’s degrees in Accounting from James Madison University. He is a Certified Public Accountant (CPA) in Virginia and Louisiana and a Certified Fraud Examiner (CFE).

Lola Neudecker is an Internal Auditor employed at the University of New Mexico. Lola has over 20 years of financial accounting experience in subjects including auditing, fraud investigations, taxation, contracts and grants, purchasing, budgeting, payroll, and banking. She has worked in public accounting, higher education, and government. Lola graduated from the University of Texas at El Paso with a Bachelor’s degree in Business Administration with a major in Accounting and a Master of Accountancy degree. Lola is a Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Financial Manager (CFM), Certified Government Auditing Professional (CGAP), Certified Internal Auditor (CIA), Certified Fraud Examiner (CFE), and Chartered Global Management Accountant (CGMA) and is Certified in Financial Forensics (CFF). She is a member of the American Institute of Certified Public Accountants (AICPA), The Institute of Internal Auditors (IIA), the Association of Certified Fraud Examiners, and the Institute of Management Accountants (IMA).

E. Lynn Nichols, CPA, is a nationally recognized authority on federal income tax issues. He has written several CPE texts, speaks at conferences, and serves as an adviser to several CPA firms on matters of federal income taxation, tax practice quality control, and IRS procedures. Lynn has produced tax update podcasts and webinars, contributes to tax discussion groups, and monitors sponsored discussion groups for The Ohio Society of CPAs and the South Carolina Association of CPAs.

Rachel Parsia, CPA, is a Manager of Tax & Advisory Content for Surgent, where she co‐authors a variety of tax CPE courses. Prior to joining Surgent, she worked at KPMG and TE Connectivity Ltd. and has experience in federal tax, international tax, and tax forecasting. She attended Penn State University, graduating with Master’s and Bachelor’s degrees in Accounting as well as a Bachelor’s degree in Finance. She holds a CPA license in the State of Pennsylvania.

Paul E. Pierson, CPA, is Director of Professional Standards and Peer Review for the Illinois CPA Society. In this capacity, he oversees the administration of the Peer Review Program for approximately 1,500 CPA firms in Illinois and Iowa. Paul has served as a discussion leader at the AICPA’s Annual Peer Review Conference and Advanced Reviewer Training Course as well as several state CPA society conferences and chapter events. He is also responsible for monitoring the continuing professional education and licensing rules in Illinois and Iowa and responding to member inquiries regarding those matters. Paul has served on the Technical Reviewers Advisory Task Force to the AICPA Peer Review Board, and currently serves as staff liaison to the Peer Review Report Acceptance and Employment Benefits Committees of the Illinois CPA Society. He also oversees the Society’s Accounting Principles, Audit and Assurance Services, Not‐for‐Profit, Governmental, and Ethics Committees. Paul graduated from Illinois State University with a BS in Accounting and was an audit manager with a large, local CPA firm in East Peoria, Illinois, prior to joining the Society.


Ciro Poppiti III, Esq., is a Delaware attorney whose practice has included estate planning, wealth management, and small business counsel. In 2015, Ciro received the Delaware Bar Association’s highest award for government service. He is a Judge Advocate in the U.S. Army–National Guard. He is regularly appointed a special master in the Court of Chancery, Delaware’s famous business court. Ciro also writes and lectures frequently and has taught legal studies at Bryn Mawr College in Pennsylvania, Wilmington University in Delaware, and the University of Delaware.

Darlene A. Pulliam, PhD, CPA, joined the faculty of West Texas A&M in 1997. A native of eastern New Mexico, Dr. Pulliam received a BS in Mathematics in 1976 and an MBA in 1978 from Eastern New Mexico University and joined the accounting firm of Peat, Marwick, Mitchell and Co. (now KPMG) in Albuquerque. After five years in public accounting, she completed her PhD at the University of North Texas and joined the faculty of the University of Tulsa in 1987. As a Regents Professor and McCray Professor of Business at WTAMU, her responsibilities include teaching tax and financial accounting, and advising the students in the Master of Professional Accounting program. Her publications include many articles appearing in Tax Advisor; the Journal of Accountancy; Practical Tax Strategies; Oil, Gas and Energy Quarterly; CPA Journal; and the Journal of Forensic Accounting as an author or coauthor.

Ellen Rackas, MBA, CPA, has more than 25 years of accounting, auditing, and tax‐related industry experience, including 10 years as an accounting professor at Delaware Valley University and currently at Muhlenberg College in Pennsylvania, where she teaches accounting and tax‐related courses. Her career started in Washington, DC, as a staff accountant for Raffa & Associates, a public accounting firm. After progressing through roles as a senior accountant and audit supervisor, she joined Harman International Industries, Inc., a designer, manufacturer, and marketer of audio and infotainment products. Over the course of her career, she has held roles as a finance manager, audit manager, controller, and CFO. Ellen has 14 years’ independent consulting experience and has assisted more than 40 corporate clients and 100 individual clients with financial statement preparation, tax return preparation, and other accounting functions. Ellen received her Bachelor of Science degree in accounting from American University in Washington, DC, and her MBA from the University of Maryland. She holds CPA designations in both Maryland and Pennsylvania.

Loredana Scarlat, CPA, MSA, is a New York–licensed CPA with over 14 years of experience in public accounting, providing tax services ranging from small and mid‐size companies to high‐net‐worth individual, trust, estate, and gift tax matters and international tax services for individuals. She holds a BA degree in Accounting and Computer Management Systems (Ovidius University, Romania) and an MS in Accounting (2013) from Baruch College (City University of New York City). Ms. Scarlat has co‐authored internal presentations on introductory courses to Form 1040, GILTI tax, and U.S. tax treatment of international pensions, and has been published in The Tax Adviser. Prior to joining Surgent, she was a Tax Manager at BDO USA, LLP (New York City office). She is a member of the New York State Society of CPAs as well as the AICPA.

Guy Schmitz, JD, LLM, MA, has practiced tax law for over 40 years. He has been a lecturer in tax law at Fontbonne University and Washington University in St. Louis, Missouri, and is the author of articles for the Journal of the Missouri Bar and St. Louis Bar Journal. He received his JD from Cornell Law School, where he was editor‐in‐chief of the Cornell International Law Journal; received his LLM in Taxation from New York University; and served as clerk to the U.S. Tax Court.

Brian E. Sebak, CPA, is a tax return specialist providing IRS and state tax resolution services. He is a Certified Public Accountant in the state of New Jersey, representing many of his clients in front of the IRS and State Department of Treasury. Brian is the President of his family‐based CPA firm.

Namita Seth is a Certified Public Accountant (CPA) licensed in New Hampshire and a Certified Management Accountant (CMA). She also has three groups of Indian CA. She has more than 14 years of work experience in the academic, private, and public accounting sectors and is an active member of the Institute of Management Accountants (IMA). At VG Learning Destination, she led the successful implementation of the CPA program and guided the students with their international credential evaluations for exams and licensure; she also created content for marketing and blogs. At Miles Education Pvt. Ltd., she was actively involved in integrating the CPA and CMA programs at top universities and corporations. She started her own company, Arguo Learning Pvt. Ltd., to


help aspirants achieve their CPA and CMA goals. Her broad knowledge base as an evaluator and content writer is valuable as she works closely with her clients to carefully guide them with their decisions for exam preparation and related risks.

Ken Smith, PhD, CPA‐Retired, is the President of Accounting Institute Seminars, for which he has written and presented CPA Review seminars in many locations around the United States since 1972. He received his BS in Accounting from the University of Montana and his PhD from the University of Texas–Austin. Ken is a professor of accounting at Idaho State University, where he has taught since 1970. He has served as accounting department chair, associate dean of the College of Business, and College of Business dean. He is actively involved with the AICPA and the American Accounting Association.

John (Jack) M. Surgent, MS in Taxation, CPA, is Chairman of Surgent Professional Education, the largest provider of tax and financial‐planning seminars to CPAs in the United States. Mr. Surgent has presented over 1,800 live seminars in the past 25 years and has been named Outstanding Discussion Leader by various professional organizations. He has worked in the tax department of a Big Four accounting firm and was an assistant professor at St. Joseph's University in Philadelphia. Mr. Surgent received his Bachelor's degree in Accounting from Villanova University and a Master's in Taxation from Villanova University School of Law.

Mark M. Ulrich, MBA, CPA, is an Assistant Professor at Queensborough Community College of the City University of New York. Prior to his career in academia, he worked for KPMG as a Senior Audit Associate and also worked at St. John's University in Queens, New York, as the Director of Budgets and Compliance for the Peter J. Tobin College of Business. Professor Ulrich currently serves on the Board of Directors of the New York State Society of Certified Public Accountants (NYSSCPA), is a Past President and current Treasurer of the Queens/Brooklyn Chapter of the NYSSCPA, and sits on the NYSSCPA’s Future of Accounting Education Committee. He received his Bachelor of Science degree in Accounting from St. John’s University in 2006, his MBA in Accounting from St. John’s University in 2007, and his CPA license from the State of New York in 2008.

Joshua R. Zender is an active Certified Public Accountant (CPA) and serves as an Associate Professor within the California State University system. He teaches financial, managerial, auditing, cost, tax, governmental, and nonprofit accounting at the undergraduate level, as well as corporate social responsibility and accounting/business ethics within the MBA program. He has published in Strategic Finance, the Journal of Government Financial Management, Treasury Management, and the Journal of Cases in Educational Leadership as well as other business journals and has contributed to several accounting textbooks. Before launching his academic career, he served as a municipal finance manager, auditor, and consultant for large governments and Big 4 consulting/accounting firms. Dr. Zender is also a Certified Internal Auditor (CIA), Certified Government Auditing Professional (CGAP), Chartered Global Management Accountant (CGMA), and Certified Government Financial Manager (CGFM). He holds his PhD from Auburn University in Alabama.


Table of Contents

Business Environment & Concepts

Section 5000 Overview of the Business Environment and Concepts Examination ........................... BEC Intro‐1

Section 5100 Enterprise Risk Management, Internal Controls, and Business Processes ......................... BEC 1‐1

Section 5200 Economics ...................................................................................................................... BEC 2‐1

Section 5300 Financial Management ................................................................................................... BEC 3‐1

Section 5400 Information Technology ................................................................................................. BEC 4‐1

Section 5500 Operations Management ................................................................................................ BEC 5‐1


______________________________________________

Section 5000 Overview of the Business Environment and

Concepts Examination

5010 The CPA Examination

5020 The Business Environment and Concepts Section of the CPA Examination

5010 The CPA Examination

5010.01 The Exam

The Uniform CPA Examination (the Exam) provides reasonable assurance to state boards of accountancy that individuals who pass the Exam possess the minimum level of technical knowledge and skills necessary for initial licensure. Ongoing changes in the business world, along with advancements in technology, have impacted the accounting profession and affected the required knowledge, skills, and professional responsibilities of newly licensed Certified Public Accountants (CPAs).

To remain relevant to the real‐world demands of the profession, the AICPA has determined that newly licensed CPAs must not only demonstrate sufficient content knowledge, but also possess:

a. higher‐order cognitive skills, including critical thinking, problem solving, and analytical ability, as well as professional skepticism,

b. a thorough understanding of professional and ethical responsibilities,

c. a strong understanding of the business environment and processes, and

d. effective communication skills.

5010.02 AICPA Skill Framework

The AICPA has adopted a skill framework based on the modified Bloom’s Taxonomy of Educational Objectives. Bloom’s Taxonomy classifies a continuum of skills that students can be expected to learn and demonstrate. The taxonomy is widely used in educational and licensure testing to define the level of skills to be assessed and to guide the development of test questions.

In applying this framework, approximately 600 representative tasks that a newly licensed CPA may be expected to complete were identified. Based on the nature of a task, one of four skill levels is assigned to each of the tasks, as follows:

BEC Intro‐2 OVERVIEW


Skill Levels

Evaluation The examination or assessment of problems, and use of judgment to draw conclusions.

Analysis The examination and study of the interrelationships of separate areas in order to identify causes and find evidence to support inferences.

Application The use or demonstration of knowledge, concepts, or techniques.

Remembering and Understanding

The perception and comprehension of the significance of an area utilizing knowledge gained.

5010.03 Exam Focus

The percentage for each skill level for each exam section is shown in the table below:

Section Remembering and Understanding

Application Analysis Evaluation

AUD 25%‐35% 30%‐40% 20%‐30% 5%‐15%

BEC 15%‐25% 50%‐60%* 20%‐30% ‐

FAR 10%‐20% 50%‐60% 25%‐35% ‐

REG 25%‐35% 35%‐45% 25%‐35% ‐

* Includes written communications

5010.04 Content Integration

As discussed previously, each of the Exam sections is designed to test higher‐order skills by incorporating the applicable content knowledge and skills that are required in the context of the work of a newly licensed CPA. Tasks that involve application, analysis, and/or evaluation skills may include some content from other Exam sections, which would occur naturally in the task from a contextual perspective. These tasks will always be based upon the primary content knowledge of a particular Exam section, but could draw upon a candidate’s basic knowledge of general accounting, auditing, tax, and business concepts. For example, in the AUD section of the Exam, a TBS designed to evaluate inventory observation audit procedures might include some inventory valuation/obsolescence or sales cutoff considerations, even though these concepts would be evaluated more extensively in FAR.

5010.05 Blueprint

The Blueprint is organized by content AREA, content GROUP, and content TOPIC. Each topic includes one or more representative TASKS. The purpose of the Blueprint is to:

a. document the minimum level of knowledge and skills necessary for initial licensure.

b. assist candidates in preparing for the Exam by outlining the knowledge and skills that may be tested.

c. apprise educators of the knowledge and skills candidates need to function as newly licensed CPAs.

d. guide the development of Exam questions.

BUSINESS ENVIRONMENT AND CONCEPTS BEC Intro‐3


The tasks in the Blueprint are representative; they are not intended to be viewed as an all‐inclusive list of tasks that may be tested. It is important to note that the number of tasks associated with a particular content group or topic is not indicative of the extent such content group, topic, or related skill level will be assessed on the Exam.

5010.06 Exam Testing Time

Total Exam time is 16 hours—four sections of 4 hours each. Candidates must complete the information on the welcome screen within 5 minutes and must accept the policy statement and confidentiality policy screens within 5 minutes. If these screens are not completed within this time frame, the exam will shut down and will not be restarted.

Each of the four exam sections consists of a series of five testlets. Each testlet contains either (but not both) multiple‐choice questions (MCQs) or task‐based simulations (TBSs); for BEC, the last testlet contains three written communication (WC) tasks. There is at least one research question (research‐oriented TBS) in the AUD, FAR, and REG sections.

A 15‐minute standardized break is given after the first TBS testlet, at approximately the two‐hour point. The Exam clock pauses for this break only; you can choose to decline the standardized break and continue testing, but the break will not be offered again. If you choose to take the standardized break, you must leave the testing room, adhering to all security protocols, and you will be readmitted to the testing room once cleared by Prometric personnel. If you have not returned and started the fourth TBS testlet prior to the expiration of 15 minutes, the Exam clock will restart. You will be asked to re‐enter your launch code to restart the exam.

Candidates may choose to take an optional break between any two testlets, but it will count against total testing time as the Exam clock continues to run.

Source: AICPA



5010.07 Testlet Organization

Section Question Type Weighting Testlet

AUD 72 MCQs

8 TBSs

50%

50%

#1 36 MCQs

#2 36 MCQs

#3 2 TBSs

#4 3 TBSs

#5 3 TBSs

BEC

62 MCQs

4 TBSs

3 Written Communications

50%

35%

15%

#1 31 MCQs

#2 31 MCQs

#3 2 TBSs

#4 2 TBSs

#5 3 WCs

FAR

66 MCQs

8 TBSs

50%

50%

#1 33 MCQs

#2 33 MCQs

#3 2 TBSs

#4 3 TBSs

#5 3 TBSs

REG

76 MCQs

8 TBSs

50%

50%

#1 38 MCQs

#2 38 MCQs

#3 2 TBSs

#4 3 TBSs

#5 3 TBSs

5020 The Business Environment and Concepts Section of the CPA Examination

5020.01 The Business Environment and Concepts (BEC) section tests a candidate’s general business concepts and associated skills required of newly licensed CPAs in performing audits, attest engagements, financial reporting, and tax services. The tasks listed in the Blueprint are representative only; they are not intended to be an all‐inclusive listing.

5020.02 Section Content

BEC content areas and allocation of content to be tested are presented in the following table:

I. Enterprise Risk Management, Internal

Controls, and Business Processes 20%–30%

II. Economics 15%–25%

III. Financial Management 10%–20%

IV. Information Technology 15%–25%

V. Operations Management 15%–25%

BUSINESS ENVIRONMENT AND CONCEPTS BEC Intro‐5


5020.03 BEC Skill Allocation

Each representative task in the BEC section blueprint is assigned a skill level. The representative tasks combine both the applicable content knowledge and the skills required in the context of the work that a newly licensed CPA would reasonably be expected to perform. The BEC section does not test any content at the Evaluation skill level as newly licensed CPAs are not expected to demonstrate that level of skill in regards to the BEC content. BEC section considerations related to the skill levels are as follows:

1. Remembering and Understanding is tested in all five areas of the BEC section. Remembering and understanding tasks focus on the knowledge necessary to demonstrate an understanding of the general business environment and business concepts, such as those involving enterprise risk management.

2. Application is also tested in all five areas of the BEC section. Application tasks focus on general topics such as those found in the subjects of economics and information technology, and the day‐to‐day financial management tasks that newly licensed CPAs perform, such as those involving calculations involving ratios, valuation, and budgeting.

3. Analysis skills, tested in Areas II, III, and V, involve tasks that require a higher level of analysis and interpretation. These tasks, such as comparing investment alternatives using calculations of financial metrics, financial modeling, forecasting, and projection, frequently require newly licensed CPAs to gather evidence to support inferences.

4. Written communication will continue to be tested in the BEC section of the Exam, representing 15% of BEC within the application skill level.

5020.04 References for the Business Environment and Concepts section include the following:

1. The Committee of Sponsoring Organizations of the Treadway Commission (COSO):

a. Internal Control – Integrated Framework (Framework and Appendices; Internal Control over External Financial Reporting: A Compendium of Examples; and Guidance on Monitoring Internal Control Systems Volume I, II, and III)

b. Enterprise Risk Management – Integrating with Strategy and Performance (Volume I and II, Compendium of Examples, and Managing Cyber Risk in a Digital Age)

2. AICPA TSP 100: 2017 Trust Services Criteria for Security, Availability, Processing Integrity, Confidentiality, and Privacy (includes March 2020 updates)

3. Sarbanes‐Oxley Act of 2002:

a. Title III – Corporate Responsibility

b. Title IV – Enhanced Financial Disclosures

c. Title VIII – Corporate and Criminal Fraud Accountability

d. Title IX – White‐Collar Crime Penalty Enhancements

e. Title XI – Corporate Fraud Accountability

4. Current business periodicals

5. Current textbooks on Accounting Information Systems, Data Analytics (for accountants), Economics, Finance, Management Information Systems, Managerial and Cost Accounting, and Production Operations



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______________________________________________

Section 5100 Enterprise Risk Management, Internal Controls,

and Business Processes (20%-30%)

5110 Enterprise Risk Management (ERM)

5111 Enterprise Risk Management Purpose and Objectives

5112 Enterprise Risk Management Components and Principles

5120 Internal Controls

5121 Internal Controls Purpose and Objectives

5122 Internal Controls Components and Principles

5123 Sarbanes‐Oxley Act of 2002

5130 Business Processes

5110 Enterprise Risk Management (ERM)

5111 Enterprise Risk Management Purpose and Objectives

5111.01 Definition: The Committee of Sponsoring Organizations of the Treadway Committee (COSO) issued the Enterprise Risk Management—Integrated Framework in 2004, and defined enterprise risk management (ERM) as follows:

“Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.”

5111.02 Purpose: The COSO Enterprise Risk Management (ERM) framework takes a risk‐based, rather than a controls‐based, approach. It expands on the elements of the internal control integrated framework and is much more comprehensive. ERM assists management in effectively dealing with uncertainty and its related risk and opportunity, thus building stakeholder value in the entity. Management, particularly the chief executive officer, is charged with the responsibility of finding a balance between growth and profit while using resources in an efficient and effective manner. ERM helps ensure that reporting and compliance laws and regulations are met, and assists in protecting the entity’s reputation.

5111.03 Objectives: The objective of the ERM framework is to achieve all the goals of the control framework and help the organization to:

a. attain reasonable assurance that company objectives and goals are achieved and problems and surprises are minimized,

BEC 1‐2 CORPORATE GOVERNANCE


b. continuously assess risks and identify the appropriate action to take and the resources to allocate to overcome or mitigate risk,

c. achieve its financial and performance targets, and

d. avoid adverse publicity and damage to the entity’s reputation.

5111.04 The COSO ERM (Enterprise Risk Management) framework is designed to help an entity’s management achieve its objectives, grouped into four overlapping categories:

1. Strategic: Ensure that high‐level goals support the entity’s mission.

2. Operations: Ensure resources are used effectively and efficiently.

3. Reporting: Ensure reliable reporting.

4. Compliance: Ensure compliance with laws, rules, and regulations.

5111.05 Limitations: Even the strongest enterprise risk management (ERM) system has its limitations, resulting from faulty human judgment in decision making. Decisions on responding to risk and establishing controls must consider the relative costs and benefits, and breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by collusion of two or more people, and management can also override enterprise risk management decisions.

5112 Enterprise Risk Management Components and Principles

ERM 2004 Framework

5112.01 Components: Enterprise risk management (ERM) components help the entity achieve its objectives. These interrelated components need to be both present and functioning effectively (i.e., no material weaknesses) in order to have an effective ERM system. The 2004 COSO ERM framework consists of eight components:

1. Internal environment: Essentially this is the “tone at the top,” consisting of risk management philosophy, risk appetite, integrity and ethical values, accountability, and commitment to competence.

2. Objective setting: Management must put into place a process to formulate objectives in order to help the company assess and respond to risks.

3. Event identification: Certain events can affect the company’s ability to implement its strategy and achieve its objectives. Management must identify these positive and negative events and determine whether they represent risks or opportunities.

a. It is important to remember that events represent uncertainty, may or may not occur, are difficult to foretell, can have an unforeseeable impact on a company, may trigger other events, and can occur individually or concurrently.

b. Managers need to understand that events may interrelate (e.g., one event might trigger another event). Some of the more common techniques companies use to identify potential events include using comprehensive lists of potential events, performing an internal analysis, monitoring leading events and trigger points, conducting workshops and interviews, performing data mining and analysis, and analyzing business processes.

4. Risk assessment: Identified risks are evaluated from a likelihood perspective and an impact perspective to determine how they affect the company’s ability to achieve and

BUSINESS ENVIRONMENT AND CONCEPTS BEC 1‐3


manage its objectives. Both qualitative and quantitative methods are used to assess risks.

5. Risk response: Management can choose to avoid, reduce, share, or accept risks after careful analysis.

a. Risk avoidance: Choosing not to engage in an activity

b. Risk reduction: Implementing some compensating or mitigating control to offset the risk of an activity

c. Risk sharing: Sharing the risk with another organization such as establishing a joint venture

d. Risk acceptance: Assuming all of the risk because it is deemed acceptable

6. Control activities: To ensure that management’s risk responses are effectively carried out, policies and procedures should be implemented.

7. Information and communication: Information about ERM components needs to be communicated through all levels of the company and with external parties.

8. Monitoring: ERM processes must be monitored, deficiencies reported to management, and modifications performed when required.

5112.02 COSO 2004 ERM framework cube: There is a direct relationship between objectives, which are what an entity strives to achieve, and enterprise risk management components, which represent what is needed to achieve them. The relationship is depicted in a three‐dimensional matrix, in the form of a cube.

Exhibit 1‐1:

Source: COSO



5112.03 Enterprise risk management (ERM) philosophies, practices, and procedures should be integrated into the entity’s strategic planning process to enable corporate governance and management to benchmark their risk management practices and processes against attainment of organizational goals and objectives. ERM can enhance and augment the role of corporate governance by clearly defining the entity’s risk‐taking and risk‐avoidance tolerances, aligning those tolerances with management’s behavior, and maintaining accountability for deviations from those tolerances.

ERM 2017 Framework

5112.04 COSO issued an update to the ERM framework in 2017, Enterprise Risk Management—Integrating with Strategy and Performance, which addresses the evolution of enterprise risk management (ERM) and the need for entities to improve their approach to managing risk to meet the demands of an evolving business environment. The updated framework focuses on the importance of considering risk in both the strategy‐setting process and in driving performance. Specifically, the update:

a. provides greater insight into the value of ERM when setting and carrying out strategy.

b. enhances alignment between performance and ERM to improve the setting of performance targets and understanding the impact of risk on performance.

c. accommodates expectations for governance and oversight.

d. recognizes the globalization of markets and operations and the need to apply a common, albeit tailored, approach across geographies.

e. presents new ways to view risk to setting and achieving objectives in the context of greater business complexity.

f. expands reporting to address expectations for greater stakeholder transparency.

g. accommodates evolving technologies and the proliferation of data and analytics in supporting decision making.

h. sets out core definitions, components, and principles for all levels of management involved in designing, implementing, and conducting ERM practices.

5112.05 Although management holds overall responsibility for managing risk to the entity, the board of directors and stakeholders need to understand that using enterprise risk management (ERM) capabilities should be an integral part of selecting and refining a strategy and gaining a competitive edge.

a. ERM adds perspective to the strengths and weaknesses of a given strategy as conditions change, and helps in determining whether that strategy fits within the organization’s mission and vision.

b. In the long run, ERM assists entities in identifying factors that represent change and in assessing how that change could affect performance, potentially resulting in the decision to revise existing strategies.

5112.06 The revised 2017 COSO ERM framework is designed to assist boards of directors in fulfilling their risk oversight role, which includes the following:

a. Reviewing, challenging, and concurring with management on:

(1) proposed strategy and risk appetite



(2) alignment of strategy and business objectives with the entity’s stated mission, vision, and core values

(3) significant business decisions, including mergers acquisitions, capital allocations, funding, and dividend‐related decisions

(4) response to significant fluctuations in entity performance or the portfolio view of risk

(5) responses to instances of deviation from core values

b. Approving management incentives and remuneration

c. Participating in investor and stakeholder relations

5112.07 The updated 2017 COSO ERM framework’s Executive Summary lists the following benefits that can be achieved when entities integrate ERM throughout the organization:

a. Increased range of opportunities

b. Improved identification and management of risk entity‐wide

c. Increased positive outcomes; reduced negative surprises

d. Reduced performance variability

e. Improved resource deployment

f. Enhanced enterprise resilience

5112.08 Although risk is already a consideration in many strategy‐setting processes, enterprise risk management (ERM) encourages management to further consider:

a. the possibility that the entity’s chosen strategy may not align with their mission, vision, and core values. A misaligned strategy increases the possibility that the organization may not realize its mission and vision, or may compromise its values, even if a strategy is successfully carried out.

b. the implications from the strategy chosen. Every alternative strategy has its own risk profile, and developing a given strategy requires trade‐offs. The board of directors and management need to ensure that the chosen strategy works in conjunction with the organization’s risk appetite, guiding the organization to set objectives and ultimately allocate resources efficiently.

5112.09 The 2017 COSO ERM framework consists of five interrelated components. The components are supported by a set of 20 principles:

Component 1: Governance and Culture: Governance sets the organization’s tone, reinforcing the importance of, and establishing oversight responsibilities for, enterprise risk management (ERM). Culture pertains to ethical values, desired behaviors, and understanding of risk in the entity.

1. Exercises board risk oversight: The board of directors provides oversight of the strategy and carries out governance responsibilities to support management in achieving strategy and business objectives.

2. Establishes operating structures: The organization establishes operating structures in the pursuit of strategy and business objectives.

3. Defines desired culture: The organization defines the desired behaviors that characterize the entity’s desired culture.



4. Demonstrates commitment to core values: The organization demonstrates a commitment to the entity’s core values.

5. Attracts, develops, and retains capable individuals: The organization is committed to building human capital in alignment with the strategy and business objectives.

Component 2: Strategy and Objective‐Setting: Enterprise risk management, strategy, and objective‐setting work together in the strategic‐planning process. A risk appetite is established and aligned with strategy; business objectives put strategy into practice while serving as a basis for identifying, assessing, and responding to risk.

6. Analyzes business context: The organization considers potential effects of business context on risk profile.

7. Defines risk appetite: The organization defines risk appetite in the context of creating, preserving, and realizing value.

8. Evaluates alternative strategies: The organization evaluates alternative strategies and potential impact on risk profile.

9. Formulates business objectives: The organization considers risk while establishing the business objectives at various levels that align and support strategy.

Component 3: Performance: Risks that may impact the achievement of strategy and business objectives need to be identified and assessed. Risks are prioritized by severity in the context of risk appetite. The organization then selects risk responses and takes a portfolio view of the amount of risk it has assumed. The results of this process are reported to key risk stakeholders.

10. Identifies risk: The organization identifies risk that impacts the performance of strategy and business objectives.

11. Assesses severity of risk: The organization assesses the severity of risk.

12. Prioritizes risks: The organization prioritizes risks as a basis for selecting responses to risks.

13. Implements risk responses: The organization identifies and selects risk responses.

14. Develops portfolio view: The organization develops and evaluates a portfolio view of risk.

Component 4: Review and Revision: By reviewing entity performance, an organization can consider how well the ERM components are functioning over time and in light of substantial changes, and what revisions are needed.

15. Assesses substantial change: The organization identifies and assesses changes that may substantially affect strategy and business objectives.

16. Reviews risk and performance: The organization reviews entity performance and considers risk.

17. Pursues improvement in ERM: The organization pursues improvement of enterprise risk management.

Component 5: Information, Communication, and Reporting: ERM requires a continual process of obtaining and sharing necessary information, from both internal and external sources, which flows up, down, and across the organization.

18. Leverages information systems: The organization leverages the entity’s information and technology systems to support ERM.



19. Communicates risk information: The organization uses communication channels to support ERM.

20. Reports on risk, culture, and performance: The organization reports on risk, culture, and performance at multiple levels and across the entity.

Exhibit 1‐2:

Source: COSO

5112.10 The updated 2017 COSO ERM framework cites several trends that will continue to have an effect on enterprise risk management (ERM):

a. Adapting to the proliferation of data: As more and more data becomes available and the speed at which new data can be analyzed increases, ERM will need to adapt. The data will come from both internal and external sources, and it will be structured in new ways. Advanced analytics and data visualization tools will need to evolve and be used to better understand risk and its impact.

b. Leveraging artificial intelligence and automation: It is important for ERM practices to consider the impact of current and future technologies, and to leverage their capabilities. Previously unrecognizable relationships, trends, and patterns can provide a rich source of information critical to managing risk.

c. Managing the cost of risk management: As ERM practices evolve, it will become important that activities spanning risk, compliance, control, and even governance be efficiently coordinated to provide maximum benefit to the organization at the least amount of incremental cost.

d. Building stronger organizations: As organizations improve integrating ERM with strategy and performance, an opportunity to strengthen resilience will present itself. By identifying and understanding the risks that will have the greatest impact on the entity, organizations can use ERM to help put in place strategies and capabilities that allow them to react in a proactive manner rather than a reactionary one.



5120 Internal Controls

Background

5120.01 A financial transaction control is a procedure that is developed to discover and/or prevent errors, misappropriations, or policy noncompliance in a financial transaction process. Such a control will aid an organization in achieving specific goals and objectives. It is an internal control that allows for a firm’s resources to be properly used, monitored, and measured. It is hoped that such controls will detect fraud and provide adequate protection to the company’s assets. Internal control objectives will include such items as:

a. providing reliable financial reporting.

b. providing timely feedback related to operational and/or strategic goals.

c. providing compliance with laws and regulations.

d. assuring such transactions as prompt payment of obligations or effective collection of receivables.

e. reducing process variation.

5120.02 Since the introduction of the Sarbanes‐Oxley Act of 2002 (SOX), companies have needed to meet certain financial reporting requirements. Per Section 404 of SOX, the management of a company is required to have an internal control report included in the annual Exchange Act Report. The responsibility of establishing and maintaining an adequate internal control structure related to financial reporting rests on management. Management is also required to assess the effectiveness of their internal control structure and procedures.

5120.03 In 2007, the Public Company Accounting Oversight Board (PCAOB) issued Auditing Standard (AS) 5 in an attempt to provide guidelines for management when developing effective and efficient internal control structure and procedures. This standard requires management to:

a. develop an understanding of the flow of transactions through the company so that points where misstatement could occur can be identified.

b. examine the risks related to the outline and the effectiveness of internal controls associated with significant financial accounts from the standpoint of the possibility of misstatement.

c. perform a fraud risk assessment and carefully examine controls meant to prevent or detect fraud during normal transactions as well as during the period‐end financial reporting process.

d. examine internal controls that correspond to the components of the COSO (the Committee of Sponsoring Organizations of the Treadway Commission) framework.

e. balance the assessment steps taken to the size and complexity of the company and its operations.

f. approach the assessment tasks related to internal control of financial reporting with competency and objectivity, and with understanding of potential risks.

g. provide a conclusion on the firm’s adequacy of internal control of financial reporting.



5121 Internal Controls Purpose and Objectives

5121.01 Controls: Internal control is a process, implemented by the board of directors, management, and those under their direction, to provide reasonable assurance that certain control objectives are achieved. Internal control permeates an organization’s operating activities and is an integral part of basic management activities. There are three types of controls:

1. Preventive: Designed to keep errors or irregularities from occurring in the first place

2. Detective: Designed to discover/detect errors or irregularities that have occurred, despite the preventive controls

3. Corrective: Designed to correct errors or irregularities that have been detected

5121.02 The Securities and Exchange Commission (SEC) defined controls as particular policies, procedures, and activities meant to meet a stated objective. Controls can:

a. be automated or manual.

b. relate to reconciliations.

c. provide segregation of duties.

d. be designed to safeguard assets.

e. be designed to prevent or detect error or fraud.

f. provide both financial reporting and operational controls.

Internal Control Objectives

5121.03 Objectives: Internal controls are designed to provide reasonable (but not absolute) assurance that objectives are achieved and compliance to laws and regulations is obtained. Control objectives related to financial reporting, operational efficiency, and law and regulation compliance include the following:

a. Valid: Only transactions that are valid, authorized, and legal are processed.

b. Timely recorded/processed: Only transactions that occurred within the period are recorded, and all necessary transactions within a given period are executed.

c. Accurately recorded: Transactions are accurately recorded free of omissions, accounting categorization errors, and/or mathematical errors.

d. Supportable: The goods and services received and provided are recorded properly and supported by documentation considered to be standard for normal practices.

e. Reasonable: Transactions are recorded using standard methodology to determine a value considered to be representative of the transaction.

f. Adequate representation of rights and obligations: The assets presented on the balance sheet fairly represent the rights of the company, and the liabilities presented fairly represent the obligations.

g. Funded: Sufficient funds are on hand to meet current obligations.

h. Appropriateness: The transactions approved directly relate to the goals of the company and seem reasonable when compared to other transactions or trends.



Internal Control Activities

5121.04 Effective and efficient control activities should be developed throughout all levels and functions of an organization; however, the cost of the control activity should not exceed the cost of the risk that is potentially being avoided by that control. Care should be taken, however, not to have so many controls that productivity is negatively impacted. As a general rule, it is less expensive to develop control procedures as a new process is being developed.

5121.05 There are numerous types of control activities, such as the following:

a. Segregation of duties: Dividing the duties of authorization, custody, and record keeping to multiple individuals. Such separations will reduce the risk of fraud and error.

b. Authorization: Review of appropriate transactions by designated individuals for approval. Such activities will help assure that company polices are adhered to and any exceptions have been reviewed by individuals with the necessary oversight.

c. Review and verification: Review of transactions for accuracy and completeness. Such an examination will help assure that all transactions have been correctly identified and recorded.

d. Information processing controls: The use of hash totals, sequential documents (checks, invoices, etc.), limited access to particular files, etc. allows for the protection that unauthorized transactions will occur.

e. Retention of records: Retention of transaction records for an appropriate period of time. This will allow any particular transaction to be substantiated if necessary.

f. Reconciliation: A periodic comparison of source documents, such as bank statements, with data recorded in the financial records. Such activities provide reasonable assurance as to the accuracy of the financial records.

g. Physical security of assets: The use of locks, security guards, alarm systems, and cameras to provide for the safeguarding of physical assets. Such steps provide for the protection against theft, fraud, and accidents.

h. Education, training, and monitoring: The use of trained and monitored employees reduces potential risks created by error and inefficiency. Properly monitored individuals with solid training provide for a more efficient workplace.

i. IT security: The use of passwords, firewalls, access logs, etc. helps to protect stored data from being accessed by unauthorized individuals, altered, or deleted.

j. Top‐level reviews: Periodic reviews of progress toward stated goals by upper management allow for corrective action to be taken if necessary.

Internal Control Limitations

5121.06 Internal controls can provide reasonable assurance that the objectives of the company will be met and that external laws and regulations will be adhered to; however, even the most effective internal control system cannot guarantee these results.

a. The reasonable assurance model is closely tied to the cost/benefit concept. Since such items as competition, economic conditions, and innovation are outside the control of management, internal controls cannot ensure the attainment of company goals; it can only provide measurement and timely feedback, thus allowing management the ability to fine‐tune specific activities.



b. Limitations related to the control process include the following:

(1) Limitations on staff size can result in the inability to properly have a segregation of duties.

(2) The judgment of employees may be affected by lack of time and pressure to provide a rapid response.

(3) Breakdowns in communication, training, and technology can result in controls not performing as designed.

(4) Two or more employees could collude to alter financial information or underlying data.

(5) Management could override various controls for illegitimate purposes.

The Control Process and Sarbanes‐Oxley

5121.07 Two important definitions related to the internal control process are those for control precision and control sufficiency:

a. Control precision is the alignment between a risk and the control activity designed to mitigate that risk. In other words, a control activity that has a direct influence on the achievement of a stated objective is considered to be more precise than one that only has an indirect influence.

b. Control sufficiency is a group of controls with a variety of degrees of precision necessary to achieve a control objective. For example, there would potentially be a number of control activities such as segregation of duties, reconciliation of bank statements, and daily deposits of receipts in order to protect all incoming receivable payments from theft or fraud.

5121.08 Section 404 of the Sarbanes‐Oxley Act of 2002 (SOX) requires that all publicly traded firms establish internal controls related to financial reporting that are documented, tested, and maintained. The purpose of these controls is to reduce the probabilities of corporate fraud. In order to be in compliance with SOX 404, a company needs to:

a. develop documentation of existing internal controls and procedures associated with financial reporting.

b. test the effectiveness of those controls and procedures.

c. provide details on any deficiencies in the controls and/or documentation.

5121.09 A top‐down risk assessment (TDRA) is done in order for a company to be in compliance with SOX 404. A TDRA is a set of steps used to identify and assess financial reporting elements, related risks, and internal control procedures meant to limit those risks. Such steps would include the following:

a. The identification of important financial reporting elements

b. The identification of material risks related to the important financial reporting elements

c. The identification of entity‐level controls that would mitigate the risks with adequate precision. These would include such items as the company policy and procedure manual, controls related to the internal auditors, controls related to the period‐ending procedures, variance analysis procedures, and oversight by senior management.

d. The identification of transaction‐level controls that would mitigate the risks in the absence of precise entity‐level controls



e. The analysis of the nature, extent, and timing of evidence collected about the internal controls as part of the assessment process

5121.10 The purpose of the TDRA (top‐down risk assessment) is for the company to analyze the internal controls currently in place and to assess the effectiveness of those controls to avoid material misstatement in the firm’s financial reporting.

a. In the TDRA, the focus of the assessment of internal controls will deal with significant (material) accounts as defined by the magnitude of the dollar amount and the likelihood of financial statement error.

b. The TDRA will focus on the identification and analysis of pertinent risks related to the achievement of the company’s objectives. These objectives are hierarchical in nature related to the entity as a whole, a particular account, an assertion, a process, and a transaction. The higher levels are examined first in the assessment process.

(1) A company‐wide control (higher level) might be that all employees have received, read, and understood the firm’s conduct guidelines.

(2) An assertion‐level control might be that ownership of inventory is recognized upon delivery of items.

(3) A process‐level control might be the separation of duties and steps required when issuing a credit for a return and/or allowance.

c. As part of the TDRA, management will develop a list of risks related to a particular account that would have a reasonable likelihood of material misstatement. In particular, such risks as what problems/errors have occurred in the past, how procedures/ circumstances have changed since the problem/error, and who might have the motivation and ability to commit fraud would be considered.

d. The existing controls meant to manage the identified risks should be examined, including the ability of senior management to mitigate such controls. This does not mean that such controls need to completely eliminate the possibility that fraud and/or errors could occur; such controls need to reduce the possibility that fraud and/or errors might occur.

e. Based upon the identification and analysis of risks and the associated internal control to mitigate those risks, management needs to conclude whether the danger of an internal control failure is low, medium, or high. Corrective action can then be taken as deemed necessary. Risk is inherent in all business transactions; however, that risk can be moderated to an acceptable level based upon a cost benefit analysis.

5122 Internal Controls Components and Principles

COSO Internal Control Framework: Components and Principles

5122.01 COSO’s Internal Control Framework

a. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is an organization in the United States that provides guidance to management on such items as organizational governance, ethics, internal control, financial reporting, fraud, and risk management. COSO studied internal controls and issued a report that:

(1) defined internal controls as the process implemented by the board of directors, management, and those under their direction to provide reasonable assurance that the following control objectives are achieved:



(a) Effectiveness and efficiency of operations

(b) Reliability of financial reporting

(c) Compliance with applicable laws and regulations

(2) provided guidance for evaluating internal control systems.

(3) has been widely accepted as the authority on internal controls.

b. COSO defines internal control as a process because it permeates an organization’s operating activities and is an integral part of basic management activities. Internal control does not provide absolute assurance because the possibilities of human failure, collusion, and management override of controls make the internal control process an imperfect one.

5122.02 COSO’s internal control framework is designed to aid firms when assessing control systems, includes the following five components:

1. Control Environment: The foundation of a business is its people and the environment in which it operates.

2. Risk Assessment: Organizations must set objectives to identify, analyze, and manage their risks.

3. Control Activities: Policies and procedures are needed to make sure control objectives are effectively carried out.

4. Information and Communication: Organizations should create and use information and communication systems to plan, conduct, manage, evaluate, and control their operations.

5. Monitoring: Information systems and internal control policies and procedures must be monitored so that needed modifications can be made.

Exhibit 1‐3:

Source: COSO



5122.03 Principles: Under COSO, the internal control environment consists of 17 principles spread over the five major components listed below:

a. Control Environment

(1) Demonstrates commitment to integrity and ethical values

(2) Exercises oversight responsibility

(3) Establishes structure, authority, and responsibility

(4) Demonstrates commitment to competence

(5) Enforces accountability

b. Risk Assessment

(6) Specifies suitable objectives

(7) Identifies and analyzes risk

(8) Assesses fraud risk

(9) Identifies and analyzes significant change

c. Control Activities

(10) Selects and develops control activities

(11) Selects and develops general controls over technology

(12) Deploys through policies and procedures

d. Information and Communication

(13) Uses relevant information

(14) Communicates internally

(15) Communicates externally

e. Monitoring

(16) Conducts ongoing and/or separate evaluations

(17) Evaluates and communicates deficiencies

COSO Internal Control Framework: Underlying Structure

Control Environment

5122.04 Demonstrates commitment to integrity and ethical values: Management should:

a. foster an organizational culture based on integrity and ethical values.

b. make integrity a basic operating principle by consistently encouraging and rewarding honesty and articulating the distinction between honest and dishonest behavior. Punishing or rewarding honesty without identifying or explaining it or using an inconsistent standard of honesty will result in inconsistent moral behavior.

c. actively teach and practice integrity.

d. establish policies that clearly and explicitly describe honest and dishonest behaviors, especially for uncertain or unclear issues such as conflicts of interest and accepting gifts.

e. thoroughly investigate all dishonest acts.



f. dismiss employees found guilty of dishonesty and prosecute employees when it is warranted so that the remaining employees understand that dishonesty is not tolerated and will be punished.

g. require employees to report any incidents of dishonest, illegal, or unethical acts and discipline employees who knowingly fail to report violations.

h. make a commitment to competence, which begins with having competent employees. Competence is a factor of knowledge, experience, training, and skills.

5122.05 Exercise of oversight responsibility: The board of directors is charged with the responsibility of overseeing management’s role in establishing and maintaining the organization’s system of internal controls. The board should challenge management, ask the tough questions, and seek input and support from informed personnel (e.g., internal and external auditors). The board must be apprised of:

a. risks and deficiencies of the internal control.

b. assessments of internal control deficiencies.

c. assessments of internal control effectiveness.

5122.06 Establishes structure, authority, and responsibility: An organizational structure defines lines of authority, responsibility, and reporting. An overly complex or unclear organizational structure may indicate more serious problems. Important aspects of organizational structure include:

a. what the company’s overall framework is for planning, directing, and controlling its operations.

b. how a company defines lines of authority and responsibility.

c. whether authority is centralized or decentralized.

d. how responsibility is assigned for specific tasks.

e. how the allocation of responsibility affects management’s information requirements.

f. how the accounting and information system functions are organized.

5122.07 Demonstrates commitment to competence: The entity demonstrates a commitment to attract, develop, and even retain competent individuals. The following are a few examples of how the entity may achieve this commitment:

a. Hire employees based on how well they meet written job requirements.

b. Check resumes and reference letters and perform background checks when evaluating job applicant qualifications.

c. Promote employees based on merit and performance.

d. Train the members of the organization:

(1) All employees:

(a) Why security measures are important to the organization's long‐run survival

(b) Safe computing practices, such as not opening unsolicited email attachments, only using approved software, not sharing or revealing passwords, and physically protecting laptops when traveling



(c) How to prevent attacks that use deception to obtain unauthorized access to passwords or other information about their accounts or computers

(d) To not allow outsiders or unauthorized employees to follow them through restricted access entrances such as computer rooms, data storage areas, inventory storage areas, and any other internally or externally locked doors

(2) New and existing employees: Regarding their responsibilities and regarding organization policies and procedures

(3) Computer security professionals:

(a) Regarding new IT developments that create new security threats and make old solutions obsolete

(b) To keep abreast of recent hacking developments. White‐hat hackers monitor hacker activities and publish on web pages how to perpetrate all known hacking activities and how to protect systems from each hacking approach.

(4) Top management: To support training efforts and the enforcement of sanctions against employees who willfully violate security policies

e. Establish formal compensation, job incentive, career advancement, and working condition policies.

f. Enforce mandatory annual vacations and assign employees' jobs to others during their absence.

g. Require all employees, suppliers, and contractors to sign and abide by a confidentiality agreement.

h. Rotate sensitive duties among key employees.

i. Purchase fidelity bond insurance for all key employees.

j. Prosecute hackers and fraud perpetrators.

k. Remove discharged or disgruntled employees from sensitive jobs and deny them access to the information system to prevent retaliation.

5122.08 Enforces accountability: High‐level corporate executives should make individual departments or individuals responsible for specific business objectives or processes and then hold them accountable. They can do this with:

a. formal job descriptions.

b. a formal code of conduct that covers ethical behavior standards, conflicts of interest, acceptable business practices, and regulatory requirements.

c. a written policy and procedures manual that:

(1) explains proper business practices.

(2) documents how transactions and errors are to be processed and handled.

(3) contains the chart of accounts.

(4) contains example copies of forms and documents.

(5) is used to train new and existing employees.

d. operating plans, schedules, and budgets.



Risk Assessment

5122.09 An entity’s risk assessment process for financial reporting purposes is its identification, analysis, and management of risks relevant to the preparation of financial statements that are fairly presented in conformity with GAAP. Objectives should be specified for the identification and assessment of risk in each of the four objective areas:

1. Operations objectives

a. Reflects management’s policies

b. Factors risk tolerance

c. Indicates goals for both operational and financial activities

d. Establishes a foundation for allocation of resources

2. External financial reporting objectives

a. Adheres to accounting standards

b. Scrutinizes materiality

c. Reflects organization’s activities

3. Internal reporting objectives

a. Reflects management’s decisions

b. Examines the required level of accuracy

c. Reflects organization’s activities

4. Compliance objectives

a. Complies with external laws and regulations

b. Factors risk tolerance

5122.10 Identifies and analyzes risk: Identify risks related to achievement of the objectives and determine how to manage the risks.

a. Includes entity, subsidiary, division, operating unit, and functional levels

b. Analyzes internal and external factors

c. Involves appropriate levels of management

d. Estimates significance of risks identified

e. Determines how to respond to risks

5122.11 Assess fraud risk: The organization should consider potential for fraud.

a. Considers various types of fraud

b. Assesses incentive and pressures

c. Assesses opportunities

d. Assesses attitudes and rationalizations

5122.12 Identifies and analyzes significant change: The organization should identify changes that could affect the current control system.

a. Assesses changes in the external environment



b. Assesses changes in the business model

c. Assesses changes in leadership

5122.13 Types of risk: Inherent risk is the risk that exists before management takes any steps to control the likelihood or impact of a risk. Residual risk is the risk that remains after management reacts to the risk, such as by implementing internal controls.

5122.14 An internal control risk assessment has six steps and is performed as follows.

Step 1: Identify threats. Companies face the following types of threats:

a. Strategic (doing the wrong things)

b. Operating (doing the right things, but in the wrong way)

c. Financial (financial resources are lost, wasted, or stolen; inappropriate liabilities are incurred)

d. Information (incorrect input data, faulty or irrelevant stored information, an unreliable system, incorrect or misleading reports)

Step 2: Estimate risk, which is a measure of how likely an error is to occur. Errors are more likely than fraud.

Step 3: Estimate exposure, which is a measure of the magnitude of an error. For example, there is a small risk of an earthquake, but the exposure is enormous if it destroys the information system.

Step 4: Identify controls. One or more controls should be identified to protect the company from each threat. Preventive, detective, and corrective controls complement each other, and a good internal control system employs all three.

a. A preventive control is superior to a detective one.

b. If preventive controls fail, detective controls are essential for discovering the problem.

c. Corrective controls help recover from the problem.

Step 5: Estimate costs and benefits. The following principles should govern this analysis:

a. An internal control system provides reasonable assurance that control problems do not take place; no system can provide foolproof protection, as the cost would be prohibitive.

b. Too many controls slow the system down and negatively affect operational efficiency.

c. The benefits of an internal control procedure must exceed its costs. Otherwise, the procedure is not worth implementing.

d. The benefit of a control procedure is the difference between the expected loss with the control procedure(s) and the expected loss without it.

e. Expected loss is the mathematical product of risk and exposure. (Expected loss =

Risk Exposure)

Step 6: Respond to risk.

a. Reduce the risk. Implementing an effective system of internal controls is the most effective way to reduce the likelihood and impact of risk.

b. Accept the risk by not acting to prevent the risk or lessen its impact.



c. Share some of the risk or transfer it to another party by outsourcing an activity, acquiring insurance, or hedging transactions.

d. Avoid the risk by not engaging in the activity that produces the risk.

Exhibit 1‐4:



Control Activities

5122.15 Control activities are the policies and procedures that help ensure that management directives are carried out and necessary actions are taken to address risks that threaten the achievement of the entity’s objectives. The organization should develop activities to mitigate identified risks.

a. Integrates with risk assessment

b. Considers entity‐specific factors

c. Determines relevant business processes

d. Evaluates a mix of control activity types

e. Considers at what level activities are applied

f. Addresses segregation of duties, authorization, safeguarding, asset accountability

5122.16 Selects and develops general control over technology: The organization should develop general control activities over technology.

a. Determines dependency between the use of technology in business process and technology general controls

b. Establishes relevant technology infrastructure control activities

c. Establishes relevant security management process control activities

d. Establishes relevant technology acquisition, development, and maintenance process control activities

5122.17 Deploys through policies and procedures: The organization should deploy control activities with policies about what is expected and procedures to implement those policies.

a. Establishes policies and procedures to support deployment of management’s directives

b. Establishes responsibility and accountability for executing policies and procedures

c. Performs in a timely manner

d. Takes corrective action

e. Performs using competent personnel

f. Reassesses policies and procedures

Information and Communication

5122.18 The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures, whether automated or manual, and records established to initiate, record, process, and report entity transactions and to maintain accountability for the related assets, liabilities, and equity. The organization generates and uses relevant, quality information to support the functioning of the control system.

a. Identifies information requirements

b. Captures internal and external sources of data

c. Processes relevant data into information

d. Maintains quality throughout processing



e. Considers costs and benefits

5122.19 An entity’s communication involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting. The organization should internally communicate information necessary to support functioning of the control system.

a. Communicates internal control information

b. Communicates with the board of directors

c. Provides separate communication lines

d. Selects relevant method of communication

5122.20 Communicates externally: The organization should internally communicate information necessary to support functioning of the control system.

a. Communicates to external parties

b. Enables inbound communications

c. Communicates with the board of directors

d. Provides separate communication lines

e. Selects relevant method of communication

Monitoring Activities

5122.21 Monitoring of controls is a process to assess the quality of internal control performance over time. It involves assessing the design and operation of controls on a timely basis and taking necessary corrective actions. The organization should evaluate whether the components of internal control are present and functioning.

a. Considers a mix of ongoing and separate evaluations

b. Considers rate of change

c. Establishes baseline understanding

d. Uses knowledgeable personnel

e. Integrates with business processes

f. Adjusts scope and frequency

g. Objectively evaluates

5122.22 Evaluates and communicates deficiencies: The organization should communicate control deficiencies to those responsible for taking corrective action.

a. Assesses results

b. Communicates deficiencies

c. Monitors corrective actions

5122.23 The Control Self‐Assessment (CSA) framework helps improve the efficiency and effectiveness of financial statements. The process consists of all employees taking part in the responsibility of internal controls by lower‐level employees and managers completing risk assessment and internal control evaluations.



COSO Internal Control Framework: Identifying Controls for Risk Scenarios

5122.24 Control deficiencies: A control deficiency exists when the design or operation of a control does not allow management or employees to prevent or detect material misstatements on a timely basis. Compensating controls should be considered when determining whether an identified control deficiency is a significant deficiency or material weakness.

a. Significant deficiency: A significant deficiency is a flaw in internal control that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. A deficiency is significant if it can adversely affect the company’s financial reporting process.

b. Material weaknesses: A material weakness is a deficiency in internal control such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis by employees in the normal course of performing their assigned functions. The existence of a material weakness precludes management from concluding that internal control is effective, and precludes the external auditor from issuing an unqualified opinion that internal control is effective.

5122.25 Professional judgment: Determining the severity of a finding is a matter of professional judgment. What may be considered a material weakness in one company may not be considered a material weakness in another. Factors that should be considered include materiality, mitigating controls, and intent. Currently, there is no consistent methodology for making determinations of significant deficiencies and material weaknesses.

Corporate Governance Structure

5122.26 Corporate governance is the framework of internal and external rules, policies, and practices by which accountability, fairness, and appropriate disclosure in a corporation’s relationship with all its stakeholders (owners, creditors, customers, employees, government, and the community) is ensured. Corporate governance is accomplished under the direction of the board of directors and top management officials. It is a process of decision making and control through policies including the internal control system and communication of those policies and procedures throughout the organization.

5122.27 Tone at the top: An accounting term used to describe the attitude of an entity’s board of directors, audit committee, officers, and senior management toward internal controls, thus forming the foundation of the entity’s general ethical climate. Establishing and maintaining a strong tone at the top helps in corporate governance and in preventing and detecting fraud and other unethical practices. This is particularly true for a small‐ to mid‐size entity's control culture, where some controls, such as adequate segregation of duties, may not be cost effective.

5122.28 Board of directors (BOD): A board of directors (BOD) is an elected or appointed committee, required for corporations that issue publicly traded equity or debt securities, and responsible for supervising and overseeing the activities of a corporation. The board should include executive and non‐executive people. This will bring knowledge from outside and inside the organization. The board is able to monitor the organization’s management regarding financial decision making. The board of directors should maintain an attitude of independence from top management in order to help with the checks and balances on the actions taken by the CEO (chief executive officer) and CFO (chief financial officer). The board is usually organized into committees to:



a. approve compensation for board members and corporate officers.

b. establish and communicate a code of conduct.

c. review significant management decisions.

d. design and enforce effective internal control procedures.

e. manage internal and external audits.

5122.29 The board of directors (BOD) provides governance, guidance, and oversight for management. The BOD has a fiduciary duty to act in the best interests of the corporation. As fiduciaries, board members are held to a higher standard of care than would be exercised in discharge of those people’s personal affairs. Directors may not put themselves in a position where their interests and duties conflict with the duties that they owe to the company. If a conflict exists, the board member should disclose it to the BOD so that it may take appropriate and timely action. Fiduciary duties fall within three categories:

1. Duty of care: Directors and officers must use care and be diligent when making decisions on behalf of the corporation and its shareholders. Directors and officers must act in good faith, with the care of a reasonable person in a similar position, and with reasonable belief their decisions are in best interest of the corporation

2. Duty of loyalty: Directors and officers must have an undivided loyalty to the corporation and shareholders; they must put the interests of shareholders and the corporation above their own interests.

3. Duty of due diligence: Due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party; it is essentially a way of preventing unnecessary harm to either party involved in a transaction

5122.30 Audit committee: An audit committee is an operating committee of the board of directors, independent of the corporation. This committee should include independent directors (not stockholders or officers) and should be chaired by someone with significant financial reporting qualifications and experience. Typically audit committees oversee the financial reporting process; monitor the choice of accounting policies and principles; monitor the internal control process; appoint, compensate, and oversee the external auditors; and receive communications and audit reports directly from the external auditors. The audit committee periodically meets with the internal and external auditors (without management present) to discuss the financial reporting process, the system of internal control, and any significant issues or recommendations.

5122.31 Officers: Corporate officers are appointed by the board of directors and serve at the board’s pleasure. Officers are agents of the corporation and have fiduciary responsibilities similar to those of the board.

a. The president is usually known as the chief executive officer (CEO) and is responsible for the day‐to‐day management of the company. The CEO is ultimately responsible for the development and implementation of the internal control of the company. It is expected that this individual will set the ethical tone for the firm by providing direction and leadership to the senior staff reporting to him/her.

b. The Sarbanes‐Oxley Act of 2002, Section 302, requires that CEOs and CFOs of a corporation include certifications that:

(1) the signing officers have reviewed the reports.



(2) the signing officers are evaluating the internal controls within 90 days and reporting their findings.

(3) all deficiencies in internal controls are being reported.

(4) negative impacts on internal controls are being reported and corrected.

(5) the financials do not contain untrue statements or material misstatements.

(6) the financial statements present fairly the financial condition of the company.

c. The officers are not permitted to reincorporate the activities of a company to attempt to avoid these requirements. They are also not permitted to move the activities outside of the United States to attempt to avoid these requirements.

d. Senior staff is responsible for the specific internal control functions employed in the various areas. Without properly implemented internal controls, members of management have the ability to override necessary controls, enabling potential dishonest dealings or recording of transactions.

5122.32 Internal audit: Internal auditors are required to assist management in maintaining adequate internal controls by evaluating their effectiveness and efficiency and by promoting their continuous improvement. The internal audit activity must evaluate the adequacy and effectiveness of controls in regard to the:

a. reliability and integrity of financial and operational information.

b. effectiveness and efficiency of operations and programs.

c. safeguarding of assets.

d. compliance with laws, regulations, policies, procedures, and contracts.

e. potential for the occurrence of fraud and how the organization manages fraud risk.

5122.33 The internal audit function must also determine whether risk management processes are effective; this judgment results from the internal auditor's assessment that:

a. organizational objectives support and align with the organization’s mission;

b. significant risks are identified and assessed;

c. appropriate risk responses are selected that align risks with the organization's risk appetite; and

d. relevant risk information is captured and communicated in a timely manner across the organization, enabling staff, management, and the board to carry out their responsibilities.

5122.34 Both internal and external auditors continually assess the effectiveness of the internal control system in place. These individuals would:

a. assess whether internal controls are correctly designed.

b. assess whether internal controls are properly implemented.

c. assess whether interest controls are effective.

d. make recommendations for improvements in the internal control procedures.



5122.35 In evaluating the design of the entity’s control environment, the external auditor should consider the following elements and how they have been incorporated into the entity’s processes:

a. Communication and enforcement of integrity and ethical values

b. Commitment to competence

c. Participation by those charged with governance

d. Management’s philosophy and operating style

e. Organizational structure

f. Assignment of authority and responsibility

g. Human resource policies and practices

5123 Sarbanes‐Oxley Act of 2002

5123.01 The Sarbanes‐Oxley Act (SOX) is a law that establishes new, stricter standards for all U.S. publicly traded companies.

a. SOX was enacted to enhance the transparency of a company and hold its officers more accountable. Public companies must implement controls against illegal and unethical business practices, and top management must individually certify the accuracy of financial information.

b. Since the inception of SOX, the external auditor is no longer permitted to simultaneously perform both auditing and other non‐attestation services, such as management consulting. This reduces the potential that the audit firm will try to appease a firm’s management (by engaging in a weaker audit) in order to help generate more profitable consulting arrangements.

5123.02 Administration: The Sarbanes‐Oxley Act (SOX) is administered by the Securities and Exchange Commission (SEC), and created a new agency, the Public Company Accounting Oversight Board (PCAOB), which is in charge of overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies.

a. The financial statements are required to be audited by an independent CPA firm that is certified by the PCAOB to perform audits of corporations under the jurisdiction of the SEC.

b. The independent auditor is hired by and interacts directly with the board of directors’ audit committee. This committee should include independent directors (not stockholders or officers) and should be chaired by someone with significant financial reporting qualifications and experience.

5123.03 Voluntary compliance: Nonpublic entities and not‐for‐profit entities are exempt from SOX requirements. These entities may adopt SOX requirements voluntarily to achieve a quality of internal control with a recognized standard. Plans for going public or future sale of a company also may include SOX compliance as buyers generally are willing to pay a premium for companies that already have SOX‐quality internal controls in place.



Title III: Corporate Responsibility

5123.04 Title III of SOX mandates senior executives take individual responsibility (and liability) for the accuracy and completeness of corporate financial reports, defines the interaction between external auditors and corporate audit committees, and limits the permissible behavior of corporate officers.

5123.05 Audit committees: The audit committee is directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm (firm) employed by that public company (issuer); external CPA firms report directly to the audit committee.

a. Procedures: Each audit committee will establish procedures for the receipt, retention, and treatment of complaints about internal controls or auditing matters; and accepting confidential, anonymous employee comments concerning questionable accounting or auditing matters.

b. Members: Each member of the audit committee must be a member of the board of directors, and must otherwise be independent. Audit committee members may not accept any consulting, advisory, or other compensation from the issuer or be an affiliated person of the issuer.

c. Financial expert: The audit committee should contain at least one financial expert. If an issuer does not have an audit committee financial expert, that issuer must disclose the reason why the role is not filled. Financial expertise includes an understanding of generally accepted accounting principles and financial statements, experience in the preparation or auditing of financial statements of generally comparable issuers, experience with internal accounting controls, and understanding of audit committee functions.

5123.06 Corporate responsibility for financial reports: The chief executive officer (CEO) and the chief financial officer (CFO) must certify that, for certain annual and quarterly reports:

a. they have reviewed the report(s) and, based on their knowledge, the reports do not contain any material misstatements or material omissions; and the financial statements fairly present, in all material respects, the financial condition and results of operations of the issuer.

b. they are responsible for establishing and maintaining internal controls to ensure that material information is made known to the officers of the entity; the effectiveness of the internal controls has been evaluated within 90 days prior to the report; and their report includes their conclusions about the effectiveness of the internal controls.

c. they have disclosed to the auditors and the audit committee all significant deficiencies in the design or operation of internal controls which could adversely affect the financial statements, and any fraud, material or not, that involves management or other employee with a significant role in internal controls.

The officers are not permitted to reincorporate the activities of a company to attempt to avoid these requirements. They are also not permitted to move the activities outside of the United States to attempt to avoid these requirements.



5123.07 Improper influence on conduct of audits: It is unlawful for any officer or director of an issuer, or any other person acting under the direction thereof, to take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of making the financial statements materially misleading.

5123.08 Forfeiture of certain bonuses and profits: If an issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement under the securities laws, the chief executive officer (CEO) and chief financial officer (CFO) may have to reimburse the issuer for certain bonus, incentive‐based, or equity‐based payments and/or any profits realized from the sale of issuer securities during the 12‐month period following the first public issuance or filing with the Securities and Exchange Commission (SEC).

Title IV: Enhanced Financial Disclosures

5123.09 Title IV of the Sarbanes‐Oxley Act describes the enhanced reporting requirements and disclosures for financial transactions, and requires internal controls for assuring the accuracy of financial reports and disclosures, as well as mandates audit and reporting controls.

5123.10 Disclosures in periodic reports: Each financial report that contains financial statements prepared in accordance with GAAP must reflect all material correcting adjustments that have been identified by the external auditors.

a. Off‐balance sheet transactions: Annual and quarterly financial reports should disclose all material off‐balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.

b. Pro forma financial information: Pro forma financial information cannot contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the pro forma financial information not misleading.

5123.11 Enhanced conflict of interest provisions: In general, personal loans to executives are prohibited, except for certain loans that are made in the ordinary course of the consumer credit business of such issuer. The loans must be of a type that is generally made available to the public, on market terms or terms that are no more favorable than those offered by the issuer to the general public.

5123.12 Directors, officers, and principal stockholders: An individual who is directly or indirectly the beneficial owner of more than 10% of a registered equity security, or who is a director or an officer of the issuer of such security, shall file a statement with the Securities and Exchange Commission (SEC) within 10 days after he/she becomes such beneficial owner, director, or officer, and before the end of the second business day following the day on which there has been a change in such ownership.

5123.13 Management assessment of internal control: Each required annual report must contain an internal control report that states the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures.



5123.14 Code of ethics for senior financial officers: Each issuer must disclose in its periodic reports if they have adopted a code of ethics for senior financial officers; if there is no code, the issuer must disclose the reasons. Any change in or waiver of the code of ethics for senior financial officers must be promptly disclosed.

5123.15 Real‐time issuer disclosures: Each issuer must disclose to the public, in a timely manner, any additional information concerning material changes in the financial condition or operations of the issuer.

Title VIII: Corporate and Criminal Fraud Accountability

5123.16 Title VIII of the Sarbanes‐Oxley Act describes the criminal penalties associated with being guilty of manipulating, destroying, or altering of financial records or otherwise interfering with investigations. The title also provides certain protections for whistleblowers.

5123.17 Criminal penalties for altering documents: Individuals who knowingly alter, destroy, mutilate, conceal, cover up, falsify, or make a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of the United States can be fined, imprisoned for not more than 20 years, or both.

5123.18 Criminal penalties: Audit or review workpapers must be retained for a period of 5 years from the end of the fiscal period in which the audit or review was concluded; violations will result in fines, imprisonment for not more than 10 years, or both. Individuals who execute a scheme to defraud, or who obtain, by false or fraudulent pretenses, any money or property in connection with the purchase or sale of securities of an issuer, can be fined, imprisoned for not more than 25 years, or both.

5123.19 Statute of limitations: Violations of security laws may be brought no later than the earlier of two years after the discovery of the facts constituting the violation, or five years after the violation.

5123.20 Whistle‐blower protection: Companies may not discharge, demote, suspend, threaten, harass, or in any manner discriminate against an employee that provided information or assisted in an investigation of security law violations. An employee who alleges discharge or other discrimination can file a complaint with the U.S. Secretary of Labor or bring action in the appropriate U.S. district court. Compensatory damages may include reinstatement with the same seniority, back pay with interest, and compensation for special damages, including litigation costs.

Title IX: White Collar Crime Penalty Enhancements

5123.21 Penalties: The penalties prescribed in the Sarbanes‐Oxley Act for the attempt and conspiracy of an offense shall be the same as the penalties for the offense itself. This title increases penalties as follows: mail and wire fraud carries a maximum sentence of 20 years, up from 5 years; violations of the Employee Retirement Income Security Act of 1974 carry an increased maximum fine of $500,000 from $100,000 and an imprisonment sentence of up to 10 years, up from 1 year.



5123.22 Certification violations: A criminal punishment is implemented for corporate officers who fail to certify corporate financial reports filed with the Securities and Exchange Commission (SEC). Penalties include fines of not more than $1,000,000, imprisonment for not more than 10 years, or both for certification violations; and fines of not more than $5,000,000, imprisonment for not more than 20 years, or both for willful certification violations.

Title XI: Corporate Fraud Accountability

5123.23 Tampering: Individuals who alter, destroy, mutilate, or conceal records, documents, etc., with the intent to impair objectivity or availability of use, or otherwise obstruct, influence, or impede any official proceeding, will be fined, imprisoned for not more than 20 years, or both.

5123.24 Prohibit persons from serving as officers/directors: In any cease‐and‐desist proceeding, the Securities and Exchange Commission (SEC) can issue an order to prohibit any person who has violated certain security laws, rules, and regulations, from serving as an officer or director of the issuer.

5123.25 Retaliation against informants: Any individual who knowingly retaliates (i.e., takes any harmful action) against any person who has provided truthful information to law enforcement can be fined, imprisoned for not more than 10 years, or both.

5130 Business Processes

Business Process Controls

5130.01 Internal controls are policies and procedures that are put in place by any organization to protect its property and ensure reliability of its accounting systems. The system of internal controls put in place by any organization does not eliminate the risk of fraud or error; however, it reduces the risk to an acceptable level. An effective system of internal controls helps an organization to achieve not only operational and reporting objectives but also its strategic and compliance goals.

5130.02 Controls are policies, procedures, and technical safeguards that are implemented to avoid or minimize undue losses and protect the assets of an organization. Internal controls can be either preventive or detective. Although both of these types of controls are established to protect the organization from losses due to errors or fraud, the purpose and other features of these controls are different:

Category Preventive Controls Detective Controls

Purpose

Prevent errors/fraud before they occur

Detect errors/fraud that have already occurred

Cost effectiveness More cost effective than detective controls

More expensive than preventive controls

Examples Segregation of duties

Training program

Firewalls

Physical controls

Internal Audits

Reviews

Reconciliation

Data backup



These controls can be manual or automated:

Category Manual Controls Automated Controls

Suitability

When judgment and discretion are required

When there is a high volume of similar transactions

Benefits Low cost

Monitors automated controls

Reduced risk that controls will be circumvented

Enhanced segregation of duties

Timeliness and availability

Risks Easily overridden

Susceptible to human error

Less consistent than automated controls

Reliance on inaccurate systems

Unauthorized access to data

Unauthorized changes to data

Possible loss of data

5130.03 Segregation of duties (SoD) involves the breaking down of the business processes to ensure that no single individual is responsible for any stage in the process. If only one single individual performs all stages of a process, there is a possibility that fraud or error may exist, resulting in financial loss and damage of reputation to the company.

The duties of authorizing transactions, recording transactions, and maintaining custody of assets should be assigned to different individuals to prevent them from:

a. gaining unauthorized access to the assets, programs, and data files.

b. making unauthorized changes to the programs and data files.

In other words, there should be proper division of labor.

5130.04 As opposed to a manual system, an IT‐based system facilitates integration of multiple tasks associated with a transaction. In an IT‐based system, internal controls can be accomplished by segregation of duties and clearly defined responsibilities. For example, in an IT environment, the payroll system can maintain personnel files containing information related to:

a. position,

b. insurance,

c. hours worked, and

d. hourly pay rate.

Along with this, the system can also:

a. prepare employee pay and payroll checks.

b. update the payroll records.

In such an environment, segregation of duties can be achieved by building controls into the computer hardware and programs.

5130.05 Segregation of duties (SoD) helps prevent and detect errors by:

a. preventing recording errors and other administrative errors as independent reviews of transactions take place.

b. preventing unauthorized transactions as no single individual is responsible for controlling revenue, expenditure, payroll, and other business functions.



c. reducing the risk of organizations not achieving their goals as more reliable data is made available.

d. making fraud prevention and detection easier due to appropriate segregation of duties.

e. helping with Sarbanes‐Oxley Act (SOX) compliance as SOX requires auditors of public companies to report on internal controls over financial reporting. (If SoD is inappropriate, then the internal controls will be considered deficient.)

Appropriate segregation of duties leads to effective internal controls, less work for auditors, and lower costs to the organization.

5130.06 Examples of segregation of duties in an IT environment

a. In an IT environment, program designers can restrict program access based on level of authority. For example, only the academic team of a school may be given access to student progress‐related data; other teams will not have access.

b. As most companies use SAP (systems, applications, and products) systems nowadays, the role of the user on the SAP system is used as a basis to grant access permissions to the user and forms the basis of segregation of duties. So, if an employee working in the payables department has not been authorized to sign a check, he will not be allowed to access the check authorization part of the SAP solution because of the role assigned to him.

c. Unauthorized access to the system database and other key systems by administrative staff can be prevented by maintaining secure log files to record activities.

d. Proper policies and procedures can be put in place to ensure that administrative staff is prevented from reviewing files containing business‐related and operations‐related data.

5130.07 Segregation of duties serves as a good start for preventing or detecting fraud; however, it does not completely ensure that fraud and errors will be prevented or detected. For smaller entities, supervision can serve as an effective compensating control. Particularly in the case of smaller organizations, which have fewer employees, the extent to which segregation of duties is practicable may be limited. However, other forms of effective controls can compensate for the lack of segregation of duties.

For example, the mailroom clerk receives and opens all of the organization’s mail, including checks and remittance advices, and prepares a daily list of checks received, performing the recording function and custody of the checks. The clerk can easily cash the checks and destroy the remittance advice without anyone knowing. As there is no evidence supporting the transaction, the perpetrator of the fraud may be prompted to commit the fraud multiple times. The company may not be able to uncover the fraud until later, if and when the customer is billed for another transaction and in return produces a canceled check. Supervision of the mailroom clerk or any employee performing multiple tasks which are mutually exclusive can help reduce the risk of fraud and serve as an effective compensating control.

5130.08 Supervision acts as:

a. a compensating control in situations where it is not practicable to achieve segregation of duties (SoD).

b. an impediment for employees performing mutually exclusive tasks.



5130.09 Authorization and approval

Authorization of transactions by those acting within the scope of their authority can prevent the processing of invalid transactions. Authorization becomes an effective preventive measure when:

a. policies and procedures clearly state the persons having authority and the transactions that they can approve.

b. individuals entrusted with authorization understand their responsibility and review supporting documents to ensure the validity and propriety of the transactions being authorized.

c. authorization is properly documented.

5130.10 Authorization and approval help prevent invalid transactions through the following steps:

a. All invoices must be approved before entry in the general ledger so that only valid sales are recorded.

b. Purchases should be duly authorized by the supervisor to ensure that only quality products from approved vendors are ordered at fair prices. This also limits unnecessary spending.

c. Checks should be signed and approved prior to payment to ensure unauthorized payments are not made.

d. The reimbursement of expenses to employees must be approved by the supervisor to ensure only actual expenses incurred by employees are reimbursed.

e. Changes to the customer master file should be authorized only by responsible persons to prevent order processing for fictitious customers.

f. Alterations to the price list master file that contains product unit prices for billing the customers should be duly authorized by persons having the power to authorize price changes and customer billings.

5130.11 Spreadsheet controls

Over the years, spreadsheets have been widely used by companies for financial reporting purposes. However, lack of proper controls and testing has often led to a significant number of spreadsheet errors which may indicate an ineffective financial reporting system. As most companies use a large number of spreadsheets for financial reporting, the collective impact of significant deficiencies in individual spreadsheets may result in material internal control deficiency. Section 404 of the Sarbanes‐Oxley Act requires the management of public companies to assess the effectiveness of the internal control of issuers for financial reporting. Spreadsheet controls should be put in place to ensure the accuracy and integrity of the financial records.

5130.12 Effective spreadsheet controls that help mitigate risk include the following:

a. Access controls: Access controls like username, passwords, and biometric verification should be provided to restrict access to only those individuals who need to use the spreadsheets.

b. Change control: Any change requests or testing of the spreadsheets should be authorized.

c. Version control: Only a current and approved version of the spreadsheet should be used.



d. Data: Accuracy checks should be performed on input as well as output data.

e. Security and data integrity: Access should be restricted on spreadsheet cells that perform critical computations.

f. Backup and archiving: Regular backups should be taken to prevent loss of data.

5130.13 Application controls

Apart from supervision, authorization and approval, and spreadsheet controls, there are master file controls that help ensure the ongoing integrity of the standing data contained in the master files. These are application controls, which are imposed at three different stages of the processing cycle:

1. Input

2. Processing

3. Output

Note: Standing data is information held on a computer file for long‐term use because it does not change often. Names and addresses of clients are examples.

5130.14 Application controls include the following:

a. Source data controls

b. Input validation routines

c. Online data entry controls

d. Data processing and storage controls

e. Output controls

f. Data transmission controls

SOC® 1 Reports

5130.15 The system and organization controls (SOC®) reports are prepared in accordance with AT‐C 320, Reporting on an Examination of Controls at a Service Organization Relevant to User Entities’ Internal Control Over Financial Reporting.

The purpose of the SOC® reports is to help service organizations that provide services to other organizations to build trust, confidence in services performed, and controls related to those services through a report issued by an independent auditor. As more and more companies outsource data storage, data processing, business processes, and systems, it is important that such companies (user entities) gain confidence that the data, processes, inputs, and outputs are handled efficiently and do not expose the user organization to any risk. SOC® reports help the user entities and the auditors of their financial statements in evaluating the effect of the controls at the service organization on the user entities’ financial statements.

5130.16 The SOC® report should clearly communicate the risks related to:

a. internal controls over financial reporting.

b. availability of systems to process information.

c. security available to protect the information assets.



5130.17 When a user entity outsources functions that affect its internal control over financial reporting (ICFR), management of the user entity needs to gain an understanding of the design and operating effectiveness of certain controls that are performed by the service organization. This is generally accomplished through a SOC® 1 engagement, which is an engagement performed by a CPA (a service auditor) to report on:

a. the service organization’s description of its system,

b. the suitability of the design of the service organization’s controls included in the description, and

c. the operating effectiveness of those controls (type 2 engagement).

5130.18 There are two types of SOC® 1 engagements:

1. SOC 1® Type 1 report: A report in which the service auditor expresses an opinion on whether management’s description of the service organization’s system is fairly presented, and the controls included in the description are suitably designed as of a specified date

2. SOC 1® Type 2 report: A report in which the service auditor expresses an opinion on whether management’s description of the service organization’s system is fairly presented, and the controls included in the description are suitably designed and operating effectively for a period of time covering between 6 months to 1 year. The report also includes a detailed description of the tests of controls performed by the service auditor and the results of those tests.

5130.19 Internal controls by definition are mechanisms, rules, and procedures that are implemented by management to help management and employees prevent or detect deviations in assigned functions in a timely manner. There are four main types of internal controls that support the systems and services provided by the service organizations to the user organization:

1. Manual controls

2. IT‐dependent manual controls

3. Application controls

4. IT general controls

5130.20 Manual controls are controls that are manually performed by individuals. Examples of manual controls include:

a. bank reconciliation statements,

b. matching of cash received with the accounts receivable accounts, and

c. supervisor verification.

5130.21 IT‐dependent manual controls are controls that are manually performed by individuals but rely on system‐generated reports to test the validity of those controls. In order to ensure the effectiveness of IT‐dependent manual controls, it is important to ensure the effectiveness of the manual portion of the control as well as validate the accuracy and completeness of the system‐generated report.

Example 1: Management review of the weekly exception report and follow‐ups on significant exceptions: The IT‐dependent portion of the control includes the reliance of management on the computer‐generated report to identify exceptions. The manual portion



of the control includes ensuring the controls are in place to ensure that the exception report is complete and accurate.

Example 2: Segregation of duties for authorizing transactions, recording transactions, and custody of assets: The IT‐dependent portion of the control includes system access as per the job responsibilities assigned to the employees. The manual portion of the control includes the appropriate segregation of duties among employees.

5130.22 Application controls are automated controls that relate to the processing of transactions within the business process and are embedded within the system application. These controls are entirely performed by the computer system and determine how the transactions will be input, processed, and output by the computer system.

Examples of application controls are edit checks, completeness checks, data input validations, calculations, interfaces, and authorizations.

5130.23 IT general controls apply to all systems, components, processes, and data for IT. These controls are the focal point of the SOC® audit.

Examples include system development life cycle controls, data center physical security controls, computer operation controls, backup controls, and recovery controls. In addition to these types of controls, internal controls can be either preventive or detective.

5130.24 The control objectives in the SOC® 1 report assist the auditor of the user entity in determining how the controls at the service organization affect the user entity’s financial statement assertion. The control objectives address the risks that controls are intended to mitigate, whereas controls provide reasonable assurance that the control objectives are met. Individual internal controls are linked to these control objectives; these controls provide the process the service organization undergoes to ensure the achievement of the stated control objectives.

A service organization’s control objectives include IT general control objectives that are necessary to achieve the application control objectives (related to classes of transactions and events as well as account balances) and are therefore likely to be relevant to controls over financial reporting of user entities.

Example: Service organization general IT controls provide reasonable assurance that the following control objective is met: Logical access to programs, data, and computer resources relevant to user entities’ internal control over financial reporting (ICFR) is restricted to authorized and appropriate users, and such users are restricted to performing authorized and appropriate actions.

5130.25 The following risks threaten the achievement of the IT general control objectives:

a. Unauthorized users gain access to and modify data or applications.

b. Authorized users make unauthorized or inappropriate use of or modifications to applications or application data.

c. Segregation of duties is not effective or is not enforced by logical access security measures.

d. Logical access security measures are bypassed through physical access to sensitive system resources, resulting in unauthorized access and changes to data or applications.



Illustrative Control Objectives for Payroll Processing

Note: The following information is from the AICPA publication, Information for Management of a Service Organization in a SOC® 1 Engagement.

5130.26 Payroll processing setup controls provide reasonable assurance that the following control objectives are achieved:

a. Client requirements are properly authorized and set up in the system completely, accurately, and timely.

b. Payroll taxes and other deductions are authorized and set up completely, accurately, and timely.

c. Payroll tax and other deductions tables are updated completely, accurately, and timely, as required.

d. Changes to client requirements, payroll taxes, and other deductions are updated completely, accurately, and timely.

5130.27 Payroll data authorization and recording controls provide reasonable assurance that the following control objectives are achieved:

a. Payroll data are received from authorized sources.

b. Payroll data are recorded completely, accurately, and timely.

c. Rejected transactions and errors are identified, reported to user entities for follow‐up, and properly re‐entered into the system on a timely basis.

d. Payroll transactions are processed completely, accurately, and timely.

e. Payroll adjustments are received from authorized sources and processed completely, accurately, and timely.

f. Data transmissions to or from clients are authorized, complete, accurate, secure, and processed timely.

5130.28 Payroll processing controls provide reasonable assurance that the following control objectives are achieved:

a. Processing is scheduled and performed appropriately in accordance with client specifications; deviations from the schedule are identified and resolved timely.

b. Payroll deductions and tax withholdings are calculated by the system in accordance with statutory and client specifications.

5130.29 Reporting controls provide reasonable assurance that the following control objectives are achieved:

a. Payroll checks, pay statements, and reports are produced completely, accurately, and timely in accordance with client specifications.

b. Disbursements of direct deposits are authorized, complete, accurate, and processed timely.

c. Data transmissions of money movement and files from the system to outside parties and to the clients’ banks are authorized, complete, accurate, secure, and processed in a timely manner.



5130.30 Use of SOC® 1 report

The system and organization controls (SOC® 1) report:

a. helps the management of the user entity and their auditor to:

(1) evaluate the effect of a service organization’s controls on their financial statement assertions.

(2) evaluate their internal controls over financial reporting for the purpose of compliance with laws and regulations and performance of financial statement audits by their auditor.

b. helps the auditor of the service organization to determine:

(1) whether the service organization has described its system and services accurately.

(2) that the controls of the service organization have been designed suitably to achieve the related control objective.

(3) that the controls that have been described by the service organization are operating effectively during the period covered by the report to achieve the related control objectives.

Enabling Technologies

5130.31 Recent technological advances have had a huge impact on the way business is conducted. These technologies can be used to improve internal business processes to save costs, increase profitability, and increase customer satisfaction. They include the following:

a. Artificial intelligence (AI) refers to the ability of a computer or machine to mimic the capabilities of the human mind by:

(1) learning from examples and experience,

(2) recognizing objects,

(3) understanding and responding to language, and

(4) making decisions, solving problems, and combining these and other capabilities to perform functions a human might perform.

Companies can use AI to improve their business processes.

b. Robotic process automation (RPA) is the automation of the most mundane and repetitive, high‐volume computer‐based tasks and processes that are rule‐based and trigger‐driven to improve operational efficiency, reduce costs, and increase margins by the application of technology, governed by business logic and structured inputs. Using these tools, a company can configure software, or a “robot,” to:

(1) capture and interpret applications for processing a transaction,

(2) manipulate data,

(3) trigger responses, and

(4) communicate with other digital systems.

c. Cloud computing is the delivery of computing services including servers, databases, storage, networking, software, and analytics over the internet—in other words, “the cloud”—offering flexible resources, economies of scale, and faster innovation.



d. Electronic data interchange (EDI) is the electronic interchange of business information between business partners using a standardized format. EDI helps businesses like Wal‐Mart improve their business processes:

(1) Paperless recording: EDI replaces paper‐based purchase orders and invoices.

(2) Efficient data storage: All data about the company, inventory, and sales can be easily stored in the database.

(3) Data safety: EDI keeps the data safe.

(4) Data availability: EDI makes data available for organizational decision making; there is a reduced need for human work as the use of paper‐based information is reduced.

e. Radio frequency identification (RFID) is the wireless, non‐contact use of radio frequency waves to transfer data. Tagging items with RFID tags allows users to automatically and uniquely identify and track inventory and assets. A system consisting of RFID tags, an antenna, an RFID reader, and a transceiver is used to receive and send data.

5130.32 Revenue cycle

In order to avoid errors that may eventually lead to huge losses, it is imperative for any company to have carefully designed business operating procedures. The steps involved in the revenue cycle include the following:

a. Registering the purchase order of the customer, followed by a review of the items (including the quantities mentioned) to determine if the order can be fulfilled within a reasonable period of time. This is then followed by preparation of the sales order for the guidance of various departments, including the credit department, warehouse, and shipping. Before the sales order is processed, the credit department determines the credibility of the customers, both new and existing, by studying their financial statements and by referring to the reports of the credit agencies like Dun & Bradstreet.

b. Once the line of credit has been granted to the customer and the credit department has approved the sales order, the storekeeper/warehouse keeper issues the goods that are covered by the sales order to the shipping department. At the same time, the perpetual accounting records that are maintained by the accounting department (not the storekeeper) are updated for the goods shipped.

c. The shipped goods are accompanied by the shipping documents, such as a bill of lading. Before these numerically controlled shipping documents are sent to the billing department, they must be entered in the shipping register.

d. After comparing the shipping documents with the sales order and customer’s purchase order, the billing department prepares and mails the invoice to the customer.

5130.33 How the revenue process can be improved by using technology

a. Cloud computing can improve the sales process through sales order/lead generation:

(1) It can transform both field‐based and call center–based sales by creating a direct, personal connection and enhancing collaboration.

(2) It allows the sales force to utilize their time efficiently and direct their efforts to increasing lead conversions and closing deals with customers.

(3) It provides a single platform for sales representatives for their day‐to‐day applications as well as automatic syncing of their data.



b. Artificial intelligence (AI) can be used by companies to improve sales:

(1) Enhancing sales and marketing: AI analytics are incorporated in many customer relationship management (CRM) solutions that enable sales teams to automatically generate valuable insights. For example, Salesforce’s Einstein AI technology helps to increase win rate by predicting if a customer is more or less likely to purchase a product by integrating AI technology with Salesforce’s software‐as‐a‐service (SaaS) CRM. Another example is chatbots, software applications that mimic written or spoken human speech, which are widely used to help organizations boost sales and increase customer base. For example, when UK‐based retailer Marks & Spencer added a virtual digital assistant function to its website to help customers solve common issues, it helped them generate sales worth millions of pounds that would otherwise have been lost due to frustrated customers.

(2) Improving customer service: Call center inquiries are met with automated menu services; however, Transcosmos’ AI solution automatically assesses the quality of service given “at speed with human accuracy” and can detect inappropriate and problematic customer service with more than twice the accuracy of a voice recognition system.

c. Robotic process automation (RPA) can be used by companies to improve sales:

(1) Processing sales orders and related invoices: RPA helps in automation of all tasks related to sales order processing, including entry of sales orders and creating the related invoices.

(2) Improved lead interactions: Follow‐ups and interactions with the leads are made faster and easier, resulting in increased sales. RPA also facilitates prompt and appealing responses to further communication with leads.

(3) Data management facilitates automatic data aggregation and CRM updates, saving time that the sales team might have to spend looking for missing critical information. RPA bots (programs) can file the missing contact information and help with the mapping of the accounts in‐depth.

5130.34 Cash collection process

The cash collection cycle is the number of days in which cash is collected from receivables. It is an important measure as it helps evaluate the operating efficiency of a company. The shorter the cash collection cycle, the better.

The cash collection cycle (CCC) is calculated using the following formula:

Average receivables ÷ (Annual sales/365 days)

5130.35 How AI improves the cash collection process

a. Debt collection for overdue accounts can become a daunting task for companies. Artificial intelligence (AI) enables companies to combine existing data, machine learning, and advanced analytics to automate the debt collection process and make it more efficient and effective.

b. AI makes predictions based on past payment patterns to identify customers who may default or not pay at all. Parameters like age, salary, and prior communications are used to build debt collection strategies. This helps companies identify the best method to contact the customer to get a positive response. For example:

(1) reminder emails to customers can include a quick response (QR) code to facilitate payment by simply scanning the code with their smart phone for payment, or



(2) automated emails and short message service (SMS) reminders can include links to the payment landing page, where the customers can pay using a credit card.

c. Incentives such as early payment discounts, options for payment plans, and fee waivers can be used to resolve conflicts, settle accounts receivables, and make the customer experience positive.

d. AI helps companies make a choice on when and how to contact customers based on their behavior. This is made possible by algorithms with predictive analysis that are designed using information gathered from data and machine learning. More personalized experiences can increase the probability of collection.

5130.36 How RPA helps cash collection for businesses

a. Robotic process automation (RPA) helps businesses reduce DSO (days sales outstanding), past due receivables, and bad debt reserves. This can be achieved by automating invoice delivery and accounts receivables, thereby eliminating the need for employees to complete repetitive manual tasks.

How it works: Inefficiencies in generating accurate invoices can result in delays in receiving payment. Too much employee time is taken up in retrieving data from multiple systems to create an invoice manually. This can lead to missed or delayed payments. An improved billing process will help reduce DSO and improve cash flow. Sending invoices immediately upon the sale of goods or services rendered helps eliminate delays in receiving payment from customers. The longer a company takes in sending invoices to its customers, the longer it will take to receive the payment.

b. Automating accounts receivables can help reduce costs related with payment processing. The time saved by automating the system will save the company money, enhance productivity, improve operational efficiency, and reduce human error.

5130.37 Purchase cycle

a. The purchase cycle begins when any department in an organization needs material, supplies, or equipment. The department makes a request by sending a purchase requisition to the purchasing department. The purchase requisition includes the following details:

(1) Department that needs the material, supplies, or equipment

(2) List of items required

(3) Authorization signature of the person authorized to approve the expenses for the concerned department

(4) Details of the account to which the related costs will be charged

b. The purchase department places the order after reviewing the purchase requisition (generally from an approved vendor). In case of purchases from unapproved vendors, the bill of lading received from delivery is matched with the purchase order. The receiving department creates a receiving report after inspecting the goods in terms of quantity and quality.

c. The goods are then sent to the department that requisitioned the goods. A voucher indicating the details of the account debited for purchases is attached to the purchase order, vendor’s invoice, and receiving report by the accounts payable department. The related inventory/asset/expense account is debited with corresponding credit to the accounts payable account.



5130.38 How EDI helps improve the purchase cycle

a. Paperless recording: Electronic data interchange (EDI) replaces paper‐based purchase orders and invoices with system‐generated purchase orders through an automatic replenishment system.

b. Reduced lead times: Lead time is reduced as orders are placed in a real‐time environment by sending automatic links to the vendors when inventory is required, without the lag that manual input may cause.

c. Reduced cost: As EDI automatically transfers data, it reduces data entry errors that result in chargeback fees. Use of advance shipping notices reduces processing time, which reduces labor costs. Reduced processing time results in customer satisfaction and further reduces processing costs due to reduced labor hours. Reducing the use of paper results in reduced transaction costs.

d. Improved customer relations: Improved communications with the customers enables them to track their orders within the supply chain, leading to customer satisfaction.

5130.39 Accounts payable/disbursement cycle

The accounts payable disbursement cycle is the process by which the company makes purchases and in turn pays for items with cash resources.

How AI helps in disbursement

a. Artificial intelligence (AI) helps in automating repetitive tasks in accounts payable such as data entry and transaction processing. This allows employees to focus on more value‐added activities.

b. Machine learning, along with natural language processing (NLP) and optical character recognition (OCR), enables companies to extract data and to understand and categorize documents. This enables the transformation of documents into a digital system that simplifies search functionality.

c. Automation of the payables process helps reduce processing time as well as errors, as it involves less human intervention.

d. There is significant cost savings as the need for paper storage and retrieval costs for payables processing is eliminated.

5130.40 How Starbucks® uses artificial intelligence (AI) for payments

a. The Starbucks® Corporation’s My Starbucks Barista app (application) for mobile ordering allows customers to:

(1) select their preferred Starbucks location.

(2) type or speak their order into the app and make payment.

The customer then only needs to pick up their order.

b. Starbucks uses Automated Clearing House (ACH) payments as well as natural language processing (NLP) in the same app. (See sections 5130.41 and 5130.42 for ACH and NLP definitions.)

c. The ACH payment system automates the process of clearing payments that are to be paid out from the client company. This results in faster processing of payments as ACH forms a single stream for payments to follow; the method for transferring money remains the same irrespective of the customer. This helps retail companies avoid transfer of money using wire transfers, check, cash, or credit card.



d. Starbucks uses NLP technology to leverage artificial intelligence on the Starbucks app or the drive‐through menu to help customers from the time of placing the order to making the payment by presenting them with personalized choices based on the customers’ preferences and other factors like weather and time of day.

Source: Starbucks Stories

5130.41 Electronic funds transfers in the United States are facilitated through the Automated Clearing House (ACH). The National Automated Clearing House (NACH) runs the ACH. Most debit and credit transactions clear the same business day due to recent rule changes.

5130.42 The branch of artificial intelligence (AI) that addresses computers being given the ability to understand spoken words and text in the same way as humans is natural language processing (NLP). NLP is the compilation of computation linguistics: rule‐based modeling of human language with utilization of statistical and machine learning models. These technologies provide the means allowing computers to process human language in either voice or text form. Additionally, the computers are able to understand the full meaning, including speaker’s or writer’s intent.

