BUSINESS
1
Corporate Governance and Operations Management
1.
Corporate governance
3
2.
Control environment
25
3.
Operations management: Performance management and impact of measures on behavior
33
4.
Operations management: Cost measurement methods and techniques
43
5.
Operations management: Process management
69
6.
Operations management: Project management
81
7.
Terminology
93
8.
Class questions
95
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CORPORATE GOVERNANCE
I.
FINANCIAL REPORTING OF PUBLIC COMPANIES The Sarbanes Oxley Act of 2002 has had a profound impact on the financial reporting requirements of public companies. In particular, there are numerous provisions for expanded disclosures by corporations and specific representations required by officers of public companies that must accompany published financial statements. Key provisions of the Act related to those disclosures are described in Title III and Title IV of the Act. A.
Title III - Corporate Responsibility The corporate responsibility section of the Act relates to the establishment of an audit committee and the representations made by key corporate officers, typically the chief executive officer (CEO) and the chief financial officer (CFO). 1.
Public Company Audit Committees a.
b.
c.
2.
Public companies are responsible for establishing an audit committee that is directly responsible for the appointment, compensation and oversight of the work of the public accounting firm employed by that public company (also referred to as an issuer). (1)
The auditor reports directly to the audit committee.
(2)
The audit committee is responsible for resolving disputes between the auditor and management.
Audit committee members are to be members of the issuers' board of directors but are to be otherwise independent. Independence criteria are as follows: (1)
Audit committee members may not accept compensation from the issuer for consulting or advisory services.
(2)
Audit committee members may not be an affiliated person of the issuer. (Affiliation means a person having the ability to influence financial decisions).
Audit committees must establish procedures to accept reports of complaints regarding audit, accounting or internal control issues. (1)
Procedures must accommodate confidential, anonymous reports by employees of the issuer.
(2)
Procedures must accommodate receipt and retention of complaints as well as a method to address those complaints.
Corporate Responsibility for Financial Reports Corporate officials, typically the chief executive officer (CEO) and chief financiai officer (CFO) must sign certain representations regarding annual and quarterly reports including their assertion that:
It) 1010 DeVrv/Becker
a.
They have reviewed the report.
b.
The report does not contain untrue statements or omits material information.
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c.
The financial statements are fairly stated in conformity with generally accepted accounting principies (GAAP).
d.
The CEO and CFO signing the report have assumed responsibility for internal controls including assertions that:
e.
f.
3.
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(1)
Internal controls have been designed to ensure that material information has been made available.
(2)
Internai controls have been evaluated for effectiveness as of a date within 90 days prior to the report.
(3)
Their report includes their conclusions as to the effectiveness of internal controls based upon their evaluation.
The CEO and CFO signing the report assert that they have made the following disclosures to the issuer's auditors and the audit committee: (1)
All significant deficiencies in the design or operation of internal controls which might adversely affect the financial statements.
(2)
Any fraud (regardless of materiality) that involves management or any other employee with a significant role in internai controls.
The CEO and CFO signing the report must also represent whether there have been any significant changes to internal controls.
Improper Influence on the Conduct of Audits No officer or director may take any action that would frauduiently influence or coerce the auditor in a manner that would make the financial statements materialiy misleading.
4.
Forfeiture of Certain Bonuses and Profits Non compliance may result in surrender of compensation including repayment to the issuer of:
B.
a.
Bonuses or incentive based or equity based compensation.
b.
Gains on sale of securities.
Title IV - Enhanced Financial Disclosures The enhanced financial disclosures associated with issuer reports include additional details regarding the financial statements, internal controls and the operations of the audit committee. 1.
Disclosures in Periodic Reports (generally quarterly or annual) Financial statement disclosures are intended to ensure that the application of GAAP reflects the economics of the transactions inciuded in the report and that those transactions are transparent to the reader. Disclosures include:
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a.
Ali material entries identified by the auditor.
b.
Ali off balance sheet transactions: (1)
Contingent obligations.
(2)
Relationships with unconsolidated subsidiaries.
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d. 2.
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Conformance of proforma financial statements to the following requirements: (1)
No untrue statements.
(2)
No omitted material information.
(3)
Reconciled with GAAP basis financial statements.
Use of special purpose entities.
Conflict of Interest Provisions Issuers are generally prohibited from making personal loans to directors or executive officers.
3.
4.
a.
Exceptions apply if the consumer credit loans are made in the ordinary course of business by the issuer.
b.
Exceptions apply if the terms offered to the officer are generally made available to the public under similar terms and conditions.
Disclosure of Transactions Involving Management and Principal Stockholders a.
Disclosures are required for persons who generally have direct or indirect ownership of more than 10 percent of any class of most any equity security. Disclosures are made by filing a statement.
b.
Statements are filed at the following times: (1)
At the time of registration.
(2)
When the person achieves 10 percent ownership.
(3)
If there has been a change in ownership.
Management Assessment of Internal Controls The assessment of internal controls is commonly referred to as Section 404. Management's assessment of internal controls includes the following assertions a.
Management is responsible for adequate Internal control structure.
b.
Management has made conclusions regarding its assessment of the effectiveness of the internal control structure and procedures for financial reporting. (1)
5.
The auditor must also attest to management's assessment of internal control.
Certain Exemptions Investment companies are exempted from this act.
6.
Code of Ethics for Senior Financial Officers a.
issuers must disclose of senior financial officers (e.g., CFO, controller, and chief accountant) who are subject to a code of ethics adopted by the issuer.
b.
The code of ethics contemplates standards for: (1)
Honest and ethical conduct (including handling of conflicts of interest).
(2)
Full, fair, accurate and timely disclosures in periodic financial reports.
(3)
Compliance with laws, rules and regulations.
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Disclosure of Audit Committee Financial Expert At least one member of the audit committee should be a financial expert. Financial reports of the issuer must disciose the existence of a financial expert on the committee or the reasons why the committee does not have a member that is a financial expert. a.
A financial expert qualifies through education, past experience as a public accountant, or past experience as a finance officer for an issuer.
b.
Knowledge of the financial expert should include: (1)
Understanding of GAAP.
(2)
Experience in the preparation or auditing of financial statements for comparable issuers.
(3)
Application of GAAP.
(4)
Experience with internal controls.
(5)
Understanding of audit committee functions. CONCEPT EXAMPLE
According to the Sarbanes-Oxley Act of 2002, which of the following statements is correct regarding an issuer's audit committee financial expert? a.
The issuer's current outside CPA firm's audit partner must be the audit committee financial expert.
b.
If an issuer does not have an audit committee financial expert, the issuer must disclose the reason why the role is not filled.
c.
The issuer must fill the role with an individual who has experience in the issuer's industry.
d.
The audit committee financial expert must be the issuer's audit committee chairperson to enhance internal control.
Solution: Choice "b" is correct. Sarbanes-Oxley Section 407 requires that an issuer's audit committee have at least one financial expert or disclose why that role is not filled. Section 407 requires that the financial expert have an understanding of GAAP and financial statements, be able to assess the application of accounting principles, have comparable experience with applying accounting principles to entities that present the level of complexity of the issuer, and understand both internal controls and audit committee functions. Choice "a" is incorrect. The audit committee is charged with negotiating the engagement of the external auditor and supervising their work. The auditor is accountable to the audit committee. The partner in charge of the audit firm engaged to do the audit should not be the financial expert on the audit committee. Choice "c" is incorrect. Section 407 requires that the audit committee's financial expert understand the application of accounting principles to the issues representative of the complexity ofthe issuer but does not require specific experience in the industry. Section 407 defines four ways in which the necessary attributes of a financial expert can be achieved: education, experience supervising a financial officer, experience overseeing auditors or other relevant experience. Choice "d" is incorrect. Section 407 does not require that the audit committee's chairman be its financial expert.
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INTERNAL CONTROLS The Committee on Sponsoring Organizations (COSO), an independent private sector initiative, was initially established in the mid 1980's to study the factors that can lead to fraudulent financial reporting. The private "sponsoring organizations" included the five major financial professional associations in the United States: the American Accounting Association (AAA), the American Institute of Certified Public Accountants (AI CPA), the Financial Executives Institute (FEI), the Institute of Internal Auditors (IIA), and the Institute of Management Accountants (IMA). In 1992, the COSO issued Internal Control- Integrated Framework (the Framework) to assist organizations in developing comprehensive assessments of internal control effectiveness. The COSO's Framework is widely regarded as an appropriate and comprehensive basis to document the assessment of internal controls over financial reporting. PASS KEY
The COSO is sometimes referred to as the Treadway Commission after its original Chairman, James Treadway, Jr., an executive in the private sector. The "commission" is neither a governmental body nor an authority sponsored by Congress. Mr. Treadway was not a member of Congress.
The COSO's Framework consists of five components that are each supported by specific principies. The components logically step the individual responsible for the assessment from the tone at top through and evaluation of the entity's exposure to material misstatement to the control activities designed to mitigate the exposure and ongoing communication and follow up. The components are: •
Control activities
•
Risk assessment
•
Information and communication
•
Monitoring
•
Control environment PASS KEY
Purely identifying the components of the Framework has been a subject of released questions. Reorganize the letters and remember it would be a CRIME if you forgot these five components:
C
~ontrol
R
Risk Assessment
Activities
~
information and Communication ~
Monitoring
E
Control
~nvironment
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Control Activities Control activities generally represent the policies and procedures used to implement internal controls. 1.
Risk Assessment Integration The integration with the risk assessment principle is a bridge between the risk assessment and the control activities. a.
Attributes of the Principle Control activities should be designed to mitigate risk.
b.
Approaches to Applying the Principle Management will possibly create inventory controls, document controls with various matrices and consider conducting workshops as part of their approach to risk assessment integration.
2.
Selection and Development a.
Attributes of the Principle Management will select control activities from a range of possibilities that appropriately addresses such attributes as segregation of duties and the efficiency and effectiveness of controls.
b.
Approaches to Applying the Principle Management will likely ensure that duties are appropriately segregated by studying processes and using organizational charts. Cost benefit analysis will also factor into selection of controls by way of management's judgment.
3.
Policies and Procedures a.
Attributes of the Principle Policies and procedures should be appropriately integrated into the business and periodically reassessed.
b.
Approaches to Applying the Principle Standardized documentation methodologies that encourage periodic review and renewal is a valid approach to applying the policies and procedures principle.
4.
Information and Technology Information systems should be designed to achieve financial reporting objectives.
a.
Attributes of the Principle Management will consider both application and general controls.
b.
Approaches to Applying the Principle Approaches to information and technology control activities include consideration of systems development, system changes, security and access, etc.
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Risk Assessment The risk assessment component includes principles associated with management's consideration of the risk of material misstatement. 1.
Financial Reporting Objectives Management will generally specify its reporting objectives as presentation in accordance with GAAP. a.
Attributes of the Principle Financiai statements should be appropriately condensed but include all necessary detail and be reflective of company activities. The statements should be supported by relevant financial statement assertions and consider materiality.
b.
Approaches to Applying the Principle Management might consider giving an overall review to financial statements to ensure that they are representative of the economic substance of the company's activities, compare its accounting policies to those of similar organizations and specifically analyze its financial statement assertions including:
2.
(1)
Existence
(2)
Completeness
(3)
Rights and obligations
(4)
Valuation or allocation
(5)
Presentation and disclosure
Financial Reporting Risks Management wili determine what might interrupt their ability to present their financial statements in accordance with GAAP a.
Attributes of the Principle Management needs to consider its process and personnel as well as information technology infrastructure as part of evaluating risks. Management will also consider the likelihood of misstatements and the impact of those misstatements.
b.
Approaches to Applying the Principle Management will map its controls (procedures) to each of the internal control components (CRIME) to evaluate the likely effectiveness of those controls in achieving objectives. Meeting with company personnel and considering the impact of external factors (e.g., industry conditions) would be included in the risk assessment. Management would also likely set triggers to investigate control effectiveness (e.g., variance analysis, changes in accounting principles, etc.).
3.
Fraud Risk a.
Attributes of the Principle The fraud risk principle considers incentives and pressures to commit fraud and the responsibility and accountability for fraud policies.
b.
Approaches to Applying the Principle The approach to applying this principle would include considering approaches to circumvent or override controls. conducting fraud assessments and developing incident investigation processes.
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Information and Communication Information systems identify, capture, process and distribute information supporting accomplishment of financial reporting objectives. 1.
Financial Reporting Information a.
Attributes of the Principle Financial reporting systems will be designed to capture all financial transactions in a manner that allows for timely, current and accurate reporting.
b.
Approaches to Applying the Principle Management will consider documenting its controls with various matrices and corroborating the effectiveness of reporting with external parties.
2.
Internal Control Information a.
Attributes of the Principle Internal control systems will be designed to capture internal control compliance data and trigger responses where appropriate.
b.
Approaches to Applying the Principle Management may consider the development of information maps that document controls and discuss the information with affected parties.
3.
Internal Communication a.
Attributes of the Principle Communications with personnel and the board are attributes of the internal communications principle. The principle also considers separate communications lines outside the normal chain of command.
b.
Approaches to Applying the Principle Management might consider use of its intranet, periodic meetings with audit committee and publishing guidelines for communication to staff as means of implementing this principle.
4.
External Communication a.
Attributes of the Principle Open communications with all interested parties from customers to suppliers as well as the external auditor is the major attribute of external communication.
b.
o
Approaches to Applying the Principle Surveys and ongoing contacts with external parities applies this principal to the achievement of the information and communication component.
END
OF ANCILLARY MATERIAL
D.
Monitoring Monitoring is discussed in greater detail later in this text. The basic structure of the principles is somewhat intuitive.
1.
Ongoing and Separate Evaluations Monitoring of internal control effectiveness may be done on an ongoing basis or in separate evaluations.
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----------------------
Reporting Deficiencies Deficiencies in internal control design or operation should be reported to appropriate leadership.
E.
Control Environment The control environment is sometimes referred to as the "tone at the top." It is discussed in greater detail later in this text. The basic structure of the principles is somewhat intuitive. 1.
Integrity and Ethical Values High standards of integrity and ethical conduct are adopted by top management and demonstrated throughout the organization.
2.
Board of Directors The Board of Directors is actively involved in their oversight responsibility related to both financial reporting and internal controls.
3.
Management's Philosophy and Operating Style Management's philosophy and operating style are congruent with effective financial reporting and internal control.
4.
Organizational Structure Organizational structure does not undermine the commitment to effective financial reporting and internal control.
5.
Financial Reporting Competencies The company retains qualified personnel to handle financial reporting.
6.
Authority and Responsibility The authority and responsibility assigned to individuais within the organizational structure are appropriate to maintain effective internal controls.
7.
Human Resources Human resources policies and procedures are fuily compatible with effective financial reporting and internal control. PASS KEY
The principles that comprise internal control components have been the subject of AICPA released questions. Remember that the "tone at the top" is how the control environment component is often PHRASED. Reorganize the letters to remember these principles:
P
f,hilosophy and operating style of management
H
Human resources
R
.Beporting {financial} competencies
A
t,uthority and responsibility
,;
~tructure (organizational)
~
E "thieal values (and Integrity) \)
Qirectors
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Applying the Framework to Smaller Companies Smaller companies typically have limited resources to invest in support functions such internal audit, human resources, accounting or legal. Application of the Framework requires judgment with regard to the active participation of management and those charged with governance in ensuring strong internal controls.
III.
ENTERPRISE RISK MANAGEMENT In 2004, the COSO issued Enterprise Risk Management - Integrated Framework (ERM) to assist organizations in developing a comprehensive response to risk management. The intent of enterprise risk management is to allow management to effectively deal with uncertainty, evaluate risk acceptance, and build value. Value is maximized when strategy balances risks and returns as well as efficiency and effectiveness in accomplishing objectives. Each enterprise is unique and has its own individual features. The ERM framework helps identify those features. A.
Introduction The COSO defines enterprise risk management 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."
The ERM framework encompasses the following themes. 1.
Aligning Risk Appetite and Strategy Organizations set strategy and objectives based on their individual willingness to bear risk. The levels and types of risk, including the mechanisms used to manage risk, are important themes in ERM.
2.
Enhancing Risk Response Decisions ERM provides that framework to evaluate how an organization will respond to risk. The alternative risk responses are generally:
3.
a.
Risk avoidance
b.
Reduction
c.
Sharing
d.
Acceptance
Reducing Operational Surprises and Losses ERM devotes time to event identification. Events may be positive (opportunities) or negative (risks). The early identification of events and the establishment of responses to those events reduce surprises and losses or lost opportunities.
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Identifying and Managing Multiple and Cross-enterprise Risks The character of risks changes when viewed from an entity wide perspective through to the division and business unit levels. Applying the framework at each level identifies unique and common risks which helps management identify appropriate responses.
5.
Seizing Opportunities Management can better capitalize on opportunities when they know their own strengths and weaknesses.
6.
Improving Deployment of Capital Management can maximize the efficiency and effectiveness of capital investments when it can fit those investments into the context of a strategy that has been established based upon an individualized risk appetite.
B.
Objectives ERM defines enterprise objectives in four categories:
C.
1.
Strategic - High level goals designed to achieve the mission.
2.
Operations - Achievement objectives through the effective and efficient use of resources.
3.
Reporting - Achievement of reliable reporting.
4.
Compliance - Ensuring compliance with laws and regulations.
Components of Enterprise Risk Management ERM includes components that are similar to the components of the Framework but are somewhat broader in scope. The components of ERM are supported by key elements. The components of ERM are as follows:
• • • • • • • •
Internal environment Setting objectives Event identification Assessment of risk Risk response Control activities Information and communication Monitoring PASS
KEY
Knowing the logical order of the enterprise risk management framework has been a topic of released questions. Memorize the sequence of the component as: IS EAR AIM.
A Activities (control)
I Internal environment
E
'S Setting objectives
A Assessment of risk
I Information and communication
R Risk response
M Monitoring
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Internal Environment The internal environment component of ERM is similar to the control environment of the Framework and defines the tone of the organization. The internal environment component is supported by eight key elements: •
Risk management philosophy
•
Risk appetite
•
Board of Directors
•
Integrity and Ethical Values
•
Commitment to Competence
•
Organizational Structure
•
Assignment of Authority and Responsibility
•
Human Resources Standards
a.
Risk Management Philosophy The shared beliefs and attitudes of management that impact the entire organization are defined by risk management philosophy.
b.
Risk Appetite The amount of risk an organization will accept in the pursuit of value is defined by risk appetite. Risk appetite factors heavily into balancing strategy with return.
c.
Board of Directors The degree of involved and appropriate oversight prOVided by the board of directors establishes an organization wide tone that recognizes authority and accountability.
d.
Integrity and Ethical Values Adoption and demonstration of high ethical values by leadership will shape the internal environment.
e.
Commitment to Competence Management's jUdicious specification of required competency levels for each job function establishes the organization wide expectation of individual and thus corporate competence.
f.
Organizational Structure Organizational structure anticipates that the organization makes sense (e.g., the internal audit department reports to a level of the organization independent of Finance). A logically organized effort will garner individual and thus corporate respect.
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Assignment of Authority and Responsibility The degree to which individuals are given appropriate authority to handle their responsibilities and the degree to which they are held accountable influences the internal environment.
h.
Human Resou rces Standards The commitment to hiring the most qualified people will influence the internal environment. Minimum educational and experience requirements, background checks, and the like demonstrate the commitment and promote individual and corporate accountability. CONCEPT EXAMPLE
According to COSO, which ofthe following components of enterprise risk management addresses an entity's integrity and ethical values? a.
Information and communication.
b.
Internal environment.
c.
Risk assessment.
d.
Control activities.
Solution: Choice "b" is correct. Integrity and ethical values are addressed in the Internal Environment component of the Committee on Sponsoring Organizations Enterprise Risk Management Integrated Framework. Other elements of internal environment include risk management philosophy, risk appetite, organizational structure, and assignment of authority and responsibility and human resources standards. Choice "an is incorrect. The information and communication component of the Committee on Sponsoring Organizations Enterprise Risk Management Integrated Framework includes information and communications standards, not ethical values. Choice "c" is incorrect. The risk assessment component of the Committee on Sponsoring Organizations Enterprise Risk Management Integrated Framework includes the identification of inherent and residual risk, the evaluation of likelihood and impact of risk, and data sources. Ethical values are not a primary component of this area. Choice "d" is incorrect. The control activities component of the Committee on Sponsoring Organizations Enterprise Risk Management Integrated Framework includes types of control activities, policies and procedures and integration of control issues with risk responses. Ethical values are not a primary component ofthis area.
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2.
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Objective Setting Organizations set objectives and then identify the events that may block the achievement of those objectives. This thought process is similar to the establishment of financial reporting objectives followed by the evaluation of risk in the Framework but expands the idea to include operations. Objective setting is supported by the following key elements: •
Strategic objectives
•
Related objectives
•
Selected objectives
•
Risk appetite
•
Risk toierances
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Strategic Objectives The broad mission driven objectives of an organization are strategic objectives. Strategic objectives often remain the same year after year while remaining objectives are more dynamic.
b.
Related Objectives Strategic objectives are supported by related objectives that help to identify critical success factors at each ievel of business operation. Related objectives generally fail into the three categories: (1)
Operations Objectives Efficiency, effectiveness and profitability objectives that are subject to management discretion or style dominate the operations category.
(2)
Reporting Objectives Externai reporting and internal reporting objectives associated with timeliness and accuracy are associated with both financial and non financial data.
(3)
Compliance Objectives Adherence to all manner of laws rules and regulations associated with operations are described in compliance objectives. Tax and financial reporting compliance is a part of this objective, however, workplace safety, environmental and other laws wiil also impact this objective.
c.
Selected Objectives Objectives ultimately selected for implementation and foilow through by the organization must not only support the mission, but also align with the entity's risk appetite.
d.
Risk Appetite Management establishes risk appetite with the oversight of the board of directors. The entity's risk appetite is the benchmark for strategy setting. It is the theoretical balance of willingness to accept risk to return and growth. Risk appetite is sometimes expressed as a risk-adjusted shareholder value-added measure. Risk appetite impacts strategy which in turn impact resource ailocations.
e.
Risk Tolerances An organization's risk tolerance is the accepted level of variation relative to the achievement of objectives. For example, a company's target for company training is 90% while the minimum pass rate is 75%.
3.
Event Identification Events, both negative (risks) and positive (opportunities) are identified. Event identification is supported by the following key elements:
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•
Events
•
Influencing factors
•
Event identification techniques
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•
Event interdependencies
•
Event categories
•
Distinguishing risks and opportunities
a.
Events Events are at the core of risk assessment processes. An event is an internal or external occurrence that impacts strategy or the achievement of objectives. Events may be either positive or negative. Events mayor may not happen. It is the uncertainty of the event along with its potential severity or benefit that drives the risk assessment and response process.
b.
Influencing Factors Event identification recognizes that occurrences can come from anywhere. Events can be external such as economic (recession), natural (storms), social (changes in society). Events might also be internal such as technology choices, personnel, etc.
c.
Event Identification Techniques Identifying events can take any number of forms. Workshops and brainstorming sessions might be useful in some instances. Analytics applied to data including trend analysis might also be of use. Event identification techniques may include (1)
Event Inventories Lists of potential events cornmon to companies in a particular industry.
(2)
Internal Analysis Analysis performed by internal staff as part of business planning.
(3)
Escalation or Threshold Triggers Comparison of activity to pre defined criteria may trigger identification of events (e.g., variances from standards).
d.
Event Interdependencies Event identification considers event interdependencies. For example, changes in interest rates might impact exchange rates which might change supplier costs or foreign demand.
e.
Event Categories Events might be categorized in any number of ways to ensure comprehensive consideration of potential events. (1 )
External (a)
Economic
(b)
Natural Environment
(c)
Political
(d)
Social
(e)
Technological
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(2)
f.
4.
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Internal (a)
Infrastructure (e.g., assets, capital and other resources)
(b)
Personnel
(c)
Process
(d)
Technology
Distinguishing Risks and Opportunities (1)
Negative events that prevent achievement of objectives are a risk.
(2)
Positive events the promote achievement of objectives are an opportunity.
Risk Assessment Risks are analyzed in relation to their likelihood and their severity and the anticipated risks that continue even after management has taken action. Risk assessment is supported by the following key elements:
• • •
Inherent and residuai risk
• •
Assessment techniques
a.
b.
c.
Establishing likelihood and impact Data sources
Event relationships Inherent and Residual Risk (1)
Inherent risk is the risk to an organization that exists if management takes no action to change the likelihood or impact of an adverse event.
(2)
Residual risk is the risk to an organization that exists after management takes action to mitigate the adverse impact of the event.
Establishing Likelihood and Impact (1)
Likelihood of an event is the probability that an event might occur.
(2)
Impact of an event is the consequence of its occurrence. Impact is alternately referred to as severity or seriousness.
(3)
in establishing the likelihood and impact of events managers should use the same time horizon as strategic pians. The likelihood of a natural disaster occurring that would negatively impact operations with an unlimited time horizon is virtually assured, however, the likelihood of a natural disaster over a shorter period of one to five years will be much smaller.
Data Sources Data sources are generally drawn from past experience with similar events.
d.
Assessment Techniques Assessment techniques include empirical and intuitive methods such as: (1)
Benchmarking Use of common data from organizations with similar characteristics.
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Probabilistic Models Use of a range of events and impact with likelihood estimated using assumptions.
(3)
Non-probabilistic Models Use of subjective assumptions to estimate event impact without estimating likelihood.
e.
Event Relationships Management must determine if events correlate or are related.
5.
Risk Response Management's response to risk can be anywhere in a range of alternatives but must align with the organization's overall risk appetite. Risk response is supported by the following key elements: •
Evaluating possible responses
•
Selected responses
•
Portfolio view
a.
Evaluating Possible Responses Management will generally respond to risk in one of four ways based upon their evaluation and will decide upon an approach after reviewing the likelihood and impact of the risk and weight the cost and benefit of the response. (1)
Avoidance Management may elect to avoid or terminate risk. For example, a company discontinues a product line.
(2)
Reduction Management may elect to reduce or mitigate risk. For example, a company elects to invest in inventory technology to more closely monitor inventory levels and avoid the risk of stock outs.
(3)
Sharing Management may reduce risk by transferring risk. For example, a company buys insurance to cover potential losses.
(4)
Acceptance The company takes no action.
b.
Selected Responses Management selects a response from the alternatives.
c.
Portfolio View Risk should be considered entity-wide using a portfolio perspective. Ultimately entities must review their entire residual risk in comparison to risk tolerances. Simply put, once the organization has done all it can do, is the potential return worth the risk.
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Control Activities Policies and procedures used to effect management's response to risk are included in control activities. The control activities component is supported by following key elements: •
Integration with risk response
•
Types of control activities
•
Policies and procedures
•
Controls over information systems
•
Entity specific
a.
Integration with Risk Response Policies and procedures should mirror the actions anticipated by the risk response and should be anticipated to be effective.
b.
Types of Control Activities The ERM identifies numerous types of control activities that might be used to fully respond to risk. The activities include: (1)
Top-level Reviews Review of major initiatives and budget vs. actual performance is reviewed by top managers.
(2)
Direct Function or Activity Management Review of performance reports and reconciliations by operating managers to ensure the transactions and other operations are executed as prescribed.
(3)
Information Processing Use of common information processing controls such as edit checks, batch totals, etc.
(4)
Physical Controls Assets are kept in physically secure locations.
(5)
Performance Indicators Comparison of financial or other operating results to standard.
(6)
Segregation Duties Division of authorization, record keeping and custodial duties to ensure that no one individuai can control a transaction from beginning to end and thereby manipulate results.
c.
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Policies and Procedures (1)
Policies describe what should be done.
(2)
Procedures affect the policy.
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Controls over Information Systems (1)
General controls deal with infrastructure, security management, software acquisition, etc.
(2)
Application controls focus directly on data capture and processing.
Entity Specific Controls will be specific to each entity and be impacted by the size and complexity of the organization and its processes.
7.
Information and Communication The identification, capture and communication of information throughout the organization in an effective manner are induded in the information and communication component. The Information and communication component is supported by following key elements: •
Information
•
Communication
a.
Information Information is needed at all levels of the organization to manage risks.
(1)
Strategic and Integrated Systems Improved technologies integrate internal and external communications. Information systems must be flexible enough to fully integrate with others.
(2)
Integration with Operations Information systems must fully integrate with operations to be effective. Web and web based systems give the ability to place information in the hands of users on a timely basis. Enterprise Resource Planning concepts are made more effective.
(3)
Depth and Timeliness of Information Information systems must capture data in the level of detail necessary to make decisions (reduce risk) and in time to make a difference.
(4)
Information Quality Effective information generally has the following qualities: (a)
Appropriate content;
(b)
Timeliness;
(c)
Current;
(d)
Accurate; and
(e)
Accessible.
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Communication (1)
Internal Management provides specific and directed communication that conveys the behavioral responsibilities of personnel.
(2)
External Effective external communication is required to ensure that supplier and customer feedback can provide input to product or service design.
(3)
Means of communication Communication can use any number of media (e-mail, formal correspondence, social networking sites, or bulletin boards). Appropriate media is a matter of judgment.
8.
Monitoring The continuous monitoring of activities used to manage risk are included in the monitoring component. The monitoring component is supported by following key elements: •
Ongoing monitoring
•
Separate evaluations
•
Reporting deficiencies
a.
Ongoing Monitoring Activities Operating or functional support managers provide ongoing monitoring activity to verify the effective operation of controls. Activities may be performed monthly, weekly, daily or at whatever time increment is appropriate.
b.
Separate Evaluations A fresh look at the effectiveness of internal controls can be highly valuable. Internal audit staff or ad hoc teams can conduct the evaluation.
c.
Reporting Deficiencies Deficiencies in the operation of risk management procedures are normally reported through the normal chain of command but may require special treatment given the nature and character of the finding.
o
END OF ANCILLARY MATERIAL
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Relationship Between Components The enterprise risk management framework is illustrated by the COSO as a cube that illustrates the three dimensional quality of the framework. Each objective of the entity is characterized by all of the risk management components for each level of the business.
1...,__'
Existing Control Activities ___ if
1.
", ",
Each Objective is Supported by all Components Strategic, operating, reporting and compliance objectives should be evaiuated for each of the risk management components.
2.
Each Level of Business has Objectives and Components Objectives are developed for each level of the business: entity level, division business unit, and subsidiary.
E.
Effectiveness 1.
2.
Elements of Effectiveness a.
Each component of enterprise risk management must be present and functioning. The components are the effectiveness criteria.
b.
There can be no material weaknesses for enterprise risk management to be considered effective.
Significance of Effective Enterprise Risk Management Management and the board of directors have reasonable assurance that: a.
They understand the extent to which the entity's strategic and operating objects are being achieved.
b.
Reporting is reliable and applicable laws and reguiations are being complied with.
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Limitations Enterprise risk management is an outstanding tool, but it is subject to human judgment. ERM evaluations could be made in error and managers could override controls. SUMMARY OF COSO FRAMEWORK COMPONENTS
Internal Control Framework
ERM Framework
(financial reporting)
(entity-wide management)
Control Environment
Internal Environment
1. 2. 3. 4. 5. 6. 7.
1. 2. 3. 4. 5. 6. 7. 8.
Integrity and ethical values Board of directors Management's philosophy and operating style Organizational structure Financial reporting competencies Authority and responsibility Human resources
Risk management philosophy Risk appetite Board of directors Integrity and ethical values Commitment to competence Organizational structure Assignment of authority and responsibility Human resources standards
Objective Setting 1. 2. 3. 4. 5.
Strategic objectives Related objectives Selected objectives Risk appetite Risk tolerances
Event Identification 1. 2. 3. 4. 5. 6.
Events Influencing factors Event identification techniques Event interdependencies Event categories Distinguishing risks and opportunities
Risk Assessment
Risk Assessment
1. Financial reporting objectives 2. Financial reporting risks 3. Fraud risk
1. 2. 3. 4. 5.
Inherent and residual risk Establishing likelihood and impact Data sources Assessment techniques Event relationships
Risk Response 1. Evaluating possible responses 2. Selected responses 3. Portfolio view
Contra! Activities
Control Activities
1. 2. 3. 4.
Risk assessment integration
1. Integration with risk response
Selection and development
2. Types of control activities 3. Policies and procedures
Policies and procedures Information and technology
4. Controls over information systems 5. Entity specific
Information and Communication
Information and Communication
1. Financial reporting information 2. Internal control information 3. Internal communication
1. Information 2. Communication
4. External communication
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Monitoring
Monitoring
1. Ongoing and separate evaluations 2. Reporting deficiencies
1. Ongoing monitoring activities 2. Separate evaluations 3. Reporting deficiencies
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CONTROL ENVIRONMENT
The portion of the content specification outline that addresses control environment is drawn from the Framework's discussion of control environment, monitoring and change control.
I.
TONE AT THE TOP - Establishing Control Environment Establishing and effective control environment draws upon seven principles described below: •
Integrity and ethical values
•
Board of directors
•
Management's philosophy and operating style
•
Organizational structure
•
Financial reporting competencies
•
Authority and responsibility
•
Human resources
A.
Integrity and Ethical Values High standards of integrity and ethical conduct are adopted by top management and demonstrated throughout the organization.
1.
Attributes of the Principle The integrity and ethical values principal has the following attributes:
2.
a.
Statements of ethics are clearly articulated.
b.
Processes are in place to monitor adherence to ethical values.
c.
Departures from ethical conduct are addressed.
Approaches to Applying the Principle a.
Articulating and Demonstrating Integrity and Ethics The CEO and all members of management must demonstrate their commitment to ethical behavior through their ongoing dealings with vendors, customers and employees. There should be zero tolerance for unethical behavior.
b.
Informing Employees about Integrity and Ethics Management should pUblish a code of ethics or standards of conduct. Employees should be trained with regard to the code and periodically provide confirmation of understanding of key principles.
c.
Demonstrating Commitment to Integrity and Ethics instituting an ethics or compliance hotline and timely and appropriateiy following up on reported non compliance.
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Board of Directors The Board of Directors is actively involved in their oversight responsibility related to both financial reporting and internal controls. 1.
Attributes of the Principle The Board of Directors principle has the following attributes:
2.
a.
Operates independently;
b.
Monitors risk;
c.
Appoints an audit committee and at least one member of the committee is a financial expert;
d.
Oversees quality and reliability; and
e.
Appoints an audit committee that oversees audit activities.
Approaches to Applying the Principle A number of approaches can be used that demonstrate the Board of Directors principle. These approaches include: a.
Establishing standard content and action items at regularly scheduled board meetings.
b.
Using national listings from reputable accounting and finance associations to identify independent and appropriately skilled board members.
c.
Ensuring the bylaws and charters describe Board member responsibilities.
d.
Establishing an audit committee and ensuring they:
e. C.
(1)
Consider the effectiveness of internal control.
(2)
Meet with the auditors.
(3)
Review policies and procedures.
(4)
Maintain skepticism.
(5)
Consider whistle-blower information.
(6)
Annually certify compliance with statutory and bylaw requirements.
Conducting a portion of each Board meeting with no member of management present.
Management Philosophy and Operating Style Management's philosophy and operating style are congruent with effective financial reporting and internal control.
1.
Attributes of the Principle Management philosophy and operating style as the following attributes:
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a.
Management's operating style should emphasize reliable financial reporting.
b.
Management's attitude supports an objective selection of accounting principles and a rigorous development of estimates.
c.
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Approaches to Applying the Principle a.
Management emphasizes reducing the risk of material misstatement in their discussions with others.
b.
Management insists on appropriate documentation for all transactions entered into the financial records.
c.
Diligence in performance of duty is emphasized by management.
d.
Personnel involved in financial statement preparation are informed of management's commitment to fair presentation.
Organizational Structure Organizational structure does not undermine the commitment to effective financial reporting and internal control.
1.
Attributes of the Principle The organization structure principle has the following attributes:
2.
E.
a.
Management designs appropriate financiai reporting structures that provides relevant information at appropriate functional and business unit levels.
b.
Management maintains an organizational structure that facilitates reporting and other communications regarding internal control over financial reporting.
Approaches to Applying the Principle a.
Organizational charts - Organization charts define relationships and roles.
b.
Aligning roles to process - Each function within the organization aligns with key processes that support financial reporting objectives.
c.
Job Descriptions - Job descriptions should be formally documented and updated from time to time.
d.
Organization structure - No more than three layers of organization existed between the CFO and the individuals involved in financial reporting.
e.
Internal audit - Internal auditors should report directly to the CEO with direct access to the audit committee.
Financial Reporting Competencies The company retains qualified personnel to handle financial reporting. 1.
Attributes of the Principle The financial reporting competencies principle includes the following attributes:
2.
a.
Competencies necessary for financial reporting are identified.
b.
Individuals who possess the necessary competencies for financial reporting are hired for that purpose.
c.
Needed competencies are regularly evaluated and maintained.
Approaches to Applying the Principle a.
Management establishes appropriate knowledge, skills and abilities for individuals to be hired for financial reporting responsibilities.
b.
Training is provided in house.
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c.
The board of directors or audit committee regularly evaluates the competencies of the CFO.
d.
Management provides ongoing evaluation of competencies.
Authority and Responsibility The authority and responsibility assigned to individuals within the organizational structure are appropriate to maintain effective internal controls. 1.
Attributes of the Principle Authority and responsibility have the following attributes: a.
b. 2.
G.
Responsibilities are defined as follows: (1)
Audit committee oversees the management process for defining responsibility for key financial reporting roles.
(2)
Executive management is responsible for solid internal control over financial reporting. Executive management is responsible for starting and maintaining the internal control system.
(3)
Senior and functional management is responsible for ensuring all employees understand their responsibilities and adhere to internal control policies.
Authority is properly limited by position.
Approaches to Applying the Principle a.
Establish clear job descriptions.
b.
Document audit committee review of key finance personnel.
c.
Employee positions are aligned with appropriate authority.
Human Resources Human resources policies and procedures are fully compatible with effective financial reporting and internal control. 1.
Attributes of the Principle The human resources principle has the following attributes:
2.
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a.
Human resources policies demonstrate commitment to competence and ethics.
b.
Recruitment is guided by ethical principles that seek competent individuals.
c.
Management supports appropriate training.
d.
Performance evaluations and compensation practices support achievement of financial reporting objectives.
Approaches to Applying the Principle a.
Maintain current job descriptions.
b.
Maintain current human resources procedures.
c.
Screen job applicants though reference checks and resume reviews.
d.
Establish a review and appraisal process.
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e.
Design and review compensation plans to ensure market rates are paid and that senior management salaries are tied to achievement of non financial goals.
f.
Regularly evaluate the competency of personnel.
MONITORING CONTROL EFFECTIVENESS A.
Ongoing and Separate Evaluations Monitoring of internal control effectiveness is done to provide an assessment of the performance of the system over time and may be done on an ongoing basis or in separate evaluations. 1.
Attributes of the Principle The ongoing and separate evaluations principle has the foilowing attributes:
2.
a.
Internal control effectiveness monitoring should be built into or integrated with the company's operations,
b.
Evaluations should provide an objective consideration of internal control over financial reporting,
c.
Evaluators are knowledgeabie regarding financial reporting and controi activities,
d.
Management receives and considers feedback on internal control over financial reporting, and
e.
Scope and frequency of evaluations varies based on the significance of the risk being controiled.
Approaches to Applying the Principle a.
Metrics to Track Performance Metrics are established to compare current performance to target performance. Metrics correlated with financial reporting outcomes such as staffing levels or receivables management (sometimes referred to as key controi indictors) are monitored and adjustments are made if results faii to comply with standards.
b.
Relating Metrics to Financial Reporting Management confirms that metrics correlate to the effectiveness of controls over financial reporting. (Are staffing ieveis indicative of control effectiveness or is the level of staff a stronger indicator?)
c.
Self-assessments Management might use a self-assessment questionnaire to be completed by personnel involved in executing the controls.
d.
Computer Network Testing Periodic tests of computer connectivity to test the access to data and the effectiveness of information safeguards may be undertaken in a separate evaluation.
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e.
Internal Auditing Internal auditing departments perform both ongoing and separate evaluations of controls and report to both senior management and the audit committee.
f.
Scope and Frequency of Separate Evaluations Financial statement accounts are grouped with risk exposures that are higher, moderate or lower. Management prioritizes accounts based on risk, evaluates the past effectiveness of controls and then schedules separate evaluations for higher risk accounts with particular attention to those areas that have not been effective in the past.
B.
Reporting Deficiencies Deficiencies in internal control design or operation should be reported to appropriate leadership in a timely manner. Reporting should be made to the individuals responsible for corrective action. 1.
Attributes of the Principle The reporting deficiencies principle has the following attributes:
2.
a.
Reports are made to process owners who control and can correct process errors. Reports should also be made to a level of supervision at least one level above the process owner.
b.
Significant deficiencies are communicated to top management and the board or audit committee.
c.
Corrective actions are taken on a timely basis.
Approaches to Applying the Principle a.
Alternate Reporting Channels Compliance and ethics hotlines provide the opportunity for employees or report observed behaviors or actions that might undermine effective financial reporting.
b.
Levels of Reporting All deficiencies in internal control should be reported to the responsible manager and one supervisory level above the manager. The materiality will dictate the additional levels that may receive reports.
c.
Guidelines for Reporting Deficiencies Management develops a list of controls weakness that would seriously threaten the reliability of financial reporting and establish standards for immediate reporting. For example, any illegal or improper acts, significant lost assets or improper financial reporting would be issues that might be considered eligible for immediate reporting to senior management.
III.
CHANGE CONTROL PROCESS Change control management and processes consider the manner in which management monitors and authorizes changes to a variety of information technology matters including software application programs, system software, database administration, networks and security, and job scheduling .
• '·30
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AN elL l A R Y MAT E R I A l
A.
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o
(for Independent Review)
Applying Change Management in Less Complex Computer Environments Less complex operations generally relate to small companies that have implemented pre packaged applications without significant modifications. Although user configurations are possible, they do not impact the function of the applications. 1.
2.
Selection and Deployment of Systems a.
Senior management approves the selection of the system.
b.
Implementation follows the logical steps: (1)
Risk assessment is performed.
(2)
Application controls are considered.
(3)
Security requirements are considered.
(4)
Data conversion requirements are developed.
(5)
Testing is performed.
(6)
Implementation.
(7)
Post implementation review.
Patch Management Process A software developer's updates to its system to eliminate system problems or to promote system efficiencies are known as patches. A patch is a system update that, in a figurative way, covers a hole.
B.
a.
Patches are tested prior to implementation.
b.
Patches might be tested by third parties.
c.
Only authorized individuals are authorized to move changes into production and the function of making the change is segregated from the function of putting the change into production.
Applying Change Management in More Complex Computer Environments More complex operations may relate to larger companies but, at any rate, involve a wider variety of changes than less complex operations. 1.
2.
Complex computer environments share many of the following characteristics: a.
Source code may be developed in house for critical applications.
b.
Pre-packaged software may be significantly customized to meet specific entity requirements.
Change management controls adapt to more sophisticated requirements. a.
Changes that require documentation are defined.
b.
Access and updates to source code are managed with version control systems.
c.
All significant changes are tested before being released into production.
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d.
Back out plans exist for change that cannot be performed in segregated environments.
e.
Only authorized individuals are permitted to move changes into production and that function is, where possible, segregated from the individuai responsible for making the change.
f.
Notification, evaluation and documentation steps are performed by a system manager to resolve emergency change requests.
g.
Where segregation of duties is not practical, management partitions servers into development, test, and production environments to mimic segregation of duties and reviews the operation of partitioned environment from time to time.
END OF ANCILLARY MATERIAL
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OPERATIONS MANAGEMENT Performance Management and Impact of Measures on Behavior
Accounting systems include both technical and behavioral components. Technical components assist managers in making appropriate economic decisions while behavioral components serve to motivate managers to accomplish the goals of the organization.
I.
FINANCIAL AND NON-FINANCIAL MEASURES Both financial and non-financial measures are ultimately designed to provide feedback that will motivate appropriate behaviors. Feedback tied to self interest is most effective. The issue associated with any measurement system is the appropriate linkage of measures, incentives and goals.
A.
Financial Measures The technical features of the measures described below are included in other chapters. The impact on behavior, however, is described below. Financial measures are often easy for accountants to develop since the data is readily available from the accounting records.
1.
Profit The "bottom line" measurement of any business is the amount of profit or earnings generated by operations and is a frequently used performance measure. It captures so many elements of performance, however, that it may not be effective in motivating targeted behavior.
2.
Return on Investment The return on investment (ROI) measurement motivates achievement of levels of net earnings on company resources that are worthwhile. ROI is expressed as a percentage of profit to investment. While the ROI provides an outstanding tool for measuring performance, it can inappropriately motivate managers to delay or avoid increasing the investment base thereby making achievement of ROI targets easier.
3.
Variance Analysis Variance analysis typically compares performance to budget and is expressed as an amount. The comparison of cost or revenue to standards can be highly effective in achieving standards if managers agree with the standards.
4.
Balanced Scorecard The balanced scorecard seeks to fully integrate financial measures of performance with non financial measures of performance. The balanced scorecard has the potential to fully integrate financial and non financial measures. The baianced scorecard is described later in this text, but generally links vision and strategy from four perspectives: a.
Learning and growth (leveraging human resources capabilities)
b.
Customer (measuring the effort that adds to customer satisfaction)
c.
Business process (measuring efficiency and effectiveness of business process)
d.
Financial (measuring financial reSUlts)
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Non-financial Measures Including Benchmarking Techniques and Best Practices in General Operations can be improved with non-financial measures. Non-financial measures have the potential of being more timely and relating to issues (pounds of material used, time to process, miles driven) that the manager can directly affect. Benchmarking can be used to develop non-financial measures and is the process often used to identify standards that define or quantify critical success factors. Benchmark standards are used for comparison to actual performance, determination of gaps in performance, and implementation of Improvements to meet or exceed the benchmark. Benchmarks may be internally developed or externally researched. Externally deterrnined benchmarks are typically best practices. Best practices represent world-class performance standards and are meant to encourage achievement of goals.
C.
External Benchmarks - Productivity Measures Productivity is defined as the measure of the ratio of the outputs achieved to the inputs into production. Productivity is a measure of efficiency and uses the relationships derived from actual performance in comparison to similar organizations over time. 1.
2.
Productivity Measurement Objectives a.
Determine whether more inputs have been used than necessary to obtain the actual output.
b.
Determine whether the best mix of inputs has been used.
Two Types of Productivity Ratios are Generally Recognized a.
Total Productivity Ratios (TPRs) Total productivity ratios (TPRs) reflect the value of all output relative to the value of all input.
b.
(1)
TPRs consider all inputs simultaneously as well as the prices of the inputs.
(2)
A TPR is calculated as the quantity of output produced in a given period divided by the cost of inputs in the same period.
Partial Productivity Ratios (PPRs) Partial productivity ratios (PPRs) reflect the value of all outputs as compared to the value of major categories of input.
Bl-34
(1)
PPRs are concerned only with the quantity of a single input (such as direct material or direct labor) and do not consider the price of the input.
(2)
A PPR is calculated as the quantity of output produced divided by the quantity of the single input used.
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Internal Benchmarks - Techniques to Find and Analyze Problems Development of internal benchmarks often employs a variety of techniques to find and analyze problems or measure performance. Among the most common quality monitoring and investigative techniques are the procedures described below.
1.
Control Charts
Control charts graphically display the impact of measuring goalpost conformance (see Quality Control Principles below). Actual results by batch or other suitable constant interval are plotted in comparison to an acceptable range. Control charts show if there is a trend toward improved quality conformance or deteriorating quality conformance.
Control Chart 16
Upper Limit
14
-Upper Limit
12
0
o
~ 10
.!!
o
-
-
-Average
o
~ 8
t
o
Lower Limit
6 '" 4
lower Limit
o
o
o
o
Results
2
o 1
2
3
4
5
6
7
8
BatcheS/Intervals
a.
Statistical Control Processes for which none of the actual measures fall outside of boundaries are in "statistical control." Simple compliance does not indicate if trends point to deterioration in quality.
2.
Pareto Diagrams
Pareto diagrams combine the elements of a histogram of quality control issues displayed in order of most to least frequent with a line graph that displays the cumulative occurrence of the problems.
a.
Use Managers use Pareto charts to determine the quality control issues that are most frequent and often demand the greatest attention.
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Interpretation The Pareto diagram below shows the individual and cumulative frequency of six types of quality issues. Addressing half of the types of defects (Type 3, Type 2 and Type 1) would address three quarters (75%) of all defects.
Pareto Diagram Incidents of Defect By Type 100%
600 100%
90% SOD
.
.., ~
,E
80% 7S%
400
70% 60%
S8%
~
ll'
~
• ~
~
300
50% :. 40%
Z
200
~
~
~
30% '5 E 20%
a
100
10% 0 .~
~"q
eO. ~"q
0%
.'
• ,,,qe'"
...."\(:{"
~"q
•
...."\~e
Facility
3.
Cause·and-Effect (Fish bone) Diagram Cause-and-effect diagrams provide a framework for managers to analyze the problems that contribute to the occurrence of defects. Productive processes that lead to the manufacture of an item are displayed along a production line in a manner that looks like a fish bone. (Machinery)
(Materials)
. .:s: :.et:ti:ng:,.: ~:.:m: .:ng:-_- =~_. .:w.: r: :on: :g~c: :on': 'i: :": :~: :C!. .Y
_,,::'-_ _...
incomPI~V
Ine,perienced worker<
(Method)
(Manpower)
Preparation
a.
b.
• ,-36
/
Defect
~
/
Elements of the manufacturing process often include:
(1 )
Machinery
(2)
Method
(3)
Materials
(4)
Manpower
Managers identify the sources of problems in the production process by resource and take corrective action .
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Characteristics of Effective Performance Measures Effective performance measures promote the achievement of goals and typically the characteristics of those measures:
II.
1.
Relate to the goals of the organization.
2.
Balance long and short term issues.
3.
Refiect management of key activities sometime referred to as critical success factors in the balanced scorecard.
4.
Are under the control or influence of the employee.
5.
Are understood by the employee.
6.
Are used to both evaluate and reward the employee or otherwise constructively influence behavior.
7.
Are objective and easily measured.
8.
Are used consistently.
IMPACT OF MARKETING PRACTICES ON PERFORMANCE Marketing practices can generally focus on one of five different elements including the product, the market segment (which customer), the delivery system (e.g., wholesalers or retailers) the communication strategy and the price). Marketing decisions must consider the objectives of management and manner in which alternative practices will achieve those objectives. A.
Marketing Practices and Methods Marketing seeks to establish value for an organization's products. Customers seek a fair price and also quality and timeliness. Marketing decisions relate to the establishment of value and the methods used to promote and sell products to customers or prospective customers. 1.
Transaction Marketing Customers are attracted for the sake of a single sale. (A used car sold purely based on price).
2.
Interaction-based Relationship Marketing Customers are attracted for the purpose of a sale that serves as the basis for an ongoing relationship (a new car sale emphasizes value with anticipation of repeat sales and ongoing service).
3.
Database Marketing Information is gathered on customers and the information from that database is used to segment customers into target markets for a more effective selling effort. (A sale of a specialty item such as vitamin supplements to target groups.)
4.
E-marketing Use of the internet to accomplish marketing functions is known as E-marketing.
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Network Marketing Network marketing, sometimes referred to as multilevel marketing, focuses on relationships and referrals to accomplish marketing functions.
B.
Performance Marketing methods are selected to both efficiently promote and sell the product and drive the methods used to direct customer and employee behavior. 1.
Marketing Methods are Aligned with Products As noted above, certain products will be compatible with specific marketing practices.
2.
III.
Performance and Performance Incentives a.
Sales volume driven compensation and evaluation methods are well suited to transaction marketing that involve a single transaction.
b.
Customer Satisfaction and quality measures are more significant in relationship based marketing.
INCENTIVE COMPENSATION A.
Types of Compensation Compensation for managers comes in any number of forms. Generally there are three types. 1.
Fixed Salary Fixed salaries represent guaranteed payments from an employer in a fixed amount.
2.
Bonuses Incremental increases in pay may be awarded and are often based on either profit or stock performance.
3.
a.
Profit based bonuses provide incentive for operating performance that result from increases in sales or decreases in expenses.
b.
Stock based bonuses provide incentives for targeted stock prices. Bonuses provide incentives for achieving stronger market positions through higher stock prices. (1)
Stock based bonuses are often structured as stock options.
(2)
Options typically involve giving employees the right to buy a specified number of shares at a specified price within a future time period.
Other ("perks') Employee perks provide employees with non salary benefits such as use of vacation homes, use of company jets, company cars, lawn maintenance, etc.
• ,·38
a.
Perks must be authorized by the board of directors and properly disclosed in proxy statements.
b.
Perks may also need to be included in the taxable income of the manager.
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-
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H.cview - - ---------------
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Design Choices for Management Compensation 1.
Time Horizon Incentive compensation must balance employee focus between current rewards for current performance and the impact of current decisions on future performance.
2.
a.
Cash bonuses reward current performance.
b.
Restricted stock option may reward current performance but the plan emphasizes future performance. (1)
The empioyee must typically stay through the option strike period.
(2)
The option is only worthwhile if the stock price increases.
Fixed vs. Variable Bonuses Incentive programs may be fixed (formuia driven) or variable (subjective).
3.
a.
Fixed programs provide predictable payouts to participants but may be adversely impacted by uncontrollable events.
b.
Fixed plans are somewhat rigid and do not accommodate balanced scorecard presentations.
Stock vs. Accounting-based Performance Evaluation Incentives can be driven by stock price or by accounting information such as sales volume, profit margin, or return on investment.
4.
a.
Stock-based incentives align the manager's interests with the shareholders but can create risk averse behavior.
b.
Stock-based incentives are often linked with accounting based evaluations to balance performance between current and future performance.
Local vs. Company-wide Performance Rewards for division performance that erode company-wide performance do not contribute to entity wide strategic objectives.
5.
a.
Local performance might result in fixed salary.
b.
Bonuses might result from company-wide performance.
Cooperative vs. Competitive Incentive Plans Rewards may emphasize compensation for team performance or emphasize individual performance in relation to peers. a.
Cooperative incentive plans may result in stock options for companywide performance. Both the basis for the award and the type of award emphasize the corporate good. Manufacturers might consider cooperative incentives.
b.
Competitive incentive plans might result in tiered commission structures in which commission rates increase for individuals as thresholds are reached and exceeded. Car sales, insurance sales, etc. are ideal for competitive incentive plans.
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PEFORMANCE MEASUREMENT UNDER IFRS
Globalization of business environments require the uniform accounting rules that can be used by international trading partners or affiliates. Those ruies are embodied in International Financial Reporting Standards (IFRS) as developed by the International Accounting Standards Board (IASB). Candidates are expected to have a high level understanding of IFRS, explain the underlying economic substance of transactions and their accounting implications. The impact of IFRS is most prevalent in the changes to key performance metrics yet system controls and customer interaction may also change.
A.
Impact of Initial Conversion The initial conversion of financial statements to IFRS represents a retroactive restatement of historical financiai statements. The retroactive restatement could show any number of differences but are subject to optional and mandatory exemptions. 1.
Revenues are generally recognized much quicker under IFRS.
2.
Impairments and impairment reversals are more frequent under IFRS.
3.
Debt and equity classifications may change as certain securities are evaluated differently under IFRS.
4.
More entities will be consolidated under IFRS rules.
5.
Accounting policy alternatives should be explored to ensure that IFRS options do not better reflect the economic substance of transactions.
AN C III A R Y MAT ER IA l {for Independent ReView}
B.
Revenue Recognition Revenue recognition under GAAP requires the revenue be realized (collected) or realizable (generally receivable) and that the earnings process be complete. The completion of the earnings process is industry specific for U.S. GAAP. IFRS recognizes earnings when there is probability that economic benefits will come to the entity and both revenues and costs can be measured reliably. IFRS allows reasonable estimates of fair value (cost plus margin).
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1.
U.S. GAAP revenue recognition may unbundle revenue transactions (different contracted services for example) and then adjust the timing of revenue recognition accordingly. IFRS tends to bundle earnings.
2.
IFRS has uniform application of percentage of completion methodologies and, for construction, prohibits the use of the completed contract method. GAAP only uses percentage of completion for construction. IFRS conversions would result in accelerated revenue recognition for construction contracts and may defer revenues for service contracts.
3.
Customer loyalty program revenues are delayed under IFRS.
4.
Non monetary transactions are measured under IFRS based on the value of the asset received, then the asset surrendered. GAAP requires use of the fair value surrendered as a starting point.
5.
IFRS applies discounting approaches to a broader category of transactions reSUlting in lower income under IFRS. ©2010 OeVrv/6ecker Educational Development Corp_ All right, reserved
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Expense Recognition
Expense recognition is quicker in some instances. Stock option expenses are faster and, thus, the implications to managers compensated based on net income is obvious. Restructuring the deal could change the accounting but also the effectiveness of the incentive.
D.
E.
1.
Gradedistep vesting of stock awards produces faster expense recognition under IFRS than GAAP which may result in conversion to step programs. (A GAAP basis recognition of a stock option over four years would produce an expense equal to one quarter of the option. The IFRS basis would treat each of the option years separately and apply the same principles to each. Consequently, the entire amount of the first year would be recognized, one half of the second year, one third of the third year and one quarter of the fourth year.) Expense under IFRS would be over double the expense of GAAP in the first year.
2.
IFRS more rigorously recognizes compensation costs for employee stock purchase plans.
3.
Amortization of actuarial gains and losses may be recognized in a separate financial statement rather than the income statement.
4.
Pension costs maybe be distributed around the income statement rather than shown as a single line item.
5.
Full funded status not required for display on the balance sheet under IFRS.
Assets
1.
IFRS uses a one vs. a two step impairment test. IFRS comparison of carrying amount to recoverable amount results in more frequent revaluations of assets.
2.
IFRS allows more fair value adjustments of intangibles and property and equipment than GAAP.
3.
IFRS provides more latitude in capitalizing development costs.
4.
IFRS requires greater granularity and property and equipment display as well as depreciation. IFRS uses component rather than composite accounting.
5.
IFRS uses less restrictive criteria for determination of capital leases and breaks leases into components based on asset values.
6.
IFRS does not allow for LIFO based inventory while GAAP does. GAAP inventory values may be lower in periods of rising prices.
Liabilities IFRS and GAAP are very similar however the more significant differences in the two frameworks relate to deferred taxes.
F.
Equity Some financial instruments considered equity under U.S. GAAP will be debt under IFRS. Securities with contingent settlement provisions (e.g., redemption in the event of changes in control) are no longer equity but debt securities. The change in debt equity produces a different leverage metric and additional interest expense.
~
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GAAP vs
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IFRS
Compound financial instruments that include both equity and debt features are recognized by IFRS but not
GMP.
G.
Business Combinations IFRS produces a greater level of consolidations since the IFRS rules are simplified, more inclusive and allow for less exceptions than U.S. GAAP Business implications include expanded debt covenants and Sarbanes Oxley certifications. EXAMPLE
The Chairman of the Audit Committee is a retired executive with limited experience in the area of International Financial Reporting Standards (IFRS). Your company is starting the conversion of reports to IFRS and the chairman of the audit committee has asked you in your role as controller to describe some of the key differences that he will see in reported amounts and what they might mean to the company. The chairman was interested in a general discussion of how the initial conversion might look and what the conversion would mean in particular to the treatment of management's stock option incentives.
To:
Chairman of the Audit Committee
Subject:
International Financial Reporting Standards conversion
The International Financial Reporting Standards (IFRS) conversion will have a significant influence on the presentation of our financial position and the results of our operations in coming years. Although we are still not required to make the conversion, we are carefully evaluating what the results may be. When we convert our financial statements to IFRS you will be presented with a retroactive restatement that uses IFRS for all periods presented. You will see comprehensive accounting changes. On the Balance Sheet we will still own the same assets and owe the same liabilities, but the IFRS framework has a number of significant differences that generally relate to the valuation and revaluation of those items. For assets in particular, IFRS will have us break down assets into more components for purposes of valuation and assessment for impairment. With more assets, we have greater exposure to impairment. Our balance sheet will likely become more volatile. In addition we will be recording more development costs as assets instead of expensing them directly. On the income statement, revenues are subject to broader, less rule-based recognition criteria than our current GAAP basis financial statements. The consequence is that our earnings may be higher since revenues are recognized sooner. The incentive based programs create one of the most interesting features of the IFRS conversion. Our total stock based incentives are currently allocated evenly to each period. With IFRS each tranche will be allocated evenly to each period effectively more than doubling our expense in the first year. The conversion to IFRS represents a significant change in our financial reporting and it will require some re education. I would be glad to discuss this with you in person.
o
END OF ANCILLARY MATERIAL
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Business 1
OPERATIONS MANAGEMENT Cost Measurement Methods and Techniques
I.
INTRODUCTION A.
Cost Measurement in General The topic of cost measurement contemplates three major areas of study including the foundational accounting concepts of cost measurement, basic methods of cost accumulation and assignment, and the theoretical economic ideas of the business enterprise. Ultimately, the measurement and evaluation of the performance of the business enterprise are shaped by these economic ideas.
B.
Cost Measurement Concepts "Cost measurement concepts" is a phrase typically associated with the terms managerial accounting and internal reporting, which are distinct from the generally accepted accounting principles associated with financial accounting and external reporting. Cost measurement concepts for business and economic decision-making are often different from the rule-based valuation standards typically associated with financial accounting.
1.
Future Orientation While conservatism and historical orientation typify financial accounting statements, usefulness and a future orientation characterize managerial accounting reports. Future-oriented cost measurements might not follow promulgated rules.
2.
Internal Users Managerial accounting focuses on measuring costs that are specifically relevant to a particular cost object or the cost objectives (described below) that impact internal management decisions. While most financial accounting reports are directed to creditors and potential investors external to the organization, managerial accounting reports are prepared for internal users making operational decisions.
II.
IDENTIFYING COST DRIVERS AND CAUSAL RELATIONSHIPS Cost drivers are the dynamic factors that have the ability to change total costs (i.e., there is a direct causal relationship between the change in the cost driver and the total costs incurred). Cost drivers may be based on volume (output). activity (value added), or any number of other operational characteristics that we will define in this section. EXAMPLE
If a firm wishes to mail holiday cards to its clients, the costs would include the cost of the card and the postage, and the cost driver would be the number of clients. If the number of clients increased or decreased, so would the total cost of the activity (Le., a causal relationship).
A.
Types of Theoretical Cost Drivers 1.
Executional (short-term) Executional cost drivers are the dynamic factors that are helpful to the firm in managing the short-term costs of the firm (e.g., relationships with suppliers, enhancements to the production process, and involvement of staff in creating a more efficient process).
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Structural (long-term) Structural cost drivers are strategic decisions or plans made by the firm that have a long-term effect on the cost (e.g., experience, available technology, complexity, etc.).
B.
Types of Operational Cost Drivers 1.
Volume-based Volume-based cost drivers are based on an aggregate volume of output (e.g., the number of direct labor hours used or the number of production units). Volume-based cost drivers are usuaily associated with traditional cost accounting systems.
2.
Activity-based Activity-based cost drivers relate to an activity that adds value to output (e.g., packaging, inspection, etc.). Activity-based cost drivers are generally associated with contemporary cost accounting systems.
C.
Cost Drivers as Overhead Allocation Bases While the causal relationship between direct costs and cost drivers (direct labor hours or direct material invoices) is obvious, overhead costs are indirect and must be applied on some basis. Cost drivers are used as that basis. 1.
Allocation Bases Manufacturing overhead may be allocated to products or other cost objects (described below) through the use of cost drivers. Cost drivers used for this purpose are referred to as "allocation bases." EXAMPLE
Traditional industries uses direct labor hours as the allocation base for overhead application. Overhead costs are pooled in an indirect labor and materials account and then applied to products computed on a predetermined rate based on direct labor hours incurred. Direct labor hours is the cost driver.
2.
Activity Centers Identified cost drivers are often activity bases that are closely correlated with the incurrence of manufacturing overhead costs in an activity center. EXAMPLE
Contemporary industries accumulate the overhead costs associated with its manufacturing operations in various activity centers that accumulate costs that add value to its products. These activity centers include machine maintenance, packaging, etc. Contemporary industries uses machine hours as the cost driver for usage of its machine maintenance activities, numbers of items packaged to drive the assignment of its packaging costs to products, etc.
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_
I (p/\ [xarn Review ...•.... _--_ ..
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. .' - ' - - -
_-'
COST OBJECTS (or objectives) Cost objects (or cost objectives) are defined as resources or activities that serve as the basis for management decisions. Cost objects may take most any form; however, they will represent the most relevant components of a particular business's decision·making requirements. Cost objects require separate cost measurement and may be products, product lines, departments, geographic territories, or any other classification that aids in decision·making.
A.
Focus of Cost Objectives Integration of product costing with cost control measurement and assignment objectives maximizes the effectiveness of management accounting systems. 1.
Valuation Costing (valuation) of product or inventory (I.e., product costing) may be the measurement and assignment focus.
2.
Cost Control Cost control (I.e., cost comparison to standards and budgets) may be the measurement and assignment focus. PASS KEY
A single cost object can have more than one measurement. Inventory (product) costs for financial statements are usually different than costs reported for tax purposes. Both inventory (product) costs and costs reported for tax purposes are different from costs used by management to make decisions.
Prime "co~m~m=o=n=F=IO=W=Of=C~O~st~s=ld~.n~t~ifj=.d=bY=C=O=st=o=b=ie~c~ts~ / costs~_ Direct Materials
Direct labor
Factory Overhead
'-Product costs
Conversion costs
.-/
Work in Process
+
Finished Goods
+
Cost of Goods Sold
B.
Common Cost Objects and their Definitions 1.
Product Costs Product costs are all costs related to the manufacturing of the product.
a.
Inventory and Cost of Goods Manufactured and Sold Product costs are inventoriable (I.e., considered as assets before the product is sold). These costs attach to the units of output.
b.
Components Product costs consist of direct materials, direct labor, and manufacturing overhead applied.
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Period Costs Period costs are expensed in the period in which they are incurred and are not inventoriable.
a.
Expenses Period costs include selling and administrative expenses, interest expense. Components
b.
Period costs consist of selling the product and administering and managing the operations of the firm. 3.
Manufacturing Costs (treated as product costs) Manufacturing costs include all costs associated with the manufacture of a product. a.
Inventory and Cost of Goods Manufactured and Sold Manufacturing costs are specifically capitalized to the cost of the manufactured product, according to various available and appropriate methods.
b.
Components Manufacturing costs consist of both direct and indirect costs (described below).
4.
Non-manufacturing Costs (treated as period costs) Non-manufacturing costs are those costs that do not relate to the manufacturing of a product. These costs (e.g., selling, general, and administrative expenses) are expensed in the period incurred. PASS KEY
Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include:
IV.
•
Product costing (inventory and cost of goods manufactured and sold)
•
Efficiency measurements (comparisons to standards)
•
Income determination (profitability)
TRACING COSTS TO COST OBJECTS Tracing costs to the cost objects or cost pools is complicated by the existence of direct or indirect relationship of the cost to the cost object. While direct costs are relatively easy to assign, the assignment of indirect costs is often much more complicated.
A.
Direct Costs (easily traced) A direct cost can be easily (i.e., without excessive cost and without significant effort) traced to a cost pool or object, as the cost directly reiates to that item. Common direct costs include: 1.
Direct Raw Materials Direct raw materials are the costs of materials used in production or purchased (including freight-in net of any applicable purchase discounts) plus a reasonable amount for normal scrap created by the process.
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2.
-~---~_.-
.. _------------------
Business 1 --------------_.-------~. ------~-------
Direct Labor Direct labor is the cost of the labor that is directly related to the product or the performance of a service plus a reasonable amount of expected "down time" for the labor (e.g., breaks, setup, training, etc.). EXAMPLE
Spud Furnishings, Inc. manufactures custom couches. Raw materials (fabric or leather) used in the production process of a custom order (a couch) are considered direct materials and are easily traced to the cost object, the custom order. The time spent by the upholsterer to make the couch is considered direct labor and is also easily traced to the cost object, the custom order.
B.
Indirect Costs An indirect cost is not easily traceable to a cost pool or cost object. Indirect costs are typically incurred to benefit two or more cost pools or objects. The specific benefit each cost gave to the cost pool or object cannot be determined without making some sort of reasonable estimate or using an allocation methodology. Common indirect costs inciude: 1.
Indirect Materials Indirect materials are the cost of materials that were not used specifically or could not be traced to the completed product with ease. EXAMPLE
Spud Furnishings, Inc, manufactures custom couches. In addition to the direct material for fabriC, wood for framing, springs, it uses in its couches, the company purchases cleaning supplies used in the manufacturing area and small replacement parts for the manufacturing machines. These items are
indirect materials that do not directly benefit any specific cost object. These costs are included in overhead.
2.
Indirect Labor Indirect labor is the cost of labor that is not easily traceable to a particular product, service, etc. Most often, this type of labor supports the manufacturing process but does not work directly on the specific job, etc. EXAMPLE
Spud Furnishings, Inc. manufactures custom couches. In addition to upholsterers, Spud Furnishings employs forklift drivers, maintenance workers, shift supervisors, workers in the receiving department, janitorial staff, inspectors, engineers, training and other human resource staff. These costs are indirect
labor and are included in overhead.
3.
Other Indirect Costs Other indirect costs are indirect costs other than those for materiais or iabor. EXAMPLE
Spud Furnishings incurs costs for depreciation of the facility and machinery, rent of the production warehouse, machine maintenance, property taxes on the building, insurance, rent, utilities, etc. These miscellaneous facility costs are other indirect costs and are included in overhead.
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KEY
Prime cost = Direct labor + Direct material Conversion cost = Direct labor + Manufacturing overhead
C.
"Overhead" Allocation Using Cost Drivers Indirect costs are allocated (assigned) to benefiting cost pools or cost objects using cost drivers that are considered to have a strong relationship to the incurrence of these costs. 1.
Allocation bases The cost drivers that are used to allocate indirect costs are referred to as "allocation bases. 1I
2.
Accounting Often, all indirect costs are allocated to a single cost pool (or account) called "overhead" and allocated as a single pool. Overhead in the manufacturing business is termed manufacturing overhead.
V.
COST BEHAVIOR (fixed vs. variable) Cost measurement concepts include classification of costs by their behavior, the degree to which those costs are either fixed or variable. Direct material and direct labor are generally variable costs while the indirect costs included in manufacturing overhead consist of both fixed and variable components. Cost behaviors are graphically illustrated in relation to output as follows: F I XED 60
a0
",
"' . VARIABLE
a
60
a0
50
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20
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2
3
4
5
6
7
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Volume in (000) of Units
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1
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2
3
4
5
6
7
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Volume in (000) of Units
Variable Cost 1.
Behavior A variable cost changes proportionally with the cost driver (e.g., typical cost drivers include sales volume and production volume).
2.
Amount (constant per unit, total varies) Variable costs change in total, but they remain constant per unit. As production volume increases (or decreases), the total variable cost will increase (or decrease), but the variable cost per unit will always remain the same.
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Long-run Characteristics The short-run and long-run impacts of variable costs are the same within relevant ranges (the range of production over which cost behavior assumptions are valid).
B.
Fixed Cost 1.
Behavior In the short-term and within a relevant range, a fixed cost does not change when the cost driver changes.
2.
Amount (varies per unit, total remains constant) Fixed costs remain constant in total, but they vary per unit. As production volume increases (or decreases), fixed costs remain the same, but the cost per unit will decrease (or increase), respectively. PASS KEY
The distinction between variable costs and fixed costs allows managers to determine the effect of a given percentage change in production output on costs. Be careful! The examiners often attempt to trick candidates by providing a fixed cost per unit for a given volume of production. As fixed costs are "fixed," the candidate must convert this format to a dollar amount that will not change as production volume changes within a relevant range.
3.
Long-run Characteristics Given enough time (and a long enough relevant range), any cost can be considered variable. EXAMPLE
Depreciation is typically a fixed cost in a relevant manufacturing range of units or up to production capacity but can be considered variable in the long run. A new building will have to be purchased if the production levels exceed plant capacity (thus, possibly increasing depreciation expense, depending upon the extent to which other facilities have been depreciated).
C.
Semi-variable Costs (mixed costs) Costs frequently contain both fixed and variable components. A cost that includes components which remain constant over the relevant range and includes components that fluctuate in direct relation to production are termed semi variable. Semi-variable costs vary with incremental changes in capacity and are graphically displayed in a stair step pattern.
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0r---
---,
AN elL L A R V MAT E R I A L (for Independent Review)
EXAMPLE
Semi-variable expenses are best explained by example. While some direct and indirect costs are automatically associated with semi variable expense, others are not. Different circumstances will often change the behavior classification of the expense.
1. Direct Cost - Utilities and Labor Utilities contain fixed components (e.g., heat and light charges are incurred regardless of production) and variable components (e.g., power to run machinery, which should increase in proportion to output). Utilities can be semi-variable if cost components are not segregated. Direct labor may be a pure variable cost in some circumstances (e.g., piece work or commissions) and fixed in other circumstances (e.g., fixed labor force that is not increased or decreased in the short run with volume). Direct labor can be semivariable if cost components are not segregated.
2. Indirect Labor - Supervisors A supervisor who is able to supervise five line staff at a time is an example of a mixed cost-up to the point where there are five or less line staff, the cost of the supervisor's salary is fixed. However, upon the addition of one more line staff, another supervisor will be needed. The firm will have entered into a new relevant range for this cost, which has this variable component.
3. Other Indirect Costs - Telephone Expense Cellular telephone expenses and other utility-type expenses are often mixed costs. There is typically a flat fee for a fixed amount of minutes each period, and this fee is charged regardless of the amount of minutes actually used during the period. Also, there is a variable component for additional minutes used, which is billed at a certain cost per minute times the amount of additional minutes used over the amount allocated in the fixed component.
4. Other Indirect Costs - Depreciation Although it is typically viewed within a long relevant range, even depreciation can be considered a mixed cost. For example, depreciation of a warehouse with the capacity to produce 100,000 units a year is fixed, but when more units are required to be produced (above capacityt an additional warehouse would also be required, causing the firm to enter another relevant range with respect to that cost and making that cost increase incrementally with production.
D.
Relevant Range The relevant range is the range for which the assumptions of the cost driver (i.e., linear relationship with the costs incurred) are valid. When the cost driver activity is no longer within the relevant range, the variable and fixed cost assumptions for that cost driver cannot be used to allocate costs to cost objects. Reievant range is graphically illustrated as follows: Relevant Range (4,800 - 5,400 units)
Assume linearity
\
•.............
4,800 5,400 Cost Driver Units
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4,800 5,400 Cost Driver Units
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E.
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Concept Example - Cost Behavior Classify each transaction type by behavior. Answer assuming that transactions occur within the relevant range of an identified cost driver. Assume normal cost patterns. CONCEPT EXAMPLE
Variable
Fixed
Semi-Variable
L C= C I SALES
I
X
Less: Returns and allowances
I COSTS OF SALES
X
I
Direct materia I
X
Direct labor
X
Indirect labor
X
Fringe benefits (lS% of labor)
X
Royalties (1% of product sales)
X
X
Maintenance and repairs of building Factory production supplies
X X
Depreciation-straight-line
X
Electricity-used in the mfg. process
X
Scrap and spoilage (normal)
X
X
SELLING, GENERAL, AND ADMINISTRATIVE EXPENSE Sales commissions
X
Officers' salaries
X
Fringe benefits (relate to labor)
X
Delivery expenses
X
Advertising expenses (annual contract expenses)
X
X
o
END OF ANCILLARY MATERIAL
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STANDARD COSTING Cost measurement systems are divided between Actual, Normal, and Standard Costing systems or methods. Each costing method is distinguished by the costs assigned to each of the components of production (direct labor, direct material, and manufacturing overhead). Standard costing systems are the most common. A.
Standard Costs Standard costs, in the aggregate, measure the costs the firm expects it should incur during production. 1.
Standard Cost Per Unit Standard costs are sometimes referred to as per unit budgets that, within the context of a standard costing system, serve as targets with which to measure production goals.
2.
Efficiency (Cost) and Effectiveness (Productivity) Standards are an expression not only of cost, but also of productivity. Standard costs contemplate an allowed cost for an anticipated output. The firm sets standard costs it hopes to attain using various techniques.
B.
Standard Costing Systems In a standard costing system, standard costs are used for all manufacturing costs (i.e., raw materials, direct labor, and manufacturing overhead). 1.
Calculations a.
Direct Costs Standard price x Standard quantity
b.
=Standard direct costs
Indirect (Overhead) Costs Standard (predetermined) application rate x Standard quantity = Standard indirect costs
2.
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Purposes of Standard Costing Systems a.
Cost control.
b.
Data for performance evaluations (variance analysis).
c.
Ability to learn from standards and improve various processes.
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JOINT PRODUCT COSTING AND BY-PRODUCT COSTING (common cost allocation) Accountants face the problem of allocating the cost of a single process Uoint costs) among several final products (or by products) if two or more final products are produced from the same raw material or input. The process of joint costing is illustrated below:
Joint Costing Process Statement Product X Joint costs Direct material, direct labor and manufacturing overhead
lsplit-off point)
Product Y
EXAMPLE
The meat packing industry takes a single input, a steer, and produces many different final products. Each product must be assigned a cost including the different cuts of meat for human consumption, different food products for animal consumption (pet food) and basic ingredients for glue.
A.
Introduction Common (or joint) costs relate to more than one product and cannot be separately identified. Common costs must be allocated in some manner to the benefiting cost object.
B.
Summary of Terms 1.
Joint Products Joint products are two or more products that are generated from a common input.
2.
By-products By-products are minor products of relatively small value that incidentally result from the manufacture of the main product.
3.
Split-off Point The split-off point is that point in the production process where the joint products can be recognized as individual products.
4.
Joint Product Costs (or joint costs) Joint product costs are costs incurred in producing products up to the split-off point.
5.
Separable Costs Separable costs are costs incurred on a product after the split-off point. PASS KEY
~
As a general rule, joint product costs are only allocated to the main product. By-products do not receive an allocation of joint costs.
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Joint Products Joint products represent outputs of significant value that are the object of a manufacturing process. Cost drivers in the manufacturing process cannot be distinguished for each product, so common costs must be allocated by some arbitrary means.
1.
Allocation by Unit Volume Relationships EXAMPLE
Volume
10,000 gal
Product A Product B Total
20,000 gal 30,000 gal
Joint costs are $10,000. Question: What portion of joint costs will each be allocated if they share by volume? Solution:
2.
Product A:
10,000/30,000 ($10,000)
$ 3,333
Product B:
20,000/30,000 ($10,000)
6.667 $10000
Relative Net Realizable Values at Split-off Point Net realizable value equals sales value less cost of completion and disposal. Relative sales value at split-off point is used purely for inventory costing and is of little use for cost planning and control purposes. a.
Sales Price Quotations Available at Split-off The relative sales value at split-off point can be used to allocate joint costs if sales price quotations are known or can be determined. The relative sales value approach assigns costs to the separate joint products in relation to their market values. EXAMPLE
$1,000
Joint Costs Joint product produced: Product A -100 units, sales value at split-off Product B- 400 units, sales value at split-off
$ $
20 15
Allocation based on relative sales value:
Product A- 100 units @ $20 Product B- 400 units @ $15
$2,000 6,000 $8,000
Joint cost allocated to A:
$1,000 x ($2,000 + $8,000) = $
Joint cost allocated to B:
$1,000
x
$1000
Total allocated joint cost
.,-54
250
($6,000 + $8,000) = -----.Z2Q
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Sales Values Not Available at Split-off If sales values at split-off are not explicitly available because there are no markets for the joint products at split-off; computation of sales values at split-off are derived on the ultimate sales value at point of sale.
(1)
Work Backwards Working backwards estimates net realizable values at the split-off point.
(2)
Separable Costs Identifiable costs incurred after the split-off point (separable costs) must be subtracted from the final selling price to arrive at the net realizable value at split-off. EXAMPLE
Smith Company produces two joint products: F and G. Joint production costs for October were $30,000. During October, further processing costs beyond the split off point (separable costs), needed to convert the products into saleable form, were
$16,000 and $24,000 for 1,600 units of F and 800 units of G, respectively. Fsells for $25 per unit, and G sells for $50 per unit. Smith uses the net realizable value method for allocating joint product costs. What were the joint costs allocated to Fduring October? Product F- Net realizable value Sales value, $25 per unit x 1,600 units Further processing costs Net realizable value
$ 40,000 116.000) $ 24 000
$24,000
Product G - Net realizable value Sales value, $50 per unit x 800 units Further processing costs Net realizable value
$ 40,000 !24.000) $16.000
Total net realizable value
16.000 $40000
Joint costs allocated to F
$30,000 x ($24,000/$40,000)
$18,000
Joint costs allocated to G
$30,000 x ($16,000/$40,000) Total joint costs
D.
$ 12,000 $ 30,000
By-products By-products represent outputs of relatively minor value that are incidental to a manufacturing process. By-products have relatively low sale values that are not sufficient to cover their share of common costs (otherwise, they would be joint products). Revenue accounting can take one of two forms:
1.
Applied to Main Product Any proceeds from the sale of by- products are a reduction to common costs for joint product costing. The revenue earned from their sale is credited to joint costs incurred either at the time of production or the time of sale.
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Miscellaneous Income As an alternative, revenue from the sale of by-products may be credited to miscellaneous income.
E.
Decisions Regarding Method to Use (by-product or joint) Decisions regarding whether to use by-product costing or joint costing are practical ones, and they depend on relative sales demand. EXAM PlE
Before the invention of the automobile, the gasoline produced when the oil was refined had no value and was scrap for disposal. After the invention of the automobile, gasoline was first priced as a by-product and then priced as a joint product (when the demand for gasoline increased).
VIII. ACCUMULATING AND ASSIGNING COSTS -Introduction Cost accumulation systems represent the manner in which the accounting system develops costs. The system used is driven by the cost object involved. If the cost object is a custom order, job costing may be used. If the cost object is a mass-produced homogeneous product (e.g., steel), process costing would be used. Activity-based costing may be used to assign costs, regardless of the cost accumulation system used. PASS
KEY
Although the most commonly tested cost accumulation systems are job order costing and process costing, there are many variations of cost accumulation systems that may appear on your examination: •
Operations costing uses components of both job order costing and process costing.
•
Back-flush costing accounts for certain costs at the end of the process in circumstances where there is little need for in-process inventory valuation.
Life cycle costing seeks to monitor costs throughout the product's life cycle and expand on the traditional costing systems that focus only on the manufacturing phase of a product's life.
IX.
COST OF GOODS MANUFACTURED AND SOLD Production costs generally experienced by a manufacturing company may be summarized in the form of "cost of goods manufactured statement" and a "cost of goods sold statement." These statements may be prepared separately or combined as a "cost of goods manufactured and sold statement. " A.
Cost of Goods Manufactured The cost of goods manufactured statement accounts for the manufacturing costs of the products completed during the period. These costs consist of direct material, direct labor, and manufacturing overhead costs. The manufacturing costs incurred during the period are increased or decreased by the net change in work-in-process inventory (beginning WIP minus Ending WIP) to equal cost of goods manufactured. An example of a cost of goods manufactured statement follows:
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EXAMPLE XYZCompany
COST OF GOOOS MANUFACTURED For the Month Ended November 3D, Year 1
$ 40,000
Work-in-process inventory, beginning
$ 30,000
Add: Direct material used
50,000
Direct labor Manufacturing overhead applied
120,000
Total manufacturing costs incurred Total manufacturing costs available
160,000
less: Work-in-process inventory, ending
(10,000) $ 150000
Cost of goods manufactured
B,
Cost of Goods Sold The cost of goods sold statement for a manufacturer is very similar to one prepared for a retailer except that cost of goods manufactured is used in place of purchases, An example of a cost of goods sold statement follows: EXAMPLE XYZ Company
COST OF GOODS SOLD For the Month Ended November 3D, Year 1
Finished goods inventory, beginning
20,000
Add: Cost of goods manufactured
150,000
Cost of goods available for sale
170,000
less: Finished goods inventory, ending Cost of goods sold
X.
$
150,000)
$ 120000
JOB ORDER COSTING (cost accumulation system) Job-order costing is the method of product costing that identifies the job (or individual units or batches) as the cost objective and is used when there are relatively few units produced and when each unit is unique or easily identifiable,
A.
Cost Objective is the Job (or unit) Under job order costing, cost is allocated to a specific job as it moves through the manufacturing process, Record keeping for job-costing emphasizes the job as the cost objective,
B.
Job Cost Records Job-cost records are maintained for each product, service, or batch of products, and they serve as the primary records used to accumulate all costs for the job, Job-cost records are also referred to as job-cost sheets or job orders, Job-cost records accumulate data from the following internal documents:
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Materials Requisitions Materials requisitions are documents showing materials requested for use on the job.
2.
Labor Time Tickets (time cards) Labor time tickets (time cards) are documents that show the labor hours and labor rate associated with the time applied to the job.
3.
Overview of Job Order Costing Job-costing systems require a limited number of work-in-process accounts. EXAMPLE
Job-cost systems are best suited for customized production environments such as construction, aircraft assembly, printing, etc. A new job-cost record would be started every time a new job (building project, airplane or print job) is started.
PICTORIAL OVERVIEW-JOB ORDER COSTING
Raw Materials Indirect materials Direct materials (Issuance)
\
Beginning balance
D M+DL+OH=
Wages Payable
Work·in-Process
/
Cost of goods manufactured
Total manufacturing costs
Direct labor (incurrence of cost)
Finished Goods Beginning balance
Indirect labor
Cost of goods sold
Cost of goods manufactured
Manufacturing Overhead Actual costs incurred:
Overhead applied
Indirect labor Indirect materials Utilities Depreciation on buildings and equipment Taxes (payroll, property) Fire insurance Other indirect costs
Underapplied overhead
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_
Cost of Goods Sold
~
Cost of goods sold
Overapplied overhead
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.. -
---~_
PASS
...
..
_-_.~
_---~----.-
KEY
Application of overhead is accomplished in two steps: Step #1: Calculated overhead rate = Budgeted overhead costs -;- Estimated cost driver Step #2: Apply overhead = Actual cost driver x Overhead rate (from Step #1)
XI.
PROCESS COSTING (cost accumulation system) Process costing is a method of product costing that averages costs and applies them to a large number of homogeneous items. PASS
KEY
Computation of how each segment of the process should compute cost of goods transferred out and the cost of goods remaining in work-In-process (inventory) is the central product costing issue in process cost environments. Five steps are normally followed to resolve this issue: 1.
Summarize the flow of physical units (beginning with the Production Report).
2.
Calculate "equivalent unit" output.
3.
Accumulate the total costs to be accounted for (Production Report).
4.
Calculate the unit costs based on total costs and equivalent units.
s.
Apply the average costs to the units completed and the units remaining in ending work-in-process inventory.
CPA exam questions will frequently require you to compute one of these items: the appropriate number of units to be used, the appropriate cost to use, the cost per unit, or ending inventory.
A.
Units and Costs Collected on a Production Report Costs incurred for a period as well as all units produced during that period are accumuiated on a production report that accounts for the physical flow of units. The report inciudes the beginning inventory, the number of units started, the number of units completed, and the number of units remaining in inventory.
1.
Unit (Quantity) Accounting The number of units accounted for must equal the number of units charged to the department (or separate process).
2.
Cost Accounting The amount of costs accounted for must also equal the amount of costs charged to the department (or separate process). PASS KEY
I
Accounting for the physical flow of units is an important first step in process costing. Remember, however, that the pure physical flow of units will be different than the equivalent units of production.
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PASS KEY
The determination of the components of inventory cost can be confusing; however, with the use of the "BASE" mnemonic, it all gets a little easier! The following shows how the components "fit" together with the flow of activity: Inventory: Raw Materials
Inventory: Work-In-Process
Inventory: Finished Goods
B Beginning inventory of raw
B Beginning inventory of work-in-process
B Beginning inventory of finished
materials
II
goods
A Add: Raw materials used plus direct
A Add: Purchases of raw materials Raw materials available for use/ S Subtract: Raw materials use4. / E Ending inventory of raw materials
A Add: I~ventory transferred from
labor and overhead used Work-in-process inventory
availab~'I/e to iJf
be finished S Subtract: Inventory transferred to finished goods
Finished goods inventory available for sale S Subtract: Cost of goods sold
E Ending inventory ofwork·in.process
EXAMPLE -
work-in-process
E Ending inventory of finished goods
PRODUCTION REPORT ILLUSTRATED
Quantities
Charged to dept: In process, beginning Transferred in Total units charged to department
5,000 20,000 25 000
Units accounted for: Transferred out
15,000
In process, end
10,000
Total units accounted for
25 000
Costs
Charged to dept: In process, beginning During the period Total units charged to department
$ 12,000 85,000
$ 97,000
Costs accounted for: Transferred out In process, end Total costs accounted for
B.
$ 60,000 37,000
$ 97 000
Equivalent Units Costs must be attached to the completed units as well as to the units that are partially complete at the end of each period. This calculation is made by taking into account the partially completed units and by making use of equivalent units.
1.
Equivalent Unit Defined An equivalent unit of direct material, direct labor, or conversion costs (direct labor plus factory overhead) is equal to the amount of direct material, direct labor, or conversion costs necessary to complete one unit of production.
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EXAMPLE
10,000 actual units of OM, DL, or OH in process that are 75% complete would represent 7,500 equivalent units of (OM, DL, or OH) production.
2.
Equivalent Unit Account Analysis Format Determination of equivalent unit amounts often requires development of the account analysis format, as shown above. Beginning Balance Additions Subtotal Subtractions Ending Balance
3.
a.
Set up a column in the worksheet for each component of cost (e.g., direct material, conversion cost, etc.).
b.
Beginning and ending inventory are generally given. (The units can be counted, and the percentage completion can be estimated.)
c.
Transfers out are always 100% complete for all components of cost. (If they were not complete, they would not have been transferred out. They would still be in work-in-process (WIP) inventory.)
d.
Additions to equivalent units must always be squeezed based on beginning WIP, ending WIP, and the amount transferred out.
Percentage of Completion Assumptions a.
Transfers In are 100% Complete Transfers in from departments are always considered 100% complete. The transfer in costs (of direct material) from a previous department are treated as direct materials (OM), even though they are called "transfer in" costs or "previous department" costs.
b.
Timing of Addition of Direct Material (1)
Addition at the Beginning or During a Process Direct material added at the beginning of or during a second or later process may either be 100% complete or "partially complete," depending on how much work has been done on that component of the process.
(2)
Addition at the End of a Process Any material added at the (very) end of a process will not be in work-inprocess inventory at the month end.
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Costing Issues 1.
Calculations of Average Unit Costs The calculation of average unit costs and the appiication of those costs to various segments of the process is complicated by a number of issues. a.
Averaging of Costs from Prior Month's WIP Frequently, costs from the previous month's work-in-process inventory are different from costs of the current month. These costs must be averaged.
b.
Cost Flow Assumptions Cost averaging computations depend upon FIFO and/or weighted (or moving) average cost flow assumptions. These computations require a well-labeled account anaiysis format for each unit of direct material, direct labor, or overhead.
2.
Spoilage (or shrinkage) Spoilage (or shrinkage) is generally taken care of automatically because the equivalent units added for the month are "squeezed" and are generally iess than the actual units added during the months. Lost or spoiled units reduce the denominator and raise the cost per unit.
a.
Normal Spoilage (inventory cost) Normal spoilage occurs under regular operating conditions and is included in the standard cost of the manufactured product.
(1)
Computation For normal spoilage (or shrinkage), per unit cost is automatically increased as a result of spoilage because actual costs are spread over fewer equivalent good units rather than actual units produced.
(2)
Accounting Treatment Normal spoilage is capitalized as part of inventory cost. Normal spoiiage costs, if accounted for separately, are allocated to good units produced.
b.
Abnormal Spoilage (period expense) Abnormal spoilage should not occur under normal operating conditions and is not included in the standard cost of a manufactured product.
(1)
Computation For abnormal spoilage (or shrinkage), the per unit cost is based on actual units. Equivalent units of production include spoiled units.
(2)
Accounting Treatment The cost of abnormal spoilage is normally expensed separately on the income statement as a period expense. Abnormal spoilage is charged against income of the period as a separate component of cost of goods sold.
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Specific Cost Flow Assumptions 1.
Calculation Using First-In First-Out (FIFO) Under FIFO accounting, the ending inventory is priced at the cost of manufacturing during the period, assuming that the beginning inventory was completed during the period. a.
Equivalent Unit Components The equivalent units are composed of three separate elements: completion of units on hand at the beginning of the period, units started and completed, and units partially complete at the end of the period.
b.
Cost Components Current costs incurred during the period are allocated to the equivalent units produced during the period.
2.
Calculation Using Weighted-average The weighted-average cost method averages the cost of production during the period with the costs in the beginning work-in-process inventory. a.
Equivalent Unit Components The equivalent units, or output divisor, as it is sometimes called, is defined as the units completed during the month (regardless of when the work was done) plus the equivalent units of work done on the work-in-process at the end of the period.
b.
Cost Components Total costs include both the costs of beginning inventory and current costs are allocated to equivalent units to arrive at a weighted-average unit cost. EXAMPLE -
EQUIVALENT UNITS OF PRODUCTION
Assume the following information: Work-in-process, beginning
100 units, 25% complete
Units completed and transferred out Work-in-process, ending
600 units 200 units, 40% complete
Weighted-average Eguivalent Units of Production
600
Units completed and transferred out (always 100%) Work-in-process, ending 200 units x 40% Equivalent units of production
FIFO Equivalent Units of Production Work-in-process, beginning
75
100 units x 75% (to complete) Units started and completed this period Units completed and transferred out Units in beginning inventory
600 (100)
500
Work-in-process, ending 200 units x 40% Equivalent units of production
~
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Comparison of FIFO and Weighted-average
a.
Unit Components Equivalent unit calculation under FIFO consists of three elements representing current period production, whereas the calculation under the weighted-average method consists of only two elements that embrace units completed and are available in beginning inventory.
b.
Cost Components FIFO represents only costs incurred in the current period. The weighted-average approach includes both current period units plus prior period units. PASS KEY
Equivalent units of production may be computed using either First In First Out (FIFO) or weighted-average assumptions. The FIFO approach specifically accounts for work to be completed, while the weighted-average approach blends the units as follows:
1.
Weighted-average (2 steps)
xxx
a. Units completed b. Ending WIP x % completed
+
XXX
Equivalent units 2.
XXX
FIFO (3 steps)
XXX
a. Beginning WIP x % to be completed b. Units completed - Beginning WIP
+
XXX
c.
+
XXX
Ending WIP x % completed
XXX
Equivalent units PASS
KEY
Cost per equivalent unit is computed by dividing total costs by equivalent units. FIFO anticipates using only current costs, while the weighted-average approach uses both beginning inventory and current costs as follows: 1.
Weighted-average Weightedaverage
2.
FIFO FIFO
Bl-64
Beginning cost+Current cost EqUivalent units
Current cost only Equivalent units
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E.
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Recordkeeping Recordkeeping for process costing is generally simpler and less costly than a job-order costing system since individuai units produced are not identified.
1.
Increased Accounts Recordkeeping focuses on processes and typically requires more work-in-process accounts than job order costing.
2.
Record Sequence Records generally follow the sequential pattern of the production process.
XII.