5130.43 Human resource cycle

The human resource (HR) cycle includes hiring, training, compensating, and promoting employees for their time and effort as well as firing employees.

5130.44 How AI helps improve the HR process: recruitment

a. Artificial intelligence (AI) makes the recruitment process faster, less expensive, and easier to manage. Apart from this, AI:

(1) allows hiring on a large scale by enabling teams to evaluate the applications in a few days’ time rather than months without compromising the quality of the hiring process.

(2) allows remote hiring by using automated online screening and interview tools and increasing the hiring pool across the globe.

(3) improves recruiter performance by processing thousands of applications in an instant for qualified candidates.

(4) reduces hiring costs by reducing the time and cost of screening candidates.

b. AI combines historical data about employee past performance with skills and competencies required for the role to select the most suitable candidate.

c. Automated screeners are used to detect the required skills on a candidate’s resume, simplifying and accelerating the early stages of the recruitment process.

d. AI helps companies like Unilever, which recruits thousands of people every year, to streamline and improve the recruitment process. AI recruitment specialist Pymetrics has helped Unilever create an online platform capable of conducting initial assessments of candidates in their own homes, thereby helping Unilever to eliminate approximately 70,000 person‐hours of interviewing and assessing candidates through automated screening.

e. Examples of AI candidate interview tools include HireVue and VCV.



5130.45 Inventory management

Companies can use radio frequency identification (RFID) for inventory management. Companies like Wal‐Mart use this tiny electronic tag on individual pieces of clothing, including men’s and women’s wear, jeans, and socks.

5130.46 How RFID helps inventory management

a. The tag tracks the inventory shipments from the manufacturer’s warehouse to the store.

b. This end‐to‐end system ensures that products are available on the shelves at the right time and in quantities suitable to customer demand.

c. The tag emits weak radio signals that enable the employees to know:

(1) what sizes are missing on the shelf.

(2) what items are available in the storeroom.

5130.47 Payroll process

a. The payroll process involves arriving at the net pay of employees, filing payroll taxes, and making adjustments for taxes and applicable deductions.

b. The information required for the payroll process includes data on the employees, tax‐related information, and verification of hours worked for employees working on an hourly basis.

5130.48 How AI helps improve the payroll process

Artificial intelligence (AI) can do much more than calculating employee wages, making payments, and generating payroll reports:

a. AI can analyze the vast amount of payroll data to assist in identifying unnecessary expenses.

b. AI can perform quality assurance, which helps prevent errors in payroll.

c. Significant variations in payroll can be identified by comparing average of earnings, deductions, and taxes of employees using past payment history to current payroll.

5130.49 How RPA helps improve the payroll process

Major benefits of robotic process automation (RPA) in payroll processing include the following:

a. Improved efficiency: RPA processes payroll based on rules. Unless there are errors in inputting the rules or changes in the rules are not updated, the payroll processing by RPA is highly accurate.

b. Regulatory compliance: Businesses operate from different locations not only within a country but worldwide as well. Keeping track of regulatory changes can lead to complexities. RPA being rule‐based, compliance with regulation and any changes thereto are made much easier to manage by adjusting the parameters of the rules at any time.

c. Easy to install: An RPA system for payroll processing can be installed with modest investment as it does not require IT infrastructure changes.



d. Automatic error correction: RPA automatically corrects errors without human intervention. For example, a missing zip code in the address details of a new employee data will automatically be corrected in the RPA system.

e. Reduction in payroll staff: An RPA system can lead to reduction in human payroll department staff whose services can be used to perform more value‐added tasks.

5130.50 Production process

The production process involves the conversion of raw materials into finished goods. The process has various components which include the design of products, their incorporation into a production schedule, and manufacturing activities.

5130.51 Technologies that can be used to improve the production process

a. Big data analytics is a process by which huge volumes of complex data (big data) are analyzed using statistical methods to reveal market trends, patterns, and customer preferences.

(1) The production process involves multiple interrelated processes that can be constraints and affect overall productivity. Big data analytics helps streamline these processes by examining each process in detail. This examination of processes enables manufacturers to identify problem areas (underperforming processes and bottlenecks) and discover patterns that improve the processes, resulting in improved efficiency and productivity.

(2) Using historical data on breakdown of equipment from machine logs, predictive analytics can be used to schedule predictive maintenance, which enables manufacturers to reduce unscheduled downtime and prevent asset breakdown using the industrial internet of things (IIoT). This significantly impacts operating costs and lost revenue.

(3) Other areas in which companies are using big data analytics include:

(a) predicting customer preferences.

(b) reducing investment in working capital.

(c) improved cash flow forecasting.

b. The industrial internet of things (IIoT) combines technologies such as big data, cloud integration, and machine learning to allow for data collection, exchange, and analysis to help enterprises achieve better efficiency and reliability in their operations.

(1) IIoT enables businesses to plan predictive maintenance of company equipment. As the performance of the machines is monitored in real time, maintenance can be scheduled when actually required. This prevents unplanned outages and loss of productivity. This also results in minimizing downtime. IIoT can also be used to communicate with other employees and give them the required instructions.

(2) As an example of how cloud‐based IIoT systems can be used to create smart factories, Siemens, a multinational company in Germany, created automated internet‐based smart factories using a cloud‐based IIoT system. This system collects data from all the machines and devices in the factory automatically and then analyzes that data to make production smoother and produce optimal results for each machine.

c. Virtual reality (VR) utilizes computer technology to create a simulated environment. The simulated environment is three‐dimensional and utilizes various electronic devices



such as a head‐mounted display, body sensors, and gloves to enhance the realism of the experience.

(1) Virtual reality is used by engineers and designers to:

(a) create models for their products that allow them to see their designs digitally.

(b) explore options that are otherwise impossible using traditional methods because of the cost and time involved.

(c) troubleshoot issues before actual production begins.

(d) decrease the time and cost involved in modifying designs, tolerances, and safety features.

(2) For example, Ford, the automobile company, uses virtual reality specialists that guide the engineers in designing and building entire vehicles in a virtual environment. Every vehicle at Ford must go through multifunctional VR review before going into production. This results in improved cost, time, and quality.

Data Analytics

5130.52 Data analytics is the process of gathering, combining, and analyzing data to identify trends, relationships, and cause‐and‐effect orders in the data. It consists of descriptive, predictive, and prescriptive analysis.

5130.53 Data can be classified into three categories:

1. Structured

2. Semi‐structured

3. Unstructured

While structured data is important, unstructured data can provide rich insights if analyzed correctly.

a. Structured data is data organized neatly in a tabular format with clearly defined relationships between different rows and columns. It is stored in a relational database. Examples are spreadsheets (e.g., Microsoft Excel), point‐of‐sales data, and credit card numbers.

b. Semi‐structured data is qualitative data loosely organized by categories. For example, an email application can search categories such as Inbox, Sent, and Drafts. However, the email content is unstructured data.

c. Unstructured data is qualitative data stored in its native form and processed only when required. Examples are pictures, email text, audio and video files, social media sites, blogs, survey responses, and online reviews.



5130.54 Differences between structured and unstructured data

Structured Data Unstructured Data

Clearly defined data

Unorganized data

Easy to store, process and access Difficult to process and organize

Allows optimal resource utilization

Does not allow optimal resource utilization

Requires less storage space Requires more storage space

Easy to understand Difficult to understand

Nonflexible Flexible

Stored in relational database, data warehouses

Stored in NoSQL (nonrelational) database, data lakes, data warehouses

Can work with standardized data models

Specialized tools required to manipulate unstructured data

5130.55 Why data analytics of unstructured data is important

As per recent estimates, almost 80% of a company’s data is unstructured data. It is important for businesses to find ways to organize and analyze this data in order to gain competitive advantage. Data analytics tools using machine learning and natural language processing can be used to scan through thousands of emails to gain important insights.

Unstructured data analysis can be used in particular for increased customer satisfaction:

a. Text mining software enables real‐time monitoring of emails, chats, social media posts, and customer support portals, enabling customer concerns to be routed directly to the concerned department, resulting in early resolution of customer concerns.

b. Machine learning can be used to perform opinion mining (sentiment analysis) to detect opinions regarding the services/products offered by the company.

5130.56 How to analyze unstructured data

a. Set clear goals: Knowing the end goal will help identify the unstructured data that needs to be collected for analysis.

b. Collect the required data: Data can be real‐time, historical, or survey data, depending on the goals.

c. Clean the collected data: For easy analysis, unstructured data must be cleaned by removing irrelevant words.

d. Use of technology: NoSQL (non‐relational) databases can be used to manage dataflow. Visualizations tools like Tableau can be used to summarize the unstructured data.

5130.57 Data analytics techniques for structured data

a. Descriptive analytics analyze and describe historical data and include statistics such as means, medians, mode, and correlations.

b. Predictive analytics use historical data to model potential outcomes based on the historical data. This includes regression analysis, stress tests, and other tools used to establish the likelihood of a future event occurring.

c. Prescriptive analysis often combines descriptive and predictive analytics to derive a possible solution or plan.



5130.58 Steps involved in data analytics of structured data

Normally, there are five steps involved in using analytical procedures:

1. Expectation‐formation: Develop an expectation about a current‐year financial statement amount from sources such as prior‐year amounts or budgets.

2. Identification: Determine the amount of difference from the expectation that should lead to investigation or other action.

3. Investigation: Compare the expectation with the current‐year amount.

4. Evaluation: Take action with respect to a significant variation between the expectation and the current‐year amount, i.e., investigate the difference.

5. Documentation: Document the work that is performed.

5130.59 For example, in the case of a business retailing books, structured data includes the following:

a. Sales by number of books sold by:

(1) Title of the book

(2) Author

(3) Publisher

(4) Month

(5) Region

b. Ratings given by customers

5130.60 Unstructured data

Using a book retailer as an example, huge volumes of data are available with online bookstores based on searches made and ratings and reviews given by people visiting the website. While the ratings given by readers constitute structured data, the written text in the reviews constitutes unstructured data. Every time someone visits the portal by clicking on the landing page of the website, buys a book, searches the website, communicates in the live chat window, or clicks on an advertisement, data is created—all of this is data, some structured (like website traffic) and the rest unstructured (like communication in a live chat). It is not possible for spreadsheets to capture and analyze all of this data.

a. Meaningful insights can be drawn from unstructured data through advanced analytics using natural language processing (NLP).

b. Artificial intelligence (AI) pattern recognition algorithms can be used to sort images.

c. Structured data can be analyzed using descriptive, predictive, and prescriptive analysis.

Accounting and Financial Reporting Systems

5130.61 The purpose of any accounting and financial reporting system is to provide financial information about the reporting entity to the users of the financial statements to facilitate financial decision making. The financial information should include a summary of the transactions of the reporting entity for a period of time, and the system must be able to capture, summarize, and appropriately present data regarding relevant transactions and events occurring during the financial year in an easy‐to‐understand, user‐friendly format.



5130.62 The flow of information in an accounting and financial reporting system is as follows:

a. Receive data about the transaction/event

b. Record the transaction/event in the books of prime entry

c. Summarize ledger balances in a trial balance

d. Transfer trial balance totals to the financial statements

5130.63 There are two types of accounting and financial reporting systems:

1. A single‐entry system is generally used by very small businesses as they do not have many transactions in any given day. Every transaction is recorded as a line item in the ledger. A single‐entry system is simple to use, does not require complex software, and can be run on a spreadsheet program (e.g., Excel). Although the single‐entry system is convenient, it does not help in planning and financial analysis and it is not recognized by tax authorities.

2. A double‐entry system is more detailed as it records every transaction both as a debit and credit in separate accounts. As a result, it ensures that company books are balanced. Although it provides complete records depicting a more accurate picture of a company’s financial position, a double‐entry system is not error‐free. Although a single‐entry system can use a spreadsheet to input information, a double‐entry system requires accounting software to manage it properly. Accounting software can help a business automate most steps of the accounting cycle.

5130.64 Benefits of using accounting and financial reporting software include the following:

a. Improved invoicing and billing: Businesses can send scheduled invoices automatically every time an order is placed by creating recurring profiles for regular customer orders. The payment terms and conditions can also be included in the invoices. Reminders can be set based on invoice due dates or expected payment dates and sent to customers automatically.

b. Easy expense tracking: Accounting software can improve tracking of expense. It can also upload expense receipts, scan them, and record information from the scanned receipts automatically.

c. Bank reconciliation: Accounting software can be used to streamline bank reconciliation. A statement from the bank can be fed into the company accounts automatically by connecting the company bank account to the accounting software. Imported bank transactions can be matched automatically and further verified to confirm with the company accounts.

d. Better inventory management: Good inventory management ensures the availability of sufficient stock and provides better customer service. Accounting software helps in recording stock‐keeping unit (SKU) codes, adding item images, creating bundles, and tracking the movement of items by serial or batch number. Stock can be tracked and reorder levels can be set to place timely orders automatically in order to avoid stock outages. Inventory reports can be generated to manage inventory more efficiently.

e. Tax compliance: Accounting software can make calculation of taxes faster and determine the taxes for company transactions more accurately. Summary reports can be generated for a better understanding of the applicable taxes.

f. Report generation: Reports are crucial for an organization’s decision making. Generating reports in spreadsheets is very demanding as data needs to be consolidated by manually entering formulas to create each report. Accounting software can generate



a number of reports automatically, saving time and effort with built‐in reporting features that analyze cash flow. Profit and loss statements and balance sheet reports can help explain the key financial aspects of the business.

Process Improvement

5130.65 Process improvement is the methodology businesses can use to identify problem areas where improvement can increase profit margins, cut down on expenditures, and improve operational efficiency. There are many methods and techniques through which a company can identify problem areas in their business processes.

5130.66 Six Sigma: Six Sigma tools involve the collection and analysis of data to reduce cycle time and defects to a minimum. In addition, the process improves customer satisfaction. Six Sigma uses the DMAIC (define, measure, analyze, improve, and control) and DMADV (define, measure, analyze, design, and verify) methods to improve processes. While DMAIC focuses on improving existing processes, DMADV is used when creating new processes.

5130.67 Simulation: A simulation is a model that mimics the operation of the proposed or real system. It is time‐based and considers resources and constraints as well as interactions. Modeling using a simulation provides a great amount of insight without actually deploying the changes in the real world. This saves business costs as the investment is made only after knowing if an idea will work by first identifying the risks involved in a particular situation. Simulation allows testing of improvements in a cost‐effective and risk‐free manner and makes the checking of process changes fast and easy.

5130.68 Lean manufacturing: Lean manufacturing works toward eliminating business waste, eventually leading to increased output. Types of waste that can be reduced by lean manufacturing include:

a. transportation waste,

b. time wasted between finishing one task and starting another (motion),

c. time wasted between production steps (waiting time),

d. more than the required resources and time being consumed in producing a product,

e. producing excess goods without enough orders (overproduction),

f. time wasted in improving defects in the production process, and

g. holding excessive inventory.

5130.69 Process mapping: A process map, like a flowchart, depicts the finest details of a company’s processes from initial to final tasks. This helps to explain how a process works and identifies the exact areas that can be improved.

5130.70 Fishbone diagram: Fishbone diagrams, also known as cause‐and‐effect diagrams, help process improvement teams identify the core reasons behind the underperformance of a process as well as the point where improvement is required. These diagrams can be produced entirely offline.

5130.71 Pareto chart: Pareto charts rank defects, causes, and data in a process from most significant to least significant. This ranking filters out major factors that need the most attention from other details that do not affect the process. This helps focus on factors that have a greater impact.



5130.72 Information systems are documented using the following methods:

a. Narrative documentation is a written, step‐by‐step explanation of system components and interactions.

b. A flowchart graphically describes an information system in a clear, concise, and logical manner. Flowcharts use a standard set of input/output, processing, storage, and data flow symbols to pictorially describe the system.

(1) A document flowchart graphically describes the flow of documents and information among areas of responsibility (or departments) within an organization. Document flowcharts trace a document from its cradle to its grave. They show where each document originates, its distribution, the purposes for which it is used, its ultimate disposition, and everything that happens as it flows through the system.

(2) An internal control flowchart is particularly useful in analyzing the adequacy of control procedures in a system, such as internal checks and segregation of duties. It can reveal weaknesses or inefficiencies in a system, such as inadequate communication flows, unnecessary complexity in document flows, or procedures responsible for causing wasteful delays.

(3) A system flowchart graphically describes the relationship among the input, processing, and output functions of an accounting information system (AIS). A system flowchart begins by identifying both the inputs that enter the system and their origins. The input is followed by the processing portion of the flowchart; that is, the steps performed on the data. The logic the computer uses to perform the processing task is shown on a program flowchart. The resulting new information is the output component, which can be stored for later use, displayed on a screen, or printed on paper. In many instances, the output from one process is an input to another.

c. Diagrams: A data flow diagram (DFD) graphically describes the source of data, the flow of data in an organization, the processes performed on the data, where data is stored in the organization, and the destination of data. It is used to document existing systems and to plan and design new ones.

d. Dictionaries: A data dictionary contains a description of all data elements, stores, and flows in a system. Typically, a master copy of the data dictionary is maintained to ensure consistency and accuracy throughout the development process.

e. Other written material that explains how a system works

f. Operating documentation is all information required by a computer operator to run a program, including the equipment configuration used, variable data to be entered on the computer console, and descriptions of conditions leading to program halts and related corrective actions.


______________________________________________

Section 5200 Economics (15%–25%)

5210 Economic and Business Cycles – Measures and Indicators

5211 Business Cycle Components and Economic Indicators

5212 Market Types

5213 Effect of Government Policy on Business Financial Position and Operations

5220 Market Influences on Business

5221 Supply and Demand

5222 Inflation

5223 Currency Markets

5224 Opportunity and Production Costs

5225 Market Influences

5226 Differentiation/Competitive Strategies

5230 Financial Risk Management

5231 Market, Interest Rate, Currency, Liquidity, Credit, Price, and Other Risks

5232 Means for Mitigating/Controlling Financial Risks

5240 Appendix: Ratio Analysis

BEC 2‐2 ECONOMIC CONCEPTS AND ANALYSIS


5210 Economic and Business Cycles – Measures and Indicators

5211 Business Cycle Components and Economic Indicators

5211.01 Introduction: A business cycle is a more or less regular pattern of expansion and contraction around the trend of gross domestic product (GDP) growth. The concept of the business cycle is designed to help explain the path of the economy and the behavior of certain economic variables such as the economic growth rate as it fluctuates around its long‐term trend.

5211.02 The business cycle phases

a. The business cycle is characterized by four phases:

(1) The “expansion” phase, where more resources become employed and actual output approaches potential output. In the extreme, there may be over‐employment as workers work overtime and the utilization rate for plant and equipment exceeds normal levels. However, this cannot be sustained.

(2) The “peak,” which is the highest point of output during the cycle. The economy is operating above the long‐term growth trend of real GDP.

(3) The “contraction” (or recession) phase, where more resources become unemployed and actual output falls below potential output

(4) The “trough,” which is the lowest point of output during the cycle. There are high unemployment rates, a decline in annual income, and overproduction. This is the time at which the real GDP stops declining and starts expanding.

b. A business cycle is measured as the period of time from the peak of one cycle through the four phases to the peak of the next cycle.

5211.03 Economic growth: The trend or the path of economic growth measures the level of output (potential output) that could be produced if all the resources were fully employed over time.



a. The business cycle measures cyclical deviations from the potential output.

b. If the current level of output is below trend output, there is a recessionary gap.

c. If the current level of output is above trend output, there is an inflationary gap.

d. Economic growth can occur if a society has access to more or better resources and/or the productivity of existing resources increases, allowing the existing resources to be used more efficiently.

Circumstances Affecting the Business Cycle

5211.04 Theories explaining business cycles

a. There are several competing theories that economists have developed that try to explain the causes for the business cycle. While there is no universal agreement as to the exact combination of factors that cause business cycles, a brief review of some of the more accepted theories helps to potentially explain how changes at the firm level might affect the economy at the macroeconomic level.

b. The real business cycle model is based on the premise that fluctuations in output and employment result from real supply shocks that periodically hit the economy, and that markets adjust rapidly to the shock and always remain in equilibrium.

(1) Monetary policy is assumed to have no real effect on the business cycle.

(2) Toward the end of the expansionary phase of the business cycle, employment is high and jobs are easy to find. The supply of labor is highly elastic with respect to temporary changes in wages as workers are very willing to substitute work for leisure on a short‐term basis because wages are high.

(3) The most important shock that can impact the economy is a productivity shock that often results from technological change and leads to an increased level of output from the given amount of inputs. Workers will be willing to work more hours to take advantage of the higher wages caused by the higher productivity.

(4) In the absence of an increase in aggregate demand (aggregate demand is the amount of goods and services—the amount of real national income—that will be purchased at each possible price level), the necessary level of output could be produced by a smaller level of inputs, thus increasing unemployment until aggregate expenditures increase. Rising productivity also increases the incentive for business investment.

(5) Illustration: Assume that productivity declines significantly because of a supply shock that raises the price of crude oil. This would lead to a dramatic increase in the cost of energy. This in turn would lead to an increase in operating costs for most firms. The cost increases would reduce society’s ability to produce real output. At the same time, the increased cost of energy would reduce consumer purchasing power and expenditures on consumer goods. This would further reduce the incentive for businesses to invest.

c. The political business cycle model explains the business cycle as resulting from interactions between economic policy decisions and political decisions designed to influence voter behavior.

(1) Economic policy choices often represent trade‐offs between unemployment and inflation.



(2) Surveys indicate the voters are worried about both issues and perceive rising unemployment to be a problem. Voters are also concerned about the rate of inflation, the rate of increase in the inflation rate, and the effect that inflation could have on their buying power.

(3) Politicians desire to have the economy “moving in the right direction” as an election approaches.

(4) Politicians tend to run restrictive fiscal policies early in their terms and to blame the previous administration for current economic problems.

(5) Fiscal policy tends to become more expansionary as an election year approaches.

(6) There is little doubt that most administrations tend to pursue certain of these policies; however, it is very difficult for any administration to “fine‐tune” fiscal policy since the executive branch does not control the major policy tools. Monetary policy is controlled by the Federal Reserve and fiscal policy measures are enacted by the legislative branch.

d. The insufficient aggregate expenditure model is based on the premise that a business cycle is caused by inadequate spending. The key components of aggregate expenditure are personal consumption (C), business investment (I), government expenditures (G), and the net difference between exports (X) and imports (M). It is represented by the formula:

GDP = C + I + G + (X - M)

Each of these expenditure categories is assumed to be a function of other economic variables:

(1) The level of personal consumption depends primarily on consumer disposable income and wealth. In addition, the demand for consumer durable goods such as housing and automobiles is influenced by the impact of interest rate changes on monthly payments.

(2) Business investment depends primarily on the level of interest rates and business expectations concerning the net present value of the cash flows from potential projects.

(3) Government expenditures are determined by the fiscal policy that is developed by the executive and legislative branches of government.

(4) Exports are driven by consumer income and wealth in foreign nations as well as foreigners’ tastes and preferences for foreign (in this case U.S.) goods. The demand for imports depends primarily on the same factors as personal consumption plus the tastes and preferences U.S. citizens have for foreign goods.

e. The accelerator model assumes that the business cycle is caused by the volatility of investment spending.

(1) Expenditures on capital goods and investment in inventory are related to the rate of change in GDP.

(2) It assumes that a given level of capital goods is required to produce a given level of output. Also, firms desire a given level of inventory at a given level of demand.

(3) If the economy is operating at full capacity and there is an increase in aggregate demand, then there would be an increase in the demand for capital goods, which stimulates increases in aggregate demand, causing a secondary increase in the demand for capital goods.



(4) With the increase in aggregate demand, inventory levels will fall below desired levels and firms will increase their investment in inventory, which will cause an increase in production and employment at the wholesale level.

5211.05 Unemployment

a. The unemployment rate measures the percentage of the labor force that is not working. It is calculated as the number of unemployed workers divided by the number of workers in the labor force multiplied by 100. The labor force equals all U.S. residents 16 years of age or older who are not institutionalized, who are working, or who are unemployed and actively looking for work. Part‐time workers are counted as being employed.

b. Discouraged workers are unemployed workers who are not actively seeking employment, and they are not considered to be part of the labor force. Discouraged workers are also defined as workers who are able and willing to work, but who have not made specific efforts to find work during the past four weeks.

c. Example: The data below indicates what happened in the labor market in the United States during the period June 2009 to June 2010. The unemployment rate stayed constant at 9.5%, but the average duration of unemployment rose more than 10 weeks to 32.8 weeks and more than 400,000 additional workers gave up looking for work, and became classified as discouraged workers.

June 2009 June 2010

Civilian Labor Force 154,759,000 153,741,000 Employed Workers 140,038,000 139,119,000 Unemployed Workers 14,721,000 14,623,000 Unemployment Rate 9.5% 9.5% Average Duration of Unemployment (weeks) 22.5 32.8 Discouraged Workers 793,000 1,207,000

5211.06 Types of unemployment

a. Frictional unemployment occurs due to normal labor turnover. “Search unemployment” includes workers looking for jobs. “Wait unemployment” includes workers waiting to take jobs in the near future. Frictional unemployment is an inevitable and necessary part of well‐functioning labor markets.

b. Seasonal unemployment occurs in regular and recurring patterns in some industries (e.g., retail layoffs in January following the holiday season, construction layoffs during the winter in northern areas of the country, or employment patterns in agriculture tied to the harvest season). The key unemployment measure is “adjusted” by using statistical techniques to account for these expected seasonal patterns.

c. Cyclical unemployment is unemployment that is related to the general level of economic activity and tends to rise during the recession phase of the business cycle.

d. Structural unemployment arises when changes in technology and international competitiveness change the skills required to perform jobs and/or change the location of jobs. Workers often find it difficult to obtain jobs without retraining, relocating, or getting additional education.



5211.07 Costs of unemployment

a. Unemployment represents foregone output and causes actual output to be less than potential output. The primary economic cost of unemployment is the loss of output. The economy is not producing its potential output.

b. There is a social dimension to unemployment, as the loss of a job causes problems with self‐esteem. Generally, there is also an increase in domestic violence as the unemployment rate increases and the average time workers remain unemployed increases. Bankruptcy filings also increase as the duration of unemployment increases. Extended unemployment increases the percentage of the population living in poverty, raises social tensions, and has been linked to increases in domestic violence and mental illness.

c. The burden of unemployment is unequally shared. Lower‐skilled workers have higher unemployment rates than higher‐skilled workers. They also tend to have longer periods of structural unemployment. Teenagers have higher unemployment rates than adults. Unemployment rates for minorities are higher than those for whites.

5211.08 Full employment and the natural rate of unemployment

a. Full employment is defined as the level of employment where the actual unemployment rate is equal to the natural rate of unemployment (NRU). At this point the economy would be producing its “potential output” with the economy operating at full capacity. The NRU occurs when the number of job seekers is equal to the number of job vacancies, and actual unemployment would be greater than zero due to frictional unemployment.

b. Cyclical and structural unemployment would cause the unemployment rate to exceed the NRU.

c. The NRU has fluctuated over time. During the 1950s, it was estimated to be in the range of 3.0% to 3.5%. It climbed to approximately 6.5% by the mid‐1980s and has declined to the 5.0% range by the end of the 1990s. Key factors explaining the changes were as follows:

(1) Demographics: Young adults and teenagers spent a larger portion of their time in the labor force looking for jobs, and their percentage of the population rose during the 1970s and then declined in the 1980s and 1990s.

(2) Higher rates of imprisonment: The percentage of the male population that was imprisoned almost doubled to 2.3% in the period 1985–1998.

(3) The use of temporary help enhanced by IT‐based job matching has helped to reduce the NRU.

5211.09 Economic indicators

a. Economic indicators are a set of variables that measure various aspects of economic activity that provide information to policy‐makers as to the state of the economy. The best‐known set of indices is developed by the Conference Board, a private business research group.

b. Leading indicators are an index of 10 economic variables that have generally provided advance signals of a change in the level of economic activity.

(1) Average work week for manufacturing workers

(2) S&P 500 stock index



(3) Average weekly initial unemployment insurance claims

(4) New orders for consumer goods

(5) New orders for nondefense capital goods

(6) Permits for new residential construction

(7) A measure of vendor delivery performance

(8) Inflation‐adjusted growth in the money supply (M2)

(9) Consumer sentiment index

(10) Interest rate spread between the 10‐T bond and the Fed funds rate

c. Coincident indicators are an index of four economic variables that tend to change in tandem to the changes in economic activity.

(1) Number of employees on nonagricultural payrolls

(2) Personal income minus transfer payments

(3) Industrial production index

(4) Manufacturing and trade sales

d. Lagging indicators are an index of seven economic indicators that tend to follow in the same direction as the change in the level of economic activity but lag and only begin to change after the level of economic activity has been changing for some period.

(1) Average duration of unemployment (measured in weeks)

(2) Changes in per‐unit labor costs

(3) Average prime rate charged by banks

(4) Ratio of manufacturing and trade inventories to sales

(5) Outstanding volume of commercial and industrial loans

(6) Ratio of consumer credit outstanding to personal income

(7) Change in the consumer price index (CPI) for services

5211.10 Gross domestic product

a. Gross domestic product (GDP) is a measure of the market value of all final goods and services produced in an economy during a year. It is a monetary measure to value the nation’s output. It excludes intermediate goods, which are goods that are purchased for resale or for further processing or manufacturing. This is done to prevent double counting. It also excludes nonproductive transactions that have nothing to do with the production of final goods and services, such as:

(1) public transfer payments such as Social Security, welfare, and veteran’s payments.

(2) transfers such as interfamily gifts and immigrant remittances.

(3) buying and selling of stocks and bonds and other financial assets in the financial markets.

(4) secondhand sales.

b. The expenditure approach for calculating GDP can be summarized as:

ng XGICGDP



(1) Personal consumption expenditures (C) are the personal consumption expenditures on durable consumer goods, nondurable consumer goods, and services. Primary determinants of personal consumption are disposable income, consumer wealth, and interest rates on consumer credit. Personal consumption accounts for approximately two‐thirds of GDP.

(2) Gross private domestic investment (Ig) are all final purchases of machinery and equipment, all construction, all changes in inventory, and purchases of new residential housing. This can be summarized as:

Net investment = Gross investment - Capital consumption allowance

Primary determinants of investment spending are interest rates, capacity utilization rates, and a firm’s ability to develop projects with a positive net present value.

(3) Government purchases (G) are the spending for goods and services used in providing government services, including spending on social capital such as buildings and highways.

(4) Net exports (Xn) is equal to exports minus imports or (X – M). Primary determinants for exports are similar to those for consumption, and those for exports would include similar measures for citizens of foreign nations.

c. The income approach for calculating GDP deals with the income derived or created to produce the output. National income (NI) is the sum of all payments to factors of production. However, since all the expenditures noted above do not flow directly to factors of production in the form of income, it is necessary to make certain adjustments to (NI) to derive GDP. The process is as follows:

(1) National income (NI) = Compensation of employees + Rental income + Interest income + Proprietor’s income + Corporate profits

(2) GDP = NI + Indirect business taxes + Capital consumption allowance + Net foreign factor income

d. There are several other national accounts that provide useful information concerning the economy’s performance. Key among them are the following:

(1) Net domestic product (NDP) = Gross domestic product - Capital consumption allowance

(2) National income (NI) = NDP - Net foreign factor income - Indirect business taxes

(3) Personal income (PI) = NI - Social Security contributions - Corporate income tax - Undistributed corporate profits + Transfer payments

(4) Disposable income (DI) = PI - Personal taxes

5211.11 Real vs. nominal measures

a. Gross domestic product (GDP) is the market value of final goods and services and thus is measured in current dollar or nominal terms. In simple terms, it would be measured by multiplying the quantity of goods produced by the prices of the various goods. One of the possible measures of well‐being for a society is the growth in GDP. Nominal GDP growth can be the result of either an increase in the quantity of goods produced and/or an increase in the price of goods. Adjusting nominal data for price increases involves the use of a price index.



Price index in a given time period

= Price of a market basket in a specific year Price of the same market basket in the base year

100

Real GDP = Nominal GDP GDP deflator

b. There are a number of price indices that are used in economic analysis, including the consumer price index (CPI), producer price index (PPI), and GDP deflator.

(1) The CPI is used to calculate real income, to adjust Social Security payments, and as a base for many cost‐of‐living adjustments (COLA).

(2) The PPI is a measure of the increase in prices paid by producers for their inputs.

(3) The GDP deflator is an index that was developed to calculate real GDP given nominal GDP.

c. Possible shortcomings of the use of GDP as a measure of economic well‐being include the following:

(1) It does not account for non‐market transactions; for example, services of homemakers and individuals who do their own repairs.

(2) It fails to account for changing attitudes toward leisure, as reflected in the fact that the average workweek has declined during the 1990s as legislation increased vacation time, the number of holidays, and the amount of available leave time. It also does not account for any “psychological income” that some workers derive from their work.

(3) It does not account for improved product quality. This is dealt with by periodically revising the market basket of goods and re‐indexing the base year for the index used to calculate real GDP.

(4) It does not account for activities in the underground economy. This would include illegal activities such as the sale of illicit drugs and gambling, and fencing stolen goods, as well as income legally earned but not reported as income to the IRS.

(5) It does not account for most negative externalities, with the primary example being its failure to account for the economic and social costs of pollution.

5212 Market Types

5212.01 Perfect competition

a. The market structure of perfect competition is characterized by a large number of sellers producing a standardized product with easy entry and exit into and out of the industry. The seller has no ability to influence the product price.

b. There are a number of assumptions involving perfect competition:

(1) There are many small independently acting buyers and sellers who produce a standardized or homogeneous product, none of whom can influence price.

(2) Each firm produces such a small portion of total output that they have no influence over price. The firm is a price taker, that is, the firm must accept the market price.

(3) There is free entry into and exit from the industry. There are no significant legal, technological, or financial barriers to entry. Information is free and readily available.

(4) Firms face a perfectly elastic demand curve at the market price that is determined where consumer demand equals industry supply.



(5) For the perfectly competitive firm, Price = Average revenue = Marginal revenue.

(6) If the firm is making an economic profit, there is an incentive for new firms to enter the market. The entry of new firms will increase supply and shift the industry supply curve to the right, reducing the equilibrium price. Entry will continue until there is no economic profit, that is, the firm is earning only a normal profit.

c. The market equilibrium occurs where price equals marginal cost at the minimum point on the average cost curve. This means that in equilibrium, a firm is operating at its most efficient level of output. The following graph represents the equilibrium position in a perfectly competitive industry. Marginal revenue equals marginal cost as minimum average cost. At this point, the firm is making only a normal profit.

PO = Price Q0 = Quantity demanded D0 = Demand

MR0 = Marginal revenue MC = Marginal cost ATC = Average total cost

5212.02 Monopolistic competition

a. The market structure for monopolistic competition is characterized by having many small firms that produce differentiated products. The firm has some degree of control over product price.

b. There are a number of assumptions for monopolistic competition:

(1) There are a relatively large number of independent and small buyers and sellers.

(2) There is free entry into and exit from the industry.

(3) Firms are producing a differentiated product. The differences may be found in product attributes such as materials, design and workmanship, varying degrees of customer service, convenient location, packaging, and brand image.



c. In monopolistic competition:

(1) the firm faces a downward‐sloping demand curve and marginal revenue is less than price. Firms can make an economic profit in the short run.

(2) there tends to be significant use of advertising as a form of non‐price competition. The goal of advertising is to shift the firms demand curve to the right and to make demand less elastic; that is, to make consumers less responsive to price changes.

(3) product differentiation leads to firms competing on quality, price, and marketing.

(4) the existence of economic profit provides an incentive for firms to enter the industry, shifting the industry supply curve to the right. Entry will continue until economic profit disappears.

d. Firms in markets that are imperfectly competitive face a downward‐sloping demand curve, which implies that marginal revenue is less than price. In the graph below, the firm would maximize price at the point where marginal revenue equals marginal cost. At the profit maximizing level of output (Qo), the firm would change price (Po) and make an economic profit as shown in the area Po ABP.

P = Price Q = Quantity demanded D = Demand

MC = Marginal cost MR = Marginal revenue ATC = Average total cost

5212.03 Oligopoly

a. Oligopoly is a market structure characterized by a few firms that sell either a standardized or differentiated product and where entry into the industry is difficult.

b. There are a number of assumptions for an oligopoly:



(1) There are a small number of relatively large firms.

(2) Firms may produce either a standardized or differentiated product.

(3) Firms in the industry are interdependent.

(4) Firms tend to engage in non‐price competition.

c. In oligopolies:

(1) firms face a downward‐sloping demand curve and have some degree of control over price.

(2) there generally are barriers to the entry for new firms into the industry, including economies of scale (that is, the firm must be large to be efficient), ownership of raw materials, patents, and brand image.

(3) firms can benefit from collusion. A cartel is one form of collusion where producers create formal agreements specifying how much each member will produce and charge. OPEC is an example of a cartel. Such collusion is illegal in the United States.

d. A kinked demand curve is one type of demand curve that a firm operating in an oligopoly might face. One strategic assumption is that competitors will follow a price reduction but will not follow a price increase. Under these circumstances prices would tend to remain relatively stable.

(1) A firm will not gain market share by lowering prices and thus revenue would fall.

(2) A firm would lose market share if it raises prices, and thus revenue would fall if the firm were operating on the elastic portion of its demand curve.

(3) If competitors fail to understand this logic, there is a strong possibility of a price war as firms engage in successive rounds of price cutting in an attempt to maintain market share.

e. If a firm in an oligopoly faces a kinked demand curve, demand is relatively more elastic in response to a price increase and more inelastic if the firm reduces price. The theory indicates that in the range of costs between points A and B on the graph, the firm would not change price or output even though marginal costs increased.



P = Price q = Quantity

MR = Marginal revenue d = Demand

MC = Marginal cost

f. Since firms in an oligopoly prefer to engage in non‐price competition, advertising wars often occur. Product improvements and successful advertising campaigns cannot be easily replicated by the competition. Since many oligopolies have sufficient resources to finance advertising, an increase in advertising expenditures on the part of one firm may force competitors to respond or lose market share. This would be one example of a barrier to entry for competitors.

This often is akin to the inverse of a price war in that, in the end, advertising is self‐canceling, and firms have increased cost without increasing revenue.

Price leadership is another form of competition in oligopoly. It often results in an implicit agreement that coordinates prices without having the firms engage in illegal collusion. Basic tactics of leadership include the following:

(1) Infrequent price changes. The firm does not respond immediately to day‐to‐day fluctuations in demand. Price tends to change only when costs have increased significantly (an industry‐wide wage increase or increases in energy costs).

(2) Potential impending price changes are usually “announced” by the price leader.

(3) The goal is not to maximize short‐term profit but rather to discourage the entry of new firms into the industry and protect long‐term profitability. The price leader often has a cost advantage over other firms in the industry and can still be profitable at a price level that smaller, higher‐cost firms could not.



5212.04 Monopoly

a. In a monopoly, there is a single seller of a product for which there are no close substitutes. The firm has considerable control over price and is a price maker.

b. A monopolist:

(1) has strong barriers to entry that keep competitors out of the industry. These barriers might include economies of scale, legal barriers such as patents and licenses, advertising or competitive pricing strategies, and control of existing resources.

(2) faces a downward‐sloping demand curve with marginal revenue less than price.

(3) may have its monopoly position derived from government action. In this instance, the firm may go to great limits to maintain that monopoly by engaging in rent‐seeking activities such as lobbying legislators.

(4) will tend to set price in the elastic range of their demand curve.

(5) tends to have less incentive to innovate and improve efficiency than firms in monopolistically competitive or oligopolistic industries.

A public utility is a common example of a regulated monopoly.

c. Natural monopolies arise when economies of scale extend beyond the market’s size and total costs are minimized by having only one firm in the industry. Conditions often exist for local public utilities where competition is impractical.

(1) Often the government regulates the industry with a key form of regulation being the setting of prices that can be charged.

(2) In some instances in the United States, natural monopolies have been moved to private ownership. For example, the U.S. Postal Service has been privatized.

(3) Some regulation (for example, early regulation of the airline industry) was designed to prevent creation of a natural monopoly.

5212.05 Consumer surplus and producer surplus: The demand curve and supply curve show what consumers and producers are willing and able to buy or offer for sale at various alternative prices at a given moment in time. The interaction of buyers and sellers in the marketplace determines an equilibrium price. If a consumer is able to buy the product at the equilibrium price, and that price is below what the consumer would be willing to pay for the product, a “consumer surplus” exists. The same would be true for producers who are able to sell their product above the price they would have been willing to use. This difference is known as a “producer surplus.” The graph below demonstrates the degree of consumer and producer surplus at a market equilibrium.



p = Price q = Quantity D = Demand S = Supply

5212.06 Price discrimination

a. A firm can increase profits if different prices can be charged to different buyers. This would be price discrimination. Price discrimination is the practice of selling a product or service at different prices to different consumers when those price differences are not justified by cost differences.

b. Price discrimination is possible when:

(1) the firm is able to have some degree of control over output and price.

(2) buyers can be segregated into distinct classes that have different abilities (or willingness) to pay for the product or service often based upon different elasticities of demand. Prices are often varied for different age groups. For example, admission to entertainment facilities often varies with age, with children and senior citizens receiving discounts.

(3) purchasers from the lower‐priced market would not have the ability to resell to purchasers from the higher‐priced market. Examples would be airline tickets and legal or medical services. Price discrimination is widely used in the airline industry. For example, the business traveler often has an inelastic demand when the need for traveling arises. The vacationer, however, has a more elastic demand and is willing to buy advance purchase tickets to obtain lower fares.

c. The logic of price discrimination is to attempt to segment the market, change the price consumers would be willing to pay, and recapture a portion of the consumer surplus.



5213 Effect of Government Policy on Business Financial Position and Operations

5213.01 Economic variables

a. The approaches used to forecast the path of the business cycle and the probable future trends provide a sense of the importance of the statistical information that is gathered by various government agencies and business organizations. It is also important to look at how specific economic variables behave during the various phases of the business cycle.

b. Leading economic indicators are a set of variables that historically have demonstrated a high correlation with the level of economic activity. This has allowed economic policymakers to use this data to forecast the future direction of gross domestic product (GDP) and to develop and implement appropriate macroeconomic policies. The list below provides a brief explanation as to how these indicators might be changing if they were predicting a contraction in the business cycle.

(1) Average manufacturing‐worker workweek: A decline in the number of hours worked in the average workweek for production workers in the manufacturing sector suggests a downturn in manufacturing output.

(2) Initial claims for unemployment insurance: If the number of first‐time claims for unemployment compensation is increasing, it suggests rising unemployment and a subsequent decline in real GDP.

(3) New orders for consumer goods: If manufacturers receive fewer orders from retailers for consumer goods, it suggests that consumer spending is declining and that there will be a decline in future production in the consumer goods sector and therefore a decline in real GDP.

(4) Vendor performance: An improvement in delivery times, such as measured by a survey conducted by the Purchasing Managers Association, ironically suggests an economic slowdown with declines in real GDP.

(5) New orders for non‐defense capital goods: A decline in the orders for capital goods points to a reduction in business investment and aggregate expenditure and thereby real GDP.

(6) Building permits for residential construction: A decline in building permits suggests a downturn in the construction industry.

(7) Stock prices: Sustained declines in stock prices, measured by an index such as the S&P 500, tend to point to declining corporate profits. Additionally, price declines also make it less attractive for firms to issue new stock, and the declines would also lead to a decrease in consumer wealth and consumer spending.

(8) The inflation‐adjusted money supply (M2): Actions by the Federal Reserve to reduce the money supply tend to be related to declines in real GDP. As the Fed reduces the money supply, everything else being equal, interest rates would rise, and this would reduce the incentive for business investment and the spending on consumer durables. (Leading indicators such as money supply are forecasts, not measurements.)

(9) Interest rate spread: Increases in short‐term nominal interest rates generally indicate the monetary authorities wish to slow the level of economic activity. These moves tend to reduce the spread between short‐term and long‐term interest rates



that have a negative impact on business investment. Thus, a restrictive monetary policy is likely to cause a decline in future real GDP.

(10) Consumer expectations: Declining consumer optimism, as measured by a consumer survey such as that conducted by the Survey Research Center at the University of Michigan or the Conference Board, suggests declines in consumption and possibly future declines in real GDP.

c. While none of these indicators in isolation forecasts an economic slowdown, historically a decline in the index of leading economic indicators for three consecutive months has provided advance notice of a decline in real GDP. It is important to note, however, that these forecasts have not been infallible and, at times, have not provided sufficient advance warning for policymakers to be able to respond in a timely manner.

5213.02 Unemployment and the business cycle

a. Unemployment is a lagging indicator in that the unemployment rate lags behind the phase of the business cycle. The rate does not begin to decline significantly until the economy is well into an economic recovery.

b. Cyclical unemployment rises as the economy moves into the contractionary phase of the business cycle and tends not to decline until the trough is reached and the recovery is well underway.

(1) Firms tend to have existing workers work overtime or to hire part‐time workers during the early stages of a recovery as a means of controlling labor costs until the recovery seems certain.

(2) During the recessionary phase, a number of workers become what is known as “discouraged workers” and drop out of the labor force entirely as they cease to be actively looking for work. As the recovery begins, these people again begin to look for work and re‐enter the labor force, thus slowing the decline in the unemployment rate.

5213.03 Inflation and the business cycle

a. Inflation is positively correlated to the business cycle. Policies designed to stimulate aggregate expenditures tend to increase inflationary pressures unless they occur when the economy is experiencing high rates of unemployment. The inflationary pressures increase as the economy gets closer to full employment of labor, machinery, and equipment.

b. As a general rule, many firms have an ability to pass cost increases (cost‐push inflation) on to consumers near the end of the expansionary phase of the business cycle. Even firms with a significant degree of pricing power have difficulty increasing prices near the trough of a business cycle. In today’s world, with increased competitive pressures, most firms are facing increased pressures on operating margins, i.e., reduced ability to pass through cost increases, whatever the phase of the business cycle. This has been a major factor in making cost control increasingly important for a firm to maintain profitability.

5213.04 Inventory investment and gross private domestic investment

a. Inventories and utilization of existing plant capacity fluctuate more with the business cycle than any other components of aggregate expenditures. Changes in inventory investment exhibit sharp, but generally short‐lived, fluctuations during the business cycle.



b. Inventory investment occurs when firms increase their level of inventory. Anticipated (desired) inventory investment must be distinguished from unanticipated (undesired) inventory investment. Inventory investment will tend to be high:

(1) if an unanticipated sales increase causes the firm’s inventory to decline below desired levels (an unanticipated change).

(2) if the firm builds up inventory levels in anticipation of an expected increase in sales (an anticipated change).

c. Generally, a firm has an inventory policy that sets a target inventory and attempts to maintain that desired level of inventory.

(1) Problems often arise as sales begin to increase and the firm finds inventories falling below desired levels. The firm acts to increase inventories to return to the desired level, and then often, because further sales increases are expected, many firms continue to increase inventory levels in anticipation of the increase. When sales first begin to fall, inventory levels rise rapidly (unanticipated), causing a rapid decline in orders for new products.

(2) At the trough of the business cycle, inventories tend to be low as firms have sold off inventories and are pessimistic about the possibility of future sales increases. Thus, inventories tend to fall below desired levels as the unanticipated sales increases begin. As firms overcome their pessimism and begin to believe that the sales increase represents a real change in the sales trend, inventory investment begins to climb rapidly.

d. Illustration: Assume that an auto dealer has sales of 40 cars per month and desires to hold an inventory equal to one month’s sales. As long as sales stay stable at 40 units a month, the firm’s desired level of inventory will remain unchanged. Now suppose that demand drops to 30 units a month and it takes the firm two months to respond to the change. By the time the change in demand is recognized, inventory will have climbed to 60 units. For the foreseeable future the dealer would want to hold 30 units in inventory. Thus, when responding to the change in demand, the dealer’s orders would fall to zero for the next period before stabilizing at the new demand level of 30 units.

Thus we see that inventory fluctuations can be significant, even if there are only small changes in the level of final demand. Today, many firms are using computer‐based tracking programs to be better able to shorten the time between a demand change and their ability to recognize that change and adjust their inventory.

5213.05 Sectors of the economy and the business cycle

There are several sectors of the economy that demonstrate a direct relationship to various phases of the business cycle:

a. Durable goods include capital goods, commercial buildings, and heavy equipment and farm implements.

(1) During good times the demand for durable goods increases as manufacturing firms order new machinery and equipment to meet demand for their products. New capital goods are purchased before old equipment is fully depreciated. The impact of this new investment is magnified by the multiplier effect, causing an increase in income, employment and output.

(2) During the contraction phase of the business cycle, there generally is a significant decline in spending on durable goods as firms find they have excess capacity. Rather



than purchase new equipment, there is a tendency to continue to use old or existing equipment.

b. Consumer durable goods include items such as homes and automobiles.

(1) Purchases of these goods tend to be very sensitive to interest rates and consumer income. Near the peak of the business cycle, strong consumer income tends to keep purchases high. Rising interest rates tend to slow the rate of the increase in demand and become a negative factor when income begins to fall as a recessionary phase begins.

(2) One key driver of the demand for consumer durables is the monthly payment (that is, the fixed expenditure a consumer is committing to make when the good is purchased on credit). When times are good, lenders tend to be willing to accept more risk and make marginal loans by reducing their credit standards. This supports the consumer willingness and ability to buy their products.

(3) As the contraction phase begins and unemployment begins to climb and income falls, lenders tighten their credit policies. Additionally, there is an increasing concern about possible unemployment among employed workers. These factors cause the demand for consumer durables to fall as these purchases can be postponed. The outcome is an unanticipated increase in inventories in the retail sector.

5220 Market Influences on Business

5221 Supply and Demand

5221.01 Demand

a. Demand is the quantity of goods or services that buyers are willing and able to purchase at various alternative prices at a given moment in time. A critical point to remember is that consumers must be both “willing and able” to purchase for their desires to be included as demand.

b. Demand schedules are simply tables of information that relate price and quantity demanded. Demand curve is a graphical representation of the information found in the demand schedule.

c. It is key to understand the difference between change in quantity demanded (moving along a given demand curve) and a change in demand (where one of the demand determinants other than the price of the good changes and causes a shift to a new demand curve).

d. The law of demand states that there is an inverse relationship between price and quantity demanded.

e. Firms try to forecast the demand for their products by using surveys, focus groups and test marketing, and information systems and inventory control systems to monitor consumer buying patterns.

5221.02 Change in demand

a. A change in quantity demanded relates to movement along a given demand curve when all demand determinants other than the price of the good are held constant. The



movement from Point A to Point B on the curve below represents a change in quantity demanded.

b. A change in demand is caused by a change in one of the demand determinants other than the price of the good. Examples of demand determinants are:

(1) the price of other goods.

(2) disposable income.

(3) consumer tastes and preferences.

(4) the number of buyers in the market for the product.

(5) future price expectations.

(6) advertising.

c. A change in demand is a shift in the demand curve. For example, assume that consumer disposable income increases and the product is a normal good. The demand for the product would increase from D0 to D1.

D1 represents an increase in demand, and D2 represents a decrease in demand.



5221.03 Supply

a. Supply is the quantity that producers are willing and able to offer for sale at various alternative prices at a given moment in time.

b. Supply schedules are simply tables of information that relate price and quantity supplied. The supply curve is nothing more than the graphical representation of the information found in the supply schedule.

5221.04 Change in supply

a. A change in quantity supplied relates to a movement along a given supply curve when all supply determinants other than the price of the good are held constant. The movement from point A to point B on the supply curve would represent a change in quantity supplied.

b. A change in supply is caused by a change in one of the supply determinants other than the price of the good. Examples of supply determinants are:

(1) the price of the resources needed to produce the product.

(2) technology.

(3) taxes and subsidies.

(4) prices of other goods.

(5) future price expectations.

(6) the number of sellers in the market.

c. A change in the supply is a shift in the supply curve. Assume that wages increase (the price of resources). The firm would be less willing and able to offer goods for sale at all prices and supply would decrease from S0 to S2. Supply curve S1 represents an increase in supply and supply curve S2 represents a decrease in supply.



5221.05 Market equilibrium

a. A market is the place where buyers and sellers interact.

b. The intersection point of the demand curve and supply curve represents the market equilibrium price. This is the point where the market is cleared and there is no shortage or surplus. At this point, quantity demanded equals quantity supplied.

c. A change in demand or a change in supply creates a surplus or a shortage of goods at the current equilibrium price.

d. If the market is allowed to function, there will be a tendency for a new equilibrium to be created.

(1) If there is an increase in demand, both equilibrium price and equilibrium quantity will increase.

(2) If there is an increase in supply, equilibrium quantity increases and equilibrium price falls.

(3) If there is a decrease in demand, both equilibrium quantity and equilibrium price fall.

(4) If there is a decrease in supply, equilibrium quantity falls and equilibrium price increases.

e. The market equilibrium occurs where quantity supplied equals quantity demanded. In the event there is a price floor, that is, a price above the equilibrium price, then the quantity supplied is greater than quantity demanded and there would be a surplus of the product at that price ceiling. On the other hand, at a price below the equilibrium price (a price ceiling), the quantity demanded is greater than quantity supplied and there is a shortage of the product at that price. For example, looking at the graph below, if the price were fixed at a price (P2) that is above the equilibrium price, then there would be a surplus (equal to s2 – d2) in the market. Alternatively, if the price ceiling were set at a price (P1) that is below the equilibrium price, then there would be a shortage (d1 – s1) in the market.



d1 – s1 = Shortage at a price below the market equilibrium price s2 – d2 = Surplus at a price above the market equilibrium

f. The table below provides a summary of the impact on equilibrium price and quantity demanded for the various situations where there are changes in both demand and supply at the same time.

Change in Supply

Change in Demand

Effect on Equilibrium Price

Effect on Equilibrium Quantity

1 Increase Decrease Decrease Indeterminate 2 Decrease Increase Increase Indeterminate 3 Increase Increase Indeterminate Increase 4 Decrease Decrease Indeterminate Decrease

5221.06 Price elasticity of demand

a. The price elasticity of demand is a measure of the responsiveness of consumers to a change in a product’s price.

b. The law of demand states that there is an inverse relationship between the price and quantity demanded of a product. However, it does not provide the information about the relationship between the two variables.

c. The formula for measuring the price elasticity of demand is:

dd

%QE

%P

the change in the particular variable

d. The law of demand states that price and quantity move in opposite directions. In other words, as price increases, quantity demanded falls. By convention, economists use the absolute value of the measure rather than using the minus sign when stating price elasticity of demand.

e. A problem arises depending upon which value is used as the base value when performing the calculation. The following situation could arise. If the base price is $10 and the price increases to $12, the price has increased by 20%. If the base were $12 and



the price fell to $10, then the percentage change would be 16.67%. To solve this problem, the formula is modified to use a mid‐point and is calculated as follows:

2

2

1010

1010

PPPP

QQQQEd

QO = Original quantityQ1 = New quantityPo = Original priceP1 = New price

f. Summary of price elasticity of demand (Ed):

ConditionElastic Ed > 1

Inelastic Ed < 1Unit elastic Ed = 1

Perfectly elastic Ed = ∞Perfectly inelastic Ed = 0

5221.07 Determinants of elasticity of demand

a. The larger the number of substitutes generally available for the product, the greater its price elasticity of demand.

Narrowness of definition of the product has a significant impact on the number of substitutes that are available. For example, the demand for Fords would be more elastic than the demand for automobiles. There are other brands that are readily substitutable for Fords, but there are few, if any, good substitutes for automobiles for most types of individual transportation.

b. All other things being equal, the higher the price of the good relative to the consumer’s income, the more elastic the demand for the product. Everything else being equal, the demand for a new automobile would be more responsive to a price change than the demand for clothing.

c. Generally speaking, the more the consumer considers the good to be a “luxury” rather than a “necessity,” the greater the price elasticity of demand. Everything else being equal, the demand for entertainment would be more responsive to price changes than the demand for food.

d. Generally, the longer consumers have to respond to a price change, the more elastic the demand would be. A classic example relates to the demand for gasoline. When gasoline prices rise, in the short run consumers have little opportunity to respond; however, if prices remain high, over the long run they can replace their automobiles and trucks with more fuel‐efficient vehicles.

5221.08 Price elasticity and total revenue (the total revenue rule)

Firms are interested in being able to estimate their revenue from sales. The concept of elasticity provides one method to facilitate making such measurement. In the simplest case, revenue is defined as the price of the product times the quantity sold.

a. If demand is elastic at the current price, then reducing the price will increase the total revenue and vice versa.

b. If demand is inelastic at the current price, then increasing the price will increase total revenue and vice versa.



c. If demand is unitarily elastic, then changing the price will have no impact on total revenue.

This set of relationships is known as the “total revenue rule” and allows a firm to determine the general impact that a price change would have on the firm’s revenue if the product’s elasticity of demand can be estimated.

5221.09 Other measures of elasticity

a. There are other measures of elasticity that could help a firm estimate the demand for their product as other demand determinants change. These measures are used to define various relationships among and between products.

b. Income elasticity of demand measures the responsiveness of consumer demand for a product relative to a change in income.

c. The formula for calculating income elasticity of demand is:

Ey = Percentage change in demand for the good

Percentage change in income

d. When Ey > 0, then the product is a normal good. If Ey is < 0, then the product is an inferior good.

e. Summary of income elasticity of demand (Ey):

Condition Normal good Ey > 0 Inferior good Ey < 0

f. Cross‐elasticity of demand measures responsiveness of consumer demand for a product relative to the change in the price of another product. If consumers buy less of the original product, then the goods are complements.

g. The formula for calculating cross‐elasticity of demand is:

EPy = Percentage change in the demand for one good Percentage change in the price of another good

h. If EPy > 0, then the goods are substitutes. If EPy < 0, then the goods are complements. A summary of elasticity:

Condition

Complements Epy < 0 Substitutes Epy > 0 Unrelated Epy = 0

5221.10 Other supply and demand topics

a. Complementary goods are goods and services that are used in conjunction with each other. When the price of one good falls and the quantity demanded of that good rises, the demand for the other good rises. The cross‐elasticity of demand of complementary goods is negative since as the price of product A declines, the more of product B will be purchased at any price. For example, if the price of hot dogs falls, consumers will purchase more hot dogs, and they will also purchase more hot dog buns, a complementary good.

b. Inferior goods are goods or services whose demand decreases as a consumer’s income increases, assuming prices remain constant. The “inferiority” being described has nothing to do with the actual quality of the item but with the consumer’s ability to purchase needed items. For example, when consumers have limited incomes, canned



vegetables will often be purchased rather than fresh vegetables; however, as incomes rise, less canned vegetables will be purchased as the consumer substitutes fresh vegetables for the “inferior product” that was purchased only because of the consumer’s limited income. Inferior goods have a negative income elasticity of demand.

c. Normal goods are good or services whose demand increases as consumer’s income increases, assuming prices remain constant. Normal goods have a positive income elasticity of demand.

d. Substitute goods are goods and services that can be used in place of each other in at least some of their uses. When the price of one good falls, the quantity demanded of that good increases and the demand for the other good without a price decrease falls. If goods are perfect substitutes, the consumer is indifferent as to which product to purchase and will purchase the one with the lower price. If goods are imperfect substitutes, the purchase decision would be based on the price change of one good relative to trade‐offs being made such as differences in quality between the two goods. For example, a consumer may believe a Ford truck is of better quality that a Toyota truck, but at some difference in price, some consumers would substitute the Toyota truck. A substitute good is the opposite of a complementary good.

e. Law of diminishing marginal utility is a proposition that describes how an individual’s satisfaction (or marginal utility) derived from the consumption of each additional unit of the good or service declines as consumption of that good or service increases. For example, a guest may desire a piece of pie at the end of dinner on Thursday evening and derives a level of “satisfaction” from consuming it. The host offers the guest a second piece of pie and the “satisfaction” the guest receives from consuming that piece of pie is less than that received from consuming the first.

5222 Inflation

Inflation and Deflation

5222.01 Inflation

a. Inflation is a sustained increase in the average level of prices and is measured by using a fixed‐weight price index. In measuring the consumer price index (CPI), consumers are assumed to buy a specified group of goods and services—a “market basket of goods.” The items in the market basket are “weighted” based on their relative importance in terms of consumer spending. The rate at which the weighted‐average price for these goods increases is the inflation rate.

b. The inflation rate is determined by comparing the prices paid for the market basket of goods in one period to that paid in another. The CPI is reported by the government every month and is used to adjust Social Security benefits annually and to adjust income tax brackets for inflation.

c. Biases in the CPI calculation include the following:

(1) New goods bias. New goods constantly replace old goods, and the index does not compare both the price and quality between the old and new goods. This problem is handled by periodically revising the market basket of goods used to calculate the CPI. This factor creates an upward bias in the CPI.

(2) Quality change bias. The quality of many items improves each year and the improvement must be compared to the increase in price of the good. This factor generally creates an upward bias in the CPI.



(3) Commodity substitution bias. Consumers have a tendency to cut back on the consumption of relatively more expensive goods and substitute relatively cheaper goods as prices rise. This factor tends to have increases in the CPI overstate the overall rate of inflation.

(4) Outlet substitution bias. As prices increase, there is a tendency for more people to shop at discount stores, and in recent years, online shopping has allowed consumers to search for lower prices for many products.

d. Other commonly reported measures of inflation include the producer price index (PPI) that measures the rate of increase in wholesale prices and the GDP deflator that measures the price changes for all goods and serviced included in GDP. It is used when calculating real GDP.

5222.02 Types of inflation

a. Demand‐pull inflation is caused by an excess in total spending relative to the economy’s current capacity to produce goods and services. It is an excess of demand relative to output at the current price level. This is often referred to by the phrase “too much money chasing too few goods” and will continue as long as there is excess total spending.

b. Cost‐push inflation occurs when rising prices result from an increase in resource costs and thus a rise in per‐unit costs of production. Rising per‐unit production costs squeeze profits and reduce a firm’s willingness and ability to produce goods and services. Examples of factors that might cause cost‐push inflation include negotiated increases in wage rates, and supply shocks such as the rapid rise in energy prices during the 1970s and early 1980s as OPEC reduced production. Each of these factors increased the cost of producing and transporting most products, and created a period of rapid cost‐push inflation. This type of inflation tends to be self‐limiting since the rising prices will cause firms to reduce output, and this leads to an increase in unemployment and a reduction in demand.

c. Hyperinflation is an extremely rapid rate of inflation that usually has a devastating impact on real output and employment. Creditors avoid debtors to prevent being repaid with cheap money, and money eventually becomes worthless. Examples include Germany where prices increased by 322% per month from late 1922 to late 1923, culminating with a monthly price increase of 32,000% in October 1923. Argentina, Brazil, Bolivia, Nicaragua, Peru, Poland, and the Congo Democratic Republic each had a 1000% inflation rate (an average of 22% per month) in at least one year during the 1980s and 1990s.

d. Deflation is a sustained decline in the general price level. Creditors gain at the expense of debtors. Japan has been experiencing deflation on an irregular basis for more than 20 years.

5222.03 Impact of inflation

a. Redistribution effects: There is a difference between nominal income (the amount of income a household receives as wages, rent, interest, and profit) and the purchasing power of that income (real income). When inflation occurs, not everyone’s nominal income rises at the same rate and, therefore, there will be some redistribution of purchasing power as inflation persists. The redistribution effects of inflation are highly dependent on whether or not the inflation was anticipated or unanticipated.

b. Illustration: Assume that Tom’s nominal income increases by 3%. If prices rise by 3%, his real income remains the same. However, if prices rise by 5%, his real income will decline



by 2%. A simple formula provides an approximation of how much real income will change:

% change in real income = % change in nominal income - % change in price level

c. Who is hurt by inflation: A key group that is hurt by unanticipated inflation is those individuals who receive a fixed income. They see their real income fall as prices rise. This group would include individuals who receive fixed pension payments, firms that receive fixed lease payments, workers with fixed‐step raises that do not keep pace with inflation, minimum wage workers, and families living on welfare. A second group that is hurt by unanticipated inflation is savers. As prices increase, the purchasing power of accumulated savings declines. To the extent that the savings earn interest, part of the impact of inflation can be offset. The third major group hurt by unanticipated inflation is creditors. Ignoring interest payments, the same number of dollars will be repaid as are borrowed. As prices go up, the purchasing power of these dollars goes down. This fact strongly suggests that one component of nominal interest rates would be a premium designed to compensate lenders for the risk of anticipated inflation.

d. Illustrations: Assume that a saver has $5,000 deposited in a savings account and is earning 3% on the funds. The nominal value of the account would be $5,150 at the end of the year. If the inflation rate was 2%, the purchasing power of that $5,150 at the end of the year would be approximately $5,050; and if inflation ran at 4%, the purchasing power would be approximately $4,950.

e. Illustration: If the bank lent Jane $2,000 that is to be repaid in three years and inflation averages 5% above the loan interest rate during the period, a rough approximation of the purchasing power of the principal amount that is repaid would be $1,700. The bank gets repaid in “cheap dollars.”

f. Who is helped (or unaffected) by inflation: Individuals who are fortunate enough to have flexible income may be able to be less affected by inflation. Some payments are indexed to the consumer price index (CPI). For example, payments to Social Security recipients are adjusted annually for increases in the CPI. Historically, union contracts have cost‐of‐living adjustments (COLA) that provide partial protection from the impact of rising prices on the purchasing power of the income received. Property owners are often able to increase rents when inflation is high. Firms with pricing power often are often able to pass through a portion of cost increases on to consumers in the form of higher prices.

Unanticipated inflation provides a benefit to debtors. They are able to pay back the principal and fixed‐rate interest with “cheaper dollars.” Real income is redistributed from the bank’s owners to the borrowers. Inflation during the 1980s helped fuel a rapid increase in housing prices, providing a windfall capital gain to many existing homeowners and reducing the real cost of their fixed‐mortgage payments.

The federal government’s outstanding debt was $13 trillion in mid‐2010. With the government operating at a deficit, the government tends to pay off maturing bonds by issuing new debt, thereby repaying the debt with dollars that had less purchasing power than the dollars originally borrowed.

g. Anticipated inflation: If inflation is anticipated, some individuals and firms may be able to reduce the impact of inflation on their purchasing power. For example, lenders can add an inflation premium to the interest rates they charge, and even may begin to offer variable‐rate loans to shift the impact that inflation has on interest rates to the borrower. Savers might choose to hold their funds in short‐term instruments, reinvesting at higher rates as they mature.



h. Impact of inflation on output: The impact of inflation on the nation’s level of real output depends on the type of inflation that is occurring and its severity. Cost‐push inflation reduces the level of real output and also redistributes the resulting lower level of real income.

Many economists suggest that having full employment and economic growth depends on a high level of consumer spending. This spending generates profits, leads to low unemployment, and provides an incentive for firms to expand capacity. However, at some point the resulting level of aggregate expenditures might lead to demand‐pull inflation.

A commonly held belief is that a low level of inflation is a small price to pay if it supports full employment and continued growth. Moderate inflation also makes it easier for a firm to adjust real wages downward if demand for their product falls. In this case, simply holding nominal wages constant would reduce the firm’s real wage costs. From a public relations perspective, reducing costs in this manner would be preferable to highly visible decreases in nominal wages.

i. Impact of inflation related to deflation: A relatively low rate of inflation serves as a buffer against deflation if there is a decline in the level of aggregate demand.

5222.04 Deflation

a. Deflation is a sustained decline in general price levels.

b. The deflation rate is measured by comparing prices paid for a market basket of goods in one period to that paid in another.

5222.05 Causes of deflation

a. Deflation is almost always the side effect of a significant decline in aggregate demand that is so large as to force producers to cut prices on current output to attract buyers.

b. Deflation often follows a period of rising productive efficiency generally caused by technological innovation at a time when credit markets and consumer demand support business investment, which often results in excess capacity when demand recedes, creating one of the underlying conditions for potential deflation.

c. Globalization has been one of the drivers of deflationary pressure as shifting production to countries where the price of production falls increases the potential for prices to decline.

5222.06 Impact of deflation

a. The economic impact of a deflationary spiral would be recession, rising unemployment, and significant stress on financial institutions.

b. Severe deflation can cause nominal interest rates to decline close to zero. With a “zero bound” on interest rates, lenders would have no incentive to accept negative nominal interest rates when they have the opportunity to hold cash. This would have a negative impact on a bank’s willingness to lend.

c. With severe deflation, the real interest rate paid by borrowers would become equal to the expected rate of deflation as loans would be repaid with money that has increased purchasing power.

(1) As the real cost of borrowing becomes increasingly costly, capital investment, home purchases, and consumer spending would decline and make any economic downturn even worse.



(2) The cost to existing borrowers would increase as well, causing an increase in delinquencies and defaults, and place more financial stress on financial institutions.

d. There is an implicit tax on borrowers and holders of liquid assets and, as the risk‐adjusted rate of return becomes negative, it encourages investors and consumers to hoard money rather than purchase hard assets.

e. There is a tendency for consumers to postpone consumption in anticipation of further price declines.

Policy Implications Related to Inflation

5222.07 Purchasing power

a. Inflation hurts many people and leaves some unaffected. By its very nature, inflation has an impact on the purchasing power of a person’s income. Income is measured in nominal terms (for example, you earn $30,000 per year). Real income is a measure of the amount of goods and services the nominal income can buy. Real income is computed by dividing nominal income by the consumer price index (measured in hundredths). Real income compares the purchasing power of nominal income at different points in time. Since not all individuals’ nominal income rises at the same rate, inflation will redistribute real income from one group of individuals to another.

b. People on a fixed income (for example, an elderly couple receiving a fixed pension) experience a decline in purchasing power with inflation. Also, creditors will find themselves being repaid with dollars that are worth less in terms of purchasing power. Savers are hurt by inflation as the purchasing power of their savings declines.

c. Some fixed‐income recipients receive protection from inflation due to cost‐of‐living adjustments (COLA) that are built into their contracts. Social Security recipients receive a COLA adjustment each year based on the change in the consumer price index (CPI) for the previous year.

d. Homeowners have tended to benefit from inflation as the price of homes in many areas of the country has generally increased more rapidly than rate of inflation.

5222.08 Costs of inflation

a. Inflation is the equivalent of a “tax” on money as its purchasing power is reduced.

b. People hold money to finance transactions or for convenience. Since cash is a non‐earning asset, higher interest rates increase the opportunity cost of holding money. The result is that inflation causes people to hold less money.

c. Holding less money in the face of inflation causes what is called “shoe leather” inconvenience of going to a financial institution or an ATM more often to acquire cash.

d. These problems have been reduced. Deregulation has allowed financial institutions to pay interest on nearly all accounts, and the introduction of debit cards and the now ubiquitous ATM networks has dramatically reduced the “cost” of acquiring cash.

e. An increase in inflation expectations will cause nominal interest rates to increase. If the rate of inflation increases beyond some point, people tend to spend their money more rapidly as it tends to lose its value as a medium of exchange and a store of value. At the extreme of hyperinflation, money tends to be spent as soon as it is received.



5222.09 Inflation and interest rates

The nominal interest rate is the stated rate on a loan or a deposit. The real interest rate is calculated in terms of purchasing power and is equal to the nominal interest rate minus the expected inflation rate. One way financial institutions can protect themselves against the impact of inflation is by offering variable‐rate loans to borrowers. Most short‐term business loans are variable in nature in that the contract rate is often tied to the prime rate. Therefore, at a minimum, the rate can be adjusted every time the loan is renewed, and at the extreme, immediately as the prime rate is changed.

5222.10 Anticipated (or expected) inflation

Forecasts tend to be based on recent behavior of the inflation rate and expectations concerning the money supply and GDP growth. Individuals and firms can achieve some protection if they anticipate inflation. Adding cost‐of‐living adjustments (COLAs) to union contracts, financial institutions offering variable‐rate loans to consumers on savings accounts, and financial institutions having loan interest rates that include an inflation premium or have an adjustable rate can help protect against inflation. Retirees receiving Social Security receive a COLA adjustment each year based on the change in the consumer price index (CPI) for the previous 12 months.

5223 Currency Markets

The Federal Reserve and the National Economy

5223.01 Functions of money:

a. To serve as a medium of exchange to facilitate the exchange of goods and services and promote specialization and division of labor

b. To act as a unit of account to serve as a common denominator to measure the relative value of goods and services and define debt obligations, taxes owed, and measure the value of economic output

c. To serve as a store of value; this allows for the transfer of purchasing power from the present to the future and allows individuals to accumulate wealth in the form of assets that can be converted to money when the individual wishes to spend it.

d. To be used as a standard of deferred payment that facilitates the creation of debt

5223.02 Components of the money supply

a. Money is defined as anything that is readily acceptable as a medium of exchange. In the United States today, the major portion of M1 money supply consists of debt of the U.S. government and financial institutions.

(1) M1: The most narrowly defined component of the money supply. It consists of coins and currency in the hands of the public and the checkable deposits held in commercial banks and thrift institutions. Currency and checkable deposits held by the government, the Fed, and other financial institutions are excluded from this figure.

(2) M2: A broader definition of the money supply that is equal to M1 plus noncheckable savings deposits, small time deposits (less than $100,000), and individual money market mutual fund balances. It consists of near‐monies and highly liquid financial assets that do not serve as a medium of exchange but are readily convertible into currency or checkable deposits.



(3) M3: The broadest definition of the money supply that is equal to M2 plus time deposits in excess of $100,000. This includes the most illiquid components of the money supply. While these assets can be converted to cash, they often would not be able to be disposed of quickly at their current market value.

b. Credit cards are a convenient way to make purchases, but these purchases are not included as part of the money supply since when credit cards are used, the transaction creates a short‐term loan that allows the consumer to defer the payment for some period of time.

c. Debit cards are the equivalent of an “electronic check” when funds are transferred immediately from the purchaser’s account to the merchant’s account. Many brokerage firms offer a product to their customers that will allow the payment for the purchases (that is, a debit to their account) to be deferred with the account being debited on a particular day of each month.

d. Velocity of money is the rate at which money is exchanged or spent in an economy—the number of times that money moves from one transaction to another. The velocity of money is measured as the ratio of nominal gross domestic product (GDP) to the money supply. It can be interpreted as the number of times one unit of money (e.g., U.S. dollar) is exchanged or spent in a given economy. For example, if the M2 money supply is $200 and the nominal GDP is $500, the velocity of money is 2.5. Typically, higher velocity of money ratios are associated with higher spending levels and a growing economy, while lower ratios are associated with lower spending levels and a contracting economy.

5223.03 Creation of money

To understand the manner in which the Federal Reserve can impact the level of economic activity, the process by which financial intermediaries create money needs to first be understood.

a. Financial intermediaries take in deposits and make loans.

b. The Federal Reserve requires financial intermediaries to hold reserves against their deposits. This creates a fractional reserve system in that only a portion of the total money supply must be held as reserve deposits.

(1) Reserves = Reserve deposits at the Fed and vault cash

(2) Required reserves = Required reserve ratio (r) Checkable deposits

Reserve deposits must be held on deposit with the Federal Reserve Bank or kept within the bank (known as vault cash).

c. Any reserves that the bank has that are more than their required reserves are defined as excess reserves.

Excess reserves = Reserves – Required reserves

d. When a bank makes a loan, it is assumed that the borrower will spend the money, and the funds will then be deposited elsewhere in the financial system.

e. Under these assumptions, a bank can make loans only if it has excess reserves. It is also true that the “banking system” can expand loan balances if, and only if, there are excess reserves somewhere in the banking system.

f. When a bank creates a loan, it generally gives the borrower a demand deposit. Thus, the bank “creates money” by creating an asset in the form of the loan and a liability (debt) in the form of a checkable deposit which is defined as part of the money supply.



5223.04 The money multiplier

a. Using the money multiplier, we can determine the degree to which the banking system can expand the money supply when new deposits or an infusion of reserves are received.

b. Illustration: There are the limits to money supply growth when a bank gets a new deposit. Assume that ABC Bank is loaned up; that is, it has no excess reserves and receives a deposit of $100,000. Also, assume that the reserve requirement is 10% (0.10). The bank must hold $10,000 in required reserves and would have $90,000 in excess reserves ($100,000 - 10,000 = $90,000). Thus, the bank can lend up to $90,000.

c. Illustration: Assume that the proceeds of this new loan ($90,000) are deposited in XYZ Bank. XYZ Bank must hold $9,000 in required reserves and would have $81,000 in excess reserves, which it can lend. The maximum amount the money supply can be expanded can be determined by the following formulas:

Money multiplier = 1 Required reserve ratio Potential money creation = Excess reserves Money multiplier

In our example, the money multiplier = 1 0.10 = 10. Thus, since the original increase in the banking system’s excess reserves increase was $90,000, as a result of the deposit

the potential growth in the money supply would equal $900,000 (10 $90,000).

d. Illustration: Assume that the Federal Reserve wishes to expand the money supply and purchases $10 million in government securities from Bank XYZ. These funds are deposited in Bank XYZ’s reserve account.

Bank XYZ now has $10 million in excess reserves with the potential to increase loans by $10M, and if the reserve requirement is 8%, then the potential increase in the money supply for the banking system is:

Potential money creation = Excess reserves Money multiplier = $10M (1 ÷ 0.08) = $10M 12.5 = $125M

5223.05 Monetary policy tools available to the Fed

a. The Fed has monetary policy tools available that impact the ability of financial intermediaries to expand the money supply.

b. Reserve requirement

(1) All banks are required to hold a percentage of all their deposits on reserve. The amount ranges from 3% to 10%. These required reserves are legally mandated reserves and include cash held in the bank’s vault and deposits held at the regional Federal Reserve banks. Since 2008, the Fed has paid interest on these accounts.

(2) A bank is limited to lending their excess reserves, that is, the difference between the bank’s total reserves and its required reserves.

(3) The Fed can control the money supply by changing the reserve requirement percentage. This would impact the money multiplier. For example, if the Fed were to increase the reserve ratio from 8% to 10%, the money multiplier would decline from 12.5 to 10, which would reduce the system’s ability to expand the money supply from any given level of excess reserves.

(4) The Fed generally does not utilize this tool of monetary control.



c. Discount rate

(1) The Fed serves as the “lender of last resort” for commercial banks and thrifts, and the discount rate is the rate the Fed charges when it lends reserves to member institutions. By providing a loan, the Fed would be creating excess reserves that would allow the financial intermediaries to extend additional credit.

(2) Raising the discount rate would make borrowing money from the Fed less attractive, and it also represents a “signal” from the Fed to the banking system that they would prefer to slow the rate of growth of the money supply.

(3) The Fed generally utilizes this tool of monetary control only sparingly.

d. Open market operations

(1) Open market operations are transactions involving buying and selling of U.S. Treasury or federal agency securities by the Fed in the open market. They purchase (or sell) the securities from (to) financial institutions and individuals. If purchased from financial institutions, the funds are deposited in the institution’s reserve account at the Fed and represent both an increase in the amount of excess reserves in the banking system and the potential for a multiple expansion of the money supply. Funds purchased from individuals result in a deposit of funds into a checkable deposit that would increase the level of required reserves as well as the amount of excess reserves and thus be less expansionary than if the securities were purchased from a bank.

(2) If the Fed wishes to decrease bank reserves, they would sell securities in the open market, draining excess reserves from the system.

(3) This is the most commonly used tool of monetary policy.

e. Term Asset‐Backed Securities Loan Facility: The Term Asset‐Backed Securities Loan Facility (TALF) is a funding facility to help market participants meet the credit needs of households and small businesses by supporting issuance of asset‐backed securities (ABS) that will be collateralized by loans of various types to consumers and businesses of all sizes. Under the TALF, the Federal Reserve Bank of New York will issue up to $200 billion on a nonrecourse basis to holders of certain newly originated AAA‐rated loans.

f. Term deposit facility: Term deposits will facilitate the implementation of monetary policy by providing a tool that allows Federal Reserve Banks to accept term deposits from depositary institutions. These deposits are removed from the institution’s account for the term of the deposit and thereby will drain reserves from the banking system to the degree that they are purchased by the depository institutions.

5223.06 Fed funds market

a. With the continual movement of money through the financial system, it is very unlikely that an individual financial institution would always have an adequate level of reserves to meet their reserve requirements, even though there were excess reserves available within the banking system. As a means of facilitating the efficient allocation of excess reserves, banks lend their excess reserves among and between themselves in the federal funds market.

b. The Fed funds rate is the interest rate that banks charge each other when they lend their excess reserves. This rate is determined by the interaction of supply and demand for these reserves. Thus, as the Fed moves to change the amount of reserves in the system, it is attempting to change the “Fed funds rate.” For example, an increase in the amount of excess reserves would cause the Fed funds rate to decline.



c. When a bank borrows in the “Fed funds market” the funds are simply transferred from one bank’s account to another’s on the books of the Fed. These loans are generally short‐term, often only overnight to allow the borrowing institution to raise their reserve deposits to the required level.

5223.07 Impact of monetary policy on economic aggregates

a. Monetary policy is one of the key policy tools that is available to attempt to influence the real GDP and the price level. Monetary policy works through the following process:

(1) Money market: Nominal interest rates are determined by the interaction of the supply and demand for money in financial markets. Monetary policy can impact the supply of money and therefore nominal short‐term interest rates.

(2) Business investment: Increasing interest rates makes business investment less attractive by increasing a firm’s weighted‐average cost of capital, thereby reducing the net present value of a project’s future cash flows.

(3) Equilibrium GDP: If business investment is reduced, then real GDP will decline by some multiple of the decline in investment (multiplier effect).

b. Monetary policy to contain inflation

(1) The Fed would have a restrictive monetary policy and sell bonds.

(2) Excess reserves would fall, and the money supply would fall.

(3) Interest rates would rise, and business investment would decline.

(4) Aggregate demand would fall, and the inflation rate would decline.

c. Monetary policy to deal with deflation

(1) With nominal interest rates near zero, the Fed can no longer use traditional monetary policy tools to deal with deflation.

(2) The Fed can act in a preventative mode by preserving a “buffer zone” for inflation in the 1%–3% range to reduce the probability that a large and expected drop in aggregate demand will drive the economy to a level that will drive nominal interest rates to zero.

(3) The Fed should act more preemptively and more aggressively in cutting interest rates when signs of potential deflation occur.

(4) The Fed would need to reduce the value of the dollar in terms of purchasing power (that is, aggressively promote inflation), which is the equivalent of raising the price in dollars of goods and services.

(5) The Fed would need to expand the level of asset purchases and expand the menu of the assets it is willing to purchase.

(a) Use existing authority to purchase agency debt such as mortgage‐backed securities.

(b) Buy foreign government debt, but with concern about the impact on exchange rates.

(6) The Fed would act to lower interest rates out further along the yield curve by purchasing assets with longer maturities and provide a commitment to keep short‐term interest rates near zero for a specified period of time.



d. Monetary policy to deal with unemployment

(1) The Fed would have an expansionary monetary policy and would buy bonds.

(2) Excess reserves would increase, and the money supply would increase.

(3) Interest rates would fall and business investment would increase. There is a potential problem here since it is possible firms would not have viable projects at the trough of a business cycle as a decline in the net present value (NPV) of expected future cash flows might more than offset the positive effect of a lower weighted‐average cost of capital (WACC). Also, banks might have raised their credit standards and not be willing to lend to firms that have had a poor financial performance during the recession.

(4) Aggregate demand would increase, and real GDP would climb by some multiple of the increase in investment.

5224 Opportunity and Production Costs

Opportunity Costs

5224.01 Overview

Opportunity costs differ from traditional accounting expenses. As opposed to assessing the historical sacrifice of resources, these costs are forward‐looking and based on inferences. The simplest definition of opportunity cost is the benefit foregone as a consequence of selecting one alternative over another. For example, the opportunity cost of studying for the CPA exam might represent any other activity you could be doing right now, such as earning money at a job, watching television, or spending time with friends and family. The opportunity cost is time spent studying (and, if applicable, any money losses) when time or resources could have been directed elsewhere. Before calculating opportunity cost, the alternative opportunity options must be clearly identified.

5224.02 Illustrations of decisions based on opportunity cost

In a business context, managers must estimate the opportunity cost and out‐of‐pocket cost associated with proposed decisions. These costs are known as differential or relevant to managerial decisions because they should be considered as part of the total cost associated with a particular pathway. Out‐of‐pocket costs are those that require a future outlay of cash, whereas opportunity cost is the potential benefit lost by taking a specific course of action when one or more alternatives were available to the decision maker. While out‐of‐pocket and opportunity costs are not recorded into the accounting system, they are likely to be applied when doing scenario planning on spreadsheets or related software systems. Practical business applications of the concept include the following:

a. When a company commits to deploying working capital for the purpose of purchasing plant equipment, the interest revenue foregone from using the money for investment activities represents an opportunity cost.

b. If the company uses all available stockpiles of rubber to produce its most popular product, the opportunity cost is the inability to utilize rubber for the development of new product lines.

c. When management decides to retain delivery vans that will naturally devalue due to economic asset depreciation, the opportunity cost sacrificed is the one‐time money that could have been generated by selling the vehicles to a third party before the asset lost market value.



d. If a business owner elects to use a retail space to sell clothing attire, the opportunity cost is the inability to use the space for different activities, such as selling computers and accessories.

e. The decision to provide front‐line staff who are on fixed hourly schedule training results in the loss of productive hours that could be spent on the factory line.

f. If employees elect to scrap defective products, the opportunity cost is the potential additional source of revenue that could be derived from reworking the products.

g. When plant operations move from 85% to 95% utilization, the opportunity cost is greater manufacturing congestion and a diminished “excess capacity” buffer in the event of demand fluctuations.

5224.03 Opportunity costs should not be mistaken for costs that have already been incurred and cannot be changed by any decision made now or in the future, called sunk costs. These costs are historical expenditures incurred that cannot be recouped. For example, if a company purchased a specialized machine for $100,000 five years ago that is now obsolete and holds no value from a resale perspective, this historical cost should have no bearing on the company’s decision to purchase new equipment. Unlike opportunity costs, sunk costs are irrelevant for business decision‐making.

Production Costs

5224.04 Short run vs. long run

a. Short run is a time period so short that at least one input is fixed. It is usually assumed that plant and equipment is the fixed factor. A firm can change the amount of labor, material, and other factors. The time period is a function of the nature of the industry and the level and type of plant capacity they hold.

(1) The short run for a utility wishing to construct a nuclear plant may be more than 10 years while a small retail firm can add to (or dispose of) its capacity nearly instantaneously.

(2) The short run is also known as the “operating period,” where a firm makes decisions related to determining what level of output to produce.

b. Long run is a time period where all inputs are variable. The long run is also known as the “planning period,” where the entrepreneur or the firm makes decisions such as whether to enter or exit an industry, whether to expand or contract plant capacity, or whether or not to adopt new technology. Once the firm has made the decision concerning plant capacity, they are then “operating in the short run.”

5224.05 Law of diminishing marginal returns

The law of diminishing marginal returns states that as a firm adds additional units of a variable resource to a fixed resource, output (marginal product) will first increase at an increasing rate, then will increase at a decreasing rate, and at some point may become negative.

5224.06 Cost of capital

a. The cost of capital is the opportunity cost of acquiring the funds necessary to support the asset base of the firm.

b. The sources of funds are:



(1) debt—provided by borrowing from financial institutions or by issuing bonds.

(2) equity—funds provided by the owners of the firm, either directly by the purchase of common stock, or through retaining profits earned from operations.

5224.07 Explicit/implicit costs

a. Explicit costs (accounting costs) are cash expenditures that a firm makes to acquire the resources necessary for production that are owned by others.

b. Implicit costs (economic costs) are the opportunity costs of using the resources provided by the owner of the firm. They represent the earnings that these resources could have received had they been used in their next best alternative use. They could include rental or lease income that is forgone if the owner of a business uses a building for the firm, the lost wages that could have been earned if an individual were employed by an outside firm, or interest that is forgone when funds that were invested elsewhere are now being used by the business.

5224.08 Various types of profits

a. Accounting profit is revenue minus explicit costs.

b. Economic profit is accounting profit minus implicit costs. It is the residual amount that goes to the owners of the firm. Its existence provides a strong signal to other firms to enter the industry.

c. Normal profit is defined as the amount necessary for the firm to be willing to keep the resources deployed in the firm. Normal profit is also defined as the point where the firm’s economic profit is equal to zero; that is, it is covering all its explicit costs and implicit costs (and the owners are making a return sufficient to cover the opportunity cost of the resources they are providing to the firm).

5224.09 Profit maximizing rule (MR = MC)

Marginal cost represents the change in total cost associated with producing one additional unit. Marginal revenue represents the change in total revenue derived from selling one more unit. If the marginal revenue from selling one more unit is greater than the marginal cost of producing the unit, it makes sense to produce and sell the unit as doing so will increase the firm’s profit.

If marginal revenue is greater than marginal costs, then producing more will increase profits. However, if marginal revenue is less than marginal cost, then producing more will lower profit. Thus, profit is at a maximum when marginal revenue equals marginal cost: MR = MC.

5224.10 Shape of and relationship between the various cost curves

a. Average fixed cost (AFC) declines as output increases. It is defined as Fixed costs ÷ Quantity.

b. Average variable cost (AVC) is a U‐shaped curve. It reflects the operation of the law of diminishing returns. Since the marginal returns of adding variable resources initially increase, the variable costs per unit decrease. At some point, as diminishing returns require more units of the variable factor for each additional unit of output, AVC begins

to rise. It is defined as Variable costs Quantity.

c. Average total cost (ATC) is AFC + AVC. It is also U‐shaped but turns up at a slower rate than AVC since, for some number of units, AFC will decline by more than AVC increases.

It is defined as Total cost Quantity.



d. Marginal cost (MC) is the change in total costs associated with producing one more unit of output. Marginal costs are the costs that the firm can control directly; for example, the firm cannot incur them simply by choosing not to produce the last unit of output. (Note: Only variable costs are relevant when marginal cost is calculated.)

e. Illustration: A relationship exists between MC, AVC, and ATC. The marginal cost curve always intersects the AVC and the ATC at their minimum points. For example, a basketball player has 23.4 points per game (PPG) average. When she plays an additional (marginal) game, if she scores more than 23.4 points, her (PPG) average will rise. If the marginal is greater than the average, then the average rises. If the marginal is less than the average, then the average falls. Therefore, if the average is neither rising nor falling, the marginal equals the average.

f. Cost curves will shift if the firm is faced with increased resource costs or if the firm changes its technology.

5224.11 Economies of scale

a. Economies of scale occur when increases in a firm’s capacity and output are accompanied by decreases in the firm’s long‐run average cost of production. These are the economies provided by mass production.

b. The law of diminishing returns does not exist in the long run since all factors are variable.

c. Primary causes for economies of scale include:

(1) increased labor and managerial specialization.

(2) the ability to use more efficient equipment and generally larger facilities.

(3) the ability to spread costs such as R&D expenditures and advertising expenditures over larger volumes of output.

d. Diseconomies of scale occur when increases in a firm’s capacity and output are accompanied by increases in the firm’s average cost of production in the long run.

e. Primary causes for diseconomies of scale include:

(1) increased difficulty in efficiently controlling coordinating the firm’s operations due to the expansion of management hierarchy.

(2) reduced decision‐making flexibility.

(3) potential for increased worker alienation that would require increased management supervision.

f. The graph below pictures a firm’s long‐run average cost curve that shows the range for economies of scale and diseconomies of scale. It also shows the minimum efficient scale, which is the range of output over which the firm can achieve its minimum average cost.

SAC = Short‐term average costs

LRAC = Long‐run average costs



5225 Market Influences

Impacts of Globalization on Companies

5225.01 Globalization

a. Globalization involves an ongoing process by which national and regional economies, societies, and cultures become integrated through global networks of communication and trade, which has resulted in growing connectivity and interdependence between businesses in the broader world market.

b. Globalization often specifically relates to economic globalization: the integration of national economies into the international economy through trade, foreign direct investment, capital flow migration, and the spread of technology.

c. Globalization is usually recognized as a process being driven by a combination of economic, technological, socio‐cultural, political, and ecological factors, as well as the circulation of ideas, languages, and popular culture through acculturation, or adoption of the behavior patterns of the surrounding culture.

d. The term globalization is used by some to talk of global integration through trade and investment flows as well and the movement of goods and services in order to enhance international competitiveness.

e. At the most basic level, globalization is an extension of outsourcing at an international level, which simply refers to a company that contracts with another company to provide services that might otherwise be performed by in‐house employees. The first wave of outsourcing took advantage of labor arbitrage resulting from significant wage differentials, and saw the outsourcing of jobs such as call center, e‐mail services, and payroll. A second wave of globalization was in manufacturing related to the dispersion of lean production methods and flexible computer‐aided manufacturing systems. A third wave that encompasses moving to value‐added services such as market research, IT, and product inspection is now underway.



5225.02 Historical perspective

a. The current wave of globalization is not the first time we have seen globalization. The first economic‐based wave of globalization took place during the European conquests starting in the late 15th century, starting with Columbus and lasting for some 100 years.

(1) Raw materials from colonies were considered key to creating home country wealth, with political and economic issues being different for the various colonial powers.

(2) At many levels, this period was a disaster, with a genocidal depopulation of the Americas and the opening of Africa to the slave trade.

(3) This was also a period of inter‐European wars, which represented the first global wars.

(4) The wave ended as technology began to replace raw materials in the drive to increasing wealth and the cost of maintaining an empire increased dramatically.

b. The post‐colonial wave was the heyday of European imperialism from the mid‐19th century to 1918.

(1) Global corporations looked around the globe for investment, searching out markets for manufactured goods, trading partners, cheap labor, and inexpensive raw materials.

(a) During this period, Britain engaged in a forced drug trade with China.

(b) The United States “forced open” Japanese markets with gunboat diplomacy.

(2) There was voluntary trans‐ocean mass migration of peoples.

(3) Globalization was sustained by new and faster means of transportation and communication.

(4) The period ended with German colonies being taken by other world powers under the Treaty of Versailles. By the late 1920s there was a negative period, with retrenchment from globalization involving shrinking world trade, national abandonment of the gold standard, the growth of state action versus market expansion, and national and ethnic clashes.

c. The third wave of globalization followed World War II, with the costs of communication and transportation again declining rapidly.

(1) The main thrust was political, with the ongoing struggle between the United States and the USSR.

(2) Cold War globalization peaked in the 1970s to mid‐1980s.

d. Today’s globalization is characterized by a massive increase in trade between emerging nations such that there is now a new “Silk Road.”

(1) Historically, the old Silk Road was a set of trade routes that crisscrossed Asia some 2,000 years ago, linking merchants in China with India, Arabia, and the Middle East.

(2) The new Silk Road connects countries in Asia, Latin America, the Middle East, and Africa, with current data indicating trade on the order of $2.8 trillion among and between these regions.

5225.03 Causes for today’s globalization

a. There was an increasing ability of large and smaller companies worldwide able to exploit the benefits from trade in commodities, goods, services, and capital, including labor



arbitrage; and the opportunities for new investments and expansion into international markets.

b. There was a spread of consumer knowledge about what is available through increased travel, advertising encouraged by enhanced communications, and specifically global TV networks.