ACTIVITY·BASED COSTING (ABC) - A Cost Assigning System Traditional cost systems assign overhead as a single cost pool with a single plant-wide overhead application rate using a single allocation base. These rates are generaliy voiume-based and use an application basis such as direct labor hours or machine hours. Assigning these overhead costs based on volume will distort the amount of costs assigned to various product lines since all overhead costs do not fluctuate with volume. Application of activity-based costing techniques attempts to improve cost allocation by emphasizing long-term product analysis. A.
Introduction to Activity·based Costing Activity-based costing (ABC) is defined as a cost accounting system that is based on activity level as the fundamental cost object. ABC refines traditional costing methods and assumes that the resource-consuming activities (tasks. units of work, etc.) with specific purposes cause costs. Activity-based costing is a cost system that assumes that the best way to assign indirect costs to products (cost objects) is based on the product's demand for resource-consuming activities (i.e., costs are assigned based on the consumption of resources).
1.
Terminology a.
Activity An activity is any work performed inside a firm. Activities are identified for ABC.
b.
Resource A resource is an element that is used to perform (or applied to perform) an activity.
c.
Cost Drivers Cost drivers used in ABC are activity bases that are closely correlated with the incurrence of manufacturing overhead costs in an activity center, and they are often used as allocation bases for applying overhead costs to cost objects. PASS
KEY
A cost driver is a factor that has the ability to change total costs. Cost drivers (including nonfinancial, statistical measurements of activities such as sales or production volume) are identified by ABC and are related to one of multiple cost pools for cost allocation.
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Resource Cost Driver A resource cost driver is the amount of resources that will be used by an activity.
e.
Activity Cost Driver An activity cost driver is the amount of activity that a cost object will use, and it is used to assign the costs to the cost objects.
f.
Activity Centers An operation necessary to produce a product is an activity center. EXAMPLE
Hope Hospital applies ABC to costing its services. The surgical unit is identified as an activity center that includes various professional service (surgeon and nurse) functions as well as facilities (operating room) functions. Resources used include hours of staff time for surgery and for operating room preparation as well as facilities maintenance. Resource drivers may include the complexity of surgical procedures (including set up time) while activity drivers may be purely admissions or scheduled surgeries.
g.
Cost Pool A cost pool is a group of costs (e.g., raw material or direct labor) or a specially identified cost center (e.g., a department or a manager) in which costs are grouped, assigned, or collected.
2.
Characteristics of ABC ABC applies a more focused and detailed approach than using a department or plant as the level for gathering costs. ABC focuses on multiple causes (activities) and effects (costs) and then assigns costs to them. The cost of activities is used to "build up" the engineered cost of products using increased cost pools and allocations.
3.
a.
ABC can be part of a job order system or a process cost system.
b.
ABC can be used for manufacturing or service businesses.
c.
ABC takes a long-term viewpoint and treats production costs as variable.
d.
The cost driver is often a non-financial variable.
e.
ABC may be used for internai but not for external purposes.
Transaction-based Costing Activity-based costing (ABC) is aiso referred to as transaction-based costing. The cost driver is typically the number of transactions involved in a particular activity.
4.
Focuses on Cost/Benefit of Activities ABC focuses management on the cosUbenefit of activities. Value-added activities increase the product value or service.
a.
Value Chain (value-added activities) A value chain is a series of activities in which customer usefulness is added to the product. Support activities directiy support value-added activities.
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Non-Value Added Activities
Non-value added activities do not increase product value or service and are targeted for elimination. Oftentimes, these types of activities (e.g., warehousing) should be eliminated. B.
C.
Basic Operation of Activity-based Costing
1.
Analysis of Cost Drivers - Identify the activity centers and the activities that drive the costs in each activity center.
2.
Accumulate the Costs in Cost Pools - Many small cost pools are accumulated.
3.
Trace Indirect Costs to Activity Centers - Trace any indirect costs to the activity centers that can be assigned without allocation.
4.
Allocate Remaining Indirect Cost Pools - Costs of each activity are applied to cost objects based on the most appropriate cost drivers.
5.
Divide Assigned Costs by Level of Activity for the Cost Center - Divide the costs assigned to the activity center by the estimated levei of activity for the center to derive an application rate for that center.
6.
Cost the Product - Cost the product by multiplying their demand for the resources of an activity center by the rate for that activity center.
Effects of Activity-based Costing An ABC system will apply high amounts of overhead to a product that places high demands on expensive resources. If a product places few demands on expensive resources, the system will assign little of that cost to the product. This will remove much of the cost distortion caused by traditionai, volume-based overhead systems.
D.
ABC and Standard Cost Systems
Standard cost systems are a natural extension of activity-based costing. Standards are set at activity levels based on cost drivers. Useful variances are calculated by comparing actual and standard costs that consider levels of activity. These variances can be due to price (rate for labor), usage (efficiency), or other factors. Further, flexible budgets are derived at the activity level. 1.
Normal and abnormal scrap or spoilage is estimated for activity levels.
2.
Standards may be difficult to set on a per unit basis. a.
Per unit costs are often inversely proportional to volume.
b.
Assumption of a relevant range may be necessary to set a per unit standard.
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EXAMPLE
Iowa Products makes two products in their Boone factory. They have used a traditional cost accounting system for the application of overhead to the products. Currently they use direct labor hours as an application base. The product Can incurred 150,000 direct labor hours, and Bottle incurred 45,000 direct labor hours. They are considering converting to an activity-based costing system. The estimated data for their Year 1 operations is summarized below:
Activity Center Units Material handling Production orders Product redesign Plant utilities
1.
Activity Level Cans Bottles
Cost Driver $ 480,000 $ 90,000 $ 250,000 $ 2,300,000
Pounds Number of production orders Number of changes Machine hours
500,000 100,000 100 50 150,000
150,000 60,000 100 200 80,000
Illustration of the overhead application rate under a traditional system using direct labor hours as an application base Material handling Production orders Product redesign Plant utilities Total overhead costs
Overhead application rate
$
480,000 90,000 250,000 2,300,000 $ 3120000
Total overhead costs Total direct labor hours
=$3,120,000/{150,000 + 45,000) =$16 per direct labor hour
2.
Cans:
150,000 direct labor hours x $16 $2,400,000/500,000 cans
$2,400,000 $4.80 per can
Bottles:
45,000 direct labor hours x $16 $720,000/150,000 bottles
$720,000 $4.80 per bottle
Illustration of the overhead application rate under an activity-based costing system using each activity as a cost pool Material handling: Production orders: Product redesign: Plant utilities:
$480,000/160,000 pounds $90,000/200 orders $250,000/250 changes $2,300,000/230,000 machine hrs
=$3 per pound =$450 per order =$1,000 per change =$10 per machine hour
Cons: Material handling, 100,000 Ibs x $3 Production orders, 100 orders x $450 Product redesign, 50 changes x $1,000 Plant utilities, 150,000 machine hrs x $10 Total overhead costs $1,895,000/500,000 cans
$ 300,000 45,000 50,000 1,500,000 $1895000
=$3.79 per can
Bottles: Material handling, 60,000 Ibs x $3 Production orders, 100 orders x $450 Product redesign, 200 changes x $1,000 Plant utilities, 80,000 machine hrs x $10 Total overhead costs
$ 180,000 45,000 200,000 800,000
>u25.-QOO
$1,225,000/150,000 bottles =$8.167 per bottle Bottle cost significantly increased with activity-based costing. This resulted because bottles required a large amount of the redesign resource. Redesign is a very costly resource and not related to volume. Since bottles required a large amount of this resource, a high amount of indirect cost was assigned to bottles. The cost of cans decreased significantly since it used comparatively little redesign resource.
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OPERATIONS MANAGEMENT Process Management
o
ANCILLARY MATERIAL (for Independent Review}
---------------......,
Process management represents a variety of activities that relate to planning and monitoring the performance of a process. Process management applies knowledge and skills as well as taoh." and techniques to control and improve processes for the sake of customer satisfaction and profitability ~-
I.
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APPROACHES, TECHNIQUES, MEASURES AND BENEFITS TO PROCESS MANAGEMENT DRIVEN BUSINESSES A.
Approaches and Techniques 1.
2.
Approaches a.
Business process management (BPM) is a management approach that seeks to coordinate the functions of an organization to customer satisfaction. Process management seeks effectiveness and efficiency through promotion of innovation, flexibility, and integration with technology.
b.
Business process management attempts to improve processes continuousiy. The focus on process makes the organization more nimble and responsive than hierarchal organizations that are managed by function.
Activities Business process management activities can be grouped into five categories: design, modeling, execution, monitoring, and optimization. a.
Design The design phase involves the identification of existing processes and the conceptual design of how processes should function once they have been improved.
b.
Modeling Modeling introduces variables to the conceptual design for what-if analysis.
c.
Execution Design changes are implemented and key indicators of success are developed.
d.
Monitoring Information is gathered and tracked and compared to expected performance.
e.
Optimization Using the monitoring data and the original design, the process manager continues to refine the process to optimization.
3.
Techniques Specific approaches and philosophies of management are discussed at the end of this section. The general technique or approach to process management mirrors the Iifecycle. a.
Define The original process is defined as a baseline for current process functioning or process improvement.
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Measure Anticipate the indicators that will show a change to the process (e.g., reduced time, increased customer contacts, etc.).
c.
Analyze Determine from various simulations or models what the targeted or optimal improvement.
d.
Improve Select and implement the improvement.
e.
Control Use dashboards and other measurement reports to monitor the improvement in real time and apply the data to the model for improvement.
4.
Other Techniques and Approaches Process management has also been commonly referred to as plan, do, check, act (PDCA).
B.
a.
Plan - Design the planned process improvement.
b.
00 - Implement the process improvement.
c.
Check - Monitor the process improvement.
d.
Act - Continuously commit to the process and reassess the degree of improvement.
Measures Measures or process metrics can be financial or non financial and should correlate directly to the managed process. The measures are compared to expectations to monitor progress. Examples of measures include: 1.
Gross Revenue Gross revenue is an outstanding measure for sales or other revenue volume driven organizations.
2.
Customer Contacts Customer contacts can be used in sales driven organizations.
3.
Customer Satisfaction Organizations using relationship marketing techniques may consider customer satisfaction measures.
4.
Operational Statistics Manufacturing operations might use operational statistics such as throughput times, delivery times or other logistical measures to determine the efficiency of a process .
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Benefits The benefits of a studied and systematic approach to process management allows you to monitor the degree to which efforts have been made and the degree to which process improvements have been achieved. The benefits often mentioned for process management are as follows:
II.
1.
Efficiency - Less resources are used to accomplish organization objectives.
2.
Effectiveness - Accomplish objectives with greater predictability.
3.
Agility - Faster more reliable responses to change.
ROLES OF SHARED SERVICES, OUTSOURCING, AND OFF-SHORE OPERATIONS, AND THEIR IMPLICATIONS ON BUSINESS RISKS AND CONTROLS A.
Shared Services
Shared services refers to seeking out redundant services, combining them and then sharing those services within a group or organization. Two not-for-profit organizations, for example, might agree to share information technology or human resource infrastructure as a means of creating efficiencies. The distinguishing feature of shared services is that they are shared within an organization or group of affiliates. 1.
Implications on Business Risks and Controls Consolidation of redundant services creates efficiency but might also result in the following issues: a.
Service Flow Disruption The consolidation of work to a single location can create waste in transition, rework and duplication as well as increases in the time it takes to deliver a service.
b.
Failure Demand The demand caused by a failure to do something or do something right for a customer is called failure demand.
B.
Outsourcing
Outsourcing is generally defined as the contracting of services to an external provider. Examples might include a payroll service or even a call center to provide support or back office services for a fee. A contractual relationship exists between the business and its outsource provider. 1.
Implications on Business Risks and Controls Outsourcing can provide for efficiencies, but there can be disadvantages. Those risks include: a.
Quality risk - An outsourced product or service might be defective. Supplies might provide substandard products or services.
b.
Quality of service - Poorly designed service agreements may impede quality of service.
c.
Productivity - Real productivity may be reduced even though outsourced workers are paid less.
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d.
Staff turnover - Staff whose functions have been outsourced may turnover and leave the organization or institutional knowledge for the function solely with the outsource firm.
e.
Language skills - Outsourced services may go offshore. Language barriers may reduce the quality of service.
f.
Security - Security of information with a third party might be compromised.
g.
Qualifications of outsources - Credentials of outsourcers may be flawed. Offshore degrees may not include the same level of training as domestic degrees.
h.
Labor insecurity - Labor is generally threatened by their jobs moving to an outsourcer or, as a result of globalization, out of the country.
Offshore Operations 1.
Definition Offshore operations relate to outsourcing of services or business functions to an external party in a different country. A computer manufacture in the United States, for example, might have its call center in India. Offshore outsourcing generally comes in one of four types:
2.
a.
Information Technology Outsourcing
b.
Business Process Outsourcing (call centers)
c.
Software Research and Development (software development)
d.
Knowledge process outsourcing (high skill sets such as reaching securities, reading X rays, etc.)
Implications on Business Risks and Controls Business risks of offshore outsourcing are generally the same as outsourcing with greater emphasis on the lack of controls associated with proximity and potential language issues.
III.
SELECTING AND IMPLEMENTING IMPROVEMENT INITIATIVES
A.
Selecting Improvement Initiatives Selection of improvement initiatives are generally described as rational or irrational.
1.
Irrational Irrational methods are intuitive and emotional. They lack structure and systematic evaluation. The irrational methods are based on fashion, fad or trend.
2.
Rational Rational assessments are structured and systematic and involve the following:
a.
Strategic Gap Analysis - External (environmental) assessments and Internal (organizational) assessments are performed to create a strategic gap analysis.
b.
Review Competitive Priorities - Generally review price, quality or other considerations.
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c.
Review Production Objectives - Review of performance requirements.
d.
Choose Improvement Program - Decide how to proceed for improvement.
Implementing Improvement Initiatives
Implementing improvement initiatives represents a project management function (described later), however, there are several crucial features of successful implementation activities.
IV.
1.
Internal leadership - Senior management must provide direction and commit resources to the implementation.
2.
Inspections - Ongoing implementation must be monitored and measured.
3.
Executive support - Executive management must be visibly supportive of the initiative.
4.
Internal process ownership - The individuals most deeply involved with process management must be committed to the need for process improvement and have the resources to carry it out.
BUSINESS PROCESS REENGINEERING A.
Definition
Business process reengineering (BPR) refers to techniques to help organizations rethink how they do their work in order to dramatically improve customer satisfaction and service, cut costs of operations and enhance competitiveness. Development of sophisticated information technology systems and networks have been the impetus for many reengineering efforts. Business process reengineering is not synonymous with business process management. Business process management seeks incremental change while business process reengineering seeks radical changes. B.
Concepts 1.
Fresh Start The basic premise of business process reengineering is the idea that management will "wipe the slate clean" and essentially re think how business is done from the ground up. Reengineering used benchmarking and best practices to evaluate success.
2.
Current Status Reengineering is not as popular as it once was when introduced in the mid-1990s. The technique has been criticized for what some believe was over aggressive downsizing. In addition, the programs have not produced the benefits that were originally anticipated.
o
END OF ANCILLARY MATERIAL
V.
MANAGEMENT PHILOSOPHIES AND TECHNIQUES FOR PERFORMANCE IMPROVEMENT Although we identify numerous management philosophies for performance improvement, the ideas associated with each item listed overlap and Ultimately seek to provide the highest quality goods and services in the most efficient and effective manner possible. A.
Just-In-Time (JIT)
Just-in-time management anticipates achievement of efficiency by scheduling the deployment of resources just-in-time to meet customer or production requirements. © 2010 OeVryj8ecker Education.1 Development Corp. All rights reserved.
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Inventory Does Not Add Value The underlying concept of JIT is that inventory does not add value. The maintenance of inventory levels purely produces wasteful costs. Reducing inventory by ensuring that resources arrive only when they are needed Uust-in-time for use) is the idea behind JIT.
2.
Benefits The benefits of JIT implementation are obvious in some instances and subtle in others. Benefits include:
B.
a.
Synchronization of production scheduling with demand.
b.
Supplies arrive at regular intervals throughout the production day.
c.
Improved coordination and team approach with suppliers.
d.
Flow of goods between warehouses and production.
e.
Reduced set up time.
f.
Employees with multiple skills are used with greater efficiency.
Quality Quality is broadly defined by the marketplace as a product's ability to meet or exceed customer expectations. The product specifications necessary to delight the customer more narrowly define quality for operating purposes as the production of a product or service in conformity with a pre-specified standard and sold at a price that the customer is wiiling to pay.
1.
Goalpost Conformance with Standards Goalpost conformance represents compliance within an acceptable range. Goalpost conformance is also referred to as zero-defects conformance because management has the full expectation that production will conform to the range of quality standards with no exception. EXAM PlE
Bolts are manufactured with threads that meet specifications that are plus or minus a tolerable error. The tolerable error may be small, but it represents a range of acceptable performance.
2.
Absolute Conformance with Standards Absolute conformance represents perfect or ideal compliance with standards. Absolute conformance is also referred to as the robust quality approach.
3.
Goalpost vs. Absolute Conformance Absolute conformance standards will result in higher quality products. Firms with longterm profitability and customer satisfaction as its goal will be best served by absolute conformance. Companies at the beginning of their product's life cycle with a mission focused on building their business will most likely use absolute conformance standards.
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Quality Control Principles - Costs of Quality Costs associated with activities related to conformance with quality standards and opportunity costs or activities associated with correcting nonconformance with quality standards represent the cost of quality.
5.
Conformance Costs The costs of ensuring conformance with quality standards are classified as prevention and appraisal costs. a.
Prevention Costs Prevention costs are incurred to prevent the production of defective units. This includes such cost eiements as:
b.
(1)
Employee training
(2)
Inspection expenses
(3)
Preventive maintenance
(4)
Redesign of product
(5)
Redesign of processes
(6)
Search for higher quality suppliers
Appraisal Costs Appraisai costs are incurred to discover and remove defective parts before they are shipped to the customer or the next department. These costs include:
6.
(1)
Statistical quality checks
(2)
Testing
(3)
Inspection
(4)
Maintenance of the iaboratory
Nonconformance Costs The costs of dealing with nonconformance with quality standards are classified as internal and externai costs. Nonconformance costs are often difficult to compute because most of this cost is in the form of an opportunity cost (e.g., lost sales or reputation damage). a.
Internal Failure
Internal failure costs are the costs to cure a defect discovered before the product is sent to the customer. These costs include: (1 )
Rework costs
(2)
Scrap
(3)
Tooling changes
(4)
Costs to dispose
(5)
Cost of the lost unit
(6)
Downtime
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External Failure External failure costs are the costs to cure a defect discovered after the product is sent to the customer. These costs include:
7.
(1)
Warranty costs
(2)
Cost of returning the good
(3)
Liability claims
(4)
Lost customers
(5)
Re-engineering an external failure
Summary - Quality Reporting Traditional approaches to quality management center on inspection for errors and achievement of acceptable quality levels. "Cost of quality" reports display the financial impact of quality by measuring four different categories just described. There is an inverse relationship between conforming and non-conforming costs. Increased investment in conforming costs should result in decreases in non-conforming costs, while the consequence of reduced investment in conforming costs may result in increased non-conforming costs.
o
Appraisal includes the costs incurred (e.g., statistical quality control, inspection and testing) to identify defective products or services
o
£,revention includes the costs incurred (e.g., engineering or training) to prevent the production or delivery of defective products or services
o o 8.
!nternal failure is the cost of defective parts or lost production time (e.g., scrap and rework)
} Conforming
} Non-conforming
External failure is the cost of returns and lost customer loyalty due to defective products or services
Quality Control Principles - Total Quality Management Total quality management (TOM) represents an organizational commitment to customer-focused performance that emphasizes both quality and continuous improvement. Total quality management identifies seven critical factors.
a.
Customer Focus The TOM organization is characterized by the recognition that each function of the corporation exists to satisfy the customer. Customers are identified as both external customers and internal customers.
(1)
External Customers The ultimate recipient or consumer of an organization's product or service is the external customer.
(2)
Internal Customers The expectations of each link in the value chain (and within the value chain) comprise the internal customers.
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EXAMPLE
Supplies inventory managers provide services to internal customers, such as production managers. A TQM organization will demand that the supplies inventory manager value the satisfaction of production managers in the timely delivery of supplies adequate to meet production requirements.
b.
Continuous Improvement Ouality is not viewed as an achievement in a TOM organization. The organization constantly strives to improve its product and processes.
c.
Workforce Involvement - Quality Circles TOM organizations are characterized by team approaches and work input to process deveiopment and improvement. Small groups of workers assembled to use team approaches to process improvements are called quality circles.
d.
Top Management Support - Delegation and Empowerment Top management must actively describe and demonstrate their support for the quality mission of the organization. Management can communicate their support by meaningful delegation of authority to quality circles and involvement of suppliers.
e.
Objective Measures Measures of quality must be unambiguous, clearly communicated, and consistently reported.
f.
Timely Recognition AcknoWledgement of TOM achievements (both in terms of compensation and general recognition) must occur to encourage the ongoing involvement of the workforce.
g.
Ongoing Training TQM training should occur on a recurring basis to ensure workforce understanding and involvement.
9.
Quality Audits and Gap Analysis a.
Quality Audits Quality audits are a technique used as part of the strategic positioning function in which management assesses the quality practices of the organization. Ouality audits produce the following:
(1)
Analysis that identifies strengths and weaknesses.
(2)
A strategic quality improvement plan that identifies the improvement steps that will produce the greatest return to the organization in the short-term and long-term.
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Gap Analysis Gap analysis determines the gap or difference between industry best practices and the current practices of the organization. Gap analysis produces the foilowing:
C.
(1)
Target areas for improvement.
(2)
A common objective database from which to develop strategic quality improvement.
Lean Manufacturing Lean manufacturing or lean production anticipates the use of only those resources required to meet the requirements of customers. It, somewhat like activity based approaches, seeks to only invest resources in value added activity.
1.
Waste Reduction The focus of lean is on waste reduction and efficiency. The concept of preserving value while expending on the effort necessary is not uncommon and has a long history in business and economics. Kaizen and activity based management initiatives are waste reduction methodologies that use empirical data to measure and promote efficiencies.
2.
Continuous Improvement (Kaizen) Kaizen is synonymous with continuous improvement efforts that improve the efficiency and effectiveness of organizations through greater operational control. a.
Implementing Kaizen-based Standards Kaizen occurs at the manufacturing stage where the ongoing search for cost reductions takes the form of analysis of production processes to ensure that resource uses stay within target costs.
3.
Process Improvements/Activity-based Management ActiVity-based costing (ABC) and activity-based management (ABM) are highly compatible with process improvements and total quality management (TOM). a.
Cost Identification Activity-based costing and management systems highlight the costs of activities. The availability of cost data by activity makes the identification of costs of quality and value-added activities more obvious.
b.
Implementation Organizations with ABC and ABM programs are more likely to have the information that they need to implement a TOM program. Process improvement results from a detailed process management program (sometimes referred to as an activity-based management system or ABM).
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D.
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(1)
Process management focuses on the activities performed by an organization and designs the structure of the organization around those processes.
(2)
Process management emphasizes the continuous improvement in the efficiency of these processes.
Process management incorporates many of the attributes of activity-based costing, TOM, and value chain analysis.
Demand Flow
Demand flow manages resources using customer demand as the basis for resource aliocation. Demand flow contrasts with resource aliocations based on sales forecasts or master scheduling. 1.
Relationship to Just-in-Time Demand flow is akin to just-in-tJiTle processes that focus on the efficient coordination of demand for goods in production with the supply of goods in production. Kanban systems, which visualiy coordinate demand requirements on the manufacturing floor with suppliers, are techniques used to coordinate demand flow.
2.
Relationship to Lean Demand flow is designed to maximize efficiencies and reduce waste. One-piece-f1ow manufacturing environments in which components move progressively from production area to production benefit from demand flow ideas.
E.
Theory of Constraints (TOC)
Theory of constraints anticipates that organizations are impeded from achieving objectives by the existence of one or more constraints. The organization or project must be consistently operated in a manner that either works around or leverages the constraint. 1.
Constraints A constraint is anything that impedes the accomplishment of an objective. Constraints for purposes of TOC are limited in total and, sometimes, organizations may oniy face one constraint. a.
Internal Constraints Internal constraints are evident when the market demands more than the system can produce.
b.
(1)
Equipment may be inefficient or used inefficiently.
(2)
People may lack the necessary skilis or mindset necessary to produce required efficiencies.
(3)
Policies may prevent efficient use of resources.
External Constraints External constraints exist when our system produces more than the market requires.
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U'A E:<:,ii11 Ho'/ic'//
Five steps TOC generally involves five steps:
3.
a.
Identification of the constraint - Use of process charts or interviews results in identification of the constraint that produces sub optimum performance.
b.
Exploitation of the constraint - Plan around the constraint using capacity that is potentially wasted by making or selling the wrong products, improper procedures in scheduling, etc.
c.
Subordinate everything else to the above decisions - Management directs its efforts to improving the performance of the constraint.
d.
Elevate the constraint - Add capacity to overcome the constraint.
e.
Return to the first step - Re-examine the process to optimize the results. Remain cognizant that inertia can be constraint.
Buffer The concept of buffers is used throughout TOC. Managers add buffers before and after the constraint to ensure that there are enough resources to accommodate the constraint either before or after the constraint is encountered. Buffers, thus, eliminate impact of the constraint on work flow.
F.
Six Sigma
Six sigma anticipates the use of rigorous metrics in the evaluation of goal achievement. The program is a continuous quality improvement program that requires some specialized training. Six sigma expands on the Plan-Do-Check-Act model of process management described earlier and logically anticipates methodologies to improve current processes and develop new processes. 1.
2.
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Existing Product and Business Process Improvements (OMAIC) a.
Define the problem - Based on customer comments, failed project goals, or other issues determine the existence of a problem.
b.
Measure key aspects of current process - Collect relevant data.
c.
Analyze Data - Examine relationships between data elements.
d.
Improve or optimize current processes - Use models and data to determine how the process can be optimized.
e.
Control- Develop a statistical control process to monitor results.
New Product or Business Process Development (OMAOV)
a.
Define design goals - Design goals consistent with customer demands.
b.
Measure CTQ (critical to quality issues) - Analyze the value chain to determine the features that provide value to the customer and the production capabilities that are available.
c.
Analyze design alternatives - Develop different methodologies to produce the new product.
d.
Design optimization - Use modeling techniques to determine optimization of the proposed process.
e.
Verify the design - Implement and test the plan.
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OPERATIONS MANAGEMENT Project Management
I.
PROJECT PLANNING, IMPLEMENTATION AND MONITORING A.
General 1.
Definitions a.
Project A project is a temporary undertaking intended to produce a unique service, product, or result. Unlike continuing operations, a project has a definite beginning and an end.
b.
Project management Project management consists of 5 major processes carried out by a project manager tasked with balancing the needs and expectations of various stakeholders against the organization's constraints. The five major processes consist of:
2.
(1 )
Budget;
(2)
Risk;
(3)
Time;
(4)
Quality; and
(5)
Resources.
Project Authorization Requires the Creation of a Project Charter The project charter is a document that contains a business justification to fulfill the needs and expectations of initial stakeholders by carrying out a statement of work that will achieve the project objectives. It formally establishes a partnership between the requesting organization and the receiving organization. a.
b.
Stakeholders are all individuals, internal business units, and external organizations that are positively or negatively impacted by the project. Examples include the following: (1)
Projectteam;
(2)
Sponsors;
(3)
Steering committee;
(4)
Customers;
(5)
Customer co-workers who will be affected by the change in Customer work practices due to the new product or service; and
(6)
Customer managers affected by modified workfiows or logistics.
Statement of work - Describes the product or services the project must deliver at completion.
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Planning Planning involves all the activities necessary to determine the scope of the project, refine the project objectives, and define the course of action required to attain the project objectives. Planning never stops throughout the life of the project, because any change that occurs subsequent to the initial plan compels the project manager to assess the change and if necessary, revise the plan.
0....---_ _ AN elL LA R Y MAT E R I A l
3.
Planning Process Activities a.
Develop the initial project management plan.
b.
Collect requirements - Define and document stakeholders' requirements.
c,
Define the scope of the project with a detailed description of the project and finished project deliverables.
d.
Create a work breakdown sequence.
e.
f.
B1-82
(for Independent Review)
(1)
Subdivide the project work and deliverables into smaller, more manageable tasks.
(2)
Update the project document to reflect the work breakdown structure.
Define the activities that must be performed in order to produce the project deliverables. (1)
Activities are presented in an activity list.
(2)
Milestones list is also generated.
Sequence the activities by determining the relationships between project activities. (1)
Dependent activities cannot be scheduled for completion before a previous task (or input) has been completed.
(2)
Independent activities can be scheduled for completion when they make sense within the project.
g.
Estimate the activity resources by listing out the supplies and equipment that will be needed to complete the activities defined above.
h.
Estimate the duration of the activities - How much time will it take to complete the activities defined above?
i.
Develop the schedule of activities based on the availability of resources, the event sequence, and amount of time to complete.
j.
Estimate the costs of the activities.
k.
Develop the budget.
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Plan Quality/Set Plan Quality Standards Define what a quality outcome is or define the standard of quality for the project and list those attributes that will form the benchmark against which the success of the project wili be measured.
m.
Develop the Human Resource Plan Identify and document project roles, responsibilities, skiils, and reporting relationships.
n.
Plan Communications identify the information needs of the stakeholders and define a communication approach. Create a document showing who needs to be kept informed about the project and how they will receive the information.
o.
Plan Risk Management Determine how you wiil conduct risk management activities.
p.
Identify Risks Identify risks based on cost, schedule, communications, organization environmentai factors and determine and document those that may affect the project.
q.
Perform Qualitative Risk Analysis Prioritize the risks identified above by assessing the iikelihood of their occurrence and impact on the project.
r.
Perform Quantitative Risk Analysis Numericaily analyze the effect of the identified risks on the project objectives.
s.
Plan Response to Risk Develop options in the event that risks identified above manifest themselves as the project unfolds.
\.
Plan for Procurement of Resources Identify where you wiil get your equipment and supplies. Make or buy decisions, source selection criteria.
o
END OF ANCILLARY MATERIAL
C.
Implementation The activities that are associated with completing the work that has been specified in the project pian and producing the deliverables. 1.
Direct and manage the project by performing the work that has been planned above.
2.
Perform quality assurance to make sure that the project procedure and deliverables conform to the standard of quality that was defined in the planning stage.
3.
Assemble the project team and distribute project assignments. Make sure everyone stays on task and gets along.
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4.
Manage the project team by providing timely feedback and resolving problems.
5.
Distribute relevant information to project stakeholders.
6.
Manage the stakeholder expectations by addressing issues as they occur.
7.
Conduct procurements by obtaining seller responses, seiecting a seller, and awarding a contract.
Monitoring Monitoring and controlling consists of procedures performed to observe project execution so that potential problems can be identified in a timely manner and corrective action can be taken to ensure the completion of the project. 1.
Monitor and control project work by reviewing where the project is against the baseline defined in the plan.
2.
Evaluate how the actual variables of time, cost, schedule, quality, and risk compare to the same variables defined in the project plan.
3.
Prepare status report, progress measurement, and forecasts for stakeholders.
4.
Identify the need for any changes that might be required in order to keep the project on schedule. Changes must be reviewed, approved, and evaluated for their impact on the scope and project deliverable.
5.
Verify scope by formalizing acceptance of the completed project deliverables.
6.
Control the scope by monitoring status of project and documenting changes to the scope baseline.
7.
Control the schedule by updating and documenting completion of activities on the schedule.
8.
Control the costs by updating the project budget to reflect the current status of the project.
E.
9.
Perform quality control by recording the results of quality control activities.
10.
Report performance - Distribute performance information such as status reports, progress measurements, and forecasts.
11.
Monitor and control risks - Implement a risk response plan, track identified risks, identify new risks, and evaluate risk process effectiveness throughout the project.
12.
Administer procurements - Manage the vendor relationships, monitor contract performance, and adjusting as necessary.
Ending or Closing the Project The project management process is summarized by the following phrase:
An authorized project plan, implemented, monitored, and controlled, eventually ends when the objectives have been completed.
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o .------------------------------, AN C t L L A R Y MAT E R I A L (for Independent Revl(:'w)
II.
ROLES OF PROJECT MANAGERS, PROJECT MEMBERS, AND OVERSIGHT OR STEERING GROUPS
A.
Project Manager The project manager is responsible for project administration on a day to day basis including the following responsibilities:
B.
1.
Must achieve all of the project objectives while balancing the project constraints of budget, time, and resources.
2.
Has to identify and manage internal and external stakeholder expectations.
3.
Has to develop the project, implement the plan, monitor and control the plan and end the plan when the project objectives have been met.
4.
Has to identify and procure the project team members, resolve project team conflict and provide feedback to team members.
5.
Must break the project down into smaller manageable tasks and assign and delegate responsibilities to various team members.
6.
Must communicate project metrics to stakeholders and team members.
Project Members Project members perform the project tasks and their roles generally include:
C.
1.
Carrying out the work and producing the deliverables that have been defined by the project manager. (Project members may be either individuals or organizations.)
2.
Understanding the work that must be completed, planning out the assigned activities in more detail if needed, completing the work within the budget, time, and quality expectations, and proactively communicating the status of their work to the project manager.
Project Sponsor A project sponsor is an individual at the executive level of management who is responsibie for allocating funding and resources to the project. The role of the project sponsor includes: 1.
Responsibility for overall project delivery.
2.
Participation in high level planning and leading the development of the project charter in the project authorization stage.
3.
Support the project manager in resolving major issues and problems.
4.
Chair the steering committee.
5.
Champion the project to upper management and other lateral executives across an organization.
6.
Remove or overcome organization obstacles and barriers through diplomacy and negotiation.
7.
Sign off on approvals required to proceed to the next phase of project work.
8.
Review the project work with the broader goals of the organization in mind.
9.
Interface between the organization and the project itself.
10.
Communicate project needs to the steering committee.
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Executive Steering Committee An executive steering committee is to a project what the board of directors is to a company; both groups direct, but they do not manage on a daily basis.
III.
1.
The steering committee is a group of executive level people or external organizations charged with regular oversight of a project and taking responsibility for the business issues associated with a project.
2.
Collectively, the group should represent all significant areas of participation (or departments I business units) in an organization so that they have the authority to make binding decisions on behalf of those areas. Examples might include departmental heads, vice presidents, or directors.
3.
Established to give guidance on overall strategic direction of the project to the Project Sponsor or Project Manager. Guidance is not the same thing as daily management of the project which is the responsibility of the program manager.
4.
Approve project deliverables.
5.
Help resolve issues and policy decisions.
6.
Approve scope changes.
7.
Authorize the project in a project charter.
8.
Approve budget strategy.
9.
Monitor risk, quality and timeliness.
10.
Mandate, control, empower and make key decisions.
PROJECT RISKS A.
Project Risk - General 1.
Risk is the chance that something will go wrong with a project and this event will have an adverse impact on the success of the project.
2.
Risk is inherent in every aspect of the project management process. Therefore, to plan for It, the project manager must consider the kinds of things that could go wrong in the authorization, planning, execution, monitoring and control, and closing processes.
3.
There is always a tradeoff between risk and reward. Organizations are willing to accept varying degrees of risk along the way if the risk is in balance with the rewards derived from successfully achieving project objectives. This concept is called risk tolerance.
4.
Planning for Risk Management a.
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Risk Assessment (1)
Anticipate every1hing that could go wrong throughout the project plans.
(2)
Analyze each risk to specify how those uncertainties can impact the performance of the project in time, cost, or meeting user expectations.
(3)
Prioritize risk and determine which ones must be eliminated completely (severe risk), which should receive regular management attention (significant risk), and which risks are immaterial to the project.
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(4)
b.
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Examples of common project risks include time and cost estimates too optimistic, unclear roles and responsibilities, stakeholder input not sought, needs not properly understood, etc.
Risk Control (1)
Spend money in advance to mitigate or prevent the most severe risks identified above.
(2)
Plan for emergencies by having a written emergency plan in place before significant risks transpire.
(3)
Track the effects of identified risk in a risk register by adding each risk to the log, writing down what you will do in the event it occurs, and writing down what you will do to prevent it from occurring.
Inputs Used to Plan and Identity Risk Scope statement Cost management plan Schedule management plan Communications management plan Enterprise environmental factors Organizational process assets Activity cost estimates
Tools & Techniques SWOT analysis - strength, weakness, opportunity, threat analysis
Outputs Risk register
Expert judgment Checklists Assumptions analysis Documentation reviews Brainstorming
Activity duration estimates Stakeholder register Quality management plan
5.
B.
Inputs Used for Planning for Risk a.
Scope statement
b.
Cost management plan
c.
Schedule management pian
d.
Communications management plan
e.
Enterprise environmental factors
f.
Organizational process assets - Institutional lessons learned from previous projects, project files, organizational and project process controls.
Resource The project manager must put together staff to work on the project, assign each team member responsibility for tasks, acquire the staff both internally and externally as necessary, and develop the team members by providing feedback and guidance so that the team collaborates effectively. The human resource plan formally documents these planning assumptions in writing.
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1.
2.
3.
4.
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Influences on the Human Resource Plan a.
Organizational culture
b.
Existing staff levels throughout the organization
c.
Condition of the market place
d.
Institutional memory on previous projects (is there known conflict among certain possible team members or departments?)
e.
Organization charts
f.
Industry regulations/current laws
g.
Sources of additional staff (e.g., will you use consultants, existing employees, or will you hire?)
Tools to Enhance Communication and Success in the Human Resource Plan Include: a.
Hierarchical charts (e.g., typical organization chart enhanced with work break down structures).
b.
Matrix (e.g., responsibility assignment matrix (RAM) shows all activities associated with one person and all people associated with one activity).
c.
Text-oriented narrative description outlining responsibility, authority, competencies, and qualification.
d.
Staffing Management Plan to explain how and when the project manager will acquire all the humans.
e.
Training and team-building activities.
f.
Recognition and rewards.
g.
An issue log can be used to monitor conflict resolution and other issues that arise during the project.
Conflict Resolution Strategies a.
Retreat from the conflict.
b.
Focus on areas of agreement and ignore/deemphasize areas of disagreement
c.
Compromise so that all parties have some of their wants/needs met.
d.
Do it my way.
e.
Build consensus through incorporating various perspectives.
f.
Problem solving by actively engaging the team to solve the problem through discussion.
Plan for Things to Go Wrong and Identify an Appropriate Response a.
Time originally allocated for the completion of a task might vary significantly.
b.
Additional staff may be required leading to cost overruns.
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c.
The duration of an activity may need to be modified based on the competency level of the team member assigned to complete the task.
d.
Team members may hate each other and their inability to get along can derail a project.
e.
The project manager might be managing a virtual team that has members in various time zones.
Scope The challenge in managing scope is to include all the work required to complete a project and nothing else. There is an infinite number of wants and needs and a finite amount of resources available to successfully produce the product deliverables. 1.
2.
3.
Types of Scope Management a.
Product scope must define the attributes of the product, service, or result.
b.
Project scope defines the work that must take place to produce the product, service, result defined in the product scope. It can also describe work that is specifically excluded from the project.
c.
A scope baseline is the formal written statement describing both the end product (product scope) and the project scope.
Tools and Techniques to Help Define the Scope a.
Focus groups
b.
Facilitated workshops
c.
Questionnaires and surveys
d.
Creation of prototypes
e.
Interviews
f.
Brainstorming
g.
Observations
Key Documents a.
Requirements Documentation - A written document describing the project requirements from all stakeholders. It can include quality requirements, acceptance criteria and training requirements.
b.
Requirements Management Plan - Documents how requirements will be analyzed, documented, and managed, tracked, and reported. Also describes how changes will be approved and processed.
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Change is Inevitable Project management anticipates processing change request forms which will affect the scope. The change order process must be decided in advance and ask the questions: what criteria will dictate a scope change? Who will authorize it? How will it affect the deliverable/cost/resource plans. etc.?
D.
Cost Cost baseline represents the amount of money that is expected to be spent on a project. When graphed, the cost baseline generally represents an S curve because little money is spent at the beginning and the end of a project. The maximum expenditure of money generally occurs during the middle of the project. Project Fund/ng Requ/rements specifies the total funding requirements and periodic funding requirements based on the cost baseline. Estimating and tracking costs are integral to project management.
Methods for estimating costs include: 1.
Judgment Managers consider a combination of historical information and the cost of materials and labor.
2.
Parametric Estimating Parametric estimating is a technique that relies on a statistical relationship between historical cost and other variables. such as square footage. Examples include regression analysis and the learning curve model. Learning curve model assumes the cost per unit decreases as more work gets completed.
3.
Analogous Estimating With analogous estimating, the cost of similar sized projects conducted in the past is used to approximate the cost of the current project. The method is considered less accurate because it is a top down approach and really doesn't address the unique qualities of the project on hand.
4.
Work Breakdown Structure Estimation Work breakdown structure (WBS) estimation is considered a bottoms-up analysis because each WBS activity is estimated, and then the costs of each WBS activity are aggregated to form the project budget.
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5.
Three-point Estimates Three point estimates refer to a range of cost estimates based on a most-likely assumption (realistic) of project costs.
6.
a.
Optimistic assumption - Reflects the best-case scenario of project management.
b.
Pessimistic assumption - Assumes the worst-case scenario will occur.
Reserve Analysis Reserve analysis is monetary padding to allow for uncertain cost estimations.
7.
Project Management Estimating Software
8.
Vendor Bid Analysis Vendor bid analysis assumes the vendor will bid on the work and a contract will be awarded.
9.
Earned Value Management Earned value management combines project scope, cost and schedule measures to help the project management team measure progress and performance on the project considering the following elements:
a.
Planned Value (PV) - The amount of money that the project should be worth at a particular point in the schedule
b.
Earned Value (EV) - The physical work that has been completed to date on the project and the authorized budget for that task
c.
Actual Cost (AC) - The actual cost of the project that has been spent so far
d.
Estimate at Completion (EAC) - The estimated total cost of the project at completion
e.
Cost Performance Index (CPI) over budget.
=EViAC.
If the CPI is less than 1, the project is
10.
Change is inevitable, so each change request must be incorporated into the cost performance baseline.
11.
Risk includes all processes required to estimate, budget and control project costs. It also includes defining levels of tolerance, level of accuracy, and control thresholds. In order to compile a cost estimate, information from the scope baseline, project schedule, risk register, human resource plan, organizational process assets, and enterprise environmental factors is used to develop a cost baseline and a project funding requirements document.
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Deliverables Quality of deliverables may be identified in terms of SMART:
o o o o o
~pecific
-Is the criteria clearly defined and precise?
Measurable -Is the criteria objective and measurable?
Attainable - Do we have realistically achievable results?
Relevant - Does the deliverable correlate to the project objective?
rime-based - Has sufficient time has been allowed? Has there been enough time to achieve this? (There is no point expecting a year's worth of work in one week.)
Time Management Scope
1. Define activities
1. Collect requirements
2. Sequence the activities
2. Define scope
3. Estimate activity resources
3. Create the work breakdown sequence
4. Estimate activity durations
1. Estimate costs
5. Develop the schedule
2. Develop the budget
~
Cost Management
-/
DEVELOP AND REFINE THE PROJECT PLAN
Procurement Management
1. Plan procurements
Quality Management
1. Plan for quality
~
/ Risk Manaaement
Communication Management
Human Resource Management
1. Plan risk management
1. Plan communications
1. Develop the human
2. Identify risks
resource plan
3. Perform qualitative risk analysis
4 Perform quantitative risk analysis 5. Define risk responses
o
END OF ANCILLARY MATERIAL
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TERMINOLOGY
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
Absorption Costing
Direct Material
Activity-based Costing
Direct Material Price Variance
Appraisal Costs
Direct Material Usage Variance
Avoidable Costs
Discretionary Costs
Backflush Costing
Economic Value Added (EVAI
Balanced Scorecard
Economies of Scale
Benchmarking
Efficiency Variance
Breakeven Point
Engineered Costs
Budget (Controllable) Variance
Equivalent Unit (EQU)
Carrying Costs
Experience Curve
Cause-and-Effect Diagram
Expired Costs
Coefficient of Correlation
External Failure Costs
Coefficient of Determination
FIFO Method of Process Costing
Committed Costs
Fixed Costs
Common Cost
Flexible Budget
Contribution Margin
Full Product Costing
Contribution Margin Ratio
High-Low Method
Control Chart
Ideal Standards
Conversion Costs (and Conversion Cost Pricing)
Indirect Costs
Cost Assignment
Internal Failure Costs
Cost Driver
lnventoriable costs
Cost of Goods Manufactured
Infrastructure Costs
Cost of Goods Sold
Job Order Costing
Cost Object
Joint Costs
Cost Pool
Just-In-Time (JIT)
Cost-Volume-Profit Analysis
Kaizen
Currently Attainable Standards
Learning Curve
Depreciation Tax Shield
Management by Objective
Defective Units
Manufacturing Overhead
Differential Costs
Margin of Safety
Direct labor
Market Size Variance
Direct Labor Efficiency Variance
Market Share Variance
Direct labor Rate Variance
Master BUdget
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Mixed Costs
Total Quality Management (TQM)
Operational Costing
Transfer Price
Operating leverage
Unexpired Costs
Opportunity Costs
Underapplied Overhead
Overapplied Overhead
Value Engineering
Overhead
Variable Costs
Pareto Diagram
Variable Cost Ratio
Prevention Costs
Variable (Direct) Costing
Period Costs
Variance Analysis
Practical Capacity
Volume Variance
Prime Costs
Waste
Product Costs
Weighted-Average Method of Process Costing
Process Costing
Zero-Based Budget
Regression Analysis Relevant Costs Relevant Range Residual Income Responsibility Accounting Rework Sales Mix Variance Sales Quantity Variance Sales Volume Variance Scrap Selling Price Variance Sensitivity Analysis Spending Variance Spoilage Spoiled Goods Standard Costs Standard Error of the Estimate Statistical Quality Control Strategic Business Unit (SBU) Step-variable Costs Sunk Costs T-Value Target Costs Throughput Costing (Super-variable Costing)
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CLASS QUESTIONS
c
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~
~ ~
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u: «
~
u
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5 «c
u
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.
1st
Multiple-choice questions correct + 17 questions =
2nd
Multiple-choice questions correct + 17 questions
3rd
Multiple-choice questions correct + 17 questions =
%
Final
Total questions correct
%
=
+ 17 questions -
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1. CPA-06480 According to the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, which of the following components of enterprise risk management addresses an entity's assignment of authority and responsibility? a. b. c. d.
Internal environment. Control activities. Information and communication. Monitoring.
2. CPA-06481 According to the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, which of the following components of enterprise risk management addresses an entity's reporting deficiencies? a. b. c. d.
Internal environment. Event identification. Control activities. Monitoring.
3. CPA-06482 According to the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, which of the following components of the internal control integrated framework addresses an entity's timely reporting of identified internal control deficiencies? a. b. c. d.
Control environment. Monitoring. Control activities. Information and communication.
4. CPA-06483 A company that retains a CPA with the appropriate knowledge, skills and abilities to prepare timely and effective financial reporting is applying the ideas from which principle of effective internal control over financial reporting? a. b. c. d.
Integrity and ethical values. Management philosophy and operating style. Human resources. Financial reporting competencies.
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5. CPA·06484 The Sarbanes Oxley Act of 2002 requires that the members of the audit committee be independent with regard to the issuer. Within the meaning of the law, which of the following corporate officers would be considered independent?
a. b. c. d.
Board Member
Independent Auditor
Yes Yes No No
Yes No Yes No
6. CPA-06485 The Barstan Corporation has adopted the internal control integrated framework and regularly surveys local employers and uses national services to ensure that the accounting staff is appropriately compensated. The principle of the control environment most closely related to this practice is: a. b. c. d.
Financial reporting competencies. Management philosophy and operating style. Authority and responsibility. Human resources.
7. CPA-06486 Corbin Corporation is evaluating the sample sizes associated with periodic tests of the existence of a fleet of taxis. Cash receipts associated with fares deposited daily are periodically reconciled to both the fares charged and the taxi's odometer readings. With respect to monitoring controls over cash vs. vehicles, Corbin will likely: a. b. c. d.
Review cash Review cash Review fixed Review cash
on an ongoing basis and fixed assets on a less frequent periodic basis. and fixed assets on an ongoing basis. assets on an ongoing basis and cash on a less frequent periodic basis. and fixed assets on a periodic basis, neither one daily.
8. CPA·06487 Big Box Retailers is a cost leader that offers the lowest possible prices on consumer goods. The marketing practice that best describes Big Box Retailer's approach would be: a. b. c. d.
Transaction marketing. Interaction-based relationship marketing. Database marketing. Network marketing.
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9. CPA-03477 A processing department produces joint products Ajac and Bjac, each of which incurs separable production costs after split-off. Information concerning a batch produced at a $60,000 joint cost before split-off follows: Product
Ajac Bjac
Separable costs
$ 8,000 22,000 $ 30000
Sales value
$
80,000 40,000 $120000
What is the joint cost assigned to Ajac if costs are assigned using the relative net realizable value? a. b. c. d.
$16,000 $40,000 $48,000 $52,000
10. CPA-03584 Mason Company uses a job-order cost system and applies manufacturing overhead to jobs using a predetermined overhead rate based on direct-labor dollars. The rate for the current year is 200 percent of direct-labor dollars. This rate was calculated last December and will be used throughout the current year. Mason had one job, No. 150, in process on August 1 with raw materials costs of $2,000 and direct-labor costs of $3,000. During August, raw materials and direct labor added to jobs were as follows: No. 150
Raw materials Direcllabor
$ 1,500
No. 151
No. 152
$4,000 5,000
$1,000 2,500
Actual manufacturing overhead for the month of August was $20,000. During the month, Mason completed Job Nos. 150 and 151. For August, manufacturing overhead was: a. b. c. d.
Overapplied by $4,000. Underapplied by $7,000. Underapplied by $2,000. Underapplied by $1 ,000.
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11. CPA·03601 Kerner Manufacturing uses a process cost system to manufacture laptop computers. The following information summarizes operations relating to laptop computer model #KJK20 during the quarter ending March 31: Units
Work-in-process inventory, January 1 Started during the quarter Completed during the quarter Work-in-process inventory, March 31 Costs added during the quarter
100 500 400 200
Direct Materials
$ 70,000
$ 750,000
Beginning work-in-process inventory was 50% complete for direct materials. Ending work-in-process inventory was 75% complete for direct materials. What were the equivalent units of production using the FIFO method, with regard to materials for March?
a. b. c.
d.
450 500 550 600
12. CPA-03628 The following information concerns Forming's equivalent units in May 20X1: Units
Beginning work-in-process (50% complete) Units started during May Units completed & transferred Ending work-in-process (80% compiete)
2,000 8,000 7,000 2,500
Using the weighted average method, what were Forming's May 20X1 equivalent units? a. b. c. d.
7,000 9,000 10,000 19,500
13. CPA-03655 What is the normal effect on the numbers of cost pools and allocation bases when an activity-based cost (ABC) system replaces a traditional cost system?
a. b. c. d.
Cost pools No effect Increase No effect Increase
• ,-100
Allocation bases No effect No effect Increase Increase
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14. CPA·03883 Listed below are selected line items from the Cost of Quality Report for Watson Products for last month. Category
Amount
Rework Equipment maintenance Product testing Product repair
$ 725 1,154
786 695
What is Watson's total prevention and appraisal cost for last month?
a. b. c. d.
$786 $1,154 $1,849 $1,940
15. CPA·03890 In a quality control program, which of the following is (are) categorized as internal failure costs? I. Rework. II. Responding to customer complaints. III. Statistical quality control procedures. a. b. c. d.
I only. II only. III only. I, II, and III.
16. CPA·06488 Performance of quality assurance occurs in which of the following processes? a. b. c. d.
Authorization. Planning. Implementation. Close.
17. CPA·06489 Comparing the project work completed to date to the baseline defined in the plan occurs in which of the following processes? a. b. c. d.
Planning. Monitoring. Implementation. Authorization.
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Economic Concepts
1.
Changes in economic and busrness cycles
3
2.
Economic measures/indicators
3.
Globalization and local economies
4.
Market influences on business strategies
35
5.
Financial risk management
83
6.
Task-based simulations
6.
Terminology
111
7.
Class questions
113
, ,
,
13 ,
, 27
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CHANGES IN ECONOMIC AND BUSINESS CYCLES I.
BUSINESS CYCLES A.
Introduction Business cycles refer to the rise and fall of economic activity relative to its long-term growth trend (Le., the swings in total national output, income, and employment over time). Although the economy tends to grow over time, the growth in economic activity is not stable. Rather, economic activity is characterized by fiuctuations, and these fiuctuations are known as business cycles. Business cycles vary in duration and severity. Some cycles are quite mild. Others are characterized by large increases in unemployment and/or infiation. The analysis of business cycles is part of the field of macroeconomics. Macroeconomics is the study of the economy as a whole. It examines the determinants of national income, unemployment, and infiation and how monetary and fiscal policies affect economic activity. On the other hand, microeconomics studies consumers, producers, and suppliers operating in a narrowly defined market.
B.
Measuring Economic Activity - Gross Domestic Product Because business cycles refer to the rise and fall of economic activity, it is important to first examine how economic activity is measured. The most common measure of the economic activity or output of an economy is Gross Oomestic Product (GOP). GOP is the total market value of all final goods and services (the term "final goods and services" excludes used goods that have been resoid) produced within the borders of a nation in a particular time period (Le., the nation's output of goods and services). Note that GOP includes all final goods and services produced by resources within a country regardless of who owns the resources. Thus, U.S. GOP includes the output of foreign-owned factories in the U.S. but excludes the output of U.S.-owned factories operating abroad.
C.
Nominal versus Real GOP 1.
Nominal GOP Nominal GOP (unadjusted) measures the value of all final goods and services in prices prevailing at the time of production. That is, nominal GOP measures the value of all final goods and services in current prices.
2.
Real GOP a.
Definition Real GOP (adjusted) measures the value of ali final goods and services in constant prices. That is, real GOP is adjusted to account for changes in the price level (Le., it removes the effects of infiation by using a price index). Real GOP is the most commonly used measure of economic activity and national output (Le. the total output of an economy).
b.
Price Index (GOP deflator) The price index used to calculate real GOP is called the GOP Oefiator. It is a price index for all goods and services included in GOP. Using the GOP defiator, real GOP is calculated as the ratio of nominal GOP to the GOP defiator times 100. Real GOP = Nominal GOP x 100 GOP deflator
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Real GOP per Capita and Economic Growth Real per capita GDP (real GDP per capita) is real GDP divided by population. Real GDP per capita is typically used to compare standards of living across countries or across time. Real GDP per capita is also used to measure economic growth. Economic growth is the increase in real GDP per capita over time.
E.
Summary Composition of Business Cycles As noted above, economic activity is characterized by fluctuations, and these fluctuations are known as business cycles. Business cycles are typically comprised of: 1.
Expansionary Phase An expansionary phase is characterized by rising economic activity (real GDP) and growth. During an expansionary phase, economic activity is rising above its long-term growth trend. Firm profits are likely to be rising during an expansionary phase as the demand for goods and services increases. Firms are also likely to increase the size of their workforce during an expansion, and the price of goods and services is likely to be rising.
2.
Peak A peak is a high point of economic activity. It marks the end of an expansionary phase and the beginning of a contractionary phase in economic activity. At the peak of a business cycle, firm profits are likely to be at their highest level. Firms are also likely to face capacity constraints and input shortages (raw material and labor), leading to higher costs and a higher overall price level.
3.
Contractionary Phase A contractionary phase is characterized by falling economic activity and growth and follows a peak. During a contractionary phase, firm profits are likely to be falling from their highest levels.
4.
Trough A trough is a low point of economic activity. At this point of the business cycle, firm profits are likely to be at their lowest level. Firms are also likely to experience significant excess production capacity, leading them to reduce the size of their workforce and cut costs.
5.
Recovery Phase A recovery phase follows a trough. During a recovery phase, economic activity begins to increase and return to its long-term growth trend. Further, firm profits typically begin to stabilize as the demand for goods and services begins to rise.
II.
TERMINOLOGY USED IN DESCRIBING BUSINESS CYCLES A.
Recession A recession occurs when the economy experiences negative real economic growth (declines in national output). Economists define a recession as two consecutive quarters of falling national output. During a recession, firm profits tend to fall and many firms incur losses. Firms are also likely to have excess capacity. As a result, during a recession resources (including labor) are likely to be underutilized and unemployment is likely to be high .
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Depression A depression is a very severe recession. It is characterized by a relatively long period of stagnation in business activity and high unemployment rates. As a result, firms will experience significant excess capacity. Furthermore, due to the significant reduction in the demand for goods and services, it is likely that many firms will go out of business during a depression.
C.
Illustration Graph A illustrates the business cycle. GRAPH A
Output (Real GOP) Contractionary phase
Peak Expansionary phase
~
~
/
Long-term growth trend
~
~---!/
in national output
--
Recovery phase
Trough
Trough
Time (Years)
III.
ECONOMIC INDICATORS Although business cycles tend to be irregular and unpredictable, economists nevertheless attempt to predict business cycles and their severity and duration using economic indicators. Economic indicators (gathered by The Conference Board) are variables that have historically correlated highly with economic activity. They can be "leading indicators," "lagging indicators," or "coincident indicators." A.
Leading Indicators Leading indicators tend to predict economic activity. The government routinely revises the numbers as more data becomes available. Thus, leading indicators are subject to change. They include: 1.
Average new unemployment claims.
2.
BUilding permits for residences.
3.
Average length of the workweek.
4.
Money supply.
5.
Prices of selected stocks.
6.
Orders for goods.
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Price changes of materials.
8.
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Lagging Indicators Lagging indicators tend to follow economic activity. They give signals after the fact and include the following:
C.
1.
Prime rate charged by banks.
2.
Average duration of unemployment.
3.
Bank loans outstanding.
Coincident Indicators Coincident indicators tend to occur coincident to economic activity. They include the following:
IV.
1.
Industrial production.
2.
Manufacturing and trade sales.
REASONS FOR FLUCTUATIONS While there are a variety of theories regarding the cause of business cycles, economists generally agree that business cycles result from shifts in aggregate demand and/or aggregate supply. Aggregate demand and aggregate supply curves can be used to illustrate the relationship between a country's output (real GOP) and price level (the GOP Deflator). They are also used to examine the causes of economic fluctuations.
A.
Aggregate Demand (AD) Curve The aggregate demand (AD) curve illustrates the maximum quantity of all goods and services that households, firms, and the government are willing and able to purchase at any given price level. It shows the relationship between total output (real GDP) of the economy and the price level. Note that this "aggregate" demand curve is the macroeconomic demand curve of the "total" demand in the economy as a whole. This particular "line" just happens to be drawn as a straight line; although it is often drawn as a curve. The x-axis is real GOP.
B.
Aggregate Supply (AS) Curve The aggregate supply (AS) curve illustrates the maximum quantity of all goods and services producers are willing and able to produce at any given price level. Note that this "aggregate" supply curve is the macroeconomic supply curve of the "total" supply in the economy as a whole.
1.
Short-run Aggregate Supply Curve The short-run aggregate supply (SRAS) curve is upward sloping, illustrating the fact that as the price level rises, firms are willing to produce more goods and services.
2.
Long-run Aggregate Supply Curve The long-run aggregate supply (LRAS) curve is vertical, illustrating the fact that in the long-run, if all resources are fUlly utilized, output is determined solely by the factors of production. This curve corresponds to the potential level of output in the economy.
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Potential Level of Output (potential GOP) Potential GOP refers to the level of real GOP (national output) that the economy would produce if its resources (capital and labor) were fUlly employed. When real GOP is below the potential level of output, the economy will typically be experiencing a recession. Similarly, when real GOP rises above the potential level of output, the economy will typically be experiencing an expansion.
C.
Illustration
Graph B illustrates the aggregate demand and aggregate supply curves for an economy.
GRAPH B
Price Level
Long-Run Aggregate Supply Short-Run Aggregate Supply
Po
Aggregate Demand y'
Real GDP
The intersection of the Short-Run Aggregate Supply (SRAS) curve and the Aggregate Demand (AD) curve determines the level of output (real GOP) and price level in the short run. The position of the long-run aggregate supply (LRAS) curve determines the level of output in the long run. The LRAS curve is vertical at the economy's potential level of output.
y* = GOP at the potential (equilibrium) level of output.
D.
Aggregate Demand, Aggregate Supply, and Economic Fluctuations Business cycles, or economic fluctuations, are the result of shifts in aggregate demand and short-run aggregate supply (note that shifts in the long-run aggregate supply curve are associated with long-run growth in the economy and do not affect business cycles). 1.
Reduction in Demand If circumstances cause individuals, businesses, or governments to reduce their demand for goods and services, economic activity (real GOP) will decline, leading to a contraction in economic activity and possibiy a recession. As a result, a reduction in demand tends to cause firm profits to decline. Firms are also likely to experience an increase in excess capacity, leading them to reduce the size of their workforce.
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Increase in Demand In contrast, if circumstances cause individuals, businesses, and governments to increase their demand for goods and services, economic activity will rise, leading to a recovery or an expansion in economic activity. As a result, an increase in demand tends to cause firm profits to rise. Firms are also likely to experience a reduction in excess capacity, leading them to increase the size of their workforce.
3.
Reduction of Supply If circumstances cause firms to reduce their supply of goods and services, economic activity will fall, leading to a contraction or possibly a recession. As firms reduce their supply, they are also likely to reduce the size of their workforce, leading to higher unemployment.
4.
Increase in Supply If circumstances cause firms to increase their supply of goods and services, economic activity will rise, leading to an expansionary phase of economic activity. As firms increase their supply, they are also likely to increase the size of their workforce, leading to lower unemployment.
Graphs C and 0 illustrate recessions caused by shifts in aggregate demand and shortrun aggregate supply. GRAPH C
GRAPH 0
LRAS
Price Level
LRAS
Price Level
SRAS I
SRAS
SRAS
Po
-------- --------
PI
------------
PI
/
Po
AD
---------,
,,,
---- ...,------
,, ,,
AD
AD, Y1
Yo
Output (Real GDP)
A recession caused by a shift in the aggregate demand curve: A decrease in aggregate demand causes actual GDP to fall below potential GOP. This is illustrated as the leftward shift in aggregate demand. As a result, real GOP falls from Yo to YI .
E.
Y,
Yo
Output (Real GOP)
A recession caused by a shift in the short run aggregate supply curve: A decrease in short-run aggregate supply causes actual GOP to fall below potential GDP. This is illustrated as the leftward shift in the short run aggregate supply curve. As a reSUlt, real GOP falls from Yo to Yl'
Factors that Shift Aggregate Demand The primary factors that shift aggregate demand are:
1.
Changes in Wealth a.
Increase in Wealth An increase in wealth causes the aggregate demand curve to shift to the right. Thus, an increase in wealth causes the economy to expand and leads to an increase in national output (real GOP).
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Decrease in Wealth A decrease in wealth causes the aggregate demand curve to shift to the left. A decrease in wealth does the opposite of an increase in wealth. For example, a large decline in stock prices would decrease consumer wealth and therefore shift the aggregate demand curve to the left. As a result, national output would fall, causing a contraction and possibly a recession.
2.
Changes in Real Interest Rates a.
Increase in Real Interest Rates An increase in interest rates increases the cost of capital and, therefore, tends to reduce consumer demand for durable goods such as new cars and homes and firm demand for new plants and equipment.
b.
Decrease in Real Interest Rates A decrease in real interest rates does the opposite of an increase in real interest rates. A decrease in real interest rates reduces the cost of capital, thereby increasing the demand for investment goods and shifting the aggregate demand curve to the right, causing national output to rise. Conversely, an increase in real interest rates causes the cost of capital to rise and shifts the aggregate demand curve to the left, causing national output to fall.
3.
Changes in Expectations about the Future Economic Outlook (consumer confidence) a.
Confident Economic Outlook If households become confident about the economic outlook (consumer confidence increases), the willingness to acquire investment and consumer goods increases and the aggregate demand curve shifts right, causing national output to rise.
b.
Uncertain Economic Outlook When the economic outlook appears more uncertain, consumers tend to reduce current spending, shifting aggregate demand to the left and causing national output to fall.
4.
Changes in Exchange Rates a.
Appreciated Currencies If the currency of a country appreciates in real terms relative to the currencies of its trading partners, its goods will become relatively expensive for foreigners, while foreign goods will become relatively cheap for its residents. As a result, net exports (exports minus imports) will fall, shifting the aggregate demand curve to the left and causing national output to fall.
b.
Depreciated Currencies If the currency of a country depreciates in real terms relative to the currencies of its trading partners, its goods will become relatively cheap for foreigners, while foreign goods will become relatively expensive for its residents. As a result, net exports (exports minus imports) will rise, shifting the aggregate demand curve to the right and causing national output to rise.
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Changes in Government Spending a.
Increase in Government Spending An increase in government spending shifts the aggregate demand curve to the right, causing national output to rise.
b.
Decrease in Government Spending A decrease in government spending shifts the aggregate demand curve to the left, causing national output to fall.
6.
Changes in Consumer Taxes a.
Increase in Consumer Taxes An increase in consumer taxes (e.g., the personal income tax) reduces the disposable income (gross income minus taxes) of consumers and, therefore, shifts the aggregate demand curve to the left, causing national output to fall.
b.
Decrease in Consumer Taxes A decrease in taxes increases the disposable income of consumers and therefore shifts the aggregate demand curve to the right causing national output to rise.
7.
Illustration: Changes in Government Spending and/or Taxes Graph E illustrates the effect of an increase in government spending andlor a decrease in taxes (known as expansionary fiscal poiicy), and Graph F illustrates the effect of a decrease in government spending andlor an increase in taxes (known as contractionary fiscal policy).
GRAPH E
GRAPH F
LRAS
Price level
LRAS
Price level
SRAS
SRAS
P, Po
/
AD, AD
Yo
Y,
Output (Real GOP)
In Graph E, the economy is initially in a recession, illustrated as output level Yo, which is below the potential level of output Yl . The government can stimulate the economy by increasing government spending or decreasing taxes (or both) shifting the aggregate demand curve to the right and causing national output (real GDP) to rise .
• 2-10
Po
-------
PI
-----------
,/ AD,
AD
Output (Real GOP) In Graph F, the economy is initially in an expansionary phase, illustrated as output level Yo, which is above the potential level of output Yl • The government can contract the economy by decreasing government spending or increasing taxes (or both), shifting the aggregate demand curve to the left and causing national output (real GDP) to fall.
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Multiplier Effect The multiplier effect refers to the fact that an increase in consumer, firm, or government spending, produces a multiplied increase in the level of economic activity. For example, a $1 increase in government spending results in a greater than $1 increase in reai GOP. The multiplier effect stems from the fact that increases in spending generate income for firms, which in turn spend that income. Their spending gives other households and firms income, and so on. Therefore, the effect of a $1 increase in spending is magnified by the multiplier effect. The multiplier effect results from the marginal propensity to consume (MPC). The MPC is the change in consumption due to a $1 increase in income. Because people tend to save part of their income, the MPC is typically less than one. Using the MPC, the size of the multiplier effect can be calculated using the following formulas:
1
Multiplier = .,----(1- MPC)
Change in real GDP = Multiplier x Change in spending
....I~
Note: The examiners could refer to "1- MPC" as the marginal propensity to save (MPS), so be aware of this terminology as well.
~
For example, suppose the MPC is 0.8 (Le., the change in consumption due to a $1 increase In income is 80 cents) and that spending increases by $100. Then the multiplier effect would be:
Change in real GDP =_1_ x $100 =$500 (1- 0.8)
Thus a $100 dollar increase in spending results in a $500 increase in real GOP. G.
Factors that Shift Short-run Aggregate Supply Recall that shifts in long-run aggregate supply are associated with economic growth NOT business cycles. Therefore, when discussing business cycles we focus on shifts in the shortrun aggregate supply curve. The primary factors that shift short-run aggregate supply are: 1.
Changes in Input (Resource) Prices a.
Increase in Input Prices An increase in input prices (raw material prices, wages, etc.) causes the shortrun aggregate supply curve to shift left. Thus, an increase in input prices causes the economy to contract and leads to a decrease in national output (real GOP). EXAM PlE
For example, a large increase in oil prices (oil is a primary input in production) would shift the short-run aggregate supply curve to the left. As a result, national output would fall, causing a contraction and possibly a recession. This was illustrated in Graph 0, prior.
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Decrease in Input Prices A decrease in input prices causes the short-run aggregate supply curve to shift to the right. A decrease in input prices causes the economy to expand and leads to an increase in national output (real GDP).
2.
Supply Shocks a.
Supplies are Plentiful If resource supplies become more plentiful, the short-run aggregate supply curve will shift to the right, causing national output to increase.
b.
Supplies are Curtailed If resource supplies are curtailed (e.g., crop failures, damage to infrastructure caused by earthquakes, etc.) the short-run supply curve will shift to the left, causing national output (real GDP) to decline.
H.
Shifts in Aggregate Demand and Supply and the Effects on Firm Business Operations Shifts in either the aggregate demand or aggregate supply curve affect the business conditions of firms. 1.
Example As was discussed above, when the aggregate demand curve shifts right (an increase in aggregate demand), firm profits tend to increase. In addition, firms are likely to experience a decrease in excess capacity, leading them to increase the size of their workforce.
2.
Effect of Economic Events on the Firm When economic events (such as those discussed above) cause either the aggregate demand curve or short-run aggregate supply curve to shift, they also affect the business conditions of firms.
a.
Shifts in Aggregate Demand Economic events that cause aggregate demand to increase (e.g., an increase in wealth or a decrease in interest rates) tend to cause firm profits to rise. In contrast, economic events that cause aggregate demand to decrease (e.g., a decline in consumer confidence) tend to cause firm profits to fail.
b.
Shifts in Aggregate Supply Economic events that shift the aggregate supply curve also affect firm profits, empioyment, and other conditions. For example, a rise in input costs tends to reduce firm profits and cause firms to reduce the size of their workforce .
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ECONOMIC MEASURES/INDICATORS
I.
OVERVIEW Economists and policy-makers rely on a host of economic measures or indicators to determine the overall state of economic activity. Some of the most commonly cited economic measures are: (1) real gross domestic product (real GOP), (2) the unemployment rate, (3) the inflation rate, and (4) interest rates. It is important to remember that these economic measures tend to move together. For example, when real GOP is rising, unemployment tends to be falling. Similarly, when the unemployment rate is rising, the inflation rate tends to be falling.
II.
THE NATIONAL INCOME ACCOUNTING SYSTEM The National Income and Product Accounting (NIPA) system was developed by the U.S. Oepartment of Commerce in order to monitor the health and performance of the U.S. economy. The two approaches to measuring GOP (expenditure approach and income approach, both discussed in detail below) are calculated using NIPA. The combined economic output of the following four sectors is called gross domestic product (GOP); the total dollar value of all new final goods and services produced within the economy In a given time period. •
Households (or consumers)
•
Businesses
•
Federal, state, and iocal governments
•
The foreign sector
Remember that GOP was introduced on page B2-3 where nominal GOP and real GOP were discussed. A.
Two Methods of Measuring GOP The two methods of measuring GOP are the expenditure approach and the income approach. 1.
Expenditure Approach Under the expenditure approach, GOP is the sum of the following four components:
o
o o o
Government purchases of goods and services Gross private domestic Investment (nonresidential fixed investment, residential fixed investment, and change in business inventories) Personal Consumption expenditures (durabie goods, non-durable goods, and services) Net Exports (exports minus imports)
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The Income Approach The income approach accounts for GOP as the value of resource costs and incomes generated during the measurement period. a.
The income approach includes business profits, rent, wages, interest, depreciation, and business taxes.
b.
Calculate GOP through the income approach by using the following mnemonic:
o o o o o o o
Income of proprietors Profits of corporations Interest (net) Rental income Adjustments for net foreign income and miscellaneous items Taxes (indirect business taxes)
o
B.
Employee compensation (wages) Depreciation (also known as capital consumption allowance)
Comparison of Approaches The different approaches to preparing an "income statement" for the domestic economy (the GOP) are shown in the table below. 1.
The aggregate expenditures approach on the left is a flow-of-product approach (at market prices).
2.
The income approach on the right is a flow of earnings and costs approach (valueadded items plus taxes). COMPARISON OF APPROACHES (billions of dollars)
Expenditures Approach Government purchases
(fIow~of-productl
Income Approach (earnings and costJ
$1,314.7
Income of proprietors
$ 450.9
Investment
1,014.4
Profits of corporations
526.5
Consumption
4,698.7
Interest (net)
392.8
Rental income
116.6
Exports (net)
(96.4)
Adjustments for net foreign income/miscellaneous
572.5
Employee compensation
4,008.3
Depreciation (consumption of fixed capital) Aggregate Expenditure
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$6.931.4
45.0
Taxes (indirect business)
Domestic Income
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,......--------------------------....,o AN C III A R Y MAT E R I A l
C.
(for Independent Review)
Other Measures of National Income While GOP is the most common measure of national income and an economy's output and performance, there are several other noteworthy measures. These measures are calculated by making specific deductions and additions to GOP and include: Net domestic product (NOP), gross national product (GNP), net national product (NNP), national income (NI), personal income (PI), and disposable income (01).
1.
Net Domestic Product Net domestic product (NOP) is GOP minus depreciation (the capital consumption allowance), the expenditure necessary to maintain production capacity (or "depreciation" to accountants).
2.
Gross National Product (GNP) Gross national product (GNP) is defined as the market value of final goods and services produced by residents of a country in a given time period. GNP differs from GOP because GNP includes goods and services that are produced overseas by U.S. firms and excludes goods and services that are produced domestically by foreign firms. For example, if BMW produces cars in the U.S., that production is counted as part of U.S. GOP, but it is not counted as part of U.S. GNP because BMW is a foreign-owned company.
3.
Net National Product (NNP) Net national product (NNP) is defined as the total income of a country's residents less losses from economic depreciation (I.e., losses in the value of capital goods due to age and wear). Thus, NNP equals GNP minus economic depreciation. This depreciation is not accounting depreciation, which is allocation of costs to accounting periods.
4.
National Income (NI) National income (NI) is NNP less indirect business taxes (e.g., sales tax). It measures the income received by all factors of production within a country.
5.
Personal Income (PI) Personal income (PI) is the income received by households and noncorporate businesses, as illustrated below: National income Less: Undistributed corporate profits (retained earnings)
Net interest Contributions for social measures (social security contributions) Corporate income taxes
Plus; Government transfer payments to individuals Personal interest income Business transfer payments/dividends
Personal income
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Disposable Income (01) Disposable income (01) is personal income less personal taxes. It is the amount of income households have available either to spend or save.
o
END OF ANCILLARY MATERIAL
III.
THE UNEMPLOYMENT RATE The unemployment rate measures the ratio of the number of people classified as unemployed to the total labor force. The total labor force includes all non-institutionalized individuals 16 years of age or older who are either working or actively looking for work. (An unemployed person is defined as a person 16 years of age or older who is available for work and who has actively sought employment during the previous four weeks.) Note that to be counted as unemployed a person must be actively looking for work. The unemployment rate can be expressed as:
Unemp Ioyment Rate =
Number of Unemployed
x 100
Total Labor Force
A.
Types of Unemployment
1.
Frictional Unemployment Frictional unemployment is normal unemployment resulting from workers routinely changing jobs or from workers being temporarily laid off. It is the unemployment that arises because of the time needed to match qualified job seekers with available jobs.
2.
Structural Unemployment Structural unemployment occurs when:
3.
a.
Jobs available in the market do not correspond to the skills of the work force, and
b.
Unemployed workers do not live where the jobs are located.
Seasonal Unemployment Seasonal unemployment is the result of seasonal changes in the demand and suppiy of labor. For example, shortiy before Christmas, the demand for labor increases and then decreases again after Christmas.
4.
Cyclical Unemployment Cyclical unemployment is the amount of unemployment resulting from declines in real GOP during periods of contraction or recession or in any period when the economy fails to operate at its potential. When real GOP is below the potential level of output, cyclical unemployment is positive. When real GOP is above the potential level of output, cyclical unemployment is negative. Thus, cyclical unempioyment rises during a recession and falls during an expansion.
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Natural Rate of Unemployment and the Meaning of Full Employment 1.
Natural Rate of Unemployment The natural rate of unemployment is the "normal" rate of unemployment around which the unemployment rate fluctuates due to cyclical unemployment. Thus, the natural rate of unemployment is the sum of frictional, structural, and seasonal unemployment or the employment rate that exists when the economy is at its potential output level (recall that the position of the Long-Run Aggregate Supply (LRAS) curve is determined by the potential level of output).
2.
Full Employment Full employment is defined as the level of unemployment when there is no cyclical unemployment. Full employment does not mean zero unemployment. When the economy is operating at full employment, there is still frictional, structural, and seasonal unemployment.
C.
Link between Unemployment and National Output (real GOP) The unemployment rate and national output (real GDP) tend to move in opposite directions. That is, when real GDP is rising, the unemployment rate tends to be falling. Similarly, when real GDP is falling (for example, when the economy is in a recession), the unemployment rate tends to be rising. The reason for the link between the two variables is straightforward. When the demand for goods and services increases (when real GDP is rising), firms typically need to hire additional workers to produce the additional goods and services demanded and hence the unemployment rate tends to fall. Obviously the opposite Is true when the demand for goods and services decreases.
IV.
PRICE LEVEL AND INFLATION A.
Definitions 1.
Inflation Inflation is defined as a sustained increase in the general prices of goods and services. It occurs when prices on average are increasing over time.
2.
Deflation Deflation is defined as a sustained decrease in the general prices of goods and services. It occurs when prices on average are falling over time. Most economists believe deflation is a much bigger economic problem than inflation. During periods of deflation, firms are likely to experience significant excess production capacity. This occurs because consumers tend to hold off purchasing goods and services during a period of deflation because they realize the price of goods and services is likely to continue to fall. Consequently, firm profits are likely to be falling during periods of deflation.
3.
Inflation/Deflation Rate The inflation or deflation rate is typically measured as the percentage change in the consumer price index (CPI) from one period to the next.
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Consumer Price Index (CPI) The consumer price index (CPI) is a measure of the overall cost of a fixed basket of goods and services purchased by an average household. (The producer price index (PPI) measures the overall cost of a basket of goods and services typically purchased by firms.)
b.
Formula Using the CPI, the inflation rate is calculated as the percentage change in the CPI from one period to the next:
Inflation Rate =
CPI'h·IsperlO . d - CPI"as
. d xl00
penD
CPl last period
B.
Causes of Inflation and Deflation Inflation and deflation are caused by shifts in the aggregate demand and short-run aggregate supply curves. A shift right in the aggregate demand curve will cause the price level to rise, leading to inflation. Similariy, a shift left in the short-run aggregate supply curve will also cause the price level to rise, leading to inflation.
1.
Demand·Pull Inflation Demand-pull inffation is caused by increases in aggregate demand. Thus, demand-pull inflation could be caused by factors such as:
2.
a.
Increases in government spending.
b.
Decreases in taxes.
c.
Increases in wealth.
d.
Increases in the money supply.
Cost·Push Inflation Cost-push inffation is caused by reductions in short-run aggregate supply. Thus, costpush inflation could be caused by factors such as:
3.
a.
An increase in oil prices.
b.
An increase in nominal wages.
Illustrations Graphs G and H illustrate demand-pull and cost-push infiation using the aggregate demand and short-run aggregate supply curves.
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GRAPH G
GRAPH H
Price level
Price level
SRAS ,
SRAS
PI
--------- ---------
,, ,
Po
--------------
V
SRAS
PI Po
----------- - --
AD ,
I
,, ,,
- - - - - -r - - - - --
,, ,,, ,
AD Output (Real GOP)
Demand-Pull Inflation: An increase in aggregate demand causes the short-run equilibrium price level to rise from Po to PI-
4.
AD Y,
Yo
Output (Real GOP)
Cost-Push Inflation: A decrease in short-run aggregate supply causes the short-run equilibrium price level to rise from Po to PI-
Deflation Deflation is also caused by shifts in aggregate demand or short-run aggregate supply. A shift left in aggregate demand (perhaps brought about by a stock market crash or a large increase in taxes) will cause the aggregate price level to fall. Similarly, a shift right in the short-run aggregate supply curve will also cause the aggregate price level to fall.
C.
Inflation and the Value of Money Inflation has an inverse relationship with purchasing power. As the price level rises, the value of money declines. 1.
Definitions a.
Monetary Assets and Liabilities Monetary assets and liabilities (e.g., cash, accounts receivable, notes payable, etc.) are fixed in dollar amounts regardless of changes in specific prices or the general price level.
b.
Non-monetary Assets and Liabilities The value of non-monetary assets (e.g., a bUilding, land, machinery, etc.) and non-monetary liabilities will fluctuate with inflation and deflation.
2.
Holding Monetary Assets During a period of inflation, those with a fixed amount of money or income (e.g., retired persons) will be hurt (i.e., their purchasing power will be eroded). Similarly, firms that lend out money at fixed interest rates are likely to be hurt by inflation.
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3.
Holding Monetary Liabilities During a period of inflation, those with a fixed amount of debt (e.g., those with home mortgages) will be aided (i.e., the debt will be repaid with inflated dollars). Thus, inflation also tends to benefit firms with large amounts of outstanding debt.
o
AN C I I I A R Y MAT E R I A l
(for Independent Review)
EXAMPLE: OPEC AND THE STAGflATION OF THE 1970s
Between 1973 and 1974, OPEC (Organization of Petroleum Exporting Countries) substantially curtailed its production of crude oil. As a result, the price of a barrel of crude oil rose from approximately $2.00 per barrel in late 1973 to $10.00 per barrel in late 1974. This increase in the price of crude oil had a substantial effect on the
u.s. economy.
Specifically, rising crude oil prices
represented an increase in input costs for U.S. firms. As a result, firms cut back production and the short-run aggregate
supply curve shifted left. This is the situation depicted in Graph 0, prior. As the short-run aggregate supply curve shifted left, national output (real GOP) began to decline, unemployment began to rise, and the aggregate price level began to rise (cost-push inflation). The combination of falling national output and a rising price level is known as
stag/lation.
The actions of OPEC in 1973-74
led to a recession in the u.s. that was particularly harsh because not only was the unemployment rate rising, but the newly unemployed were facing higher prices for goods and services due to inflation!
EXAMPLE; THE GREAT DEPRESSSION AND DEflATION
The Great Depression began with the stock market crash of October 24,1929. By 1932, the Dow Jones industrial average had fallen 89% from its peak in 1929, In addition, shortly before the stock market crash, the Federal Reserve (the Central Bank of the U.S.) increased interest rates in an attempt to control inflation. It then increased interest rates again in early
1931. While the stock market crash was not the only cause of the great depression, it does mark the beginning of the depression. The depression was caused by a number of factors including ill-timed interest rate hikes by the Federal Reserve, the stock market crash, and protectionist trade policies. The table below shows what happened to real GOP, the unemployment rate,
and the price level (as measured by the CPI) between 1929 and 1933. Real GOP
Unemployment
Year
(8ffffonsof1987Dono~)
Rate
(ePI)
1929
821.8
3.15%
17.1
1930
748.9
8.71%
16.7
1931
691.3
15.91%
15.2
1932
599.7
23.65%
13.7
1933
587.1
24,87%
13.0
Price Level
As the table illustrates, the Great Depression was characterized by falling output (falling real GOP), rising unemployment and deflation. The deflation that occurred can be seen by noting that between 1929 and 1933 the price level fell continuously. Furthermore, at the height of the Great Depression, one out of every four workers was unemployed! The data suggests that the Great Depression was caused by a shift left in aggregate demand, as in Graph C. Specifically, the stock market crash reduced household wealth, which shifted the aggregate demand curve to the left. In addition, the interest rate hikes orchestrated by the Federal Reserve, increased the cost of capital, thereby decreasing the demand for investment goods and shifting the aggregate demand curve even further to the left. As aggregate demand fell, the price level also fell and the nation experienced a period of deflation.
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INVERSE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT A.
The Phillips Curve Inflation and unemployment are traditionally thought to have an inverse relationship in the short run. The Phillips Curve illustrates the inverse relationship between the rate of inflation and the unemployment rate. It illustrates the tradeoff that exists in the short run between inflation and unemployment. Whiie unempioyment and inflation have historically moved in opposite directions, during the oil shocks of the 1970s the Phillips Curve broke down. Specifically, the oil shocks (negative supply shocks) of the 1970s led to a situation where both unemployment and the price level were rising.
B.
Illustration of the Phillips Curve The Phillips Curve is illustrated in Graph I.
GRAPH I
Inflation Rate The Phillips Curve illustrates the tradeoff between inflation and unemployment. When unemployment is high, inflation tends to be low, and when unemployment is very low, inflation tends to be high. /
Unemployment Rate
VI.
BUDGET DEFICITS AND SURPLUSES The budget is the federal government's plan for spending funds and raising revenues through taxation, fees, and other means (and for borrowing funds if necessary). The budget deficit and the budget surplus are important indicators of the current and future health of an economy. A.
Budget Deficits A budget deficit occurs when a country spends more than it takes in (mostly in the form of taxes). 1.
Financing Budget Deficits Budget deficits are usually financed by government borrowing, which affects interest rates. The government could aiso finance budget deficits by printing new money. However, financing budget deficits by printing money causes inflation.
2.
Cyclical Budget Deficit A cyclical budget deficit is caused by temporarily low economic activity. For example, a cyclical budget deficit might be caused by a recession.
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Structural Budget Deficit A structural budget deficit is one that is caused by a structural imbalance between government spending and revenue. Structural deficits are not caused by temporarily low economic activity.
B.
Budget Surpluses A budget surplus occurs when government revenues exceed government spending during the year.
o
END OF ANCILLARY MATERIAL
VII.
INTEREST RATES A.
Nominal and Real Interest Rates 1.
Nominal Interest Rate The nominal interest rate is the amount of interest paid (or earned) measured in current dollars. When the economy experiences inflation, nominal interest rates are not a good measure of how much borrowers really payor lenders really receive when they take out or make a loan. A more accurate measure of the interest borrowers payor lenders receive is the real interest rate.
2.
Real Interest Rate The real interest rate is defined as the nominal interest rate minus the inflation rate. It is a measure of the purchasing power of interest earned or paid. Real interest rate::: Nominal interest rate -Inflation rate
EXAMPLE
For example, if you take out a loan with a 10% nominal interest rate and the inflation rate is 3%, then your real interest rate is only 7%. That is, after adjusting for the fact that the dollars with which you will repay the loan in the future are worth less than current dollars due to inflation, you are really only paying 7% to borrow the money!
3.
Relationship between Nominal Interest Rates and Inflation Nominal interest rates and infiation tend to move together. When the inflation rate increases, so does the nominal interest rate. The relationship between nominal interest rates and inflation may be shown by rearranging the above equation for real interest rates as follows: Nominal interest rate::: Real interest rate + Inflation
Thus, if real interest rates do not change, a 1% increase in the inflation rate will lead to a 1% increase in nominal interest rates.
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NOMINAL INTEREST RATES AND INFLATION
Interest Rate/Inflation Rate 20.00%
18.00% 16.00%
Nominal Interest Rate
14.00% 12.00% 10.00% 8.00% 6.00% 4.00% Inflation Rate
2.00%
0.00% 1955
1960
1965
1970
1975
1980
1985
1990
1995
Year
Note the close relationship between nominal interest rates and the inflation rate. As the inflation rate increases, the nominal interest rate also increases. Also note that around 1974/1975 the inflation rate was actually higher than the nominal interest rate, implying real interest rates were negative! B.
Definition of Money and the Money Supply Money is the set of liquid assets that are generally accepted in exchange for goods and services. The money supply is defined as the stock of all liquid assets available for transactions in the economy at any given point in time. There are several definitions of money supply. M1 and M2 are the most common measures of money supply and are reported (periodically) in financial publications (e.g., the Wall Street Journal). 1.
M1 M1 is defined broadly as money that is used for purchases of goods and services. It typically includes coins, currency, checkable deposits (accounts that allow holders to write checks against interest-bearing funds within them), and traveler's checks. M1 does not typically include savings accounts or certificates of deposit (CDs).
2.
M2 M2 is defined broadly as M1 plus liquid assets that cannot be used as a medium of exchange but that can be converted easily into checkable deposits or other components of M1. These include time certificates of deposit less than $100,000, money market deposit accounts at banks, mutual fund accounts, and savings accounts.
3.
M3 M3 includes all items in M2 as well as time certificates of deposit in excess of $100,000.
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Monetary Policy and the Money Supply Monetary policy is the use of the money supply to stabilize the economy. The Federal Reserve uses monetary policy to increase or decrease the money supply in an effort to promote price stability and full employment. Understanding the effects of changes in the money supply is important because changes in the money supply lead to changes in interest rates, changes in the price level, and changes in national output (real GDP). The Fed controls the money supply through:
1.
Open Market Operations (OMO) Open market operations consist of the purchase and saie of government securities (Treasury bills and bonds) in the open market.
a.
Increase in the Money Supply When the Fed purchases government securities, it increases the money supply (i.e., puts money into circulation to pay for the securities).
b.
Decrease in the Money Supply When the Fed sells government securities, it decreases the money supply (i.e., takes money out of circulation).
2.
Changes in the Discount Rate The discount rate is the interest rate the Fed charges member banks for short-term (normally overnight) loans.
3.
a.
Member banks may borrow money from the Fed to cover liquidity needs, increase reserves, or make investments.
b.
Raising the discount rate discourages borrowing by member banks and decreases the money supply.
c.
Lowering the discount rate encourages borrowing by member banks and increases the money supply.
Changes in the Required Reserve Ratio (RRR) The required reserve ratio is the fraction of total deposits banks must hold in reserve.
D.
a.
Raising the reserve requirement decreases the money supply.
b.
Lowering the reserve requirement increases the money supply.
Interest Rates and the Supply of and Demand for Money 1.
Demand for Money is Inversely Related to Interest Rates Changes in the money supply have a direct effect on interest rates because interest rates are determined by the supply of and demand for money. The demand for money is the relationship between how much money individuals want to hoid and the interest rate. The demand for money is inversely related to the interest rate-as interest rates rise. it becomes more expensive to hold money (because holding money rather than saving or investing it means you do not earn interest), thus reducing the demand for money.
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2.
Supply of Money is Fixed at a Given Point in Time As noted above, the supply of money is determined by the Federal Reserve and is therefore fixed at any given point in time at the level set by the Federal Reserve. Graph K illustrates the demand for and supply of money. The intersection of the money demand curve and the money supply line determines the interest rate. a.
An increase in the money supply will cause interest rates to fall.
b.
Conversely, a decrease in the money supply will cause interest rates to rise.
GRAPH K - The Money Market
MS
MS,
Interest Rate
Equilibrium interest rate: 10
1,
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - -~ Demand for Money
Quantity of Money The equilibrium interest rate is found where the demand for money intersects the supply of money. The money supply curve is vertical since the Federal Reserve controls the supply of money (thus it is independent of the interest rate). If the Fed increases the money supply, interest rates will fall, as illustrated by the fall in interest rates from 10 to 11.
VIII.
MONETARY POLICY AND ITS EFFECTS ON INTEREST RATES, THE PRICE LEVEL, OUTPUT (REAL GOP) AND UNEMPLOYMENT When the Federal Reserve increases or decreases the money supply it has a direct effect on interest rates and an indirect effect on the price level, real GDP, and the unemployment rate. Specifically, when the Fed changes the money supply, it causes interest rates to either increase or decrease. As we saw earlier, changes in the interest rate directly affect the cost of capital and thus shift the aggregate demand curve. Finally, shifts in aggregate demand cause changes in the price levei, real GDP, and the unemployment rate.
A.
Expansionary Monetary Policy (increase in the money supply) Expansionary monetary policy resuits when the Fed increases the money supply, affecting the economy through the following chain of events: 1.
An increase in the money supply causes interest rates to fall.
2.
Falling interest rates reduce the cost of capital and hence stimulate the desired levels of firm investment and household consumption.
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3.
Increases in desired investment and consumption cause an increase in aggregate demand.
4.
Aggregate demand shifts to the right, causing real GDP to rise, the unemployment rate to fail, and the price level to rise.
Contractionary Monetary Policy (decrease in the money supply) Contractionary monetary policy results when the Fed decreases the money supply. The effect is the exact opposite of expansionary monetary policy. Specifically: 1.
A decrease in the money supply causes interest rates to rise.
2.
Rising interest rates reduce the desired ievels of firm investment and househoid consumption.
3.
Decreases in desired investment and consumption cause a decrease in aggregate demand.
4.
Aggregate demand shifts to the left, causing reai GDP to fail, the unemployment rate to rise, and the price level to fail. EXAMPLE: THE 2001 RECESSION AND MONETARY POLICY
After growing steadily for almost a decade, the U.S. economy started to slow down at the end of 2000. The slowdown in the economy was accompanied by a large drop in stock prices that marked the end of the bull market of the late 1990's. In 2001, the U.S. economy experienced two consecutive quarters of negative real GOP growth implying the economy had slipped into a recession. As the economy began to falter, Alan Greenspan, the Chairman of the Federal Reserve, initiated expansionary monetary policy. Specifically, the Federal Reserve began lowering interest rates by increasing the money supply. lower interest rates helped keep the economy from slipping even further into a recession. Specifically, lower interest rates led to a large increase in home purchases starting in 2001 and continuing through 2002. In addition, lower interest rates made it possible for the auto industry to offer attractive financing rates, including zero-percent financing! This helped increase consumer purchases of automobiles and overall demand for goods and services in the economy. The recession of 2001 and the actions taken by the Federal Reserve are illustrated in Graphs Land M. GRAPH L
GRAPH M
Price Level
Interest Rate MS,
lRAS
MS,
SRAS
10
-------------
Pl 11
---
--------
Po .---------
------------------------
Money Demand
/
AD, AD,
M1
Quantity of Money
Real GDP
Graph M illustrates the recession of 2001. During the recession, output (real GOP) is at Yo, which is below the potential level of output Y11 indicating a recession. Graph L illustrates the money market and the expansionary monetary policy of the Federal Reserve. By increasing the money supply, the Federal Reserve caused interest rates to fall from
10
to
11 ,
Lower
interest rates spurred new home investments and consumer consumption of durable goods such as automobiles. The increased consumption and investment led to a shift right in aggregate demand as depicted in Graph M. As aggregate demand shifted right, real GOP began to increase and the economy began to recover from the recession.
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GLOBALIZATION AND LOCAL ECONOMIES
I.
IMPACT OF GLOBALIZATION ON COMPANIES G/obalization is defined as the distribution of industrial and service activities across an increasing number of nations. Globalization produces deeper integration of the world's individual national economies and makes them more interdependent. Reduced barriers to trade have created business opportunities to conduct operations in multiple countries or conduct import/export operations within the context of a traditional domestic operation. Entities that conduct business outside the country In which they are organized are frequently referred to as multinationa/ corporations (MNC).
A.
Globalization Globalization of the economy describes a world-wide economy. Globalization is often measured by world trade as a percentage of GDP-the greater the percentage, the greater degree of globalization. 1.
Factors that Drive Globalization a.
Improvements in Transportation Increased efficiencies in transportation enhance the competitive status of importers in domestic markets.
b.
Technological Advancements Knowledge-based products (such as technical support for software, etc.) eiiminate the importance of location.
c.
DeregUlation of International Financial Markets Eiimination of capital controls increase the options for direct foreign investment (although poiitical and legal iimitatlons iikely to exist are still an Inherent risk of international commerce).
d. 2.