(1) There was a move to cheap, rapid, and reliable communication.

(2) The internationalization of production, marketing, consumption, capital flows, standards, and tastes created investment opportunities that made global advertising more feasible.

c. During the 1980s, there was a dramatic rise in the importance of markets, with a near‐demise of state controls of capital markets that:

(1) opened up new world financial markets,

(2) dismantled tariffs, and

(3) led to a significant privatization of state enterprises.

d. Following the financial crisis of 2008, there was a significant turnaround and a return toward state capitalism in many countries.

e. A relatively peaceful world that induces economic agents to exploit the opportunities presented by globalization

f. The main effects of rapid technological change included the following:

(1) Disaggregation of production, integrating manufacturing decisions including activities such as CAD‐CAM (computer‐aided design and computer‐aided manufacturing) and using activity‐based costing

(2) Dispersion of lean production methods, which call for the use of limited resources, in comparison to the more traditional mass production methods with a combination of innovations within the productive organization, supply chain management, product development, and customer interaction

(3) Migration of labor‐intensive standard production for components, sub‐assemblies, and finished goods production to low‐wage countries

(4) The “brain drain” or immigration of highly educated and skilled labor to countries with advanced IT

(5) When immigration limited this migration, then technology (e.g., “research centers”) began to migrate to the location of skilled workers.

g. The use of flexible computer‐aided manufacturing systems has allowed the production of custom output where systems combine the low costs of mass production processes with the flexibility to meet the tastes and preferences of ever smaller groups, i.e., mass customization.

h. There was a shift that caused economies of scope to replace economies of scale as the focus for reducing costs for large‐scale production.

(1) Economies of scope states that the average cost of production declines as the result of increasing the number of different goods produced and can be achieved not only by a single firm that produces a variety of related goods and services, but also by a group of firms located very near each other in a district that produces related goods and services.



(2) Firms take advantage of the available inputs rather than specializing in the production and delivery of a single product. Sharing or joint utilization of inputs among similar products is the main reason for economies of scope leading to lower costs.

i. The underlying strength of many emerging economies is based on an undervalued currency, which stimulates exports, low‐cost labor, high savings rates, and strong investment in infrastructure.

j. Two key socioeconomic elements have enhanced globalization and the rise of emerging market economies which has reached a tipping point in their favor:

(1) There was significant labor force growth coupled with declining birth rates in virtually every emerging market economy. The result is a declining dependency ratio, which is arbitrarily defined as the ratio of the elderly (those 65 years and over) plus the young (those under 15 years of age) to the population in the “working ages” (those 15–64 years of age). Declining dependency ratios have historically been associated with dynamic positive economic change in the now‐developed economies.

(a) Over the next 40 years, Japan and Europe will see their population fall by 30 million and 37 million respectively, with the over‐65 population climbing from the current 1 in 5 to 1 in 3 respectively by 2060.

(b) China’s population will continue increasing for the next 15 years, but given current low birth rates, will result in there being 100 million fewer workers than today by 2050, with the over‐80 population rising from a current 1.4% of the population to 7.2% by that date.

(c) India’s population will increase by 300 million in the next 40 years, and the U.S. population will increase slightly during the same period, primarily due to immigration.

(2) The largest urban migration in history, with nearly 1‐1/2 million people moving to cities each week in the emerging economies, led to an economic output gain enhanced by rapid labor productivity growth supported by technological enhancements.

5225.04 The benefits of globalization

a. Foreign direct investment (FDI) brings the best technology and other forms of intellectual capital to countries that would otherwise have to make do without it. FDI benefits the U.S. economy through the following:

(1) Creating new jobs: U.S. affiliates of majority‐owned foreign companies employ more than five million U.S. workers.

(2) Increasing wages: On the average, U.S. affiliates of foreign companies pay 25% higher wages and salaries than the rest of the private sector.

(3) Increasing exports: Approximately 19% of U.S. exports come from U.S. subsidiaries of foreign companies.

(4) Strengthening manufacturing and services: Some 39% of jobs in U.S. affiliates of foreign companies are in the manufacturing sector.

(5) Bringing in new research, technology, and skills: In 2005, U.S. affiliates of majority‐owned foreign companies spent $32 billion on R&D and $121 billion on plant and equipment.



b. FDI brings products that would otherwise be unavailable to the countries where the investment occurs, which presumably increases the quality of output and therefore increases the value of world output.

c. International capital flows can transfer savings from countries where the marginal product of capital is low to those where it is high, which again increases world output.

d. The IT revolution has made it very difficult for governments to control cross‐border capital movements, even if they have political incentives to do so.

e. IT has allowed for the creation of just‐in‐time supply chains.

(1) Products can be made “everywhere,” with many products containing inputs from several countries.

(2) These supply chains take the form of complex adaptive systems, which are complex in that they are diverse and made up of multiple interconnected elements (i.e., part of a network) and adaptive in that they have the capacity to change and learn.

(3) Emerging networks and links have formed new opportunities for strategic alliances.

(4) Most countries have some portion of their economy that is market‐based.

(5) Labor inflexibility (immobility) has led to a competitive advantage for emerging economies.

(a) This has created a painful outcome for developed‐economy workers.

(b) Labor arbitrage was difficult to capture in the past. However, due to urbanization, improved education, significant infrastructure investment, cheaper transportation, and the spread of advanced production technologies and digital standards that allow production to be more readily shifted globally, it is now much easier to shift production to take advantage of low‐cost labor. (Global labor arbitrage is the result of removing or lessening barriers to international trade, which will cause jobs to move to nations where labor costs and the cost of doing business due to factors such as labor laws and environmental regulations are least expensive.)

5225.05 Costs associated with globalization

a. The economic restructuring caused by the impact of globalization may cause significant economic dislocations to labor markets in developed economies.

b. World financial markets are more vulnerable to being impacted by regional financial crises.

c. The global ecosystem is subject to degradation, as businesses often seek to locate in countries with the weakest regulatory requirements for extractive industries and environmental safeguards.

d. Increased demand for products and infrastructure development has dramatically increased the demand for many nonrenewable resources.

e. Communication has allowed more people to become aware of what is available elsewhere in the world, causing pressure for more migration.

f. Transportation improvements have increased the possibility of a more rapid spread of disease.



g. There are significant differences in attitude toward protection of intellectual property rights (IPR), i.e., the protection of patents, trademarks, and copyrights, and the disclosure of trade secrets.

(1) IPR provides a degree of monopoly power that allows the developer the right to capture some economic profit from the invention or innovation.

(2) Historically, in Asia, copying and improving was a sign of tribute to the developer.

(3) Increasingly, Western nations have moved to improve legal protection of IPR, as they are engaging in foreign direct investment (FDI) that has the potential to make trade secrets more readily available.

5225.06 Implications of globalization for business strategies

a. The traditional desire for product standardization takes a back seat to the current need to adapt products to meet local tastes.

b. The internet is “digitizing” some current physical goods. It is possible to both buy products such as music, movies, and books online as well as have the “goods” shipped via the internet.

c. The IT revolution has been intimately connected with the rise of strategic alliances among firms. The key feature is that these alliances do not entail transferring any equity.

d. Executives should not assume that the prevailing reality of globalization will continue.

(1) Labor arbitrage opportunities that allow short‐term wage savings will shift geographically over time.

(2) With globalization creating a higher probability of financial shocks, managers will need to become more adept at risk management. (Risk management is the process of determining the maximum allowable overall level of risk a firm is willing to accept, using risk assessment techniques to determine the original level of risk, and developing a strategy to control individual risks such that the firm does not engage in excessively risky behavior.)

e. Scenario planning causes a firm to shift focus from strategic planning to the analysis of potential future events and related outcomes. For example, a firm might forecast the possible economic outcomes if the economy was growing rapidly, moderately, or slowly. When dealing with potential scenarios involving globalization, firms might do scenario planning for situations such as the following:

(1) Rapid shifts in currency or commodity prices

(2) Accepting that emerging economies are now becoming “drivers” in consumption as well as their current position as “drivers in production”

(3) Shifts in currency prices that will make purchasing power parity more likely as the relative prices of goods and services in various countries change (Purchasing power parity is the economic theory that indicates that the long‐term equilibrium exchange rate for two currencies will be that which equalizes their purchasing power for goods and services.)

(4) The fact that sophisticated labor arbitrage will replace the earlier “easy pickings” of simply moving to a low‐labor‐cost country, which will require firms to:

(a) build better products, find employees, deliver services, and reach consumers efficiently



(b) capture a winning position in global supply chains by creating chokepoint technologies on which larger industries depend and are not able to obtain elsewhere (An example of a choke point would be the ability to control unlike sales channels that would allow a firm to control distribution and/or that influences customer relationships.)

(c) find business applications that use scenario planning that conceptualizes a changing mindset about the factors related to the outside world prior to formulating specific strategies. (Scenario planning involves aspects of systems thinking, specifically the recognition that many factors may combine in complex ways to create sometimes surprising futures due to nonlinear feedback loops.)

f. The rebalancing that gives more power to emerging economies will require a significant shift in strategic focus. Emerging markets become the locus of growth in consumption, production, and most of all innovation.

g. More and more, global leadership will depend on winning in the emerging markets first as:

(1) more than 70 million people per year are crossing the threshold to middle class in the emerging markets.

(2) companies that can reduce cost structures by 20% or 30% of developed world levels or lower will be able to capture the new demand.

(3) the business model must be reinvented to include factors such as:

(a) developing alternative delivery models.

(b) working with potential consumers to co‐design products for unique environments.

(c) being willing to attempt to capture massive unit share long before generating revenue share (similar to the path taken by Japanese firms during the 1960s–1970s).

(d) understanding that the importance of emerging markets is not simply due to low‐cost production with technological innovation.

h. Firms will need to manage multiple business models that allow them to thrive while competing in broadly diverse markets. There will often be a struggle with trade‐offs between potential long‐term revenue growth in emerging markets versus pursuing here‐and‐now profits in established markets.

i. Emerging markets are where tomorrow’s champions will hone long‐term competitiveness.

j. There will be “innovation blowbacks” as low‐priced, high‐quality products created for the mass market of emerging countries will be effectively marketed and sold in the developed world. (Innovation blowback is the idea that countries from developed markets that attempt to sell in emerging markets may in fact find themselves under attack in their home markets by companies who are more aggressive in realizing the potential for innovation in emerging markets.)

5225.07 Tariffs

Tariffs are essentially taxes or duties placed on an imported good or service by a domestic government, making domestic goods cheaper and imported goods more expensive. There are a number of negative effects from import tariffs:



a. Tariffs protect inefficient domestic industries at the expense of efficient industries, creating an internal misallocation of resources. In other words, land, labor, and capital will flow toward inefficient industries that are subsidized by protectionist policies and thus not as readily available to those industries that are competitive.

b. The increased cost of imported products can lead to an increase in domestic inflation.

c. Domestic producers will take advantage of the situation and raise their prices due to less competitive pressure to keep their prices low.

d. Tariffs decrease the amount of imported goods, thus sending less cash to the exporting nation. The end result is that the exporting nation will have less money to spend and there will be a decrease in exports of domestically produced goods.

Shifts in Economic Balance of Power

5225.08 Shifting balance of power

a. It is expected that emerging economies will be contributing more to world growth than developed countries in the coming decade:

(1) There is a large and growing number of middle‐class consumers in these countries.

(2) It is also expected that emerging economies will become increasingly important in terms of innovation, efforts to change product design, improving national infrastructures, and improving supply‐chain effectiveness.

(a) China has a very robust supplier network that can easily serve other Asian nations and has a shipping infrastructure that is able to move products throughout the region.

(b) There is a growing consideration toward developing a “common market” with investment in rail infrastructure throughout the Asian region to allow these nations to become more competitive with China.

b. One of the outcomes of the recent globalization has been a shift in the pattern of foreign direct investment (FDI), with funds now increasingly flowing from emerging market economies to the more developed economies. This represents an unprecedented shift from the traditional patterns of FDI in the post-World War II era, which saw capital flow from slower‐growing rich economies to emerging economies. (Foreign direct investment (FDI) is long‐term participation by one county in another in such areas as management, joint ventures, transfers of technology, and business expertise.)

c. Emerging market economies are capturing an increasing amount of foreign exchange earnings, either from the sale of raw materials or rising trade surpluses.

d. Emerging market economies tend to have the following:

(1) Low debt‐to‐GDP ratios

(2) Large currency reserves and rising trade surpluses

(3) Low‐cost labor

(4) High savings rates

(5) Investment in infrastructure

e. In addition, the level of trade among and between emerging market economies is increasing significantly.



f. Developed economies will need to generate strong productivity gains in order to have reasonable levels of economic growth.

g. The changing pattern of trade flows are dominated by transnational corporations, where vertical specialization has caused a marked increase in the use of imported components in the production process that have been exported from emerging economies.

5225.09 Sovereign wealth funds

a. Sovereign wealth funds (SWFs) are government investments funded by foreign currency reserves but managed separately from official currency reserves and invested for profit. Official reserves traditionally have been held in foreign government securities, e.g., low‐risk U.S. government securities.

b. Many SWFs take the form of state‐managed companies designed to invest current profits from commodity revenue flows and absorb current account surpluses and high savings inflows that are too large to be absorbed by limited domestic investment opportunities.

5225.10 Sources of funds for sovereign wealth funds

a. The primary sources of funds come from earnings from commodity‐based investments (primarily energy), from exports, and from surpluses driven by manufactured goods exports to developed economies.

(1) A key driver is expected to be that commodity prices are likely to remain relatively strong due to the growth of emerging economies and the fact that they have a very high‐income elasticity of demand for commodities. (Income elasticity of demand is the measurement of the responsiveness of the proportional change in the demand of a good to the change in the income of the people desiring the good. It is calculated as the ratio of the percent change in demand to the percent change in income.)

(2) The surging price for commodities has shifted the terms‐of‐trade (the relative price of exports compared to the price of imports) in favor of any country exporting from extractive and commodity‐based industries.

b. A key determinant of the export earnings is generally a weak currency that makes a country’s goods and services lower priced in terms of the foreign currency.

c. Developed economies are running fiscal policy deficits and borrowing funds from emerging economies to finance them. In addition, developed economies are increasingly running current account deficits as their consumers desire products produced by emerging market economies. To finance these twin deficits, they borrow funds from the emerging economies.

d. Central Banks in emerging economies often do not have the policy tools necessary to absorb or sterilize all the domestic currency created to support the trade surplus.

(1) The classic form of sterilizing the excess monetary base is issuing local currency bonds, and Central Banks in many emerging economies do not have that tool available.

(2) High savings rates and a lack of well‐functioning capital markets, coupled with insufficient local investment opportunities, will create a pool of funds available for investment.



(3) Many Central Banks are now accepting a myriad of currencies in addition to dollars, which compounds the foreign exchange risk problems they are dealing with.

5225.11 Uses of funds by sovereign wealth funds

a. There is a growing effort to diversify holdings from traditional debt instruments into foreign direct investment (FDI) in developed and emerging economies. These may be greenfield investments in new enterprises, in the form of expansion of production facilities, or M&A activity, which involves the purchase of existing enterprises. Greenfield investments are a direct foreign investment, when the parent company starts a new venture in a foreign company, as opposed to purchasing existing production facilities.

b. There has been a dramatic shift in relation to the type of investment in agriculture that is now occurring.

(1) Historically, such investment was used to produce cash crops that could be sold on world markets for profit‐boosting world trade and economic activity.

(2) Farmers were often encouraged to shift from staple crops to growing crops that could be exported and sold for hard currency.

(3) Now governments, through their sovereign wealth funds (SWFs), are investing in staple crops with a protectionist impulse designed to circumvent world markets.

(a) Those who support such efforts suggest that they provide new seeds and techniques that will modernize agricultural practices in recipient nations, and those who are critical suggest that due to lack of enforceable property rights, small farmers in these nations will be forced off land they have utilized for years.

(b) These governments find investing in their own domestic agriculture to be problematic due to a scarcity of arable land and, more importantly, often a shortage of water.

(c) The governments use the SWFs to buy or lease farmland abroad, thus outsourcing food production, growing crops abroad, and shipping them back to the home country.

(d) The investment is designed to prevent wide price swings from impacting their economies.

(i) The governments could afford the higher prices, but cannot afford the possibility of trade bans when crops would be in short supply worldwide. This would curtail their ability to import such crops. Food security is the primary driver.

(ii) Several countries, including Pakistan, which is the largest recipient of food aid, are letting investors export a significant portion of their agricultural output to help reverse a long‐term underinvestment in agriculture and to obtain increasing amounts of hard currency.

c. China is investing to acquire technologies, brands, resources, and better access to international markets as they use technology to enhance productivity and augment earnings. China uses two primary organizational structures for making FDI. The first is the Chinese Investment Corporation (CIC), which is generally seen as an arm of the government, and the second are state‐owned enterprises (SOEs).



(1) The primary goal of CIC investment is to diversify the use of foreign exchange reserves. The Chinese government is concerned that the nature of their investments will appear to others as if the government is attempting to control the management of target companies and/or purchase politically sensitive raw materials.

(2) SOEs, on the other hand, have a goal of “going global” and establishing a Chinese presence. They are attracted by the low valuations of increasingly desperate foreign operations (particularly in strategically important sectors such as energy and raw materials) attempting to achieve energy security and access to strategic materials at a known contract price.

(3) To facilitate their investments, the Chinese government has eased and decentralized regulatory procedures and made financing more available for such ventures, while also making no‐strings‐attached loans to governments rather than meddling directly in their affairs, such as in the case with World Bank lending.

(4) There is an attempt to learn how U.S. companies operate and transfer the information to improve the operation of SOEs.

(5) A significant portion of Chinese FDI involves investing in Hong Kong, with the funds then immediately reinvested in China, where these investments receive special treatment as “FDI.”

5225.12 Political issues

a. The increase in capital flows internationally has made it more important that participating countries tend to follow relatively consistent monetary and exchange rate policies, or they will be penalized by the market.

b. Tensions between developed‐world currencies and those of emerging market currencies will increase as emerging market economies capture an increasing share of jobs, increasing structural pressure on labor markets in developed economies.

c. Rapid expansion in emerging market economies is driving up inflation pressures and creating asset‐based bubbles. This causes governments to consider curbing government spending and raising interest rates; however, too much pressure could lead to a slowdown in global economic growth.

d. The social safety nets put in place in many developed economies are increasingly under pressure and becoming unsustainable.

e. There is a potential collision between the increasing demand for resources, constrained supplies, and changing attitudes toward environmental protection, with a move toward increased regulation and the development of clean‐tech industries.

f. The policies of China, Japan, and South Korea seek to keep their currencies undervalued.

5225.13 State capitalism

a. State capitalism is an economic system where the state manipulates market outcomes for political purposes. Vast amounts of financial capital come under the control of state officials, either directly or through sovereign wealth funds, and it is generally used to guard their political power.

b. In the traditional form of industrial policy, the state attempts to pick the winners and losers in the choice of firms to support.



c. In a more modern definition of industrial policy, often seen in countries like Japan and South Korea, the state determines which sectors should be supported and encourages investment in that sector. The state often attempts to attract foreign investment in the sector, expecting that there will be domestic production and access to innovative technology as they attempt to become a leader in an emerging industry.

d. China has embraced capitalism only as far as it can be used as an instrument of state power.

e. After a move toward adopting a market‐based system in the 1980s, authoritarian governments in Latin America, Asia, and the Middle East are currently moving closer and closer to a Chinese form of state capitalism.

f. Given the relatively weak world economy following the financial crisis and subsequent Great Recession, the United States and several European states began to place limited emphasis on an industrial policy designed to promote jobs and attempt to rebalance their economies away from finance and property. In the United States, this may be seen in:

(1) aid to the auto industry,

(2) bank bailouts through TARP (the Troubled Assets Relief Program started during the George W. Bush administration),

(3) promotion of green jobs, with a primary focus on R&D, and

(4) the historic subsidies of fossil fuel energy and support for various defense industries.

g. Many countries are attempting to capture an increasing portion of linkages in the supply chain, offering tax holidays, investing in capital grants, and providing free infrastructure construction.

5225.14 Business strategy

a. Managers will need to learn to operate with shorter product life cycles.

b. New financial instruments and new digital methods for transferring funds have created the demand for more appropriate international exchange and payments systems.

c. The high cost of information technology infrastructure and the need for highly skilled labor in the production process requires a market niche that caters to a large global market, which requires that the firm has the ability to provide mass customization and increased sensitivity to cultural diversity.

d. Global entrepreneurship requires upscaling from a national image in the marketplace to a global image. This involves promoting the same standards of quality throughout the world on a consistent basis while at the same time incorporating the flexibility to tailor packaging or the image of the product to suit the customs and traditions of the local market. This requires using flexible manufacturing and distribution systems to develop cost‐effective mass customization.

e. Global entrepreneurs must become catalysts of change and enhance the use of R&D and integrate innovation to develop new products, improve products, reduce the cost of existing products, and develop the long‐term customer‐oriented focus.

f. Process innovation and the transfer of technology are increasingly becoming key to global success.



g. In the human resources area, Chinese leaders see a talent shortfall in the areas of strategic management skills, and Indian leaders see shortfalls in R&D skills among the emerging managerial class.

h. There are several approaches to success as the rebalancing in the world economy moves forward, with two major approaches:

(1) Identifying clusters of similar customers across multiple domestic and/or international markets that would allow for building revenue and profit streams to continue to support ongoing capital investment for continuing growth.

(2) At a local level, building operations of an adequate scale in specific regions and territories by teaming up with very knowledgeable on‐the‐ground partners for product development, distribution, and market positioning, which are critical steps in successful entry into highly localized consumer markets.

(a) Consumers in emerging market economies are diverse and, as consumers worldwide, they are aware of and want brands with a variety of products at different prices. However, at the same time, they desire to have products available they can aspire to own even if they cannot currently afford them.

(b) Tastes are highly localized, and emerging market consumers, while locally part of the middle class, are not wealthy enough to replace products regularly since only a relatively lower percentage of their income is available for discretionary spending.

Cryptocurrency

5225.15 A cryptocurrency is a digital or virtual currency which functions as an online medium of exchange, allowing owners of the currency to buy goods and services. Cryptocurrencies are not currencies in the traditional sense and are not considered the same as cash. They are not developed or backed by a government and are not considered legal tender. A cryptocurrency uses cryptography to secure and verify transactions as well as to control the creation of new units of cryptocurrency. Cryptography scrambles plaintext into ciphertext (i.e., unintelligible text) and vice versa.

a. One of the most important problems that any payment network has to solve is double‐spending: a fraudulent technique of spending the same amount twice. The traditional solution was a trusted third party—a central server—that kept records of the balances and transactions. However, this method permits that third party to be in control of the owner’s funds and have access to all their personal details.

b. In 2009, an anonymous programmer (or a group of programmers) under the alias Satoshi Nakamoto created Bitcoin. Satoshi described it as a “peer‐to‐peer electronic cash system.” Bitcoin is completely decentralized (i.e., there are no servers involved and no central controlling authority, such as a government).

c. In a decentralized network like Bitcoin, every participant acts as a monitor of the transactions. This is done via the blockchain—every transaction is a file that consists of the sender’s and recipient’s public keys and the amount of coins transferred. The transaction also needs to be signed off by the sender with their private key, which is not part of the blockchain.

d. Cryptocurrencies can be transferred or spent electronically without other members of the blockchain, or even members to a mutual transaction, knowing the true identity of the sender or recipient outside of their public key.



Blockchain

5225.16 A blockchain is a digitized, decentralized, and distributed public ledger. Completed blocks (the most recent transactions) are recorded and added to the chain in chronological order, allowing market participants to keep track of transactions on the blockchain without central recordkeeping. Upon joining the network, each node (a computer or user connected to the network) gets a copy of the blockchain, which includes every transaction ever executed. This differs from a traditional ledger or database in that no single entity, computer, or location maintains the records of the blockchain.

a. Originally developed as the accounting method for the virtual currency Bitcoin, blockchain technology is used to verify transactions (and prevent double‐spending) within all digital currencies, not just Bitcoin. Since its initial application, blockchain usage has expanded to include more than just cryptocurrencies. Blockchain technology can be used to manage cryptocurrencies, manage a supply chain and logistics network, execute smart contracts, or issue securities without the use of an underwriter or bank.

b. A block is the “current” part of a blockchain, which records some or all of the recent transactions. Once completed, a block goes into the blockchain as a permanent database.

(1) Each time a block gets completed, a new one is generated. There is an endless number of such blocks in the blockchain, connected to each other (like links in a chain) with hashes, in chronological order.

(2) The blockchain has complete information about different user addresses and their balances from the genesis block to the most recently completed block.

c. Each user has a “public key” which is stored in a block and becomes an “address” on the blockchain. Keys are cryptic strings of characters of sufficient length to make the odds of guessing them astronomical. Files such as cryptocurrencies or other digital assets are recorded as belonging to a specific block. A corresponding "private key" is required to access the associated digital assets. Without the private key, users cannot access the blockchain, post blocks, or approve transactions.

d. Documents can be digitized, coded, and inserted into the blockchain, creating a sequential record that cannot be changed; the record’s authenticity can be verified by the entire community using the blockchain instead of a single centralized authority.

5225.17 There are two types of blockchain networks: public networks (also known as permissionless), where each user has a copy of the entire blockchain and helps process and confirm transactions; and private (or permissioned) networks, where permission is required to possess a copy of the blockchain and to help process and confirm transactions. The majority of cryptocurrencies are maintained on public networks, while the majority of business uses of blockchain occur on private networks. For both types of networks, the business logic is encoded using smart contracts. Smart contracts are self‐executing code on the blockchain framework that allows for straight‐through processing, which means that no manual intervention is required to execute transactions. Smart contracts rely on data from outside entities referred to as “oracles” and can act on data associated with any public address or with another smart contract on the blockchain.

Foreign Exchange Markets

5225.18 Foreign exchange (often abbreviated “forex”) markets are global marketplaces where buyers and sellers of foreign currencies can exchange various currencies for other currencies. Unlike



many stock exchanges, the markets operate non‐stop, 24‐hours per day, most days of the week. The market is comprised of futures markets and forward markets as well as a spot (at the given point in time) markets. Currencies in the forex market are quoted in prices against each other in terms known as the exchange rates. For example, if a U.S. currency holder wanted to buy euros on the forex market, the euros would be quoted in U.S. dollars to the U.S. currency holder (e.g., $1.20 USD:€1 implies the U.S. currency holder would need to exchange $1.20 USD to receive €1).

5226 Differentiation/Competitive Strategies

5226.01 Overview

a. The focus when developing differentiation strategies is to create a competitive advantage for the firm. This can be done through a variety of means as long as the firm is favorably positioned in the marketplace in comparison to the competition. The firm needs to create a competitive edge that successfully attracts customers by providing products that fit the needs and wants of the consumer.

b. Companies that are successful in creating sustainable competitive advantages are likely to have above‐average profits.

5226.02 The low‐cost provider

a. The low‐cost provider has the ability to reduce nonvalue‐added costs better than the competition, and at least a portion of those costs savings are passed on to the consumer in the form of lower prices. Firms that successfully lower costs must examine the entire value chain looking for imaginative ways to reduce costs and to control the use of activities that drive costs. The successful low‐cost provider continually looks for ways to reduce costs year after year in areas as diverse as the purchasing of raw materials and the delivery of the finished goods. This would be an example of continuous improvement.

b. In a market that is extremely price sensitive, the low‐cost provider is in a superior position to attract customers as well as to earn a profit.

c. The low‐cost provider strategy works best in markets where:

(1) the products produced by all firms in the industry are essentially identical. The consumers have common uses and needs for the product, and product differentiation is minimal.

(2) buyers tend to be price sensitive and have the ability to shop for the best price. The use of the internet has made comparison shopping easier for many products and has expanded the search possibilities for individuals in non‐urban areas as well.

(3) consumers can easily switch from one product to another and see few differences between the various alternatives offered by different companies within the industry.

5226.03 The best‐cost provider

a. The best‐cost provider attempts to provide a product with superior quality, features, durability, service, etc. at a low price. In other words, the strategy is to give consumers more value for their money. This is done by matching or beating the competition’s product attributes while being able to produce the product at a lower cost.



b. The firm that successfully competes using the best‐cost provider strategy needs to be able to incorporate upscale product attributes while still aggressively controlling costs. The most successful firms using this strategy have unique proficiencies and abilities that allow them to produce high‐caliber products while controlling costs at the same time. The better a firm does at successfully balancing these two important aspects of production, the more advantage it has over competitors.

5226.04 The differentiation strategy

a. A differentiation strategy seeks to create a competitive advantage by developing a product that has unique attributes that are not offered by the competition. The firms that are the most successful using the differentiation strategy develop products that provide value to customers and cannot be easily duplicated by the competition. Generally product features that can be easily duplicated, improved upon, or replaced by a substitute do not provide sustainable differentiation. Unfortunately, any differentiation strategy that works well for a company will attract imitators.

b. In order for a differentiation strategy to be successful, it must be tied to something that cannot be easily copied, such as core competencies, available resources, or other internal attributes that cannot be easily copied.

c. A variation on the differentiation strategy is for a firm to make a product that requires replacement parts that are slightly different than standard parts available made by other companies. Once the product is sold, the consumer is “locked into” purchasing the specific replacement part produced by the original firm. Often these replacement parts have high mark‐ups.

5226.05 The niche strategy

a. A niche strategy can either focus on low cost or differentiation in a particular market niche by doing something different than competitors. The firm can be small and often unable to compete in the total market, but if there is a substantial product competitive strength and unique features that are attractive to the niche members, it can still be highly successful.

b. The niche strategy can work best if:

(1) the niche market is large enough to be profitable, if sustainable, and offers growth potential.

(2) the market leaders have little interest in the niche. This could be due to the fact that it would be difficult or costly to meet the expectations of the mainstream market as well as the expectations of the niche.

(3) few, if any, other competitors are focusing on the particular niche in question.

(4) the firm supplying the niche has developed facilities and resources particularly to service the niche market and has developed significant customer relations.

5226.06 Creating strategic alliances

a. As the global market becomes smaller, many firms are turning to strategic alliances in order to gain a competitive advantage in new markets. As technologies, resources, skills, and competitive capabilities become more complex, it has become more difficult for one organization to “do it all.” By developing strategic alliances, companies can gain access to needed technology, business capabilities, resources, and markets that would not have been cost effective to obtain. There is often synergy in the collection of the various organizations’ expertise that allows for a competitive advantage to develop that



a single firm on its own would have been unable to obtain. These developing alliances in the current world market are creating competition between various sets of firms forming alliances.

b. Alliances are beneficial in gaining access to international markets. It is not unusual for alliances to include suppliers, producers, distributors, or makers of companion products. One of the difficulties in maintaining alliances is the possibility of conflicts and unresolved differences among the alliance members often relating to control of proprietary technologies.

5226.07 Mergers and acquisitions

a. Mergers and acquisitions can also be used to create competitive advantages. By acquiring a firm in another country, a company can gain access to a new market and take advantage of the acquired organization’s reputation. Needed technology or resources are often acquired through mergers and acquisitions, allowing an organization to strengthen market segments where they are weak or allowing that organization to enter new segments.

b. Either domestic or global mergers/acquisitions allow an organization to:

(1) lower risk by diversifying into additional industries.

(2) enter new markets.

(3) provide possible opportunities to more rapidly reach profitability in new areas.

(4) take advantage of economies of scale.

(5) potentially lower costs along the value chain of activities.

(6) strengthen its resource base and production capabilities.

c. Diversification often becomes the best means to expand when the firm has run out of reasonable growth opportunities in the core business.

5226.08 Other differentiation strategies

a. Outsourcing various activities can provide a strategic advantage, providing the outsourced activity can be performed better or more cost effectively by an outside firm.

(1) When outsourcing an activity, it is important that the firm’s core competencies not be diminished.

(2) Outsourcing can provide access to greater competencies and capabilities as well as better technology. For example, many organizations are currently outsourcing human resource activities. Employment laws and requirements are complex, and often small firms do not have the expertise to run their own human resource departments in an efficient and effective manner.

(3) Outsourcing can improve flexibility and reduce production cycles. Often a component part can be produced faster and with a higher quality by a firm that specializes in the production of that part.

(4) Outsourcing allows a firm to reduce costs, lowers labor costs in various countries, and has created an opportunity for some firms to outsource production and, therefore, jobs.

b. E‐commerce technology has allowed many organizations to reach new markets in an efficient and effective manner; however, it has also allowed easier entry into a firm’s current markets by new competitors. It has allowed some organizations to sell directly



to the consumer. Since consumers can now quickly compare prices from a number of competitors, price competition has increased in many cases.

c. A firm can offset domestic disadvantages by using many of the strategies discussed. A global competitive advantage can be achieved by:

(1) having alliances (or mergers/acquisitions) that allow for the transfer of competitive competencies and capabilities as they relate to the world market.

(2) developing value chain activities that lower costs and/or achieve greater product differentiation.

(3) outsourcing production to take advantage of lower labor costs.

Supply Chain Management

5226.09 Overview

Supply chain management is simply defined as getting the right product, to the right place, in the right quantity, at the right time, etc. at minimum cost. Alternative definitions of a supply chain might include the following:

a. A network of autonomous or semi‐autonomous business entities collectively responsible for procurement, manufacturing, and distribution activities associated with one or more families of related products

b. A network of facilities that produces raw materials, transforms them into intermediate goods and then final products, and delivers the products to customers through a distribution system

c. A network of facilities and distribution options that performs the functions of procurement of materials, the transformation of these materials into intermediate, and then final goods, and the distribution of the final goods to customers

5226.10 Key objectives of supply chain management

a. To improve communications at all levels of the supply chain to create an uninterrupted flow of materials and products

b. To reduce inventory levels while improving customer service levels

c. To reduce the supplier base while developing supplier relationships

d. To coordinate logistical activities to ensure that trade‐offs between the various activities are understood to allow for the lowest possible logistical cost

e. To arrange credit terms and methodologies of exchanging funds across entities and within supply chains

5226.11 Supply chain business processes

a. Successful supply chain management calls for a change from managing individual functions to integrating the activities into key supply chain processes.

b. Customer relationship management provides a structure for how the relationships with customers will be developed and maintained. Key customers and potential target customer groups are identified as part of the firm’s mission. Service agreements are developed to meet the needs of the key groups.

c. Customer service management provides the firm’s face to the customer with a key function being to administer the service agreements. Customers are provided with real‐



time information as to product availability and delivery and providing assistance with product applications.

d. Demand management is the process that balances the customers’ requirements with the capabilities of the supply chain. Customer demand provides the greatest source of variability in inventory stocking. The goal is to synchronize supply and demand to reduce variability and to use point‐of‐sale data to make flows through the supply chain move efficiently.

(1) If lead times are assumed to be constant, then the ability to fill orders is dependent on the level in the supply chain. The levels of all three types of inventory have increasingly indirect effects on the ability to avoid stockouts.

(2) The trade‐off is between inventories that are too large and those that are too low to prevent stockouts. This is the classic issue relating logistics and supply chain management.

e. Customer orders are what set the supply chain in motion, and fulfilling them efficiently and effectively is the first key step in providing customer service.

f. In traditional manufacturing flow management, firms produced products that were made‐to‐stock and placed in the distribution channel based on historical forecasts. Often the wrong mix of products was produced, resulting in undesired inventory with all the typical costs. Within supply chain management, production is pulled through the plant in response to specific customer needs and requires that manufacturing processes have the flexibility to respond to market changes.

g. Supplier relationship management is the process that defines how a company will interact with its suppliers. Strategic alliances are developed with key suppliers to support manufacturing management and product development. Long‐term partnerships are developed with a small core group of suppliers, thus controlling costs and assuring input quality and an adequate level of inventory.

h. If new products are essential to the success of the firm, then the firm must have a process in place that will identify existing and potential customer needs. It is also necessary to select materials and suppliers in conjunction with the supplier management process and develop the appropriate production technology to integrate into the best possible supply chain for the product/market combination.

i. Returns management is, in a sense, reverse logistics in that it is designed to handle a reverse product flow efficiently and, at the same time, identify opportunities to reduce unwanted returns and control reusable assets.

5226.12 Metrics and data collection

a. Metrics provide a measure of the performance of the supply chain and form the basis for the control cycle. Determining the appropriate metrics to be developed is highly dependent upon the structure of the supply chain.

b. It is important to have metrics that can measure customer satisfaction. These could include such things as fill rates, on‐time delivery, and average time from order to delivery.

c. Metrics used to monitor the reduction of inventory levels are also important. It is estimated that for many firms 30%–40% of inventory value represents dead inventory and results in end‐of‐life write‐offs.

d. It is important to have metrics that measure the ability of the firm to respond to environmental changes. These would include items such as flexibility to change output



in response to demand changes, determining the degree of interdependence between various components of the supply chain, and determining the appropriate level of safety stock.

e. Other problem areas that might create pitfalls to successful supply chain management include:

(1) having an inadequate information system that would preclude participating in the supply chain of potential suppliers or customers.

(2) having an incomplete supply chain that is often missing certain key external elements for dealing with suppliers and/or customers.

5226.13 Supply chain evolution

a. Modern supply‐chain management practices began as a response to the need for large‐scale changes driven by the need for cost reductions driven by Japanese business practices in the 1980s.

b. Early progress was enhanced by the introduction of electronic data interchange (EDI) and evolving internet collaborative information exchange systems.

c. Globalization further enhanced the impact of supply chain management to allow firms to increase competitive advantage and decrease costs by global sourcing.

d. While the core issues related to supply chain management have remained relatively stable, the nature of the delivery of solutions has evolved in the last two decades.

(1) During the 1990s, the key move was increased outsourcing of manufacturing and distribution with companies now dealing with their supply base from above rather than from within the organization. Many firms specialized, and partnership arrangements varied according to the particular market or distribution channel.

(2) The next evolutionary step was specialization within the supply chain into aspects of providing supply planning, collaboration, execution, and performance management. Changing market forces required rapid response, and specialization allowed for honing of particular competencies with an outsourcing technology hosting for supply chain solutions.

(3) The ever‐increasing pace of change and complexity and speed of supply chains resulting from rapid price fluctuations, ever shorter product life cycles, and more offshoring have led to a need for enhanced creativity in information sharing and often a talent scarcity within individual organizations necessary to accomplish the needed changes.

5226.14 Supply chain sustainability

a. Supply chain sustainability deals with the growing incorporation of social concerns and the environment in supply chain value creation.

b. In addition to traditional supply chain functions, sustainability incorporates issues such as:

(1) environmental impact,

(2) social responsibility,

(3) economic stability,

(4) health and safety, and



(5) stakeholder interests.

c. Risk management now is also incorporated into supply chain management to deal with considerations such as the following:

(1) New “green”‐oriented suppliers attempting to gain market share as companies redefine their metrics of quality to incorporate sustainability into their supply chain decisions

(2) Firms beginning to think about the environmental impact through the entire product life cycle and communicating their desires down the supply chain

(3) From a financial perspective, firms becoming more attuned to the long‐term ability of their suppliers to succeed financially

(4) The growing concern of a changing legal and regulatory environment that will force change through regulations such as imposing a “carbon tax”

5230 Financial Risk Management

5231 Market, Interest Rate, Currency, Liquidity, Credit, Price, and Other Risks

5231.01 What is financial risk management?

a. Financial risk management is the process of dealing with uncertainties resulting from events in the financial markets. It involves assessing the financial risks facing an organization and developing and implementing management strategies and policies consistent with the organization’s internal priorities and policies.

b. A firm must decide which risks are acceptable and which are not to optimize the amount of risk it is willing to accept, recognizing that a passive strategy of no decision means accepting all risks by default.

c. Whatever strategies are adopted, they need to be evaluated, monitored, and refined as market conditions change.

(1) Changes to be monitored include changes in market rates, changes in the business environment, and changes in international or political considerations.

(2) Effective monitoring often requires working with tactical risk takers such as portfolio managers.

5231.02 Financial risk management is one component of the concept of enterprise risk management of the firm, which includes items such as the following:

a. Business risk: the uncertainty associated with the ability to forecast EBIT due to factors such as sales variability and operating leverage

b. Operations risk: the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events

c. Supply‐chain risk: the potential disruptions to continued manufacturing production and thereby commercial financial exposure

d. Product liability risk: the responsibility of the firm or vendor of goods to compensate for injury caused by defective merchandise that it has provided for sale



e. Political and economic risk: the risk that a government buyer or a country prevents a transaction from being completed, or fails to meets its payment obligations; and/or the risk associated with the overall health of the economy

5231.03 Key elements of financial risk management include the following:

a. Interest rate risk: the risk to earnings or capital arising from changes in interest rates

b. Liquidity risk: the risk that clearing or settlement payments will not be made when due, even though counterparties do have sufficient assets and net worth ultimately to make them. There is an inability to convert assets to cash in a timely fashion.

c. Foreign currency risk: the uncertainty of the value of net income that would result from the variability of the market value of foreign‐currency‐denominated assets and liabilities due to fluctuating exchange rates

d. Credit risk: the risk that the counterparty will not meet an obligation when due and will never be able to meet the obligation at full value. Bankruptcy is a primary source of such risk, and losses are associated with loss of principal and foregone interest.

e. Default risk: the risk that the counterparty will default on clearing obligations. This risk is often related to the liquidity risk and/or credit risk inherent in the transaction.

f. Systematic risk: the risk that inherently exists in the market in which a firm operates. It cannot be reduced or eliminated through diversification.

g. Counterparty risk: the inability of a counterparty to meet its commitments

The Risk Management Process

5231.04 The risk management process includes the strategies that allow a firm to manage its risks related to participating in financial markets.

5231.05 The firm has a choice to accept, transfer, or manage risk.

a. Management may choose to absorb the potential impact of volatility on earnings, assuming that over time the eventual upside may outweigh the short‐term downside.

b. A risk manager may attempt to transfer the risk along the supply chain. This would involve shifting the risk to the end customer or to suppliers.

5231.06 The risk management process includes an understanding the requirements for valuation of derivative securities and applicable accounting regulations per FASB ASC 815 or IAS 39. Often a firm will attempt to manage the risk through the use of some form of hedging program. (A hedge is a strategy to insulate a firm from exposure to price, interest rate, or foreign exchange fluctuations.)

5231.07 The risk management process includes both internal and external controls, and involves:

a. identifying and prioritizing risks and understanding their relevance.

b. understanding the stakeholder’s objectives and their tolerance for risk.

c. developing and implementing appropriate strategies in the context of a risk management policy.

5231.08 The risk management process requires understanding the interconnectedness among and between the basic components of economics, accounting, and control.



a. Economics requires being able to measure the risk before attempting to manage it.

b. The control function provides the needed guidelines for the hedging activity and any necessary oversight.

c. The accounting function requires understanding the requirements set forth in FASB ASC 815. As per the FASB, the following points relate to FASB ASC 815:

(1) Under FASB ASC 815, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

(2) For a derivative designated as hedging, the exposure to changes in the fair value of a recognized asset or liability, or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

(3) For a derivative designated as hedging, the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

(4) For a derivative designated as hedging and the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available‐for‐sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign‐currency‐denominated forecasted transaction.

(5) For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.

5231.09 Special issues facing small businesses

a. Small firms have problems with various components of the financial risk management process that are effective for larger firms. While these problem areas exist for large firms as well, the specific problems facing smaller firms relate to dealing with the problems in a manner consistent with the firm’s resource capabilities, and include the following:

(1) The fact that small firms are unable to use broader capital markets (i.e., expand past the use of banks as a source of funds) because investors in these markets require higher rates of return on what would appear to be riskier investments (i.e., the investor would have little ability to assess the creditworthiness of the firm).

(2) These firms are generally unable to diversify their operations (i.e., reduce business risk).



(3) Such firms usually have few suppliers and/or the clout or logistical ability to purchase from a large number of vendors (i.e., unable to reduce supply‐chain risk).

b. A smaller firm must understand its full economic exposure to foreign exchange or interest rate risk and identify the degree to which there are any natural offsetting positions in its operations to take advantage of any benefits of diversification that exist. (Economic exposure is defined as the degree to which a firm’s present value of expected future cash flows can be impacted by unanticipated exchange rate fluctuations.)

c. If the firm chooses to hedge, they must be certain to use a derivative that is specifically related to the risk in question. Risks dealing with cash flow from operations are often best dealt with options (a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame). More predictable asset positions often are best dealt with forwards and futures.

d. Speculation with derivatives should never occur. It is helpful to employ some outside entity to monitor any hedge or derivative positions that are held.

Interest Rates

5231.10 Introduction to interest rates

a. Interest rate risk arises from differences between the timing of interest rate changes and the timing of cash flows (re‐pricing risk); from the risk that changes in interest rates will re‐price interest‐incurring liabilities differently from re‐pricing the interest‐earning assets, thus causing an asset‐liability mismatch (basis risk); from changing rate relationship across the spectrum of maturities (yield curve risk); and from interest rate‐related options embedded in a financial institution’s products (option risk).

b. An evaluation of interest rate risk must consider the impact of complex, illiquid hedging strategies or products, and also the potential impact on fee income that is sensitive to changing interest rates.

c. Re‐pricing risk is the most common form of interest rate risk and some firms make a bet on the typical upward‐sloping nature of the yield curve and deliberately mismatch the portfolio by holding longer‐duration assets when compared to liabilities in an attempt to enhance earnings.

d. Basis risk may be seen in the following example. A retail bank generally funds loans from customer deposits. Thus, since loan rates tend to adjust upward more rapidly than deposit rates, there is a tendency for interest margins to increase spontaneously when rates are rising. However, as rates stabilize, the improvement may disappear as deposit rates catch up, and then interest margins would fall when rates began to decline.

e. Yield curve risk arises from variations in interest rate moves along the yield curve, such as different changes for the 90‐day T‐bill and a 10‐year Treasury bond. The yield curve flattens, steepens, or becomes inverted during an interest rate cycle. These types of changes tend to accentuate the possible impact of any asset‐liability mismatches held by the firm.

f. Option risk arises from legal rights to engage in a future transaction at a predetermined price (puts and calls). The owner of a put option has the right, but not the obligation, to sell a given quantity of an underlying asset at a specified strike price during a specified period to the seller of the put if the option is exercised. These protect against the risk of a decline in market value of the underlying asset.



For example, a farmer is concerned that the market price of a growing crop may decline before harvest. The farmer can buy a put option to guarantee a minimum price. If the price declines below that price the option is exercised and the crop sold for that minimum price. Of course, if after harvest the price is above the floor, the farmer has no obligation to sell the crop at the floor and will happily sell it for the higher market price.

The owner of a call option has the right, but not the obligation, to buy a given quantity of an underlying asset from the seller of the option during a specified period for a specific strike price. The seller of the option is obliged to sell the underlying asset if the option is exercised.

For example, an airline has sold a number of tickets for future flights assuming the cost of jet fuel stays constant, but a large increase in the cost of jet fuel would make those future flights uneconomic. The airline can buy a call option on the price of jet fuel in the future, giving the airline the right to buy the fuel at a maximum price. If the price of fuel rises, the airline will exercise the option, buying the fuel at the strike (maximum) price. If future jet fuel prices remain below the maximum price, the airline is not obligated to buy the fuel at that strike price. Instead, the airline will buy the fuel at the lower market price, saving the difference in cost.

5231.11 Various interest rate formulas and their uses

Short‐term debt is that debt that will be repaid within one year. Interest rates on short‐term bank debt are calculated in a number of ways, including the following:

a. Basic interest is calculated on an annual basis using the stated rate of interest.

Illustration: The customer takes out a $10,000 loan with a one‐year maturity and a 10% interest rate. The basic interest is:

Basic interest rate = Interest Amount borrowed = $1,000 $10,000 = 10%

b. Interest is discounted (discounted interest) when the amount of interest to be collected during the life of the loan is subtracted from the loan proceeds, with the customer repaying the loan principal amount.

Illustration: The customer takes out a $10,000 loan with a one‐year maturity and a 10% interest rate. The interest for the year is $1,000 and the individual receives $9,000. The

effective interest rate on the loan is 11.11% ($1,000 $9,000).

The add‐on interest method is one where interest is calculated on the full amount of the original principal. The calculated interest is added to the principal and the payment is determined by dividing the sum of principal plus interest by the number of payments to be made. The add‐on interest rate can be calculated as follows using the following example:

(1) Approximate add‐on annual rate = Interest paid (Amount received 2)

= $1,000 ($10,000 2) = $1,000 $5,000 = 20%

(2) Add‐on effective rate = (1 + i)n - 1 = (1 + .0167)12 - 1 = 1.2199- 1= 22%

(If the approximate annual rate is 20%, then the monthly rate is 1.67% (or 20% ÷ 12)).



Simple interest is computed on the remaining outstanding balance using the daily periodic rate times the number of days since the prior payment.

c. Under certain situations with add‐on loans where interest is paid according to the Rule of 78s, the monthly payment is allocated first to the payment of interest and then to principal. If the amount of interest due is greater than the amount of the payment, the difference would be added on to the loan principal and is termed negative amortization. This can commonly occur on longer‐term loans such as 15‐year mobile home loans.

(In the Rule of 78s, 78 is equal to the sum of the digits from 1 to 12. For an annual installment loan, 12/78ths or 15.4% of the interest due on the loan would be charged to the first payment before anything was credited to principal. This concept can be applied to installment loans of any maturity by summing the digits of the number of payments. For example, a 15‐year loan with monthly payments would sum the digits from 1 to 180.)

d. Miscellaneous considerations:

(1) Compound interest involves the paying or charging interest on interest. The most common usage relates to the effective return on deposits. Federal legislation in 1991 (the Truth in Savings Act) was designed to provide consumers with information that would allow them to be able to compare the effective yield on alternative instruments.

Illustration: Assume that an individual deposits $10,000 in a one‐year certificate of deposit paying 6% interest. If interest is compounded annually, he would receive $600 in interest. If the interest were compounded semi‐annually, there would be two payments received. The first payment would be $300 and the second payment would also include interest on that $300 and the consumer would receive $609. Quarterly compounding would result in interest earnings in the amount of $614, and daily compounding $618.

(2) 360‐day vs. a 365‐day year. Many credit card issuers compute the daily periodic rate using a 360‐day as opposed to a 365‐day year, yet charge interest for 365 days. This has the result of increasing the effective annual rate on a loan. (The effective annual interest rate is the investment’s annual rate of interest when compounding occurs more often than once a year.)

Illustration: Assume that you have an 18% loan. With a 365‐day year, the daily periodic rate would be 0.0493%, while with a 360‐day year the daily periodic rate would be 0.05%.

(a) Effective interest rate using a 365‐day year with a 365‐day daily periodic rate:

((1 + 0.000493)365 - 1) = 19.71%

(b) Effective interest rate using a 365‐day year with a 360‐day daily periodic rate:

((1 + 0.0005)365 - 1) = 20.02%

5231.12 Why interest rates differ

a. There is risk that the borrower will not repay the loan in a timely fashion. The greater the likelihood that the borrower will default on the loan, the higher the interest rates will be in order to compensate the lender for bearing that risk.

b. Interest rates tend to be higher for longer‐term loans. Borrowers tend to like the certainty of a known fixed expense. Lenders are concerned about the possibility of an



increase in their cost of funds over the period of the loan and charge a premium to compensate for this risk.

c. There are fixed and variable costs associated with making loans. There tend to be high administrative and processing costs associated with making loans. The costs tend to be higher per dollar loaned for smaller loans and for loans that require more frequent payments. This causes effective interest rates on smaller loans to often be higher than on larger loans issued at the same time.

5231.13 Role of interest rates

Interest rates have a significant impact on the level and composition of investment goods purchased and the level of spending for research and development (R&D).

a. Lower interest rates encourage an increase in business investment. This would cause a firm to expand output and increase capital spending once the firm no longer has idle capacity. The reverse would be true if interest rates increase. The Federal Reserve can influence rates in an attempt to influence the level of economic activity.

b. Interest rates are the price of money and serve to ration the supply of available loanable funds to projects with the highest rate of return. The rationing is not perfect, however, because firms with market power and/or a strong financial position are able to obtain funds at lower rates, which gives them an advantage over other firms that might have more profitable projects but a relatively weak financial position.

Lower interest rates tend to make R&D expenditures more profitable. Thus, lower rates would cause firms to increase such expenditures.

5231.14 Determination of interest rates

The use of credit has become ubiquitous in the American economy. Individuals and households receive credit when they take out mortgage and auto loans and use credit cards. Many times it is difficult to determine the interest rate being paid on such loans. Truth‐in‐lending laws, which were passed in 1968, were passed to provide consumers with a method for comparing the true cost of loans.

5231.15 Methods for quoting rates of return

There are a myriad of methods for computing the rate of return on a loan. Returns on loans such as mortgage loans and bonds that have regular periodic payments are quoted in terms of annual percentage rates (APR). This APR can be translated into an effective annual rate (EAR).

a. APR = Period interest rate Number of periods per year. The period interest can be defined as semi‐annual, quarterly, monthly, etc. For example, if the monthly rate is

1.5%, then the APR would be 18% (1.5% 12 months).

b. To compute the effective annual rate (EAR) we would use the following formulas:

EAR = ((1 + Rate per period)2 – 1), where the rate per period = APR/2, or

APR = ((1 + EAR)1/n – 1) n, where n is the number of periods

5231.16 Bond prices and yields

Since bond cash flows occur in the future, the price an investor is willing to pay for those payments depends on the value that can be received compared to the value of the dollars today. The nominal rate of return is a combination of the risk‐free rate plus a premium for expected inflation. The value of a bond can be computed as follows:



Bond value = PV of the interest payments + PV of par value

And, given a particular maturity, t, and a discount rate, r, the bond value can be defined as:

Illustration: Assume that there is a bond with a 6% coupon, 20‐year remaining maturity with a $1,000 par value, paying 40 semiannual payments of $30 each. If the market interest is equal to the coupon rate (6%), the value of the bond can be calculated as:

The interest payments represent an annuity, and the final payment is a lump‐sum payment. If the market interest rate were equal to the coupon rate, the price of the bond would be equal to the par value as shown above. If, however, the market rate was 8%, the value of the bond would decrease due to the fact that the bondholder would still be getting only the $30 semiannual payments. Given these circumstances, the bond’s value could be calculated as:

5231.17 Usury laws

Many states have usury laws that set a maximum rate that can be charged for a certain type of credit. Such laws are designed to limit the cost of credit.

a. Today, many of these laws are designed to place a ceiling on the rates charged for “payday loans” or “title loans,” where these lenders often charge effective annual rates in excess of 400%.

b. If the state usury limits are restrictive enough, this type of lender often simply would not offer this type of loan in a state with such limitations.

c. Since interest rates (price) no longer ration funds, less creditworthy borrowers will be excluded from the market, and thus the credit for lower‐income borrowers will be reduced.



5232 Means for Mitigating/Controlling Financial Risks

5232.01 Mitigating financial risk from a regulatory perspective

a. In the new financial risk framework, regulators need to be more counter‐cyclical in their approach toward devising regulatory arrangements. Approaches being developed see regulators acting transparently to change capital requirements for market participants when early warnings of market “bubbles” first appear.

b. Regulators need to recognize capital as a “shock absorber” to deflate bubbles before they burst and to then allow capital “drawdowns” during periods of market stress, with the understanding capital will be replenished as market conditions improve.

c. There is a strong need for increased cooperation between national jurisdictions that would:

(1) develop an agreed‐upon risk management policy for key marketwide risk indicators.

(2) manage and monitor risk indicators within that policy.

(3) publicly report macro‐risk indicators.

(4) facilitate risk identification and communication with appropriate decision makers, at both national and international levels.

Mitigating Financial Risk at the Firm Level

5232.02 There is growing consensus that the regulatory framework should apply a set of comprehensive risk management concepts that include key concepts used by insurance regulators and actuaries that use a “control cycle” approach:

a. Incorporating allowances (risk margin) for extreme or outlier events (i.e., black swan events):

(1) Traditional regulatory approaches previous to the 2008 financial crisis did not identify or lessen critical risk concentrations (e.g., the level of collateralized debt obligations (CDOs)).

(2) Historically, there has been inadequate capital support at both the system and individual institution level for accepting such risks that resulted in a significant underpricing of the risks as the 2008 financial crisis began.

(3) There must be an ability to track risk in the unregulated financial sector.

(4) There should be development of models that track the expected level of loss from an expected event rather than the current “value at risk” (VAR) approach that only measures the minimum amount of loss from a low‐probability event.

Note: A “black swan” event has a high impact, is hard to predict, and is a rare event that is beyond the realm of normal expectations in history, science, finance, and technology. The result is that there is a noncomputability of the probability of the consequential rare events using scientific methods owing to their very nature of small probabilities. A collateral debt obligation (CDO) is a type of structured asset‐backed security (ABS) whose value and payments are derived from a portfolio of fixed‐income underlying assets. The portfolio of fixed‐income assets are rated at different levels of risk with some collateralized debt obligations invested in subprime mortgage bonds.

b. There should be requirements for specific financial condition reporting.



c. There should be an independent sign‐off of liability and provisioning for regulatory purposes by someone such as an actuary who is subject to professional codes of conduct, and that individual should have the freedom and capability to take an objective view that may differ from management. This would be made possible by enforceable professional codes of ethics with disciplinary standards.

The incentive structures within the industries should not distort the proper evaluation of risk:

(1) Capital requirements should be increased for any market participant where remuneration and incentives focus excessively on short‐term results.

(2) Regulators should develop a deep understanding of the risk culture within a particular enterprise that often might mitigate against timely reporting of critical information.

(3) The concept of “risk margin” developed by actuaries to measure the value of illiquid assets should be used.

5232.03 Improved firm risk management practices

Reporting risk measures should require applying a total balance sheet approach, which evaluates on a consistent basis:

a. the amount of capital required to support the assets and liabilities of the business (given all the commitments and obligations to stakeholders).

b. increasing the actual level of capital available from time to time after excluding all interests that are not at “arm’s length.”

c. looking at what could happen in the future that requires sensitivity testing as to the potential value of assets and/or liabilities as market conditions change.

5232.04 The control cycle used by actuaries includes the following:

a. Modeling expected results using a set of initial assumptions

b. Doing a profit test to determine if the product provides a positive contribution margin

c. Measurement of actual results

d. Determination in both quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results, and determining what actions need to be taken with respect to the product, including adjusting the reserves that might need to be held

e. Use of the findings to strengthen the model and update the assumptions as necessary with a feedback into the profit test (item b. above)

5232.05 Risk margin

a. The concept of risk margin is related to the insurance industry and is generally defined as a component of insurance liabilities that is established in addition to best estimate liabilities.

b. Risk margin reserves tend to create a cushion to cover any fluctuations or misestimation of errors in best estimate liabilities (reserves) and to cover risk of fluctuations under “normal situations” with required capital serving as a buffer against more extreme black swan events.



c. The risk margin covers risks linked to the future liability cash flows over their whole time horizon. It should be determined in a way that enables the (re)insurance obligations to be transferred or put into run‐off.

d. The goal is to have the concept of risk margin be made applicable to determining potential losses in the more broadly defined financial risk areas as well as to insurance.

5232.06 Exchange rates and risk

a. Arbitrage is an action undertaken to capitalize on inefficiencies in financial markets. It is a response to the belief in the “law of one price” that states that a product should sell for the same price in all markets, less the cost of transfer between markets. Arbitrage involves buying in the low‐priced market and reselling in the high‐priced market. The increased demand in the low‐priced market causes the price to increase and the increased supply in the high‐priced market causes the price to decline. Arbitrage profits are available until the two prices are equal.

b. Speculation is an attempt to use what is believed to be relevant information to “outguess the market.” Financial transactions in foreign exchange markets are very sensitive to market expectations regarding exchange rates. The decision to hold securities denominated in any particular currency is generally tied to expectations concerning the market value of the currency. If news causes expectations concerning currency values to change, it will affect the supply or demand for the particular currency, and thereby exchange rates.

5232.07 Exchange rate systems and practices

a. The exchange rate is simply the price of one currency expressed in terms of another. For example, assume that the exchange rate between the dollar and the yen is expressed as $1 = 120 yen. This could also be expressed as 1 yen = $0.008333 ($1/120).

b. Exchange rates are determined by the interaction of supply and demand for the various foreign currencies in foreign exchange markets. If the demand for a nation’s currency increases, the price of the currency will appreciate. If a currency appreciates, it increases in value in terms of the other currencies. In this instance, if the yen were to appreciate, it would take fewer yen to buy a dollar. For example, as the yen appreciates, the exchange rate might fall to $1 = 110 yen. This would make Japanese exports more expensive for American consumers. If the supply of the nation’s currency increases, the price of the currency will depreciate or decline in value in terms of other currencies.

c. Exchange rate determinants include the following:

(1) Changes in consumer tastes for the products of a particular country. If consumers wish to buy more products from a country, they will increase the demand for that country’s currency.

(2) Relative income changes. If, for example, disposable income rises more rapidly in Europe than in the United States, all other things being equal, Europeans will demand more American goods. The demand for dollars will increase and the supply of euros that will be required to purchase the additional dollars will increase.

(3) Relative interest rates. Suppose that real interest rates rise in the United States while they stay constant in Europe. Europeans will find the United States a more attractive place to make financial investments in fixed‐income securities and will increase the supply of euros.



d. Over time flexible exchange rates will adjust and eliminate balance‐of‐payments surpluses or deficits between two nations. Disadvantages of flexible exchange rate systems include:

(1) a flexible exchange rate produces uncertainty in the future price of a foreign currency and reduces the amount of trade.

(2) if a country’s currency strengthens, it will need to export fewer goods and services to get a specific level of imports from another country. Thus, in this instance, it would be said that the country’s terms of trade have improved.

5232.08 Fixed exchange rate system

a. Governments determine specific boundaries within which they will allow their currency’s exchange rate to fluctuate and commit to making economic policy adjustments which maintain the exchange rate within those limits. A government cannot do anything directly to stop changing patterns of the supply and demand for its currency in international financial markets.

b. The advantage of a fixed rate system is that multinational companies (MNCs) would be able to engage in international trade without worrying about exchange risk.

c. A key disadvantage of the fixed exchange rate system is that a government, faced by economic pressures, will choose to alter the value of its currency. While the exchange rate does not fluctuate on a regular basis, it may be revalued or devalued by a significant amount unexpectedly.

5232.09 Managed float system

Today most countries allow the value of their currency to float, but at times intervene in the market when exchange rate changes are counter to national objectives. Some nations peg their currency to the dollar and then allow their currency to fluctuate against other currencies as the dollar fluctuates. The key reasons for intervention are:

a. to smooth exchange rates, that is, to minimize volatility.

b. to respond to temporary disturbances that cause undesired exchange rate movements.

5232.10 Exchange rate determinants

a. Changes in demand and/or supply of the currency: As the demand for a currency increases, the exchange rate will also increase. As the supply of a currency increases, the exchange rates will decrease.

b. Changes in consumer tastes: If consumers desire a foreign product, the demand for that product and the resulting increase in demand for the foreign currency will affect exchange rates.

c. Relative income changes: As incomes rise, the demand for imports increases, thus having an effect on exchange rates.

d. Relative price changes: As prices decrease for a particular foreign product relative to domestic prices, the demand for that product will increase, thus having an effect on exchange rates.

e. Relative interest rates: As interest rates increase in a given country, interest in investing in securities in that country rises. As investing activities increase, the supply and demand for those currencies are affected as well as the exchange rates.



f. Relative inflation rates: Changes in inflation can have an effect on international trade activity. The changes in this activity will in turn influence the supply and demand for various currencies, resulting in changes in exchange rates.

g. Government controls: Governments can influence exchange rates by imposing exchange and trade barriers, buying and selling securities in foreign exchange markets, and changing interest rates in their home country.

5232.11 Mitigating risk related to dealing with foreign currencies

a. MNCs (multinational companies) constantly face the decision as to whether or not to hedge future payables and receivables. Often these decisions are based on the magnitude of the potential risks and the firm’s forecast of future foreign exchange rates.

b. Short‐term financing decisions: Firms that borrow often have access to loans denominated in several currencies. A favorable choice would be to borrow in the currency where market interest rates are low and the value of the currency is expected to weaken in value over the term of the loan.

c. Short‐term investment decisions: Firms often have significant amounts of excess cash available for short periods of time and can choose to make their deposits in a variety of currencies. A favorable choice for the deposit would be in a market with high interest rates where the value of the currency is expected to strengthen during the term of the deposit.

d. Capital budgeting decisions: As an MNC assesses the viability of investing in a foreign project, it must account for the fact that the project may generate cash flows that periodically must be converted to another currency. The analysis can only be completed when the estimated cash flows are ultimately measured in the parent’s local currency.

e. Long‐term financing decisions: Corporations that issue bonds may wish to consider denominating the bonds in a foreign currency. Their preference would be to have the bonds denominated in a currency that would depreciate over time against the currency they are receiving from the sale. Exchange rate forecasts are needed to estimate the expected cost differential from borrowing in different currencies.

f. Earnings assessment: When earnings are reported, subsidiary earnings are consolidated and translated into the currency of the parent’s home country.

5232.12 Forecasting techniques

The fact that firms must make decisions that can be impacted by exchange rate movements suggests that they either explicitly or implicitly make forecasts about exchange rate movements in the decision‐making process. If the firm engages in explicit forecasts, the basic techniques for forecasting include the following:

a. Technical forecasting involves the use of historical exchange rate data to predict future values. This type of forecasting is generally limited to forecasting the near future, which is often not effective for developing corporate policies. This type of forecasting is generally more relevant for speculators who are concerned with day‐to‐day exchange rate movements.

b. Fundamental forecasting is based on the presumed relationship between exchange rates and economic variables. This forecasting methodology is subject to a series of limitations, including:

(1) the precise timing of the relationships predicted by the regression model cannot be determined.



(2) some of the data for which relationships have been determined cannot be obtained in a timely manner so that it would be usable for current forecasts.

(3) the probability of many events that have an impact cannot be readily quantified.

(4) regression coefficients that are obtained from the forecasting model are often not constant over time.

c. Market‐based forecasting starts from the premise that financial markets provide an unbiased estimate of future events, and uses either the spot rate or the forward rate.

(1) Illustration: For example, if the current spot rate shows that the Japanese yen is expected to appreciate against the dollar in the very near future, this should encourage speculators to buy the yen with U.S. dollars today in anticipation of its appreciation. These purchases would tend to drive the yen’s value up at once and, therefore, the current value of the yen should reflect its expected value in the very near term.

(2) The forward rate that is quoted for a specific date in the future is commonly used as a proxy for the forecasted future spot rate on that date. An example would be as follows: If speculators expect the spot rate on the Japanese yen in 60 days to be $1 = 122 yen and the 60‐day forward rate is $1 = 119 yen, they might simply buy yen 60‐days forward at $1 = 119 yen, and then sell them when they are received at the spot rate. If this is the common speculator strategy, then the forward purchases of yen will cause the forward rate to increase until the speculative demand runs its course. Thus, the forward rate reflects the market’s expectations of the spot rate at the end of the period. To the degree that the forward rate is shown to be an unbiased estimate of the future spot rate, then corporations can monitor the forward rate as they develop their exchange rate expectations. Arbitrage activity would tend to eliminate any differential.

Types of Exposure

5232.13 The rationale for forecasting foreign exchange rates is to help the firm make decisions as to whether they should remain exposed to exchange rate fluctuations or if they should attempt to hedge their foreign exchange positions. Forecasting methodologies can be evaluated over time by comparing the actual values of the currencies to those predicted by the forecast over long periods of time.

5232.14 While exchange rates cannot be forecasted with perfect accuracy, a reasonable forecast can allow a firm to estimate its exposure to exchange rate fluctuations. To the degree that a firm discovers that it is highly exposed, it then can begin to consider approaches to reduce the exposure.

5232.15 Transactions exposure is simply defined as the degree to which the value of a firm’s future cash transactions can be affected by exchange rate fluctuations. It can be measured by determining (1) the projected net amount of inflows or outflows in a particular foreign currency and then (2) the overall risk of exposure for each of the currencies.

a. Exposure to “net” cash flows: Forecasts of net cash flows tend to be for relatively short periods where the anticipated cash flows can be predicted with reasonable accuracy. Such predictions require a reasonably sophisticated information system to track the positions in the various currencies.

The firm needs to project a consolidated “net” position in the currency. These positions must be converted into dollars so that the firm can measure the exposure in each



currency using a standardized measure. Since the actual level of period cash flows and end‐of‐period exchange rates are unknown, it would be reasonable to construct a range of estimates for both cash flows and exchange rates.

b. The firm may not have its own method for forecasting end‐of‐period exchange rates, but at a minimum the firm can use historical data to measure the degree of currency variability. The standard deviation measure is a common way to define the variability of a particular currency. Currency variability can change over time, and use of this method would require periodic updating of the measure.

The key is to determine how each individual currency could affect the firm by assessing the standard deviations and correlations between the various currencies over the period of the transaction.

5232.16 Managing transactions exposure

a. The firm should identify the net transaction exposure on a currency‐by‐currency basis. This data would be gathered from all subsidiaries.

b. If possible, a firm may be able to modify its pricing policy. For example, by invoicing its exports in the same currency that would be needed to pay for imports, or in its domestic currency, the exchange rate risk could be shifted to the foreign firm.

c. To the degree that the firm cannot match the inflows and outflows with foreign currencies, hedging should be considered.

5232.17 Currency correlations: The correlation coefficient measures the degree to which the two currencies move in relation to each other. Over the long run, the correlations tend to be positive, which indicates that currencies tend to move in the same direction against the dollar, albeit not in the same magnitude. This information would help the firm determine the degree to which they have transaction risk among and between various currencies to which they might be exposed. For example, if the firm has exposure with the Swiss franc and the Japanese yen, and those two currencies are correlated vis‐a‐vis the dollar, then an expected inflow of Swiss francs can serve as a partial offset against an expected outflow of Japanese yen.

5232.18 An alternative method to assess exposure would be the value‐at‐risk (VAR) measure that would combine the methods above to predict the potential maximum one‐day loss for a firm that is exposed to exchange rate fluctuations. In this instance, the firm might have a policy that would trigger hedging activities if the VAR reaches a certain magnitude.

5232.19 Economic exposure measures the degree to which a firm’s present value of expected future cash flows can be impacted by exchange rate fluctuations. As an example, a firm’s local sales in its home country would be expected to decrease if its home currency appreciates because the firm will face increased foreign competition as foreign substitute products will now be cheaper in terms of the local currency. At the same time, cash inflows on exports denominated in the local currency will decline due to the appreciation of the currency since foreign importers will need more of their currency to pay for their imports.

5232.20 We must note that if a firm’s local currency depreciates, it would be impacted in the opposite direction from when the currency appreciates. Local sales would be expected to increase due to reduced foreign competition, and their exports denominated in local currency will appear cheaper to importers, which will lead to increased foreign demand for their products.



On the cost side with regard to cash outflows, imported supplies denominated in the local currency will not be directly affected by exchange rate movements. However, the cost of supplies denominated in foreign currencies will rise because more of the depreciated currency will be needed to acquire the foreign currency needed to make the purchase.

5232.21 Even firms that are not involved in foreign sale of goods or purchase of foreign supplies may be subject to economic exposure due to the impact of exchange rate movements on the price of substitute goods offered by foreign competitors in their local markets. The degree of economic exposure is likely to be much greater for multinational corporations (MNCs). An MNC needs to assess the degree to which economic exposure exists and then make a determination as to whether or not they wish to attempt to insulate themselves against it. Economic exposure can be measured by the following:

a. Sensitivity of earnings to exchange rates: This method involves classifying cash flows into specific income statement items and then making a subjective prediction about the value of these items based on an exchange rate forecast. The base forecast then can be compared with alternative exchange rate forecasts. Comparing the resulting income statements would allow the firm to assess the impact of exchange rate movements on earnings and cash flows.

b. Sensitivity of cash flows to interest rates: This method involves using regression analysis of historic cash flows and comparable exchange rates. The following formula illustrates:

ttot eaPCF 1

PCFt = Percentage change of inflation‐adjusted cash flows measures in the home

country currency over period t et = Percentage change in exchange rate of the currency over period t μt = Random error termα0 = y‐intercepta1 = Slope coefficient

The regression coefficient (a1) indicates the sensitivity of PCFt to et. This method is valid if the firm expects no major adjustments to its operating structure.

5232.22 Translation exposure is the exposure of the MNC’s consolidated financial statements to foreign exchange fluctuations. A subsidiary’s earnings are translated into the reporting currency and, therefore, are subject to exchange rate fluctuations.

There are some questions concerning the relevance of translation exposure, with arguments in favor including the following:

a. Cash flow perspective: The key consideration is the degree to which a subsidiary would remit earnings to the parent. If the earnings are retained by the subsidiary and reinvested if feasible investment opportunities exist, then the earnings would not be converted and sent to the parent. If a portion of the earnings are remitted, or expected to be remitted in the future, then it could be expected that future cash flows could be adversely affected if the foreign currency is weakening.

b. Stock price perspective: Investors tend to use expected future earnings forecasts to derive an expected value per share. If an MNC conducts a large portion of its business in foreign countries that have changing exchange rates that are expected to negatively affect the translation of future earnings, then it is likely that the market stock price for the MNC will decline.

5232.23 Determinants of translation exposure



a. Proportion of business conducted through foreign subsidiaries: The larger the percentage of the firm’s business conducted by foreign subsidiaries, the larger the percentage of a given financial statement item that is likely to be susceptible to translation exposure.

b. Location of foreign subsidiaries: Since the financial statements of a subsidiary are typically measured in the subsidiary home currency, the correlation between that currency and the parent’s home currency will determine the degree to which translation exposure is likely to become a problem.

c. Accounting methods used: Many of the important rules for financial statement consolidation for U.S.‐based firms are found in FASB ASC 830. Under FASB ASC 830, consolidated earnings are sensitive to the functional currency’s weighted‐average exchange rate.

5232.24 Managing transaction exposure

Transaction exposure exists when the future cash transactions of a firm are impacted by exchange rate fluctuations. The problem arises when a firm knows the amount of the foreign currency it will need to complete the transaction but not the amount of domestic currency that will be required to purchase it. Once the degree of transaction exposure is measured, if the firm decides to hedge all or part of the exposure, it must then choose among the various hedging techniques that are available.

There is one possible non‐hedging possibility that might be available to the firm to manage the exposure. Depending on the negotiating strength of the two parties involved in the transaction, it might be possible for the firm to invoice the transaction in the currency that will be used to pay for the import, effectively shifting the transaction exposure to the exporter.

Techniques to eliminate all or part of transaction exposure:

a. Future hedges: A firm buys a currency futures contract that gives the firm the right to receive a specified amount of a specified currency for a given price on a specific date. By buying such a contract, the firm is able to lock‐in the amount of the foreign currency needed to make the expected payment. These contracts are designed to hedge currency needs in the short term.

A firm could sell a futures contract if it desired to sell a specific amount of a specified currency for a stated price on a specific date. This type of hedge might be used to hedge future receivables denominated in a foreign currency.

b. Forward hedge: A forward hedge is very similar to a futures hedge except that it is designed to be used by large corporations who have relatively large positions to hedge. These hedges are negotiated between the corporation and a commercial bank with the contract specifying the currency, the exchange rate, and the settlement date. These contracts may be used to either purchase or sell foreign currency with a company that needs foreign currency in the future. A company expecting to need to sell currency in the future would negotiate a contract to sell the currency forward to lock in the rate at which the currency can be sold.

c. Money market hedge: This type of hedge involves the firm taking a position in domestic or foreign money markets to hedge a payables or receivables position.

d. Currency option hedge: This type of hedge ideally would insulate the firm from adverse foreign exchange movements, but also allow the firm to benefit from favorable exchange rate movements if the currency does not move in the expected manner during the hedging period. This could create a situation where not hedging a position could



produce a better outcome than hedging. A currency option hedge resolves this problem by allowing the firm to hedge the exchange risk, and at the same time participate in any gains that might result from unexpected currency fluctuations.

5232.25 The techniques described in section 5232.24 could be used in the following fashions to hedge specific transaction exposures:

Hedging Technique

Hedging Receivables Hedging Payables

Futures Hedge A currency futures contract could be sold in the local currency in the amount of the particular receivable.

A currency futures contract could be purchased in the local currency in the amount of the particular payable.

Forward Hedge A forward contract could be negotiated in the foreign currency to sell the amount of the receivable.

A forward contract could be negotiated in the foreign currency to purchase the amount of the payable.

Money Market Hedge

Borrow funds in the denominating currency of the receivable, convert the loan to the local currency, and invest it. When the receivables are received, the loan is then paid off with the cash inflows.

Borrow funds in the local currency of the payables, and invest the funds until they are needed to meet the payable obligation.

Currency Option Hedge

A currency put option is purchased in the local currency for the amount related to the receivables.

A currency call option is purchased in the local currency for the amount related to the payables.

5232.26 Mitigating risks related to changing interest rates

a. Interest rate risk is the risk of holding fixed interest‐bearing instruments such as a bond when interest rates are changing. The price of long‐term securities is more sensitive to changes in interest rates than the price of short‐term securities. There is an inverse relationship between the direction of the change in interest rates and the price of the fixed interest‐bearing security.

b. Although a nonfinancial firm will usually report its bonds on issue in financial statements at their market value at the time of issuance less premium or discount amortization, early redemptions must be done at the market value. These amounts may be significantly different as interest rates will change the value of fixed‐rate debt. This risk is not commonly considered by most nonfinancial firms.

c. This risk could be mitigated by hedging or acquiring an offsetting exposure, which could be a derivative such as an option, a futures contract, or a swap, or by acquiring an offsetting asset or liability.

d. The main reasons for hedging include reducing the volatility in cash flow, avoiding financial distress, or providing predictability. Financial distress could be as simple as a liquidity crunch with an inability to meet short‐term demands on cash, which could ultimately result in bankruptcy. A hedge would reduce the probability of the outcome.

e. A firm is concerned about the uncertainty of cash flows related to asset and liability structure caused by changes in interest rates that impact the value of the assets and liabilities.

f. A firm is concerned about the changes in market value of fixed‐rate assets as market interest rates change.



g. There is a flow risk that relates to the sensitivity of interest rate changes that could be hedged with fair value hedges or a risk on the ability to make interest payments that may be covered by developing a cash flow hedge (a hedge that is the result of the exposure to the variability of cash flow attributable to a particular risk associated with a recognized asset or liability (IAS 39.86)).

5232.27 An example of a cash flow hedge would be to use an interest rate swap to convert variable‐rate interest exposure to a fixed interest rate.

a. The swap is an instrument that, in its usual form, transforms one kind of interest stream to another, such as floating to fixed or fixed to floating. Each swap has two counterparties and, therefore, in each swap one party pays fixed and receives floating, while the other party receives fixed and pays floating.

b. There are two basic forms for a swap:

(1) First, a floating‐rate borrower converts to a fixed rate. In this case, a borrower has floating‐rate bank debt and carries out a pay‐fixed swap, converting the debt to a fixed rate.

(2) Second, a fixed‐rate borrower converts to a floating rate. In this case, a borrower has fixed‐rate bond debt and undertakes a receive‐fixed swap, converting the debt to a floating rate.

c. From an accounting perspective, the changes in the fair value of the interest rate swap would accumulate first in the statement of comprehensive income, and a portion of the gains or losses would be transferred from comprehensive income to the income statement whenever interest is paid on the hedged debt.

5232.28 There is a price risk related to the sensitivity of the market value of assets and liabilities to the level of changes in market interest rates that could be covered by a fair value hedge.

a. A derivative would be used to hedge changes in the fair value (market value) of a fixed‐rate bond that would occur when interest rates move up or down. Hedging the risk associated with a bond’s price risk would be a fair value hedge.

b. An example would be that a firm issues fixed‐rate debt and then uses a swap for floating‐rate debt.

c. The swap would be marked to market. Any change in value of the swap would be recognized as current earnings, and the change in the value of the debt instrument related to change in market interest rates would be recognized on the income statement as earnings.

5232.29 One must be aware of the differences between interest rate‐fixing products (such as a swap) and options:

a. A swap binds its user to the rate that is set when it is transacted. An option gives the buyer the right to walk away if it would be less expensive to do so.

b. So, a firm taking out a pay‐fixed swap after which rates decline is left paying the higher rates. The risk is transformed rather than transferred. Exposure to rising rates has become an exposure to falling rates.

c. Options offer an alternative, but with a cost. The two key factors determining the cost of the option are time (the longer an option has until expiration, the higher the premium) and volatility (the higher the volatility in the underlying risk being hedged, the higher the premium).



d. Both of these factors tend to deter firms from using options, and for longer‐term risk‐transfer alternatives, interest rate swaps are usually chosen.

Mitigating Risks Through the Use of Transfer Pricing

5232.30 Transfer pricing problems

a. Special problems arise when applying the rate of return or residual income approaches to performance evaluations whenever segments of a company do business with each other. One of the difficult issues has to do with the establishment of transfer prices for intracompany sales. A transfer price is the price charged for goods or services by one segment of a company for those goods or services to another segment of the company (intracompany sale).

b. The determination of the transfer price can:

(1) include a “profit,”

(2) include only the accumulated costs to that point, or

(3) be negotiated between the two segments.

c. The problems arise when a division sells the product or service in question to outside companies as well as the sister organization. Since the price charged by one division becomes the cost to the second division, the purchasing division would like the price to be low while the selling division would like the price to be high.

5232.31 Transfer pricing approaches

a. Transfer prices can be set using:

(1) variable costs only or

(2) full absorption costs.

b. Transfer prices can equal current market prices.

c. Transfer prices can be set at a negotiated market price agreeable to both business segments. The negotiated price could be less than, equal to, or more than the current market price. Many times when a negotiated price is used, the selling segment does not have an outside market for the particular product or service.

5232.32 Transfer prices at cost

a. When transfer prices are set at cost, there will be no profits for the selling division for the sale.

b. When cost‐based transfer prices are used, dysfunctional decisions can result since there are no built‐in mechanisms for telling the manager when it is in the best interest of the organization for transfers to be made between divisions. As a result, profits for the company as a whole may be adversely affected if the savings to one segment is less than losses to the other.

c. Illustration: XYZ Company has two divisions, Relay and Motor. The Motor division needs 50,000 relays a year and could purchase them from the Relay division. The following information is available:

Relay division:

(1) Sells relays to the outside for $20 each.



(2) Has $12 of variable costs per relay.

(3) Has the capacity to produce 50,000 relays a year.

(4) Could produce relays for the Motor division for $10 of variable costs per relay since there would be no selling or marketing expenses.

(5) There is only capacity to produce 50,000 relays a year, so production can either be sold to the outside or internally, but not both.

Motor division:

(1) Needs 50,000 relays a year.

(2) Can purchase relays from the outside for $15 each.

(3) Adds $25 of additional variable costs to each motor.

(4) Sells the motors for $60 each.

(5) Has variable costs of $40 per relay. Relay

Division Motor Division

Total

Sales ($20, $60) $1,000,000 $3,000,000 $4,000,000 Less Variable ($12, $40) 600,000 2,000,000 2,600,000

Contribution Margin $ 400,000 $1,000,000 $1,400,000

If the Motor division purchases the relays from the Relay division for $12 each (the Relay division’s variable costs), the contribution margins of the divisions and the total organization will be changed to:

Sale of 50,000 units Relay

Division Motor Division

Total

Sales ($12, $60) $600,000 $3,000,000 $3,600,000 Less Variable ($12, $35) 600,000 1,750,000 2,350,000

Contribution Margin $ ‐0‐ $1,250,000 $1,250,000 Decrease in Contribution Margin $ 150,000

This situation, however, would potentially be different if the Relay division had excess capacity, and the sales to the Motor division at $12 each would not have an adverse effect on the outside sales.

d. Another problem with the above illustration is that the only division to show a profit is the one that makes the final sale to an outside party. Thus, there is little incentive for the first division to control costs since all of the costs are simply passed on to another division. Unless costs are subject to some type of competitive pressure at transfer points, waste and inefficiency almost invariably develop.

e. Despite the shortcoming of setting transfer prices at cost, this method is frequently used. It is easy to understand and highly convenient to use. If, however, transfer prices are based upon costs, standard costs should be used. This will avoid passing on inefficiencies from one division to another.

f. Transfer prices at cost frequently use a cost that includes at least some level of fixed costs. However, there are numerous variations of the definition of fixed costs:

(1) Only selling division fixed costs

(2) Only manufacturing fixed costs for the selling division

(3) Selling division’s fixed costs and corporate costs allocated to the selling division



Obviously, there would need to be an annual allocation rate for the fixed costs in question applied to the units transferred from one division to another if some level of defined fixed costs were to be included in the transfer price.

5232.33 Developing a formula for negotiated transfer prices

a. One method for developing transfer prices between divisions is to set the transfer price equal to the variable costs of the goods being transferred plus the contribution margin per unit that is lost to the selling division as a result of giving up the outside sales. The transfer price computed by this formula is a price based on competitive market conditions.

b. An important point to consider is that the price set by the transfer price formula represents the lower limit for the transfer price. In other words, the selling division must be at least as well off as if it only sold to outside customers.

c. Whenever the selling division must give up outside sales in order to sell internally, it has an opportunity cost that must be considered in setting the transfer price. The opportunity cost is the contribution margin that will be lost as a result of giving up outside sales. Unless the transfer price can be set high enough to cover this opportunity cost along with the variable costs associated with the sale, no transfers should be made.

d. Illustration: The pump division needs 20,000 special valves per year, requiring an unusual production process. The variable costs to manufacture the valve in the valve division would be $20 per unit. To produce the special valve that requires a complicated production process, the valve department would have to give up the production of 50,000 normal valves per year sold to the outside that would provide a contribution margin of $14 per unit. What would be the lowest price that the valve division would be willing to sell the special valve to the pump division?

Solution: The contribution margin that would be lost would be $700,000 (50,000 valves

$14 per unit). Spreading the lost contribution margin over the 20,000 special valves, it can be determined that the lost contribution would be $35 per unit ($700,000 lost

contribution margin 20,000 special valves).

Using the transfer pricing formula:

Transfer price = Variable costs per unit + Lost contribution margin = $20 + $35 = $55 per unit

The valve division would be indifferent to selling the special valve to the pump division and selling the other normal valves to the outside if it received a minimum of $55 per unit. Providing that the pump division cannot purchase the special valve for less than $55 on the outside, it should accept the $55 per unit price.

5232.34 Production for internal transfer by a division with idle capacity

a. When idle capacity exists, the selling division’s opportunity cost may be zero. Depending upon what alternative uses this division might have for its idle capacity it may be advantageous to sell to the purchasing division.

b. Under the idle capacity condition, as long as the selling division can receive a price greater than its variable costs, it will be better off—at least in the short run. As long as the purchasing division can purchase the product for less from the sister division than the current purchase price from the outside, it will be better off and, thus, the corporation as a whole will benefit.



Illustration: Returning to our original illustration, the Motor division (purchasing division) can purchase from the outside for $15. If the Relay division (selling division) has enough idle capacity to meet the purchasing division’s needs and there are no additional outside sales prospects at the current $20 per unit, then the organization will benefit from the transfer. Using the transfer price formula:

Transfer price = Variable costs per unit + Lost contribution margin per unit)

It can be determined that the minimum transfer price should be $12, the variable costs to produce the relays, since there is no lost contribution margin for sales that would not otherwise have occurred. The organization as a whole will benefit if the transfer price is set anywhere within the range of $12 and $15. If the Relay division (selling division) refuses to sell to the Motor division (purchasing division), the company as a whole will lose up to $3 of contribution margin on each unit. This can be summarized as follows:

Sale of 100,000 units (50,000 to the outside

and 50,000 to the Motor division) Relay

Division Motor Division Total

Original sales ($20, $60) $1,000,000 $3,000,000 $4,000,000 Additional internal sales 500,000 ‐0‐ 500,000

Total sales 1,500,000 3,000,000 4,500,000 Less outside sales variable costs ($12) (600,000) (600,000)

Less variable costs for internal sales ($10, $35) (500,000) (1,750,000) (2,250,000) Contribution margin $ 400,000 $1,250,000 $1,650,000

Original contribution margin $1,400,000 Increase in contribution margin $ 250,000

5232.35 International issues and transfer pricing

a. Many multinational corporations (MNCs) have international sales among the components of the organization. That means that transfer prices must be set between divisions and/or subsidiaries that reside in different countries. The MNCs have the same basic transfer pricing issues just discussed; however, there is an additional issue of taxes. Not all governments have identical tax rates; therefore, it is in the best interest of an MNC to use transfer pricing to shift the profit to subsidiaries in countries with lower tax rates when possible.

b. The flexibility to shift profit through the use of transfer pricing may be limited due to the fact that some host governments restrict such transfers when the intent is to avoid taxes. In other words, sales/purchases between subsidiaries of a firm are expected to use the principle of an arm’s‐length transaction when setting prices. There is still, however, a bit of flexibility in setting transfer prices without violating laws or regulations. Even though there is a limited range for setting transfer prices, subsidiaries often can shift costs for technology, research and development, etc. to subsidiaries in countries with high tax rates.

c. Currently, the U.S. tax code requires that transfer prices are “arm’s‐length transactions.” On March 12, 2003, the Pacific Association of Tax Administrators (PATA) reached an agreement for a final Transfer Pricing Documentation Package. The result is the PATA members have agreed to certain principles that allow taxpayers to prepare one set of documentation to meet the transfer pricing documentation provisions of each country. If a taxpayer complies with the provisions under the agreement, the taxpayer is shielded from transfer documentation penalties that might otherwise apply in each of the four jurisdictions (Australia, Canada, Japan, and the United States). The IRS extended the tax code to include transfer pricing of services as well as products in 2004.

d. Illustration: Two subsidiaries located in different countries transfer products. Subsidiary A supplies materials to Subsidiary B. Subsidiary A has a higher tax rate (50%) than



Subsidiary B (30%). Subsidiary A is currently charging $200,000 to Subsidiary B for a component part.

Subsidiary A Subsidiary B Total

Sales $200,000 $400,000 $600,000 COGS 100,000 200,000 300,000

Gross profit 100,000 200,000 300,000 Operating expenses 40,000 150,000 190,000

Earnings before taxes 60,000 50,000 110,000 Income tax (50%, 30%) 30,000 15,000 45,000

Net income $ 30,000 $ 35,000 $ 65,000

If the transfer price is changed to favor Subsidiary B (only charging $150,000 for the component part), the total net income will increase due to the fact that Subsidiary B has a lower tax rate.

Subsidiary A Subsidiary B Total

Sales $150,000 $400,000 $550,000 COGS 100,000 150,000 250,000

Gross profit 50,000 250,000 300,000 Operating expenses 40,000 150,000 190,000

Earnings before taxes 10,000 100,000 110,000 Income tax (50%, 30%) 5,000 30,000 35,000

Net income $ 5,000 $ 70,000 $ 75,000 Increase in total net income $ 10,000

5232.36 Federal Financial Institutions Examination Council (FFIEC) expectations

a. On January 6, 2010, the Federal Financial Institutions Examination Council (FFIEC) issued an advisory dealing with the need for sound practices for mitigating interest rate risk with recommendations that all institutions manage their interest rate risk (IRR) exposures using processes and systems commensurate with their earnings and capital levels, complexity, business model, risk profile, and scope of operations.

b. This advisory held senior management responsible for ensuring that board‐approved strategies, policies, and procedures for managing interest rate risk are appropriately executed within the designated lines of authority and responsibility. Management must maintain:

(1) appropriate policies, procedures, and internal controls, including controls over risk‐taking to ensure that they stay within board‐approved tolerances.

(2) a provision for updating IRR measurement scenarios and key underlying assumptions that drive the institution’s IRR analysis.

(3) a sufficiently detailed reporting process to inform senior management and the board of the level of IRR exposure. The institution’s IRR tolerance should be communicated so the board and senior management clearly understand the institution’s risk tolerance limits and the capital adequacy based on those limits.

c. Institutions should engage in scenario planning and test stress scenarios that should, at a minimum, include tests of the following:

(1) Significant changes in the level of interest rates (instantaneous rate shocks)

(2) Substantial changes in rates over time (prolonged rate shocks)

(3) Changes in relationship between key market rates (basis risk)

(4) Changes in the shape and slope of the yield curve (yield curve risk)



d. Regulators suggest that under certain conditions, once institutions come close to reaching a limiting positions set for IRR within their policies, that balance sheet alterations of hedging might be an appropriate response. However, even then, they make several suggestions related to the conditions under which such hedging operations might be conducted, including the following:

(1) Balance sheet alterations designed to achieve an appropriate distribution of assets maturities or re‐pricing structures to avoid the potential for severe maturity or duration mismatches between assets and liabilities

(2) The level and formality of the process should be commensurate with the activities and level of risk approved by the board and should not be undertaken unless the board and senior management understand the institution’s hedging strategy.

(3) Reliance on outside consultants to assist in the establishment of such a strategy would be appropriate.

5240 Appendix: Ratio Analysis

5240.01 The analysis and interpretation of financial statements is carried out in part through ratio analysis, which relates different financial statement elements in a meaningful way. Ratios are computed and analyzed on a comparative basis as follows:

a. Comparing operating characteristics of an enterprise over a series of successive years

b. Comparing operating characteristics of the enterprise with other similar enterprises, preestablished standards (target ratios), or legal requirements

5240.02 Many different ratios are computed and used to analyze the operating characteristics of enterprises, primarily by investors and creditors, both present and potential. Several of the frequently encountered ratios are presented in the next paragraph in the illustration of the Ratio Company, whose income statement (year 20X2) and comparative balance sheet (years 20X1 and 20X2) are presented as follows. The ratios are computed as of December 31, 20X2.



Ratio CompanyIncome Statement

For Year Ended December 31, 20X2

Net sales (all credit) $1,000,000Cost of goods sold ($25,000 depreciation) 600,000Gross profit on sales $ 400,000Selling and administrative expenses 225,000Income from operations $ 175,000Interest on long‐term debt 50,000Income before taxes $ 125,000Taxes, 40% 50,000Net income $ 75,000Dividends declared on common stock 10,000Dividends declared on preferred stock 15,000Net income to retained earnings $ 50,000

Net earnings per common sharea $ 3

a ($75,000 - $15,000)/20,000 shares = $3

Ratio CompanyComparative Balance Sheets

At December 31, 20X1 and 20X2

12/31/X2 12/31/X1 Assets: Cash and marketable securities $ 250,000 $ 200,000 Net accounts receivable 200,000 100,000 Inventories 100,000 150,000 Total current assets 550,000 450,000 Net plant and equipment 400,000 450,000 Goodwill 100,000 100,000 Total assets $1,050,000 $1,000,000 Liabilities and equities: Accounts payable $ 200,000 $ 150,000 Long‐term debt 450,000 500,000 Preferred stock, $100 par 100,000 100,000 Common stock, $10 par (market price $17.00)

200,000 200,000

Retained earnings 100,000 50,000 Total liabilities and equity $1,050,000 $1,000,000



Ratio CompanyStatement of Cash Flows

For Year Ended December 31, 20X2

Cash flows from operating activities: Cash received from customers $ 900,000 Cash paid to purchase inventory (475,000) Cash paid for selling and administrative expenses (225,000) Cash paid for interest (50,000) Cash paid for taxes (50,000) Net cash provided by operating activities $100,000Cash from investing activities: Cash paid for plant and equipment (75,000)Cash from financing activities: Proceeds from long‐term debt $ 50,000 Cash paid for dividends on common stock (10,000) Cash paid for dividends on preferred stock (15,000) Net cash provided by financing activities 25,000Net increase in cash $ 50,000Cash, beginning of 20X2 $200,000Cash, end of 20X2 $250,000

5240.03 These ratios should be understood in terms of the following:

a. Definition (i.e., how is the ratio computed?)

b. Significance (i.e., what does the ratio tell you?)

c. Limitations (i.e., what care should be taken in the use of the ratio?)



Ratios Used in Financial Statement Analysis

Ratio Definition Significance Computation Limitations

a. Current ratio

Current assets Current liabilities

Measures ability to discharge currently maturing obligations from existing current assets

$550,000 $200,000

Balance sheet account totals based on historical cost do not necessarily represent market values. A sizable amount of the current asset total might be tied up in inventory which is less liquid. Implies liquidation of assets and elimination of liabilities (neither of which is likely in a “going concern”).

b. Quick (acid test) ratio

Current assets less Inventories and prepaid assets Current liabilities

Measures ability to discharge currently maturing obligations based on most liquid (quick) assets

$550,000 $100,000 $200,000

Receivables may be subject to a lengthy collection period and might have to be factored at less than carrying value if cash is needed immediately. Securities are subject to fluctuating market conditions which affect their liquidation amount.

c. Inventory turnover

Cost of goods sold Average inventory

Measures relative control over inventory investment. May provide basis for determining the presence of obsolete inventory or pricing problems (in case of low turnover).

$600,000

$150,000 + $100,000 2

= 4.80

Different inventory cost flow assumptions can produce widely different inventory valuations and thus turnover ratios.

d. Receivables turnover

Net credit sales

Average receivables

Confirms the fairness of the receivable balance. May indicate presence of possible collection problems (in case of low turnover).

$1,000,000

$200,000 + $100,000 2

= 6.67

Affected by significant seasonal fluctuations unless denominator is a weighted‐average. Poor collection policy can understate this ratio by increasing average receivables.

e. Cash from operating activities to current liabilities

Net cash provided by operating

activities

Current liabilities

Shows extent to which a company has covered its current liabilities by generating cash from normal operations

$100,000

$200,000

Current liabilities may understate short‐term demands on cash.

= 2.75

( )

= 2.25

= 0.50

( )




f. Total asset turnover

Net sales Average total assets

Measures how efficiently assets are used to produce sales

$1,000,000

$1,050,000 + $1,000,000 2

= 0.98

Does not take into account that certain assets make no tangible contribution to sales. Assumes that an asset’s participation in generating sales is relative to its recorded amount. Rate of return is based on historical asset cost which does not reflect current values.

g. Rate of return on total assets

Net income

Average total assets

Measures the productivity of assets in terms of producing income

$75,000

$1,050,000 + $1,000,000 2

= 0.073 or 7.3%

Similar to total asset turnover ratio. Accrual net income subject to estimates and does not reflect actual cash return. Rate of return is based on historical asset cost which does not reflect current values.

h. Return on common stock‐holders’ equity

Net income less preferred dividends

Average common stockholders’ equity

Measures return to common stockholders in aggregate

$75,000 $15,000

$300,000 + $250,000 2

= 0.22 or 22%

Book value of common stockholders’ equity reflects historical cost and not current value. Accrual net income involves estimations and does not reflect actual cash return.

i.(1) Debt ratio

Total liabilities Total assets

Indicates extent of leverage used and creditor protection in case of insolvency

$200,000 + $450,000

$1,050,000

= 0.62 or 62%

Denominator reflects historical costs and not current values.

i.(2) Debt/ equity ratio

Total liabilities

Stockholders’ equity

Determines the equity’s long‐term debt‐paying ability

$200,000 + $450,000 $100,000 + $200,000 +

$100,000

= 1.62

There is a lack of uniformity in calculating this ratio.

j. Equity ratio Total stockholders’ equity

Total assets

Measures total asset investment provided by stockholders

$100,000 + $200,000 + $100,000

$1,050,000

= 0.38

Assets are recorded at historical cost and not at current value.

k. Times interest earned

Income before interest expenses and taxes

Interest expense

Measures ability to cover interest charges

$175,000

$50,000

Accrual income does not necessarily indicate availability of cash to pay interest charges.

l. Price‐ earnings ratio

Market price per common share

Earnings per share

Indicates relationship of common stock to net earnings

$17.00

$3.00

Earnings per share computation subject to arbitrary assumptions and accrual income. EPS is not the only factor affecting market prices.

(

(

(

)

)

)

= 3.50

= 5.67




m. Dividend yield

Dividend per common share

Market price per common share

Shows return to stockholders based on current market price of stock

$10,000 20,000 shares $17.00

= 0.03

Dividend payments to stockholders are subject to many variables. The relationship between dividends paid and market prices is a reciprocal one.

n. Profit margin on sales

Net income

Sales

Measures efficiency of earning income from sales

$75,000

$1,000,000

Accrual income includes estimations. Income includes costs over which management has little or no control (e.g., taxes).

o. Book value per common share

Common stock‐ holders’ equity

Common shares outstanding

Measures net assets applicable to each common share

$200,000 + $100,000

20,000 shares

Assets are recorded at historical cost and not at current value.

p. Cash flow per common share

Income plus noncash adjustments

Common shares outstanding

Measures resources (i.e., cash) generated per common share

$75,000 + $25,000

20,000 shares

This ratio is the least understood and therefore the most likely to mislead an investor. FASB ASC 230‐10‐45‐3 strongly recommends against the isolated disclosure of this ratio.

q. Payout ratio to common share‐holders

Common dividends

Net income less preferred dividends

Measures portion of net income to common shareholders paid out in dividends

$10,000

$75,000 $15,000 Income does not necessarily measure cash available for dividend payment. Heavily influenced by management policy, nature of business, and stage of development, all of which diminish comparability.

r. Cash from operating activities to net income

Net cash provided by operating activities

Net income

Shows cash flow effects of the company’s net income for the period

$100,000 $75,000

Net income includes noncash revenues and expenses recognized by accrual accounting principles.

5240.04 For analytical purposes, the ratios presented in this table can be grouped as follows:

a. Measures of liquidity (i.e., ability to meet current debt):

(1) Current ratio

(2) Quick ratio

(3) Inventory turnover

(4) Receivables turnover

(5) Cash from operating activities to current liabilities

b. Measures of return on investment:

(1) Total asset turnover

(2) Rate of return on total assets

= $15.00

= 0.08

= $5.00

= 0.17

= 1.33



(3) Return on common stockholders’ equity

(4) Price‐earnings ratio

(5) Dividend yield

(6) Profit margin on sales

(7) Payout ratio to common

c. Measures of solvency (i.e., long‐term financing and debt‐paying ability):

(1) Debt to equity ratio

(2) Equity ratio

(3) Times interest earned

(4) Book value per common share

(5) Cash flow per common share

(6) Cash from operating activities to net income

5240.05 Care must be taken in the use of ratios such as those described for several reasons, as can be seen by the specific limitations stated. In summary, several of the critical considerations of which you must be continually mindful of in ratio analysis include the following:

a. Accounting methods used to state assets, liabilities, stockholders’ equity, revenues, and expenses are not necessarily designed to produce the most useful numbers for the purposes for which the ratios are intended.

b. Differences in the underlying economic events, the types of enterprises involved, the stage of development of enterprises, and other factors affect comparability between enterprises.

c. Several ratios include the use of external market values of stock which are influenced by numerous variables over which management has little influence or control.

d. Management policy may influence many ratios.


______________________________________________

Section 5300 Financial Management

(10%-20%)

5310 Capital Structure

5311 Risk and Leverage

5312 Capital Structure (Including WACC)

5313 Financial Structure

5320 Working Capital

5321 Working Capital Fundamentals

5322 Key Metrics

5323 Strategies for Managing Working Capital

5330 Financial Valuation Methods and Decision Models

5331 Valuation Fundamentals

5332 Valuations Assumptions

5333 Valuation Methods

5334 Asset and Investment Management

5335 Capital Budgeting

BEC 3‐2 FINANCIAL MANAGEMENT


5310 Capital Structure

5310.01 Overview

a. The earnings of an organization can vary widely. The volatility of earnings (and earnings per share) results from:

(1) the industry within which a company operates and the products sold.

(2) the choice of operating structure; in other words, the mix of fixed and variable operating costs.

(3) the choice of capital structure; in other words, the mix of financing through debt and equity.

b. Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes). It is influenced by the company’s operating cost structure, product characteristics, and marketing locations, as well as the firm’s competitive position. Generally, smaller firms that rely heavily on a small number of customers have greater business risk.

c. Business risk is driven by the creation of revenues. Following are the four basic elements affecting revenues:

(1) Sensitivity to the business cycle. Consumer durable goods such as housing and appliances are more likely to have large swings within a business cycle than necessities such as basic clothing and food.

(2) Competition. The greater the competition, the more likely that a company will have to lower selling prices.

(3) Stability of the local economy. The more stable the local economy, the fewer the revenue swings.

(4) Stability of foreign economies. Since many firms in today’s business environment trade internationally, the stability of foreign economics can have a significant effect on revenues for firms located in the United States.

d. Operating risk is created when the firm incurs an increasing level of fixed relative to variable costs in its operating structure. As a greater proportion of fixed costs are employed within the operating structure, the greater the risk that the breakeven point will not be met.

e. Business and operating risk increase due to any of the following circumstances:

(1) The more volatile the demand for the organization’s product or service, the greater the risk.

(2) The higher the fixed cost of the firm (operating level), the greater the risk that the breakeven point will not be reached.

(3) The more variable the sales price for the firm’s products, the greater the risk.

(4) The more volatile the cost of inputs, the greater the risk.

(5) The less the firm’s ability to pass on price increases for materials, the greater the risk.

(6) The less the firm’s ability to develop new products in a timely, cost‐effective manner, the greater the risk.



5311 Risk and Leverage

5311.01 Interest rate risk

a. Interest rate risk is the risk of holding fixed interest‐bearing instruments such as a bond when interest rates are changing. The price of long‐term bonds is more sensitive to changes in interest rates than the price of short‐term securities; thus, a rise in interest rates would cause the price of a fixed interest‐bearing instrument to drop. Generally, the longer the maturity value, the greater the interest rate risk.

b. Illustration: 8%, 20‐year bonds are purchased at par for $100,000 when the market was yielding 8%. If interest rates rise to 10%, the price of the bond will decrease so that the actual yield will equal 10% to match the current market rate. The market value is the PV of the future cash flows, and for a bond that matures in 20 years and pays $8,000 of interest annually to yield 10%, the PV would be calculated as follows:

$100,000 .1486 = $14,860

+ $8,000 8.5136 = 68,109

$82,969

The potential drop in market value is the risk associated with holding a long‐term fixed interest‐bearing instrument.

c. If a short‐term Treasury bill is held during a period of rising interest rates, the loss in market value related to that increase in interest rates is much less significant. For example, given the same interest rate scenario described above, the price of a $100,000, 180 T‐bill would decline to $99,069.

5311.02 Reinvestment risk

Reinvestment risk arises when investments must be rolled over. If rates have declined, the interest earned will decline.

5311.03 Liquidity risk (marketability risk)

a. A highly liquid asset can be sold on short notice for close to its market value; however, an asset that changes hands infrequently often does not have a ready market. Therefore, a price reduction is often necessary if the asset is sold on short notice. Liquidity risk is the risk that an asset cannot be sold for market value on short notice.

b. Securities such as U.S. Treasury bills or stock in major corporations have a ready market and can be sold quickly for the quoted market price. Bonds issued by an obscure firm would probably have to be sold at a discount over market price in order to find a willing buyer on short notice. Bonds such as these have a high level of liquidity risk.

5311.04 Market risk

Market risk is the risk associated with a security that cannot be eliminated by diversification. This includes such items as recessions, inflation, and changing interest rates that affect all firms. This is also known as systematic risk.

5311.05 Company risk (company‐specific risk)

Company risk is risk that is specifically associated with a particular firm due to mix of products, new products, competition, patents, lawsuits, etc. Within a portfolio, company risk can be eliminated by proper diversification.



Credit Risk

5311.06 Credit risk is the risk that receivables will not be collected in full on a timely basis. Increased risk includes costs related to bad debt losses, higher receivable balances resulting in higher carrying costs, higher customer investigation fees, and collection costs.

5311.07 Credit risk can be evaluated by looking into the customer’s:

(1) character. Will the customer make an honest effort to pay all obligations?

(2) capacity. Does the customer have the ability to make necessary payments on a timely basis?

(3) capital position. Does the customer have a good financial position such as discovered or measured through ratio analysis?

(4) collateral. Are assets pledged as security on the obligation?

(5) general conditions. What are the probable economic conditions and how might they affect the customer’s ability to pay?

5311.08 Default risk

a. Default risk is the risk that the borrower will be unable to make interest and/or principal payments as scheduled on the obligation. The higher the possibility of default, the greater the return required by the lender.

b. U.S. Treasury bonds are considered to be default risk free. Securities and bonds do have some degree of risk, and several organizations such as Moody’s Investment Service and Standard & Poor’s Corporation rate bonds for default risk. The lower the quality of the bonds, the greater the interest rate the issuing firm is required to pay in order to compensate for the risk.

5311.09 Purchasing risk

Purchasing risk (purchasing power risk) is the risk that inflation will result in less purchasing power for a given sum of money. Assets that are expected to rise in value during a period of inflation have a lower risk. For example, real estate often appreciates during an inflationary period; however, cash loses value during that same period.

Leverage

5311.10 Operating leverage

a. Business risk is built partially on the degree a company uses fixed costs in its operations. The higher the fixed costs, the greater the risk that the breakeven point will not be reached given a drop in sales. When fixed costs are high, a small drop in sales can result in a loss for the period. Operating leverage relates the percentage changes in EBIT to the percentage change in revenue. The greater the operating leverage, the greater the change in operating income will be given a particular change in sales. Therefore, a company with a high degree of operating leverage would have a large change in operating income for a relatively small change in sales.

b. The degree of operating leverage (DOL) is the percentage change in EBIT related to a given percentage change in revenue.

DOL = % change in net operating income

% change in sales =

Contribution margin Contribution margin – Fixed costs



A DOL of 2 means that the percentage change of EBIT will be twice the size of the percentage change in sales. If sales increase by 20%, then EBIT will increase by 40%; however, if sales decrease by 20%, then EBIT will decrease by 40%.

c. A firm can change the DOL by changing the proportion of fixed costs to variable costs. The larger the proportion of fixed costs, the higher the DOL and the higher the breakeven point. The higher the proportion of variable costs, the lower the DOL and the lower the breakeven point.

Also, notice that after the breakeven point is reached with a high DOL, the operating profit increases quickly; thus, the additional risk associated with high fixed costs also contains the possibility of higher profits in the event of a positive sales outcome. The following diagram shows how income can increase rapidly after reaching the breakeven point if high fixed costs and low variable costs are used in the production process.

The lower the fixed costs, the lower the DOL and breakeven point will be. Given the same sales as in the above diagram, a lower percentage of fixed cost will cause the breakeven point to be reached at an earlier sales level; however, the operating profit will increase slowly in relation to increased sales. The operating profit (loss) is the difference between the sales and total costs.

d. Illustration: Tally Company has the following information available regarding sales and costs from the last period:

What is the DOL?

Solution:

DOL = Contribution margin Contribution margin - Fixed costs

= 10,000 Units ($10.00 – $6.00) 10,000 Units ($10.00 – $6.00) – $20,000

= 2

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000



5311.11 Financial leverage

a. Financial leverage refers to the extent to which debt and preferred stock (fixed income securities) are used in the capital structure. The larger the percentage of debt and preferred stock that is used for financing, the greater the risk that the company will not earn enough to cover the fixed interest and preferred dividend payments. The more leverage, the greater the risk, and the higher the cost of capital.

b. Degree of financial leverage (DFL) is the percentage change in earnings available to common stockholders related to a given percentage change in EBIT.

DFL = % change in net income % change in net operating income

= EBIT EBIT – Interest

When there is no debt financing used, the DFL will equal 1. When debt does exist, a change in EBIT will result in a greater proportional change in the earnings per share.

If the DFL were 2, then a 10% increase in EBIT would result in a 20% (10% 2) increase in earnings per share.

If the organization has preferred stock, the DFL equation is modified to:

DFL = EBIT

EBIT – Interest expense – Preferred dividends

1 – Tax rate

c. If a firm has no debt and begins to substitute debt for equity, at first the value of the firm will rise, reach a peak, and then begin to fall due to the increased risk of additional debt. This peak in maximized value is the target capital structure.

d. Illustration: Tally Company has the following information available about sales and costs from the last period:

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000 Interest costs for period $15,000

What is the DFL?

Solution: DFL = EBIT EBIT – Interest expense

=

10,000 Units ($10.00 – $6.00) – $20,000 [10,000 Units ($10.00 – $6.00) – $20,000] – $15,000

= 4

5311.12 Total leverage (degree of combined leverage)

a. If a company used both high degrees of operating and financial leverage, only small changes in sales will result in large fluctuations in EPS. This can be shown in equation form:

Degree of total leverage = % change in net income

% change in sales = DOL DFL

b. This ratio can be used to predict the effect of a change in sales on income and ultimately the earnings available to common stockholders.

c. This ratio is determined by the relationship between operating and financial leverage. For example, if risk is lowered by reducing the degree of operating leverage, then the



firm would be in a better position to increase the use of debt, thus increasing the financial leverage.

d. The financial statement effects of DOL and DFL can be shown by using the income statement format:

Previous

Percentage Increase

Resulting Change

DTL of 8

DOL of 2

Sales $100,000 10% $110,000

Variable costs 60,000 66,000

Fixed costs 20,000 20,000

EBIT 20,000 20% 24,000

DFL of 4

Fixed financing costs 15,000 15,000

EBT 5,000 9,000

Taxes (40%) 2,000 3,600

Net income $ 3,000 80% $ 5,400

Please note that the results were based on the assumptions that the cost relationships remain unchanged (fixed and variable) as well as the firm’s capital structure, including the amount of the fixed financing payments. As the relationships change, the DOL, DFL, and DTL would also change.

e. Illustration: Tally Company has the following information available about sales and costs from the last period:

Sales in units 10,000 Selling price per unit $10.00 Variable costs per unit $6.00 Fixed costs for period $20,000 Interest costs for period $15,000

What is the DTL?

Solution: DTL = DOL DFL

= 10,000 ($10 – $6) 10,000 ($10 – $6) – $20,000

10,000 ($10 – $6) – $20,000 10,000 ($10 – $6) – $20,000 – $15,000

= 2 4 = 8

5312 Capital Structure (Including WACC)

5312.01 Overview

a. The sources of financing for an organization can be found on the right side of the balance sheet—debt and equity.

b. Since accounts payable and other accrued expenses are created spontaneously in the course of doing business and have no clear interest expense, they do not require a special approval by management. The financing structure items that do require the discretion of management are short and long‐term debt as well as preferred stock and common equity. These items are referred to as the firm’s capital structure. The relationship between financial structure and capital structure can be demonstrated as follows:

Financial structure = Non‐interest‐bearing liabilities + Capital structure



c. The goal of management is to minimize the firm’s cost of capital resulting in the maximization of the common stock price. This point is referred to as the optimal capital structure. There are two basic questions that must be answered by management related to capital structure:

(1) What mix of short‐ and long‐term debt should be employed?

(2) What mix of debt and equity should be employed?

d. The pecking order theory indicates that the order of financing of a company (or project) follows the path of least effort.

(1) Companies will use internal financing first.

(2) Dividend policy will be adapted to financing needs while at the same time attempting to avoid sudden changes in dividends paid.

(3) If outside financing is required, a company will start with the cheapest security, thus starting with debt financing, followed by hybrid securities, and ultimately equity securities.

e. Modigliani and Miller developed the MM theorem related to the financing of a firm, which can be summarized as follows:

(1) In a world with no taxes, no bankruptcy costs, or no agency costs, the value of a company would be indifferent to its capital structure due to the fact that the cost of capital would be the same for all financing sources.

(2) In a world with taxes but no bankruptcy costs, the value of a company would be highest with the use of 100% debt since the cost of debt financing would be lower than the cost of equity financing due to the interest tax shield.

(3) In a world with taxes and bankruptcy costs, the maximum value of the firm would be the point when the marginal cost of debt based upon the marginal tax shield would be equal to the marginal cost of bankruptcy or financial distress costs. In other words, the optimal capital structure would be a combination of debt and equity that would provide the lowest overall WACC (weighted‐average cost of capital).

f. When reviewing capital structure decisions, two basic models are regularly used:

(1) When comparing two funding options, the EBIT‐EPS indifference point is where the EPS will be the same no matter which financial funding plan is employed. After the indifference point is met, EBIT in excess of that amount will result in a higher EPS the more leverage that is employed. An EBIT less than the indifference point will result in a higher EPS the less leverage that is used. The tool can help management determine whether more or less leverage should be used based upon the likelihood of achieving a particular EBIT level. The indifference point can be determined mathematically using the following formula:

EPS with stock at level “a” = EPS with stock at level “b”

(EBIT – I)(1 – T) – P Sa

=(EBIT – I)(1 – T) – P

Sb

Where:

I = Interest expense

T = Tax rate

P = Preferred dividends



Sa = Number of common shares using plan “a”

Sb = Number of common shares using plan “b”

(2) Firms often use ratio analysis to aid in capital structure decisions. For example, an average company in the meat processing industry has a debt‐to‐equity ratio of 2.17. If ABC Meat Processing Company has a debt‐to‐equity ratio of 1.75, management may decide to use debt financing for a proposed expansion. If, however, that same company has a debt‐to‐equity ratio of 2.5, management may decide to use equity financing instead. The whole idea here is for an organization to keep their debt‐to‐equity ratio in line with the industry average.

g. Items that management may wish to consider when making capital structure decisions would include the following:

(1) Financial flexibility: As the proportion of debt increases, the less likely that additional debt will be available at a reasonable interest rate; therefore, management tends to act on the conservative side and use proportionally more debt increasingly sparingly.

(2) Tax position: Unlike dividends, interest expense provides a tax shield for companies and will generally make debt financing less expensive than equity financing.

(3) Interest rates: When interest rates are low, companies will look more favorably on long‐term borrowing than when rates are high.

(4) Industry comparison: Lenders often will use industry averages as a criterion when evaluating the creditworthiness of a firm, as will potential investors.

(5) Internal funds: Companies will generally use internally generated funds before seeking additional debt or issuing additional equity.

(6) Risk: The more debt a company has, the greater the financial distress costs and the higher the risk for bankruptcy. Also, the higher the debt level, the lower the potential credit rating. As a firm’s credit rating drops, the cost of borrowing increases.

(7) Stock values: If a company’s stock is undervalued, management is not likely to issue additional shares, since such an action could potentially have a negative effect on an already low stock price. Using an additional stock issue to raise necessary funds when a company’s stock is overvalued stock, however, would be desirable.

Weighted‐Average Cost of Capital

5312.02 Weighted‐average cost of capital

a. The cost of capital is an important element in making investment decisions, as projects with a higher rate of return than the firm’s cost of capital will increase the value of the firm. The relevant cost of capital is the firm’s long‐term cost of capital since we are evaluating long‐term projects or investments.

b. The weighted‐average cost of capital is the weighted average of the cost of debt and the various equity components of the firm’s capital structure. It is preferable to use weights based on the market value of the items or the firm’s target capital structure.

(1) The cost of debt for the issuing firm is based upon the required rate of return for debt holders and the marginal tax rate for the issuing company. Due to the tax shield associated with interest‐bearing debt, the effective cost of the debt is lower than the interest rate paid due to the reduction in the taxes paid.



Cost of debt = kd (1 – T)

Where:

kd = Cost of debt

T = Marginal tax rate

(2) Preferred stock provides the investor with a constant stream of dividends; however, these dividends do not provide a tax shield since they are not a deductible expense for the issuing company. The cost of preferred stock to the issuing company can be calculated by dividing the annual return (interest payment) by the net issuance price for the preferred stock.

kp =Dp Pp

Where:

kp = Cost of preferred stock

Dp = Preferred dividend

Pp = Price of preferred stock

Generally, however, when looking at the cost of issuing new preferred stock, the company would have to pay flotation costs to an investment house; thus, the proceeds received by the company would be less than the issue price. This would increase the cost of this form of financing. Taking flotation costs into consideration, the formula to calculate the cost of preferred stock to the issuing company would be:

Kp = Dp (1 – f)Pp

Where:

kp = Cost of preferred stock

Dp = Preferred dividend

Pp = Price of preferred stock

f = Flotation costs

(3) The cost of retained earnings is the opportunity cost that stockholders of a firm could earn elsewhere if they made investments of comparable risk. This figure would need to be imputed.

(4) The cost of equity (ke) is more expensive than the cost of debt since stockholders are subject to more risk than debt holders. There are a number of ways to estimate the cost of equity, and one commonly used method to obtain the estimate is the dividend growth model. The formula used is:

ke = (D1 Po (1 – F)) + g

This formula assumes that the firm pays a future dividend per share equal to D1, would issue new stock at price Po, and would pay a flotation cost (F) that is equal to some percentage of the value of the stock being issued. It is assumed that the firm’s dividend will grow at a constant rate (g). The result is the cost of using internally generated equity. If new stock is going to be issued, the cost of new equity would be the result obtained for internally generated equity divided (1 – Percent of flotation costs).



Illustration: The firm’s current dividend was $1.50 and is expected to grow 6% per year. They expect to be able to sell new stock at a price $30 per share and flotation costs are expected to be 10% of the value of the stock issue. What is the firm’s cost of equity?

ke = (($1.50 × 1.06) ($30 × (1 – 0.10))) + 6.0% = ($1.59 $27.00) + 6.0% = 5.89% + 6.0% = 11.89%

c. Most analysts use the CAPM (capital asset pricing model) to estimate the required return on a firm’s cost of equity. The basic equation for estimating the required return on equity (Ri) is:

d. The primary conclusion of the capital‐asset pricing model (CAPM) is that the relevant risk on any security is its contribution to the risk of a well‐diversified portfolio. A commonly used benchmark portfolio for the market portfolio is the S&P 500.

e. Illustration: Assume that the current T‐bill rate is 3.35% and the market risk premium is 7% for a diversified market portfolio.

Ri = RF + β i (Rm – RF)

= 3.35% + 1.0 (7.0%) = 10.35%

Under this scenario, investors would expect to earn 10.35% on a diversified market portfolio. (Note: The beta coefficient for the diversified market portfolio is 1.0.)

Given the information in the example above and assuming that the beta coefficient for an individual security is 1.4, what return would investors require to hold this security?

Solution: Using the formula from (c) above, that is, Ri = RF + βi (Rm – RF), the return required by investors would be 13.15%. Again, this is the cost of internally generated equity. The cost of issuing new stock would be the cost of internally generated equity divided by (1 – Percentage of flotation costs).

Ri = RF + βi (Rm – RF)

= 3.35% + 1.4 (7.0%) = 13.15%

f. The weighted‐average cost of capital can be computed as follows:

WACC = (wtd kd) + (wtpf kpf) + (wte ke)

Example: Assume that the firm can issue new debt at 5% and that the marginal tax rate is 40%. The firm has $1,000 par preferred stock that pays a dividend of 4%. Using the CAPM, it is estimated that investors require a 16% return on equity investments. The firm has a target capital structure of 30% debt, 10% preferred stock, and 60% equity. What is the firm’s WACC?

Solution:

WACC = (.30 [.05 (1 – .40)]) + (.10 .04) + (.60 .16) = .009 + .004 + .096 = .109 or 10.9%

Ri = RF + βi (Rm – RF)



5312.03 Optimal capital structure

a. Finance theory indicates that the goal for a firm should be to minimize its weighted‐average cost of capital, and it can do so by achieving its optimal capital structure.

b. The tax shield for debt makes debt a very attractive component of the capital structure. However, increasing the amount of debt in the structure beyond some point causes increasing financial distress costs that would cause the cost of additional debt to climb. Theoretically, the firm should continue to issue debt until the increasing financial distress costs offset the positive value of the tax shield.

c. It is very difficult to accurately determine the optimal capital structure, and in practice a firm attempts to find an optimal range of debt‐to‐equity that would minimize the weighted‐average cost of capital.

d. Key elements in making capital structure decisions include the following:

(1) Sales stability: A firm whose sales are stable can take on more debt than a firm with unstable sales.

(2) Asset structure: Firms with assets that are suitable to be pledged as security for a loan can use debt more heavily than firms with special purpose assets.

(3) Operating leverage: Firms with less operating leverage are better able to employ financial leverage.

(4) Growth rate: Faster‐growing companies are more likely to rely more heavily on debt.

(5) Profitability: Firms with high profitability are better able to support more of their financing needs with internally generated funds.

(6) Taxes: The higher a firm’s marginal tax rate, the greater the advantages of using debt.

(7) Management attitude: Management can exercise judgment as to the appropriate capital structure.

e. As shown by the following graphs, the lower the firm’s weighted‐average cost of capital (WACC), the greater the value of the firm since the WACC is used to discount the firm’s expected cash flows. Thus, many firms are concerned about creating a capital structure that minimizes its cost of capital. As a firm moves from being an all‐equity firm (that is, with debt equal to zero) to adding debt to the capital structure, the firm’s WACC will begin to decline. This is true because debt is less risky than equity (demanding a lower return) and debt has a “tax shield” in that the interest cost is tax deductible. Therefore, adding debt to the capital structure mix reduces WACC. This decline will continue until financial markets perceive that the firm’s debt‐to‐asset (or equity) ratio has reached a point where additional debt will increase the firm’s “financial distress costs” (that is, the possibility of bankruptcy) and require a higher return on the debt to compensate for the increased risk. At this point, the firm’s WACC will begin to rise. A firm’s “optimal capital structure” is the ratio that minimizes WACC; in the example found in Graph B it is found to be 40%.



Graph A:

Graph B:

5313 Financial Structure

5313.01 Overview

a. As discussed earlier, financial leverage is created through the use of debt. If the firm has superior profits (excess return on total assets above the cost of debt), the return above the cost of the debt accrues to the shareholder. Thus assets financed through debt can provide increased worth to the stockholder. Borrowed funds generally require a fixed payment (interest) so debt holders cannot share in superior profits after receiving the necessary interest payments.



b. Financial structure (use of debt and equity) is influenced by:

(1) management’s attitude toward risk.

(a) Smaller firms are not likely to want to use additional equity sold to new shareholders as a source of financing due to the diluting effect; however, large firms generally will not be opposed to selling additional stock since a stock sale will have little effect on company control.

(b) A small firm may be reluctant to use debt as a source of funds due to the extreme risk that failure of one product or a slight down‐turn in the economy may have on cash flow. Default is more likely in a small firm than a large one.

(2) the industry norms.

Debt service is related to sales volume and the control of costs leading to profitability. Growth industries tend to have high profit margins. Mature industries tend to have stable sales and profit margins. Lenders are concerned about a specific company’s ability to make necessary payments. Generally, debt holders will not lend funds to a firm that has a debt to equity ratio above the normal range for the industry or a times interest earned ratio below the normal range for the industry without higher interest rates to compensate for the additional risk. Lenders are particularly interested in an organization’s solvency ratios as compared to the industry norms when deciding whether additional funds should be lent to the firm in question.

(3) the anticipated future growth rate.

If new financing is used to expand, it is important to estimate the future growth of sales in order to determine whether cash flows resulting from the new productive assets will create a cash flow large enough to service the debt.

(4) lenders’ attitudes toward the industry and the specific firm.

Lenders’ attitudes play an important role in capital structure. As lenders become concerned about rising debt levels, they will either demand higher interest rates to compensate for the additional risk, or they may refuse to lend the necessary funds. A firm’s ability to grow may often be limited to the funds available through the use of debt.

c. Whenever additional long‐term funds are needed, management can choose between debt and equity. Long‐term debt is likely to be used when:

(1) sales and profits are estimated to be stable or increasing.

(2) anticipated profits are sufficient to make good use of leverage.

(3) control (through voting privileges) is important.

(4) the existing capital structure has a low use of debt.

(5) requirements or covenants of debt issues are not arduous.

5313.02 Financing approaches

a. Assets are generally divided into current and long‐term, or permanent assets. Current assets can be further divided into:

(1) temporary current assets that would include assets that would fluctuate with the business cycle as sales vary with the corresponding changes in the levels of



accounts receivable and inventory between the maximum and minimum levels over the annual business cycle.

(2) permanent current assets that would include assets that are more permanent in nature in that they are carried even at the low points of the business cycle such as the minimum accounts receivable and inventory levels during the lowest part of the business cycle.

b. The conservative approach to financing short‐term debt uses permanent assets to finance all of the permanent operating assets requirements and also some of the seasonal needs. Spontaneous credit (accounts payable) is used to finance the remaining seasonal needs. A firm using this approach would hold liquid assets in marketable securities during the low points of the seasonal cycle.

c. The maturity matching approach to financing matches assets to liability maturities. This approach minimizes default risk and is considered to be a moderate approach to financing.

Illustration: If a new factory is financed with short‐term funds, it is unlikely that the new facility would have been built and produced a large enough cash flow at the end of one year in order to repay the loan at maturity. In this scenario, if the lender refused to renew the loan, the company would be in a difficult position. If the new facility had been financed with long‐term debt, the cash flows provided by the new operation would have more closely matched the repayment cash outflows, and the need for refinancing is less likely to arise.

d. The difficulty with maturity matching is that imperfect estimates are used in determining the lives of assets. In reality, firms tend to attempt to develop a reasonable approximation of matching. Also, it is necessary to have some percentage of the financing come from equity that has no maturity.

e. The aggressive approach to financing short‐term debt would be to finance part of the permanent current assets with spontaneous credit such as accounts payable. The aggressive approach can be carried to a high degree by also financing part of the fixed assets with short‐term borrowing. Such a firm would be at risk if interest rates increase as well as face possible difficulties with loan renewals. The degree of aggressiveness is defined by the degree to which permanent NOWC (net operating working capital) and fixed assets are funded by spontaneous credit and/or short‐term debt.

5313.03 Financing sources

a. The right side of the balance sheet represents the sources of funds used to finance a company. These sources are:

(1) short‐term debt.

(2) long‐term debt.

(3) preferred stock.

(4) common stock.

(5) retained earnings.

b. When considering each of the above types of financing, management must consider:

(1) cost.

(2) risk.

(3) the lender’s (owner’s) point of view of the investment alternatives.



Short‐Term Debt Financing

5313.04 Types of short‐term debt:

a. Spontaneous financing created through the use of accounts payable and accruals generated in the course of doing business

b. Unsecured bank loans

c. Commercial paper

d. Secured loans

5313.05 Spontaneous financing

a. Accounts payable and accruals provide instant financing at no cost for a firm. For example, employees provide continual services and are paid only at set intervals. In a sense, employees provide the equivalent of small loans to the company.

b. Trade credit is an appealing source of financing since it is free; however, the length of this credit is only for a very limited time.

c. On occasion, vendors will offer discounts for prompt (early) payment of obligations. Not taking advantage of these offers is a particularly expensive form of short‐term financing. For example, if a vendor offers 1/10, net 30, this means that a 1% discount can be taken if the invoice is paid within 10 days as opposed to 30 days, but this is 1% discount for only paying 20 days earlier than required. This rate can be converted to an effective annual rate by using the following formula:

Days in year Lost trade credit days by taking discount

=365 20

× 1% = 18.25%

Thus, if a company can borrow funds for less than 18.25% in order to take advantage of a prompt payment discount, it is in the firm’s best interest to do so.

5313.06 Unsecured bank loans

a. Unsecured loans are not backed by any collateral and come in a variety of forms.

b. A line of credit is an agreement with a bank to have up to a specific amount of funds available as a short‐term loan during a particular period. If the line of credit is for $100,000, a firm can borrow $20,000 in January, borrow an additional $35,000 in May, repay $40,000 in July, and borrow $50,000 in September, etc. As long as the total amount borrowed at a given point in time remains under $100,000 during the period of the agreement, the firm will continue to have access to additional funds. Interest is usually paid monthly and calculated on the average outstanding balance during the period. This method of financing allows a firm to smooth out its cash flow cycle as well as to have funds available for possibly both precautionary and speculative needs.

The use of the line of credit affects both current assets and current liabilities equally. They increase and decrease in a parallel fashion. However, as long as the current ratio is greater than one, an increase in a line of credit (increase to cash and an increase to current liabilities) will decrease the current ratio.

Illustration: A firm has $100,000 of current assets, $50,000 of current liabilities, and a current ratio of 2 to 1 ($100,000 ÷ $50,000). If $25,000 is borrowed on the line of credit, current assets will increase to $125,000, current liabilities to $75,000, and the current ratio will become 1.7 to 1 ($125,000 ÷ $75,000).



c. A variation on the line of credit is the revolving credit agreement that is generally used by large corporations. This is an agreement by a bank to extend credit to a company over a specified period of time; however, if the firm does not make use of the revolving credit, there still is an annual commitment fee. For example, the approved revolving credit could be for three years to allow a corporation to borrow up to $50 million. Even if the company does not use any of the credit during the year, it will still have to pay a significant commitment fee expressed in terms of a percent (for example, a quarter of 1% or $125,000 annually in the above illustration). If the corporation borrows $25 million on the revolving credit agreement, the commitment fee would drop to a percent of the unused portion of the agreement ($62,500 in this illustration), and the corporation would pay interest on the outstanding borrowed balance as well. The biggest difference between a line of credit and a revolving credit agreement is that there is a legal obligation with a revolving credit agreement that does not exist with a simple line of credit. This legal obligation guarantees the company access to the funds over the life of the agreement.

d. A letter of credit is an international financing tool that guarantees payment to an international supplier upon the safe arrival of the goods by issuing a loan to the purchaser. A letter of credit can be irrevocable (not subject to cancellation if the specific conditions are met) or revocable.

e. Commercial paper is an unsecured promissory note that is issued by large banks and big corporations to meet short‐term cash needs. It is a promise to repay the borrowed funds at a future given date with a maturity of no more than 270 days. Rates for these loans are normally lower than for bank loans. This financing option is considered to be quite safe due to the short time frame and the strength of the borrowing companies; however, there is no flexibility in the repayment date as might be received with a bank loan.

5313.07 Secured loans

a. Short‐term credit is often secured by current assets such as receivables and inventory, and is often used by seasonal businesses where cash flow and working capital needs are not synchronized.

b. Pledging of receivables entails using the cash value of the receivable as collateral for a loan. In this case, the borrowing company agrees to remit the cash received from the collection of particular receivables as repayment of the loan; however, the receivables continue to be owned by the borrowing company, and if a particular receivable proves to be uncollectible, the borrowing company is still liable for the repayment of the loan. Interest rates for these loans can range from 2% to 5% over prime, often with a fee equal to 1% to 2% of the receivable pledged.

c. Factoring involves selling accounts receivable to a factor as a form of short‐term financing. The factor assumes the risk of collection, and the purchaser is notified of the factoring arrangement and usually remits payments directly to the factor. (In some instances, factoring can be done with recourse.) Since the risk is shifted to the factor, the factor will take over the responsibility of doing the credit check on a potential customer. Therefore, functions performed by the factor include credit checks, lending, and bearing of default risk. Generally, the selling firm receives funds from the sale immediately upon shipment of goods to the purchaser. The amount received is the full amount of the sale less a factor fee (usually some percentage of the total sale). The fee incorporates a reserve for sales returns and allowances, interest costs, and profit for the factor. At the end of a specified period, the reserve amount is paid to the seller, providing there have not been sales returns and allowances in excess of the reserve



assumed in the factoring agreement. It is not uncommon for factoring arrangements to be ongoing.

Illustration: A company sells $50,000 of goods with the terms net/30. The receivable is immediately factored with a 3% factor fee, 10% interest, and a reserve of 8%. How much does the selling firm immediately receive from the factor?

Solution: The factor fee will be $1,500 (3% of $50,000). The reserve will be $4,000 (8% of $50,000). The interest will be calculated on 10% of the balance available to the seller and adjusted for a monthly period length.

This can be summarized as follows:

Sales: $50,000 Less: Factor fee (3% × $50,000) $1,500 Reserve (8% × $50,000) 4,000 5,500 Amount due firm 44,500 Less interest on amount for 30 days (10% × $44,500 × 30/360) 371 Amount paid to seller $44,129

After 30 days, any remaining part of the reserve (maximum of $4,000 in this case) that was not absorbed by returns and allowances will be remitted to the seller.

The cost of factoring needs to be compared to the costs of running a credit department when making a decision as to which alternative to pursue.

d. Inventory financing entails the use of inventory as security for a short‐term loan. Such a loan can attach to all inventory held or a particular portion of inventory identified by serial numbers or placed in a particular location.

5313.08 Advantages of short‐term debt financing

a. A short‐term loan can generally be obtained quickly.

b. The cost of obtaining short‐term debt is generally low since the lender tends to only do a minimal financial examination of the firm applying for funds. Spontaneous credit has no cost.

c. There are generally no prepayment penalties.

d. Short‐term debt often provides flexibility for management as it generally has few restrictions.

e. Since the yield curve is typically upward sloping, short‐term interest rates are generally lower than long‐term interest rates.

f. Interest expense is tax deductible and, therefore, provides financial leverage.

g. Accounts payable is a primary source of short‐term debt and it is spontaneously created when inventory is purchased.

5313.09 Disadvantages of short‐term debt financing

a. Short‐term interest rates can vary widely over time, subjecting the firm to refinancing risk.

b. An unexpected need for cash during a recession could cause cash flows to be insufficient to meet the short‐term obligations.



c. Due to changing financial conditions, short‐term debt may not be renewable and thus, depending upon the level of short‐term debt, may put a firm in an illiquid position that could lead to bankruptcy.

d. On occasion, compensating balances are required when unsecured debt is received. This increases the effective cost of that debt.

Long‐Term Debt Financing

5313.10 A term loan is a legal agreement between a borrower and lender where the borrower promises to make interest and principal payments at specific times to the lender for the use of borrowed funds. It is a form of funded debt (long‐term debt).

a. Term loans have advantages over the issuance of bonds and equity.

b. Term loans can be drawn up quickly since the borrower and lender work directly together.

(1) The terms of the loan can have more flexibility since they are not registered with the Securities and Exchange Commissions (SEC). Also, modifications can potentially be made during the life of the loan.

(2) Term loans have low issuance costs.

c. Generally, term loans are paid off in equal installments. This is a protection to both the lender and the borrower that funds will be available for repayment. When funds from the loan are used to purchase equipment, the repayment schedule is frequently matched to the productive life of the equipment.

d. Interest rates can be either fixed or variable.

5313.11 A bond is generally a publicly offered form of long‐term debt where the borrower agrees to makes payments of interest and principal on specific dates to the bondholder. Most bond issues are advertised and held by many different investors as opposed to the one lender of a term loan. The bonds have a coupon rate (rate of interest) that is generally fixed.

5313.12 An indenture is the legal document that contains the terms of the bond issue. This document is approved by the SEC before the bond issue is offered to the public. It will clearly state the provisions of the issue. Common provisions include the following:

a. Call provision: The right of the issuer to redeem the bond issue prior to the maturity date under certain circumstances

b. Sinking fund: Requires the issuer to retire a portion of the bond issue each year or deposit funds into a restricted account to be accumulated for the retirement of the bonds

c. Restrictive covenants: Conditions that must be met by the issuer during the life of the bond issue, such as maintaining a debt ratio no higher than a specified amount, restricting dividend payments, maintaining a minimum current ratio, or other similar requirements

5313.13 Bond ratings are determined using a rating system such as Standard & Poor’s, based upon the probability that the issuing corporation will go into default. These ratings range from AAA (very strong) to D (in default). AAA and AA are considered to be of a high investment quality, and they along with A and BBB rated bonds are considered to be investment grade, BB and B are considered to be substandard, and CCC to D are considered to be speculative.



5313.14 The bond rating is based upon the financial health of the issuing organization (capital structure as well as stable profitability), bond provisions, pending legal actions, and time to maturity. The rating is done by rating agencies using subjective judgment. The bond rating has a direct effect on the bond’s coupon rate, and thus the firm’s cost of capital if a firm wishes to issue new debt. Since many bonds are purchased by institutional investors who are generally restricted to purchasing no lower than investment‐grade bonds, this rating is extremely important. The issue here is that there is an additional impact in the event a firm’s rating is downgraded. Then there would be a decrease in the market price of outstanding bonds.

5313.15 The market value of bonds is based upon the present value of discounted future cash flows, comprised of an annuity plus a lump sum. The bond’s market value fluctuates with changes in the market interest rates. If the coupon rate equals the market interest rate, then the market value of the bond will be equal to the face value (par value). If the market interest rate is above the coupon rate, the bond will be selling at a discount to par. If the market interest rate is lower than the coupon rate, the bond will sell at a premium to par.

As the bond approaches maturity, its market value will approach par. Changing interest rates will have an impact on the market value of the bond, the impact being greater the longer the remaining maturity of the bond. The issuing corporation, however, will be required to make the same semi‐annual interest payment no matter what changes occur in the interest rate over the life of the bond. When bonds are issued, the coupon rate on the bond generally is set close to the current market rate.

Illustration: A $1,000 bond with a 7% coupon rate, maturing in 10 years, is selling in a 6% market. What is the current market value of the bond?

Solution: The bond is valued by determining the PV of the future cash flows (maturity value of $1,000 and semi‐annual interest payments of $35 each ($1,000 × 3.5%)). Using present value tables for 3% (due to semi‐annual interest payments), 20 periods, the value of the bond can be calculated:

PV of maturity ($1,000 × .5537) $ 553.70 PV of interest payments ($35 × 14.8775) 520.71 Present value $1,074.41

Due to the fact that the coupon rate is higher than the current market rate, the bond will sell at a premium.

5313.16 Advantages of long‐term debt financing

a. Ownership of the company is not shared with the debt holder.

b. No matter how profitable an organization is, the bondholder will still only receive the same semi‐annual interest payments over the life of the bond. Operating income in excess of the bond interest goes to the equity holder.

c. The interest on the loan is a fixed amount that can be budgeted, or in the case of a variable interest rate, the interest for a particular period can be adequately estimated.

d. The interest paid on the debt is a tax‐deductible expense; the tax shield lowers the effective after‐tax cost of the debt.

e. Raising debt capital is less complicated than issuing either preferred or common stock.

f. Some debt issues have call provisions that supply flexibility to the issuing firm.



5313.17 Disadvantages of long‐term debt financing

a. Long‐term debt frequently has various restrictive covenants that can dramatically limit choices available to management. Examples include setting dividends, obtaining additional debt, holding compensation balances, maintaining levels of liquidity and/or solvency ratios, and prepayment penalties.

b. If interest rates fall, a firm could be locked into a high interest rate.

c. Long‐term debt has a maturity date at which time the principal needs to be repaid.

d. Interest payments are a fixed cost that increase the breakeven point of the firm. Interest must be paid whether a profit is made or not. During a downturn, making interest payments can become difficult.

e. Debt increases the financial leverage (risk) of the company, and the higher the leverage, the less flexibility a company has for raising future financing.

f. Long‐term debt is often obtained in larger amounts, and since predicting actual cash needs is not an exact science, long‐term borrowing is often out of tune with actual needs.

g. The amount of debt financing is limited, and as the percentage of debt in the capital structure increases, so does the cost of issuing additional debt.

Lease Financing

5313.18 The FASB defines a lease in ASU 2016‐02 to be “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” An entity will determine whether a contract contains a lease by assessing whether the use of an identified asset is either explicitly or implicitly specified and whether the customer controls the use of the identified asset.

5313.19 There are two sets of lease criteria: the first set is for both lessees and lessors, and the second set is for lessors only.

5313.20 The first set of criteria result in a finance lease for a lessee or sales‐type lease for the lessor if the lease meets any of the following criteria at commencement:

a. Title (ownership) transfers to the lessee by the end of the lease term.

b. The lease contains a purchase option that the lessee is reasonably certain to exercise.

c. The lease term is for the major part of the remaining economic life of the underlying asset. This criterion shall not be used if the lease commencement date is near the end of the asset’s economic life.

d. The present value of the sum of the lease payments and any lessee guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.

e. The underlying asset is specialized and is not expected to have an alternative use to the lessor at the end of the lease term.

5313.21 For most leases of property (e.g., land or building), a lessee would classify the lease as an “operating” lease if none of the five criteria listed in section 5313.20 are met and will recognize the following:



a. At commencement, a right‐of‐use (ROU) asset and a lease liability, initially measured at the present value of lease payments, using the interest rate implicit in the lease if known; otherwise, the lessee uses its incremental borrowing rate.

b. Subsequent to commencement, a single lease cost, combining the unwinding of the discount on the lease liability (i.e., interest expense) with the amortization of the ROU asset, on a straight‐line basis. In other words, the lease liability is reduced by the amount of the periodic payment less the amount of that payment attributable to interest. The lessee then “plugs” the ROU asset amortization at whatever amount is needed for interest plus amortization to equal the straight‐line payment in the lease contract. Impairment, if any, is recorded.

5313.22 If any of the five criteria in section 5313.20 are met (control is deemed to have transferred), the lessor accounts for the lease as a sales‐type lease with or without a selling profit and will:

a. at commencement, recognize the net investment in the lease [lease receivable (lease payments plus guaranteed residual values) plus the unguaranteed residual asset]; derecognize the carrying amount of the underlying asset; and recognize sales revenue and cost of goods sold at the beginning of the lease such that selling profit (usually when the fair value of the asset exceeds the cost or book value of the asset) if any, is immediately recognized. Expense initial direct costs if a selling profit exists and defer initial direct costs by increasing the net investment in the lease if there is zero profit.

b. subsequent to commencement, recognize interest income (interest on the lease receivable and interest from the unguaranteed residual asset accretion) using the effective interest method and reduce the net investment in the lease.

5313.23 When none of the first set of criteria in section 5313.20 are met, a lessor shall classify the lease as an operating lease unless both of the following second set of criteria are met to classify the lease as a direct financing lease:

a. The present value of the sum of the lease payments and any lessee or other third party guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.

b. It is probable that the lessor will collect the lease payments plus the residual value guarantee.

5313.24 The availability of credit is sometimes a major part of the decision to purchase or lease. If an organization wishes to maximize financial leverage while maintaining a high level of (superficial) solvency, operating leases may be chosen.

5313.25 Advantages of lease financing

a. It can be less expensive to lease than to borrow funds in order to purchase necessary equipment.

b. Generally, lessors do not require down payments and thus provide 100% financing. However, lenders commonly will not finance the entire purchase price of an asset.

c. Any restrictions placed by lessors are normally less restrictive (or non‐existent) than those of lenders.

d. Short lease periods allow a company to avoid the risk of obsolescence.

e. If land is leased, the lease payment is a tax‐deductible expense; however, land that is owned is not depreciable.



f. Leasing provides for fixed‐rate financing in that the lease payment is set for the life of the lease.

g. Commonly, it is easier to lease than to borrow.

5313.26 Disadvantages of lease financing

a. In general, all lease payments during the contracted period are required to be paid; thus, flexibility is taken away from management in the case of a downturn in business.

b. Although the leased equipment is not owned, frequently maintenance costs for the asset are the responsibility of the lease holder.

c. Over the life of a lease, the payments made on the lease are greater than if the asset were purchased for cash. The additional amounts of the basic cost of the asset are similar to the interest payments made on borrowed funds.

d. There is no ownership during the lease period, thus no effective equity related to ownership.

Equity Financing

Preferred Stock

5313.27 Preferred stock is often referred to as a hybrid in that it has some of the characteristics of debt and some of the characteristics of equity. Preferred stock is more risky than debt; however, it is less risky than common stock.

a. Similarities to debt:

(1) There is a fixed dividend similar to the fixed interest charge for debt.

(2) Preferred stockholders have priority over common stockholders in the case of liquidation and dividend payments.

(3) Preferred stockholders have no voting rights.

b. Similarities to equity:

(1) Preferred stock increases equity.

(2) The original investment does not need to be paid back.

(3) There is no maturity date.

(4) Preferred dividends are not a deductible expense.

(5) The preferred dividend is not required to be paid.

(6) The liability for preferred stockholders is limited to their initial investment.

c. There are a number of varieties of preferred stock.

(1) Participating preferred stock allows for a limited participation in dividend increases based on a stated formula.

(2) Dividends on preferred stock can be cumulative or noncumulative.

5313.28 Advantages of preferred stock financing

a. No matter how profitable an organization is, the preferred stockholder will receive only a maximum dividend payment that is either fixed or has a limited participation; hence,



superior earnings still potentially go to the common stockholders as the preferred stockholders’ participation in earnings is limited.

b. Most preferred stock issues do not allow for participation in the control of the corporation; thus the common stockholders’ control is not diluted.

c. In a period of low profitability or loss, preferred dividends do not have to be paid or at minimum can be delayed if there is a cumulative feature. Failure to pay dividends will not lead to bankruptcy.

d. Preferred stock generally does not have a maturity date, and some issues are convertible into common stock and some have a callable feature that provides a level of flexibility for management.

e. The equity position of the company is increased, thus improving the creditworthiness of the firm.

f. The convertible feature coupled with the callability feature can be used to force conversion. This gives management some degree of flexibility.

5313.29 Disadvantages of preferred stock financing

a. Dividends paid to preferred stockholders are paid with after‐tax income since they are not a deductible expense; therefore, the interest tax shield is not available as with bond financing.

b. Although dividends are not paid unless declared, preferred stock often has a feature that allows for the accumulation of dividends (dividends in arrears) that must be paid before any common dividend can be distributed.

c. Preferred stockholders have priority over common stockholders in both dividends and assets in the case of liquidation.

Common Stock

5313.30 Common shareholders are owners of the company and have all of the rights given to them in the corporate charter. A common stock investment is the most risky of the investments presented in this section since the common stockholders are not guaranteed any type of return in either dividends or stock appreciation, and these investors are the last to receive anything in a liquidation. As a matter of fact, it is the common stockholders who provide a cushion for the debt holders should a loss occur in the liquidation process.

5313.31 Common shareholders have a right to the earnings of a company after obligations to creditors and preferred stockholders are met. This residual income can be paid to the shareholders in the form of dividends or reinvested (retained) in the business. Shareholders can benefit from the earnings that are retained due to the fact that the value of the firm is increased, and the firm’s earnings power can increase due to the additional investment resulting in future dividends and a potential appreciation in the value of each share of stock.

5313.32 Although common shareholders hold ownership interests in a company, they have limited liability in that the only amount that they have at risk is the amount of their investment. This limited liability provides potential safety in the case of legal proceedings against the firm and/or liquidation. It is unlikely that most investors would purchase stock without the limited liability provision.



5313.33 Common shareholders have the right to:

a. elect the board of directors.

b. approve changes in the corporate charter.

c. share in a company’s profits.

d. share in any remaining assets upon liquidation.

e. maintain a proportionate share of ownership in the company should additional stock be issued (preemptive rights).

5313.34 Advantages of common stock financing

a. In a period of low profitability or loss, common dividends do not have to be paid. Failure to pay dividends will not lead to bankruptcy. Growth companies also frequently do not pay dividends.

b. There is no maturity date for repayment of investment since it represents permanent ownership.

c. Common stock increases the equity position of the corporation and can provide a basis for increasing debt.

d. For a firm with solid growth, common stock is often an attractive investment since common stock will provide a higher return to the investor than debt.

5313.35 Disadvantages of common stock financing

a. As more common stock is issued, ownership and earnings per share are diluted.

b. Common dividends are not tax deductible and result in double taxation due to the fact that corporate earnings are taxed at the corporate level and dividends are taxed at the individual level.

c. As more common stock is issued in proportion to other financing options, the weighted‐average cost of capital increases.

d. As a general rule, underwriting costs are high.

Retained Earnings

5313.36 Retained earnings are GAAP profits that have not been paid out to shareholders. The “cost” associated with this source of funding is the opportunity cost for the common shareholders.

a. The directors of a company have two choices when a firm has profits:

(1) Pay those profits out in the form of dividends.

(2) Retain those earnings and reinvest them in the organization.

b. The cost of retained earnings is the opportunity cost to the investors who would have had free choice in how to use those profits in whatever investment possibility deemed as to hold the highest return possibility had dividends been paid.

c. If earnings are retained in the company as opposed to issuing new common stock, flotation costs associated with a new issue are avoided; thus, the cost of retained earnings is lower than the cost of a new issue of common stock.



5313.37 Advantages of retained earnings financing

a. Retained earnings do not have the flotation costs associated with the issuance of bonds and common stock.

b. Firms tend to prefer internal financing sources first due to their ease of availability, lack of additional cost to obtain, and the fact that no company information must be given to third parties.

c. The equity position of the company is improved, leading to improved creditworthiness without diluting ownership.

d. No interest needs to be paid on retained earnings nor are dividends ever expected to be paid out.

5313.38 Disadvantages of retained earnings financing

a. Earnings retained in the company cannot be paid out to shareholder, thus limiting investment/spending choices for investors (opportunity costs).

b. Cash dividends lower the cash available in the business.

c. Due to the expectations of shareholders, the actual cost of retained earnings is higher than the cost of debt and preferred stock as represented in the weighted‐average cost of capital calculation.

5320 Working Capital

5320.01 Overview

a. Working capital is short‐term assets such as cash, receivables, and inventory. Net working capital is current assets less current liabilities. Working capital is tied to the cash conversion cycle where inventory is purchased or produced and sold on account, and payments are made. It focuses on the difference between the cash collection period and cash payment period.

(1) The inventory conversion period is the average time that inventory is held in days

before being sold. (Average inventory Average cost of goods sold per day)

(2) The receivables collection period is the average time that receivables are

outstanding before they are turned into cash. (Average accounts receivable Average sales per day)

(3) The payables deferral period is the average time that short‐term obligations related to the purchase/production of inventory are outstanding. (Average payables

Average purchases per day)

(4) The cash conversion cycle is the inventory conversion period and the receivable collection period less the payables deferral period. It represents the amount of time that funds are tied up in non‐cash current assets.

Illustration: If the inventory conversion period is 45 days, the receivable collection period is 35 days, and the payable deferral period is 30 days, what is the cash conversion cycle?

Solution: The cash conversion cycle is simply:

Inventory conversion period + Receivable collection period - Payable deferral period = 45 days + 35 days ‐ 30 days = 50 days



Thus cash is tied up in non‐cash current items for 50 days. This represents a permanent financing need.

b. As long as the cash conversion cycle can be shortened without encroaching on sales or increasing costs, a firm should attempt to do so since that will mean that a lower amount of permanent financing will be necessary, and there is a cost to any financing. This can be done by:

(1) selling products more quickly.

(2) collecting receivables more quickly.

(3) slowing down payments.

Illustration: Using the above example, if $25,000 of obligations related to the purchase/production of inventory are created each day, the necessary working financing

needs would be $1,250,000 given the cash conversion cycle of 50 days ($25,000 50 days). If products could be sold on average two days earlier, receivables collected on average three days earlier, and payments on payables delayed on average one day more, then the conversion cycle would be decreased by six days. That translates into a decrease of $150,000 tied up in non‐cash current assets. If the cost of borrowing is 6%,

that would mean that the organization would save $9,000 per year ($150,000 6%).

c. The concept of zero working capital is when Inventories + Receivables - Payables = zero. This equation can be translated as the use of payables for the sole source of financing for inventories and receivables. If a company moves to zero working capital, there are two results:

(1) There is a one‐time infusion of cash as either inventory and/or receivables are decreased or payables increased.

(2) Income is permanently increased on an annual basis due to the fact that financing is no longer needed to support working capital (higher level of inventory and receivables, including the costs of carrying inventory and receivables). The costs of financing operating assets are shifted to suppliers. Inventory reductions can often be accomplished through the use of JIT (just‐in‐time).

d. If working capital is reduced, the amount of financing decreases; thus, EVA (economic value added) will increase since the after‐tax dollar cost of operating capital will decrease.

5321 Working Capital Fundamentals

Cash Management

5321.01 Reasons to hold cash

There are four primary reasons for a company to hold cash.

1. Transactions purposes: Cash is necessary for a company to conduct its day‐to‐day business.

2. Precaution purposes: Since cash flows do not flow evenly over time and often cash inflows are not matched with cash outflows (a business cycle consideration), it is necessary to have enough cash on hand to compensate for unanticipated fluctuations in cash flows.

a. Precautionary cash is often held in highly liquid marketable securities. This provides security and additional interest income.



b. Today, most companies have a line‐of‐credit arrangement to cover the precautionary needs.

3. Speculative purposes: Cash balances are also necessary to allow a firm to take advantage of potential business opportunities such as bargain purchases.

a. Near‐cash is advisable for speculative purposes so that additional interest/dividend income can be earned.

b. Organizations often do not hold cash for speculative purposes if they have a readily available source of funds such as a line of credit.

4. To meet compensating balance requirements: Compensating balances are amounts required to be kept in an account by a bank and are often mandatory in order to obtain a loan or to avoid paying fees for individual bank services.

5321.02 The cash budget

a. The cash budget is a cash management tool that details cash inflows and outflows over a specified period of time. It can be prepared on a yearly, quarterly, monthly, weekly, or even daily basis. Since cash inflows and outflows are not necessarily uniform throughout the year, the cash budget highlights when cash shortages are likely to occur, allowing management to plan necessary borrowing, and also highlights when cash surpluses will be available for repayments or investments.

b. The cash budget is based upon estimates of sales, credit terms, and bad debt levels (cash collections); estimates for purchases and payment terms (cash payments); estimates for production and payment terms for conversion costs (cash payments); estimates for borrowings (cash inflows), repayments, and associated interest payments (cash outflows); estimates for capital purchases (possible cash outflows) and disposals (possible cash inflows); and potential dividend payments (cash outflows). Since this budget is based upon estimates, it is necessary to update the cash budget on a regular basis when data on actual inflows and outflows become available.

c. The target cash balance is the desired cash balance management believes to be necessary to safely conduct business. This amount may vary during the year due to the cyclical nature of many industries. When estimated cash inflows exceed estimated cash outflows for a given period including planned capital expenditures, the excess can be used to repay short‐term credit and/or be invested. When estimated cash outflows exceed estimated cash inflows for a given period, investments can be turned into cash to meet these cash needs, or short‐term borrowing can be arranged. Many companies have line‐of‐credit arrangements to help them smooth out cash flows throughout the year.

5321.03 Synchronizing cash flows

Synchronizing cash flows matches the cash outflows with the timing of the receipt of cash inflows. This allows firms to keep transaction balances to a minimum. Many companies stagger the billing of customers throughout the month in an attempt to create fairly even daily cash inflows while planning the timing of payments for various obligations so that due dates are during various weeks of the month. The lower the target cash balance, the more funds that are available for productive uses.

5321.04 Speed of cash collections and disbursements

a. From the perspective of an individual firm, collections need to be made as quickly as possible and disbursements delayed as long as possible, providing discounts are not lost



nor unnecessary interest charges incurred. This allows for the maximum cash balance at any given time.

b. When a check is received from a customer, it does not mean that funds are necessarily available at the time of receipt. Due to the check clearing process, it may be one to three days before the funds are available. The difference between the checks that have been received and those credited by the bank is the collection float. The goal of management is to keep this float as low as possible.

c. Techniques such as the use of lockboxes and electronic funds transfers allow firms to speed up the collection process.

d. The net float is the difference between the firm’s checkbook balance and the balance of the account in the bank’s records. The difference is due to the collection float and the disbursement float. The disbursement float is the amount of the checks written but that have yet to clear the bank. The disbursement float allows a firm to have lower cash balances.

e. Techniques such as the use of zero balance accounts allow a firm to not hold funds in non‐interest‐bearing accounts to meet anticipated disbursement needs.

Marketable Securities

5321.05 Use of marketable securities

a. Marketable securities are generally low‐risk investments that can be quickly turned into cash. Marketable securities include:

(1) U.S. Treasury bills.

(2) bank certificates of deposit.

(3) commercial paper.

Since most firms attempt to minimize cash balances, excess cash is often invested in marketable securities that are purchased with maturities that coincide with seasonal needs, maturing debt, tax payments, or other potential needs.

b. Marketable securities have low risk and high liquidity.

(1) Since safety is an important factor, short‐term marketable securities are generally lower yielding since safety is traded for higher yield and minimizes default risk.

(2) Short‐term investments also minimize interest rate risk since their market values do not show a high degree of price fluctuation related to interest rate changes.

c. Marketable securities are held as a substitute for cash. By transferring excess cash to interest‐bearing investments, the surplus can add value to the firm. The funds are still readily available to meet transaction, precautionary, and speculative needs.

d. Marketable securities are held as temporary investments to be used to meet seasonal needs or to protect against business downturns.

e. Marketable securities are held to meet planned financial needs such as a maturing bond issue, upcoming tax payments, or a possible expenditure for plant or equipment.

f. Marketable securities can be used as a temporary place for funds received but yet to be invested in long‐term investments or capital additions.

g. With the use of lines of credit, the need for marketable securities has diminished for companies that have access to such financing options.



By using a line of credit to meet short‐term needs for funds as opposed to marketable securities:

(1) a firm’s current ratio could be lower without indicating a greater risk that the obligations would not be repaid on a timely basis. There is, however, a risk that funds available from this method of financing might not meet all of the firm’s actual short‐term needs.

(2) if excess cash is not expected to be needed for precautionary and speculative purposes, it might be feasible to put these additional funds to better use, such as by investing them in higher‐yield, medium‐term investments or to fund capital enhancements to improve the productivity of the existing capacity.

5321.06 Cash management and the multi‐company, international firm

a. A multi‐company firm has additional cash management issues. Each subsidiary needs to manage cash on an individual basis; however, a centralized cash management group needs to manage the cash flows between the parent‐subsidiary and within inter‐subsidiaries in order to optimize cash flows. Such management can benefit subsidiaries in need of funds by supplying the needed cash from excess funds from another subsidiary or the parent.

b. The need to increase the speed of cash inflows is magnified in the international setting due to increased mailing times. The use of lockboxes around the world is one method of speeding up collection. Another method is to have preauthorized payments where the firm can charge a customer’s account up to a specified limit. Today, most large firms use an electronic method such as the internet to transfer funds.

c. International cash flows result in the need for currency conversions. By using a tool called netting, administrative and transaction costs resulting from currency conversions can be reduced. For example, if two subsidiaries are located in different countries and A purchases parts from B, transactions resulting from the sale of the parts from B to A are “netted” for a period of time (generally a month), and one net payment involving currency exchanges is made per period, thus reducing conversion costs.

A more complex multilateral netting system is used when there are a parent and several subsidiaries. The transactions among the various entities are netted so that conversion costs are minimized.

d. The use of various cash transfers for international organizations may be hampered by foreign government restrictions and characteristics of the banking systems in less developed countries.

Accounts Receivable Management

5321.07 Introduction to accounts receivable management

a. Firms extend credit on sales in order to increase revenues. Since the objective of increased sales is to increase profit, a firm will theoretically extend credit until the cost of offering additional credit equals the costs incurred in generating those sales (incremental analysis).

b. The value of the trade accounts receivable at any given time is directly tied to sales volume, which in turn is influenced by factors some of which management has control of, such as product price and quality and advertising. Another major controllable factor influencing sales is the firm’s credit policy that consists of the following:



(1) Credit period: the length of time the customer is given to pay for the purchases. For example, credit terms of “3/10, net 30” allows buyers to take up to 30 days to pay without incurring interest charges.

(2) Discounts: the credit terms “3/10, net 30” allow customers to take a 3% discount if the payment is received within 10 days of the invoice. The full amount would be due in 30 days if the discount opportunity was not taken.

(3) Credit standards: the required financial strength of acceptable customers. Relaxing the standards is likely to boost sales, but also to increase bad debt losses.

(4) Collection policy: how tough or lax the firm is in terms of attempting to collect slow‐paying accounts. Again, there is a trade‐off between attempting to speed up the collection of an account and possibly losing a customer.

c. The credit manager is generally responsible for administering a firm’s credit policy. However, credit policy is generally set at an administrative level within the firm.

d. A change in credit policy involves the interaction between several variables. Below are some of the issues management would need to analyze when considering a change in the credit policy.

(1) Sales: What is the projected increase in the level of gross sales that would result from the change?

(2) Account receivable: There is generally a proportional relationship between an increase in sales and an increase in accounts receivable. An increase in accounts receivable would mean that additional funds would be tied up until collection. Increasing accounts receivable would require increasing funding (debt or equity) with a possible increase in interest costs.

(3) Discounts and bad debt losses: What proportion of customers would be expected to take the discount? What proportion of the additional receivable would become bad debts?

(4) Costs of running a collection department: Would more staff (higher costs) be needed to run collection department due to higher volume? Would there be fixed costs associated with the expansion of the credit collection efforts?

(5) Management would have to compare the increased revenues expected with the increased costs to determine whether the firm would be better off on an incremental profit basis.

e. A firm’s credit policy includes the credit standards, credit period, available discounts, and collection procedures.

f. The quality of credit is defined as the ability to collect receivables in full and in a timely manner.

g. A firm’s credit policy is often dictated or strongly influenced by competitors since unless the firm’s policies are competitive, sales will often be lost.

5321.08 Credit standards

Credit standards are the firm’s standards by which potential customers are measured in the process of being approved for credit. The lower the standards, the higher the sales and the higher the associated costs such as bad debt losses that come from extending credit to less creditworthy customers. Optimal credit standards allow for the marginal cost of extending the additional credit to equal the margin profits produced by the increased sales resulting from the relaxed credit standards.



5321.09 Credit period

a. The credit period is the length of time for which credit is extended. It is the time that elapses between the sale and the expected collection of funds. Lengthening the credit period often encourages sales, but also increases financing needs due to the fact that additional funds will be tied up in the additional receivables. Longer credit periods are also associated with higher bad debt expenses.

b. If the credit period is extended, trade accounts receivable will increase due to the increased holding time of receivables as well as increased credit sales.

c. The cost of extending the credit period can be calculated by multiplying the increase in accounts receivable by the marginal cost of capital.

Illustration: If a firm increases its credit period from 30 to 45 days, average accounts receivable are predicted to increase from $400,000 to $500,000. If the cost of capital is

10%, then the marginal cost of changing the credit period is $10,000 ($100,000 10%).

d. In poor economic times, a firm needs to be concerned that customers will unilaterally extend the credit period.

5321.10 Available discounts

a. Discounts are used as an incentive to get the customer to make an early payment. This would reduce the cash outflow needed by the customer to meet the obligation. A common discount would be stated as “2/10, net 30.” This is interpreted to mean that the customer may take a 2% discount if the payment is received within 10 days, with the full amount due and deemed current if received between 11 to 30 days.

b. Discounts provide:

(1) a price reduction for customers.

(2) a means to attract new customers.

(3) a way to reduce the average collection period.

c. Seasonal discounts are also offered by some organizations. By placing an order by a specified date, customers are offered discounts even if the merchandise is shipped months later. This is a tool designed to lock in sales that would help to facilitate scheduling production.

5321.11 Collection procedures

Collection procedures are steps that a firm takes to collect past‐due accounts. These steps might include a series of increasingly severe letters or telephone calls with the account ultimately turned over to a collection agency. Collection procedures are expensive and can often be reduced by screening customers more carefully or by tightening credit standards. These choices generally involve a cost/benefit issue.

5321.12 Alternative credit

The acceptance of bank credit cards and debit cards is an alternative to providing in‐house credit to customers and can often be less expensive. Retail organizations are often forced into accepting this form of payment due to widespread consumer use and the acceptance by competitors.

a. Charge tickets can be deposited daily, much like a check.



b. Funds are available immediately for debit card transactions and almost immediately for credit card transactions.

c. Banks charge fees in the range of 3% to 10% of the dollar sales volume based upon average transaction amount and total dollar volume. The higher the volumes and the larger the average per transaction, the lower the fee would be.

Inventory Management

5321.13 The importance of inventory

Inventories can take many forms—raw materials, work‐in‐process, finished goods, supplies—and inventories are extremely important to many organizations. Without the appropriate inventories, there will possibly not be an adequate level of goods available to meet demand. Thus, it is important that management prepare adequate sales forecasts in order to assure that enough inventory will be available to meet the forecasted demand. Without the necessary inventory, sales are lost. On the other hand, excessive inventories lead to high carrying costs.

There are two major issues involved in inventory management—having the right inventory at the right place at the right time, and not having too much inventory, which would result in excessive carrying costs.

5321.14 Just‐in‐time

a. A just‐in‐time (JIT) production system purchases raw materials and component parts just as they are needed in the production process, thus reducing raw material inventory close to zero. It is part of a manufacturing philosophy that promotes the simplest, least costly means of production. Under ideal conditions, the company would receive raw materials just in time to go into production, manufacture parts just in time to be assembled into products, and complete products just in time to be shipped to customers. JIT shifts the production philosophy from a push approach to a pull approach.

(1) The push approach begins with the acquisition of raw materials that are pushed into production through the various stages of production, and finally into finished goods inventory. The goal is to have finished goods ultimately sold to customers without deep discounting.

(2) The pull approach starts with the demand for finished goods from a customer. The customer’s order triggers the production of the goods. Inventories are acquired only to meet production needs.

b. Under ideal conditions, the company would attempt to create a situation where both raw material inventory as well as finished goods inventory would be eliminated and work‐in‐process inventory kept to a minimum.

c. Raw materials are delivered just in time to meet the production schedule, with a guaranteed high level of product quality so that they can bypass inspection and go directly to production. This requires long‐term purchase agreements with suppliers and coordination between purchasing and production. The result is a virtual elimination of raw material inventory. The cost of carrying inventory is shifted to the supplier.

d. The rate of production for individual departments is determined by the needs of each succeeding department. Inventory buffers with a predetermined size are used to signal when a department should be working. The department works as long as the buffer is less than the desired level. This eliminates most work‐in‐process inventory.



e. As soon as products are finished, they are immediately shipped to the customer, thus eliminating finished goods inventory and immediately converting the product into cash or accounts receivable. Close supplier/customer relations can allow both supplier and customer to use JIT systems.

f. Generally there are changes required in several areas of the manufacturing process to make JIT successful.

(1) Activities that do not add value need to be eliminated. Activities are identified as value‐adding activities and nonvalue‐adding activities. A nonvalue‐adding activity is any activity that could be eliminated without detracting in any way from customers’ satisfaction with the final product. Moving time, inspection time, and times in queues are all nonvalue‐adding activities and should be eliminated as much as possible. Machining, milling, and polishing of products are all value‐adding activities, as customer satisfaction would be reduced without them.

(2) Supplier relationships are of key importance. It is important to select a small number of suppliers who can guarantee both the quality and timely delivery of raw materials. Raw materials are usually delivered in small quantities as needed for production. Responsibility for raw material quality is also shifted to the supplier.

(3) Manufacturing cells are developed. Traditional departments and processes are replaced with manufacturing cells that contain families of machines typically spread through several departments. A component or a complete product can be produced within one cell rather than being transferred between several departments.

(4) The workforce is highly trained and flexible. The cellular manufacturing environment requires a labor force that is capable of operating several different machines. The workforce must be capable of servicing the machines and performing inspections on finished products.

(5) Total quality control is implemented at the inventory and production level. The streamlined flow of raw materials and components through the production process does not allow for product defects. No defects can be allowed in parts or raw materials received from suppliers, in work‐in‐process, or in finished goods. Emphasis is placed on doing things right the first time and avoiding rework or waste of any type. Products are inspected for quality at each stage of the process. When a defect is discovered, the production process is halted until the problem is corrected. Responsibility for inspecting products is shifted from inspectors to production workers. There is a commitment for continuous improvement in all aspects of the company.

(6) Set‐up time is reduced. Set‐up time is the time required to change equipment, move materials, and obtain forms needed to shift production from one product to another. Meeting customer demand on short notice without any finished goods inventory requires the ability to shift production from one product to another with a short set‐up time.

g. When using JIT methods, the differences between net operating income using the absorption method or variable costing method will be reduced since the differences relating to the costing of inventory are eliminated with the elimination of the finished goods inventory. If inventories are almost non‐existent, then differences in inventory valuations will be extremely small, bringing the results of net income using absorption or variable costing extremely close.



h. Advantages of JIT production systems:

(1) Funds are no longer tied up in inventories and can be more effectively used elsewhere.

(2) Warehouses formerly used to store inventory can be put to more productive use.

(3) As defects are reduced, less waste occurs, and customers’ satisfaction is increased.

(4) As production time is decreased, a greater output potential is created.

(5) Customers’ satisfaction is increased due to the shorter delivery time from the point the order is received (order lead time).

i. Disadvantage of JIT production systems: Increased possibility of stockouts if delivery of a critical part is delayed due to strikes, disasters, or other unexpected occurrences

5321.15 Economic order quantity

a. The economic order quantity is the least amount of inventory that should be ordered given the various costs involved. The economic order quantity model (EOQ) provides a formula for determining the quantity of a particular inventory item that should be ordered in order to minimize inventory costs.

Ci

DSEOQ

2

b. Relevant items in determining the economic order quantity:

D = The demand per year in units

S = Setup or ordering cost per order or batch

C = The cost per unit

i = The carrying costs expressed as a percentage of inventory cost

c. Inventory decision models contain costs that move in opposite directions. Carrying costs increase as the size of the order increases. Set‐up or ordering costs, however, decrease as the size of the production run or order increases. The EOQ model seeks to minimize the combined total of these two costs, as illustrated in the following graph.



d. Assuming that there is constant demand and no change in lead time, the reorder point is equal to the sum of expected units of demand during the lead time plus any required safety stock. This relationship can be illustrated as follows:

The formula for the reorder point (RP) is:

RP = DLT + SS

DLT is the average demand during the lead time period. This can be calculated by determining the demand per day and multiplying that result by the number of days in the lead time. SS is the safety stock required.



e. Illustration: Use the following data to compute the economic order quantity and reorder point assuming 300 business days per year.

Demand (D) 40,000 units per year Unit cost (C) $50 Carrying cost rate (i) 20% per year Order cost (S) $115 per order Lead time (LT) 3 days Safety stock (SS) 500 units

Solution:

units

Ci

DSEOQ

960%2050$

115$000,402

2

unitsdaysxdaysunitsSSDRP LT

9005003300/000,40

5321.16 Reasons for not minimizing inventory levels

a. Larger inventory levels can guarantee the availability of inventory as needed. When stockout costs are high, carrying a larger safety stock may be appropriate.

b. Through use of large discounts or more favorable credit terms, customers may be convinced to purchase larger quantities. Thus, inventory policy needs to be coordinated with other policies such as credit policies.

c. If competition is very high, suppliers may feel the need to increase inventory levels to insure prompt deliveries to customers.

d. Inventories can be a good hedge against inflation if the cost of replacing inventory is increasing.

e. Safety stock is a level of inventory that is held in excess of the desired inventory level to cover unanticipated demand. This additional inventory provides security from stockouts and lost sales when the time to replace inventory exceeds the anticipated period. The level of safety stock is determined by a balancing of the cost of holding additional inventory items and the cost, or lost revenue, associated with not having goods available for the customer when they wish to purchase them.

Accounts Payable Management

5321.17 Trade credit

a. Most companies purchase on credit, making trade credit a significant part of current liabilities. Trade credit is a spontaneous source of financing created when goods and services are purchased on account in the normal course of business. If a firm purchases

$10,000 of goods per day on average, at the end of 30 days, $300,000 ($10,000 30) of financing has been created. If suppliers’ credit terms increase to 45 days, an additional

$150,000 [$10,000 (45 days - 30 days)] of credit can be generated.

b. As a general rule, firms will hold cash payments until the last minute that an obligation is due in order to increase their average cash balance. This is the case unless the cost of making an early payment is less than the firm’s cost of capital.



5321.18 Free trade credit

a. Firms frequently have credit terms that include offering a discount on invoices if paid within the discount period. “2/10, net 30” provides a discount of 2% if the invoice is paid within 10 days and full payment is expected within 30 days if the discount is not taken.

b. Free trade credit is credit received during the discount period. In the example mentioned above, the discount period would be the first 10 days of the net purchase period.

c. Illustration: A firm purchases $50,000 of merchandise on credit with the terms 2/10, net 30. What amount is paid to satisfy the obligation if the payment is made by the 10th day of the net 30 period?

Solution: $50,000 - ($50,000 2%) = $49,000 with the firm gaining a $1,000 discount

5321.19 Cost of trade credit

a. If payment is not made on trade credit within the discount period, the discount is lost, and the full amount of the credit is paid within 30 days. The results of this lost discount are:

(1) the savings of the discount are lost.

(2) the size of trade credit increases, thus increasing the debt load.

b. Illustration: A firm purchases $2 million of merchandise throughout the year (assuming a 360‐day year) and is offered a 2% discount on all invoices paid within 10 days. If all invoices are paid within the discount period, the full amount paid will be $1,960,000 ($2

million 98%). This results in a savings of $40,000 per year.

If all discounts are taken, payables at any given time will average $54,444 [($1,960,000 360 days) 10 days]. If the discounts are not taken and payment is made within the 30‐

day period, then average accounts payable will increase to $163,333 [($1,960,000 360 days) 30 days]. That is an additional $108,889 of trade credit that is being used.

There is a cost to this additional credit—the lost $40,000 in discounts. The lost discounts represent increased cost for the merchandise; therefore, the price of the additional $108,889 of trade credit is $40,000. The cost of this credit is computed as follows:

Lost discount Additional credit supplied

= $40,000 $108,889

= 36.7%

c. If a firm can borrow funds at an interest rate lower than the cost of the foregone discount, then the funds should be borrowed and the discounts taken. If the firm above can borrow $108,889 at 10% for an annual interest cost of $10,889, then $29,111 would be saved on an annual basis ($40,000 - $10,889).

d. The return on taking discount can also be calculated using the following formula:

360 Total credit period – Discount period

Percentage of discount 100% - Percentage of discount

Using the above illustration, the return can be calculated:

360 30 days – 10 days

2% 100% – 2%

= 36.7%

e. Payment of trade credit beyond the normal credit terms will likely result in interest charges, thus increasing the cost of credit as well as hurting relations with the supplier.



Firms that do not take advantage of discounts are generally in a weaker financial position with poor cash flow and/or limited access to other sources of funds.

5321.20 Trade credit and financial statements

a. Not taking discounts can have a dramatic effect on the financial statements—affecting profitability as well as liquidity.

b. The effect on profitability can be shown in the following tables comparing the results on income of a firm taking versus not taking trade discounts. In this example, it is assumed that a company will have to borrow at 10% ($10,889 annual interest) in order to take advantage of the available discounts (see above information).

Do Not Take

Discounts Take

Discounts

Sales $4,000,000 $4,000,000 Purchases 1,960,000 1,960,000 Other costs 1,500,000 1,500,000 Interest 0 10,889 Discounts lost 40,000 0 Total costs 3,500,000 3,470,889 Income before tax 500,000 529,111 Tax (40%) 200,000 211,644 Net income after tax $ 300,000 $ 317,467

Since the discounts exceed the cost of the interest expense, net income is increased by taking the discounts. In this case, income is increased by $17,467 or approximately 6%.

c. Assuming that the firm goes to the bank to finance a note payable so that funds are available to take advantage of the discounts, the liability/equity sections of the balance sheet will have the following comparison when taking versus not taking trade discounts:

Do Not Take

Discounts Take Discounts

Accounts payable $163,333 $54,444 Note payable 108,889 Accruals 50,000 50,000 Long‐term debt 75,000 75,000 Equity 250,000 250,000 Total liabilities and equity $538,333 $538,333

Thus, the total liabilities and equity will be the same. The only difference is that the firm will be able to choose how to finance the amount needed to take advantage of the discount for early payment and reduce the cost of financing—short‐term loan, long‐term loan, or equity. This example was presented using a short‐term note. The nature of the spontaneity of the trade credit financing often causes these cost‐saving options to be missed.

5322 Key Metrics

5322.01 General comments on ratio analysis

a. The analysis and interpretation of financial statements are carried out in part through ratio analysis that relates different financial statement elements in meaningful ways. A particular ratio is not significant by itself. The importance of ratio analysis lies in the relationship between ratios (intercompany comparisons, peer group comparisons) and their changes over time for a given firm (intracompany comparisons). Ratios are computed and analyzed on a comparative basis as follows:



(1) Comparing operating characteristics of an enterprise over a series of successive time periods

(2) Comparing operating characteristics of an enterprise with other similar enterprises, pre‐established standards (target ratios), or legal/contractual requirements

b. Ratios can be divided into major categories:

(1) Liquidity

(2) Solvency/leverage

(3) Asset utilization/activity

(4) Market measures

(5) Profitability

c. Many ratios, especially the profitability and asset utilization ratios, compare elements from the balance sheet to elements from the income statement. In some cases, the balance sheet element that is used should often be an average for the period. For example, the inventory turnover ratio should use the average inventory level for the period. If the beginning and ending inventory levels are not representative of the entire period, then a rolling, monthly, or weighted average should be used.

5322.02 General limitations of ratio analysis

a. While ratio analysis can be very helpful, the user must be aware of its limitations and make adjustment as necessary. Judgment must be used in interpreting the results of ratio analysis.

b. For many ratios, there is not a standard definition for how to derive the ratio due to a lack of uniformity in the formula used to calculate the ratio. Different formulas for identical ratios may be used by different companies, as well as before‐ versus after‐tax figures as ratio components, thus leading to an inability to make exact inter‐firm comparisons. This lack of uniformity is due to, among other reasons, the following:

(1) Some firms may elect to use the average of balance sheet accounts in computing the ratios while others may use the total period‐end balances.

(2) Standard days in a year may vary based on the user between 365, 360, and 300 days.

(3) Other definitions (earnings before interest and taxes (EBIT), cash equivalents, etc.) may vary based on company.

These differences do not make any one ratio more correct or accurate than the other. The focus is on understanding what the ratio is telling the user, regardless of the exact specifications used to derive the ratio itself.

c. Ratio analysis tends to be more useful for narrowly focused firms as it is difficult to develop industry averages for large firms that have different divisions in different industries.

d. Since the goal for most firms is to be better than average, merely attaining average performance generally is not deemed to be satisfactory. One alternative is to attempt to benchmark performance against industry leaders’ ratios.

e. Inflation may cause balance sheet distortion making book values significantly different from market values. Inflation may also have a significant impact on depreciation charges, inventory costs and/or profitability.



f. Seasonal factors might also distort ratio analysis. This problem can be minimized by using monthly or rolling averages for the variables that are subject to seasonal fluctuation.

g. Analysts need to be aware that firms may use “window dressing” to attempt to improve the appearance of their financial position. This could cause a firm to manipulate data to show positive short‐term effects that do not represent the underlying economic situation of the firm.

h. Different accounting practices can distort ratios and/or comparisons between companies. For example, a firm that leases assets on a short‐term basis rather than purchasing them can artificially improve fixed asset turnover and debt ratios. Also, different fiscal years, different markets, different locations (affecting taxation, labor costs, governmental regulation, etc.), different sizes, different stages of development (growth vs. mature), different dividend payment policies, use of LIFO vs. FIFO, differences in the use of operational and financial leverage, and different industries can make intercompany comparisons difficult.

i. There is often disagreement among analysts as to what constitutes a “good” or “bad” value for a ratio. For example, underlying circumstances such as the availability of an unused line of credit may allow for a particular company to have a low current ratio that is not considered to be “inadequate” if the line of credit was not available.

j. Firms often have a mix of ratios, some of which would present a “good” picture and others that might present a “bad” picture. This requires an analyst to use some form of statistical technique such as discriminate analysis to assess the probability that the firm would have financial trouble based upon the particular mix.

k. Some balance sheet and income statement accounts are based on estimates and judgments (receivables and inventory).

l. Accrual income does not necessarily indicate the availability of cash, and current liabilities may understate short‐term demands on cash.

m. Unless data from an adequate number of years is used, performance measures and trends may be misinterpreted and/or misstated.

n. Some ratios include the use of external market values such as the price of stock and are influenced by numerous variables over which management has little influence or control in the short term.



5322.03 Sample data

Many different ratios are computed and used to analyze the operating characteristics of enterprises by investors and creditors, both present and potential, as well as management. Some of the frequently used ratios are described in the next sections using hypothetical information for the Sample Company for the years 20X1 and 20X2.

Sample Company

Comparative Balance Sheets December 31, 20X2 and 20X1

12/31/20X2 12/31/20X1

Assets

Cash $250,000 $200,000 Net Accounts Receivable 200,000 100,000 Inventories 100,000 150,000 Total Current Assets 550,000 450,000 Net Plant and Equipment 400,000 450,000 Goodwill 100,000 100,000 Total Assets $1,050,000 $1,000,000

Liabilities and Equities

Accounts Payable $200,000 $150,000 Long‐Term Debt 450,000 500,000 Preferred Stock, $100 par 100,000 100,000 Common Stock, $10 par 200,000 200,000 Retained Earnings 100,000 50,000 Total Liabilities and Equities $1,050,000 $1,000,000

Sample Company Income Statement

For the Year Ended December 31, 20X2 Net Sales $1,000,000 Cost of Goods Sold 600,000 Gross Profit on Sales 400,000 Operating Expenses 100,000 Selling and Administrative Expenses 125,000 Income from Operations 175,000 Interest on Long‐Term Debt 50,000 Income Before Taxes 125,000 Income Taxes 50,000 Net Income $ 75,000 Dividends Declared on Preferred Stock $15,000 Dividends Declared on Common Stock $10,000 Net Earnings per Common Share $3 Market Price per Share on December 31, 20X2 $17

Liquidity

5322.04 Liquidity measures a firm’s ability to satisfy short‐term obligations. It also measures the amount of cash a company has available. It implies that the company has the ability to turn assets into cash or the ability to obtain cash to meet current obligations. It is also related to the speed with which given assets can be converted into cash.



Lack of liquidity:

a. is a matter of degree as opposed to being strictly liquid or illiquid.

b. may mean that an organization is unable to take advantage of favorable discounts.

c. may mean that an organization might be unable to take advantage of profitable business opportunities and may cause lower profitability.

d. limits management’s flexibility.

5322.05 Working capital

a. The concept of net working capital assumes that all current assets are liquid and may readily be turned into cash that can be used to satisfy all current liabilities.

Net working capital = Current assets – Current liabilities

b. Working capital is expressed in absolute dollars, and in that form, it would be difficult to judge the adequacy of the measure when making inter‐firm comparisons. It also has limited value when judging adequacy of working capital.

c. Working capital only has significance when related to other variables such as sales, total assets, etc.

d. Care should be used in determining the actual availability of current assets. For example, cash held as a compensating balance under a bank loan should not be considered to be available.

e. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Net working capital = Current assets – Current liabilities

$350,000 = $550,000 – $200,000

5322.06 Current ratio

a. The current ratio (also called the working capital ratio) is a relative comparison of current assets to current liabilities. It calculates the number of dollars of current assets that are available to cover each dollar of current liabilities.

Current ratio = Current assets Current liabilities

b. The higher the ratio, the more likely that current obligations can be met (safety issue). For example, a current ratio of 2:1 implies that a company has $2 of current assets to cover each $1 of current liabilities it owes. A current ratio below the industry average suggests to potential lenders that the firm might have difficulty meeting its current obligations and, if the problems were severe enough, a low current ratio could limit access to additional external funds.

c. A higher than average current ratio could be positive, or it might mean that the firm is holding idle cash, has slow‐paying customers, or is having problems moving inventory. This could mean that too much capital is tied up in receivables and inventory, which might lead to a future decrease in net income. These factors might be viewed as indicating an increasingly risky position, and banks might become hesitant to lend to the firm except at higher rates.

d. The current ratio can easily be manipulated in the short term (“window dressing”); however, a higher manipulated ratio is difficult to sustain over the long term. This is done by using cash to pay current liabilities, thus increasing the current ratio.



e. In determining the adequacy of the current ratio, some consideration must be given to the relationship between the current ratio and the operating cycle. If the cycle is relatively short, a lower current ratio may be adequate. Conversely, a lower accounts receivable turnover and/or inventory turnover would necessitate the need of a higher current ratio to provide the same level of safety.

f. If a line of credit is available, a lower current ratio would be acceptable because the company can readily utilize the line of credit to meet short‐term obligations.

g. If LIFO is used and there are old LIFO layers in inventory, the current ratio will be understated if inflation has occurred.

h. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Current ratio = Current assets Current liabilities

= $550,000 $200,000

= 2.75 to 1

5322.07 Quick or acid‐test ratio

a. The quick ratio (acid‐test ratio) is a stricter test for liquidity than the current ratio because it includes only the most liquid of the current assets in the calculation. It is a measure of the ability to discharge currently maturing obligations based on the most liquid (quick) assets and does not include inventory.

Quick ratio = Cash + Marketable securities + Net accounts receivable

Current liabilities

b. Since inventory is not included, the problems with inventory valuation are avoided as well as the additional business cycle issues related to turning inventory into cash.

c. This ratio might still need to be adjusted if receivables are subject to a lengthy collection period (dollars may not be available as needed), or if they might be factored at less than the carrying value (fewer dollars will be available).

d. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Quick ratio =

Cash + Marketable securities + Net accounts receivable Current liabilities

= $250,000 + $200,000 Receivable

$200,000 = 2.25 to 1

5322.08 Cash ratio

a. The cash ratio is a further refinement of the current ratio in that only cash, cash equivalents, and marketable securities are compared to current liabilities, thus making it the most rigorous of the current, quick, and cash ratios. The question being asked is, if all current liabilities had to be paid off today, how close could the company come to meeting those obligations?

Cash ratio = Cash + Cash equivalent + Marketable securities

Current liabilities

b. Very few companies would have a 1:1 cash ratio or higher; however, this is not necessarily a bad thing since not all current liabilities need to be met today and more cash will be available as additional sales are made and receivables are collected.



c. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Cash ratio = Cash + Cash equivalent + Marketable securities

Current liabilities

= $250,000 + $0 + $0

$200,000 = 1.25 to 1

Solvency/Leverage

5322.09 Solvency/leverage is the organization’s ability to meet long‐term obligations (repayment of principal as well as interest) using cash or by converting noncash assets into cash. It also measures the degree to which a company is indebted or leveraged.

a. Solvency ratios are related to questions about the firm’s long‐term viability.

b. Solvency is closely related to financial risk. As the financing of the organization shifts from equity financing toward debt financing, the risk that the firm could default on its long‐term obligations increases.

c. Solvency is also measured on a continuum. A lack of solvency could lead to:

(1) the inability to refinance long‐term debt at favorable rates, thus leading to lower profitability.

(2) a greater risk of defaulting on current maturities that could ultimately lead to bankruptcy and liquidation.

d. Leverage is created when a portion of the company’s assets are acquired by issuing debt rather than using equity to finance the purchase; therefore, solvency is also related to the use of leverage.

e. The use of debt tends to reduce a firm’s cost of capital. Since debt tends to be less risky than equity (interest on debt is legally required to be paid while dividends are not), it has a lower cost. This advantage is enhanced by the fact that interest on debt is tax deductible (creating what is known as the “tax shield” on debt) while dividends paid on common equity are not.