Various Organizational/Operational Options for International Business
Globalization Promotes Specialization Economies of scale are larger in a global economy. Specialization that leverages comparative advantage is a natural outcome.
3.
Globalization Imparts Responsibilities of World Citizenship Corporations have an impiied duty to:
B.
a.
Act responsibly regarding environmental issues.
b.
Promote political stability and cooperation among nations.
Motivations for International Business Operations Entities are encouraged to look beyond the poiitical borders in which they were organized to maximize shareholder value. Several economic theories support international trade as a means of achieving improved shareholder value.
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1.
Comparative Advantage Specialization in the production and trade of specific products produce a comparative advantage in relation to trading partners. Companies and countries use this comparative advantage as a means of maximizing the value of their efforts and resources. EXAMPLE
The island nation of Bermuda produces no gasoline or vehicles, yet its roadways are filled with vehicles of all types. The country predominantly specializes in tourism and uses the money it earns from its visitors to buy (import) vehicles and petroleum products. The country maximizes the number of resources it can import by specializing in tourism and buying transportation resources elsewhere.
2.
Imperfect Markets Resource markets are often deemed to be imperfect. The ability to trade freely between markets is often limited by the physical immobility of the resource or regulatory barriers. In order to retrieve more resources, companies must trade outside their borders. EXAMPLE
Auto manufacturers in Detroit may seek a vacation from time to time on a sandy beach with a balmy breeze. Lake Michigan is breezy but, in January, is not balmy and won't compare with Bermuda! In order to capitalize on resources available from that vacation destination, the auto manufacturer must go to Bermuda and spend dollars there. Clearly there is not an opportunity to simply import the resource.
3.
Product Cycle Product manufacture or delivery is subject to a definable cycle, starting with the initial development of the product to meet needs in the domestic markets. Product cycle theory anticipates that domestic success will result in domestic competition, encouraging the export of products or services to meet foreign demand and maintain efficient use of capacity. Foreign success will, in turn, promote foreign competition. The entity is then motivated to actually establish a business outside its boundaries to more effectively differentiate itself and compete with foreign competitors.
C.
Methods of Conducting International Business Operations Multinational operations are structured in any number of ways. The following terms help define different methods of organization. 1.
International Trade Import/export operations characterize the use of purely international trade as a means of conducting international business.
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Licensing Entities that provide the right to use processes or technologies in exchange for a fee are engaged in licensing activities. EXAMPLE
Wireless, Inc., a u.s. corporation, obligates itself to establishing and maintaining cellular telephone systems in Mexico in exchange for a licensing fee to use its technology.
3.
Franchising Entities whose marketing service or delivery strategy provides training and related service delivery resources in exchange for a fee are franchisors. EXAMPLE
Flip-a-burger, Inc., a U,S. corporation, obligates itself to providing training and the use of unique company logos to businesses that operate in Peru.
4.
Joint Ventures Joint ventures take advantage of comparative advantage of one or both of the participants in marketing or delivering a product. EXAM PlE
Engulf & Devour Food Products, a U.s. corporation, teams with Chez Brule, a French concern, to distribute U.S. confections throughout France using Chez Brule's distribution network.
5.
Direct Foreign Investment (DFI) a.
Acquisitions of Existing Operations The outright purchase of foreign companies as subsidiaries serves as a means of establishing international operations.
b.
Establishing New Foreign Subsidiaries The startup of a subsidiary operation within the borders of a foreign country serves as a means of establishing international operations.
6.
Global Sourcing a.
Definition Global sourcing is synchronization of all levels of product manufacturing, including research & development, production, and marketing, on an international basis.
b.
Implementation Global sourcing is frequently implemented through a range of organizational and business arrangements (e.g., imporUexport operations, licensing, franchises, joint ventures).
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Relevant Factors of Globalization Factors relevant to assessing the impact of globalization on a company, including its financial reporting, are described below. 1.
Political and Legal Influences
2.
Potential for Asset Expropriation Nations may expropriate (take) assets from the international companies owning them. Assessing the risk of political intervention is integral to business planning and financial reporting.
3.
Taxes and Tariffs Governments may attempt to control economic activity through taxes and tariffs. Mitigation of this risk is typically handled through transfer pricing.
4.
Limitations on Asset Ownership or Joint Venture Participation Governments may limit the amount of ownership or entirely restrict any ownership of business ventures within their borders, thereby limiting joint ventures and direct investments.
5.
Content or Value Added Limits Sometimes referred to as sourcing requirements, governments may provide tariff reductions to companies whose imports include specified percentages of material and labor in their products.
6.
Foreign Trade Zones Governments may establish trade zones in which tariffs are waived until the goods leave the zone. The creation of foreign trade zones has obvious implications on the government's control of imports and the location of import facilities.
7.
Economic Systems a.
Centrally Planned Economies Some economies (such as China) are centrally planned. Factors of production (capital, land, etc.) are owned by the government and subject to restriction.
b.
Market Economies Most industrialized economies (such as the United States and Japan) are market economies. The factors of production are owned by individuals.
c.
Conglomerates Establishment of integrated conglomerates (e.g., the Japanese keiretsu or the Korean chaebol) creates self-sustaining entities that could not exist in the United States (fully integrated financing, manufacturing and supplying organizations would likely violate antitrust laws). Anticipating different types of commercial organization used by international trading partners may be critical.
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Culture Different cultures impact international business. Culture can be defined as the shared values and attitudes of a group. The cultures of nations or regions typically involve the following issues. a.
Individualism vs. Collectivism As the name implies, some cultures (like the United States) place a high value on individualism, while others (often Asian) are more likely to place a higher value on the collective.
b.
Uncertainty Avoidance Certain cultures have a difficult time dealing with uncertainty. The United States typically has guarded ability to accept uncertainty, while Asian and South American cultures may be highly averse to dealing with uncertainty.
c.
Short-term vs. Long-term Orientation Certain cultures are thrifty while others are more focused on immediate gratification. The United States tends to have a short-term orientation while many Asian cultures have a longer-term focus.
d.
Acceptance of Leadership Hierarchy Cultures have varying degrees of acceptance of vast differences between leadership and the rank and file. Some accept large differences in power while others anticipate greater levels of equality. The United States has a balanced view on this issue, while former European monarchies may be more accepting of wide differences in power. Less developed former colonial counterparts in Asia and South America are often more distrustful of wide dispersions of power.
e.
Technology and Infrastructure International business may require factoring in wide differences in:
E.
(1)
Communications systems.
(2)
Transportation systems.
(3)
Power and water sources.
(4)
Training of staff.
(5)
Differences in accounting practices.
Inherent Risks of International Business Operations The risks associated with conducting international business operations consider factors shaping economic globalization and are generally categorized in the following manner. 1.
Exchange Rate Fluctuation Exchange rate risks are generally divided into the three categories, which are discussed-along with mitigation techniques-under the section titled "Financial Risk Management":
a.
Transaction risk.
b.
Economic risk.
c.
Translation risk.
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Foreign Economies An operation within a foreign economy carries the risk of functioning within the general health or weakness of a particular economy. Domestic economies may be booming while international economies are suffering and acting as a drag on overall performance.
3.
Political Risk The potential of unstable political environments that are potentially disruptive, corrupt, or destructive amplifies the risk of doing business outside domestic borders. Ultimately, political climates or actions can disrupt cash flows.
F.
Complications of Global Sourcing 1.
2.
Global Sourcing Anticipates Multiple Sources for Materials a.
Raw materials (e.g., petroleum products) may be produced in the Middle East.
b.
Refining petroleum products into ethylene (plastic) may take place in Asia.
c.
Molding and assembling of plastic may take place in China.
d.
Transportation and distribution might take place in the United States.
Global Sourcing Anticipates Multiple Exchange Rates MUltiple exchange rates and tariffs may exist as the products raw materials find their way into the final product.
II.
SHIFTS IN ECONOMIC BALANCE OF POWER The dominance of the United States as the world's lone superpower is referred to as unipolar distribution of power. The expansion of the rest of the world's economies, including those of the European Union (EU) and the emerging nations, lead by Brazil, Russia, India and China (BRIC), will gradually shift power, thereby ushering in an era of muitipolarity, wherein power is distributed among many nations. Although the United States will likely not reduce in absolute strength, its relative power will likely decline as the strength of other nations' grows. A.
Defining National Power National power is generally defined with any number of the dimensions described below. Our focus is primarily on economic power; however, all dimensions of power are significant in a global environment.
1.
Geography Land mass and strategic locations on the globe are significant to power. The United States and China, for example, are located in temperate zones and have significant land. Other nations may be smaller or located in areas where weather is more severe.
2.
Population Population translates to work force-the larger and more talented the workforce, the more potentially powerful the nation.
3.
Resources Nations rich in natural resources have the potential to be more powerful.
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Economy The size of a nation's economy as a percentage of worldwide GDP is a strong measure of power. In addition, the development of the economy and its integration with other economies of the world are a measure of power. Typically, the larger, better developed and integrated economies are more powerful.
5.
Military The size and effectiveness of a nation's mJ1ltary equates to power.
6.
Diplomacy The influence of diplomats around the world impacts the perception of strength or weakness and, by extension, the power of the nation.
7.
Identity A nation's sense of identity and its acceptance of global responsibilities contribute to its perceived power.
B.
Multipolarity and Interdependence
1.
Functional Interdependence Functional interdependence contemplates the participation of nations in worid-wide institutions, such as the United Nations (UN), the World Trade Organization (WTO), and the International Monetary Fund (1M F).
2.
Systemic Interdependence Systematic interdependence acknowledges all members of the global community share the planet earth. Actions of governments adversely impacting the climate or reducing our safety (nuclear proliferation) impact all nations.
3.
Multipolarity The distributed power anticipated by the increase in multipolarity will require an acknowledgement of the interdependence of nations and cooperation among nations consistent with shifts in the balance of power. a.
Emerging nations will likely abide by the governance of world-wide institutions in the event that they are fully represented. EXAMPLE
The ability of the world's emerging nations to contend with the economies of the industrialized world for power, resources, influence, etc. is a change or shift in the economic balance of power from previous decades. Balance of power theory holds that states whom are members of the global economy can either engage in balancing or bandwagoning behavior. An emerging nation might side with the United States or other industrialized nations in an embargo or other economic sanction (bandwagoning) or could join with other emerging nations in ignoring the leadership of the United States (balancing). The significance of their decision to change the impact of the embargo represents an important shift in the balance of economic power.
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Dynamics of the Balance of Power 1.
2.
3.
Developed vs. Emerging Nations a.
Developed nations are generally regarded as the world's largest industrial economies.
b.
Emerging nations are generally regarded as the countries not included on the list of developed nations and are lead by Brazil, Russia, India and China (BRIC).
Trade Deficits a.
Developed nations have generally produced trade deficits as their domestic consumption results in more imports than exports.
b.
Emerging nations often produce trade surpluses as their exports feed the consumption of developed nations.
Balance of Power Emerging nations, notably China, have maintained an artificially low valuation of their currency to those of developed nations (particularly the U.S. dollar), keeping their goods cheap. Consequently, the poor emerging country effectively finances the richer country.
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MARKET INFLUENCES ON BUSINESS STRATEGIES
I.
INTRODUCTION The strategic goals of a firm are influenced by the market in which the firm operates. The ability of a firm to achieve success is a direct result of how well the strategic plan fits the market in which the firm operates, and how well the firm carries out its strategic plan. The firm must create an overall plan (a strategic plan) to assist in combating competition and helping it to develop an approach to achieve its objectives (in line with the firm's vision and mission statement). Strategic thinking encompasses a wide variety of issues with various types of benefits, such as the unification of organizational and operational decisions, goal-orientation toward the desired company achievements, directed focus on planning for flexible responses for new developments in the market, the creation of bases for evaluation, and the overall company focus on the vision, mission statement, and objectives of the firm. A.
Steps in Strategic Management (strategic positioning) Strategic management (positioning) normally involves defining the mission, identifying the strategy, Identifying the critical success factors, and analyzing those success factors by recognition of strengths, weaknesses, opportunities, and threats.
1.
Define the Firm's Vision and Mission Statements Organizational mission statements usually represent one or two line descriptions of what the organization Is in business to do. Ultimately, however, mission philosophies fall into one of three basic categories that impact the overall manner in which the organization conducts its business.
a.
Build Missions Build missions are for organizations that accommodate a volume or range of work as a means of accomplishing organizational objectives. Organizations with build missions tend to take a long-term view and are likely to invest in significant capital projects.
b.
Hold Missions Hold missions are for organizations that maintain their current competitive position.
c.
Harvest Missions Harvest missions are for organizations that reap immediate benefits from the organization. Organizations with harvest missions tend to have a short-term view, are less likely to invest in significant capital projects, and are more likely to focus on net income, cash flows, and immediate return.
2.
Set the Goals of the Firm Organizations can choose any number of ways to achieve their missions. Generally, however, there are two broad and distinct paths for achieving organizational goals: cost leadership and differentiation. Each path has its own characteristics and implications for operational planning, bUdgeting, and corporate culture, and will be discussed in detaJllater in this lecture.
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Define the Objectives of the Firm a.
Financial Objectives Financial objectives are the improvement of the overall financial outcome of a firm's strategy.
b.
Non-financial Objectives Non-financial objectives are the improvement of the overall ability of the firm to compete in the market in the long run, which is the ultimate focus for overall shareholder wealth maximization.
4.
Decide What to Measure and Take a Baseline Measurement Organizations use various measures of success to determine the achievement of strategic objectives. These measures are generally referred to as critical success factors, which may be either financial or non-financial. a.
Financial Measures of Success (financial) Financial measures of success are generally derived from the financial reporting system of the organization or the marketplace. Examples include sales or earnings growth, dividend growth, and growth in the market value of the organization's stock, credit ratings, cash flows, etc.
b.
Internal Business Process Measures of Success (non-financial) Internai business process measures of success generally relate to non-financial measures of efficiency or production effectiveness derived from internal records. These include quality measures, cycle time computations, yields, reduction in waste, etc.
c.
Customer Measures of Success (non-financial) Customer measures of success are non-financiai measures of organizationai effectiveness derived from information provided directly or indirectly by customers, or from data derived from responses to customers. Examples include market share data, customer satisfaction data, brand recognition information, on-time delivery data, etc.
d.
Learning and Innovation Measures of Success (non-financial) Learning and innovation measures of success are internal measures of effective use of human resources, including morale and corporate culture, innovation in new products and methods, education and training, etc.
5.
Strategic Analysis (SWOT) Organizations use strategic or SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis to ascertain the overall strategy and critical success factors the organization will measure. Factors internal to an organization that impact strategy are the source of strengths and weaknesses. Outstanding skills representing strengths in relation to competitors are referred to as core competencies. Factors external to the organization are the sources of opportunities and threats. As managers review these factors, the organization builds clarity regarding the mission, consensus as to strategy, critical success factors, and the impact of internal and external factors on the business.
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Create the Strategic Plan a.
Focus of the Plan In general, the strategic plan of a company must create a set of steps to aChieve the objectives of the firm while staying in line with the firm's vision and mission statement. The plan must provide an environment and model under which the goals and profitability of the firm can be achieved. The plan must focus on the ways the company will:
b.
(1)
Conduct business operations.
(2)
Respond to competitive movements and other issues.
(3)
Achieve/maintain competitive advantage.
(4)
Provide a way to address the needs and preferences of its customers.
Strategic Plans Vary Based on Segments Strategic plans may vary for each segment of an organization based on the characteristics of that segment. Characteristics affecting strategic planning include:
7.
(1)
Growth potential as indicated by industry maturity and regulatory constraints.
(2)
Profitability.
(3)
Discretionary cash flow.
(4)
Contribution margins.
(5)
Levels of risk.
(6)
Management talent (e.g., limited career opportunities in low-growth industries and markets will reduce the pool of talent available for management).
Implement the Strategic Plan In general, the overall vision, mission statement, Objectives, and strategy of the firm must be embraced and executed at various levels within the organization. The plan should be able to address those areas that will be applicable at all the different levels of the firm so that the plan is executed as a team that shares a common goal. The levels (from top to bottom) include:
8.
a.
Corporate level.
b.
Business level.
c.
Functional level.
d.
Operating level.
Evaluate and Revise the Strategic Plan The plan must be evaluated and revised as necessary.
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B.
Continual Revision and Evaluation of the Plan (contingency planning)
Contingency planning addresses development of alternative plans in the event that adopted plans do not work, assumed variables prove to be faulty, or objectives become impractical or irrelevant. Contingency planning will first consider the impact of changes in variables and then document and quantify management's corrective action to deal with those changes. For example, contingency plans that are part of the strategic plan focus on the ability of the firm to change products or adapt to new markets.
1.
Three Questions a Firm Should Ask The firm must have an on-going process of attempting to determine three things:
2.
a.
Do the goals of the firm continue to be aligned with the mission statement and current strategy?
b.
Has the firm been able to attain or maintain competitive advantage?
c.
Is the firm able to be profitable under the current strategy?
Flexibility of the Plan is Necessary The selected strategic plan of the firm must be flexible to adapt to changes in areas such as:
3.
a.
Technology.
b.
Competition.
c.
Crisis situations.
d.
Regulatory laws.
e.
Customer preferences.
Proper Reaction is Essential The firm must have a strategic plan that will allow it to be able to react to the changes in the market in such a way as to still maintain competitive advantage and attain its goals in line with its vision and mission statement. Sustaining competitive advantage is crucial to the success of a firm.
C.
Choice of a Business Model Once a strategic plan is in place, the company will choose a business model concerned with cash fiows and profits under which it will best be able to achieve its goals.
o
END OF ANCILLARY MATERIAL
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THE LAWS OF DEMAND AND SUPPLY Basic principles of microeconomic theory are very important on the CPA Exam, but understanding the fundamentals is also important to the business manager. Managers are more likely to be successful if they understand how their actions and various governmental policies or collusive actions (e.g., cartels) affect their market and firm. A market is simply a collection of buyers and sellers meeting or communicating in order to trade goods or services. A.
Demand 1.
Definitions a.
Demand Curve The demand curve illustrates the maximum quantity of a good consumers are willing and able to purchase at each and every price (at any given price), all else equal. Note that this demand curve is similar to the aggregate demand curve discussed on page B2-7, except that the x-axis here is quantity and not real GOP. It does, however, illustrate the same kind of relationship. However, this demand curve is the microeconomics demand curve for a certain good or product and not the total demand in the economy as a whole.
b.
Quantity Demanded Quantity demanded is defined as the quantity of a good (or service) individuais are Willing and able to purchase at each and every price (at any given price), all else being equal.
c.
Change in Quantity Demanded A change in quantity demanded is a change in the amount of a good demanded resulting solely from a change in price. Changes in quantity demanded are shown by movements along the demand curve (0). When assumptions regarding price or quantity change, the "demand point" will change along this demand curve. For example, if the price of a product increases, there will be a move up the demand curve.
d.
Change in Demand A change in demand is a change in the amount of a good demanded resulting from a change in something other than the price of the good. A change in demand cannot be due to a change in price. A change in demand causes a shift in the demand curve.
2.
Fundamental Law of Demand The fundamental law of demand states that the price of a product (or service) and the quantity demanded of that product (or service) are inversely related. As the price of the product increases, the quantity demanded decreases. Quantity demanded is inversely related to price for two reasons:
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Substitution Effect The substitution effect refers to the fact consumers tend to purchase more (less) of a good when its price falls (rises) in relation to the price of other goods. The substitution effect exists because people tend to substitute one similar good for another when the price of a good they usually purchase increases. For example, if the price of Pepsi-Cola decreases, it will be used as a substitute for Coca-Cola (a similar good).
b.
Income Effect The income effect means that as prices are lowered with income remaining constant (i.e., as purchasing power or real income increases), people will purchase more of all of the lower priced products. For example, a decrease in the price of a good increases a consumer's real income even when nominal income remains constant. As a result, the consumer can purchase more of all goods.
3.
o o o o
o o
Factors that Shift Demand Curves (factors other than price)
a.
Changes in Wealth For example, people whose wealth increases may increase their demand for luxury cars.
b.
Changes in the Price of Related Goods (substitutes and complements) For example, if the price of a similar good (a substitute good) increases, the demand curve will shift to the right (increase) for the original good, now perceived as a bargain. If the price of a good used in conjunction with the original good (referred to as a complementary good) decreases, the demand for the original good will increase (e.g., if personal computer prices diminish, demand increases for peripherals, such as monitors and laser printers).
c.
Changes in Consumer Income For example, an increase in income will shift the demand curve to the right (depicted as the shift from 0, to O2 ),
d.
Changes in Consumer Tastes or Preferences for a Product For example, in the clothing industry, a revival of the "1960s era" will increase the demand for bell-bottom jeans (retro clothing). This is also depicted as the shift from 0, to O2 .
e.
Changes in Consumer Expectations For example, if consumers anticipate that there will be a future price increase, immediate demand will increase for that product (at the current lower price).
f.
Changes in the Number of Buyers Served by the Market For example, an increase in the number of buyers will shift the demand curve to the right.
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GRAPH N: Change in Quantity Demanded
GRAPH 0: Change in Demand
Price (in $)
Price (in $)
D
Px,
L
0 1 O2
~/
I/
1"'in demand
D
X, X,
03
I
~
Px,
I
Quantity
Changes in price cause movements along the demand curve.
D, D, D, - - - --:---" Quantity
Shift in demand curve or change in demand caused by external influences (other than
the price of the good).
4.
Market Demand Market demand is the total amount of a good all individuals are Willing and able to purchase at each and every price, all else being equal. The market demand curve for a good is the sum totai of all the individual demand curves and is also downward sloping (demonstrating the inverse relationship between price and quantity demanded). It is derived by summing the quantities demanded at each price over all individuals. Graph P illustrates how the market demand curve is constructed when the market contains just two individuals.
GRAPH P
Price
Price
----------------P2- ---- 1--------------------- P2-
P,
---- I
P,
---- .., -- ,-------------P 1 - ----~--, ,-----------------P1
,
,, ,, ,
,,
4
6
, ,,
Quantity
Individuall's demand curve
B.
Price
,, , ,,
,, ,, ,
3
5
Individual 2's demand curve
,, ,, ,,
_ _ _ _ _ _ _ _ _ .J
_
,, Quantity
7
11
Quantity
The market demand curve
Supply 1.
Definitions The fundamental law of supply states that price and quantity supplied are positively related (I.e., they have a positive correlation). The higher the price received for a good, the more sellers will produce (higher quantity).
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Supply Curve The supply curve illustrates the maximum quantity of a good sellers are willing and able to produce at each and every price (at any given price), all else being equal. Note that this supply curve is similar to the aggregate supply curve discussed on page 82-8, except that the x-axis here is quantity and not real GOP. It does, however, illustrate the same kind of relationship. This is the microeconomics supply curve for a certain good or product and not the total demand in the economy as a whole.
b.
Quantity Supplied
Quantity supplied is the amount of a good that producers are willing and able to produce at each and every price (at any given price), all else being equal.
c.
Change in Quantity Supplied A change in quantity supplied is a change in the amount producers are willing and able to produce resulting solely from a change in price. A change in quantity supplied is represented by a movement along the supply curve. When price changes, move up or down the supply curve to find the new quantity that will be supplied.
d.
Change in Supply A change in supply is a change in the amount of a good supplied resulting from a change in something other than the price of the good. A change in supply cannot be due to a change in price. A change in supply causes a shift in the supply curve.
o 2.
o
o o
o B2-42
Factors that Shift Supply Curves a.
Changes in Price Expectations of the Supplying Firm For example, if prices are expected to decrease, the firm will supply more now at each price level to take advantage of the currently higher prices. This is represented by the shift in the supply curve from 8 , to 8,.
b.
Changes in Production Costs (price of inputs) For example, a decrease in wages paid to workers would cause a shift to the right in the supply curve because for the same total amount of production dollars, the firm is willing to supply more products. This is represented by the shift in the supply curve from 8 , to 8,.
c.
Changes in the Price or Demand for Other Goods For example, a decrease in the demand for another good supplied by a firm would cause the firm to shift its resources and increase the supply of its remaining goods.
d.
Changes in Subsidies or Taxes For example, a decrease in taxes or an increase in subsidies would increase the amount supplied at each price level.
e.
Changes in Production Technology For example, an improvement in technology would cause a shift to the right of the supply curve.
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GRAPH Q: Change in Quantity Supplied
GRAPH R: Change in Supply
5,
5
Price (in $)
5,
Price (in $)
5,
: ::::::::::z--: Xl
X2
Quantity
Quantity
Shifts in supply caused by external factors (other than price).
Changes in price cause movements along the supply curve.
3.
Market Supply
Market supply is the total amount of a good all producers are willing and able to produce at each and every price. all else being equal. The market supply curve for a good is the sum total of all the individual supply curves, and is also upward sloping (demonstrating the positive relationship between price and quantity supplied). It is derived in the same manner as the market demand curve; namely. by summing the quantities supplied at each price over all producers. Graph S illustrates how the market supply curve is constructed when the market contains just two producers.
GRAPH 5
Price
P, P,
Price
Price
:::::::~:::_:::::: /+---- :~:::::::::::: " ,, ,
4
10 Quantity
Producer l's supply curve
C.
,, ,,, ,, ,
_ _ _ _ _ _ _ _ _ _ _ _ _ .J
,, ,
2
5
Producer 2's supply curve
Quantity
6
15 Quantity
The market supply curve
Market Equilibrium
A market is in equilibrium when there are no forces acting to change the current price/quantity combination.
~
1.
The market's equilibrium price and output (quantity) is the point where the supply and demand curves intersect.
2.
The interaction of demand and supply determines eqUilibrium price.
3.
Graph T illustrates equilibrium price.
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GRAPH T
P
.
D
Surplus
$12
s - - . for example, minimum wage
Price (PI
10
s
4.
D
a.
As illustrated above, price (P) is $10 at equilibrium, and the quantity supplied (0) is OE.
b.
If price is set below the equilibrium price, the quantity demanded will exceed the quantity supplied, and a shortage will result.
c.
If price is set above the equilibrium price, the quantity demanded will be less than the quantity supplied, and a surplus will result.
Changes in Equilibrium If supply and/or demand curves shift, the equilibrium price and quantity will change.
a.
Effects of a Change in Demand on Equilibrium A shift right (increase) in demand from curve D to curve D as shown in Graph U, " will result in an increase in price (from P to P, ) and an increase in market clearing quantity (from 0 to 0 , ), Conversely, a shift left (decrease) in demand from curve D to curve D as shown in Graph V, will result in a decrease in price " (from P to P , ) and a decrease in market clearing quantity (from 0 to 0 , ),
GRAPH V
GRAPH U
5
Price
5
Price
Pi ---------- --------
P
P
Pi ----------
D,
D
D,
D
Q
B2-44
Q,
Quantity
Q,
Q
Quantity
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Effects of a Change in Supply on Equilibrium A shift right (increase) in supply from curve 5 to curve 5" as shown in Graph W, will result in a decrease in price (from P to P, ) and an increase in market clearing quantity (from Q to Q , ). Conversely, a shift left (decrease) in supply from curve 5 to curve 5" as shown in Graph X, will result in an increase in price (from P to P, ) and a decrease in market clearing quantity (from Q to Q , ). Market clearing quantity is the equilibrium quantity. Market clearing is the idea that the market will "eventually" be cleared of all excess supply and demand (all surpluses and shortages), assuming that prices are free to change.
GRAPH W
5,
GRAPH X
5 Price
$1
5
Price
P,
P
P
1--------
o
o 0, Quantity
c.
Q,
Q
Quantity
General Effects of Changes in Demand and Supply on Equilibrium (1)
(2)
An increase in demand and supply results in an increase in equilibrium quantity, but the effect on price is indeterminate. It is certain the effect is an increase of equilibrium quantity (because both an increase in demand and an increase in supply cause quantity to increase), however, the effect on equilibrium price is indeterminate because an increase in demand and supply could cause an increase, decrease, or no change (if equal changes) in equilibrium price. (a)
If the increase in demand is larger than the increase in supply, the equilibrium price will rise.
(b)
Conversely, if the increase in supply is larger than the increase in demand, the equilibrium price will fall.
The effect of other complex cases such as 1) a decrease in demand and an increase in supply, 2) an increase in demand and a decrease in supply, and 3) a decrease in demand and a decrease in supply, can be analyzed in a similar manner. The table below summarizes the effect of all four cases discussed above on equilibrium price and quantity. To understand them more fUlly, you should draw supply and demand diagrams for each case to verify the effects listed.
Change in Demand
Change in Supply
Effect on Equilibrium Price
Effect on Equilibrium Quantity
Increase
Increase
Indeterminate
Increase
Increase
Decrease
Increase
Indeterminate
Decrease
Decrease
Indeterminate
Decrease
Increase
Decrease
Indeterminate
Decrease
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ELASTICITY OF DEMAND AND SUPPLY Elasticity is a measure of how sensitive the demand for, or the supply of, a product is to a change in price. A.
Price Elasticity of Demand The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. 1.
In a normal demand curve, the price elasticity of demand is usually negative. This negative price elasticity reflects the downward sloping demand curve; as price goes up (positive percentage change), the quantity demanded goes down (negative percentage change). A negative price elasticity coefficient results if the demand curve is normal.
2.
Generally, the absolute elasticity coefficient (positive value) is considered when elasticity problems are posed on the examination, because it is presumed that price elasticity is negative for a demand curve.
3.
Measuring the Price Elasticity of Demand The price elasticity of demand can be measured in two ways. a.
Point Method The point method measures the price elasticity of demand at a particular point on the demand curve. For example, suppose that when the price of a product increases from $100 to $120, quantity demanded decreases from 1,000 units to 900 units. Using the point method, the price elasticity of demand would be: . Eastlclty I .. 0 f Deman d = .:..:%.:..:c.:..:ha.:..:n~g.:..:e.:..:in.:..:q-..:.u.:..:an.:..:t.:..:itY,--d.:..:e.:..:m.:..:a.:..:nd.:..:e:..::.d ep = Price % change in price
% Change in Quantity
900 (new demand) - 1,000 (old demand) 1,000 (old demand)
(-100) units = (10%) 1,000 units
jDivided by:l % Change in Price
=
$120 (new price)- $100 (old price) $100 (old price)
$20 $1 =--=-=20% $100 $5
. . . (10) ep = Price ElastiCity of Demand = ~,or = ~.5 (Absolute Value = .5) 20
b.
Midpoint Method The midpoint method measures the price elasticity of demand between any two points on the demand curve. For example, suppose once again that when the price of a product increases from $100 to $120, quantity demanded decreases from 1,000 units to 900 units. Using the midpoint method, the price elasticity of demand wouid be:
ep
e
p
82-46
(0, -0,)/(0, +0,) (P, -P,)/(P, +P,)
(900-1,000)/(900+1,000) (120-100)/(120+ 100)
.58 (Absolute Value=.58)
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Price Inelasticity (absolute price elasticity of demand < 1.0) Demand for a good is price inelastic if the absoiute price elasticity of demand is less than 1.0. The smaller the number after the minus sign, the more inelastic the demand for the good.
5.
a.
If price inelasticity is zero, demand is perfectly ineiastic. Note also that perfectly inelastic demand curves are vertical, depicting that the quantity demanded stays the same no matter how price changes (e.g., in the pharmaceutical industry, the demand for insulin by diabetics).
b.
The calculation above with a 0.5 value is an example of inelastic demand.
Price Elasticity (absolute price elasticity of demand> 1.0) Demand is price elastic if the absolute price elasticity of demand is greater than 1.0. When the value is greater than 1.0 (defined as elastic), the greater the number, the more elastic the demand.
6.
Unit Elasticity (absolute price elasticity of demand = 1.0) Demand is unit elastic if the absoiute price elasticity of demand is equal to exactly 1.0. Demand is unit elastic if the percentage change in the quantity demanded caused by a price change equals the percentage change in price.
7.
8.
Factors Affecting Price Elasticity of Demand a.
Product demand is more elastic with more substitutes available but is inelastic if few substitutes are available.
b.
The ionger the time period, the more product demand becomes eiastic because more choices are avaiiabie.
Price Elasticity Effects on Total Revenue If we know the price elasticity of demand for a good, we can determine how a change in price will affect a firm's total revenue. Total revenue is simpiy the price of a good mUitiplied by the quantity of the good sold. a.
Effects of Price Inelasticity on Total Revenue (positive relationship) If demand is price inelastic, an increase in price wiil resuit in an increase in total revenue (positive relationship), and a decrease in price will resuit in a decrease in total revenue. When demand is price inelastic, an increase in price results in a decrease in quantity demanded that is proportionaliy smallerthan the increase in price. As a result, total revenue (equal to price times quantity) will increase.
b.
Effects of Price Elasticity on Total Revenue (negative relationship) If demand is price elastic, an increase in price will result in a decrease in total revenue (negative relationship), and a decrease in price will result in an increase in total revenue. When demand is price elastic, an increase in price results in a decrease in quantity demanded that is proportionally larger than the increase in price. As a resuit, total revenue (equal to price times quantity) will decrease.
c.
Effects of Unit Elasticity on Revenue (no effect) If demand is unit eiastic, a change in price will have no effect on total revenue.
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Summary The table below summarizes the relationship between the price elasticity of demand and total revenue.
B.
Price Elasticity of Demand
Implied Elasticity
Impact of a Price Increase on Total Revenue
Impact of a Price Decrease on Total Revenue
Elastic
Greater than 1
Total revenue decreases
Total revenue increases
Inelastic
Less than 1
Total revenue increases
Total revenue decreases
Unit Elastic
Equal to 1
Total revenue is unchanged
Total revenue is unchanged
Price Elasticity of Supply The price elasticity of supply is calculated the same way as the price elasticity of demand, except that the change in quantity supplied is now measured.
1.
Formula for Price Elasticity of Supply . I .. f I es = Pnce E astlclty 0 Supp y =
% Change in Quantity
% change in quantity supplied
----"---,----'------'--~"---
% change in price
= 600 (new supply) . 500 (old supply) = 100 =20% 500 (old supply)
500
IDivided by:l % Change
in Price .
=
$11 (new price)· $10 (old price) $10 (old price) . .
20%
e s = Pnce Elasticity of Supply = -
1 =-=10% 10
=2
10%
2.
Price Inelasticity
(supply < 1.0)
Supply is price inelastic if the absolute price elasticity of supply is less than 1.0. If supply is perfectly inelastic, the price elasticity of supply equals zero. Perfectly inelastic supply curves are vertical, which reflects that quantity supplied is insensitive to price changes.
3.
Price Elasticity Isupply> 1.0) Supply is price elastic if the absolute price elasticity of supply is greater than 1.0.
4.
Unit Elasticity
(supply = 1.0)
Supply is unit elastic if the absolute price elasticity of supply is equal to 1.0.
5.
82-48
Factors Affecting Price Elasticity of Supply a.
Feasibility of customers storing the product will affect the price elasticity of supply. For example, it may result in high elasticity if the product can be stored and does not have to be bought today.
b.
The time it takes to produce and supply the good will affect the price elasticity of supply. For example, longer production time leads to lower price elasticity.
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Cross Elasticity Cross elasticity of demand (or supply) is the percentage change in the quantity demanded (or supplied) of one good caused by the price change of another good. Ce = Cross Elasticity of Demand/Supply
% change in number of units of X demanded (supplied) % change in price ofY
1.
Substitute Goods: Positive Coefficient If the coefficient is positive (I.e., the price of Product A goes up, causing the demand for Product B to go up), the two goods are substitutes (people stop buying the higher priced goods and begin to buy the substitute).
2.
Complement Goods: Negative Coefficient If the coefficient is negative (I.e., an increase in the price of Product A results in a decrease in quantity demanded for Product B), the commodities are complements.
3. D.
If the coefficient is zero, the goods are unrelated.
Income Elasticity of Demand The income elasticity of demand measures the percentage change in quantity demanded for a product for a given percentage change in income. Ie = Income Elasticity of Demand % change in number of units of X demanded
% change in income
1.
Positive Income Elasticity If the income elasticity of demand is positive (e.g., demand increases as income increases), the good is a normal good. A normal good is a product whose demand is positively related to income. As income goes up, demand for normal goods Increases (e.g., premium foods such as steak and lobster).
2.
Negative Income Elasticity If the income elasticity of demand is negative (e.g., demand decreases as income increases), the good is an Inferior good. An inferior good is a product whose demand is inversely related to income (opposite of normal good). As income goes up, demand for inferior goods decreases (e.g., canned vegetables or hamburger).
o
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GOVERNMENT INTERVENTION IN MARKET OPERATIONS Sometimes, the government will intervene in a market by mandating a price different from the "market price" (causing either a surplus or a shortage). This is most often accomplished by using price ceilings and price fioors. A.
Price Ceilings A price ceiling is a price that is established below the equilibrium price, which causes shortages to develop. Price ceilings cause prices to be artificially low, creating a greater demand than the supply available. For example, if the government sets a ceiling price (i.e., price cannot go above this amount) for a good (e.g., $9), then 0 0 (Graph G on page B2-19) will be demanded, but only Os will be supplied. Hence, there will be a market shortage.
B.
Price Floors A price floor is a minimum price set above the equilibrium price, which causes surpluses to develop. Price fioors are minimum prices established by law, such as minimum wages and agricultural price supports. For example, if the government sets a price fioor for a good (e.g., prices cannot go below an amount), a market surplus will result.
o
AN C III A R Y MAT E R I A l
V.
(for Independent Review)
ECONOMIC COSTS A.
Types of Costs 1.
Explicit Costs
Explicit costs are documented out-of-pocket expenses (e.g., wages, materials, and utilities). 2.
Implicit Costs (includes opportunity costs)
Implicit costs are opportunity costs of inputs supplied by the owners (entrepreneurship, equity, capital, etc.). A key point in economics is opportunity cost, which represents the value of the next best alternative foregone (or not chosen). Opportunity cost is usually considered to be the profits that are lost from business because one strategy is pursued instead of another. B.
Cost Concepts The two major concepts of costs to economists are accounting costs and economic costs. 1.
Accounting Costs
Accounting costs measure the explicit costs of operating a business (e.g., purchases of input services).
B2-50
a.
Accounting costs do not consider opportunity costs.
b.
For example, accountants treat entrepreneurial costs (e.g., the value of a sole proprietor's time) as profits (i.e., no expense to the company), but economists view these as added costs to the organization.
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Economic Costs
Economic costs are accounting (explicit) costs plus opportunity (implicit) costs. The most common economic costs are land (rent), labor (wages), capital (interest), and entrepreneurial.
VI.
ECONOMIC PROFIT VS. ACCOUNTING PROFIT A.
Economic Profit
Economic profit equals the difference between total revenue and total economic costs, which include opportunity costs. B.
Accounting Profit
Accounting profit equals the difference between total revenue and total accounting costs. Accounting profit is generally higher than economic profit as it takes into account both explicit and implicit (opportunity) costs.
o
END OF ANCILLARY MATERIAL
VII.
PRODUCTION COSTS IN THE SHORT RUN Economists differentiate between the short run and the long run. The short run is a period of time in which some of the inputs used for production are fixed. In the short run, some of the economic costs are fixed because the inputs are fixed. The long run is a period of time in which all of the inputs used for production are variable. In the long run, all costs have the opportunity to change, even capital costs. Thus, in the long run, all costs are variable. A.
Production Function A firm's production function refers to the relationship between the firm's input of productive resources (the mnemonic "CELL": output of goods and services.
B.
apital, cmtrepreneurial talent,!and, and labor) and its
Production Concepts The three main production concepts are: 1.
Total Product
Total product (TP) equals the total amount of output (Q) produced. 2.
Marginal Product
Marginal product (MP) equals the change in total product resulting from a one-unit increase in the quantity of an input employed. For example, the marginal product of labor (L) is:
3.
Average Product
Average product (AP) equals the total product divided by the quantity of an input. For example, the average product of labor (L) is AP L = TP I L. © 2010 DeVry!Becker Educational Development Corp_ All riehts reserved.
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Law of Diminishing Returns One of the main economic concepts that govern production is the law of diminishing returns which states that, when more and more units of an input are combined with a fixed amount of other inputs, output increases but at a diminishing rate. For example, adding additional workers to the production process, while holding the amount of other inputs constant, causes output to increase at a decreasing rate.
D.
Fixed and Variable Costs Because some resources are fixed and others are variable in the short run, the short-run total cost structure of a firm consists of fixed costs and variable costs:
E.
1.
Fixed costs are the cost of acquiring the fixed resources used in production (one example is depreciation). Fixed costs do not change during the production period; they are independent of the level of production.
2.
Variable costs are the costs of acquiring the variable resources (such as labor); they are dependent upon the level of production.
Cost Functions The four major cost functions are: 1.
Average Fixed Cost
Average fixed cost (AFC) equals total fixed costs (FC) divided by quantity (Q). AFC = FC/ Q
2.
Average Variable Cost
Average variable cost (AVC) equals total variable cost (VC) divided by quantity. AVC=VC/Q
3.
Average Total Cost
Average total cost (ATC), or unit cost, equals total (fixed plus variable) costs (TC) divided by quantity. ATC=TC/Q
4.
Marginal Cost
Marginal cost (MC) (incremental cost) is the change in total cost associated with a change in output quantity over a period of time. For example, the marginal cost of the 10th unit is the total cost of producing 10 units less the total cost of producing 9 units (the difference between the total cost of each). Marginal cost, or incremental cost, equals the change in total cost, reSUlting from a one-unit increase in quantity. MC = IITC / IIQ
•2·52
a.
Marginal cost depends solely on variabie costs.
b.
Fixed costs do not influence marginal costs.
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Illustration and Analysis of Short-run Cost Curves GRAPH Y: Short-run Cost Curves
Costs (dollars) MC ATC AVC
----_AFC Output (quantity)
VIII.
1.
The average fixed cost (AFC) curve decreases continually over the range of quantity produced (as output increases).
2.
ATC is the sum of AFC and AVC. Thus, the vertical distance between the AVC curve and the ATC curve is equal to AFC.
3.
The average total cost (ATC) curve is U-shaped. At low levels of output, average total costs are high because average fixed costs are high. As output increases, average fixed costs fall and thus average total costs fall. However, as output continues to Increase, marginal costs and average costs start to increase causing average total costs to rise.
4.
The marginal cost (MC) curve intersects the AVC and ATC curves at their minimum points.
5.
The short-run supply curve is the marginal cost (MC) curve above the minimum point of its average variable cost (AVC) curve.
PRODUCTION COSTS IN THE LONG RUN
A.
In the long run, all resource inputs are variable.
B.
To be in position to produce at the lowest possible cost means adjusting the scale of production by adjusting plant size or numbers of plants.
C.
Generally the long-run average total cost (LRATC) curve is U-shaped. Therefore, the optimal size or number of plants is at the minimum point of the LRAC curve.
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Long-run Cost Graph Graph Z illustrates the long-run average total cost (LRATC) curve and the long-run marginal cost (LRMC) curve. GRAPH Z
Long-run Costs
Economies
Diseconomies
of Scale
of Scale LRMC LRATC
Quantity of Output
E.
Economies of Scale Companies that are able to reduce per unit costs by using large plants to produce large amounts of output are said to have economies of scale. Economies of scale are reductions in unit costs resulting from increased size of operations. In the long run, economies of scale will cause the long-run average total cost (LRATC) curve to decline within the range of production. Economies of scale will eventually be lost, and diseconomies of scale will result (see Graph Z). Factors enabling economies of scale (increases in the productivity of inputs) include:
F.
1.
Opportunity for specialization.
2.
Utilization of advanced technoiogy.
3.
Mass production is normally more efficient.
Diseconomies of Scale Diseconomies of scale may occur when these large firms become inefficient and are no longer cost productive. Diseconomies of scale are increases in average costs of operations resulting from problems in managing large-scale enterprises. For example, diseconomies of scale can also cause workers to feel disassociated from the firm with a resulting iack of motivation. Factors causing diseconomies of scale include:
B2-54
1.
Bottlenecks and costs of transporting materials.
2.
Difficulty of supervising and managing a large bureaucracy (reasons for diseconomies of scale for the firm result almost entirely from the inefficient performance of the management function).
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MARKET STRUCTURES AND PRICING Operating environments influence the strategic plan. Following is a brief discussion of the overall market structures in which firms may operate.
A.
Perfect (Pure) Competition 1.
Introduction Under perfect competition, strategic plans may include maintaining the market share and responsiveness of the sales price to market conditions. In a perfectly competitive market, no individual firm can infiuence the market price of its product, nor shift the market suppiy sufficiently to make a good more scarce or abundant. Attributes of perfect competition include:
2.
a.
A large number of suppiiers and customers acting independently.
b.
Very little product differentiation (homogeneous products).
c.
No barriers to entry because firms exert no influence over the market or price (thus, goods and services are produced at the lowest cost to the consumer in the long run).
Maximizing Short·run Profits (MR = Me = P) It is assumed that the objective of any business is to maximize its profits. To do this, a firm must find that price/quantity combination that will produce the largest spread between its revenues and its costs. Average revenue (AR) is total revenue (TR) divided by total output. Marginal revenue (MR) is the additional revenue brought in by producing one additional unit of output. Marginal cost (MC) is the cost of producing one additional unit. A profit-maximizing firm will continue adding units to production until the cost of producing one more unit is greater than the revenue that unit will generate. In other words, the firm will continue adding units to production until it becomes unprofitable to do so (MR - MC = 0). Therefore, the condition for maximizing profit is:
MR=MC To maximize short-run profits, competitive firms must produce at the output rate where price = marginal revenue = marginal cost (or P = MR = MC). This is illustrated in Graphs AA and BB below.
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THE PROFIT MAXIMIZING PRICE AND OUTPUT FOR A FIRM OPERATING IN A PERFECTLY COMPETITIVE MARKET ENVIRONMENT
GRAPH AA
-The Whole
Industry
$/Unit
GRAPH BB -
One Firm
$/Unit
MC
5
P=MC=MR
P --------- ---------
\
P I-+------,f-----,L-p = MR
ATC
-------- ---- ---
D
Q
ATC
Quantity of Output
Q,
Total Profit
Quantity of Output
P is the price at which all firms in the industry sell their product in the short run and Q is industry output. Ql is the profit-maximizing level of output of an individual firm. As iilustrated in Graph BB, the firm's total profit in the short-run is given by the shaded area.
3.
Operating at a Loss (P > AVC) In the short run, firms may operate at a loss. If price is less than ATC at the profit maximizing level of output (i.e., where MR = MC), economic profits will be negative (i.e., the firm incurs economic losses). However, the firm should continue to operate in the short run as long as price is greater than average variable costs (i.e., P > AVC) because it will still cover all of its variable costs and some of its fixed costs.
4.
Firms are Price Takers Note that although the industry (market) demand curve slopes down, under conditions of perfect competition, each firm has a horizontal demand curve at the equilibrium price for the industry; thus, the firm is a "price taker" (i.e., cannot change the price itself). Because the price of an individual firm's output is the same regardless of how much it produces, price equals marginal revenue, which equals average revenue (P = MR = AR). (In a monopolistic market, the monopoly firm sets prices and is a "price selter," discussed below.)
5.
Long-run Profits with Perfect Competition The long-run equilibrium position for a competitive firm is where price equals marginal cost equals minimum average total cost (i.e., P = MC = Minimum ATC). In the long run, economic profits are zero because firms produce where price equals minimum average total cost. The entry and exit of new firms ensures that economic profits are zero in the long run; thus, firms earn a normal rate of return.
6.
Advantages Derived from Perfect Competition a.
• 2-56
The market maintains a lower price and larger quantity than in any other market structure. If abnormal profits exist, new competitors enter and drive the price down .
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Each buyer that is willing to pay the market price will get as many units as the buyer desires; thus, utiiity is maximized.
Monopoly Under a monopoly, strategic plans will likely ignore market share and focus on profitability from production levels that maximize profits. Monopoly (e.g., the classic utility company, which was a "regulated" monopoiy) represents concentration of supply in the hands of a single firm. 1.
2.
Assumptions and Market Characteristics of Monopoly a.
A single firm with a unique product.
b.
Significant barriers to market entry.
c.
The ability of the firm to set output and prices (e.g., through patents or regulatory restrictions against competition).
d.
No substitute products (the firm's demand curve is the same as the industry's demand curve).
Firm is a Price Setter Monopolies are "price setters," as opposed to firms in perfect competition (which are "price takers"). Higher prices are charged for supplying less of the product. In a monopoly, the firm will maximize profits where marginal revenue equals marginal cost; however, the monopolist's price will be higher than marginal revenue. GRAPH CC PROFIT MAXIMIZING PRICE AND OUTPUT OF A MONOPOLIST p
MC Monopoly Profit
ATC
ATC
,, ,
i
.
~ f"m Demand
,, ,, , I
0
In dust,,! Demand
MR:; Me
Q,
Q
MR MR = Me and P > MR (and Me) In pure monopoly, the firm's demand curve coincides with the industry demand curve for the product (because the firm and the industry are the same). Since the firm produces where MR::: Me, it produces at a lower output and higher price than the competitive firms and earns above-normal profits.
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Operating at a Loss In the short run, firms may operate at an economic loss. If price is less than ATC at the profit maximizing level of output (i.e., where MR = MC), economic profits will be negative (i.e., the firm incurs economic losses). If the situation does not change in the long run, a monopolist that operates at an economic loss will shut down.
4.
Natural Monopoly A natural monopoly exists when economic and technical conditions permit only one efficient supplier.
5.
Inefficiency of Monopoly Monopolists produce at a point where price is greater than marginal cost. As a result, the quantity produced by a monopolist is below the socially efficient level. Thus, the economic consequence of monopoly is that less output is produced than is socially optimal. In that sense, monopolies are inefficient because they produce a deadweight loss to society.
C.
Monopolistic Competition Under monopolistic competition, strategic plans may include maintaining the market share (as with pure competition) but will also likely include a plan for enhanced product differentiation and extensive allocation of resources to advertising, marketing, product research, etc. Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible (e.g., brand name cosmetic products). 1.
2.
Assumptions and Market Conditions a.
Numerous firms with differentiated products.
b.
Few barriers to entry.
c.
The ability of firms to exert some influence over the price and market.
d.
Significant non-price competition in the market (e.g., competition to increase brand awareness and loyalty).
Brand Loyalty Instead of reducing prices, the firms spend money to create brand loyalty (e.g., aspirin, soft drinks, etc.).
3.
Little Market Control by the Firm Because many firms compete in this scenario, no one firm will be able to affect the prices charged by the other firms, and therefore, there is little market control by each firm.
4.
Maximize Profits where MR = MC Graph DO illustrates the profit maximizing output level and price of a monopolistically competitive firm. Because the firm sells a differentiated product, it faces a downward sloping demand curve (similar to a monopolist). The firm maximizes profits by producing the level of output that equates marginal revenue and marginal cost (Le., produce where MR = MC). The firm earns an economic profit, illustrated as the shaded area.
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GRAPH DD -
Business 2
Profit Maximization
Price
MC
ATC P
AVC
ATC
MR Q,
5.
Demand
Quantity of Output
Zero Economic Profit in the Long Run Economic profit equals the difference between total revenue and total economic costs, which include opportunity costs. Because there are few barriers to entry under monopolistic competition, in the long run, monopolistically competitive firms will earn zero economic profits. If profits are positive in the short run, more firms will enter and drive profits down to zero. If firm profits are negative in the short run, firms will exit and drive profits up to zero. The long-run equilibrium position for a monopolistically competitive firm is, therefore, to produce where MR = MC and P = ATC.
D.
Oligopoly Under an oligopoiy, strategic plans focus on market share and call for the proper amount of advertising (to ensure appropriate product differentiation) and ways to properly adapt to price changes or required changes in production volume. An oligopoly is a market structure in which a few sellers (e.g., the "Big Three" automotive manufacturers) dominate the sales of a product and entry of new sellers is difficult or impossible. 1.
2.
Assumptions and Market Conditions a.
Relatively few firms with differentiated products.
b.
Fairly significant barriers to entry (e.g., high capital cost of designing a safety tested car and bUilding an auto plant).
c.
Strongly interdependent firms (prices tend to be fixed).
Illustration of Kinked Demand Curve a.
Oligopolists face a kinked demand curve because firms match price cuts of competitors but ignore price increases. This causes the demand curves to have different slopes above and below the prevailing price.
b.
Graph EE illustrates the effects of price adjustment by an oligopolist.
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GRAPH EE - An Oligopolist's Kinked Demand Curve
$
D
""", X
--------- , P, P,
If price is raised above the prevailing level, rival firms will ignore the increase, and the firm will lose a large portion of ItS sales A kink In the demand-AR curve appears at the prevailing prICe
---------~,
:
, ,: " ' / - - - - - - - - - - ~ - - -- - - ~ - - - - ~ -- : : ,
If price IS cut, rival firms Will match the reduction, thereby limiting the potential gain in sales.
"
-~-
----------?-----------~---;----
,, ,, ,,, ,, ,, ,,,
" "
,, ,,, ,,, ,,,
, ,, ,, ,
,
D'
D
Quantity of output per period of time The matching of price cuts and the ignoring of price increases by rival firms has the effect of making an oligopolist's demand curve highly elastic above the ruling (prevailing) price. This causes the demand curve to be kinked, illustrating that there is not a direct relationship between price and quantity at all points on the demand curve. Firms would be foolish to engage in price cutting because rivals merely match the price reduction (e.g., the airline industry).
E.
Market Assumptions and Conditions 1,
Regardless of the model that represents the industry, the firm will operate best when marginal revenue equals marginal cost (MR Me),
=
2,
Microeconomic theory holds that firms make decisions based upon marginal cost and marginal revenue (essentially ignoring fixed or sunk costs),
3,
The following table summarizes the market assumptions and conditions underlying perfect competition, monopoly, monopolistic competition, and oligopoly, MARKET
Characteristic
Perfect Competition
5 T Rue T U R E
Monopolistic Competition
Oligopoly
Monopoly
Number offirms in the industry
Many
Many
Few
One
(Highly competitive)
(Highly competitive)
(Moderately competitive)
(No competition)
Size offirms relative to industry
Small
Small
Large
100% of industry
Barriers to entry
None
Low
High
Insurmountable
(Easy to enter industry)
(Easy to enter industry)
(Difficult to enter industry because of economies of scale)
(No entry is possible)
B2-60
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Perfect Competition
Characteristic Differentiation of product
Elosticity of demond
Long-run profitability
F.
Monopoly
Oligopoly
Some
Various
None
(All firms sell the same commodity product)
(Firms sell slightly different products that are close substitutes)
(Firms usually sell differentiated products)
(One firm sells only one product)
Perfectly elastic
Highly elastic but downward sloping
Inelastic
Inelastic
(Firms face a kinked downward-sloping demand curve)
(Firm faces the entire demand curve for the product, which slopes downward)
Firm has control over both price and
(Firm can adjust quantity of products sold without affecting the price very much)
Firm has control over
Firm has control
Firm has control over
quantity produced only; price is set by the market, firm must
mostly over quantity produced; price is
both the quantity produced and the price charged
quantity
accept the market price
Pricing strategy
Monopolistic Competition
None
(Firm sells as much, or as little, as it wants at the given market price)
Firm's control over price and quantity
Business 2
mostly set by the market
Accepts market price; can only adjust production so that
Searches for best price to maximize profits P > MR = MC in
Does not like to
Searches for optimum
engage in price competition
price P > MR = MC in the short and the
P=MR=MC
the short run
P > MR= MC
long run
Zero economic profit
Zero economic profit
Positive economic profit
Positive economic profit
Effects of Boycotts and Cartels on Pricing and Output 1.
Cartels Cartels are groups of firms acting together to coordinate output decisions and control prices as if they were a single monopoly (Le., OPEC and the Central Selling Organization of De Beers). The likely effect of a cartel is to increase price and reduce output below the socially efficient level.
2.
Boycotts Boycotts are organized group refusals to conduct market transactions with a target group (using only social pressure, not legal obligation). The effectiveness of a boycott is measured as the achieved change in the target's disputed policies (normally price). Results indicate that a boycott will be most effective when economic and image pressure on the target are high and the target's policy commitment (how firm the company is on not changing Its mind) is low.
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AN C III A R Y MAT E R I A l
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.-------X.
THE ECONOMY AS A SYSTEM OF MARKETS A.
Production and Demand for Economic Resources 1.
Factors of Production (resources) Businesses use resources to make final products. The primary resources from which final products are made consist of land (natural resources), labor (human capital), and capital (non-human physical capital accumulated through past investment). These resources are known as factors of production. Factors of production are bought and sold in markets just like final goods and services are bought and sold in markets.
2.
a.
To maximize profits, firms need to decide on the optimal levels of inputs to employ.
b.
The price firms must pay for the factors of production is determined by the interaction of supply and demand in the input market.
Types of Inputs a.
Complementary Inputs Inputs are complementary inputs if an increase in the usage of one input results in an increase in the usage of the other input.
b.
Substitute Inputs Inputs are substitute inputs if an increase in the usage of one input results in a decrease in the usage of the other input.
3.
Derived Demand Derived demand is the demand for factors of production. A firm's demand for inputs is derived from its decision to produce a good or service. Therefore, the demand for inputs is directly related to the demand for the goods and services those inputs produce.
a.
Demand for Inputs Depends on Demand for Outputs The demand for any input depends on the demand for the product the input produces (Le., the firms output) and the marginal product of the input itself. (Recall that marginal product (MP) is the change in total product resulting from a one-unit change in an input.)
b.
62-62
(1)
If the demand for a firm's output increases, the demand for the inputs used to produce that output will also increase.
(2)
Similarly, if the marginal product of an input increases, the demand for that input will also increase.
Examples (1)
The demand for labor is directly related to the demand for the goods and services that labor produces.
(2)
If the demand for medical services increases, the derived demand for doctors, nurses, and medical equipment will also increase.
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The Labor Market In modern economies, workers sell their services to employers in labor markets, where workers independently offer skills of a given quaiity to employers who compete for the workers' services. Just like in any other market, the supply of labor and demand for labor determines the price, or wage, of workers. Thus, in the labor market, wages are the price paid for labor. The laws of demand and supply prevail in labor markets as they do in product markets. The lower the wage, the greater the quantity of labor service demanded by employers.
1.
Illustration Graph FF illustrates equilibrium in the labor market. The equilibrium wage depends on the supply of and demand for labor. The equilibrium wage is found where the demand curve for labor intersects the supply curve for labor.
GRAPH FF -
The Labor Market
Wage
Supply of Labor
Wl - - - - - - - - - -
Demand for Labor
L,
2.
Hours per Year
Labor Demand and Supply under Monopsony A monopsony occurs when there is only one employer in a market. For example, if a town contains a single firm, that firm is known as a monopsonist. Much like a monopolist has market power in the product market, a monopsonist has market power in the input (labor) market. Relative to a purely competitive labor market, a monopsony results in lower wages and lower levels of employment.
3.
Unions and Wages a.
Effect on Unionized Workers By forming a union and acting collectively, workers gain market power much in the same way that a monopoly or cartel has market power. The union may use its market power to bargain collectively for higher wages or restrict the supply of labor. As a result, wages of unionized workers increase.
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Effect on Non-unionized Workers Unions may also affect the wages of non-unionized workers. Suppose there are two sectors in an economy, one unionized and the other not. Because employment falls in the unionized sector, displaced workers may seek employment in the nonunion sector. As a result, wages in the nonunion sector may fall as the supply of labor in that sector increases. Thus, while wages rise in the unionized sector, they may fall in the sector that is not unionized.
4.
Minimum Wage Laws The use of minimum wage laws to increase the wages of low skilled labor is controversial. If the minimum wage is set above the equilibrium wage, an excess supply of labor will result. In other words, if the minimum wage is above the equilibrium wage, the result is unemployment. As a result, the imposition of a minimum wage increases the income of those workers who have a job, but it decreases the income of workers who find themselves unemployed as a result of the imposition of the minimum wage. The effect of a minimum wage is illustrated in Graph GG. GRAPH GG - Minimum Wages Wage Supply of Labor
w
mm
w]
f---"""o---------,rl"'----.o-,
~Minimum Wage
,, ,,
---------~------
Demand for Labor
l,
l,
When the minimum wage is set at w
Ls m1n
,
Hours per Year
the quantity of labor
demanded decreases from L] to Lo and the quantity of labor supplied increases from L1 to Ls_ As a result, the minimum wage causes unemployment, or an excess supply of labor, of (Ls - Lo).
o
END OF ANCILLARY MATERIAL
XI.
VALUE CHAIN ANALYSIS Companies strive to attain competitive advantage in a variety of means. While this includes doing all that is possible to match or beat what its competitors do, it also means analyzing what drives the consumers in the marketplace. What does the consumer value and how does the firm deliver? Firms desiring to achieve competitive advantage must focus on the needs and preferences of the buyers, and then either meet or exceed their expectations.
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Strategic Tool Value chain analysis is a strategic tool that assists a firm in determining how important its perceived value (perceived by the buyers) is with respect to the market the firm operates in. The firm will go through exercises to assess how its activities create value in the marketplace. Managers must determine the flow of activities undertaken by the organization to produce a service or product and critique the value added to the customer by each link in the value chain. Once the firm is aware of how its product is perceived, value chain analysis is invaluable in assessing the ability of the firm to attain competitive advantage.
B.
Link Value Chain Analysis to Strategy Value chain analysis must be used in conjunction with the organizational objectives and goals as well as the strategic plan that the firm employs so that competitive advantage can be assessed. Once costs have been analyzed relative to each activity, incremental analysis of relevant costs associated with changing the manner in which the identified activity in the value chain is accomplished can be performed. Reduced cost or improved innovation can result. Relationship between strategic planning activities:
r
Strategic Positioning
Value Chain Analysis
* Balanced scorecard is discussed in chapter B5.
·
Balanced Scorecard*
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C.
Value Activities - Michael Porter's Work in 1985 In 1985, Michael Porter first suggested the idea of value chain analysis so that the firm could assess how the perceived value of the customer grows along the "chain" of activities that the firm goes through to bring its product to the marketplace. According to Porter, two major categories of business value activities exist: 1.
Primary Activities Primary activities are those that are involved with the direct manufacture of products, the delivery of the products through distribution channels, and the support of the product that exists after the sale is made (e.g., handling the raw materials, the manufacturing process, taking orders for the product, advertising the product, and servicing the product after it is sold).
2.
Support Activities Support activities are those activities that are performed by the support staff of an organization (e.g., purchasing of the materials and supplies, development of the technology used, management of employees, accounting, finance, strategic planning, etc.).
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Shank and Govindarajan's Work in 1993 John Shank and V. Govindarajan took a look at the value chain in an even broader sense than Michael Porter. They indicated that the firm itself is a part of the overall value chain of the industry. In this view, the value starts with the suppliers who provide the raw materials for the production process, continues with the firm and its strategic plan, continues further with the value created by the customers, and then ends with the disposal and recycling of the materials.
E.
Approach of Value Chain Analysis Value chain analysis is part of an overall strategic plan, and it is an ongoing process used with strategic thinking. When firms must assess every part of the value chain to allow them to provide their customers with maximum value, they must determine the parts of the value chain that will provide them with the largest amount of competitive advantage. Three major forms of analysis are performed. 1.
Internal Costs Analysis In order to determine the internal value-creating ability of a firm, the sources of profit and costs of the internal activities within the firm must be analyzed.
2.
Internal Differentiation Analysis The firm may analyze its ability to create value through differentiation (e.g., what are the sources of differentiation and what are the related costs?) when the customer perceives that the firm's product is superior to those of its rivals.
3.
Vertical Linkage Analysis Analyzing the vertical linkage of the firm means understanding the activities of the suppliers and buyers of the product (i.e., all links from the sources of the raw materials through the recycling and disposal of the product after use) and determining where value can be created external to the firm's operations. Often the greatest value and competitive advantage stems from the information obtained from this analysis because the activities that create the most and least amount of value can be determined. Remember, the ultimate consumer actually ends up paying for the profit margins that exist all along the value chain.
F.
Steps in Value Chain Analysis Considering all of the above Introductory material regarding value chain analysis, three general "steps" emerge. 1.
Identify Value Activities Organizations must identify value activities performed as part of their business. Value activities are generally those processes that are involved with designing, preparing, manufacturing, and delivering a good or service.
2.
Identify Cost Drivers Associated with Each Activity Cost drivers represent factors that increase total cost. Identification of cost drivers assists the organization in determining those areas in which it has a competitive advantage. Organizations might also identify those areas in which outsourcing is valuable.
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Develop a Competitive Advantage by Reducing Cost or Adding Value The final step in value chain analysis is to study the cost drivers associated with each activity in the value chain from a specific perspective. a.
Identify Competitive Advantage Firms with cost leadership strategies will look at cost saving opportunities, while firms with differentiation strategies will look at opportunities for innovation.
b.
Identify Opportunities for Added Value Identification of activities that add value to the customer foliows from our review of competitive advantage. Opportunities to add value depend on our overall strategy. Product innovation for those organizations depending on differentiation and reduced prices for those organizations focused on cost leadership will be the work product of this phase of value chain analysis.
c.
Identify Opportunities for Reduced Cost Analysis of the cost drivers should show where the organization is not competitive. Elimination or outsourcing of those items for which the organization is not cost competitive is generally proposed from this step in value chain analysis.
4.
Exploit Linkages among Activities in the Value Chain Analysis of the value chain might also show synergies or connections that can be used to create greater efficiencies or greater value. Each step of the value chain should produce some value. In some cases, that value not only benefits the specific activity in the chain but also benefits other activities. For exampie, in-house customer service departments handle customer complaints in an efficient and courteous manner that establishes organizational responsiveness to the customer and creates loyalty. Inhouse customer service can also be alert for patterns of complaints and can influence product design.
G.
Strategic Frameworks in Value Chain Analysis Although value chain analysis is hardly a science, three types of strategic frameworks have proven to be useful for value chain analysis. 1.
Industry Structure Analysis Michael Porter's work in 1980 and 1985 identified five forces that influence profitability (either of an industry or a market) of the firm and, thus, impact the competitive environment of a firm. These five forces assist the firm in determining what makes a firm more profitable compared to another firm. They also playa significant role with respect to the market influence on business strategy. They will each be discussed in detail later in this chapter, so they are listed here for introductory purposes only. a.
Barriers to market entry.
b.
Market competitiveness.
c.
Existence of substitute products.
d.
Bargaining power of the customers.
e.
Bargaining power of the suppliers.
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Core Competencies Analysis While industry structure analysis assists in determining what it is that makes one firm more profitable than another, it does not focus on why one firm is able to create, attain, and sustain new types of competitive advantage and profits while another firm always seems to follow or why some firms are always abie to come up with the best innovations while others attempt to copy them. Anaiysis of the core competencies of a firm answers these questions and attempts to reveal what it is within the firm that enables it to create advantage.
a.
How Core Competencies are Created Core competencies are the glue that allows a firm to work as a team and to transfer good ideas from one product or segment of a business to another. When a firm has a solid foundation in excellent employees, quality physicai resources, and superior technology and is also able to integrate them appropriately, the ability of the firm to adapt to change, learn new things (e.g., best practices), work as a team, and reduce inherent risks is increased, thus increasing the firm's competitive advantage.
b.
Identifying Core Competencies A competency is deemed a core competency if it has the ability to:
3.
(1)
Reduce the threat that competitors may copy the product,
(2)
Increase perceived customer value, and
(3)
Provide leverage (I.e., can a large amount of markets be accessed?).
Segmentation Analysis Sometimes, a firm is vertically integrated, which means that it is involved in almost every aspect of the firm's value chain, from supplying the raw materials to distribution to the ultimate consumer. (Vertical integration is aiso discussed later in this chapter as a possible strategy for firms to follow.) When vertical integration exists within a firm and when analysis of the industry structure and the core competencies varies among the activities in the value chain, segmentation analysis, which takes a look at the competitive advantages that exist in the various segments, is often heipful.
H.
GLOBAL COMPETITIVE ADVANTAGE AND VALUE CHAIN ANALYSIS Along with his "five forces" that impact the profits and competitive environment of an industry (1980 and 1985), in his work in 1990, Michael Porter focused on the competitive forces that exist globally in an effort to study the ability of a nation to attain and sustain worldwide competitive advantage. When the various parts of the value chain (and thus the vaiuecreating processes) exist in different parts of the world, this often poses problems of costs of transportation and lack of controi and communication, which can negatively impact the overall customer value. Porter indicated four major factors that impact global competitive advantage (to be considered along with the risks of the political environment of the nation, inflation rates, currency fluctuations, tax regulations, social vaiues, etc.):
1.
Conditions of the Factors of Production If the nation has a strong set of factors of production (e.g., a skilled labor force) which are required in a given industry, it will fare better with regard to global competitive advantage.
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2.
Conditions of Domestic Demand If the nation's domestic demand for the product is high, the nation will fare better with regard to global competitive advantage.
3.
Related and Supporting Industries If suppliers of material inputs exist within the nation, it may help the nation fare better with regard to global competitive advantage (unless the costs are prohibitively high). If other rivai firms who are competitive in the international environment exist, the nation's competitive advantage is increased.
4.
Firm Strategy, Structure, and Rivalry The practices of a nation with respect to how companies are managed and organized, along with the laws of the nation that regulate the formation of companies and how intense the rivalry is with respect to competing firms within the nation, all influence the ability of the nation to attain and sustain competitive advantage.
XII.
FACTORS THAT INFLUENCE STRATEGY When determining the effects of the market on business strategy, a look at the overall macroenvironment in which the firm operates is essential because it can significantly assist the company in developing and choosing the best strategy to meet its goals. A.
Two General Types of Factors that Influence Strategy Firms use SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis to assist in developing their appropriate strategic plans. Any strategy must consider these factors in its development. 1.
Internal Factors (strengths and weaknesses) Factors internal to the organization that impact strategy are sources of strengths and weaknesses and include:
2.
a.
Innovation of product lines.
b.
Competence of management.
c.
Core competencies (outstanding skills that are better than those of the competitors).
d.
Influence of high-level managers.
e.
Capital improvements.
f.
Leadership in research and development.
g.
Cohesiveness of the values of the organization.
h.
Marketing effectiveness.
i.
Effectiveness of communication.
j.
Clarity of the strategic mission.
External Factors (opportunities and threats) Factors external to the organization are sources of opportunities in the market and threats to the firm's ability to continue with its strategic plan.
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a.
b.
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Factors that Affect the Overall Industry and Competitive Environment of the Industry (1)
The economy.
(2)
Regulations and laws.
(3)
Demographics of the population.
(4)
Technological advances and existing technology.
(5)
Social values.
(6)
Political issues.
Factors that Affect the Competitive Environment of the Firm A detailed discussion of the following five factors that affect the competitive environment of the firm is provided in item B, below.
o
(1)
Barriers to market entry.
(2)
Market competitiveness.
(3)
Existence of substitute products.
(4)
Bargaining power of the customers.
(5)
Bargaining power of the suppliers.
END OF ANCILLARY MATERIAL
B.
Five Forces that Affect the Competitive Environment (and Profitability) of the Firm (Michael Porter, 1980 and 1985)
One of the goals of a firm is to create a strategy that attempts to keep the operations of the firm away from the unnecessary and oftentimes hazardous influences of the following five forces as much as possible. A strategic plan must be put in place so that a move in any of the forces that can have a significant impact on the operations of the firm cannot seriously jeopardize the ability of the firm to operate. A good strategic plan will position the firm so that it is always "on the lookout" for changes in the forces so that it can preempt and predict the strategic moves of rival firms, respond appropriately and timely, and maintain its competitive advantage. The amount of overall competition the firm is faced with can only be determined after analysis of how significant of an impact the following five forces have with respect to the competitive environment of the firm.
1.
Barriers to Entry The firm faces the threat of new firms entering the market in which it operates. Barriers to entry are the various "hoops" and other obstacles that firms must combat, along with facing the retaliation of those firms already competing in the market and the competitive cost advantages that existing firms enjoy.
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Types of Barriers to Entry Often, rival firms face barriers to entry in the form of government regulation, supplier access, high up-front capital requirements, pre-existing customer preferences and loyalties, economies of scale, learning curve issues, and other up-front competitive cost disadvantages, including patents, trade barriers, and other restrictions.
b.
When New Companies will Attempt to Enter New companies will attempt to enter the competition when barriers to entry are low, potential high profits exist in the market, and the risk of retaliation by other firms is low. If the industry as a whole is earning a profit, other firms will desire to enter the market. Unless barriers to entry exist, firms will enter until profits fall to a competitive level. It is also possible that the simple threat of new entrants will scare firms into keeping their prices at competitive levels.
2.
Market Competitiveness (intensity of competition) The existence of competition from rival firms is often the most significant of the five forces of competition. Firms need to be cognizant of their rivals' competitive moves and evaluate their current actions in an attempt to determine the futu re moves of the competition in the market. a.
Ability of Rival Firms to Respond to Change If a firm is in competition with other firms who are all able to respond to changes in various components affecting business (e.g., regulation, input costs, labor issues, technology changes, consumer desires for improved quality and service, etc.), the firm faces a strong competitive force.
b.
Advertising of Rival Firms If rival firms are apt to spend large amounts of money on advertising aimed at changing customer preferences and creating loyalty, the impact of this competitive factor is increased.
c.
Research and Development of Rival Firms When rival firms expend large amounts of money on research and development to improve their products or create new innovations in technology, the impact of this competitive factor is increased.
d.
Alliances of Rival Firms and Suppliers Often, rival firms focus on developing strong alliances with suppliers, and this could impact the firm's ability to obtain its inputs to the production process at advantageous prices and, thus, reduce its competitive advantage. When alliances are created, the impact of this competitive factor is increased.
e.
Increase in Competition Competition becomes an even stronger force impacting the firm when the market is not growing fast (in contrast, in fast growing markets, competitors are usually able to sustain profitability without having to take market share from their rivals), several equal-sized firms exist in the market, customers do not have strong brand preferences, the costs of exiting the market exceed the cost of continuing to operate, some firms profit from making certain moves to increase market share, and the various firms employ different types of strategic plans.
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Existence of Substitute Products If a firm operates in a market in which substitute products are available, it faces issues that need to be addressed in its strategic plan. If the firm faces heavy competition from substitute products, this force will have a stronger influence on the firm's competitive environment because the ability of a firm to sustain profits is significantly impacted by the maximum amount that buyers are willing to pay for a product. This is especially true if the substitutes are readily available to consumers, have equal performance, and are priced at or below the price of the firm's product. The effect is further intensified when the costs of the buyer switching to the substitute product are low. If few substitutes exist, buyers have little choice of products and may be willing to pay a higher price for the products that are available. If close substitutes exist, buyers may have a limit on the maximum price that they are willing to pay, and this has a direct impact on the profits of the firm.
4.
Bargaining Power of the Customers If buyers are in the position to bargain with suppliers on the conditions of service, price, and quality, they are a strong force in the competitive market in which the firm operates and will have a large impact on the competitive environment of the firm. Buyers may be quite price sensitive and change products solely based on price, or they may have such brand loyalty and strong preferences they will stay with a product regardless of price (oftentimes depending on the elasticity of demand). Marketing strategies are focused on the consumer of goods, and large amounts of funds are expended by firms each year in this area. The strength of the relationship between the value chains of buyers and firms impacts the bargaining power that buyers have.
a.
Large Volume of a Firm's Business (high buyer concentration) If one group of customers makes up a large volume of the firm's business, the bargaining power (negotiating power) of the customer will significantly impact the competitive environment of the firm, and the strategy of firms should focus on pleasing this group of customers.
b.
Availability of Information The more information that is available to the buyer, the more the buyer will be able to compare and contrast features of a product and choose one over the other.
c.
Buyer's Low Cost of Switching Products If the costs of switching from one product to another are low, the impact of the effect on the competitive environment from buyers is increased. This result is intensified if the firm cannot easily change production without incurring high costs to begin producing another product.
d.
High Number of Alternate Suppliers When a large number of suppliers exist to serve the customers, the bargaining power of the buyer is increased.
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Bargaining Power of the Suppliers When the bargaining power of the suppliers of inputs to the production process is high, the firm must take a good look at its strategic plan with respect to the suppliers. Suppliers can take profits away from a firm simply by increasing the cost of the inputs to the firm's production process. The strength of the relationship between the value chains of sellers and firms impacts the bargaining power that suppliers have. a.
Firm is Unable to Change Suppliers If the firm is unable to use different suppliers or cannot change its inputs (i.e., no substitutes are available), changes in the operations of the supplier, and thus the price of the input, will affect the profitability of firms, especially when those input costs are a significant part of the overall product cost.
b.
Reputation of Supplier and Demand for its Goods If the reputation of the supplier (e.g., the quality of its product) is excellent and crucial to the success of the firm's product and the demand for its goods from other firms is high, the firm could be placed in a difficult situation, especially if the firm is not a large client of the supplier or if strategic alliances have been formed between the supplier and a competitor.
AN C III A R Y MAT E R I A l (for Independent RevIew)
XIII.
TYPES OF COMPETITIVE STRATEGIES Building a successful competitive strategy requires being able to attain some sort of competitive advantage while still holding customer loyalty and having value to the customer. Value chain analysis (a strategic management tool that requires managers to determine the flow of activities undertaken by the organization to produce a service or product) was discussed earlier in this chapter. In any of the following strategic alternatives, the related value chain would be altered to take into account the chosen strategy. A.
Competitive Advantage in General The overall competitive advantage of a firm is determined by the value the firm offers to its customers minus the cost of creating that value. When firms desire to achieve competitive advantage with respect to products, there are two basic forms of advantage that they wili choose from. 1.
Cost Leadership Advantage The cost leadership advantage stems from the fact that the buyers of the product are better off because the firm has been able to produce and sell its product for less than its rivals. If the total costs of the firm are less than those of rival firms, the firm has a competitive market advantage. This advantage may be used by the firm in one of two ways: a.
Build Market Share If the firm lowers the price of its product below the price of its competitors, it may be able to secure a larger part of the market as its customer base and gain market share while still maintaining the profits that are required.
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Match the Price of Rivals If a firm enjoys a low-cost competitive advantage, it will be able to match the price of its rivals and, because it has overall lower total costs, beat the profitability of its rivals.
2.
Differentiation Advantage (offering advantage) The differentiation advantage (product differentiation) stems from the fact that buyers are better off because the customer perceives the firm's product to be superior in some way to those of its rivals. Therefore, they are willing to pay a higher price for its uniqueness. All parts of the buying decision are affected by the perceived value of the product (e.g., higher quality, timeliness of delivery, superior service, wide range of goods, less risks, performance measures, etc.). After the product has been differentiated, the firm must always be sure to remain profitable and recoup the cost of the "premium" they have included with their product. This advantage may be used by the firm in one of two ways: a.
Build Market Share The firm may attempt to build market share by pricing its product below what it would charge to recoup the premium with a standard number of buyers and try to recover its costs because it captures more than an average share of the market.
b.
Increase Price The firm may increase the price of its product to the point where it exactly offsets the value the customer perceives from the product.
B.
C.
Five Basic Types of Competitive Strategies 1.
Cost leadership focused on a broad range of buyers.
2.
Cost leadership focused on a narrow range (niche) of buyers.
3.
Differentiation focused on a broad range of buyers.
4.
Differentiation focused on a narrow range (niche) of buyers.
5.
Best cost provider.
Cost Leadership Strategies Organizations may choose to achieve their organizational missions by selling their product or service for less than any other participant in the marketplace. Cost leaders undermine the profitability of their competitors as a means of achieving overwhelming market share. 1.
Lowest Overall Costs In order to be a low cost provider, the overall cost of a firm must be lower than other firms in the market. Careful analysis of all the costs in the process must be made and costs must be eliminated, if necessary. Also, evaluation of budgets and benchmarks are crucial. In this way, the firm will gain competitive advantage by either having higher overall profit margins or being able to undercut the prices of the other firms. Firms may choose to evaluate the value chain for areas to cut costs while still maintaining the perception of maintaining the value to the consumer.
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When Cost Leadership Strategies Work Well Cost leadership strategies work well in markets where the buyers have large amounts of bargaining power and are able to switch between competitive products without incurring significant cost. They are aiso successful in markets where there is heavy price competition and where firms (especially new entry firms) can influence buyers to switch to their product and then increase their base of customers simply by cutting the price of the product for a period of time.
3.
When Cost Leadership Strategies Fail If firms focus too much on cutting costs of the current process, they may end up overlooking technological advances that may also assist in lowering costs (especially those that the rivals have latched onto) or overlooking the fact that consumers may desire improvements to the product or may not care much anymore about the existence of a lower price in the desired product. If new features exist in other products, and customers desire those features, and the firm has ignored this fact, the firm has lost its cost leadership competitive advantage. Further, the strategy of cost leadership is not "rocket science." Any firm could easily use the same strategy (thus, reducing the firm's competitive advantage) if It sees that this strategy has worked in the marketplace.
D.
Differentiation Strategies (product differentiation) Organizations may choose to achieve their organizational missions by creating the perception that their product is better or has a unique quality that differentiates it from competing products in the marketplace. Firms that successfully differentiate their products are able to command higher prices. 1.
Create/Promote a Unique Feature in the Product When firms employ a differentiation strategy, they desire to create a competitive advantage by focusing customer preference on their products and away from the products of competitors. They are able to do this by setting their product "aside" from the others through a unique feature (e.g., quality, superior customer service, special taste, image, value, prestige, etc.).
2.
Build Customer Brand Loyalty If the firm can achieve differentiation and still make a profit (i.e., the firm cannot succeed if it loses profit because of the higher costs of the feature in the differentiation strategy), it will succeed in achieving competitive advantage because it will build customer brand loyalty and increase sales.
3.
Perception is Often Greater than Reality Firms with differentiation strategies will evaluate their vaiue chains and perhaps put more money into research and development and innovation and focus on heavy marketing of their "superior products" to customers, highlighting the areas the ultimate consumer cares about (e.g., quality, superior customer service, prestige, etc.). Remember, "perception is often greater than reality," and this is especially important to firms whose products are not purchased frequently or are directed towards first-time or one-time buyers who are not that sophisticated in that market. It is possible for the firm to create a perception of value that is often as significant as the real value that exists in the product.
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When Differentiation Strategies Work Well Differentiation strategies work well when customers are able to see value in a product, when the product appeals to different people for different reasons, and when the firms who are competing in the market choose different features with which to differentiate their products.
5.
When Differentiation Strategies Fail When a firm chooses to differentiate in an area without properly assessing the requirements of the consumer for desired features and preferences or without creating value for the consumer, a differentiation strategy can fail. Further, firms that focus too much on one area (or the wrong area) may "overdo it" and end up creating a product whose value does not exceed the higher price that must be charged for the feature. If a firm is in a market where customers do not care about differentiation, will not pay extra for unique features, and are happy with paying a lower price for a more generic product, the differentiation strategies can fail.
E.
Best Cost Strategies The best cost strategy combines the cost leadership strategy with the differentiation strategy to give customers higher value for their purchase price (i.e., a quality product at a reasonable price). If the firm is able to create a strategy that will allow it to evaluate and change its value chain so that it can achieve the lowest cost among its closest competitors while matching them on the features desired by consumers, it will succeed. 1.
Overall Lowest Cost in Industry is Not an Option Of course, a firm employing a best cost strategy cannot have the overall lowest cost in the entire industry or it could not compete profit-wise because of the special, unique features that are part of the differentiation strategy. Therefore, the firm strives to be the low cost leader among firms in the marketplace that have comparable quality products that have been differentiated in some way.
2.
When Best Cost Strategies Work Well Best cost strategies work well when generic products are not acceptable to the varied needs and preferences of the buyers but the buyers are still sensitive to the value that they are receiving for the money they are spending and the overall price they are paying.
3.
When Best Cost Strategies Fail Because the best cost strategist plays the "middle," it faces risks of losing customers to other firms that are using cost leadership strategies or those that are specifically focused on differentiation. It often becomes difficult to attain the proper "middle" ground in the marketplace, and some firms may end up leaning to one side or the other and then finding themselves attempting to compete in a market where their chosen strategy does not work.
F.
Focus/Niche Strategies Firms with cost leadership or differentiation strategies may choose to focus their chosen strategy on a select small group of consumers, or a niche. Rather than having to address the needs and preferences of a broad range of consumers, these firms are able to focus on market niches where consumers have specialized needs and preferences.
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When Focus/Niche Strategies Work Well The focus/niche strategy works well provided the niche has a large enough demand to create a profit for the firm, and provided the firm has the proper resources to adequately serve the needs of the niche group, and that provided that few firms are focusing in an area where others cannot compete in price or are not currenliy addressing with a particular feature.
2.
When Focus/Niche Strategies Fail When other firms see that the niche has been successful for those serving it, they will attempt to enter the market as competitors and take away some of the sales of the firm, Iikeiy reducing the firm's profits and its competitive advantage. The firm also faces a risk that those consumers in the current niche may find that they actually prefer the features of products that the overall market desires (i.e., preferences change or the standard products have significantly improved), thus causing consumers to buy the standard products on the market and stop buying the niche product that the firm offers. If the firm is not easily responsive to change (flexible) for whatever reason, the focus/niche strategies can fail.
G.
Other Types of Strategies 1.
Merger and Acquisition Firms may choose to combine with or acquire other firms in a formal process of merger or acquisition in order to obtain opportunities for cost reductions that they could not otherwise obtain, to obtain technoiogical knOWledge of others that they do not currently have, to combine research and development activities for efficiency and effectiveness, expand, or to cover areas of market demand that they are not currently serving. While all of this can be beneficial for firms, uniess the combined management is able to work together well and unless the combined operations can be run effectively together, this strategy may not work well.
2.
Cooperative/Strategic Alliances When companies desire to achieve such things as economies of scaie (in marketing or production), to share the cost of obtaining information on innovations in technology, or to obtain information as a group that they could not obtain individually (or that may be too costly to obtain indiVidually), they may choose to form strategic alliances in a cooperative strategy. While this strategy is not as formal as a merger or acquisition, the participating firms are usually able to obtain competitive advantage by acquiring information and skills they couid not obtain on their own (or were prohibited from obtaining because it was too costly, etc.). However, this strategy requires that the individual partners are able to work as a team toward a common goal and that the partners do not take the information they receive and begin to compete heavily with each other.
3.
Vertical Integration A firm may desire to improve its competitive advantage through vertical integration, a strategy in which the firm seeks to control the value chain on the supply end (backward integration to the suppliers) and on the demand end (forward integration to consumers via distribution channels) within the same industry via integration of these processes to the firm's operations. When more of the competitive factors are controlled, a firm may be able to be successful in achieving the desired competitive advantage. However, this may end up redUcing the firm's flexibility with respect to suppliers and distribution channels and force the firm to be too focused on one industry or too committed to one supplier or distribution channel.
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XIV. SUPPLY CHAIN MANAGEMENT/INTEGRATED SUPPLY CHAIN MANAGEMENT (ISCM) A.
Collaborative Effort of Buyers and Sellers If a firm and the entire supply chain (producers, distributors, retailers, customers, and service providers) are able to reasonably predict the expected demand of consumers for a product and then plan accordingly for supplying that demand, it would be employing the concept of integrated supply chain management (ISCM). Integrated supply chain management is a collaborative effort between buyers and sellers, and the relationship between them must be evaluated and managed as goods flow through the value chain.
B.
Goal is to Understand Needs and Preferences of Customers In order to attain and sustain competitive advantage, profits must be made and consumers must have perceived value. To increase value to the consumer, supply chain operations should generally be improved. The goai of ISCM is to better understand the needs and preferences of customers and cultivate the relationship with them. If the actual demand of the customer is met and excess supply does not sit on the market, the firm will be able to minimize costs all along the supply chain (e.g., raw materials, production, packaging, shipping, etc.).
C.
Supply Chain Operations Reference (SCOR) Model The SCOR Model was developed by the Supply Chain Council, which attempted to create a generic model for any organization to use in order to look at the activities of the organization from the "supplier of the supplier" (the ultimate supplier) to the "customer of the customer" (the ultimate customer), which is essentially the entire supply chain. The SCOR Model assists a firm in mapping out its true supply chain and then configuring it to best fit the needs of the firm and consists of four key management processes (i.e., core activities of SCOR). 1.
Plan The process of planning consists of developing a way to properly balance aggregate demand and aggregate supply within the goals and objectives of the firm and plan for the necessary infrastructure. According to the Supply Chain Council, examples of activities associated with "plan" are: a.
Determining the demand requirements.
b.
Assessing the ability of the suppliers to supply resources.
c.
Planning the inventory levels.
d.
Planning the distribution of inventory.
e.
Planning for the purchase of raw materials.
f.
Assessing capacity concerns and capabilities.
g.
Identifying viable distribution channels.
h.
Configuring the supply chain.
i.
Managing the product's life cycle.
j.
Making make/buy decisions.
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Source Once demand has been planned, it is necessary to procure the resources required to meet it and to manage the infrastructure that exists for the sources. According to the Supply Chain Council, this process deals with the following types of activities:
3.
a.
Selecting vendors.
b.
Obtaining vendor feedback and certification.
c.
Overseeing and obtaining proper vendor contracts.
d.
Collecting and processing vendor payments.
e.
Ordering, inspecting, and storing inputs to the production process.
f.
Overseeing the quality assurance process.
g.
Assessing vendor performance.
Make The "make" process encompasses all the activities that turn the raw materials into finished products that are produced to meet a planned demand. According to the Supply Chain Council, the process includes the following types of activities:
4.
a.
Managing the production process.
b.
Implementing changes in engineering.
c.
Requesting products for use in the production process.
d.
Manufacturing the product.
e.
Testing the product.
f.
Packaging the product.
g.
Releasing inventory for shipment.
h.
Maintaining the production equipment and the facilities.
i.
Performing quality assurance measures.
j.
Scheduling production runs.
k.
Analyzing capacity availability.
Deliver The "deliver" process encompasses all the activities of getting the finished product into the hands of the ultimate consumers to meet their planned demand. According to the Supply Chain Council, this process includes the following types of activities:
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a.
Managing of orders (e.g., provide quotes, grant credit, enter orders, etc.).
b.
Forecasting.
c.
Pricing.
d.
Managing transportation (e.g., freight, imporUexport issues, truck coordination, etc.).
e.
Managing accounts receivable and collections.
f.
Shipping of products.
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Labeling of products.
h
Scheduling installation of products.
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Delivering the inventory according to channel distribution rules. D.
Stages of Supply Chain Management Not every firm implements supply chain management in the same way. Most are somewhere between implementing only the fundamentals of the process and having integration of the business enterprise. However, some firms have developed extended supply chains or elaborate supply chain communities. The following stages of supply chain management range from the least sophisticated to the most sophisticated. 1.
The Fundamentals In this stage, the firm is focused on its day-to-day operations and internal practices (such as standardization of operating procedures) it can employ to best manage its finished goods, transportation issues, and warehousing. The firm may use spreadsheets to assist in delivering finished goods at costs that are predictable and reasonable because the main business issue it is concerned with is the cost of quality.
2.
Cross-functional Teams In this stage, management will turn its attention to consolidation of the various departments that make up operations in order to solve the firm's problems. The main business issue the firm is concerned with at this stage is unreliable order fulfillment, and it is very concerned about customer service. The firm will seek to achieve communication at the cross-functional level for on-time and complete delivery of its product.
3.
Integrated Enterprise In this stage, management will move away from simple consolidation of its operations to an internally-integrated supply chain, which all work together with cross-functional purposes (rather than simply cross-functional communication) towards the main business issue of the cost of customer service. For this stage to be successful, it is essential that the people involved are able to work well as a team and eliminate bias so that they are all aligned with the goals of the firm (i.e., goal congruence is essential). The firm will focus on the total cost of delivery, being profitable, and responding to customer needs.
4.
Extended Supply Chain If integration of the supply chain moves external to the firm, firms may see potential for increased profits by unifying the supply chain and forming mutual objectives. The need for those involved to be able to work as a unified team without bias is even more essential, as this process strives to integrate the supply chains of many operations, not just those internally. The main business issue of this stage is slow, profitable growth, and the extended supply chain may plan with point-of-sale tools and implement with customer management systems.
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Supply Chain Communities When the extended supply chain actually forms a single competitive entity, a synchronized supply chain community is formed. However, this is significantly more difficult to impiement than the previous four stages. While the other stages focus on the operational side of the supply chain, this stage directs its attention toward creating market leadership through working with partners to form strategic initiatives to assist in bringing new forms of value to the customer. Networks playa large role in this stage, and the main business issue facing the firm is creating networks of preferred suppliers. The community may be able to attain significant economies of scale, increase and leverage core competencies, and create new types of vertical integration, but all of this hinges on whether the members of the community can cooperate within the workforce and among management and maintain a solid commitment to the established objectives of the community.
E.
Benefits of Implementing Supply Chain Management Typically, management requires a quantified benefit before it will embark on any new type of plan, and integrated supply chain management is no exception. While it is generally accepted that the coordination and integration of goods being brought to market is a valid business endeavor, the quantification of the benefits derived from such actions is not easily obtained. By themselves, improvements in various aspects and activities aiong the supply chain can provide areas of cost savings for the firm, but when considered together, the firm could enjoy a significant positive impact on its profitability and competitive advantage. Examples of benefits derived from implementing supply chain management include:
F.
1.
Reduced costs in inventory management.
2.
Reduced costs in warehousing.
3.
Optimization of the distribution network and facility locations.
4.
Enhanced revenues.
5.
Improved service times.
6.
Strategic shipment consolidation.
7.
Reduced cost in packaging.
8.
Improved delivery times.
9
Cross-docking (the minimization of handling and storage costs while receiving and processing of goods in the shortest time possible).
10.
Identification of inefficiencies in supply chain activities.
11.
Integration of suppliers.
12.
Management of suppliers.
General Steps in Implementing Integrated Supply Chain Management Although there is no set method for which to implement integrated supply chain management because there are so many variables in operational and strategic plans, the generai steps a firm would follow are: 1.
Assess the opportunities in the supply chain.
2.
Develop a vision for ISCM.
3.
Develop a strategy for ISCM.
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Create an optimum organizational structure for ISCM.
5.
Establish an information and communication network for ISCM.
6.
Translate the ISCM strategy into actions.
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Aligning the Supply Chain and Business Strategy A firm must be able to manage its supply chain in a way that is aligned with its business strategy, which is directed at serving the needs of the consumers of the firm's product. 1.
Efficiency and Responsiveness The supply chain of a firm must be both responsive to the changing needs of customers and allow the firm to do so in an efficient manner. This is essential to the ability of the firm to increase its market share and protect profits.
2.
3.
o
Supply Chain Drivers a.
Production.
b.
Inventory.
c.
Location.
d.
Transportation.
e.
Information.
Steps to Align the Supply Chain and the Business Strategy a
Understand the markets the firm operates in and the customers it services.
b.
Identify the core competencies of the firm and how the firm will use these to best serve its customers.
c.
After the company has chosen how it will best serve its customers, create value along the supply chain to achieve the planned goals.
END OF ANCILLARY
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FINANCIAL RISK MANAGEMENT
I.
ANALYZING THE TRADE-OFFS BETWEEN RISK AND RETURN Risk, in its most basic sense, may be defined as the chance of financial loss. More formally, the term "risk" may be used interchangeably with the term "uncertainty" to refer to the variability of returns associated with a given asset. Return may be defined as the total gain or loss experienced on behalf of the owner of an asset over a given period of time. Typically, greater risk yields greater returns. The seller of financial securities compensates the buyer of financial securities with increased opportunity for profit by offering a higher rate of return. Risk and return are a function of both market conditions and the risk preferences of the parties involved. A.