5322.10 Debt to total assets

a. The debt to total assets ratio indicates the extent that leverage has been used to finance the assets held and the degree to which creditor protection is provided in the case of insolvency. It is also called the debt ratio. It indicates the percentage of assets financed through debt.

Total debt to total assets = Total debt Total assets

b. Since creditors are concerned about a firm’s ability to repay long‐term debt and their protection in the case of liquidation, they prefer that this ratio is within an acceptable range, relative to the company’s industry and peers, in order to provide a cushion against potential loss. Generally, the lower the ratio, the greater is the firm’s solvency.

c. A higher ratio indicates:

(1) more leverage has been used.

(2) there is a greater risk of default to creditors.



(3) there is a greater risk that the firm would not be able to meet its long‐term obligations under adverse conditions.

d. Care needs to be taken with this ratio since there are many possible definitions for the variables used in both the numerator and denominator. Often, all liabilities are included in the total debt numerator. Also, the denominator reflects the historical cost of assets and not their current market values.

e. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Total debt to total assets = Total debt Total assets

= $200,000 + $450,000 $1,050,000

= 61.9%

5322.11 Debt to equity

a. The debt to equity ratio is an alternative leverage ratio used to measure the relationship of debt to capital. In this ratio, the dollars of debt per dollar of equity are measured. It clearly shows whether creditors or stockholders have a bigger stake in the organization.

Debt to equity = Total debt Total stockholders’ equity

b. The debt to equity ratio measures the company’s ability to meet long‐term obligations. As with other ratios, care must be used when comparing the results to other organizations since there are a variety of definitions for the variables used in both the numerator and denominator. The conservative approach is to use total debt as the numerator.

c. From a creditor’s point of view, the lower the ratio, the lower the risk of insolvency.

d. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):

Debt to equity = Total debt Total stockholders’ equity

= $200,000 + $450,000 $100,000 + $200,000 + $100,000

= 1.63 to 1

5322.12 Equity multiplier

a. The equity multiplier (Total assets/Total stockholders’ equity) measures the portion of assets that are financed through stockholders’ equity (owners). The larger the ratio, the greater the financial leverage will be and the more debt a company will possess. A lower multiple implies the company is unwilling or unable to take on higher levels of debt and is instead funded more through owners of the company in the form of common or preferred stock.

b. Alternative definitions may use average total assets and average total stockholders’ equity in place of total assets and total stockholders’ equity.

c. Calculation using data from the Sample Company for December 31, 20X2 (section 5322.03):



Equity multiplier = Total assets Total stockholders’ equity

= $1,050,000 $100,000 + $200,000 + $100,000

= 2.63

5322.13 Times interest earned

a. The times interest earned (TIE) ratio measures a firm’s ability to cover interest charges based on its earnings before interest and taxes (EBIT). This is important since, at minimum, a company would need to pay current interest charges in a given period. This is also known as the interest coverage ratio.

Times interest earned = Earnings before interest and taxes

Interest expense

b. A higher ratio is associated with greater solvency and demonstrates a greater margin of safety for meeting fixed interest payments.

c. This ratio measures the ability to add new debt in the future.

d. A concern is that accrual income is not necessarily representative of the cash available to pay the interest obligations.

e. Since interest is tax deductible, both interest and taxes are added back to net income indicating the amount available to cover the fixed interest payments.

f. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Times interest earned = Earnings before interest and taxes Interest expense

= $175,000 $50,000

= 3.5 times

5322.14 Cash coverage

a. One of the problems with the times interest earned ratio (TIE) is that interest requires a cash payment and EBIT (earnings before interest and taxes) does not represent the actual cash available to be used during the period due to the use of accrual accounting. In most cases, the most significant differences between EBIT and cash flow are noncash expenses such as depreciation and amortization; therefore, the TIE ratio can be modified to provide a better picture of the actual cash coverage of interest payments. The cash coverage ratio adds back depreciation and amortization to EBIT.

Cash coverage = EBIT + Depreciation + Amortization

Interest expense

b. As with TIE, a higher cash coverage ratio is associated with greater solvency and demonstrates a greater margin of safety for meeting fixed interest payments.

c. This ratio measures the organization’s ability to add new debt in the future.



d. Calculation using data from the Sample Company for the year ended December 31, 20X2 (section 5322.03), assuming that, within operating expenses, depreciation expense for the period was $30,000 and amortization expense for the period was $10,000:

Cash coverage = EBIT + Depreciation + Amortization

Interest expense

= $175,000 + $30,000 + $10,000 $50,000

= 4.3 times

5322.15 Fixed charge coverage

a. Both the times interest earned ratio (TIE) and the cash coverage ratio treat interest as a fixed expense compared to a benefit stream (EBIT or cash flow). Fixed expenses are those that are considered to require a payment no matter how well the firm has performed during the period in question. Other fixed obligations related to the acquisition of equipment and other long‐term assets in many firms are lease payments. Many of these leases are noncancelable; therefore, they become fixed payments similar to interest. Another adjustment to the TIE ratio is to include these fixed lease expenses.

Fixed charge coverage = EBIT + Lease payments Interest + Lease payments

b. As with TIE, a higher fixed charge coverage ratio is associated with greater solvency and demonstrates a greater margin of safety for meeting fixed payments.

c. This ratio measures the organization’s ability to add new debt in the future.

d. Calculation using the data from the Sample Company for the year ended December 31, 20X2 (section 5322.03), assuming that the lease expenses within operating expenses are $10,000:

Fixed charge coverage = EBIT + Lease payments Interest + Lease payments

= $175,000 + $10,000

$50,000 + $10,000 = 3.1 times

Asset Utilization/Activity (Efficiency)

5322.16 Asset utilization or activity ratios (also called efficiency) measure how well a company is utilizing its assets by turning the assets into sales or revenues. For certain shorter‐term assets such as accounts receivable and inventory, the ratios can also be used to measure how efficiently the company can convert revenue‐producing assets into cash.

5322.17 Total asset turnover

a. The total asset turnover ratio indicates how many dollars of sales were created by each dollar of total assets. It helps to determine whether the available assets were used efficiently to create sales. One goal of management is to generate the highest possible amount of sales per dollar of invested capital. Note that different industries tend to have different reasonable ranges for this ratio.

Total asset turnover = Net sales revenue Average total assets

b. As in all turnover ratios, a high asset turnover is a desirable outcome since it results from an effective use of available assets; however, it is not unusual for a company that



has recently expanded to see a decrease in asset turnover until the expansion is fully utilized.

c. For internal use, it is desirable to calculate this ratio comparing divisional sales to divisional assets.

d. Comparison between firms within an industry can be difficult due to the fact that the age of the assets used in the production of the sales may vary. This is a limitation caused by the use of historical costs of assets as opposed to fair market values for the productive assets. There is also a problem when comparing a capital‐intensive firm to a labor‐intensive firm.

e. There are also interpretation issues created because the turnover ratio does not take into account that certain assets make no tangible contribution to sales. It is assumed that an asset’s participation in generating sales is related to its recorded amount. Adjustments to the asset figure are used in attempts to compensate for this problem. For example, long‐term investments are not involved in the production and sale of the product and are often not included in the calculation.


Total asset turnover = Net sales revenue Average total assets

= $1,000,000 $1,050,000 + $1,000,000

= 0.98

2

5322.18 Accounts receivable turnover ratio

a. The accounts receivable turnover ratio measures the quality of the accounts receivable collection process and the ability of the company to turn their accounts receivable balance into cash.

Accounts receivable turnover = Net credit sales Average accounts receivable

b. The quality of the receivables is determined based on the company’s ability to collect them without losses. It is assumed that the longer receivables are outstanding, the more likely it is that they will not be collected.

c. The turnover is an indicator of the age of the receivables. It indicates how many times, on average, the receivables are generated and collected during the year.

d. Credit terms should provide an approximation of an expected turnover rate. For example, if the credit terms are net 60, it would be expected that the turnover would be 6 times if receivables were collected within the 60 days. A ratio lower than 6 in this case suggests the possibility of collection problems.

e. This ratio would be affected by significant seasonal fluctuations unless the denominator is a weighted‐average.

f. It is frequently necessary to use net sales since specific information concerning credit sales is often not available.



g. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Accounts receivable turnover = Net credit sales Average accounts receivable

= $1,000,000 $200,000 + $100,000

= 6.67 times

2

5322.19 Number of days sales in trade accounts receivable (average collection period)

a. The number of days sales in trade accounts receivable measures the number of days on average that it takes to collect accounts receivable. For ease of calculation, many companies use 360 days as a “year” for ratio analysis; 365 days is also a common acceptable numerator.

Number of days sales in accounts receivable = 360 Accounts receivable turnover

Or

= Average accounts receivable

Credit sales 360

b. This ratio can easily be compared to the credit terms in order to evaluate the performance of the receivables department.

c. Significance is gained when comparing the ratio to credit terms or to industry averages.

d. Significantly higher than expected ratios could mean the firm:

(1) has poor collection procedures.

(2) has difficulty in obtaining prompt payment from customers even though they have made diligent collection efforts.

(3) has customers that are experiencing financial difficulty.

e. The best way to investigate a problem is to do a comparative aging of receivables.


Number of days sales in accounts receivable

= 360 Accounts receivable turnover

=

360 6.67 times

= 54 days

or

=

Average accounts receivable Credit sales

=

$200,000 + $100,000 2

=54 days 360 $1,000,000

360

5322.20 Inventory turnover ratio

a. The inventory turnover ratio measures the speed with which inventory can be converted into sales. In other words, the control that management has over inventory is assessed. The quality of the inventory is determined by the company’s ability to use and dispose of inventory without a loss.

Inventory turnover = Cost of goods sold Average inventory



b. Since inventories are purchased or produced for the purpose of obtaining a return, it is extremely important to determine if corrective action needs to be taken. A low turnover can be caused by a variety of factors, some of which are anticipated and based upon management’s actions, and others that are unanticipated and require corrective action. These factors include:

(1) obsolete items.

(2) unanticipated weak demand.

(3) build‐up to meet expected future demand or firm commitments.

(4) build‐up to avoid future price increases.

(5) build‐up in anticipation for a strike or material shortages.

c. Excessive inventories can lead to:

(1) high storage and insurance costs.

(2) a greater risk of obsolescence, physical deterioration, or theft.

(3) tying up funds that could be used in a more productive fashion, thus leading to decreased profitability.

d. A high turnover may be an indication that:

(1) the firm is managing its inventory well and thereby achieving higher productivity.

(2) the inventory that is held is highly marketable.

(3) obsolete and slow‐moving inventory does not appear to be a problem.

However, an extremely high turnover may indicate a higher probability of stockouts.

e. Different inventory cost flow assumptions (FIFO vs. LIFO) can produce widely different inventory valuations and thus turnover ratios. This can make comparisons between organizations difficult.

f. For seasonal businesses, it is best to use a monthly average inventory figure in the calculation of this ratio, since that is generally more representative of what has actually occurred.

g. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Inventory turnover = Cost of goods sold Average inventory

= $600,000 $150,000 + $100,000 = 4.8 times

2



5322.21 Number of days sales in inventory

a. The number of days sales in inventory (DSI) measures the number of days it takes to sell existing inventory. Similar to the average collection period, for ease of calculation many companies use 360 days as a “year” for ratio analysis; 365 days is also a common acceptable numerator.

Number of days sales in inventory = 360 Inventory turnover

Or

= Average inventory

Cost of sales 360

b. This ratio converts the inventory turnover into days and is also a good indicator of how long it takes a company to turn inventory into cash.

c. Generally, a lower (shorter) DSI is preferred.

d. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Number of days sales in inventory

= 360 Inventory turnover

=

360 4.8 times

= 75 days

Or: = Average inventory

Cost of sales ÷ 360 =

($150,000 + $100,000) ÷ 2 $600,000 ÷ 360

= 75 days

Profitability

5322.22 Profitability is the measure of success in terms of income defined in a variety of ways over a period of time. In analyzing profitability, earnings are compared to a base such as sales, productive assets, or equity. Increased profitability provides the potential for increased dividend payments as well as from stock appreciation. Increased profitability also provides greater security for debt holders.

5322.23 Gross margin

a. The gross margin ratio compares the gross margin (gross profit) generated by the net sales revenue to the sales revenue. It tells the seller what percentage of sales revenue was directly attributable to the cost of the items sold. In other words, what percentage of the sales dollars were used to cover the cost of goods sold? The remaining amount is left to cover the general and administrative expenses as well as to provide a profit. This is also known as the gross profit ratio.

b. Gross margin is net sales revenue less cost of goods sold. The gross margin ratio is:

Gross margin ratio = Gross margin Net sales revenue

c. This ratio is generally more useful to management than to creditors or investors since the data necessary to analyze why changes occurred in the ratio are only available internally. Changes are often caused by one of the following elements or a combination of the following items:

(1) Increase/decrease in unit sales price



(2) Increase/decrease in cost per unit


Gross margin ratio = Gross margin Net sales revenue

= $400,000 $1,000,000

= 40%

5322.24 Net profit margin

a. The net profit margin ratio calculates the percentage of each dollar of sales that is recognized as net income. In other words, it measures the efficiency of earnings as compared to sales. It indicates how well management has controlled expenses in relationship to revenues earned. This ratio is an excellent way to compare the profits of companies of varying sizes. This is also known as the return on sales ratio.

Net profit margin ratio = Net income Net sales

b. In alternative definitions, the numerator for this ratio can take a variety of forms: operating income, net income, or income available to stockholders.

c. The use of accrual income includes estimates and items over which management has little or no control.


Net profit margin ratio = Net income Net sales

= $75,000 $1,000,000

= 7.5%

5322.25 Return on assets (ROA)

a. The return on assets ratio measures the productivity of assets in terms of producing income. This ratio depends upon the organization’s ability to generate a high profit from each dollar of sales while generating high sales per dollar of invested capital. A consistently high ROA is an indication that management is making effective decisions and that the organization is effectively utilizing their assets to generate income.

Return on assets = Net income Average total assets

b. The DuPont equation breaks ROA down to the asset turnover and profit margin.

Return on assets = Net income Net sales

× Net sales Average total assets

Through the use of the DuPont equation, ROA is broken down to the profit margin showing the effective control of cost (Net income/Net sales) and the asset turnover showing the efficient use of assets (Net sales/Average total assets).

c. Since neither profit margin nor asset turnover can increase indefinitely, at some point the only way to create further increases in earnings is to increase the asset base by adding to production capacity.



d. Limitations specific to this ratio include the use of accrual net income that is subject to estimates and does not reflect actual cash return. The rate of return is also based upon historical asset costs that do not reflect current market values.

e. The numerator can use a variety of income figures, including EBIT (earnings before interest and taxes). The philosophy behind the use of EBIT is that the earnings available to three parties, stockholders, creditors, and the government (taxes) is created through the use of the assets available to the organization. The denominator is often restricted to only income‐producing assets by excluding long‐term investments and intangibles.


Return on assets = Net income Average total assets

$75,000 ($1,050,000 + $1,000,000) ÷ 2

= 7.3%

5322.26 Return on equity (ROE)

a. The return on equity ratio measures the return to common stockholders. The ratio calculates how many dollars were earned for each dollar of common equity. When comparing this ratio with ROA (return on assets), the investment of creditors and debt holders is removed. This ratio is affected by the net income available to the common stockholders (Net income – Preferred dividends), the profit margin available to the stockholders, the asset turnover, and the extent to which assets are financed by common stockholders. The method of financing used (debt vs. equity) has a major effect on this ratio.

Return on equity = Net income – Preferred dividends

Average common equity

Or, using the DuPont equation:

ROE = Net income – Preferred dividends

Sales ×

Sales Average assets

× Average assets Average stockholders’

equity

b. The denominator consists of the average of the total equity less preferred shares and minority interests. One of the major problems with this ratio is that the historical issue price is used as opposed to the current market value.

c. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Net income – Preferred dividends Average common equity

= Return on equity

$75,000 – $15,000 ($300,000 + $250,000) ÷ 2

= 21.8%

Market Measures

5322.27 Market measures

Investors use a variety of ratios to analyze the price and yield behavior of securities. These measures use a variety of market data as well as financial statement information.

5322.28 Price‐earnings ratio

a. The price‐earnings (P/E) ratio indicates the relationship between the market value of common stock per share to its earnings per share (EPS). The ratio can be interpreted as



how much an investor is willing to currently pay for $1 of earnings. The market price is the investors’ perception of the future; therefore, this ratio combines the performance measure of the past (EPS) with perceptions of the future.

Price‐earnings ratio = Market price per common share

Earnings per share

b. The earnings per share computation is subject to company‐specific assumptions and accrual income. EPS is not the only factor affecting market prices.

c. A high P/E ratio is a possible indication of a growth company, indicating investors are willing to pay for expected future earnings.

d. Negative P/E ratios can occur if a company experiences net losses. Negative P/E ratios should be interpreted with caution as their direct interpretation is not clear.

e. Calculation using data from the Sample Company for 20X2 (section 5322.03):

Price‐earnings ratio = Market price per common share

Earnings per share

= $17.00 $3.00

= 5.67

5322.29 Dividend yield

a. The dividend yield ratio shows the annual return per share to common stockholders based on the current market price of the stock.

Dividend yield =Annual dividend per common share Market price per common share

b. Annual dividend payments to common stockholders are subject to many variables. The relationship between dividends paid and market prices is a reciprocal one.

c. This ratio is calculated using the current market price; however, most of the shareholders did not purchase their shares at the current price, thus making their personal yield different than the calculated yield.

d. Calculation using data from the Sample Company for 20X (section 5322.03)2:

Dividend yield =Annual dividend per common share Market price per common share

=$10,000 ÷ 20,000 shares

$17.00 per share = 2.9%

5322.30 Dividend payout ratio to common shareholders

a. The dividend payout ratio to common shareholders measures the portion of net income available to common shareholders that is paid out in dividends.

Dividend payout ratio to common shareholders

= Common dividends Net income – Preferred dividends

b. Income does not necessarily measure cash available for dividend payments. Payments are heavily influenced by management’s policy, the nature of the industry, and the stage of development of the firm. All of these items diminish comparability between companies.

c. Organizations that have high growth rates generally have low payout ratios since most earnings are kept as retained earnings with the funds being reinvested in the company instead of providing cash dividends. A firm that has consistently paid a dividend and



suddenly lowers its dividend payout often is signaling a lack of available cash and the existence of liquidity or solvency problems.


Dividend payout ratio to common shareholders

= Common dividends Net income – Preferred dividends

= $10,000 $75,000 – $15,000

= 16.67%

5322.31 Economic value added (EVA)

a. Economic value added (EVA) is the economic profit as it relates to cost of capital as opposed to GAAP profit. The focus of this indicator is on the earnings above the required cost of capital for shareholders. In other words, if the required rate of return is 12% and the company earns 16%, then value has been created for the shareholders; therefore, it could be said that the investors value the firm above the amount of capital that was originally invested. Conversely, if the company earns 10%, then the company is not creating value from the funds it has utilized.

b. Another way of looking at EVA is that a cost is assigned to the equity capital in addition to the cost of debt. On the traditional income statement, interest expense represents the cost of debt; however, there is nothing to denote the cost of equity. Since EVA focuses on economic profits, the opportunity cost of the equity capital must be taken into consideration. For example, if the shareholders could earn 12% on an investment of similar risk, then this opportunity cost of 12% must also be accounted for. The cost of all capital employed in the first would be considered to be the weighted‐average cost of capital (WACC). NOPAT is the net operating profit after tax and is equal to the operating profit times (1 – Tax rate).

EVA = NOPAT – (Weighted‐average cost of capital × (Total assets – Current liabilities))

c. The EVA concept is often used by firms during the decision‐making process when determining whether a large investment in plant and equipment would be in the best interest of the shareholders.

d. Calculation using the data from the Sample Company for the year ended December 31, 20X2 (section 5322.03), assuming that the WACC is 10%:

EVA = NOPAT – (Weighted‐average cost of capital × (Total assets – Current liabilities))

= ($175,000 × (1 – 0.40)) – (10% × ($1,000,000 – $150,000)) = $20,000

5322.32 Price‐to‐sales (P/S)

The price‐to‐sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its sales or revenues (an income statement item). The price‐to‐sales ratio is a key analysis and valuation tool for investors and analysts. The ratio shows how much investors are willing to pay per dollar of sales. Like all ratios, the P/S ratio is most relevant when used to compare companies in the same sector. A low ratio may indicate the stock is undervalued, while a ratio that is significantly above the average may suggest overvaluation.

The formula for the price‐to‐sales (P/S) ratio is:

P/S ratio = Market price per common share

Sales per share



5322.33 Price‐to‐cash flow (P/CF)

The price‐to‐cash flow (P/CF) ratio is a stock valuation indicator or multiple that measures the value of a stock’s price relative to its operating cash flow per share. The ratio uses operating cash flow, which adds back noncash expenses such as depreciation and amortization to net income. It is especially useful for valuing stocks that have positive cash flow but are not profitable because of large noncash charges.

The formula for the price‐to‐cash flow (P/CF) ratio is:

Price to cash flow = Market price per common share Operating cash flow per share

5322.34 Price‐to‐book (P/B)

Companies use the price‐to‐book (P/B) ratio to compare a firm's market to book value by dividing price per share by book value per share (BVPS). It is derived from the market‐to‐book ratio. An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it by netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities, or sometimes, more simply, total assets minus total liabilities.

A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company. As with most ratios, this varies by industry. This ratio is also known as the price‐equity ratio.

The formula for the price‐to‐book (P/B) ratio is:

P/B ratio = Market price per common share

Book value per share

5322.35 Other price multiples

A price multiple is any ratio that uses the share price of a company in conjunction with some specific per‐share financial metric for a valuation snapshot. The share price is typically divided by a chosen per‐share metric to form a ratio.

Some common price multiples are the price‐to‐earnings (P/E) ratio, forward price‐to‐earnings (forward P/E) ratio, price‐to‐book (P/B) ratio, and price‐to‐sales (P/S) ratio. Other ratios include price‐to‐tangible book value (P/TBV), price‐to‐cash flow (P/CF), price‐to‐EBITDA (earnings before interest, taxes, depreciation, and amortization) (P/EBITDA), and price‐to‐free cash flow (P/FCF). These price multiples are easy to compute on the surface, but care must be taken to analyze the components of the denominator to make sure the numbers are clean, i.e., no extraordinary items, one‐offs or nonrecurring factors that may distort a normalized financial metric.

5323 Strategies for Managing Working Capital

5323.01 Compensating balances

a. A compensating balance is a cash balance required to be held in an account by a bank in order to obtain a loan or to avoid paying directly for certain bank services. Required balances are either a fixed minimum amount or a minimum average balance for a given period such as a month.

b. Compensating balances increase the cost of a loan or impart a cost to services provided.



(1) Illustration: If a compensating balance of $10,000 is required in order to receive free bank services, the company would not hold these funds otherwise, and the money could be invested receiving a 5% return; then the actual cost of those

services would be $500 per year ($10,000 5%). This could be compared with the actual cost of the services to determine if it would be less expensive to pay for the services directly.

(2) Illustration: If a compensating balance of $10,000 is required in order to receive a $100,000 bank loan at 10%, then the effective cost of that loan will be increased, since only $90,000 will actually be available for use. The stated rate of interest on a $100,000 loan at 10% would be $10,000 per year. The effective rate of interest

would then be 11.1% ($10,000 $90,000).

5323.02 Trade credit

Trade credit is a source of funds that is spontaneously created as a result of the purchase transaction. Trade credit (accounts payable) is often the largest short‐term debt item held by firms. If a firm purchases an average of $10,000 a day under the terms of net 30, then financing of $300,000 has been spontaneously supplied to that firm providing the payment terms are met.

5323.03 Commercial paper

a. Commercial paper is short‐term, unsecured notes that are offered by stable companies. These are in large amounts with short‐term maturities generally ranging from one month to a maximum of 270 days. Access to the market for commercial paper is limited to a small number of companies that are exceptionally good credit risks. The interest rates on commercial paper tend to be somewhat below the prime rate.

b. The advantages of commercial paper include:

(1) providing the firm an additional source for funds that is readily accessible once the firm’s paper has been rated.

(2) lower rates than are available with traditional bank loans—generally ranging from 1½ to 3½ percentage points below the prime rate.

(3) absence of costly financing arrangements and the need for potential compensating balances.

(4) the repeated issuance of successful commercial paper improves a borrower’s reputation in the financial markets.

c. The primary disadvantage of commercial paper is that if a firm is facing temporary financial difficulties, it would not be able to utilize this source of funding.

5323.04 Zero balance accounts (sweep accounts)

a. Zero balance accounts are held at zero until a claim is made against the account. At that time, the holding bank transfers sufficient funds from an interest‐bearing account to the zero balance account. The firm must have at least one additional account with the bank, and there is generally a small fee associated with transfers.

b. A zero balance account can be effectively used by an organization when the interest earned in the interest‐bearing account is greater than the fees associated with the transfers of funds. Operationally, it reduces the need for the firm to monitor daily fund flows.



c. A hybrid of the zero balance account is a payroll account where funds necessary to cover payroll are transferred automatically as the payroll checks are being issued.

5323.05 Electronic funds transfers

a. Firms are increasingly expecting payment of large bills by use of automatic electronic debits. Funds are automatically deducted from one account and added to another. This is the ultimate in terms of speeding up the collection process. Today, many electronic transfers are done on the internet.

b. The use of debit cards by individuals is an example of the application of this technology for small payments made by consumers.

5323.06 Lockbox systems

a. A lockbox is a system where checks are sent to post office boxes rather than corporate headquarters. The checks are collected several times a day by a local bank, and the funds are immediately deposited into the company’s local account.

b. A lockbox system can significantly reduce the time required to receive funds and make them available for use, often by two or three days, since multiple lockboxes can be located throughout the United States and internationally.

c. Today, the bank generally notifies the firm with a daily record of receipts collected via an electronic data transmission system and wires funds to the firm’s cash concentration account.

5323.07 Official bank checks (a.k.a. depository transfer checks)

a. Depository transfer checks (DTC) are official bank checks that provide a means of moving funds from one account to another within the banking system. A DTC is payable to a particular account in a particular bank.

(1) The payer prepares and mails a DTC.

(2) The DTC is deposited by the payee (often through the use of a lockbox).

(3) The DTC is sent to a concentration bank that serves as a clearing house for funds within the banking system. Often the lockbox is located at the concentration bank as a means of speeding up the collection process.

(4) The concentration bank begins the clearing process by sending the check to the central bank.

(5) Ultimately, the funds are deducted from the payer’s account when the payer’s bank is notified of the funds transfer.

b. Float is the difference between the company’s checkbook balance and the bank’s balance. It represents the net effect of checks in the process of collection. Checks written by the firm create disbursement float and reduce the book cash. Checks received and deposited by the firm create collection float and increase the book balance. As checks are cleared, the bank cash position is reconciled to the book cash position.



5330 Financial Valuation Methods and Decision Models

5331 Valuation Fundamentals

5331.01 Fair value basics

a. As part of the FASB’s Convergence Project working with the IASB (International Accounting Standards Board) as well as other standard‐setting bodies to work toward compatible international reporting requirements, the FASB issued Fair Value Measurements and Disclosures (FASB ASC 820) to clarify the definition of fair value as well as to provide guidelines for measuring fair value. Per this statement, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

b. Since the calculation of fair value assumes that the value determination is for a particular asset, liability, or equity ownership, the following items must be taken into consideration:

(1) Age and condition of the valuation object

(2) Attributes for the valuation object

(3) Ability of the valuation object to stand alone or the need to function as part of a unit

(4) Location of the valuation object

(5) Restrictions placed on the use or sale of the valuation object

c. In determining the price under a fair value assumption, the conditions under which the hypothetical sale are assumed to occur would be orderly and not under conditions of liquidation or distress. The seller would be able to take advantage of normal market activities and would have the ability to take enough time prior to the date of measurement to take advantage of normal exposure to the market given the item being valued.

d. Under fair value assumptions, the hypothetical transaction is considered to have occurred in either the principal market for the subject transaction or, in the absence of such a market, in the most advantageous market for that transaction. The principal market is considered to be where the holder of the transaction asset or liability could locate the greatest volume of similar transfers. The most advantageous market is considered to be where either the sales price for an asset can be maximized or the transfer costs for a liability can be minimized. Note that these hypothetical transfers are considered from the perspective of the holder of the asset or liability. Also, if there is a principal market for the subject item, then the fair value measurement is determined using that market even if the most advantageous market would yield a more beneficial transfer for the holder.

e. The market participants to be considered when determining fair market value are the actual holder of the asset or liability being valued and the hypothetical buyer in the principal (or most advantageous) market. Characteristics for both the buyer and seller would include:

(1) buyer and seller are not related parties (independence).

(2) both parties are knowledgeable about the item being transferred and have access to usual and customary information.



(3) both parties have the ability to complete the transaction.

(4) both parties are willing to complete the transaction but are not being forced to do so.

f. A fair value measurement assumes that the item being valued will be put to the highest and best use resulting in the maximization of value that would be physically possible, legally permissible, and financially feasible. Note that the highest and best use is not determined from the perspective of the current holder but by the hypothetical market participants.

g. The fair value determination of a liability assumes that the liability will continue to exist after the transfer and maintain the same risk of nonperformance after the transfer as before.

5331.02 Approaches to determining fair value

a. Fair value can be determined by using one of three different approaches. The approach to be used is based upon the circumstances of the particular asset, liability, business segment, or business entity to be valued. The three approaches are the cost approach, the market approach, and the income approach.

b. The cost approach to determining fair value is based upon what it would cost to replace the subject item with an asset of like function and capacity. This is similar to the economic substitution principle. Such items as functional obsolescence, physical deterioration, and economic obsolescence need to be taken into consideration. Note that book value per GAAP using financial depreciation is not related to the fair value of an asset.

c. The market approach to determining fair value uses market comparison of identical or comparable assets or liabilities. A comparable is an item that has reasonable and justifiable similarity to the subject item being valued. This process is similar to that used by real estate agents in determining a reasonable market price for a home.

d. The income approach to determining fair value uses the company’s ability to create earnings or cash inflows and the risk involved in the specific investment. Capitalization or discount rates are applied to the benefit stream (earnings or cash inflows) in order to establish a value. The theory behind the use of the income approach is that an investor will require a particular investment to yield a benefit sufficient to recover the initial cost of the investment as well as a return to offset the riskiness of that investment. The higher the perceived risk, the higher the required return. The income methods incorporate the use of discounted cash flows. For example, future cash flows are estimated, and then those cash flows are discounted to present value using a discount rate suitable to reflect the risk of the subject investment. The income approaches require a careful analysis of cash inflows and outflows, capital assets, capital structure, the industry, and economic environment.

e. The method used to determine fair value should be based upon the particular circumstance of the valuation as well as the data that are available. In some cases, a single method will be used, and in others, multiple methods. When multiple methods are used, the results should be analyzed and weighted taking the range of the results into consideration. An acceptable fair value measurement should be the point that is most representative of the fair value given the particular circumstances.

f. When measuring fair value over multiple periods, methods should be used consistently; however, a change in methods is appropriate providing the change results in an equally or more representative fair value under the particular set of circumstances.



5331.03 Fair value hierarchy

a. FASB ASC 820 has grouped possible inputs used to determine value fair into three groups (hierarchies) in an attempt to achieve consistency and comparability. Note that it is the inputs that are classified as to the preferred usage and not the methods or techniques used to determine fair value. In determining fair value of a particular asset or liability when inputs from two or more levels are used, then the fair value measurement will be classified at the lowest input level that is significant to those measurements. For example, if significant inputs from both Level 2 and Level 3 are used to determine fair value, then the fair value measurement will be considered to be based upon Level 3.

b. Observable inputs are the most desirable ones to use when determining fair value. Observable inputs are those that reflect the assumptions based on market data obtained from sources independent of the reporting entity used in pricing an asset or liability. When possible, it is expected that more observable inputs will be used than unobservable inputs.

c. Unobservable inputs are the least desirable ones to use when determining fair value. Unobservable inputs are those based upon assumptions developed using the best information available in the circumstances reflecting the reporting entity’s own speculations used in pricing assets or liabilities.

d. Level 1 inputs are observable and considered to be the highest level and most desirable when determining fair value. Level 1 inputs would include unadjusted quoted active market prices of identical assets. An active market is where there is adequate trading to provide constant market data.

(1) Generally accepted business valuation techniques often apply a blockage discount to the quoted market price when valuing a large block of stock, since it is assumed that the market price would drop if a large block of stock was put on the market on a particular date. FASB ASC 820 specifically disallows the use of such a blockage discount.

(2) It is not unusual for a company to announce information that will have a negative impact on market price at the end of the day or shortly after the close of the market. If the quoted market price is adjusted for the new information, then the fair value should be listed at the lower price.

e. Level 2 inputs are considered to be the middle level when determining fair value, and include such items as prices of assets or liabilities that can be either directly or indirectly observed but do not include the Level 1 quoted market prices. Often market values of similar assets or liabilities (as opposed to identical) are used to determine fair value. In such cases, the degree of comparability must be determined, and often adjustment must be made when determining fair value. A higher degree of adjustment could cause the fair value measure to fall to a Level 3 category. Level 2 items would include such items as the following:

(1) Active market prices for similar assets or liabilities

(2) Available market prices for identical or similar assets or liabilities when markets are not active

(3) Inputs such as interest rates, default rates, yield curves, and credit risks

(4) Other market‐corroborated inputs

f. Level 3 inputs are unobservable and considered to be the lowest and least desirable level when determining fair value.



(1) Level 3 inputs should be used to develop an exit price to represent fair value from the perspective of the reporting entity.

(2) Level 3 inputs should reflect the reporting entity’s market assumptions.

(3) Level 3 inputs should be based upon the best available information that can be obtained without undue cost and effort.

5331.04 Disclosures needed when using fair value

a. Information needs to be disclosed related to fair value measurement that:

(1) allows for enough information to be provided so that the user of that information can do a fair assessment of the inputs used to develop the fair value.

(2) provides enough information so that the use of significant unobservable inputs (Level 3) can be assessed.

b. When a fair value measurement is done on a recurring basis, the following information needs to be disclosed:

(1) The fair value measurement as of the reporting date

(2) The level within the hierarchy (Level 1 market information, Level 2 other significant observable inputs, and/or Level 3 significant unobservable inputs) of the inputs used in the fair value measurement

(3) Reconciliation of the beginning and ending balances when using significant unobservable inputs (Level 3)

(4) The amount of the total gains or losses that are attributable to the change in unrealized gains or losses still held at the date of measurement

(5) The valuation method(s) used

(6) A discussion of any changes in valuation techniques, if any, within the period

c. When a fair value measurement is done on a nonrecurring basis, the following information needs to be disclosed:

(1) The fair value measurement as of the reporting date and the reason for the measurement

(2) The level within the hierarchy (Level 1 market information, Level 2 other significant observable inputs, and/or Level 3 significant unobservable inputs) of the inputs used in the fair value measurement and a description of any Level 3 inputs used

(3) Reconciliation of the beginning and ending balances when using significant unobservable inputs (Level 3)

(4) A discussion of the valuation method(s) used

5331.05 Other standards of value

a. In a valuation engagement, a standard of value is the identification of the type of value being utilized. It is important that this standard be defined before the engagement begins since different standards lead to potentially different estimated values. Common standards include fair market value, fair value, intrinsic value, replacement value, and investment value. No matter how the standard of value is defined, the potential exists to use any of the three generally accepted valuations approaches (asset‐based, market, or income) in preparing the valuation.



b. Fair market value is probably the most common standard value used in business valuation work. In the International Glossary of Business Valuation Terms, it is defined as follows:

“The price, expressed in terms of the cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

c. The differences between fair market value and fair value are quite substantial:

(1) Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing.

(2) Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value.

(3) Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.

d. Per the International Glossary of Business Valuation Terms, intrinsic value is defined as follows:

“The value that an investor considers, on the basis of an evaluation of available facts, to be the ‘true’ or ‘real’ value that will become the market value when other investors reach the same conclusion.”

e. Per the International Glossary of Business Valuation Terms, replacement cost new is defined as “the current cost of a similar new property having the nearest equivalent utility to the property being valued.” Reproduction cost new is defined as “the current cost of an identical new property.”

f. Per the International Glossary of Business Valuation Terms, investment value is defined as “the value to a particular investor based on individual investment requirements and expectations.”

5331.06 Other valuation items

a. Valuations are often necessary for items such as a specific capital asset or investment, a business segment, or a complete business. Accountants have become increasingly involved in the valuation process, and the AICPA has developed the Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, that became effective in 2008 to help provide guidance to practitioners and promote consistency within the valuation niche. Per the AICPA Professional Code of Conduct, a CPA should only undertake a valuation engagement providing the individual (or firm):

(1) possesses a good understanding of valuation principles and theory.

(2) has the skill necessary to apply the theoretical knowledge.

(3) has the professional judgment necessary to develop a conclusion or a calculation of value.

b. Beyond the identification of the subject of a valuation (asset, business segment, entire business, etc.), the date of the valuation, and the standard of value to be used, it is important to determine the premise of value before initiating any work on the engagement. The International Glossary of Business Valuation Terms defines the premise of value as an assumption regarding the most likely set of transactional



circumstances that may be applicable to the subject of the valuation. For example, if an entire business is being valued, is the entity considered to be a going concern or in the process of liquidation?

c. There are two types of business valuation engagements outlined in SSVS 1:

(1) In a valuation engagement, the valuation analyst is free to employ the use of any valuations approach or method that is professionally deemed appropriate under the circumstances. The results are expressed in terms of a conclusion of value and can either be a single number or a range.

(2) In a calculation engagement, the valuation analyst and the client agree upon the valuation methods and approaches to be used; therefore, the analyst is not free to use any approach or method available. The results are expressed in terms of a calculated valued and can be either a single number or a range.

5332 Valuation Assumptions

5332.01 Price, worth, and value

a. Price, worth, and value are three terms that are often used interchangeably; however, they each have distinct meanings. It is important to understand which of these three items is being considered when evaluating assumptions used in valuations.

b. Price is the actual observed exchange price that is used in the marketplace.

c. Worth relates to the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use.

d. Value is based upon the amount that would be received in exchange for an asset or settlement of a liability between willing parties in an arm’s‐length transaction where both parties had acted with knowledge, with prudence, and without compulsion.

When determining market value, assumptions are made about market conditions, sellers, and buyers. The more assumptions made or the greater the uncertainty related to those assumptions, the less the confidence in the valuation results.

e. Valuation is based upon events yet to occur and is therefore dependent upon various assumptions made during the valuation process. The use of assumptions results in the risk that either the assumptions were incorrect or that future events will not occur as assumed. It is crucial to carefully examine any assumption used in the process of a valuation in order to assess the validity of the valuation results.

5332.02 Premise of value

a. At the beginning of the valuation process, the premise of value must be determined. Per the International Glossary of Business Valuation Terms, the premise of value is defined as “an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation.”

b. The premise of value will be one of two situations—a going concern or liquidation. For a going concern, the company will be expected to continue operations into the future. This would include situations where a company will have to reorganize due to such events as a past poor business decision or a court judgment in order to continue. Companies can falter, regroup, and continue. A company in liquidation will have its assets sold or disposed of in some fashion and will ultimately discontinue operations completely.



c. The first assumption that needs to be carefully reviewed in the process of a valuation is the choice of the premise of value, due to the fact that generally a going concern is worth more than an organization in liquidation for the following reasons:

(1) When in liquidation, few if any additional receivables will be created, and the receivables currently on the book may be difficult to collect due to lack of staff and debtors trying to take advantage of a liquidating firm. A going concern would continue to create and collect receivables in the course of doing business.

(2) When in liquidation, inventories will likely have to be sold at dramatically reduced prices if they cannot be returned, and if returned, there is likely to be a high restocking charge. A going concern would continue to purchase and sell inventory in the course of doing business.

(3) When in liquidation, equipment on hand is not likely to be of the most recent technology; therefore, any disposal price would tend to be low. A going concern would continue to use the equipment on hand to create products to sell.

(4) When in liquidation, leasehold improvements would be of no further use and could not be sold. A going concern would continue to use leasehold improvements.

(5) When in liquidation, no goodwill would exist. A going concern would potentially continue to have goodwill associated with its good name, reputation, and brand.

(6) When in liquidation, the costs of asset disposal and the administration of the liquation process can be costly. A going concern would not have any costs related to a liquidation process.

d. When the premise of value is liquidation, the valuator will assume that historical records will provide little valuable information needed to predict future inflows and outflows for the organization.

e. When the premise of value is a going concern, the valuator will generally base future predictions at least in part on the firm’s historical performance.

f. The assumption related to the premise of value must be translated into estimates of future inflows and outflows.

5332.03 Due diligence

When evaluating assumptions used in a valuation of a particular asset, business segment, or business, it is important to verify the assumptions related the following items as appropriate:

a. Existence of physical assets and their value:

(1) A physical inspection should be performed.

(2) Inquiries should be made to possible liens and encumbrances.

(3) Inquiries should be made to determine that the physical assets are suitable for their intended use.

b. Projections of future benefit streams (e.g., income or cash flow):

(1) All assumptions related to the prediction of revenue streams should be examined for reasonableness, taking past trends, market share, economic conditions, etc. into consideration. Sales forecasts are affected by products produced, changes in product lines, changes in markets, changes in promotion, changes in the competition, etc. Each of these areas will require assumptions when predicting the



future that need to be potentially challenged for validity and evaluated for reasonableness.

(2) The future of all product lines and/or projects should be reviewed for the likelihood for future profitability. Profit margins are affected by sales price of goods and services, physical capacity, human resource capacity, union contracts, cost and availability of raw materials, etc. Each of these areas will require assumptions when predicting the future that need to be potentially challenged for validity and evaluated for reasonableness.

(3) Past and future budgets should be examined for reasonableness of cost relationships with both the revenue stream and working capital requirements.

c. Existence of risk: All businesses operate in an environment filled with risk. When valuing a business or business segment, it is important to identify various risks that could have negative impacts on the subject of the valuation such as general market risk, labor efficiency, attrition, availability risk, supplier risk, and competitive risk. The higher the risk level, the lower the value of the subject of the valuation.

5332.04 Assumptions using cost (asset) approaches for valuation

a. The cost basis valuation approach is used when liquidation is defined as the premise of value or when the value for a firm is basically related to the assets held such as a holding company.

b. Since the basic value determined using the cost approach is related to the value of the assets including property, plant, and equipment, the use of an appraiser is often necessary. Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, issued by the AICPA, states that the evaluation of the outside professional be based upon the following:

(1) The education, professional certification, license, or other indication of professional competence

(2) The reputation and standing of the specialist among peers

(3) The knowledge and understanding of valuation concepts by the specialist

(4) The experience of the specialist with like assignments

(5) The knowledge and experience of the specialist within the industry of the subject company

5332.05 Assumptions using market approaches for valuation

a. Using the market approach, the value of an asset is based upon what similar or comparable assets have recently sold for on the open market. The difficulty is to find guideline companies (comparables) that are truly comparable to the subject being valued. In the case of a business, it would be impossible to find guideline companies reasonably similar in all manners to the subject of the valuation.

b. There are data sources available containing information about publicly and privately held companies that can be used to help find appropriate guideline organizations. It is important that financials of the subject company be free of GAAP errors and that the guideline and subject company use similar GAAP choices such as a LIFO or FIFO inventory in order for a valid comparison to be made.

c. Some key assumptions related to finding compatible guideline companies would include the following:



(1) Diversification of operations: Are one or more products sold? A one‐product firm cannot successfully be compared to those having a variety of product lines.

(2) Markets served: Are one or more markets served? A firm serving only a limited market cannot be effectively compared to those serving many and varied markets.

(3) Geographic diversification: How diverse are the geographic regions served? A firm only serving one particular metropolitan area cannot be effectively compared to those serving all of North America or international markets.

(4) Size of organization: A company with annual sales of $100,000 cannot be successfully compared to those with annual revenues over $10 million.

(5) Operating leverage: A firm with a high degree of operating leverage cannot be effectively compared to those with few fixed costs.

(6) Comparability of products (services) sold: A company producing racing bikes cannot be reasonably compared to those manufacturing bicycles for children.

(7) Financial leverage: A company with a high debt‐to‐equity ratio cannot be successfully compared to those with low financial leverage.

(8) Liquidity: In order to be considered comparable, the subject company and the guideline organizations should have similar liquidity ratios.

(9) Asset and debt management: In order to be considered comparable, the subject company and the guideline organizations should have similar asset and debt management ratios.

(10) Profitability: In order to be considered comparable, the subject company and the guideline organizations should have similar profitability ratios.

(11) Growth: In order to be considered comparable, the subject company and the guideline organizations should have similar recent growth patterns.

It is not unusual that, after evaluating the items listed above, few if any guideline companies can be found.

d. One company does not make a comparable. In other words, if only one publicly traded company can be found to have reasonable comparability to the subject organization, then the market method cannot be use as an appropriate valuation method. As a general rule, four to six guideline firms need to be found in order to provide validity when using the market valuation method.

5332.06 Assumptions related to normalization adjustments

a. Publicly traded organizations are required to follow GAAP, and there is a great deal of oversight by various individuals or groups such as the board of directors, the CEO, the CFO, and internal and external auditors. On the other hand, smaller, private companies often do not follow GAAP religiously, and it is not unusual for business owners of such firms to have a mixing of business and personal expenses. In order to make comparisons to guideline organizations or predict future benefit streams to be employed when using an income approach to valuation, it is often necessary to make normalization adjustments so that the comparisons or predictions can be performed.

b. IRS Revenue Ruling 68‐608 provides guidance as to this normalization process. Although this passage refers to one specific valuation method (the treasury method), the direction as to the form that the financial statement should take in order to perform an adequate valuation is valid for all methods and approaches. The ruling states:



“The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business.”

c. When doing a valuation, it may be necessary to adjust the financial statements for the subject company when:

(1) it is necessary to compare non‐GAAP statements to guideline firms that employ the use of GAAP.

(2) items that are not considered to be part of normal operations are included in the financial statements of the subject company.

(3) items that are considered to be part of normal operations are not included in the financial statement of the subject company.

(4) an unusual item not considered to be recurring is included in the historical statements used to predict the future.

(5) discretionary items not considered to be normal business expenses are included in the financial statements. These would include such items as personal expenses run through the business, such as family members on the payroll being paid above‐market wages for the work done; personal vacations; and other items of a private as opposed to a business nature.

d. The valuator may need to make normalization adjusts for one or more of the following items:

(1) Nonoperating adjustments: The removal of nonoperating items included in the historical financial statements that are not assumed to be part of normal operations

(2) Nonrecurring adjustments: The removal of unusual, unexpected, or infrequent items not likely to occur again from the historical financial statements

(3) Comparability adjustments: Adjustment of the historical financial statements to match GAAP choices of potential guideline companies. For example, a company that used a LIFO inventory could not be compared to one using a FIFO inventory.

(4) Discretionary adjustments: Adjustments to the historical financial statements to include or remove items considered to be part of normal operations. For example, it is not unusual for owners of small, private companies to pay either excessive or below‐average salaries to themselves. It is also common for personal expenditures to be run through the business.

5332.07 Assumptions using income approaches for valuation

a. There are four basic assumptions that are crucial when using an income approach to valuation:

(1) The prediction the future benefit stream used to establish value

(2) The number of periods in the projection

(3) The terminal value at the end of the projection

(4) The discount/capitalization rate used

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b. When predicting a future benefit stream (income or cash flow), the following assumptions need to be examined carefully since these future benefit streams need to be accurately predicted in order to develop a reasonable estimate of value.

(1) Historical growth patterns and whether they could be expected to continue into the future

(2) Expectations as to actions expected to be taken by competitors

(3) Expectations as to future economic conditions that are likely to affect operations

(4) The cost to innovate and remain competitive

(5) Expected capacity and the cost to enlarge capacity, if necessary, including increases in net working capital

c. When using an income approach, a benefit stream for some number of periods must be projected, which is then discounted to the present as part of the value of the subject company. The further out the projections go, the less likely it is that those projections will be accurate. Many valuators do not like to use increasingly speculative projections going out more than five years.

d. When using an income approach, the present value of the terminal value at the end of the projection period used needs to be calculated. Here the valuator must decide whether the company is expected to still be a going concern at the end of the projection period before calculating terminal value. If not, terminal value would be the present value of the liquidation value of the net assets at the end of the projection period. If the company would be expected to continue as a going concern at the end of the projection period, then terminal value would be based upon the projected cash flows during the first year of the terminal period, the expected growth rate into perpetuity, and the discount rate. Obviously, there are a number of assumptions that need to be examined closely.

e. A discount rate is the total required rate of return that an investor would expect on an investment given the risk level inherent in that investment. The discount rate (also known as the cost of capital) is extremely critical in the valuation process since it is used to convert projected income streams to present value. The higher the risk, the higher the discount rate, and the lower the present value of the subject company. Discount rates reflect the risk involved in a particular investment. Techniques used to develop a discount rate include the capital asset pricing model (CAPM), build‐up methods, and the weighted‐average cost of capital (WACC). Again, many assumptions related to the development of discount rates need to be examined closely.

5332.08 Assumptions using rules of thumb

a. Rules of thumb have been used for many years in relation to business valuations. These are often based upon multiples or a percentage of revenues, earnings, book value, some type of measurement such as number of beds, number of rooms, number of tables, etc. These calculations are quick and easy; however, they do not take specifics related to a particular business into consideration since these rules of thumb are based upon the general averages for an industry.

b. Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, specifically states that a rule of thumb should not be used as the method to set value; however, it can be used as a reasonableness check for the results achieved using other methods. The use of a rule of thumb can:

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(1) show that the valuator is knowledgeable about the subject company’s industry.

(2) support a valuation arrived at using another method with similar results.

(3) support a valuation arrived at using another method with different results along with arguments as to why the subject company is not “average” within the industry.

5332.09 Evaluating use of various approaches

a. The use of an asset‐based (cost) approach for a valuation is appropriate when the company:

(1) is in liquidation or is worth more in liquidation than as a going concern.

(2) is particularly asset‐rich.

(3) has no income in recent years and future benefit streams cannot be adequately predicted.

b. The use of a market‐based approach for a valuation is appropriate when relevant guideline (comparative) data are available.

c. The use of an income‐based approach for a valuation is appropriate when:

(1) a reliable benefit stream projection such as cash flow or income is available.

(2) the projected future benefit stream is expected to differ significantly from the past.

(2) a substantial amount of goodwill appears to exist.

d. It is not unusual in a litigated situation to have the choice of valuation methods dedicated by the court.

5333 Valuation Methods

5333.01 Financial decision models: Generally it is assumed that the company being valued will continue to operate for the foreseeable future (i.e., is a going concern). On the operating side of the business, the objective is to value the earnings power and cash generation capability, while on the nonoperating side, intangible assets (e.g., trademarks, customer brand loyalty, supplier relationships, etc.) and nonoperating assets (e.g., financial interests in other companies) owned by the company are valued.

Black‐Scholes

5333.02 Black‐Scholes (also called Black‐Scholes‐Merton) is a price variation model of financial instruments that can be used to determine the price of a European call option by incorporating five input variables: the current stock price, the related stock option's strike price, the time to the option's expiration, the risk‐free rate, and the volatility.

a. Assumptions: The model assumes that stock prices follow a lognormal distribution given that asset prices cannot be negative; there are no transaction costs or taxes; the risk‐free interest rate is constant for all maturities; short selling of securities with use of proceeds is permitted; and there are no riskless arbitrage opportunities.

b. Formula: The call option formula is calculated by multiplying the stock price by the cumulative standard normal probability distribution function. In both of the formulas below, S is the stock price, K is the strike price, r is the risk‐free interest rate, and T is the time to maturity.



(1) The net present value of the strike price, multiplied by the cumulative standard normal distribution, is then subtracted from the resulting value of the previous calculation. In mathematical notation, C = S*N(d1) - Ke^(‐r*T)*N(d2).

(2) The value of a put option could also be calculated using the formula P = Ke^(‐r*T)*N(‐d2) - S*N(‐d1).

(3) The formula for d1 is (ln(S/K) + (r + (Annualized volatility)^2 / 2)*T) / (Annualized volatility * (T^(0.5))). The formula for d2 is d1 - (Annualized volatility)*(T^(0.5)).

c. The binomial model of pricing options is a variation of the Black‐Scholes model. The binomial model incorporates the underlying security for a period of time rather than a point in time. This is accomplished by allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option's expiration date.

(1) The model reduces possibilities of price changes and removes the possibility for arbitrage.

(2) With binomial option price models, the assumptions are that there are two possible outcomes, hence the binomial part of the model. The two outcomes are a move up or a move down.

(3) The major advantage to a binomial option pricing model is that it is mathematically simple.

Capital Asset Pricing Model

5333.03 Capital asset pricing model (CAPM): The capital asset pricing model, also called the security market line (SML), attempts to quantify the relationship between investment risk and the rate of return on the investment. The CAPM model assumes that the individual investment contains two types of risk, and is primarily concerned with measuring the former:

1. Systematic risk: Market risks that cannot be diversified away; examples include interest rates, recessions and wars.

2. Unsystematic risk (also known as specific risk): This risk is specific to individual stocks and can be diversified away. In other words, it represents the component of a stock's return that is not correlated with general market moves.

5333.04 The return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The CAPM formula is as follows:

a. Risk‐free rate of return: A default‐free rate of return is estimated as the rate of return on long‐term (i.e., 10 years) U.S. Treasury bonds.

b. Market risk premium: The market risk premium is the additional return over the default‐free rate required for the average stock.



c. Rate of return estimates: The required rate of return is the default‐free rate of return plus the beta times the market risk premium.

5333.05 Beta coefficients: CAPM assumes that the beta coefficient is the only relevant measure of a stock’s risk. It measures a stock’s volatility (i.e., how much a stock’s price increases or decreases compared to movement in the stock market). If a given stock moves precisely as the overall market, it is said to have a beta of 1.

Dividend Discount Model

5333.06 Dividend discount model (DDM): A procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

a. There are many variations in this procedure. The most common DDM is the Gordon growth model (GGM), computed as follows:

Predicted dividend per share Discount rate - Dividend growth rate

b. Limitation: The model assumes a constant dividend growth rate in perpetuity. This assumption is generally true for very mature companies, but newer companies have fluctuating dividend growth rates in their earlier years.

5334 Asset and Investment Management

5334.01 Asset management is defined in a variety of ways. In a global sense, it might be considered as a global management process through which a firm consistently makes and executes the best decisions about the use and care of its assets.

5334.02 In a finance context, asset management is the act or practice of an investment advisory firm making investment decisions on behalf of a client. The professional manager of various securities and other assets works to meet the specified investment goals of the client. The purpose for choosing to use a firm to act in an advisory capacity is to obtain access to a broader range of investment vehicles and acquire the knowledge and expertise of the asset managers. Due to the cost of this service, it is generally limited to high‐wealth individuals. This is also sometimes known as investment management.

Portfolio Management

5334.03 Portfolio management moves to the next level and involves deciding which assets to include in the portfolio given the goals of the investor and the changing economic conditions within which the portfolio is being managed. Portfolio management decisions are often judged by some performance measure relative to the goals and circumstances of the investor, and investors differ in the degree to which they are risk averse.

5334.04 An investment philosophy is the cornerstone for developing an investment portfolio. It is a set of core beliefs of the investor that may be used to devise an investment strategy.

a. A key element of an investment philosophy is to understand human nature and behavior as it relates to the investment process.



b. Implicitly or explicitly, the investor needs to use their views on market efficiency or inefficiency as a foundation for their philosophy as they attempt to discover undervalued securities.

(1) An investor who accepts the strong form of market efficiency believes that it is impossible to outperform the market, and a reasonable investment strategy might be to purchase an index fund.

(2) An investor who accepts the weak form of market efficiency believes that current market prices reflect all past prices and information, and therefore would not use technical analysis.

(3) An investor who accepts the semi‐strong form of market efficiency believes that current market prices reflect all publicly available information, and therefore would not use fundamental analysis.

c. Finally, these beliefs related to human behavior and how markets work are used to devise investment strategies that reflect the investor’s beliefs.

d. Investment philosophies may be categorized as:

(1) using market timing as a bet on moves in the market versus asset selection, which deals with choosing good investments based upon what is happening in the market.

(2) using passive investing once the investment choice is made. In this scenario, investments are held for a long time horizon, while active investing involves attempting to outguess the market, often resulting in short holding periods.

Investment Process

5334.05 The investment process requires the following:

a. Understanding the client. Understanding the investor includes factors such as knowing their risk tolerance or risk aversion (an investor avoids risk unless adequately compensated for taking it), knowing their investment time horizon, determining the portfolio size, and understanding their current and expected future tax status.

b. Determining an appropriate grouping of assets in which to invest available portfolio funds. Asset allocation is related to several factors:

(1) Determining what asset classes are to be included, such as stocks or bonds, as well as other real assets

(2) Determining whether to include domestic and/or international investments

(3) Considering market information such as the outlook with respect to inflation, interest rates, and economic growth, and how that information relates to portfolio choices

c. Choosing the manner in which the strategy will be developed. A determination needs to be made of which individual stocks, mutual funds, exchange traded funds (ETFs), or real assets to include in the portfolio. A decision needs to be made with respect to active or passive management that is generally driven by the fund manager’s attitude with respect to the role of efficient markets. Individual stock choices would be driven by fundamental or technical analysis.

(1) A mutual fund is a collection of various stocks professionally managed using the funds supplied by many investors.



(2) An exchange traded fund (ETF) tracks an index but can be traded like a stock; the securities are bundled together in a portfolio that mirrors an index.

(3) Active management is the utilization of a manager to make specific investments with the goal of outperforming an investment benchmark index, while passive management is a financing strategy used by a fund manager in order to minimize transaction costs by making as few portfolio changes as possible.

(4) Market beliefs related to efficient markets take three forms: weak‐form efficiency suggests that information about past prices would not be of use in predicting future performance; semi‐strong efficient markets suggest that all publicly available information is incorporated in market prices; and strong‐form efficient markets suggest that all available information is incorporated in current market prices.

(e) Fundamental analysis is a technique used to detect inaccurately valued securities utilizing factors such as ratio analysis, projected earnings growth, and dividend yield. Technical analysis is a method of stock or commodity analysis through the use of historic market data, including price and trade volume.

d. Evaluating the performance of the portfolio

5334.06 Execution of the choices by trading in the market is also a major consideration. Questions that must be addressed include the following:

a. How often should one trade? A key element here would be commission costs.

b. How large will the trades be? What are the bid/ask spreads on the trades, and what would be the price impact of the size of the trade?

c. Should derivatives such as options, futures, or swaps be used to hedge the portfolio?

5334.07 Measuring portfolio performance

a. In the investment management process, there must be a determination of the success of the manager’s performance with the portfolio. This measurement should be in terms of the following:

(1) Whether or not the return was commensurate with the risk taken

(2) How returns compare with those achieved by their peers

(3) Whether the success was due to skill or luck

b. Returns must be adjusted for risk before they can be compared meaningfully. In today’s world, methods of risk adjustment are generally based on mean‐variance criteria. (Mean‐variance criteria selects portfolios based on the means and variances of their expected returns. The choice is the higher expected return portfolio for a given level of variance or the lower variance portfolio for a given expected return.)

5334.08 The Treynor index was the first index developed as an objective measure that could apply to all investors whatever their risk preferences. Treynor suggests that there are two components of risk: those produced by fluctuations in the market, and the risk of fluctuation of individual stocks.

a. Treynor developed the concept of the security market line, which defines the relationship between portfolio returns and security returns where the slope of the line measures the volatility between the portfolios and the market (represented by β). Beta (β) represents the systematic risk of the portfolio, the risk inherent to the entire market or entire market segment (also known as nondiversifiable risk or market risk).



b. The β coefficient is the volatility measure of a stock portfolio or the market itself.

c. The greater the slope of the line, the better the risk‐return trade‐off.

d. Treynor index = (Portfolio return – Risk‐free rate) ÷ β, with the resulting value representing the portfolio return per‐unit risk.

5334.09 The Sharpe measure is very similar to the Treynor index, except that the risk measure is the standard deviation of the portfolio. The ratio follows the capital asset pricing model and compares portfolios to the capital market line.

Sharpe measure = (Portfolio Return – Risk‐free rate) ÷ Standard deviation

(The capital asset pricing model (CAPM) is the risk of price change due to the unique circumstances of a specific security, as opposed to the overall market that can be virtually eliminated from a portfolio through diversification. The capital market line is used in the CAPM to illustrate the rates of return for efficient portfolios depending on the risk‐free rate of return and the level of risk (standard deviation) for a particular portfolio.)

5334.10 The Jensen measure is a measure of absolute performance on a risk‐adjusted basis and measures the portfolio manager’s predictive ability to achieve higher return than expected for the level of risk accepted in the portfolio.

Return on the portfolio = Risk‐free rate + (Return on market index – Risk‐free rate) × β

(β represents the systematic risk of the portfolio, the risk inherent to the entire market or entire market segment, also known as nondiversifiable risk or market risk.)

5335 Capital Budgeting

5335.01 Capital budgeting fundamentals

a. Capital budgeting is the analysis of investment decisions that have a useful life longer than one year. Management uses capital budgeting to allocate resources to investment opportunities in an attempt to obtain the maximum value for the firm. Investment decisions are project oriented. Poor capital budgeting decisions can often be difficult to reverse. Questions such as the following are addressed:

(1) Should machinery be replaced by more expensive but more efficient models?

(2) Should a new product or market be added?

(3) Should existing debt be extinguished or refinanced?

(4) How can a constrained resource best be used?

b. The relevant data in capital budgeting is cash‐flow oriented. Regardless of the approach used, the following items are essential:

(1) Initial investment

(2) Future net cash inflows or net savings in cash outflows

c. Data for capital budgeting is relevant only if it affects the cash flows. Some data accumulated for financial reporting is either not useful or must be adjusted to be useful for capital budgeting purposes. Financial accounting is primarily concerned with computing periodic earnings using the accrual basis of accounting for the firm or a reportable segment of the firm. Accrual accounting is not relevant in capital budgeting. The decision is project oriented, and relevant data includes the expected cash flows associated with that project. Items such as the depreciation expense are sunk costs as



they relate to capital decisions, and only become relevant as they relate to tax consequences.

d. Because capital budgeting is long‐term oriented, the time value of money is very important. Some approaches to capital budgeting account for the time value of money and some do not. Those that account for it are considered preferable because of the difference between a $1 investment today and a $1 return sometime in the future. Inflation that persists and the opportunity cost of having money sit idle make present and future earnings unequal. Present‐value techniques are useful in adjusting dollar amounts received or paid at different points in time to a common point in time.

e. The statistical term expected value describes the numerical average of a probability distribution. It can be used to estimate future cash receipts from a capital budgeting project. This method is employed to estimate the weighted‐average amount of future cash receipts by (a) estimating the various amounts of cash receipts from the project each year under different assumptions or operating conditions, (b) assigning probabilities to the various amounts estimated for each year, and (c) determining the mean value of the estimated receipts for each year.

f. Cost of capital refers to an overall cost of obtaining investment funds. While different techniques may be used in computing cost of capital, it is generally agreed that a cost factor should be assigned to both debt and all stockholders’ equity (including retained earnings). Some authorities suggest using a weighted‐average cost of capital for capital budgeting purposes. Cost of capital is the desired or target rate of return used in the net present value method of discounted cash flow computations. It is also the minimum acceptable (cutoff) rate used in choosing among projects employing the time‐adjusted rate of return method, described below (section 5335.07-.08).

g. There are several techniques for capital budgeting. These approaches are often used, first to screen project possibilities, and second to rank existing choices. Those commonly used techniques include the following:

(1) Payback method

(2) Discounted payback

(3) Accounting rate of return

(4) Net present value

(5) Internal rate of return

(6) Profitability index

(7) CVP analysis/margin of safety

5335.02 Time value of money

a. Cash received at different points in time is not comparable because of the time value of money. Money held today has a greater value than money that will be received tomorrow. The time value of money is determined by the price of the money (interest) and the length of the time period. Present value or future value computations are made to adjust for time and interest so that all cash flows are set at a common point in time. There are two basic questions involving the time value of money computations. First, what is the future value (value at some specified point in the future) of a sum of money to be received today? Second, what is the present value (value today) of a sum of money received in the future? These questions can be answered for a single, lump‐sum cash flow or a series of cash flows. A series of equal cash flows is called an annuity.



b. Future value of a $1 sum. A sum of money (P) invested today at a given interest rate (i) will increase in value over time (n). The future value (F) of that sum can be computed as:

F = P(1 + i)n

Factors have been computed for various combinations of i and n where the interest factor is specified as fin = (1 + i)n and are contained in future value tables. A portion of a future value table is shown below.

Period 8% 10% 12%

1 1.0800 1.1000 1.1200 2 1.1664 1.2100 1.2544 3 1.2597 1.3310 1.4049 4 1.3605 1.4641 1.5735 5 1.4693 1.6105 1.7623

When using the factors from the table, the equation F = P(fin) is used.

Illustration: How much will $10,000 be worth in four years if the interest rate is 10%?

Formula solution: F = P (1 + i)n = $10,000 (1 + .10)4

= $14,641 Table solution: F = P(fin) when i = 10% and n = 4

= $10,000 (1.4641) = $14,641

c. Present value of a $1 sum: The method for computing the present value or discounted value of a $1 sum is just the opposite of future value. The question is, what amount (P) must be invested today at a given interest rate (i) to be worth a specified amount (F) in a given number of years (n)? The present value equation can be solved for P to obtain the following:

niFP

1

1

…where the PV factor for a sum received in the future is specified as:

nini

P

1

1

The present value tables contain various combinations of i and n. Note that Pin is the reciprocal of fin. A portion of the PV tables is shown below.

Period 8% 10% 12%

1 0.9259 0.9091 0.8929 2 0.8573 0.8264 0.7972 3 0.7938 0.7513 0.7118 4 0.7350 0.6830 0.6355 5 0.6806 0.6209 0.5674

Illustration: An investment will pay $15,000 in four years. What is the present value of the payout if the interest rate is 10%? In other words, what amount of money would have to be invested today to pay $15,000 in four years?



Formula solution:

1

x 1

1$15, 000 x 41.10

$15, 000 x (0.6830)

$10, 245

P F ni

Table solution:

P = F(Pin) where i = 10% and n = 4

= $15,000(0.6830)

= $10,245

d. Annuity: An ordinary annuity (annuity in arrears) is a series of equal cash flows received at the end of equal intervals of time. An annuity due (annuity in advance) is a series of equal cash flows received at the beginning of equal intervals of time. The difference between these two cash flows is that no interest is computed on the last payment of an annuity in arrears. When dealing with future value/present value tables, care must be taken that the correct annuity table is used.

An example of an annuity in arrears (regular, ordinary, or deferred annuity) with three annual payments of $1,000 each would be:

Time Period Payment 0 0 1 $1,000 2 $1,000 3 $1,000

An example of an annuity due (annuity in advance) with three annual payments of $1,000 each would be:

Time Period Payment

0 $1,000 1 $1,000 2 $1,000 3 0

e. Future value of an ordinary annuity: The future value of an ordinary annuity represents equal annual payments received at the end of the period that are accumulated and earn interest. In other words, what will be the value of a series of payments that are compounded at a given rate of interest at a point in the future? There will be no interest earned until the first payment is made, and no interest will be earned on the last payment. (FVA = future value of an annuity, PMT = the payment)

i

iPMTFVA

n 11

As with future value and present value of a $1 sum, there are tables available to speed the calculation of the future value of an annuity. A portion is shown below:



Period 8% 10% 12% 1 1.0000 1.0000 1.0000 2 2.0800 2.1000 2.1200 3 3.2464 3.3100 3.3744 4 4.5061 4.6410 4.7793 5 5.8666 6.1051 6.3528

Illustration: What is the future value of a three‐year, ordinary $1,000 annuity when money is worth 10%?

Formula solution:

1 1

31 .10 1

$1, 000.10

$1, 000(3.3100)

$3, 310

ni

FVA PMTi

Table solution:

FVA = PMT(FVIFAin) where i = 10% and n = 3

= $1,000(3.3100)

= $3,310

The future value of an annuity due has a similar formula to the one above. Remember, an annuity due has the cash flow occurring at the beginning of the period.

ii

iPMTFVA

n

due

1

11

There are also annuities due tables available in order to make calculations easy.

f. Present value of an annuity: The present value of an annuity is the value today of a future series of payments discounted at a particular interest rate. The present value of an annuity can be computed by restating each of the annuity amounts to the present time period using the present value of an annuity formula or the factor from a table of present values of an annuity of $1. Remember to be careful to determine whether an annuity in arrears (ordinary annuity) or an annuity in advance (annuity due) is appropriate.

The formula for the present value of an ordinary annuity is:

i

iPMTPVA

n

n11

There are tables available to speed the calculation of the present value of an annuity. A portion for an annuity due is shown below:



Period 8% 10% 12% 1 0.9259 0.9091 0.8929 2 1.7833 1.7355 1.6901 3 2.5771 2.4869 2.4018 4 3.3121 3.1699 3.0373 5 3.9927 3.7908 3.6048

Illustration: What is the present value of a $1,000 annuity received at the end of the year for three years when interest is 10% and payments are made at the end of the period?

Formula solution: PVAn = $1,000 ( 1 - (1 + i)‐n

i

)

= $1,000 ( 1 - (1 + .10)‐3 .10

)

= $1,000 (2.4869) = $2,489 Table solution: PVAn = PMT (PVIFAin) where i = 10% and n = 3

= $1,000 (2.4869) = $2,489

The present value of an annuity due has a similar formula to the one above. Remember, an annuity due has the cash flow occurring at the beginning of the period.

ii

iPVA

n

due

111

000,1$

There are also annuities due tables available in order to make calculations easy.

g. Compound interest: When dealing with capital budgeting problems, assume that interest is compounded annually. However, it is not unusual to have interest stated at an annual rate but paid semi‐annually (bonds), quarterly, or even monthly. In these cases, the interest rate and number of periods must be adjusted when making the calculation by using the following steps:

(1) Adjust the interest rate according to the compounding period. For example, 16% interest compounded semi‐annually is 8% each period.

(2) Adjust n from the number of years to the number of compounding periods. For example, five years compounded semi‐annually is 10 periods.

5335.03 Payback method

a. The payback period method does not adjust for the time value of money. It computes the length of time required to recover the initial cash investment with net cash flows. When the annual cash flows are equal, the payback period is computed by dividing the initial investment by the annual cash flow.

Payback period = Initial investment Annual cash flow

If the annual cash flows are not equal, they are accumulated until the cumulative amount equals the initial investment. The payback period is the length of time required to accumulate cash that equals the amount of the initial investment.

b. When several investment alternatives are being considered, they can be ranked according to the payback period. The investment alternatives with the shortest period are considered most desirable. This method is simple to compute and easy to



understand and explain. Early paybacks provide managers with the flexibility to reinvest funds at an earlier date; therefore, managers who are uneasy about predicting cash flows into the distant future will often choose projects with early paybacks. Managers who expect to be transferred in the near future may also seek projects that will provide quick results.

c. The chief limitation is that the payback method emphasizes liquidity and disregards profitability. This method is most appropriate when precise estimates of profitability are not crucial. Its use often occurs when a firm has a weak cash and/or credit position, or if there is considerable risk involved in the proposed project. The time value of money is not considered. For example, two projects each requiring an initial investment of $1 million and yielding cash inflows of $250,000 a year would be considered to be identically attractive even if the first project has cash inflows for 5 years and the second project for 10 years.

d. The payback method can be a good screening tool but as a general rule should not be used as the primary investment evaluation tool.

e. Illustration: Payback method

Problem: Compute the payback period for an investment opportunity that costs $20,000 and provides equal annual cash flows of $4,000 per year for eight years.

Solution: $20,000

$4,000 = 5 years

Notice how the payback method does not even consider the cash flows between the end of the payback period and the end of the investment’s useful life—in this case, between years 5 through 8.

5335.04 Discounted payback

a. The discounted payback is the length of time required to recover the initial cash investment using a sum of the discounted future cash flows.

Since the discounted annual cash flows will not be equal, they are accumulated until the cumulative sum equals the initial investment. The discounted payback period is the length of time required to accumulate the amount of the initial investment using the discounted cash flows.

b. As with the payback method, the investment alternative with the shortest payback period is considered the most desirable. This method is simple to compute, easy to understand and explain, and also takes the time value of money into consideration, albeit in a very limited manner. The chief limitation is that the discounted payback method also emphasizes liquidity and disregards profitability.

c. Illustration: Discounted payback method

Problem: Compute the discounted payback period for an investment opportunity that costs $10,000 and provides equal annual cash flows of $5,000 per year for three years given an expected 10% return.

First, the cash flows need to be discounted.



Cash flows:

Initial Investment

Annual Cash Flows

Discounted Value

$10,000.00 $10,000.00 $5,000 .9091 4,545.50

5,000 .8264 4,132.00

5,000 .7513 3,756.50

Solution: $10,000 - [$4,545.50 (Year 1) + $4,132.00 (Year 2) + $1,322.50 (Year 3)] = 0

Since the discounted cash flows for Year 3 equal $3,756.50 and only $1,322.50 is needed in Year 3 to complete the payback, it can be extrapolated that approximately 2.4 years will be needed to pay back the initial investment in discounted terms. Note that using the traditional payback method, the payback period would be only 2 years. When using the discounted payback method, the payback period increases.

5335.05 Accounting rate of return (simple rate of return)

a. The accounting rate of return does not consider the time value of money. The annual net cash inflow is adjusted for depreciation to arrive at annual accounting income and divided by the investment. It focuses on the average income generated by a project in relation to the investment. Unlike other methods, it focuses on income and not cash flows.

Accounting rate of return = Net cash inflow - Depreciation

Investment

b. The average annual profits (or increased income) is the numerator. This method does not differentiate between projects that have high early cash inflows and projects that have high late cash inflows. Thus, the time value of money is not taken into account.

c. There is not unanimous agreement as to how the investment should be defined. Some alternatives include (a) initial cost, (b) average book value, or (c) annual book value. Either (a) or (b) is preferable to (c). The use of annual book value results in an increasing rate of return over the life of the investment, providing the accounting income was relatively stable over the life of the project, since the book value would decrease as accumulated depreciation increases.

d. When using this method as a screening tool, the accounting rate of return must be equal to or greater than the company’s hurdle rate for the project to be acceptable.

e. This method is popular due to consistency with financial reporting techniques commonly used to evaluate company and divisional performance; however, it does bring all of the accrual income problems into the formula. It is also simple and easy to understand.

f. Illustration: Accounting rate of return method (simple rate of return)

Problem: Compute the accounting rate of return for an investment opportunity that costs $100,000 and provides equal net cash inflows of $20,000 per year for 10 years. Straight‐line depreciation is used in calculating net income; therefore, annual depreciation will be $10,000 ($100,000 ÷ 10 years). The average investment will be the initial investment divided by 2, or $50,000.



Solution:

Accounting rate of return = Net cash inflow - Depreciation

Investment

= $20,000 - $10,000

$50,000

= 20%

5335.06 Net present value

a. The net present value method adjusts for the time value of money. It seeks to determine whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment. Using this method, initial investment, net cash inflows (or cash savings), and the discount rate are givens. The present value (PV) of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its net present value (NPV) is positive. In other words, the present value of the future cash inflows is greater than the cost of the investment.

b. When several investment proposals with reasonably similar investment sizes are being considered, they can be ranked by net present values. The proposal with the highest NPV should be chosen. An implicit assumption of this method is that all net cash inflows can be reinvested at the discount rate used in computing NPV. If the proposals have unequal investments, they should be ranked according to their profitability index. The profitability index is computed by dividing the present value of the cash flows by the initial investment.

The net present value method can also be used when examining cost‐saving projects. For example, when considering projects that would replace equipment with newer, more efficient models, the costs with the lowest NPV would be the most desirable alternative.

c. Illustration: Net present value

Problem: An investment costing $20,000 will reduce production costs by $5,000 per year. The useful life will be eight years, and there will be a zero salvage value. The desired minimum rate of return of 12% is used for capital budgeting purposes. Should this investment be considered?

Solution: The NPV is calculated by determining the PV of the $5,000 annual cash savings for eight periods using a 12% rate. The present value factor for eight periods at 12% is 4.968.

Net present value:

Cash flows ($5,000 4.968) $ 24,840

Initial investment (20,000) Net present value $ 4,840

Since the NPV is positive, this is a desirable investment at a 12% return.

d. The NPV method can easily be applied if the annual cash flows are not equal.

Illustration: An investment alternative costs $10,000 and results in cash flows of $5,000, $4,000, and $3,000, respectively, for three years. The desired minimum rate of return is 14%. In this case, the PV of cash flows for each year is calculated, summed, and compared to the cost of the investment. If the NPV is negative, the investment is rejected.



Solution: The NPV is calculated by determining the PV of the cash flows for each year using a 14% discount rate.

Net present value:

Cash flows

Year 1: $5,000 .877 $ 4,385.00

Year 2: $4,000 .769 3,076.00

Year 3: $3,000 .675 2,025.00

Total PV of cash flows 9,486.00 Initial investment (10,000.00) Net present value $ (514.00)

Since the NPV is negative, this is not a desirable investment at a 14% return.

e. The discount rate (or hurdle rate) is the required internal rate of return for projects considered by a company or investor. This rate is often based upon a company’s weighted‐average cost of capital, incorporating a risk premium related to the riskiness of the project in question. In other words, this rate must reward the investor for the risk that is being assumed when undertaking the investment.

5335.07 Internal rate of return (time‐adjusted rate of return)—equal annual cash flows

a. The internal rate of return (IRR) is the rate of discount (interest) that equates the present value of the net cash flows including the initial cash outlay to zero. This method can be used when the cost of the investment and annual cash flows are known, and the calculated rate of return is then compared to the firm’s desired rate of return (hurdle rate). If the return is less than the desired rate of return, the project should be rejected. This method is also known as the time‐adjusted rate of return.

Investment required Net annual cash inflow

= Factor of the internal rate of return

b. After the factor of the internal rate of return is calculated, the present value tables of an annuity are used in order to determine the rate of return that equates the present value of the cash inflows and outflows to zero. Since the discount factors frequently do not coincide with the annuity table, extrapolation is often necessary.

c. The IRR can be interpreted as the highest rate of interest an investor could pay for borrowed funds to finance the investment being considered and be no worse off than if the investment were not undertaken. In other words, the investment equals the present value of the payoff.

d. When more than one project is being considered, they are ranked according to their projected rate of return. Those with the highest rate of return are the most desirable. An implicit assumption of this method is that all net cash inflows from the project under consideration can be reinvested at the computed rate of return, and the method is, therefore, a less reliable method than the NPV method for ranking investments. This method is a good tool for making an accept/reject decision for potential projects that have met the initial requirements for consideration. Using this method, all projects that have a return greater than the company’s hurdle rate should be given further consideration.

e. The NPV and IRR methods will potentially rank projects differently if the initial investment differs and/or the timing of the cash flows differs between the projects. The NPV method is the better method since the reinvestment assumption is the cost of capital as opposed to the IRR assumption of reinvestment at the computed rate of return on the cash flows for the particular project.



f. The payback reciprocal can be used to approximate a project’s internal rate of return if the cash flow pattern is relatively stable.

g. Illustration: Internal rate of return

Problem: The company is considering the acquisition of a new machine that costs $20,000. It will provide a savings of $5,000 per year over its useful life of eight years. The salvage value is expected to be zero. What is the internal rate of return, and should the machine be acquired?

Solution: The cash flows are charted as follows:

Initial cash outflow $20,000 Cash inflows

Year 1 $5,000 Year 2 $5,000 Year 3 $5,000 Year 4 $5,000 Year 5 $5,000 Year 6 $5,000 Year 7 $5,000 Year 8 $5,000

When the cash flows are an annuity, the present value factor can be determined by dividing the initial investment by the annuity:

Investment required Net annual cash inflow

= Factor of the internal rate of return

=$20,000 $5,000

= 4.0000 present value factor

The internal rate of return (time‐adjusted rate of return) can be obtained from the present value table for an annuity in arrears (since it is assumed that the cash flows occur at the end of the period) by finding the rate for the number of periods (in this case, eight) that has a factor closest to 4.000. In this case, the rate is approximately 18.5%. This project would be desirable if the minimum acceptable rate of return (hurdle rate) is less than 18.5%.

Period 17% 18% 19% 20% 21%

8 4.207 4.078 3.954 3.837 3.726

5335.08 Internal rate of return (time‐adjusted rate of return)—unequal annual cash flows

a. The internal rate of return (IRR) is not easily applied when the cash flows are not equal annuity payments. A trial‐and‐error method must be used to obtain the rate of return when hand‐calculated; however, computer software is available to compute the IRR that frequently uses an iterative trial‐and‐error method. Required inputs to such a program are cash flows (both inflows and outflows) by period and a seed internal rate of return. The computer program uses the seed (rough approximation) IRR on the initial calculation and refines the rate on subsequent calculations until it has a rate that produces a net present value of zero (or very close to zero).

b. Illustration: An investment opportunity costs $10,000 and returns $5,000, $4,000, and $3,000, respectively, the first three years. What is the internal rate of return (IRR)?

(1) First attempt: Using an interest rate of 10%, the net present value is $105, computed as follows:



Cash flows:

$5,000 .9091 $ 4,545.50

4,000 .8264 3,305.60

3,000 .7513 2,253.90

Present value cash inflows 10,105.00 Cash investment (10,000.00)

Net present value $ 105.00

Since this is a positive amount, a higher interest rate is selected.

(2) Second attempt: Using an interest rate of 11%, the net present value is ($55.50), computed as follows:

Cash flows:

$5,000 .9009 $4,504.50

4,000 .8116 3,246.40

3,000 .7312 2,193.60

Present value cash inflows 9,944.50 Cash investment (10,000.00)

Net present value ($ 55.50)

Since the NPV is a negative amount, the interest rate is somewhat less than 11%. By extrapolation, a rate of approximately 10.7% is obtained. If the desired minimum rate of return is greater than 10.7%, the project should be rejected.

5335.09 Profitability index (excess present value index)

a. The profitability index takes both the size of the original investment and the value of the discounted cash flows into account. This is calculated by dividing the present values of the cash flows after the initial investment by that investment.

Present value of cash flows not including the initial investment

Initial investment = Profitability index

This allows for the comparison of various projects with differing initial investment amounts. Note that any project with a positive NPV will, by definition, have a profitability index greater than 1. The present value of cash flows not including the initial investment equals the NPV of that project plus the initial investment.

b. The profitability index is often used to compare two or more mutually exclusive projects. Potential projects might be mutually exclusive in that they represent viable options to accomplish the same task. Other constraints might include a limited capital budget or lack of adequate resources to accomplish multiple projects. The alternative project with the highest profitability index is the most desirable.

c. Example: Assume that the information is available on two mutually exclusive projects:

Project 1 Project 2 Initial investment $50,000 $75,000 NPV $20,250 $25,000

Calculate the profitability index:

Project 1: $20,250 + $50,000 $50,000

= 1.41

Project 2: $25,000 + $75,000

$75,000 = 1.33

Assuming that funds are available, the most desirable project based upon the profitability index would be Project 1. Note that the profitability index uses the PV of the



cash flows and not the NPV; therefore, the initial investment amount must be added back to the NPV.

d. The profitability index is also known as the benefit‐cost ratio.

e. An alternative formula used to calculate the profitability index is:

Net present value of the project Initial investment

+ 1 = Profitability index

Using this alternative formula and the above data for Project 1, the profitability index would be calculated as:

$20,250 $50,000

+ 1 = 0.41 + 1 = 1.41

f. The project profitability index is an additional variation of the profitability index. When an organization with limited funds is considering projects that require different initial investments, the NPV of one project cannot be directly compared to the NPV of another potential project. If the NPV of each project is divided by the required investment of that project, the project profitabilities can then be compared. The project with the highest project profitability index would be the most desirable project.

Project profitability index = Net present value of the project

Investment required

g. Example: Look at the following information regarding two possible investment opportunities.

Project 1 Project 2 NPV of proposed project (a) $8,000 $4,500 Investment required (b) $10,000 $5,000 Project profitability index (a ÷ b) 0.80 0.90

Since the project profitability is higher for Project 2 than Project 1, Project 2 is the more desirable choice.

h. An additional variation of the profitability index is used when there is a constrained resource that can be used to produce incremental profits in multiple segments. Here the profitability index formula is:

Profitability index = Incremental profit from the segment Constrained resource required by the segment

If machine hours were the constraint (bottleneck) and multiple segments of the organization could use the limited machine hours to produce incremental profits, then by determining the profitability of one unit of the constraint, management can determine the most profitable way to use the constraint.

This formula is really the basis for the formula shown in section (a) to be used for projects of a more long‐term nature. For that formula, the incremental profits from the segment are defined as the positive net present values of the cash flows after the initial investment, and the amount of the constrained resource is defined as the investment required by the project.

i. Example: The following information is available regarding incremental profits that could be produced by two different segments using a constrained resource (machine hours).

Product 1 Product 2 Incremental profit possible $250,000 $400,000 Amount of machine hours necessary to produce the incremental profit 100 hours 200 hours



Segment 2 may appear to be more attractive since an additional $400,000 of profit is possible; however, more machine hours (constraint) are necessary for each dollar of profit; therefore, the constraint of machine hours can be best be utilized in producing Product 1 than Product 2.

Product 1 Product 2 Incremental profit possible (a) $250,000 $400,000 Amount of machine hours necessary to produce the incremental profit (b) 100 hours 200 hours Profitability index (a ÷ b) $2.50 per hour $2.00 per hour

5335.10 CVP analysis/margin of safety

a. In the context of capital budgeting, cost‐volume‐profit analysis (CVP) is often used to determine the margin of safety for a project. In other words, how much could projected sales fall and still not fall below the breakeven point?

b. The CVP formula:

Profit = Sales – Variable costs – Fixed costs

Sales = Number of units sold times sales price per unit

Variable costs = Number of units sold times variable costs per unit

Fixed costs = Total fixed costs for anticipated range

The breakeven point is a special case of CVP analysis where the profit equals zero. In other words, sales revenue equals total costs.

Illustration: Product A sells for $5 per unit. Variable production costs are $3 per unit and fixed costs per period are $50,000. What will the profit be if 100,000 units are produced and sold? What is the breakeven point?

Solution:

Profit = Sales - Variable costs - Fixed costs

= ($5 100,000) ($3 100,000) - $50,000

= $150,000

Breakeven in units: 0 = $5x - $3x - $50,000 x = 25,000 units

c. Margin of safety is the excess sales over the breakeven sales point. This can be important when looking at projects with projected sales. The methods used to evaluate capital budgeting decisions use projected sales (savings). If, however, the projections are incorrect, then there could be significant changes in the calculations of the payback period, NPV, and IRR. When evaluating a project, the likelihood that the sales/production projected will be achieved needs to assessed.

Illustration: Using the above illustration, calculate the margin of safety:

Margin of safety = 100,000 projected unit - 25,000 breakeven units = 75,000 units

This could also be expressed in term of dollars. The margin of safety for sales is

$375,000 ($5 per unit 75,000 units). In this case, sales could fall significantly (by 75%) and there would still be a profit.



5335.11 The implications of tax on capital budgeting decisions

a. Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation are not relevant in basic PV calculations. They must, however, be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant. Items that do not affect cash flows except as they relate to the payment of income taxes include depreciation and gains and losses on asset dispositions.

b. The implications of income tax on capital budgeting include the following:

(1) Cash flows in the form of revenue are taxable. Revenues must be computed net of tax. This can have a dramatic effect on the NPV of a project.

(2) Cash outflows in the form of expenses are deductible in computing taxes payable. These cash outflows must be computed net of tax.

(3) Depreciation is not a cash flow, but it affects the amount of taxes payable. The reduction in taxes payable due to depreciation is a cash inflow item that must be included in the analysis.

(4) Gain or loss on the disposition of an existing facility (piece of equipment) is a taxable gain or a deductible loss for computing income tax.

(5) Salvage value at book value results in no gain (loss) and has no tax consequences.

c. The generally accepted approach is to compute all items net of tax and apply one of the capital budgeting approaches described previously. The marginal tax rate is most often used.

Illustration: ABC Company is considering the replacement of the current machine with a new one. The old machine has a book value of $0 and a salvage value of $8,000. The new machine would cost $30,000 and will result in an annual savings of $10,000 per year because of improved operating efficiency. It has a useful life of six years and an expected salvage value of $6,000. Straight‐line depreciation is used, and the company has a marginal tax rate of 40%. The desired minimum rate of return is 20%. (Note, when evaluating a project that would increase sales or reduce costs, the marginal tax rate should be used.)

Solution:

(1) After‐tax cash flow from selling the old machine:

Sales price $ 8,000 Book value 0 Gain 8,000 Taxes (40%) 3,200 Net cash inflow $ 4,800

(2) Net cash outflow to purchase the new machine:

Cost of new machine $30,000 Cash available from sale of old machine after tax 4,800 Net initial investment $25,200



(3) Annual cash inflows or cash savings:

Depreciation =Cost - Salvage value

Life =

$30,000 - $6,000 6 years

= $4,000/year

Operating savings $10,000 Less: Depreciation 4,000 Taxable savings 6,000 Taxes (40%) 2,400 Net savings $ 3,600

Total annual cash flows:

Net savings $3,600 Add back depreciation 4,000 Annual cash flow $7,600

(4) The salvage value of the new machinery has no tax consequences in Year 6 since the salvage value will equal book value. The cash flows for the six years will look like:

Period Cash Flow

0 ($25,200) 1 7,600 2 7,600 3 7,600 4 7,600 5 7,600 6 7,600 + 6,000

The calculation of net present value at 20% for six years:

Cash savings Annual: $7,600 3.326 = $25,278 Salvage, Year 6: 6,000 0.335 = 2,010 Present value of cash flows 27,288 Less: Initial investment 25,200 Net present value $ 2,088

Since the NPV is positive, replacing the old machine would be a desirable investment.



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______________________________________________

Section 5400 Information Technology

(15%-25%)

5410 Understanding of Information Technology (IT)

5420 Risk Associated with Information Technology (IT)

5421 Risk Assessment

5422 Change Management

5423 Security, Availability, Confidentiality, and Privacy

5430 Controls That Respond to Risks Associated with Information Technology (IT)

5431 General IT Controls

5432 Logical and Physical Controls

5433 Business Resiliency

5440 Data Management and Relationships

5441 Data Governance

5442 Extract, Transform, and Load Data

5443 Data Visualization

BEC 4‐2 INFORMATION TECHNOLOGY


5410 Understanding of Information Technology (IT)

IT Strategies

5410.01 Information systems are important tools for effectively meeting organizational objectives. Readily available, complete, and accurate information is essential for making informed and timely decisions. Being unable to obtain needed data, wading through unneeded data, or inefficiently processing needed data wastes resources. The organization must identify its information needs on the basis of a systematic identification and analysis of its mission and functions to be performed, who is to perform them, the information and supporting data needed to perform the functions, and the processes needed to most usefully structure the information. Successful information systems development and acquisitions must include a rigorous and disciplined process of data gathering, evaluation, and analysis prior to committing significant financial and human resources to any information system development. While implementing such an approach may not preclude all information system acquisition problems, it should produce detailed knowledge of organizational missions and operations, user information needs and alternatives to address those needs, and an open and flexible architecture that is expandable or that can be upgraded to meet future needs.

5410.02 Most organizations use information technology (IT) to manage, manipulate, and disseminate information, as information is one of the resources of an organization. Strategic planning can help organizations achieve these goals. Strategic planning is the process of deciding organizational direction. Strategic planning is a key tool for moving from where one is to where one wants to be. Managers apply analytic techniques, creativity, and sound judgment to anticipate the requirements of the future. When properly executed, IT strategic planning helps an organization to efficiently and effectively carry out its mission. By recognizing the value of strategic thinking and developing the resulting strategic plans, managers can better position their organization to meet tomorrow’s challenges.

One of management’s major objectives when designing an IT strategic plan is to make sure a company’s information resources are secure and adequately controlled. The use of computer‐based information systems does not change basic internal control objectives. However, the extensive use of information technology and the changes in the way companies operate have changed the ways these internal control objectives are achieved. Internal control systems have evolved to parallel the involvement in information systems. Information systems are vulnerable to hacks, data breaches, and system failures. Among the reasons are the following:

a. Organizations are dependent on their information systems to manage their businesses, communicate with business partners, manufacture goods, and render services.

b. We live in an interconnected world and it is often not possible to lock others out of our information systems. Increasingly, a company’s success is dependent on the ability to quickly and efficiently add and communicate with customers, vendors, employees, business partners, shareholders, and various governmental entities.

5410.03 IT advancements have made it possible for an organization to strengthen its internal control structure.

a. Controls were developed to eliminate or minimize the risks introduced when companies moved to a mainframe‐based computer system from a paper‐based system.

b. Controls were also developed when businesses moved to a distributed, client/server system from a centralized, mainframe‐based system.



c. Controls were developed to respond to the risks that arose when moving into an internet‐based, e‐commerce environment.

5410.04 The Assurance Services Executive Committee of the AICPA introduced Trust Services, including SysTrust and WebTrust, which are defined as a set of attestation and advisory services based on a core set of principles and criteria that addresses the risks and opportunities of IT‐enabled systems and privacy programs. The following five principles have been developed by the AICPA and CICA (Canadian Institute of Chartered Accountants) for use by practitioners in the performance of Trust Services engagements:

1. Security: The system is protected against unauthorized physical and logical access to prevent or minimize the theft, improper use, alteration, destruction, or disclosure of data and software.

2. Availability: The system is available for operation and use as committed or agreed.

3. Processing integrity: System processing is complete, accurate, timely, and authorized.

4. Confidentiality: Information designated as confidential is protected as committed or agreed.

5. Privacy: Personal information is collected, used, retained, disclosed, and destroyed in conformity with the commitments in the entity’s privacy notice and with criteria set forth in generally accepted privacy principles issued by the AICPA and CICA.

5410.05 Ensuring system reliability is a top management issue and of upmost importance. Management is responsible for the reliability and accuracy of the organization’s information. For instance, the Sarbanes‐Oxley Act requires:

a. the CEO and CFO to certify that financial statements accurately represent company activities.

b. an annual report on the company’s internal controls. Included in the report is:

(1) a management acknowledgement that it is responsible for designing and maintaining internal controls.

(2) management’s assessment of the effectiveness of those controls.

5410.06 To successfully implement system reliability principles, a company must:

a. develop and document a comprehensive set of control policies before designing and implementing specific control procedures. Otherwise, they will most likely end up purchasing a mish‐mash of products that do not protect every information system resource.

b. effectively communicate policies to all employees, customers, suppliers, and other authorized users. All users should be sent regular, periodic reminders about security policies and be trained in how to comply with them.

c. design and employ appropriate and cost‐beneficial control procedures to implement the policies.

d. monitor the system and take corrective action to maintain compliance with policies. System reliability is a moving target as IT advances create new threats, alter the risks associated with existing threats, and provide new ways to deal with threats.



5410.07 To ensure system reliability, companies must implement a set of preventive controls and supplement them with methods for detecting incidents and procedures for taking corrective remedial action. A company must also employ multiple layers of controls so that if one control fails or is circumvented, another control will prevent, detect, or correct the reliability breakdown.

5410.08 Strategic planning and budgeting

a. Organizations face several strategic planning and budgeting threats related to information technology:

(1) The information system does not support business strategies.

(2) Resources are not used efficiently or effectively.

(3) Information needs are not met or are unaffordable.

b. Several controls can eliminate or minimize these threats:

(1) Develop a multiyear (three‐ to five‐year) strategic plan that shows how the organization will achieve its long‐range goals and the role information technology will play in meeting those goals.

(a) Management should update the plan at least twice a year.

(b) Top management should review and approve the strategic plan at least yearly.

(2) Establish a research and development group that is responsible for assessing how emerging technologies will impact business operations. Use their findings to update the plan.

(3) Budget resources to support the strategic plan.

5410.09 Strategic planning is an organization’s formal process of defining its future course or direction. By devising appropriate strategies and making decisions on allocating its resources (e.g., staff and capital) to pursue those strategies, an organization can determine its direction over a span of time, usually three to five years. To determine that direction, an organization needs to know its current status or position, its future goals, and the strategy or strategies needed to achieve those goals. The results of this process are gathered in a document called the strategic plan.

5410.10 While strategic planning is an effective tool for determining the direction of an organization, the strategic plan cannot predict how a market will evolve and what other issues may surface that affect an organization’s strategy. A turbulent business climate requires innovation and modification of the strategic plan for an organization to survive.

5410.11 Strategic planning deals with the following questions:

a. What do we do?

b. For whom do we do it?

c. How do we excel?

d. How can we beat or avoid competition?

5410.12 Strategic planning uses business analysis techniques such as the following:

a. EPISTELS (environment, political, informatic, social, technological, economic, legal, and spiritual)

b. PEST (political, economic, social, and technological analysis)



c. STEER (sociocultural, technological, economic, ecological, and regulatory factors)

d. SWOT (strengths, weaknesses, opportunities, and threats)

5410.13 An operational plan is part of the strategic plan and describes short‐term methods of achieving milestones. It explains how the strategic plan (or part of the plan) will be put into operation during a given operational period (e.g., a fiscal year). Operational plans establish the activities and budgets for each part of the organization for the next one to three years. They link the strategic plan with the activities the organization will deliver and the resources needed to deliver them. An operational plan describes agency and program missions and goals, program objectives, and program activities, and draws directly from the agency and program strategic plan.

5410.14 Operational plans should contain clear objectives, desired outcomes, activities to be delivered, staffing and resource requirements, quality standards, implementation timetables, and a process for monitoring progress. The operational plan justifies and provides the basis for annual operating budget requests. Therefore, a separate operational plan is needed for each operating budget.

5410.15 An operational plan addresses the following questions:

a. Where are we now?

b. Where do we want to be?

c. How do we get there?

d. How do we measure our progress?

5410.16 An operational plan should be prepared by the same staff responsible for its implementation and there is a need for cross‐departmental cooperation, as plans created by one part of the organization inevitably have implications for the other parts.

5410.17 When preparing an operating budget request, an operational plan provides a plan for resource allocation. Later in the process, the plan may be modified to reflect policy decisions or financial changes made during the budget development process.

5410.18 Develop a system reliability plan

One reason some organizations cannot ensure system reliability is they lack a plan to achieve this objective. To develop and implement a systems reliability plan, an organization should:

a. assign plan responsibility and accountability to a top‐level manager.

b. review and update the plan regularly.

c. make management, users, and all personnel with system reliability responsibilities aware of the plan.

d. require all new and existing employees to follow all security procedures.

e. identify, document, and test:

(1) availability, security, maintainability, integrity, and user reliability requirements.

(2) performance objectives, policies, and standards for the reliability requirements.

f. determine ownership, custody, access, and maintenance responsibility for information resources (hardware, software, data, infrastructure, and people).

g. develop a security awareness program and use it to train employees.



h. document and report all system reliability problems and analyze them, looking for causes and possible trends.

i. identify and review all new or changed legal requirements for their impact on system reliability.

j. log and review all changes requested by users for their impact on system reliability.

k. assess system reliability risks each time the system is changed, modified, or updated.

5410.19 Documentation

It is hard to ensure systems reliability without proper documentation, as this can result in ineffective system design, operation, review, audit, and modification. Documentation can also be used in training system users. It is important to develop and maintain three different types of documentation:

a. Administrative (standards and procedures for analysis, design, programming, processing file handling, and storage)

b. Systems (input, processing, output, and error handling procedures for each application)

c. Operating (equipment configurations, programs, files, setup and execution procedures, and corrective actions for each program)

5410.20 Training

Organizations should spend the time and money necessary to make sure the people who design, develop, implement, and operate the company’s information system are qualified and well trained. There should be an adequately staffed information center help desk in computer operations to deal with errors in user interactions with the information system. The same holds true for those in charge of any aspect of system security.

Organization: Information Technology Governance Structure

5410.21 It is important to understand the control components of a typical organization (adapted from the IT Governance Institute’s IT Control Objectives for Sarbanes‐Oxley Discussion Document):

Figure 4‐1:

Management Direction or “Tone at the Top”

Applications and Business Processes

IT and Supporting Systems



Management Direction or “Tone at the Top”

Applications andBusiness Processes IT and Supporting Systems

Enterprise‐Level Controls Application Controls IT General ControlsEnterprise‐level controls include:

System Planning

Strategic Direction

Operating Styles

Company Policies

Governance

Controls embedded in business processes and transactional applications, designed to support the control objectives of completeness, accuracy, and validity. Examples include:

Authentication of Transactions

Approvals

Tolerance Levels

Reconciliations

Input Edits Note that the discussion of Business Process Cycles gives many examples of common threats and controls for those business processes, along with examples of application controls.

Controls implemented, managed, and monitored by IT. These are embedded throughout all systems and IT policies, and represent the “foundation” upon which all application and business processes are built. Examples include:

System Development Life Cycle (SDLC)

Application Development

Security, both Physical and System

System Maintenance

Backup and Disaster Recovery

Appropriate Segregation of Duties

Systems and Processes

5410.22 While different entities define “business process” uniquely, the Association of Business Process Management Professionals defines a business process as “a defined set of activities or behaviors performed by humans or machines to achieve one or more goal. Processes are triggered by specific events and have one or more outcome(s) that may result in the termination of the process or a handoff to another process.”

5410.23 Business processes are typically comprised of the following:

a. Input(s)

b. Actor(s)—either automated, like a computer, or an actual person

c. The actual activity or process that transforms the input(s)

d. Output(s)—the final result

Any of the above items can be part of an automated system, integrated into an automated system, or a purely manual process.

Basic Business Processes

5410.24 Many business activities are repetitive and engaged in frequently. For example, a retail company sells merchandise to customers in exchange for cash on a daily basis. It frequently buys inventory from suppliers to replenish the merchandise that is sold.

5410.25 These basic exchanges can be grouped into several transaction cycles or business processes. The most common are:

a. the revenue cycle, where goods or services are sold in exchange for cash or a promise to pay cash.

b. the expenditure cycle, where goods or services are purchased in exchange for cash or a promise to pay cash.



c. the production cycle, where raw materials are turned into products that can be sold.

d. the human resources (payroll) cycle, where people are hired, trained, compensated for time and effort they expend, and dismissed.

e. the financing cycle, where companies obtain funds from investors and creditors and pay dividends and repay borrowings.

5410.26 While the basic cycles do not change, there are differences in cycles among companies. For example:

a. Some organizations do not use every cycle. For example, retail stores do not have a production cycle.

b. Some organizations have unique requirements. For example, financial institutions have demand deposit and customer loan cycles.

c. Transaction cycles differ depending upon the type of organization. For example, the expenditure cycles of a service company (CPA or law firm) do not purchase, receive, or pay for merchandise to resell to customers.

5410.27 The transaction cycles are implemented as separate modules in most accounting software packages (also known as the general ledger system).

Figure 4‐2 uses a merchandising company to show how these transaction cycles relate to one another and their relationship with the general ledger and reporting system, which is used to generate information for internal and external parties.

Figure 4‐2:

Customers

Investors

Creditors

Management

Vendors

Employees

Government Agencies

General Ledger and Reporting Cycle

Revenue Cycle

Human Resources Cycle

Expenditure Cycle Goods and services

Cash receipts

Merchandising Company

Managerial reports and financial statements

Taxes

Cash disbursements

Wages and salaries

Loan payments

Dividends

Financial statements

Investment

Loans

Goods and services

Labor services

Tax forms and regulations



Transaction Cycle Transactions (Business Activities)

Revenue Customer orders, sales, shipping/delivery, cash receipts, sales discounts, sales returns and allowances, bad debts.

Expenditure Purchase requisitions, purchases, receipt of inventory, cash disbursements, purchase returns and allowances, purchase discounts.

Human resources Hiring, training, promotion, firing, payroll, and taxes.

General ledger and reporting Nonroutine transactions, adjusting entries, closing entries, managerial reports and financial statements.

5410.28 Objectives

Each cycle has specific objectives that it needs to accomplish. Each cycle also faces a number of threats that put company assets at risk. Controls are put in place to eliminate or minimize these risks. There are several objectives, threats, and controls that apply to all the cycles.

All cycles have the following objectives:

a. Data must be available when it is needed.

b. All activities must be performed efficiently and effectively.

5410.29 Threat

Multi‐cycle threat: Loss or unauthorized disclosure of data. Data can be lost, resulting in:

a. inaccurate external and internal reporting,

b. inaccurate responses to customer and vendor inquiries,

c. customer or vendor information leaked to competitors,

d. inventory and fixed assets not being monitored effectively,

e. manufacturing activities not being performed efficiently and effectively,

f. morale problems,

g. lawsuits and fines, or

h. the potential demise of the entire organization.

5410.30 Controls

a. Back up all master and transaction files regularly, including the general and subsidiary ledgers.

(1) Keep one backup copy on‐site or accessible via cloud storage so it can be immediately accessed if the original is damaged or destroyed.

(2) Store another backup copy off‐site as insurance against a major disaster such as a fire or earthquake.

b. Develop, implement, and periodically test a disaster recovery plan to handle major disasters that can destroy a computer system, including servers.

c. Use physical security controls to restrict physical access to data and computer equipment.

d. Use passwords, user IDs, and an access control matrix to limit logical access to sensitive files, data items, and terminals to authorized employees. For example:

(1) Only sales staff should be allowed to create sales orders.

(2) Only the cashier should be able to indicate that an invoice has been paid.



(3) Sales staff should have read‐only access to customer credit limits and current account balances.

(4) Access controls should exist for individual terminals so the terminal can only process transactions its department is authorized to perform.

e. Encrypt data to make it unintelligible to anyone able to get unauthorized access to files or data.

f. Use simple, easy‐to‐complete documents with clear instructions so transaction data can be recorded accurately and efficiently.

g. Record who completed and who reviewed a document as evidence of proper transaction authorization.

h. Prenumber documents to make sure all transactions are recorded.

i. Restrict access to blank documents and to programs that create documents to reduce the risk of unauthorized transactions.

j. Log all activities, especially actions involving managerial approval (e.g., extending credit limits), so they can be reviewed later as part of the audit trail.

5410.31 Threat

Multi‐cycle threat: Poor performance. It is important that all business activities be performed efficiently and effectively.

5410.32 Controls

a. Prepare and review performance reports to assess the efficiency and effectiveness of cycle activities and to look for inefficient or ineffective performance. For example:

(1) Assess sales force effectiveness by breaking sales down by salesperson, region, or product.

(2) Assess marketing performance by breaking down the marginal profit contribution of each territory, customer, distribution channel, salesperson, or product.

(3) Evaluate the frequency and size of back orders to determine how well inventory management policies satisfy customer needs.

(4) Identify slow‐moving products to avoid excessive inventory levels.

(5) Prepare an accounts receivable aging schedule to monitor accounts receivables collections, estimate bad debts, and evaluate credit policies.

(6) Prepare cash budgets to know when to borrow funds to meet short‐term cash shortages and when to invest excess funds.

(7) Monitor vendor performance using vendor performance reports.

b. Track employee knowledge and skills so they can be shared and used to provide a sustainable competitive advantage.

c. Monitor employees who telecommute or work remotely to make sure they are:

(1) working the hours for which they are being paid.

(2) not using company‐provided computing resources inappropriately:

(a) visiting pornographic websites, sending or forwarding offensive e‐mail, or storing and using pirated copies of software.



(b) operating a personal business on the side, using company‐provided assets for personal use.

d. Train employees to maximize the efficiency and effectiveness of business processes and keep abreast of changes in information technology and legal requirements.

Each of the major business cycles is discussed in the following sections.

The Revenue Cycle

5410.33 The revenue cycle is a recurring set of business and data processing activities associated with selling goods and services to customers in exchange for cash.

The revenue cycle produces information that is used by other accounting cycles:

a. Both the expenditure and the production cycles use sales information to purchase or produce additional inventory.

b. The payroll cycle uses sales information to compensate employees (calculate sales commissions and bonuses).

c. The general ledger and reporting function uses revenue cycle information to prepare financial statements and performance reports.

As shown in Figure 4‐3, there are four basic business activities in the revenue cycle. Each of these activities, the threats the activities face, and the controls used to eliminate or minimize these threats are now discussed.

Figure 4‐3:

5410.34 Sales order entry

The revenue cycle begins when customer orders are received. The primary objectives of the sales order entry process are to:

a. accurately and efficiently process customer orders.

b. make sure all sales are legitimate.

c. make sure the company gets paid for all credit sales.

As shown in Figure 4‐4, the sales order entry process consists of three steps:

4. Collect Cash

3. Billing and Accounts

Receivable

1. Sales Order Entry

2. Ship Goods



Figure 4‐4:

5410.35 The three steps in the sales order entry process are take customer orders, approve credit, and check inventory availability.

5410.36 Take customer orders. Customer orders are received over the internet, in the store, by mail, by phone, or from a salesperson in the field. Companies have used information technology advancements to improve the efficiency and effectiveness of the sales order entry process. For example:

a. Customers can enter sales order data themselves on a company website.

b. Customers can use interactive sales order entry websites called choiceboards to design their own products. For example, Dell customers can mix and match parts and features to create a computer to meet their needs at an affordable price.

c. Electronic data interchange (EDI), where suppliers and customers are linked, eliminates the need for data entry and improves the efficiency and effectiveness of the sales order process.

d. E‐mail can be used to communicate price changes, special needs and interests, and sales promotions.

5410.37 Threats and controls in taking customer orders

1. Threat: Incomplete or inaccurate customer orders

a. This results in inefficiencies (the customer must be contacted and data re‐entered).

b. This can negatively affect customer perceptions and adversely affect future sales.

2. Controls

a. Use automatic data lookups to retrieve data already stored in the customer master file, thereby preventing data entry errors.

b. Perform validity checks of customer account numbers and inventory item numbers (to make sure the numbers entered match information in the customer and inventory master files).

4. Collect Cash

2. Ship Goods


1. Take Customer

Order

2. Approve Credit


Receivable

3. Check Inventory

Availability



c. Use reasonableness tests to compare items and quantities ordered with past sales history for these items and customers.

d. Use completeness tests to make sure all required information is entered.

3. Threat: Orders that are not legitimate

4. Controls

a. Require signed purchase orders from customers.

b. Require a digital signature and digital certificate for all e‐business transactions.

5410.38 Approve credit. A credit sale should be approved before goods are released from inventory.

5410.39 Threat and controls in making credit sales

1. Threat: Credit sales that later become uncollectible

2. Controls

a. Set credit limits for each customer based on their credit history and ability to pay.

b. Give sales order personnel general authorization to approve an order if its total plus the customer’s existing balance does not exceed the customer’s approved credit limit.

c. Have someone other than the salesperson approve special circumstances (new customer, exceeding credit limits), especially if sales personnel are paid on commission.

d. Do not allow sales order entry clerks or sales personnel to change a customer’s credit limit.

e. Maintain accurate and current customer account balances and credit limits.

5410.40 Check inventory availability. There are several steps to this process:

a. Have the system find out if there is enough inventory on hand to fill the order. If so:

(1) notify shipping, inventory control, and billing of the sale,

(2) create an order and enter it into the system, and

(3) let the customer know the expected delivery date.

b. If there is insufficient inventory, back‐order the item so the production department can produce the requested item or purchasing can order it.

5410.41 Threats and controls in inventory availability

1. Threat: Stockouts, carrying costs, and markdowns

a. Sales are lost when stockouts occur.

b. Excess inventory increases carrying costs and may require significant markdowns.

2. Controls

a. Make periodic physical inventory counts to verify the accuracy of recorded amounts.

b. Create accurate systems for sales forecasting and inventory control.

(1) Develop sales forecasts (review them regularly for accuracy and revise them as needed) to predict the demand for goods.



(2) Develop ordering procedures (reorder points, economic order quantities, etc.) that ensure that sufficient inventory is on hand to meet forecasted needs.

c. Monitor supplier performance, such as:

(1) on‐time delivery rates.

(2) defect rates and other quality measures.

5410.42 Ship goods

The second revenue cycle activity is filling customer orders and shipping merchandise. This process has two steps (as shown in Figure 4‐5):

Figure 4‐5:

5410.43 Pick and pack orders. After the sales order is entered, a picking ticket that lists the items and quantities to be shipped is printed. Warehouse employees or robots in the warehouse:

a. use it to identify the items and quantities to remove from inventory,

b. record quantities picked on the picking ticket (or enter them into the system), and

c. forward the inventory to shipping.

5410.44 Ship the order

Shipping:

a. counts the inventory to be shipped.

b. compares their counts to:

(1) quantities on the picking ticket and

(2) quantities on the sales orders copy that was sent to shipping.

c. initiates a back order for any missing items.

d. enters the correct quantities or scans the items shipped on the packing slip.

e. enters or scans the sales order number, item number(s), and quantities into the system. This:

(1) updates the quantity‐on‐hand field in the inventory master file.

4. Collect Cash


Receivable

1. Sales Order

Entry

2. Ship Goods

1. Pick and Pack Orders

2. Ship the Order



(2) produces a packing slip that lists the quantity and description of each shipment item.

(3) produces multiple copies of the bill of lading (a legal contract that states who is responsible for goods in transit; specifies the carrier, sources and destination of the shipment, and special shipping instructions; and indicates whether the customer or vendor is to pay the carrier).

5410.45 Threats and controls in shipping goods

1. Threat: Shipping errors. Shipping incorrect items, incorrect quantities, or sending the shipment to the wrong address can:

a. negatively impact customer satisfaction and future sales.

b. result in the loss of assets if the erroneously shipped goods are not paid for.

2. Controls

a. Require shipping personnel to enter or scan quantities to be shipped into the system before the goods are shipped to detect and correct mistakes prior to shipment. Print packing slips and bills of lading after the system has verified shipment accuracy.

b. Use barcode scanners to record picked and shipped inventory.

c. Use field checks and completeness tests to ensure data accuracy.

3. Threat: Inventory theft. This results in:

a. reduced profitability.

b. lost assets.

c. inaccurate inventory records, which can cause problems with filling customer orders.

4. Controls

a. Keep inventory in a secure location and restrict physical access to that location.

b. Document all inventory transfers. Require warehouse and shipping employees to sign the document transferring inventory to shipping or scan the inventory before it is transferred (or make the appropriate acknowledgment of the transfer online).

c. Release inventory to shipping employees only when there is an approved sales order and a system‐generated picking ticket.

d. Periodically count physical inventory on hand and reconcile it to recorded inventory.

e. Hold the employees who are responsible for storing inventory accountable for any shortages.

5410.46 Billing and accounts receivable

a. The primary objectives of the billing and accounts receivable functions are to ensure that:

(1) customers are billed for all sales,

(2) invoices are accurate, and

(3) customer accounts are accurately maintained.



b. There are two steps in the billing and accounts receivable activity (as shown in Figure 4‐6).

Figure 4‐6:

(1) Bill customers. After goods are shipped, a sales invoice is sent to customers to let them know how much they owe and where to send payment. EDI and EFT technology is often used to reduce billing costs and the time required to send invoices and receive payment.

(2) Update accounts receivable. Sales invoice information is used to update customer accounts.

(a) There are different ways to maintain accounts receivable depending on when customers remit payments, how payments are updated on the accounts receivable master file, and monthly statement format.

i. With the open‐invoice method, customer payments are applied against specific invoices. Two invoice copies are transmitted to the customer. One serves as a remittance advice and is returned with the payment.

ii. With the balance‐forward method, customers pay the balance shown on a monthly statement that lists all sales and payment transactions that occurred during the past month.

Cycle billing can be used to spread out billing and cash receipts. Monthly statements are prepared and mailed at different times for subsets of customers. For example, the master file could be divided into four parts, and each week monthly statements sent to one‐fourth of the customers.

(b) As part of the update process, adjustments to customer accounts are sometimes needed due to:

i. items that are returned.

ii. allowances for damaged goods.

iii. customer’s accounts that must be written off.

In such cases, the credit manager fills out a credit memo. When the credit memo is for damaged or returned goods, the customer is sent a copy.

4. Collect Cash


2. Ship Goods

3. Billing and Accounts Receivable

1. Bill Customers

2. Update Accounts

Receivable



5410.47 Threats and controls in billing and accounts receivable

1. Threat: Failure to bill customers for items shipped. When this occurs:

a. companies suffer financial loss due to cash not being collected, and

b. sales, inventory, and accounts receivable data are inaccurate.

2. Controls

a. Segregate shipping and billing to prevent an employee from shipping merchandise and then not billing the customer.

b. Prenumber all documents sequentially.

c. Match sales orders and packing slips to sales invoices to make sure shipments have been billed.

d. Make sure every shipment is recorded in an information system that does not produce invoices and then compare data between the two systems.

3. Threat: Billing errors. This includes pricing mistakes and billing customers for items not shipped or on back order.

a. Overbilling can result in customer dissatisfaction.

b. Underbilling results in the loss of assets and reduced profitability.

4. Controls

a. Have the computer automatically retrieve inventory prices from the inventory master file rather than having employees enter them into the system.

b. Reconcile packing slip quantities with sales order quantities to avoid shipping mistakes.

c. Use barcode scanners to read universal product codes (UPC) or other types of barcodes to minimize data entry errors.

5. Threat: Errors in customer accounts. This can:

a. decrease future sales.

b. lead to the theft of cash.

6. Controls

a. Use validity checks to make sure all customer numbers and invoice numbers are valid.

b. Use closed‐loop verification tests (enter the customer number and the system retrieves the customer name) to make sure the proper account is being credited.

c. Use field checks on payment amounts to make sure all values entered are numeric.

d. Use batch totals when customer payments are processed in batches. Have someone other than the person processing the original transactions reconcile the batch totals.

e. Compare the accounts receivable subsidiary file balance to the general ledger accounts receivable control account balance after customer payments are processed. If they are not equal, a posting error has occurred and should be corrected.

f. Compare the number of customer accounts updated with the number of checks received to make sure all remittances were processed.



g. Mail or email monthly statements to all customers so they can do an independent review of their accounts (customers will complain if their accounts are incorrect).

5410.48 Collect cash

Companies use a variety of cash receipt processes to collect and identify where cash remittances come from and to determine what account or invoice to credit.

a. Two copies of each invoice can be mailed to customers; one is returned with the payment.

(1) Accounts receivable is sent either the copy returned in the mail or a remittance list that identifies the names and amounts of all customer payments. Customer payments are sent to the cashier.

(2) Companies can use a bank lockbox, which is a postal address that customers use to mail in their payments. The bank:

(a) gets the mail from the post office;

(b) deposits the checks in the company’s account; and

(c) sends the remittance advice, an electronic list of all remittances, and photocopies of all checks to the company.

(3) An electronic lockbox has an additional advantage: The bank electronically sends information about customer account numbers and amounts remitted as soon as checks are received and scanned.

(4) Electronic funds transfer (EFT) is used to electronically send customer payments to their supplier’s bank.

(5) EFT with EDI can be integrated (called financial electronic data interchange [FEDI]) to automate the billing and cash collections processes.

5410.49 Threats and controls in collecting cash

1. Threat: Theft of cash. An employee intent on stealing company assets is most likely to go after cash, as it is the most liquid asset.

2. Controls

a. Segregate duties so employees with custody of (physical access to) cash do not record or authorize any cash transactions. It is especially important to segregate the following duties:

(1) Handling cash or checks and posting remittances to customer accounts, as employees could lap customer accounts

(2) Handling cash or checks and authorizing credit memos, as employees could issue a credit memo to conceal embezzlement

(3) Issuing credit memos and maintaining customer accounts, as employees could write off amounts owed by friends or customers they collude with

b. Minimize the amount and extent of money and checks that are handled.

Use a bank lockbox, EFT, or FEDI for customer payments when the benefits of reduced processing costs, lower thefts, and faster access to customer payments outweigh their costs.

c. Promptly document all remittances, as cash is most likely to be lost at the time it is received.



(1) Have two people open all incoming mail to minimize the risk of cash or checks being stolen.

(2) Prepare a list of all checks received as the mail is opened.

(3) Restrictively endorse each check after it is removed from the envelope.

d. Segregate the recording and custody functions by sending remittance data to accounts receivable and customer payments to the cashier. Use the following control checks:

(1) Compare accounts receivable credit totals to cash deposited totals.

(2) Have internal audit compare remittance lists with validated deposit slips and bank statements to make sure all checks and cash were deposited.

e. Send monthly statements to customers, as they will complain if there are errors.

f. Use cash registers that record all cash receipts when cash is received directly from customers.

g. Encourage customers to watch their purchase being rung up and to ask for a receipt by using signs to let them know that:

(1) their purchase is free if they are not given a receipt or

(2) they are entitled to a discount if their receipt has a red star on it.

h. Deposit all customer receipts daily to:

(1) reduce the amount of cash and checks that can be stolen.

(2) make it easier to reconcile bank statements with sales, accounts receivable, and cash collection records.

i. Make sure the bank statement is reconciled by someone who has no other cash handling and recording duties. This:

(1) provides an independent check on the cashier and

(2) prevents bank statement manipulations that conceal cash embezzlements.

j. Make sure accounts receivable (a recording function) does not have physical access to cash or checks.

The Expenditure Cycle

5410.50 The expenditure cycle is a recurring set of business and data processing activities associated with purchasing and paying for goods and services. A primary objective of the cycle is to minimize the cost of acquiring and maintaining inventories, supplies, and other needed organizational services.

There are several information flows in the expenditure cycle (as shown in Figure 4‐7):



Figure 4‐7:

Information technology can be used to improve the efficiency and effectiveness of expenditure cycle activities. A company can also require customers to modify their own expenditure and revenue cycles. In other words, changes in one company’s operations may necessitate IS (information system) changes in companies they do business with. For example, the major automobile manufacturers may require suppliers to transmit invoices via EDI (electronic data interchange) and receive payments using EFT (electronic funds transfer).

Expenditure Cycle

Management

Vendors

General Ledger and Reporting System

Revenue

Cycle

Performance Reports

Purchase Orders

Invoices

Goods & Services

Back Orders

Receipt of Goods Notification

Production

Cycle

Inventory and Departments

Raw Material Needs


Purchases & Payments Summary Data

Purchase Requisitions

Payments




5410.51 Expenditure cycle business activities

There are three expenditure cycle business activities and they interact with the four activities of a vendor’s revenue cycle (as shown in Figure 4‐8). We will now discuss the expenditure cycle activities, the threats that these activities face, and the controls used to eliminate or minimize these threats.

Figure 4‐8:

5410.52 Order goods

The first expenditure cycle activity is ordering raw materials, inventory, or supplies. There are two steps in the order goods activity.

1. Requisition goods. When the inventory control function or company employees notice that goods are needed, they create a purchase requisition (either a document or an electronic form) that identifies:

a. the person or machine making the request;

b. delivery location and date;

c. item numbers, descriptions, quantity, and price of each item requested; and

d. in some cases, a suggested supplier.

2. Prepare purchase order. Purchase requisitions are sent to a purchasing agent who purchases the goods.

The purchasing agent:

a. selects an approved supplier that sells the desired items.

(1) Supplier selection depends on factors such as price, quality, and reliability.

(2) To monitor suppliers, organizations track and periodically evaluate supplier performance.

1. Order Goods

2. Receive and Store

Goods

3. Pay for Goods and Services

1. Sales Order

Entry

2. Ship Goods


Receivable

Expenditure Cycle Revenue Cycle

4. Cash Collections

Purchase Order

Goods & Services

Sales Invoice

Cash Disbursement



b. prepares a purchase order and sends it to the chosen supplier. A purchase order:

(1) is a formal request to sell and deliver specified products at designated prices.

(2) is a promise to pay.

(3) becomes a contract once the supplier accepts it.

(4) includes supplier and purchasing agent’s names, order and delivery dates, delivery location, shipping method, and information about the items ordered.

5410.53 Information technology can be used to improve the purchasing process by:

a. using EDI (electronic data interchange) or the internet to communicate electronically.

(1) Costs can be reduced by eliminating printed and mailed paper documents.

(2) Stockouts can be minimized or reduced by eliminating the delivery time associated with paper documents.

b. developing vendor‐managed inventory programs to minimize or eliminate stockouts.

Suppliers access inventory data in company databases and automatically ship inventory when needed.

c. running reverse auctions where suppliers compete to sell goods at the lowest price.

d. using trading exchanges (electronic marketplaces) that link buyers and sellers of commodity‐type goods that are differentiated by price.

e. using procurement cards (corporate credit cards) to improve efficiency and reduce purchasing costs.

(1) Each card has a spending limit.

(2) All employee purchases are summarized on one monthly bill.

(3) The purchases from each card can be allocated to appropriate general ledger accounts.

5410.54 Threats and controls in ordering goods (Part 1)

1. Threat: Stockouts and excess inventory

a. Stockouts result in lost sales and customer dissatisfaction.

b. Developing excess inventory incurs carrying costs, causes cash flow problems, may result in obsolete inventory, and reduces profitability.

2. Controls

a. Develop an accurate sales forecast system to know the demand for each product.

b. Develop an accurate perpetual inventory control system to make sure inventory information is always current. Periodically count inventory and reconcile the counts to the perpetual records.

c. Select suppliers that meet delivery commitments, monitor supplier performance, and select new suppliers when performance falls below acceptable levels.

d. Prepare performance reports to highlight deviations in product quality, prices, and delivery commitments. Review them periodically.



e. Use barcode technology to eliminate human data entry and improve perpetual inventory record accuracy as barcode scanners capture data quickly and are easy to use. One example of a barcode type is a universal product code (UPC).

3. Threat: Purchasing errors. This includes:

a. buying unnecessary items and

b. failure to take advantage of available volume discounts.

4. Controls

a. Develop an accurate perpetual inventory control system to make sure inventory information is always current. Periodically count inventory and reconcile the counts to the perpetual records.

b. Have department supervisors review and approve all purchase requisitions before they are sent to the purchasing department.

c. Integrate subunit databases so items do not have different numbers in various databases and make the database available to all who need it.

d. Prepare reports that link item descriptions to part numbers.


1. Threat: Purchasing goods at inflated prices

2. Controls

a. Store the prices of frequently purchased items in the computer and require purchasing agents to consult them when ordering goods.

b. Require competitive, written bids for high‐priced as well as specialized items.

c. Charge purchases to the budget of the department requesting the goods.

d. Periodically compare actual costs with budget allowances and investigate any significant deviations.

e. Review purchase orders to make sure the policies mentioned above are followed.

3. Threat: Purchasing goods of inferior quality. Substandard products can result in:

a. costly production delays, and

b. high scrap and rework costs.

4. Controls

a. Monitor supplier prices to determine which provide the highest‐quality goods at the most competitive prices.

b. Create a list of approved suppliers known to provide goods of acceptable quality. Collect and periodically review supplier performance data to:

(1) keep approved supplier lists current and

(2) drop suppliers if the quality of their goods diminishes.

c. Review purchase orders to make sure approved suppliers are used.

d. Hold purchasing managers responsible for all purchase costs, including scrap and rework costs.




1. Threat: Purchasing from unauthorized suppliers. This can result in:

a. inferior quality goods,

b. overpriced goods, or

c. legal problems (such as violating import quotas).

2. Controls

a. Review all purchase orders to make sure that only approved suppliers are used.

b. Develop a process for adding suppliers to the approved list.

(1) Limit the number of people who can add suppliers.

(2) Require approval of all additions to the list of authorized suppliers.

c. Restrict access to the approved supplier list and periodically review it for unauthorized changes.

3. Threat: Kickbacks. Suppliers may give purchasing agents gifts to persuade them to buy from the supplier. This can:

a. impair buyer objectivity or

b. result in inflated prices or inferior quality goods.

4. Controls

a. Do not allow purchasing agents to accept gifts from potential or existing suppliers.

b. Have purchasing agents sign a conflict of interest statement each year that discloses any and all direct or indirect financial interests in current or potential suppliers.

c. Conduct supplier audits, where company personnel visit suppliers to check their records and determine their policies and practices.


1. Threat: EDI‐related risks (electronic data interchange)

2. Controls

a. Use passwords, user IDs, access control matrices, and physical access controls to limit logical and physical access to equipment, files, and data items to authorized personnel.

b. Establish procedures to verify and authenticate all EDI transactions. Send transaction acknowledgements to help ensure transaction accuracy.

c. Time‐stamp and number all EDI transactions to prevent orders from being lost.

d. Maintain a log of all EDI transactions. Periodically review them to make sure they have all been processed according to established policies.

e. Use data encryption to ensure EDI transaction privacy.

f. Use digital signatures to make sure transactions are authentic.

3. Threat: Purchase of phantom services. When fraud perpetrators set up fictitious vendors they are likely to use a vendor that provides services, as they do not require purchase orders or result in receiving reports. Therefore, different procedures are needed to control the purchase of services, such as lawn maintenance or maintenance work. A major challenge is verifying that the services were actually performed.



4. Controls

a. Make visual inspections to make sure the service was rendered where possible.

b. Hold department supervisors responsible for all service costs they incur.

c. Charge the services to accounts for which the requesting department is responsible.

d. Compare actual and budgeted expenses and investigate any discrepancies.

5410.58 Receive and store goods

During this activity:

a. goods are accepted only when a valid purchase order indicates they were ordered.

b. the receiving department accepts deliveries from suppliers and counts the goods to make sure all ordered items were received.

It is important to verify the quantity and quality of goods delivered, so the company pays only for goods actually received.

c. a receiving report is completed for all accepted deliveries. It contains delivery details, such as date received, shipper, supplier, purchase order number, the items received, and the quantity of each item received.

The person inspecting and approving the receipt of goods should initial the receiving order.

d. the received goods are sent to stores to be stored until needed.

5410.59 Information technology advancements can be used to improve the efficiency and effectiveness of the receiving and inventory storage functions:

a. Companies can minimize data entry errors by:

(1) requiring suppliers to barcode their products and receiving clerks to scan the barcodes to get product numbers and quantity of items received.

(2) requiring vendors to attach, to each crate of goods, a radio frequency identification tag that emits a signal and installing a receiving unit at the company that can read the radio signal.

b. Trucks can be equipped with GPS (Global Positioning System) that tracks the exact location of all incoming shipments.

5410.60 Threats and controls in receiving and storing goods

1. Threat: Receiving unordered goods. This incurs unnecessary costs related to storing and returning goods.

2. Controls

a. Require the receiving department to accept only deliveries for which there is an approved copy of the purchase order.

(1) The receiving clerk should make sure the purchase order number on the vendor’s packing slip matches an unfilled purchase order.

(2) For this to happen, the receiving department needs access to the open purchase order file.



3. Threat: Errors in counting goods received. This results in:

a. inaccurate perpetual inventory records and

b. paying for goods not received.

4. Controls

a. Use barcodes to improve the efficiency and accuracy of receiving counts.

b. Do not let receiving clerks know order item quantities. Otherwise, the receiving clerk could simply do a quick visual comparison of quantities received with those indicated on the packing slip.

(1) Let receiving clerks know how important it is to carefully and accurately count all deliveries.

(2) Require receiving clerks to sign the receiving report (or enter their employee ID numbers in the system) so they can be held accountable.

(3) Offer bonuses to receiving clerks who catch discrepancies between the packing slip and actual quantity received before the delivery person leaves.

(4) Require inventory stores to count all items from receiving and hold stores responsible for any subsequent shortages.

(5) Require receiving clerks to check for inventory damage while making their counts.

5. Threat: Losing inventory

6. Controls

a. Store inventory in secure locations and restrict access to the storage area.

b. Document all intra‐company inventory transfers to know who to hold responsible for shortages and to make sure all inventory movements are recorded accurately. For example:

(1) Receiving and inventory stores should acknowledge the transfer of goods from the receiving dock into inventory.

(2) Inventory stores and production should acknowledge the release of inventory into production.

c. Take physical inventory counts regularly. Critical items should be counted frequently and less critical items counted less often. Reconcile the counts with the inventory records.

5410.61 Pay for goods and services

The third expenditure cycle activity involves two steps: approve vendor invoices for payment and pay approved invoices.

5410.62 Approve vendor invoices for payment

a. Accounts payable should authorize payment for goods and services only if they were ordered and actually received.

(1) A valid purchase order is evidence that the goods or services were actually ordered.

(2) A valid receiving report is evidence the goods were received.



b. Most companies record accounts payable after a supplier invoice has been received and approved. Vendor invoices are processed in two ways:

(1) In a nonvoucher system, approved invoices are posted to the appropriate supplier record in the accounts payable file and stored in an open‐invoice file.

When an invoice is paid, it is removed from the open‐invoice file, marked paid, and stored in the paid‐invoice file.

(2) In a voucher system, a disbursement voucher is created to summarize one or more vendor invoices and specify which general ledger account to debit.

The voucher identifies the supplier, lists all outstanding invoices, and indicates how much is to be paid after applicable discounts and allowances are deducted.

c. Information technology advancements can help improve the accounts payable process by:

(1) requiring invoices to be submitted electronically (by EDI (electronic data interchange) or the internet) and using the system to automatically match invoices to appropriate purchase orders and receiving reports.

(2) using an “invoiceless” approach, called evaluated receipt settlement (ERS), that replaces the traditional three‐way matching process (vendor invoice, receiving report, purchase order) with a two‐way match (purchase order, receiving report).

(3) using procurement cards or corporate credit cards to eliminate most small invoices.

(4) using electronic forms for submitting travel expenses.

5410.63 Pay approved invoices. A voucher package consists of a vendor invoice, a purchase order, and a receiving report. After voucher packages are approved, funds are disbursed by check or EFT (electronic funds transfer) and sent to suppliers.

5410.64 Threats and controls in paying for goods and services (Part 1)

1. Threat: Errors in vendor invoices. These errors include:

a. discrepancies between quoted and actual prices charged, and

b. errors in calculating the total amount due.

2. Controls

a. Have an independent person, or the system:

(1) verify prices and quantities on vendor invoices and compare them with those on the purchase order and receiving report.

(2) verify the mathematical accuracy of vendor invoices.

b. Require employees who have procurement cards to keep receipts and verify monthly statement accuracy.

c. Adopt ERS to eliminate vendor invoices errors (companies pay after matching receiving reports with purchase orders).

d. Train purchasing and accounts payable staff on transportation practices and terminology so the company does not pay unnecessary transportation costs.

e. Negotiate significant discounts with designated carriers to reduce costs.

f. Capture data on carriers, so reports identifying suppliers who fail to comply with shipping instructions can be prepared.



3. Threat: Paying for goods not received

4. Controls

a. Compare vendor invoice quantities with the quantities the inventory control person entered into the system.

Inventory control should make sure that when goods are transferred from receiving, their count agrees to receiving’s count.

b. Use budgetary controls and careful reviews of departmental expenses to find potential problems when purchasing services.


1. Threat: Failing to take available purchase discounts

2. Controls

a. Set up procedures to make sure approved invoices are filed by due date.

b. Have the system track invoice due dates and organize a report in the accounting system, or print a list of all outstanding invoices by due date.

c. Use a cash flow budget that indicates expected cash inflows and outstanding commitments so the company can plan to take advantage of purchase discounts.

3. Threat: Paying the same invoice twice. An invoice can be paid more than once.

a. A duplicate invoice could be sent after the company’s check is in the mail.

b. An invoice could become separated from the documents in the voucher package.

Duplicate payments are usually detected by the supplier, who may or may not return the duplicate payment. Duplicate payments affect a company’s cash flow needs and result in incorrect financial records until the duplicate payment is detected.

4. Controls

a. Approve invoices for payment only when accompanied by a purchase order and receiving report.

b. Only pay based on an original copy of an invoice; do not authorize payment based on a photocopy.

c. When payment is made, invoices and voucher packages should be canceled (marked “paid”) so they cannot be resubmitted for payment.

d. Automate accounts payable, to eliminate most clerical errors associated with processing invoices.

e. Use invoiceless accounts payable systems to improve efficiency.

(1) Control access to the supplier master file and monitor all changes made to it.

(2) The supplier master file contains the prices of goods being purchased and unauthorized changes to those prices can result in overpayments to suppliers.

f. Use internal auditors to detect and recover overpayments to suppliers.




1. Threat: Accounts payable recording and posting errors. This can result in:

a. errors in financial and performance reports, and

b. poor decisions.

2. Controls

a. Compare supplier account balances before and after processing checks with the total amount of invoices processed.

b. Reconcile the accounts payable control account balance in the general ledger to one of the following:

(1) The total of all supplier account balances

(2) Unpaid vouchers

3. Threat: Misappropriated cash, checks, or EFTs (electronic funds transfers)

4. Controls

a. Restrict access to cash and blank checks.

b. Pre‐number checks sequentially and periodically account for them.

c. Restrict access to the check‐signing machine and online bank account.

d. Require two signatures for checks in excess of a certain amount, to provide an independent review of the expenditure.

e. Have the cashier or treasurer mail signed checks, rather than returning them to accounts payable, to make sure checks are mailed to the intended recipients.

f. Segregate duties.

(1) Have accounts payable assemble voucher packages and authorize payments.

(2) Have the treasurer or cashier sign checks.

g. Have internal auditors periodically review the supplier master file to check for duplicate supplier entries.

h. Have someone who has no involvement in processing cash collections or disbursements reconcile all bank accounts promptly.

(1) This provides an independent check on accuracy.

(2) It prevents someone from misappropriating cash and concealing the theft by manipulating the bank reconciliation.

i. To prevent check alteration and forgery:

(1) use check‐protection machines that print check amounts in distinctive colors.

(2) use special inks that change colors if altered.

(3) print checks on special paper that contains watermarks.

(4) send a list of all legitimate checks to the bank, which will clear only those checks appearing on the list.

j. For minor purchases, use a petty cash fund managed by an employee with no cash‐handling or accounting responsibilities.

(1) The petty cash fund should be an imprest fund for a small, fixed amount.



(2) Require vouchers for every disbursement so that, at all times, the sum of cash plus vouchers equals the imprest fund balance.

(3) When needed, turn the vouchers in to accounts payable to get the fund replenished.

(4) Cancel petty cash fund vouchers so they cannot be reused.

(5) Have internal auditors make periodic, unannounced counts of the fund balances and vouchers.

(6) Hold the person in charge of the petty cash fund responsible for any shortages.

k. To control electronic funds transfers:

(1) implement strict access controls such as passwords and user IDs that are changed regularly.

(2) record the user and the location of the originating terminal to monitor the adequacy of access controls.

(3) encrypt EFT transmissions to prevent alteration.

(4) time‐stamp all EFT transactions and number them to facilitate subsequent reconciliation.

(5) establish a control group and have them monitor EFT transactions for validity and accuracy.

(6) use special programs, called embedded audit modules, to monitor all transactions and flag these with specific characteristics for further review.

The Production Cycle

5410.67 The production cycle is a recurring set of business and data processing activities associated with manufacturing products. The production cycle interacts with the other cycles as indicated in Figure 4‐9:

Figure 4‐9:

There are four basic activities in the production cycle (as shown in Figure 4‐10). Each of these activities is briefly explained. The threats a system faces during each activity are also explained, along with the controls used to prevent the threat.

Production Cycle

Expenditure

Cycle

Human Resources

Management

General Ledger/

Reporting System

Revenue

Cycle

Purchase Requisitions

Raw Material Acquisitions

Manufacturing Overhead

Expenses

Labor Availability

Hiring Requests

Labor Costs

Customer Orders

Finished Goods

Available for Sale

Cost of Goods

Manufactured

Sales Forecasts



Figure 4‐10:

5410.68 Design products

Products are designed to meet customer requirements at the lowest possible production costs. Two main documents are produced during product design:

a. Bill of materials, which lists the part number, description, and quantity of each item used in a finished product

b. Operations list, which lists labor and machine requirements for manufacturing the product

5410.69 Threats and controls in designing products

1. Threat: Poor product design, which drives up costs in several ways:

a. Too many unique components, which increases costs associated with purchasing and maintaining raw materials inventories

b. Inefficient production processes, which makes moving from producing one product to another overly complex and costly

c. Poorly designed products, which results in excessive warranty and repair costs, an impaired reputation, and a reduction in future sales

2. Controls

a. Use complete and accurate data about the relationships between components and finished goods.

b. Analyze warranty and repair costs to find out why products fail, and redesign the products to increase quality.

5410.70 Plan and schedule production

a. An efficient production plan helps organizations:

(1) fill existing orders,

(2) have sufficient product to meet anticipated short‐term demand, and

(3) avoid excess finished goods inventories.

4. Cost Accounting

3. Produce Products

1. Design Products

2. Plan and Schedule

Production



b. Two common production planning methods are:

(1) Manufacturing resource planning (MRP‐II):

(a) Meets forecasted sales demands by balancing existing production capacity and raw materials needs.

(b) Since goods are produced based on sales forecasts, it is often referred to as push manufacturing.

(2) Just‐in‐time (JIT) manufacturing systems:

(a) JIT minimizes or eliminates raw materials, work‐in‐process, and finished goods inventory.

(b) Since goods are produced in response to customer demand, JIT is often referred to as pull manufacturing.

c. The planning and scheduling activity produces several documents:

(1) Master production schedule (MPS):

(a) MPS shows how much product to produce and when to produce it.

(b) Customer orders, sales forecasts, and finished goods inventory quantities are used to determine production amounts.

(c) The bill of materials is “exploded” to determine the raw materials needed to meet the MPS production goals.

(i) Raw material requirements are compared with current inventory levels.

(ii) Purchase requisitions are generated for needed materials and sent to the purchasing department.

(2) Production order:

(a) authorizes a specified amount of product to be produced.

(b) lists the operations to be performed, how much product to produce, and where to deliver the finished product.

(3) Materials requisition:

(a) authorizes the storeroom to release the specific quantity of raw materials.

(b) contains the production order number, date of issue, and the part numbers and quantities of all necessary raw materials.

(4) Move tickets identify the raw materials moved within the factory, where they are moved to, and the time of transfer.

5410.71 Threats and controls in planning and scheduling production

1. Threat: Over‐ or under‐production

a. Overproduction results in too many goods, cash flow problems, reduced profitability, and obsolete inventory.

b. Underproduction results in lost sales and customer dissatisfaction.

2. Controls

a. Develop an accurate sales forecast system to know the demand for each product.

b. Develop an accurate perpetual inventory control system to make sure inventory quantities are always correct.



(1) Periodically count inventory and reconcile the counts to the perpetual records.

(2) Use barcode technology to eliminate human data entry and improve perpetual inventory record accuracy.

c. Prepare production performance evaluation reports to evaluate production quantities, product quality, and delivery schedules.

d. Require approval and authorization of production orders:

(1) Use passwords and an access control matrix to restrict access to the production scheduling program.

(2) Use closed‐loop verification to make sure correct production orders are released. The production planner enters the product number.

(a) The system retrieves the description, order quantity, and other relevant data.

(b) The system requests the user to verify that the correct production order is being released.

e. Select suppliers that meet delivery commitments, monitor supplier performance, and select new suppliers when performance falls below acceptable levels.

3. Threat: Unauthorized acquisition of fixed assets. This can result in:

a. overinvestment in fixed assets and

b. reduced profitability.

4. Controls

a. Require supervisory personnel to recommend large capital expenditures and do a feasibility analysis of the proposed expenditure.

b. Require a capital investments committee to review acquisition recommendations and prioritize them.

c. Require small capital expenditures to be purchased directly out of departmental budgets.

d. Hold managers accountable for their department’s return on fixed assets.

e. Send potential suppliers a request for proposal (RFP) that specifies the desired asset properties and invite them to send in a bid.

f. Require the capital investments committee to review RFP responses and select the best bid.

5410.72 Produce products

This is the production cycle step where products are actually manufactured.

Using information technology, such as robots and computer‐controlled machinery, is referred to as computer‐integrated manufacturing (CIM) and can significantly reduce production costs.

5410.73 Threats and controls in producing products

1. Threat: Theft or overstatement of inventories and fixed assets

2. Controls

a. Limit physical access to inventories and fixed assets.



b. Use access controls and compatibility tests to restrict access to information about inventories and fixed assets to authorized personnel.

c. Document all internal movements of inventory through the production process.

(1) Use materials requisitions to authorize the release of raw materials to production.

(2) Require inventory control clerks and production employees receiving raw materials to sign the materials requisition or scan the barcodes on the goods to acknowledge that goods were released to production.

(3) Document and authorize requests for materials in excess of the amounts specified in the bill of materials.

(4) Use move tickets, scanners, or RFID (radio‐frequency identification) to document the movement of inventory through the production process.

(5) Document any return of materials not used in production.

d. Segregate duties

(1) Have the inventory stores department be responsible for maintaining physical custody of raw materials and finished goods inventories.

(2) Have department or factory supervisors be responsible for work‐in‐process inventories.

(3) Have production planners and the production information system be responsible for preparing production orders, materials requisitions, and move tickets.

e. Use barcode scanners and online terminals to record inventory movement and help maintain accurate perpetual inventory records.

f. Have an employee without any custodial responsibility count inventory on hand periodically. Discrepancies between physical counts and recorded amounts should be investigated and corrected.

g. Identify and record all fixed assets.

(1) Make managers responsible and accountable for fixed assets under their control.

(2) Authorize and document all disposals of fixed assets.

(3) Prepare a report of all fixed‐asset transactions periodically and send it to the controller, who should verify the proper authorization and execution of each transaction.

h. Maintain adequate insurance to cover losses and replace assets.

5410.74 Cost accounting

a. The final production cycle step is cost accounting, which has two objectives:

(1) Provide the information to plan, control, and evaluate production operation performance. To make timely and accurate decisions, management needs the information system (IS) to collect real‐time data about production activity performance.

(2) Provide accurate cost data about products, and collect and process the information needed to calculate inventory and cost of goods sold. To assign costs to specific products and organizational units, the IS must categorize costs. This requires cost



data to be carefully coded during collection, as costs may be allocated in multiple ways, for several different purposes.

For example, factory supervision costs are assigned to departments for performance evaluation purposes and to specific products for pricing and product mix decisions.

b. Most companies use either job‐order or process costing to assign production costs.

(1) Job‐order costing:

(a) assigns costs to specific production batches or jobs and

(b) is used when a product or service consists of discretely identifiable items.

(2) Process costing:

(a) assigns costs to processes and calculates the average cost for all units produced and

(b) is used when similar goods or services are produced in mass quantities and discrete units are not readily identified.

5410.75 Threats and controls in cost accounting

1. Threat: Production activity data is not recorded or processed accurately, resulting in:

a. erroneous decisions about which products to produce and how to price products.

b. inaccurate inventory records that lead to overstocking or shortages of goods.

c. errors in financial statements and managerial reports that misrepresent performance and lead to poor decisions.

2. Controls

a. Automate data collection (barcode scanners, badge readers) to improve accuracy.

b. Use passwords, user IDs, and an access control matrix to restrict access to production data to authorized personnel.

c. Use check digits and closed‐loop verification to make sure data about raw materials used, operations performed, and employee numbers are entered correctly.

d. Use validity checks to make sure that requested materials are on the bill of materials.

e. Count physical inventory and periodically compare the counts to recorded quantities.

3. Threat: Inefficiencies in production operations and quality control problems

4. Controls

a. Monitor manufacturing activities closely and take prompt action to correct any deviations from standards.

b. Prepare appropriate performance reports.

c. Maintain and carefully review measures of throughput (number of good units produced in a given period of time).

d. Maintain quality control measures such as:

(1) productive capacity (maximum number of units that can be produced with current technology). To increase productive capacity: improve labor or machine



efficiency, rearrange the factory floor to expedite material movements, or simplify product design.

(2) productive processing time (percentage of total production time used to manufacture a product). To improve productive processing time: improve maintenance to reduce machine downtime and schedule new material deliveries more efficiently to reduce wait time.

(3) yield (percentage of nondefective units produced). To improve yield: use higher‐quality raw materials and improve worker skills.

e. Develop information about the following quality control costs and use that information to minimize the costs.

(1) Prevention costs (production process changes that reduce product defect rates)

(2) Inspection costs (tests to make sure products meet quality standards)

(3) Internal failure costs (reworking or scrapping defective products)

(4) External failure costs (selling defective products, which results in product liability claims, warranty and repair expenses, loss of customer satisfaction, and damage to the company’s reputation)

The Human Resources Cycle

5410.76 The human resources management (HRM)/payroll cycle is a recurring set of business and data processing activities associated with managing employee information and compensating employees.

a. The more important tasks include the following:

(1) Recruiting and hiring new employees

(2) Training new and existing employees

(3) Assigning jobs to employees

(4) Compensating employees

(5) Evaluating employee performance

(6) Voluntary and involuntary terminations

The first and last activities are performed once for each employee. The other activities are performed periodically for as long as the person is employed.

b. Compensating employees is the payroll system’s main function. The HRM system takes care of the other tasks. These two systems are organizationally separate in larger organizations. The director of human resources manages the HRM system and the controller manages the payroll system.

The main inputs to the payroll system and their sources are as follows:

(1) The HRM department provides data about hirings and terminations as well as pay‐rate changes.

(2) Employees make changes to their files (deductions, address changes, dependents).

(3) Departments send data about how many hours each employee works.

(4) Government agencies are the source of tax rate changes and instructions for meeting regulatory requirements.



(5) Other organizations provide information on calculating various withholdings (insurance, union dues).

c. The principal outputs of the payroll system are paper checks or electronic remittance and reports.

(1) Paychecks are sent to employees or their pay is sent by direct deposit to their bank accounts.

(2) A payroll check transfers funds from the company’s payroll account.

(3) Checks are sent to government agencies, insurance companies, and other organizations for amounts withheld from gross pay.

(4) Reports are sent to management and external parties.

d. Payroll is usually processed in batch mode because:

(1) paychecks are prepared periodically (weekly, biweekly, or monthly) and

(2) most employees are paid at the same time.

5410.77 Payroll cycle activities

There are seven common payroll cycle activities (as shown in Figure 4‐11). These activities, along with threats the organization faces in these activities and the controls used to minimize or eliminate the threats, are now discussed.

Figure 4‐11:

5410.78 Update payroll master file

The HRM department authorizes and oversees payroll file updates, including:

a. new hires.

b. terminations.

c. changes in pay rates and discretionary withholdings.

5410.79 Threats and controls in updating payroll master file

1. Threat: Unauthorized changes to the payroll master file. This can:

1. Update Payroll Master File

2. Update Tax Rates and Deductions

3. Validate Employee Time, Attendance Data

4. Prepare Payroll

6. Calculate Employer-Paid

Benefits and Taxes

5. Disburse Payroll

7. Disburse Payroll Taxes, Misc. Deductions



a. be costly if the data used to calculate employee pay (wages, salaries, commissions) is fraudulently inflated and

b. make labor cost reports unreliable and result in erroneous decisions.

2. Controls

a. Restrict authority to update the payroll master file to the HRM department.

b. Prohibit HRM personnel from processing payroll or distributing paychecks.

c. Have someone other than the person recommending a payroll master file change review and approve the change.

d. Use passwords, user IDs, and an access control matrix to restrict access to payroll files and data to authorized personnel. The system should verify the identity and authority of anyone making and approving payroll master file changes.

e. Require each department supervisor to review reports documenting changes that affect their employees or department.

5410.80 Update tax rates and deductions

The payroll department makes these infrequent changes when they receive:

a. tax rate changes from government agencies or

b. payroll deduction changes from insurance companies, unions, etc.

5410.81 Validate employee time and attendance data

This information comes from various sources:

a. Hourly employees scan an ID badge or biometrically log in and out to record arrival and departure times.

b. Production employees complete job‐time tickets to record the jobs they perform.

(1) These labor costs are allocated among various departments, cost centers, and production jobs.

(2) Professionals record time spent so they can bill clients.

(3) Salaried employees are paid a fixed wage and supervisors monitor their time and attendance.

(4) Sales staff may be paid a fixed wage, a commission, or a wage plus commission. In addition, they may be paid bonuses for meeting or exceeding targets.

5410.82 Threats and controls in validating employee time and attendance data

1. Threat: Inaccurate time data. This can:

a. result in inaccurate labor expenses and labor expense reports,

b. result in poor decisions, and

c. hurt employee morale, if paychecks are incorrect or not prepared.

2. Controls

a. Use badge readers, barcode scanners, and online terminals to:

(1) collect data on employee time and attendance electronically and

(2) collect job‐time data and send it to the payroll processing system.



b. Include edit checks in data entry programs:

(1) Field checks, for numeric data in fields such as employee number and hours worked

(2) Limit checks, on the hours worked field

(3) Validity checks, on the employee number field

c. Restrict payroll master file changes to someone not directly involved in processing payroll.

d. Require payroll master file changes to be approved by appropriate supervisors.

e. Reconcile time clock data to job‐time ticket data.

(1) This should be done by someone who does not generate the data.

(2) All timecard hours should be accounted for on the job‐time tickets.

5410.83 Prepare payroll

To prepare payroll:

a. departments provide data about the hours their employees work. The time should be approved by a supervisor.

b. gross pay is calculated using the payroll master file and the transaction file containing time and wage information for the period.

c. net pay is calculated by subtracting all payroll deductions, tax withholdings, and voluntary deductions from gross pay.

d. gross pay, deductions, and net pay year‐to‐date fields in each employee’s record in the payroll master file are updated.

e. the following items are printed:

(1) Employee paychecks and earnings statements (gross pay, deductions, net pay, and year‐to‐date totals)

(2) Payroll register (a list of each employee’s gross pay, deductions, and net pay). The payroll register authorizes the transfer of funds to the company’s payroll bank account.

(3) Deduction register (voluntary deductions for each employee)

f. labor costs are allocated to appropriate general ledger accounts and a running total of these allocations is maintained.

g. a summary journal entry is posted to the general ledger using total labor costs and the column totals in the payroll register.

5410.84 Threats and controls in preparing payroll

1. Threat: Inaccurate payroll processing. This can:

a. be costly if the company overpays its employees,

b. hurt employee morale, particularly if paychecks are late or not ready on time, and

c. result in penalties if an incorrect payroll tax amount is sent to the government.

2. Controls

a. Calculate batch totals prior to data entry.



(1) Check them against totals calculated during each subsequent processing stage.

(2) If original and subsequent totals agree, all payroll records were processed, data input was accurate, and bogus timecards were not entered during processing.

b. Cross‐foot the payroll register to make sure the total of the net pay column equals the total of gross pay less the total deductions column.

c. Use a payroll clearing account (a zero balance account) to verify payroll cost recording accuracy and completeness, and to allocate costs appropriately.

(1) Debit gross pay to the payroll control account.

(2) Credit net pay to cash and credit the various withholdings.

(3) Cost accounting distributes labor costs to appropriate expense categories and credits the payroll control account for the allocation total. The payroll control account credit should equal the previous debit to net pay and the various withholdings.

(4) The payroll control account should be zero after posting both entries.

d. Properly classify workers as employees or independent contractors. Misclassification can result in back taxes, interest, and penalties.

e. Have the HRM department review decisions to hire temporary or outside help.

5410.85 Disburse payroll

Employees are paid by check or direct deposit. To disburse payroll:

a. the payroll register is sent to accounts payable for review and approval.

b. Accounts Payable prepares a disbursement voucher to authorize a funds transfer from the organization’s general account to its payroll account.

c. the disbursement voucher and payroll register are sent to the cashier, who:

(1) reviews the document,

(2) prepares and signs a check (or electronic disbursement) transferring funds to the payroll bank account,

(3) reviews, signs, and distributes employee paychecks,

(4) redeposits unclaimed paychecks in the company’s general bank account, and

(5) sends a list of the unclaimed paychecks to the internal audit department for review and follow‐up.

d. the payroll register is returned to the payroll department where it is filed by date along with the timecards and job‐time tickets.

e. the disbursement voucher is sent to the accounting clerk, who uses it to update the general ledger.

5410.86 Threat and controls in disbursing payroll

1. Threat: Paychecks are prepared and disbursed for fictitious or terminated employees.

2. Controls

a. Segregate duties.

(1) Have Accounts Payable authorize and record payroll transactions.



(2) Have someone who does not authorize or record payroll distribute paychecks (such as the cashier) to prevent a supervisor from not reporting employee terminations and keeping their paychecks.

(3) Make sure someone independent of the payroll process reconciles the payroll bank account.

b. Restrict access to blank payroll checks, bank account login information, and the check signature machine.

c. Periodically account for sequentially prenumbered payroll checks.

d. Make sure the cashier does not sign payroll checks until he/she checks and reviews the payroll register and disbursement voucher.

e. Use a separate payroll bank account to limit payroll check fraud.

(1) Use an imprest fund (fund deposits are for the net pay for that period) so when all paychecks are cashed, the payroll account will have a zero balance.

(2) When the account is reconciled, fraudulent checks can be spotted easily.

f. Require positive identification when distributing paychecks.

g. Require internal audit to periodically observe paycheck distributions.

h. Make sure unclaimed paychecks are:

(1) returned to the treasurer’s office for prompt redeposit,

(2) traced back to time records, and

(3) compared to the employee master payroll file to make sure they are for legitimate employees.

i. Deposit employee paychecks directly into employee accounts.

5410.87 Calculate employer‐paid benefits and taxes

a. Employers are required by law to pay certain taxes and benefits, including:

(1) payroll taxes,

(2) Social Security taxes, and

(3) a percentage of employee gross pay (capped at a maximum annual limit) to unemployment compensation insurance funds.

b. Employers voluntarily pay for certain benefits, including:

(1) all or a portion of employee health, disability, and life insurance premiums;

(2) flexible benefit plans that provide:

(a) minimal medical insurance and pension contributions and

(b) benefit credits that can be used for vacation time or health insurance; and

(3) savings plan contributions.

Providing these benefits and services, and making employee‐requested changes on a timely basis, can be expensive and time‐consuming. To provide better service without increasing costs, companies can have employees make the changes themselves using the company’s intranet.



5410.88 Disburse payroll taxes and miscellaneous deductions

Companies periodically pay the various tax liabilities they have incurred by check or electronic funds transfer.

5410.89 Threats and controls in disbursing payroll taxes and miscellaneous deductions

1. Threat: Hiring unqualified or dishonest employees. This can result in:

a. increased production expenses and

b. theft of assets.

2. Controls

a. Explicitly state skill qualifications in the job postings for each open position.

b. Require candidates to sign a statement on the job application form that:

(1) confirms the accuracy of the information on the form.

(2) gives permission to do a thorough background check.

c. Perform thorough background checks to verify:

(1) the applicant does not have a prior criminal record (if relevant to the job).

(2) job applicant skills and references.

(3) college degrees earned (if required).

(4) actual job titles of people listed as references.

3. Threat: Employment law is violated. This can result in:

a. stiff penalties from the government and

b. civil suits by alleged victims of employment discrimination.

4. Controls

a. Carefully document all actions and decisions relating to advertising, recruiting, and hiring new employees. This demonstrates compliance with applicable government regulations.

b. Send employees to training courses that keep them current with employment law.

5410.90 Outsourcing payroll and HRM functions

a. Some organizations outsource their payroll and HRM functions to reduce costs. There are two types of outsourcers:

(1) Payroll service bureaus process payroll.

(2) Professional employer organizations (PEO) process payroll and also provide HRM services (employee benefits plans, etc.).

b. Both options are attractive to smaller businesses because:

(1) their fees are less than the cost of doing payroll in‐house due to the economies of scale that come from preparing paychecks for many companies.

(2) the need for tax law expertise is eliminated.

(3) a wide range of benefits can be offered because the costs of administering benefits can be spread across all of the PEO’s clients.



(4) computer resources are freed up by eliminating payroll and HRM applications. They can be used to improve service in other areas.

General Ledger and Reporting System

5410.91 The general ledger and reporting system plays a central role in a company’s information system.

a. Primary functions of this system are to collect and organize:

(1) data from each of the accounting cycle subsystems,

(2) data from the treasurer about financing and investing activities,

(3) data from the budget department, and

(4) adjusting entries from the controller.

b. In the general ledger and reporting system, data is organized and stored such that the information needs of internal and external users can be met. Examples of these information needs are:

(1) managers need information to plan, control, and evaluate their operations.

(2) users need regular reports, as well as information, to meet their real‐time inquiry needs.

(3) investors and creditors need financial statements, as well as more detailed and more frequent reports, to evaluate organizational performance and make investment and credit‐granting decisions.

(4) government agencies require periodic reports of organization performance to evaluate compliance with laws and regulations.

c. There are four basic activities in the general ledger and reporting system (as shown in Figure 4‐12). Each of these activities is briefly explained. The threats a system faces during each activity are also explained, along with the controls used to prevent the threat.

Figure 4‐12:

1. Update General

Ledger

4. Prepare Managerial Reports

3. Prepare Financial

Statements

2. Post Adjusting Entries



5410.92 Activities in general ledger and reporting system

a. Update general ledger. These updates are journal entry postings that originate from:

(1) accounting subsystems. These are summary journal entries of transactions that took place during a specific period of time.

(2) the treasurer. These are individual journal entries for nonroutine transactions and are often documented using journal vouchers. Examples include:

(a) issuance or retirement of debt,

(b) purchase or sale of investment securities, and

(c) acquisition of treasury stock.

b. Post adjusting entries. The controller’s office makes the following types of adjusting entries:

(1) End‐of‐period accruals, to record events where cash has not yet been received or disbursed. Examples include:

(a) interest revenue earned and

(b) wages payable.

(2) End‐of‐period deferrals, to record that cash has been exchanged, but services or goods have not been. Examples include:

(a) recognizing the portion of advance payments from customers earned during a specific period and

(b) expensing the portion of prepaid assets (e.g., rent, interest, and insurance) used this period.

(3) Estimates of expenses that occur over several accounting periods. Examples include:

(a) depreciation and

(b) bad debt expense.

(4) Evaluations to reflect differences between the actual and recorded value of an asset or a change in accounting principle. Examples include:

(a) changing inventory valuation methods,

(b) reducing inventory due to obsolescence, and

(c) adjusting inventory records based on physical counts of inventory.

(5) Correcting general ledger errors

c. Prepare financial statements. Most companies prepare three basic financial statements:

(1) Income statement

(2) Balance sheet

(3) Statement of cash flows

d. Produce managerial reports. Several general ledger control reports are used to verify the accuracy of the posting process.

(1) Examples include:

(a) general ledger account balances and



(b) journal vouchers listed by date, numerical sequence, or account number.

(2) A number of budgets are produced for planning and evaluating performance:

(a) Operating budgets show planned revenues and expenditures.

(b) Cash flow budgets show estimated cash inflows and expenditures.

5410.93 Threats and controls in general ledger and reporting system (Part 1)

1. Threat: An error in updating the general ledger produces incorrect information, which can result in:

a. misleading reports and

b. poor decisions

2. Controls

a. Input controls, such as the following:

(1) Making sure summary journal entries represent actual reporting period activity

(2) Validity checks to make sure a general ledger account exists for each journal entry account number

(3) Field checks to make sure amount fields in a journal entry contain only numeric data

(4) Zero‐balance checks in journal entries to make sure total debits journal entries equal total credits

(5) Completeness tests to make sure all pertinent journal entry data is entered

(6) Closed‐loop verification tests to make sure account numbers match account descriptions, so that the correct general ledger account is accessed

(7) Adjusting entry files for standard recurring adjusting entries, such as depreciation expense

(a) Because the entries are not keyed in each time, this improves input accuracy.

(b) Because the entries are not forgotten, this improves input completeness.

(8) Signing checks on general ledger account balances to make sure the balance is of the appropriate nature (debit or credit)

(9) Run‐to‐run totals to verify batch processing accuracy

(a) Calculate new general ledger account balances, based on beginning balances and total debits and credits applied to the account.

(b) Compare that total with the actual account balance in the updated general ledger.

(c) Investigate any discrepancies, as they indicate a processing error that must be corrected.

b. Reconciliations and controls that help detect general ledger updating errors

(1) Compare total debit balances to total credit balances in a trial balance to determine if a posting error has occurred.

(2) Determine if clearing and suspense accounts have end‐of‐period zero balances.



(3) Determine if general ledger control account balances agree to corresponding subsidiary ledger totals.

(4) Examine end‐of‐period transactions to make sure they are recorded in the proper time period.

c. An audit trail provides the information needed to:

(1) trace transactions from source documents to the general ledger and any report or document using that data,

(2) trace items on reports back through the general ledger to the original source document, and

(3) trace general ledger account changes from their beginning to their ending balance.

5410.94 Threats and controls in general ledger and reporting system (Part 2)

1. Threat: Unauthorized access to the general ledger, which can result in:

a. confidential data leaks to competitors,

b. corruption of the general ledger, and

c. concealing asset theft

2. Controls

a. User IDs, passwords, and access control matrix to:

(1) control general ledger access and

(2) enforce proper segregation of duties, by limiting the functions legitimate users may perform

b. Limit the functions performed at a terminal. For example, entering adjusted entries can be restricted to terminals in the controller’s office.

c. Check for a valid authorization code for each journal voucher record before posting that transaction to the general ledger.

(1) This authorization code is part of the audit trail.

(2) Inspecting the audit trail can detect unauthorized general ledger access.

Artificial Intelligence

5410.95 Artificial intelligence (AI) is the science and engineering of simulating human intelligence processes by machines (i.e., making intelligent machines), especially intelligent computer programs. These processes include learning, reasoning, and self‐correction.

a. AI was coined by John McCarthy, an American computer scientist, in 1956. Today, it is an umbrella term that encompasses everything from robotic process automation to actual robotics.

b. AI has gained prominence recently due, in part, to big data, or the increase in speed, size, and variety of data businesses are now collecting. AI can perform tasks such as identifying patterns in the data more efficiently than humans, enabling businesses to gain more insight from their data.



5410.96 AI can be categorized as narrow (or weak) AI, or general (or strong) AI:

a. Narrow/weak AI: Designed to perform a narrow task (e.g., facial recognition, Apple’s Siri)

b. General/strong AI: Strong AI, also known as artificial general intelligence, is an AI system with generalized human cognitive abilities so that when presented with an unfamiliar task, it has enough intelligence to find a solution.

Machine Learning

5410.97 Machine learning (ML) is one application of artificial intelligence (AI) based around the idea that we should be able to give machines access to data and let them learn for themselves. Machine‐learning applications can read text and work out whether the person who wrote it is making a complaint or offering congratulations. They can also listen to a piece of music, decide whether it is likely to make someone happy or sad, and find other pieces of music to match the mood. In some cases, they can even compose their own music expressing the same themes or which they know is likely to be appreciated by the admirers of the original piece.

a. Successful systems often use a training set of data with millions of examples, each of which has been labeled with the correct answer. The system can then look at new examples and, if the training was sufficient, the system will predict answers with a high rate of accuracy.

b. The algorithms that drive this process depend on an approach called deep learning, which uses neural networks. Deep‐learning algorithms have a significant advantage over earlier generations of machine‐learning algorithms because they can make better use of much larger data sets.

c. A neural network is a computer system designed to recognize images and classify them according to elements they contain. It basically works on a system of probability—based on data fed to it, it is able to make statements, decisions, or predictions with a degree of certainty. The addition of a feedback loop enables “learning”—by sensing or being told whether its decisions are right or wrong, it modifies the approach it takes in the future.

5410.98 Machine learning (ML) is driving business changes at three levels:

1. Tasks and occupations: Using machine vision systems to identify potential cancer cells, freeing up radiologists to focus on truly critical cases, to communicate with patients, and to coordinate with other physicians

2. Business process redesign: Redesigning and optimizing workflow and plant layouts in conjunction with the introduction of robotics

3. Business models: Using ML systems that can intelligently recommend choices to consumers in a personalized way; for example, creating a subscription to a personalized radio station that predicted and played music a particular customer would like, even if the person had never heard it before

5410.99 Machine learning (ML) brings with it certain risks. ML systems often have low “interpretability,” meaning that humans have difficulty figuring out how the systems reached their decisions. Deep neural networks may have hundreds of millions of connections, each of which contributes a small amount to the ultimate decision.

a. Machines may have hidden biases, derived from the data provided to train the system. For instance, if a system “learns” which job applicants to accept for an interview by using a data set of decisions made by human recruiters in the past, it may inadvertently



learn to perpetuate their racial, gender, ethnic, or other biases. Moreover, these biases may not appear as an explicit rule but, rather, be embedded in subtle interactions among the thousands of factors considered.

b. Neural network systems deal with statistical truths rather than literal truths. That makes it almost impossible to guarantee that the system will work in all cases—especially in situations that were not represented in the training data. Lack of verifiability can be a concern in mission‐critical applications, such as controlling a nuclear power plant, or when life‐or‐death decisions are involved.

c. When the ML system does make an error, diagnosing and correcting exactly what went wrong can be difficult. The underlying structure that led to the solution can be unimaginably complex, and the solution may be far from optimal if the conditions under which the system was trained change.

5410.100 Most researchers agree that even a “superintelligent” AI object would not exhibit human emotions like love or hate, and that there is no reason to expect AI to become intentionally benevolent or malevolent. Instead, when considering how AI might become a risk, experts think two scenarios most likely:

1. The AI is programmed to do something devastating: Autonomous weapons are artificial intelligence systems that are programmed to kill; these weapon systems could easily cause mass casualties. This risk is present even with narrow AI, but grows as levels of AI intelligence and autonomy increase.

2. The AI is programmed to do something beneficial, but it develops a destructive method for achieving its goal: This can happen whenever humans fail to fully align the AI’s goals with our own, which is strikingly difficult. If a superintelligent system is tasked with an ambitious geoengineering project, it might wreak havoc with our ecosystem as a side effect, and view human attempts to stop it as a threat to be met.

Automation

5410.101 Automation is the technology which allows machines to perform tasks once performed by humans via programmed commands, combined with automatic feedback control, to ensure proper execution of the instructions without human intervention. Over time, automated systems have become increasingly sophisticated and complex, often surpassing human capabilities.

5410.102 Automation technology has resulted in the creation of a number of other technologies, such as robotics, a specialized branch of automation in which the automated machine possesses certain anthropomorphic, or humanlike, characteristics. The most humanlike characteristic of an industrial robot is its powered mechanical arm, which can be programmed to move through a sequence of motions to perform useful tasks, such as loading and unloading parts at a production machine or making a sequence of spot‐welds on the sheet‐metal parts of an automobile body during assembly.

5410.103 As automation has grown, so too has the fear that humanoid service robots and machine‐learning algorithms will replace millions of service workers in the future. In a widely noted study published in 2013, Carl Benedikt Frey and Michael Osborne examined the probability of computerization for 702 occupations and found that 47% of workers in America had jobs at high risk of potential automation. They concluded that “recent developments in machine learning will put a substantial share of employment, across a wide range of occupations, at risk in the near future.”



5410.104 Figures published by the Federal Reserve Bank of St. Louis (in “Jobs Involving Routine Tasks Aren’t Growing,” 2016) show that in America, employment in nonroutine cognitive jobs that require highly paid, skilled workers and nonroutine manual jobs that require low‐paid, unskilled workers has grown steadily since the 1980s, whereas employment in routine jobs has been broadly flat. As more jobs are automated, this “job polarization” or workforce bifurcation seems likely to continue.

Internet Language and Communication

5410.105 XBRL: An IT opportunity to improve financial reporting

a. Disseminating financial and nonfinancial information electronically previously was a cumbersome, inefficient process because:

(1) recipients had different requirements for the way information was delivered to them. As a result, organizations spent a great deal of time and incurred significant expense to format the same information a number of different ways.

(2) the organizations that received the data had to manually reenter much of it into their own information systems.

The problem is caused by the way information is displayed on the internet. HTML code specifies how data is displayed; it does not provide information about data content. Extensible business reporting language (XBRL) was developed to provide a way to communicate the content of data. XBRL uses tags to identify the contents of each data item. For example, an XBRL tag might indicate that a data item represents accounts receivable.

b. There are several benefits to creating and electronically disseminating financial data using XBRL:

(1) Organizations can publish information once, using XBRL tags, in a format that anyone can use as they see fit.

(2) Information systems and analysis tools can interpret the XBRL tags. Recipients do not need to manually reenter data they obtain electronically. Instead, they can be fed directly into any information system or analysis tool that understands XBRL.

(3) XBRL tags result in more efficient and accurate internet searches.

5410.106 Internet technologies

a. The internet is a worldwide web of interlinked computers and networks. An incredible amount of information and services are available to internet users. The internet facilitates e‐business and makes it more cost effective by eliminating the need for companies and consumers to use VANs (value‐added networks) and special telephone lines to exchange information.

b. Internet service providers (ISPs) own and maintain portions of the internet backbone and provide access to the internet.

c. Browsers make it possible for users to easily navigate through vast amounts of information found on the internet.

d. An intranet is a company‐specific internal network that is navigated with internet browser software. Intranets significantly reduce the costs of disseminating and sharing information and increase the effectiveness of operations. These benefits can be magnified by giving suppliers and customers limited access to company intranets.



e. Extranets link the intranets of two or more companies. Access to extranets is typically limited to trusted trading partners.

f. A gateway, often implemented via software, translates between two or more different protocol families and makes connections between dissimilar networks possible.

g. An application service provider (ASP) uses the internet to rent software programs to its customers. This service can also be known as “software as a service” (or SaaS).

(1) Using an ASP has several advantages:

(a) Customers significantly reduce the costs associated with purchasing software because the ASP spreads its costs among its many customers.

(b) Customers do not have to purchase expensive hardware to run the latest and greatest software and can often run the software remotely.

(c) Customers can always have the most current software.

(d) Customers can achieve greater security and privacy protection if the ASP uses better and more elaborate controls than does the customer.

(2) The major disadvantages of the ASP model are:

(a) Customers must rely on the ASP for essential business services. If an ASP goes out of business, its customers are in a very precarious position.

(b) Customers face the very real risk that sensitive data can be compromised since ASPs serve many different customers (possibly even direct competitors).

5410.107 Languages and technologies used for information exchange

a. eXtensible Markup Language (XML) is a set of standards for defining the content of data on web pages.

b. ebXML is a variation of XML that sets standards for coding common business documents. Because it eliminates the need for proprietary software to translate documents created by different companies, it is easier to use and less expensive than EDI.

c. Electronic funds transfer (EFT) is disbursing cash electronically, rather than by check. EFT is made possible by the Automated Clearing House (ACH) network created by the banking system.

d. Electronic data interchange (EDI) is used to electronically transfer information between and within organization computers.

(1) This eliminates the need to manually reenter data, improves accuracy, and cuts costs associated with mailing, processing, and storing paper documents.

(2) With the advent of the internet, third‐party networks are no longer needed to transmit EDI messages.

e. Financial electronic data interchange (FEDI) integrates EFT with EDI.

(1) The buyer’s IS (information system) sends orders and delivery instructions to the seller’s IS.

(2) The seller delivers the goods.

(3) The buyer’s IS sends a message, containing both the remittance data and EFT instructions, to its bank.

(4) The buyer’s bank forwards that message to the seller’s bank.



(5) The seller’s bank deposits money electronically into the seller’s account.

(6) The seller’s bank sends the remittance data and the notification of the funds transfer to the seller.

Network Technologies

5410.108 A financial value‐added network (FVAN) is an independent organization that provides hardware and software that allow the various EDI (electronic data interchange) networks to communicate with the ACH (Automated Clearing House) network.

a. The buyer’s IS (information system) sends the remittance data and funds transfer instructions together to the FVAN.

b. The FVAN translates the payment instructions from EDI format into ACH format and sends that information to the buyer’s bank.

c. The buyer’s bank makes a traditional EFT (electronic funds transfer) payment to the seller’s bank, and the FVAN sends the remittance data to the seller in EDI format.

d. As the seller receives the EFT and EDI portions separately, both must contain a common reference number to facilitate proper matching.

e. Although the buyer realizes the full advantage of FEDI, the seller does not.

5410.109 A value‐added network (VAN) offers specialized hardware, software, and long‐distance communications to private networks so they can exchange data.

5410.110 A virtual private network (VPN) uses the internet to create a privately owned network that:

a. provides a secure, cost‐effective method of providing remote access to an organization’s network.

b. saves companies money, as the cost of the VPN software and higher‐capacity lines linking the organizational network to the internet is less than the leased lines and toll‐free phones that the internet replaces.

5410.111 A local area network (LAN) links computers and other devices located close to each other, such as in the same building. These devices are connected to the network using a network interface card (NIC). LANs can be configured in one of three basic ways:

1. In a star configuration, each device is connected to a central server that controls all communications between devices. Devices send messages to the server, which forwards it to the appropriate device.

2. In a ring configuration, each device is linked to two other devices. To control data flow, a software token (these LANs are often called token ring networks) is continually passed around the ring. To send a message, a device grabs the token and attaches a message. Each device checks for messages as the token travels around the ring.

3. In a bus configuration, each device is connected to a main channel called a bus. A software algorithm controls communications between devices. To send a message, a device waits until the bus is free. The other devices check the message to see if it is for them.

5410.112 A wide area network (WAN) covers a wide geographic area.

a. There are three ways to configure a WAN:

(1) Centralized, where all devices are linked to a mainframe



(a) Advantages: better control, more experienced IT staff, and economies of scale

(b) Disadvantages: greater complexity, higher communications costs, and less flexibility in meeting department and user needs

(2) Decentralized, where each department has its own computer and LAN

(a) Advantages: meets department and user needs better, lower communication costs, and locally stored data

(b) Disadvantages: coordinating data stored at many locations, higher hardware costs, and implementing effective controls

(3) A distributed data processing (DDP) system, where computers at each location handle local processing and are also linked to the corporate mainframe

(a) Advantages: local computers back each other up, risk of catastrophic loss is reduced, there is quick local access to large amounts of processed data, and local systems can easily be added, upgraded, or deleted

(b) Disadvantages: coordinating the system, maintaining hardware and software, difficulty standardizing documentation and control, more difficult to achieve adequate security controls and separation of duties, and data duplication and inconsistencies

b. Downsizing is a procedure of shifting data processing and problem solving from mainframes to smaller computer systems. Downsizing saves money and allows the end user to be more involved in the processing of the data.

c. A metro‐area network (MAN) connects multiple sites with multiple workstations for shared use of common resources.

5410.113 A communications channel connects sending and receiving devices. A communications network often uses several different channels, as each possesses characteristics that affect the network’s reliability, cost, and security.

a. Common channels include telephone lines, fiber optic cables, terrestrial microwaves, satellite, and cellular radio frequencies.

b. A channel’s information carrying capacity is measured by its bandwidth. The greater the bandwidth, the greater the capacity and speed of transmission.

5410.114 In a client/server system a desktop computer, referred to as the client, sends a data request to a server. The server retrieves the relevant subset of data from the database and sends it to the client. Client/server systems can be configured in two ways:

1. A two‐tiered system, where the central database is stored on the server and each client has its own application software

a. Advantages: better able to meet user needs, and easier to design and control

b. Disadvantages: powerful clients, with abundant disk storage, are needed for local processing; applications software must be purchased and maintained for each client.

2. A three‐tiered client/server system, where a top‐tier server stores the central database and a second‐tier server uses applications programs to do most of the data processing. All the client has to do is request data from the servers and format data.

a. Advantages: inexpensive “thin clients” or network PCs can be used, less applications software to purchase and maintain, and lower data transmission costs



b. Disadvantages: high cost, and more complex applications development is required

5410.115 E‐business applications require communications software that:

a. controls network access (link and disconnect devices, restrict access to authorized users).

b. manages the network (determine if network devices are ready to send or receive data, queue input and output, determine system priorities, route messages, log network use and errors).

c. controls the transfer of data, files, and messages among the various devices and protects them from unauthorized access.

d. detects and controls errors.

e. works with protocols, which are rules and procedures for exchanging data. The internet protocol is called Transmission Control Protocol/Internet Protocol (TCP/IP). When a file, document, or e‐mail is ready to be sent over the internet:

(1) the TCP protocol breaks it up into small packets, gives each a header that contains the destination address, and sends the packets over the internet.

(2) the IP protocol guides the packets to the proper destination using the packet header information.

(3) The TCP protocol reassembles the packets into the original message.

Data

5410.116 An effective information system is essential to any organization’s long‐run success. Without a means of monitoring the events that occur, there is no way to determine how well the organization is performing or to track the effects of various business activities on company resources.

5410.117 An information system has five components:

1. The people who operate the system and perform various functions

2. The procedures, both manual and automated, involved in collecting, processing, and storing data about the organization’s activities

3. The data about the organization’s business processes

4. The software used to process the organization’s data

5. The information technology infrastructure, including computers, peripheral devices, and network communications devices

5410.118 The accounting information system (AIS) is a subset of the management information system (MIS). The AIS includes the human and capital resources within an organization that are responsible for (a) the preparation of financial information and (b) the information obtained from collecting and processing company transactions. The AIS is a subset of the management information system. The AIS is composed of both the human and capital resources within an organization that are responsible for:

a. the preparation of financial information and

b. the information obtained from collecting and processing company transactions.

The AIS performs several important functions in an organization:



a. It collects and stores data about activities and business transactions.

b. It processes data into information and provides reports that are useful for making decisions.

c. It provides adequate controls to safeguard the organization’s assets.

5410.119 According to the AICPA, an AIS has five primary objectives:

1. Identify and record all valid transactions. For example, if a company intentionally records a fictitious sale, it can overstate revenues and income. If a company forgets to record some expenses or understates expenses at the year’s end, it can overstate net income.

2. Properly classify transactions. For example, improperly classifying an expense as an asset overstates assets and net income.

3. Record transactions at their proper monetary value. For example, an account receivable that becomes uncollectible should be written off.

4. Record transactions in the proper accounting period. Recording 20YY sales in 20XX overstates sales and net income for 20XX and has the opposite effect for 20YY.

5. Properly present transactions and related disclosures in the financial statements. Failing to disclose a lawsuit or a contingent liability could mislead the reader of a financial statement.

5410.120 An information system (IS) should fulfill several important functions:

a. Provide adequate controls to:

(1) safeguard the organization’s assets and data.

(2) ensure that the information produced is both reliable and accurate.

b. Collect and store data. Data is any and all of the facts that are collected, stored, and processed by an information system. Data is one of an organization’s most valuable assets. Data includes both quantitative and qualitative items and may be financial or operational in nature.

c. Transform data into information. Once collected, it is the job of the IS to transform data into information so it can be used to make decisions. Thus, information is data that has been organized and processed to provide meaning.

d. There are several characteristics that make information useful for decision making. In Statement of Financial Accounting Concepts (SFAC) 8, the Financial Accounting Standards Board (FASB) states that in order for financial information to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely, and understandable.

(1) Relevant: Information is relevant if it reduces uncertainty, improves decision makers’ ability to make predictions, or confirms or corrects their prior expectations.

(2) Faithfully represented: Information is faithfully represented if it is free from error or bias and completely represents the events or activities of the organization.

(3) Comparable: For information to be comparable, it must enable users to identify similarities and differences between two sets of economic phenomena.

(4) Timely: Information is timely if it is provided in time to enable decision makers to use it to make decisions.



(5) Understandable: Information is understandable if it is presented in a useful and intelligible format.

(6) Verifiable: Information is verifiable if two knowledgeable people acting independently would each produce the same information.

e. There are limits to the amount of information that the human mind can effectively absorb and process. Information overload occurs when those limits are passed. Information overload is costly, because decision‐making quality declines while the costs of providing that information increase. Thus, information overload reduces the value of information.

f. Information systems must use advances in IT to filter and condense information, thereby avoiding information overload. An important decision involves identifying which potential IS improvements are likely to yield the greatest return. Making this decision wisely requires an understanding of an organization’s overall business strategy.

g. There are costs associated with producing information, including the time and resources spent in collecting, processing, and storing data, and in distributing information to decision makers.

h. Improve decision making. An information system should provide feedback on the results of actions so it can be used to improve future decisions. For example:

(1) Reports can help to identify potential problems that require management action.

(2) Query languages can facilitate the gathering of relevant data upon which to make decisions.

(3) Tools (such as graphical interfaces, decision models, and analytical tools) can help the decision maker interpret information and evaluate and choose among alternative courses of action.

5410.121 An information system adds value to an organization by:

a. improving the quality and reducing the costs of products or services.

b. improving efficiency of operations by providing more timely information.

c. improving decision making by providing accurate information in a timely manner.

d. sharing knowledge and expertise, thereby improving operations and providing a competitive advantage.

e. improving the efficiency and effectiveness of its supply chain.

Types of Management Information Systems

5410.122 Decision support system (DSS): A DSS is an extension of a management information system. It is designed to aid in semi‐structured decision making. Some processes and functions are preprogrammed in a DSS; the decision is not made by the system. Instead, the decision maker must apply insight and exercise judgment while interacting with the system.

5410.123 Executive information system (EIS): An EIS is an information system designed to provide executives with the needed information to make strategic plans, to control and operate the company, to monitor business conditions in general, and to identify business problems and opportunities.



5410.124 Expert system (ES): An ES is a computerized information system that allows non‐experts to make decisions about a particular problem that are comparable with decisions of experts in the area. These systems include knowledge bases that represent facts and inferences they know. They use heuristics (rules of thumb) in processing information.

5410.125 Strategic information system (SIS): An SIS provides information that may allow an organization to make strategic, competitive decisions.

5410.126 Transaction processing system (TPS): A TPS is a completely programmed and automated system, treating every problem in exactly the same way. This type of system is used in AISs so that each transaction is processed in an identical manner.

Big Data, Data Analytics, and Data Visualizations

5410.127 Big data is a term that describes the large volume of data—both structured and unstructured—available to business on a day‐to‐day basis. The data sets are so voluminous and diverse that traditional data processing application software is inadequate to deal with them. Big data can be analyzed for insights that lead to better decisions and strategic business moves. Big data is often defined by the three “V’s”: volume, velocity, and variety.

a. Volume: As more systems and entities collect data from a variety of sources on a continuing basis, organizations must have the technology in place to safely secure the data and possess the necessary tools to process and interpret the available data.

b. Velocity: Velocity describes the speed at which data is collected, transmitted, stored, and integrated into the decision‐making process.

c. Variety: Data is collected from a multitude of sources in various formats. This includes text, numeric, photographic, GPS (Global Positioning System), and other sources and formats. Data can be time series, cross‐sectional, live, or point‐in‐time.

5410.128 Data analytics rapidly examine large amounts of data to identify hidden patterns and correlations. In his report Big Data in Big Companies, IIA (Institute of Internal Auditors) Director of Research Tom Davenport interviewed more than 50 businesses to understand how they used big data. He found they got value in the following ways:

a. Cost reduction: Big data technologies such as Hadoop and cloud‐based analytics bring significant cost advantages when it comes to storing large amounts of data—plus they can identify more efficient ways of doing business.

b. Faster, better decision making: With the speed of Hadoop and in‐memory analytics, combined with the ability to analyze new sources of data, businesses are able to analyze information immediately—and make decisions based on what they have learned.

c. New products and services: With the ability to gauge customer needs and satisfaction through analytics comes the power to give customers what they want. Davenport points out that with big data analytics, more companies are creating new products to meet customers’ needs.

5410.129 Data analytics can often be described through three principal types: descriptive, predictive, and prescriptive:

a. Descriptive: Descriptive analytics analyze and describe historical data and include statistics such as means, medians, mode, and correlations.

b. Predictive: Predictive analytics use historical data to model potential outcomes based on the historical data. This includes regression analysis, stress tests, and other tools



used to establish the likelihood of a future event occurring. (This is discussed further in section 5410.133.e.)

c. Prescriptive: Prescriptive analysis often combines descriptive and predictive analytics to derive a possible solution or plan of action based on a range of possible outcomes.

5410.130 Data visualization is a general term that describes any effort to help people understand the significance of data by placing it in a visual (pictorial or graphical) context, helping to understand and communicate complex concepts and ideas.

a. Data visualization software plays an important role in big data by detecting patterns, relationships, emerging trends, and correlations that might have gone undetected in analyzing text‐based data.

b. Visualization is central to advanced analytics as well. When a data scientist is writing advanced predictive analytics or machine‐learning algorithms, it becomes important to visualize the outputs to monitor results and ensure that models are performing as intended; visualizations of complex algorithms are generally easier to understand and interpret than numerical outputs.

5410.131 Most data visualization tools come with connectors to popular data sources, including many of the more common relational databases, Hadoop, and cloud storage platforms. The visualization software pulls in data from these sources and applies a graphic to the data.

a. Data visualization software allows the user to select the best way of presenting the data, although sometimes software automates this step. Some tools can automatically interpret the shape of the data and detect correlations between certain variables and then place these discoveries into the chart type that the software determines is optimal.

b. Interactive visualization allows the user to drill down into the charts and graphics, changing the data and observing the revised output.

5410.132 Sources for big data generally fall into one of three categories:

1. Streaming data: Data that reaches IT systems from a web of connected devices on a continuous or regularly updated basis. It can be analyzed as it arrives and used to make decisions on what data to keep, what not to keep, and what requires further analysis.

2. Social media data: Data extracted from social interaction platforms is used for marketing, sales, and support functions. It is often in unstructured or semi‐structured forms, creating a unique challenge when it comes to consumption and analysis.

3. Publicly available sources: Massive amounts of data are available through open data sources like the U.S. government’s data.gov, the CIA World Factbook, or the European Union Open Data Portal.

5410.133 Several areas of technology are generally used for big data analytics, including the following:

a. Data management: Data needs to be high‐quality and well‐governed before it can be reliably analyzed. Once data is reliable, organizations should establish a master data management program that gets the entire enterprise on the same page.

b. Data mining: Data‐mining technology helps examine large amounts of data to discover previously unobserved patterns or relations. With data‐mining software, companies can sift through all the chaotic and repetitive noise in data, pinpoint what is relevant, use that information to assess likely outcomes, and then accelerate the pace of making informed decisions.



c. Hadoop: Hadoop is a free, open‐source software framework that stores large amounts of data and rapidly runs applications on clusters of commodity hardware.

d. In‐memory analytics: By analyzing data from systems, companies can derive immediate insights from data analytics and respond accordingly. This technology removes data preparation and analytical processing latencies to test new scenarios and create models, enabling organizations to stay agile and make better business decisions, as well as allowing them to run iterative and interactive analytics scenarios.

e. Predictive analytics: Predictive analytics technology uses data, statistical algorithms, and machine‐learning techniques to identify the likelihood of future outcomes based on historical data. Some of the most common applications of predictive analytics include fraud detection, risk, operations, and marketing.

f. Text mining: With text‐mining technology, entities can analyze text data from the web, comment fields, books, and other text‐based sources to uncover insights not previously identified. Text mining uses machine learning or natural language processing technology to comb through documents—emails, blogs, Twitter feeds, surveys, competitive intelligence, and more—to help analyze large amounts of information and discover new topics and term relationships.