Risk Preferences Different managers are defined by different attitudes towards risk. There are generally three basic risk preference behaviors. 1.
Risk-indifferent Behavior Risk-indifferent behavior reflects an attitude toward risk where an increase in the ievel of risk would not result in an increase in management's required rate of return.
2.
Risk-averse Behavior Risk-averse behavior reflects an attitude toward risk where an increase in the level of risk would result in an increase in management's required rate of return. Because they are risk-averse, these types of managers require higher expected returns to compensate them for taking greater risk. Most managers are risk-averse.
3.
Risk-seeking Behavior Risk-seeking behavior reflects an attitude toward risk where an increase in the level of risk would result in a decrease in management's required rate of return. Because they are risk-seeking, these types of managers are willing to settle for lower expected returns as the level of risk increases. PASS KEY
There are three different risk behaviors.
Most common: Risk averse - The investor seeks greater return in exchange for assumed risk and is likely to prefer certainty (guaranteed returns) over uncertainty (fluctuating or variable returns).
Less common: Risk seeking - The investor actually seeks uncertainty and may entertain less expected return for more risk. Risk indifferent - The investor is indifferent to expected return in exchange for assumed risk. Certainty or uncertainty of return is irrelevant. PASS KEY
Risk preferences are defined in relation to an individual manager's point of risk indifference. Risk indifference is defined by the term certainty equivalent. Investors who are neutral when presented with an amount of money returned in exchange for no risk, in comparison to an amount of money returned with higher risk, are risk indifferent. The value of the risk is equal to the value of no risk. The certainty equivalent is expressed in one of three formulas: Certainty equivalent < expected value represents risk averse behavior Certainty equivalent = expected value represents risk indifferent behavior Certainty equivalent> expected value represents risk seeking behavior
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Diversification Risk is often reduced by diversification, the process of mixing investments of different (or offsetting) risks. Not all risk can be managed in this way. Total risk is the combination of the diversifiable and the nondiversifiable risk of a single asset. 1.
Diversifiable Risk Diversifiable risk (which might also be referred to as non-market, unsystematic, or firm-specific risk) represents the portion of a single asset's risk that is associated with random causes and can be eliminated through diversification. Diversifiable risk is attributable to firm-specific events (e.g., strikes, lawsuits, regulatory actions, or the loss of a key account).
2.
Nondiversifiable Risk Nondiversifiable risk (which might also be referred to as market or systematic risk) is attributable to market factors that affect all firms and cannot be eliminated through diversification. Nondiversifiable risk is attributable to factors such as war, inflation, international incidents, and political events.
3.
Managing Different Types of Risk The only relevant risk is nondiversifiable risk, because (in theory) any investor can create a portfolio of assets that eliminates all, or virtually all, diversifiable risk. The investor, therefore, must only be concerned with nondiversifiable risk. PASS
KEY
It will be important to be able to classify risk into their two broad categories using any number of terms.
D
Diversiflable Risk
U
N S
Unsystematic Risk (Non-market/firm specific)
Nondiversifiable Risk Systematic Risk (Market)
Remember the mnemonic DUNS to keep these risk types and their alternate names clear.
C.
Various Types of Risk Measurements of risk attempt to capture the multiple dimensions of risk. Risk exposures include interest rate, market, default and credit risk. 1.
Interest Rate Risk (or yield risk) Interest rate risk (or yield risk) is often used in the context of financial instruments and represents the exposure of the owner of the instrument to fiuctuations in the value of the instrument in response to changes in interest rates. EXAMPLE
Thayer Thermodynamics, Inc. owns a $10,000 Duffy International bond purchased at par with a coupon rate (the rate paid by the bond according to the bond agreement) of 7 percent until bond maturity in five years. If the market rate of interest abruptly increases to 8 percent immediately after purchase, the value of the bond in the marketplace would be discounted to $6,810 to account for the increase in rate. Compared to the bond's carrying value of $7,140 as originally discounted at par, Thayer Thermodynamics has suffered a $330 loss in bond value as a result of its exposure to interest rate risk.
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Market Risk The exposure of a security or firm to fluctuations in value as a result of operating within an economy is referred to as market risk. Market risk is sometimes referred to as nondiversifiable risk because it is a risk inherent in the operation within the economy. EXAM PtE
Stock prices generally increase and decrease together with overall market activity. Although the prices may not increase or decrease identically, they often move in the same direction. Microsoft Corporation stock, for example, might increase in value on a given day from $25.00 per share to $25.50 per share. It would not be surprising to find that the NASDAQ similarly increased by 2 percent, more or less, in response to general improvements in the market.
3.
Credit Risk Credit risk impacts borrowers. Exposure to credit risk includes a company's inability to secure financing or secure unfavorable credit terms as a result of poor credit ratings. As credit ratings decline, interest rates demanded by lenders increase and other terms are generally less favorable to the borrower. EXAM PtE
Duffy International seeks to borrow $10,000 for five years, but the company has both a history of late payments and displays a high debt to income ratio and high debt equity ratio (measurements discussed later). Although market rates of interest are 7 percent, lenders may only loan Duffy International money at an 8 percent rate and insist on shortening the term of the loan to three years. Duffy International's inability to borrow the funds it needs at the market rate of interest illustrates the company's exposure to credit risk and demonstrates the creditors' attempt to mitigate default risk (see below).
4.
Default Risk Default risk impacts lenders. An organization is exposed to default risk to the extent that it is possible that its debtors may not repay the principal or interest due on their indebtedness. EXAMPLE
Duffy International defaults on the $10,000 bond issue held by Thayer Thermodynamics, Inc. The loss incurred by Thayer Thermodynamics, Inc. results from the company's exposure to default risk, the possibility that the debtor will not repay its debts.
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Computation of Return Return compensates investors and creditors for assumed risk and is typically calculated first by determining the sum of the asset's change in value plus any cash distributions received during the period and then by dividing that sum by the asset's value at the beginning of the period. Return is often stated or measured by interest rates. The risk-free rate of return or interest rate (normally associated with short-term federally insured securities) is the basis to which additional interest is added to accommodate risk of loss due to the character of the security, the maturity of the investment, etc. Interest rates may also include anyone of the following characteristics and can be expressed as either a cost (interest expense) or revenue (interest earnings).
1.
Stated Interest Rate a.
Definition The stated interest rate (sometimes referred to as nominal interest rate) represents the rate of interest charged before any adjustment for compounding or market factors.
b.
Computation The stated interest rate is the rate shown in the agreement of indebtedness (e.g., a bond indenture, promissory note, etc.). EXAMPLE
A $10,000 promissory note states that payments will be made quarterly at a 10 percent interest rate per annum. What is the stated rate? Hint: You do not need a calculator!
Stated rate = 10%
2.
Effective Interest Rate a.
Definition The effective interest rate represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees reiated to a loan origination.
b.
Computation Effective interest rates are computed by diViding the amount of interest paid based on the ioan agreement by the net proceeds received.
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EXAMPLE
A $10,000 promissory note has a stated rate of 10 percent per annum and is due in one year. The bank charges a loan origination fee of $75 and the state in which the loan is made levies a $50 documentary stamp charge. Taxes and fees are taken from loan proceeds. The effective interest rate is computed as follows:
Interest paid (10,000 x 10%)
$
Divided by net proceeds ($10,000 - $75 - $50) Effective interest rate
3.
1,000 9.875 10.12%
Annual Percentage Rate a.
Definition The annual percentage rate of interest represents a non-compounded version of the effective annual percentage rate described and computed below. The annual percentage rate Is the rate required for disclosure by federal regulations.
b.
Computation Annual percentage rates are computed as the effective periodic interest rate times the number of periods in a year. Annual percentage rate emphasizes the amount paid relative to funds available. EXAMPLE
A $10,000 promissory note displays a stated rate of 8 percent compounded semi-annually. The bank charges a $75 loan origination fee and documentary tax of $50 is assessed by the state. What is the annual percentage rate? Step #1
Compute the effective periodic interest rate (as per above)
Interest paid ($10,000 x 8% x 6(12)
Step #2
$
Divided by available funds ($10,000 - $75 - $50)
9,875
Effective periodic interest rate
4.05%
Multiply the effective periodic interest rate by the number of periods in a year Effective periodic interest rate Periods in a year Annual percentage rate
4.
400
4.05%
x
2 8.10%
Effective Annual Percentage Rate a.
Definition The effective annual percentage rate represents the stated interest rate adjusted for the number of compounding periods per year. The effective annual percentage rate is abbreviated APR.
b.
Computation Computation of the effective annual percentage rate (APR) is computed as follows:
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Effective annual interest rate = (1 + (i/p))' - 1 =
Stated interest rate. Compounding periods per year.
p
EXAMPLE
A note with an 8 percent stated rate of interest compounded biannually, 2 times per year, has the following effective annual percentage rate or APR:
Effective annual interest rate = (1 + (i/p))' - 1 Effective annual interest rate = (1 + (.08/2))'-1 Effective annual interest rate = (1 + (.04))' - 1 Effective annual interest rate = 1.0816-1 Effective annual interest rate = 8.16%
5.
Simple Interest (amount) a.
Definition Simple interest is the amount represented by interest paid only on the original amount of principal without regard to compounding.
b.
Computation Simple interest is formulated as follows:
51 = Poli)(n) 51 Po i n
= = = =
simpie interest. Original principal. Interest rate per time period. Number of time periods.
EXAMPLE
A $10,000 promissory note bears simple interest at 8 percent for two years. What is the simple interest on this obligation?
SI = Po (i)(n) SI = $10,000 (8%)(2) SI = $1,600
6.
Compound Interest (amount) a.
Definition Compound interest is the amount represented by interest earnings or expense that is based upon the original principal pius any unpaid interest earnings or expense. Interest earnings or expense, therefore, compound and yield an amount higher than simple interest.
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Computation Compound interest is computed as a future value as follows: FVo =P o(l+ijO FVo
=
Future value (with compounding).
Po
=
Original principal.
i
=
Interest rate.
n
=
Number of periods.
EXAMPLE
A promissory note for $10,000 carries and interest rate of 8 percent for two years, compounded annually. What is the maturity value of the promissory note? FVn = Po(l + i)n
FV o= $10,000 (1 + .08)' FVo= $10,000 (1.1664) FVo= $11,664
o
END OF ANCILLARY MATERIAL
II.
INTERNATIONAL RISKS - Exchange Rate Risk: Factors and Exposure Categories Business transactions are typically denominated and valued in terms of money. Currency (or money) is the medium of exchange. Within domestic environments, a single currency defines the value of assets, liabilities, and operating transactions. In international settings, the values of assets, liabiiities, and operating transactions are established not only in terms of the single currency, but also in relation to other currencies. The relationship between currencies is not always stable and, therefore, creates exchange rate risk. •
Risk factors include trade and financial factors.
•
Risk exposure categories include transaction, economic and translation exposures.
Financial managers must understand the risk factors and mitigate the risk exposures. A.
Factors Influencing Exchange Rates Circumstances that give rise to changes in exchange rates are generaliy divided between trade-related factors (including differences in inflation, income, and government regUlation) and financial factors (including differences in interest rates and restrictions on capital movements between companies).
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Trade Factor - Relative Inflation Rates When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money. The increase in demand for foreign currency will force the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange from domestic to foreign currency. EXAM PLE
Assume the United States dollar is relatively stable while the Mexican peso is suffering from sudden inflationary pressures. As the Mexican peso buys less in the domestic Mexican economy, Mexicans and their banking institutions seek the safe haven of the United States dollar to maintain the purchasing power of their liquid resources. The demand for United States dollars created by Mexicans buying them with Mexican pesos makes the United States dollar more valuable in terms of the peso and drives up the exchange rate. The United States dollar commands more pesos in an exchange of currency.
2.
Trade Factor - Relative Income Levels As income increases in one country relative to another, exchange rates change as a result of increased demand for the currency in the country where income in increasing. EXAMPLE
The income level in the United States increases significantly in the second quarter. Americans flock to Mexico City on vacation to buy pinatas. The increased supply of American dollars seeking to buy pesos to purchase Mexican goods causes the value of the American dollar to fall in relation to a stated number of pesos. The exchange rate is thus impacted by relative income levels and the associated demand for foreign currency created by new domestic income.
3.
Trade Factor - Government Controls Various trade and exchange barriers that artificially suppress the natural forces of supply and demand will impact exchange rates. EXAMPLE
A tariff on imported pinatas would have the impact of discouraging the purchase of imports, thereby reducing demand for the peso and maintaining the exchange rate.
4.
Financial Factors - Relative Interest Rates and Capital Flows Interest rates create demands for currency by motivating either domestic or foreign investments. The forces of supply and demand create changes in the exchange rate as investors seek fixed returns. The impact of interest rates is directly impacted by the volume of capital that is allowed to flow between countries. EXAMPLE
Assume that guaranteed returns on institutional investments in Mexico skyrocket in the third quarter while interest rates in the United States remain low. American investors find the opportunity to earn high returns in Mexican banks irresistible. The demand for pesos increases as American investment increases. The exchange rate changes as the peso commands more United States dollars.
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ANCILLARY MATERIAL (for Independent Review)
SUMMARY CHART: CIRCUMSTANCES THAT IMPACT EXCHANGE RATES
Trade Related Factors Relative inflation rates Relative income levels Government controls
-----+
Demand for goods
-----+
Demand/ supply of currency
Exchange rate
(Trade Restrictions)
Financial Factors Relative interest rates
-----+
Capital flow
B.
l
Demand for securities
-----+
Demand/ supply of
r
currency
Theories Explaining Exchange Rate Risk Several theories are used to explain the dynamic relationship between inflation rates and interest rates in the determination of currency exchange rates. These theories include the purchasing power parity theory, the International Fischer effect, and the interest rate parity theory. 1.
Purchasing Power Parity Theory The purchasing power parity theory generally suggests that the price of identical goods sold in separate economies are identical when measured in a common currency. Exchange rates will constantly adjust to ensure purchasing power parity (equality). a.
Absolute Form The absolute form of the purchasing power parity theory is referred to as the "law of one price." The absolute form asserts that identical goods sold in separate economies will command equal prices when denominated in a common currency. Differences are self-adjusting.
b.
Relative Form The relative form holds to the basic theory of the absolute form but accounts for transportation and government regulation (such as tariffs and quotas) as determining factors and acknowledges that the price of identical items in different countries will not necessarily be absolutely equal even when measured in a common currency. The rate of incremental change in the exchange rate should be approximately equal assuming no change in the market imperfections associated with government regulation and transportation costs.
2.
International Fisher Effect The International Fisher effect explains the fluctuation in exchange rates through analysis of interest rates. Interest rates are viewed as a compound measurement of both financing costs and expected inflation that more accurately explains exchange rate changes. a.
Interest Rate Components Interest rates are deemed to include a real risk-free rate of return and an additional component that accounts for inflation.
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Inflation Rates Changes in inflation derived from the International Fisher effect pinpoint the anticipated fluctuation in exchange rates.
3.
Interest Rate Parity Theory The interest rate parity theory holds that foreign and domestic interest rates will reach equilibrium once covered interest arbitrage is no longer possible. a.
Covered Interest Arbitrage
Covered interest arbitrage is a currency swap in which the counterparties exchange currencies at both the spot and forward rates simultaneously (see Glossary for definitions of spot and forward rate). In other words, the party engaging in covered interest arbitrage for an investment exchanges its domestic currency for a foreign currency to make the investment and also at the same time enters into a forward contract to sell an equal amount of the foreign currency to coincide with the maturity of the investment (and the attendant proceeds of the investment). The swap restores currency exposures to the original position without a currency gain or loss, making this a way to adjust exposure to a narrowing or widening of interest rate differentials. Covered interest arbitrage also ensures interest rate parity because this relationship prevents speculators from profiting by borrowing in a low interest rate country and simultaneously lending in a high interest country and hedging the currency risk. b.
Interest Rate Parity Theory The difference between forward contract prices represents the difference in interest rates in effect in each country and thereby accounts for exchange rate differences.
C.
Transaction Exposure - Definition and Measurement Exchange rate risk is defined, in part, by transaction exposure. Transaction exposure is defined as the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates. Transaction exposure is generally measured in relation to currency variability or currency correlation.
1.
General Measurement of transaction exposure is generally done in two steps: a.
Project foreign currency inflows and foreign currency outflows.
b.
Estimate the variability (risk) associated with the foreign currency. EXAMPLE
Seattle Import/Export, a U.S. import/export company, imports commodities from Canada that it pays for in Canadian dollars and exports commodities to Canada for which it receives Canadian dollars. If Seattle Import/Export anticipated that it would export C$10,OOO,OOO to Canada over the next year while importing C$8,OOO,OOO over the same period, the net exposure in Canadian dollars is a
($2,000,000 inflow. Ifthe exchange rate is $.75 to each Canadian dollar, the net exposure in United States dollars is
$1,500,000 (($2,000,000 x ,75), If the rate is anticipated to fluctuate five cents, between $.70 and $.80, the total fluctuation exposure would be expected to be between $1,400,000 and $1,600,000.
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Currency Variability (single foreign currency) While the projected net inflow or outflow of a foreign currency may be determined from a budget or business pian, the expected variability in exchange rates is more difficult. a.
Standard Deviation Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over a single period.
b.
Standard Deviation over Time Currency variability may be estimated by computing the standard deviation of monthly exchange rates to the average exchange rate over multiple periods and selecting, judgmentally, the most likely exchange rate.
3.
Currency Correlation (multiple foreign currencies) Currency correlation scenarios anticipate the settlement of future transactions in multiple foreign currencies. The degree of transaction exposure is determined statistically by the degree to which the movement of exchange rates of multiple foreign currencies correlate.
a.
4.
The higher the degree of correlation, the greater the possibility that changes in exchange rates (either favorable or unfavorable) will compound and increase the risk of exchange rate fluctuation.
Value-at-Risk The value-aI-risk method computes the maximum one day loss based on exchange rate fluctuations using both variability and correlation measurements.
o
END OF ANCILLARY MATERIAL
D.
Economic Exposure - Definition and Measurement In addition to transaction exposure, exchange rate risk is defined, in part, by economic exposure. Economic exposure is defined as the potential that the present value of an organization's cash flows could increase or decrease as a result of changes in the exchange rates. Economic exposure is generally defined through local currency appreciation or depreciation and is measured in relation to organization earnings and cash flows. 1.
Currency Appreciation and Depreciation Currency appreciation and depreciation refer to the strengthening (appreciation) or weakening (depreciation) of a currency in relation to other currencies.
a.
Impact of Currency Appreciation As a domestic currency appreciates in value or becomes stronger, it becomes more expensive in terms of a foreign currency. As currency appreciates, the volume of outflows tends to decline as domestic exports become more expensive. However, the volume of inflows tends to increase as foreign imports become less expensive.
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Impact of Currency Depreciation As a domestic currency depreciates in value or becomes weaker, it becomes less expensive in terms of a foreign currency. As a currency depreciates, the volume of outflows tends to rise as domestic exports become less expensive. However, the volume of inflows tends to decline as foreign imports become more expensive.
The economic exposure created by domestic currency appreciation or depreciation with respect to a foreign currency depends upon the net inflow or outflow of foreign currency and is summarized as follows:
Foreign
2.
FOREIGN
CURRENCY
Currency
Domestic Currency
Netlnf/ows
Net Outflows
Depreciation
Appreciation
Loss
Gain
Appreciation
Depreciation
Gain
Loss
Measuring Economic Exposure through Earnings Economic exposure can be measured using the sensitivity of earnings to changes in exchange rates. The approach to sensitivity analysis involves three different steps:
3.
a.
Prepare an income statement computing earnings expressed in terms of the foreign currency.
b.
Apply a range of likely exchange rates to each line item of the income statement and compute earnings under each scenario.
c.
Compare the earnings amounts in relation to fluctuations in expected exchange rates to determine the sensitivity of earnings to changes in exchange rates.
Evaluation As the exchange rate increases, the foreign currency becomes more expensive in terms of the domestic currency. Profitability tends to decline because fixed costs, expressed in the foreign currency, become more expensive.
o...----------------------------....., AN C III A R Y MAT E R I A l (for Independent Review)
E.
Translation Exposure - Definition and Measurement
In addition to the transaction and economic exposures, exchange rate risk is defined, in part, by translation exposure. Translation exposure is defined as the potential that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in the exchange rates and defines the effect of exchange rate fluctuations on financial position and operations. Translation exposure is generally defined by the degree of foreign involvement, the location of foreign subsidiaries, and the accounting methods used and measured in relation to the impact on the organization's earnings or comprehensive income.
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Degree of Foreign Involvement The translation exposure to exchange rate risk increases as the proportion of foreign involvement by subsidiaries increases. EXAMPLE
Domestic International, Inc. has no foreign subsidiaries but is deeply involved in exporting to neighboring countries. Global International, Inc. has twelve foreign subsidiaries that, combined, comprise sixty-five percent of consolidated revenues. Domestic International has less translation exposure than Global International because it has no foreign subsidiaries. Domestic's international business does expose the company to exchange rate risks, however, in terms of both transaction and economic exposure.
2.
Locations of Foreign Investments Measurements of financiai resuits of foreign investments frequently occur in the foreign currency in which the investee company operates. The exposure of the parent company to translation risk is impacted by the stability of the foreign currency in comparison to the parent's domestic currency. The more stable the exchange rate, the lower the translation risk. The less stable the exchange rate, the higher the translation risk.
3.
Accounting Methods The translation of financiai statements reported in foreign currencies is specificaiiy defined by the Financial Accounting Standards Board, and one of two methods is used. Each method requires that the parent company assess the functional currency of the foreign subsidiary and then apply accounting and reporting principles based on that assessment. Each method accounts for a subsidiary's financial results and represents a translation exposure to exchange rate risk. a.
Temporal Method (remeasurement method) The temporal method assumes that the functional currency is the currency of the parent. Translation gains or losses flow through the income statement. (1)
The functional currency is defined as the currency in which the primary economic activities of the subsidiary are transacted.
(2)
When the transactions are denominated in the foreign currency and measured in the foreign currency, but the foreign subsidiary Is dependent upon the parent's domestic currency for cash flows, the parent's domestic currency is the functional currency.
(3)
Financial results of the foreign subsidiary must be remeasured into the functional currency used for reporting.
(4)
Steps in remeasurement include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for as a remeasurement gain or loss through income.
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The parent company's translation exposure to exchange rate gain or loss is composed of both the increase or decrease in net income as a result of exchange rates applied to income statement line items as well as the adjusting entry to determine the income necessary to balance the balance sheet through the income statement as a remeasurement gain or loss.
Current Method (translation method) The current method assumes that the functional currency is the currency used by the foreign subsidiary. Translation gains and losses flow through other comprehensive income.
o
(1)
When the transactions are denominated and measured in the foreign currency and the foreign subsidiary is not dependent upon the parent's domestic currency for cash flows, the subsidiary's currency (the foreign currency) is the functional currency.
(2)
Financial results of the foreign subsidiary must be translated into the currency used for reporting.
(3)
Steps in translation include restatement of the balance sheet using various exchange rates and restatement of the income statement using various exchange rates. Any difference between the balance sheet and the income statement is accounted for through other comprehensive income and accumulated other comprehensive income, which is a component of stockholders' equity on the balance sheet.
(4)
The parent company's translation exposure to exchange rate gain or loss is composed of the increase or decrease in net income as a result of exchange rates applied to income statement line items. However, the "plug" goes to other accumulated comprehensive income on the balance sheet.
END OF ANCILLARY MATERIAL
III.
FINANCIAL RISK MANAGEMENT - Exchange Rate Transaction Exposure Businesses have various methods of managing the transaction exposure associated with exchange rate risks. Generally the use of financial instruments and hedge transactions attempts to mitigate the impact of exchange rate ftuctuations on individual transactions. The following discussion analyzes hedging as it relates to foreign currency transactions. A.
Measuring Specific Net Transaction Exposure Net transaction exposure is the amount of gain or loss that might result from either a favorable or an unfavorable settlement of a transaction. 1.
Selective Hedging Hedging is a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial security whose financial behavior is opposite that of the hedged item.
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£XAMPLE
Worldwide Sweet Peaches buys crates for its product for shipping from Mexico. The company incurs liabilities denominated in pesos that it satisfies in pesos bought with U.S. dollars at the time of settlement. The company incurs a significant liability in pesos at a spot rate of $.10. The company is fearful that the peso will strengthen to $.20 by the time the bill is due and thereby double its cost. Because the anticipated exchange rate (the rate at which two currencies will be exchanged at equal value) in the future of the peso is greater than the current spot rate (the exchange rate at the current date), the company will hedge its position by locking into an exchange rate that is less than the feared appreciation of the peso.
2.
a.
Hedges can be effective or ineffective. depending upon the actual exchange rate at the time of settlement in comparison to the hedge price and other factors. You will not be asked on the CPA Exam to determine hedge effectiveness or ineffectiveness.
b.
Hedges are likely to be effective just as often as they are likely to be ineffective if done consistently and, therefore, theoretically have no impact on income.
c.
Management may elect to hedge inconsistently or selectively in order to ensure that hedge transactions are carried out with maximum effectiveness.
Identifying Net Transaction Exposure Consolidated entities consider their net transaction exposure prior to considering hedge strategies. Net transaction exposure considers the impact of transaction exposure on the entity taken as a whole rather than individual subsidiaries. While exchange rate issues might adversely affect one subsidiary, they might favorably affect another. The net transaction exposure is the aggregate exposure associated with a particular foreign currency for a particular time and is computed as follows:
3.
a.
Accumulate the inflows and outflows of foreign currencies by subsidiary.
b.
Consolidate the impact on the sUbsidiary by currency type.
c.
Compute the net impact in total.
Adjusting Invoice Policies International companies may hedge transactions without complex instruments by timing the payment for imports with the collection from exports.
B.
Techniques for Transaction Exposure Mitigation The following hedge transactions are used to mitigate exchange rate risk presented by foreign currency transaction exposure. 1.
Futures Hedge A futures hedge entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date. Futures hedges are denominated in standard amounts and tend to be used for smaller transactions.
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Accounts Payable Application (1)
Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency weakens in relation to the foreign currency. Should the domestic currency weaken, more domestic currency will be required to purchase the foreign currency and pay the payable. An exchange loss will result.
(2)
A futures hedge contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate the risk of a weakening domestic currency.
Accounts Receivable Application (1)
Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens in relation to the foreign currency. Should the domestic currency strengthen, less domestic currency than originaliy anticipated from the sale that created the receivable can be purchased with the foreign currency received. An exchange loss will result.
(2)
A futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time the accounts receivable is due will mitigate the risk of a strengthening domestic currency.
Forward Hedge A forward hedge is similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point in time. While futures hedges tend to be used for smaller transactions, forward hedges are contracts between businesses and commercial banks and normally are larger transactions. While a futures hedge might hedge a particular transaction, a forward hedge would anticipate a company's needs to either buy or sell a foreign currency at a particular point in time. a.
b.
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Accounts Payable Application (1)
Accounts payable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the foreign currency strengthens.
(2)
A forward hedge contract to buy the foreign currency at a specific price at the time accounts payable are due for an entire subsidiary will mitigate the risk of a weakening domestic currency.
Accounts Receivable Application (1)
Accounts receivable denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens.
(2)
A forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the time the accounts receivable are due or on the monthly cycle of a particular subsidiary will mitigate the risk of a strengthening domestic currency.
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Money Market Hedge A money market hedge uses international money markets to plan to meet future currency requirements. A money market hedge uses domestic currency to purchase a foreign currency at current spot rates and invest them In securities timed to mature at the same time as related payables.
a.
Money Market Hedge - Payab/es (excess cash) Firms with excess cash use money market hedges to lock in the exchange rate associated with the foreign currency needed to satisfy payables when they come due. Money market hedges for payables satisfaction are easy to understand. (1)
Determine the amount of the payabie.
(2)
Determine the amount of interest that can be earned prior to settling the payabie.
(3)
Discount the amount of the payable to the net investment required.
(4)
Purchase the amount of foreign currency equal to the net investment required and deposit the proceeds in the appropriate money market vehicle. EXAMPLE
Duffy's Discount Pinatas has a payable due to its Mexican suppliers in the amount of 1,000,000 pesos in 90 days. The current exchange rate is $.08 per peso and Mexican interest rates are 16%. Duffy has $100,000 in excess cash and elects to use a money market hedge to mitigate transaction exposure to exchange rate risk. Duffy performs the following steps: 1. Determine the required investment in pesos at Mexican interest rates: 1,000,000/1.04 = 961,538.
2. Purchase 961,538 pesos with $76,923 (961,538 pesos x .08). 3. Invest pesos at Mexican interest rates and satisfy payables upon maturity of the investment.
Duffy has secured the satisfaction of its current $80,000 payable for $76,923.
b.
Money Market Hedge - Payab/es (borrowed funds) Firms that do not have excess cash would follow the same basic procedure for a money market hedge on payabies except that they would first borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency. EXAMPLE
Duffy's Discount Pinatas has a payable due to its Mexican suppliers in the amount of 1,000,000 pesos in 90 days. The current exchange rate is $.08 per peso, Mexican interest rates are 16%, and U.S. interest rates are 6%. Duffy computes that it must borrow $76,923 to use a money market hedge to mitigate transaction exposure to exchange rate risk consistent with the first money market hedge example but has no excess cash. Duffy borrows the needed amount for 90 days in the United States.
Duffy has secured the satisfaction of its current $80,000 payable for $78,077 (76,923 x 1.015, 6 percent for 90 days).
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Money Market Hedge - Receivables A money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans. Foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency. Borrowed foreign currency amounts are converted into the domestic currency. EXAMPLE
Duffy's Discount Pinatas has a receivable from a Mexican customer in the amount of 1,000,000 pesos due in 90 days. The current exchange rate is $.08 per peso and Mexican interest rates are 16%. Duffy, as usual, is broke and cannot wait to receive $80,000 in 90 days. Duffy needs the money now, so it elects to use a money market hedge technique to expedite collection and mitigate any transaction exposure to exchange rate risk.
Duffy computes that it can borrow 961,538 pesos and convert them to $76,923 consistent with the first money market hedge example. Duffy borrows the pesos from Mexican financial institutions. Duffy will be able to meet whatever its current cash requirements are in the United States with
the $76,923, and when the 90-day discounted note for 961,538 pesos matures for 1,000,000 pesos, Duffy will satisfy it with the collections from the foreign accounts receivable.
o
AN elL L A R Y MAT E R I A L (for Independent Review)
IV.
ADDITIONAL TECHNIQUES FOR MITIGATING TRANSACTION RISK AND EVALUATING STRATEGY A.
Currency Option Hedges Currency option hedges use the same principles as forward hedge contracts and money market hedge transactions. However, instead of requiring a commitment to a transaction, the currency option hedge gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is most favorable.
1.
Currency Option Hedges - Payables A call option (an option to buy) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables.
•2-100
a.
Similar to a futures contract or forward contract, the business plans to buy a foreign currency at a low rate in anticipation of the foreign currency strengthening in comparison to the domestic currency in order to ensure that it can settle its liability at predicted vaiue.
b.
The business has the option (not the obligation) to purchase the security at the option (strike) price. The business evaluates the relationship between the option price and the exchange rate at the settiement date. Generally, if the option price is less than the exchange rate at the time of settlement, the business will exercise its option. If the option price is more than the exchange rate at the time of settlement, the business will allow the option to expire. While premiums are used to compute any net savings associated with option transactions, they are a sunk cost and are irrelevant to the decision to exercise the options.
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EXAMPLE
Gearty International owes its Mexican supplier 1,000,000 pesos due in 30 days. Although the peso is currently exchanged for the US dollar at $.08, the company is fearful that the Mexican peso will
strengthen in comparison to the dollar before the settlement to as much as $.10. Gearty International pays a $.005 premium to secure a call option to buy 1,000,000 pesos in 30 days for $.08. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) increases as predicted, Gearty will exercise its option to achieve a $15,000 net savings, computed as follows:
Spot Rate at Settlement
Option Price
Premium
Total Option
$.08
$.005
$.085
$.10
Net savings
Settlement Cost for 1.000.000 Pesos
$100,000 (85.000) $ 15000
Gearty's consideration for the option, the $.005 premium, is $5,000 and is paid regardless of whether
the option is exercised. The gross savings of $20,000 [(.10 - .08)
* 1,000,000 pesos] is reduced by the
$5,000 premium to reflect a $15,000 net savings. Remember, however, that the premium is not included in the decision to exercise the option. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.08, then the company will allow its option to expire because exercising the option would actually be equal to simply settling the transaction at the spot rate, computed as follows:
Spot Rate at Settlement $.08
Option Price
Premium
Total Option
$.08
$.005
$.085
loss
Settlement Cost for 1,000,000 Pesos $ 80,000 85.000 ($ 5000)
Gearty will likely buy pesos at the spot rate regardless of the loss associated with the premium,
2.
Currency Option Hedges - Receivables A put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for receivables. a.
Similar to a futures contract or forward contract. the business plans to sell a foreign currency at a high rate in anticipation of the foreign currency weakening in comparison to the domestic currency in order to ensure that it can capitalize on receivable collections at a stable or predicted value.
b.
The business has the option (not the obligation) to sell the collected amount of the foreign currency from the receivable at the option (strike) price. The business evaluates the relationship between the option price and the exchange rate at the settlement date. Generally, if the option price is more than the exchange rate at the time of settlement, the business will exercise its option. If the option price is less than the exchange rate at the time of settlement, the business will allow the option to expire. While premiums are used to compute any net preserved values associated with option transactions, they are a sunk cost and are irrelevant to the decision to exercise the options.
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EXAMPLE
Gearty International is owed 1,000,000 pesos due in 30 days from its Mexican customer. Although the peso is currently exchanged for the US dollar at $.08, the company is fearful that the Mexican peso will weaken in comparison to the dollar before the settlement to as little as $.06. Gearty International
pays a $.005 premium to secure a put option to sell 1,000,000 pesos in 30 days for $.08. If Gearty is correct in its assessment of international exchange rates and the exchange rate at the time of the settlement (the spot rate) decreases as predicted, the company will exercise its option to achieve a net preservation of $15,000 in asset value, computed as follows: Spot Rote ot Settlement $.06
Option Price
Premium
Total Option
$.005
$.075
-
-
-
$.08 Net preserved value
Settlement Cost for 1,000,000 Pesos $ 60,000 75.000 $ 15,000
Gearty's consideration for the option, the $.005 premium, is $5,000 and paid regardless of whether the option is exercised. The gross value "preserved" of $20,000 [(.08 - .06) * 1,000,000 pesos] is reduced by the $5,000 premium paid to reflect a net $15,000 preserved receivable value. Remember, however, that the premium is not included in the decision to exercise the option. If Gearty is incorrect in its assessment of international exchange rates and the exchange rates stay constant at $.08, then it will allow their option to expire since to exercise the option would actually be equal to simply settling the transaction at the spot rate, computed as follows: Spot Rate at Settlement $.08
-
Option Price
Premium
Total Option
-
-
-
$.08
$.005
$.075
Loss
SetdementCostfor 1,000,000 Pesos $ 80,000 75,000 1$ 5000)
Gearty will likely sell pesos at the spot rate regardless of the loss associated with the premium.
B,
Asse ssing Hedging Strategy Effectiveness The business decision to hedge or not to hedge using forward contracts may be evaluated using the formula for the real cost of hedging payables and the real cost of hedging recei vables. The formulas take the difference between the nominal cost of hedging and the cost of not hedging to derive the additional cost of a hedge in comparison to the charges alrea dy incurred before the hedge.
1,
Costs of Hedging or Not Hedging a.
The nominal cost of hedging a foreign currency is the known exchange rate for the currency times the underlying. EXAMPLE
Assume the cost of the Canadian dollar is $.75. The nominol cost of hedging C$l,OOO,OOO is known to be $750,000.
b,
The nominal cost of not hedging a foreign currency represents the expected value of a transaction settlement given a range of exchange rates and associated probabilities.
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EXAMPLE
Assume the cost of the Canadian dollar is $.75, and we anticipate that the exchange rate has a
.10 probability of falling to $.65, a .50 probability of falling to .70, and a .40 probability of rising to .8. We would compute the nominal cost of not hedging a planned C$l,OOO,OOO as follows: Possible Rates
Probability
.65 .70 .80
.10 .50 040
Domestic Value
Nominal Cost arNot Hedging
C$l,OOO,OOO
$ 65,000
C$l,OOO,OOO
$350,000
C$l,OOO,OOO
$320,000 $735,000
Nominal cost of not hedging
2.
Real Cost of Hedging Payables The real cost of hedging payables is expressed in the following formula:
RCH p is the real cost of hedging payables. NCH p is the nominal cost of hedging payables. NCp
is the nominal cost of payables without hedging.
Negative results indicate that the business should enter into a hedge transaction, while positive results indicate that the business should not hedge the transaction. EXAM PlE
Assuming the results of the previous two concept examples, the real cost of hedging payables with the stated exchange rate is as follows:
RCH p = NCH p - NCp RCH p = $750,000 - $735,000 RCH p = $15,000 The business should not hedge. The real cost of hedging payables indicates that the company will pay
$15,000 less if it does not hedge.
3.
Real Cost of Hedging Receivables The real cost of hedging receivables is expressed in the following formula: RCH, = NR, - NRH, RCH, is the real cost of hedging receivables. NR,
is the nominal domestic revenues received without hedging.
NRH, Is the nominal domestic revenues received from hedging.
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Negative results indicate that the business should enter into a hedge transaction, while positive results indicate that the business should not hedge the transaction. EXAMPLE
Assuming the results of the previous concept examples, the real cost of hedging receivables with the stated exchange rate is as follows: RCH, = NR,- NRH,
RCH, = $735,000 - $750,000 RCH, = -$15,000 The business should hedge. The real cost of hedging receivables indicates that the business will likely receive $15,000 less if it does not hedge. Logically, the same fact pattern applied to a liability and an asset produce equal and opposite results.
C.
Limitations on Hedging 1.
Uncertainty The amount of hedged transactions (e.g., payables or receivables) may not be known precisely prior to the execution of the futures, forward, or money market hedge. If the business hedges too much, the company is said to be overhedged. To avoid the potential of overhedging, the company should only hedge the minimum amount known to be due or payable.
2.
Continual Short·term Hedging Continual short-term hedging can be ineffective over time because it mirrors the current trends of the market. Longer-term hedges expand the gap between the exchange rate for the hedged item and the hedge itself thereby maximizing the savings or value of the hedged item.
D.
Other Techniques for Transaction Exposure Mitigation - Long-term Transactions The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure.
1.
Long-term Forward Contracts Mechanically, long-term forward contracts deal with the same issues as any other forward contracts. Long-term forward contracts are set up to stabilize transaction exposure over long periods. Long-term purchase contracts may be hedged with longterm forward contracts.
2.
Currency Swaps Transaction exposure associated with exchange rate risk for longer-term transactions can be mitigated with currency swaps.
a.
Two Firms Two firms with coincidental needs for internationai currencies may agree to swap currencies collected in a future period at a specified exchange rate. The two entities essentially swap their currencies in an exchange negotiation completed years in advance of their receipt of the currencies.
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Financial Intermediaries Typically financial intermediaries are contacted to broker or match firms with currency needs.
3.
Parallel Loan Two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date.
E.
Other Techniques for Transaction Exposure Mitigation - Alternative Hedging
Techniques The following hedge transactions are used to mitigate exchange rate risk presented by transaction exposure. 1.
Leading and Lagging Leading and lagging represent transactions between subsidiaries or a subsidiary and a parent. The entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until the exchange rate is favorable before settling (lagging).
2.
Cross-Hedging The technique known as cross-hedging involves those transactions that cannot be hedged. Hedging one instrument's risk with a different instrument by taking a position in a related derivatives contract. This is often done when there is no derivatives contract for the instrument being hedged, or when a suitable derivatives contract exists but the market is highly illiquid.
3.
Currency Diversification The simplest hedge for long-term transactions is to diversify foreign currency holdings over time. A substantial decline in the value of one currency would not impact the overall dollar value of the firm if the currency represented only one of many foreign currencies.
V.
EXCHANGE RATE RISK - Managing Economic and Translation Exposure Businesses have various methods of managing the economic and translation exposure associated with exchange rate risks. Generally, the use of organization-wide solutions related to the entity itself and related reporting requirements are included in the approach. A.
Assessing Economic Exposure Economic exposure is defined by the degree to which cash flows of the business can be impacted by fluctuations in exchange rates. The extent to which revenues and expenses are denominated in different currencies could seriously impact the profitability of an organization and represents economic exposure.
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EXAMPLE
Pete's Primo Pinatas manufactures pinatas in Mexico. The company's expenses paid to local suppliers are denominated in the peso. The company exports nearly 80 percent of its product to the United States and receives revenues denominated in United States dollars from upscale Mexican theme party planners. Ifthe peso were to strengthen in relation to the dollar, then imported revenues could be significantly less than domestic expenses. Pete's Primo Pinatas would suffer economic losses as a result of its economic exposure to exchange rate risk.
B.
Techniques for Economic Exposure Mitigation Economic exposures typically relate to organization-wide issues and can usually only be mitigated with organization-wide approaches that involve restructuring and adjustments to the business plan.
1.
Restructuring Economic exposure to currency fluctuations can be mitigated by restructuring the sources of income and expense to the consolidated entity. a.
Decreases in Sales A company fearful of a depreciating foreign currency used by a foreign subsidiary may elect to reduce foreign sales to preserve cash flows.
b.
Increases in Expenses A company anticipating a depreciating foreign currency may elect to increase reliance on those suppliers to take advantage of paying for raw materials or supplies with cheaper currency.
2.
Characteristics of Restructuring and Economic Exposure Restructuring tends to be more difficult than ordinary hedges. Economic exposures to exchange rate fluctuations are viewed as more difficult to manage than transaction exposures.
VI.
FOREIGN ECONOMIES AND POLITICAL RISK International business is subject to the generalized risk of operating within a foreign economy and to changes in the political climate. Although very little can be done to fully mitigate this risk exposure, international companies can perform a country risk analysis to fully assess the degree of their exposure. Unsatisfactory evaluation of country risk could either result in divestiture of foreign operations or avoidance of development of foreign operations in a particular country. A.
Country Risk Analysis - Foreign Economy Considerations The state of the foreign economy in which the multinational company operates is highly significant to risk evaluation.
1.
Foreign Demand A multinational corporation exporting to a foreign country is vitally concerned with demand within that country. Demand is directly affected by the health of the economy of the county in which it operates. a.
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Measures to reduce foreign penetration may either require curtailment of foreign operations or export of goods produced by the multinational inside the foreign country instead of selling within the foreign country.
Interest Rates a.
Higher interest rates in the foreign country are indicators of slower economic growth and reduced demand.
b.
Lower interest rates in the foreign country may be indicative of increased growth and demand.
Inflation Higher local inflation and reduced purchasing power makes imported goods more expensive and reduces local demand for them.
4.
B.
Exchange Rate a.
Weak local currency reduces demand for imported goods.
b.
Strong local currency increases demand for imported goods.
Country Risk Analysis - Political Risk Considerations Political risks represent non-economic events or environmental conditions that are potentially disruptive to financial operations. Although expropriation of productive resources represents the most extreme political risk, other features of political risk must also be considered inclUding:
VII.
1.
Bureaucracies and related inefficiencies or barriers to trade.
2.
Corruption.
3.
Host government attitude toward foreign firms.
4.
Attitude of consumers toward foreign firms.
5.
Inconvertibility of foreign currency.
6.
War.
FINANCIAL RISK MANAGEMENT - Transfer Pricing International businesses will likely transact businesses between the subsidiaries that cross political boundaries or between the domestic parent and foreign subsidiary. Valuation of these transactions involve transfer pricing. Transfer pricing decisions serve the purpose of minimization of local taxation while remaining within the guidelines of foreign or other host governments. A.
Intercompany Transactions - Relative Tax Rates Transfer prices (selling prices) in countries with higher tax rates will be reduced to optimum levels. 1.
Transfer selling prices in countries with higher taxes increase the tax burden but also increase the tax protection afforded to foreign subsidiaries operating in other countries, even if those subsidiaries have lower rates.
2.
Transfer prices should be set up to maximize consolidated benefit, reduce income in countries with higher taxes, and maximize the tax shield in countries with lower taxes.
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Intercompany Cash Transfers Intercompany cash transfers are often managed through use of leading and lagging. 1.
Strong Cash Position Subsidiaries with a strong cash position tend to follow a "leading" transfer policy and pay other subsidiaries in advance.
2.
Weak Cash Position Subsidiaries with a weak cash position tend to follow a "lagging" transfer policy where they would pay richer subsidiaries long after obligations were incurred as a means of preserving cash.
o
END OF ANCILLARY MATERIAL
02-108
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TASK-BASED SIMULATIONS
TASK-BASED SIMULATION SAMPLE 1 - Written Communication
,
J!
Wrftten Conununlcatlon
eltt
I I Help
ILtl Copy I ~ Pas" I ., Undo I l" .ed. I
Your company trades internationally and has strong imporUexport business. The company's exports are increasing and the dollar is getting stronger in relation to the company's trading partners. In the midst of all this good news, profitability is falling. In a memorandum to stockholders, explain why this might be happening. Type your communication in the response area below using the word processor provided.
REMINDER: Your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation.
CUT
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TASK-BASED SIMULATION SAMPLE 2 -
,
jI,
Wrltten Communlcatfan
Col
I CPA Exam Review
Written Communication
I I Help
I c<.l Copy I ~ .,,'" I "I Undo I (Ii .odo I
The president of your company, Dave Smith, is concerned about fluctuations in exchange rates on your import and export business. He has asked how the company might protect itself against these risks. In a memorandum to president, let him know your thoughts on how to reduce the risks of loss due to exchange rate fluctuations. Type your communication in the response area below using the word processor provided. REMINDER: Your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation.
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TERMINOLOGY
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
Accounting Costs
Cross Elasticity of Supply
Frictional Unemployment
Accounting Profit
Cross Hedging
Forward Exchange Rate
Accounting Rate of Return (ARR)
Currency Appreciation
Forward Hedge
Aggregate Demand (AD)
Currency Depreciation
Full Employment
Aggregate Supply (AS)
Currency Variability
Functional Currency
Annual Percentage Rate (APR)
Current Method
Futures Hedge
Average Fixed Cost (AFC)
Cyclical Unemployment
G6
Average Product (AP)
Default Risk
GOP Deflator
Average Revenue (AR)
Deflation
Globalization
Average Fixed Cost (AFC)
Demand Curve
Gross Domestic Income (GDI)
Average Total Cost (ATC)
Demand Pull Inflation
Gross Domestic Product (GOP)
Average Variable Cost (AVC)
Depression
Gross National Product (GNP)
Balance of Power
Derived Demand
Hedge Transaction
Balanced Budget
Differentiation Strategy
Implicit Costs
Best Cost Strategy
Discount Rate
Income Approach
Boycott
Diseconomies of Scale
Income Elasticity of Demand
BRIC
Disposable Income
Industry Structure Analysis
Budget Deficit
Diversifiable Risk
Inferior Good
Budget Surplus
Economic Costs
Inflation
Business Cycle
Economic Exposure
Interest Arbitrage
Cartel
Economic Profit
Interest Rate Parity
Comparative Advantage
Economies of Scale
Interest Rate Risk
Competitive Strategies
Effective Interest Rate
Internal Factors
Complements
Emerging Nations
International Fischer Effect
Compound Interest
Expenditure Approach
International Money Fund (IMF)
Consumer Price Index (CPI)
Explicit Costs
Kinked Demand Curve
Constant Returns to Scale
Exchange Rate
lagging Indicator
Contractionary Monetary Policy
Exchange Rate Risk
law of Demand
Core Competency
Expansionary Monetary Policy
law of Diminishing Returns
Cost leadership Strategy
External Factors
Law of Supply
Cost Push Inflation
Factors of Production
leading Indicator
Country Risk
Federal Reserve (Fed)
Liquidity Risk
Covered Interest Arbitrage
Final Products
long Run
Credit Risk
Fiscal Policy
Long-Run Aggregate Supply (LRAS)
Cross Elasticity of Demand
Fischer Effect
Ml
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M2
Nominal Interest Rate
Recession
M3
Non-Diversifiable Risk
Reporting Currency
Marginal Cost (MC)
Non-Monetary Assets and Liabilities
Required Reserves Ratio (RRR)
Marginal Product (MP)
Normal Good
Risk Averse
Marginal Propensity to Consume (MPC)
Oligopoly
Seasonal Unemployment
Marginal Revenue (MR)
Open Market Operations
Short Run
Marginal Revenue Product (MRP)
Opportunity Cost
Spot Rate
Market Demand
Options Hedge
Stated Interest Rate
Market Equilibrium
Parallel loan
Structural Unemployment
Market Risk
Perfect Competition
Substitutes
Market Supply
Personal Income Phillips Curve
Supply Curve
Monetary Assets and Liabilities
Price Ceiling
Supply Shock
Monetary Policy
Price Floor
Temporal Method
Money Market Hedge
Price Elastic Demand
Total Cost (TC)
Money Supply
Price Elasticity of Demand
Total Fixed Cost (TFC)
Monopoly
Price Elasticity of Supply
Total Output (Q)
Monopolistic Competition
Price Inelastic Demand
Total Variable Cost (TVC)
Monopsony
Price Inelastic Supply
Total Product
Multiplier Effect
Price Searcher
Total Revenue (TR)
Multipolar
Price Setter
Transaction Exposure
National Income
Price Taker
Translation Exposure
National Income Accounting
Production Function
Unemployment Rate
Natural Rate of Unemployment
Production Possibilities Curve
Unipolar
Natural Monopoly
Profit
Unit Elastic Demand
Natural Rate of Unemployment
Purchasing Power Parity
United Nations (UN)
Net Domestic Product
Quantity Demanded
Value at Risk
Net National Product
Quantity Supplied
Value Chain Analysis
Niche Strategy
Real GDP
Vertical Integration
Nominal GDP
Real Interest Rate
World Trade Organization (WTO)
62-112
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Business 2
CLASS QUESTIONS
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2. 3. 4. 5. 6. 7. 8. 9. 10. ll.
12. 13. 14. 15. 16. 17. 18.
1st
Multiple choice questions correct: 18 questions-
%
2nd
Multiple-choice questions correct + 18 questions:::
%
3rd
Multiple-choice questions correct + 18 questions:::
%
Final
Total questions correct
+ 18 questions:::
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NOTES
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Business 2
1. CPA-03291 Which of the following is not likely to cause a rightward shift in the aggregate demand curve? a.
An increase in wealth.
b.
An increase in the level of real interest rates.
c.
An increase in government spending.
d.
An increase in the general level of confidence about the economic outlook.
2. CPA-03307 Suppose real GDP is rising while the overall price level is falling. The most plausible explanation for this is: a.
A shift left in the aggregate supply curve.
b.
A shift right in the aggregate supply curve.
c.
A shift left in the aggregate demand curve.
d.
A shift right in the aggregate demand curve.
3. CPA-03396 Assume the following data for the U.S. economy in a recent year: Personal consumption expenditures Exports Government purchases of goods/services
M1 Imports
Gross private domestic investment Open market purchases by Federal Reserve
$5,015 billion $106 billion $1,040 billion $262 billion $183 billion $975 billion $5 billion
Based on this information, which of the following was the U.S. GDP for the year in question? a.
$6,953 billion.
b.
$6,958 billion.
c.
$6,691 billion.
d.
$7,215 billion.
4. CPA-03404 What type of unemployment is shown when individuals do not have the qualifications or skills necessary to fill available jobs? a.
Frictional.
b.
Natural.
c.
Cyclical.
d.
Structural.
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5. CPA-03395 An increase in the discount rate would cause: a.
The money supply to increase and interest rates to fali.
b. c.
The money supply to decrease and interest rates to rise. The money supply to increase and interest rates to rise.
d.
The money supply to decrease and interest rates to fali.
6. CPA-03412 If the nominal interest rate is 10% and the rate of inflation is 5%, the real interest rate is: a.
15%
b. 2% c.
50%
d.
5%
7. CPA-06081 Globalization is often measured using the following statistic: a.
Exchange rate velocity.
b. c.
World trade growth as a percentage of GOP. Exports as a percentage of imports.
d.
Shifts in global supply and demand curves.
8. CPA-06082 Globalization is frequently associated with comparative advantage and: a. b.
Increased specialization. Decreased specialization.
c.
Maintenance of global economic balance of power.
d.
Elimination of tariffs.
9. CPA-03471 Which of the following is not true regarding strategic plans? a.
Various levels of the organization will implement strategic plans differently.
b.
Continual re-evaluation and revision of strategic plans is necessary.
c. d.
The process of strategic planning begins with the creation of the plan. Strategic plans will vary by segment based on the characteristics of the segments.
10. CPA-03667 Which one of the following changes will cause the demand curve for gasoline to shift to the left? a.
The price of gasoline increases.
b. c.
The supply of gasoline decreases. The price of cars increases.
d.
The price of cars decreases.
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11. CPA-03670 The competitive model of supply and demand predicts that a surplus can only arise if there is a: a.
Maximum price above the equilibrium price.
b.
Minimum price below the equilibrium price.
c. d.
Maximum price below the equilibrium price. Minimum price above the equilibrium price.
12. CPA-03497 Elasticity of demand or supply is: a.
A measure of how flexible the firm is with respect to responding to the needs of the consumers.
b. c.
A measure of how flexible the demand or supply of a product is when preferences change. A measure of how sensitive the demand for or supply of a product is to a change in its price.
d.
A measure of how well a firm's strategic plan is able to adapt to changes in demand or supply.
13. CPA-03479 Under pure competition, strategic plans focus on: a. b.
Profitability from production levels that maximize profits. Maintaining the market share and being responsive to market conditions related to sales price.
c. d.
Maintaining the market share and planning for enhanced product differentiation. Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.
14. CPA·03493 Under oligopoly, strategic plans focus on: a.
Profitability from production levels that maximize profits.
b. c.
Maintaining the market share and being responsive to market conditions related to sales price. Maintaining the market share and planning for enhanced product differentiation.
d.
Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.
15. CPA-03583 A firm is in heavy competition with a rival firm, and its rivals are consistently able to effectively respond to changes in consumer preferences by making strategic moves in an effort to win over the buyers and gain competitive advantage. Wh ich of the five forces that affect the competitive environment and profitability of a firm does this best demonstrate? a. b.
Barriers to entry. Market competitiveness.
c.
Existence of substitute products.
d.
Bargaining power of customers.
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16. CPA-03609 When do differentiation strategies fail? a.
The firm's product appeals to different people for different reasons.
b.
The value of the firm's premium does not exceed its cost.
c.
Customers are able to see (or perceive) a value in the firm's product compared to products of other firms.
d.
The various rival firms have chosen different features on which to differentiate their products.
17. CPA·03380 If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be: a.
Risk indifferent.
b.
Risk averse.
c.
Risk seeking.
d.
Cautious.
18. CPA-03382 Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called: a. b.
Non-market risks. Unsystematic risks.
c.
Firm-specific risks.
d.
Systematic risks.
• 2-118
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Financial Management
1.
Financial modeling projections and analysis
2.
Financial decisions
3.
Capital management, including working capital
4.
Financial valuation
73
5.
Financial transactions processes and controls
78
6.
Terminology
85
7.
Class questions
87
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NOTES
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FINANCIAL MODELING PROJECTIONS AND ANALYSIS
Financial models used for capital decisions focus the financial manager on the cash flows associated with the investment and the comparison of those cash flows to expected rates or amounts of return. Financial models are designed to isolate relevant cash flows, those cash flows that will change under different alternatives, as the basis for decision-making. Because capital decisions involve long periods of time, the cash flows are frequently discounted to clearly compare investments today with cash flows anticipated in the future.
I.
FORECASTING AND TRENDS - Cash Flows Related to Capital Budgeting Proper capital budgeting is crucial to the success of an organization. The amount of cash the company takes in and pays out for an investment affects the amount of cash the company has avaiiable for operations and other activities of the company. A.
Cash Flow Effects 1.
Direct Effect When a company pays out cash, receives cash, or makes a cash commitment that is directly related to the capital investment, that effect is termed the direct effect. It has an immediate effect on the amount of cash available.
2.
Indirect Effect Transactions either indirectly associated with a capital project or that represent noncash activity that produces cash benefits or obligations are termed indirect cash flow effects. EXAMPLE
Depreciation is a non-cash expense taken as a tax deduction that will affect the amount of cash flow available. The expense will reduce the amount of taxable income, and, consequently, the related taxes. The reduced tax bill resulting from increased depreciation expense associated with a new project decreases the cash paid out. This type of effect is termed an indirect effect (or tax effect) of capital budgeting.
3.
Net Effect The total of the direct and indirect effects of cash flows from a capital investment is called the net effect.
B.
Stages of Cash Flows Cash flows exist throughout the life cycle of the capital investment project. There are three general stages in which cash flows are categorized. 1.
Inception of the Project (time period zero) Both direct cash flow effects (acquisition) and indirect cash flow effects (working capital requirements or anticipated salvage value of the replaced asset) occur at the time of the initial investment. The initial cash outlay for the project is often the largest amount of cash outflow of the investment's life.
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EXAMPLE - INDIRECT CASH FLOW EFFECTS AT TIME PERIOD ZERO
Working capital is defined as current assets minus current liabilities. When a capital project is implemented, the firm may anticipate either additional or reduced working capital commitments to ensure the success ofthe project. Additional Workinq Capital Requirements
An increase in payroll, supplies expenses, or inventory requirements means that part of the working capital ofthe organization will be allocated to the investment project and will be unavailable for other uses in the organization. Reduced Workinq Capital Requirements
Implementing a just~in*time inventory system (in which the amount of inventory required to be on hand is reduced) represents a decrease in current assets.
2.
Operations Ongoing operations of the project will impact both direct and indirect cash flows of the company.
3.
a.
The cash flows generated from the operations of the asset occur on a regular basis. These cash flows are an annuity.
b.
Depreciation tax shields create ongoing indirect cash flow effects.
Disposal of the Project Disposal of the investment at the end of the project produces direct or indirect cash flow effects. EXAMPLE
The disposal of the investment at the end of the project's life may have both direct and indirect effects. •
There may be indirect effects associated with changes in the amount of working capital committed once the project is disposed of (e.g., employees that worked on the project may no longer be needed).
•
Certain direct expenses may be incurred for the disposal (e.g., severance pay).
•
If the asset is sold, there is a direct effect for the cash inflow created on the sale and an indirect effect for the taxes due (in the case of a gain) or saved (in the case of a loss).
•
If the asset is scrapped or donated, there may be a tax savings (an indirect effect) if the net tax basis is greater than zero (i.e., the asset has not been fully depreciated).
C.
Calculation of Pre-tax and After-tax Cash Flows 1.
Pre-Tax Cash Flows The traditional computation of an asset's value is based on the cash flows it generates. Thus an investment's value is often based on the present value of the cash flows that investors expect to receive from the investment in the future. Larger cash outflows than inflows may indicate that a project is unprofitable.
2.
After-tax Cash Flows a.
General Relevant cash flows are those that we can keep after paying taxes. After-tax cash flows are computed as follows:
B3-4
(1)
Estimate net cash inflows (cash inflows minus cash outflows).
(2)
Subtract noncash tax deductible expenses to arrive at taxable income.
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(3)
Compute income taxes related to a project's income (or loss) for each year of the project's useful life.
(4)
Subtract tax expense from net cash inflows to arrive at after-tax cash flows.
(5)
Alternatively, mUltiply net cash inflows by (1 - Tax rate) and add the tax shield associated with noncash expenses (non-cash tax shield such as depreciation times the tax rate). The sum of these two amounts will equal the after-tax cash flows. Refer to the concept example below for further detail.
(6)
The tax savings or expense related to a particular cash flow equals the amount of the expense or income times the firm's marginal income tax rate. EXAMPLE
Compute after-tax cash flows based on the following facts: Annual cash inflows Depreciation Tax rate
$40,000 $10,000 40%
Transaction data Cash inflows Depreciation Pre-tax income Tax rate Net income
Pre-tax
After-tax
$40,000 10.000 30.000 407. 112,000) $18 000
After-tax Cash Flows Cash inflows
$40,000
Taxes
(\2.o0Q)
After-tax cash flows
:IU,ooo
After-tax cash inflows = Pretax cash inflows x (1- Tax rate) Tax shield for expenses = Expense x Tax rate
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Additional Taxation Issues (1)
Operating cash flows can differ from net income.
(2)
All taxes reported on an income statement may not be applicable to the current year. Further, actual taxes paid may exceed the tax estimate made on the income statement.
(3)
Changes in working capital will represent a source or use of cash but are not taxed when computing tax expenses on cash flows. PASS
KEY
•
Multiply pre-tax cash flow by (1- Tax rate) as a shortcut to compute the after-tax cash flows.
•
Multiply noncash tax shield items (such as depreciation) by the tax rate as a component of total after~tax cash flows.
EXAMPLE - FACTORS THAT AFFECT INCOME TAXES AND CASH FLOWS, ASSET DISPOSITION
When a company's assets are abandoned, sold, or traded~in as a result of a new asset acquisition, there may be immediate income tax effects. The increase or decrease in income taxes paid at that time causes an increase or decrease in the cash outlay related to the acquisition.
1. Asset Abandonment If an asset is abandoned, the net salvage value is treated as a reduction of the initial investment in the new asset. The abandoned asset's book value is considered a sunk cost, and therefore not relevant to the decision~making process. The remaining book value (for tax purposes) is deductible as a tax loss, which reduces the liability in the year of abandonment. This tax liability decrease is considered a reduction of the new asset's initial investment.
2. Asset Sale If new asset acquisition requires the sale of old assets, the subsequent gain or loss has no effect on the capital expenditure decision because the book value of the old asset is a sunk cost. The cash received from the sale of the old asset reduces the new investment's value. If a gain or loss (for tax purposes) exists, there is also a corresponding increase or decrease in income taxes. The amount of income tax paid on a gain on a sale is treated as a reduction of the sales price (which increases the initial expenditure). Conversely, a reduction in tax resulting from a loss on sale is treated as a reduction ofthe new investment. 3. Asset Trade-In Generally, no gain or loss is recognized on the trade~in of an old asset for tax purposes; hence, there is no tax effect. The traded~in
asset's book value becomes a portion of the depreciable basis of the new asset, resulting in additional
depreciation for tax purposes in later years and the reduction of taxes payable in those later years. Therefore, the cash outflows in the later years will decline.
B3-6
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Review
Comprehensive Concept Example - Cash Flows for Capital Budgeting The following comprehensive example is broader in scope than a multiple choice question but addresses the following cash fiow issues associated with: •
Determining total cash outfiow (similar in concept to asset capitalization),
•
Computing after-tax cash infiows after consideration of both the net cash inflows and depreciation tax shield, and
•
Computing the impact of salvage value in the final year. EXAMPLE
Facts
The divisional management of Carlin Company has proposed the purchase of a new machine that will improve the efficiency of the operations in the company's manufacturing plant. The purchase price of the machine is $100,000. Costs associated with putting the machine into service include $10,000 for shipping, $15,000 for installation, and $5,000 for the initial training. Carlin expects the machine to last 10 years and to have an estimated salvage value of $7,000. The machine is expected to produce 4,000 units a year with an expected selling price of $800 per unit and prime costs (direct materials and direct labor) of $750 per unit. Tax depreciation will be under the accelerated straight-line rules (not MACRS) for S-year property with no consideration for salvage value (Le., the entire asset amount capitalized will be depreciated). Carlin has a marginal tax rate of 40%. Cash Flow at the Beginning
of the First Year fDr Capital Budgeting Analysis
The net cash outflow at the beginning of the first year is calculated as follows: Initial investment
$(100,000)
Shipping
(10,000)
Installation
(15,000) (5,000)
Training
$(130,000) [Outflow]
Total
Sample Year: Net Cash FIDw fDr the THIRD Year (Year 3) for Capital Budgeting Analysis
Net cash flow from sales less: Taxes on net sales
$200,000 [4,000 x ($800 - $750)] (80,000) [$200,000 x ,40]
Add: Net indirect effect of depreciation on machine
Total
10.400 [($130,000/5) x .40] $130,400 [Inflow]
Net Cash Flow for the FINAL Year (Year 10) for Capital Budgeting Analysis
Net cash flow from sales less: Taxes on net sales Depreciation Salvage value
Total
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$200,000 [perabove] (80,000) [per abovel -
[fully depreciated by Year 10J
4.200 [$7,000 gain x .60, which is net of tax) $124.200 [inflow)
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FINANCIAL ANALYSIS - Discounted Cash Flow (DCF) DCF valuation methods (including the net present value and the internal rate of return methods discussed below) are techniques that use time value of money concepts to measure cash inflows and cash outflows of a project as if they occurred at a single point in time. DCF methods are considered the best methods to use for valuation of assets and liabilities that are realized over long periods of time. A.
Objective and Components of Discounted Cash Flow as Used in Capital Budgeting The objective of the discounted cash flow (DCF) method is to focus the attention of management on relevant cash flows appropriately discounted to present value. The factors used to evaluate capital investments under discounted cash flow include the dollar amount of the initial investment, the dollar amount of future cash inflows and outflows, and the rate of return desired for the project. 1.
Initial Investment The initial investment using discounted cash flows include both direct and indirect cash effects. EXAMPLE
If additional working capital is required, it is treated as an immediate cash outflow that is recovered at the end of the investment's life. The inflow at the end of the period must be discounted because costs typically come in the early years and the benefits typically come in the later years. By discounting the later cash flows, the cash flows can be compared as if they had occurred in the same year. 1.
In some projects, increasing sales may require increasing working capital. This may be considered an outflow in period zero (current time), but it may also require outflows in future periods.
2.
When the project is shut down, typically that working capital is not needed, so it becomes a cash inflow in the last period.
3.
Final cash inflow (savings) should be discounted back to the present using the appropriate discount factor for the final year of the outflow.
2.
Future Cash Inflows and Outflows DCF methods distill the incremental expected direct and indirect future cash inflows and cash outflows, not accrual (GAAP) accounting, from proposed investment transactions.
3.
Rate of Return Desired for the Project The rate used to discount future cash flows is set by management using any number of different approaches.
B3-8
a.
Management may use a weighted-average cost of capital (WACC) method,
b.
Management may simply assign a target for new projects to meet,
c.
Management may recommend that the discount rate be related to the risk specific to the proposed project. If the proposed project is similar in risk to the ongoing projects of the company, WACC is appropriate because it reflects the market's assessment of the average risk of the company's projects.
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Applying Cash Flows with Discounting to Business Decisions EXAMPLE -
CASH FLOWS WITH
DISCOUNTING
Facts Rainmaker Industries is considering the purchase of an attachment for its molding machine that will cost $5,000. The attachment will be usable for five years, after which time it will have zero salvage value. It is estimated that the attachment will increase net cash flows by $2,000 per year in the molding department. Rainmaker's CEO has advised that no investments are to be made unless they promise an annual return of at least 12%. Initial cost
$5,000
Life of machine (in years)
5
Annual net cash inflow
$2,000
Salvage value
$0
Required rate of return
12%
Amount of Cash Flow
Year!sl
Element Annual net cash inflow Initial investment
12%
Factor
1,2,3,4,5
$2,000
x
3.605
Current year
(5,000)
x
1.000
Present Value of Cash Flows 15.000) $2210
Net present value
1.
$7,210
Note that the present value factor of an ordinary annuity of $1 (annuity in arrears) for five (5) years at
12% is 3.605. 2.
Note also that the molding attachment promises a return greater than 12% on the original investment because the net present value is greater than zero at a 12% discount rate. (NPV is discussed in more detail later in this outline.)
3.
Each annual cash inflow arising from the attachment is comprised of two parts. The first part represents a recovery of a portion of the original $5,000, and the second part represents a return on this investment. (continued)
PASS
KEY
Discounted cash flow is the basis for net present value methods (introduced later):
5lep #1:
Calculate after-tax cash flows = Annual net cash flow x (1- Tax rate)
Slep #2:
Add depreciation benefit = Depreciation x tax rate
Slep #3:
Multiply result by appropriate present value of an annuity
5lep #4:
Subtract initial cash outflow
Resull:
Net present value
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EXAMPLE -
CASH FLOWS WITH DISCOUNTING (continued)
Requirement Review the following schedule of annual cash inflows related to the Rainmaker molding attachment using the 12% discount rate.
A Investment Outstanding During the Year
B
C
D
Cash Inflaw
12% Return on Investment
E Unrecovered Investment at the End of the Year
$2,000
$600
2
$5,000 3,600
Recovery of Investment During the Year (8 - C) $1,400
2,000
432
1,568
$3,600 2,032
1,756
276
Year
fA x 12%)
1
(A-D)
3
2,032
2,000
244
4
276
2,000
33
276*
-
5
-
2,000
-
-
-
Total investment recovered:
llil!!Q
* Note that full recovery occurs in Year 4 because $2,000 $33 =$1,967, and this is greater than the unrecovered $276 at the beginning of Year 4. Explanation
1.
The cash inflow is usually easily determinable (or given) for these decisions.
2.
The cash inflow for a particular year will be used to calculate the annual recovery of the investment.
a.
The annual recovery of the investment (Le., return of capital) is calculated as the annual cash flow less the return on investment (i.e., 12% times the outstanding investment during the year).
b.
For example, the $2,000 cash inflow for Year 1 consists of a $600 return (12%) on the original investment of $5,000 plus a $1,400 return of that $5,000 investment.
3.
As the amount of the unrecovered investment decreases over the five years, notice that the dollar amount of the original investment also decreases.
o
4.
By the end of the fourth year, all $5,000 of the original investment has been recovered.
5.
Cash inflows in Year 5 represent a return above and beyond what was initially required by the Rainmaker CEO.
END OF ANCILLARY MATERIAL
C.
Limitation of Discounted Cash Flow - Simple Constant Growth Assumption Discounted cash flow methods are widely viewed as superior to methods that do not consider the time value of money; however, discounted cash flow methods do have an important limitation-they frequently use a simpie constant growth (single interest rate) assumption. This assumption is often unrealistic because, over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate.
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PAYBACK PERIOD METHOD The payback period is the time required for the net after-tax cash inflows to recover the initial investment in a project. A.
Objective of Payback Period Method The payback period method focuses decision makers on both liquidity and risk. 1.
Liquidity The payback period method measures the time it wiil take to recover the initial investment in the project thereby emphasizing project's liquidity and the time during which return of principal is at risk.
2.
Risk The payback method is often used for risky investments. The greater the risk of the investment, the shorter the payback period that is expected (tolerated) by the company.
B.
Calculation The formula for calculating the payback period is as foilows:
Payback period ~
C.
Net initial investment ---=======--Increase in annual net after-tax cash flow
Cash Flow Assumptions 1.
Uniform Cash Inflows The net cash inflows are generaily assumed to be constant for each period during the life of the project. The payback period is computed at the point of initial investment using after-tax cash flows. Cash flows involve the foilowing factors: a.
Project Evaluation In the case of a project, the net cash inflow would be the net cash receipts associated with the project.
b.
Asset Evaluation In the case of the purchase of equipment, the net annual cash inflow will be the savings generated by use of the new equipment.
c.
Depreciation Tax Shield Depreciation expense is not considered, except to the extent that it is a tax shield. The formula for the tax shield is: Depreciation tax shield = Depreciation expense x Marginal tax rate
PASS KEY
Some questions on the CPA Exam have asked the candidate to calculate the before-tax operating cash savings from given information. If this is the case, drop the given information into the formula in item B, above. Calculate the expected depredation tax shield (as shown above), and use algebra to solve for the unknown.
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2.
Non-Uniform Cash Flows (use cumulative approach) The standard payback formula shown above applies to uniform annual cash inflows. If cash flows are not uniform (i.e., they vary from period to period over the life of the project), a cumulative approach (rather than the standard payback formula) to determining the payback period is used. a.
Accumulate Until Equal to Initial Net Investment The net after-tax cash inflow per year is used as the basis for evaluation of projects with non-uniform cash flows. These net after-tax cash inflows are accumulated until the time that they equal the initial net investment.
b.
End of the Payback Period The point where the cumulative net after-tax inflows equal the initial net investment is the end of the payback period.
D.
Advantages and Limitations of Payback 1.
Advantages of the Payback Method a.
Easy to Use and Understand The simplicity of the objective and the absence of complex formulas or multiple steps makes the payback method easy to use and understand.
b.
Emphasis on Liquidity The computation focuses management on return of principal. The method's emphasis on liquidity is a very important consideration when making capital budgeting decisions (e.g., most companies will prefer shorter payback periods, all other factors being equal).
2.
E.
Limitations of the Payback Method a.
The time value of money is ignored.
b.
Project cash flows occurring after the initial investment is recovered are not considered.
c.
Reinvestment of cash flows is not considered.
d.
Total project profitability is neglected.
Alternate Payback Approach - Bailout Payback Method Cash flow assumptions of the payback method can be conservativeiy modified by using "bailout" payback assumptions. This modification to the payback method assumes that the investment salvage value should be included in cash inflows before the end of the project. 1.
Objective The bailout payback method computes the minimum amount of time to recover the initial investment using both cash flows from the project and liquidation of the investment.
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Bailout Assumption The method assumes the investor "bails out" of the investment before the end of the project and the salvage value serves as part of the cash flow needed to recoup the initial investment.
o
END OF ANCillARY MATERIAL
F.
Applying Payback Period to Business Decisions EXAMPLE
Facts Helena Company is planning to acquire a $250,000 machine that will provide increased efficiencies, thereby reducing annual operating costs by $80,000. The machine will be depreciated by the straight-line method over a five-year life with no salvage value at the end of five years. Assuming a 40% income tax rate, calculate the machine's payback period. Answer
(1)
Calculate the annual net cash savings (also referred to as the "average expected cash flows"), as follows: Expected cash flow savings Net income increase Less: Annual depreciation Net income before income taxes Times 40% tax rate Net cash savings
$80,000 $80,000 (50,000) $30,000 ~%
(2) Calculate the payback period, as follows: _ _---'I"nv"e"s"tm"e"n"t = $250,000 Average expected cash flows $68,000
3.68 years
(or net cash savings)
AN C III A R Y MAT E RIA l
IV.
(for Independent ReView)
DISCOUNTED PAYBACK METHOD Companies may use the discounted payback method as an alternative to the non-discounting payback method described above. This variation computes the payback period using expected cash flows that are discounted by the project's cost of capital (the method considers the time value of money). Discounted payback is also referred to as the "breakeven time method" (or BET).
A.
Objective of Discounted Payback The objective of the discounted payback method (or BET) is to evaluate how quickly new ideas are converted into profitable ideas. 1.
Focus on Liquidity and Profit The measure focuses decision makers on the number of years needed to recover the investment from discounted net cash flows. Profit is built into cash flows using the discount rate.
2.
Evaluation Term The computation begins when the project team is formed and ends when the initial investment has been recovered (based on cumulative discounted cash flows).
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Common Projects Using Discounted Payback Discounted payback (or BET) is often used to evaluate new product development projects of companies that experience rapid technological changes. These companies want to recoup their investment quickly, before their products become obsoiete.
B.
Advantages and Limitations of Discounted Payback The advantages and limitations of discounted payback are the same as the payback method (except that discounted payback incorporates the time value of money, a feature ignored by the payback method). Both focus on how quickly the investment is recouped rather than overall profitability of the entire project.
C.
Applying Discounted Payback to Business Decisions EXAMPLE
Facts Radon Technologies is considering the purchase of a new machine costing $200,000 for its surfboard manufacturing plant in
San Diego, CA. The company's discount rate for projects of this type is 10%. The management of Radon estimates that the new machine will last approximately 4 years and will be directly responsible for efficiencies that will increase the company's after-tax cash flows by the follOWing amounts (non-uniform cash flow): Year 1
$90,000
Year 2
80,000
Year 3 Year 4
75,000
GO,ono
The present value interest factors for 10% are as follows: Year 1 Year 2 Year 3 Year 4
.909 .826 .751 .683
Requirement What is the discounted payback period for this investment?
Solution 1.
2.
Calculate the Present Value of the Future Cash Flows Year
Cash Flow Increase
Discount Factor
10% PV of Cash Flow
Cumulative PV
Year 1 Year 2 Year 3 Year 4
$90,000 80,000 75,000 60,000 $305000
.909 .826 .751 .683
$81,810 66,080 56,325 40,980 $245195
$81,810 147,890 204,215 245,195
Determine the Discounted Payback Period The cumulative present value reaches the initial investment amount of $200,000 in year 3. Therefore, the discounted payback period would be over two years and under three years. Assume that the cash flow is earned evenly throughout the year. The discounted payback period is then calculated as follows: a.
Amount of cash flow in year 3 needed to attain $200,000 cumulative cash flows: $200,000 - $147,890 (Year 2'5 cumulative amount) = $52,110
b.
Percentage of Year 3 until cumulative amount of $200,000 is attained: $52,110 $56,325
c.
o
2 + .925
:=
92.5%
2.925 years discounted payback
END OF ANCillARY MATERIAL
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NET PRESENT VALUE METHOD (NPV) A.
Objective The net present value method of capital budgeting is one of several discounted cash flow techniques used to screen capital projects for implementation. 1.
Objective of the Net Present Value Method The objective of the net present value method is to focus decision makers on the initial investment amount that is required to purchase (or invest) in a capital asset that will yield returns in an amount in excess of a management designated hurdle rate.
2.
Basis of Evaluation NPV requires managers to evaluate the dollar amount of return rather than either percentages of return (as described below for the internal rate of return method) or years to recover principal (as described above for the payback methods) as a basis for screening investments.
B.
Calculation of Net Present Value 1.
Estimate the Cash Flows Estimate all direct and indirect after-tax cash flows (both inflows and outflows) related to the investment. a.
Ignore Depreciation (unless a tax shield) As with DCF methods, depreciation is ignored except to the extent that it reduces tax payments (i.e., a tax shield). Use of accelerated (instead of straight-line) depreciation methods increases the present value of the depreciation tax shield.
b.
Ignore Method of Funding The method of funding has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. The method of financing the project and the related cost are independent of the process of screening investment alternatives under NPV.
2.
Discount the Cash Flows Discount all cash flows (both inflows and outflows) to the present using the appropriate discount factor based on the hurdle rate and the timing of the cash flow. (The net present value method assumes that the cash flows are reinvested at the same rate used in the analysis.) a.
Hurdle Rate (desired rate of return) The hurdle (target) rate is the desired (or minimum) rate of return that is set by management to evaluate investments.
b.
Hurdle Rate Options (1)
Opportunity Cost The discount rate could be set at the next best alternative rate the firm could have achieved had it invested the same funds in a project with similar risk (the next best alternative is the opportunity cost); however, it is often very difficult to determine (and often quite costly!).
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Management Selection Companies may choose to use a different method of selecting the hurdle rate as an alternate to opportunity cost. These may include the cost of capital or the minimum rate of return set by management based on the strategic plans of the company, the returns earned in the industry, and the other choices it has to invest.
3.
Compare Compare the present values of inflows and outflows.
C.
Interpreting the NPV Method The net present value method is interpreted based upon whether the net computation is positive or negative. 1.
Positive Result (Result> or
=Zero) =Make Investment
If the result is positive (greater than zero), the rate of return for the project is greater than the hurdle rate (the discount percentage rate used in the net present value calculation), the investment should be made. If the company has unlimited funds all projects with a net present value greater than (or equal to) zero should be accepted. Project ranking and acceptance techniques in circumstances involving limited capital are described below. 2.
Negative Result (Result < Zero)
=Do Not Make Investment
If the result is negative (less than zero), the rate of return for the project is less than the hurdle rate and the investment should not be made because it does not meet management's minimum rate of return. (As discussed below, a negative NPV means that the internal rate of return on the investment is less than management's hurdle rate for the project.) D.
Interest Rates Adjustments for Required Return As mentioned above, net present value analysis may incorporate many types of hurdle rates, such as the cost of capital (the average rate of return demanded by investors), the discount rate of the opportunity cost, or some other minimum required rate of return. All rates, except for the cost of capital, are determined by management. 1.
Adjustments to Rate Rates may be modified (generally increased) to adjust for: a.
Risk Discount rates may be increased to further factor differences in risk into the analysis. EXAMPLE
Management would select a high hurdle rate for certain projects to factor risk into its consideration of acceptance of those projects. The higher hurdle rate discounts (reduces) future cash flows more, creating a smaller present value, which stands a larger chance of being below zero and not being selected. By "devaluing" the cash flows for a certain project, the NPV model compensates for risk.
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Inflation (also affects cash flows) Rates may be raised to compensate for expected inflation. EXAMPLE
Assume management anticipates higher than normal inflation. To compensate for the falling value of the dollars it anticipates from its cash flows, the interest rate (discount factor) may be increased. In addition, the future cash flows should also be increased to the extent of predicted inflation, If management anticipates no change in tax rates, cash flows generated from the effects of depreciation would not be adjusted because they relate to the original investment.
2.
Differing Rates Different rates may be used for different time periods using the NPV method. For example, 12% might be the rate for the first three years, and 15% (Which reflects a greater risk) might be the rate for subsequent years. If the NPV is greater than zero, the decision will be acceptable. PASS
KEY
The NPV method of capital investment valuation is considered to be superior to the Internal Rate of Return (lRR) method (discussed below) because it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.
3.
Discount Rate Applied to Qualitatively Desirable or Non-optional Investments A project that meets qualitative management criteria for investment (e.g., mandated technology investments) is purely subject to financing, rather than capital budgeting, considerations. The discount rate used for NPV evaluation should be the after-tax cost of borrowing, sometimes called the incremental borrowing rate.
E.
Applying the Net Present Value Method to Business Decisions The following comprehensive concept example is broader in scope than a mUltiple choice question but demonstrates the treatment of several of the most significant issues associated with NPV including: •
Fluctuating depreciation amounts resulting in different tax shield amounts each year;
•
Computation of after-tax cash flows;
•
Discounting of uneven cash flows;
•
Computation and discounting of cash flows associated with salvage; and
•
Assembly of all amounts into a net present value computation.
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NET PRESENT VAULE
Facts Mclean, Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity that the equipment will be fully depreciated for tax purposes 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects. Discount rates for a 16% rate are as follows: Present Value of$l .862 .743 .641
Year! Year 2 Year 3
Present Value of an Ordinary Annuity 0($1 .862 1.605 2.246
Requirement What is the net present value of this project, and should this project be accepted if there are unlimited funds available in the capital budget? Solution 1. Annual Depreciation Shield First, calculate the annual depreciation tax shield as follows (depreciation x tax rate): Years 1 and 3 (30%} Cost of asset Depreciation % Annual depreciation Tax rate Tax shield 2.
$150,000 x 30% $ 45,000 x 40% $ 18.000
Year 2 $150,000 x 40% $ 60,000 x 40% $ 24,000
Annual Savings Calculate the after-tax annual savings as foHows (savings x (!- tax rate)):
Annual savings = $85,000 [savings per year] x (1 - 040) Annual savings =$85,000 x .60 Annual savings = $51,000 3.
Salvage Value Inflow Calculate the salvage value inflow as follows: Proceeds from salvage less: Basis of machine Gain on salvage
$10,000 [fully deprecialed] $10,000 (4,000) [$10,000 x 40%] $ 6,000 [$10,000 x (1- 040)]
Less: Taxes Cash inflow 4.
Net Present Value Schedule and Calculation Equipment cost Depreciation tax shield Annual savings Salvage value inflow After-tax cash flow Discount rate Present value
Year 1
Year 2
$18,000 51,000
$24,000 51,000
Year 0 $(150,000)
x
(150,000) 1.00 (150,000)
x
69,000 .862 59,478
x
75,000 .743 55,725
Year 3
$18,000 [from 1, above] 51,000 [from 2, above] 6,000 [from 3, above] 75,000 .641 48,075 = $13,278
x
Reminder: If after-tax cash flow was the same each year, use an annuity table.
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Advantages and Limitations of the Net Present Value Method 1.
Advantages The Net Present Value method is flexible and can be used when there is no constant rate of return required for each year of the project.
2.
Limitations Even though NPV is considered the best single technique for capital budgeting. the net present value method of capital bUdgeting is limited by not proViding the true rate of return on the investment. The NPV purely indicates whether or not an investment will earn the "hurdle rate" used in the NPV calculation.
AN C III A R Y MAT E R I A l
VI.
(for Independent ReView)
INTERNAL RATE OF RETURN (IRR) The IRR is one of several discounted cash flow methods used to screen the acceptability of investments. The IRR is the expected rate of return of a project and is sometimes called the timeadjusted rate of return. The IRR method determines the present vaiue factor (and related interest rate) that yields an NPV equal to zero. (The present value of the after-tax net cash flows equals the initial investment on the project.)
A.
Objective The IRR method focuses the decision-maker on the discount rate at which the present value of the cash inflows equals the present value of the cash outflows (usually the initial investment). PASS KEY
While the NPV method highlights amounts, the IRR method focuses decision makers on percentages.
B.
Computing Internal Rate of Return (IRR) IRR is generally calculated through trial and error and interpolation. IRR is the rate used to compute an NPV of O. The process is as follows: Set up the formula for NPV = 0 and derive key amounts Annuity x Present value factor = Investment Present value factor = Investment + Annuity Note: The present value factor
=the payback period.
1.
Determine the Life of the Project or Asset
2.
Calculate the Payback Period (present value factor) Net incremental investment Payback period (present value factor) = ----c----:-:c--Net annual cash flows
3.
Find Proper Present Value Table to Use Refer to the present value table that relates to the type of cash flow (e.g .. if the cash flows represent an annuity, the present value of an annuity of $1 table would be used).
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_._._--------------------------, 4.
Locate Present Value Interest Factor
Locate the section of the table that equals the life of the project or asset determined in Step 1 (above). Locate the factor on the table that is closest to the payback period (present value factor) derived in Step 2 (above). 5.
Find 'Approximate IRR The interest rate that corresponds to the factor located in the line associated with the life of the project is the approximate IRR.
C.
Interpreting IRR for Investment Decisions Using IRR, the targeted rate of return or hurdle rate is predetermined and is compared to the computed IRR. 1.
Accept when IRR > Hurdle Rate Projects with an IRR greater than the hurdle rate will be accepted.
2.
Reject when IRR < or Equal to the Hurdle Rate Projects with an IRR less than or equal to the hurdle rate will be rejected.
D.
Applying IRR to Business Decisions EXAMPLE
Facts The purchase of an asset with a life of 5 years is being evaluated. The asset costs $12,000 and is estimated to produce a net annual cash inflow of $3,000. Calculate the approximate IRR.
Calculation offRR Calculation of the approximate IRR follows: Step 1: The life of the asset is five (5) years.
Step 2: The payback period is calculated to be 4.00 ($12,000 / $3,000). Step 3: Because the annual cash flow is an annuity, the present value of an annuity of $1 table is used. Present Value of an Annuitv of $1 for n Periods
n
4%
5%
6%
7%
8%
9%
1 2 3 4 5
.962 1.886 2.775 3.630 4.452
.952 1.859 2.723 3.546 4.329
.943 1.833 2.673 3.465 4.212
.935 1.808 2.624 3.387 4.100
.926 1.783 2.577 3.312 3.993
.917 1.759 2.531 3.240 3.890
6 7 8 9 10
5.242 6.002 6.733 7.435 8.111
5.076 5.786 6.463 7.108 7.722
4.917 5.582 6.210 6.802 7.360
4.767 5.389 5.971 6.515 7.024
4.623 5.206 5.747 6.247 6.710
4.486 5.033 5.535 5.995 6.418
Step 4: The closest factor (closest to the calculated payback period of 4.0) located on the line for five (5) periods in the present value of an annuity of $1 table is 3.993. Step 5: The interest rate that corresponds to the 3.993 factor is 8%. Answer
The approximate IRR for the above concept exercise is 8%.
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PASS
KEY
IRR does not lend itself to effective testing in a multiple choice format. The likelihood of seeing complex computational questions in this area is low; however, having a general understanding of the concepts that underlie this technique is important as a basis for comparing and contrasting IRR to the NPV method.
E.
Limitations of IRR 1.
Unreasonable Reinvestment Assumption Cash flows from the investment are assumed in the IRR analysis to be reinvested at the internal rate of return. If internal rates of return are unrealistically high or unrealistically low, assumed returns on reinvested cash flows based on IRR rates could lead to inappropriate conclusions.
2.
Inflexible Cash Flow Assumptions The timing or the amount of cash flows used to determine IRR can be misleading when compared to the NPV method. The IRR method is less reliable than the NPV method when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the cash flows differ significantly. IRR and NPV may rank investments differently if the cash flow amounts and timing differ significantly.
3.
Evaluates Alternatives Based Entirely on Interest Rates The IRR method evaluates investment alternatives based upon the achieved IRR and does not consider the amount of the profit. EXAMPLE
If an investment of $50 earns $100, then there is a 200% return [100/50 = 200%]. If an investment of
$50,000 earns $25,000, then there is a 50% return [25/50" 50%1. The IRR method would suggest that it would be best to invest $50 to earn $100 and receive a 200% return, while the NPV method would favor the
larger $25,000 NPV on the $50,000 investment.
o
END OF ANCILLARY MATERIAL
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VII.
CAPITAL RATIONING Financial models for capital decision making represent methods used by management to screen projects for minimum rates of return. Ultimately the decision to invest or not is limited by the amount of capital available to fund the investment. The concept of capital rationing describes how limited investment resources are considered as part of investment ranking and selection decisions.
A.
Unlimited Capital Ideally, a company has virtually unlimited resources at its disposal, so the company may do everything (or nearly everything) that meets the company's screening criteria. Investments are undertaken in the order that they are ranked. If a company has unlimited capital, all investment alternatives. with a positive NPV should be pursued.
B.
Limited Capital Realistically, a company has extremely limited resources that make its investment choices mutually exclusive (i.e., if one investment Is chosen over another, the company does not have the option of "hedging its bet" with the second alternative because resources are entirely committed).
1.
Importance Capital bUdgeting decisions involve a tremendous amount of money, time, and risk. If the company is down to two mutually exclusive choices, the importance of clearly defined calculations is just that much more critical.
2.
Ranking and Acceptance If capital is limited and must be rationed, managers will allocate capital to the combination of projects with the maximum net present value. Ranking of projects from a group of qualifying investments (those that exceed the hurdle rate) is best accomplished using the profitability index (described below) and becomes especially important when projects are independent (i.e., mutually exclusive).
VIII. PROFITABILITY INDEX The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Ranking and selection of investment alternatives anticipate positive net present values for all successfully screened investments. The profitability ratio will likely be over 1.0, which means that the present value of the inflows is greater than the present value of the outfiows. " b'l" . d Pro f Ita I Ity In ex
A.
Present value of net future cash inflow Present value of net initial investment
Measures Cash Flow Return per Dollar Invested The profitability index measures cash-flow return per dollar invested; the higher the profitability index the more desirable the project.
B.
Application Projects that meet the screening criteria (e.g., positive NPV) are ranked in descending order by their profitability index. Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.
B3-22
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FINANCIAL DECISIONS
The financial manager is often required to decide between different alternatives. These decisions frequently involve identification of variables and the development of financial models. The manager uses the model to predict outcomes for various alternatives using different assumptions for the variables included in the model. This section deals with financial decisions and, by extension, various factors that impact financial models. Financial decisions involve numerous elements including consideration of relevant costs and probability analysis.
I.
IDENTIFYING THE STEPS NEEDED TO REACH A DECISION Steps commonly recognized as being necessary to reach a decision include obtaining information, identifying alternative courses of action, making predictions about future costs, choosing an alternative, implementing a decision, and evaluating performance to provide feedback. Steps necessary to make decisions are generally evaluated within the context of a decision-making process. A.
Determine the Strategic Issues Managers begin the decision-making process by identifying problems and focusing on strategic, rather than short-term issues associated with those problems.
B.
Specify Criteria and Identify Alternative Courses of Action Managers identify multiple criteria associated with the decision. 1.
Short-term Quantifiable Criteria Managers may initially focus on short-term operational issues that produce quantifiable criteria (e.g., reduced cost, increased profitability, improved return on investment, etc.).
2.
Non-quantifiable Criteria Managers must also often focus on non-quantifiable criteria (e.g., shareholder value requirements required by owners, quality requirements imposed by customers, etc.).
C.
Perform Analysis of Relevant Costs and Strategic Costs 1.
Obtain Information Managers must identify and collect information relevant to the decision criteria.
2.
Make Predictions about Future Costs Managers must predict the future values of relevant costs and revenues.
3.
Consider Strategic Issues Managers must consider the degree to which quantifiable and non-quantifiable data address the issues associated with the multiple objectives.
D.
Choose an Alternative Seiection and implementation of the best course of action is the concluding step in the decision-making process. Managers select a course of action that best addresses the strategic objectives identified in the first step, and they then implement the decision.
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Evaluate Performance to Provide Feedback The final phase of the decision-making process is to evaluate the effectiveness of the decision in accomplishing strategic objectives as a means of identifying and refining future decisions.
F.
Applying Decision Making Steps to Business Situations Determining strategic issues and identifying both the relevant costs and strategic costs associated with a particular decision are logical, sequential, and easily understood with an example. EXAM PlE
Nurture Corporation has focused on reducing its general and administrative expenses as part of its overall strategy to improve profitability. The company has targeted the Human Resources Department as a potential area where costs savings might be achieved without jeopardizing the company's longstanding goal of nurturing and developing its employees. The managers follow a general decision-making process as follows:
Determine the strategic issues: The company desires cost savings without sacrificing employee satisfaction. Specify the criteria and identifY alternative actions: Managers identify targeted cost savings and their anticipated employee satisfaction survey results. They identify actions such as reducing staffing in Human Resources, replacing human resource employees with contract labor, outsourcing the process altogether, or implementing employee leasing.
Relevant cost and strategic cost analysis: Managers identify the costs that will change in the event that alternatives are selected in comparison to current operations as well as the long-term impact on program changes. Select and implement the best course of action: Management decides on outsourcing various functions of Human Resources (including staff training and development and recruiting) as a means of stabilizing the costs of these functions. As a means of maintaining its nurturing objectives, however, management elects NOT to outsource employee relations or performance evaluations.
Evaluate performance: Compare human resource costs before and after implementation of the outsourcing. Compare results of employee satisfaction surveys before and after implementation of the outsourcing initiative.
II.
RELEVANT DATA CONCEPTS - Future-oriented Revenues and Costs Future revenues and costs are only deemed to be relevant if they change as a result of seiecting different alternatives. Costs that do not change as a result of a course of action are not relevant because they do not impact the total costs that result from the decision. Traditional absorption costing, which commingles fixed and variable costs in the determination of net income, does not consistently produce relevant information.
A.
Cost Behavior Although variable costs are more likely to be relevant because they change with production volume and output, relevant costs can be either fixed or variable.
B.
Characteristics of Relevant Costs Relevant costs often share similar characteristics. including their specific traceability to cost objects that may change as a result of selecting different alternatives. Ultimately, a cost's relevance pertains to its potential to affect the decision.
1.
Direct Costs Direct costs are costs that can be identified with or traced to a given cost object. Direct costs are usually relevant (variable costs are generally direct costs).
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Prime Costs Prime costs include direct material and direct labor and are generally relevant. EXAMPLE
1. Costs related to a special device that is necessary if a special order is selected are relevant. 2. Costs associated with alternative uses of plant space are relevant.
3.
Discretionary Costs Discretionary costs are costs arising from periodic (usually annual) budgeting decisions by management to spend in areas not directly related to manufacturing. Discretionary costs are generally relevant. EXAMPLE
Costs to maintain landscaping at corporate headquarters are generally viewed as discretionary.
C.
Alternate Terms for Relevant Costs Relevant costs are also referred to using a number of the following alternate terms: 1.
Incremental Costs Incremental costs (also known as differential costs or out-of-pocket costs) are the additional costs incurred to produce an additional amount of the unit over the present output.
2.
Avoidable Costs Avoidable costs (revenues) result from choosing one course of action instead of another. As a result, the firm avoids the cost (revenue) associated with the other course of action. a.
Costs or revenues that will be the same regardless of the chosen course of action are not relevant to future decisions. These costs (also called unavoidable) will continue regardless of the course of action taken. They have no effect on the decision.
b.
Absorption costs represent the allocated portion of fixed manufacturing overhead. Absorption costs are not relevant to future decisions to the extent that they represent unavoidable fixed costs. EXAMPLE
Electramag Corporation is evaluating whether or not to replace a piece of equipment. Under either alternative (keep the old equipment or replace it), the anticipated cost of electricity remains the same. Electrical costs are a variable cost. Even so, they are not relevant because they do not change regardless of the selected alternative.
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D.
Value Chain Considerations The value chain defines each of the major activities that add value to the product or service produced by an organization. Changes in activities or approaches often result in changes in costs. Decisions regarding the value chain represent evaluation of relevant costs at the highest level. EXAMPLE
Comprehensive value chains are typically represented as beginning with product development and ending with product delivery. Multiple decisions are included within each major component of the value chain. The following chart illustrates the manner in which decisions accompany value chain categories:
Value Chain
Decisions
~esearch and Development
In-house development? Outsource development?
I
~ 1Product Design
I
~
IProduction ~ IMarketing
~
IDistribution ~ !;ustomer Service
Evaluate market segment and compatibility with overall corporate strategies including anticipated product pricing and margins.
I
In-house production? Outsource production?
I
Use of national advertising campaign? Use of local advertising?
I
Retail outlets? Wholesale outlets? Private distributors? In-house customer service? Outsource customer service?
Each element of the value chain includes numerous relevant decisions that change total costs. From the beginning of the firm's search for new products, decisions are required that represent strategic initiatives that will change outcomes. A cost leader, a company focused on pricing strategy and attempting to maintain market share is likely to select less expensive options that are compatible with strategy. Adjustments to strategy may impact the manner in which management plans to produce value in the marketplace. Strategic refinements to the value chain may involve decisions that impact costs. The firm may elect to focus on product design and to outsource manufacturing, thereby eliminating the factory overhead and the administrative costs associated with contract negotiations for purchases, maintaining a larger employee base, etc. The firm might decide to manufacture in house in anticipation that outsourced manufacturing may be more expensive after consideration of the quality control issues that ultimately surface when accepting the work of others.
B3-26
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"-""","'''~.~-'''''''''''~~._._ ",,",,~''''''''.'''''~--- ="""'-,,,~
E.
Types of Relevant Information Relevant information may be either qualitative or quantitative. Quantitative information may be either fin ancial or non-financial. Either the characteristics or the amount of these measureme nts would change in response to selecting different alternatives. 1.
Quail tative Quali tative considerations in various decisions represent those aspects of seiected altern atives whose measurements may often be difficult or imprecise and are generally not nu merical. Employee morale and customer satisfaction are examples of qualitative consi derations.
2.
Quan titative Quan titative considerations in various decisions represent those aspects of selected altern atives whose measurements may be reduced to numerical measurements.
a.
Financial Financial measurements are denominated in currency (e.g., dollars and cents). EXAMPLE
Reduction of travel expense from 50 dollars per day to 45 dollars per day represents a quantitative financial measurement.
b.
Non-financial Non-financial measurements are displayed in numerical terms other than dollars. EXAMPLE
Reduction in travel time or distance displayed in hours or miles represents a non-financial quantitative consideration.
-...
o
'<=>=
END OF ANCILLARY MATERIAL
III.
FINANCIAL DECISIONS USING PROBABILITY AND EXPECTED VALUE MODELS Probability is the chance that an event will occur. Probabilities are assigned values between zero (0) and one (1). A zero (0) probability indicates that there is no chance the event will ever occur (i.e., an impossibility). A probabiiity of one (1) indicates that the event will always occur (i.e., a certainty). A.
Types of Probability 1.
Objective Probability a.
Objective probability is based on past outcomes.
b.
The objective probability of an event is equal to the number of times that an event will occur divided by the total number of possible outcomes. EXAMPLE
The chance of selecting the letter "a" from the 26 letters in the alphabet is 1 in 26, or 1/26.
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SUbjective Probability Subjective probability is based on an individual's belief about the likelihood that a given event will occur. It is estimated based on judgment and past experience of the likelihood of future events.
B.
Expected Value Expected value is the weighted-average of the probable outcomes of a variable where the weights are the probability of an outcome occurring.
1.
Calculation of Expected Value Expected value is found by multiplying the probability of each outcome by its payoff and summing the results. EXAMPLE 1 -
EXPECTED VALUE
The expected value of profits (EIXj) can be found by multiplying the different possible profit levels by the associated probabilities and summing the results (e.g., a 5% chance of earning $0 profit, a 10% chance of earning $100 profit, etc.). E[X]
=($0 x .05) + ($100 x .10) + ($200 x .35) + ($300 x .20) + ($400 x .20) + ($500 x .10)
EIX]
=$0 + $10 + $70 + $60 + $80 + $50 =$270
Thus, given the possible profit outcomes and their associated probabilities, expected profits are $270. EXAMPLE 2 -
EXPECTED VALUE
Question
Dough Distributors has decided to increase its daily muffin purchases by 100 boxes. A box of muffins costs $2 and sells for $3 through regular stores. Any boxes not sold through regular stores are sold through Dough's thrift store for $1. Dough assigns the following probabilities to selling additional boxes through regular stores: Regular Store Sales
Thrift Store Sales
Probabilitv
60 100
40
.6 .4
0
What is the expected value of Dough's decision to buy 100 additional boxes of muffins? a. $28
c.
b. $40
d. $68
$52
Answer
Choice "c" is correct. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit. The sum of the product of the probability times each outcome is the expected value. There is a GO% probability that Dough will sell GO of the 100 additional boxes through regular stores and 40 of the 100 through thrift stores. That means that Dough would have a 60% chance of making a profit of $20 {GO boxes at a $1 profit ($3 - $2) sold through the regular stores and 40 boxes at a $1 loss ($1- $2) sold through thrift stores). There is a 40% probability that Dough will have a profit of $100 (100 boxes sold at a $1 profit through regular stores and zero boxes sold at a loss through thrift stores). 60% probability of a $20 profit
$20~
40% probability of a $100 profit
$12 [.60' 40 [.40' $1001
Expected value
ill
._-------
Choices "a", "b" and "d" are incorrect. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit.
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Expected Value of Perfect Information The expected value of perfect information is the difference between the expected payoff under certainty and the expected monetary value of the best alternative under uncertainty.
3.
4.
Shortcomings of Probability Concepts and Expected Values a.
Expected value is based on repetitive trials, not on one trial, as is the case with many business decisions.
b.
Expected value represents the average outcome, not the outcome that is actually observed.
Benefits of Probability Concepts and Expected Values Expected values provide an objective framework for assessing risks and probable outcomes and are useful in decision-making.
IV.
FINANCIAL DECISIONS (short-term and long-term financing strategies) Although most companies meet their capitalization requirements with some form of long-term financing, it is certainly possible to select short-term financing options to meet this need. Long-term minimum needs are termed permanent working capital, while seasonal needs are termed temporary working capital. Choices to use either long-term or short-term financing to meet these needs have different effects on a firm. Companies compare choices that provide higher risk, lower cost, and increased profitability with choices offering lower risk, higher cost, and reduced profitability. A.
Short·term Financing Strategies and Factors 1.
Characteristics Short-term financing is generally classified as current and will mature within one year. a.
Rates Rates associated with short-term financing tend to be lower than long-term rates and presume greater liquidity on the part of the organization using short-term financing.
b.
Strategies The extent to which an organization uses short-term financing strategies is dependent on both the amount of current assets it maintains and the risk tolerance of management. Shorter-term financing strategies anticipate higher levels of temporary working capital that require greater agility and flexibility.
2.
Advantages a.
Increased Liquidity Short-term financing presumes higher turnover of financing instruments and matching of receipts (liquidation of assets) and disbursements (liquidation of liabilities) within a year.
b.
Increased Profitability Rapid conversion of operating cycle components into cash carries the potential of increased profitability.
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Decreased Financing Cost Short-term rates are generally lower than long-term rates.
3.
Disadvantages a.
Increased Interest Rate Risk Interest rates may abruptly change and require greater financing charges than anticipated.
b.
Increased Credit Risk Lender evaluation of credit worthiness may change and thereby make financing impossible or less favorable by virtue of increased rates and less favorable terms.
B.
Long-term Financing Strategies and Factors 1.
Characteristics Long-term financing is generally classified as non-current and will mature after one year. a.
Rates Rates associated with long-term financing tend to be higher than short-term rates and presume less liquidity on the part of the organization using long-term financing.
b.
Strategies The extent to which an organization uses long-term financing strategies is dependent on both the amount of current assets it maintains and the risk toierance of management. Longer-term financing strategies anticipate higher levels of permanent working capitaL
2.
Advantages a.
Decreased Interest Rate Risk For the borrower, long-term financing locks in an interest rate over a long period of time, thereby reducing the exposure to fluctuations in rates.
b.
Decreased Credit Risk Securing long-term debt guarantees financing over a long period of time and reduces the company's exposure to any risk that refinancing might be denied.
3.
Disadvantages a.
Decreased Profitability Increased financing costs in combination with an increased time span for conversion of operating activity into cash reduces profitability.
b.
Decreased Liquidity Longer-term financing commits organizations to payments over a longer period of time and thereby reduces flexibility and liquidity.
c.
Increased Financing Costs Long-term debt generally carries a higher interest rate.
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Interest Rate Risk, Lender's Perspective For the lender, a higher interest rate is charged for longer-term debt because the likelihood that interest rates will change over the period of the loan increases as the term of the loan increases. Higher financing charges compensate the lender for increased interest rate risk. Therefore, the lenders recognize their exposure to interest rate risk with long-term financing and charge a premium to the borrower in the form of higher rates.
(2)
Interest Rate Risk, Borrower's Perspective The borrowers, on the other hand, lock themselves into a long-term interest rate to eliminate further exposure to interest rate risk, and they pay a premium to do that. PASS KEY
Short-term debt
Long-term debt
Rates:
Lower
Higher
Advantages:
Increased liquidity
Decreased interest rate risk
Increased profitability
Decreased credit risk
Increased interest rate risk
Decreased liquidity
Increase credit risk
Decreased profitability
Use with higher levels of temporary working capital
Use with higher levels of permanent working capital
Disadvantages:
Strategy:
AN C III A R Y MAT E R I A l
C.
(for Independent Review)
Specific Shori-term or Long-term Financial Instruments 1.
Working Capital Financing a.
Definition Working capital financing contemplates the spontaneous financing of current assets with trade accounts payable and accrued liabilities with the expectation that the maturities of current assets (collections) will coincide with the maturities of current liabilities (disbursements), often termed maturity matching. EXAMPLE
WUTFUN Toy Company maintains a permanent inventory of toys year round but dramatically increases its inventory in November and December in anticipation of increased sales during the holidays. Generally, the company carries few receivables but extensive inventory. Longerterm financing is used for its permanent inventory needs while shorter-term financing, particularly accounts payable, is used to finance seasonal requirements. Use of longer-term financing is appropriate for permanent inventory while sales are light, and use of shorter-term financing is appropriate as inventory levels are increased and then liqUidated. Clearly, WUTFUN is exposed to higher levels of risk at year-end in the event that inventory is not sold, profit margins are not realized, and inventory must be permanently financed or liquidated at reduced or negative margins.
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~~--------------'-"--~.'~'-'--"-----. 2. Letter of Credit a.
Definition Letters of credit represent a third party guarantee, generally by a bank, of obligations Incurred by the company. Letters of credit may be used by the company issuing otherwise unsecured debt to enhance its credit or can be reqUired by a creditor to ensure payment. EXAMPLE
WUTFUN Toy Company is stocking up for its year-end inventory requirements and seeks to issue commercial paper to its suppliers upon delivery of stock. Toy wholesalers anticipate weak sales and are reluctant to accept unsecured debt. WUTFUN arranges for a letter of credit to guarantee payment of its indebtedness in order to ensure delivery of inventory.
3.
Line of Credit a.
Definition A line of credit represents a revolving line of credit with a bank that is generally renewable annually. Not a guarantee, lines of credit represent a loan from the bank. EXAMPLE
WUTFUN Toy Company anticipates that it will need cash in excess of its cash reserves to fund the acquisition of inventory at year-end. The company's suppliers are unwilling to accept unsecured credit beyond the normal30-day cycle associated with its trade accounts payable. WUTFUN must stock up in early October and is likely not to convert its inventory into cash until late December. WUTFUN has a 30- to GO-day exposure to negative cash flows and balances. WUTFUN makes arrangements with its bank to draw upon a line of credit to pay its suppliers. The bank and WUTFUN anticipate that the line of credit will only be used to satisfy short-term temporary cash requirements.
4.
Leasing Options a.
Definitions Leases represent agreements in which the owner of an asset, the lessor, allows another party, the lessee, to use the property in exchange for lease payments.
63-32
(1)
Operating leases represent those instances in which a property is rented over a portion of the assets useful life with no obligation (or opportunity) to assume ownership of the property.
(2)
Capital leases represent the acquisition of an asset either in substance or in legal form. In legal form, the capital lease represents an agreement in which the lessor either sells the asset or purely finances the sale of the asset to the lessee. In a sale agreement, ownership may change hands or be subject to a bargain purchase option. In an in-substance financing arrangement, the capital lease includes terms in which the lessee uses up more than 75 percent of the useful life of the asset or assumes lease payments whose principal components pay for more than 90 percent of the leased asset's fair market value. Ownership does not change hands in a pure in-substance capital lease.
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EXAMPLE
Upstart Starter Corporation is a start-up company founded last year to manufacture automobile components. The company's profitability is marginal. Upstart leases its plant from Consolidated Properties. Upstart cannot take full advantage of accelerated depreciation from ownership that would normally be used as a tax strategy by virtue of its low net income. leasing provides greater flexibility and is more advantageous than ownership. Consolidated, however, continues to depreciate the property to its own advantage. Ownership of the plant by Consolidated works to its benefit.
5.
Debentures and Bonds a.
Definitions - General Debentures and bonds represent longer-term indebtedness that are generally supported by formalized agreements known as indentures which specify the terms and conditions of the bond including the interest rate and maturity date. Bonds are frequently administered by a trustee, who acts as a third party representative of the bondholder. Debentures are unsecured, while bonds are often secured by either revenue pledges or pledges of property.
b.
Debentures A debenture represents an unsecured obligation of the issuing company. In the event of default, the holder of a debenture has the status of a general creditor. Risks associated with debentures may be mitigated by a negative-pledge clause that stops a company from pledging assets to additional debt.
c.
Subordinated Debentures A subordinated debenture defines a bond issue that is unsecured and that ranks behind senior creditors. Subordinated debentures command higher interest rates than debentures to allow for additional risk.
d.
Income Bonds Income bonds represent securities that pay interest only upon achievement of target income levels. Income bonds represent a risky bond that is typically only used in reorganizations.
e.
Junk Bonds Junk bonds are often unsecured and are characterized both by high risk and high return. Junk bonds are referred to as "non investment grade" by virtue of their high risk. Junk bonds are frequently used to raise capital for acquisitions and leveraged buyouts.
f.
Mortgage Bonds Mortgage bondholders are protected from default by a lien on assets of the issuing company. Trustees may act on behalf of bondholders to foreclose on mortgaged assets in the event of default. EXAMPLE
Rust Belt Industries is looking to close its machinery plant in the small town of Oxidation, Ohio. Rust Belt Industries is the only major employer in Oxidation. To preserve their way of life, employees have decided to band together to buy the company from its current owners. The group of employees uses borrowed funds in a leveraged buyout of the owners by issuing noninvestment grade bonds (also known as junk bonds).
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6.
----------------------_.-
-------_._----
------
Equity Financing a.
Definitions - General Equity financing represents the issuance of non-debt securities that represent different forms of ownership of the company. Degrees of ownership interest increase as rights to income decrease.
b.
Preferred Stock The issuance of preferred stock represents the election to raise capital through a hybrid security that shares the features of both debt and equity. Preferred shares are like debt because they offer or require a fixed payment to their holders. They are like equity because the timing of the payment is at the discretion of the Board of Directors and the payments are not deductible. Preferred shares have the following features, potential features, and uses: (1)
Cumulative Dividends Provisions of preferred stock may require that unpaid dividends on preferred stock be paid and, at any rate, the obligation be recognized ahead of common shareholder claims in liquidation.
(2)
Participating Feature Preferred shares may participate in declared dividends along with common shareholders to the extent that undistributed dividends exist after satisfying both preferred dividend requirements and common shareholder requirements at the preferred dividend rate.
(3)
Voting Rights In rare circumstances, preferred shares are given voting rights. Usually these situations are associated with dividends in arrears for significant periods.
(4)
Uses Preferred stock is often used by pUblic utilities because the deduction for dividends is an allowable expense in rate development. Commercial enterprises find the use of preferred shares less favorable because the finance charge is not deductible. Preferred shares are, nonetheless, flexible because the dividend obligation does not always represent a fixed cash outflow and the lack of a fixed maturity date indefinitely postpones final settlement. Commercial enterprises may elect to invest in preferred shares as a result of the dividend exclusion allowance.
c.
Common Stock Common stock represents the basic ownership security of a corporation. Common stock includes voting rights but no guaranteed income participation. Common shareholders are the last claim to assets upon liquidation. PASS KEY The following table summarizes some of the general characteristics of debt and equity financing. Debt Flexibility Tax deductibility EPS dilution Increased risk Cost Return
o
No
~ Yo>
Yo>
No
No
Ye,
Yo> Low Fixed
High Variable
No
END OF ANCILLARY MATERIAL
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CAPITAL MANAGEMENT, INCLUDING WORKING CAPITAL
Capital management considers topics that range from the strategic manner in which financial managers structure their balance sheets to maximize shareholder value to the tactical management of current assets to ensure that cash flows are adequate to meet current obligations as they come due. Selection of long-term and short-term capitalization for a company's permanent financing is decided w'lthin a context that considers the nature of a specific business, its industry, and the market. The cost and characteristics of specific financial instruments cannot be considered in isolation. Selection of financial instruments used for an organization's capital structure involves consideration of a broad range of concepts, including management's risk tolerance, operating leverage characteristics of specific industries and companies, and the degree to which capital structure magnifies or mitigates risk for the organization.
I.
OPERATIONAL AND FINANCIAL LEVERAGE Financial and operating leverage impacts the variability of specific company profits and, therefore, impacts the risk assumed (and return required) by creditors and owners. Leverage is a significant consideration as a factor in designing capital structure. Financial managers must consider both operating leverage and financial leverage and the manner in which they relate to each other in combination.
L-
A.
--'
Leverage Computations 1.
Operating Leverage a.
General (1)
Definition Operating leverage Is defined as the degree to which a firm uses fixed operating costs (as opposed to variable operating costs) to magnify the effects of a given percentage change in sales on the percentage change in its earnings before interest and taxes.
(2)
Implication High operating leverage implies that new sales dollars will go straight to the bottom line. Low operating leverage implies that new sales dollars can oniy be achieved with additional variable costs. For companies with low operating leverage, only the margin in excess of variable costs is profit. Operating leverage is not synonymous with equity financing.
b.
Formula A firm's degree of operating leverage (DOL) is a numerical measure of its operating leverage. DOL can be computed as follows: DOL
Percentage change in EBIT (earnings before interest and taxes)
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Percentage change in sales
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Concept Example EXAMPLE
If a firm experiences a 21% increase in EBIT as a result of a 7% increase in sales, its DOL is
3 [.21 + .07].
d.
Applying Operating Leverage to Risk/Return Decisions Managers must consider the leverage implied by business operations in considering the risks that they will assume in adopting their capital structures. Firms with a higher percentage of fixed costs relative to variable costs will have a higher degree of operating leverage.
2.
(1)
A higher degree of operating leverage implies that a relatively small change in sales (increase or decrease) will have greater effect on profits and shareholder value.
(2)
The higher a firm's degree of operating leverage, the greater its profitability (but also the greater its risk).
Financial Leverage a.
General (1)
Definition Financial leverage is defined as the degree to which a firm uses fixed financiai costs to magnify the effects of a given percentage change in earnings before interest and taxes (EBIT) on the percentage change in its earnings per share (EPS). Financiai leverage is an extension of operating leverage that purely focuses on one type of fixed cost, debt financing.
(2)
Implication High financial fixed costs can have the impact of allowing each additional dollar of sales to go to the bottom line. A low financial fixed cost eliminates financial ieverage as a consideration in operations.
b.
Formula A firm's degree of financial leverage (DFL) is a numericai measure of its financial leverage. DFL can be computed as follows: DFL = Percentage change in EPS Percentage change in EBIT
c.
Concept Example EXAMPLE
If a firm experiences a 42% increase in EPS as a result of a 21% increase in EBIT, its DFL
is 2 [.42 + .211.
d.
Applying Financial Leverage to Risk/Return Decisions Firms with a higher percentage of fixed financing costs will have a higher degree of financial ieverage. Managers must consider leverage implied by capitai structure.
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(1)
A higher degree of financial leverage implies that a relatively small change in earnings before interest and taxes (increase or decrease) will have greater effect on profits and shareholder value.
(2)
The higher a firm's degree of financial leverage, the greater its profitability (but also the greater its risk).
Combined (Total) Leverage a.
General (1)
Definition Combined (total) leverage results from the use of fixed cost resources and fixed cost financing to magnify returns to the firm's owners.
(2)
Implication High combined leverage implies that a greater portion of sales goes to the bottom line. Combined leverage shows the relationship between operating and financial leverage as it relates to shareholder value.
b.
Formula A firm's degree of combined leverage (DCl) is a numerical measure of its combined (or total) leverage. DCl can be computed as follows: e :..: rc..:: e ":..:t",ag",e:..:c:..:h:::a"cog..::e..::i":..:E:..:P::-S DCl = -c-p..:: Percentage change in sales
c.
Concept Example EXAMPLE
If a firm experiences a 42% increase in EPS as a result of a 7% increase in sales, its Del is 6 [.42 + .07].
d.
Applying Combined Leverage to Risk/Return Decisions Firms with a higher percentage of fixed operating leverage in addition to fixed financing costs will have a higher degree of combined leverage.
4.
(1)
A higher degree of combined leverage implies that a relatively small change in sales (increase or decrease) will have greater effect on earnings per share, profits, and shareholder value.
(2)
The higher a firm's degree of combined leverage, the greater its profitability (but also the greater its risk).
Formula Relationship between Operating, Financing, and Combined Leverage The degree of operating leverage and degree of financial leverage both consider the change in earnings before interest and taxes (EBIT). The degree of operating leverage focuses on the extent to which EBIT changes as a result of changes in sales. The degree of financial leverage builds on that concept and measures the degree to which earnings per share (EPS) changes as a result of changes in EBIT. Combined (total) leverage changes the focus of the anaiysis to isolate the change in EPS as a result of changes in sales.
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a.
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Formula The relationship between operating, financing, and combined leverage is expressed by the following formula: DOlxDFl = Del
b.
Formula Analysis The relationship between operating, financing, and combined leverage is also expressed in the following diagram: DCL
%Ll.inEPS %Ll. in sales
B.
Applying Leverage Concepts to Business Decisions 1.
Operating Leverage Operating leverage decisions are often the result of industry characteristics rather than management decisions. An investment or extension of credit to a company in a particular industry involves assuming risks associated with high or low operating leverage. EXAMPLE -
INDUSTRY WITH HIGH OPERATING LEVERAGE
The health care industry, particularly nursing homes and hospitals, requires minimum staffing patterns to maintain bed capacity. Direct salaries represent a fixed cost of maintaining capacity and translate to higher operating leverage. Additional revenues (e.g., maximizing capacity utilization and increasing rates per day) go straight to the bottom line; however, declining revenues quickly impact profitability by virtue of high fixed costs.
EXAMPLE -
INDUSTRIES WITH LOW OPERATING LEVERAGE
Professional service firms, such as CPA firms, typically require productivity levels from their staff. Additional revenues (fees) cannot be earned without hiring additional staff members. Managers are able to quickly shed variable costs in the event that revenue begins to decline.
2.
Financial Leverage Financial leverage decisions are foundational to capital structure and are influenced by the amount of operational leverage (risk) implied by the industry. To a greater extent than operating leverage, financial leverage is a decision made by management. The degree to which a company borrows from others to meet its capital requirements or uses investor capital is a function of their ability to proVide appropriate returns. The required returns are defined within the firm's cost of capital.
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Business 3
THE WEIGHTED AVERAGE COST OF CAPITAL AND OPTIMAL CAPITAL STRUCTURE The weighted average cost of capital (WAGG) serves as a major link between the long-term investment decisions associated with a corporation's capital structure and the wealth of a corporation's owners. The theoretical optimal capital structure is that mix of financing instruments that produces the lowest WAGG. At some point, investors will demand a greater return as leverage becomes more pronounced and debtors will require compensation in anticipation of default risks. The mixture of debt and equity securities that produce the lowest WAGG maximizes the value of the firm.
A.
Capital Structure and Firm Value 1.
Firm Value The value of an entity, like a security, is traditionally computed as the discounted value of its future cash flows (see section below titled, "Financial Valuation").
2.
Financial Managers Objective - Maximizing Firm Value The value of a firm can be theoretically computed as the present value of the cash flow it produces, discounted by the costs of capital used to finance it. The lower the overall cost of capital, the higher the value of the firm.
B.
Computing the Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WAGG) is the average cost of debt and equity financing associated with a firm's existing assets and operations.
1.
Formula The weighted average cost of capital is determined by weighting the cost of each specific type of capital by its proportion to the firm's total capital structure.
2.
Individual Capital Components Individual capital components include both long-term and short-term elements of the firm's permanent financing mix.
a.
Long-term Elements Long-term elements include long-term debt, preferred stock, common stock, and retained earnings.
b.
Short-term Elements Short-term elements may include short-term interest-bearing debt (e.g., notes payable). Other forms of current liabilities (e.g., accounts payables and accruals) are rarely, if ever, included in the cost of capital estimate, mainly because they usually represent "free" capital (sources of cash) and are not very controllable by management.
c.
After-tax Cash Flows In evaluating the cost of the components of capital structure, after-tax cash flows are the most relevant. Gost of capital must be developed on an after-tax basis.
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Computation The following concept example demonstrates the formula and computation of the WACC and considers the following issues: a.
Cost of equity,
b.
Cost of debt, and
c.
Sum of weighted average costs of equity and debt. EXAMPLE -
DEBT AND EQUITY
Facts The cost of debt is much easier to calculate than the cost of equity. Debt costs are usually explicitly stated as the interest rate of the various debt instruments. In some cases, debt costs are stated according to basis points above u.s. Treasury Bond rates (where 1 basis point is equal to one-hundredth of one percent, or 0.01%). Calculate the weighted average interest rate by dividing a company's total interest obligations on an annual basis by the debt cash available: Weighted average interest rate =
Effective annual interest payments
--------~~-
Debt cash available
The weighted average cost of capital (WACq accounts for the cost of equity and the weighted average cost of debt simultaneously, as follows: Cost of equity multiplied WACC = by the percentage equity in capital structure
Weighted average cost of debt
+ multiplied by the percentage debt in capital structure
Assume the cost of equity capital for XYZ Company is 17.8%. Also assume a weighted average interest rate of 10% and a targeted capital structure composed of 75% equity and 25% debt. Finally, assume a tax rate of 30%. What is XYZ's WACC?
Solutions 1.
Cost of debt (after tax): = = = =
2.
Interest rate x (1- Tax rate) 10% x (1-30%) 10% x 70% 7%
WACC = (17.8% x 75%) + (7% x 25%) = 15.1%
Therefore, XYZ should invest in any project that will yield a return higher than 15.1%.
C.
Optimal Capital Structure - Determination of the Lowest WACC The optimal cost of capital (theoretically) is the ratio of debt to equity that produces the lowest WACC. Required rates of return demanded by debt and equity holders will fluctuate as the ratio of debt to equity changes. The following graph displays the cost of using equity financing (kre), the cost of using debt financing (kdx) and the resulting WACC as debt/equity conditions change. 1.
Assumptions of Information Contained on the Graph (below) a.
Equity Assumptions (1)
Investors begin with 100% equity financing.
(2)
Investors demand an 11 % return.
(3)
Income is earned at $100,000 per year.
(4)
Equity owners demand an increasing return when the debt equity ratio exceeds 4.5:1. © 2010 D"Vry!Becker Educat;onal Development Corp. All rights reserved
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b.
2.
Debt Assumptions (1)
The firm can find financing at 6%.
(2)
The firm borrows $200,000 in the first year and increases its additional leverage by prior year borrowing plus $100,000 each year.
(3)
Debt financing costs increase as the debt equity ratio approaches 6.0:1.
Conclusions Based on the foregoing unique assumptions, the firm described above achieves its lowest WAGG (and highest leveraged return to equity shareholders) when its debt equity ratio is at 4.38.
DETERMINATiON
OF
LOWEST
WACC
Cost of Capital
18.0%
_ _ kre
,.
16.0%
.• WACC _ _ kdt
//
14.0%
///
12.0% , 10.0%
///
,, "
...-:.~/ .~
8.0%
6.0% - - - - - - - - - - - - - - - - - - - -
4.0% 2.0% 0.0% 1.00
D.
1.67
2.25
2.80
3.33
3.86
4.38
4.89
5.40
5.91
6.42
6.92 Debt/Equity Ratio
Application to Capital BUdgeting Generally, new projects are funded by sources of capital that maintain the optimum capital structure (ratio of debt to equity) and meet or exceed the hurdle rate implied by its cost. The historic weighted average cost of capital may not be appropriate for use as a discount rate for a new capital project unless the project carries the same risk as the corporation and results in identical leveraging characteristics.
1.
Marginal Cost of Capital The weighted average cost of capital changes mathematically as the components of capital structure change. It may also be infiuenced by changes in the rates associated with its components as risk increases or decreases in response to changes in capital structure. Appropriate application of the weighted average cost of capital as a hurdle rate for capital projects involves use of the weighted average cost of each additional new dollar of capital raised at the margin as that capital need arises.
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Target Capital Structure Management develops a target capital structure as a means of evaluating performance and achievement of corporate valuation goals. Incremental changes in financing as projects arise require management to rebalance their achieved capital structure in relation to their target.
3.
Application The present value (principai value) of an annuity increases as the discount rate decreases. Using target capital structure as a performance measure that is focused on achieving the lowest weighted average cost of capital minimizes overall cost of capital, maximizes the firm's stock price, and maximizes the company's overall market value.
III.
COST OF CAPITAL COMPONENTS The cost of capital is comprised of the cost of borrowing (interest rates on debt) and the cost of equity (return required by investors in exchange for assumed risk). A.
Cost of Long-term Debt - kdx The cost of long-term debt is expressed in formulas using the letters "kdx." The relevant cost of long-term debt, kdx, is the after-tax cost of raising long-term funds through borrowing. Sources of long-term debt generally include issuance of bonds or long-term loans. 1.
Net Proceeds - Nd Net proceeds (Nd) received by a company that issues long-term debt is defined as the funds that are actually received by the firm from the sale of the bonds (e.g., gross proceeds minus fiotation costs).
a.
Gross Proceeds Gross proceeds represent the total amount paid by investors to acquire a debt instrument. Gross proceeds will be reduced by various fiotation (issuance) costs before being remitted to the company issuing the debt.
b.
Flotation Costs Flotation costs are the charges that reduce the total proceeds from the sale of the debt. Flotation costs represent the total cost of issuing and selling a security. Because they are typically a very small percentage of the proceeds from the sale of bonds, fiotation costs are often ignored in estimating the cost of debt.
2.
Pre-tax Cost of Debt - kdt The pre-tax cost of debt represents the cost of debt before considering the tax shielding effects of the debt. Estimation of the pre-tax cost of debt involves one of three methods: cost quotations, internal rate of return, or approximating cost. a.
Cost Quotations The pre-tax cost of the bonds is exactly equal to the coupon rate of interest on the bonds only if the net proceeds from the sale of bonds equal the par value of the bonds. Yieid to maturity is more frequently used and considers differences in the par value of the bonds and the net proceeds.
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b.
[x
Internal Rate of Return Determining the internal rate of return on the bond's cash fiows represents an estimate of the cost of the bonds. The cost to maturity of the cash flows associated with the bonds considers the opportunity costs of using debt financing rather than other alternatives.
c.
Approximation of Cost Approximation of cost uses the ratio of cash and non-cash financing charges to the average amount of debt outstanding.
d.
Formula - kdt The cost of debt is computed as the interest amount paid, plus or minus the average cost or benefit of any discount or premium, divided by the average net proceeds from the debt issue expressed as follows: kdt
I+(PV-Ndl/n (Nd+PV)/2
PV :: Par value of the bonds. I
:: The annual interest payment in dollars.
Nd :: The net proceeds from the sale of the bonds. n
3.
:: The number of years to the bond's maturity.
After-tax Cost of Debt - kdx Interest on debt is tax deductible. Avoided taxes reduce the cost of debt to an amount equal to the deductible interest times 1 minus the firm's tax rate. The future benefit of the tax deduction on interest payments depends on future taxable income and future statutory tax rates. The formula for computing the after-tax cost of debt may be expressed:
kdx:::
Pre-tax cost of debtx(l- Tax rate) or
kdtx(l- Tax rate I
EXAMPLE
Facts Assume the long-term debt component of the weighted average cost of capital for a firm includes a pre-tax cost of debt of 12.5% and a 30% tax rate. Compute the after-tax cost of long-term debt.
Calculations and Solution After-tax cost of long-term debt
kdx = kdt' (1- Tax rate) kdx = .125' (1- .30) kdx
.125' .7
kdx
.0875
Although the pre-tax interest rate is 12.5%, the after-tax interest rate, after considering the deductibility of the interest expense, is 8.75%.
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PASS KEY
• The lower the cost of capital, the higher the return. • Debt carries the lowest cost of capital and is tax deductible. • The higher the tax rate, the more incentive exists to use debt financing.
AN C J II A R Y MAT E R I A l
B.
(for Independent Review)
Cost of Preferred Stock - kps Formula notation for the cost of preferred stock is the letters "kps." After-tax considerations are generally irrelevant with equity securities because dividends are not tax deductible. Preferred stock cash dividends represent payments to preferred stockholders. 1.
Net Proceeds of Preferred Stocks - Nps Net proceeds of a preferred stock issue represent gross proceeds yielded from the market, net of fiotation costs (i.e., issuance costs). Formula notation for net proceeds of preferred stock issue is Nps.
2.
Preferred Stock Cash Dividends - Dps Preferred stock dividends represent the finance charge to the company for raising capital with preferred stock. Formula notation for preferred stock dividends is Dps. Preferred stock dividends can be stated as a dollar amount or a percentage. a.
Dollar Amount With $5 per share dividends on preferred stock, dollar amount references are stated as "$5 preferred stock."
b.
Annual Percentage With 5% dividends on preferred stock, annual percentage rate references are stated as "5% preferred stock." The rate represents the percentage of the preferred stock's par (or face value) that equals the annual dividend. For example, 5% preferred stock with a $100 par value per share would be expected to pay an annuai dividend of $5. Dividends expressed as percentages should be converted to annual dollar dividends before calculating the cost of preferred stock.
3.
Formula - kps kps = Dps / Nps
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Concept Example - Cost of Preferred Stock EXAMPLE
Facts Assume the preferred stock component of a weighted average cost of capital for a firm is comprised of 10%, $100 par value preferred stock that was issued at a flotation cost of $5 per share. Compute the cost of preferred stock.
Calculations l.
Convert annual percentage rate quotation of dividends to annual dollar amount quotation
2. 3. 4.
Annual dollar amount = Percentage times par value Annual dollar amount = 10%
* $100
Annual dollar amount = $10
Formula
Kps = Dps / Nps Solution
Kps = $10 / ($100 - $5) kps = $10 / $95 kps = .10526
o
END OF ANCILLARY MATERIAL
C.
Cost of Retained Earnings - kre Formula notation for the cost of retained earnings is the symbol kre. A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk. This return is represented by the cost of retained earnings, kre. As mentioned above, after-tax considerations are generally irrelevant to equity securities because dividends are not tax deductible. The cost of equity capital obtained through retained earnings, kre, is equal to the rate of return required by the firm's common stockholders. Arriving at the components of the formula for the cost of retained earnings is extremely difficult and potentially SUbjective. 1.
2.
Three Common Methods of Computing kre a.
Capital asset pricing model (CAPM)
b.
Discounted cash flow (DCF)
c.
Bond yield plus risk premium (BYRP)
Return to Common Stockholders - Residual Earnings The residual earnings accruing to the common stockholders represents the amount of the return and may either be paid out in the form of dividends or retained for reinvestment in the business. a.
All of the firm's earnings remaining after interest payments have been made to bondholders and fixed dividend payments have been made to preferred stockholders belongs to the common stockholders.
b.
The opportunity cost associated with earnings that are retained and reinvested by the business is equal to the return stockholders could have earned if they had received those earnings and reinvested the earnings themselves. It represents the "rent" paid on the capital provided by the stockholders.
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The Capital Asset Pricing Model (CAPM) a.
b.
c.
d.
Key Assumptions (1)
Cost of retained earnings is equal to the risk-free rate pius a risk premium.
(2)
Risk premium is equal to the risks associated with the entire market risk.
(3)
Risk premium is the product of systematic (non-diversifiable) risk.
(4)
Arbitrage pricing theory assumes multiple risks (e.g., systematic and unsystematic risks) should be considered as part of capital asset pricing, not simply one risk.
Key Factors and Their Formula Notations (1)
The cost of retained earnings - kre
(2)
The risk-free rate - krf
(3)
The risk premium - the stock's beta coefficient (bi) times the market risk premium (PMR, below)
(4)
The market risk premium (PMR) - the market rate (km) minus the risk-free rate (krf)
Cost of Retained Earnings Formula (CAPM) (1)
kre = Risk-free rate + Risk premium
(2)
kre = krf + (bi x PMR)
(3)
kre
= krf + fbi x (km - krf)]
Concept Example - kre Using the CAPM Method EXAMPLE
Facts Assume that a firm's beta (bi) is 1.25, the risk-free rate (krf) is 8.75%, and the market rate (km) is 14.25%. Compute the cost of retained earnings using the capital asset pricing model (CAPM).
Cost of retained earnings using the capital asset pricing model (CAPM). kre ::: Risk-free rate + Risk premium
kre " krf + [bi
* (km -
krf)]
kre " .0875 + [1.25 * (.1425 - .08751] kre " .0875 + [1.25
* .0550]
kre " .0875 + .06875 kre " .15625
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PASS KEY
The overall cost of capital represents the cost of each component of capital structure. Be sure that you know the components of the capital structure. Recognize that the relative simplicity or difficulty of computing the cost of capital for each component relates to the characteristics of the ownership rights of each financial instrument.
Cost of long-term debt (after tax) - kdx •
Fixed return
•
Tax benefit
Cost of preferred stock - kps •
Fixed return
•
No tax benefit
Cost of retained earnings - kre (common shareholders' equity)
IV.
•
No fixed return
•
Growth relates to corporate and industry performance
•
No tax benefit
ASSET EFFECTIVENESS AND/OR EFFICIENCY - Return on Investment A.
Return on Investment/Return on Total Assets Formula Return on investment (ROI) provides for the assessment of a company's percentage return relative to its capital investment risk. The ROI would be an ideal performance measure for investment SBUs (strategic business units). In simplest terms, ROI is expressed as income divided by invested capital; however, ROI is also expressed as a product of profit margin and investment turnover. ROI = Income/Investment capital
ROI = Profit margin (or return on sale) x Investment turnover
B.
Definition and Interpretation Return on investment (ROI) can be disaggregated as indicated in the flowchart (below), where income is expressed as a percentage of sales (i.e., the profit margin calculation) and sales are expressed as a percentage of assets (i.e., the asset turnover calculation). The higher the percentage return, the better.
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ROA
I
FLOWCHART
Return on assets (ROA)
I
------------------------------~-----------------------------------~I I
I
I ] Income
- -- --
I Sales
I
Profit margin
I
I+ I
Sales
x
I
I
I
+
Sales
I
T ;>-;FIRS lEV E l
I Assets
-------------------------------------------------i----------
I-
I Costs
I
Current assets
+
Noncurrent assets
I I
I
Selling expenses
+
--
I
I
I I Cost of sales
I
Asset turnover
a
+
1
SECON D
Administrative and other expenses
LEV El
I
+I Receivables I+I
Inventories
+1
Other
I
Fixed assets
+
Intangibles and other assets ,/'
EXAMPLE
Question: Assume sales are $1,000,000, net income is $40,000, and invested capital is $250,000. If the organization's required rate of return (hurdle rate) is 12%, is the organization meeting performance expectations using ROI?
--,-$1",,,-00,-,0-,-,0,-,0-,-0 x $250,000
$40, 000
$40, 000
$1,000,000
$250,000
16%
Solution: The organization is meeting their requirements based on ROI computations. The ROI of 16% exceeds the required rate of return of 12%.
C.
Return on Investment Issues 1.
Variations on Asset Valuation Asset valuations used in the ROI computation impact the results. The appropriate asset valuation depends upon the strategic objectives of the company and the direction organization leadership wants to give its managers. The following terms define different asset valuations. a.
Net Book Value Assets valued at net book value represent historical cost less accumulated depreciation. This value is defined consistently with the amounts displayed on the financial statements presented in accordance with generally accepted accounting principles.
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Gross Book Value Assets valued at gross book value represent historical cost prior to reduction for accumulated depreciation. (1)
DuPont Method Adjustment The accumulated depreciation adjustment (called the DuPont Method) adds to the amount of invested capital the accumulated depreciation on depreciable assets. Advocates argue that if accumulated depreciation is not added back, earnings in succeeding periods relate to an everdecreasing investment base, thereby overstating returns.
c.
Replacement Cost Assets valued at replacement cost represent the cost to replace assets at their current level of utility.
d.
Liquidation Value Assets valued at liquidation value represent the selling price of productive assets.
e.
Other Asset Valuation Issues (1)
Capitalization Policy The policy used by the organization to include items in fixed assets or to expense them creates differences in basis of the ROI calculation; therefore, its result is referred to as the "capitalization policy."
(2)
Treatment of Unproductive Assets Unproductive assets or idle capacity in the organization's investment base will distort (understate) return on investment computations. Removal of unproductive assets (e.g., idle plant, facilities under construction, surplus plant, surplus inventories, surplus cash, and deferred charges) from the invested capital base is referred to as the "unproductive asset adjustment."
(3)
Treatment of Intangible Assets intangible asset valuation in the context of return on investment computations is controversial. Analyst skepticism with regard to the vaiue or earnings contributions of intangibles sometimes results in removal of intangibles from the Invested capital base. The elimination of intangibles from the investment base increases returns and is referred to as the "intangible asset adjustment." PASS
KEY
Adjustments to the ROI denominator raise the bar on asset, project or company performance. The higher the denominator used in the ROI computation, the lower the return.
2.
Alternate Denominators ROI calculations may use shareholder equity (instead of total assets) as the denominator; however, this technique is criticized because it combines the effect of operating decisions made at another organizationai level.
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Limitations of the ROJ The ROI, like any performance measure, is designed to direct managers to achieve corporate objectives and provide a basis for incentives. ROI computations have limitations. a.
Short-term Focus Use of the ROI exclusively as a measure of the performance can inadvertently focus managers purely on maximizing short-term returns. (1)
Investment Myopia The overemphasis of managers on investment balances is referred to as investment myopia.
(2)
Balanced Scorecard Use of a balanced scorecard can focus managers on business process, customer, and human resource issues.
b.
Disincentive to Invest Profitable units are reluctant to invest In additionai productive resources because their short-term result wili be to reduce ROI.
V.
ASSET EFFECTIVENESS ANDIOR EFFICIENCY - Residual Income The residual income method measures the excess of actual income earned by an investment over the required (target or hurdle) return rate required by the company. While ROJ provides a percentage measurement, residual income provides an amount. Like ROI, residual income is a performance measure for Investment SBUs. A.
Computation and Interpretation 1.
Formula The formula for residual income is as foliows: Residual income = Net income (from the income statement)- Required return where: Required return = Net book value x Hurdle rate
2.
Interpretation A positive residual income indicates that performance is meeting standards, while a negative residual Income indicates that performance is not meeting standards. EXAMPLE
Question: Instafab Manufacturing has an investment in its southeast regional plant with a net book value of $200,000. lnstafab's expected hurdle rate is 10 percent, and the division produces net income of $30,000. Calculate residual income.
Solution: Net income Net book value Hurdle rate Required return Residual income
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$30,000 $200,000 x
10%
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Residual Income Method Issues 1.
Benefits of Residual Income Performance Measures Advantages of using residual income include the ease of measurement of actual dollars earned by an investment above its required amount. a.
Realistic Target Rates Usually. the target rate in the residual income method will be less than the highest return rates actually earned by the best performing investment centers in a company. Historical weighted average cost of capital is often used as the target or hurdle rate; however, the rate optimally used is the target return set by the company's management.
b.
Focus on Target Return and Amount Residual income controls and performance measures encourage managers to invest in projects that generate income in excess of the hurdle rate, thereby improving company profits and promoting the congruence of individual and corporate goals. Divisions with high rates of return do not fear dilution of their rates and, therefore, do not avoid investments that demonstrate strong residual income performance.
2.
Weaknesses of Residual Income Performance Measures a.
Reduced Comparability Use of an absolute amount to compute performance distorts comparison of units with unequal size. Larger units of an organization may produce larger dollar volumes of residual income even though their performance is identical to a smaller unit on a percentage basis.
b.
Target Rates Require Judgment Reliance on computing a target rate of return may be sometimes difficult to establish.
VI.
ASSET EFFECTIVENESS AND/OR EFFICIENCY OF LONG·TERM FINANCING: OTHER Evaluation of the effectiveness of iong-term financing or solvency is typically associated with return on investment and residual income. Additional measures include return on total assets, debt to equity, and debt to total assets. A.
Return on Total Assets Capital structure measurements relate the components of capital structure to each other or in total and serve as screening measurements to determine if an organization's financial solvency is worthy of a second look. 1.
Debt to Total Capital Ratio a.
Formula Debt-to-total-capital ratio
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Total debt Total capital (= Debt + Equity)
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Interpretation The debt-to-total-capital ratio provides indications related to an organization's long-term debt-paying ability. The lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts. The debt-to-totalcapital ratio is alternatively expressed as the debt-to-asset ratio (below).
2.
Debt (to Asset) Ratio a.
Formula . Total debt Debt (to asset) ratio ~ =---,----Total assets
b.
Interpretation This ratio indicates long-term debt-paying ability. The lower the ratio, the better protection afforded to creditors.
c.
Variations Some analysts adjust the debt to asset ratio to exclude certain items from the denominator (such as reserves, deferred taxes, minority shareholder interests, and redeemable preferred stock) as a basis for refining the amount trUly available to liquidate debt.
B.
Debt-to-Equity Ratio While comprehensive ratios provide insights into the overall solvency, relationships between the elements of capital structure proVide more refined views of solvency. 1.
Formula Debt-to-equity ratio
2.
Total debt Total shareholders' equity
Interpretation The debt-to-equity ratio relates the two major categories of capital structure to each other and indicates the degree of leverage used. The lower the ratio, the lower the risk involved.
3.
Variations Some analysts use the reciprocal of this ratio (total shareholder's equity to total debt) to measure the amount of equity backing up every dollar of debt. Another alternative version of this ratio uses only long-term debt in the numerator to purely compare only the long-term elements of capital structure.
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WORKING CAPITAL MANAGEMENT Working capital policy and management involves managing cash so that a company can meet its short-term obligations and includes all aspects of the administration of current assets (CA) and current liabilities (Cl). The goal of working capital management is shareholder wealth maximization. The optimal mix of current assets and current liabilities depends upon the nature of the business and the industry and requires offsetting the benefit of CA and Cl against the probability of technical insolvency. A.
Definition of Net Working Capital Net working capital is defined as the difference between current assets (CA) and current liabilities (Cl).
B.
Classification of "Current" Classification of assets and liabilities assumes management has the ability and intent to liquidate the liabilities within its operating cycle and that assets will be available for use in the operating cycle. Working capital measures are meaningful because of the appropriate alignment of asset and liability classifications. Construction loans, for example, are often due within the operating cycle, but management often takes measures to refinance the full amount over a longer period. Construction loans are, as a consequence, often classified as non-current, regardless of their due date, because of management's ability and intent to refinance the debt.
C.
Balancing Profitability and Risk Working capital is expensive to carry because it must be financed either with long-term or short-term debt or with stockholders' equity. Adequate working capital reserves, however, mitigate risk, potentially reduce returns, and thereby increase profitability. 1.
Working Capital Concepts and Measures of Solvency While the net amount of working capital (CA minus Cl) measures the amount by which current assets exceed or "cover" current liabiiities, the current ratio (CA divided by Cl) measures the number of times current assets exceed current liabilities and is a way of measuring short-term solvency. This ratio demonstrates a firm's ability to generate cash to meet its short-term obligations.
2.
Current Ratio a.
Formula Current ratio
Current assets Current liabilities
PASS KEY
Aggressive Working Capital Management:
Increase the ratio of current liabilities to non-current liabilities (more current assets financed with current liabilities). Conservative Working Capital Management:
Increase the ratio of current assets to non-current assets (more current assets financed by non-current liabilities).
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Analysis In general, the higher the current ratio, the better. The current ratio is generally regarded as the best single indicator of the company's ability to meet short-term obligations. Classification of Assets and Liabilities as Current
(1)
The classification of an asset as "current" is based on the operating cycle, which occasionally can extend beyond a year, but for purposes of financial reporting, will never be less than a year. Historical
(2)
The current ratio measures liquidity at a point in time, but it is not indicative of future cash flows. c.
Deteriorating Current Ratio A decline in the current ratio, which implies a reduced ability to generate cash, can be attributable to increases in short-term debt, decreases in current assets, or a combination of both.
d.
Improving Current Ratio An increase or improvement in the current ratio implies an increased ability to payoff current liabilities and may be attributable to using long-term borrowing to repay short-term debt (in cases where the firm lacks cash to reduce current debts).
3.
Quick (Acid Test) Ratio a.
Formula . k
QUIC
b.
Cash +Marketable securities + Receivables ratio = -----------c---c---------'Current liabilities
Interpretation The quick ratio is a more rigorous test of liquidity than the current ratio; inventory and prepaids are excluded from current assets. Inventory is the least liquid of current assets; the ability to meet current obligations without liquidating inventory is important.
c.
Variations Some analysts elect to include prepaid assets in the numerator of the quick ratio, but it is more conservative to exclude such items. The higher the quick ratio (or, acid test ratio), the better.
4.
Limitations of the Current Ratio Unless short-term liquidity is a relevant issue, the current ratio is not necessarily the best measure of the health of a business. EXAMPLE
A restaurant might have low CA (e.g., accounts receivable and inventory) relative to Cl (e.g., accounts payable and payroll obligations), but might otherwise be healthy in terms of increasing cash flows, growing reputation, good location, and limited long-term debt obligations. A bookstore might have a high CA (e.g., inventory) relative to Cl (e.g., accounts payable), but might otherwise be unhealthy in terms of diminishing cash flows, poor location, and increased competition from Internet vendors.
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Working Capital and Risk a.
Less working capital increases risks by exposing the company to the likelihood of a possible failure to meet current obligations.
b.
Less working capital increases risks because it may reduce the firm's ability to obtain additional short-term financing.
MANAGEMENT OF CASH AND CASH EQUIVALENTS Factors infiuencing the levels of cash include the volume of collections and their timing, the volume of disbursements and their timing, and the degree to which idle cash is invested in marketable securities. Businesses use various techniques to maximize cash balances including managing float, synchronizing cash infiows and outflows, speeding collections and deposits, and mitigating risks with overdraft systems or compensating balances. A.
Motives for Holding Cash Companies hold cash to make routine payments for business transactions, to repay loans and other financing costs, to maintain compensating balances for banks, to prepare for future uncertainties, and to prepare for future opportunities. Motives for holding cash include: 1.
Transaction Motive A transaction motive for holding cash is concerned with having enough cash to meet payments arising from the ordinary course of business.
2.
Speculative Motive A specuiative motive for holding cash is concerned with having enough cash to take advantage of temporary opportunities.
3.
Precautionary Motive A precautionary motive for holding cash is concerned with having enough cash to maintain a safety cushion so that unexpected needs may be met.
B.
Disadvantages of High Cash Levels Maintaining high levels of cash can be a disadvantage because of:
C.
1.
The "negative arbitrage" effect (i.e., interest obligations exceed interest income from cash reserves),
2.
Increased attractiveness as a takeover target, and
3.
Investor dissatisfaction with allocation of assets (i.e., failure to pay dividends).
Primary Methods of Increasing Cash Levels (reducing the operating cycle) Either speeding up cash infiows or slowing down cash outflows increases cash balances. Improved rates of cash collection are generally achieved through faster accounts receivable collections. Reduced cash outflows are often achieved through delayed (or deferred) disbursements. The combination of current cash infiows and current cash outfiows related to a business is called the operating cycle. The objective of financial managers is to shorten the operating cycle.
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Methods to Speed up Collections a.
Customer Screening and Credit Policy The company can choose to extend credit to more responsible customers, who are more likely to pay bills promptly.
b.
Prompt Billing Timely billing of charges to credit customers ultimately serves to speed up collections.
c.
Payment Discounts Offering payment discounts may influence customers to pay faster and can result in improved cash collections. Discounts forgone represent a higher cost to the customer than a bank loan for similar financing. The formula for calculating the annual cost (APR) of a quick payment discount follows: APR of quick payment discount
360
Discount
Pay period-Discount period
x-,-,-,-,----:c
100-Discount %
EXAMPLE
Facts
Terranova Company is considering offering quick payment discounts to customers in order to speed cash collections. Terms of the discount would be 1/10, net 30. Assuming a 360-day year, what would be Terranova's annual cost of credit for extending the discount if all customers took advantage of it? Solution
_3_6_0_ x _ _ 1"_Yo__ _ = .3_6_0 x _1_%_ = 18.2% 30-10
100%-1%
20
99%
Note: Calculating the cost of quick payment discounts is a favorite CPA Exam exercise. Memorize this formula!
d.
Expedite Deposits Financial managers must not only collect credit sales timely but must also ensure that funds are both deposited and credited to their account in a timely manner. The following techniques reduce the time during which payments received by the firm still remain "uncollected" (not yet credited as cash in the bank). (1)
Electronic Funds Transfer The electronic movement of funds from one institution to another is termed electronic funds transfer or EFT. Electronic funds transfer (EFT) and credit cards ensure timely payment. EXAMPLE
The State collects gasoline taxes for the benefit of municipalities within its borders. Gas taxes are remitted to the cities for use in road improvement projects. State statute requires that the gas taxes be delivered to the benefiting cities by the 10th day of the month following collection. The State implements an electronic funds transfer procedure to move funds from the State Treasury to the municipalities to not only expedite the transfer but also to document compliance with the State's statute.
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Lockbox Systems Lockbox systems expedite cash inflows by having a bank receive payments from a company's customers directly, via mailboxes to which the bank has access. Payments that arrive in these mailboxes are deposited into the company's account immediately. PASS KEY
Retail Lock Box Systems Retail lock box systems describe instances in which low dollar, high volume transactions take place (such as a credit card company that arranges for all payments to go to a lock box).
Wholesale Lock Box Systems Wholesale lock box systems describe instances in which high dollar, low volume transactions take place (such as accounts receivable for a custom machine manufacturer).
EXAMPLE
A company seeks to maximize its investment of idle cash. The cash management techniques used to achieve this objective might include a sweep account to invest idle cash in overnight investments but may go deeper to include procedures that slow down disbursements, speed up collections, and increase control over available cash. Slowing down disbursements might include spontaneous credit through trade accounts payable. Speeding up collections might include use of lock box or insistence that customers use
electronic funds transfer. Securing control over available resources might include use of a zero balance account for payroll as well as negotiation of concentration banking arrangements to ensure that all cash is accounted for in order to invest.
Compare the lockbox fees to additional interest income earned to determine effectiveness.
L-
e.
-----'
Concentration Banking Concentration banking is characterized by the designation of a single bank as a central depository. Advantages of concentration banking include:
f.
(1)
Improved controls over inflows and outflows of cash,
(2)
Reduced idle balances (reduction of idle balances may also mean more timely satisfaction of compensating balance requirements, which represent minimum account balances maintained with a bank in lieu of bank charges and other fees), and
(3)
Improved effectiveness for investments.
Factoring Accounts Receivable Factoring accounts receivable entails turning over the collection of accounts receivable to a third-party factor in exchange for a discounted short-term loan. Cash is collected from the factor immediately rather than from the customer according to the credit terms.
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Methods to Delay Disbursements a.
Defer Payments Postponing payment of accounts payable provides a spontaneous source of credit to which management can resort if the company is confronted with a shortterm cash shortage. Communications to creditors that payments will arrive later than usual serve to mitigate possible damage to credit ratings.
b.
Drafts The use of drafts or checks serves to delay cash disbursements. Using drafts instead of checks increases the payable float. A draft, once presented, must also be first approved before it is paid (i.e., slower than a check).
c.
Line of Credit Establishing a line of credit with a bank serves to slow down payments (i.e., the line of credit extends the company's trade credit by paying off the company's trade accounts with borrowed funds and allowing the company a longer period of time to pay that loan back to the bank). The company replaces one form of credit (trade credit) with another form of credit (line of credit) to deiay the ultimate disbursement of cash from the company, while still allowing bills to be paid on time. Generally, banks will lend up to 80% of the value of "good" accounts receivable and up to 40% of inventory. The bank may require compensating cash balances to offset its credit risk. Revolving lines of credit vary over time as interest rates change. Banks have a legal obligation to honor revolving credit agreements, in return for which they receive a commitment fee from the firm.
d.
Zero Balance Accounts An account that maintains a zero balance is termed a zero balance account or ZBA. Zero balance accounts are accompanied by a master (or parent) account that serves to fund any negative balance. Delegating account management work to the bank through zero balance accounts helps to slow down cash disbursements because disbursements are made only when there is a demand for it (i.e., no float management). EXAMPLE
A company wants to maximize its idle cash and sees its payroll float as a terrific opportunity to capitalize on available resources. The company establishes its payroll account as a zero balance account and links it to its operating account. The payroll account has a zero balance, but payroll checks are honored upon presentation by virtue of an automatic transfer arranged by the company to fund the checks presented to the zero balance account. By eliminating the lump sum transfer of payroll, the company is able to capitalize on the time its payroll transfer is available prior to employees cashing their checks.
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Other Cash Management Techniques Financial managers may use fioat, overdraft protection or compensating balance measures as additional cash management techniques. a.
Elements of Float (1)
Definition Float occurs when there is a difference between the balance in a company's cash accounts and the balance in the bank's records. Float can come in the form of disbursement fioat or collections fioat. Disbursement float (positive) occurs when checks have been written but not received and recorded by the bank. Collections fioat (negative) occurs when deposits have been recorded in the company's books but not recorded by the bank.
(2)
Consideration Float includes consideration of the time required for checks and deposits to travel to the bank, the time required for processing at the receiving bank, and the time required for check clearance.
b.
Managing Float Firms that handle their receipts more efficiently than the firms that receive their checks achieve positive net fioat. (1)
Significance of Positive Float Proper management of the fioat allows firms to maintain a negative cash balance while showing a positive bank balance.
(2)
Methods for Managing Float Devices and procedures to measure float include wire transfers, zero balance accounts, controlled disbursing, centralized processing of payables, and lock boxes.
c.
Overdraft Protection Companies using fioat can provide some protections against overdrafts by arranging overdraft loans with the bank. These loans are usually activated only when an overdraft occurs and may be automatically repaid with the next deposit. The short outstanding loan time reduces interest costs.
d.
Compensating Balances Minimum balances maintained by a bank customer in lieu of bank charges is referred to as a compensating balance. Amounts may serve to eliminate fees or to effectively collateralize credit lines.
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Cash Conversion Cycle The cash conversion cycle (sometimes called "net operating cycle") is the length of time between the date of cash expenditure for production and the date of cash collection from customers (cash-to-cash). 1.
The Cash Conversion Cycle Formula Cash conversion cycle
2.
Inventory Receivables conversion + collection period period
Payables deferral period
Elements of the Cash Conversion Cycle Formula .. Average inventory Inventory conversion period = _--,--,--,-,,---,=::....c-,_ Average cost of sales per day Receivables collection period = Days sales outstanding (D50)
Average receivables Average sales per day
Payables deferral period =
Average payables -,--'-==="-===cAverage purchases per day
3.
Concept Example EXAMPLE - SYNCHRONIZING CASH INFLOWS AND OUTFLOWS
Facts ABC Computers has annual sales of $36 million. On average, the company carries $5 million in inventory, $3 million in accounts receivable, and $3 million in accounts payable. Ifthe annual cost of goods sold for ABC is $27 million, what is the length of the cash conversion cycle for the firm?
$5,000,000 $27,000,000/ /360
Inventory conversion period ~ >~=~=-.,--=
$5,000,000 $75,000
66 2/3 days
$3,000,000 $3,000,000 Receivables collection period ~'$"3-o6-c,0'"'0::;0",0'"'0'"'0"'/-= $100,000 1360 $3,000,000 $27,000,000/ /360
Payables deferral period ~ ,o:::O-==cO-'~:-T-=
$3,000,000 $75,000
30 days
40 days
Cash conversion cycle~66 2/3+30-40~56 2/3 days
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AN C III A R Y MAT E R I A l
IX.
Review
Business 3
o
(for Independent Review)
LIQUID ASSET MANAGEMENT - Securities A.
Trade Credit Trade credit represents the use of credit from suppliers to finance current operations either through formal negotiated arrangements or spontaneously through standard business practice. Trade credit is generally recognized to occur in four forms.
1.
Open Accounts (accounts payable) Trade accounts payable represent spontaneous credit received by suppliers. Typically, suppliers will not require payment for goods on delivery and will allow for payment within a specified period of time. The extension of credit represents defacto financing. a.
Trade credit is frequently granted with a net period and cash discount quoted, for example, as 2/10, net 30 (net period-cash discount). The quoted terms offer the buyer a 2 percent discount if the bill is paid within 10 days but requires full payment within 30 days.
b.
Trade credit may be extended using seasonal incentives to avoid the rush and to guarantee sales (seasonal dating). EXAM PlE
A snowblower manufacturer might offer retail buyers terms under which equipment purchased in the summer would not have to be paid until February.
2.
Accrued Expenses Accrual of expenses (e.g., unpaid salaries, taxes, etc.) that occurs purely as a result of the timing of accounting periods in relation to liabiiity due dates is the purest form of spontaneous short-term financing.
3.
Notes Payable Formalized promissory notes may be executed between suppliers and their customers to evidence the extension of trade credit.
4.
Trade Acceptances Extension of trade credit in a manner less rigid than a note payable, but more formal than an open account, may take the form of a trade acceptance. Trade acceptances are generated in the following manner: a.
The seller extends credit through execution of a draft signed by the buyer. The draft typically is a "time draft" that orders the buyer to settle the obiigation at a specific future date.
b.
The buyer accepts the draft and designates the bank at which it will pay the debt.
c.
The buyer's agreement to the terms of the draft creates a trade acceptance that may be marketable on its own at varying degrees of discount depending on the buyer's creditworthiness.
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Commercial Paper A formalized method of short-term financing is the issuance of short-term unsecured promissory notes known as commercial paper. Given their character, only the most stable and creditworthy companies can access commercial paper as a means of short-term financing. 1.
Dealer Markets Medium-sized companies and utilities typically access commercial paper financing through dealer markets. Dealers will purchase commercial papers in large denominations (usually $100,000) and then remarket them to investors.
2.
Direct-placement Markets Larger companies will directly place (sell) their commercial paper offerings to investors. Clearly, only the largest companies can afford to maintain the infrastructure needed to handle their own financing needs in a manner that beats the discount incurred in dealer markets.
C.
Official Bank Checks Companies that wish to insulate themselves from check fraud or to simplify bookkeeping may use official bank checks. Cashier's checks and other official checks include checks that are provided to a bank depository customer. Official checks may also include checks acquired from a bank by non-customers for remittance purposes (e.g., certain loan disbursement checks).
X.
1.
The definition excludes checks that a bank draws on itself for other purposes (e.g., as a payroll service or as a bill-paying service).
2.
Cashier's checks are generally sold by banks to substitute the bank's credit for the customer's credit and thereby enhance the collectability of the checks.
MANAGEMENT OF MARKETABLE SECURITIES Marketable securities typically provide much lower returns than operating assets but higher returns than cash. Each security has its own features relating to safety, marketability, yield, maturity, and taxability. A.
Common Marketable Securities
1.
United States Treasury Bills (or "T-bills'J T-Bills are sold with 30-day, 60-day, and gO-day maturities and are backed by the U.S. government. T-Bills are default risk-free, liquidity risk-free, and maturity risk-free; therefore, they are the safest securities on the market. T-Bills set the base level of interest in the U.S. economy.
2.
Negotiable Certificates of Deposit (CDs) CDs are negotiable money market instruments with maturities of one (1) year or less. As is true of all money market instruments that are relatively safe, there is an active secondary market for CDs on Wall Street. The guarantees of the largest commercial banks, FDIC regulations and insurance, and the secondary market keep CD risk and return at low levels. Bank failure and default, however, are possible, and this slight additional risk gives CDs higher returns than T-Bllls.
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Banker's Acceptances Banker's acceptances are the short-term IOUs of large, credit-worthy corporations that are guaranteed by commercial banks. The risks associated with bankers acceptances are only slightly higher than those of CDs, thus yields are only slightly higher.
4.
Commercial Paper Commercial paper refers to the short-term lending of idle cash from one credit-worthy corporation to another. Commercial paper loans usually have terms of 90 to 180 days, and they are usually sold in denominations of $100,000.
5.
Equity Securities of Public Companies Investment of idle cash in stocks is risky because of the volatility of the stock market. Gains are potentially far greater than yields from other marketable securities, but losses are also more likely.
6.
Eurodollars Eurodollars represent United States dollars that are deposited in banks outside the United States and are free from United States banking regulations. Often, Eurodollar investments are simply time deposits.
7.
Hedge Transactions Short selling represents selling of a security that is not owned by the seller. Hedge transactions are used to protect asset value or anticipated cash flows.
B.
Factors Influencing the Level of Marketable Securities In many cases, companies hold marketable securities for the same reasons they hold cashmost marketable securities can be converted to cash on short notice. Because marketable securities yield higher returns than cash, many firms will hold marketable securities in lieu of large cash balances. 1.
Liquidity When cash outflows exceed inflows, companies can liquidate marketable securities to increase the cash account.
2.
Credit Hedge In most cases, however, marketable securities are held primarily as a precaution against a possible shortage of bank credit in times of cash need.
C.
Strategies for Holding Marketable Securities 1.
Periods of Low Rates If interest rates for marketable securities are low, and if the time required to liquidate these securities is substantial, then cash holdings are preferable to marketable securities.
2.
Periods of High Rates If interest rates for marketable securities are high, and if the time required to liquidate these securities is minimal, then marketable securities are advisable.
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Risk and Return Factors - Types of Financial Risk
1.
Maturity Risk Premium (MRP) Maturity risk premium (MRP), or interest rate risk, is the compensation investors demand for bearing risk, and it increases with the term to maturity.
2.
Purchasing Power Risk or Inflation Premium (IP) Purchasing power risk or inflation premium (IP) is the compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars (e.g., real estate).
3.
Liquidity Risk Premium (LP) Liquidity risk premium (LP) is the additional compensation demanded by lenders for the risk that an asset will be sold on short notice at a deep discount (e.g., junk bonds). Liquidity is defined as the ability to convert an asset to cash at fair market value.
4.
Default Risk Premium (ORP) Default risk premium (DRP) is the additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest or fail to repay the principal.
E.
Calculation of Required Rate of Return The required rate of return is calculated by determining the risk-free rate, which is the sum of the reai rate of return (i.e., the "rent" investors charge for use of their funds, typically 2-3%) plus the inflation premium and adding risk premiums to the risk-free rate. EXAMPLE
Real rate of return + Inflation premium liP) = Riskvfree rate
3% 2% 5%
+ Risk premium: Interest rate risk (MRP) Liquidity risk (LP) Default risk IDRP)
= Required rate of return
o
3% 8%
END OF ANCILLARY MATERIAL
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MANAGEMENT OF ACCOUNTS RECEIVABLE Accounts receivable management objectives include arriving at an appropriate balance between the accounts receivable balance outstanding and the amount of bad debts and converting accounts receivable into cash quickly enough to meet short-term obligations without angering customers. A.
Factoring Selling accounts receivable to a factor is a mechanism for speeding up cash collections. EXAM PlE
Facts Radon Technologies enters into an agreement with a firm who will factor the company's accounts receivable. The factor agrees to buy the company's receivables, which average $50,000 per month, and have an average collection period of 30 days. The factor will advance up to 80 percent of the face value of receivables at an annual rate of 12 percent and charge a fee of 2 percent on all receivables purchased. The controller of the company estimates that the company would save $10,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the annual cost of financing?
AR submitted Amount withheld
(20%)
Amount subject to interest
AR
x Fee
$50,000 ($10,000)
2%
360/30
$12,000
$40,000
12%/12
360/30
$ 4,800
Cost to company less expense saved (due to outsourced collections}
x (Days in year/days in period)
Subtotals
$16,800 ($10,000) $ 6,800
Net cost
Net cost/average amount advanced = $6,800/ $40,000 = 17% (APR)
B.
Calculating Average Collection Periods Collection period calculations are primarily tools for measuring the effectiveness of a company's credit policy (where 30-50 day collection periods are regarded as healthy) and determining short-term lending risk (performed by banks and other lending institutions to define terms of loan covenants). The average collection period for a firm measures the number of days after a typical credit sale is made untii the firm receives payment. 1.
Formula Collection periods are caiculated by dividing a company's accounts receivable balance (year-end or average, depending on the situation) by its average daily sales.
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Concept Example EXAMPLE
Facts Jackson Furniture has annual sales of $10 million, and carries a year-end accounts receivable balance of $1 million. Calculate the average collection period for Jackson Furniture, assuming a 360-day year.
Solution Annual sales
$10,000,000 $27,778 [$10,000,000 + 3601
Average sales per day Accounts receivable balance
$1,000,000
Average number of days in collection period
C.
36 days [$1,000,000 + $27,7781
Calculating Number of Days Sales in Ending Trade Receivables The number of days of receivables outstanding provides a liquidity measurement of how quickly the receivable asset will be converted into cash. 1.
Formula Number of days receivables outstanding (average collection period)
2.
Ending accounts receivable Average daily sales
Interpretation The number of days of sales in the receivables balance may be calculated by using the ending accounts receivable balance instead of the average. Use of the ending receivable balance may distort results because year-end balances might either be abnormally low due to stepped up collection efforts or abnormally high due to stepped up sales efforts.
D.
Credit Policy Credit policy is one of the major determinants of demand for a firm's products or services, along with price, product quality, and advertising. The credit policy of a company is typically established by a committee that is made up of senior company executives. Credit policy variables (or factors used in developing an optimal credit policy) include: 1.
Credit Period Credit period is the length of time buyers are given to pay for their purchases. The seller must remain mindful of the buyer's operating cycle. If a seller extends credit to a purchaser for a period of time longer than the purchaser's operating cycle, the seller is, in effect, financing more than just the purchaser's inventory needs.
2.
Credit Standards Credit standards refer to the required financial strength of credit customers.
3.
Collection Policy Collection policy is measured by its stringency or laxity in collecting delinquent accounts.
4.
Discounts Discounts include the discount percentage and period.
03·66
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MANAGEMENT OF ACCOUNTS PAYABLE A.
Trade Credit 1.
Trade Credit Trade credit (or accounts payable) generally provides the largest source of short-term credit for small firms. Trade credit represents the purchases of goods and services as part of usual and customary business transactions that are paid for only 30 to 45 days after acquisition.
2.
Discounts Although extension of payments under trade credit arrangements can be very effective in preserving cash balances and financing current operations, the effective annual interest cost can be extremely high if discounts are offered and forgone as part of this working capital management strategy. PASS KEY
When computing the weighted annual interest rate associated with trade discounts, begin by 1.
Computing the annualized increment for the discount: Days per year + Days outstanding after discount (e.g., 2/10 net 30: 360 days.;. (30 -10))
B.
2.
Compute the effective interest rate with discount (e.g., 2/10 net 30: 2% / (100% - 2%))
3.
Multiply the annualized increment by the rate.
4.
Weight according to discounts associated with other similar debt.
Accruals Accruals represent routine transactions that remain unpaid at the end of an accounting period (e.g., wages payable and taxes payable) purely as a result of transaction timing. Accruals are another common form of short-term credit.
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MANAGEMENT OF INVENTORY Inventories represent the current non-cash resource of an organization. The character and importance of inventories depend on the character of the organization and its business. Inventories may be classified as supplies, raw materials, work-in-process, and finished goods. Inventories are typically most significant in businesses that involve the sale or manufacture of goods. Inventories associated with service industries are generally fairly minor. Inventory supplies the necessary "back end" to any sales transaction. Buyers purchase products with the assumption that sellers can deliver those products in a timely fashion, which requires prudent inventory management that balance the cash requirements of the firm with the product delivery requirements of its customers. A.
Factors Influencing Inventory Levels 1.
Inventory Management Inventory depends upon the accuracy of sales forecasts. Lack of inventory can result in lost sales while excessive inventory can result in burdensome carrying costs, including: a.
Storage costs;
b.
Insurance costs;
c.
Opportunity costs of inventory investment; and
d.
Lost inventory due to obsolescence or spoilage.
The lower the carrying costs of inventory, the more inventory companies are willing to carry.
2.
Trends In United States manufacturing companies, short-term assets as a percentage of total assets have declined in recent years, primarily due to inventory reductions. Companies are seeking to maintain liquidity while operating as efficiently and profitably as possible.
B.
Optimal Levels of Inventory Numerous factors impact the optimal level of inventory. Some of the factors are self-evident and include usage rate of inventory per period of time, cost per unit of inventory, cost of placing orders for inventory, and the time required to receive inventory. Significant concepts and calculations associated with inventory control and planning as well as inventory models and systems used in the determination of the optimal level of inventory include:
'3-68
1.
Safety stock
2.
Inventory turnover
3.
Economic order quantity
4.
Materials requirements planning
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Safety Stock A company needs to maintain a certain level of safety stock in inventory to ensure that either its manufacturing or customer supply requirements are met. The determination of safety stock depends upon the reliability of sales forecasts, the possibility of customer dissatisfaction (resulting from back orders), and the cost of running out of inventory, the lead time (the time that elapses from the placement to the receipt of an order) for stock shipments, and any seasonal demands on inventory. EXAMPLE
Facts Worldwide Widgets sells 8,000 Widgets per year, manufactures Widgets in groups of 1,500, and requires 5 weeks of lead time for widget production. Worldwide also maintains an absolute minimum safety stock of 1,200 widgets. Assuming a 50-week year and constant demand, what is Worldwide's reorder point for widgets?
Solution Worldwide sells an average of 160 Widgets per week, meaning that 800 Widgets (Le., 160 x 5) would likely be sold during the 5 week lead time between reorder and inventory arrival. Given the safety stock minimum of 1,200 widgets, the reorder point would therefore be 2,000, or the sum of the safety stock and the number of Widgets sold during lead time.
D.
Stockout Costs Stockout costs include loss of income from product unavailability, the cost of restoring goodwill, and additional expenses incurred to expedite shipping. EXAMPLE
Facts For Jordan Manufacturing, stockout costs average $8 per unit, and the probability of a 100-unit stockout per inventory order cycle is 0.30. If the company orders inventory 6 times annually, what is the total stockout cost on an annual basis?
Solution Stockout Costs x x x
E.
100
Stockout units Stockout costs per unit Probability of stockout Average cost per cycle Orders per year Annual stockout costs
$8 $800 0.30
$240 6
$1,440
Inventory Turnover The inventory turnover calculation is an important ratio in measuring the effectiveness of inventory management. The calcuiation divides cost of goods sold by the average inventory balance to determine how many times the investment in inventory balances has been sold to customers. PASS KEY
• Increased inventory turnover reduces inventory. • Decreased inventory x APR = Cost savings.
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EXAMPLE· INVENTORY TURNOVER
Facts Sydney Company had sales of $10 million in 2002, with costs of goods sold equal to $7 million and an average inventory balance of $2 million. What was Sydney's average days of sales in inventory for 2002?
Solution Cost of Goods Sold
$7,000,000
Average Inventory Balance
$2,000,000
Inventory turnover
3.5 times/yr
Average days of sales in inventory
104.3 days (365 + 3.51
(365 days divided by turnover)
Sydney could provide product to its customers for 104 days if manUfacturing were to cease immediately. Such a high level of inventory reduces the risk of stockouts, but likely imposes high carrying costs.
F.
Number of Days Sales in Inventory
1.
Formula Number of days of inventory in stock
2.
365 (or 360) Inventory turnover ratio
Ending inventory x 365 (or 360 ] 1 [ Cost of goods sold
Interpretation The days sales in inventory measures the degree to which resources have been devoted to inventory to support sales.
G.
Economic Order Quantity The economic order quantity (EOO) inventory model attempts to minimize ordering and carrying costs. The model can be applied to the management of any exchangeable good.
1.
Assumptions EOO assumes that demand is known and is constant throughout the year, so EOO does not consider stockout costs, nor does it account for costs of safety stock. EOO also assumes that order cost is fixed and that carrying costs include the following elements:
0 0 0 0 0
B3-70
~torage
Qbsolescence Materials
Insurance interest
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The EOQ Equation and Equation Components
o o o o ~arrying
Order size (J;OQ)
Annual
~ales (in units)
Cost per Purchase Qrder (primarily production set-up costs)
3.
cost per unit
Concept Example - EOQ EXAMPLE· EOQ
Facts Maximus Company has an economic order quantity of 100 units, and each order costs the firm $5,000. If Maximus goes through 50 units of inventory monthly, what is the carrying cost for Maximus per unit per month?
Solution Annual cost:
lSO
E= -
C
100 = /2 x (50 x 12) x $5,000 C
10000 = $6,000,000 ,
C
c = $6,000,000
= $600/year
10,000
Monthly cost: $600/ 12 = $50 / month
4.
Concept Example - EOQ EXAMPLE - EOQ
Facts If the EOQ for a product is 300 units and the company maintains a safety stock of 100 units, what is the average inventory level for the product?
Solution If the order quantity is 300 units, then half of this quantity indicates the average quantity of 150 within the reorder group. Add this to the safety stock constant of 100, and the average inventory level for the product is 250 units.
H.
Just-in-Time Inventory Models The just-in-time (JIT) inventory model was developed to reduce lag time between inventory arrival and inventory use. JIT ties delivery of components to the speed of the assembly line.
1.
Advantages JIT reduces the need of manufacturers to carry large inventories, but requires a considerable degree of coordination between manufacturer and supplier.
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AN C ILL A R Y MAT E R I A L (for Independent Review)
2.
Application In some cases, small companies are better-suited to JIT than large companies because small companies can manage inventory more tightly.
I.
Kanban Inventory Control Kanban inventory control techniques give visual signals that a component required in production must be replenished. 1.
Advantages The technique prevents oversupply or interruption of the entire manufacturing process due to lack of a component.
2.
Application Kanban cards have been used in manufacturing environments to provide easily interpreted visual cues to expedite supplying manufacturing production.
J.
Computerized Inventory Control Technology has provided opportunities to synchronize inventory utilization and recordkeeping in retail environments. Computerized inventory control operates by estabiishing realtime communication iinks between the cashier and the stock room. 1.
Advantages Inventory levels are monitored instantaneously for improved control.
2.
Application Every purchase is recognized instantaneously by the inventory database, as is every product return. Computers are programmed to alert inventory managers as to reorder requirements. In some cases, company databases interface directly with supplier software to allow for instantaneous reorders, thereby removing the human element.
K.
Materials Requirements Planning Materials requirements planning (MRP) systems extend the idea of computerized inventory controi to manufacturing operations. MRP systems are generally computer-based and are designed to control the usage of raw materials in the production process. 1.
Advantages MRP improves the coordination and control of raw materials used in the manufacturing process.
2.
Application The MRP system calcUlates the raw materials reqUired when a given number of finished units are needed. The computer generates a iist of each component and part needed, exactly as they are needed, and also generates purchase orders. MRP also creates precise schedules of which items will be needed and at what times they will be needed during the manufacturing process.
'--------_.----------------------'
o
END OF ANCILLARY MATERIAL
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FINANCIAL VALUATION
Traditional financial valuation is based upon the annuity present value formula. The formula is somewhat complex, but is applied in various forms through the financial management topic. Alternate valuations use variations on the Price Earnings (PIE) ratio. The significance of the topic is less related to the formulas and more focused on the implied assumptions of the formulas and the impact of the behavior of financial managers on the evaluation of those assumptions.
I.
METHODS OF CALCULATING VALUATIONS A.
Annuity Present Value Formula (also referred to as discounted cash flow) The traditional approach to asset valuation is the annuity present value formula. The formula divides cash flows by the rate of return. 1.
Annuity Present Value Annuity present value = C x (1- Present value factor I r)
= C x (1- [1 / (1 + r)'] / r Terms are defined as:
C = Cash flow annuity. r = Rate of return. t = Number of years.
2.
Assumptions Key assumptions implied by the variables of the formula include: a.
Recurring Amount of the Annuity The amount of the periodic annuity must be specified (e.g., $10,000 per year).
b.
Appropriate Discount Rate Assumptions must specify the discount rate (e.g., the company requires a 15% return per year).
c.
Duration of the Annuity Assumptions must specify how long the annuity will continue (e.g., 2 years, 10 years or even perpetuity, etc.).
d.
Timing of the Annuity An annuity may be received or paid in any number of ways. Assumptions must specify if the annuity recurs monthly, quarterly, annually, etc. The assumptions must also specify if the annuity occurs at the beginning or the end of the period.
B.
Zero Growth Stock The traditional annuity formula for perpetual cash flow streams (such as stock) is simplified since no duration is known.
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Per Share Valuation Per Share Valuation = P = D/R
Terms are defined as: P = Price. D = Dividend, R = Required return.
2.
Assumptions a,
The assumptions must specify the dividend (and assume it will never change),
b,
The formula implies that the stock price will never grow (that it will grow at the same rate as the dividend, which is zero),
c,
The assumptions must specify the required return, CONCEPT EXAMPLE
Baker Company pays a dividend of $5 per year. Able wants to invest in Baker and wants to earn a 20% return. What will Able pay for Baker?
P = D/R P=$5/20% P = $25 Able would pay $25 for a share of Baker
C.
Constant Growth The traditional annuity formula for perpetual cash flow streams (such as stOCk) is derived from the annuity present value formula, 1.
Per Share Valuation with Assumed Growth Value of equity: Per Share Valuation with Assumed Growth = Pt = D(t+l)/ (R - g)
Terms are defined as: Pt
= Current price (price at period "til).
D(t+l} = Dividend one year after period "t".
2.
B3-74
R
= Required return.
G
= Growth rate.
Assumptions a,
The assumptions must specify dividends one year in the future,
b,
The assumptions must include a required return,
c,
The assumptions must include a growth rate,
d,
The formula implies that the stock price will grow at the same rate as the dividend (not unreasonable),
e,
The formula anticipates that the required rate of return is greater than the growth rate, Unless that required return exceeds that growth rate, the formula is unreasonable, © 2010 OeVry/Becker EdUC3tion31 Oevelopment Corp. All
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CONCEPT EXAMPLE
Baker Corporation pays a dividend of $5 per year and is projected to grow at 4% per year. Able wants to invest in Baker and wants to earn a 20% return. What will Able pay for Baker in one year?
P, = 01'''I/(R - g) D(t+l)
= $5 x 1.04
°1'.'1 = $5.20 P, = $5.20 I (.20 - .04) P, = $5.20 I (.16) P, = $32.50 CONCEPT EXAMPLE
Baker Corporation pays a dividend of $5 per year and is projected to grow at 4% per year. Able wants to invest in Baker and wants to earn a 20% return. What will Able pay for Baker in three years?
°
P, = 1.. ,)1 (R - g) D(t+ll
=$5 x 1.04 x 1.04 x 1.04, or
O{",{ = $5 x (1.04)'
°1",) = $5 D(t+ll
x
1.124864
=$5.62
P,= 01..,{/(R-g) P, = ($5.62 x 1.04) I (.20 - .04) P, = $5.84 I (.16) P, = $36.53
D.
Alternate Approaches - PIE Ratio Value af equity:
(Po) = (Pol E,) x E, Terms are defined as: Po = Price or value today. E1 = Expected earnings in one year. CONCEPT EXAMPLE
The PIE ratio is an identity formula that focuses on the relationships that will later serve as a basis to forecast share price. Assume Baker Corporation has a current price of $10 and anticipates earnings per share in the coming year of $2 based on current year earnings per share of $1.50. Using price earnings formulas, we would confirm the value of Baker's stock as follows:
(Po) = (Pol E, ) x E, (Po) = ($10 I $2) x $2 (Po}=5 x $2 (Po) = $10
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Alternative Approaches - PEG Ratio Value af equity:
{Pol = PEG x E, x G
[(Pol Eo) I G) x E, x G Terms are defined as: Po = Price or value today. Eo = earnings per share today. E1 = expected earnings in one year. G = growth rate = 100 x expected growth rate.
CONCEPT EXAMPLE
Baker wants to use the PEG ratio to project the price of its stock. The company's current stock price is $50 and its earnings per share are $5. The growth rate for earnings is anticipated to be 4%. The projected price of Baker's shares would be computed as follows:
{Pol = PEG x E, x G (Po) = [(Pol Eo) I G)
X
E, x G
(Po) = [($50 I $5) 14] x ($5 x 1.04) x 4 {Pol = $2.50 x $5.20 x 4 (Po) = $52.00
F.
Alternative Approaches Price Sales Ratio Similar to the PIE ratio, this computation is an identity formula that confirms relationship in arriving at stock price. The statistics are used when earnings are low and would not produce meaningful results. Value of equity:
{Pol = {Po 15,1 x 5, Terms are defined as: Po = Price or value today.
51 = Expected sales in one year.
G.
Assumptions PIE ratios have similar assumption requirements, each of which can be influenced by management behaviors including:
63-76
1.
Future earnings.
2.
Future grow1h rate.
3.
Future sales.
4.
Duration of sales or earnings trends.
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EVALUATING ASSUMPTIONS USED IN VALUATIONS A.
Behavioral Influences Forecasting has numerous subjective elements that are subject to behavioral influences. These influences generally include: 1.
Generalized Rules of Thumb Generalized rules of thumb distort objective evaluation of evidence. a.
Tendency to Use Stereotyped Characterizations The uses of PEG and DCF techniques are useful but all analytical techniques are not equal. PEG and other PIE techniques are less rigorous than the detailed analysis required for DCF.
b.
Use Adjustments from Presumed Baselines Adoption of an earnings or price amount that is "correct" and adjusting it upward or downward for assumptions can result in errors since adjustments are usually not sufficient.
c.
Use of Intuition Rather than Analysis Failure to use objective analysis in favor of beliefs or emotions can result in miscalculation of values or assumptions.
d.
Use of the Most Easily Available Data to Confirm Intuitive or Stereotyped Beliefs Managers experience confirmation bias when they purely use data that confirm their conclusions and ignore data that challenge their ideas. For example, managers and analysts may mistake growth in EPS for growth opportunities. The idea that price can be adjusted for growth factors based purely on growth of EPS ignores the corporate objective of beating the hurdle rate. Growth in EPS may be purely indicative of meeting minimum hurdle rate requirements which maintain firm value.
2.
Biases a.
Excessive Optimism The strong belief or overestimation of positive results.
b.
Over-confidence The strong belief that decisions and evaluations are correct.
c.
Illusion of Control The erroneous belief that the financial manager has control over valuation outcomes that are ultimately the resuit of market forces.
3.
Context a.
Losses are More Distracting than Gains Managers are more likely to try and beat the odds to restore profitability. Riskier behavior comes when losses are higher. Prudent and analytical management of gains is more likely than management of losses.
b.
Managers are Generally Averse to Sure Losses Even knowing that the likelihood of reversing project losses is remote will not motivate the financial manager to take a sure loss. The chance, however remote, that losses might be reversed will keep the manager from making the logical decision to absorb a sure loss with no opportunity to recover and, instead, escalate the commitment in hopes that the project results will reverse.
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FINANCIAL TRANSACTIONS PROCESSES AND CONTROLS
o
AN C III A R Y MAT E R I A l (for Independent RevIew)
Identifying and controlling financial transactions is integral to financial management. The individual transactions of a business are typically processed and controlled through an Accounting Information System (AIS) that is customized to the requirements of a specific business.
I.
TRANSACTIONS Transactions represent economic events denominated in currency. Similar economic events are typically grouped for repetitive processing into five transaction cycles. Individual industries might have additional or customized transaction cycles. A.
Revenue Cycle Transactions associated with the sales of goods or services that produce cash or other assets (e.g., receivables). Modules may interface with other cycles but often include:
B.
1.
Customer orders and credit verification
2.
Accounts receivable
3.
Cash receipts
Expenditure Cycle Transactions associated with purchase of goods or services that use cash or produce debt or other obligations. Modules may interface with other cycles but often include:
C.
1.
Purchasing
2.
Inventory control (work in process)
3.
Accounts payable
4.
Cash disbursements
Production Cycle Transactions associated with the conversion of resources (e.g., raw material or time) into products or services. Modules may interface with other cycles but often include:
D.
1.
Product design and production planning
2.
Product manufacturing
3.
Inventory control (Finished goods)
Human Resources/Payroll Cycle Transactions associated with all phases of employee administration (hiring, determining compensation, paying employees, benefits administration and termination). Modules may interface with other cycles but often include:
B3-78
1.
Human resources (hire, evaluate, administer benefits, etc.)
2.
Time and Attendance
3.
Payroll disbursements
4.
Payroll tax reporting
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Financing Cycle Transactions associated with equity and debt financing including issuance of stock or debt, payment of dividends or debt service payments, etc.
II.
PROCESSES Transaction processes are generally divided into the following four functional areas that comprise the data processing cycle. A.
Data Input Transactions must be captured or gathered and entered into a system. 1.
2.
Basic Issues Associated with Gathered Data a.
All transactions of interest are accounted for.
b.
All transactions comprehensively accounted for in affected accounts.
c.
All the people originating the transactions are identified.
Input Verification Tracing the data to appropriate supporting evidence contributes to validation of the accuracy of the transaction and its authorization. a.
Source Documents Purchase orders, customer orders, and timesheets are examples of source documents used in data input. Documents may be either manual or computer generated.
b.
Turnaround Documents Turnaround documents pre-print data in machine readable form. A customer pays their mortgage with a check and an input document. The input document is machine readable and expedites accounting for the receipt.
3.
B.
Features of Desirable Data Input Procedures a.
Pre-numbered source documents allow for verification of all data input.
b.
Source documents are efficiently designed to capture all reqUired information.
c.
Data input is verified prior to acceptance by the system (e.g., the reasonableness of hours worked, the availability of inventory to ship, etc.).
Data Storage The concept of data storage anticipates the methods and media used for keeping data available for retrieval. 1.
Methods a.
Journals and Ledgers Generally speaking, data is entered into an AIS first to journals (for individual transactions) and summarized (by account groups) into ledgers. Audit trails allow for summary ledger data to be traced to journals and then to specific transactions and source documents.
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Coding Transaction coding is used to control transactions. There are several different types of coding methods: (1)
Sequence Codes Transactions are assigned a sequential number to ensure that all transactions are accounted for (e.g., check numbers, cash register receipt numbers, etc.).
(2)
Block Codes Transactions are assigned to a block of numbers that categorizes the transaction. General ledger account number blocks (series of numbers for assets, liabilities, etc.) and inventory number blocks (series of numbers for household goods, appliances, etc.) are examples of block codes.
(3)
Group Codes Logic imbedded into block codes refines the meaning of the data (e.g., the first two digits of an inventory code might indicate whether the item is an appliance, the next digits might indicate whether the item is a kitchen appliance or laundry, etc.).
c.
Charts of Accounts Charts of accounts represent a form of coding that summarizes accounting data by transaction classification (e.g., assets, liabilities, revenues, expenses, etc.) for purposes of financial analysis and presentation.
2.
Computer Storage Computer storage of data follows a very logicai sequence. That sequence includes the following definitions: a.
Entity The subject of the stored information (e.g., employee, customer, etc.).
b,
Attributes The data of specific interest for each entity (e.g., rate of pay for employees, credit rating for customers, etc.).
c.
Field Data values are stored in a physical space known as a field. The field might be the employee's name or the customer's street address.
d.
Record The attributes gathered about an entity are accumulated in fields that comprise a record (e.g., the employees, name, address, W-4 status, rate of pay, etc.).
e.
Data Value The contents of fields are typically referred to as data values.
f.
File Records are grouped into files.
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Master file Similar to a ledger, the master file stores cumulative information.
h.
Transaction File Similar to a journal, the transaction file stores individual transactions.
i.
Database Files that are interrelated and coordinated are referred to as a database.
C.
Data Processing Transactions are processed to keep information current, and include various functions and methods described below: 1.
Functions Data processing functions are listed logically, but not necessarily sequentially. a.
Data Creation The concept of data creation includes adding new records to a file such as adding a new employee to a Human Resources data base.
b.
Data Reading The concept of reading data includes retrieving and using information such as identifying a class code for the new employee based on position.
c.
Updating The concept of updating includes revisions to the master fiie, such as changes in cumulative year-to-date payroll each payday, changes in employee status, etc.
d.
Deleting The idea of deleting involves purging information from the system such as older employee records or deleted positions.
2.
Methods Methods of data processing generally refer to the timing of the update cycle. a.
Batch Processing Periodic updates of system data are accomplished using batch processing. Periodic updates anticipate that immediately current data is not required and that time lags are acceptable. Batch processing might be used for payroll transactions assuming that data is only needed to generate compensation payments to employees at the end of each payroll. Time and attendance records are batched and input to the system in batches and payroil is generated.
b.
Online Real-time Processing Continuous updates of system data are accomplished using real time processing. Continuous updates produce immediately current data that enhances the decision usefulness of the data and facilitates timely correction of errors. Realtime processing might be used for airline ticket sales. The database must be continuously updated for seat occupancy to ensure that tickets are not sold on a full flight.
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c.
Online Batch Processing Oeta Os en1ered into the system as • occurs and then master files are updated periodically. Online time and anendance systems update employee altendance with ead! entry to the system. ye1 Pi'yroI i$ processed periodically.
O.
InfonTUllion OUlpu! Transactions are ulU'nately reported and used in some manner. OutpulS number 01 'oons and include ~ral convnon lopics.
I.
can lake any
Form
a.
Document.
Documents (somelimes referred 10 as opeI'8Iional doaJmentsj include OUIpulS s.uch as ched'.$. purdla5e on.le
Report. Reports c.an be ekher Inlernal (e,g" sales analysis) or external (e g.. financial stalemenlS). Infoonation is produc:e
c.
Query A query is generally an online request 'or specil'ic dale (e.g.. da'(s sales). The user enlars ll1e qoory and lhe systam produces a response as of lhe time and in the paramelar5 spadf>e(l by lhe user. Queries ma1 be pre-establis/le(f for freq..ent and spontaneous req..eSl!i by u5ers.
2.
Topic Rapx1topics c.an cover IN'ly number 01 are generally as folows:
III.
purposes.
a.
Budgets
b.
PrOOudion and ljeliYery schedule's
c.
Perfoonance Reports
Financial rapoItS generated by AIS
COOTROI..S The CommiIlf!f! on Spon$Ofing O
:alion5 (COSO) identiflf!d four types 01 oIljectives for Iotemal control systems and live components of internal control:
A.
Objectlvn I.
Sfrateglc O,*",ctivu Higher level goals associaled with the compall'(s miS$lon are 1Ile
'0CltS of lhis
objedive.
2.
Operations Objectiws OpeIll1il)nal goals associated witll efficienCy and effeetlveness. Pefloonance. proIi1abilky and asset salegulll'ding proce
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Reporting Objectives Accuracy, completeness and reliability of internal and external reports are the focus of reporting objectives. Reporting objectives seek to improve decision making and monitor company activities.
4.
Compliance Objectives Compliance with laws, rules and regulations is the focus of compliance objectives.
B.
Components 1.
Control Environment The control environment embraces management's philosophy and operating style. The commitment of management to ethical standards and the corresponding policies and organizational structures that ensure proper control over assets, financial reporting and fraud prevention help define the control environment.
2.
Control Activities Policies and procedures that implement controls.
3.
Risk Assessment Organizational evaluations of inherent and control risks as well as periodic reevaluations of changing circumstances.
4.
Information and Communication Organizational controls that capture and disseminate information in a manner that allows the organization to monitor its objectives.
5.
Monitoring Monitoring/reviewing the control process and updating as necessary to ensure achievement of control objectives.
o
END OF ANCILLARY MATERIAL
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TERMINOLOGY
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
Accounting Information System (A1S)
Database
Accounting Rate of Return (ARR)
Dealer Markets
Annual Percentage Rate (APR)
Debenture
Application controls
Debt to Total Capital Ratio
Asset Turnover
Debt to Assets Ratio
Average Collection Period
Debt to Equity Ratio
Avoidable Costs
Depreciation Tax Shield
Banker's Acceptance
Direct Costs
Batch processing
Direct Placement Market
Bill of Materials
Discretionary Costs
Block codes
Discounted Cash Flow Methods
Bond Indenture
Discounted Payback Method
Bond Yield Plus Risk Premium Method
Dividend Yield plus Growth Rate Method
Call Provision
Draft
Capital Asset Pricing Model (CAPM)
Economic Order Quantity (EOQ)
Capital Budgeting
Electronic Funds Transfer (EFT)
Capital Rationing
Eurodollars
Cash Conversion Cycle
Eurobonds
Commercial Paper
Expected Value
Compensating Balance
Expenditure cycle
Concentration Banking
Factoring
Conversion Costs
Field
Cost of long-Term Debt
File
Cost of Preferred Stock
Financial cycle
Cost of Retained Earnings
Financial leverage
Cost Object
Float
Coupon Interest Rate
Floating Rate Securities
Cumulative Preferred Stock
General controls
Current Ratio
Group codes
Data
Human resources/payroll cycle
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Hurdle Rate of Return
Quick Ratio
Indirect Costs
Receivables Collection Period
Income Bonds
Record
Incremental Costs
Reinvestment Risk
Internal Rate of Return Method
Relevant Costs
Inventory Conversion Period
Residual Income
Inventory Turnover
Return on Assets (ROA)
Investment Turnover
Return on Investment (ROI)
Junk Bonds
Revenue cycle
Just-In-Time (JIT)
Risk-Free Rate
Kanban
Safety Stock
L180R
Simple Interest
Line of Credit
Secondary Market
loan Covenant
Sequence codes
Lockbox
Source documents
Materials Resource Planning (MRP)
Stockout Cost
Maturity Risk Premium
Subjective Probability
Mortgage Bond
Subordinated Debenture
Net Book Value
Sunk Costs
Net Present Value Method (NPV)
Total Leverage
Number of Days Sales in Inventory
Trade Acceptance
Objective Probability
Trade Credit
Online Realtime Processing (OLRT)
Transactions
Operating Cycle
Treasury Bills
Operating Leverage
Treasury Notes
Optimal Capital Structure
Treasury Bonds
Participating Preferred Stock
Turnaround document
Payables Deferral Period
Value Added Activities
Payback Method
Value Chain
Preferred Stock
Weighted Average Cost of Capital (WACq
Primary Market
Working Capital
Prime Costs
Zero Balance Accounts
Probability
Zero Coupon Bonds
Review
Production cycle Profitability Index
B3-86
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CLASS QUESTIONS
c
~
o "';::::;
'" ..D
lil E z ~
~
0
~
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c
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0
u
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CLASS QUESTIONS ANSWER WORKSHEET
1. 2. 3.
4. 5. 6. 7.
8. 9.
10. 11. 12. 13. 14. 15. GRADE
Attempt
Multiple~choice
Questions
Notes
1st
Multiple-choice questions correct + 15 questions :::
%
2nd
Multiple-choice questions correct + 15 questions -
%
3rd
Multiple-choice questions correct + 15 questions:::
%
Final
Total questions correct
+ 15 questions:::
1D2010 DeVry{Becker EduC
%
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1. CPA-03283 In equipment-replacement decisions, which one of the following does not affect the decision-making process? a. b. c. d.
Current disposal price of the old equipment. Original fair market value of the old equipment. Cost of the new equipment. Operating costs of the new equipment.
2. CPA-G3358 When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to: a. b. c. d.
Compute the net present value of each cash flow using the firm's cost of capital. Compare the internal rate of return from each cash flow to its risk. Utilize the accounting rate of return. Discount each cash flow using a discount rate that reflects the degree of risk.
3. CPA-03337 If the net present value of a capital budgeting project is positive, it would indicate that the: a. b. c. d.
Present value of cash outflows exceeds the present value of cash inflows. Internal rate of return is equal to the discount percentage rate used in the net present value computation. Present value index would be less than 100 percent. Rate of return for this project is greater than the discount percentage rate used in the net present value computation.
4. CPA-03326 Oak Company bought a machine, which they will depreciate on the straight-line basis over an estimated useful life of seven years. The machine has no salvage value. They expect the machine to generate after-tax net cash inflows from operations of $110,000 in each of the seven years. Oak's minimum rate of return is 12%. Information on present value factors is as follows: Present value $1 at 12% at the end of seven periods Present value of an ordinary annuity of $1 at 12% for seven periods
.0452 4.564
Assuming a positive net present value of $12,000, what was the cost of the machine? a. b. c. d.
$480,000 $490,040 $502,040 $514,040
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5. CPA·03782 During 1994, Deet Corp. experienced the following power outages:
Number of outages per month
o 1 2 3
Number of months 3 2 4
....l 12
Each power outage results in out-of-pocket costs of $400. For $500 per month, Deet can lease an auxiliary generator to provide power during outages. If Deet leases an auxiliary generator in 1995, the estimated savings (or additional expenditures) for 1995 would be: a.
b. c. d.
($3,600) ($1,200) $1,600 $1,900
6. CPA·03423 The overall cost of capital is the: a. b. c. d.
Rate of return on assets that covers the costs associated with the funds employed. Minimum rate a firm must earn on high-risk projects. Cost of the firm's equity capital at which the market value of the firm will remain unchanged. Maximum rate of return on assets.
7. CPA·03385 DOZ Telecom is considering a project for the coming year, which will cost $50 million. DOZ plans to use the following combination of debt and equity to finance the investment. Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par. • Use $35 million of funds generated from earnings.
•
The equity market is expected to earn 12 percent. U.S. Treasury bonds are currently yielding 5 percent. The beta coefficient for DOZ is estimated to be .60. DOZ is SUbject to an effective corporate income tax rate of 40 percent. Assume that the alter-tax cost of debt is 7 percent and the cost of equity is 12 percent. Determine the weighted average cost of capital. a. b. c. d.
10.50 percent. 8.50 percent. 9.50 percent. 6.30 percent.
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8. CPA-03420 Using the Capital Asset Pricing Model (CAPM), the required rate of return for a firm with a beta of 1.25 when the market return is 14 percent and the risk-free rate is 6 percent is: a. b. c. d.
14.0 percent. 7.5 percent. 17.5 percent. 16.0 percent.
9. CPA-03435 Residual income is a better measure for performance evaluation of an investment center manager than return on investment because: a. b. c. d.
The problems associated with measuring the asset base are eliminated. Desirable investment decisions will not be neglected by high-return divisions. Only the gross book value of assets needs to be calculated. The arguments about the implicit cost of interest are eliminated.
10. CPA-03528 Which one of the following would increase the working capital of a firm? a. b. c. d.
Cash collection of accounts receivable. Refinancing of accounts payable with a two-year note payable. Cash payment of accounts payable. Payment of a thirty-year mortgage payable with cash.
11. CPA·03456 Which of the following transactions would increase the current ratio and decrease net profit? a. b. c. d.
A federal income tax payment due from the previous year is paid. A long-term bond is retired before maturity at a discount. A stock dividend is declared. Vacant land is sold for less than the net book value.
12. CPA.()3458 Garo Company, a retail store, is considering foregoing sales discounts in order to delay using its cash. Supplier credit terms are 2/10, net 30. Assuming a 360-day year, what is the annual cost of credit if the cash discount is not taken and Garo pays net 30? a. b. c. d.
24.0 24.5 36.0 36.7
percent. percent. percent. percent.
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13. CPA-03522
A working capital technique, which delays the outflow of cash, is: a. b. c. d.
Factoring. A draft. A lock-box system. Compensating balances.
14. CPA-06133 Investors are likely to view a high price earnings (PIE) ratio as an indication that: a. b. c. d.
Earnings have growth potential Earnings have peaked and will remain fiat Earnings have peaked and will likely fall There is no logical conclusion to reach about the relationship between price and earnings
15. CPA-06134 An analyst notes the current price of Karnani Enterprises stock is $15 per share while the EPS is $3. If the PEG ratio is 1.25, what has the analyst projected as the growth rate for Karnani Enterprises? a. b. c. d.
25%. 20%. 5%. 4% .
• 3-92
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Information Systems and Communication
1.
Organizational needs assessment
,
3
2.
Systems design and other elements
23
3.
Security
44
4.
Internet implications for business
53
5.
Types of information systems and technology risks
69
6.
Disaster recovery and business continuity
98
7.
Terminology
103
8.
Class questions
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ORGANIZATIONAL NEEDS ASSESSMENT
I.
INTRODUCTION TO INFORMATION SYSTEMS AND COMMUNICATION Why should a person preparing for an accounting career be studying information technology? It is quite a simple answer, survival! In today's world, without a basic understanding of information technology, one would find it very difficult to successfully audit a client, provide basic consuiting services, or even function effectively in most modern business organizations. In the Statement of Financial Accounting Concepts No.2, the Financial Accounting Standards Board defined accounting as being an information system. It also stated that the primary objective of accounting is to provide information useful to decision makers. The Accounting Education Commission recommended that the accounting curriculum should be designed to provide students with a solid understanding of the three essential concepts: -/ The use of information in decision making. ./ The nature, design, use, and implementation of an AIS. .;' Financial information reporting.
A.
Information Technology The phrase information technology is a very general term that encompasses many different computer-related components. This section will cover the most important of these information technology components, as seen in the figure below. The old saying, "a chain is only as strong as its weakest link," certainly applies to the information technology of any given organization. Even if an organization has spent millions of dollars on computer hardware and the training of its employees, if the software systems it uses are flawed and the data contained in those systems is unreliable, all of the organization's spending as well as the employees' hard work has been wasted, and any financial reports will be meaningless.
INFORMATiON TECHNOLOGY
One of the most basic and vital information technology components of any business is that of the software known specifically as the "Business Information System." This component is where our more detailed discussion of Information Technology will begin. In order to operate successfully, businesses need computer systems that can accurately record and summarize their business transactions. This type of information technology is called a business information system. Business information systems have become an essential component of every business organization. It would be very difficult, if not impossible, to successfully run a business without some type of information system. Business information systems support the business functions of accounting, finance, marketing, operations management, human resources, and almost all other parts of an organization. The business information system terminology can be used whether or not an organization might or might not actually be considered a business. ©2010
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Business information systems can be divided into the categories of transaction processing systems, knowledge systems and office systems, management information systems, decision support systems, and executive information systems. Most of these categories, the ones most relevant to accountants and auditors, will be discussed in this chapter. The categories are not mutually exclusive; many business information systems perform multiple functions and can fit into several of these categories.
B.
Components of Information Technology Information technology is generally comprised of five components:
1.
Hardware Hardware is the actual physical computer or computer peripheral device. For example, a PC or some other kind of workstation, a mainframe, a disk drive, a tape drive, a monitor, a mouse, a printer, a scanner, and a keyboard are all considered hardware.
2.
Software Software is the systems and programs that process data and turn that data into information. Software can be very general and be used by any organization (e.g., a word processing program such as WordPerfect® or Microsoft Word®). Software also can be very specific (e.g., an internal auditing program). Software can be developed internally by the organization or can be purchased as an application package from an outside vendor. Software can be divided into the categories of system software, programming languages, and application software.
3.
Network A network is made up of the communication media that allows multiple computers to share data and information simultaneously. There are many different types of media that can allow computers to be connected (e.g., traditional twisted pair networking cables and coaxial cables). More recent technology allows computers to be connected with fiber optic cable, microwaves, wireless cellular, and even satellites.
4.
People There are many different people associated with business information systems. The various job titles and job descriptions are discussed in much more detail later. Note that job titles can vary widely among organizations, but the functions are somewhat standard given a particular hardware, software, and network configuration. Regardless of titles, there are always the functions of initial setup and maintenance/support after initial setup. It is possible that certain functions may not be performed by people within an organization (e.g., those functions may be outsourced to other organizations).
5.
Data/Information a.
Data Data is raw facts (e.g., a quantity, a name, or a dollar amount). Data is stored in computer systems in various ways, which are discussed in detail later. In a computer environment, data stored on devices is often described either as production data (that results from production processing and is stored in production systems) and test data (that results from test processing and is stored in test systems). Production and test data are normally kept totally separate, and access to production data and access to test data must be controlled separately and differently.
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Information Information is organized and processed data that is meaningful to somebody.
C.
Roles of Business Information Systems 1.
Three Primary Roles in Business Operations Regardless of the category, a business information system has three primary roles in business operations. a.
Process Detailed Data A business information system may allow a business to process detailed data and perform specific business operations (e.g., completing a sale of a product to a consumer, processing an airline or hotel reservation, or printing an employee paycheck). Transaction processing systems, which process and record the transactions necessary to conduct the business, perform this role. EXAMPLE
computerized systems tend to eliminate the kind of errors that are made by people either misunderstanding or misapplying transaction processing rules or just plain making mistakes. People errors in manual systems tend to be somewhat random. However, computerized systems tend to introduce errors that are written in the system itself by incorrect programming. These errors tend to be systematic.
b.
Assist in Making Daily Decisions A business information system may assist managers and key personnel in making daily business decisions. Management information systems, decision support systems, and knowiedge systems, which meet the varied information needs of the different organizational levels of the business, perform this role. A system which provides certain accounting and cost information might be considered a management information system; a system that records and tracks product specifications, product defects, and product changes to correct the defects might be considered a knowledge system; and a system that assists sales personnel in bidding on jobs might be considered a decision support system.
c.
Assist in Developing Business Strategies A business information system may assist executives in developing business strategies for future growth. Executive information systems (EIS), which collect and summarize data on which strategic decisions will be made, perform this role.
2.
Hierarchy of Roles Note that these roles, and the systems that support them, are a hierarchy that tracks the organizational structure of the business, with the lower-ievel and more detailed systems serving the needs of the lower levels of the organization and the higher-level and less detailed systems serving the needs of the higher levels of the organization. Where a specific system fits in the hierarchy is a question of the data in the system and the functions that are performed on that data by that system.
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Functional Perspective From a functional perspective, business information systems might be divided into sales and marketing systems, manufacturing and production systems, finance and accounting systems, and human resources systems. Systems may be developed for a particular part of a business or a specific department or may perform an entire business process cutting across different parts of the business. Other systems, such as customer relationship management systems and supply chain management systems, may reach outside the business to customers and to vendors.
II.
DATA CAPTURE The first step in processing business transactions is to capture the data for each transaction that takes place and enter them into the system. A.
Business Events The data capture process is usually triggered by the occurrence of a business activity. Relevant data must be captured for each activity. EXAMPLE
A common transaction within the revenue cycle is a sale. For each sale, an organization may find it useful to collect data regarding the date and time of the day the sale occurred, the employee who made the sale and the checkout clerk who processed the sale, the checkout register where the sale was processed, the item(s) sold, etc.
B.
Data Capture Techniques Data about business activities is often recorded directly through computer data entry screens. 1.
Manual Entries Data may be physically input by individuals. The data entry screen often retains the same name as the paper source document it replaced (e.g., the cash receipts screen).
2.
Source Data Automation Source data automation devices capture transaction data in machine readable form at the time and place of their origin (e.g., ATMs used by banks, point-of-sale (PaS) scanners used in retail stores, and bar code scanners used in warehouses).
C.
Data Accuracy Ensuring captured data are accurate and complete is a highly significant element of data capture. Techniques for ensuring data accuracy and completeness are well established. 1.
Well-designed Input Screens Well-designed data entry screens will request all required data, and source data automation captures set data automatically.
2.
Prenumbered Forms Use of preprinted, prenumbered source documents or arranging for automatic system assignment of sequential numbers provides a mechanism for ensuring that all transactions have been recorded and that none of the documents has been misplaced.
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PROCESSING Once data about a business activity has been collected and entered into the system, they must be processed. This processing helps keep the data stored in files or databases current. A.
Functions Performed on Data A single piece of raw data (e.g., a person's weekly salary or a sales transaction's total cost) does not provide a large amount of information about an organization. But after all of the data for a particular period is processed (i.e., it is sorted, organized, and calculated), it is no longer considered data. It is now considered information. Information is processed data that tells a much more detailed story about an organization than just raw data. 1.
Functions Performed on Data Business information systems ailow a business to perform the following functions on data: a.
Collect
b.
Process
c.
Store
d.
Transform
e.
Distribute EXAMPLE
For example, an order entry system might: •
Allow the entry or collection of the various details of an order,
•
Store the order as order information and customer information, Process the order by applying the appropriate prices and discounts, Transform the order into separate transactions for the warehouse to pull and ship the inventory that was ordered and ensure that the accounting system makes the appropriate journal entries to record the sale, and
•
Distribute (transmit) the transactions that resulted from the order to the warehouse in the form of a pick list with shipping information and to the accounting system in the form of debits and credits.
B.
Normal Series of Events in a Business Information System After a business information system is set up and configured by hardware technicians, network administrators, and software developers, the system will be considered functional. Once the system is fully functional, a person (generally an end user) inputs data. After the data is collected, stored, and processed, the information output can be shared across a network with other end users.
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Accounting Information Systems (AIS) The business information system that is most important to an accountant is the accounting information system. An accounting information system is a type of management information system; it may also be partly a transaction processing system and partly a knowledge system. There may be separate systems for each accounting function such as accounts receivable, accounts payable, etc., or there may be one integrated system that performs all of the accounting functions, culminating in the generai ledger and the various accounting reports. A weil-deslgned AIS will create an audit trail for accounting transactions. An example of a basic accounting audit trail is as foilows:
OUTPUT
INPUT Source document (invoice, timecard) /---Store File
Journal
~I
Ledger
~
Trial Balance
'-------
Financial Statements Reports
1
File original paper source document
1.
Objectives of an AIS The objectives of an AIS are to record valid transactions, properly classify those transactions, record the transactions at their proper value, record the transactions in the proper accounting period, and properly present the transactions and related information in the financial statements (although the actual preparation of the financial statements may be manual) of the organization.
2.
Sequence of Events in an AIS The sequence of events in an AIS is as foilows:
3.
a.
The transaction data from paper source documents is entered into the AIS by an end user. Alternately, there may be no paper source documents If, for exampie, an order is entered through the Internet by a customer.
b.
The original paper source documents, if they exist, are filed.
c.
The transactions are recorded in the appropriate journal.
d.
The transactions are posted to the general and subsidiary ledgers.
e.
Trial balances are prepared.
f.
Financial reports are generated.
Audit Trail that Allows Proper Tracing and Vouching A weil-designed AIS contains an audit trail that ailows a source document or a source transaction to be traced from input ail the way to the final output. An auditor also should be able to work backwards and vouch information from a financial statement ail the way back to the source documents or source transactions.
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An auditor can use manual audit procedures (called "auditing around the computer"), computer-assisted audit techniques (CAAT, commonly called "auditing through the computer"), or a combination of both. In either event, because the reliability of automated systems is highly dependent on the adequacy of control design and execution, it is critical that the auditor gain a thorough understanding of the structure and usage of the control system through inquiry and observation. In selecting the appropriate audit procedures in a computerized environment, the auditor should consider:
D.
a.
The extent of computer utilization in each accounting application;
b.
The complexity of the entity's computer operation;
c.
The organizational structure of the information technology department;
d.
The availability of an audit trail; and
e.
The use of computer-assisted audit techniques (covered below).
Transaction Processing Modes Although many of the documents, validation techniques, and processing procedures used in manual accounting systems are also used in computerized systems, the terminology used in a computerized environment is different from that used in a manual environment. 1.
Terminology a.
Transaction Files In a computerized environment, journals are called transaction files (i.e., the sales journal is called the sales transaction file, etc.). (1)
Data Entry/Data Capture The process of entering transactions into journals is called "journalizing" in a manual environment and data entry or data capture in a computerized environment. In the past, much of the data entry was performed by separate data entry personnel; now, transactions are often entered by end user personnel as part of their normal job functions or acquired in some automated manner, such as by scanning, importing, or interfacing it from some other application.
(2)
Transaction Files Transaction files are files used to update the master files. Transaction files are temporary files, and, if not needed for audit trail or other permanent retention purposes, they are periodically purged.
b.
Master Files In a computerized environment, ledgers are called master files (i.e., the accounts receivable ledger is called the accounts receivable master file, etc.). (1)
Master File Update In a manual system, transactions are posted from the journal to the ledger. In a computerized system, transactions are used to update balances in the master files. This process is called file maintenance or master file update. The concept of a master file is most important in traditional batch processing (described later).
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Permanent Files Master files represent data at a certain point in time. There are many different iterations of a master file; one for each point in time the master file is updated. Master files are permanent files and may be retained permanently or semi-permanently. Older iterations of a master file are often needed if significant processing problems are discovered and data has to be reconstructed. A grandfather-father-son file rotation procedure may be utilized, in which the newest file (the son) is kept for the next processing cycle, the next newest file (the father) is retained in case there are problems in processing and that processing has to be repeated, and the oldest file (the grandfather) is retained off-site for disaster recovery.
2.
Processing Methodology In a computerized environment, there are two major methods of performing file maintenance on a master file or master files (in this case, master files would include databases, which, from a processing methodology standpoint, are just another way of storing data). The CPA exam has tested both methods of processing. a.
Batch Processing With batch processing, input documentsitransactions are collected and grouped by type of transaction. These groups (called batches) are processed periodically (e.g., daily, weekly, monthly, etc.). Batch processing systems may use either sequential storage devices (e.g., magnetic tape) or random access storage devices (i.e., disks). Sometimes, input transactions may be entered and verified online, but the processing of those transactions and the updating of the appropriate master files may be done with batch processing. (1)
Always a Time Delay With batch processing, there is always a time delay between the time the transaction is entered and the time that it is fUlly processed. Thus, the accounting or other master files are not always totally current and some error detection may be delayed. Whether this lag is a problem is a function of the use of the data and the requirements of the end users for the data.
(2)
Steps in Batch Processing Batch processing is accomplished in the following two steps. (a)
Create a Transaction File The first step in batch processing is to create a transaction file by manually (usually) entering the data, editing the data for completeness and accuracy, and making any necessary corrections. The process of editing and correcting the data is known as an edit process or data validation. Data editing is discussed in more detail iater.
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Update the Master File The second step in batch processing is to update the master file or files by sorting the transaction files into the same order as the master files and then updating the relevant records in the master file or files from the transaction files. If the master fiie or files are stored on random access devices, the sorting is not needed.
(3)
Compare Manual and Computer-generated Batch Control Totals With batch processing, a batch total for a transaction file is manually calculated and then compared, either manually or in an automated manner, to a computer-generated batch control total. Any difference between the two totals indicates some kind of error in accuracy, completeness, or both. The batch total term is most often used for totals of dollar fields (a batch might contain $1,000,000 of debits and $1,000,000 of credits). When the item totaled is not dollars, it is called a hash total (a hash total might be a total of the various customer numbers in a batch; it is meaningless other than for checking during the various parts of the processing of the batch). Document counts can be used in the same manner.
(4)
Often Used in Traditional Systems Batch processing is most often found in "traditional" systems, such as payroll or general ledger systems, where the data in the system does not need to be totally current at all times. However, system-to-system transfers of data or extracts and transfers of data to update separate data warehouses may also be done in batch.
b.
Online, Real-time (OLRT) Processing With OLRT processing, transactions are entered and the master files updated as the transactions are entered. Unlike batch systems, OLRT systems require random access storage devices because there is no assurance of the order in which transactions might be entered. These days, OLRT processing is normally just called online processing. (1)
Immediate Processing (no delay) OLRT processing is an immediate processing method in which each transaction goes through all processing steps (data entry, data validation, and master file update) before the next transaction is processed. OLRT files are always current, and error detection is immediate. OLRT systems are used whenever it is critical to have very current information available or when individual accounts need to be accessed in a random order (e.g., accounts receivable balances or perpetual inventory records associated with a point-of-sale system).
(2)
OLRT Often Used in Networked Systems Because transactions are processed as they occur, OLRT systems generally require the use of some type of computer network to permit data entered at many locations to update a common set of master files.
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(3)
Point-of·Sale (POS) Systems Point-or-sale systems are one of the most widely used automated datacapture techniques. POS systems use scanners to capture data encoded on product bar codes and then transmit that data over a LAN or other network to a central database. A POS system is generally connected to an electronic cash register that also feeds data to the central database.
(4)
Online Analytical Processing (OLAP) A second category of online processing, other than OLTP, is analytical processing, which allows end users to retrieve data from a system and perform analysis using statistical and graphical tools.
(5)
Scanners Technology now allows for infrared scanners and bar code scanners to be hand-held and mobile so that inventory and point-of-sale data can be simply collected in real time. Flatbed scanners with document feeders now allow data from paper to be entered into databases in a much more rapid and efficient manner than the conventional method of end users retyping handwritten data.
(6)
Importing Data Different programs can now share data very simply by exporting the data from one program into a data file that can later be imported into a different program that can interpret the same data file. An example would be an inventory program "dumping" data concerning the latest inventory count into a data file that can be imported by the accounting program that will use this data to estimate the value of the inventory. Importing and exporting of data is not the same as data transfers from one application or system to another by data interface. With data interfaces, the transferor program and the transferee program both use a specialized format to transfer the data. In importing and exporting data, a standard format (e.g., a text file format) is used. EXAMPLE
Energy Company has a variety of systems for its various business units. Its E&P (exploration and production) business utilizes a mainframe for revenue accounting due to the high transaction volume. Revenue transactions are received throughout the month and are entered online in batches by accounting end users as the transactions are analyzed. All of the batches are processed in a first and second close immediately after the end of the accounting month. After the second close, the appropriate journal entries are transmitted to the General Ledger system for financial reporting purposes. The individual transactions are also exported to a revenue accounting data warehouse for historical analysis purposes. Because oil and gas revenue transactions often have to be re-processed for various reasons, the transactions are retained for a considerable period of time. The data warehouse resides on a separate processor so that it will not interfere with the continuing processing of normal monthly transactions.
o
Energy's wholesale and retail fuel business utilizes different systems. Two ofthe most important aspects of this business are product inventory and customer credit limits. Fuel inventory data is updated once per day, or more often if needed, from each product terminal or sales location, and overall product inventories are replenished as necessary based on this information. Because wholesale customers can purchase products from various terminals, customer sales and credit information is maintained online as each (credit) sale is made. Customer credit analysis is an ongoing, continuous function of the credit department.
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Centralized vs. Decentralized (Distributed) Processing 1.
2.
3.
Centralized Processing a.
Centralized processing environments maintain all data and perform all data processing at a central location. If end-user PCs are used merely to connect to a LAN to allow data entry from remote locations, and all editing and other such processing is accomplished by programs running on the central processors, the processing would be considered centralized. However, if the end user pes actually have small pieces of application software installed on them that performed part of the data validation, the processing would not be considered centralized. Today, centralization and decentralization are often a matter of degree.
b.
Mainframe and large server computing applications are often examples of centralized processing.
Decentralized (Distributed) Processing a.
Decentralized processing occurs when computing power, applications, and work is spread out (or distributed) over many locations (i.e., via a LAN or WAN).
b.
Decentralized processing environments often use distributed processing techniques, where each remote computer performs a portion of the processing (e.g., a portion of the data validation), thus reducing the processing burden on the central computer or computers.
Advantages of Centralized Processing a.
Enhanced Data Security Data is secured better, once it has been received at the central location.
b.
Consistent Processing Processing is more consistent. Decentralized systems may result in inconsistent processing at the various locations where that processing occurs. Even if the theoretically same software is used at each remote location where processing occurs, processing can still be inconsistent due to other factors such as timing or problems affecting only certain locations.
4.
Disadvantages of Centralized Processing a.
Possible High Cost The cost of transmitting large numbers of detailed transactions can be high; although the cost has been decreasing and is not as much of a factor as it used to be.
b.
Increased Need for Processing Power and Data Storage There are increased processing power and data storage needs at a central location, but that increased cost is sometimes more apparent than real if the cost of the processing power, data storage, and human support is accumulated for all of the distributed processors (i.e., even though it may appear that the cost of the individual distributed networks is less than the cost of one mainframe, that is not always the case, as in addition to the hardware costs, there are costs of software and support for each of the smaller systems, which, in aggregate, often exceed the total cost of a mainframe).
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c.
Reduction in Local Accountability There is a reduction in local accountability if the processing is centralized. The remote locations can and will always blame the central location for any processing problems.
d.
Bottlenecks Input/output bottlenecks can occur at high traffic times.
e.
Larger Delay in Response Time There may be a lack of ability to respond in a timely manner to Information requests from remote locations. EXAMPLE
Farflung Company has operations throughout the world. At one time, when it was smaller and had no foreign operations, its IT processing had been centralized, with all processing occurring on a midrange processor at a centralized data center in its headquarters in Plano, Texas. Since that time, however, the company has expanded. Farflung now has IT operations throughout the world at its major regional offices. Each remote data center has its own midrange processor, where it uses Farflung's applications to process its own local data. Once a week, on the weekend, it uploads the results of that processing to Farflung's main data center in Plano, where the local results are merged with what was processed in Plano for the U.s. operations. Farflung's major problem is keeping its midrange software in sync, both from an operating system standpoint and from an application standpoint. For operating systems, it utilizes HPUx. Fixes and new releases are continually being released; Farflung tests those fixes and releases in Plano and then carefully distributes them to each of its remote locations, where they are applied by local staff. Application software works much the same way. Application changes are made continuously; they are tested and first installed in production in Plano, and then they are distributed to the remote locations. Farflung's remote software release procedure is very formal and structured to attempt to ensure that the same software, or at least known versions ofthe software, is running at each of its data centers. Sometimes, business at a remote location dictates that additional software be installed at that location, but remote personnel are prohibited from installing any software that has not been approved by the central data center.
F.
Other System Operation Considerations 1.
Applications that Computerize Auditing and the Audit Trail Performing an audit using a computer is similar to aUditing in the conventional manner; however, there are certain differences and problems of which an auditor needs to be aware. Maintaining accounting records electronically also affects both the evaluation of internal control and the procedures used to gather evidence. Note, however, that the audit objectives are the same in a computerized environment as they are in a manual environment.
a.
Disappearing Audit Trail (1)
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Paper audit trails are substantially reduced in a computerized environment (particularly in online systems). If a client processes most of its financial data in electronic form, without any paper documentation, audit tests should be performed on a continuous basis.
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Computer systems should be designed to supply electronic audit trails, which are often as effective as paper audit trails.
Uniform Transaction Processing (1)
Processing consistency is improved in a computerized environment because clerical errors (e.g., random arithmetic errors, missed postings, etc.) are virtually eliminated.
(2)
In a computerized environment, however, there is an increased potential for systematic errors, such as errors in programming logic (e.g., using the incorrect tax rate).
Computer-initiated Transactions Automated transactions are not subject to the same types of authorizations that are found in manual transactions and may not be as well-documented.
d.
Potential for Increased Errors and Irregularities Several characteristics of computerized processing help to increase the likelihood that fraud may occur and remain undetected for long periods of time. (1)
The opportunity for remote access to data in networked environments increases the iikelihood of unauthorized access. Therefore, specific controls should exist to ensure that users can access and update only authorized data elements.
(2)
Concentration of information in computerized systems means that, if system security is breached, the potential for damage is much greater than in manual systems.
(3)
Decreased human involvement in transaction processing results in decreased opportunities for observation.
(4)
Errors or fraud may occur in the design or maintenance of application programs.
(5)
Computer disruptions may cause errors or delays in recording transactions.
e.
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Potential for Increased Supervision and Review (1)
Computer systems provide more opportunities for data analysis and review, inclUding integration of audit procedures in the application programs themselves.
(2)
Utilization of these opportunities can help reduce the additional risk associated with a lack of segregation of duties.
(3)
In a computerized environment, the increased availability of raw data and management reports affords greater opportunity for both the client and the auditor to perform analytical procedures.
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Transaction Flow 1.
Flowcharting Symbols The symbols shown in this box and used in the diagrams that follow represent those that are most commonly used.
Data (e.g., journals, ledgers, etc.)
Computer Process
GevEntrv]
0
~peFj
~
~iSkFi~
\'l
G
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~ S
On-page connector
Off-page connector
Off-line (paper) file; filed by: D :: Date, A:: Alpha, N :: Numeric
Data flow arrows
Communication link
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Flowchart Comparison of Batch and OLRT Processing Payroll Batch Processing
Payroll Online Processing (OLRT)
Segregate documents into small groups of similar transactions, calculate control totals, assign batch identification numbers, and prepare transmittal sheet
Employee Master File
Transfer to data entry
~-~--- ~ Transaction File
~
Update Employee Master File
Batched Time Cards
Perform Preliminary Editing
Edited Time Card File
Processing Report (error listing)
Sort Transactions (in employee order)
and Update Master File
Processed Time Card File
Processing Report (error listing)
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End-user Computing In information systems terminology, an end user is an organizational function other than the information systems function that requires computer data processing, The sales or marketing function is an end user that requires computer processing for sales reports, market analyses, sales projections, sales budgets, and so forth, The accounting function is an end user that requires computer processing support for posting of journals and preparation of reports, End-user computing (EUC) is the hands-on use of computers by end users, Functional end users do their own information processing activities with hardware, software and professional resources provided by the organization, A common EUC application is information retrieval from the organization's database using the query language feature of database management systems (DBMS),
III.
REPORTING Information is usually drawn from a business information system in one of three forms: a document, a report, or a response to a query, Documents are typically operational outputs such as invoices or checks, Reports, both standard and customized are prepared for both internal and external users, Periodic reports are frequently inadequate to fUlly respond to business needs, Customized on demand reports may be necessary to provide managers with the information needed for rapid action, Responding to this need often involves personal computers or terminals used to query the system, End users can obtain a variety of information through different types of reports, A.
Periodic Scheduled Reports Periodic scheduled reports are the traditional reports that display information in a predefined format and are made available on a regular basis to end users of the system, The reports may be automatically printed or may be made available via report viewing software and then printed only if a hard copy is actually needed, EXAMPLE
An example of a periodic scheduled report is a weekly commission report of all the salespeople for a particular sales manager. Another example of this type of report is a monthly financial statement produced as a part of the closing process. This financial statement might be produced on the same workday of each month.
B.
Exception Reports Exception reports are produced when a specific condition or exception occurs, In other words, specific criteria are established, and any transaction or entity that meets the criteria is reported on the exception report, EXA M P l,E
An exception condition could be related to a customer's credit limit (in this case, the customers would be considered entities). If the customer's credit balance exceeds the customer's credit limit, then that customer meets the exception. The exception report would print the names, credit balances, and credit limits of every customer whose credit balance is greater than their credit limit. This example assumes, of course, that customers are able to exceed their credit limits, at least under certain circumstances. Just about anything that might need to be reviewed by a person to determine its acceptability could be considered an exception and printed on an exception report.
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Demand Reports Normally, some information from a management information system is available on demand. If, for example, on a Wednesday, a manager needs a specific report that is normally given to her each Monday, she could print that report. This type of report would be known as a demand report. These reports are sometimes referred to as response reports because an end user can log onto a workstation and obtain a response in the form of a report without waiting for the scheduled time. Again, the reports may be automatically printed or may be made available via reporting viewing software and then printed if a hard copy is actually needed.
D.
Ad Hoc Reports
1.
Definition One of the most attractive features of a well-designed MIS is the ability of an end user to be able to print a demand "ad hoc" report. An ad hoc report is a report that does not currently exist but that can be created on demand, without haVing to get a software developer or programmer involved. This capability is often called a user report writer.
2.
Query A query is a specific question made up of various criteria that the end user can pose to the management information system and extract all transactions or other information that meet these criteria. Some query systems are very structured and require little knowledge to use effectively, and others are more in the form of an end user report writer with a considerable amount of flexibility but that require a considerable amount of knowledge, and often some rudimentary programming knowledge, to use effectively. EXAMPLE
Assume that a national sales manager needs a listing of aU the sales transactions occurring in the period from February 11 to February 15, 20XX that were over $50,000 in the state of New York. A predefined report matching this criterion will probably not exist. However, if the MIS has a demand ad hoc report writer built into it, this report can normally be produced very quickly.
E.
Push Reports Under push reporting, information can actually be "pushed" and sent to a computer screen or computer desktop. Traditional "pUll" reporting entails the end user or the report programmer defining what information is desired and then extracting that information using some tool (query or report writer or just searching the Internet to find the information); or, if the report is already available, the end user has to request it. Push reporting requires the same process (i.e., determination of the data that is to be selected for an end user, selection of the specified data by the push reporting software, and delivery of the specified data to the end user), but it can be more automated, even from the Internet. Delivery of the information can be to a PC, a PDA, or a cellular phone, depending on volume of the response. If every time an end user logged on to a computer network, a report window displayed the latest and most up-to-date report that the end user needed; these reports would be considered push reports. Push reports can be specific internal reports of a particular organization, or they can be general industry reports or information downloaded and possibly aggregated from the Internet.
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Generally, in push reporting, end users fill out some kind of profile specifying the kind of information desired. Based on the user's profile, some kind of software searches for content that meets the requirements of the profile. The information is then sent to the end user's desktop. EXAMPLE
It is interesting to note the historical progression of reporting. Initially, reports were invariably printed in a computer room somewhere on high-speed printers. Printers were expensive, and the end users got the reports that had been defined distributed to them in large report packages. (Alas, many trees died.) Eventually, when everybody got their own desktop PCs (or before that, their own IBM tubes), somebody figured out that the same reports could be distributed electronically, and the end users could print only what reports were desired. They also figured out that in some cases, a particular report or subset of data could be requested (the trees, of course, were elated I). Then, somebody figured out that specific reports could be automatically generated and distributed to the end users by email or other manner without the person doing anything other than defining what he wanted.
F.
o
Dashboard-style Reports Dashboard reports are used by organizations to present summary information necessary for management action. Dashboard reports (like a car dashboard with information on vehicle speed, engine activity, oil pressure and engine temperature) give management the critical data it needs in summary format to quickly determine the extent to which the entity's activities are operating within prescribed limits. If activities are not within management risk tolerances or plans, top management knows existing risk responses or controls are not performing as expected and management can take corrective action.
AN elL l A R Y MAT E R I A l
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ROLE OF INFORMATION TECHNOLOGY IN BUSINESS STRATEGY A company adopts a business strategy to both sustain it and help it to grow as a value-adding organization. The design of an information systems architecture and acquisition of technology are important aspects of an entity strategy and choices regarding technology can be critical to achieving objectives. EXAM PlE
A computer manufacturer might adopt a strategy to reach directly to the end users of its products and services. The company might consider a Web model for the delivery of its products and services to achieve this strategy. Selling online through the Web would allow the company to avoid intermediaries and thereby permit current and prospective customers direct access to the company. Clearly, a robust and well designed web application will command the company's resources and attention.
Technology plays a critical role in enabling the flow of information in an organization, including information directly relevant to enterprise risk management. The selection of specific technologies to support enterprise risk management for an organization typically is a reflection of the:
• • • •
B4-20
Entity's approach to enterprise risk management and its degree of sophistication Types of events affecting the entity Entity's overall information technology architecture Degree of centralization of supporting technology
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Enterprise Risk Management Enterprise risk management includes a number of key components that enable an organization to identify, assess and respond to risk. Monitoring risk through control activities and information systems is critical to the achievement of objectives.
1.
Information Management Approaches In some organizations, information is managed separately by unit or function, whereas others have integrated systems.
2.
Availability and Usefulness of Data To address risk management, some organizations have enhanced their technology architectures to allow greater connectivity and usability of data, with increased use of the internet. Web-services based information strategies enable real time information capture, maintenance, and distribution across units and functions, often enhancing information management
B.
Types of Events Affecting the Entity Event identification is integral to enterprise risk management. Events might be adverse (representing risks) or positive (representing opportunities). Selecflon of information technology systems and procedures are driven by strategies that capitalize on opportunities and mitigate risks.
C.
Information Technology Architecture Various methods of organizing technology resources may be used to accomplish organization objectives. This organization of resources is generally referred to as technology architecture.
1.
Customized Systems Some companies develop customized systems for handling information systems requirements. Customized systems are often characterized by data warehouses to support the entity's management.
2.
Open Architecture Open architectures utilize such technologies such as XBRL, XML, and Web Services to facilitate data aggregation, transfer, and connectivity between multiple systems
a.
XBRL (Extensible Business Reporting language) XBRL is derived from XML (Extensible Markup Language).
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(1)
XBRL is an open, royalty-free, Internet-based information standard for business reporting of all kinds.
(2)
XBRL labels data so that they are recognized by different software.
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Web Services Web services are an Internet protocol for transporting data between different applications, within a company's boundaries or across companies.
(1 )
XBRL may be used with Web Services to produce automated information exchange between computers and software and to automate business reporting processes. EXAMPLE
Ruiz Manufacturing uses XBRL technology to obtain more complete information on exposures in its accounts receivable. Prior to implementing XBRL technology, comprehensive reporting was deemed impractical so business units reported receivables from individual customers exceeding a monetary threshold. The composite reports did not include exposures slightly under the threshold. With XBRL, the reports used by the company's management include all exposures to a particular customer, enabling quicker and more timely action.
D.
Degree of Centralization of Supporting Technology Information technology infrastructure can be highly complex and developed to support operations, reporting and compliance objectives. Information generated by these systems is integral to the enterprise risk management process.
1.
Business Domains Organizations are described in terms of business domains, which are defined as groups of business functions, business processes, and concepts for which management may be assigned responsibility.
2.
Centralization Business domains may correspond to the organization chart, but in many cases, management may plan domains that significantly differ from the organization chart as a way of redefining or improving the organization. Greater centralization has the potential of creating greater control.
o
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SYSTEMS DESIGN AND OTHER ELEMENTS
I.
BUSINESS PROCESS DESIGN (integrated systems, automated, and manual interfaces) A.
Categories Business Information Systems 1,
Decision Support System (DSS) A decision support system is a computer based information system that provides interactive support for managers during the decision making process. A DSS is an extension of an MIS (below) and is useful for developing information directed toward making particular decisions. DSS do not automate decisions, but rather provide managers with interactive, computer-aided tools that combine their subjective judgments and insights with objective analytical data to guide the decision. DSS address problems where the procedure for arriving at a solution may not be fully predefined in advance. DSS may automate decision procedures, provide information about certain aspects of the decision, facilitate the preparation of forecasts based on the decision, or allow the simulation of various aspects of the decision. DSS are often divided into data-driven and model-driven systems. DSS are sometimes called expert systems. EXAMPLE
Examples of decision support/expert systems are production planning, inventory control, bid preparation, revenue optimization, traffic planning, and capital investment planning systems. A cargo revenue decision support system for an international airline would have as its objective accepting profitable orders from customers and also filling up as much as possible of its cargo carrying capacity on each flight. When an order is received from a customer, the system might check to determine if there is capacity on the flight requested. If capacity exists, the company would accept the order. If that flight was already full from a cargo standpoint, it might suggest to the customer that the customer might book on an alternate flight at a slightly discounted rate, with the discount a function of the probability of obtaining other orders for the available space and the profitability of the customer. Because cargo capacity might be limited by the overall weight of the loaded aircraft, the system might have to take into account the actual and anticipated passenger bookings for the flight. If the airline charged different rates for different priorities or types of freight, and if certain types of freight might be bumped, the system might also have to determine if any lower priority freight already booked might be bumped onto a later flight. Another example of a 055 is a system for an exploration and production company that helps in the evaluation of drilling sites. The system might take into consideration all of the geological and geophysical information for that site and also other recent discoveries in the immediate Vicinity. A further example of a 055 is a system to assist in underwriting decisions for a life insurance company. The system might record the information for a potential customer and the information on the company's experience with that type of customer. It might be able to calculate a rate given that combination of information. A final example of a 055 is a system maintained by a bank call center to determine what kind of priority to give to a particular customer's call. If a particular customer is very profitable, his/her call might be answered by a person almost immediately (after the account number has been entered to identify the customer). If a particular customer is merely one of many, that customer may be directed to an automated attendant, where it is difficult, if not impossible, for that customer to actually talk to a person.
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Management Information Systems (MIS) Like transaction processing systems, management information systems, sometimes called management reporting systems, are a type of business information system. All of the general characteristics of business information systems apply to management information systems, but a management information system has a more specific function in an organization. A management information system provides managerial and other end users with reports. These predefined management reports provide managers with the information they need to assist them in the business decisionmaking process.
a.
Objective to Assist Decision-making A management information system provides information to assist managers and others in making daily business decisions. Sometimes, the type of information needed will be predefined and will be provided in a printed report; other times, the information will be accessible on a computer screen and printed if desired. The objective of supplying this predefined information is to fulfill the needs of decision makers at both the organizational and tactical levels of the organization. EXAMPLE
A sales manager who must rely on sales analyses to assist in determining the efficiency of the sales people for whom the manager is responsible would find a management information report helpful. Such a report could help the manager determine which sales people have exceeded the organization's expectations and which need further sales training or other remedial actions. Actual vs. budget reporting is another good example of reports that assist decision-making.
b.
Methods of Processing (1)
Integrated Integrated processing design anticipates the seamless flow of information between systems.
(2)
Automated Automated processing contemplates the import or download of information between systems. While some measure of manipulation is still required to share information between systems, manual data entry is reduced.
(3)
Manual Manual processing contemplates gathering information from subsidiary records or sources, and manually or individually entering the data into a centralized system.
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EXAMPLE
A company uses the XYZ general ledger package but processes payroll using ABC software. A company that takes summary data from ABC payroll journals and enters it into the XYZ general ledger package is operating under a manual design. The company might elect to purchase an interface of ABC payroll data with the XYZ general ledger package. The interface purely downloads data into the general ledger package where it is analyzed and ultimately posted. In this circumstance, the company is using an automated design. A company might buy the XYX suite of software and fully integrate the payroll and general ledger. In that instance, the general ledger is automatically updated by a payroll system that fully integrates with general ledger and reporting functions.
3.
Executive Information Systems (EIS) Executive information systems, or executive support systems, provide senior executives with immediate and easy access to internal and external information to assist the executives in monitoring business conditions in general. EIS assist in strategic, not daily, decision-making. EIS are collectors and synthesizers of business and economic information. A premium is normally placed on ease of use so that the systems can be used by executives who might lack full computer literacy. Extensive graphics are often used in presentation. A drill-down capability is often provided so that detail can be obtained in areas of interest. EXAMPLE
Examples of executive information systems are systems for forecasting sales and budgets, operating plans, personnel, and profit planning. Other EIS may merely collect and organize data external to the company or may combine internal and external data. An EIS might be used for high-level decision support or for high-level monitoring.
4.
Transaction Processing Systems Transaction processing systems are the systems that process and record the routine daily transactions necessary to conduct the business. The functions of such a system are normally predefined and highly structured. In high volume situations, a premium may be placed on system speed and efficiency, especially if a customer is involved in providing or entering the initial data into the system. EXAMPLE
Examples of transaction processing systems are sales order entry and tracking systems, hotel and airline reservation systems, payroll and human resources systems, accounting systems of all types, and manufacturing, plant scheduling, securit'les trad'lng, and shipping systems.
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System Development Life Cycle (SDLC) Every systems development project goes through essentially the same systems development life cycle. Defining the iife cycle provides a framework for planning and controlling the detailed activities associated with system development. The development process produces a sequence of events generally defined by five steps. The traditionai approach to the systems development life cycle is rigid and is sometimes referred to as to the "big-design-up-front" approach (the pian is viewed as unchanging) or as the waterfall approach, (sequential steps of analysis, planning, design, and implementation flow only in a single 'downward' direction, like a waterfall). The traditional rigid approach is most appropriate in situations in which the plans and designs can be very clearly defined. 1.
System Analysis The first step in systems development is a systems analysis that gathers the information needed to purchase or develop a new system. Steps will likely include the following: a.
Define the nature and scope of the project and identify its strengths and weaknesses.
b.
Conduct an in-depth study of the proposed system to determine its feasibility.
c.
Identify the information needs of system users and managers.
d.
Document the information needs of system users and managers.
e. 2.
(1)
Needs are used to develop and document systems requirements.
(2)
Systems requirements are used to select or develop a new system.
A report is prepared to summarize the work done during a system analysis and submitted to appropriate levels of management.
Conceptual Design The company decides how to meet user needs during the conceptual design phase. This phase likely includes the following steps:
3.
a.
Identify and evaluate appropriate design alternatives. New systems might involve buying software, developing it in-house, or outsourcing system development to someone else.
b.
Develop detailed specifications outlining what the system is to accomplish and how it is to be controlled.
Physical Design The company uses the conceptual design to develop detailed specifications that are used to code and test the computer programs. This phase will likely include the following steps:
B4-26
a.
Design input and output documents
b.
Write computer programs
c.
Create files and databases
d.
Deveiop procedures
e.
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Implementation and Conversion The implementation and conversion phase translates the plan into action. Development of an implementation and conversion plan serves as an instrument to monitor the project. The scope of the document may include:
5.
a.
Install new hardware or software
b.
Hire or relocate employees to operate the system
c.
Test or modify new processing procedures
d.
Establish and document standards and controls for the new system
e.
Convert to the new system and dismantle the old one
f.
Fine tune the system after it is up and running
Training Training programs will likely include:
6.
a.
Hardware and software skill training
b.
Orientation to new policies and operations
c.
A variety of training options, including vendor-based programs, self-study manuals, computer-assisted instruction, videotape presentations, etc.
Testing System testing will likely include:
7.
a.
Tests of the effectiveness of documents and reports, user input, operating and control procedures, processing procedures, and computer programs
b.
Tests of capacity limits and backup and recovery procedures
Operations and Maintenance During its life, the system is periodically reviewed. Modifications are made as problems arise or as new needs become evident, and as the organization uses the improved system. Eventually, a major modification or system replacement is necessary and the SDLC begins again. The operations and maintenance phase (indeed the entire life cycle) may also include planning, managing the behavioral reactions to change, and assessing the ongoing feasibility of the project.
C.
Participants in Business Process Design 1.
Management One of the most effective ways to generate systems development support is a clear signal from top management that user involvement is important. Top management's most important roies are providing support and encouragement for deveiopment projects and aligning information system with corporate strategies.
2.
Accountants Accountants may play three roles during systems design:
a.
As AIS users, they must determine their information needs and system requirements and communicate them to system developers.
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b.
As members of a project development team or information systems steering committee, they help manage system development.
c.
As accountants, they should take an active role in designing system controls, and periodically monitoring and testing the system to verify that the controls are implemented and functioning properly.
Information Systems Steering Committee Formulation of an executive-level information systems steering committee to plan and oversee the information systems function addresses the complexities created by functional and divisional boundaries.
4.
a.
Membership of the committee often consists of high level management, such as the controller and systems and user-department management.
b.
Functions of the steering committee include: (1)
Setting governing policies for the AIS,
(2)
Ensuring top-management participation, guidance, and control, and
(3)
Facilitating the coordination and integration of information systems activities to increase goal congruence and reduce goal confiict.
Project Development team The team members planning each project undertake the successful design and implementation of a business system. The tasks undertaken by the team are designed to not only ensure technical implementation but also user acceptance. These tasks include:
5.
a.
Monitoring it to ensure timely and cost-effective completion,
b.
Considering the human element (e.g., resistance to change), and
c.
Frequently communicating with users and holding regular meetings to consider ideas and discuss progress, so there are no surprises upon project completion.
External Parties (major customers or suppliers) Many people outside an organization playa role in systems development, Including customers, vendors, auditors, and governmental entities. A major retailer might mandate that their vendors must implement and use electronic data interchange (EDI) if they want to do business with the company.
D.
Enterprise Risk Management Framework
Enterprise Risk Management Integrated Framework (ERM) as pUblished by the COSO (Committee of Sponsoring Organizations) provides an all encompassing tool that addresses enterprise risk management. The ERM framework defines enterprise risk management as a "process, affected 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." A significant component of the ERM is information and communication.
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INFORMATION TECHNOLOGY (IT) CONTROL OBJECTIVES A.
Objectives of Internal Control Effective control systems mitigate a company's risk exposure to behaviors that might harm them. Internal Control is the process that is implemented by the board of directors, management, and those under their direction to provide reasonable assurance that the following control objectives are achieved:
B.
1.
Safeguarding assets, including preventing or detecting, on a timely basis, the unauthorized acquisition, use, or disposition of material company assets.
2.
Maintaining records in sufficient detail to accurately and fairly reflect company assets
3.
Providing accurate and reliable information.
4.
Providing reasonable assurance that financial reporting is prepared in accordance with GAAP.
5.
Promoting and improving operational efficiency, including making sure company receipts and expenditures are made in accordance with management and director's authorizations.
6.
Encouraging adherence to prescribed managerial policies.
7.
Complying with applicable laws and regulations.
Types of Internal Controls Internal controls used to accomplish objectives are classified by the following characteristics when they occur within process design: 1.
Preventive Controls Controls which occur prior to an error or irregularity are defined as preventive controls. Preventive controls are designed to deter problems before they arise. Examples of preventive controls include hiring highly qualified personnel, appropriately segregating employee duties; and effectively controlling physical access to assets, facilities, and information.
2.
Detective Controls Controls that occur after an error or irregularity are defined as detective controls. Detective controls are needed to discover problems as soon as they arise since not all control problems can be prevented. Examples include duplicate checking of calculations and preparing bank reconciliations and monthly trial balances.
3.
Corrective Controls Controls in place to ensure that the companies remedy control problems that have been discovered are referred to as corrective controls. They include the procedures taken to identify the cause of a problem, the correction of the resulting errors or difficulties, and the modification of the system so that future problems are minimized or eliminated. An example would be a procedure for correcting data entry errors.
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ROLE OF TECHNOLOGY SYSTEMS IN CONTROL MONITORING
A.
General and Application Controls Change management is the process of making sure changes do not negatively affect the reliability, security, confidentiality, integrity and availability of an information system. Change management generally embraces two categories of control: general controls and application controls.
1.
General Controls General controls are designed to make sure an organization's control environment is stable and well managed and include:
2.
a.
Information systems management controls
b.
Security management controls
c.
IT infrastructure controls
d.
Software acquisition, development, and maintenance controls
Application Controls Application controls prevent, detect, and correct transaction error and fraud and are application-specific, providing reasonable assurance as to system:
B.
a.
Accuracy
b.
Completeness
c.
Validity
d.
Authorization
Input Controls The phrase "garbage in, garbage out" highlights the importance of data quality. If the data entered into a system is inaccurate or incomplete, the output will be too. Controls over the quality of data that is collected about business activities and entered into the information system are vital. The following source data controls regulate the integrity of input:
C.
1.
Forms design - Prenumbering forms improves controls by making it possible to verify that all input is accounted for.
2.
A turnaround document is a record of company data sent to an internal party and then returned by the external party to the system as input. A turnaround document ensures that all input is accounted for.
Processing Controls Important processing controls include the following:
1.
Data Matching Matching two or more items of data prior to taking an action improves processing controls (e.g., processes should include matching information on the vendor invoice to both the purchase order and the receiving report before paying a vendor).
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File Labels Use of file labels provides an opportunity to ensure that the correct and most current files are being updated. External labels are readable by humans, while internal labels are written in machine-readable form on the data recording media. Both internal and external labels should be used. Two important types of internal labels are header and trailer records.
3.
a.
The header record is located at the beginning of each file and contains the file name, expiration date, and other identification data.
b.
The trailer record is located at the end of the file and contains the batch totals calculated during input.
Recalculation of Batch Totals Comparison of amounts input to amounts output ensures that the volume of transactions processed by the system is the volume the user intended.
4.
Cross-footing and Zero-balance Tests Testing the sum of a column of row totals to the sum of a row of column totals to verify identical results provides some assurances as to accuracy. A zero-balance test applies this same logic to control accounts. For example, the payroll clearing account is debited for the total gross pay of all employees in a particular time period. It is then credited for the amount of all labor costs allocated to various expense categories. The payroll clearing account should have a zero balance after other sets of entries have been made; a nonzero balance indicates a processing error.
5.
Write-protection Mechanisms Common file protections guard against the accidental writing over or erasing of data files stored on magnetic media.
6.
Database Processing Integrity Procedures Database systems use database administrators, data dictionaries, and concurrent update controls to ensure processing integrity. a.
The administrator establishes and enforces procedures for accessing and updating the database.
b.
The data dictionary ensures that data items are defined and used consistently.
c.
Concurrent update controls protect records from errors that occur when two or more users attempt to update the same record simultaneously. This is accomplished by locking out one user until the system has finished processing the update entered by the other.
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Output Controls Verification of system output provides additional control over processing integrity. Output controls include: 1.
User Review of Output Examination by users of system output for reasonableness, completeness and verification that the outputs are provided to the intended recipient.
2.
Reconciliation Procedures Reconciliation of individual transactions and other system updates to control reports, file status/update reports, or other control mechanisms provides assurances that outputs have been produced as intended.
3.
External Data Reconciliation Reconciliation of database totals with data maintained outside the system provides assurances that outputs have been produced as intended (e.g., the number of employee records in the payroil file be compared with the totai from human resources to detect attempts to add fictitious employees to the payroil database).
4.
Output Encryption The authenticity and Integrity of data outputs must be protected during transmission.
E.
a.
Encryption techniques satisfy this objective in reducing the chance for data interception.
b.
Controls designed to minimize the risk of data transmission errors. (1)
When a receiving unit detects a data transmission error, it requests the sending unit to retransmit that data. Generally, the system wili do this automaticaily and the user is unaware that it has occurred.
(2)
Parity checking and message acknowledgement techniques are two basic types of data transmission controls.
Managing Control Activities It is important to establish controls relating to the use and accountability of ail resources relating to the information systems. Budgets should be established for the acquisition of equipment and software, for operating costs, and for usage. Actual costs should be compared with budgeted amounts, and significant discrepancies should be investigated. Specific control procedures designed to provide reasonable assurance that the control objectives are met are as foilows:
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1.
A plan of organization that includes appropriate segregation of duties to reduce opportunities for anyone to be in a position to both perpetrate and conceal errors or irregularities in the normal course of his or her duties.
2.
Procedures that include the design and use of adequate documents and records to help ensure the proper recording of transactions and events.
3.
Limits to access to assets in accordance with management's authorization.
4.
Independent checks and reviews on the accountability of assets and performance.
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5.
Information processing controls are applied to check for proper authorization, accuracy, and completeness of individual transactions.
6.
Design and use of documents and records - The proper design and use of electronic and paper documents and records help ensure the accurate and complete recording of all relevant transaction data.
7.
Implementation of security measures and contingency plans. a.
Security measures focus on preventing and detecting threats;
b.
Contingency plans focus on correcting the effects of threats.
c.
It is a well-accepted concept in information system security that some active threats cannot be prevented without making the system so secure that it is unusable.
OPERATIONAL EFFECTIVENESS Evaluating the ongoing effectiveness of control policies and procedures provides added assurance that controls are operating as prescribed and achieving their intended purpose. A diagnostic control system measures company progress by comparing actual performance to planned performance.
A.
Diagnostic Controls Diagnostic controls are designed to achieve efficiency in operations of the firm to get the most from resources used. For example, for a mainframe computer system, capacity utilization may be a primary concern, for it requires significant amount of investment to acquire a mainframe.
B.
Control Effectiveness The following principles of control should be applied to systems development and maintenance:
1.
Strategic Master Plan To align an organization's information system with its business strategies, a multiyear strategic master plan should be developed and updated annually. The plan would show the projects that must be completed to achieve long-range company goals and address the company's hardware, software, personnel, and infrastructure requirements.
2.
Data Processing Schedule All data processing tasks should be organized according to a data processing schedule.
3.
Steering Committee A steering committee should be formed to guide and oversee systems development and acquisition.
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System Performance Measurements For a system to be evaluated properly, it must be assessed using system performance measurements. Common measurements include throughput (output per unit of time), utilization (percentage of time the system is being productively used), and response time (how long it takes the system to respond).
V.
SEGREGATION OF DUTIES Good Internal control requires that no single employee be given too much responsibility over business transactions or processes. An employee should not be in a position to commit andlor conceal fraud. In a highly integrated information system, procedures once performed by separate individuals are combined. Therefore, any person who has unrestricted access to the computer, its programs, and live data could perpetrate and conceal fraud. To combat this threat, organization must implement control procedures such as the effective segregation of systems duties within the information system function. A.
Organization and Operating Controls Organization and operating controls deal mainly with the structure of an IT department and how duties are segregated within that department. The IT department is a support group in that it normally does not initiate or authorize transactions. In a well-structured IT department, the duties discussed below are segregated. As always, proper segregation of duties is easier to achieve in larger organizations than in smaller organizations with a smaller number of personnel.
Segregation of duties is defined as dividing responsibilities for different portions of a transaction (authorization, recording, and custody) among several different people or departments. The objective is to prevent anyone person from having total controi over all aspects of the transaction. Because many transactions in an IT environment are actually performed by the application software, segregation of duties in an IT environment normally revolves around granting andlor restricting access to production programs and to production data. B.
Separate Duties within Information Technology Within the IT department, the duties of system analysts and computer programmers, computer operators, and security administrators should be kept separate, at least to a certain extent.
1.
System Analysts vs. Computer Programmers Traditionally, if the duties of system analysts and computer programmers were not properly segregated, one person performing both functions would have had too much responsibility and power. System analysts help users determine their information needs, and then design an information system to meet those needs whereas computer programmers take the design provided by systems analysts, and create an information system by writing the computer programs. Analysts often are in charge of hardware and computer programmers are in charge of the application software. They choose or develop the application software. Theoretically, if the person who is in charge of setting up the hardware is also in charge of setting up and maintaining the software, that person could easily bypass security systems without anyone knowing and steal organizational information or assets (e.g., embezzling of funds).
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In many organizations, however, the duties of system analysts and computer programmers have been combined into a programmer/analyst or analyst title. Many people see no real problem with this particular combination of functions. However, combining the duties of system programmers and application computer programmers would be an entirely different malter. 2.
Computer Operators vs. Computer Programmers It is important that computer operators and computer programmers be segregated because a person performing both functions would have the opportunity to make unauthorized and undetected program changes. Of course, there would still have to be a computer operations function for a lack of segregation of duties in that area to be a problem.
3.
Security Administrators vs. Computer Operators and Computer Programmers Security administrators are the people who are responsible for restricting access to systems, applications, or databases to the appropriate personnel. If the person who is in charge of restricting access is also a programmer or an operator (or an administrator) for that system, then that person could give himself/herself or another person access to areas they are not authorized to enter. This security bypass would also allow that person to steal organizational information or assets (e.g., embezzling of funds) without anyone knOWing about it.
Segregation of duties in a PC or midrange-computing environment is often complicated when people have the title of system administrator. In many environments, system administrators perform the functions both of system programmers (for their smail systems) and of security administrators. Without other compensating controls, combining these two functions is akin to providing the keys to the kingdom to one person. EXAMPLE
Omaha Company's application systems are built around a database management system from a major database vendor. Due to the size and complexity of the various databases, Omaha's database administration staff is almost continually occupied with organizing and reorganizing databases and updating the database management system software. The database management system has its own security mechanism, and that security mechanism is integrated with Omaha's overall security system. A separate IT security administrator administers both types of security. Omaha's applications programmers have no access to the data that is maintained in the production database. They do have access to the data that is maintained in the test database. The test database is a separate subset of the production database that is used for application/program testing purposes.
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EXAMPLE
CWS Company had, in its opinion, an outstanding security system, including a very rigidly enforced segregation of duties within its IT organization. CWS kept the various functions as separate as it could; none of the IT people were given write access to data in the production database; system programming and application programming were done by separate people. CWS thought it was following every rule in the book. CWS had made only one mistake. It had hired, as its manager of system programming, one of the best systems programmers in the world. That individual was intimately knowledgeable in all of its system software, including its security software. He was able to bypass the security systems without leaving any track of what he had done. Once the security was bypassed, he was able to obtain unrestricted access to the accounts payable system, establish several dummy vendor companies, and submit dummy invoices from those companies, which were then automatically paid. This defalcation continued for several years until it was discovered by an external auditor. During an internal control review, the auditor decided to vouch some accounts payable transactions. She started with a random sample of payments that just happened to include the payment of an invoice from one of the dummy companies that the manager of system programming had established. She traced from the payment back to the invoice in the system, but could find no paper backup for that invoice in the Accounts Payable department. She could find no evidence of a receiving report or a purchase order. The system performed a three-way match of the purchase order, invoice, and receiving report, and the appropriate switch was set indicating that the match had occurred, but she could find nothing to support those two documents. She notified the senior on the job, and a full-scale investigation was launched. The manager of system programming was quietly fired, but no criminal charges were pressed because CWS did not want the bad publicity. (On a side note, apparently, nobody had ever wondered how the manager of system programming owned more than one brand new Porsche.)
C.
Roles and Responsibilities of Information Technology Professionals Information technology professionals include many different types of people. such as administrators (for the database, the network, and the web), librarians, computer operators, and programmers (for systems and applications). The roles and responsibilities of IT professionals are defined individually by each organization, and, as indicated previously, job titles and responsibilities can vary widely depending on the needs of the organization and, in some cases, the personal preferences of IT management. In all organizations, however, segregation of duties, or lack thereof, is one of the most important characteristics of the organization. Like in any other organization, the appropriate segregation of duties in an IT organization, especially a smaller organization, may be difficult to achieve.
1.
System Analyst a.
Internally-developed System If an application system is developed internally, system analysts design the overall application system. Depending on the application system, they may also decide what type of computer network is needed, and they may recommend changes to the overall network. With traditional formal system development methodologies, the system analyst's responsibility is to work with the end users to determine the requirements for a system, and then design the specifics of the system to satisfy those requirements. The roles of system analysts are sometimes combined with those of programmers to create programmer/analysts. Initially, that combination was created to provide a career path for programmers.
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Purchased System If an application package is purchased from an outside vendor and installed, system analysts may be called system integrators. In that case, his/her responsibilities may be to learn the purchased application (so that the system can be maintained after it is installed), to integrate that application with existing internal and package applications by designing interfaces with the existing applications, to determine how to convert the initial data for the application from other applications or manually, and to provide training to end users. Purchasing an application package from an outside vendor is not a panacea. An organization has to find the right package (or at least one that will work) and then must install it or have it installed correctly. It must maintain the package after it is installed. And then the organization must hope that the vendor stays in business, is not acquired by one of its competitors, and continues to support the package. However, purchasing an application package does eliminate the majority of application programming. A major problem that many organizations encounter is when somebody in the organization insists that the application itself be "customized," either by the vendor or by the organization (either can be done under different sets of conditions). If an application package is customized, all or most of the changes that were made when the package was installed will need to be made again when the package is updated. This continual update of customizations is an extremely labor-intensive and time-intensive process and should be avoided if at all possible. Sometimes it is considerably easier over the long haul to change the business rather than to change the package. Considerable thought is warranted in these situations. EXAMPLE
In the old days, organizations wrote their own general ledger systems because no other option was available. As technology and software improved, organizations started to figure out that there was really nothing magic about general ledger systems; they all accepted transactions either manually entered or interfaced from another system, stored those transactions in terms of debits and credits, and produced relatively standard reports in terms of financial statements and supporting worksheets of variaus types. At that point, general ledger systems and the related accounting systems, such as accounts receivable and accounts payable, all became imminently purchasable. The same thing has happened to many other types of "standard" systems.
2.
Computer Programmer Computer programmers include application programmers and system programmers. a.
Application Programmer/Software Developer An application programmer is the person responsible for writing and/or maintaining application programs. The application programmer also normally handles the testing of application programs and the preparation of computer operator instructions, if there are any computer operators in the organization.
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If programs are developed internally, a surprisingly large portion of the overall programming bUdget will normally be devoted to program maintenance. Programs, once written, are often notoriously difficult to maintain. A considerable number of the new ideas for the IT industry have been devoted to techniques to minimize or facilitate program maintenance. As with system analysts, if application packages are purchased from outside vendors, the application programmers are often called system integrators because the major functions will be integrating the purchased software in with existing systems. Applications programmers are also sometimes called software engineers. For internal control purposes, application programmers should not be given write/update access to data in production systems or unrestricted and uncontrolled access to application program change management systems. EXAMPLE
Joan Barrister is an application programmer working for the law firm of Dewey, Cheatham, & Howe. Because DC&H is a relatively small firm with a small number of application programmers, Joan has been given unrestricted access to the firm's production data so that she can quickly fix production data problems. Further, because there is no program change management function, she makes changes to production programs as she needs to. Her supervisor, the firm's office manager, is too busy and does not have the technical knowledge to provide detailed supervision anyway. From the facts provided, DC&H is wide open for problems. Joan, with almost totally unrestricted access to the firm's production data, can make whatever changes to that data she desires. She can also make whatever changes to the programs that process that data, thus enabling her to cover up any data changes that she has made. For example, she could change the payroll program to give her a bonus and then change the program back to the way it was to hide what she had done. She could change production data to whatever she wanted. It might take some work, but she could do it. Hopefully, Joan is honest. Controls to address these shortcomings will be addressed in detail later.
b.
System Programmer A system programmer is responsible for installing, supporting (troubleshooting), monitoring, and maintaining the operating system (and often the related hardware if that function is not performed by a separate hardware technician). System programmers may also forecast hardware capacity and perform other capacity planning functions. In complex computing environments, a considerable amount of time can be spent testing and applying operating system upgrades. In non-mainframe computing environments, a system programmer is sometimes called system support or system administration, but, regardless of the name, somebody somewhere is performing the function of installing and updating the operating system software. In spite of the name, system programmers spend little or no time actually writing programs.
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For internal control purposes, system programmers should not be given write/update access to data in production systems, anymore than application programmers should. System programmers should normally not have access to application program change management systems. Such restrictions on system programmers are often hard to maintain because the system programmers have access to the operating system and often know enough, if they want to, to bypass normal system security and change logging facilities.
3.
Computer Operator In mainframe computing environments, computer operators are responsible for scheduling processing jobs, running or monitoring scheduled production jobs, hanging tapes, and possibly printing and distributing reports. Much of the job scheduling and job running work can be automated and, in large computing environments, must be automated due to the sheer volume of the processing that occurs. Today, reports are often distributed to the end users electronically and are printed by those end users only if needed. End users are not computer operators. They may operate, or more correctly use, a computer, or more normally a PC connected in a network to a computer. but they are not computer operators. End users now routinely enter much of their own data or transactions. Computer operators never have done that. EXAMPLE
Monolithic Corporation has had a mainframe-computing environment since the early 1960s. In the good old days, production jobs were submitted individually according to detailed operating instructions. Data was either on punched cards input with the program or on magnetic tapes, and the tapes had to be retrieved from the tape library and mounted on the appropriate tape drives when required by program instructions displayed on the operator's console. Reports were printed in the computer room on high-speed printers and then burst, de-collated, and distributed to the end users by report delivery personnel. Over the years, however, production job scheduling and production job running were automated utilizing job scheduling software. In addition, magnetic tape data storage was mostly replaced by disk
data storage, and most of the tape library was eliminated; the remaining tapes were loaded by a tape library robotic system. Report printing was slowly shifted to printers in end user areas, and fewer and fewer reports were printed in the computer room. The computer itself called "home" whenever it felt there was some kind of problem, and the vendor dispatched a service technician. Slowly but surely, the need for computer operators vanished. The computer room went "lights out."
4.
IT Supervisor IT supervisors manage the functions and responsibilities of the IT department. There is no real difference between IT supervisors and supervisors in any other area.
5.
File Librarian File libraries store and protect programs and tapes from damage and unauthorized use, and file librarians control the file libraries. In large computing environments, much of this work has been automated. Software program librarians are available as part of the program change control process.
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Security Administrator Security administrators are responsible for the assignment of initial passwords and often the maintenance of those passwords (if the end users do not maintain their own passwords). Security administrators are responsible for the overall operation of the various security systems and the security software in general.
Most database management systems (discussed later) have their own security. In that case, the various security systems have to be set up to work together. 7.
System Administrator a.
Database Administrator (DBA) Within a database environment, database administrators are responsible for maintaining and supporting the database software. The database administrator may aiso perform some or ali of the security functions for the database. Database administrators perform somewhat the same functions for database software as system programmers perform for the operating system as a whole. Database administrators are different from data administrators; a database administrator is responsible for the actual database software, while a data administrator is responsible for the definition, planning, and control of the data within a database or databases. The function of a database administrator is more technical, and the function of a data administrator is more administrative.
b.
Network Admin istrator Network administrators support computer networks. Network performance monitoring and troubleshooting is an especialiy important aspect of their work. A network administrator sets up and configures a computer network so that multiple computers can share the same data and information. After a network is established, the work is mostly monitoring and troubleshooting. Sometimes, network administrators are calied telecommunication analysts or network operators.
In smali organizations, system administration/system programming and network administration are often performed by the same person (or people). in those organizations, the line between system administration and network administration is often hard to draw. c.
Web Administrator Web administrators are responsible for information on a web site.
8.
Data Input Clerk Data input personnel prepare, verify, and input data to be processed if that function has not been distributed to the end users.
9.
Hardware Technician A hardware technician sets up and configures hardware and troubleshoots any resulting hardware problems. Most of the time, the hardware maintained includes pes and peripheral equipment; the hardware vendors normaliy maintain mainframes and midrange computers.
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End User End users are any workers in an organization who enter data into a system or who use the information processed by the system. End users could be secretaries, administrators, accountants, auditors, CEOs, and so on.
VI.
POLICIES A.
Purpose IT policies represent management's formal notification to employees regarding the entity's objectives. Policies assign authority and responsibility for business objectives, including the individual who is responsible for designing and implementing the company's information security policy. Policies surrounding system design should promote communication. Policies should describe the means of communicating significant information upstream. There is also effective communication with external parties, such as customers, suppliers, regulators, and shareholders.
B.
Implementation Authority and responsibility are assigned through formal job descriptions; employee training: operating plans, schedules, and budgets; a formal company code of conduct; and written policy and procedures manual.
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.---------------------_._----, VII.
COMPUTER ASSISTED AUDIT TECHNIQUES (CAAT) An auditor can use manual audit procedures (called "auditing around the computer"), computerassisted audit techniques (CMT, commonly called "auditing through the computer"), or a combination of both. In either event, because the reliability of automated systems is highly dependent on the adequacy of control design and execution, it is critical that the auditor gains a thorough understanding of the structure and usage of the computerized control system through inquiry and observation. A.
Transaction Tagging Transaction tagging is a technique the auditor uses to electronically mark (or "tag") specific transactions and to follow them through the client's system. Tagging allows the auditor to test both the computerized processing and the manual handling of the transactions.
B.
Embedded Audit Modules Embedded audit modules are sections of the application program code that collect transaction data for the auditor. For example, an auditor might want to examine all transactions affecting a specific account that are greater than $500. Embedded audit modules are most often built into an application program when the program is developed.
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Test Deck (test data) Test deck (test data) is a technique that uses an application program to process a set of test data, the results of which are already known. The client's system is used to process the auditor's data off-line.
D.
1.
The test data contains the types of invalid conditions in which the auditor is interested (it Is not necessary to test all combinations of invalid conditions).
2.
An advantage of the test data technique is that live computer data is not affected in any way.
Integrated Test Facility Integrated test facility (ITF) is similar to the test data approach, except that the test data is commingled with live data. The client's system is used to process the auditor's data online.
E.
1.
The test data must be separated from the live data before the reports are created. This separation is usually accomplished by processing the test data to dummy accounts (e.g., a fictitious customer, branch, vendor, etc.).
2.
Client personnel are not informed that the test is being run.
Parallel Simulation 1.
Definition Parallel simulation (re-performance) is a technique where the auditor re-processes some or all of the client's live data (using a copy of the client's software controlled by the auditor) and then compares the results with the client's files.
2.
a.
With controlled re-processing, the auditor observes the actual processing and compares the actual results to the expected results (based on the auditor's program).
b.
With controlled re-processing, the auditor uses an archived copy of the program in question (generally the auditor's control copy) to re-process transactions. The results are then compared to the results from the normal processing run. Differences indicate that there have been changes to the program.
Source Code Comparison Program Software Source code comparison programs are programs that compare two versions of software to determine if they match. This type of software can be used to look for unauthorized program changes.
3.
Types of Software Programs to accomplish parallel processing can be specifically developed for the application, bought as a packaged program or utility, or produced by a generalized audit software package.
F.
Generalized Audit Software Packages Generalized audit software packages (GASPs) allow the auditor to perform tests of controls and substantive tests directly on the client's system. The auditor first defines the client's system (to the GASP) and then specifies the tests and selections of data to be made. The GASP generates the programs necessary to access the files and extract and analyze the data.
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Tasks typically performed by GASPs include: a.
Examining transactions for control compliance.
b.
Selecting items meeting specified criteria.
c.
Recalculating amounts and totals.
d.
Reconciling data from two separate files.
e.
Performing statistical analysis on transactions.
Advantages of using GASPs include: a.
GASPs allow the auditor to sample and test a much higher percentage of transactions, which results in a more reliable audit.
b.
GASPs require little technicai knowledge.
c.
After the initial use, GASPs can significantly reduce audit time without sacrificing quality.
o
END OF ANCILLARY MATERIAL
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SECURITY
I.
TECHNOLOGIES AND SECURITY MANAGEMENT FEATURES Data and procedural controls are implemented to ensure that data is recorded, errors are followed up on during processing, and output is properly distributed. A.
Safeguarding Records and Files Safeguarding of records and files is important because inadequate protection may result in loss or damage that might drive an organization out of business; hardware can always be replaced, but data often cannot be. Accidental destruction of data can be prevented or recovered from by the use of internal and external labels, file protection rings, and storing copies of key master files and records in safe places located outside of the company. Copies of files kept on-site should be stored in fireproof containers or rooms.
B.
Backup Files Magnetic tape files are usually kept in a system that provides a backup file in the event that one file is destroyed. Data backups are necessary both for recovery in a disaster scenario and also for recovery from processing problems.
1.
Son-Father-Grandfather Concept The son-father-grandfather concept introduced previously incorporates such a backup file system. The most recent file is called the son, the second most recent file is called the father, and the preceding file is called the grandfather. The process includes reading the previous file, recording transactions being processed, and then creating a new updated master file. The daily (or any other interval) transactions are stored separately. If the son file is destroyed, a new file can be reproduced by using the transaction file (which was stored separately) and the father file to create a new son file. With this system of safeguarding for accidental destruction or mishandling of a file, there are always at least two backup files that can be used to create the file destroyed.
2.
Backup All Critical Application Data All critical application data should be backed up somehow. In the past, even for large systems, there were often times when the system was down for backups and maintenance. The backup process was relatively simple; files or databases that had been changed since the last backup (or just all data) was backed up, using the sonfather-grandfather or some other concept. Certain data was often stored off-site at some other location.
3.
Backups of Systems that Do Not Shut Down Currently, there are often systems that are never scheduled to be down. Effective backups are much more difficult under those conditions. The attendant recovery process is also much more technically complex. Recovery often includes applying a transaction log (a file of the transactions that had been applied to the databases) and reapplying those transactions to get back to the point immediately before the failure.
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Uninterrupted Power Supply UPS (uninterrupted power supply) units are used to prevent systems from shutting down inappropriately during an outage. A UPS is a device which maintains a continuous supply of electrical power to connected equipment. UPS is also called battery backup. When a power failure or abnormality occurs, the UPS switches from electrical power to its own power source (the battery) almost instantaneously.
a.
A UPS is not, however, a backup standby generator; the battery will run out sooner or later, but there should be enough time to bring the connected equipment down in an orderly fashion.
b.
A backup generator will not provide protection from a momentary power interruption. EXAMPLE
Data that is often not backed up well enough is data on end user PCs. For example, an accounting system might be run on a mainframe or a midrange processor. Financial statement data might then be downloaded to end user PCs for the preparation of eliminating journal entries and the preparation of the final financial statements. Because the accounting system is running in a data center controlled by the IT department, its data is backed up. However, the same might not be true for the data on the end user PCs. Backups do not happen automatically; they have to be planned, implemented, and then the backups have to be regularly run. Data residing on laptop PCs is seldom backed up by most organizations. EXAMPLE
ValidData Company has programmed an extensive number of inputs and edits controls for its various batch and online computer systems. For its batch systems, transactions are entered and are not validated upon entry. However, as the initial step in the processing of each batch, the data is validated extensively. Field checks are performed on certain data elements to ensure that the data is of the appropriate type (e.g., alphabetiC, numeric, etc.) and to ensure that all data has been entered. Validity checks are performed on certain codes to ensure that the codes are contained in valid code tables (other less extensive codes are entered from drop down lists so that only valid codes could be entered). Validity checks are performed on other data, such as customer numbers, to ensure that the customer numbers exist; limit checks are performed on other data to ensure that that data is within appropriate ranges, and reasonableness checks are performed on still other data to ensure that the data combinations are reasonable. On certain key data, check digits are used. Batch totals of transaction amounts are maintained for each batch, and the batch totals are inserted in a batch header that is added to each batch. As part of the last step of validation, debit and credit journal entries are generated from the transactions. Transactions that do not pass the edit checks are listed on an edit report. Batches containing transactions with errors, batches with incorrect batch totals, and batches where the debits do not equal the credits are written to a suspended transaction file. The transactions are then corrected and resubmitted. All transactions have to be corrected and resubmitted before end-ofmonth processing can begin. For its online systems, the same types of edits are performed. However, because the data has not yet been completely entered, the person entering it can make immediate corrections. No transactions are suspended. Both batch and online data entry is available only to authorized personnel with generic system logon IDs and specific application IDs for sensitive applications (e.g., payroll and human resources).
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Program Modification Controls Program modification controls are controls over the modification of programs being used in production applications. Program modification controls include both controls that attempt to prevent changes by unauthorized personnel and also controls that track program changes so that there is an exact record of what versions of what programs are running in production at any specific point in time. This function was performed by a program librarian (a person) in the past, but currently it is typically an automated function that utilizes program librarian/program change control software. EXAM PlE
Program change control software includes a software configuration management tool and a problem report and change request tracking tool. Program change control often involves changing what are effectively the same programs in two different ways simultaneously. Normally, an environment has both production programs and programs that are being tested. Sometimes, production programs require changes (production fixes) at the same time the test versions are being worked on. This process must be controlled so that one set of changes does not incorrectly overlay the other.
D.
Data Encryption Encryption is an essential foundation for electronic commerce. Encryption involves using a password or a digital key to scramble a readable (plaintext) message into an unreadable (ciphertext message). The intended recipient of the message then uses the same or another digital key (depending on the encryption method) to convert the ciphertext message back into plaintext.
Decryption or decipherment is the step where the intended recipient converts the ciphertext into the plaintext. If the encrypted content is simply stored, there may not be senders and receivers of such content. Instead, there are authorized users who will know how to encrypt and decrypt content so they can use it for authorized purposes. If the content is communicated by an entity (a person or a machine) using cryptography, the sender is the entity that encrypts and the receiver is the entity that decrypts the content. Between the sender and the receiver lies the unsecured environment where the garbled message travels. EXAMPLE
Think of encryption and decryption somewhat like keys to a car. When you lock your car, you are encrypting it, and theoretically, nobody else can get into it. However, you can give your key, or a copy of your key, to another person or other people, and that person or people can unlock the car. Add two different types of keys, the private key, which is not distributed to authorized recipients, and the public key, which is, and the result is public key encryption. Of course, encryption keys have the same potential problems as car keys. They can be lost or stolen.
1.
Digital Certificates Digital certificates are yet another form of data security. It behaves in the online worid the same way driver's licenses, passports, and other trusted documents behave outside the online world. It's an electronic document, created and digitally signed by a trusted party, which certifies the identity of the owners of a particular public key. In fact, the digital certificate contains that party's public key.
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The term public key infrastructure (PKI) refers to the system and processes used to issue and manage asymmetric keys and digital certificates. The organization that issues public and private keys and records the public key in a digital certificate is called a certificate authority. Digital certificates intended for E-Business use are typically issued by commercial certificate authorities, such as Comodo and VeriSign. The certificate authority hashes the information stored on a digital certificate and then encrypts that hash with its private key. That digital signature is then appended to the digital certificate, which provides the means for validating the authenticity of the certificate. An individual wishing to send an encrypted message applies for a digital certificate from a certificate authority (CA). The certificate authority issues an encrypted digital certificate containing the applicant's public key and a variety of other identification information. The certificate authority makes its own public key readiiy available through print publicity or perhaps over the Internet. The recipient of an encrypted message uses the certificate authority's pUblic key to decode the digital certificate attached to the message, verifies it as issued by the certificate authority, and then obtains the sender's public key and identification information contained in the certificate. With this information, the recipient can send an encrypted reply. CA's maintain a "tree of trust" that's checked each time a certificate is presented as proof of one's identity. Once the tree of trust is successfully traversed, proof of identity and proof of a person's right to use the key can be ascertained by the recipient. When used for signing electronic messages (creating a digital signature), the private key associated with the public key that's contained in the digital certificate creates the unforgettable fingerprint (digest) for the message.
2.
Digital Signatures vs. E-Signatures Digital Signatures use asymmetric encryption to create legally-binding electronic documents. Web-based e-signatures are an alternative mechanism for accomplishing the same objective. An e-signature is a cursive-style imprint of a person's name that is applied to an electronic document. Users must first register with a company that provides Web-based e-signatures, a process that includes getting a password. When the user company logs in and answers a series of authentication questions and clicks on the location of the document where they want their 'signature' to appear, the software then affixes a cursive imprint of the user's name. Note that the user does not actually "sign" the document, as you do when using credit card readers at many stores. Instead, the software just attaches their name in a cursive font of the user's choice. Nevertheless, e-signatures are legally-binding, just as if the user had really "signed" a paper copy of the document.
Notes:
• With encryption keys, the longer the length of the key and the more sophisticated the algorithm, the less likely that the message or transaction will be decrypted by the wrong party. One of the most popular encryption methods uses a key length of 128 bits. This provides a tremendous number of combinations that a hacker would need to try to break the key. In point-to-point transmissions, encryption can prOVide a reasonable level of security. • The longer the key, the less likely the key could be broken by a brute-force attack. In a brute-force attack, the attacker simply tries every possible key until the right one is found. The longer the key, the more possible combinations and the longer until the correct key would be located. • By maintaining the private key as a secret and only offering the public key to known parties, access is limited. Because only trusted parties have access to the keys, users can feel confident of the privacy of the transaction. However, this does not mean the communication is perfect or that hackers are not trying to develop software that would break encryption schemes.
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EXAMPLE
A local bank uses encryption methods (symmetric and asymmetric) and hashing in all of their online banking transfers. The bank has previously used a digital certificate from a trusted certificate authority (CAL such as Veritas or Network Solutions. A bank customer wants to make an on~line transfer between accounts. The encrypted transaction will be processed as follows: STE P 1
When a bank customer visits the bank's website, he or she will notice the lock icon displayed at the bottom of the screen once they click on a 'Money transfer' button or its equivalent. The bank customer's browser software will then obtain the Web site's digital certificate, verify its validity, and open it to get the bank's public key. The bank's website software follows the same concept to acquire the user's public key. STEP 2
Once the bank customer clicks on the 'Money Transfer' button to view his or her online banking transactions, the encryption software performs the following steps: •
It creates a hash of the money transfer by using a hashing algorithm,
•
It creates a digital signature for the money transfer by encrypting the hash using the bank customer's private key.
•
It encrypts the money transfer using the advanced encryption standard (AES) symmetric key in order to protect the confidentiality of the bank customer since only those with the AES key can decrypt the transfer. The AES key is encrypted by using the bank's public key in order to ensure that only the intended recipient (bank) will be able to decrypt the AES key needed for the money transfer.
STEP 3
The encrypted money transfer (created in step 2c), the AES key needed to decrypt the money transfer (created in step 2d), and the user's digital signature (created in 2b) are all sent over the Internet to the Bank. STE P 4
Once the bank's computer system receives the package of information via the Internet, it performs the following steps: • •
The system uses the user's public key, obtained in step 1, to decrypt the digital signature created in step 2b, in order to yield the hash of the money transfer that was created by the bank customer. The system uses its own private key to decrypt the AES key sent by the customer in step 2d. The system uses the AES key from step 4b to decrypt the encrypted money transfer created in step 2c in order to produce the plaintext version of the customers transfer.
•
The system uses the same hashing algorithm used on the user's computer in step la to hash the plaintext copy ofthe money transfer created in step 4c.
•
The system compares the hash created in step 4d to the one produced in 4a. If there is a match, the bank's system knows that the money transfer has not been changed or corrupted during transmission.
STEP 5
The bank sends the customer an acknowledgement that the money transfer has been received.
E.
Managing Passwords One of the biggest challenges in information security is password-related policies. Passwords are designed to protect access to secure sites and information. The first rule in password policy is that every account must have a password. The second rule is that the password is to be kept secret (this includes not writing it down)! A small password management policy must address the following password characteristics:
1.
Password Length Longer passwords are generally more effective. IT policies often require passwords greater than seven characters. Many organizations standardize on eight characters.
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Password Complexity Complex passwords are more effective and generally feature three of the following four characteristics: uppercase characters, lowercase characters, numeric characters, and ASCII characters (e.g., !, @, #, $, %, " &, " or ?).
3.
Password Age Although there is no true standard, passwords should be changed frequently in order to be effective. The NSA (National Security Agency) recommends that passwords should be changed every 90 days. Administrative passwords should be changed more frequently.
4.
Passwords Reuse Although there is no true standard, passwords should not be reused until a significant amount of time has passed. The NSA (National Security Agency) recommends that password reuse of the previous 24 passwords be restricted. The goal is to prevent users from alternating between their favorite two or three passwords.
F.
User Access User accounts are the first target of a hacker who has gained access to an organization's network. Diligent care must be used when designing procedures for creating accounts and granting access to information. Word of mouth is not the way to go. This function should be one of the more strictly controlled functions of user management. 1.
Initial Passwords and Authorization for System Access The first point of contact for a new employee is generally the Personnel or Human Resources (HR) department. HR should be tasked with the responsibility of generating the initial paperwork that will culminate with a user account being created and access right assigned. Depending upon the leve! of access being granted, the Information Security Officer many also need to approve the account.
2.
Changes in Position
Changes in position coordination of effort between HR and IT.
II.
a.
It is important to have procedures in place to address promotions, lateral moves, or demotions within the company. If jobslroles change and access does not, the employee may not be able to perform the new job.
b.
There must be a mechanism to disable accounts should relations end between the organization and any of its employees. The best case scenario is that HR alerts IT prior to termination. If that's not possible, IT should be notified as soon as possible.
POLICIES
Policies are the most crucial element in a corporate information security infrastructure and must be considered long before security technology is acquired and deployed. Effective policies can rectify many of the weaknesses from failures to understand the business direction and security mission and can help to prevent or eliminate many of the faults and errors caused by a lack of security guidance.
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Security Policy Defined Information security policy can be defined as a document that states how an organization plans to protect the organization's tangible and intangible information assets. Security policies also include: 1.
Management instructions indicating a course of action, a guiding principle, or an appropriate procedure.
2.
High-level statements that provide guidance to workers who must make present and future decisions.
3.
Generalized requirements that must be written down and communicated to certain groups of people inside, and in some cases outside the organization.
4.
Policies are "institutional memory". Policies transcend the current personnel within an organization and act as a sort of written memory for how things should operate, and how people within an organization, and in some cases outside of an organization, should behave.
B.
Security Policy Goal The goal of good information security policies is to require people to protect information, which in turn protects the organization, its people, and its customers.
C.
States and Locations of Information Covered by Security Policies 1.
2.
3.
Policy should seek to secure information that exists in three distinct states: a.
Where and how it is stored
b.
Where and how it is processed
c.
Where and how it is transmitted
Identify the three piaces where information resides: a.
Information technology systems
b.
Paper
c.
Human brains
Relationship between states and locations of information - The following table illustrates the relationship between the three states of information and the places where information resides. When writing policies, we must first know what we are protecting and where it exits. STATES OF INFORMATION
Information Location
Stored
Processed
Transmitted
Information systems
Hard drives; physical memory, backup takes; all portable storage such as CD-ROMs, thumb drives; cell phones; cameras
Server computers, mainframe, computers, desktop computers, portable devices
Via Internet, Wide Area
Paper
Desks, file cabinets, pockets, briefcases, shredding rooms
Copy machines, fax machines, read by people
Fax, standard postal service, courier, pictures, read by people
Human brain
Long- and short-term memory
All synapses firing
Spoken and sign language
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Network (WAN). Local Area Network (LAN), wired or
wireless
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Types of Policies There are four types of computer security policies that start out at a very high level of understanding and become more specific (granular) at the lower levels. 1.
Program-level Policy Program-level policies are used for creating a management-sponsored computer security program. A program-level policy, at the highest level, might prescribe the need for information security and may delegate the creation and management of the program to a role within the IT department. This is the mission statement for the IT security program.
2.
Program-framework Policy A program-framework policy establishes the overall approach to computer security (i.e. a computer security framework). A framework policy adds detail to the program by describing the elements and organization of the program and department that will carry out the security mission. This is the IT security strategy.
3.
Issue-specific Policy Issue-specific policies address specific issues of concern to the organization.
4.
System-specific Policy System-specific policies focus on policy issues that management has decided for a specific system (e.g., the payroll system).
E.
Development and Management of Security Policies To develop a comprehensive set of system policies, a management process is required that derives security rules from security goals such as a three-level model for system security policy: .(
Security objectives
.(
Operational security
.(
Policy implementation
1.
Security Objectives The first step is to define the security objectives. The objectives should consist of a series of statements to describe meaningful actions about specific resources. These objectives should be based on system functionality or mission requirements and also state the security actions to support the requirements.
2.
Operational Security Operational security would define the manner in which a specific data operation would remain secure (e.g., operational security for data integrity might consider a definition of authorized and unauthorized modification: the individuals authorized to make modifications, by job category, by organization placement, by name, etc.).
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Policy Implementation Security is normally enforced through a combination of technical and traditional management methods. Although technical means are likely to include the use of access control technology, there are other automated means of enforcing or supporting security policy (e.g., technology can be used to block telephone systems users from calling certain numbers.) Intrusion detection software can alert system administrators to suspicious activity or take action to stop the activity. Personal computers can be configured to prevent booting from a floppy disk.
F.
Policy Support Documents Policies are defined as statements of management's intent. Procedures then provide a recipe for the execution of steps that are intended to comply with a policy directive. Documents that serve to support policies include: 1.
Regulations Laws, rules, and regulations generally represent governmentally imposed restrictions passed by regulators and lawmakers (i.e., Sarbanes-Oxley Corporate Responsibility and Accountability Act, HIPPA, etc.).
2.
Standards and Baselines Topic-specific (standards) and system specific (baselines) documents that describe overall requirements for security are called standards and baselines.
3.
Guidelines Guidelines represent documentation that aids in compliance with standard considerations, hints, tips and best practices in implementation.
4.
Procedures Procedures are step-by-step instructions on how to perform a specific security activity (configure a firewall, install an operating system, and others).
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INTERNET IMPLICATIONS FOR BUSINESS
Sometimes referred to as "network of networks", the Internet is an interconnection of different-sized networks (LANs) around the world. Today, many business transactions are conducted over electronic networks, that is, over groups of computers linked together electronically. Networks can be classified according to the distance they span. Hence, networks can be classified as local, metropolitan, or wide area. The Internet is the largest WAN available today. In the broadest sense, electronic business (E-Business) refers to the use of information technologies in any aspects of the business or organization. Electronic commerce (E-Commerce), on the other hand, is that part of E-Business that directly
involves the exchange or products and services among organizations and individuals. Web commerce is a type of ECommerce, and E-Commerce is a type of E-Business.
I.
ELECTRONIC COMMERCE AND BUSINESS A.
Electronic Commerce (E-Commerce) E-Commerce is the electronic consummation of exchange (buying and selling) transactions.
E-Commerce uses a private network or the Internet as the communications provider. Certain types of E-Commerce involve communication between previously known parties or between parties that have had no prior contracts or agreements with each other. In the recent past, ECommerce was an option for many kinds of businesses. Today, it is a cost of doing business for most types of business. B.
Electronic Business IE-Business) E-Business is a more generai term than E-Commerce and refers to any use of information
technology, particularly networking and communications technology, to perform business processes in an electronic form. The exchange of this electronic information mayor may not relate to the purchase and sale of goods or services. E-Commerce relates to buying and selling transactions. II.
ELECTRONIC DATA INTERCHANGE (EDI) One of the first types of E-Business/E-Commerce was EDI. EDI is computer-to-computer exchange of business transaction documents (e.g., purchase orders, confirmations, invoices, etc.) in structured formats that allow the direct processing of the data by the receiving system. EDI started with buyer-seller transactions (e.g., invoices and purchase orders) but was then expanded to inventory management and product distribution. Any standard business document (including an information request) that one organization can exchange with another can be exchanged via EDI, provided both organizations have made the proper preparations. EDI has been availabie since the
19705. EXAMPLE
An example of EDI would be a manufacturer sending an electronic purchase order to a supplier. Instead of sending a paper purchase order or emailing an electronic purchase order, the manufacturer's purchasing system sends an electronic purchase order to the supplier's order entry system. The vendor's order entry system responds with a confirmation of the receipt of the order, an estimated price for the order, and an estimate of the shipping date for the order. When the order is shipped, the vendor's accounts receivable system sends an electronic invoice. To do this, of course, the sending system and receiving system need to be able to communicate electronically, and an agreement has to be reached, before the fact, on what transactions will be communicated and in what format.
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Reduced Handling Costs and Increased Processing Speed Compared to traditional paper-based processing, EDI reduces transaction handling costs and speeds transaction processing.
B.
Standard Data Format EDI requires that all transactions be submitted in a standard data format. 1.
Mapping Mapping is the process of determining the correspondence between data elements in an organization's terminology and data elements in standard EDI terminology. Once the mapping has been completed, translation software can be developed or purchased to convert transactions from one format to the other.
2.
Standards There are several different sets of standards, such as ANSI X.12 in the U.S., EDIFACT in Europe, and IPPM for the healthcare industry. XML (extensible markup language) is a technology that is being developed to transmit data in flexible formats, instead of the standard formats of ED!. XML tells systems the format of data and also what kind of information the data is. XML utilizes user-defined tags similar to the data formatting tags that are used in HTML for the display of Web pages in browsers. XML is likely to become the standard for automating data exchange between systems, not just in EDI but in other applications also. Currently, XML extensions are being grafted onto EDI; if XML standards can be deveioped and adopted, XML may replace EDI in the distant future.
C.
Communications EDI can be implemented using direct links between the organizations exchanging information, through communication intermediaries (called service bureaus), through VANs or networks of VANs, or over the Internet.
D.
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Features of EDI
1.
EDI allows the transmission of electronic documents between computer systems in different organizations. These organizations are often called trading partners or business partners.
2.
EDI reduces handling costs and speeds transaction processing compared to traditional paper-based processing. However, to actually reduce such costs, the EDI system must be integrated with the organization's accounting information systems.
3.
EDI requires that all transactions be submitted in a standard data format. Translation software is required to convert transaction data from the internal data format in the sending system into EDI format and vice versa.
4.
EDI can be implemented using direct links between the trading partners, through communication intermediaries, through VANs or networks of VANs, or over the Internet. As discussed previously, VANs are privately owned communications networks that provide additional services beyond standard data transmission; for EDI, those additional services include the provision of a mailbox where EDI transactions are left by one trading partner until they are retrieved by the other trading partner. Internetbased EDI is starting to replace VAN-based EDI because it is considerably cheaper. ©2010 D~Vry/B~,k~r Educational O~v~lopment Corp. All right5 fe5~JV~d
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Uses of EDI 1.
EDI may be used to permit direct but very controlled access to databases of other organizations by those other organizations allowing the transactions submitted to update their databases, exactly as if a paper document had been sent and a person had entered the appropriate transaction. What has been eliminated is the processing of the documents by people.
2.
Suppliers and buyers can use EDI to improve inventory management by speeding up the processing of sales/purchase/inventory transactions.
Costs of EDI EDI costs include: 1.
Legal Costs The legal costs associated with modifying and negotiating trading contracts with trading partners and with communications providers are costs of ED!. EDI occurs only when organizations have an established relationship and have agreed to conduct certain business through ED!. EDI cannot be turned on with the flip of a switch. Many large companies with significant numbers of transactions have required their suppliers to use EDI as a condition of doing business.
2.
Hardware Costs Hardware costs (if additional hardware such as communications equipment, improved servers, modems, routers, etc., is required) are costs of ED!.
3.
Costs of Translation Software The cost of acquiring/developing and maintaining the translation software to translate data into the very specific EDI formats can be significant. Sometimes, however, the translation software and/or the translation itself can be provided by third-party service providers.
4.
Costs of Data Transmission The cost of data transmission is one cost that has been decreasing, especially with the evolution of EDI to the Internet.
5.
Process Reengineering and Employee Training Costs for Affected Applications The implementation of EDI can significantly reduce human effort in the processing of business documents related to the transactions for which EDI has been implemented. However, the main advantage of automation such as EDI is when EDI processes are heavily integrated into other applications such as inventory control, shipping/receiving, and even production planning. Such changes may require significant business process reengineering.
6.
Costs Associated with Security, Monitoring, and Control Procedures EDI systems tend to need relatively constant monitoring and troubleshooting to make sure that they are working properly. Security must be tight to ensure that EDI transactions are not received from or sent to unauthorized trading partners. Some controls over EDI can be automated.
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G.
I (YA EX,lI11 Rcvic\'.'
EDI Controls Because EDI involves the direct processing of data by a receiving system, generally with little human involvement, controls designed to prevent errors are crucial. Data encryption (as discussed previously, this is the process of scrambling stored or transmitted information so that it is unintelligible until it is unscrambled by the intended recipient) should be performed by physically secure hardware because software encryption may be subject to unauthorized tampering from remote locations. Audit trails in EDI systems should include: 1.
Activity logs of failed transactions.
2.
Network and sender/recipient acknowledgments.
Normally, people have to follow up on the failed transactions. Thus, human effort Is not totally eliminated from EDI systems.
H.
EDI Risks The greatest risk in an organization's use of EDI is unauthorized access to the organization's systems.
I.
Comparison of EDI and E-Commerce ED I V S
E-COMMERCE COMPARISON SUMMARY
Item
EDI
EMCommerce
Cost
More Expensive
Less Expensive
Security
More Secure
Less Secure
Speed
Slower (Batch)
Faster (OlRT)
Network
VAN (Private)
Internet (Public)
EXAMPLE
SmallV Company has just won a contract to supply a major manufacturer in the automotive industry. The automotive company requires that all vendors use EDI to accept purchase orders, to submit shipping documents, to submit invoices, and to exchange all other related business documents that might be needed. SmallV's accounting system had a purchase order entry component that allowed SmallV's order entry clerks to enter orders received over the telephone. The orders were then tracked through the system, and shipping documents and invoices were printed when the orders were shipped. Traditionally, the shipping documents were sent with the products and the invoices were mailed separately. This method of doing business was not acceptable to the automotive company, but was still acceptable to SmallV's other customers. SmallV contracted with the VAN utilized by the automotive company for its EDI transactions. It then modified its order entry system to include an EDI front-end. That EDI front-end would log onto the VAN and accept any electronic purchase orders that were stored there in the automotive company's mailbox. It would then translate those purchase orders from the automotive company's EDI data elements and formats into SmallV's internal data elements and formats and submit those transactions to its accounting system. When products were shipped, shipping documents were translated and sent in the other direction, to the automotive company through the VAN, Along with the shipping documents went invoices, translated from SmallV's data elements and formats to that of the automotive company. In both directions, the information was encrypted to protect against interception by other organizations. The original telephone order entry component of the system was retained for SmallV's customers who were not interested in ED!.
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Business 4
OPPORTUNITIES FOR BUSINESS PROCESS REENGINEERING A.
Defining Business Process Reengineering Business process reengineering (BPR) is the analysis and redesign of business processes and information systems to achieve significant performance improvements. BPR reduces a company to its essential business process and reshapes organizational work practices and information flows to take advantage of technological advancements. This simplifies the system, makes it more effective, and improves a company's quality and service. Business process management (BPM) soflware has been developed to help organizations automate many BPR tasks. Reengineering typically involves the efficient and effective use of the latest information technology.
B.
Challenges Faced in Business Process Reengineering BPR is challenging and many efforts fail or do not accomplish all they set out to do. To successfully complete the BPR process, a company must face and overcome the following obstacles: 1.
Tradition Old ways of doing things do not die easily, especially practices associated with the organization's culture. Successful reengineering requires changes in employee culture and beliefs.
2.
Resistance Change is often met with a great deal of resistance. Managers must continually provide support to those affected, reassuring and persuading them that the necessary changes will work.
3.
Time and Cost Requirements BPR is costly and almost always takes two or more years to complete.
4.
Lack of Management Support Many top managers are afraid of the "big hype, few results" syndrome. Without topmanagement support, reengineering has little chance of succeeding.
5.
Skepticism Some people view BPR as traditional systems development in a new wrapper with a fancy name.
6.
Retraining Employees must be retrained, which is time-consuming and expensive.
7.
Controls Important controls that ensure system reliability and integrity cannot be deleted.
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I CPA Exam Review
BUSINESS-TO-BUSINESS (B2B) In order to make a profit, all businesses need to sell their products or services. When a business sells its products or services to the public, it is called a Business-to-Consumer (B2C) transaction. When a business sells its products or services to other businesses, it is called a Business-toBusiness (B2B) transaction. When consumers sell products to other consumers (such as on eBay), it is called a Consumer-to-Consumer (C2C) transaction. A.
B2B E-Commerce Many businesses buy, sell, or trade their products and services with other businesses. This usually occurs in the wholesale markets and on the supply side of commercial processes.
B.
Electronic Market It is very common for B2B transactions to occur electronically via the Internet. The Internet transactions can occur between businesses where there is no pre-existing relationship.
C.
Direct Market It is also very common for B2B transactions to occur electronically between businesses where there is a pre-existing relationship. These transactions are called direct market transactions. Examples of these transactions are transactions that occur via EDI, corporate intranets, and extranets.
D.
Importance of B2B B2B commerce sites make purchasing decisions faster, simpler, safer, more reliable, and more cost effective because companies can use websites to do more research and transact business with many different vendors. The following are some advantages of B2B e-commerce: 1.
Speed Time is money. The faster transactions can occur between businesses, the faster the business can manufacture or resell its products to the public. B2B E-Commerce allows businesses to transact with each other more rapidly than with traditional phone, fax, or mail transactions. This emphasis on speed is often called Internet time.
2.
Timing E-Commerce transactions do not have to occur during normal business hours. Transactions between businesses in different countries can occur regardless of the different time zones of each country.
3.
Personalization Once a business registers and completes an online profile with a new business partner, every time that business returns to the website, it can be guided to the areas of the website in which it is most interested.
4.
Security Transactions that contain private information are encrypted such that if the electronic transmission is intercepted, it will be undecipherable and therefore useless to the interceptor.
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Reliability Because transactions occur electronically from one computer directly to another computer, the transactions should be very precisely performed because generally there is no opportunity for any human errors.
6.
Factors to Consider Factors for an organization to consider when deciding when and how to engage in electronic commerce are (1) the selection of the business model (many electronic commerce or Internet business models are unproven), (2) channel conflicts (the possibility of stealing business from existing sales or channels), (3) legal issues (laws governing electronic commerce are still being developed), and (4) security (electronic commerce and Internet usage are vulnerable to penetration by outsiders, and security is essential).
E.
Components of B2B A reasonably simple E-Commerce B2B site (on the selling side) might consist of the following elements:
V.
1.
The customer connecting to the site through the Internet;
2.
The seller's site behind an enterprise firewall;
3.
The seller's Internet commerce center consisting of an order entry system and a catalog system containing product descriptions and other information on what is for sale and which acts as an interface to the customer's browser;
4.
The seller's back office system(s) for inventory management, order processing, and order fulfillment, which could include a shipping or transportation system;
5.
The seller's back office accounting system; and
6.
The seller's payment gateway communicating through the Internet to validate and authorize credit card transactions or other payment methods.
B2B V5. B2C B2C is less complex than B2B because there is IT infrastructure and a supply chain only on one side of the transaction. In addition, B2B transactions often involve many more participants in each individual transaction, often involve more complex products, and normally require that order fulfillment be more certain and predictable. The payment mechanisms for B2C are much more of a problem than those for B2B. Internet trading exchanges (or e-marketplaces) are aggregation points tailored to specific markets that bring buyers and sellers together to exchange goods and services. Exchanges may be managed by buyers, suppliers, distributors, or third parties called content aggregators (content aggregators pull information together from multiple Web sites). Digital Cash (also electronic cash or E-cash) is currency in an electronic form that moves outside the normal channels of money. Digital cash can be used by people who want to make purchases over the Internet but do not want to use their credit cards. An example of digital cash is PayPal.
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VI.
ENTERPRISE RESOURCE PLANNING SYSTEMS (ERP) A.
ERP Defined An enterprise resource planning system is a cross-functional enterprise system that integrates and automates the many business processes that must work together in the manufacturing, logistics, distribution, accounting, finance, and human resource functions of a business. ERP software is comprised of a number of modules that can function independently or as an integrated system to allow data and information to be shared among all of the different departments and divisions of large businesses. ERP software manages the various functions within a business (enterprise) related to manufacturing, from the entering of sales orders to the coordinating of shipping and aftersales customer service. In spite of the name, ERP normally does not offer anything in the way of planning. The enterprise part, however, is correct. ERP is often considered a back office system, from the customer order to fulfillment of that order.
B.
ERP Functions ERP has many purposes and objectives. The most common are listed below: 1.
ERP systems store information in a central repository so that data may be entered and accessed and used by the various departments.
2.
ERP systems act as the framework for integrating and improving an organization's ability to monitor and track sales, expenses, customer service, distribution, and many other business functions.
3.
ERP systems can provide vitai cross-functional information qUickly to managers across the organization in order to assist them in the decision-making process. EXAMPLE
Overwhelmed Company contracted with a major worldwide software vendor to acquire its prime ERP software package, OurOwnERP. For many years, Overwhelmed had utilized separate systems for each piece of its manufacturing process; each individual system seemed to work reasonably well, and the individual systems seemed to transfer data back and forth reasonably well. However, the data associated with its various business processes was scattered throughout the various systems in different formats and with various different meanings at times, making it extremely difficult for Overwhelmed's employees to understand what was happening. Because OurOwnERP was an integrated system, all data was stored in one centralized relational database. There were thousands of tables, each of which had decision switches that led the system down one path or another. Due to the complexity of the system, Overwhelmed decided to contract with the system's vendor to install the system. In addition, Overwhelmed would also use its internal personnel because the vendor personnel would not know or understand Overwhelmed's business processes. Unfortunately, Overwhelmed failed to consider the full costs of the installation. Despite the vendor's pre-sale claims to the contrary, OurOwnERP would not run on Overwhelmed's existing hardware, either at the processor level or at the end-user workstation level. All of the workstations had to be totally replaced, even though they had just been acquired 6 months earlier, and the processor had to be upgraded.
(continued)
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EXAMPLE (continued) {continued)
In addition, OurOwnERP would not support two of Overwhelmed's major business processes. Because the two choices were to change the system or to change the process, Overwhelmed decided to change one of its processes, which changed longestablished ways of doing business and caused considerable employee resentment and resistance to the new system and increased the already extensive need for employee training that Overwhelmed had originally underestimated. With the other business processes, Overwhelmed decided to change the system. The changes required rippled throughout the system and caused considerable additional work and schedule slippage. In addition to working with the vendor's personnel, Overwhelmed used its personnel to convert data from the eXisting systems that would be replaced and also to build the interfaces from the existing systems that would be retained. With all this work, these people learned enough about the new software by the time it was implemented that they were almost immediately hired by other consulting firms. Thus Overwhelmed lost most of its knowledgeable people who it had counted on to maintain the system after implementation. Overwhelmed was forced to hire contractors to maintain the system at a considerably higher rate than it paid its own people. Partly because of these problems, Overwhelmed's project to implement OurOwnERP was 2 years late and $20 million over budget. Unfortunately, this is not an uncommon occurrence for projects that attempt to implement such complicated systems.
VII.
SUPPLY CHAIN MANAGEMENT SYSTEMS (SCM) A.
Supply Chain Management Defined Supply chain management is concerned with the four important characteristics of every sale: what, when, where, and how much. For example, all customers, whether business or consumer, expect the following:
1.
The goods received should match the goods ordered,
2.
The goods should be delivered on or before the date promised,
3.
The goods should be delivered to the location requested, and
4.
The cost of the goods should be as low as possible.
Supply chain management is the integration of business processes from the customer to the original supplier and includes purchasing, materials handling, production planning and control, logistics and warehousing, inventory control, and product distribution and delivery. SCM systems may perform some or all of these functions. B.
Reengineering of Supply Chains Companies must constantly reengineer their supply chains to increase efficiency, reduce costs, and ultimately meet the customers' needs. SCM software can help the various parties coordinate more efficiently.
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SCM Objectives 1.
Achieve Flexibility and Responsiveness The overall objectives of SCM are achieving flexibility and responsiveness in meeting the demands of customers and business partners. SCM might incorporate the following functions:
2.
a.
Planning (e.g., demand forecasting, product pricing, and inventory management)
b.
Sourcing (e.g., procurement and credit and collections)
c.
Making (e.g., product design, production scheduling, and facility management)
d.
Delivery (e.g., order management and delivery scheduling)
Supply Chain Planning Software Each of the functions of SCM comprises dozens of specific steps, many of which have their own specific software. Supply chain planning software is utilized to improve the flow and efficiency of the supply chain and reduce inventory. Supply chain execution software automates the various steps of the supply chain.
3.
Often Termed an Extension of ERP SCM is often defined as an extended ERP system that goes outside the enterprise and addresses the entire supply chain (i.e., there are additional modules that extend outside the organization itself). Much of the information used by an SCM system resides in ERP systems. However, because the system does extend beyond the company, it is even more complex than ERP.
EXAMPLE
Century 22 Company manufactures communications equipment. For several years, it has run an SCM system made up of system components acquired from various vendors, each component performing a part of the SCM function. It has a network of suppliers, distributors, and contract manufacturers that are linked through its extranet. In many cases, the manufacturing facilities of these suppliers are located in close physical proximity to Century 22's facilities. Century 22's intent is to operate a Just-in-Time inventory system and thus to maintain little or no inventory (inventory in the telecommunications industry can become obsolete overnight as products and product specifications change). When a customer orders equipment from Century 22, its SCM system determines what products and individual components of products are needed to assemble the order. It searches through the inventories in its distributors' warehouses to determine if those products or components are available on the shelf; if they are, it automatically places a purchase order. If not, it places a manufacturing order with the appropriate contract manufacturer or manufacturers. The system then tracks any manufactured items through the manufacturing process. All manufactured products are identified by bar codes. When the product is finished, the system provides shipping information, either to the next manufacturer in the supply chain (if the product does not constitute an end product) or to the customer itself (if the product does constitute an end product). The manufacturer or distributor then submits its invoice to Century 22 electronically.
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Business 4
CUSTOMER RELATIONSHIP MANAGEMENT SYSTEMS (CRM) A.
Customer Relationship Management Defined Customer relationship management systems provide sales force automation and customer services in an attempt to manage customer relationships. CRM systems record and manage customer contacts, manage salespeople, forecast sales and sales targets and goals, manage sales leads and potential sales leads, provide and manage online quotes and product specifications and pricing, and analyze sales data.
B.
CRM Objectives The objective of CRM (and of CRM systems) is to increase customer satisfaction and thus increase revenue and profitability. CRM attempts to do this by appearing to market to each customer individually. The assumptions are that 20% of customers generate 80% of sales and that it is 5-10 times more expensive to acquire a new customer than to obtain repeat business from an existing customer. CRM also attempts to reduce sales costs and customer support costs. It attempts to identify the best customers and possibly provide those best customers with increased levels of service or simply drop the worst customers.
C.
Categories of CRM CRM is sometimes divided into two categories:
1.
Analytical CRM Analytical CRM creates and exploits knowledge of a company's current and future customers to drive business decisions.
2.
Operational CRM Operational CRM is the automation of customer contacts or contact points. EXAMPLE
Anybody who has logged on to Amazon and repeatedly bought from them has seen a CRM system in action. Amazon attempts to make the buying process as simple as possible. With one-cnck purchasing/checkout, and a previously stored shipping address and credit card number, a customer can quickly purchase anything offered with minimum effort. Because Amazon has kept track of past purchases, customized recommendations for future purchases are available. It is easy to simulate leafing through the pages of books by viewing the table of contents, index, or sample pages. Used books are available if a customer does not want a new copy. Partly as a result of these features, Amazon has a higher customer return (retention) rate than the normal lie-tailer,"
o .....-----------------------------, AN C I I I A R Y MAT E RIA L (for Independent Review)
IX.
OTHER E-COMMERCE TECHNOLOGIES A.
Electronic Funds Transfer(s) Electronic funds transfer systems are a form of electronic payment for banking and retailing industries. EFT uses a variety of technologies to transact, process, and verify money transfers and credits between banks, businesses, and consumers. The Federal Reserve Fedwire system (Automated Clearing House Network) is used very frequently in EFT to reduce the time and expense required to process checks and credit transactions.
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EXAMPLE
The Federal Reserve Automated Clearing House Network is a payment mechanism that allows the replacement of paper payment transactions with electronic payment transactions and the clearing of those transactions through participating financial institutions. Most of the time, the ACH operator is the Federal Reserve. To some extent, the system can be thought of as a large EDI system among varied institutions, and the system can be used to illustrate certain characteristics of EDI systems. Payment transactions are created by a company and then electronically transmitted in a batch or batches to a participating depository financial institution or a third-party processor. The financial institution or third~party processor electronically transmits those transactions to the Federal Reserve. The transactions are sorted by the Federal Reserve and transmitted to the receiving (paying) financial institution, which then transmits them to their customer's accounts. Basically, this process is the same thing that happens with paper checks, except that the transactions are electronic instead of paper. Data is transmitted in batches. Each batch contains a batch header with certain identifying and control information for that batch, and an entire file of batches (which is actually what is transmitted) contains a file header (and a file footer) with certain identifying and control information for the file. If the transactions in a batch are payment transactions (Le., payments by the originating companies). the batches can contain addendum data that can act as payment advices. Like all EDI-type transactions, the transactions must be in a prescribed format and must follow certain rules. Like checks, ACH items can be returned for several reasons such as insufficient funds, account closed, unauthorized transaction, payment stopped, etc. Of course, the most common return reason is insufficient funds. Nobody ever said that electronic checks could not bounce. When ACH items are returned, for whatever reason, there are other transaction types that would then have to be transmitted. Extending beyond an EDI type system, the ACH system can also be used for such transactions as direct deposits of checks into bank accounts (e.g., payroll checks, interest and dividend checks) and direct withdrawals from bank accounts (e.g., mortgage payments, utility payments, etc.). In addition, the system offers a point-of-purchase facility that gives consumers and businesses the ability to convert paper checks into electronic payments at the point-of-purchase. The MICR information from the paper checks is captured by an MICR reader, and the information is used to process an ACH debit to the consumer's account. A point-of-sale feature gives merchants the ability to utilize debit cards to make deductions from bank accounts.
1.
Third-party Vendor EFT service is often provided by a third-party vendor who acts as the intermediary between the company and the banking system. That third party might accept transactions from a business and perform all of the translation services.
2.
Data Encryption EFT security is provided through various types of data encryption.
3.
Reduction in Errors EFT reduces the need for manual data entry, thus reducing the occurrence of data entry errors.
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Business 4
Application Service Providers (ASP) Application service providers provide access to application programs on a rental basis. They allow smaller companies to avoid the extremely high cost of owning and maintaining today's application systems by allowing them to pay only for what is used. The ASPs own and host the software.
1.
Advantages of ASP The benefits of utilizing an ASP (Application Software Provider) are lower costs, both from a hardware, software, and people standpoint, and greater flexibinty.
2.
Disadvantages of ASP The drawbacks of utilizing an ASP are the possible risks to the security and privacy of the organization's data, the financial viability or lack thereof of the ASP, and possible poor support by the ASP (a concern any time anything is outsourced).
3.
Similar Concepts to ASP a.
IBM offers a somewhat similar concept in its utility computing and E-Commerce on demand strategies.
b.
ASPs are similar to the timesharing providers or service bureaus of the past that rented raw computing power (time on computers) to customers, except that ASPs rent applications instead of just the computer processing.
c.
Somewhat related to ASPs are present-day service bureaus, which perform processing outside the organization. EXAMPLE
Outsourced Company utilizes an ASP for its ERP system. It could not afford to acquire and install the full system itself on an individual basis (which would have cost millions of dollars), but it was able to find an ASP that had licensed the same software and provided the use and support of the software. Data was stored on the ASP's computer system. All was not rosy, however. Every year or so, the ERP vendor updated its system and the ASP converted to the new version. Outsourced received the new and changed system whether it wanted it or not. Sometimes the changes did not meet Outsourced's business requirements, and because Outsourced could not change the system, it was forced to change its business. In addition, several of Outsourced's direct competitors used the same ASP, and Outsourced was never totally sure that its data was completely secure (i.e., that it was not accessible by those competitors). Further, the system had been down several times in the past year, and the ASP had not been particularly quick to respond. Outsourced had complained and had threatened to take its business elsewhere, but it hadn't seemed to make much difference. Finally, the last straw. Outsourced received notification that the ASP had declared bankruptcy, was dissolving, and was terminating service in two weeks. Outsourced had two weeks to find an alternative, someway, somehow.
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ROLES OF INTERNET EVOLUTION ON BUSINESS OPERATIONS AND ORGANIZATION CULTURES Advances in technology have created an extremely robust relationship between technological advancements and business opportunities. A.
Web 2.0
Web 2.0 emerging technologies have had a considerable impact on E-Commerce. In its earlier years, the Internet was mostly a repository of documents that Web surfers could browse. But technology advances led to the development of "Web 2.0", in which Web surfers began to interact with Web sites. 1.
Collaborative Web Sites and Social Networking This lead to the emergence of the Wiki, a type of collaborative Web site in which users not only browse content, but also add and modify content. The Wikl was especially popularized by Wikipedia (www.wikipedia.com). a tremendously popular Web-based encyclopedia that contains millions of articles contributed from people allover the world. Other well-known Web sites that helped to popularize the era of Web collaboration include Myspace and Facebook.
2.
Dynamic Content Other Web 2.0 has been associated with an increase in Web pages with dynamic content. Such content is often linked to databases, such as price lists, catalog product lists, and so on. Such data can be dynamically embedded in Web Pages through XML, with the data being stored in database separate from the Web page.
B.
Mashups
Mashups are Web pages that are collages of other Web pages and other information. Google maps, (maps.google.com) is an example of a mashup. Google Maps allows the user to view various sources of information (e.g., places of interest and street names) superimposed on a single map. C.
Web Stores 1.
Standalone Web Stores Many small companies have stand-alone Web stores that are not integrated with larger accounting systems. Such stores are typically hosted by shopping cart software that manages a product catalog, user registrations, orders, email confirmations, and so on. Financial reports, such as order summaries, are generated as needed by the software. The reports are then imported into general accounting software.
2.
Integrated Web Stores Many larger companies, and an increasing number of small companies, have turned to ERP systems that integrate all the major accounting functions, as well as the Web Store, into a single software system. Such systems process Web orders and then automatically update cash and revenue accounts, handie inventory reordering, and so on. In effect, such systems treat Web Store sales the same as sales made in retail stores.
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VARIOUS DEFINITIONS Certain definitions are foundational to your understanding of contemporary web-based IT operations and have been included below as supplementary information. A.
Hypertext Markup Language (HTML) Hypertext markup language (HTML) is a tag-based formatting language used for web pages. It provides a means to describe the structure of text-based information in a document and to replicate that information in a web page by using the tags in the text.
B.
Hypertext Transfer Protocol (HTTP) Hypertext transfer protocol (HTTP) is the communications protocol used to transfer web pages on the World Wide Web. HTTPS is the secure version of HTTP that uses SSL (secure socket layer) for its security.
C.
URL A URL (uniform resource iocator) is a string of characters that refers to specific resources on a computer. A URL consists of three different parts. The first part is the protocol that will be used (for example: the http in http://). The second part is the computer on which the requested resource is located (for example: the www.BeckerCPA.com). The third part is the resource (file) requested (for example: students). A web address is composed of a number of features including the transfer protocol, the domain name, etc. The technical name for a web address is the uniform resource locator that consistently directs the user to a specific location on the web. Web addresses include the foiiowing (many web addresses are considerably more complex than this example):
D.
1.
Transfer protocol, such as http:// (Hypertext Transfer Protocol) or ftp:// (File Transfer Protocol)
2.
Setver, such as www (indicates a web server)
3.
Domain name, such as BeckerCPA (BeckerCPA is the subdomain name and BeckerCPA.com is the full domain name)
4.
Top-level domain, such as .com, .net, .edu (often caiied generic top level domains)
5.
Country, such as .US, .DE, .FR, .IT (often caiied country code top level domains)
6.
Example: http://www.BeckerCPA.com.us(the.usis reaiiy not needed)
TCP TCP (Transport Control Protocol) is the transmission protocol of the Internet protocol suite. TCP is a transport layer protocol. TCP is a reliable and a connection-oriented protocol.
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E.
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Domain Name A domain name is a name which includes one or more IP addresses; domain names are merely something that is easier to remember than an IP address. In web addresses such as www.BeckerCPA.com.thedomainnameisBeckerCPA.com.The.comis the top level domain name for commercial organizations. Other such top level domain names are .gov for governments, .edu for educational institutions, .org for nonprofit organizations, and .mil for the military. The BeckerCPA is the second level domain name, and the www indicates that the PC with that address is a web server. Organizations with second level domain names have to have a DNS server. A third level domain name is an individual host and would be something like olinto.BeckerCPA.com if a host were named after Peter Olinto. The entire address is called a fully qualified domain name. The word "domain" has multiple uses in IT and is normally not used here other than in "domain name;" if it were, the domain would be the routers, networks, and hosts under the control of a single organization. If the name had a Istudents attached to it, like in www.BeckerCPA.com/students. the Istudents (and anything after it in more complex domain names) would be a file name. A DNS root server is the server that administer the top level domain names.
F.
Domain Name System (DNS) The domain name system is the system of domain names that is employed by the Internet. The Internet is based on IP addresses, not domain names, and each web server requires a domain name server to translate domain names into IP addresses. Think of domain name servers as large electronic telephone books.
G.
Domain Name Warehousing Domain name warehousing is the practice of obtaining control of domain names with the intent of warehousing (hanging onto them without using them).
H.
Web Server A web server is a computer that delivers a web page upon request. Every web server has an IP address. Any computer can be turned into a web server by installing web server software and connecting it to the Internet.
I.
Web Hosting Service A web hosting service is an organization which maintains a number of web servers and provides fee-paying customers with the space to maintain their web sites.
J.
WiFi WiFi is the set of standards for wireless LANs.
1.
WiFi Alliance The WiFi Affiance is a global non-profit organization created in 1999 with the goal of driving the adoption of a single worldwide accepted standard for high-speed wireless local area networks.
o
END OF ANCILLARY MATERIAL
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TYPES OF INFORMATION SYSTEMS AND TECHNOLOGY RISKS
Risk represents the possibility of a loss or harm to an entity. Such an entity can be a person, an organization, a resource, a system, or a group. There is hardly any entity that does not face some type of risk. Information assets face risks such as unauthorized modification to programs or data, theft of information, unauthorized access to data, unauthorized use of information assets, and compromise of confidentiality of information. Information assets are also exposed to forces of nature, accidental human error, or malicious intent of people. Sources of such risks are many and can be broadly classified as internal to the entity (that is, the business) and external. Internal sources include employees, whereas external sources include customers and suppliers. Risks can also be viewed in terms of how they affect organizational structure, business process, or information.
I.
RISKS Listed below are the four main risks with respect to systems: A.
Strategic Risk Strategic risk includes the risk of choosing inappropriate technology. For example, an organization may choose a web-based program to share data between remote offices in different cities. If one of the offices does not have a high speed Internet connection and cannot enter data at the same speed as the other offices, this problem could lead to the generation of reports thought to be up-to-date but actually missing data from the office with the slow Internet connection.
B.
Operating Risk Operating risk includes the risk of doing the right things in the wrong way. For example, assume a payroll manager is supposed to run the biweekly payroll after the human resources manager enters newly hired employees into the system. If the payroll manager runs the payroll too early (I.e., before the newly hired employees are entered), the newly hired employees do not get paid, and the payroll report generated is inaccurate.
C.
Financial Risk Financial risk includes the risk of having financial resources lost, wasted, or stolen. For example, an inventory report lists several laptop computers, but some of the laptops were not returned when employees left the organization. This problem could lead to inaccurate financial reports that are reporting assets that no longer exist.
D.
Information Risk Information risk includes the risk of loss of data integrity, incomplete transactions, or hackers. For example, an organization may purchase a new, very powerful system and then not train its employees in the proper use of the system. This situation could lead to employees incorrectly entering data and, thereby, creating inaccurate reports. Or, if a network system that is connected to the Internet does not have a secure firewall (a protective hardware device that prohibits unauthorized entry) or another type of security measure, hackers could enter the system and corrupt or destroy data.
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Specific Risks Risks can be divided into the categories of errors, intentional acts, and disasters. 1.
Errors Errors might be plain mistakes on the part of employees utilizing the systems (e.g., carelessness, failure to follow directions, or ignorance due to poor training), lost or misplaced data (e.g., transactions are misplaced and are never entered), application or system software problems, bugs, crashes, problems due to temporary power outages or power surges or other temporary equipment problems, data transmission errors, and computer equipment lost or stolen.
2.
Intentional Acts Intentional acts might be sabotage, embezzlements, viruses, denial of service attacks, and other types of computer fraud.
Denial-of-Service Attack - A denial-of-service attack (DoS) is an attack on a computer system in an attempt to make the computer system unavailable to its intended users. One common method of attack is to bombard the target machine with external communication requests so that it cannot respond to legitimate requests. A distributed denial-of-service attack (DDos) occurs when multiple compromised systems (a botnet) flood the target machine. See aiso botnet and internet protocol address spoofing. 3.
Disasters Disasters might be fire, flood, earthquakes, high winds, terrorism, and war.
II.
RISK MANAGEMENT A.
Definitions 1.
Risk In general, a risk is the possibility of harm or loss.
2.
Threat A threat is any eventuality that represents a danger to an asset or a capability linked to hostile intent.
3.
Vulnerability For business information systems, vulnerability is a characteristic of a design, implementation, or operation that renders the system susceptible to a threat.
4.
Safeguards and Controls Safeguards and controls are policies and procedures that, effectively applied, reduce or minimize vulnerabilities.
B.
Risk Assessment Risks can be assessed and, to some extent, managed. Before risks can be managed, they must be assessed. The steps in risk assessment are to identify the risks, to evaluate the risks in terms of the probability of occurrence, to evaluate the exposure, in terms of potential loss, from each risk, to identify the controls that could guard against the risks, to evaluate the costs and benefits of implementing the controls, and to implement the controls that are cost effective.
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Evaluation and Types of Controls Controls are always evaluated on a cost/benefit basis. The access controls and data and procedural controls discussed are important tools of risk management, as is disaster recovery. Controls can be divided into several categories such as: 1.
General Controls General controls are controls over data center operations, system and application software acquisition and maintenance, access security, and application system development and maintenance.
2.
Application Controls Application controls appiy to the processing of individual transactions.
3.
Physical Controls Physical controls encompass the physical security of IT assets, inciuding access to facilities and access to programs and data.
4.
Segregation of Duties Controls also include segregation of duties, which has been discussed previously but which merits mentioning again here. EXAMPLE
•
A data entry clerk at a company enters 7.65% instead of 7.56% for the nominal rate on an annualpay bond issue, and nobody catches the error. Because $100,000,000 of 30-year bonds is being issued, the total cost of the error over the life of the bonds (without present value) will be $2,700,000 ($100,000,000 x .0009 x 30).
•
The audit confirmation department of a major New York City bank received a cash confirmation request from an audit firm. At the bottom of that form, as is standard, outstanding loan balances were requested. The bank's report that contained this information did not print the decimal point on the numbers to save space on the printed line. A new employee was not aware of this particular feature and assumed that the entire amount was dollars. Therefore, an amount that was actually $10,000,000 was reported on the cash confirmation request as $1,000,000,000. The error caused considerable excitement at the audit firm before it was corrected by a second (phone) request to the head ofthe department at the bank. A consumer products company fired a regional sales manager. The company had an excellent procedure for providing system access to new employees but almost no procedure for removing access from terminated employees or employees who had simply resigned. After a short period of time, the company realized that is was losing a considerable number of sales in all geographic areas. After an investigation and additional lost sales, the company realized that the terminated regional sales manager still had access to its systems, including its marketing system, where the details of its sales proposals were stored. The terminated sales manager had been able to continue to access this data and to determine the company's negotiating positions; as a result, he had been easily able to submit lower bids. Needless to say, plugging this security hole was given high priority. Deactivating a departing employee's access to the various systems was made an integral part of the exit process. Implementing this step required a major system effort to automate the collection of user access data, which previously was scattered around
'In
various secur'lty systems.
Before this data was collected, nobody knew who had what access to what data.
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ACCESS CONTROLS Access controls limit access to program documentation, data files, programs, and computer hardware to those who require it in the performance of their job responsibilities. These controls include the use of multi-level security, user identification (passwords), limited access rooms, callbacks on dial-up systems, the use of file attributes, firewalls, and numerous others.
A.
Physical Access Actual physical access to computer rooms should be limited to the computer operators and other personnel of the IT department who req uire it in the performance of their job responsibilities. Restricted access can be accomplished through locked computer rooms requiring specialiy coded ID cards or keys for entry. Manual key locks on the equipment, if utilized, could provide additional security. Note, however, that ID cards can be lost or stolen. A type of equipment that is quite difficult to protect is laptop pes. They tend to walk away, even in the best of circumstances. Even if that does not happen, they are subject to being lost or stolen. Sensitive data should not be stored on laptops that have the potential to go outside the organization. EXAMPLE
QuePaso Company acquired several companies in the energy business. Its most recent acquisition was a major competitor, and that acquisition took almost a year to pass the federal and state regulatory hurdles. On the day that the acquisition was finally approved, extra security guards were hired to cheek employees who were departing the building of the company that had been acquired, most of whom had been laid off as a result of the acqUisition, to ensure that those former employees were not walking away with their laptop PCs or other equipment. However, anything that was going to be taken had already been taken in the preceding year. Because the company that had been acquired had no effective inventory records for laptop PCs and most other PC equipment, there was no real way to even guess who was supposed to have what.
B.
Electronic Access Unauthorized access to data and application programs is a major concern. With the advent of numerous computer-based fraud schemes, more attention is being given to data access. Such data access controls include:
1.
User Identification Codes User identification codes (user iDs) coupled with regularly changed passwords are common access controls. Passwords should not be public, nor should they consist of words that can be found in a common dictionary (password cracking software often utilizes a dictionary), nor should they consist of spouse and children names, or anything else that might be easily guessed by either a person or a program. Passwords should be of a minimum length to make guessing harder. In addition, application systems normally have master passwords that are set by the vendor. Such passwords should be changed when the system is instalied. Also, some programmers have installed backdoors. A backdoor is a means of access to a program or system that bypasses normal security mechanisms. A programmer will sometimes install a backdoor so that the program or system can be easily accessed for troubleshooting or other purposes. Backdoors should be eliminated.
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Some organizations disconnect a hardware device and deactivate the user 10 when there are three (or some other small number) consecutive failed attempts to access the system. Other organizations require that all hardware devices be logged off when not in use or automatically log them off when they are inactive for a certain amount of time. Other organizations utilize password scanning programs that look for weak or easiiy guessed passwords. a.
Firewall Access Controls (see below) Firewalls (hardware and/or software) are normally used to prevent outside users from accessing company networks or applications. They are not the same as passwords although the basic idea of providing access only as authorized is the same.
b.
File Attributes File attributes or privileges control or limit access to data. Read oniy access/privileges means that data can be read but cannot be changed. Write access/privileges means that data can be read or changed. Execute access/privileges grant the ability to execute a program. Unix-type systems normally employ these types of privileges (permissions). EXAMPLE
Some organizations generate initial default passwords for their employees as the employee's last names or some such easily established standard word. This approach might work fine if there is also a mechanism to ensure that the passwords are changed within a very short time period. If not, some of the end users will never get around to changing the passwords, and a vulnerability will have been introduced.
2.
Assignment and Maintenance of Security Levels Assignment and maintenance of security levels that restrict functions and program accessibility are common access controls. EXAMPLE
There might be general user IDs and passwords to obtain access to a human resources system (for employee access to their personal data) and additional security and or restrictions to obtain access to payroll data (only for selected human resources personnel) who maintain that payroll data. Passwords for the various levels of security might be granted by different parts of the organization. In the payroll example, the generic user IDs and passwords might be provided to employees by the IT security department, and passwords for access to the payroll data might be provided by the manager of the Human Resources department.
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EXAMPLE
The following is a released question from a recent BEe exam. Which of the following risks can be minimized by requiring all employees accessing the information system to use passwords? a.
Collusion.
b.
Data entry errors.
c.
Failure of server duplicating function.
d,
Firewall vulnerability.
Solution: Choice "d" is correct, or it is the best of the answers. It is certainly questionable whether a firewall vulnerability would be compensated for by requiring all employees to use passwords, but choice "d" is much better than the other answers, Collusion would not be minimized at all by requiring employees to have passwords; the employees conspiring to do bad things could merely share their passwords. Passwords would not do anything about data entry errors. It is difficult to determine what "failure of server duplicating function" even means, but, certainly, whatever it is, the usage of passwords or the lack of passwords would have no effect on it.
3.
Callbacks on Dial-up Systems For systems that allow users to access files from remote terminals via modems, system security might require the system to automatically look up the phone number of an authorized user and call that user back before access is allowed. The initial caller would enter a user 10 and password as normal, and the system would call back the supposedly authorized caller at the phone number the caller was authorized to call from.
4.
File Attributes File attributes are set to restrict writing, reading, and/or directory privileges for a file. File attributes are extremely basic, almost primitive, security mechanisms. The same can be said for external and internal labels on magnetic tape volumes and file protection rings, which are physical plastic rings that are manually inserted in magnetic tapes before anything can be written onto the tape.
5.
Firewalls A firewall is a system, often both hardware and software, of user identification and authentication that prevents unauthorized users from gaining access to network resources; acting as a gatekeeper, it isolates a private network from a public network. This word firewall may also be applied to a network node used to improve network traffic and to set up a boundary that prevents traffic from one network segment from crossing over to another.
a.
Firewalls Deter; Do Not Prevent Access rules for firewalls have to be established and maintained. Firewalls can deter, but cannot completely prevent, intrusion from outsiders. Firewalls do not prevent or protect against viruses.
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Network Firewalls Traditionally, firewalls have been network firewalls that have protected the network as a whole.
c.
Application Firewalls A new type of firewall is an application firewall. An application firewall, as opposed to a network firewall, is designed to protect specific application services from attack. Application firewalls are not designed to replace network firewalls but are designed to supplement network firewalls and protect against attacks on specific applications instead of attacks on the network. They do this by examining the data in packets as opposed to just the data in packet headers that is examined by network firewalls. Packets are small pieces of data that travel over a network; they are normally small parts of the complete message. Each packet has a packet header to identify the packet and to indicate its sending and receiving locations.
d.
Firewall Methodologies Firewall methodologies can be divided into several different categories, and they can be used individually or combined in a specific product. The main difference between the types of firewalls is the level at which the firewall examines the data packets.
(1)
Packet Filtering Packet filtering examines packets of data as they pass through the firewall according to the rules that have been established for the source of the data, the destination of the data, and the network ports the data was sent from. Packet filtering is the simplest type of firewall configuration, but it can be circumvented by an intruder who forges an acceptable address (called IP spoofing).
(2)
Circuit Level Gateways Circuit level gateways only allow data into a network that result from requests from computers Inside the network by the gateway keeping track of requests that are sent out of the network and only allowing data in that is in response to those requests.
(3)
Application Level Gateways Application level gateways (also known as proxies) examine data coming into the gateway in a more sophisticated fashion. Proxies are more secure than the other two, but they can be slow. EXAMPLE
An application level gateway can be used to control which computers in a network can access the Internet and also which Internet pages they are allowed to view (access to certain websites may not be allowed).
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EXAMPLE
The following is a released question from a recent BEC exam: What is the primary advantage of using an application firewall rather than a network firewall? a.
It is less expensive.
b.
It offers easier access to applications.
c.
It provides additional user authentication.
d.
It is easier to install.
Solution: Choice "c" is correct. An application firewall, as opposed to a network firewall, is designed to protect specific application services from attack. Application firewalls are not designed to replace network firewalls but are designed to supplement network firewalls and to protect against attacks on specific applications instead of attacks on the network. They do this by examining the data in packets as opposed to just the data in packet headers that is examined by network firewalls. The wording in the question implies that an application firewall might be used "rather than" a network firewall, and this wording is misleading. If an application firewall is installed in addition to a network firewall, it will provide "additional" user authentication. If an application firewall is installed rather than a network firewall, it will not provide "additional" user authentication. Nevertheless, choice "c", however weak it might be as an answer, is still better than the other answers. Application firewalls are certainly not designed to provide easier access to applications; firewalls of any kind are not designed to make access easier, but more difficult, at least for unauthorized users. There is nothing about an application firewall that would make it less expensive, or easier to install, than a network firewall. So even if you do not have the slightest idea what an application firewall is, you still have a reasonable chance of picking the right answer by eliminating the answers that are worse.
6.
Threats in a Computerized Environment a.
Virus A virus is a piece of computer program that inserts itself into some other program, including operating systems, to propagate. It requires a host program to propagate it, so it cannot run independently.
b.
Worm A worm is a program (and a special type of virus) that can run independently and normally propagates itself over a network. It cannot attach itself to other programs.
c.
Trojan Horse A Trojan horse (like the wooden horse in Helen of Troy) is a program that appears to have a useful function but that contains a hidden and unintended function that presents a security risk. A Trojan horse normally does not replicate itself.
d.
Denial-of-Service Attack In a denial-or-service attack, one computer bombards another computer with a flood of information intended to keep legitimate users from accessing the target computer or network.
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Phishing Phishing is the sending of phony emails to try to lure people to phony web sites asking for financial information. Spam, or unsolicited email, is an increasing burden both to individuals and to companies. EXAM PlE
Vulnerable Company has a private internal network that connects its various operations throughout the world. Because of the nature of its business, it has allowed all of its employees to have access to the Internet. All workstations in the network, most of which were laptops with docking stations, were supplied with the latest in virus protection software when the workstations were installed. Vulnerable did, however, rely on the workstation users to periodically log onto its virus protection vendor's website and update their virus protection data. Unfortunately, during periods of high travel or other high activity, some of the end users skipped this step. After a series of extremely difficult virus attacks, Vulnerable replaced most of the laptops with workstations that were permanently connected to the network. It started distributing virus data updates centrally over its network. That way, at least the permanently attached workstations would be protected.
IV.
IT FUNDAMENTALS A.
Components of Computerized Systems Most organizations depend on some kind of computer technology to process their transactions and maintain their records. As mentioned on the first page of the Information Technology material, there are five main components of Information Technology: people, data, hardware, software, and networks. People and data have already been discussed. The next three areas (hardware, software and networks) will be discussed in more detail in the following sections.
B.
Hardware 1.
Central Processing Unit The central processing unit (CPU) is the control center of the computer system. Its principal components are: a.
Processor The processor interprets program instructions; coordinates input, output, and storage devices (the control unit); and performs arithmetic calculations (the arithmetic logic unit).
b.
Primary Storage Primary storage (main memory) is used to store program instructions and data until the program instructions can be executed. For personal computers, primary storage is further divided into random access memory (RAM), which stores data temporarily while it is being processed, and read-only memory (ROM), which is used to permanently store data needed to power the computer.
Virtual memory is not real memory. Portions of a program that are not being executed are stored on disk as virtual memory pages and are retrieved and brought into actual physical memory when they are needed. (;12010 DeVry/8ecker EdUC3lional Development Corp. All right~ re~erved
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Secondary Storage Devices Secondary storage devices (e.g., hard drives or magnetic disks, floppy disks, CD-ROM disks, optical disks, and magnetic tape) are a means to permanently store programs and data. With sequential storage devices (such as tapes), data is accessed sequentially. With random storage devices, data is normally accessed randomly. Currently, what is called RAID (Redundant Array of Independent Disks) is often used for disk storage. The basic idea of RAID is to combine multiple inexpensive disk drives into an array of disk drives to obtain performance, capacity and reliability that exceed that of a single large disk drive. RAID can be implemented in hardware, in software, or a combination of both, although software implementations do not provide as good performance as hardware implementations since the software has to be run somewhere. Hardware implementations require a specialized RAID disk controller. RAIDO is non-redundant where sequential blocks of data are written to multiple disks in stripes; all of the disks can be read back in parallel, thus improving read performance. RAID1 writes all data to two disks, the original disk and a redundant disk, without parity; if one disk faiis, the other copy is used. RAID4 through RAID6 write the data to one disk and a parity bit or bits to a second disk; if one disk fails, the data can be recreated using the parity bit. A hot spare disk may be used to automatically replace a failed disk. RAID10 is a combination of RAIDO and RAID1. Mirroring - Mirroring is the use of a backup computer to duplicate ALL of the processes and transactions on the primary computer. If the primary computer fails, the backup computer can immediately take its place without any interruption in service. Mirroring, which can obviously be very expensive, is sometimes used by banks and other such organizations where absolutely no downtime can ever be accepted.
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3.
Peripherals
Peripherals are devices that transfer data to or from the CPU but that do not take part in the actual processing of the data. Peripherals include input devices and output devices.
a.
Input Devices Input devices supply the data to be processed. Examples of common input devices are keyboards, mice, scanners, magnetic ink character readers (MICR), touch sensitive screens, and microphones.
b.
Output Devices Output devices transfer data from the processing unit to various output media. Examples of common output devices are printers, speakers, cathode ray tubes (CRTs or monitors), and plotters (graphics printers). Many hardware devices, of course, can act as both input and output devices.
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Classes of Processors Classes of processors (in terms of overall processing power) normally found in business environments are mainframes, midrange and mini computers, and personal computers. Supercomputers are also sometimes used for specialized processing. Mainframes include specialized processors to handle certain specialized functions such as input, output, and telecommunications, which tend to be relatively slow. a.
Processing Power Processing power is often described in terms of MIPS (millions of instructions per second). However, there are many other factors that determine the overall processing power of a computer system than just the power of the processor. For many applications, the speed of the input and output devices can be just as important.
b.
Multiprocessing Multiprocessing is the coordinated processing of programs by more than one processor. Multiprogramming is several parts of a program running at the same time on a single processor. Parallel processing is the simultaneous use of more than one computer to execute a program, which first has to be divided into parts that can be executed separately. Multiprocessing is a general term that is divided into symmetric multiprocessing (in which one operating system controls the processing) and parallel processing (in which each processor has its own operating system).
C.
Software As mentioned previously, software can be divided into three broad categories of system software, programming languages, and application software. 1.
System Software System software consists of the programs that run the computer and support system management operations. a.
Operating System An operating system provides the interface between the user and the hardware. It defines what commands can be issued and how they are issued (e.g., typing in a command, pointing at an icon and clicking, issuing a verbal command, etc.). The operating system also controls all input and output to main memory, and it may include certain utility programs that might be used stand-alone or in application software. The operating systems that most people are familiar with are the various versions of Microsoft Windows® for PCs. Other operating systems are the various IBM operating systems for mainframes, the various brands of UNIX for smaller midrange processors (each vendor has its own name for its brand of UNIX, which are all a little bit different), and Linux.
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Linux is a public domain open source and thus a somewhat free UNIX-based operating system for pes that was developed in 1991 by a Finn named Linux Torvalds. Linux is becoming more and more of an option to Microsoft, especially for servers. The reasons for the popularity of Linux is that it is cheap, it is outside the control of Microsoft and its sometimes oppressive licensing practices, it is stable (even though it is developed as a hobby by UNIX programmers throughout the world), and it is apparently not as vulnerable to security problems as are the various Microsoft operating systems. The use of Linux, however cheap it might be, does introduce a new operating system that does need to be supported. EXAMPLE
Spuyten Corporation, headquartered in northern Manhattan, is a conglomerate with operations in various parts of the world. Spuyten started out as a relatively small organization in the retail banking business and expanded by acquiring companies in the businesses that it was interested in expanding into. Spuyten believed in decentralization, and it left the existing information technology environments and organizations of the acquired businesses pretty much alone. As a result, Spuyten has a very disparate and complex computing environment in its various businesses. Its original retail banking business systems are run on a mainframe located in Brooklyn. Other retail banking subsidiaries at other locations run their separate individual and distinct business systems on separate mainframes at their locations. All of the mainframes run different versions of the same IBM operating system, but at different release levels because the operating system maintenance is performed locally by the separate system programming personnel. Other smaller businesses utilize midrange UNIX processors, from different hardware vendors because there is no central purchasing of hardware; the hardware vendors are different, and so are the UNIX operating systems. Access to the mainframes and to the midrange systems is by interconnected PCs running various versions of the various Microsoft operating systems. Lastly, in a belated attempt to control costs, Spuyten had introduced Linux into the environment. Of course, Spuyten then wonders why it is having problems keeping everything running effectively and efficiently. Everything runs separately with no problems, but interconnectivity is sometimes problematic and difficult.
b.
Database Management System (DBMS) In organizations that employ mainframe and midrange computer systems, a database management system is a very important software package because it controls the development, use, and maintenance of the databases used by the organization. Quite often, the terms "database" and "DBMS" are used interchangeably. This usage is inaccurate. It is important to understand what each term means.
(1)
Definitions (a)
Data Storage Definitions
(i)
Bit A bit is a binary digit (0 or 1) with which all computer data is stored.
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(ii)
Byte A byte is a group of normally 8 bits that can represent a number or a letter, with the specific form dependent on what internal representation format is being used. Sometimes, bytes are called characters. 1 Kilobyte =lKB
=1,000 bytes
1 Megabyte = 1MB = 1 million bytes 1 Gigabyte = 1GB = 1 billion bytes 1 Terabyte = ITB = 1 trillion bytes
(iii)
Field A field is a group of bytes in which a specific data element such as an employee number or name is stored.
(iv)
Record A record is a group of fields that represents the data that is being stored for a particular entity such as a customer or an account receivable.
(v)
File A file is a collection of related records often arranged in some kind of sequence, such as a customer file made up of customer records and organized by customer number. Traditionally, files were often classified as master files, which were stored permanently, and transaction files, which were used to update the master files and were normally not retained permanently.
(b)
Traditional File Storage Traditionally, data was stored in files, with the formats and organization of the data often specific to each particular application system. As a result, what was supposedly the same data was often stored in multiple files, often with different names and different formats, almost always resulting in different values for the same data. In addition, if the size or the format of a data element changed, the programs utilizing that data element often had to be changed (called program-data dependence).
(c)
Database A database is an integrated collection of data records and data files. It is comprised of nothing more than stored data. A database most often centralizes data and minimizes redundant data (think of the data as all being in one place, although it mayor may not be physically stored that way). The structure of the data in the database often provides the data relationships that start to change the data into information.
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(d)
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Database Management System A DBMS is not a database; it is a tool. A DBMS is a separate computer program that allows an organization to create new databases and use and work with the data in the databases after the databases have been created. It also allows for maintenance to be performed on a database after it has been placed into operation. Database maintenance may include the addition or subtraction of data elements or changes to the structure of the database itself. A database management system normally includes a data dictionary or data repository, in which each individual data element in the databases is defined. The database management system that most people are familiar with is Microsoft Access® for PCs. The Oracle® database management system is also quite common.
(e)
Relational Technology Early databases organized records in hierarchies or trees (like an organization chart) implemented by indexes and linked lists. Today, most successful databases are based on what is called relational technology. In a relational database, the data is stored in two-dimensional tables that are "related" to each other via keys. The initial relational database management systems were often siower than their hierarchical predecessors, but made up for it with ease of definition and access. Relational databases often include ad hoc report writers. Normalization is the process of separating data into logical tables. Often, a process of data modeling is used. Before a relational database can be designed, a process of normalization has to occur.
(f)
Object-oriented Databases A new type of database is an object-oriented database. Conventional databases, both relational and non-relational, are designed for homogeneous data that can be structured into predefined data fields and records organized (in the case of relational databases) in rows and tables. Data such as comments, drawings, images, voice, and video does not fit into this definition. Object-oriented databases store such data. Of course, because it is more flexible, an object-oriented database can be even slower than a relational database.
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Major Uses of a DBMS A DBMS has many functions with respect to working with databases. Listed below are the four main functions of a DBMS. (a)
Database Development Database development is the procedure where a database administrator uses the DBMS to create a new, empty database. Once a database has been created (the data elements and the structure of the database are defined), data can be imported into the database by the DBA from other sources such as traditional files (called conversion or data conversion) or input by end users.
(b)
Database Query Database query is the process where end users can retrieve specific data or information from the database by running a query. Constructing a query is often a very simple procedure where an end user establishes certain criteria and runs the query. All data that matches the criteria is displayed on the computer screen or in a printabie report. The end user often must have some basic knowledge of the DBMS or database structure in order to construct an efficient query. Poorly written queries can be quite hazardous to the performance of a DBMS. Monitoring database usage and hopefully discovering pooriy written queries is often an important function of a DBA. Database query is most often provided in a relational database by a language called SOL (structured query language). SOL provides the ability to "seiect" data from individual tables in a database based on the data satisfying certain conditions (customers who had ordered more than a certain amount in a certain period) and to "join" certain tables such as suppliers and part numbers, etc. SOL consists of a data definition language (DDl), which is used to define the database, a data manipulation language (DMl), which is used to query the database, and a data control ianguage (DCl).
(c)
Database Maintenance Database maintenance is the updating of the DBMS software and the revision of the database structure to reflect new business needs and demands. A DBMS will permit databases to grow with the organization by allowing the databases to be modified after they are initially created. Database maintenance not only has to do with modifying a database after it is created, but also with testing the effectiveness and efficiency of the database. Most DBMS have built-in diagnostic and maintenance programs. The programs allow a DBA to intermittently test the database to ensure that the database is operating both effectively and efficiently. This function is called database tuning.
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Effectiveness A major job responsibility of a DBA is to determine if databases are functioning properly (effectively). If a database is not functioning effectively, it may not be accurately recording the data that is entered, which could lead to a major problem within the organization.
(ii)
Efficiency The DBA also must determine if a database is functioning efficiently, meaning that the database is working fast enough. If it takes an end user an hour to run a simple query or generate a simple report, it is not an efficient use of the end user's time or of the DBMS itself.
(d)
Application Development A DBMS allows a DBA or a computer programmer to use a programming language or a series of macros to "turn a database into a computer software application." (A macro is a series of prerecorded commands that will be executed on the occurrence of certain events.) Rather than having to teach end users how to create queries or reports using the DBMS, the database can be automated and converted into an application made up of userfriendly (hopefully) screens and forms that anyone can use even if he/she has little or no knowledge of the DBMS. The end user simply types into text boxes and clicks buttons to run queries and generate reports. Like any other application, transforming a database into a software application can be very expensive. The more end users accessing a database, the more economically feasible it is to develop an application from a database. EXAMPLE
The investment advisory firm of Thoughtful & Wise had been in business for many years. It recently replaced its eXisting file-oriented business systems with a new business information system using a relational database management system from a major database vendor. Its old file-oriented systems were designed around the needs of the individual departments for which they were written. Its new system is designed around the needs of the organization as a whole. The database management system was utilized by T&W database administrators to create empty databases with data element definitions and a certain database structure. The exact format of each data element was contained in the data dictionary that was a part of the database management system. The database itself was composed of data entities (e.g., customers, orders, parts, suppliers, accounts, journal entries, etc.) that were all related by "keys" (e.g., customer numbers, order numbers, part numbers, supplier numbers, account numbers, etc.). To the maximum extent possible, no data element was stored more than once in the database. T&W's DBA converted the initial data in the database from the existing files. Other new data was entered by the end users. An ad hoc query capability was included with the new database management system. T&W's DBA conducted training sessions for the end users to provide information on the structure of the database and train them in how to best construct database queries. After that, the DBA monitored the database on a daily basis to ensure that the production programs and the end user queries were working efficiently.
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Types of Databases A database is a structure that can house information about muitiple types of entities and the relationship(s) among those entities. Types of databases include: (a)
Operational Databases Operational databases store detailed data needed to support the day-to-day operations of an organization. Examples of operational databases are customer databases and personnel databases.
(b)
Analytical Databases Analytical databases store data and information extracted from operational databases. These databases consist of summarized data used primarily by managers in an organization.
(c)
Data Warehouses Data warehouses store data from current and previous years, often from both operational and management databases. A major use of data warehouses is in data mining, where the (often a very large amount of very diverse) data is processed to identify trends, patterns, and relationships. Sometimes, a limited scope data warehouse is called a data mart.
(d)
Distributed Databases Distributed databases are databases that are physically distributed in some manner on different pieces of either local or remote hardware. Depending on the specific circumstances, certain data might be replicated (i.e., stored in multiple locations), and other data might be distinct and stored only in one location.
(e)
End-user Databases End-user databases are databases developed by end users at their workstations. For example, e-mail, downloads from the Internet, and documents generated through word processing might be stored in end-user databases. In addition, end users might develop their own small applications using simple databases.
(4)
Advantages of a DBMS (a)
Reduction of Data Redundancy and Inconsistency Data redundancy and inconsistency are reduced, so that data is entered only once and stored at only one location. As indicated previously, when what is supposedly the same data is stored in multiple locations and updated using different applications, that data is almost assuredly going to be inconsistent. The only way to really solve that problem is to have the data entered once, in one application, and stored at only one location.
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Potential for Data Sharing There is the potential for data sharing so that eXisting and newer applications can share the same data. When data is scattered around in separate files, it is often difficult to even determine what it is and exactly how it is defined.
(c)
Data Independence There is data independence, in which the definition of the data Is separate (independent) from the programs that use the data, so that data storage structures or access strategies in the database can change without affecting the data itself and without affecting the programs that process that data.
(d)
Data Standardization There is data standardization, which facilitates data interchange between systems.
(e)
Improved Data Security Data security is improved. Most database management systems have their own security systems, which might supplement external security systems.
(f)
Expanded Data Fields Data fields can be expanded without adverse effects on application programs. This is another aspect of data independence.
(g)
Enhanced Information Timeliness, Effectiveness, and Availability Timeliness, effectiveness, and availability of information are normally increased or enhanced.
(5)
Disadvantages of a DBMS (a)
Cost The DBMS itself is not cheap, and neither is the conversion to it.
(b)
Highly Trained Personnel are Necessary A DBMS requires highly trained personnel. The DBA is a technical position, normally requiring a considerable amount of training and experience in the specific DBMS being utilized.
(c)
Increased Chances of Breakdowns With a common integrated database, there are increased repercussions of hardware or software breakdowns. Uniess specific precautions to replicate part or all of the data are taken, when the DBMS is down, it is down.
(d)
Possible Obscuring of the Audit Trail There may be an obscuring of the audit trail as a result of data movement from one fiie to another.
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Specialized Backup and Recovery Procedures Required Specialized backup and recovery procedures are necessary, especially if the databases are distributed or replicated.
(6)
Referential Integrity In a relational database, referential integrity prevents the deleting of key values in related records (tables). If, for example, there is a relational database with customer records (tables) and invoice records (tables), the invoice records will normally contain a customer number in them to reference back to the customer record. If a customer is deleted, there must be something done about the invoice records with that customer number in them (they can be deleted also, or the customer deletion can be disallowed). Referential integrity is enforced by the database management system itseif. EXAMPLE
After it implemented its "new" database management system, T&W grew considerably. Initially doing business only in the U.S, from its office in Houston, it expanded into other parts of the world. Its database management system, which at one time needed to be operational during U.S. business hours, now had to be available 24 hours a day and 7 days a week. rt was also subject to a considerably higher transaction road than what it was originally designed for. To improve overall performance, T&W first distributed the database. It split the database so that certain parts of the database were physically stored on one server and other parts were physically stored on other servers. This ensured that the processing loads on the various servers would be equalized to the maximum extent possible. Then, to improve performance for its Japanese and Far Eastern operations, T&W distributed the data for those operations on to servers that were physically located at its foreign offices. The data that was stored at those locations was actually replicated on the central servers in Houston; the data residing on the central servers was updated each night from the remote databases. Because the databases now had to be available on a 24/7 basis, backup of the database became difficult because the database was always being used by somebody somewhere in the world. T&W's DBA, or DBAs by now, developed a method where the data on the servers could be backed up while the servers were still being used.
2.
Programming languages Programming languages like COBOL, Pascal, Basic and Visual Basic, and C and C++ allow programmers to write programs in source code. The source code is then translated or compiied into object code, or machine language, which consists of the binary digits (the as and 1s) that comprise the instructions that the processor recognizes and interprets. Java, Visual Basic, C, and C++ are modern programming languages.
Programs, if not compiled, may be interpreted, in which each line of the program code is converted into executable code immediately before it is executed. Programs that are interpreted normally execute much more slowly than the same programs that are compiled (assuming that there is an option to interpret or compile) because the compiler is normally able to optimize the compiled code for execution speed.
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Fourth-generation Languages Fourth-generation languages are languages that enable end users to develop applications with little or no technical assistance. Fourth-generation languages tend to be less procedural than conventional programming languages, requiring less specification of the sequence of steps that the program is to follow.
b.
Object-oriented Programming Traditional programming has treated the actual software instructions and the data that was being processed by the program as two different things. Objectoriented programming combines the data and the specific procedures that operate on that data into one "thing" called an object. Object-oriented programming is intended to produce reusable code. Certain programming languages such as Java and C++ are object-oriented programming languages.
c.
Debugging Regardless of the programming language, programs contain bugs. Traditionally, desk checking (reviewing printed listings of the program) was used to discover and eliminate bugs. One of the hardest parts of a program to test is online execution speed. Currently online testing tools are available that can assist in this part of online program debugging.
3.
Application Software Application software includes the diverse group of systems and programs that an organization uses to accomplish its objectives. Application software can be generic (e.g., word processors, spreadsheets, or databases) or custom-developed for a specific application or a specific organization. Application software is made up of application programs. As indicated previously, application software can be purchased from an outside vendor or developed internally.
a.
Licensing the Use of Software Purchasing software is really a misnomer; purchasing normally means purchasing the license to use the software under certain prescribed terms and conditions, which, with some vendors, can be negotiated. Most people are familiar with the process of licensing PC software. Maintenance (updates and support) mayor may not be acqUired along with the use of the software. System software and utility software is often licensed in somewhat the same manner.
b.
Escrowing of the Source Code If application software is acquired from an outside vendor, the organization acqUiring the application mayor may not obtain access to the source code. For large commercial applications, the source code may be escrowed with an escrow agent of some type. Escrow of the source code supposedly protects the purchaser if the outside vendor fails to live up to its contractual obligations.
c.
Groupware Terminology for some types of application software includes groupware (Which is short for group working software), software that lets different people work on the same documents and coordinate their work activities. Groupware is especially useful for less structured work that requires high knowledge andior skill.
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EXAMPLE
Hector Corporation used to write all of its application software internally, because it felt that what it needed in the way of software could not be readily obtained from outside vendors. However, it eventually determined that certain application packages for certain standard applications (e.g., accounting) were more cost-efficient, and that it should devote its in-house efforts to developing applications that were unique to its business. Therefore, it started to replace some of its originally in-house applications with packages purchased from outside vendors. Hector's IT personnel and accounting end users formed a joint project team to replace its accounting system. The project team developed a list of both accounting and technical requirements, solicited bids from various vendors, and interviewed the vendors whose products showed promise. All of the vendors claimed that their packages could meet all of the stated requirements and, if not, a new release was on its way that could. Hector eventually was able to select a vendor whose products, financial stability, and reputation in the industry seemed to be most appropriate. After extensive price and other negotiations, Hector acquired a license to use the software and acquired maintenance and support for the first year. It contracted with the vendor to install the package on the hardware where it would be run and to provide some initial end-user training in the application. It utilized its own system analysts and programmers to convert data from its existing applications that were going to be replaced and to create the automated interfaces with applications that were going to continue. After a lengthy process, with much overtime on the part of all of its involved personnel, Hector successfully implemented the new system. One week later, the vendor announced that it had been acquired by a competitor and that the accounting application package that Hector had just installed was being discontinued.
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C.
Networks 1.
Network A network is a group of interconnected computers and terminals. The components of a network are computers, terminals, communications channels, communications processors, and communications software. These components are discussed in the context of a LAN because LANs have been heavily tested in the past.
2.
Local Area Network (LAN) Local area networks (LANs) permit shared resources (software, hardware, and data) among computers within a limited area. LANs are normally privately owned, which means that they do not use telephone lines or that they use private lines leased from telecommunications providers. Components of a LAN (and other networks) include the following:
a.
Node A node is any device connected to a network.
b.
Workstation A workstation is a node (usually a PC) that is used by end users.
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Server A server is a node dedicated to providing services or resources to the rest of the network (e.g., a file server maintains centralized application and data files, a print server provides access to high quality printers, a database server provides access to a specific database, etc.). A server is generally not directly accessible by individual users but only through the network software.
d.
Network Interface Card (NIC) A network interface card is a circuit board installed on a node that allows the node to connect with and communicate over the network.
e.
Transmission Media The transmission media is the physical path between nodes on a network. It may be wired (e.g., twisted pair which is normal telephone wires, coaxial cable which is similar to cable TV cables. and fiber optic cable which uses light to transmit signals) or wireless. LAN communications media are normally dedicated lines (i.e., used only by the network). Various transmission media have different transmission capabilities (speed and other characteristics). CAT 5, and CAT 6 cables are commonly used in Local Area Networks.
f.
Network Operating System (NOS) A network operating system manages communication over a network. It may be either a peer-to-peer system (in which all nodes share in communications management) or a client/server system (in which a central machine serves as the mediator of communication on the network). The most common personal computer network operating systems are the server versions of Microsoft Windows@ and Microsoft Nr® and Novell NetWare@
g.
Communications Devices/Modems A communications device provides remote access and provides a network with the ability to communicate with others. For example, modems translate digital data into the analog format needed to use telephone lines (telephone conversations are analog signals and computer communications are digital signals). and gateways allow connection of two dissimilar networks (e.g., a LAN to the Internet).
h.
Communication/Network Protocols In order to transmit information from one place to another, a telecommunications network must perform the following functions: establish an interface between the sender and the receiver (the two devices have to be talking to each other), transmit the information, route messages along the various paths the information might travel (long messages are divided into pieces and routed from the sender to the receiver with no assurance that the various pieces will follow exactly the same route), check for transmission errors, and convert messages from one speed or transmission format to another. Various pieces of hardware and software perform the various functions, all of which communicate by adhering to a common set of rules that allow them to communicate. The set of rules is called a communication or network protocol.
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Think of protocols In terms of a human-to-human conversation between people waiking down a street. To have a meaningful conversation, the two people must establish contact and must be speaking the same language. If one person does not understand something the other is saying, the words might have to be repeated. The same thing happens in computer-to-computer communication.
i.
Gateways and Routers A gateway is a combination of hardware and software that connect different types of networks by translating from one set of network protocols to another. A router is used to route packets of data through several interconnected LANs or to a WAN. A bridge is used to connect segments of a LAN which both use the same set of network protocols (LANs are often divided into segments for better performance or improved manageability).
j.
Client/Server Configurations Most LANs (and WANs) are set up as clienVserver systems. Workstations are referred to as ciients. Other processors that provide services to the workstations are called servers. The workstations send requests for data and other services to the servers. There are normally several different servers performing different types of specialized services.
k.
Network Topologies The topology of a network defines the physical configuration of the devices and the cables that connect them. Topologies that have been employed for LANs (and WANs) are bus, ring, star, and tree.
o
AN elL l A R Y MAT E R I A L (for Independent RevIew)
~---------------------------. (1)
Bus Networks
Bus networks use a common backbone to connect all of the devices on the network (imagine a single straight-line backbone with a number of devices connected to it). Signals are transmitted over the backbone in the form of messages that are transmitted to and are received by all of the devices (in both directions from the transmitting deVice), but only the intended device actually accepts and processes the message; the other devices ignore the message. If any of the devices in a bus topology are down, the entire network is down. Only one device can transmit at a time; the other devices must wait until the backbone Is free. If two devices transmit at the same time, the two messages will collide and both of them must be transmitted again. Ethernet Is an example of a bus topology. (2)
Ring Networks Ring networks are formed in a ring with each device connected to two other devices. Signals are transmitted in the form of messages that are transmitted to and are received by all of the devices sequentially, but only the intended device actually accepts and processes the message. If any of the devices in a ring topology are down, the entire network is down.
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Token ring, now almost obsolete, is an example of a ring topology. On a token ring network, a token continually passes around the network; only the device with the token can transmit, so there are no collisions.
(3)
Star Networks Star networks are formed in a star with each device connected to a central "hub." The hub controls the transmission. If any of the devices in a star topology are down, only that device is down; if the hub is down, the entire network is down. Telephone systems connected to a PBX and many home networks are examples of star topologies.
(4)
Tree Networks Tree networks connect multiple stars into a bus. Each hub is connected to the bus and handles the transmission for its star. EXAMPLE TWO-TIER ARCHITECTURE
A client/server system is composed of various workstations and servers. Some of the file servers are used to access various databases, and another file server is used as a print server. This architecture is referred to as a two-tier architecture, with the first tier being the client (workstation) and the second tier being the server. In this architecture, all application processing is performed on the client, and the servers merely provide data requested by the application. THREE-TIER ARCHITECTURE
A more complicated architecture is a three-tier architecture. In a three-tier architecture, application processing is separated between the client and an intermediate application processor. There are many different methods to divide the application processing. The client might perform presentation functions (interface with the en~ user and possibly some very simple transaction editing), and the intermediate processor might perform most of the application logic (business rules) including the determination of what data is needed. APPLICATIONS IN LARGER ORGANIZATIONS
For large organizations, with applications split between clients and intermediate servers, changing the application can involve updating the software on a very large number of clients and a large number of intermediate servers. In addition, because the clients might not be dedicated just to the application, there might be a considerable amount of software running on the clients, any of which might conflict with application upgrades. Partly for this reason, many application packages have converted to using Internet browsers for presentation functions so that only a browser need be run on the client workstations.
(5)
Backbone The backbone is that part of a network that carries the major portion of the network traffic.
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Bandwidth
Bandwidth is a measure of a communication medium's information carrying capacity. It is the range of frequencies that signals spread over or how wide a particular signal is. For analog signals, bandwidth is a measure of how rapidly the signal fluctuates with respect to time, or how fast the signal's sine wave goes from a particular point on the wave back to that same point. There are a number of different definitions of bandwidth depending on the context. See also analog signal and frequency and band and broadband and band pass filtering.
(7)
Ethernet
Ethernet is a large collection of frame-based networking technologies for LANs. Ethernet incorporates a number of wiring and speed standards for the physical layer and a common addressing and message format. (8)
File Transport Protocol (FTP)
File transport protocol (FTP) is a network protocol used to exchange files over any network that supports TCP/IP. (9)
Frame Relay
Frame relay (multiplexing) is a shared network service that is faster and sometimes less expensive than packet switching. Frame relay puts data into variable-length frames and leaves any error correction up to the endpoints of the data transmission; when frame relay detects an error in a frame, it just drops the frame. (10)
IPv4
IPv4 is the current version of IP with 32-bit addresses. IPv6 is a newer version of IP with 128-bit addresses. The Internet will run out of network addresses in fewer than 10 years. In IPv4, there are only approximately 2 32 4,294,967,296). In IPv6, there are billion network addresses (2 approximately 16 billion-billion network addresses (2 '28 ), which should be enough for a while longer.
=
(11)
Simple Mail Transfer Protocol (SMTP)
Simple mail transfer protocol (SMTP) is a protocol for transmitting textbased email. SMTPprovidesoutbound, not inbound, mail transport. (12)
Simple Network Management Protocol (SNMP)
Simple network management protocol (SNMP) is a protocol for monitoring a network. In SNMP, a piece of software called an agent runs on each of the devices being monitored (called a managed object) and reports information to the network management/monitoring system.
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(13) Single Log-in A single log-in (or single sign-on) is a system that allows a user who utilizes several different systems the ability to log in to them all with one user 10 and one password. It attempts to combat the proliferation of different user IDs and passwords that may occur in an organization with multiple security systems, possibly for multiple hardware platforms (each password with different rules and possibly different expiration dates). It is also sometimes a way to organize who has access to what on an overall organizational basis (which is nice to know when somebody quits and their access to various systems must be terminated). (14) Storage Area Network (SAN) A storage area network is a network that contains remote storage devices (disk arrays, tape libraries, and CD arrays) to servers in such a way that the devices appear to the operating system to be local devices. These days, SANs are used mostly in large organizations.
(15) VolP VolP (Voice over Internet Protocol) is the routing of voice conversations over the Internet. A protocol called Multiprotocol Label Switching is used on network backbones to label different types of IP traffic for prioritization since voice traffic needs some priority for reasonable conversations since lost packets could result in poor call quality and even dropped calls
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END OF ANCILLARY MATERIAL
3.
Wide Area Networks (WANs)
Wide area networks (WANs) allow national and international communications. They usually employ non-dedicated pUblic communications channels (e.g., fiber optic, terrestrial microwave, or satellite) as their communications media. WAN communication services may be provided by value added networks, Internet-based networks. or point-to-point networks (direct private/proprietary network links normally using leased lines). a.
Value Added Networks
Value added networks (VANs) are privately owned and managed communications networks that provide additional services beyond standard data transmission. VANs are often used for electronic data interchange (called EOI, covered previously). (1)
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VANs provide many additional services, including automatic error detection, protocol conversion, and message storing and forwarding. With VANs, the various parties attempting to communicate do not have to use the same network protocols; the VAN provides the translation or conversion.
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(2)
VANs provide good security because they are private networks.
(3)
VANs often batch transactions and send them at night when line traffic is lower. This periodic processing can delay data transfer for hours (or even days).
(4)
With VANs, messages are separated by vendor, batched together, and transmitted to their specific destinations.
(5)
VANs normally charge a fixed fee plus a fee per transaction and can be prohibitively expensive for smaller companies.
Internet-based Networks Internet-based networks use Internet protocols and public communications channels to establish network communications. The Internet itself is an international network composed of servers around the worid that communicate with each other. There is no government involvement or control. Internet service providers (ISPs) provide access for individuals to the Internet.
Internet-based networks are used to establish communication among a company's LANs (e.g., an intranet) as well as to transmit EDI transactions. Advantages to submitting EDI transactions over the Internet rather than using a VAN include:
c.
(1)
Individual transactions are transmitted immediately and usually reach their destination within minutes.
(2)
Internet transaction costs are substantially lower, making EDI more affordable for smaller companies.
(3)
The relative affordability of the Internet increases the number of potential trading partners available.
(4)
Internet-based networks are sometimes called virtual private networks. The virtual, like the virtual in virtual memory, means that the networks are not really private; they just look like they are.
Intranets and Extranets Intranets and extranets use Internet protocols and public communications media rather than proprietary systems (so that Internet browsers can be used) to create a company-wide network.
(1)
Intranets Intranets connect geographically separate LANs within a company. Companies can use low-cost Internet software such as browsers to build internet sites, such as human resources and internal job postings. An intranet is more secure than the Internet because it has restricted user community and local control.
(2)
Extranets Extranets permit company suppliers, customers, and business partners (a general term for customers, suppliers, etc.) to have direct access to the company's network.
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EXAMPLE
Energy Company is headquartered in Houston with major operations in Colorado Springs, Detroit, and Miami. In each of its Houston, Colorado Springs, Detroit, and Miami locations, Energy has separate LANs for each operating department. Each of the locations is connected to the others by a private network utilizing leased Tilines (Tis are high-speed connections) that connect Houston, Colorado Springs, and Detroit. Miami is connected in the same way but only to Houston. Both network traffic and voice (telephone) traffic is sent over the network using voice/data multiplexing (a technique to send several types of signals over the same circuit simultaneously). Other locations, both nationally and internationally, which also have their individual LANs, utilize lower-speed links terminating at a network access point slightly south of Houston. If one part of the triangular network is down, the traffic can be rerouted. For example, if the Houston to Colorado Springs link is down, traffic between Colorado Springs and Houston can be rerouted over the Houston to Detroit link and then the Detroit to Colorado Springs link (and in the other direction as well). If the Miami to Houston link is down, then that link is down. Energy Company has its own network control center where its network is continually monitored.
4.
Wireless Networks a.
Security Risks Many organizations also provide wireless access to their information systems. Wireiess access is convenient and easy. This ease of access provides another venue for attack and extends the perimeter that must be protected. For example, a number of companies have experienced security incidents in which intruders used a laptop eqUipped with a wireless network interface controller (NIC) to access the corporate network while sitting in a car parked outside the building. Wireless signals can often be picked up from miles away.
b.
Security Standards Industry standards provide security approaches based on the character of wireiess connections. (1)
WiFi WiFi is a set of standards for wireless LANs. Equipment that uses this standard often can interfere with microwave ovens, cordless telephones, and other equipment using the same frequency. The transmission is just radio waves going through the air. WIFi is a wireless form of Ethernet.
(2)
WiFi Protected Access WiFi protected access is an industry standard specifying security mechanisms for WiFi. It supersedes the previous security specification called WEP (Wired equivalent privacy). The use of WEP was optional, which meant that some organizations did not use it at all and were totally unprotected. The standard used a 40 bit encryption key and the same encryption key was shared by all users. The WiFi protected access standard provides for an encryption key that is longer and is changed periodically.
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o r----------------------------, AN C ILL A R Y MAT E R I A L (for Independent Review)
(3)
Bluetooth
Bluetooth is the popular name for the networking standard for small personal area networks. Bluetooth can be used to connect up to 8 devices (PDAs, mobile phones, laptops, PCs, printers, digital cameras, and the like) within a 1O-meter (now 1DO-meter), depending on the power of the transmission) area using low-power radio-based communication. The acronym for personal area networks is PAN. Many wireless keyboards and mice utilize Bluetooth. (4)
Wireless Networking Devices Wireless networking devices can operate in two modes: infrastructure mode and ad hoc mode. Infrastructure mode anticipates networking devices communicate through an access point. Ad hoc mode anticipates the networking devices are physically close enough together so that they can communicate without the access point.
(5)
Wireless Application Protocol (WAP) Wireless application protocol (WAP) is a protocol that enables cell phones and other wireless devices to access web-based information and services.
(6)
3G 3G is the designation for third generation cellular networks. The first generation (1G) networks in the early 1980s were analog and could be used only for voice communications. The second generation (2G) networks in the early 1990's were digitai and provided better voice quality and global roaming and could be used for voice and data communications. Third generation (3G) networks utilize packet SWitching technology for higher speeds and can be used for broadband digital services.
(7)
Access Log An access log is a file with information of each access to a file or web site. See also system access log and electronic access controls.
(8)
Access Point An access point is a device that connects wireless communication devices together to form a wireless network. An access point is often called a wireless access point (WAP, but the abbreviation should not be confused with the other WAP, wireless application protocol). The access point normally connects to a wired network. Several WAPs can link together to form a larger network that allows roaming. Wireless access points have IP addresses for configuration and management of the network.
END OF ANCILLARY MATERIAL
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DISASTER RECOVERY AND BUSINESS CONTINUITY
Disaster recovery and business continuity plans are essential if an organization hopes to survive a major catastrophe. Being without an information system for even a short period of time can be quite costly. Experience suggests that companies that have had a major disaster resulting in loss of use of their information system for more than a few days have greater than 50% chance of going out of business. In light of such experiences, it is incredible that surveys indicate that many large U.S. companies do not have adequate disaster recovery and business continuity plans. The objectives of a disaster recovery and business continuity plan are to (1) minimize the extent of the disruption, damage, and loss; (2) temporarily establish an alternative means of processing information; (3) resume normal operations as soon as possible; and (4) train and familiarize personnel with emergency operations.
I.
ALTERNATE PROCESSING FACILITIES
A.
Disaster Recovery Disaster recovery consists of plans for continuing operations In the event of destruction of not only program and data files, but also processing capability.
Short problems or outages do not normally constitute disasters. If processing can be quickly reestablished at the original processing location, it is not disaster recovery. if processing cannot be quickly reestablished at the original processing site (possibly because the original processing site no longer exists), then disaster recovery is necessary.
1.
Major Players in Disaster Recovery Major players in a disaster recovery plan are the organization itself and, assuming that the organization contracts with an external service provider, the disaster recovery services provider (e.g., IBM or Sungard).
If application software packages are utilized, the package vendors may be involved, depending upon contractual provisions (some application package licenses prohibit or severely restrict the ability to make backup copies of the software). For distributed processing, hardware vendors may be involved. Major internal personnel are IT and the business areas. Senior management support is absolutely necessary for an effective disaster recovery pian.
2.
Steps in Disaster Recovery The steps in a disaster recovery plan are to assess the risks, to identify mission-critical applications and data, to develop a plan for handling the mission-critical applications, to determine responsibilities of the personnel involved in disaster recovery, and to test the disaster recovery pian (the plan is next to worthless without testing). Depending upon the organization, the disaster recovery plan may be limited to the restoration of IT processing or may extend to restoration of functions in end user areas (often called business continuity). One factor that must be considered in business continuity is the paper records that might normally be maintained in end user areas and that might be lost in a disaster.
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Advantages of Disaster Recovery and Business Continuity If an organization does not have a disaster recovery and business continuity plan and a disaster occurs, the organization may be out of business because IT is such an integral part of most organizations today. The disadvantage is the cost and effort required. In today's world, for a substantial organization, not having a good and tested disaster recovery plan is similar to playing Russian roulette.
4.
Off-site Mirror Backup As the size of the data needed to support many large companies grows, so does the time and resources that it takes those companies to backup and recover their data. One method that is often used to achieve very high availability of systems is known as split mirror backups. With this kind of backup technology very large amounts of data can be backed up in a matter of seconds or just a few minutes to a remote location in the event of a disaster.
B.
Types of Disaster Recovery 1.
Use of a Disaster Recovery Service Some organizations contract with outside disaster recovery service providers to provide disaster recovery services. The exact services to be provided are specified in a contract, and most of the service providers are extremely exacting on the contractual provisions. Various levels and types of service can be provided, with the cost depending on what services are to be provided. The services can extend from an empty room all the way to the service provider providing facilities across the country to relocate end user personnel. Almost anything can be negotiated at some cost. However, the major emphasis is on hardware and telecommunications services.
2.
Internal Disaster Recovery Some organizations with the requirement for instantaneous or almost instantaneous resumption of processing in the event of a disaster (e.g., banks and brokerage houses) provide their own duplicate facilities in separate locations. Data might be mirrored (I.e., updated and stored in both locations), and processing can be switched almost instantaneously from one location to the other. Duplicate data center and data mirroring is very expensive, and most organizations adopt cheaper solutions.
3.
MUltiple Data Center Backups Some organizations with multiple data centers plan to use one data center to back up another, assuming that there is enough capacity to process the essential applications. Organizations also must decide what types of backups to perform in order to recover lost data. a.
Full backup is an exact copy of the entire database. Full backups are time consuming, so most organizations only do full backups weekly and supplement them with daily partial backups.
b.
Two types of partial backups are possible: (1)
~2010
An incremental backup involves copying only the data items that have changed since the last backup. This produces a set of incremental backup files, each containing the results of one day's transactions. Restoration involves first loading the last full backup and then installing each subsequent incremental backup in the proper sequence.
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A differential backup copies all changes made since the last full backup. Thus, each new differential backup file contains the cumulative effects of all activity since the last full backup. Consequently, except for the first day following a full backup, daily differential backups take longer than incremental backups. Restoration is simpler, however, because the last full backup needs to be supplemented with only the most recent differential backup, instead of a set of daily incremental backup files. Many organizations make incremental and differential backups daily.
TYPES OF OFF-SITE LOCATIONS A.
Cold Site A cold site is an off-site location that has all the electrical connections and other physical requirements for data processing, but it does not have the actual equipment. Cold sites usually require one to three days to be made operational because equipment has to be acquired. Organizations that utilize a cold site approach normally utilize very generic hardware that can be readily (and quickly) obtained from hardware vendors. Cold sites are the cheapest form of off-site location.
B.
Hot Site A hot site is an off-site location that is equipped to take over the company's data processing. Backup copies of essential data files and programs may also be maintained at the location or a nearby data storage facility. What has to happen in the event of a disaster (the disaster recovery services provider has to be notified of the disaster, which is called "declaring the disaster") is that the organization's personnel need to be shipped to the disaster recovery facility to load the backup data onto the standby equipment. Of course, for an additional fee, the disaster recovery services provider is more than happy to provide some data recovery assistance. 1.
Telecommunications Network The hardest aspect of recovery is often the telecommunications network, depending, of course, on how complex the telecommunications network is.
2.
Floor Space and Equipment Determination The hot site is not just sitting there waiting for a particular customer to declare a disaster. Disaster recovery service providers normally have an extensive amount of floor space and an extensive amount of equipment, but nowhere near enough if all (or even a significant number of similar customers) declared a disaster at the same time. How much is needed is determined on a probabilistic basis; to the disaster recovery services provider, geographic and industry diversification of customers is extremely important.
3.
Personnel Issues What some organizations forget is the availability of personnel. Regardless of how well recovery procedures may be documented (and it is often especially difficult to get IT people to document anything), effective recovery, and especially rapid effective recovery, is often a function of having knowledgeable personnel involved.
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Warm Site A warm backup site is a facility that is already stocked with all the hardware that it takes to create a reasonable facsimile of what you have in your primary data center. In order to restore the organization's service, the latest backups from your office storage facility must be retrieved and then delivered to the backup site. Once this is accomplished, a bare metal restoration of the underlying operating system and network must be completed before recovery work can be done. The advantage of the warm backup site is that it can be gotten to and a restoration accomplished in a reasonable amount of time. The disadvantage is that there is still a continued cost associated with the warm backup site because you have to make sure that you maintain a contract with the facility to keep hardware up-to-date with that which is found in the organization's data center. The warm backup site is the compromise between the hot backup site and the cold backup site.
EXAMPLE
Monolithic Corporation, introduced earlier in the "Roles and Responsibilities" section, has now moved beyond its "lights out" mainframe computing environment. In other parts of its business, it utilizes midrange UNIX processors, and in still others, it uses client/server systems running on various Microsoft operating systems and linux-based systems. Everything is hooked together into various LANs and WANs over its own private network utilizing Tl communication links leased from various telecommunications providers. Its various vendors include IBM for mainframe hardware and software, HP and Sun for midrange processors and the operating systems to run them, Dell and Microsoft for PCs and PC operating systems, and various telecommunications companies. Application software is from numerous vendors around the world. Monolithic is headquartered in the Medical Center area in Houston. The previous year, during Tropical Storm Allison, Monolithic's computer center, which was located in the basement of its office building along with its emergency generators, had flooded, and it had taken six weeks for Monolithic to recover its processing, which almost put it out of business. At that time, Monolithic had no disaster recovery plan. After extensive analysis, it determined that it could not recover from a second extended outage from a flood or for any other reason. Monolithic decided to contract with IBM in Sterling Forest, New York, for disaster recovery services. Monolithic's contract provided for a mainframe hot site. IBM had room for 8 different mainframe customers at the same time; if Monolithic declared a disaster, it would receive a room to control its operations, the use of one of IBM's mainframes (either by itself or sharing that mainframe with others), and the use of the contracted amount of disk space so that it could recover its data. Backup copies of its full mainframe data were sent each week from Houston to a nearby tape storage facility. Its telecommunications circuits from its operations outside of Houston could be redirected to Sterling Forest and hooked into IBM's local network. Restoring telecommunications was expected to be reasonably simple for Monolithic because all of the leased long-distance lines that it used for its network terminated at the same point outside of Houston, assuming that the termination point was not affected by the same disaster. In addition to its mainframe, Monolithic also had certain specialized equipment that IBM did not normally supply. Monolithic acquired duplicate copies of that equipment and stored it at Sterling Forest to use in case of a disaster. It also contracted with IBM to temporarily locate its end users to Dallas, where they could continue their normal work, being hooked into Monolithic's mainframe through IBM's network. Finally, it contracted with HP and Sun for them to make emergency shipment of replacement midrange equipment to Sterling Forest if needed. [continued)
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EXAMPLE
(continued)
Monolithic planned to simulate a mainframe disaster and test its disaster recovery plan once per year, Annual test time is included in its contract with IBM. A problem in Monolithic's development of its disaster recovery plan was the determination of its critical applications. Certain of Monolithic's accounting applications, for example, were non-critical during the month (data entry could almost always be delayed for a couple of days if there were problems) but were quite critical at the end of the month. Other applications were considered critical at all times of the month but could be down for a limited period of time. Because Monolithic was unable to forecast when a disaster might occur or how long that disaster might last, Monolithic was in a quandary. To avoid having to make a decision, Monolithic "punted." It defined all of its mainframe applications as critical and all of its non-mainframe applications as non-critical. Its plan was to restore only its mainframe applications from the weekly backups, The actual disk space and the disk drives in the disaster recovery contract matched what Monolithic had on the floor in its data center, and the data could be readily copied from the backup tapes to IBM's disk drives (it would take about 8 hours to restore all of the data). At the most, if a disaster occurred immediately before the weekly backups were run, Monolithic's data would be one week out of data (which was good enough for most of the end users). An additional provision was made to restore daily transaction logs that were maintained. Now all Monolithic needed to do in the event of a disaster was to hope that the Houston airports were not closed so that it could get its people on a flight to Newark. Equipment would be available for its non-mainframe applications, but nothing was done about the data. Monolithic's disaster recovery plan was incomplete, but it was better than nothing.
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TERMINOLOGY
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary located at the end of this textbook.
Note: Many information technology terms can be written in various ways. Client/server, for example, can be written as client server or client-server. Capitalization can also vary considerably at times. A serious attempt was also made to supply the acronyms that are normally used. However, remember that various organizations use different terminology and different acronyms. The successful candidate will be alert to the possible differences that might occur on the exam and adjust to them. As an example, operating systems have operating system software. Some people think that "operating" software or "operation" software is equivalent terminology. It really is not, but that does not mean that the Examiners might not use it that way. Very often, the context of the words must be examined to determine what might be meant in a specific circumstance. Also, the Examiners might make up some words that look and sound good but that really are not acceptable terminology; they will use such words as distracters (wrong answers). Or, the Examiners might use terminology that is very specific to a particular application or technology but not really used anywhere else. The bottom line approach is just to be aware and always examine the context of what is being asked.
Access Controls
Client/Server
Data Warehouse
Accounting Information System
Cold Site
Database
(AIS) Ad Hoc Reports
Compilation
Database Administrator (DBA)
Computer Assisted Audit
Database Management System
Techniques (CAAT)
Application Controls
(DBMS)
Application level Gateway
Computer Operator
Database Structure
Application Software
Computer Output Microfilm or Computer Output Microfiche
Debugging
Application Service Provider (ASP) Array
(COM)
Audit Software
Computer Programmer Conceptual Design
Audit Trail
Control Clerk
B2B
Control Objectives
B2e
Conversion
Backdoor
Corrective Controls
Backups Batch Processing
COSO (Committee of Sponsoring Ogranizations)
Batch Total
Customer Relationship
Management (CRM)
Bit Bridge Bus Network Business Continuity Business Information Systems Business Reengineering Business Strategy
Byte Centralized Processing
Check Digit Circuit level Gateway
Database Tuning
Decentralized Processing
(Distributed) Decision Support System (DSS) Demand Reporting Denial-of-Service Attack Desk Checking Detective Controls Digital Certificate Digital Signature Disaster Recovery
Dashboard Reporting
Distributed Processing
Data
Domain Name System (DNS)
Data Administrator
Domain Name Warehousing
Data Encryption
E-Business
Data Flow Diagram
E-Commerce
Data Independence
Electronic Access Controls
Data Mart
Electronic Data Interchange (EDI)
Data Matching
Electronic Funds Transfer (EFT)
Data Mining
End-user Computing
Data Processing
Enterprise Resource Planning (ERP)
Data Structure
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Enterprise Risk Management Framework (ERM)
Multiprogramming
Security Administrator
Network
Segregation of Duties
Ethernet
Network Administrator
Server
Exception Reporting
Network Interface Card (NIC)
Shareware
Executive Information System (EIS)
Network Operating System (NOS)
Software
Extranet
Network Protocol
Star Network
Fat Client
Neural Network
Steering Committee
Field
Node
Strategic Risk
Field Check
Review
Normalization
Structured Query Language (SQL)
File
Object-Oriented Database
Supply Chain Management (SCM)
File Attribute
Object-Oriented Programming
System Administrator
File Librarian
Online Analytical Processing (OLAP)
System Analysis
Financial Risk
Online Real-time Processing (OLRT)
System Analyst
Firewall
Operating Risk
System Development Life Cycle
Flowchart
Operating System
System Programmer
Fourth-Generation Language
Operational Effectiveness
System Software
Gateway
Output Controls
System Specific policy
General Controls
Packet
Temporary File
Groupware
Packet Filtering
Thin Client
Hardware
Parallel Processing
Threat
Hash Total
Password
Three-Tier Architecture
Hot Site
Permanent File
Transaction Processing System
Hypertext Markup Language (HTML)
Phishing
Tree Network
Physical Access Controls
Trojan horse
Physical Design
Two-Tier Architecture
Point-ol-Sale System (PaS)
Uniform Resource Locator (URL)
Policies
Validity Check
Preventive Controls
Value Added Network (VAN)
Primary Storage
Virtual Memory
Private Network
Virtual Private Network (VPN)
Hypertext Transfer Protocol (HITP) Importing Data Implementation Information Information Risk Input controls Internal Controls Internally Developed System Internet Internet-Based Networks Interpretation
Processing Controls
Virus
Program-framework policy
Vulnerability
Program-Level Policy
Warm Site
Purchased System
Web 2.0
Push Reporting
Web Administrator
Record
Web Hosting Service
Relational Technology
Web Server
Ring Network
Web Stores
Intranet Issue-specific policy Local Area Network (LAN) Macro Magnetic Ink Character Reader (MICR)
Risk
Wide Area Network (WAN)
Risk Assessment
Wireless Network
Management Information System (MIS)
Router
Workstation
Safeguard
Worm
Mapping
Secondary Storage
Multiprocessing
Security
XBRL (extensible business reporting language) XML (extensible markup language)
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CLASS QUESTIONS
~
~
0
Z
~
u:
c
<;
c
u
CLASS QUESTIONS ANSWER WORKSHEET
l.
2. 3.
4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. G RA 0 E
Attempt
Multiple-choice Questions
Notes
=
1st
Multiple-choice questions correct + 20 questions
2nd
Multiple-choice questions correct + 20 questions -
%
3rd
Multiple-choice questions correct + 20 questions =
%
Final
Total questions correct
20 questions
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%
%
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1. CPA·03490 Which one of the following statements about an accounting information system (AIS) is incorrect? a. b. c. d.
An AIS supports day-to-day operations by collecting and storing data about an organization's transactions. The information produced by AIS is made available to all levels of management for use in planning and controlling an organization's activities. An AIS is best suited to solve problems where there is great uncertainty and ill-defined reporting requirements. An AIS is often referred to as a transaction processing system.
2. CPA-03537 A new company is trying to decide between setting up a centralized processing system and a decentralized processing system. All of the following are disadvantages of a centralized processing system that the company should consider when making the decision, except: a. b. c. d.
There are increased processing power and data storage needs at the central location. There can be a reduction in local accountability. Input/output bottlenecks can occur at high traffic times. Processing can be inconsistent.
3. CPA-03581 Remittance from Customers
Sales Return andWrile-of! Authorizations
Enter
Enter
Enter
D.,
0,.
0,.
APPUCAnON PROGRAMS
Sales ransaction File
c,'"
Receipts ransaction
General Ledger ransaction
File
O A
Ge"", Ledger
F,.
B
Master File
Symbol A most likely represents: a. b. c. d.
Remittance advice file. Receiving report file. Accounts receivable master file. Cash disbursements transaction file.
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4. CPA-03587 Remillance from CustoITl!rs
Order and Shipping Data
Enter
Enter Data
D.,
APPLICATION PROGRAMS
Sales ransacUon File
C,,;h Receipts ransaction File
General Ledger ransaction
R.
General Ledger Master File
B
Symbol B most likely represents: a. b. c. d.
Customer orders. Receiving reports. Customer checks. Sales invoices.
5. CPA-03486 All of the following are examples of a decision support system (DSS) except for a: a. b. c. d.
Financial modeling application. Transaction processing system. Database query application. Sensitivity analysis application.
6. CPA-03491 Which one of the following statements about an executive information system (EIS) is incorrect? The EIS: a. b. c. d.
Provides top executives with immediate and easy access to information in a highly interactive format. Helps executives monitor business conditions in general and assists in strategic planning to control and operate the company. Is designed to accept data from many different sources; to combine, integrate, and summarize the data; and to display this data in a format that is easy to understand and use. Is likely to be one of the most widely used and the largest of the information subsystems in a business organization.
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7. CPA·03470 Which of the foliowing is a person who enters data or uses the information processed by a system? a. b. c. d.
Hardware technician. Network administrator. Software developer. End-user.
8. CPA·06385 Which of the foliowing is the step where the intended recipient converts the cipher text into plain text? a. b. c.
Decryption or decipherment. Encryption. Digital certificates.
d.
PKI.
9. CPA·06386 If Friday's file is destroyed, a new Friday file can be reproduced by using the Friday transaction file (which is stored separately) and Thursday's fiie. The backup concept that serves as the foundation for this process is often calied: a. b. c. d.
Critical application backup. Disk only backup. Son-father-grandfather concept. Backups of systems that do not shut down.
10. CPA-06387 User accounts are the first target of a hacker who has gained access to an organization's network. Which of the foliowing is a true statement when maintaining user access accounts? a. b. c. d.
It is important to have procedures in place to address promotions and lateral moves. No privileges should be granted until authorization is completed by Human Resources and the IT Security Officer. There must be a mechanism to disable accounts should relations end between the organization and any of its employees. All of the above.
11. CPA·03647 Electronic data interchange (EDI) is best described as: a. b. c. d.
An enterprise-wide database that stores data that has been extracted from other databases. A Federal Reserve wire system used for electronic, computer-to-computer money transfers. Computer-to-computer transactions for direct processing. A privately owned value added network.
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12. CPA·03649 Which of the following statements concerning Business-to-Business (B2B) transactions islare correct? I.
B2B commerce websites make purchasing decisions faster, simpler, and more cost effective because companies can do more research and transact business with many different vendors.
II.
B2B transactions are more secure than Business-to-Consumer (B2C) transactions because the government has policies and procedures to protect B2B transactions.
III. B2B transactions occur electronically and are generally very reliable because computers are very precise and there is no opportunity for human error. a. b. c. d.
I and II. I and III. II and III. I, II, and III.
13. CPA-03663 An advantage of an e-commerce transaction over an EDI transaction is that e-commerce: a. b. c. d.
Is generally less expensive than EDI. Is generally less secure than EDI. Is generally slower than EDI. Requires that organizations enter a contract before transacting business.
14. CPA-03524 B Corporation needs to share very important financial information with many regional offices around the world. It must make sure that the information wiil be secure at all times. The best type of network to use is alan: a. b. c. d.
Internet-based network. Value added network (VAN). Local area network (LAN). Wide area network (WAN).
15. CPA-03530 All of the following are characteristics of Internet-based networks, except: a. b. c. d.
High cost. Use of public communications channels. Immediate transmissions. An increase in the number of potential trading partners.
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16. CPA-03570 Which of the following statements best describes a data warehouse? a. b. c. d.
Corporation A extracts all payroll data for the Year 1 and stores this information in a separate database. Corporation B extracts all human resource data, sales data, purchasing data and data from many other departments for the Year 1 and stores this information in a separate database. Corporation C owns a large storage building and stores only computers that contain data backup in this bUilding. Corporation 0 owns a large supercomputer that stores the entire data backup for the whole organization.
17. CPA-03624 The protective device that allows private intranet users to access the Internet without allowing internet users access to private intranet information is called a (an): a. b. c. d.
Anti-virus protection program. Firewall. Browser. Password.
18. CPA-03626 Which of the following procedures would an entity most likely include in its disaster recovery plan? a. b. c. d.
Convert all data from EDI format to an internal company format. Maintain a trojan horse program to prevent illicit activity. Develop an auxiliary power supply to provide uninterrupted electricity. Store duplicate copies of files in a location away from the computer center.
19. CPA-06388 A client is concerned that a power outage or disaster could impair the computer hardware's ability to function as designed. The ciient desires off-site backup hardware facilities that are fUlly configured and ready to operate within several hours. The client most likely should consider a: a. b. c. d.
Cold site. Cool site. Warm site. Hot site.
20. CPA-06389 Which method of backup involves copying only the data items that have changed since the last backup? a. b. c. d.
Differential. Incremental. Full. Off-schedule.
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CPA EXAM R EVI EW
Jij~
BECKER PROFESSIONAL EOUCATION
BECKER PROFESSIONAL EDUCATION - CPA EXAM REVIEW COURSE DEVELOPMENT TEAM
Timothy F. Gearty, CPA, MBA, JD
Editor in Chief, FAR National Editor, Regulation (Tax) Editor
Lisa M. Thayer, CPA
Business National Editor
Angeline S. Brown, CPA, MAC
Auditing and Financial National Editor Financial (GASB & NFP) National Editor
Tom Cox, CPA, CMA, CHFP Steve Levin, BA, JD
Regulation (Law) National Editor
Peter Olinto, JD, CPA
Regulation (Law) National Editor
John B. Pillatsch, MAS, CPA/PFS
Director, Course Development Operations
Richard Sykes
Director, Course Production
Stephen Bergens
Manager, Quality Assurance
Anson Miyashiro
Course Production Manager
AI Glodan
Bookstore Purchasing Manager
Pete Console
System Support Manager
Shelly McCubbins
Course Production Supervisor CONTRIBUTING EDITORS
Eric J. Brunner, PhD
Michael Meriwether, CPA, MBA
Robert A. DeFilippis, CPA, MBA
Mike Potenza, JD
Mike Farrell, JD
Ray Rigoli, CPA, MBA
Dennis J. Green, CPA, MBA
Karen Tarbet, CPA, JD
Liliana Hickman-Riggs, CPA, CITP, CMA, CIA, CFE, FCPA, DABFA, MS
Jennifer B. Deutsch, CPA, MS
Cindy Lawrence, CPA, MBA
Chris Cocozza, CPA, JD, LLM
Edward McTague, CPA, MBA
Permissions Material from Uniform CPA Examination Questions and Unofficial Answers, 1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 copyright © by American Institute of Certified Public Accountants, Inc. is reprinted (or adapted) with permission.
Copyright © 2010 by DeVry/Becker Educational Development Corp. All rights reserved. Printed in the United States of America. No part of this work may be reproduced, translated, distributed, published or transmitted without the prior written permission of the copyright owner. Request for permission or further information should be addressed to the Permissions Department, DeVry/Becker Educational Development Corp.
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use the Software on a second computer so long as the first computer and the second computer are not used simultaneously;
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create derivate works of the Printed Materials.
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Any legal action regarding this Agreement shall be brought only in the u.s. District Court for the Northern District of Illinois, or another court of competent jurisdiction in DuPage County, Illinois, and all parties hereto consent to jurisdiction and venue in DuPage County, Illinois. Consent to Use of Your Name: As further consideration for the license granted to you under this agreement, after you pass the last part of the CPA Exam, you agree to have your name used on a listing of "Successful Former Students" which is mailed, along with announcements of the Program, to prospective students.
Becker Professional Education
I CPA barn
Business
Rcvic'/i
BUSINESS program attendance record Student:
_
Location:
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BUSINESS 1
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IMPORTANT NOTES TO STUDENTS REGARDING "THE BECKER PROMISE"
• You must stamp this sheet at the end of each class attended. This is the only acceptable record of your classroom attendance. • An overall percentage correct of 90% or higher is required of the homework to qualify for The Becker Promise. • Please fax documentation to 866-398·7375 no later than 30 days following the completion of each section.
© 2010 DeVry/Becker Educational Development Corp. All rights reserved.
v
Business
Becker Professional Education
I CPA Exam
Review
NOTES
vi
© 2010 DeVry/Becker Educational Development Corp. All rights reserved.
Becker Professional Education
I CPA Exam Review
Business
BUSINESS table of contents Program attendance record Introduction
v
,
,
,
Intro-1
BUSINESS 1 1.
Corporate governance
,
,
,
,
2.
Control environment
Bl-25
3.
Operations management: Performance management and impact of measures on behavior
Bl-33
4.
Operations management: Cost measurement methods and techniques
Bl-43
5.
Operations management: Process management
6.
Operations management: Project management
7.
Terminology
Bl-93
8.
Class questions
Bl-95
Bl-3
,
. .
..
BI-69
.
Bl-81
BUSINESS 2 1.
Changes in economic and business cycles
2.
Economic measures/indicators
B2-13
3.
Globalization and local economies
B2-27
4.
Market influences on business strategies
B2-35
5.
Financial risk management
6.
Task-based simulation samples
B2-109
7.
Terminology
B2-111
8.
Class questions
B2-3
'" B2-83
,
82-113
BUSINESS 3 1.
Financial modeling projections and analysis
2.
Financial decisions
3.
Capital management, including working capital
4.
Financial valuation
5.
Financial transactions, processes, and controls
6.
Terminology
7.
Class questions
,
B3-3
,............................................................................................................................
,
, ,
,
© 2010 DeVry/Becker Educational Development Corp. All rights reserved.
83-35
. ,
,
B3-23
,
B3-73 B3-78
B3-85 ,
B3-87
vii
Business
Becker Professional Education I CPA Exam Review
BUSINESS 4
64-3
1.
Organizational needs assessment
2.
Systems design and other elements
64-23
3.
Security
64-44
4.
Internet implications for business
64-53
5.
Types of information systems and technology risks
64-69
6.
Disaster recovery and business continuity
64-98
7.
Terminology
64-103
8.
Class questions
64-105
BUSINESS 5
1.
Market and risk analysis
65-3
2.
Strategy development, implementation and monitoring
65-9
3.
Planning techniques: Forecasting and projection
65-14
4.
Planning techniques: Budget and analysis
65-44
5.
Planning techniques: Coordinating information from various sources for integrated planning
65-72
6.
Terminology
65-75
7.
Class questions
65-77
Class questions explanations Glossary Index
viii
cQ-1 Glossary-1 lndex-1
© 2010 DeVry/Becker Educational Development Corp. All rights reserved.
COURSE INTRODUCTION and
1.
Content Specification Outline
2.
Becker's CPA Exam Review - Course Introduction
Written Communications Tutorial
lntro-3
,
Intro-S
Introduction
Intro-S
Lecture series
Intro-S
Textbooks
Intro-S
Software
lntro-6
Flashcards and mobile flashcard applications
lntro-7
Course updates and academic support
lntro-9
The Uniform CPA Exam - overview
Intro-ii
Passing the CPA Exam
Intro-13
Before the examination
lntro-iS
Surviving the examination itsef/
lntro-16
3.
Written Communications - Tutorial
Intro-17
4.
Written Communications - Additional Tips
lntro-33
Business
Becker Professional Education
I CPA Exam Review
NOTES
Intro-2
© 2010 DeVry/Becker Educational Development Corp. All rights reserved.
Becker Professional Education
I CP/\ Exam Revie':·.'
Business
BUSINESS ENVIRONMENT & CONCEPTS CONTENT SPECIFICATION OUTLINE
ENVIRONMENT &
BUSINESS
CONCEPTS
3 hours <-~~~~~~~~
Testlet #1
I
A.
--~~----->
Testlet #2
,...
24 MC Questions
40-45 minutes
8S Points
II
Testlet #3
24 MC Questions
40-45 minutes
I
40-45 minutes
A.
Rights, duties, responsibilities, and authority of the board of
1.
Financial reporting
2.
Internal control (including COSO or similar framework)
3.
Enterprise risk management (including COSO or similar framework)
II
Testlet #4 3 Written Communication Tasks
40-45 minutes
16-20% B.
Control environment
1.
Tone at the top - establishing control environment
2.
Monitoring control effectiveness
3.
Change control process
16-20%
Economic concepts and analysIs Changes in economic and business cycles - economic measures/indicators
B.
f-
15 points -----7
Corporate governance
directors, officers, and other employees
II
l
24 MC Questions
I-
]
f---
C.
Market influences on business strategies
D.
Financial risk management
Globalization and local economies
1.
Impacts of globalization on companies
2.
Shifts in economic balance of power (e.g., capital) to/from
1.
Market, interest rate, currency, liquidity, credit, price, and other risks
2.
Means for mitigating/controlling financial risks
developed from/to emerging markets
19-23%
III Financial management A.
B.
Financial modeling, projections, and analysis
C.
Capital management, including working capital
1.
Forecasting and trends
1.
Capital structure
2.
Financial and risk analysis
2.
Short-term and long-term financing
3.
Impact of inflation/deflation
3.
Asset effectiveness and/or efficiency
Financial decisions
D.
Financial transaction processes and controls
1.
Debt, equity, leasing
1.
Methods for calculating valuations
2.
Asset and investment management
2.
Evaluating assumptions used in valuations
E.
© 2010 DeVry!Be(ker Educational Development Corp_ All rights re,erved
Financial Transaction Processes and Controls
Intro-3
Business
Becker Professional Education
I CPA Exam Review
15-19%
IV Information systems and communication A.
B.
Organizational needs assessment
C.
Security
1.
Data capture
1.
Technologies and security management features
2.
Processing
2.
Policies
3.
Reporting
4.
Role of information technology in business strategy
D.
Internet - implications for business 1.
Electronic commerce
Systems design and other elements
2.
Opportunities for business process reengineering
1.
Business process design (integrated systems, automated, and manual interfaces)
3.
Roles of internet evolution on business operations and organization cultures
2.
Information technology (IT) control objectives
E.
Types of information system and technology risks
3.
Role of technology systems in control monitoring
F.
Disaster recovery and business continuity
4.
Operational effectiveness
5.
Segregation of duties
6.
Policies
V Strategic planning
10-14%
A.
Market and risk analysis
2.
Forecasting and projection
B.
Strategy development, implementation, and monitoring
3.
C.
Planning techniques
Coordinating information from various sources for integrated planning
1.
Budget and analysis
12-16%
VI Operations management A.
Performance management and impact of measures on behavior
D.
Project management
1.
Financial and nonfinancial measures
1.
Project planning, implementation, and monitoring
2.
Impact of marketing practices on performance
2.
3.
Incentive compensation
Roles of project managers, project members, and oversight or steering groups
3.
Project risks, including resource, scope, cost, and deliverables
B.
Cost measurement methods and techniques
C.
Process management
1.
Approaches, techniques, measures, and benefits to processmanagement-driven businesses
2.
Roles of shared services, outsourcing, and off-shore operations, and their implications on business risks and controls
3.
Selecting and implementing improvement initiatives
4.
Business process reengineering
5.
Management philosophies and techniques for performance improvement such as just in time (JIT), quality, lean, demand flow, theory of constraints, and six sigma
Intro-4
© Z010 DeVrv/Becker Educational Development Corp. All rights reserved.
Becker Professional Education
I CPA EXdn) Review
Business
BECKER'S CPA EXAM REVIEW - COURSE INTRODUCTION
INTRODUCTION
Becker Professional Education's CPA Exam Review products were developed with you, the candidate, in mind. To that end we have developed a series of products designed to tap all of your leaming and retention capabilities. Our course is first and foremost a time management system. The Becker lecture series, comprehensive texts, PassMaster™ software, and Simulation Software are designed to be fully integrated; but each can also stand alone. The best results are achieved when all the components are used collectively. Passing the CPA Exam is difficult, but the professional rewards a CPA enjoys make this a challenge all accounting professionals should meet. Almost all CPA candidates have the ability to pass the exam. Yet, nationwide, only 10% of candidates sitting pass all parts. Why? Approximately 50% of all candidates have no formal preparation and, therefore, lack the key element to success-exam focus. You will pass the CPA Examination if you prepare properly. Keep this in mind as you work with our course materials. We created our CPA Exam Review after evaluating the needs of CPA candidates and analyzing the CPA Exam over the years. Those efforts have enabled us to produce a CPA Exam Review unparalleled in today's market. Our course materials comprehensively present topics you must know in order to pass the examination, teaching you the most effective tactics for leaming the material. As part of the course you received a Course Disc, which contains the following:
../
New Student Orientation
../
Software Tutorial
../
CPA Exam Structure Tutorial
../
CPA Exam Registration Tutorial
../
Software User Manual
All of these resources should be viewed prior to attending your first class or viewing your first lecture.
LECTURE
SERIES
In our course you will see and hear the most dynamic CPA Exam Review lecturers in the country. Our lecturers are exam-oriented and spend countless hours analyzing past exams and developing strategies to help you
pass-this time.
TEXTBOOKS
Our textbooks, written by our teaching staff, are specifically designed for and geared toward our course. Written in outline form, they follow the same sequence as the lectures-providing reduced note-taking and allowing students to concentrate their attention on the presentation.
© 2010 DeWy/Becker Educational Development Corp. All
right~
re5erved.
Intro-S
Becker Professional Education I CPA Exam Review
Business
Textbook Icons
Throughout the Becker materials you will find icons that have been designed to assist with your preparation for the CPA Examination. These icons are located in the margins of your textbook for easy identification of important information. Pass Keys
Throughout the course materials you will find Pass Keys that have been prepared to assist in your understanding of major concepts. Pass Keys will be identified with this icon in the margins.
Memorize Notations
For important items within the materials that should be memorized, it will be identified with this icon in the margins.
Keyword Search
When working with the new task-based simulations, it will be necessary for candidates to search professional literature to find the solution to a given question. A keyword search of the given literature is a candidate's most timeeffective tool. Potential keywords to search with will be identified with this icon in the margins.
FASB Accounting Standards Codification
These numbers represent the location of this topic in the FASB Accounting Standards Codification. These will be identified with this icon in the margins.
Notes, Exceptions, etc.
III
When important notes, exceptions, etc. are included within the materials, it will be identified with this icon in the margins.
{FRS-specific Content
When IFRS-specific information is included within the materials, it will be identified with this icon in the margins.
International Comparison
When international comparison information is included within the materials, it will be identified with this icon in the margins.
SOFTWARE An integral part of Becker's CPA Exam Review program is the use of the PassMaster™ and Simulation Software. All homework questions are contained on these two software programs. PassMaster™ contains thousands of prior exam questions for use in your preparation. The homework is necessary to reinforce the concepts introduced in the materials, and is organized on a lecture-by-Iecture basis. The Simulation Software contains task-based simulations organized by lecture for each section of the exam. The software also provides a comprehensive Final Exam for each part. The Business section wili include simulations that test the candidate's writing skills. We believe exposure to the technology and content tested in these areas is advantageous to the candidate. We encourage you to watch the Written Communications Tutorial. It will help you gain an understanding of what the examiners are looking for in a well-written communication response.
Intro-6
© 2010
DeVry/Bec~er Educational
Development Corp. All rights reserved.
Becker Professional Education
FLASHCARDS
I CPA Exdrn
Review
AND
Business
MOBILE
FLASHCARD
APPLICATIONS
Flashcards are an important tool to assist in your preparation for the exam. While we believe preparing your
own flashcards is a valuable learning tool, we recognize time is a precious commodity when preparing for the exam. For that reason, we also offer enrolled students the opportunity to purchase pre-printed flashcards and mobile flashcard applications. Flashcards will help you commit to memory the most important principles and rules tested in each section of the exam. The flashcards have been designed to work in unison with the course and textbooks and are indexed by class session to allow you to focus your preparation in your weakest areas. Pre-printed Flashcards Example: Front Side
Back Side
Basic Framework
The FASB "Accounting Standards Codification" (ASC)
Name the single source of authoritative nongovernmental U.S. GAAP.
fAR 1-1
fAR1·1
Mobile Flashcards Application Example: Front Side iPod .;-.
Back Side
10:05 AM
H~,
iPod
AUDIT 1
()
0
~
H~,
Auditing & Attestation 1
~ ~
AUDIT 1·4 Nolm ..,.,.n
Audited Financial Statements The Basics What are the three standards of fieldwork? I'd like a piece of PIE'
10:05 AM
AUDIT 1
()
0
AUditing & Attestation 1
~ ~
AUDlT1-4 Nolma,l.. O
The auditor must adequately PLAN the work and must properly supervise any assistants.
The auditor must obtain a sufficient understanding of the entity and its environment, including its INTERNAL CONTROL, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. QuestIon 4 of 41
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Answer 4 of 41 8~
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The flashcards and mobile flashcard applications for the most popular mobile platforms can be purchased by calling our National Student Service Center at 1-800-868-3900 or online by simply logging on to www.becker.com/cpa and select "Flashcards" from the Courses & Products drop-down menu.
© 2010 DeVry!Be,ker Educational Development Corp. All rights reserved.
Intro-7
Becker Professional Education
Business
I CPA Exam Review
In preparing your own flashcards, we recommend the following: •
Prepare flashcards as you review your iecture notes prior to working the multiple-choice questions. You can identify those flashcards you would like to create by making a mark, such as "Fe," in the margin of your outline while viewing the lecture.
•
Select major concepts from your class materials (outlines). Do not prepare flashcards for everything in the outlines (the outlines are already in a summarized format). Only make a flashcard for the major concepts, general rules and exceptions, mnemonics, formulas, and important lists. Items to consider: ./
Mnemonics
./
Formulas
./
"Heavy on exam" notations
./
"Memorize" notations
./
Other major concepts (noted while reading the explanations to the multiple-choice questions)
./
General rules and exceptions
•
Keep your flashcards as simple as possible, but do not sacrifice correctness for brevity.
•
Use 3" x 5" or 5" x 7" cards (whichever size is easiest for you to carry around). Write the question, the general rule, or the title of the list you are trying to memorize on the front, and write the answer, the exceptions, or the list, as applicable, on the back. Example:
A-I Front side:
N"I.lMe tl.\e'> IIGe\\ev"l.ll1 st"l.\\A"I.vAs
A-I
~Codewi th
class nu mber
Ge\o\evO\l stO\\o\AO\v.J.s (-rIP) Back side:
•
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After each class, review all of your flashcards for all of the previous classes. When you believe that you have a concept memorized, place those cards in a separate pile. Do not stop reviewing those cards, but it is not necessary to review them as often. The more frequently you can review all your cards, the better your retention will be.
Intro-8
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I CPA [x,lm
Becker Professional Education
COURSE
Business
f{C'vie\v
UPDATES
AND
ACADEMIC
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The Becker Knowledgebase (http://beckerkb.custhelp.com) Is your source for course updates, supplemental materials, software downloads, and unlimited academic support.
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While every effort is made to ensure the accuracy of our course materials, when updates, corrections, or clarifications are necessary they are posted within the Course Updates shown above. Below is an example of the Business Course Updates page. Students are encouraged to sign up for automatic email notification by clicking on the "Notify Me" button located at the bottom of each answer page. Business Course Updates
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fnlro-9
Business
Becker Professional Education
I CPA EX(lnl Review
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© 2010 DeVry!Be(ker Edu<;
Becker Professional Education
THE
I CPA b;:l111
UNIFORM
Revif'w
CPA
Business
EXAM
OVERVIEW
Exam Sections The CPA Examination consists of four sections:
{;i(QI(eiailfecoMtil(! &- Re/JQI',ti/fj The Financial section consists of a 4-hour exam covering all financial accounting & reporting, governmental & not-far-profit accounting, including International Financial Reporting Standards (IFRS),
Ifal//t'irj &-lfttedatl~1( The Auditing section consists of a 4-hour exam, This section covers all topics related to auditing, including audit reports and procedures, generally accepted auditing standards, attestation and other engagements, and governmental auditing,
Re!alat'~1( The Regulation section consists of a 3-hour exam, combining topics from business law and federal taxation.
8M,ire~~ AiI'i{
financial management, information technology, managerial accounting, and process & project management.
Question Formats The chart below illustrates the question format breakdown by exam section.
I Multiple-choice Questions
Section
Task based S,mulat,ons or Written Communication Tasks
Percentage
Number
Percentage
Number
Financial
60%
90
40%
7
Auditing
60%
90
40%
7
Regulation
60%
72
40%
6
Business
85%
72
15%
3
Each exam will contain testlets, A tesllet is either a series of multiple-choice questions (either 24 or 30 depending on the section) or one task-based simulation, For example, the Financial examination will contain 4 testlets. The first three testlets will be multiple-choice questions and the last one will contain seven short taskbased simulations, In completing the exam, each testlet must be finished and submitted before continuing on to the next Candidates cannot go back and view a previously completed testlet or go forward to view a subsequent testlet before closing and submitting the earlier testlet Our final exam contains these types of restrictions, so familiarizing yourself with them by taking the final exam is very important
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lntro-ll
Business
Becker Professional Education
I CPA Exam Rf'vicw
Exam Schedule
The computer-based CPA exam is offered during two of every three months of the calendar year. Once determined to be eligible to sit, candidates can schedule an exam date directly with Prometric. Eligibility and Application Requirements
Each state sets its own rules of eligibility for the examination, so the requirements vary from state to state. Please visit www.becker.com/state as soon as possible to determine your eligibility to sit for the exam. Application Deadlines
With the computer-based exam format, set application deadlines generally do not exist. To ensure that you have a thorough understanding of your state's requirements, you should apply as early as possible. Grading System
You must pass all four parts of the examination to earn certification as a CPA. You must score 75 or better on a part to receive a passing grade. About the Pass Rate
You probably are aware that the pass rate for first-time candidates is very low. Fewer than 10% of all candidates pass all four parts of the examination on their first attempt. However, in spite of the low initial pass rate, 80% of all candidates who sit for the examination multiple times eventually pass. As you might expect, the low initial pass rate results from many causes. Some candidates do literally no preparation for the exam; while other candidates prepare minimally, improperly, or inefficiently. By preparing properly, you can succeed the first time you take the exam.
Intro-12
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Becker Professional Education
PASSING
I CPA LX(lJ)l
THE
I-\C'view
CPA
Business
EXAM
Strategy and Tactics for Taking the Examination Most successful candidates pass the examination with scores between 75 and 78. To ensure that you initially earn a passing grade, you should follow these tips.
Tips for Multiple-choice Questions
TI'
Control the amount of time you spend on each question. The exam time limits mentioned above are overall time limits. The exam will not display a timer for each testlet. The recommended time for completion on most task-based simulations will be 25 - 40 minutes. As such, you'll be forced to closely control the amount of time you spend on multiple-choice questions. For Financial, you should spend approximately 1~ - 2 minutes on each multiple-choice question; for Auditing, you should spend approximately 2 minutes per question. For Regulation and Business, you should spend approximately 1-1~ minutes per question.
Ttj 2
Become familiar with the format. The exam does not contain the typical multiple-choice format such as lettered answers (a, b, c, and d). Instead, candidates will be required to click on the radio dials or the text portion of the answer they are choosing as correct. You will see this functionality in our Final Exams.
TI3
Read all four choices before choosing one as your answer. Given that you're working under time constraints, you may be tempted to choose as your answer for any given question the first choice that seems right. That can be a costly mistake; the examiners may include two or more good answers among the choices, one of which is the best answer. You'll get no credit for choosing the wrong "good" answer.
Ttj"
Answer every multiple-choice question. Two reasons support this suggestion. First, the examiners don't penalize you for guessing; they don't subtract wrong answers from right answers. Therefore, guess when you must, and realize that you always have at least a 25% chance of getting the right answer. In fact, on some questions you may have a 50% chance of guessing the right answer because you may immediately recognize that two of the four choices are wrong. If you're uncertain about an answer you can mark that question for later review. Remember, you can go back to questions within the current testlet you are working to review. You will see this marking functionality in our Final Exams. Prior to exiting the testlet, you must make sure you have answered all questions. When you're answering multiple-choice problems that require mathematical calculations and you're unable to arrive at one of the four given numerical answers, you should perform the following procedure before you record a guess as an answer. First, check the mathematical accuracy of your calculations; that alone may lead you to the correct answer. If that doesn't produce a correct answer, check for an error in your logic by rereading the question. If that doesn't clear the ambiguity, choose your guess to answer the question, and mark it for review at the end of the current testlet if time permits. Remember though that once you submit a testlet, you cannot go back and review it.
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Intro-13
Becker Professional Education
Business
I CPA Exam Review
Tactics for Simulations
Tt; 1
Work all homework simulations. We have developed extensive task-based simulations for you to work as homework. You should familiarize yourself with the types of questions and functionalities covered by the tasks. This familiarity will save you time on the actual exam by removing any barriers to understanding how to maneuver, thus allowing you to focus on the content covered by the tasks.
Tt; 2
Follow recommended progression through tasks. It is important to have a basic approach when beginning a testlet. Following the same consistent approach will provide you an opportunity to increase the time you have to focus on the task's requirements. We recommend the following: .;' Review each task's instructions. .;' Allocate your time amongst the tasks. Remember, the AICPA approximate timeframe for all taskbased simulations to be worked. However, be sure and take into account any additional time you saved while completing earlier testlets and the difficulty of the particular simulation you are working. ../ Be sure that you have answered all requirements for each task.
[;/3
Use the keyword search function when completing research tasks. When working through the task-based simulations, a common work tab will be entitled "Research." This tab will require a candidate to answer a question using the research materials available to you. The details of how to work within the Authoritative Literature or the Standards function are covered in the course manual included with the Course Disc you received. It should be noted that the most time efficient manner to search the Authoritative Literature available on the exam is through the use of a keyword search. Please be sure and have read through the manual for additional details and tips on utilizing the functionalities within the simulations.
Intro-14
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Becker Professional Education
BEFORE
THE
I (PI\ L'\JITl Revit,\v
Business
EXAMINATION
You should have scheduled your preparation and exam date so that you have time to do a final review prior to sitting for your exam. This should entail setting aside approximately a week to review each section for which you have a scheduled exam date. During this final review period, don't begin to study new topics, as you don't have the time to master them; knowing that you don't have enough time may upset you, which in turn will disrupt your ability to show the examiners what you do know. Therefore, you should review only what you have studied-and you should do that in a manner that heightens rather than reduces your confidence. By this time, if you've followed your plan carefully, you'll know your strengths (many) and your weaknesses (few). Of course, your last week's review should focus on your areas of weakness, but don't focus on those areas exclusively. If you work only on your weak points, you'll strengthen them, but you'll be so focused on your weaknesses you may become distressed. Instead, you may want to associate each review of an area of relative weakness with a review of an area of relative strength in order to keep your confidence intact. Be sure to have located directions to the Prometric testing center where you chose to sit and have information regarding the parking and other accommodations available there. We suggest you contact the Prometric site or consult the website (www.2test.com) for additional information regarding taking a test at a Prometric location. Expect to feel tense and uncertain during the week before the examination. You can manage stress by following several tips.
1/; 1
Remember, every candidate taking the exam likely feels as tense as you do. Take some comfort from that shared misery. Realize also that the examiners indirectly recognize that stress by curving scores on the examination and by re-grading failed parts.
T?; 2
Use those activities you usually employ to reduce stress. Get as much rest as you can, exercise regularly, and eat balanced nutritional meals. The evidence is overwhelming that adequate rest, exercise, and nutrition minimize the harmful and disruptive physical and psychological effects of tension.
Ttl 3
Do not work until you drop, You'll impair your health and threaten your performance on the examination. Treat yourself to time away from concentrated study. Focus on the fact that the time to study and learn new material is behind you.
1/; "
You may want to try a technique called "imaging." Some people report that they improve their performance on difficult or stressful tasks by visualizing that they've already succeeded at the task. Imagine that you're taking the examination and handling its demands well. Or, imagine you've received your passing grade. This may boost your confidence.
{;; 5
Remember, the examiners cannot test on every conceivable subject. The examiners must limit the amount of detail they demand and the scope oftopics on which they can focus during the time allowed for the examination.
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Intra-1S
Business
r;; 6
Becker Professional Education
I CPA Exam Review
Remember, if a question pops up with which you are unfamiliar, don't panic. The odds are that it will be a surprise to most exam takers. Simply gather your wits about you and prepare the best answer you can. Do not omit the question simply because you are unfamiliar with the topic. Most likely, the examiners are looking for you to exercise professional judgment in tackling the topic.
r;;,
Remember, if you have followed your study plan, you are well prepared.
You will be able to answer most of the questions on the examination easily, and you'll know how to wrestle with the harder problems in ways that will earn you a passing grade. Even if you've accomplished only most or some of your study goals, take comfort in the knowledge that you're better prepared than many other candidates.
SURVIVING
THE
EXAMINATION
ITSELF
Make sure that you've arranged your transportation so you arrive with 30 minutes to spare before your set appointment time. This margin should enable you to handle any unexpected delays in travel that may arise. Second, dress in comfortable clothing. The "layered look" should serve you best. The room in which you take the examination may be perfectly comfortable, but it may be over- or under-heated for the season, and you'll want to be abie to adjust to prevailing conditions. Additional test center administration procedures should be available on either the AICPA exam website (www.cpa-exam.org) or at the Prometric test center website (www.2test.com).
tntro-16
©2010 DeVry/Becker £ducational Development Corp_ All r;ghts reserved.
Becker Professional Education 1 CPA Exam Review
Business
WRITTEN COMMUNICATIONS - TUTORIAL
INTRODUCTION
For the Business section of the CPA Exam, candidates will be required to complete three written communications tasks. The tasks will appear as separate tasks within the exam following the multiple-choice questions. •
Communications represents 15% of your score on the Business exam.
•
A communications task will provide you with a situation, a request for a response and a series of instructions. You answer will be typed in an area using a simple word processer.
•
The general format will appear as follows:
[Situation and request for a response] Instructions: Your response will be graded for both technical content and writing skills: Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and appropriate expression of ideas in professional correspondence. Use a standard business memorandum or letter format with a clear beginning, middle and end. Do not convey information in the form of a table, bullet point list or other abbreviated presentation. [Salutation (cannot be edited)]
[Response area]
[Signature (cannot be edited)]
The response area will be used to complete the communications task. The word processer has the appearance and the functions of a simple word processor. Many of the standard features and icons of popular word processing software are reproduced in a tool bar to allow you such functions as:
u COPY
"" '[j
lit)
PASTE
UNDO
REDO
SPEllCHECK
In addition, a spell check feature is embedded in the software. Misspelled words are underscored in red in a manner consistent with many popular word processing software packages. A right click on your mouse as you hover over the word will enable you to correct potential spelling errors. The number of spelling errors can adversely impact your written communication score, so be sure to run the spell check. Functions, while familiar, are limited and rudimentary.
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Development Corp. All rights reserved.
Intro-17
Business
Becker Professional Education
I CPA Exam Review
ANALYZING COMMUNICATIONS TASK SITUATIONS
All AICPA written communication questions take the following format consistent with the instructions provided in released questions: 1.
2.
Background information will be provided to you in the form of a brief scenario or situation. a.
The background may actually provide the content that should be included in the response.
b.
The background will define the topic that you
c.
Specific understanding of an area will make responses more effective.
You will be assigned a role in the situation. a.
The role assigned to you should influence your response.
b.
Although you are assumed to be a CPA, the roles can vary and may include:
c.
3.
must explicitly address in your response.
(1 )
CPA in pUblic accounting
(2)
CPA in private industry
(3)
Internal auditor
(4)
Consultant
(5)
CFO
(6)
Controller
(7)
Partner
(8)
Manager
The recipient of your communication is also identified so that you might select an appropriate voice or tone to use in your response. (1)
Recipients that are subordinates or peers might require (or allow) a more informal tone and a simplified explanation of concepts.
(2)
Communications to your boss, manager, business owner, or key business partner (e.g., a banker, insurance carrier, etc.) will require a formal tone.
The accuracy of your content knowledge is not assessed; however, your response MUST address the topic. For example, if the situation involves inventory, address the topic by writing about inventory. Failure to address the topic can result in a non-passing written communication score.
Note: The situation may actually provide the content that will be included in the response. 4.
Intra-iS
Your job is to create a writing sample that exemplifies good development, masterful expression, and strong topic knowledge.
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Becker Professional Education I CPA Exam Review
Business
A sample question might appear as follows: U.S. owned Multi-National Company A manufactures and sells inventory in both the United States and Country X. While Country X has already adopted IFRS, Multinational Company A continues to report using U.S. GAAP. The LIFO inventory valuation method is used in the United States while FIFO is used in Country X. Jack Connelly, the controller of Multinational Company A, has expressed concerns about implementing IFRS. In particular, he does not understand why this change is necessary and how the implementation of IFRS will be beneficial to his company. As the engagement manager, write a memo to Jack Connelly explaining the purpose of IFRS, and how applying IFRS to inventory will benefit Multinational Company A in regards to eliminating redundancy and increasing transparency and access to capital.
Analysis of the question produces the scenario, the target audience, and your role as follows:
~1l!ill\lo,,,,,~/"
A.1III. . _.,;t~,.;Y#"···
QUESTION
ej
U.S. owned Multinational Company A manufactures and sells inventory in both the United States and Country X. While Country X has already adapted IFRS, Multinational Company A continues to report using U.S. GAAP. The LIFO inventory valuation method is used in the United States while FIFO is used in Country X.
The SCENARIO suggests you will be writing on the subject of IFRS and Inventory.
Jack Connelly, the controller of Multinational Company A has expressed concerns about implementing lFRS.
Your AUDIENCE is a controller. So you can tailor your response to a sophisticated reader. Use a formal tone in your response.
In particular, he does not understand why this change is necessary and how the implementation of IFRS will be beneficial to his company.
The SCENARIO expands the requirements to tip you off as to tone of the communication; our recipient is confused and possibly upset that there is one more thing to do. In addition to including facts, you will need to persuade your reader as to the value of IFRS.
As the engagement manager, write a memo to Jack Connelly explaining the purpose of IFRS and how applying IFRS to inventory will benefit Multinational Company A in regards to eliminating redundancy and increasing transparency and access to capital.
Your ROLE is revealed as the engagement manager. So you are likely a contemporary or at least an administrative peer of the recipient. The requirement focuses you on the points to emphasize.
Furthermore, it includes content with regard to the differences between u.s. GAAP and IFRS. It's OK and, in fact, expected that you will use some of the given technical material in your response.
The purpose of your written communication is to explain the benefits derived from implementing IFRS.
RESPONDING TO WRITTEN COMMUNICATION TASKS
Your ideal response will be: •
A well developed, cohesive expository response with an introduction, main body, and a conclusion.
•
On topic, as evidenced by the use of key vocabulary words.
•
Free of grammar and spelling errors.
•
Do not use bullet points or abbreviations. o
Do not use text messaging language.
The AICPA has not released a grading sheet in over 40 years. Our best information comes from the instructions they have published consistent with our experience with analyzing CPA exam questions.
© 2010 DeVry{Becker Educational Development Corp, All rights reserved.
Intro-19
Becker Professional Education
Business
I CPA Exam Review
A full credit response might appear as follows: RESPONSE
....•..
...
....
vl\pj~
.
....... .;...
The purpose of this memo is to provide a brief overview of
Direct, business-like introduction that addresses the themes
IFRS and to describe some of the ways that your company,
described in the situation. Supporting paragraphs are
Multinational Company A, might benefit from early
organized around the ideas presented in the situation.
implementation of IFRS.
International Financial Reporting Standards (IFRS) are a
The question requires that you explain IFRS purpose and then
principal-based approach to recording accounting
gives you the purpose. Your response purely complies with
transactions where economic substance determines how a
the requirement and demonstrates your knowledge of IFRS.
transaction will be treated. In creating IFRS, the International Accounting Standards Board intended to create one universal set of accounting standards throughout the world that would
Note that International Financial Reporting Standards was not abbreviated in order to get points for "keywords." Once IFRS is fully defined, it is acceptable to use the abbreviation.
promote reporting consistency, enhance global competition and improve financial reporting transparency As more and more countries consider implementing IFRS, one
The response uses data from the fact pattern to satisfy a
of the benefits may be a significant cost savings in
discussion of specific benefits to the company. The
infrastructure required to sustain two of more reporting
elimination of redundancy from maintaining multiple
processes.
accounting systems and approaches should be obvious. The
For example, Multinational Company A currently maintains two systems that enable the company to value inventory
under both FIFO and LIFO models. Under IFRS, LIFO is not an acceptable inventory valuation method. Consequently, Multinational company A could streamline its' reporting process by
question tells you that the inventory systems are different. You do not have to know the IFRS restrictions but you do have to apply what it will mean. The implied cost and time savings persuade the controller as to value. Good development is evidenced by reference to the two
eliminating the LIFO method and relying exclusively on FIFO.
inventory systems, as well as the use of transition words such
In doing so, the company may reduce its' closing time because
as "for example" or "consequently."
inventory valued in Country X would not have to be revalued using LIFO in the U.S.
Another benefit might include the wider availability of access
Making life easier for bankers and lenders, and thereby
to capital. With only one inventory valuation model, a lender
reducing the time and effort in obtaining capital, is a logical
has an easier time evaluating the profitability of Multi-
extension of the AICPA's guidance. There is no technical issue
National Company A. This transparency eliminates some of
in this comment, purely common business sense. The
the obstacles that companies frequently encounter as they
paragraph addresses the issue identified by the question and
seek bank financing when the lender does not understand the
persuades the controller as to the benefits.
conflicting valuation models. Thus, Multinational Company A may have access to a larger pool of international lenders resulting in lower cost of capital as more lenders compete for your business.
I would be happy to discuss additional questions you may
A direct business-like close offering opportunities for further
have regarding implementation of IFRS at your earliest
communications is standard in most business
convenience.
communications.
Intro-20
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Becker Professional Education
I CPA Exam
Business
Review
CONCLUSION
The following chart links the analysis of our question with a full credit response as follows: ANALYSIS OF SITUATION
RESPONSE
Your role
Engagement manager
Your audience
Controller, sophisticated professional peer
Your subject
Benefits of IFRS
What do you want your audience to think and do
The controller should understand that lFRS is a positive step in the
as a result of the communication you are about to
development of a global economy and that it will save time and money.
write? Organization implied by situation
Describe the benefits of IFRS as: • Eliminating redundancy • Increasing transparency • Access to capital
Development
Assert that IFRS is a benefit to the company and explain the benefits in terms of: • Eliminating redundancy
•
Increasing transparency
• Access to capital Information in each paragraph should be both helpful and relevant in persuading the controller as to the benefit of IFRS. Expression
• Use standard business English • Free to use technical terms with a peer • Ability to communicate plainly without use of protocol language for boss or superior
While an academic essay may have asked you to describe the advantages and disadvantages of IFRS, the communications task is an opportunity to demonstrate practical written business communications skill. The situation largely dictates your position. You see advantages that outweigh disadvantages regarding IFRS implementation. The situation wants you to express ideas in a logical format and there are numerous clues as how to rearrange the situation facts and use them to intelligently describe the benefits of IFRS. Some released questions have asked for the candidates to recall some key points of subject matter. While typically the amount of technical material to recall is limited, you will need to be able to organize information from memory as part of your response
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DeVry/Bec~er
Educationa' Development Corp. All
right~ re~erved
Intro-21
Business
Becker Professional Education
I CPA Exam
Review
POINTERS
Analyze the situation or scenario. •
Identify the format. o
•
•
•
U/h-a t
Memo, e-mail, lelter, etc.
Identify the roles implied by the question. o
Are you communicating with a superior, peer, subordinate?
o
Are you communicating as a manager, consultant, etc.?
o
Is your audience knowledgeable, technically sophisticated, etc.?
Ask yourself what you want your reader to think and do as a result of the communication you are about to write. (The point of view should be given.) o
What information might be helpful?
o
What information might be relevant?
identify potential technical requirements not fully described in the situation. o
Are the organization points defined by the question?
o
Do you need to formulate your own keyword framework?
til
.fa,?
Prepare an outline based on key words or situation facts. •
Make sure that ideas are presented clearly. o
Start with the point of view or position on the topic.
o
Organize your main points (frequently as separate paragraphs) in a manner that develops ideas in support of your position.
o
Be alert to points of organization provided in the situation itself.
•
Ensure that concise presentation does not use bullets or tables.
•
Use standard business English appropriate for the audience.
•
Verify that you have answered the question.
Intro-22
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Becker Professional Education
I CPA Exam Review
Business
110«1 to 101"/f(IJ.!izt-? Write in clear expository language. Plan on 3-5 paragraphs, including: •
An introduction,
•
A middle, and
•
A conclusion.
U/it-I( 1J.1"t- !loa lOI(t-? Check the compositional accuracy of your response. •
Verify spelling is correct.
•
Re-read response to ensure that grammar and punctuation are correct.
•
Make sure you have addressed the requirements of the situation.
()tit-I" (J0lirtt-I"f? •
Write a logical statement if it may appear too obvious.
•
Avoid absolutes, use words like generally, usually, etc.
•
Do not abbreviate.
U/i!l 1o t Iu~ ? 15 valuabie points on your Business exam!
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Intro-23
Business
Becker Professional Education I (P/\ Exam Review
EXAMPLE 1
The new staff person at your company is confused about the underlying assumptions of net present value and internal rate of return calculations. As the manager, develop a written communication to staff person describing the difference between the two techniques as well as the advantages and disadvantages. Type your communication in the response area below using the word processor provided. POINTER
APPLICATION
Identify the format.
Memo or e-mail.
Identify the roles implied by the question.
Manager to subordinate.
Ask yourself what you want your reader to think and do as a result of the communication you are about to write. (The point of view should be given.)
The staff member should understand that NPV and IRR have the same objective but use two different measures. The preference of most toward the NPV method and the limiting assumptions of IRR would influence the staff member's understanding.
• What information might be helpful? • What information might be relevant? Identify potential technical requirements not fully described in the situation. • Are the organization points defined by the question?
The general preference of analysts to use NPV is a likely point. The idea that both IRR and NPV are time value of money approaches should likely be mentioned.
• Do you need formulate your own key word framework? Make sure that ideas are presented clearly. • Start with the point of view or position on the topic.
NPV and IRR as methods with distinct advantages and disadvantages helps organize the middle two paragraphs of the response, one for NPV and one for IRR.
• Organize your main points (frequently as separate paragraphs) in a manner that develops ideas in support of your position.
•
Be alert to points of organization provided in the situation itself.
Ensure concise presentation that does not use bullets or tables.
Paragraphs to be organized around NPV and IRR.
Use standard business English appropriate for the audience.
Tone will be geared to a new staff member.
Verify spelling is correct.
Use the spell check button in the application.
Re-read response to ensure that grammar and punctuation are correct.
Re-reading is highly significant given the limitations of the software.
Make sure you have addressed the requirements of the situation.
Re-reading will focus on tone and message.
Write a logical statement if it may appear too obvious.
NPV is more flexible that IRR.
Avoid absolutes, use words like generally, usually, etc.
Different circumstances will favor different capital budgeting methods.
Do not abbreviate.
Finance has numerous instances in which abbreviations can appear. Defining those abbreviations will make them acceptable for use.
Intro-24
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Becker Professional Education
I CPA Exam Review
EXAMPLE 1 RESPONSE:
Business
fll,11 cveJ-it
To:
Staff Person
From:
Accounting Manager
Net Present Value and Internal Rate of Return are two techniques that we can use to evaluate investment opportunities and justify the decision to accept or reject an opportunity based on quantified benefits and costs.
The net present value technique (NPV) discounts cash flows at the opportunity cost of capital, which Is generally the weighted average cost of capital to the organization. The NPV compares the value of one
dollar today with the value of one dollar In the future. It assumes that projects/investments with positive cash flows greater than zero are acceptable and those with negative cash flows are not acceptable. One of the strengths of this method is the fact it considers the time value of money. In addition, it also recognizes there is always risk associated with any kind of future cash flow, as the company may not be viable in the future. A disadvantage however, involves the underlying assumption wherein there is a never-ending
supply of capital. We also don't know exactly when a project becomes profitable. For example, a project may have a positive cash flow at the end of 10 years, but it may have negative cash flows for the first 8 years of the project life. The Internal Rate of Return (lRR) technique is similar to the Net Present Value Method in that it also relies on the time value of money. However, through trial and error, IRR is reached when the discount rate of the NPV equal to zero. Often, this can result in multiple discount rates. IRR presume reinvestment of funds at the IRR, an assumption that might not be realistic.
NPV is generally the preferred method since it allows for risk adjustments (different rates) in different periods and allows us to use different amounts. Despite its relative flexibility, both the NPV and IRR methods give us a means of evaluating whether a proposed capital project meets the minimum return requirements of management.
Please feel free to contact me at any time so we can review specific examples.
# # #
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lntro-25
Business
Becker Professional Education I CPA Exam Review
EXAMPLE 1 RESPONSE:
Less t-l-I",,, .p",\1 eyed-it-
To:
Staff Person
From:
Accounting Manager
NPV and IRR are things you probably learned in school NPV is investment minus present value of cash flows. It measures an amount. The IRR is where the rate gives you an NPV = 0 so it measures a percentage. NPV is good because you can: •
Change the amounts.
•
Change the rates.
IRR is bad because: •
You can't change the amounts, and
•
You can't change the rates,
This is a lot easier with numbers, so see me and we'll go over it together.
# # #
CRITERIA
Your ideal response will be:
•
A well developed, cohesive expository response with an introduction, a middle, and a conclusion.
•
Free of grammar and spelling errors. Free of bullet points or abbreviations.
WE/H(Nliss/p bfHTE R AP PLICA"ii"Q'Nil<"
•
Ideas are not developed.
•
Use of key words is present.
•
Spelling and grammar errors are limited, however, "... " is
On topic as evidenced by the use of key vocabulary words.
• •
.
not standard punctuation.
•
Bullet points are used to convey ideas, abbreviations are used and not defined, and dogmatic terms (good/bad) are used.
o Do not use text messaging language.
Intro-26
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Becker Professional Education
I CPA Exam
Review
Business
EXAMPLE
,
Mrs. Kelly Smith, CFO of Sunshine, Inc. (a small- medium sized company), has been told that B2B (Business to Business) eCommerce sites make purchasing decisions faster, simpler, safer, more reliable, and more cost effective because companies can use websites to do more research and transact business with many different vendors. As Mrs. Smith is interested in taking Sunshine, Inc, online, she would like to learn more about these benefits. As an Ecommerce contractor specialist, draft a memo to Mrs. Kelly Smith, discussing the different benefits of B2B e~Commerce. Also explain how its transactions would be secure by adding SSl encryption to the web browser and by providing digital signatures. Type your communication in the response area below using the word processor provided. POINTER
APPLICATION
,
Identify the format.
Written communication in e-mail or memo.
Identify the roles implied by the question.
Client/business owner.
Ask yourself what you want your reader to think and do as a result of the communication you are about to write. (The point of view should be given).
Mrs. Smith is wise to seek out B2B as an option. Mrs. Smith needs to have confidence in me and understand that there are security risks and other business model issues that come from B2B,
• What information might be helpful?
•
What information might be relevant?
Identify potential technical requirements not fully described in the situation.
Encryption techniques may not be understood.
• Are the organization points defined by the question?
•
Do you need formulate your own key word framework?
Make sure that ideas are presented clearly. • Start with the point of view or position on the topic. • Organize your main points (frequently as separate paragraphs) in a manner that develops ideas in support of your position.
•
• The position is that B2B is a great idea but the business owner must act prudently. • Security risks and changes in the business model will represent the major paragraph ideas.
Be alert to points of organization proVided in the situation itself.
Ensure concise presentation that does not use bullets or tables.
Planned use of security risk and business profitability paragraphs will organize the information without simply listing.
Use standard business English appropriate for the audience.
Tone will reflect the client/service provider relationship.
Verify spelling is correct.
Use the spell check button in the application.
Re read response to ensure that grammar and punctuation are correct.
Re-reading is critical since the capabilities ofthe software are limited.
Make sure you have addressed the requirements of the situation.
Re-reading will focus on tone and message.
Write a logical statement if it may appear too obvious.
The unlimited hours of the web creates a larger customer base.
Avoid absolutes, use words like generally, usually, etc.
Emphasize the positive and negative aspects of e-Commerce.
Do not abbreviate.
Information technology has numerous acronyms. Designing the response in a manner that defines any acronym that is used will require careful attention.
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Intro-27
Business
Becker Professional Education
EXAMPLE 2 RESPONSE:
I CPA Exam Review
F",l1 cveJ.iI-
To:
Kelly Smith, CFO
Re:
Sunshine, Inc.
The purpose of this memo is to present you with the different benefits of taking Sunshine, Inc. online, and to explain how these Internet transactions would be kept secure. You are extremely wise to avail yourself to web~based options for your business. An e-Commerce site enables the company to conduct its business via the Internet regardless of whether it has a pre-existing relationship with its vendors or customers and thereby expands potential market share. Implementation of e-Commerce also allows businesses to expedite transactions resulting in faster sale of products in the marketplace. In fact, e-Commerce allows for transactions to occur during all hours of the day or night. Using the same principles that eliminate the limitations of regular business hours, time zone differences across the country and around the world are no longer a barrier. Doing business on the web increases the productivity of the business. The convenience of the web also brings security risk. In order for Sunshine's web transactions to be secure, the data transmission would have to be encrypted. Encryption or message scrambling protects both customer information and Sunshine's data in the event ofthe transmission is intercepted. Encryption of the information would make it unreadable and therefore useless to the interceptor. Encryption techniques such as secure socket layer (SSL), commonly used for e-Commerce transactions, could be implemented on the Sunshine's web page to ensure data security on the web browser. SSL may sound complex but its function is nothing more than to scramble messages for anyone other than the intended reader. It is a standard protocol that is available to you. Digital Signatures are also a great and secure option for e-Commerce transactions, allowing business to provide and/or accept electronic signatures which would imprint a person's name to an electronic document. The software used attaches the signee's name in cursive font to the document, and since it is legally binding, it would be just as if the user had really "signed" a paper copy of the document. This would allow for businesses to close business deals from a distance, to accept the terms of purchases and/or sales and to increase the productivity of many other business to business (B2B) transactions. I would be delighted to discuss these issues in greater depth with you at your earliest convenience.
# # #
Intro-28
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Becker Professional Education
I CPA Exam Review
EXAMPLE 2 RESPONSE:
Business
Less \-,,"'" -Pl.\11 eve'!'i\-
To:
Kelly Smith, (FO
Re:
Sunshine, Inc.
The web is a really cool way to grow your business with IT. The web is needs good security though to make sure that you don't lose money. The SSL is the best option for that. Even so, you can still make a lot of money with the web because of all the time you can save and not have to close up at any particular time just because it's either to late or too early someplace where you are selling. But the security is really important still and encryption is something you will need to do. Please call. This sounds like an exciting idea.
# # #
CRITERIA
Your ideal response will be: • A well developed, cohesive expository response with an introduction, a middle, and a conclusion. • On topic as evidenced by the use of key vocabulary words. • Free of grammar and spelling errors. • Free of bUllet points or abbreviations.
WEAKNESS
I P-Q;....~_:f:iR--APPllCATION
• Ideas are not well developed and repeat. Advantages of web business are countered with security issues which are countered with more advantages of web business and then countered again with security issues.
•
Key vocabulary words are used but not defined in an orderly fashion.
• The phrase "its either to early or too late", is not well constructed but is also grammatically flawed. The phrase should read "...it's either too early or too late..."
o Do not use text messaging language. • The response is flawed with use of undefined abbreviations (IT and SSL) as well as slang (really cool).
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Intro-29
Business
Becker Professional Education
I CPA Exam
R.f'viev/
EXAMPLE 3
A peer manager is interested in learning more about the Committee on Sponsoring Organization's Enterprise Risk Management integrated framework, particularly internal environment. In a written communication to your peer, describe two key aspects of the internal environment according to the Enterprise Risk Management integrated framework. Type your communication in the response area below using the word processor prOVided. POINTER
APPLICATION
Identify the format.
Memorandum or e-mail.
Identify the roles implied by the question.
Peer to peer.
Ask yourself what you want your reader to think and do as a result of the communication you are about to write. (The point of view should be given.)
• Reader should be motivated to learn more about ERM and enthusiastically embrace its principles.
• What information might be helpful? • What information might be relevant? Identify potential technical requirements not fully described in the situation. • Are the organization points defined by the question? • Do you need formulate your own key word framework?
• The reader should feel as though this is the beginning of a partnership that will effectively address ERM implementation in the organization. • Internal environment is the foundation for ERM and is comprised of any number of points that could be developed. • Ethics could be the focus of your communication. • Organizational structure might be the focus.
Make sure that ideas are presented clearly. • Start with the point of view or position on the topic. • Organize your main points (frequently as separate paragraphs) in a manner that develops ideas in support of your position.
• Internal environment is the foundation of the ERM framework. • Integrity and ethics is foundational to operations and to decision making.
• Be alert to points of organization provided in the situation itself.
• Commitment to competence is as much driven by competition as it is by the ethical commitment to provide good service to both internal and external customers.
Ensure concise presentation that does not use bullets or tables.
Four to five paragraphs form themselves around two internal environment components, an introduction and a conclusion.
Use standard business English appropriate for the audience.
Tone will be adjusted to peer to peer communications. Less formality is needed.
Verify spelling is correct.
Use the spell check button in the application.
Re read response to ensure that grammar and punctuation are correct.
Re-reading is critical since the capabilities of the software are limited.
Make sure you have addressed the requirements of the situation.
Re-reading will focus on tone and message.
Write a logical statement if it may appear too obvious.
Noting that internal environment is the first component of the ERM help organize the information.
Avoid absolutes, use words like generally, usually, etc.
Emphasize the various ways that the ERM foundations can be interpreted.
Do not abbreviate.
ERM can be used, but it must be defined.
Intra-30
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Becker Professional Education
I CPA Exam Review
EXAMPLE 3 RESPONSE: flAil
To:
Staff Manager
From:
Accounting Manager
Business
cve,Ait
I was delighted to hear about your interest in learning more about the committee on sponsoring organizations enterprise risk management integrated structure. Enterprise risk management (ERM) is a comprehensive organizational approach to evaluating and accepting risk. There are many components to ERM and it all starts with internal environment and setting the tone for the organization. Setting the tone of our organization begins with our commitment to integrity and ethical values. Indeed the effectiveness of ERM is limited by the integrity and ethical commitment of our management team. The responsibility that we bear to our owners, our customers and even our suppliers is summed up in our code of ethics and related code of conduct. Our commitment to ethical behavior influences our decisions to only accept responsible risk and to operate in compliance with the law and in a manner that emphasizes mutual respect and fairness. Directly related to our commitment to ethical behavior is our commitment
0
competence. Our commitment
is reflected in hiring practices that screen potential job candidates to those individuals who are most qualified and our training programs that ensure that our staff continuously updates their skills for top efficiency and effectiveness. ERM is an approach to risk and organization management that begins with the tone of the organization. It is much more a journey than a list of procedures. I look forward to contributing to this effort with you and encourage you to meet with me in person on this issue.
# # #
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Intro-31
Business
Becker Professional Education
EXAMPLE 3 RESPONSE,
I CPA Exam Review
Less l-ho", -1',,11 cveJ-il-
To:
Manager
From:
Financial Manager
The COSO's ERM frame work has eight different features. Internal Environment is just one. The framework includes:
•
Internal Environment
•
Objective Setting
•
Event Identification
•
Risk Assessment
•
Risk Response
•
Control Activities
•
Information and Communication
•
Monitoring
The Internal Environment has eight things in it as follows: •
Risk Management Philosophy
•
Risk Appetite
•
Board of Directors
•
Integrity and Ethical Values
•
Commitment to competence
•
Organizational Structure
•
Assignment of Authority and Responsibility
•
Human Resources Standards
If you want to know about just two of them, I'd pick Risk Management Phiiosophy, which is about our philosophy about managing risk and the ethical values which is about knowing about wrong and right. ERM has a lot of interesting things in it that help run the business. I look forward to working with you on this some more.
# # # ~ EAR ~ESS:
CRITERIA
Your ideal response will be: • A well developed, cohesive expository response with an introduction, a middle, and a conclusion. • On topic as evidenced by the use of key vocabulary words.
• •
Free of grammar and spelling errors. Free of bullet points or abbreviations.
o Do not use text messaging language.
AP PL I CA~T
(()__,..:.
• The response never develops; it only lists components of the enterprise risk management integrated framework. The response has no introduction, no development of ideas in the middle, and no conclusion. • The response is arguably on topic with outstanding use of relevant content. The content is not used for any purpose other than to list facts. • Although there are few grammar or spelling errors, the commentary does not present sentences. It presents lists.
•
Intro-32
I. PO IN 1£ R
Heavy and inappropriate uses of lists and undefined abbreviations mar this response.
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I CPA Exam Review
Business
WRITTEN COMMUNICATIONS - ADDITIONAL TIPS PREPARING FOR THE WRITING PORTION OF THE EXAM
The AICPA suggests the following resource options for use in preparing for the communication portion of the exam: "
The Elements of Style, by Strunk and White (Macmillan Paperbacks)
./
The Business Writing Handbook, by William Paxson (Bantam Books)
./
Effective Writing for Accountants, by Writing Consultant Cos Ferrara, which is a computer-based program available via [email protected]
In addition, the following material is provided for your use. It is intended to give you an extra edge on the exam since good writing styie can sometimes make the difference between passing and failing. For many of you, this will be a review of your knowledge of proper English as used in business, but be sure to practice applying these techniques as you work the simulations throughout the course.
CHARACTERISTICS OF GOOD WRITING
Written responses should be:
• (}okl'e/(tt} OI'!M/zeri Candidates should organize responses so ideas are arranged logically and the flow of thought is easy to foilow. A response should move logically and consistently from one point to the next. Generally, short paragraphs composed of short sentences, with each paragraph limited to the development of one principal idea, can best emphasize the
main points in the answer. Each principal Idea shouid be placed in the first sentence of the paragraph, followed by supporting concepts and examples.
Candidates should present complete thoughts in the fewest words possible while ensuring important points are covered adequately. Short sentences and simple wording also contribute to concise writing. Avoid unnecessary repetition, and make sure key concepts are not "buried" in long paragraphs.
A clearly written response prevents uncertainty about the candidate's meaning or reasoning. Clarity involves using words with specific and precise meanings, including proper technical terminology. Well-constructed sentences also contribute to clarity. Ambiguous or vague terminology should be avoided.
Standard English is used "to carryon the daily business of the nation. It is the language of business, industry, government, education, and the professions. Standard English is characterized by exacting standards of punctuation and capitalization, by accurate spelling, by exact diction, by an expressive vocabulary, and by knowledgeable usage choices."
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Intro-33
Business
Becker Professional Education
• Re.r;olfoftiH- to th-e l'erUil'etf(Mtof
I CPA Exam Review
01 th-e ruediOJ(
Answers should address the requirements of the question directly, and should demonstrate the candidate's awareness of the purpose of the writing task. Responses should not be broad expositions on the general subject matter.
Writing in an appropriate manner for the reader takes into account the reader's background, knowledge of the subject, interests, and concerns. Some questions may ask candidates to prepare a document for a certain reader, such as an engagement memorandum for a CPA's client. When the intended reader is not specified, the candidate should assume the reader is a knowledgeable CPA. ALLOCATION OF TIME
CPA candidates may be concerned about having enough time to prepare well-written responses, particularly under exarn conditions. However, they should be aware that good writing involves good editing; as a result, they should allow adequate time to refine and proofread their responses. Begin by reviewing the question requirements. Consider starting with a brief outline, which will not remain as part of the final answer, but which may be helpful in organizing your thoughts and ensuring that all requirements are addressed. This outline can also be helpful in allocating time appropriately. PROOFREADING
Candidates should proofread their written responses carefully by performing the following tasks: ./
Use the spell check tool provided in the software to correct spelling errors.
./
Review the response for correct grammar, tense, and punctuation.
./
Use the cut, copy, and paste tools to reorganize the response as necessary.
./
Verify that the response is written in an appropriate format (i.e., letter, memo, etc.) .
./
Reread the question, making sure that all requirements have been addressed .
./
Review the response to ensure it is on topic, rather than being a general discourse.
./
Review the response to verify that it is appropriate for the specified reader.
ADDITIONAL TIPS
./
"Discuss" typically means the candidate should give reasons, sometimes for and/or against.
./
Assumptions are rare, but should be stated when in doubt.
./
If asked about the effect of a particular transaction, or the effect of a previous error, consider both the balance sheet and the income statement, as well as the effect on current, previous, and subsequent years.
./
Be careful of dogmatic terms such as "always" and "never." Instead, use "generally," "it appears," and "it seems."
./
Do not convey information in the form of a table, bullet point list, or any other abbreviated presentation.
USE OF STANDARD ENGLISH
Use of standard English involves sentence structure, paragraph structure, word choice, spelling, and punctuation. Additional explanations and examples to further illustrate these concepts follows.
lntro-34
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Business
SENTENCE STRUCTURE ./'
Simple sentence structure is preferred, especially when discussing a complex topic.
./'
Be careful not to use sentence fragments or run-ons .
./'
The elements in a sentence must agree as to person, number, and tense.
I am going to do the fieldwork. The subsidiaries were consolidated. Mrs. Jones said that she would negotiate with the client. Accountants must adhere to their code of ethics. The audit steps have been completed. The statement is done.
A pronoun must agree with its antecedent. Sexist pronouns should be avoided. Mr. Smith in audit acknowledges his share of responsibility, just as Ms. Johnson in tax must acknowledge hers. CHAN G E:
Every employee must sign his time sheet.
TO:
All employees must sign their time sheets.
Collective nouns may be singular or plural, depending on meaning. The ad hoc committee finished its work. The committee went back to their respective departments.
Subjects and verbs must agree. Don't let intervening clauses and phrases mislead you.
CHANGE:
The audit program, even with the new enhancements, still take several days to run.
TO:
The audit program, even with the new enhancements, still takes several days to run.
CHANGE:
The use of some GAAP rules, despite their complexity, often result in no benefit.
TO:
The use of some GAAP rules, despite their complexity, often results in no benefit.
Avoid dangling modifiers. Dangling modifiers do not clearly refer to the noun or pronoun. CHANGE:
While at lunch, the computer crashed. (Who was at lunch? The computer?)
TO;
While we were at lunch, the computer crashed.
© 2010 DeVryjBecker Educational Development Corp. All
right~
reseNed
Intro-35
Business
Becker Professional Education
I CPA bill1l Heview
Avoid misplaced modifiers. Misplaced modifiers modify, or appear to modify, the wrong word or phrase. The cure is to put the modifier as close as possible to the word(s) it is modifying. Note how moving a modifier can change the meaning of a sentence. The new junior almost ruined all of the files. => All of the files were almost lost, but none were. The new junior ruined almost all ofthe files. => The majority ofthe files were ruined, but not all of them. C HAN G E :
The statements were completed by the auditor, with footnotes.
TO:
The statements, with footnotes, were completed by the auditor.
PARAGRAPH STRUCTURE
A topic sentence should state the main idea of the paragraph, and it should be the first sentence in the paragraph. Subsequent sentences should develop and support the main idea.
WORD CHOICE
../
Be precise-avoid vague and abstract words.
ABSTRACT:
Work
Deadline
Statement
CONCRETE:
Audit
March 10
Balance sheet
../
Be clear and direct.
../
Avoid jargon (e.g., "bottom line," "cutting edge").
./
Avoid cliches.
../
Use technical terms correctly.
SPELLING
../
Generally, abbreviations should not be used in formal answers. However, an abbreviation is acceptable if it is used in the question, or if the term is spelled out in its first usage, with the abbreviation shown parenthetically.
./
Capital letters should be used to begin each sentence, for proper nouns, and for the pronoun "I". Capital letters should not be used to emphasize a point.
../
Plurals should be formed appropriately.
./
Clipped spellings should not be used .
../
The spell check provided with the simulation software should be used.
Proper nouns name a specific person, place, thing, concept, or quality. Mr. Smith General Electric Canada
Intro-36
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Becker Professional Education
I CPA Exam Review
Business
Common nouns are general in nature. The partner A company A country
To form a plural, add an "s" for most nouns. Financial statements Accounts Internal controls
Add an "es" for nouns ending in
5, Z,
x, ch, and sh.
Businesses Wishes Churches
Change "y" to "ies" for nouns ending in a consonant. Deliveries Stories
For some nouns ending in 0 add "es"; for others, simply add "s". Photos Vetoes
Some nouns require an internal change to form the plural. Woman / Women Datum / Data Mouse / Mice
The main word in compound nouns is used to form the plural. Editors-in-chief Partners-i n-charge
Avoid clipped spellings.
CHANGE:
thru the nite
TO'
through the night
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Intro-37
Becker Professional Education
Business
I CPA Exam Review
PUNCTUATION Punctuation is important to help convey a message to the reader. It often performs the functions in writing that would be performed by facial expressions, body language, and voice inflection when speaking. Many punctuation marks have more than one use.
Apostrophes Apostrophes are used to show possession or mark omission of letters. The possessive case of most nouns is shown by adding '8. The firm's case The accountant's career
The possessive case of singular nouns ending in 8 is formed by adding either's or just an apostrophe. The waitress's career The waitress' career
The possessive case of plural nouns ending in 8 is formed by adding an apostrophe. The managers' meeting The accountants' work papers
Use an apostrophe to mark the omission of letters or numbers.
Can't for cannot '705 for 19705
Colons Colons are usually used to introduce a stacked list. Our suggestions to the client included: 1.
Reducing inventory
2.
Incurring less debt
3.
Reducing staff
Colons are also used in the salutation of a business letter. Dear Stockholders: Dear Manager: Dear Mr. Smith:
Intro-38
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Becker Professional Education
I CPA Exam Review
Business
Commas Commas help readers understand the topic, and prevent ambiguity. C HAN G E :
To be successful managers with MBAs must continue to learn.
ro:
To be successful, managers with MBAs must continue to learn.
C HAN G E :
The audit result despite subsequent events did not change.
r 0:
The audit result, despite subsequent events, did not change.
Exclamation marks Exclamation marks should not be used in exam answers.
Hyphens Hyphens are used as punctuation in limited circumstances. To replace the word "to": The range is 0 - 65. To join compound words: The partner-in-charge. To form compound numbers: twenty-one.
Parentheses Parentheses are used to enclose words, phrases, or sentences. Parenthetical information can add clarity without changing meaning. Parenthetical information applies to the word or phrase immediately preceding it. Accounting Standards Codification (ASC) are set by the FASB.
Periods Periods are generally used to indicate the end of a sentence. Periods are also used after abbreviations, after initials, and after numbers in a list.
. [0 2.
3.
Two periods should not be used when a sentence ends in an abbreviation.
1
We will meet the client at 8:30 a.m.
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Becker Professional Education I CPA Exam
Business
Review
Question morks Question marks are used at the end of interrogative sentences. Was a qualified opinion issued last year?
Quotation marks Quotation marks are used to enclose direct quotes of written or spoken words. ./
Quotation marks should not be used to emphasize a point.
./
Commas and periods should always be placed inside closing quotation marks.
./
Semicolons and colons should always be placed outside closing quotation marks.
./
All other punctuation should be placed within the quotation marks if it is a part of the quoted material; if it is not, it should be placed outside.
Semicolons Semicolons link independent clauses. No one wanted the assignment; the job was too difficult.
Intro-40
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I CPA Exam Review
Business
PROBLEM WORDS AND PHRASES
The following words and phrases are commonly misused by candidates and should be reviewed.
a I an
Use
a before words beginning with a consonant or a consonant sound.
E x AMP l E:
It was a historic event for the company. A report is due this week. The manager felt that it was a unique situation.
Use an before words beginning with a vowel or vowel sound. EXAMPLE:
The report is an overview. She seems like an unlikely candidate. The award is an honor.
a lot I alot
A lot should be written as two words-alot is incorrect. However, a lot is too informal for CPA exam answers and should be avoided.
absolutely
Absolutely means "definitely," "entirely," or "completely." It should not be used as an intensifier meaning "very" or "much."
accept I except
CHANGE:
Inventory observation, given the circumstances, is absolutely impossible.
TO:
Inventory observation, given the circumstances, is impossible.
Accept is a verb meaning "consent to" or "agree to take." Except is normally a preposition meaning "other than" or excluding." EX AMP 1 E s:
I accept responsibility for the engagement. We agree on everything except the schedule.
actually
adapt I adept I adopt
Actually means "really" or "in fact." Avoid using it to add emphasis. CHANGE:
Did he actually spend four hours reconciling cash?
TO:
Did he spend four hours reconciling cash?
Adapt means "adjust to a new situation." Adept means "highly skilled." Adopt means "take or use as one's own." E X AMP 1 E:
The firm will adopt a policy of hiring experienced accountants who are adept auditors and who can adapt to new situations.
advice I advise
Advice is a noun meaning "suggestion." Advise is a verb that means "give advice." E XA M P 1 E s:
The partner's advice is sound. I advise you to listen to the partner.
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Business
Becker Professional Education
affect / effect
I CPA Exam
Review
Affect is a verb that means "influence." Effect is usually a noun that means "result." Effect can also be a verb meaning "bring about" or "cause." Generally, effect as a verb is too formal and made is a better word. EXA M P LE s:
The manager's decision will affect everyone in the firm. The manager's decision had a good effect on morale.
agree to / agree with
CHANGE:
The managers effected several changes.
TO:
The managers made several changes.
Agree to means to "give consent." Agree with means "in accord." EXAMPLES:
The client agreed to listen to counsel. The client agreed with counsel's suggestions.
all right / alright
All right means "all correct." It should not be used as a substitute for "good" or "acceptable." Alright is incorrect.
allude / elude / refer
CHANGE:
The audit committee's decision was all right.
TO:
The audit committee's decision was acceptable.
Allude means to make an indirect reference to something. Elude means to escape notice. Refer means to make a direct reference to something. EXAMPLES:
The client alluded to a problem. The discrepancy eluded the auditor.
already / all ready
Already expresses time. All ready means "completely prepared." EXAMPLES:
The year end has already passed. The working papers are all ready for review.
amount / number
Amount is used with things thought of in bulk. Number is used with things that can be counted as individual items.
ante~
/ anti-
EXAMPLE:
The amount of accounts receivable has been confirmed.
CHANGE:
A large amount of confirmations are outstanding.
TO:
A large number of confirmations are outstanding.
Ante~ means
"before." Anti~ means "against" or "opposed to."
EXAMPLES:
Antecedent debt has priority in a bankruptcy. Antisocial people should not work in public accounting.
apprise I appraise
Apprise means "to give notice" or "to keep informed." Appraise means "to value." EXAMPLES:
The senior kept the partner apprised of developments during fieldwork. The auditor used an expert to appraise the patent.
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I CPA Exam
attribute / contribute
Rcvil'w
Business
Attribute (with the accent on the second syllable) is a verb meaning "the cause or source." Attribute (with the first syllable accented) is a noun meaning "a characteristic or quality." Contribute means "give." EXAMPLES:
She attributes the performance improvement to proper planning. The attribute most important in financial statements is usefulness to users. His tenacity will contribute to our success,
augment I supplement
Augment means to increase in size, degree, or effect. Supplement means to add something to make up for a deficiency. EXAMPLES:
The firm augmented their revenues during the busy season. Footnotes supplement the financial statements.
balance / remainder
Balance means either "a state of equilibrium" or "the amount in an account." Remainder means "what is left over." EXAMPLE:
The balance seems too high.
CHANGE:
After the other entries are made, record the balance as paid-in-capital.
TO:
After the other entries are made, record the remainder as paid-incapital.
because / for
I since
Because is the best and most unequivocal word to express cause. It is stronger than for or since. CHANGE:
The client stopped production for (or since) there were no raw materials.
TO·
can / may
The client stopped production because there were no raw materials.
Can refers to capability, and may refers to possibility or permission. EXAMPLES:
I can finish the project by tomorrow. (capability) I may finish the project by tomorrow. (possibility) May I finish the project by tomorrow? (permission)
I cannot / can not cite / site / sight
Cannot is one word.
Cite means "acknowledge" or "quote an authority." Site is a location. Sight is the ability to see. EX AMP LE:
The managing partners cited the task force's report to justify the new office site.
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Becker Professional Education
Business
collaborate / corroborate
I CPA Exam R.eview
Collaborate means "to work together. Corroborate means to support with evidence II
or authority. EXA M P LE :
The attorney's letter corroborated management's assertions with respect to pending litigation.
complement / compliment
Complement means "anything that completes a whole." Compliment means to praise. EXA M P LE s:
The invoice statement complements the balance sheet. The manager complimented the staff accountant's work.
credible / creditable
Credible means believable. Creditable means worthy of credit or praise. EXA M P LE s:
The statements are credible. The auditor did a creditable job.
criterion / criteria
Criterion means "an established standard." Criteria is the plural form of criterion. EXAMPLE:
Several criteria are used to evaluate staff. The most important criterion is billable hours.
data / datum
Data is often used as a collective singular noun (data is). In formal writing, data is plural and datum is singular. The CPA examiners always use the formal treatment. E XAMP LE:
The data are overwhelming in supporting this treatment, although any individual datum alone is not.
decided / decisive
Decided means "clear-cut" or "without doubt." Decisive means "conclusive." E XAMP L E:
The managing partner's decisive action gave the firm a decided advantage.
differ from / differ with
Differ from means two things are not alike. Differ with means a disagreement between persons. E x AMP L E 5:
The tax partner's background differs from the audit partner's background. The tax partner differed with the audit partner's treatment of the deferred tax liability.
economic / economical
Economic refers to production, development, and management of wealth. Economical means "efficient" or" not wasteful or extravagant." E XA M P LE s:
The strike had a large economic impact on the client's business. The field auditors shared office space to be as economical as possible.
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e.g.
I CPA Exam
Review
Business
The abbreviation e.g. stands for the Latin "exempli gratia." Avoid its use. Use "for example" instead.
equal
Equal is an absolute word meaning "having the same quantity or value." Don't use
modifiers, such as more equal.
explicit I implicit
An explicit statement is expressed directly. An implicit statement is expressed indirectly or implied. Ex AMP LEs;
Compliance with Generally Accepted Auditing Standards is explicit in the standard audit report. Consistency is implicit in the standard audit report.
figuratively I literally
Literally means "really" or "it actually happened." Figuratively is "metaphorically" or
"in a manner of speaking, but not actually." Don't say someone "literally went through the roof" unless there is a hole in the roof. Also, avoid using literally to emphasize a point.
former I latter
CHANGE:
He is literally the best in his class.
TO:
He is the best in his class.
Former and latter may be used to refer to two items in a sentence or paragraph.
However, they are awkward because they force the reader to look back at previous material. They are best avoided. CHANGE:
It is difficult to be consistently conservative in the balance sheet and income statement, because the former may be understated and the latter overstated.
TO;
It is difficult to be consistently conservative in the balance sheet and income statement, because the balance sheet may be understated and the income statement overstated.
here in I herewith
Le.
These words should be avoided. CHANGE:
I have herewith enclosed my invoice.
TO:
I have enclosed my invoice.
The abbreviation i,e. stands for the Latin "id est" meaning "that is." Avoid its use. Use "that is" instead.
imply I infer
Imply means to hint or suggest. Infer means to reach a conclusion based on evidence. EXAM P LES:
Her memo implied the report would be late. The partner inferred from the working papers that a qualified opinion would be issued.
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Becker Professional Education
Business
insure / ensure / assure
I CPA Exam Review
All three mean "make secure or certain." Assure refers to persons, and it alone connotes setting a person's mind at rest. Ensure and insure also mean "make secure from harm." Only insure means "guaranteeing the value of life or property." EXAMPLES:
I assure you the report will be on time. We need the computer to ensure we will meet the deadline. The equipment should be insured.
interface
An interface is the "surface providing a common boundary between two bodies, machines or areas." The bodies or areas may be physical or conceptual (the interface of law and accounting). People do not interface. Do not use interface in place of cooperate, interact, or work.
irregardless / regardless
its / it's
CHANGE:
The audit department interfaces with the tax department,
TO:
The audit department works with the tax department.
Irregardless is nonstandard English and should never be used. Use regardless instead.
Its is a possessive pronoun. It's is a contraction of it is. Although nouns usually form
the possessive by the addition of's, the contraction of "it is" (it's) has already used that device. Therefore, the possessive form of the pronoun "it" is formed by adding only the s. EXAMPLE:
lend / loan
It's important that the client meet its goals,
Lend or loan each may be used as a verb, but lend is more common. Loan can also be
a noun. EXAMPLES:
The bank may lend (or loan) the money. We made arrangements for a bank loan.
libel/liable / likely
Libel is written defamation of character (slander is verbal defamation). Liable means
"legally subject to" or "responsible for." Likely indicates a condition of high probability. EXAMPLES:
The newspaper may be sued for libel. Companies are liable for their employee's actions.
maybe / may be
CHANGE:
The controller is liable to be promoted.
TO:
The controller is likely to be promoted.
Maybe means "perhaps." May be is a verb phrase. EXAMPLES:
Maybe the issue will be resolved during fieldwork. It may be necessary to consult with legal counsel.
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rjght~ re~erved
Becker Professional Education
media
I medium
I CPA Exam Review
Business
Media is the plural form of medium. EXAMPLE:
Magnetic media storage is becoming more common. CD ROMs are the most common medium.
needless to say
If it is truly needless to say, don't say it. If you're going to say it, don't start with needless ta say.
ok I okay
on account of
Okay is too informal for business use or for the CPA exam and should be avoided. CHANGE:
The balance appears to be okay.
TO:
The balance appears to be accurate.
The phrase on account afshould be avoided. Use because instead. CHANGE:
Additional substantive testing was needed on account of an inability to rely on the client's records.
TO:
Additional substantive testing was needed because we could not rely on the client's records.
over with
In the phrase over with, the word with is redunda nt. Often the word completed is better.
per I as per
CHANGE:
The report will be drafted when fieldwork is over with.
TO:
The report will be drafted when fieldwork is over (or completed).
Per means "by means of," "through," or "on account of." Sometimes per is used to
mean "according to," but this use should be avoided. EXAMPLES:
per annum
per capita
per diem
CHANGE:
As per your request, enclosed is the report.
TO:
As you requested, enclosed is the report.
per cent I percent I
Percent is preferred to per cent. It is used instead of the symbol (%), except in tables.
percentage
Percentage indicates a general size and is not used with numbers. E XA M P LE s:
Only 25 percent of the staff attended the meeting. Only a small percentage of the staff attended the meeting.
personal I personnel
Personal means "pertaining to an individual." Personnel means "a group of people
engaged in a common job." Do not use personnel when you mean persons or people. EXA M P L E s:
His work suffered because of personal problems. The personnel office keeps employee records.
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Intro-47
Business
principal! principle
Becker Professional Education
I CPA Exam
Review
Principal means either "an amount of money on which interest is earned" or "the
chief official in a school." Principal may also mean "main" or "primary." Principle means "basic truth or belief." E XAMP LE s:
The bank pays interest on the principal. The profession's principal objection has been cost. Accounting is based on underlying principles.
strata / stratum
Strata is the plural of stratum, meaning a "layer." EXAMPLE:
In stratified sampling, the inventory is divided into strata. Each stratum is then treated as a separate population.
there I their I they're
There is an introductory phrase or an adverb. Their is the possessive form of they. They're is a contraction of they are. EXAMPLES:
There were twelve members on the audit team. All team members were there. Auditors must rely on their professional judgment. If they're efficient, the budget can be met.
to Itoo I two
To is usually a preposition. Too means "also" or "excessively." Two is a number. EXAMPLES:
Send the report to the client. Send the report to the bank, too. File two copies of the report.
unique
Unique is an absolute word meaning "one of a kind." It should not be modified.
(Something is unique or it isn't. It can't be more unique or very unique.)
whether or not
CHANGE:
The client's business is very unique.
TO:
The client's business is unique. (If it is one of a kind.)
OR:
The client's business is very unusual.
When whether Dr not is used to indicate a choice between alternatives, omit or not, which is redundant.
Intro-48
CHANGE:
The partner asked whether or not the confirmations had been mailed.
TO:
The partner asked whether the confirmations had been mailed.
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re~rved.
Becker Professional Education
I CPA Exam Review
Business
PREPARE TO SUCCEED... Congratulations on your decision to join the most trusted and recommended CPA Exam Review Course in the industry - Becker Professional Education! Upon the successful completion of our course and passing the CPA Exam, we invite you to consider joining the esteemed faculty of Becker Professional Education. We employ a strong cadre of carefully selected professionals with advanced academic degrees and years of practical experience. Our faculty help students relate to the business world, make tangible connections between theory and practice, and bring immediate relevance to you. Becker's culture of passion among its faCUlty and its commitment to keeping themselves professionally up to date are the key factors driving all aspects of our mission. As a Becker faculty member, you will help others achieve their career goals and personal potential while earning a supplemental income. You get the satisfaction of making a positive impact on the quality of the CPA profession. You also get a unique opportunity to grow personally and professionally: ,f
Teach part time without interrupting your full-time career
,f
Experience the satisfaction of making a difference
,f
Expand your own expertise
,f
Enhance your communication and leadership skills
,f
Network with other professionals in your field
If you are an experienced professional with a CPA and/or an advanced degree, knowledge of the CPA profession with strong communication skills and a desire to help others succeed, you could become a faCUlty member at Becker Professional Education. Specialty areas of need include financial accounting and reporting, governmental and not for profit accounting, taxation, business law, auditing and attestation, economics, cost and managerial accounting. In addition to competitive compensation, Becker Professional Education faculty may be eligible for CPE credit (decided by each jurisdiction). Please send a resume or CV to [email protected] if you are interested in preparing the future CPAs. If you have questions, you can also contact a Becker faculty recruiter at (630) 706-3406.
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I CPA Exam Review
INSTRUCTOR EVALUATION FORM Becker Professional Education is committed to providing quality education to our students. If you are taking this course in a live classroom, you will be receiving a short instructor evaluation at the end of this section by email. Please take the 5 to 10 minutes needed to complete this evaluation. Your input is very important to us. If you do not receive this evaluation by email, please complete the evaluation below for all instructors in your section. FAX the completed evaluation to (630) 706-3577. To ensure you receive the email invitation, be sure to add [email protected] to your address book or safe senders list. For your convenience, please find the instructions for the most commonly used e-mail services and programs at: http://images.ed4.neVimages/htdocs/addressbook. During the evaluation period, the evaluations are directly available at http://beckereval.com. If you do not evaluate all your instructors, you will continue to receive periodic reminders from [email protected] until you complete the evaluation forms, or the evaluation period has ended. We thank you in advance for your cooperation.
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Please answer the questions below by checking the box to the right of the question:
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This instructor communicated in a way thai helped me learn in the class. This instructor demonstrated knowledge of the subject matter by giving examples, working questions during the lecture and answering questions while at the class. This instructor motivated me to complete the homework and to do what I could to ensure that I was prepared for the exam. This instructor showed a genuine interest in preparing me for the exam. I would recommend this instructor to others.
ITIIIJ ITIIIJ ITIIIJ ITIIIJ ITIIIJ ITIIIJ A
B
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F
A
B
c
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I would give this instructor the following grade: Describe at least one characteristic or aspect of your instructor's teaching that could be improved in order to provide students with a better learning experience.
(Use the back of this page for additional space, ifneeded.) Describe at least one of your instructor's teaching strengths that you found helpful or valuable.
(Use the back ofIhis page for addftiona/space,ffneeded)
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INSTRUCTOR EVALUATION FORM-ADDITIONAL NOTES
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Becker Professional Education
Business
I CPA Exam Review
NOTES
Intro-52
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