Customer Relationship Management (CRM) System

5410.134 Customer relationship management (CRM) refers to practices, strategies, and technologies that businesses use to interact, analyze, forecast, and manage customer relationships, trends, and behaviors. CRM is preferably a cloud‐based system that stores customer and prospect contact information, accounts, leads, and sales opportunities in one central database, available to all departments in a business, such as sales, customer service, accounting, marketing, and business development. Major vendors of CRMs include Salesforce, Microsoft, SAP, and Oracle.

5410.135 CRM technologies include the following:

a. On‐premises CRM: The company purchases licenses upfront instead of buying yearly subscriptions from a cloud CRM provider. The software resides on the company's servers and the user assumes the cost of any upgrades. There is generally a rather lengthy installation process to fully integrate a company's data. The company assumes responsibility for the administration, control, security, and maintenance of the database and information.

b. Cloud‐based CRM (also known as SaaS [software as a service] or on‐demand CRM): Data is stored on an external, remote network that employees can access anytime, anywhere via an internet connection. Cloud‐based systems have several concerns that companies must cope with:

(1) Data security: Given that the company does not physically control the storage and maintenance of its data, an entity’s data can be compromised or lost if the cloud provider goes out of business or is acquired by another company. Compatibility issues can also arise when data is initially migrated from a company's internal system to the cloud.

(2) Cost: The cost of subscription fees for cloud‐based CRM software can be more costly over time than for on‐premises models.

c. Open‐source CRM: An open‐source CRM system, such as OroCRM, SuiteCRM, or SugarCRM, offers alternatives to the proprietary platforms from Salesforce, Microsoft, and other vendors. Source code is made available to the public, permitting businesses to



make alterations to the software at no cost, thus enabling the customization of data links on social media channels.

Digital Business Models

5410.136 A digital business model defines how a business makes money digitally, based on a digital strategy. A digital strategy is a plan for maximizing the benefits of data assets and technology‐focused initiatives.

5410.137 A digital business blurs the lines between digital and physical worlds. For example, a customer could visit a retail clothing store and try on a dress. A computer image would show the customer with the dress on, offer different colors and accessories, and customize the fit to the customer. The dress would be tailored to a perfect fit, computer‐assembled, and shipped directly to the customer’s home.

5410.138 The findings of a research project at MIT's Center for Information Systems Research (CISR) concluded that a great digital business model needs to challenge the traditional physical business model that relies on places (e.g., bank branches) and people (e.g., sales teams) to satisfy customers. They see this challenge along three key axes: who owns the customer interface, how to reconfigure business processes, and how to make customer data an enterprise‐wide resource.

5410.139 It is estimated that in the near future all business leaders and chief information officers (CIOs) will need to develop digital leadership and technology capabilities in order to create and implement their digital strategy. New positions will be created, such as chief digital officer (CDO).

Cloud Computing

5410.140 Cloud computing helps computers store, manage, and process information at off‐site systems hosted on “the cloud” (the internet) instead of a computer hard drive or other local storage. For example, information stored on Microsoft OneDrive or an email server can be accessed from any computer with internet access. In other words, instead of owning data centers and servers, businesses big or small can access services on an as‐needed basis from cloud providers.

5410.141 Cloud computing is increasingly being used by companies irrespective of their size and industry for data analytics, data availability, disaster recovery, data backup, and access to cutting‐edge technologies, leading to improved productivity as well as cost reductions. Cloud computing provides three main types of computing services, which differ by level of control, flexibility, and management:

1. Software as a service (SaaS): The consumer uses an application but does not control the operating system, hardware, or network infrastructure on which it is running.

2. Infrastructure as a service (IaaS): The consumer uses fundamental computing resources such as processing power, storage, networking components, or middleware. The consumer can control the operating system, storage, deployed applications, and possibly networking components such as firewalls and load balancers, but not the cloud infrastructure beneath them.

3. Platform as a service (PaaS): The consumer uses a hosting environment for their applications. The consumer controls the applications that run in the environment but does not control the software, hardware, or network infrastructure on which they are running.



5410.142 How different companies use cloud computing

a. Financial services: Real‐time fraud prevention and detection

b. Healthcare: Personalized treatments for patients

c. Gaming companies: Delivery of online games to players around the world

5410.143 Advantages of cloud computing

a. Cost reduction: One of the biggest advantages of using cloud computing is the reduction in hardware as well as software maintenance costs, as these investments are made by the cloud service providers.

b. Back up and restore data: It is easy to get backup and recovery of data stored on the cloud.

c. Anytime, anywhere accessibility: Information stored on the cloud can be accessed anytime, anywhere in the world, leading to improved productivity for the company.

d. Easy to deploy: Applications can be easily deployed in multiple geographic locations globally, and the system can be functional very quickly.

e. Pay as you go: Companies can pay for the services as per their usage.

f. Unlimited storage capacity: As the cloud offers unlimited storage capacity, businesses can easily scale resources up or down to increase or reduce the capacity as per the needs of the business.

g. Agility: The cloud offers a range of cutting‐edge technologies which enable businesses to experiment and test new ideas.

5410.144 Disadvantages of cloud computing

Although the use of cloud computing services is on the rise, the risk exposure is also on the rise.

a. Lack of good internet connection: As cloud services depend on internet connectivity, a good internet connection is a must to use these services, lack of which can hamper work.

b. Loss of control: The cloud infrastructure is owned and managed by cloud service providers; therefore, the user has no control over the execution of the services.

c. Vendor lock‐in: One of the biggest security risks in cloud computing is the movement of services from one vendor to another. Not all vendors provide the same platform, which can make the movement of services difficult.

5410.145 Risks involved in using cloud services

a. Exposure to hackers: Cloud computing services available in the public domain can be accessed by third parties, exposing the interfaces and APIs (application program interfaces) to hackers and thereby compromising company data.

b. Denial of service (DOS): Denial of service is an attack in which cloud resources are made unavailable to the users through an attack on the web servers to disrupt services, either temporarily or indefinitely, causing loss of data.

5410.146 Despite the risks involved, companies are using cloud services to gain competitive advantage. Below are two examples of how the Starbucks® Corporation is using cloud technology to its advantage.



1. Cloud computing provides an effective way to deploy changes in business processes and find new ways to connect with clients, making the enterprise more agile. Starbucks utilizes cloud‐based email solutions and ties client relationship management tools to data from their loyalty card program to create a more agile enterprise. Starbucks Rewards program members who purchase specially marked Starbucks products in grocery stores can find “Star Code” information on the packaging and enter it on the company website or phone app (application), earning them reward points that can be redeemed for complimentary Starbucks products.

2. Cloud computing creates flexible assembly models, which allow organizations to integrate previous investments with current innovations to quickly transform their business models whenever necessary. Starbucks’ point‐of‐sale systems’ data warehouse is integrated with a cloud infrastructure that allows the company to seamlessly migrate its existing warehouse into an expanded platform that offers insight through big data tools.

System and Organization Controls (SOC®) Reports

5410.147 System and organization controls (SOC®) reports: Many companies that do not have adequate personnel, expertise, equipment, or technology for performing certain functions may choose instead to outsource those tasks to service organizations. Common examples of outsourced functions include cloud computing, security, retirement and investment plans, health care claims management and processing, and payroll processing. Even though user management has essentially delegated these functions to a service organization, they are generally still held accountable for establishing effective controls over those functions by those charged with governance, customers, shareholders, and regulators.

System and organization controls (SOC®) reports provide user management with information about the service organization’s controls to assist in assessing and addressing the risks associated with an outsourced service. These reports, prepared in accordance with AT‐C 320, Reporting on an Examination of Controls at a Service Organization Relevant to User Entities’ Internal Control Over Financial Reporting, are intended to meet the needs of the user entities and the CPAs that audit the user entities’ financial statements, in evaluating the effect of the controls at the service organization on the user entities’ financial statements.

5410.148 There are three types of SOC® reports:

1. SOC® 1: Report on Controls at a Service Organization Relevant to User Entities’ Internal Control over Financial Reporting (ICFR): SOC® 1 reports are based on Statement on Standards for Attestation Engagements (SSAE) 16. SOC® 1 addresses service organization system internal controls over financial reporting. A SOC® 1 report is generated by auditors for other auditors. Use of these reports is restricted to the management of the service organization, user entities, and user auditors. There are two types of reports for these engagements:

a. Type 1: Report on the fairness of the presentation of management’s description of the service organization’s system and the suitability of the design of the controls to achieve the related control objectives included in the description as of a specified date

b. Type 2: Report on the fairness of the presentation of management’s description of the service organization’s system and the suitability of the design and operating effectiveness of the controls to achieve the related control objectives included in the description throughout a specified period



2. SOC® 2: Report on Controls at a Service Organization Relevant to Security, Availability, Processing Integrity, Confidentiality, or Privacy: SOC® 2 reports are based on the AICPA’s AT 101 (Attestation Engagements) and the Trust Services principles used by service organizations. SOC® 2 reports contain sensitive information and are not shared outside the company. SOC® 2 reports are useful in the oversight of the entity, vendor management programs, and regulatory oversight. SOC® 2 reports focus on a business's nonfinancial reporting controls as they relate to five Trust Services principles: security, availability, processing integrity, confidentiality, and privacy of a system.

a. Trust Services consist of professional attestation and advisory services based on principles and criteria that address the risk and opportunities of IT‐enabled systems and privacy programs, including electronic commerce (e‐commerce) systems. Trust Services principles and criteria are issued by the AICPA and the Canadian Institute of Chartered Accountants (CICA). The Trust Services principles and criteria are organized into four broad areas:

(1) Policies: The entity has defined and documented its policies (i.e., written statements that communicate management’s intent, objectives, requirements, responsibilities, and standards for a particular subject) relevant to the particular principle.

(2) Communication: The entity has communicated its defined policies to responsible parties and authorized users of the system.

(3) Procedures: The entity has placed procedures in operation to achieve its principles in accordance with its defined policies.

(4) Monitoring: The entity monitors the system and takes action to maintain compliance with its defined policies.

b. The Trust Services introduce a list of criteria against which these four areas are evaluated to assess whether one or more of the following five criteria have been achieved:

(1) Security: The system is protected, both logically and physically, against unauthorized access. Access controls help prevent potential system abuse, theft or unauthorized removal of data, misuse of software, and improper alteration or disclosure of information.

(2) Availability: The system, product, or service is available for operation and use as committed or agreed to by a contract or service level agreement (SLA). This principle pertains to security‐related criteria that may affect availability, monitoring such items as network performance and availability, site failover, and security incident handling.

(3) Processing integrity: Addresses whether a system achieves its purpose (i.e., delivers the right data at the right price at the right time). Accordingly, data processing must be complete, valid, accurate, timely, and authorized.

(4) Confidentiality: Information that is designated “confidential” is protected as committed or agreed to in the contract. Data is considered confidential if its access and disclosure is restricted to a specified set of persons or organizations (e.g., data intended only for company personnel, business plans, intellectual property, or internal price lists). Encryption is an important control for protecting confidentiality during transmission; network and application firewalls and access controls are used to safeguard information being processed or stored on computer systems.



(5) Privacy: Personal information is collected, used, retained, disclosed, and disposed of in conformity with the commitments in the entity’s privacy notice and with the privacy principles put forth by the AICPA. Personal identifiable information (PII) refers to details that can distinguish an individual (e.g., name, address, or Social Security number). Some personal data related to health, race, sexuality, and religion are also considered sensitive and generally require an extra level of protection.

c. There are two types of SOC® 2 reports that service organizations can provide to user entities. A Type 2 report is required if the user entity intends to use the report for reliance on internal control or if the user entity’s management or auditor plans to use the report for the assessment of internal controls.

(1) Type 1: In a Type 1 report, the service auditor provides an opinion as to whether the service organization’s description “fairly presents” the system that was designed and implemented, and whether the controls were suitably designed to meet the criteria as of a specified date. Type 1 reports do not address the operating effectiveness of controls, nor do they provide an opinion over a period of time. In other words, the report only provides information on controls that are in place (designed) at a specific point in time and not whether the controls are operating on a continuous basis throughout a specified time period.

(2) Type 2: In a Type 2 report, the service auditor provides an opinion on whether the service organization’s description “fairly presents” the system that was designed and implemented; the controls were suitably designed to meet the criteria; the controls operated effectively during the specified period of time; and the service organization is in compliance with the commitments in its statement of privacy practices, if the report covers the privacy principle.

3. SOC® 3: Report on Controls at a Service Organization Relevant to Security, Availability, Processing Integrity, Confidentiality, or Privacy: SOC® 3 reports are “public‐facing” documents that give a high‐level overview of information in the SOC® 2 report. A SOC® 2 report contains sensitive information about specific systems and network controls which should stay confidential; therefore, a SOC® 3 report summarizes the non‐sensitive content in a SOC® 2 report for users who need assurance about the controls at a service organization relevant to security, availability, processing integrity, confidentiality, or privacy but do not have the need for or the knowledge necessary to make effective use of a SOC® 2 report. Because they are general‐use reports, SOC® 3 reports can be freely distributed.

5410.149 The table below, provided by the AICPA, compares SOC® 1, SOC® 2, and SOC® 3 reports:

SOC® 1 Reports SOC® 2 Reports SOC® 3 Reports

Under what professional standard is the engagement performed?

SSAE 16, Reporting on Controls at a Service Organization

AICPA Guide, Applying SSAE No. 16, Reporting on Controls at a Service Organization

AT 101, Attestation Engagements

AICPA Guide, Reporting on Controls at a Service Organization Relevant to Security, Availability, Processing Integrity, Confidentiality, or Privacy

AT 101, Attestation Engagements

AICPA Technical Practice Aid, Trust Services Principles, Criteria, and Illustrations



SOC® 1 Reports SOC® 2 Reports SOC® 3 Reports

What is the purpose of the report?

To provide information to the auditor of a user entity’s financial statements about controls at a service organization that may be relevant to a user entity’s internal control over financial reporting. It enables the user auditor to perform risk assessment procedures, and if a Type 2 report is provided, to assess the risk of material misstatement of financial statement assertions affected by the service organization’s processing.

To provide management of a service organization, user entities, and other specified parties with information and a CPA’s opinion about controls at the service organization that may affect user entities’ security, availability, processing integrity, confidentiality, or privacy.

To provide interested parties with a CPA’s opinion about controls at the service organization that may affect user entities’ security, availability, processing integrity, confidentiality, or privacy.

What are the components of the report?

A description of the service organization’s system.

A service auditor’s report that contains an opinion on the fairness of the presentation of the description of the service organization’s system, the suitability of the design of the controls, and in a Type 2 report, the operating effectiveness of the controls.

In a Type 2 report, a description of the service auditor’s tests of the controls and the results of the tests.

A description of the service organization’s system.

A service auditor’s report that contains an opinion on the fairness of the presentation of the description of the service organization’s system, the suitability of the design of the controls, and the operating effectiveness of the controls.

In a Type 2 report, a description of the service auditor’s tests of controls and the results of the tests.

A service auditor’s report on whether the entity maintained effective controls over its system as it relates to the principle being reported on, i.e., security, availability, processing integrity, confidentiality, or privacy, based on the applicable Trust Services criteria.

Who are the intended users of the report?

Auditors of the user entity’s financial statements, management of the user entities, and management of the service organization.

Parties that are knowledgeable about:

‐ the nature of the service provided by the service organization.

‐ how the service organization’s system interacts with user entities, subservice organizations, and other parties.

‐ internal control and its limitations.

‐ the criteria and how controls address those criteria.

Anyone



5410.150 To increase the flexibility of SOC® 2 reports, and to better address increased cybersecurity risks, the AICPA released updated Trust Services criteria. The 2017 Trust Services Criteria for Security, Availability, Processing Integrity, Confidentiality, and Privacy presents control criteria established by the Assurance Services Executive Committee (ASEC) of the AICPA for use in attestation or consulting engagements to evaluate and report on controls over the security, availability, processing integrity, confidentiality, or privacy over information and systems (a) across an entire entity; (b) at a subsidiary, division, or operating unit level; (c) within a function relevant to the entity's operational, reporting, or compliance objectives; or (d) for a particular type of information used by the entity.

5410.151 To supplement the 17 COSO principles, the Trust Services criteria were organized into the following categories:

a. Logical and physical access controls: Relate to how the service organization implements logical and physical access controls that serve to prevent unauthorized access and protect data assets

b. System operations: The criteria relevant to how the service organization manages the operation of system(s) and detects and mitigates processing deviations, including logical and physical security deviations

c. Change management: How service organizations evaluate and determine necessary changes in infrastructure, data, software, and procedures, which gives them the ability to securely make changes and prevent unauthorized changes

d. Risk mitigation: The criteria relevant to how the service organization identifies, selects, and develops risk mitigation activities arising from potential business disruptions and the use of vendors and business partners

5410.152 The AICPA has provided a mapping of the previous 2016 Trust Services criteria to the updated 2017 criteria. Below is an example of the mapping:

2017 Trust Services Criteria (TSC) 2016 Trust Services Principles and

Criteria (TSPC)

TSC Ref #

Criteria CONTROL

ENVIRONMENT

Points of Focus TSC Criteria

CC1.1 COSO Principle 1: The entity demonstrates a commitment to integrity and ethical values.

CC1.4 The entity has established workforce conduct standards, implemented workforce candidate background screening procedures, and conducts enforcement procedures to enable it to meet its commitments and system requirements as they relate to [insert the principle(s) addressed by the engagement: security, availability, processing integrity, confidentiality, or privacy, or any combination thereof].



2017 Trust Services Criteria (TSC) 2016 Trust Services Principles and Criteria (TSPC)

TSC Ref #

Criteria CONTROL

ENVIRONMENT

Points of Focus TSC Criteria

Sets the Tone at the Top—The board of directors and management, at all levels, demonstrate through their directives, actions, and behavior the importance of integrity and ethical values to support the functioning of the system of internal control.

Establishes Standards of Conduct—The expectations of the board of directors and senior management concerning integrity and ethical values are defined in the entity’s standards of conduct and understood at all levels of the entity and by outsourced service providers and business partners.

Evaluates Adherence to Standards of Conduct—Processes are in place to evaluate the performance of individuals and teams against the entity’s expected standards of conduct.

Addresses Deviations in a Timely Manner—Deviations from the entity’s expected standards of conduct are identified and remedied in a timely and consistent manner.

Considers Contractors and Vendor Employees in Demonstrating Its Commitment—Management and the board of directors consider the use of contractors and vendor employees in its processes for establishing standards of conduct, evaluating adherence to those standards, and addressing deviations in a timely manner.



5410.153 Applying the Trust Services criteria requires judgment; therefore, points of focus are provided for each criterion. COSO’s Internal Control—Integrated Framework states that points of focus (POF) represent important characteristics of the criteria; POF are intended to assist management when designing, implementing, and operating controls over security, availability, processing integrity, confidentiality, and privacy. In addition, POF can assist both management and the practitioner when they are evaluating whether the controls were suitably designed and operated effectively to meet the Trust Services criteria.

5410.154 The Trust Services criteria were designed to provide flexibility in application and use for a variety of different subject matters. Topics a practitioner may be engaged to report on using the Trust Services criteria include the following:

a. The effectiveness of controls within an entity's cybersecurity risk management program to achieve the entity's cybersecurity objectives using Trust Services criteria relevant to security, availability, and confidentiality as control criteria in the cybersecurity risk management examination

b. The suitability of design and operating effectiveness of controls included in management's description of a service organization's system relevant to one or more of the Trust Services criteria over security, availability, processing integrity, confidentiality, or privacy throughout a specified period to meet those criteria in a Type 2 SOC® 2 engagement.

c. The design and operating effectiveness of a service organization's controls over a system relevant to one or more of the Trust Services criteria over security, availability, processing integrity, confidentiality, and privacy in a SOC® 3 engagement

d. The suitability of design and operating effectiveness of controls of an entity, other than a service organization, over one or more systems relevant to one or more of the Trust Services categories of security, availability, processing integrity, confidentiality, or privacy

e. The suitability of the design of an entity's controls over security, availability, processing integrity, confidentiality, or privacy to meet the related Trust Services criteria

5410.155 If the practitioner is engaged to report on compliance with laws, regulations, rules, contracts, or grant agreements in connection with an examination of the design and operating effectiveness of an entity's controls, the compliance portion of the engagement would be performed in accordance with AT‐C 105, Concepts Common to All Attestation Engagements, and AT‐C 315, Compliance Attestation.

5420 Risk Associated with Information Technology (IT)

5421 Risk Assessment

5421.01 Information system control: Companies are heavily reliant on information systems that only grow in complexity as companies seek to meet growing needs for information, creating an ever‐present risk that their systems will be compromised.

a. Organizations experience major control failures because:

(1) the loss of crucial information is viewed as a distant, unlikely threat, so control problems are underestimated and downplayed.



(2) companies do not understand the control implications of moving from secure, highly controlled, and centralized computer systems to a less secure network, cloud server, or internet‐based system.

(3) client/server systems, which make much more information available to many more workers, are harder to control than centralized mainframe systems.

(4) companies do not fully realize that information is a strategic resource and protecting it is crucial to their survival.

(5) time‐consuming control measures are not put in place due to productivity and cost pressures.

(6) confidentiality and securing other’s data are major concerns when companies give customers and suppliers access to their system and data.

b. Companies are increasing computer control and security by taking the following, proactive steps:

(1) Hiring full‐time security and control staff

(2) Making control problems and solutions a major part of employee training

(3) Establishing formal information security policies and enforcing them

(4) Building controls into systems during the initial design stage rather than adding them after the fact

(5) Moving sensitive data to a safe and secure environment

5422 Change Management

5422.01 The change management process limits the risk associated with changes to the IT environment, systems software, application systems, and data. The goal is to ensure that the changes are implemented properly and are not exploited for fraudulent purposes.

a. A lack of change management can seriously impact system and service availability.

b. IT change risk is the risk that arises from the inability of an organization to manage IT system changes in a timely and controlled manner.

c. Inadequate controls over IT changes can increase the risk of undetected errors or vulnerabilities. Lack of testing can lead to unforeseen effects of change or a poorly managed change to software, IT systems, and data.

d. If insufficiently tested software or configuration changes are released into production, there is a risk of unexpected adverse effects on data and/or IT system performance. For example, the data could be corrupted or deleted, or there could be system breakdown or system performance degradation.

e. A lack of change management can result in a risk of uncontrolled changes to IT systems or data in the production environment.

f. Ill‐secured IT systems and internet applications create opportunities for hackers to attack the provided internet services and/or to breach the internal IT systems.

g. Without change management, there is a risk of uncontrolled changes in the source code of internally developed software.

5422.02 One of the key components that management must perform is to develop and enforce policies. These policies should at a minimum include the following:



a. A controlled method for implementing new systems or changing existing systems. This will often include a well‐defined system development life cycle (SDLC) process, as well as a change management process.

b. System maintenance and upkeep policies

c. Physical access and security policies

d. Logical access controls

e. Clear segregation of duties

f. System security, including items like firewalls, routers, and virtual private network (VPN) access

Developing Information Systems

5422.03 Three factors influence the design of an information system (IS):

1. Developments in information technology (IT). IT has had a significant impact on accounting and other business activities. In today’s world, one must continually strive to implement new IT developments. This implementation requires an understanding of those developments and how they can be used to modify business strategies. This is illustrated by the growth of the internet, which can:

a. change the way products are distributed (digitized products, such as software, are distributed electronically).

b. cut costs dramatically, thereby helping companies implement a low‐cost strategy.

c. make more information available, allowing companies to adopt new strategies.

2. Organizational strategy. Companies must develop an effective strategy and use IT to help them achieve their objectives. Two basic strategies organizations use to achieve their goals are:

a. product differentiation, which is developing products or services not offered by competitors.

b. low cost, which is trying to be the most inexpensive and most efficient producer of a product.

3. Organizational culture. An IS operates within an organization and should reflect the values and culture of that organization. IS design can influence organizational culture by controlling the flow of the organization’s information.

5422.04 Why information systems change

Since organizations continually need faster and more reliable information, an information system continually undergoes changes. These changes can be minor adjustments, so extensive the old system is replaced by a new one, or somewhere between the two extremes. Change is so constant and frequent that most organizations are undergoing some form of system improvement or change at any point in time. Among the reasons companies change their systems are the following:

1. Need for new or different information (increased competition, business growth or consolidation, mergers and divestitures, new regulations, etc.)

2. Technological changes (to use technology advances or existing IT that was previously too expensive)

3. Need for improved business processes (updating inefficient business processes)



4. Competitive advantage (Increased quality, quantity, or speed of information can result in an improved product or service and may lower costs.)

5. Productivity gains (Automate clerical and repetitive tasks, significantly decrease the performance time of other tasks.)

6. Growth (Upgrade or replace outgrown systems.)

7. Downsizing (Move from centralized mainframes to networked PCs or to internet‐based systems to reduce costs and push decision making as far down the organization chart as possible.)

5422.05 Systems development: The people involved

Many people play strategic roles in systems development, including the following:

a. Top management. The role of top management is to:

(1) align the organization’s information systems (IS) with its corporate strategies.

(2) establish goals and objectives for the information system.

(3) help make important information systems decisions.

(4) support and encourage systems development projects.

(5) establish project selection priorities and set organizational policies.

(6) review IS department performance and motivate IS leaders.

b. User management. The role of user management is to:

(1) help determine information requirements.

(2) help estimate project benefits and costs.

(3) assign appropriate staff to development projects.

(4) allocate the funds needed to develop and operate the system.

c. Accountants. During systems design, accountants:

(1) as users, determine their information needs and system requirements and communicate them to system developers.

(2) as members of project development teams or the IS steering committee, help manage systems development.

(3) as control experts:

(a) take an active role in designing system controls.

(b) periodically test the system to determine whether controls are implemented and functioning properly.

d. Information systems steering committee. Organizations usually establish an executive‐level steering committee that crosses function and divisional boundaries in order to:

(1) plan and provide oversight to the information systems function.

(2) set IS policies.

(3) ensure that top management participates in, guides, and controls system development.

(4) coordinate information systems activities.



e. Project development team. A team made up of systems specialists, managers, accountants, and users guides each development project. Their function is to:

(1) plan and supervise each project.

(2) monitor projects to ensure that they are completed on time and within budget.

(3) help manage change and help ensure proper consideration is given to the people involved in the change.

(4) keep top management and the steering committee informed of the project’s progress.

(5) interact frequently with users to ensure their needs are met.

(6) meet regularly to plan, control and monitor project progress.

f. Systems analysts. As analysts design information systems, they:

(1) study the existing information systems.

(2) work with users to make sure the system meets their needs.

(3) prepare the specifications that computer programmers need to write the new system.

(4) monitor IT improvements.

(5) help management, users, and other company employees successfully use technology.

g. Computer programmers. Programmers:

(1) write computer programs using specifications the systems analysts develop.

(2) make changes to existing computer programs to keep up with changing information needs.

5422.06 The systems development life cycle (SDLC)

Most information systems changes proceed through a five‐step systems development life cycle shown in Figure 4‐13.

Figure 4‐13:

5. Operation and Maintenance

1. Systems Analysis

2. Conceptual Design

3. Physical Design

4. Implementation and Conversion



5422.07 Systems analysis. During systems analysis, information to purchase or develop a system is gathered.

a. Systems development requests are received and prioritized so limited development resources are maximized.

b. A system survey is conducted to:

(1) define the nature and scope of the project.

(2) identify project strengths and weaknesses.

c. An in‐depth feasibility study is conducted.

d. Information needs of users and managers are identified and documented. This is a critical part of systems analysis, as these needs are used to develop and document the systems requirements used to select or develop a new system.

e. A report summarizing systems analysis results is prepared for the steering committee.

5422.08 Conceptual design. During conceptual design, the company performs the following steps to determine how to meet user needs:

a. Identify and evaluate appropriate design alternatives, such as:

(1) buying software.

(2) developing software in‐house.

(3) outsourcing software development to someone else.

b. Develop detailed specifications that describe what the system should accomplish and how it will be controlled.

c. Communicate conceptual design requirements to the information systems steering committee.

5422.09 Physical design. The company uses the conceptual design requirements to:

a. design input and output documents.

b. write computer programs.

c. create files and databases.

d. develop policies and procedures.

e. build controls into the new system.

After the new system is designed and created, physical system design results are communicated to the steering committee.

5422.10 Implementation and conversion. During this phase all physical design components are assembled and the system is put into place.

a. An implementation and conversion plan is created and implemented.

b. Hardware and software are installed and tested.

c. Employees are hired and existing employees are relocated.

d. Employees are trained.

e. Processing procedures are developed and tested.

f. Standards and controls are established and implemented.



g. System documentation is completed.

h. The organization converts to the new system and discontinues the old system.

i. Fine‐tuning adjustments are made.

j. A post‐implementation review is conducted to detect and correct any design deficiencies.

k. The new system is complete when the operational system is delivered to the organization.

l. The steering committee is sent a final report.

5422.11 Operation and maintenance. The new, operational system is used as needed.

a. The system is periodically reviewed.

b. Modifications are made as problems arise or needs change.

c. At some point the company will need to make major modifications or replace the system and the software development life cycle (SDLC) begins again.

In addition, three activities (planning, assessing project feasibility, and managing change) are performed throughout the life cycle.

Maintainability

5422.12 Two categories of controls are used to make sure a system can be adequately maintained:

1. Project development and acquisition controls

2. Change management controls

5422.13 Project development and acquisition controls

a. When project development and acquisition controls are not used, the results are:

(1) poorly managed development or acquisition projects and

(2) large sums of money wasted.

b. The following project development and acquisition controls can help minimize failures:

(1) Use a proven methodology for developing, acquiring, implementing, and maintaining information systems and related technologies.

(2) Develop and use a strategic master plan.

(3) Develop and use project development plans that:

(a) detail how projects are to be completed, including the modules or tasks to be performed.

(b) list project milestones (significant points when progress is reviewed).

(c) show who will perform each task.

(d) list project completion dates.

(e) itemize the cost of each project and its component parts.

(4) Assign each project to a manager and team and hold them responsible for the project’s success or failure.



(5) Prepare a data processing schedule so scarce computer resources can be maximized.

(6) Develop system performance measurements so the system can be properly evaluated. Common measurements include:

(a) throughput (output per unit of time).

(b) utilization (percentage of time the system is being productively used).

(c) response time (how long it takes the system to respond).

(7) Conduct a post‐implementation review to:

(a) determine if the project’s anticipated benefits were achieved.

(b) encourage accurate and objective initial cost and benefit estimates.

5422.14 Change management controls

The following change management control policies and procedures can help control information system changes:

a. Look for needed changes by periodically reviewing all systems.

b. Require all information system change requests to be submitted using a standardized format. Log and review all change requests.

c. Require IT management to review, monitor, and approve all change requests.

d. Assess what impact each change will have on system availability, security, maintainability, and integrity.

e. Use the strategic master plan to prioritize all change requests.

f. Assign specific responsibilities to the people making the change and monitor their work. Make sure that the assignments do not violate segregation of duties requirements.

g. Prevent unauthorized systems and data access by controlling system access rights.

h. Develop a plan to back out of any unsuccessful mission‐critical system change.

i. Create a quality assurance function to:

(1) make sure all standards and procedures are followed.

(2) make sure changes do not skip any appropriate system development steps (development, testing, and implementation).

(3) test all hardware, infrastructure, and software changes extensively in a separate, nonproduction environment before the change is put into live production mode.

(4) determine if changes achieved their stated objectives.

(5) keep management and those who requested the change informed of all changes.

(6) update all documentation and procedures after a change is implemented.

j. Log all emergency changes that do not follow standard procedures.

(1) Have management review and approve them as soon as possible after they are made.

(2) Make sure there is an audit trail for all urgent matters.



k. After a new system has been placed in operation, all subsequent program changes should be approved before implementation to determine whether they have been authorized, tested, and documented.

(1) The operations group may request changes to improve operational efficiency, but the group should not have final authority to approve changes.

(2) Operations personnel should have sole authority to place changed programs into production status.

(3) Temporary changes (patch programs) to a program to permit completion of a production run should be forbidden, unless specific authorization of management is obtained.

(4) All program changes should be thoroughly tested before implementation.

Conversion Strategies

5422.15 The most popular conversion strategies are the parallel run, phased rollout, “big bang” strategy, and hybrid approach.

a. Parallel: The new system is run alongside the legacy system; users are trained on the new system while the old system is still operational.

b. Phased: The cutover and adoption of the new application occur in phases over an extended period of time; all users are migrated to the new system in a predetermined series of steps. This can be by module, business unit, or location.

c. “Big bang” (also called direct changeover): The complete implementation occurs in one single instance; all legacy applications (if any) are cut out and all users move to the new system on an agreed‐upon day.

d. Hybrid: This approach combines the above methods to adapt to the entity’s unique situation. For example, the most important modules can be implemented using the “big bang” strategy, and then the less significant modules can be implemented using a phased rollout.

5422.16 Below are some of the pros and cons of each conversion method:

“Big Bang”:

Pros Cons

Much faster and less expensive than the other options

Higher risk—small details can be overlooked in the rush to convert

Efficient—complete cutover happens on a single day

Less time to learn the full scope of the application; “sink or swim” environment

Quicker return on investment Little, if any, fallback plans available

Training needed only on the new system; not a changeover

Difficult to conduct end‐to‐end testing prior to the go‐live date



Phased Rollout:

Pros Cons

Less risk; employees learn skills with each phase

Project duration for full implementation is long

More time for users to adapt to the new system; no “sink or swim”; small details and issues can be fixed as you go

Operating in a continuous state of change can be disruptive and/or costly

Implementation team can learn from the initial phases and use this knowledge for subsequent phases

“Workarounds” may need to be developed for critical information only available in later modules

Reduces the burden on the IT team Team can lose focus and the need for urgency

Parallel Conversion:

Pros Cons

This is the least risky approach; slower pace than “big bang” but faster than phased rollout

Most expensive—maintaining two systems

Users learn the new system while keeping their legacy environment

Executive commitment may waver when they are presented with the level of effort to conduct such an implementation

There is always a fallback available if the new system is unacceptable

Can lead to employee frustration because they have to do everything twice, creating inefficiencies, overtime, and data entry issues

5422.17 Factors to consider when choosing an implementation strategy include the following:

a. Size and complexity of organization: Complex organizations may find the “big bang” implementation approach quite risky, yet if the different modules or sites are highly interdependent, it may be the only solution.

b. Risk appetite: Since “big bang” implementations have an inherently higher level of risk than other approaches, they may be too risky for certain companies’ defined risk appetite.

c. Software architecture: It is much easier to implement by phase for systems which are tiered or cloud‐based.

d. Anticipated benefits: Phased rollout and parallel deployment may be less daunting for users and more beneficial to employee morale than the “big bang” deployment. Users stay motivated and convinced that changing the system is for the greater good.

e. Impact on personnel: If resources are already at full capacity, the “big bang” approach may overly tax employees; using either the phased rollout or parallel procedure will spread out the workload. In addition, staff will have more time to perform crucial tests, which are essential to the success of any implementation or conversion.

f. Budgetary and time constraints: A phased approach is less risky, but it requires more time. Additional delays translate into additional consulting fees, downtime, and support costs.



5423 Security, Availability, Confidentiality, and Privacy

System Access and Segregation of Duties Risk

5423.01 Companies that do not adequately protect their personal computers and client/server networks are vulnerable to the following threats and risks:

a. Unauthorized access to confidential data

b. Damage to computer files and equipment

c. Theft of information assets

5423.02 Personal computers (PCs) and networks are more vulnerable than mainframes because:

a. physical access is more difficult to control:

(1) PCs are everywhere, and many people are familiar with their use and operation.

(2) Networks have many PCs connected to them that must be controlled, and this increases the risk that a network can be attacked.

b. PC users are usually not as security and control conscious as mainframe users.

c. it is difficult to segregate duties in a PC and network environment, and one person may be responsible for both developing and operating a PC system.

d. end‐user computing (EUC) allows users to develop their own information systems. These systems are often difficult to integrate with the organizational information system.

e. networks can be remotely accessed from almost anywhere using modems and phone lines, the internet, and EDI (electronic data interchange).

f. PCs and laptops are portable and subject to theft.

5423.03 Many mainframe control policies and procedures apply to PCs and networks. Other important controls include the following:

a. Train PC users:

(1) in control concepts and their importance.

(2) to test and document the application programs they develop themselves.

(3) to protect their computers from viruses.

b. Install locks on PCs to protect against theft and unauthorized access.

c. Label PCs with nonremovable tags.

d. Establish and enforce policies and procedures to:

(1) restrict the data that is stored on or downloaded to PCs. Store sensitive data in a secure environment (on a server or mainframe) rather than on a PC, or on USB (universal serial bus) drives that are removed and stored in a locked safe.

(2) minimize the theft of PCs and laptops. For example, do not leave or store laptops in cars, and carry laptops onto airplanes rather than checking them.

(3) prohibit putting personal software on company PCs, copying company software for personal use, and using the system in unauthorized ways.

e. Back up hard drives and other storage medium regularly.



f. Password‐protect or encrypt files so stolen data cannot be used.

g. Use a utility program to wipe a disk clean when confidential data is deleted.

Most PCs erase the index to the data, rather than the data itself, and utility programs can retrieve data deleted in this way.

h. Use several different levels of passwords to restrict access to incompatible data.

i. Use specialists and security programs to:

(1) mimic an intruder.

(2) provide valuable information about network security.

(3) detect network weaknesses.

(4) determine where the system can be improved.

j. Log and audit user access and actions so it is easier to trace and correct security breaches.

k. When PCs are part of a local or wide area network, many of these control procedures can be enforced and monitored at the network level.

5423.04 All host devices (PCs and servers where programs reside) and applications (software on those hosts) should be hardened.

a. The default configurations of host devices and operating systems often turn on many optional settings or special‐purpose services that are never used or are not essential. This maximizes the likelihood of successful installation without the need for customer support but creates security weaknesses because they have flaws, called vulnerabilities, which can be exploited to either crash the system or take control of it.

b. Hardening is the process of modifying the configuration of hosts and application software and deleting, or turning off, unused and unnecessary programs that represent potential security threats.

Every host should have regularly updated anti‐virus software and a software‐based firewall program. Security software can be used to control access to information system resources such as data files, software, and program libraries.

Internet and Telecommunication Risks and Related Controls

5423.05 Companies need to exercise caution when conducting business on the internet because:

a. many websites have serious security flaws.

b. hackers are attracted to the internet and frequently try and break into company systems linked to the internet.

c. many websites are run by fraudsters that lure people into divulging confidential information which they use or sell to others. Others offer to sell people goods, take their money, and never deliver the goods.

d. before it arrives at its destination, an internet message can easily pass through 6 to 10 computers that can read or electronically copy the message. Even messages sent on a company’s secure intranet can be read.

5423.06 The following controls can improve internet and telecommunications security.



5423.07 Encryption is transforming data, called plaintext, into unreadable gibberish, called ciphertext. Decryption reverses this process, transforming ciphertext back into plaintext.

a. Both a key and an algorithm are used to encrypt plaintext into ciphertext and to decrypt the ciphertext back into plaintext.

(1) The key is a fixed‐length string of binary digits (a 128‐bit key has 128 0s and 1s). The longer the key, the less likely it is that someone can break the encryption code.

(2) The algorithm is a formula that combines the key and the text. A strong algorithm that has been rigorously tested is difficult, if not impossible, to break by using brute‐force guessing techniques.

b. To encrypt a document:

(1) the data to be encrypted is divided into blocks the same length as the key.

(2) the formula is applied to each block of data, producing a ciphertext version of the data that is the same size as the original.

c. To decrypt a document, the computer divides the ciphertext into 128‐bit blocks and then applies the decryption key to each block.

d. Data is encrypted using one of the following encryption systems:

(1) A symmetric, or single key, system uses the same key to encrypt and decrypt a message.

(2) An asymmetric, or public key infrastructure (PKI), system uses two keys. The public key, as the name implies, is publicly available. The private key is kept secret, and only the owner of that pair of keys knows what it is. Either key can be used to encode a message, but only the other key can be used to decode it.

e. A symmetric key is simple, fast, and efficient but has the following disadvantages:

(1) Since the sender provides the recipient with the secret key, the two parties need to have some method for securely exchanging the key. System effectiveness depends on controlling who knows the secret key.

(2) It requires a secret key for each different party with whom the company communicates.

(3) Since both parties have the same secret key, there is no way to prove who created a specific document and therefore no way to create legally binding agreements.

f. The PKI approach has the following advantages over single key systems:

(1) It eliminates problems with exchanging keys, and companies only need one key.

(2) It is more secure, because two different keys are used to encode and decode a message.

(3) Anyone can use the organization’s public key to encrypt a message, but only the organization can use its private key to decode the message.

(4) Data can be encrypted with the private key and decrypted with the public key. Since this makes it possible to prove who created a document, legally binding electronic agreements can be created.

(5) The main drawback to asymmetric encryption systems is that it is much slower than single key systems—too slow to be used to exchange large amounts of data over the internet.



5423.08 Hashing is taking plaintext of any length and transforming it into a short code called a hash. Hashing differs from encryption in two important aspects:

1. Encryption always produces ciphertext similar in length to the original plaintext, but hashing always produces a hash that is of a fixed short length, regardless of the length of the original plaintext.

2. Encryption is reversible, but hashing is not. Given the decryption key and the algorithm, ciphertext can be decrypted back into the original plaintext. In contrast, it is not possible to transform a hash back into the original plaintext, because hashing throws away information.

5423.09 A digital signature uniquely identifies the sender of an electronic message, similar to how a handwritten signature identifies the signer of a paper document.

a. In a public key infrastructure (PKI) system, a digital signature is created when the sender’s private key encrypts the sender’s message. The message can only be decoded using the corresponding public key.

b. A valid digital signature does not verify the identity of the private key’s owner. It only proves that the message was sent by the owner of the private key that corresponds to the public key used to decode the message.

5423.10 A digital summary, called a digest, creates a digital signature.

a. A common utility program creates the digest by calculating the digital values of every character in the document.

b. If a character in the original document changes, the digest value changes. This helps detect whether business document contents are altered or garbled during transmission.

5423.11 A digital certificate is an electronic document.

a. It is created and digitally signed by a trusted third party, which certifies the identity of the owner of a particular public key.

b. It contains that party’s public key and can be stored on websites.

(1) Browsers are designed to automatically obtain a copy of that digital certificate and use the public key contained therein to communicate with the website.

(2) Thus, digital certificates provide an automated method for obtaining an organization’s or individual’s public key.

c. It functions like a driver’s license or passport. It is used to identify:

(1) the owner of a private key and its corresponding public key.

(2) the amount of time the certificate is valid.

5423.12 A certificate authority issues public and private keys, records the public key in a digital certificate, and otherwise manages digital certificates.

a. The certificate authority’s digital signature is included in the digital certificate so a certificate’s validity can be verified.

b. This functions like a hologram, watermark, or other device that verifies the validity of a driver’s license or passport.

5423.13 Routers control the flow of information sent over the internet or an internal local area network.



a. Data to be sent is divided into packets and transmitted, and the device receiving the packets reassembles the packets to recreate the original message or data.

b. Two important protocols, referred to as TCP/IP, govern the process for transmitting information over the internet.

(1) The Transmission Control Protocol (TCP) specifies the procedures for dividing data into packets and reassembling them.

(2) The Internet Protocol (IP) specifies the structure of the packets and how to route them to the proper destination.

c. Every IP packet consists of two parts: a header and a body.

The header contains the packet’s origin and destination addresses, as well as information about the type of data contained in the body of the packet.

d. A router reads the destination address field in an IP packet header to determine where it is to be sent.

Rules, referred to as an access control list (ACL), determine which packets are allowed into a system.

e. A border router connects an organization’s information system to the internet.

(1) It checks the contents of the destination address field of every packet it receives. If the address is not that of the organization, the packet is forwarded on to another router on the internet.

(2) If the destination address matches that of the organization, the source and destination fields in the IP packet header undergo a number of tests before being allowed in.

(3) Packets that fail a test are not allowed into the system. Those that do not fail the tests are passed on to the firewall, where they will be subjected to more detailed testing before being allowed to enter the organization’s internal network.

5423.14 A firewall prevents outsiders and employees from gaining unauthorized access to a system.

a. It consists of hardware and software that control communications between:

(1) an external, or untrusted network, such as the internet or a value‐added network, and

(2) an internal network, often called the trusted network. The firewall prevents unwanted information from flowing into and out of the trusted network.

b. Firewalls also separate internal networks to protect sensitive data from unauthorized internal use.

c. A firewall must be able to protect itself from attack, hostile traffic, and unauthorized modification.

d. Firewalls often use redundant hardware, software, and other information technology to reduce outages and failures.

e. Like the border router, firewalls use ACLs (access control lists) to determine what to do with each packet that arrives.

f. Firewalls act as filters and only permit packets that meet specific conditions to pass. Packets not allowed to enter by a firewall rule are dropped.

g. Firewalls can be penetrated or bypassed, so:



(1) all communication network links should be continuously monitored to determine whether a firewall was bypassed by wireless communications links between the IS (information system) and outside parties.

(2) intrusion detection and prevention systems should be used to detect any penetrations.

h. Internal firewalls are often used to segment different departments within an organization. This increases security and strengthens internal control, as there is a way to enforce segregation of duties.

5423.15 An intrusion prevention system (IPS) identifies and drops packets that are part of an attack.

a. An IPS examines the data in the body of an IP packet and therefore is more effective than routers and firewalls that merely look at data in an IP header. There are several ways to check the packet contents:

(1) Checking packet contents against a database of patterns (signatures) of known attack methods

(2) Developing a profile of normal traffic and using statistical analysis to identify packets that do not fit that profile

(3) Using rule bases that specify acceptable standards for specific types of traffic and drop all packets that do not conform to those standards

b. The disadvantages of an ISP are:

(1) it is slow, as it takes more time to examine the body of an IP packet than an IP packet header, and

(2) it is prone to false alarms, which result in rejecting legitimate traffic.

5423.16 The border router, firewall, and intrusion prevention system are complementary tools to control which information is allowed to enter and leave the organization’s information system. Multiple filtering devices are more efficient than any one device.

a. Border routers quickly filter out obviously bad packets.

b. Firewalls only allow packets to enter that appear to contain specific types of data for specific types of programs.

c. The intrusion prevention system (IPS) verifies that packet contents actually conform to the organization’s security policies.

5423.17 Tunneling can be used to create a virtual private network without the cost of leased private lines. Tunneling is also used to safeguard internal networks in organizations. In tunneling:

a. networks are connected—firewall to firewall—via the internet.

b. data are split into small Internet Protocol (IP) packets.

c. the packets are encrypted, mixed with millions of other IP packets, and sent over the internet.

d. at their destinations, packets are decrypted and the original message is reassembled.

5423.18 Control dial‐in access using modems.

a. Modems create a huge hole in systems security as they often bypass organization firewalls, and users seldom use good authentication controls.

This creates a “back door” attackers can use to compromise system security.



b. This can be controlled in two ways:

(1) After users connect to their company’s remote access server, their login data is sent to a Remote Authentication Dial‐In User Service (RADIUS) server, where user identity is authenticated.

(2) Computer security or internal audit periodically checks for rogue modems and sanctions employees responsible for installing them.

5423.19 Control the risks associated with wireless access.

a. Authenticate all devices attempting to establish wireless access by routing them through a Remote Authentication Dial‐In User Service (RADIUS) server or other authentication device.

b. Treat all wireless access as if it was coming from the internet and force all wireless traffic to go through the main firewall and the intrusion prevention system.

c. Turn on the security features in wireless equipment when it is installed. Normally this equipment comes with the security features disabled.

d. Configure all authorized wireless network interface cards (NICs) such that they can only connect to wireless access points. If wireless NICs can connect with other devices that have a wireless NIC, a peer‐to‐peer network is created that has few or no authentication controls.

e. Make unauthorized connections and eavesdropping more difficult by:

(1) reducing the broadcast strength of wireless access points so it does not bleed out of the building.

(2) placing wireless access points in the interior of the building and using directional antennas.

(3) configuring wireless access points to only accept connections to authorized MAC addresses.

(4) not automatically broadcasting the access point’s address, called a service set identifier (SSID). This forces users to manually enter the SSID.

(5) having computer security or internal audit periodically find and disable rogue access points and discipline the employees who installed them.

5423.20 Electronic envelopes are used to protect e‐mail messages. The envelope is created using private or public key encryption techniques and sent over the internet.

a. The envelope containing the e‐mail is opened using the keys and the message is decrypted.

b. Encrypted e‐mail message authenticity and integrity is guaranteed if the secrecy of the keys is maintained.

5423.21 Restrict access to the internet.

a. To avoid hackers, viruses, and other internet problems, some companies do not allow employees to access the internet or use outside e‐mail.

b. Others have a one‐way, outgoing internet connection so employees can access the internet to do research, but outsiders cannot access their system.



c. Some companies use internet servers with no connection to other company systems. Data the company wants internet users to have are stored on the server. If hackers damage the system, the company merely reloads the data and restarts the system.

Cybersecurity Risks

5423.22 Cybersecurity is the practice of protecting systems, networks, devices, programs, and data from digital attack, damage, or unauthorized access. These attacks are generally designed to access, change, or destroy sensitive information such as intellectual property, financial data, personal information, or other types of data for which unauthorized access or exposure could have negative consequences.

5423.23 Some of the more common types of cybersecurity threats include the following:

a. Ransomware: A type of malicious software designed to extort money by blocking access to files or the computer system until the ransom is paid

b. Malware: A type of software designed to gain unauthorized access or to cause damage to a computer

c. Social engineering: A tactic designed to trick an individual or entity into revealing sensitive information. Social engineering can be combined with any of the threats listed here to make a person more likely to click on links, download malware, or trust a malicious source.

d. Phishing: The practice of sending fraudulent emails that resemble emails from reputable sources. The aim is to steal sensitive data like credit card numbers and login information.

e. Denial of service (DOS): An attack that bombards the receiving server with so much information that it shuts down, preventing legitimate users from accessing the service or resources they need

5423.24 From a business perspective, multiple areas of risk need to be addressed, including:

a. security over networks, applications, data and databases, infrastructure, endpoint devices (computers, smart devices, and routers), mobile devices, and cloud storage;

b. identity management;

c. disaster recovery/business continuity planning; and

d. end‐user education.

Common technology used to protect these risk areas includes next‐generation firewalls, DNS (domain name system) filtering, malware protection, antivirus software, and email security solutions.

5423.25 Traditionally, cybersecurity resources were focused on protecting perimeter security. However, advisory organizations have begun to promote more proactive and adaptive approaches. The National Institute of Standards and Technology (NIST) has issued guidelines in its risk assessment framework that recommend a shift away from the perimeter‐based model toward a data‐focused approach of continuous monitoring and real‐time assessments.

5423.26 The National Cyber Security Alliance (NCSA) recommends a top‐down approach to cybersecurity in which corporate management is charged with prioritizing cybersecurity measures across all business practices. NCSA advises that companies must be prepared to



“respond to the inevitable cyber incident, restore normal operations, and ensure that company assets and the company’s reputation are protected.”

a. NCSA’s guidelines for conducting cyber‐risk assessments focus on three key areas: identifying an organization’s most valuable information requiring protection, identifying the threats and risks facing that information, and outlining the damage an organization would incur should that data be lost or wrongfully exposed.

b. Cyber‐risk assessments should also consider any regulations that impact the way an entity collects, stores, and secures data, such as the Payment Card Industry Data Security Standard (PCI DSS), Health Insurance Portability and Accountability Act (HIPAA), Sarbanes‐Oxley Act (SOX), Federal Information Security and Management Act (FISMA), and General Data Protection Regulation (GDPR).

Information Confidentiality Risks

5423.27 Three areas related to information confidentiality need additional protection:

1. Protection of sensitive data or information. Sensitive data or information is determined by a policy or by the data owner. Encryption of specific data items can protect data from unauthorized viewing. Sensitive data will be encrypted within the database when supported natively by the database.

2. Protection of stored application source code. Application source code such as that found in procedures and functions stored within the database may contain information useful to malicious users. Custom applications software source code objects will be encrypted within the database where available.

3. Protection of database data files. Database files contain database objects and their contents. Review of the file contents may disclose sensitive data. An effective way to protect these files in addition to host system access control is to encrypt them. For example, this may be accomplished on Windows hosts by using the encrypt file property. In some cases, encryption of the database data files may have a prohibitively negative impact on database performance. Where performance permits, database data files should be encrypted on the host system.

System Availability Risks

5423.28 Many risks and exposures exist in information security that logical access controls or other complementary controls can minimize. Risks from unauthorized/authorized users are the greatest and the most difficult to handle. In addition to unauthorized/authorized users, several risks and exposures exist, including computer viruses, worms, disgruntled employees, hackers, interception of data, computer crime and fraud, and terrorism and industrial espionage.

5423.29 Unauthorized (intentional or unintentional) access, alteration, use, or destruction of programs and data files is a major risk in any computer environment. Even the authorized user can be a risk if not controlled properly. A threat can be any person, object, or event that, if realized, could potentially cause damage to a computer system. Vulnerabilities are weaknesses in the computer system that can be exploited by a threat. Risks and exposures result from threats and vulnerabilities, such as the following:

a. Unauthorized users may attempt to gain access to the computer system.

b. Authorized users may attempt to gain access to a computer system resource for which they are not allowed access.



c. Security‐relevant actions may not be traceable to the individual associated with the event.

d. The computer system may be delivered, installed, or used in an unsecured manner.

e. Data transmitted over a public or shared data network may be intercepted by an unauthorized user.

f. Data transmitted over a public or shared data network may be modified either by an unauthorized user or because of a transmission error or other communication‐related error.

g. Security breaches may occur because available security features are not used or are used improperly.

h. Users may be able to bypass the security features of a computer system.

i. Users may be denied continued accessibility to the resources of a computer system (denial of service).

5430 Controls That Respond to Risks Associated with Information Technology (IT)

5430.01 For IT management purposes, seven key questions can serve to identify organizational risk and target efficient mitigation:

1. What could happen with potential for loss or harm? (Threat events)

2. If it happened, how bad could it be? (Single loss exposure value)

3. How often might it happen? (Frequency)

4. How sure are the answers to the first three questions? (Uncertainty)

5. What can be done: To prevent/avoid risk? To mitigate risk? To detect/notify risk? (Safeguards and control)

6. How much will it cost? (Safeguard and control costs)

7. How efficient is it? (Cost/benefit or ROI (return on investment) analysis)

5430.02 Controls that respond to risks associated with IT can be designated in two broad categories:

1. General IT controls

2. Logical and physical controls

5431 General IT Controls

5431.01 According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO) study, with widespread reliance on IT, controls are needed over all information systems, whether financial, operational, large, or small. Two broad groupings of IT controls are used. The first is general IT controls (GITC), which ensure the continued, proper operation of computer IT general controls and are designed to focus on IT as a whole. The second category is application controls, which include computerized steps within the application software and related manual procedures to control the processing of various types of transactions. Together, these controls serve to ensure completeness, accuracy, and validity of the financial and other information in the system.



5431.02 General IT controls (GITC) make sure an organization’s overall control environment is secure and well managed. GITCs are a critical component of business operations and financial information controls. They provide the foundation for reliance on data, reports, automated controls, and other system functionality underlying business processes. The security, integrity, and reliability of financial information relies on proper access controls, change management, and operational controls. The importance and relevance of general IT controls to key stakeholders, such as owners, investors, regulators, audit committees, management, and auditors, continues to rise.

5431.03 General IT controls (GITC) are implemented, managed, and monitored by IT. These are embedded throughout all systems and IT policies, and represent the “foundation” upon which all application and business processes are built. Examples include the following:

a. System development life cycle (SDLC)

b. Application development

c. Security, both physical and system

d. System maintenance

e. Backup and disaster recovery

f. Appropriate segregation of duties

5431.04 GITCs typically apply to all systems from servers to end‐user computing environments. Examples of these types of controls include the following:

a. Data center operations controls: These include job setup and scheduling, operator actions, backup and recovery procedures, and contingency or disaster recovery planning. In a sophisticated environment, these controls also address capacity planning and resource allocation and use. In today’s high‐technology environment, the job scheduler is automatic, and job control language is online. Storage management tools automatically load data files onto high‐speed devices in anticipation of the next job. System logs are maintained on the system.

b. Systems software controls: These include controls over the effective acquisition, implementation, and maintenance of system software—the operating system, database management systems, telecommunications software, security software, and utility programs (service aids)—which run the system and allow applications to function. The master director of system activities, system software also provides the system logging, tracking, and monitoring functions. Systems software can report on uses of utility programs, so that if someone accesses these powerful data‐altering functions, at the least their use is recorded and reported for review.

c. Access security controls: These controls have assumed greater importance as networks have grown. System users may be halfway around the world or down the hall. Effective access security controls can protect the system, preventing inappropriate access and unauthorized use of the system. If well designed, they can intercept hackers and other trespassers. Access security controls restrict authorized users to only the applications or application functions that they need to do their jobs, supporting an appropriate division of duties. There should be frequent and timely review of the user profiles that permit or restrict access. Former or disgruntled employees can be more of a threat to a system than hackers; terminated employee passwords and user IDs should be revoked immediately. By preventing unauthorized use of and changes to the system, data and program integrity are protected.



5431.05 Deficiencies in GITCs may hinder management’s ability to prepare accurate financial information. If these deficiencies are not identified and addressed in a timely manner, they may impact the overall functioning of internal controls, thereby resulting in delayed financial closing process, impact on internal decisions, and/or public disclosure. This could ultimately affect the reputation and brand of the company. Certain GITC deficiencies present a greater risk of resulting in a misstatement that could be pervasive in nature and could have far‐reaching implications. The proximity of the GITC deficiency to financial reporting (e.g., a deficiency at the application layer versus the operating system layer) and the level of technical skill necessary to exploit the deficiency, among other factors, could affect the severity of a deficiency.

5431.06 Application controls, which represent another type of IT control focused on data quality:

a. are designed to prevent, detect, and correct transaction errors;

b. ensure the integrity of a specific application’s inputs, stored data, programs, data transmissions, and outputs; and

c. are much more effective when there are strong GITC controls.

When application controls are weak, the information system is more likely to produce information that contains errors and leads to poor management decisions. This can negatively affect relationships with customers, suppliers, and other external parties.

The following six categories of controls can improve system integrity:

1. Source data controls

2. Input validation routines

3. Online data entry controls

4. Data processing and storage controls

5. Output controls

6. Data transmission controls

5431.07 Source data controls

The following controls make sure source documents and other input data are authorized, accurate, complete, accounted for properly, entered into the system, and sent to their intended destination in a timely manner. They should also make sure the data has not been suppressed, duplicated, or otherwise improperly changed.

a. Design source documents such that they minimize errors and omissions.

b. Prenumber all documents and have the system identify and report any missing or duplicate numbers.

c. Restrict source document preparation to authorized personnel.

d. Require all source documents, where required, to be properly authorized before processing them.

e. Use machine‐readable turnaround documents (company data sent to an external party and returned to the system as input) to reduce data input time, effort, expense, and errors.

f. Cancel documents that have been entered into the system so they cannot be reused.

(1) Deface paper documents by marking them paid or perforating them.

(2) Flag electronic documents to show they have been canceled.



g. Retain original source documents long enough to satisfy legal requirements.

h. Use check digit verification.

(1) ID numbers can have a check digit computed from the other digits. For example, a six‐digit account number can have a seventh digit, which is the check digit.

(2) Data entry devices verify the check digit each time the ID number is entered by using the six digits to recalculate the seventh check digit.

(3) The verification calculation will not match the check digit if an error is made in entering the six digits or the check digit.

i. Use key verification.

(1) An employee rekeys data entered through a keyboard.

(2) The system compares the two sets of keystrokes.

(3) Discrepancies are highlighted for correction.

(4) Key verification is used for crucial input such as customer numbers and amounts.

5431.08 Input validation routines

Input validation routines, called edit programs, test input data as it is entered into a system to make sure it is accurate and valid. These tests are called edit checks. In online processing, edit checks are performed during the source data entry process, and incorrect data is not accepted until corrected. In batch processing, a separate program performs the edit checks on the input data before it is processed.

a. The following edit checks are used in input validation routines.

(1) Capacity checks, to test whether data will fit into a field

(2) Field checks, to test whether characters are the proper type. A field check on a numerical field would indicate an error if it contains blanks or alphabetic characters.

(3) Limit checks, to make sure a numerical amount does not exceed an upper or lower limit

(4) Range checks, to test for both an upper and a lower limit

(5) Reasonableness test, to make sure data makes sense when compared to other data

(6) Redundant data checks, to determine whether two identifiers in a transaction record match

(7) Sequence checks, to test whether input data is in the proper numerical or alphabetical sequence

(8) Sign checks, to test data for the appropriate arithmetic sign (An inventory balance should never possess a negative sign.)

(9) Validity checks, or existence checks, to compare ID numbers or transaction codes to those stored in the system. When vendor 12612 is entered, the computer locates that vendor in its database to confirm that vendor is valid.

(10) Hash total: a set of nonfinancial numbers not normally totaled (e.g., invoice numbers) are totaled by the system after input and are compared to the total generated by the documents themselves.

b. Companies also need to establish procedures to record, correct, and report all input validation errors.



(1) Enter all error data (date occurred, cause, date corrected, date resubmitted) in an error log.

(2) Investigate, correct, and resubmit errors on a timely basis.

(3) Use the normal input validation routine to reedit the corrected transactions.

(4) Review the log periodically to make sure all errors were corrected.

(5) Summarize errors by record type, error type, cause, date, and disposition in an error report sent to management.

5431.09 Online data entry controls

The following online data entry controls help ensure the integrity, accuracy, and completeness of transaction data entered from online devices:

a. Field, limit, range, reasonableness, redundant data, sign, and validity checks as previously described

b. User ID numbers, passwords, and compatibility tests to make sure employees are authorized to enter, access, or view data

c. Automatic entry of transaction data, where possible, to reduce keying time and errors

d. Prompt feature, to request input data (the system waits for an acceptable response)

e. Preformatting, to display highlighted blank spaces in a document (the system waits for data to be entered)

f. Completeness checks, to make sure all required input is entered

g. Closed‐loop verification, to test input data accuracy

(1) When an account number is entered, the system displays the corresponding account name so users can make sure the account number is correct.

(2) It can be used in place of redundant data checks to make sure a valid, but incorrect, identification number is not entered.

h. Transaction logs, to reconstruct online files when they are damaged. The log, which can help make sure transactions are not lost or entered twice, should include:

(1) a unique transaction identifier,

(2) the date and time the transaction occurred,

(3) the terminal, transmission line, and operator associated with the transaction, and

(4) the sequence the transactions were entered.

i. Clear error messages that indicate:

(1) when an error has occurred

(2) which item is in error

(3) what the operator should do to correct it

j. Retain data needed to reproduce online data entry documents as long as needed to satisfy legal requirements.



5431.10 Data processing and storage controls

The following controls are used to help ensure data processing integrity (all transactions are processed as authorized, no authorized transactions were omitted, and no unauthorized transactions were added) and to safeguard stored data.

a. Develop policies and procedures for:

(1) computer operators, data libraries, and data control personnel,

(2) scheduling data processing tasks, so data is not processed without authorization, and

(3) maintaining an audit trail, so the system can track people who have access to confidential data.

b. Require employees to sign confidentiality agreements.

c. Create a data control function that:

(1) logs input data as it is received, entered into the system, processed, and dispersed as output,

(2) checks to make sure all transactions are authorized,

(3) monitors data processing activities for errors and problems,

(4) develops control totals over input and reconciles them to the totals from each subsequent processing activity,

(5) notifies users of input errors and problems, and

(6) reenters all errors that have been corrected.

d. Perform the following reconciliation procedures on a periodic and regular basis:

(1) Reconcile all system updates to control reports, file status/update reports, or other control reports.

(2) Reconcile general ledger accounts to subsidiary account totals.

(3) Reconcile database totals with data maintained outside the system.

e. Test stored data to determine whether it is out of date (employees retire or quit; suppliers and customers move or fail). Unneeded data should be purged.

f. Use the following file labels to protect data files from inadvertent misuse:

(1) External labels that contain the file name, contents, and date processed

(2) Internal labels, such as (1) volume labels that identify the data recording medium (external hard drives), (2) header labels that contain the file name, expiration date, and other identification data, and (3) trailer labels that contain file control totals. These totals are compared to those calculated during data processing.

g. Use write protection mechanisms that protect files from being accidentally destroyed or erased. USB (universal serial bus) flash drives, external hard drives, and most other forms of solid‐state storage have on/off switches that accomplish the same result.

h. Implement the following database protection mechanisms:

(1) Procedures for accessing and updating the database

(2) A data dictionary to make sure data is defined and used consistently



(3) Concurrent update controls to prevent problems when multiple users simultaneously update a record (Lock other users out of the system until one has finished updating the file.)

i. Use data conversion controls to make sure new files and databases are free from errors when data from old files and databases are converted to the new format.

(1) Process data using both the old and new system at least once.

(2) Compare the results to identify differences and problems.

(3) Have internal auditors carefully supervise and review data conversion activities.

j. Protect stored data.

(1) Use a data library, where data files are logged in and out by a librarian.

(2) Back up data files and store a copy at a secure off‐site location.

(3) Protect the data library from conditions that harm stored data such as fire, dust, and excess heat or humidity.

5431.11 Output controls

The following controls help make sure data output is accurate and is only made available to authorized output users.

a. Review and reconcile data.

(1) Have data control compare output control totals to input and processing control totals and investigate any differences.

(2) Have data control review all output to make sure it is reasonable and in the proper format.

(3) Require users to carefully review computer output to make sure it is complete and accurate.

b. Establish procedures to make sure output is:

(1) distributed to an authorized individual in the appropriate user department.

(2) protected from unauthorized access, modification, and misrouting.

(3) stored in a safe and secure area.

(4) corrected when errors are discovered.

(5) properly disposed of after it is no longer needed.

5431.12 Data transmission controls

The following controls reduce the risk of data transmission errors and failures:

a. Monitor the data communicator network, looking for weak points that need to be improved.

b. Make sure networks have enough capacity to handle peak processing demands.

c. Create more than one communication path between important network components so the system can continue to function if a path fails.

d. Use faster, more efficient, and higher‐grade telecommunications lines that are less likely to fail and have fewer static problems.

e. Use encryption to:



(1) make sure data transmissions and transactions are limited to authorized users.

(2) protect data from electronic eavesdropping.

(3) prevent unauthorized tampering.

(4) determine, with a high level of certainty, who sent a message.

f. Use routing verification procedures to make sure messages are sent to the right place:

(1) Use a header label to identify transmitted data and its destination.

(2) Use mutual authentication schemes that require both sending and receiving computers to exchange passwords before initiating a data communication.

(3) Use a callback system where (1) a password is entered to identify authorized users, (2) the computer disconnects, and (3) the system calls the user back to verify the user’s identity, password, telephone number, and/or location.

g. Use parity checking.

(1) Computers use eight bits (0s or 1s) to represent a single character.

(2) Transmitted bits may be lost or received incorrectly.

(3) To detect these errors, a parity bit (a ninth bit) is added to every character.

(4) In even parity, each bit has an even number of ones; in odd parity, there are an odd number of ones.

(5) To check parity, devices that receive data verify that there are an even (or odd) number of ones.

(6) Two‐dimensional parity checking tests parity both vertically and horizontally. Dual checking is important in telecommunications, because noise bursts frequently cause two or more adjacent bits to be lost.

h. Use message acknowledgment techniques so the device that sends an electronic message knows that it was received.

(1) Use an echo check that calculates a summary statistic, such as the number of bits in the message, before sending data. The receiving unit calculates the same summary statistic and sends it to the sending device (hence the name “echo check”). If the counts do not agree, an error has occurred.

(2) Have the receiving unit make sure the entire message was received by checking for a trailer label. The receiving unit signals the sending unit when a data transmission error occurs, and the data is resent. If the system cannot automatically resend the data, it will ask the sending device to retransmit the data.

5432 Logical and Physical Controls

5432.01 The following five classifications of controls are used to make systems more secure:

1. Segregation of systems duties

2. Physical access controls

3. Logical access controls

4. Personal computers and client/server network protection

5. Internet and telecommunication controls



Physical Access Controls

5432.02 When actual, physical access to computer equipment is not restricted, computers, files, and data can be damaged or accessed by unauthorized parties. Physical access security can be achieved using the following controls.

5432.03 Where possible, there should only be one unlocked building entrance during normal business hours. Emergency exits should not permit outside entry and an alarm should sound when the exit is opened.

5432.04 A security guard or receptionist should be stationed at the main entrance to:

a. verify the identity of employees,

b. require all visitors to sign in, and

c. have an employee escort visitors to their building destination.

5432.05 Locate sensitive computer equipment, programs, and data in locked rooms.

a. Securely lock all entrances to the computer room.

b. Use security guards and closed‐circuit television systems to monitor all entrances.

c. Require proper employee ID to gain access to the computer room. Security badges that have photos and magnetic, electric, or optical codes can be used to automatically log each employee’s entry and exit. This log should be reviewed periodically by supervisory personnel.

d. Multiple failed access attempts should trigger an alarm.

e. Rooms where sensitive hardware, software, or data are stored should supplement locks with other security technologies such as card readers, numeric keypads, or various biometric devices such as retina scanners, fingerprint readers, or voice recognition.

5432.06 Monitor all visitor access to sensitive company sites.

a. Log them in and out.

b. Brief them on company security policies.

c. Require them to wear a visitor badge.

d. Escort them to their destinations.

5432.07 Install security alarms that can detect unauthorized, off‐hours access.

5432.08 Lock PCs, laptops, and other computer devices when they are not in use.

5432.09 Place hardware and critical system components away from hazardous or combustible materials.

5432.10 Restrict access to private, secured telephone lines and to authorized terminals or PCs. Restrict access to telephone and LAN wiring to prevent wiretapping. Do not expose cables and wiring to areas accessible to the public. Disconnect wall jacks not in current use. Securely lock wiring closets containing telecommunications equipment.

5432.11 Laptops, cell phones, and tablets require special attention to prevent their theft and the loss of the data they contain.



a. Employees should always lock their laptops to an immovable object.

b. Store sensitive data on removable media, rather than the hard drive, in an encrypted format and lock it up at night.

c. Install software on laptops so that if it is stolen the laptop will automatically dial a toll‐free number or use Wi‐Fi positioning to reveal its current location when the thief attempts to use it to connect to the internet.

5432.12 Restrict access to network printers, because they often store document images on their hard drives. There have been cases where intruders have stolen the hard drives from printers, thereby gaining access to sensitive information.

5432.13 Install fire and smoke detectors and use fire extinguishers that do not damage computer equipment.

Logical Access Controls

5432.14 People can damage information systems without having physical access to the system. They only need to be able to reach the systems electronically. Several levels of logical access are needed:

a. Authentication, which ensures that unauthorized users and devices are not allowed to access any part of the system

b. Authorization, which makes sure the system can recognize authorized users, but restrict their access to:

(1) data they are not allowed to use and

(2) those functions (reading, copying, updating, adding, deleting, modifying, downloading, printing) they are authorized to perform

5432.15 Inadequate logical access controls leave a company vulnerable to the unauthorized access and use of systems software, application programs, data files, and other system resources.

5432.16 The following controls are used to restrict logical access: user identification numbers and passwords, physical possession identification, and biometric identification.

5432.17 User identification numbers and passwords. This is also known as knowledge identification.

Identification numbers and passwords are used to access a system:

a. Users enter a unique user ID, such as an employee number, and a password (letters, numbers, and/or special characters known only to the user and the system).

b. The user ID and password are compared to user ID numbers and passwords stored in the system to see if they are valid.

c. If they are valid, the system assumes an authorized user.

d. The disadvantage of passwords is they can be guessed, lost, or given away, allowing an unauthorized person to access the system.

5432.18 To minimize risks associated with passwords:

a. Assign passwords randomly to users, as user‐selected passwords are easy to guess. The passwords should not be related to the employee’s personal interests or hobbies. Require the user to change their password upon first login.



b. Change passwords frequently, as often as every 90 days.

c. Passwords should be at least eight characters long and use a mixture of upper‐ and lower‐case alphabetic, numeric, and special characters so they cannot be easily guessed or cracked using special software. They should not be words found in dictionaries or words with either a preceding or following numeric character. Longer passwords such as “LongpasswordsRharder2crack&easier2remember” are harder to crack and easier to remember. In fact, passwords this long that follow the other guidelines can be virtually impossible to guess.

d. Users should be held accountable for keeping their user IDs and passwords confidential and for the actions of anyone using them.

e. Program the system to not display ID numbers or passwords as they are entered.

f. Automatically log users off the system after 15 minutes of inactivity.

g. Do not leave computers unattended if they have accessed confidential corporate databases.

h. Assign electronic ID numbers to each authorized system device.

i. Only allow authorized devices to communicate with the system.

j. Only allow authorized devices to access the data they are authorized to use.

k. Restrict user and terminal interaction to business hours, or some other appropriate time frame.

l. Terminate system access requests if a valid ID number and password are not entered within three attempts to prevent an unauthorized user from trying many combinations of user IDs and passwords.

m. Investigate devices that repeatedly attempt to use invalid ID numbers or passwords to access the system.

n. Immediately cancel a terminated employee’s user ID and password.

o. Reassess a transferred employee’s rights to access data.

p. Use smart cards that continuously generate new and unique passwords.

5432.19 Physical possession identification. Employees are often identified by something they possess, such as an ID badge or a smart card.

a. Computers and security devices (door locks, etc.) read the ID cards.

b. Security is strengthened if an ID card and a password are both required to access a system.

c. Their disadvantage: They can be lost, stolen, or given away.

5432.20 Biometric identification. Unique physical characteristics (fingerprints, voice patterns, retina prints, facial patterns and features, body odor, signature dynamics, and keyboarding patterns) can all be used to identify people. A device reads a user’s biometrics and compares them against those stored in the computer.

a. Biometric devices should be able to adapt to slight personal changes, such as bloodshot eyes.

b. Remote users must possess a biometric identification device to use the system.

c. Their disadvantage: They are expensive, can be hard to use, and are not 100% accurate.



(1) They may reject legitimate users (voice recognition systems may not recognize an employee who has a cold).

(2) They may allow access to unauthorized people.

(3) Some, such as fingerprints, have negative connotations that hinder their acceptance.

(4) The biometric templates (the digital representation of an individual’s fingerprints or voice) must be stored. Any compromise of those templates would cause serious problems for people.

5432.21 Since no single authentication method is foolproof, multi‐factor authentication, such as requiring a smart card and a password, provides much stronger authentication than either method alone.

5432.22 Authorization controls are implemented using compatibility tests and access control matrices.

a. Compatibility tests. Companies should classify data based on how its loss or unauthorized use would impact it and determine the data and program access privileges of employees and outsiders. When users request access to data or programs or try to operate the system, a compatibility test can determine if the user is authorized to perform the desired action. This prevents unintentional errors and deliberate attempts to manipulate the system. Several confidentiality levels are defined and used:

(1) Some data does not need to be restricted and is put on a website.

(2) Some data is restricted to employees.

(3) Confidential data is restricted to owners and appropriate top management and employees.

(4) No one should be able to read, add, delete, and change data without authorization of their activities.

b. Access control matrix. Compatibility tests use an access control matrix, which is:

(1) a list of authorized user ID numbers and passwords and

(2) a list of all files, data, and programs and the access each user has to them.

5432.23 Authentication and authorization controls are also used for computing devices.

a. Each device (PC, workstation, printer, etc.) requires a network interface card (NIC) to connect to a company’s internal network.

b. Each NIC has a unique identifier, called a media access control (MAC) address.

c. Access should be restricted to devices with recognized MAC addresses. The MAC addresses can also be used for authorization. For example, only devices in the payroll department and belonging to appropriate top management should have access to payroll data.

Protecting Critical Information

5432.24 IT security management should implement security measures to preserve, as needed, the integrity, confidentiality, and availability of data, including application software, while the information is being processed, in transit, and in storage. These security measures should be



incorporated into the development/acquisition phase and operation/maintenance phase of the system development life cycle.

5432.25 When preserving information, organizations should consider the methods that will be required for retrieving information in the future. The technology used to retrieve the records may not be readily available in the future. Legal requirements for record retention should also be considered when disposing of computer systems and databases.

5432.26 Protection of information system hardware usually requires that residual magnetic or electrical representations of data be deleted, erased, or written over and that any system components with nonvolatile memory be erased. This residual information may allow data to be reconstructed, providing access to sensitive information by unauthorized individuals. The removal of information from a storage medium is called sanitization. Media sanitization can be used to thwart attacks by ensuring that deleted data are completely removed from the system or media. Different kinds of sanitization provide various levels of protection.

Incident Response

5432.27 A computer security incident can result from a computer virus, other malicious code, a system intruder, either an insider or an outsider, or deliberate malicious technical activity, including theft. Malicious code includes viruses, Trojan horses, and worms. One basic aim of a computer security incident response capability (CSIRC) is to mitigate the potentially serious effects of a severe computer security‐related problem.

5432.28 Incident handling is closely related to contingency planning as well as support and operations. An incident handling capability may be viewed as a component of contingency planning because it provides the ability to react quickly and efficiently to disruptions in normal processing. Broadly speaking, contingency planning addresses events with the potential to interrupt system operations. Incident handling can be considered that portion of contingency planning that responds to malicious technical threats.

5432.29 Incident handling will be greatly enhanced by technical mechanisms that enable the dissemination of information quickly and conveniently. For rapid response to problems, a simple telephone “hotline” is practical and convenient. A centralized electronic mail (email) address that forwards mail to staff members permits the users to conveniently exchange information with the team. Email has low overhead and is easy to use. One way to establish a centralized reporting incident response capability, while minimizing expenditures, is to use an existing help desk function with escalation procedures.

5433 Business Resiliency

5433.01 Business resilience refers to the ability of an organization to quickly adapt to disruptions internal as well as external, while maintaining continuity in its business operations and safeguarding its assets.

5433.02 Business resilience is important because the business environment has become more dynamic due to recent technological advances. It is therefore imperative for organizations to understand the importance of preserving their workflows in order to survive unexpected disruptions. This is the first step in achieving business resilience.

5433.03 The resilience of an organization is interdependent on the resilience of its customers, employees, and vendors, as well as other businesses. It is further connected to the resilience of the industry in which the organization operates and, finally, the country in which it is



located. Resilient organizations are able to manage their risk not only internally but through their entire supply chain, which assures that risk does not explode into crisis.

5433.04 Companies must identify areas that can enable them to achieve competitive advantage by building business resilience for the future:

a. Financial resilience: The ability to overcome life events that affect an organization’s income and assets

b. Operational resilience: The ability of an organization to continue to run its operational services even under adverse operational conditions by anticipating, preventing, and adapting to such conditions

c. Cyber resilience: The ability of an organization to manage cyberattacks while continuing to run its operations effectively

d. IT systems resilience: The ability of computer systems to continue to function correctly despite the existence of faults in one or more component parts

Financial Resilience

5433.05 Financial resilience is the ability to overcome life events that affect an organization’s income and assets. Financially stressful events such as economic downturns and stock market crashes can have a huge financial impact on businesses. As an example, the COVID‐19 pandemic is an event which has caused severe health issues, massive unemployment, and work stoppages due to lockdowns impacting economies across the world. It has changed the way businesses have been operating over the past several years, making working from home and social distancing a “new normal.” Businesses operating in the hospitality, travel, transportation, and retail sectors have suffered huge setbacks, with many of them forced to shut down operations as they did not have the financial resources to continue operations.

5433.06 Financial resilience is built with financial resources. Practices that increase financial resilience include the following:

a. Avoid financial leverage: Keeping financial leverage low allows a company to invest in itself. The funds that would otherwise have been used to repay the outstanding debts when invested in the company increase the company’s financial resilience.

b. Prepare short‐term forecasts for early discussions with lenders: Having early discussions with lenders can ensure that cash shortfalls can be avoided.

c. Build an emergency fund: An emergency fund can keep the business operational in case of unforeseen as well as foreseen disruptions.

d. Introduce flexibility in operations: Flexibility in operations creates shareholder value; for example, if a company is able to respond to price changes of inputs and outputs by altering the nature and quantity of inputs and outputs, this flexibility will make production methods more flexible, leading to increased resilience.

Operational Resilience

5433.07 Operational resilience is the ability of an organization to continue to run its operations and services even under adverse operational conditions by anticipating, preventing, and adapting to such conditions. Operational resilience must be built into the culture of the organization.



5433.08 Operational resilience is built using the following principles:

a. Prioritize critical business services/operations.

b. Put a business continuity management (BCM) system in place.

c. Explicitly define the role of the board of directors and senior management.

d. Involve the third parties on which the business relies.

5433.09 Prioritize critical business services/operations

Businesses should:

a. understand the dependency of critical business services on organization assets.

b. identify the most critical assets that impact service delivery.

c. assess when the continuity of operations/services will be interrupted.

d. assess the duration for which disruption can be tolerated before impacting their customers.

e. assess the impact of disruption on customers and the financial system.

The products and services critical for business operations should be prioritized and made resilient, along with the supporting processes, so that the loss of customers and profits can be avoided.

5433.10 Put a business continuity management (BCM) system in place

A business continuity management (BCM) system should be built for operational resilience. BCM involves advance planning by an organization to maintain and recover business functions. It includes disaster recovery, incident management, crisis management, and emergency management. BCM provides a framework for building operational resilience by:

a. identifying and mitigating operational risk before it occurs.

b. responding to risks, thereby ensuring business continuity.

c. ensuring recovery from disruptive events within an acceptable time frame to ensure operational resilience.

5433.11 Explicitly define the role of the board of directors and senior management

Organizations can start building operational resilience by putting a business continuity management system in place. However, without management participation it is not possible for organizations to achieve operational resilience. Senior management can provide the required “tone at the top” and demand accountability by asking the right questions. This makes operational resilience a strategic objective tied to the organization’s operating results.

5433.12 Involve the third parties on which the business relies

Companies are increasingly adopting outsourcing as a business strategy. It is important to involve the outside parties, supply chains, people, and systems on which the company relies for their day‐to‐day operations to achieve operational resilience. As the operations with the company are intertwined with the operations of the third parties, any disruption in the third parties’ operations can have a serious impact on the supply of goods/services of the company. It is imperative for companies to ensure that these third parties are also resilient for their own smooth functioning (e.g., cloud computing providers).



Cyber Resilience

5433.13 Cyber resilience is the ability of an organization to manage cyberattacks while continuing to run its operations effectively. Cyberattacks and cybersecurity breaches can cause severe damage to companies by destroying or obtaining unauthorized access to their computer networks and computer information systems. Cyber resilience provides defenses against such attacks by protecting critical data and applications and ensuring recovery in a controlled manner.

5433.14 Components of cyber resilience

a. Protection against threats. The resilience program should be able to:

(1) identify, assess, and manage risks related to information systems, including those across the supply chain.

(2) provide protection to information and systems against cyberattacks, unauthorized access, and system failure.

The best option for protection against threats is endpoint detection and response (EDR) technology that addresses the need to monitor and respond to advanced threats continually.

b. Recoverability. Regular and thorough backup of data on a separate network can be used to recover lost data. Cyber resilience can be strengthened by simulating attacks against company infrastructure.

c. Adaptability. As attackers keep developing new ways to attack, it is important to have a security team that can quickly recognize a security breach in real time and immediately take action to prevent attacks. If the security team can recognize threats in real time, and incorporates automation to remove such threats, the organization will be a step closer to a more cyber‐resilient system.

d. Durability. An organization’s durability is measured by its capability to effectively operate regular and routine business again after a security breach. The durability component of cyber resilience improves with regular system updates and enhancements made by the IT team.

IT Systems Resilience

5433.15 Systems resilience refers to the ability of computer systems to continue to function correctly despite the existence of faults in one or more component parts. Business resilience can be increased with the adoption of IT security principles, such as:

a. implement layered security.

b. design and operate an IT system to limit damage and to be resilient in response.

c. provide assurance that the system is, and continues to be, resilient in the face of expected threats.

d. limit or contain vulnerabilities.

e. isolate public access systems from mission‐critical resources (e.g., data and processes).

f. use boundary mechanisms to separate computing systems and network infrastructure.

g. design and implement audit mechanisms to detect unauthorized use and to support incident investigations.



h. develop and exercise contingency or disaster recovery procedures to ensure appropriate availability.

5433.16 Threats, risks, and exposures

a. A threat is any event that could damage or harm an information system.

b. An exposure is the potential dollar loss that could result should a threat occur.

c. A risk is the likelihood or probability that a threat will actually occur.

5433.17 Companies face the following four threats to their IT systems:

1. Natural and political disasters (fires, floods, earthquakes, high winds, excessive heat, and war). Disasters can destroy an information system, cause companies to fail, and affect many companies at the same time.

2. Software errors and equipment malfunctions (software errors, operating system crashes, hardware failures, power outages and fluctuations, and data transmission errors)

3. The greatest risks to information systems, and the greatest dollar losses, are unintentional acts (accidents or innocent errors and omissions) resulting from poorly trained personnel, human carelessness, and failure to follow established procedures. Examples include the following:

a. Users lose or misplace data or enter erroneous input.

b. Files, data, and programs are accidentally erased or altered.

c. Computer operators use the wrong version of a program or the wrong data files, or misplace files.

d. Systems analysts develop systems that do not meet company needs or do not perform their intended tasks.

e. Programmers make logic errors.

4. Intentional acts or computer crimes. Examples include:

a. sabotage, which is destroying a system or some of its components.

b. computer fraud, which is stealing money, data, or computer time or services, or falsifying financial statements.

When companies do not protect their systems from these four threats, they may face an additional threat—a lawsuit.

5433.18 Systems need to be protected from occurrences such as software and hardware failures, sabotage, political and natural disasters, and power outages. As management relies more on information systems for support, system downtime has the potential to interrupt business operations. Three categories of controls are used to ensure information system availability: (1) minimizing system downtime, (2) disaster recovery plan, and (3) data and program file backups.

5433.19 Minimizing system downtime

a. When an information system goes down:

(1) significant financial losses are often incurred,

(2) critical business operations are interrupted, and



(3) data can be lost or destroyed.

b. Several controls can eliminate or minimize system downtime:

(1) Establish policies and procedures to deal with hardware failures, power outages, unintentional errors, loss or destruction of data, sabotage, and other problems.

Train employees so they can understand, follow, and implement them.

(2) Perform regular preventive maintenance on key system components.

(3) Install an uninterruptible power supply (UPS). This auxiliary power supply:

(a) prevents data loss from power surges or dips and

(b) keeps computers operating for a limited time when there is a power failure.

(4) Install redundant system components so the system can continue operating if system components fail.

(5) Obtain disaster and business interruption insurance so the company can recover from downtime failures.

5433.20 Disaster recovery plan

A disaster recovery plan is used to smoothly and quickly restore data processing capacity when there is a disaster. A recovery plan has the following objectives:

a. Minimize the disruption, damage, and loss from the disaster.

b. Establish a short‐term data processing alternative so the company can quickly resume normal operations.

c. Train and familiarize personnel with emergency procedures.

5433.21 Disaster recovery plans should contain the following:

a. Recovery priorities. The plan should identify and prioritize:

(1) hardware, software, applications, and data necessary to sustain the most critical applications.

(2) the sequence and timing of all recovery activities.

b. Insurance to:

(1) replace equipment or data lost in the disaster

(2) compensate for business interruptions

c. Specific assignments. A plan coordinator should:

(1) be responsible for implementing the recovery plan.

(2) assign individuals and teams specific recovery responsibilities such as finding new physical facilities, operating the system, installing software, setting up data communications linkages, recovering data, and procuring forms and supplies.

d. Backup computer and telecommunications facilities, which can be arranged by:

(1) establishing reciprocal agreements with companies with compatible facilities so each company can use the other’s computers if an emergency occurs

(2) signing a contract for a contingent site. A hot site is configured to meet user requirements. A cold site has everything needed (power, air conditioning, and support systems) to quickly install a computer. Cold site users rely on their



computer vendors for prompt delivery of equipment and software if an emergency occurs.

(3) fail‐soft distributing processing capacity in a multilocation organization so other facilities can take over if one location is damaged or destroyed

(4) investing in duplicate hardware, software, or data storage devices for critical applications

e. Periodic testing and revision. A recovery plan must be:

(1) regularly tested with a simulated disaster, with each disaster recovery team carrying out its assigned activities.

(2) constantly improved, since most plans fail their initial test and tested plans rarely anticipate and deal with all real‐life disaster problems.

(3) reviewed to make sure it reflects current computer application changes, equipment configurations, and new personnel assignments.

f. Complete documentation of all aspects of the system.

(1) Copies of the documentation should be stored securely at multiple locations.

(2) One copy should be some distance from the system.

5433.22 Data and program file backups

a. All program and data files should be backed up regularly and frequently.

b. A copy should be stored on‐site and another at a secure site some distance away or on a cloud storage server.

c. Backup files can be transported to the remote site in two ways:

(1) Physically, by mailing, shipping, or delivering them

(2) Electronically, by way of electronic vaulting. There are two main electronic vaulting approaches: (1) the push approach, where a company electronically sends the items to be backed up, and (2) the pull approach, where the electronic vaulting service installs its software on company computers and uses internet connections to periodically contact company computers and automatically back up data. If data is lost or needs to be accessed, the internet connection provides prompt online access to the backup data.

d. To protect data privacy, all data should be encrypted before being transmitted.

5433.23 Online databases are also backed up.

a. Periodically during processing, a checkpoint (a copy of the database at that point in time and the information needed to restart the system) is created.

b. The checkpoint data is stored on a separate storage medium.

c. The database is recreated by determining the last checkpoint and reprocessing all subsequent transactions.

d. Between checkpoints, a rollback (a pre‐updated copy of each record created prior to processing a transaction) is created. If a problem occurs, records are rolled back to the pre‐update value and the transaction is reprocessed.

e. The company should periodically practice restoring a system from the backup data so employees know how to quickly restart the system if a failure occurs.



5433.24 PC hard drives can be backed up on external hard drives or through a cloud storage device.

Do not store the on‐site backup copy next to the PC, as it can be destroyed by any disaster that wipes out the PC.

5440 Data Management and Relationships

5441 Data Governance

5441.01 Data governance is used by organizations to manage, utilize, and protect their data. It is about the roles, responsibilities, and processes for ensuring accountability for and ownership of data assets. Data governance is a system that defines who within an organization has authority and control over data as well as how data may be used. It protects company data as well as customers’ private data by setting up a data governance framework.

5441.02 The management of any organization needs to view investments in data governance as a way to:

a. enable data‐driven decision making,

b. enhance their organization’s reputation,

c. improve competitiveness by protecting intellectual property (IP),

d. reduce the costs and fines associated with data breaches,

e. increase return on investment (ROI) of their data analytics,

f. improve compliance with data regulations, and

g. increase efficiency with the ability to reuse processes and data.

5441.03 Roles in data governance

a. Chief data officer: The chief data officer (CDO) is a senior executive responsible for the utilization and governance of data across the organization. A CDO ensures that the data and analytics department is functioning to enable sustainable business growth and profitability, internal efficiencies through improved data structures, constant data cleanliness and insight, and efficient data governance and process.

b. Data owners: Data owners are individuals who have direct responsibility for data. They provide protection and ensure quality of data as a business asset.

c. Data stewards: Data stewards define and maintain data. They enforce data governance policies and procedures as well as train new data owners and employees in data governance.

d. Data governance committee: The data governance committee sets policies and procedures for data governance. It works with the CDO to establish the “who, what, when, where, and why” of data governance.

5441.04 Data governance is all about “who, what, when, where, and why”:

a. Who: “Who” includes people: the data governance committee, the chief data officer (CDO), data stewards, and data owners as well as employees that create data while performing their job. Good data governance requires cross‐functional cooperation and leadership. Senior executives must understand the importance and return on investment (ROI) of data as an asset and become its stewards. Data governance is



therefore the responsibility of the whole organization. Each person in the organization needs to be aware of their role in maintaining data quality.

b. What: One of the best practices of data governance is defining the value data holds for the organization. Data governance identifies what data will be collected, how it will be collected and protected, and how data compliance and confidentiality requirements will be achieved.

c. When: “When” refers to the time portion of the data governance framework. What kind of data retention policies does the company have to adhere to? “When” can also indicate how often to audit data and data access rights.

d. Where: “Where” is an important question. Unless the company knows where its data lives and the data owners are able to keep track of it, there will be ever‐exploding data problems. Data governance is about keeping control of data, “where” being a vital aspect of the data governance program.

e. Why: “Why” is the mission of any data governance program. It tells the organization why it needs a data‐driven culture. The message to the team explaining “why” should be clear and consistent. Employees should be willing to use data as well as encourage others to use it. Organizations should adopt a change management methodology along with a strong communication plan to successfully adopt data governance as a culture.

5442 Extract, Transform, and Load Data

5442.01 Extract, transform, and load (ETL) is a process that extracts data from different source systems, transforms the data, and finally loads the data into a data warehouse system. ETL helps organizations analyze their business data for making critical business decisions. ETL is a three‐step process:

1. Extraction

2. Transformation

3. Loading

5442.02 Stage 1: Data extraction

Data extraction is the process of gathering and retrieving data captured within unstructured sources, such as email, social media, images, and barcodes. It is the first step in the ETL (extract, transform, and load) process, the goal of which is to prepare data for analysis or business intelligence (BI). Data extraction tools automatically pull data from unstructured source documents and load structured data to target areas.

As data extraction involves the transfer of large amounts of data from the source systems, it can impose significant load on the databases involved, so the process should preferably be performed either during periods of low system load or overnight.

5442.03 Following is an example of how the ETL process works: Suppose a company wants to monitor its reputation in the market. Data would be available from many sources, including reviews, feedback forms, and social media comments. An ETL tool extracts data from these sources and loads it into a warehouse, where it can be analyzed for drawing insights into the company’s brand perception.

5442.04 Data extraction is a process that retrieves data from one format and imports that data into another, more useful format for further processing. In case similar data sets are extracted from two different sources, the extractions must be reviewed and processed to ensure they



are formatted correctly. The following are important considerations in making a data extraction:

a. Type of data source: It is important to analyze how the source data is produced and in what format it needs to be stored. The two main categories of data sources are digital and physical data.

b. Digital data source: Digital is the most common source of data; it includes more complex data structures such as web pages and databases. Evaluation of any transactional database is important as it can be limiting for business intelligence (BI) for two reasons:

(1) Querying directly in the database for a large amount of data may cause the source system to slow down and prevent the database from recording transactions in real time.

(2) Data in the source system may not be optimized for reporting and analysis.

c. Physical data source: Physical data usually refers to books, newspapers, reports, invoices, etc. Data from physical sources is usually extracted manually. Data extraction from physical sources is more involved than extraction from digital sources.

d. Usage and latency: Another consideration is how the data will be loaded and how it will be consumed at the destination. For example, if data is going to be used by the business intelligence (BI) team for reporting purposes and the frequency of retrieving the data is going to be very high but the volume is low, then a traditional relational database management system (RDBMS) is sufficient for storing the data as it will be cost effective. However, if the frequency of retrieving the data is high and the volume is also high, then a traditional RDBMS can be a bottleneck for the BI team. In such a situation, a data warehouse will be more efficient and appropriate for storing the data.

e. Audit of source data: An audit of the data source assesses the data quality and utility for a specific purpose. The audit examines metrics other than quantity to form a conclusion about the properties of the data set. In short, a data audit is dependent on a registry, which is a storage space for data assets.

f. Analyzing data extraction: The main objective of the extraction process in ETL is to retrieve all the required data from the source with ease. Therefore, the extraction process should be designed properly to avoid adverse effects on the source system in terms of performance and response time.

5442.05 There is an increased use of ETL tools by companies not only for data management but also for converting unstructured data into structured data. Information from disparate sources is standardized and made ready for further transformations so that useful insights can be drawn from the data on market research, tracking prices in multiple markets, and contact information as per the requirements of the company.

5442.06 It is vital for extraction tools to meet the data preparation requirements of an organization by converting raw data to useful information to generate actionable business insights. The attributes that a good data extraction tool must have include the following:

a. User‐friendly interface: Data extraction tools should be easy to use, supported with a user interface that is intuitive and provides a visual view of data processes and rules. It should allow easy data handling with little or no coding involved.

b. Scalability: Data extraction tools should facilitate extraction of data on a large scale, increasing the amount of data that can be deployed for specific use cases.



c. Facilitating meaningful interaction with data: Data extraction tools help organizations identify necessary data from disparate sources. This functionality can be used by organizations to migrate data from different sources to the target destination for increased meaningful interaction with data.

d. Reusable templates: Data extraction tools should provide reusable templates designed to create output files that meet predefined specifications (extraction reports) that can be applied to any unstructured document of the same layout.

5442.07 Types of Data Extraction

a. In full extraction, the data is extracted “as is” and then exported. As each extraction is independent, no checks are performed on variables such as when the last extraction occurred. Full extraction is preferred when there is no requirement to trace data and the only requirement is to get complete access to the data.

b. In incremental extraction, the changes to data are tracked, and only data changed after the last extraction is migrated into the data warehouse.

5442.08 Stage 2: Data cleansing and transformation

a. Data cleansing involves checking data against predefined rules. Examples of data cleansing include checking date format, field length, data type, and pattern validation.

b. Data transformation increases the efficiency of analytic and business processes to enable better data‐driven decision making. Data transformation can be performed during data extraction from the source systems. Tasks performed during transformation include:

(1) joining multiple fields into one field (Address 1 + Address 2 + Address 3).

(2) generating calendar tables.

(3) mapping data from one representation to another, such as Female to 1 and Male to 0.

(4) transforming data from multiple representations to a single representation, such as a common format for telephone numbers.

(5) creating surrogate keys. (Surrogate keys are sequentially generated, meaningless numbers associated with each and every record in the data warehouse that are used to join dimension and fact tables.)

5442.09 Stage 3: Data loading

Loading data into the target data warehouse database is the final step of the ETL process.

a. Once cleansed and transformed into a structure consistent with the requirements of the data warehouse, the data is ready for loading into the data warehouse. The initial load of the data warehouse populates the tables in the data warehouse schema and then checks that the data is ready for use.

b. Once the data is uploaded into the data warehouse database, the referential integrity between dimension and fact tables is verified.

c. “Data integrity” refers to the accuracy and consistency of data stored in a database, data warehouse, and data mart. Data integrity in the reverse order is not necessary; however, in some cases, it might be necessary to remove unrelated data (for example, when a dimension table has several times more records than the fact table).



Note: Referential integrity refers to the relationship between tables and ensuring that relationships between data exist and are used as they are defined. The dimension table contains the descriptive information about the numerical values in the fact table; in other words, the table contains the dimensions of a fact. They are joined to the fact table through a foreign key. For example, dimension tables for a customer application might include attributes such as customer_name, customer_address, customer_contact, and customer_preference. A fact table is a primary table in a dimensional model and contains measurements/facts and a foreign key to the dimension table.

5442.10 There are three different types of data loading:

1. Initial load: All of the data warehouse tables are populated.

2. Incremental load: Ongoing changes are applied as and when needed periodically.

3. Full refresh: The contents of one or more tables are erased and reloaded with fresh data.

Relational Database

5442.11 Relational databases

a. Most new database systems are relational databases that store data as tables. Each row in a relational table contains data about a separate entity. For example:

(1) Each inventory table row contains data about a particular inventory item.

(2) Each customer table row contains data about a specific customer.

Each column in a table contains information about entity attributes. For example, in a sales table, the columns represent specific sales transaction characteristics (date, amount, customer number).

b. Relational database tables have three types of attributes:

(1) A primary key uniquely identifies a specific row in a table. For example, the primary key in an inventory table is item number. In some tables, the primary key is two or more attributes.

(2) A foreign key is an attribute in one table that is a primary key in another table. A foreign key is used to link tables.

Customer number can be a foreign key in a sales table that links a particular sales transaction with information about the customer who participated in the transaction.

(3) Other non‐key attributes in each table store important information about that entity.

An inventory table contains information about the description, quantity on hand, and list price of each inventory item the company sells.

c. Normalization is the process of following the guidelines for properly designing a relational database that is free from delete, insert, and update anomalies. It involves breaking the database into logical tables that can then be joined to create new tables with the information of interest. Properly designed relational databases are flexible and useful for unplanned, ad hoc queries due to their reduced access time (time to retrieve data from memory).



Data Repositories

5442.12 A data repository, also known as a data library or data archive, can be defined as a place that holds data, makes data available for use, and organizes data in a logical manner to be mined for data reporting, sharing, and analysis. It is a tool that helps in scientific research as well as managing business data. Examples of data repositories are data warehouses, data lakes, data marts, metadata repositories, and data cubes.

a. A data warehouse is a type of data management system that supports business intelligence activities, mainly analytics.

b. A data lake is a large data repository that stores unstructured data.

c. A data mart is a subset of a data warehouse focused on a particular line of business or department. A data mart is more secure because it limits authorized users to isolated data sets and denies access to all data in the data repository.

d. Metadata repositories store data about data and databases. The metadata describes the data source, how it was captured, and what it represents.

e. Data cubes are lists of data with three or more dimensions stored as a table, as in a spreadsheet.

5442.13 In order to maintain the value and accuracy of the critical operational information of a business that impacts its strategic decision making, businesses should implement a data quality strategy. The data quality relates directly to how an organization does business and the entire life cycle of the data itself.

5442.14 Data is considered to be high‐quality data when it satisfies the requirements of the end user for the intended purpose. The end users are clients, decision makers, applications, and processes. The quality of data can be measured using the following criteria:

a. Accuracy: Whatever the data describes should be accurate. Example: The address of an employee in the employee database is the real address.

b. Relevancy: The data should meet the requirements for the intended use.

c. Completeness: The data should not have missing values or data records. Data is considered complete even if optional data is missing. Example: The first name and last name of customers are mandatory; however, the middle name is optional. A missing middle name does not mean the data is incomplete.

d. Timeliness: Information should be available when needed.

e. Consistency: The data should reflect the same information across all systems, and the systems should be in sync with each other across the enterprise. Example of inconsistent data: The status of employee is terminated; however, the pay status is active.

f. Conformity: Data should follow the set of standard data definitions such as data type, size, and format. Example: The date of birth of the customer is in the format “mm/dd/yyyy.”



5443 Data Visualization

Data Modeling

5443.01 Data modeling is a process of mapping and creating visuals of the information system to illustrate:

a. the type of data used and stored in the information system,

b. the relationship among the data types, and

c. the ways and formats in which data can be organized.

Data modeling enables developers to understand the requirements of the users in order to build systems that can be used to meet those requirements.

5443.02 The three most common types of data modeling approaches are:

1. conceptual/enterprise data modeling,

2. logical data modeling, and

3. physical data modeling.

5443.03 Conceptual/enterprise data modeling: Generally the first data model in the design and development of a database, a conceptual/enterprise data model understands the main needs of the business and gives an integrated view of data produced and consumed across an entire organization. In other words, it defines what the system is. It is justified in the case of business re‐engineering, when the processes are being fundamentally revised.

5443.04 Logical data modeling: More complicated than conceptual data modeling, logical data modeling defines the relationship between the data structures and elements of a company’s business. It adds further information to the conceptual data model elements.

a. The reporting requirements of the users and availability of the source data decide the scope and complexity of a logical data model. Complex reporting requirements and source data make the logical data model more complex.

b. Whatever occurs under the logical data model can change either with changes in technology or when required. However, logical data models must be independent of the technology due to rapid changes in technology.

c. Logical data independence is the ability to make changes to one (middle) level of the database management system (DBMS) without causing application programs to be rewritten (the next higher level). This helps to keep data separated from the programs that use it. Examples of logical data independence are:

(1) add/delete a new attribute without rewriting the application program.

(2) merge/break records.

5443.05 Physical data modeling: Physical data modeling is the actual blueprint for data model design. It describes how the system will be implemented using a specific version of the DBMS. It represents relational data objects and their relationships (tables, columns, and primary and foreign keys).

5443.06 Data modeling tools: Data design tools are used to create a database structure from diagrams to form a perfect data structure as per the needs of the end user. Key data modeling tools include the following:



a. Draw.io

b. Lucidchart

c. SQuirreL SQL Client

d. MySQL Workbench

e. Amundsen

f. Erwin Data Modeler

g. ER/Studio

h. Aqua Data Studio

i. DbSchema

5443.07 Data modeling can be used to perform tasks from the simplest to the largest. Before choosing a data modeling tool, it is important to match the capabilities of the tool to the user needs. Most importantly, the needs of the end users should be understood properly. Knowing what the users need can help prioritize, collect, store, and transform data for analysis to help the business function better. For example, if the data modeling tool is required to perform small tasks, the modeling capabilities available within the database can be used. On the other hand, if data modeling is required to perform a repetitive task, then niche enterprise data modeling tools are preferred.

5443.08 While choosing data modeling tools, a company should consider its current needs as well as future needs. The current needs may be simple, but if the company expects its needs to be complex in the future, decisions should be made accordingly.

Data Analytics

5443.09 Data analytics is a process of analyzing trends in data and solving problems by applying statistical analysis and technologies, including the collection, organization, and storage of data. Analytics tools help in understanding and interpreting data to identify new opportunities to generate revenue, optimize costs, mitigate risk, and improve decision making to gain a competitive edge. Analytics tools provide different insights, depending on the priorities, size, complexity, growth rate, and maturity of an organization. Choosing the right analytics tools for the business therefore becomes a challenging task, as no single tool can fulfill all the requirements.

The following factors should be considered before choosing data analytics tools:

a. Meet the needs of the end user: The first step in selecting a suitable data analytics tool is to understand the business needs of the organization, followed by an understanding of who will be using these tools. The tool should suit the needs of the users:

(1) Experienced data analysts

(2) Data Scientists

(3) Nontechnical users who need an intuitive interface

In the case of less technical users, organizations can opt for a platform focusing on point‐and‐click analysis. Otherwise, platforms providing an interactive experience using SQL (structured query language) for iterating on code development may be used.

An intuitive interface is one that works as per the expectations of the users to help new and seasonal staff learn even the most feature‐rich system quickly. Iterative



development is the breaking down of the software development of a large application into smaller pieces.

b. Provide support for data visualization: The tool should support data visualization relevant to the organization.

c. Provide data modeling support: Some tools perform data modeling themselves; however, if the chosen tool does not perform data modeling, SQL must be used to model data prior to analysis.

d. Price: Data analytics tools available in the marketplace have different cost structures. It is important for an organization to have a clear understanding of the costs associated with the tools they are evaluating. This should include a clear understanding of any subscription as well as hidden fees that may be charged.

5443.10 Data analytics tools: Popular data analytics tools include the following:

a. Microsoft Power BI

b. Qlik

c. SAS Business Intelligence

d. Tableau

e. RapidMiner

f. R

g. Python

Data Visualization

5443.11 Data visualization is the presentation of information and data in the form of charts, graphs, and maps to understand trends, correlations, and patterns in data.

5443.12 Benefits of data visualization: The human brain processes and understands visual data faster and better than text data. Benefits of visual data over textual data are the following:

a. Visualizing data helps in understanding data much faster and more easily.

b. Visualization reveals trends, comparisons, and relationships, facilitating insights on data.

c. Visualization enables even nontechnical users to draw insights on data.

Techniques Used for Data Visualization

5443.13 Box plot: A box plot is a graph that gives a good indication of:

a. distribution of data,

b. symmetry of data,

c. how tightly the data is grouped, and

d. if and how the data is skewed.

Each box plot displays the minimum, first quartile, median, third quartile, and maximum values. Mean and standard deviation can also be displayed as dashed lines while outliers appear as points in the visualization.



5443.14 Histograms: Histograms are used to summarize continuous data. They can display a large amount of data and the frequency of data values. This is done by showing the number of data points that fall within a specified range of values called “bins.” These bins are consecutive, non‐overlapping intervals of a variable. The adjacent bins do not have any gaps; the rectangles of a histogram touch each other to indicate that the original value is continuous. Histograms also determine the median and distribution of the data as well as show outliers.

5443.15 Heat maps: Heat maps are used to visualize data through color variation. They are useful for showing variance across multiple variables to indicate:

a. patterns,

b. similarities,

c. correlation, and

d. missing values in the data.

5443.16 Charts: There are different charts that can be used for data visualization:

a. Line charts depict the relationship or dependence of one variable to another.

b. Bar charts are used for comparing the quantities of different categories. Bars are used to represent the value of a category where the length or height of each bar represents the value.

c. Pie charts show proportions and percentages between categories by dividing a circle into proportional segments.

d. A scatter plot is a set of data points plotted on the x and y axis to represent two sets of variables. The shape created by these data points reveals a correlation (positive or negative) in a large amount of data.

e. A bubble chart is an extension of the scatter plot that looks at relationships between three numeric variables. Each dot in a bubble chart corresponds with a single data point, and the variables’ values for each point are indicated by horizontal position, vertical position, and dot size.

f. Timeline charts show the chronological sequence of past or future events on a timescale.

5443.17 Tree maps: Tree maps visualize hierarchical data. They are made of a series of nested rectangles of sizes proportional to the corresponding data value. A large rectangle represents a branch of a data tree, and it is subdivided into smaller rectangles that represent the size of each node within that branch.


______________________________________________

Section 5500 Operations Management

(15%-25%)

5510 Financial and Nonfinancial Measures of Performance Management

5511 Financial and Nonfinancial Measures

5512 Performance and Risk Measures

5520 Cost Accounting

5521 Cost Measurement Concepts, Methods, and Techniques

5522 Variance Analysis

5530 Process Management

5531 Approaches, Techniques, Measures, and Benefits

5532 Management Philosophies and Techniques

5540 Planning Techniques

5541 Budgeting and Analysis

5542 Forecasting and Projection

BEC 5‐2 OPERATIONS MANAGEMENT


5510 Financial and Nonfinancial Measures of Performance Management

5511 Financial and Nonfinancial Measures

Financial Measures

5511.01 Financial measures (or financial ratios) are used as tools to identify the performance of an organization. The following are examples of financial measures:

a. Earnings per share

b. Price/earnings ratio

c. Cash asset ratio

d. Return on assets

e. Capital asset ratio

f. Current ratio

g. Quick ratio

h. Return on investment

i. Return on equity

j. Free cash flow

5511.02 Financial ratios help management evaluate the overall financial condition of an organization.

5511.03 Investors use financial measures and ratios to compare the strengths and weaknesses of organizations relative to other firms.

Nonfinancial Measures

5511.04 A variety of nonfinancial measures—from the accounting system or from other data sources—can be used to evaluate performance. Examples of nonfinancial measures include:

a. inventory turnover,

b. labor efficiency,

c. on‐time deliveries,

d. schedule attainment,

e. units per hour,

f. throughput time,

g. measures of customer satisfaction (e.g., from such indicators as surveys, repairs, complaints, or number of service calls), and

h. measures of environmental compliance.



5512 Performance and Risk Measures

5512.01 Comprehensive picture: Multiple performance measures provide a more comprehensive picture of performance that considers a wider range of possibilities. When both the short‐ and long‐term implications of a decision are examined, the total performance potential of a division or management level is better understood.

5512.02 Congruent decision making: At the division level, when one performance measure (such as return on investment) is not relied upon solely or given a high emphasis, managers are free to make decisions that are more in tune with the long‐term profitability growth objectives of the company as a whole.

5512.03 Return on investment (ROI) focuses on optimal use of invested capital. Net income from the income statement is divided by invested capital from the balance sheet as follows:

ROI = Net income Invested capital

a. Return on investment can be divided into two elements:

Profit margin = Net income

Sales

Capital employed turnover rate = Sales Invested capital

b. ROI = Profit margin × Capital employed turnover rate

5512.04 Residual income is the amount of net income in excess of a minimum desired rate of return on invested capital. The minimum desired net income is first computed by multiplying the desired rate of return by invested capital. This amount is then subtracted from reported net income. A positive residual income is viewed favorably because it indicates earnings in excess of the required minimum.

Example:

Net income $150 Return on investment at minimum rate of return ($1,000 at 0.12) 120 Residual income $ 30

5512.05 Economic value added (EVA) measures surplus or excess value created by an enterprise’s investments. EVA is calculated as return on capital minus cost of capital multiplied by invested capital. It is similar to net present value and, specifically, to residual income. Shortcomings of EVA include the focus on past rather than future performance, and its complexity restricts its use to larger businesses. EVA can be depicted in an equation as

follows: EVA = (Return on capital – Cost of capital) Capital investment in project.

TQC, TQM, and JIT

5512.06 By integrating total quality control (TQC), total quality management (TQM), and just‐in‐time (JIT), several benefits are achieved: (a) fewer defective units are produced before the problem is identified, (b) the process causing the problem can be fixed before more bad units are produced, (c) immediate attention gives rise to easier problem identification and solution, and (d) higher‐quality products improve customer satisfaction.



TQC and JIT are often combined so that the production process is stopped whenever something goes wrong. Because production schedules are so tightly synchronized, all employees must be involved to identify when a quality control problem occurs. Production is halted until the problem is identified and corrected.

a. Total quality control (TQC) involves all employees in the quality control effort. It is the unending quest for perfect quality—the striving for a defect‐free manufacturing process. Emphasis shifts from an acceptable level of quality to total quality control with zero defects as the objective.

b. Just‐in‐time (JIT) is a manufacturing philosophy that promotes the simplest, most efficient means of production. Under ideal conditions, the company would receive raw materials just in time to go into production, manufacture parts just in time to be assembled into products, and complete products just in time to be shipped to customers. JIT shifts the production philosophy from a push approach to a pull approach.

c. Total quality management (TQM) is the application of quality principles to all of the organization’s endeavors to satisfy customers. It is a method of managing the organization to excel on all dimensions. The customer defines quality. Therefore, product quality performance measures are likely to include product reliability and service delivery in addition to product cost.

Cost of Quality

5512.07 Every effort should be made to produce a quality product and to produce it right the first time. Cost of quality (COQ) is an area of cost analysis that measures and monitors quality costs in four areas:

1. Prevention: Costs of preventing bad quality (such as worker training and quality circles)

2. Appraisal: Costs of monitoring the level of bad quality (such as product testing and scrap reporting systems)

3. Internal failure: Costs of fixing bad quality (such as rework labor)

4. External failure: Costs of bad quality that are not discovered before shipment (such as warranty claims or customer ill‐will)

The objective is to minimize the total cost of quality. Total cost of quality is the sum of prevention and appraisal costs, which increase with quality level, and internal and external failure costs, which decrease with quality level. This is illustrated as follows:



Continuous Improvement

5512.08 Continuous improvement (sometimes called target‐based costing) is a concept that seeks to reduce costs while maintaining quality. Cost control using traditional engineering standards maintains the status quo. Continuous improvement seeks to reduce costs that frequently disturb the established order. One way to achieve this is by using market‐driven standards rather than engineering‐driven standards. Engineering‐driven standards are based on existing technology. The engineering‐driven standard plus a desired markup equals the desired market price. Market‐driven standards work in reverse order. A competitive market price that yields the desired market share less the desired markup equals allowable cost. The allowable cost becomes the target standard. Continuous improvement is sought until the target standard is achieved. This changes the focus from optimizing within existing technology to modifying technology until the desired standard is achieved. Thus, actual cost from a prior period becomes a starting point for further tightening.

Life Cycle Costing

5512.09 Life cycle costing generally refers to the summation of a purchaser’s costs from the point of initial purchase to the point of ultimate disposition of the product by the purchaser several years in the future. This concept deals explicitly with the relationship between what the customer pays for a product and the total cost the customer incurs over the product’s entire life. This type of information can be very valuable in the following areas:

a. Better product design to reduce post‐purchase costs to the customer

b. Improved market segmentation and product positioning

Balanced Scorecard

5512.10 The balanced scorecard is a strategic planning and management tool, used extensively in business and industry, government, and nonprofit organizations to align business activities with the vision and strategy of the organization, improve internal and external communications, and monitor organizational performance against strategic goals.

http://strategymanage.com/strategic-planning-basics/



5512.11 The balanced scorecard views an organization from four perspectives; metrics are developed and data is collected and analyzed for each of the following four perspectives:

1. Learning and growth: This perspective forms the foundation of all knowledge‐worker organizations and includes employee training and corporate cultural attitudes related to individual and corporate self‐improvement. Metrics can be used to guide managers in focusing training funds where they can be the most effective.

2. Business (internal) processes: Metrics based on this perspective provide managers with feedback regarding how well their business is operating, and whether its products and services meet customer requirements (the mission).

3. Customer (satisfaction) perspective: If customers are not satisfied, they will eventually find another supplier(s) that will meet their needs. Poor performance from this perspective can be a leading indicator of future troubles, even though the current financial picture may seem strong. In developing metrics for this perspective, customers are analyzed in terms of “kinds of customers” and “kinds of processes” for which the entity provides a product or service to those customer groups.

4. Financial: Even under a scorecard system, there remains a need for traditional financial data, provided that any undue emphasis on financial‐related data does not “unbalance" the other perspectives.

Benchmarking

5512.12 Benchmarking is a measurement of quality which entails comparing an entity’s policies, products, programs, strategies, etc. with standards or peers, usually those considered best‐in‐class. These performers may be internal or external, and they are not limited to the benchmarking entity’s industry or area.

5512.13 The objectives of benchmarking are to analyze how other organizations achieve their high performance levels, determine what improvements are needed for the given entity, and implement this information to improve performance.

Incentive Compensation

5512.14 Incentive compensation programs should promote and maintain an inspired and productive work environment. An incentive compensation program should be flexible and be developed alongside the organization’s changing needs.

a. Incentive compensation should only reward employees for a job well done. If an employee gets a bonus for simply being at work, he or she might feel entitled to the compensation. The compensation should be used as a motivational tool.

b. An incentive program that is organized with the organization in mind will help steer employees to the organization’s goals as well. These programs should be incentives to push employees to the organization’s objectives.

c. Many employees are fearful of change and do not adapt to change very easily. An incentive program should be designed to provide incentive for employees to become more interested in changes and to offer further suggestions for change.



d. The program should take into consideration the impact of the employee on the organization. For example, a controller may be rewarded on average aged accounts receivable, while a salesman might be awarded on sales.

5520 Cost Accounting

5521 Cost Measurement Concepts, Methods, and Techniques

Cost Allocation

5521.01 Cost allocation is the process of assigning indirect costs (also called overhead, common costs, or joint costs) to cost objects. The focus in financial accounting is primarily on the allocation of factory overhead to inventories and cost of goods sold. However, indirect costs may also be allocated to help management plan and control operations. It is a controversial topic because, by its very nature, allocation is an arbitrary process.

5521.02 Cost allocation terms

a. Cost pool: Because indirect costs cannot be traced to the cost object, it is efficient to accumulate indirect costs in one or more cost pools. The dollars in the cost pool are then allocated to cost objects.

b. Allocation base vs. cost driver: The allocation base is an activity measure used to allocate cost pool dollars to cost objects. Any logical allocation base may be used; however, the allocation base should ideally have a cause‐and‐effect relationship to the variability of costs in the cost pool. In other words, the ideal allocation base is a cost driver, which is an activity that causes costs to increase.

5521.03 Traditional overhead cost allocation systems

a. Traditional overhead cost pools: Traditionally, production overhead costs have been accumulated in either one single cost pool or in two cost pools for fixed and variable overhead.

b. Plant‐wide vs. departmental overhead cost pools: In a traditional system, organizations may accumulate overhead costs on a plant‐wide or departmental basis. The choice depends on (a) whether production is divided into activities performed in separate departments, (b) whether different managers are responsible for controlling overhead costs in different departments, and (c) whether allocation bases are likely to vary across departments. Departmental cost pools are generally preferred to plant‐wide pools when there are several departments involved in the manufacturing process and the activities in each department are different. Furthermore, it may be desirable to break overhead cost pools down even further based on underlying drivers of activities within departments.

c. Problems with traditional allocation systems: Traditional allocation systems are plagued by three major problems:

(1) Small number of cost pools: Traditional systems use a very small number of indirect cost pools, limiting the ability of managers to analyze cost behavior, adequately control costs, and identify relevant information for decisions. In addition, manufacturing processes have become less labor‐intensive over time, with overhead costs becoming increasingly important.



(2) Traditional allocation bases: Commonly used allocation bases in a traditional product costing system include labor hours, labor dollars, materials dollars, and machine hours. Traditional allocation bases are reasonable if they are likely to have a cause‐and‐effect relationship with overhead costs. For example, labor hours or labor dollars may be reasonable for a labor‐intensive production system. Similarly, machine hours may be reasonable for a machine‐intensive production system.

However, these allocation bases are inappropriate in many settings. In an automated manufacturing environment, direct labor is a smaller and overhead a larger part of production costs. In such an environment, the allocation of overhead based on direct labor can produce significant distortions in product costs. A relatively small increase in labor input to a product can cause an enormous increase in the amount of overhead allocated to that product; products which are more labor intensive than others receive a larger burden of overhead allocation. In these situations, labor‐intensive products subsidize other products by carrying more than their proper share of overhead, leading to inappropriate decisions such as which products to emphasize.

(3) Focus on manufacturing alone: Nonmanufacturing activities such as customer support, delivery processes, and information technology have become highly important for many businesses. These activities can be quite costly, and managers want to ensure that they are managed efficiently. In addition, managers want accounting systems to provide them with useful information, such as the relative profitability of different customers. Traditional allocation systems do not address these types of management information needs.

Variable vs. Absorption Costing

5521.04 Variable costing is sometimes called direct or marginal costing. Absorption costing is sometimes referred to as full product costing. The difference between variable and absorption costing is the way fixed overhead costs are handled. Under variable costing, they are charged to expense as a period cost in the period incurred. No fixed overhead costs are allocated to the units produced. Absorption costing treats fixed costs as a product cost and allocates them to the units produced. Fixed costs follow the units through work‐in‐process and finished goods inventory, and are expensed through cost of goods sold when the units are sold.

5521.05 The following summarizes the major arguments in favor of each method.

a. Variable costing:

(1) Variable costing is felt to be more useful for management decision making because it separates fixed costs that do not change with volume. The impact of management decisions that change volume is more evident.

(2) Fixed factory overhead is more closely related to the capacity to produce than to the production of specific units. Since fixed costs would be incurred regardless of production, and since they relate to the capacity to produce for a period of time, they should be reported as a period cost.

b. Absorption costing:

(1) Fixed factory overhead is a necessary cost of production and units produced should bear all such costs. It is consistent with the concept that the cost of an asset should include all necessary costs to get it into proper form, location, and working condition.



(2) Absorption costing is required by both generally accepted accounting principles and the Internal Revenue Service (IRS).

5521.06 Over the long run, the difference between variable costing profit and absorption costing profit will be zero. The difference is not in the amount of expense but in the timing of expense. In the short run, profit will be different when production and sales are not the same. Some fixed overhead will be inventoried or taken from inventory under absorption costing, which would not be done under variable costing.

5521.07 Fixed overhead must be accounted for differently when computing product costs, cost of goods sold, or net income under the two methods. Fixed overhead is a product cost for absorption costing and a period cost for variable costing.

5521.08 Illustration: Variable and absorption costing (adapted from the AICPA).

Problem: JV Company began its operations on January 1, 20X1, and produces a single product that sells for $7.00 per unit. Standard capacity is 100,000 units per year, and 100,000 units were produced and 80,000 units were sold in 20X1.

Manufacturing costs and selling and administrative expenses were as follows:

Fixed Costs Variable Costs

Raw materials — $1.50 per unit produced Direct labor — 1.00 per unit produced Factory overhead $150,000 0.50 per unit produced Selling and administrative 80,000 0.50 per unit sold

There were no variances from the standard variable costs. Any over‐ or underapplied overhead is written off directly at year‐end as an adjustment to cost of goods sold.

Required:

a. Compute the unit cost under absorption costing for presenting inventory on the balance sheet at December 31, 20X1.

b. Compute the net income for 20X1 under variable costing.

Solution:

Part a. Absorption costing values units in ending inventory at full cost of production, including fixed factory overhead.

Production cost/unit: Raw materials $ 1.50 Direct labor 1.00 Overhead: Variable 0.50 Fixed 1.50a Total $ 4.50 a Cost per unit at standard capacity ($150,000 100,000 units)



Part b. Variable costing charges fixed factory overhead to expense as incurred. Income is computed as follows:

Sales (80,000 $7.00) $560,000

Less variable costs:

Raw materials (80,000 $1.50) $120,000

Direct labor (80,000 $1.00) 80,000

Overhead (80,000 $0.50) 40,000

Selling (80,000 $0.50) 40,000 280,000

Contribution margin $280,000 Less fixed costs: Overhead $150,000 Selling 80,000 230,000 Net income $ 50,000

Management Accounting Overview

5521.09 Management accounting is the process of measuring and using information for the following purposes:

a. Management planning, decision making, and control

b. Reporting assets and cost of goods sold for financial statements and income taxes

c. Reporting of costs under cost‐based contracts

Because management accounting information is used for many purposes, the accounting systems need to be sufficiently flexible to allow measuring and combining costs in different ways.

5521.10 Assignment of costs to cost objects: Cost assignment is the process of tracing direct costs and allocating indirect/common costs to cost objects. A cost object (or cost objective) is an item or activity for which a separate and discrete measurement of costs is desired, such as a product, function, department, division, contract, or service.

5521.11 Costs for external reporting is the financial accounting purpose of reporting the value of inventory so that the cost of goods sold and income can be determined. Costs are classified based on their attachability to inventory.

a. Matching principle: Information for external reporting is classified based on attachability to inventory and follows GAAP. The basic theory is the matching principle: “Let the expense follow the revenue.” The three methods of recognition are as follows:

(1) Associating cause and effect: Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and costs of products sold or services provided.

(2) Systematic and rational allocation: In the absence of a direct means of associating cause and effect, some costs are associated with specific accounting periods as expenses on the basis of an attempt to allocate costs in a systematic and rational manner among the periods in which benefits are provided. Examples of items that are recognized in a systematic and rational manner are depreciation of fixed assets, amortization of intangible assets, and allocation of rent and insurance.

(3) Immediate recognition: Some costs are associated with the current accounting period as expenses because:



(a) costs incurred during the period provide no discernible future benefits.

(b) costs recorded as assets in prior periods no longer provide discernible benefits.

(c) allocating costs either on the basis of association with revenue or among accounting periods is considered to serve no useful purpose. Examples include officers’ salaries, most selling costs, amounts paid to settle lawsuits, and cost of resources used in unsuccessful efforts.

b. Product costs: Direct costs can be attached to inventory based on associating cause and effect. Indirect costs are attached by systematic and rational allocation.

c. Period costs: These costs are not attached to inventory, but are recognized immediately.

Manufacturing Product Costs

5521.12 Manufacturing product costs are classified into the following categories:

a. Direct materials: Raw material costs that can be reasonably traced to a product on a per‐unit basis.

b. Direct labor: Wages relating to employees who work directly on the product (i.e., hands‐on) that can be reasonably traced to a product on a per‐unit basis.

c. Indirect materials: These are costs incurred in the manufacturing process, but either they do not become part of the product (e.g., a machine lubricant) or they are not reasonably traceable to the product (e.g., paint, varnish, glue). Such costs become part of factory overhead and are attached to the product through an allocation process.

d. Indirect labor: This incorporates factory labor costs for personnel who do not work directly on the product and whose costs cannot be reasonably traced on a per‐unit basis. This category includes salaries of peripheral production employees, notably production supervisors/managers, factory janitors, and factory security personnel. Like indirect materials, these costs become part of factory overhead and are attached to the product through an allocation process.

e. Factory overhead: This is also called manufacturing overhead, factory burden, or simply overhead. It includes all costs except direct labor and direct materials that are part of making the product, but which are not directly traced to a specific product. Costs are accumulated in factory overhead accounts. They may either vary with production (variable costs) or not (fixed costs). The costs are traditionally allocated to each unit produced on some basis such as $ per direct labor hour, per direct labor cost, or per machine hour.

f. Prime costs: Direct materials and direct labor together are called prime costs.

g. Conversion costs: All factory costs other than direct materials are called conversion costs; they are required to convert materials into a finished product. Conversion costs include direct labor and factory overhead.

5521.13 Manufacturing inventories: Traditional manufacturing environment

a. Raw materials: This inventory includes anything tangible that becomes part of the product or its packaging. Raw materials are held in inventory until requisitioned by the production department. In the just‐in‐time (JIT) production system, raw materials are not stored in inventory, because they are not delivered to the factory until they are needed in production.



Beginning raw materials inventory+ Purchases– Ending raw materials inventory = Raw materials used

b. Work‐in‐process: Once production is begun, manufacturing costs are accumulated in the work‐in‐process (WIP) account until the product is finished and transferred to the finished goods inventory.

Beginning WIP+ Raw materials used (from a.)+ Direct labor+ Overhead applied– Ending WIP = Cost of goods manufactured

c. Finished goods: These items are ready to be sold.

Beginning finished goods+ Cost of goods manufactured (from b.)– Ending finished goods = Cost of goods sold

5521.14 Sequence of manufacturing cost flows

Costs are accumulated and flow with the physical inventory from one inventory account to the next, as shown in the following T‐accounts illustration:

Inventory Cost Flows in Traditional Manufacturing Environment

Raw Materials

Purchase of Raw Materials

Materials Issued

Salaries & Wages Payable Work in Process Finished Goods Cost of Goods Sold

Labor Costs Incurred

Manufacturing Overhead

Factory Overhead Incurred

Overhead Applied



5521.15 Schedule of cost of goods manufactured: This schedule summarizes the costs assigned to the manufacturing process during the period. A condensed example follows:

Schedule of Cost of Goods Manufactured

Beginning direct materials inventory $ 10+ Purchases of direct materials 80– Ending direct materials inventory (30)

Raw materials used 60+ Direct labor 70+ Overhead (supplies, utilities, indirect labor, etc.) 40 Total manufacturing costs for the period 170+ Beginning WIP inventory 50 Total manufacturing costs 220– Ending WIP inventory (140)

Cost of goods manufactured $ 80

Assigning Costs to Inventory

5521.16 A determination of unit cost is needed for product pricing, cost control, GAAP reporting (inventory valuation, cost of goods sold), and income tax reporting. There are several methods of attaching production costs to each unit produced. Within each method, inputs can be valued using actual, normal, or standard costs.

The choice of method is influenced by the production process. Production processes range from making products individually or in identifiable batches, to making a continuous stream of indistinguishable goods. Therefore, job costing can be viewed as existing at one end and process costing at the other end of a cost‐tracking continuum. There are hybrid methods in between that have been known by various names, such as operation costing.

5521.17 Job costing, also called job order costing, is a tracking system used for customized products or services.

a. Job cost records (or sheets): Costs are accumulated by the job, or job lot, and are recorded on job cost records as work progresses. Entries are made into the WIP ledger account for manufacturing inputs from the job cost records. The job cost records make up a subsidiary ledger that supports the control account Work in Process.

b. Direct materials: Most raw materials will be traceable to the units produced through the requisition forms used to issue materials from the raw materials inventory storeroom to the production department. Indirect materials are charged to manufacturing overhead and are attached to the product through the allocation process.

c. Direct labor: This cost is recorded by the employee on a detailed time record listing the job number, operation performed, hours used, etc. Indirect labor is charged to manufacturing overhead and attached to the product through the allocation process.

d. Overhead: This is applied to jobs using the predetermined rate applied on the selected allocation base or cost driver. If this is a normal costing system, actual driver units experienced are used as the input quantity. If a standard costing system, the number of driver units that should have been used to complete the related activity is used.

e. Job completion and sale of goods: As jobs are completed and moved to the Finished Goods warehouse, entries are made to transfer the completed cost from WIP to Finished Goods and the job cost records become a subsidiary ledger for the Finished



Goods account. Ultimately, as sales occur, the job cost records become supporting documents for Cost of Goods Sold.

5521.18 Process costing is used for products whose individual units are indistinguishable from other units (e.g., sugar, corn flakes, textiles, paint). Such products are continuously produced through a series of uniform production steps called processes. Costs are accumulated by process, then applied to the units processed using an average cost for input units. There is a separate Work‐in‐Process account for each department or process through which the units flow. At the end of each period, costs are allocated between the units completed and transferred to the next department and the unfinished units remaining in ending inventory based on equivalent finished units.

5521.19 Computation of unit costs and assigning costs to inventories: To compute costs relating to completed units transferred out of the department and costs of unfinished units that remain in ending inventory, both physical units and total costs must be accounted for in a five‐step process. This process comprises a process costing report. The steps are listed below. Note that Steps 2 and 3 are interchangeable.

Step 1: Account for all physical units.

Step 2: Compute the equivalent finished units (EFU or EU) for each element of manufacturing cost that is incurred at a separate rate. Usually two computations are needed: one for materials units and one for conversion units.

Step 3: Determine the total dollars to be accounted for.

Step 4: Compute the per‐unit cost for each separately identified manufacturing element. This will usually be materials and conversion.

Step 5: Use the per‐unit cost to assign the dollars to the units transferred out and to the units remaining in the ending inventory. The sum of the dollars transferred out to the next department or to finished goods and the dollars remaining in ending WIP must be equal to the total dollars identified in Step 3.

5521.20 Equivalent finished units (EFU)

a. Work done: There are three categories of physical units being worked on during a period:

(1) Units in beginning inventory that need to be completed

(2) Units received into the department during the month that are started and completed during the month

(3) Units started but not finished (ending inventory units)

Obviously, the same amount of work is not applied to these three different categories during the period.

b. Physical units divisor: When dividing costs by a physical units denominator to arrive at a cost per unit, the denominator must be one which has “evened out” the inequality of work done as described above. The denominator used is the equivalent finished units. This is the number of units that would have been completed during the period if all work performed had been done only on units that were both started and finished during the period.

c. Equivalent units computation methods: There are two different methods used for computing the equivalent finished units:



(1) Weighted average: In this method, no attempt is made to separate the work done to complete the beginning inventory units and costs from the work performed on units started and finished. It is as though the beginning inventory data were “pulled into” the current period and a simplifying assumption is made that all units completed during the current period were started during the current period. Thus, all the costs incurred, including the beginning inventory costs, are averaged over all the equivalent units. This method is appropriate when costs and production remain relatively stable from period to period. It is not appropriate in a standard costing system.

All costs All E. units

OR Beginning inventory costs + Started costs All units completed + (EI × Completion %)

(2) First in, first out (FIFO): In this method, the beginning inventory units and costs are kept separate from the current period units and costs. The units transferred out are made up of two “layers”—the beginning inventory units finished up during the period plus units started and finished. The ending inventory is valued using the most recent costs. This method is preferred when costs fluctuate from period to period and is required if a standard cost system is in use.

Current‐period costs Current‐period E. units

OR Total costs Beg. inventory costs Completed units + (EI × %) (BI × %)

Note that when there is no beginning inventory to finish up during the period, the equivalent units will be the same for the weighted‐average and FIFO methods.

5521.21 Materials costs: Materials are added to the manufacturing process at different points in time. For example, Material A could be added as processing begins in the department and Material B added at the 60% conversion phase. In CPA Examination problems, materials are generally added at either the beginning of the process or at the end; therefore, units will be either 0% or 100% complete as to materials costs.

5521.22 Conversion costs: It is assumed that conversion occurs uniformly during the process; therefore, the CPA Examination question fact pattern will indicate the percentage of completion as to these costs for both the beginning and ending inventories. Note that conversion includes both labor and overhead costs.

5521.23 Process costing report procedure

The five steps required to produce a process costing report:

Step 1: Account for all units.

+ Units in beginning inventory + Completed units transferred out + Units started during period = + Ending WIP units Total physical units to account for Total physical units accounted for

Step 2: Compute equivalent finished units (EFU).

a. Weighted‐average method: Materials Conversion Completed Units Transferred Out X X Add Ending Inventory: Materials ‐ % added during period X Conversion ‐ % added during period X Equivalent Finished Units, WA (EFU/WA) X X



b. FIFO method: Materials Conversion Completed Units Transferred Out X X Add Ending Inventory: Materials ‐ % added during period X Conversion ‐ % added during period X Less Beginning Inventory: Materials ‐ % completed at beginning of period (X) X Conversion ‐ % completed at beginning of period (X) Equivalent Finished Units, FIFO (EFU/FIFO) X X

Step 3: Determine total costs to account for:

Beginning costs $ Add period costs: Transferred in $ Direct materials $ Direct labor $ Overhead $ Total costs to account for $

Step 4: Compute per‐unit cost for materials and conversion. (Where EFU is the same for both materials and conversion, only one computation needs to be done.)

a. Weighted‐average method:

Total materials costs

EFU/WA Materials

Total conversion costs

EFU/WA Conversion

b. FIFO method:

Current‐period materials costs

EFU/FIFO Materials

Current‐period conversion costs

EFU/FIFO Conversion

Step 5: Total costs accounted for:

Transferred‐out costs + Ending WIP costs Total costs accounted for (must equal total costs to account for in Step 3)

5521.24 Process costing report example: Levittown Company employs a process cost system for its manufacturing operations. All direct materials are added at the beginning of the process and conversion costs are added uniformly. Levittown’s production quantity schedule and costs for November are reproduced below for the first stage of processing:

Beginning WIP (60% complete as to conversion costs) 1,000 Units started during period 5,000 Ending WIP (20% complete as to conversion costs) 2,000

Materials Conversion Total Beginning inventory costs $2,000 $ 6,000 $ 8,000 Current‐period costs 5,500 38,000 43,500 $7,500 $44,000 $51,500

A process cost report for Levittown Company for this process stage would require the following steps.



5521.25 Process costing report example: Weighted‐average method

Step 1: Determine physical units to account for.

Units in beginning inventory 1,000 Completed units transferred out 4,000 + Units started during period 5,000 + Ending inventory units 2,000 Physical units 6,000 6,000

Step 2: Compute equivalent finished units.

Materials Conversion Completed units transferred out 4,000 4,000 + Ending inventory, Materials (2,000 × 100%) 2,000 Conversion (2,000 × 20%) 400 EFU (Weighted Average) 6,000 4,400

Step 3: Determine total costs to be accounted for.

Materials Conversion Total Beginning inventory costs $2,000 $ 6,000 $ 8,000 Period costs 5,500 38,000 43,500 Total costs to account for $7,500 $44,000 $51,500

Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use total costs.)

Materials $7,500 ÷ 6,000 units = $ 1.25 per unit Conversion $44,000 ÷ 4,400 units = 10.00 per unit Total unit cost (weighted average) $11.25

Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in ending inventory.

Units Transferred Out: (4,000 × $11.25) $45,000 Ending WIP Inventory Materials (2,000 × $1.25) $2,500 Conversion (2,000 × 20% × $10.00) 4,000 Total Costs in Ending WIP 6,500 Total Costs Accounted For $51,500

5521.26 Process costing report example: FIFO method

Step 1: Determine physical units to be accounted for. (Note that this is the same under both weighted‐average and FIFO methods.)

Units in beginning inventory 1,000 Completed units transferred out 4,000 + Units started during period 5,000 + Ending inventory units 2,000 Physical units 6,000 6,000

Step 2: Compute equivalent finished units.

Materials Conversion Completed Units Transferred Out 4,000 4,000 + Ending Inventory, Materials (2,000 × 100%) 2,000 Conversion (2,000 × 20%) 400 Less Beginning Inventory, Materials (100%) (1,000) 400 Conversion (60%) (600) EFU (FIFO) 5,000 3,800



Step 3: Determine total costs to be accounted for. (Note that this also is the same under both weighted‐average and FIFO methods.)

Materials Conversion Total Beginning inventory costs $2,000 $ 6,000 $ 8,000 Period costs 5,500 38,000 43,500 Total costs to account for $7,500 $44,000 $51,500

Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use current‐period costs.)

Materials $5,500 ÷ 5,000 units = $ 1.10 per unit Conversion $38,000 ÷ 3,800 units = 10.00 per unit Total unit cost (FIFO) $11.10

Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in ending inventory.

Units Transferred Out: 1. From Beginning Inventory Beginning Costs $ 8,000 Costs to Complete Beginning Inventory Materials added during period ‐0‐ Conversion added to complete during period (1,000 units × 40%* added × $10.00) 4,000 2. Started and Completed (3,000 × $11.10) 33,300 Total Costs Transferred Out (4,000 units) $45,300 Ending WIP Materials (2,000 × $1.10) $ 2,200 Conversion (2,000 × 20% × $10.00) 4,000 Total Costs of 2,000 units in WIP 6,200 Total Costs Accounted For $51,500

* Beginning inventory was 60% complete as of the beginning of the month and all materials had been added in the previous period at the beginning of the process. Therefore, 40% conversion costs were added during the period and no additional materials costs were incurred for these units.

Spoilage, Scrap, and Rework Costs

5521.27 Spoilage consists of units that are lost, broken, or otherwise defective and cannot be sold with regular good units.

a. Normal spoilage: A certain amount of spoilage is expected as part of the manufacturing process. The amount expected spoilage is often expressed as a percent relative to the good units produced. It is considered to be a cost of producing the good units and is classified as a product cost.

b. Abnormal spoilage: This is spoilage in excess of the expected level. It is treated as a period cost. Cost relating to abnormal spoilage units is transferred out of the work‐in‐process (WIP) account into a loss account.

c. Treatment in EFU calculation: Abnormal spoilage units are generally always included in the computation of equivalent units, because their cost must be calculated and recorded as a separate loss. However, the inclusion of normal spoiled units depends on whether a company wishes to separately identify and report the extent to which normal spoilage costs impact the cost of good units. There are, therefore, two treatments for normal spoilage:



(1) Include the units and add their cost to only the cost of good units passing the inspection point (separate identification of costs), or

(2) Exclude the units, thereby increasing the manufacturing cost per equivalent unit, and spreading normal spoilage cost over not only good units completed, but also over abnormal spoilage units and equivalent units in ending inventory (hidden cost method).

5521.28 Separately reported normal spoilage costs: Spoiled units are identified at an inspection point. The inspection point usually occurs upon completion of departmental processing. Therefore, normal spoilage costs should be identified and added to the costs of good units completed. No normal spoilage costs should be attached to the incomplete units in ending inventory. To accomplish this, all spoilage units are included in the equivalent unit computation to arrive at a manufacturing cost per equivalent unit. The cost of normal spoilage is added to the cost of good units produced. The cost of abnormal spoilage is removed from work in process and is charged as an expense of the period.

5521.29 Example of separately reported normal spoilage costs:

For cost control purposes, Hamilton Company requires separate identification of all spoilage costs. Normal spoilage costs are added to the cost of good units produced up to the point of inspection. The cost of abnormal spoilage is written off as a period loss. Inspection occurs upon completion of departmental processing, before units are transferred to the next department. The extracting department processed 14,000 units during the month of January. Of these, 10,000 were completed and 4,000 units remained 60% converted in the ending inventory on January 31. Of the 10,000 units completed, 1,000 were spoiled. Spoilage of 10% of good units is considered normal. No materials are added in the department. Conversion costs to account for are $59,520. The weighted‐average method is used for EFU computation.

Identify (1) the loss due to abnormal spoilage and (2) the cost of good units transferred out, including that portion of cost attributable to normal spoilage.

1. Identify normal and abnormal spoilage.

Total units completed 10,000 Less total spoilage 1,000 Good units completed 9,000

Total spoilage 1,000 Less normal spoilage (9,000 good × 10%) 900 Abnormal spoilage 100

2. Compute the equivalent units of production using the weighted‐average method (only conversion element involved).

Good units completed 9,000 Abnormal spoilage units 100 Normal spoilage units 900 Ending inventory (4,000 × 60% converted) 2,400 Equivalent finished units 12,400

3. Compute unit conversion cost.

$59,520 12,400 equivalent units = $4.80 per equivalent unit



4. Assign costs to abnormal spoilage and inventories.

Abnormal spoilage, 100 units at $4.80 (to loss account) $ 480 Good units transferred out: Good units, 9,000 at $4.80 $43,200 Normal spoilage units, 900 at $4.80 4,320 Total cost of good units transferred out 47,520 Ending inventory, 2,400 equivalent units at $4.80 11,520 Total product costs 59,040 Total costs accounted for $59,520

Note: (1) The normal spoilage costs are separately identified so that (2) the impact of those costs is seen on the unit cost of good units transferred out ($47,520 total costs ÷ 9,000 good units transferred = $5.28, as opposed to $4.80/unit overall manufacturing cost), and (3) no normal spoilage cost is included in ending inventory. Any spoilage in those 4,000 units will be identified upon their completion and allocated to those units at that time.

5521.30 Hidden normal spoilage costs: (Use this method when no information is given about spoilage inspection point or when not told to attach cost to only good units produced.)

Some companies choose not to separately identify normal spoilage costs. This is appropriate when such costs are relatively small. In this procedure, abnormal spoilage is included in the equivalent unit computation, but normal spoilage is excluded. Thus, the per‐unit manufacturing cost is proportionately higher. The normal spoilage cost is absorbed into the cost of all remaining equivalent units (including abnormal spoilage and ending inventory).

5521.31 Example of hidden normal spoilage costs: Assume the same facts for Hamilton Company as described previously, but that normal spoilage costs are not separately identified.

1. Computation of spoilage units would be the same as with separately reported normal spoilage costs.

Total units completed 10,000 Less total spoilage 1,000 Good units completed 9,000

Total spoilage 1,000 Less normal spoilage (9,000 good × 10%) 900 Abnormal spoilage 100

2. Compute equivalent units.

Good units completed 9,000 Abnormal spoilage units 100 Ending inventory (4,000 × 60%) 2,400 Equivalent finished units 11,500

3. Compute unit conversion cost.

$59,520 11,500 equivalent units = $5.18 (rounded)

4. Assign costs to abnormal spoilage and inventories.

Abnormal spoilage, 100 units at $5.18 (to loss account) $ 518 Good units transferred out, 9,000 at $5.18 46,620 Ending inventory, 2,400 equivalent units at $5.18 12,432 Total product costs 59,052 Total costs accounted for ($50 difference due to rounding) $59,520



Note: (1) The normal spoilage costs are not separately identified; rather, (2) they are hidden in the unit manufacturing cost of $5.18, and (3) both the abnormal spoilage units and ending inventory include some normal spoilage costs. For this reason, some authorities believe this method is not theoretically correct and do not advocate its use.

5521.32 Spoilage in job costing: The net cost (cost less any disposal value) related to normal spoilage that is not attributable to a particular job is charged to factory overhead. It is thus allocated to all jobs worked on through the normal overhead application procedure. The net cost of spoilage attributable to the characteristics of a particular job or job lot is charged to that particular job. The cost of abnormal spoilage not attributable to a particular job is treated as a period cost and charged to a special loss account.

5521.33 Scrap: Normally, no cost is assigned to scrap. Its disposal value is most commonly credited to factory overhead. Where feasible, it may be used to reduce the cost of a particular job or type of job.

5521.34 Rework costs: Costs of reworking defective units are generally charged to factory overhead and are spread among all units produced through the overhead application process. Special circumstances may cause such costs to be charged to a particular job.

Costing Methods

5521.35 Costing methods: Inputs into the production process can be accounted for by three different costing methods: actual, normal, and standard costing.

Input Actual Costing Normal Costing Standard Costing

Direct Materials Actual Actual Standard Input at Budgeted Rate

Direct Labor Actual Actual Standard Input at Budgeted Rate

Factory Overhead Actual Actual Input at Budgeted Rate

Standard Input at Budgeted Rate

5521.36 Actual costing: The inputs to production are valued at their actual cost, the actual number of dollars paid for direct materials, direct labor, and overhead. All factory overhead costs incurred (debit to Factory Overhead Control) would be applied to Work‐in‐Process (credit Factory Overhead Control). The problem is that the total actual costs of overhead are not known until the end of the period. It may not be practical to wait until the end of the year to cost products, particularly if cost is a factor in setting prices. If monthly overhead costs are used, unit costs could vary widely.

5521.37 Normal costing: The inputs of direct materials and direct labor are valued at their actual cost, but overhead is applied on a budgeted or “normalized” basis. Estimated overhead costs are divided by estimated production for the year to determine an application rate. If overhead is applied on a direct labor hour basis, then the overhead rate would be applied to actual direct labor hours.

5521.38 Standard costing: In a standard costing system, standard costs are developed for all inputs per unit of production. For example, if overhead is applied on direct labor hours, it would be applied according to the number of hours that should have been used to make that unit, not the actual number of direct labor hours used. Standard costs are designed to control the two components of the cost of producing something: the price paid and the quantity used. Price and quantity standards are set for materials, labor, and overhead. Standard cost is a unit concept. It represents the budget to produce one unit. Standard costs are often used to



develop a master budget and flexible budget, and variances from standard costs are then analyzed.

a. Ideal standards: These are standards that can be attained only under perfect conditions. There is no allowance for machinery to break down, or to wait for materials, or for other delays that can be expected in a normal world. Ideal standards require at all times a level of effort and skill that would be expected from the very best employees at their peak performance. Ideal standards are generally not used in practice, because they discourage the efforts of ordinary employees who know they cannot make the standard, so “why bother?” Variances are often viewed as useless because part of the variance is “normal.” Expected differences from the standard obscure the actual variances that need to be investigated. However, advocates of TQM (total quality management) and continuous improvement are often in favor of the use of ideal standards because such standards can encourage greater efficiency over time.

b. Attainable standards: Practical standards are tight, but attainable. They can be achieved by normal workers working with reasonable, efficient effort, with a reasonable allowance for breakdowns, etc. Variances provide useful information because they represent abnormal conditions that need to be investigated. Attainable standards are also useful in the planning and budget process when calculating the production budget, etc.

Applying Overhead

5521.39 Applying overhead: In both normal and standard costing systems, a process must be developed for calculating and applying a budgeted overhead allocation rate.

5521.40 Overhead application/allocation rate: Overhead is allocated to cost objects (e.g., units or jobs) using an application rate (also called an allocation rate), which may be calculated in several different ways:

a. Actual overhead application rate: This rate is calculated by dividing the overhead costs by the actual volume of the allocation base. An actual rate is useful when the goal is to measure actual costs; however, actual data may not be available on a timely basis.

b. Budgeted (or predetermined) overhead application rate: This rate is calculated by dividing estimated (or budgeted) overhead cost by the estimated (or budgeted) volume of the allocation base. A standard overhead application rate is an example of a predetermined rate.

5521.41 Example of overhead application/allocation rate: XYZ Company is a highly automated machinery manufacturer. The company estimated its manufacturing overhead expenses as follows. All of these costs are classified as fixed.

Depreciation $100,000 Rent 50,000 Utilities 35,000 Supervision 10,000 $195,000 Expected Material Cost $390,000 Expected Machine Hours (normal capacity) 19,500

1. Calculate the overhead application rate using (a) material cost and (b) machine hours as the allocation base.



2. Calculate the overhead charged to Job A if 900 hours of machine time and $20,000 of materials were used, assuming that the allocation base is (a) material cost and (b) machine hours.

Solutions:

1. Calculation of application rate:

a. Overhead application rate based on material cost (overhead cost divided by material cost):

$195,000 $390,000

= $0.50 per dollar of material cost (or 50% of material cost)

b. Overhead rate based on machine hours (overhead cost divided by machine hours):

$195,000 19,500 hours

= $10 per machine hour

2. Allocation of overhead to Job A:

a. Assuming that overhead is based on material costs:

$20,000 × $0.50 = $10,000

b. Assuming that overhead is based on machine hours:

900 hours × $10 = $9,000

5521.42 Under/overapplied overhead: In a normal costing system, overhead is allocated using a predetermined application rate and actual volume of the allocation base. In a standard costing system, overhead is allocated using a standard overhead rate per unit of output. In these costing systems, there will always be some amount of underapplied or overapplied overhead caused by deviations from budgeted or standard amounts in either the numerator or the denominator of the application rate:

a. Inaccurate cost budget: Even if actual production is equal to the anticipated levels at which the application rate is set, actual costs are likely to differ from budgeted. This affects the numerator of the ratio, resulting in an inappropriate application rate.

b. Inaccurate allocation base budget: If actual volume of the allocation base (labor hours, materials dollars, etc.) is different than the budgeted volume, the denominator in the application rate is incorrect relative to actual activities. This difference can be caused by a difference between budgeted and actual production volumes or deviations from budgeted efficiency.

5521.43 Disposition of under/overapplied overhead: The amount of underapplied or overapplied overhead must be periodically closed.

a. Fixed overhead allocated based on normal capacity: In the past, any material over/underapplied overhead was prorated among work in process, finished goods, and cost of goods sold. Now, however, FASB ASC 330‐10‐30 requires fixed factory overhead to be allocated to inventory using normal capacity, or the typical volume of production. The new accounting standard prevents the overstatement of inventory values when production volumes fall below normal. Assuming that normal capacity is used to establish the predetermined overhead rate, any over/underapplied overhead caused by differences between actual and normal capacity should be recorded in cost of goods sold.



The new accounting standard is likely to increase the number of companies that account for fixed and variable overhead separately. In addition, more companies are likely to use normal capacity as the budgeted volume when establishing predetermined overhead rates.

b. Adjustment for fixed overhead: In general, over/underapplied fixed overhead should be assigned to cost of goods sold. However, any material amounts of over/underapplied fixed overhead caused by an inaccurate cost budget should be prorated among ending units in work in process, finished goods, and cost of goods sold.

c. Adjustment for variable overhead: By definition, variable overhead is expected to vary with the volume of production. This means that over/underapplied variable overhead is caused by error in the budgeting process. Accordingly, any material amounts of over/underapplied variable overhead should be prorated among ending units in work in process, finished goods, and cost of goods sold. If the over/underapplied amount is not material, it may be adjusted to cost of goods sold alone.

5521.44 Example of disposition of under/overapplied overhead: Assume that XYZ Company incurred $180,000 of manufacturing expenses and that actual machine hours were 17,000. Before any adjustment is made, the amounts of fixed overhead applied units in work‐in‐process, finished goods, and cost of goods sold are $17,000, $34,000, and $119,000, respectively.

1. Calculate the actual fixed overhead rate based on (a) actual machine hours and (b) normal capacity.

2. Calculate the amount of over/underapplied fixed overhead, then calculate the amount attributable to (a) inaccurate cost budget and (b) difference between actual and normal capacity.

3. What adjustments should be made if the fixed overhead spending variance is considered immaterial?

4. What adjustments should be made if the fixed overhead spending variance is considered material?

Solutions:

1a. Actual fixed overhead rate based on actual machine hours:

$180,000 17,000

= $10.59 per machine hour

1b. Actual fixed overhead rate based on normal capacity:

$180,000 19,500

= $9.2308 per machine hour

Note: The rate of $9.2308 should be used to assign fixed overhead to inventory.

2. Over/underapplied fixed overhead:

Actual fixed overhead $180,000 Fixed overhead applied (17,000 hours × $10 per hour) 170,000 $ 10,000

a. Amount attributable to inaccurate cost budget:

Actual volume × (Predetermined rate – Actual rate based on normal capacity) = 17,000 hours × ($10.00 ‐ $9.2308) = $13,077 Overapplied



b. Amount attributable to difference between actual and normal capacity:

Actual rate based on normal capacity × (Normal capacity – Actual volume) = $9.2308 × (19,500 – 17,000) = $23,077 Underapplied

Math check: $13,077 + $(23,077) = $(10,000) Underapplied overhead

3. If the $13,077 amount is considered material, then it should be prorated among WIP, finished goods, and COGS. However, the $23,077 amount should be assigned only to COGS.

Overhead in WIP account ending balance $ 17,000 10% of total Overhead in Finished Goods ending balance 34,000 20% of total Overhead in Cost of Goods Sold 119,000 70% of total Total – Actual Fixed Overhead $170,000 100%

Adjustment: Debit (Credit) Allocation of over/underapplied overhead: WIP Fin. Goods COGS Inaccurate cost budget: $13,077 overapplied × 10% $(1,308) $13,077 overapplied × 20% $(2,615) $13,077 overapplied × 70% $ (9,154) Diff. between actual and normal capacity: $23,077 underapplied 23,077 Total adjustment $(1,308) $(2,615) $13,923

Journal entry:

Cost of goods sold 13,923 Work in process 1,308 Finished goods 2,615 Overhead control 10,000

4. If the $13,077 amount is considered immaterial, then it may be netted against the $23,077 amount and assigned directly to COGS:

Journal entry:

Cost of goods sold ($23,077 – $13,077) 10,000 Overhead control 10,000

Activity‐Based Management

5521.45 Activity‐based management (ABM): Activity‐based management (ABM) is a generic term used to describe the use of activity‐based information to improve business performance.

5521.46 ABC/ABM cross: Activity‐based costing (ABC) can be viewed from two perspectives, each of which has activities as the central focus. The differing perspectives are depicted in the following ABC/ABM cross diagram:

Resources

Activities

Products

Performance Drivers



Viewed vertically, the ABC (activity‐based costing) cross depicts a cost accounting allocation tool. Products result from activities; those activities consume resources. Resource costs are allocated to cost objects on the basis of the relative amount of the particular activities consumed to produce the particular product.

Viewed horizontally, however, the cross shows a management process (activity‐based management). This process is a series of activities measurable by their related drivers. Examination of the relationship between these drivers and activities is useful to management for performance evaluation, planning and control, and decision making. Thus, implementation of activity‐based costing methods provides information that can lead to better management decisions, i.e., activity‐based management (ABM).

5521.47 Steps in ABM: No consensus exists about the exact steps in ABM (activity‐based management), but it typically involves first applying activity‐based costing (ABC). Activities, costs, and drivers are identified, and costs are assigned to activities. However, the focus of ABM is on the processes, not the costs. ABM uses cost information to understand, manage, and improve processes.

5521.48 Combination of improvement methods: ABM (activity‐based management) is used in conjunction with other improvement methods such as the following:

a. Just‐in‐time

b. Theory of constraints

c. Benchmarking

d. Business process reengineering

e. Target costing

f. Life cycle management

g. Value chain analysis

h. Total quality management

5521.49 Common ABM applications: The following are common uses for ABM (activity‐based management):

a. Customer profitability analysis

b. Strategic planning

c. Life cycle management

d. Performance measurement

e. Value analysis

f. Budgeting

g. Product costing

h. Measure and monitor capacity utilization

i. Analyze costs of quality



Activity‐Based Costing (ABC)

5521.50 Activity‐based costing (ABC) addresses several of the concerns about traditional overhead costing systems. Instead of using a small number of overhead cost pools and arbitrary allocation bases, overhead costs are accumulated in cost pools related to separately identified activities that are allocated based on cost drivers.

5521.51 Activities and cost hierarchy: Activities are the separately identifiable tasks required to produce a product or provide a service. They can be referred to as the work to be done. In an ABC system, activities are grouped into cost pools, which could be a machine, a group of machines, a department, or a function.

The following hierarchy of activity levels is useful in helping accountants and managers identify activities for their organization:

a. Unit level: These activities are done a certain number of times per unit of output, and are thus volume‐related. For example, assembly of parts into a subassembly unit is a unit‐level activity.

b. Batch level: These activities are performed once for each batch, or group, of units. An example is machine setup that has to be done for each production run no matter how many units are in a batch.

c. Customer level: These activities support specific customers or groups of customers. They cannot be specifically correlated to a particular product, batch, or unit. Examples include sales calls, service and support, and advertising aimed at particular customers.

d. Product level: These activities support specific product types or services. They cannot be specifically correlated to a particular unit or batch on a cause‐and‐effect basis. They are incurred regardless of the number of units produced, and include such items as product advertising, research and development, engineering specifications, and design costs.

e. Plant (facility) level: These activities and resources are not traceable to specific products, customers, or services, but they support an individual plant or facility. Examples include building (facility) maintenance, security, and plant manager’s salary.

f. Organization level: These activities are not traceable to specific products or services or to specific facilities; they support the organization as a whole. Examples include headquarters building maintenance and depreciation, CEO and CFO compensation, and centralized accounting functions.

5521.52 Cost driver: One of the major differences between activity‐based costing (ABC) and traditional costing systems is that greater effort is made to identify cost allocation bases that are cost drivers. For example, in an assembly activity, the more parts that have to be put together, the more the cost of that activity increases. Therefore, the cost driver for an assembly activity would be the number of parts. Increased activity of the cost driver causes the total costs related to that activity to increase.

5521.53 Steps in activity‐based costing: Activity‐based costing applies the accumulated costs of identified activities to cost objects using a separate driver for each activity, using the following series of steps:

a. Identify causal relationship: Identify the causal relationship between cost incurrence and activities.

b. Determine driver: Determine the underlying driver of overhead costs for activities.

c. Establish cost pools: Establish homogeneous cost pools related to individual drivers.



d. Determine cost ratio: Develop a predetermined cost ratio for each activity cost pool.

e. Apply costs: Apply the accumulated costs (in the cost pools) to the cost objects on the basis of resources consumed (as determined by the amount of cost drivers used). Costs may be assigned to any type of cost object depending on the information management wants. For example, costs may be assigned to units of product, groups of customers, or product lines.

5521.54 Example of activity‐based costing: Glide‐Free, Inc., manufactures two models of patio swings: Deluxe (upholstered with a woven‐vinyl material) and Standard (with stained‐wood finish). The following data relate to the company’s production activities and costs:

Manufacturing Activity

Budgeted Activity Costs

for Year

Cost Driver Used as Allocation Base

Cost per Unit of Allocation Base

Materials handling $ 300,000 Number of parts $ 0.40 Cutting 1,500,000 Number of parts 2.00 Assembly 4,500,000 Number of parts 6.00 Upholstery 1,200,000 Direct labor hours 20.00 Wood refinishing 3,000,000 Direct labor hours 15.00

Actual production data for the month of April is as follows:

# of Units Direct Material Total # of Direct Labor Hours Model Produced Costs Parts Upholstery Wood Refin.

Standard 8,000 $100,000 64,000 ‐‐ 16,200 Deluxe 2,500 62,500 30,000 5,100 ‐‐

1. Compute the total manufacturing costs and manufacturing cost per unit for each product.

2. In addition, various product design and research costs (also called “upstream” costs) have been identified and applied to the Standard model at $15 per unit and to the Deluxe model at $25 per unit. Also, marketing, distribution, and customer service costs (also called “downstream” costs) of $120 and $180 have been applied to each unit of the Standard and Deluxe models, respectively. Compute the full product cost per unit of each model.

Solutions:

1. Standard model:

Direct Materials $100,000 Conversion Costs: Materials Handling: 64,000 × $0.40 $ 25,600 Cutting: 64,000 × $2.00 128,000 Assembly: 64,000 × $6.00 384,000 Wood Refinishing: 16,200 × $15.00 243,000 780,600 Total Manufacturing Costs $880,600 Manufacturing Cost per Unit: $880,600 ÷ 8,000 units $110.075



Deluxe model:

Direct Materials $ 62,500 Conversion Costs: Materials Handling: 30,000 × $0.40 $ 12,000 Cutting: 30,000 × $2.00 60,000 Assembly: 30,000 × $6.00 180,000 Upholstery: 5,100 × $20.00 102,000 354,000 Total Manufacturing Costs $416,500 Manufacturing Cost per Unit: $416,500 ÷ 2,500 units $166.60

2.

Standard Deluxe Manufacturing cost per unit $110.075 $166.60 Upstream costs 15.000 25.00 Downstream costs 120.000 180.00 Total unit cost $245.075 $371.60

5521.55 Value‐added and nonvalue‐added activities: Identification and analysis of activities is central to activity‐based costing (ABC). When managers and accountants develop an ABC system, they have an opportunity to classify each activity as either value‐added or nonvalue‐added. A value‐added activity enhances the product or satisfies an organizational need. For example, production processing activities typically add value. Nonvalue‐added activities do not enhance the product. In the manufacturing department, waiting time, move time, and inspection time are all classified as nonvalue‐added activities. Nonvalue‐added activities should be reduced to a minimum. Thus, ABC systems help managers identify ways to reduce inefficiencies.

5521.56 Applicability and benefits of ABC: Activity‐based costing (ABC) procedures are most applicable in settings where overhead costs other than organization‐level are a relatively large component of costs. Benefits of implementation include the following:

a. Provides an understanding of complex product costs and product profitability for improved resource management

b. Allows management to focus on the nature of activities performed so that nonvalue‐added activities can be controlled or eliminated, thus streamlining the production process

c. Highlights the interrelationship of costs and activities and thus provides opportunities to reduce costs

d. Provides a more appropriate means of charging overhead costs to products

Allocation of Support Department Costs

5521.57 Allocation of support department costs: Costs incurred by support (or service) departments, such as Human Resources, Purchasing, Building Maintenance, and Power Plant, that directly assist the production process can be a large part of the overhead to be allocated to user departments, which use the support services.

5521.58 Allocation bases: Support costs are allocated to user departments using an allocation base, preferably a cost driver. Typical allocation bases are as follows:

a. Human Resources: Number of employees served

b. Purchasing: Number of purchase requisitions processed



c. Building Maintenance: Square feet serviced

5521.59 Cost allocation methods: Three major methods are used to assign support costs to user departments:

1. Direct method: Service department costs are allocated directly to the production departments without any allocation to other service departments for which work might have been performed.

2. Step‐down (or sequential) method: Since service departments often provide services to the other service departments as well as to the production departments, service department costs are allocated to other service departments and to production departments in a predetermined sequence. Generally, the service department allocated first is the one that provides the most service to other service departments. Where there is no determinable difference in service levels, total costs in each service department are used, starting with the department that has the most costs, and then moving down. Once a service department’s costs have been allocated, no further costs are allocated to that service department.

3. Reciprocal method: Service department costs may also be allocated using a method that fully incorporates the interdepartmental support provided among the service departments. This method requires simultaneous equations and, where there are more than two service departments involved, a computer program is generally used. It is theoretically the most accurate method; however, the added precision resulting from its use may not exceed the cost of using it.

5521.60 Single‐ versus dual‐rate allocation systems: Regardless of which of the allocation methods is used, support costs may be allocated from a single pool (single‐rate method) or from separate pools for fixed and variable costs (dual‐rate method). A dual‐rate system for fixed and variable costs is a more correct procedure, especially if the actual volume of support activity can vary significantly from the budgeted volume.

5521.61 Example of allocation of support department costs: Spalding Enterprises has two support departments, Maintenance and Receiving, whose costs are allocated to two production functions, Machining and Assembly. During the current year, Maintenance and Receiving incurred the following costs and budgeted volume of activity:

Costs/Departments Maintenance Receiving Totals

Fixed costs $10,000 $15,000 $25,000 Variable costs 30,000 20,000 50,000 Total costs to be allocated $40,000 $35,000 $75,000 Allocation base Hours of

Maintenance Deliveries Received

and Processed

Budgeted volumes of activity are as follows:

Budgeted Support Activity Support provided by: Maintenance Receiving Machining Assembly Totals Maintenance (hours) XXX 3,000 12,000 15,000 30,000 Receiving (deliveries) 500 XXX 1,500 4,000 6,000

Using a single‐rate system, the calculations shown below demonstrate allocation of support costs to the Machining and Assembly departments using the (a) direct method and (b) step‐down method.



a. Direct method:

First, determine the ratio of support activity supplied among the user departments. Disregard any support provided by one service department to another (ratios rounded to whole percents).

Maintenance Support: Machining function 12,000/27,000 hours 44% Assembly function 15,000/27,000 hours 56% Receiving Support: Machining function 1,500/5,500 deliveries 27% Assembly function 4,000/5,500 deliveries 73%

Next, use ratios to allocate support department costs directly to user departments.

Maintenance Receiving Machining Assembly Totals Costs to be allocated: $40,000 $35,000 Maintenance (44%, 56%)

(40,000)

$17,600

$22,400

$40,000

$ 0 Receiving (27%, 73%)

(35,000)

9,450

25,550

35,000

Totals $ 0 $27,050 $47,950 $75,000

b. Step‐down method: The following steps are taken:

Step 1: Determine the ranking (order) for the support department allocation. Maintenance is budgeted to provide 3,000 hours or 10% (3,000/30,000) of its total support activities to Receiving. Receiving is budgeted to process 500 deliveries or 8% (500/6,000) of its total support activities to Maintenance. Thus, Maintenance provides more support to the other support function than does Receiving, so the ranking is Maintenance costs allocated first, followed by Receiving. Note: Had each support department provided the other one with equal levels of support, then Maintenance would still have been selected first because it has more dollars to be allocated than does Receiving.

Step 2: Determine the allocation ratios to be used for each of the support departments. For the first‐ranked department, ratios need to be developed relating to all user departments, including the other support department. Ratios for remaining support departments are based on the activity to be done for only the support departments not yet allocated and the other user departments.

Support provided by Maintenance to:

Receiving function 3,000/30,000 hours 10% Machining function 12,000/30,000 hours 40% Assembly function 15,000/30,000 hours 50%

Support provided by Receiving (without considering support to Maintenance):

Machining function 1,500/5,500 27% Assembly function 4,000/5,500 73%



Step 3: Use ratios to allocate support department costs in sequence, determined by ranking in Step 1.

Maintenance

Receiving

Machining

Assembly Totals to Prod.

Costs to be allocated: $40,000 $35,000 Maintenance (10%, 40%, 50%)

(40,000)

4,000

$16,000

$20,000

$36,000

$ 0 39,000 Receiving (27%, 73%)

(39,000)

10,530

28,470

39,000

$ 0 Totals $26,530 $48,470 $75,000

Allocation of Joint Products and Byproducts

5521.62 Joint products are two or more products whose total resale value is significant and which are produced simultaneously in the same processing operation. The joint (or common) processing costs must be allocated to the joint products using estimates. The allocations are typically based on the relative sales value or relative measures (i.e., units or pounds) of the products.

5521.63 Byproducts are a product of a process having a relatively small total resale value in relation to the sales value(s) of the main or joint products. The recovery value may be treated either as other income or a reduction of main product joint cost.

5521.64 Allocation methods: Four methods are commonly used for allocating joint costs:

1. Relative sales value at split‐off

2. Physical output

3. Net realizable value (NRV)

4. Constant gross margin NRV

5521.65 Relative sales value at split‐off: Split‐off is the point at which separately identifiable main products emerge from the joint processing phase. Where sales values at split‐off are known, they are usually used to determine the allocation percentage of joint costs to each product. This method cannot be used in cases where no market exists for one of more products at the split‐off point (i.e., some products require further processing before they are marketable).

5521.66 Physical output: The joint product cost is allocated based on each product’s percentage of the total physical quantity of all the products. This method is the least preferred because it does not consider a product’s ability to generate enough revenue to cover the costs allocated (ability‐to‐bear concept). In addition, this method requires all joint products to be measured in the same physical output, which is not always possible.

5521.67 Example of joint product cost: Gyro Company produces 15,000 pounds of Product A and 10,000 pounds of Product B in a joint production process at a total cost of $150,000. The aggregate sales values of the Products A and B at split‐off are $180,000 and $90,000, respectively. Calculate the joint cost allocable to each product using both the relative sales value and the unit of measure approaches.



Relative sales value approach: This method will result in the same gross profit percentage for each joint product at the point of split‐off. Each product receives part of the joint costs in proportion to its sales value in relation to the total sales value of all the products. In this case, the total sales value is $180,000 + $90,000 = $270,000.

Product A $180,000

$270,000 × $150,000 joint cost = $100,000

Product B $90,000

$270,000 × $150,000 joint cost = $50,000

Physical output method: This approach will result in the same cost per unit of physical output (in this example, pounds) for each joint product.

Product A 15,000 (15,000/25,000 = 60%) Product B + 10,000 (10,000/25,000 = 40%) 25,000 pounds

Joint cost $150,000/25,000 pounds = $6 per pound

Total cost allocated to:

Product A 15,000 × $6 = $ 90,000 (= $150,000 × 60%) Product B 10,000 × $6 = 60,000 (= $150,000 × 40%) $150,000

5521.68 Net realizable value (NRV): This is a variation of the relative sales value method and can be used in situations where no market value exists for one or more joint products at the split‐off point. The ultimate sales value of each product is reduced dollar for dollar by any additional processing costs after split‐off (i.e., its separable costs) to arrive at its net realizable value (NRV) at the time of split‐off. The NRV is then used to allocate joint costs.

5521.69 Example of net realizable value: Products A and B are produced in Department 1 at a joint cost of $45,000. Product A is further processed in Department 2 at a cost of $15,000, and Product B is further processed in Department 3 at a cost of $10,000. Products A and B are not in salable form after Department 1 processing. Their sales values, after all production has been completed, are $60,000 and $40,000, respectively. Using the net realizable values at split‐off, calculate the Department 1 joint cost allocable to each product.

Product A Product B Total Sales value $60,000 $40,000 Less separable costs 15,000 10,000 NRV at split‐off $45,000 $30,000 $75,000

Joint cost assigned to A $45,000 $75,000

× $45,000 = $27,000

Joint cost assigned to B $30,000

$75,000 × $45,000 = $18,000

5521.70 Constant gross margin net realizable value (NRV): Under this method, joint costs are allocated so that the gross margin percentage (after further processing, if any) for each main product is identical. Because this method requires simultaneous equations, calculations are not likely to be tested on the CPA Examination. However, this method is theoretically superior to the other methods because it avoids making some joint products appear to be more profitable than other joint products. In other words, it preserves the idea that one



joint product cannot be produced without also producing the other joint product(s). By ensuring that the gross margin for all joint products is identical, this method reduces the likelihood that managers will make inappropriate joint product decisions; managers will be encouraged to consider the entire group of joint products when making decisions to keep or drop the joint products, process a joint product further, or emphasize one joint product over another.

5521.71 Backflush costing:

a. JIT and cost tracking: Some call just‐in‐time (JIT) a costing technique; however, it is an inventory control method that could be used with any costing method. It does facilitate costing, in that very little inventory is on hand at the end of the period to complicate calculations.

b. Little or no inventory: Because inventory on hand is (ideally) eliminated or at least minimized under JIT production, it is not necessary to use an accounting system that tracks the details for each element of manufacturing costs and physical flows through inventory accounts. Instead, some form of backflush costing (also called delayed, JIT, or post‐deduct costing) may be used. These systems reflect the concept of stockless production that results from the “demand‐pull” concept of JIT production, and relatively few cost accounting transactions are recorded.

(1) Trigger points: Instead of recording every detail of the manufacturing process from acquisition of raw materials through completion of manufacturing, a triggering event or events (sometimes called a pay point or points), such as purchase of materials, completion of manufacturing, or point of sale causes accounting entries to be made that reflect (i.e., “look back” on) what has happened. There are several different versions of backflush costing, each of which uses a different trigger point or combination of points.

(2) True JIT cost tracking: Where a true JIT system is in operation (zero or very low inventories and fast throughput), only one trigger point, the completion of manufacturing, is recognized. Entries are made to finished goods, payables, and conversion costs applied accounts when manufacturing is completed. Costs are then transferred to cost of goods sold at the time the sale is made. Under this version, no inventory records are kept for raw materials or work in process because no inventories are kept on hand.

(3) Two trigger points: Other versions use two trigger points: (1) purchase of materials and completion of product or purchase of materials and (2) point of sale. In none of the versions is a Work‐in‐Process account used. An account called Raw and In Process (RIP) is used in one of the two‐trigger point methods to account for all materials that are either in process or in the materials warehouse. An account called Inventory is used in the other two‐trigger point methods to account for all materials that are either in the warehouse or in unsold finished goods.

Cost Reporting

5521.72 Cost reporting: Operating statements are prepared for both external and internal purposes. For external purposes, GAAP must be followed. The matching principle requires that an absorption (full costing) statement be presented so that product costs (both variable and fixed) are deducted when sold, and period costs are deducted when incurred. For internal purposes, management is more interested in the progress it is making toward making a profit for the period. A profit cannot be made until and unless all fixed costs for the period



are covered. Therefore, an internal report is focused on cost behavior, not on the distinction between product and period costs.

5521.73 Absorption (full) costing: This is the traditionally prepared income statement. Cost of goods sold is deducted from sales to arrive at gross margin. The cost of goods sold is made up of all manufacturing costs attached to the product, including fixed manufacturing overhead per unit. Fixed costs attached to units not sold are on the balance sheet in the ending inventory. A major problem with absorption costing is that managers have an incentive to produce more units, which allows them to defer more fixed costs in ending inventory. This method discourages managers from rapidly reducing production volumes if sales drop.

5521.74 Variable/direct/contribution costing: In this reporting approach, only variable manufacturing costs are deducted for cost of goods sold. Fixed manufacturing is regarded as a period cost and is deducted in full, regardless of the number of units sold. This approach is not acceptable for public reporting (GAAP) or for reporting to the SEC or IRS. However, variable costing can be useful for managerial decision making because it separates variable and fixed costs, regardless of whether they are product or period costs. Thus, this method helps managers analyze the effects of fluctuations in volume on profits. In addition, this method does not encourage managers to overproduce inventory.

5521.75 Operating income: Absorption versus variable costing: Because fixed manufacturing costs are treated differently between these two reporting approaches, operating income will be different if sales and production are not equal during the period. The amount of the difference is the change in inventory units times fixed overhead per unit.

a. Production greater than sales: In this scenario, inventory increases. Absorption costing operating income will be greater than variable costing net income because some of the current period’s fixed costs are held in inventory until the next period. On the variable statement, all fixed costs are deducted regardless of unit sales.

b. Production less than sales: If sales are greater than production, inventory decreases. Absorption costing operating income will be less than variable costing because, in addition to deducting all fixed costs relating to this period’s production, some fixed costs from the previous period will also be in cost of goods sold (beginning inventory), thus reducing the current period’s income. However, the variable costing statement will still include only this period’s fixed costs.

5521.76 Example of variable and absorption costing: Smith Company manufactures and sells one product. The following is information about its operations for the first two months of the current year.

Selling price per unit $ 11 Variable manufacturing cost per unit 4 Variable selling cost per unit sold 2 Monthly fixed manufacturing costs (normal production capacity of 10,000 units) 30,000 Fixed manufacturing cost per unit (based on normal production capacity of 10,000 units)

3

Monthly fixed selling costs 10,000

January February Beginning inventory ‐0‐ $ 1,000 Production $10,000 10,000 Sales 9,000 10,500 Ending inventory 1,000 500



Variable and absorption costing reports for the first two months of the year are presented below:

JANUARY – Variable Costing Report JANUARY – Absorption Costing Report

Sales – 9,000 units × $11 $99,000 Sales – 9,000 units at $11 $99,000

Variable Cost of Goods Sold Full Cost of Goods Sold

Beginning Inventory $ 0 Beginning Inventory $ 0

Plus Production (10,000 units × $4 per unit) 40,000

Plus Production (10,000 units × $7 per unit)

70,000

Less Ending Inventory (1,000 units × $4) 4,000 36,000

Less Ending Inventory (1,000 units × $7)

7,000 63,000

Manufacturing Margin $63,000 Gross Profit $36,000

Less Variable Selling Expenses (9,000 units × $2 per unit)

18,000

Contribution Margin $45,000

Less Fixed Costs: Less Period Costs:

Fixed Manufacturing Costs $30,000 Variable Selling Costs

(9,000 units × $2 per unit)

$18,000

Fixed Selling Expenses 10,000 40,000 Fixed Selling Costs 10,000 28,000

Operating Income $ 5,000 Operating Income $ 8,000

Inventory increased from 0 to 1,000 units. Therefore, absorption income as reported is higher than variable income. The difference in dollars is the Change in inventory units × Fixed manufacturing costs per unit (1,000 units × $3 per unit), or $3,000.

FEBRUARY – Variable Costing Report FEBRUARY – Absorption Costing Report

Sales – 10,500 units × $11 $115,500 Sales – 10,500 units × $11 $115,500

Variable Cost of Goods Sold Full Cost of Goods Sold

Beginning Inventory $4,000 Beginning Inventory $ 7,000


40,000


70,000

Less Ending Inventory (500 units × $4)

2,000 42,000

Less Ending Inventory (500 units × $7)

3,500 73,500

Manufacturing Margin $ 73,500 Gross Profit $ 42,000

Less Variable Selling Expenses (10,500 units × $2 per unit)

21,000

Contribution Margin $ 52,500

Less Fixed Costs: Less Period Costs:

Fixed Manufacturing Costs $30,000 Variable Selling Costs

(10,500 units × $2 per unit)

$21,000

Fixed Selling Costs 10,000 40,000 Fixed Selling Costs 10,000 31,000

Operating Income $ 12,500 Operating Income $ 11,000

Inventory decreased from 1,000 to 500 units. Therefore, absorption income as reported is lower than variable income. The difference in dollars is the Change in inventory units × Fixed manufacturing costs per unit (500 units × $3 per unit), or $1,500.

Note that the differences in operating incomes shown above represent only a timing difference in the recognition of fixed manufacturing costs as expenses. Over the long run, total operating income reported under both methods will be the same.



5522 Variance Analysis

Introduction

5522.01 The objective of a standard cost system is to help a business operate more effectively and more efficiently. It helps accomplish organizational goals by obtaining the optimum output from the inputs used. Standards and budgets are related. When the budget is broken down on a unit basis, it is called a standard. Standard costs are budgeted manufacturing costs on a unit basis.

5522.02 Standard costs have several benefits. They save on bookkeeping costs, provide a basis for performance measurements, provide useful data in product costing, and are used in the budgetary process. There are three basic types of standards that may be employed: (1) fixed or unchanging, (2) ideal or theoretical, and (3) currently attainable. Each type of standard has some advantages, but currently attainable standards are most commonly used.

a. Fixed or basic standards: Once established, are not changed. Initially, a fixed standard may be ideal and/or attainable, but because it is never changed, it is of limited use to management.

b. Ideal or theoretical standards: Based on utopian conditions for a given manufacturing process. Ideal standards presume that manufacturing costs will always be purchased at minimum prices, used at optimum efficiency, and produced at 100% manufacturing capacity. Ideal standards cannot be met and will consistently result in unfavorable variances. For this reason, they have undesirable behavioral consequences.

c. Attainable standards: Based on a high degree of efficiency. They can be met or even surpassed by employing excellent managers and employees. Attainable standards consider that manufacturing components can be purchased at good overall prices. Attainable standards also consider that (a) labor is not 100% efficient, (b) material usage will have some normal spoilage, and (c) manufacturing capacity cannot produce at 100% of theoretical capacity. Attainable standards are set above average levels of efficiency but may be met or surpassed by efficient production.

5522.03 Many people are generally involved in developing the standard costs. Those commonly involved include line personnel directly responsible for meeting the standard, engineers, accountants, and time and motion analysts. Accountants provide valuable cost data and variance analyses on existing standards that are very helpful in developing good standards.

5522.04 The approach generally followed in developing standards is to estimate the amount and cost of material, labor, and overhead required to efficiently produce one unit of product in the current period. The standards are used by accountants to value inventories of raw materials, work‐in‐process, and finished goods, and to value the cost of goods sold.

5522.05 When actual amounts differ from standard amounts, a variance is recorded. The variance should be assigned to the department or division that has the ability to control the activity that causes the variance. As a general rule, all variances should be recorded as soon as possible so corrective action may be taken. By doing so, variance analysis is useful to management because it points to the areas of operations most in need of management’s attention.



Flow of Standard Costs Through the Accounts

5522.06 Manufacturing accounts used in a standard cost system are similar to the accounts used for an actual cost system. Several variance accounts are added. Direct material has two variance accounts—material price variance and material usage variance. Direct labor also has two variance accounts—labor price (rate) variance and labor usage (efficiency) variance. Over‐ or underapplied overhead is analyzed to determine the cause. Separate overhead variance accounts may also be added.

5522.07 Exhibit A illustrates the flow of costs through the accounts. Lines and arrows connect the parts of each journal entry. Where the amounts at the ends of the lines are not equal, it is because a variance is being recorded. The letters and numbers in parentheses identify the variance account.



Direct Material Variances

5522.08 Direct materials are usually recorded in a raw material inventory account at the standard cost. The difference between the actual cost and the standard cost for the direct materials purchased is a price variance. Its computation is:

Direct material price variance = Quantity purchased (Standard price – Actual price)

5522.09 If the actual price exceeds the standard price, it is an unfavorable variance. By subtracting the actual price from the standard price, a negative amount will indicate that it is unfavorable:

Standard price – Actual price

$10.00 – $10.20 = –$0.20

5522.10 Some have proposed that both price and usage variances be recorded at the time the material is transferred into work‐in‐process. However, during a given accounting period, the quantity purchased may not be the same as the quantity used, and the price variance would be reported in the wrong period. The variance is best associated with the activity when the price variance is recorded at the time of purchase and the usage variance is recorded at the time of use.

5522.11 Under manufacturing processes where a specified number of units are being produced, the standard quantity of raw materials needed for production is known and the usage variance can be recorded at the beginning of the production process. The standard quantity is recorded in work‐in‐process at the standard price. Any difference between the standard quantity needed and the amount requisitioned is a usage variance. The computation is:

Direct material usage variance = Standard price (Standard quantity – Actual quantity)

5522.12 Under a manufacturing process where a given amount of raw material is processed to obtain as much finished product as possible, the usage variance is recorded at the completion of the production process. The actual raw materials used in production are transferred into work‐in‐process at the standard price. When production is complete and the number of units actually produced is known, the usage variance is computed as the difference between the raw materials that should have been used (standard quantity) and the amount actually used (actual quantity) to produce the units of finished product. The formula is the same, but the time of recording is different.



5522.13 The following summarizes the direct material variances when there is no change in the raw material inventory balance. This assumes that the quantity purchased is used immediately in work‐in‐process as would occur in a just‐in‐time (JIT) manufacturing process.

Direct Labor Variances

5522.14 Workers classified as direct labor are paid for the time worked at the actual or agreed price. The objective, however, is to record in work‐in‐process the standard quantity of labor needed to produce the units at the standard labor rate. The difference between the amount paid and the amount recorded in work‐in‐process can be separated into a price (rate) and a usage (efficiency) variance as follows:

Direct labor rate variance = Hours worked (Standard price – Actual price)

Direct labor efficiency variance = Standard price (Standard hours – Actual hours)

The total labor variance is summarized as follows:

5522.15 In some process cost systems, the standard quantity of labor cannot be determined until the end of the period when the number of units actually produced is known. Under these systems, the actual direct labor used is recorded in work‐in‐process, and any usage variance is recognized when the units are completed and transferred to the next process or into finished goods inventory.



Overhead Variance Analysis

5522.16 Manufacturing overhead costs are accumulated in a Manufacturing Overhead account as debit entries. Credit entries to this account record amounts allocated to work‐in‐process. The amount allocated to work‐in‐process under a standard cost system is based on an overhead rate and the earned or standard volume of activity. When volume is measured in units, earned volume is the number of units produced. Whenever volume is measured by some other input (e.g., direct labor hours, machine hours, or direct labor cost), earned or standard volume is the amount of the input that should have been used to produce the actual units of output.

5522.17 The over‐ or underapplied overhead can be analyzed in a variety of ways. The most common are called two‐way, three‐way, or four‐way analysis. The following example will be used to illustrate each of these.

5522.18 Example: Standard cost data per unit includes the following:

Direct labor: 3 hours at $5.00 per hourDirect material: 4 pounds at $4.15 per poundOverhead: $1.10 per direct labor hour 3 hours = $3.30 per unit

The flexible budget formula is based on fixed costs of $18,000 and variable costs of $0.50 per direct labor hour. A normal volume of 30,000 direct labor hours is projected for the period.

The overhead rate is $1.10, computed as follows:

$1.10 = $18,000 + ($0.50 30,000 hours)

30,000 hours

Actual cost data for the period:

Overhead Costs Fixed $18,500 Variable 16,000 Total $34,500 Units produced: 9,000 units Direct labor hours worked: 28,000 hours

Summary of over‐ or underapplied overhead:

a The earned or standard volume was 27,000 direct labor hours. This is the

number of hours that should have been worked to produce 9,000 units (9,000 units x 3 hours per unit = 27,000 DL hours).



5522.19 A two‐way analysis separates over‐ or underapplied overhead into two variances—controllable and uncontrollable or volume. The difference between the actual overhead cost and the amount of cost that should be incurred at the earned or standard volume is the controllable or budget variance. The difference between the cost that should have been incurred at the earned volume and the cost allocated to work‐in‐process is uncontrollable because it results from a difference between the normal volume and the earned or standard volume. This uncontrollable variance is often called a volume variance. The over‐ or underapplied overhead is split into these two variances by computing the overhead cost that should have been incurred at the earned or standard volume. The flexible budget formula is used. Based on the data shown in the example, the following variances are computed under a two‐way analysis:

Notice that the total of the two variances equals the underapplied overhead. Notice also that the volume variance results from inefficient utilization of fixed overhead. At the normal volume of 30,000 direct labor hours, fixed costs are $0.60 per direct labor hour. Earned volume was 3,000 direct labor hours (30,000 – 27,000) below normal, which accounts for the

$1,800 ($0.60 3,000) unfavorable volume variance.

5522.20 A three‐way analysis separates over‐ or underapplied overhead into three variances: (1) spending, (2) efficiency, and (3) volume. The volume variance is the same as computed in the two‐way analysis. However, what was a controllable variance in a two‐way analysis is split into two parts. The difference between the actual costs and the overhead costs that should have been incurred at the actual volume of production is a spending variance. This results from prices that are different from those expected at the time the flexible budget formula was developed. The difference between the overhead costs that should have been incurred at the actual volume and the costs that should have been incurred at the earned volume is an efficiency variance. Based on the data shown in the example, the following variances are computed under a three‐way analysis: