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Subject 1. The Nature of Statistics
#quantitative-methods-basic-concepts #statistics
Statistics can refer to numerical data (e.g., a company's average revenue for the past 20 years). It can also refer to methods of collecting, classifying, analyzing, and interpreting numerical data. Statistical methods provide a powerful set of tools for making decisions in business and other fields.

Statistics involves two different processes:

  • Describing sets of data. Descriptive statistical methods can be used to describe the important aspects of data sets that have been collected. This reading will focus on the use of descriptive statistics to consolidate a mass of numerical data into useful information.
  • Drawing conclusions (making estimates, judgments, predictions, etc.). Inferential statistical methods can be used to draw conclusions about a large group from a smaller group actually observed.

We use statistical methods to analyze the results of data. Since the amount of information available may be vast, it may be extremely time-consuming and expensive to collect all the necessary data. For instance, suppose we are interested in the durability of tennis balls. Theoretically, in order to carry out an accurate assessment, we would need to collect large quantities of all different makes of tennis balls from all over the world. Clearly, this is not practical; aside from taking up lots of time, it would be cost-prohibitive to purchase all the balls we would need for our study. A more practical solution would be to use a sample.

A population consists of an entire set of objects, observations, or scores that have something in common. It comprises every possible member of the specified group. In our example above, the population of tennis balls consists of every tennis ball that has ever been manufactured anywhere in the world. This is a huge number of tennis balls. Another example of a population would be all males between the ages of 15 and 18.

A sample is a subset of a population. The sample is comprised of some of the members of the population. Since it is usually impractical (or too expensive or time-consuming) to test every member of a population, using data gathered from a sample of the population is typically the best approach available for describing that population.

In our example above, a sample might be a selection of 1,000 tennis balls of various makes collected from different sources. It would be a virtually impossible task to collect every possible tennis ball in the world; this same size provides a manageable number to work with as well as a substantial amount of possible data.

Before we move on, there are several points worth noting:

  • Don't be fooled by the word "population." This does not necessarily refer to people. As with the example above, we can have a population of tennis balls. A population can consist of anything, living or not.
  • Although populations are often vast, they can also be of manageable size. For example, the population of even numbers between 1 and 9 would comprise the numbers 2, 4, 6 and 8. In this case, it is possible to sample the entire population and get accurate results. This is rare, however, and for your purposes, populations can generally be considered to be vast.
  • In general, the bigger the sample, the better your results will be (because you are using data from more of the population for analysis). However, this point can present difficulties, as you will see when we study variance and standard deviation later.
  • The ideal process would be to select a sample that is "representative" of the population (a sample that takes into account extreme values on both sides but contains many "average" values). In this way, the results that we get will be more meaningful. Because we frequently don't know about the exact values of a population (which is why we sample in the first place), we will never really know if our sample is truly representative or not. It's a
...
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Subject 4. Measures of Center Tendency
#has-images #quantitative-methods-basic-concepts #statistics
Measures of central tendency specify where data are centered. They attempt to use a typical value to represent all the observations in the data set.

Population Mean

The population mean is the average for a finite population. It is unique; a given population has only one mean.

where:

  • N = the number of observations in the entire population
  • Xi = the ith observation
  • ΣXi = add up Xi, where i is from 0 to N

Sample Mean

The sample mean is the average for a sample. It is a statistic and is used to estimate the population mean.

where n = the number of observations in the sample

Arithmetic Mean

The arithmetic mean is what is commonly called the average. The population mean and sample mean are both examples of the arithmetic mean.

  • If the data set encompasses an entire population, the arithmetic mean is called a population mean.
  • If the data set includes a sample of values taken from a population, the arithmetic mean is called a sample mean.

This is the most widely used measure of central tendency. When the word "mean" is used without a modifier, it can be assumed to refer to the arithmetic mean. The mean is the sum of all scores divided by the number of scores. It is used to measure the prospective (expected future) performance (return) of an investment over a number of periods.

  • All interval and ratio data sets (e.g., incomes, ages, rates of return) have an arithmetic mean.
  • All data values are considered and included in the arithmetic mean computation.
  • A data set has only one arithmetic mean. This indicates that the mean is unique.
  • The arithmetic mean is the only measure of central tendency where the sum of the deviations of each value from the mean is always zero. Deviation from the arithmetic mean is the distance between the mean and an observation in the data set.

The arithmetic mean has the following disadvantages:

  • The mean can be affected by extremes, that is, unusually large or small values.
  • The mean cannot be determined for an open-ended data set (i.e., n is unknown).

Geometric Mean

The geometric mean has three important properties:

  • It exists only if all the observations are greater than or equal to zero. In other words, it cannot be determined if any value of the data set is zero or negative.
  • If values in the data set are all equal, both the arithmetic and geometric means will be equal to that value.
  • It is always less than the arithmetic mean if values in the data set are not equal.

It is typically used when calculating returns over multiple periods. It is a better measure of the compound growth rate of an investment. When returns are variable by period, the geometric mean will always be less than the arithmetic mean. The more dispersed the rates of returns, the greater the difference between the two. This measurement is not as highly influenced by extreme values as the arithmetic mean.

Weighted Mean

The weighted mean is computed ...
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Flashcard 1417556397324

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Question
What is the gold standard method of assessment of baby in labour?
Answer
intermittent auscultation (IA)

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Flashcard 1417558232332

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Question
early decels are due to?
Answer
vasovagal stimulation from pressure on head (scallop shaped decels)

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Flashcard 1417560067340

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Question
List 5 maternal factors that reduce availability of oxygen to fetus which may result in abnormal fetal tracing.
Answer
(decreased maternal oxygen carrying capacity)
-significant anemia
-carboxyhemoglobin
(decreased uterine blood flow)
-hypotension
-regional anesthesia
-maternal poisoning
(chr maternal conditions)
-vasculopathies (SLE, T1DM, chr HTN)
-antiphospholipid syndrome

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Flashcard 1417561902348

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Question
List 4 utero-placental factors that can result in abnormal fetal tracings, due to reduced availability of oxygen to fetus.
Answer
(uterine hypertonus)
-hyperstimulation d/t oxytocin/prostaglandins/normal labour
-placental abruption
(uteroplacental dysfn)
-placental abruption
-placental infarction/dysfn marked by oligohydramnios/abn doppler studies
-chorioamnionitis

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Flashcard 1417563737356

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Question
List 5 fetal factors that can result in abnormal fetal tracings due to decreased oxygen delivery to the fetus.
Answer
-cord compression
-oligohydramnios
-cord prolapse/entanglement
-decreased fetal oxygen carrying capability
-significant anemia (isoimmunization, fetomaternal bleed)
-carboxyhemoglobin (smokers)

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Flashcard 1417565572364

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Question
What must be present to declare intrapartum fetal asphyxia?
Answer
-apgar score 0 to 3 for >5 min
-neonatal neurologic sequelae (hypotonia, seizures, coma)
-evidence of multi-organ system dysfn in the immediate neonatal period
-umbilical cord arterial pH <7.0 and base deficit > 16 mmol/L

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Flashcard 1417567407372

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Question
respiratory acidosis (in pregnancy) develops [how fast] ​ and disappears following [...]
Answer
rapidly; the first neonatal breaths

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Flashcard 1417569242380

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Question
List 5 causes of fetal bradycardia (<110 bpm)
Answer
• Maternal hypotension
• Drug effects
• Maternal position
• Umbilical cord occlusion
• Fetal hypoxia
• Fetal vagal stimulation (head compression)
• Fetal hypothermia
• Fetal acidosis
• Fetal cardiac conduction or structural defect

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#obgyn
respiratory acidosis (in preg) occurs in vessels when CO2 transport from fetus to placenta is disrupted (e.g. cord compression). It's a part of normal delivery.
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Flashcard 1417571077388

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Question
respiratory acidosis (in preg) occurs in vessels when [...] is disrupted (e.g. cord compression). It's a part of normal delivery.
Answer
CO2 transport from fetus to placenta

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respiratory acidosis (in preg) occurs in vessels when CO2 transport from fetus to placenta is disrupted (e.g. cord compression). It's a part of normal delivery.







Flashcard 1417572650252

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Question
respiratory acidosis (in preg) occurs in vessels when CO2 transport from fetus to placenta is disrupted (e.g. [...]). It's a part of normal delivery.
Answer
cord compression

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respiratory acidosis (in preg) occurs in vessels when CO2 transport from fetus to placenta is disrupted (e.g. cord compression). It's a part of normal delivery.







#obgyn
Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.
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Flashcard 1417575533836

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Question
Metabolic acidosis (in preg) develops as a result of [...] that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.
Answer
fetal hypoxia

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Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, a







Flashcard 1417577106700

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Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to [...] to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.
Answer
anaerobic metabolism

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Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.







Flashcard 1417578679564

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Question
Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in [...], takes longer to develop and disappear, and has the potential to cause significant fetal damage.
Answer
hypoxic tissues

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Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.







Flashcard 1417580252428

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Question
Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes [...] to develop and disappear, and has the potential to cause significant fetal damage.
Answer
longer

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<head>Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.<html>







Flashcard 1417581825292

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Question
Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause [...].
Answer
significant fetal damage

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s a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause <span>significant fetal damage.<span><body><html>







Flashcard 1417584708876

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Question
List 5 causes for fetal tachycardia (>160 bpm)
Answer
• Maternal: fever, infection, dehydration, hyperthyroidism, anxiety, drugs, anemia
• Fetal: infection, prolonged fetal activity, chronic hypoxemia, cardiac abnormality, congenital anomalies, anemia

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Flashcard 1417587330316

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Question
What are the characteristics of variable decels (FHR)?
Answer
Abrupt decrease in FHR > 15 bpm below baseline for at least 15 sec but < 2 min

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#obgyn
Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia
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Flashcard 1417589165324

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Question
[...] decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia
Answer
Early

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Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia







Flashcard 1417590738188

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Question
Early decel (FHR) is reflex vagal response due to [...]; not normally associated with fetal acidemia
Answer
head compression

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Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia







Flashcard 1417592311052

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#obgyn
Question
Early decel (FHR) is reflex vagal response due to head compression; not normally associated with [...]
Answer
fetal acidemia

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Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia







Flashcard 1417595194636

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Question
What are the characteristics of abn variable decels (FHR)?
Answer
Abnormal variable decelerations if: <70 bpm, >60 sec, prolonged return to baseline, loss of variability in baseline FHR

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Flashcard 1417597029644

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Question
What are variable decels associated with? What about abn variable decels?
Answer
Associated with vagal stimulation due to cord compression or head compression in 2nd stage
If abnormal variable decels, may be associated with fetal acidemia

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Flashcard 1417598864652

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Question
Late decels indicate poor oxygenation and can occur with: (list 5 causes)
Answer
altered maternal blood flow to placenta (maternal hypotension); reduced maternal oxygen saturation; placental insufficiency; uterine hypertonus; fetal academia

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Subject 1. Types of Markets
#cfa #cfa-level-1 #economics #microeconomics #reading-13-demand-and-supply-analysis-introduction
A market is any arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so that no single buyer or seller can influence prices.

Broadly speaking there are two types of markets:

  • Goods markets are markets where final products from businesses or firms are exchanged. Households and firms are usually buyers and firms are sellers.

  • Factor markets are markets for the factors of production. Factors include labor, capital, raw materials, entrepreneurship, etc. For example, in labor markets, households are sellers and firms are buyers.

The demand for a factor exists because there is a demand for goods that the resource helps to produce. The demand for each factor is thus a derived demand; it is derived from the demand of consumers for products. For example, engineers are needed to design cars. A car manufacturer's demand for engineers thus depends entirely upon the demand for cars. The demand for engineers is a derived demand.
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The Demand Function and the Demand Curve
#demand-and-supply #has-images #microeconomics
The demand function represents buyers' behavior.

Prices influence consumers' purchase decisions. The demand function can be depicted as a negatively sloped demand curve.

  • If all other factors are equal, as the price of a good rises, consumer demand falls. This is mainly due to the availability of substitutes, which are goods that perform similar functions.
  • As the price of a good falls, consumer demand rises.

Therefore, there is an inverse relationship between the price of a good and the amount that consumers are willing to buy. The demand curve normally slopes downward. It tells the analyst the quantity that consumers are willing to buy for each possible price when all other influences on consumers' planned purchases remain the same.

Example 1

Refer to the graph below. What is the quantity of cassettes demanded when their price is $4.00 per week?

Answer: Two cassettes per week. The demand curve tells how much is demanded at each price. To determine the quantity demanded, find $4.00 on the vertical axis and read across until you meet the demand curve. Then read the quantity from the horizontal axis.

When any factor that influences buying plans, other than the price of the good, changes, there is a change in demand for that good. When the quantity of the good that people plan to buy changes at each and every price, there is a new demand curve. These factors include changes in income, number of consumers in the market, changes in the price of a related good, etc.

Example 2

Assume the graph below reflects demand in the automobile market. Which arrow best captures the impact of increased consumer income on the automobile market?

Answer: D. Income is a shift factor of demand. An increase in income increases the number of automobiles demanded at each price. Therefore demand has shifted to the right.

  • When demand increases, the quantity that people plan to buy increases at each and every price, so the demand curve shifts rightward.
  • When demand decreases, the quantity that people plan to buy decreases at each and every price, so the demand curve shifts leftward.

A Change in the Quantity Demanded Versus a Change in Demand

The demand curve isolates the impact of price on the amount of a product purchased.

  • A change in quantity demanded (caused by price change ONLY) is a movement along a demand curve from one point to another.
  • Changes in other factors (anything other than price), such as income, tastes, expectations, and the prices of closely related goods, will shift the entire demand curve inwards or outwards. This is referred to as change in demand.

Example 3

Refer to the graph below. Consumers began purchasing more of a product due to a decrease in price. Which arrow best represents this statement?

Answer: C. A change in price causes a movement along the demand curve. When price falls, the movement is downward and to the right.

The Supply Function and ...
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Subject 3. Market Equilibrium
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-13-demand-and-supply-analysis-introduction #subject-3-market-equilibrium
Aggregate Demand and Aggregate Supply

An aggregate demand curve is simply a schedule that shows amounts of a product that buyers collectively desire to purchase at each possible price level.

An aggregate supply curve is simply a curve showing the amounts of a product that all firms will produce at each price level.

Example 1

Refer to the graph below. What is the market quantity that would be supplied at a price of $2.00?

Market quantity is the sum of individual quantities supplied at each price. At a price of $2.00, Ann supplies 4, Barry supplies 3, and Charlie supplies 0. The market supply is 7.

Market Equilibrium

Equilibrium is a state in which conflicting forces are in balance. In equilibrium, it will be possible for both buyers and sellers to realize their goals simultaneously.

The following graph depicts the market supply and demand for concert tickets at Madison Square Garden in New York City.

Equilibrium price and quantity are where the supply and demand curves intersect. Draw a horizontal line from the intersection to the price axis. This is equilibrium price: $60. Draw a vertical line from the intersection to the quantity axis. This is equilibrium quantity: 300. It is equilibrium because quantity demanded equals quantity supplied at $60 per ticket. At this price, there is neither surplus (excess supply) nor shortage (excess demand), so there is no downward or upward pressure for the price to change.

Surplus will push prices downward towards equilibrium.

  • Suppose the price is initially above the equilibrium price (P2) and sits at P1.
  • Quantity supplied (Q1s) will exceed quantity demanded (Q1D), creating a surplus.
  • The surplus will put downward pressure on prices since producers will begin to lower their prices to sell the surplus.
  • As a result, the price will fall, the quantity supplied will decrease, and the quantity demanded will increase until the equilibrium price (P2) is restored.
  • This process involves movements along supply-and-demand curves since the changes are caused by price fluctuations.

Similarly, shortages push prices upward towards equilibrium.

Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains constant if it is at equilibrium, the price is pulled toward equilibrium and remains there until some event changes the equilibrium. We refer to such an equilibrium as being stable because whenever price is disturbed away from the equilibrium, it tends to converge back to that equilibrium.

An unstable equilibrium is an equilibrium that is not restored if disrupted by an external force. While most equilibria studied in economics are of the stable variety, a few cases of unstable equilibria do emerge from time to time, in limited circumstances.
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Subject 4. Auctions
#cfa #cfa-level-1 #economics #microeconomics #reading-13-demand-and-supply-analysis-introduction #subject-4-auctions
Auctions can be used to arrive at equilibrium price.

  • Auctions can have bidders trying to buy an item (e.g., Christie's, eBay).
  • Auctions can have bidders trying to sell an item (e.g., Procurement, priceline.com).

Auctions can be classified as one of two types:

  • Common value auction: the value of the item is the same to everyone but different bidders have different estimates about the underlying value. Examples: oil, timber, items with resale value.
  • Private value auction: bidders know the value of the item to themselves with certainty but there is uncertainty regarding other bidders' values. Examples: collectibles, art items.

There are also many different methods for auctioning items:

  • Open outcry English (ascending price) auction: The auctioneer starts at a reserve price and increases the price until only one bidder is left. That bidder wins the auction at the current price.
  • First-price sealed-bid auction: Everyone writes down a bid in secret. The person with the highest bid wins the object and pays what he bids.
  • Second-price sealed-bid (Vickery) auction: Everyone writes down a bid in secret. The person with the highest bid wins the object and pays the second highest bid (used for stamps and by Goethe).
  • Dutch (descending price) auction: The auctioneer starts at a high price and decreases the price until a bidder accepts the price.

The winner's curse means that the winner of an auction will frequently have bid too much for the auctioned item: you win, you lose money, and you curse.

A Dutch auction share repurchase is when a company agrees to buy back a fixed amount of its outstanding shares within a certain price range. Offers come in from investors who specify the price within the given range at which they'll sell their shares. The company then buys back the shares of those who bid the lowest first and continues on up the line until they have bought back the amount that they said they would.

The U. S. Treasury security auctions are conducted using the single-price auction method. All successful competitive bidders and all noncompetitive bidders are awarded securities at the price equivalent to the highest rate or yield of accepted competitive tenders.
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Subject 5. Consumer Surplus, Producer Surplus, and Total Surplus
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-13-demand-and-supply-analysis-introduction
Consumer Surplus

Consumer surplus is the area below the demand curve but above the actual price paid. It is the difference between the amount consumers are willing to pay and the amount they have to pay for a good.

Consider the market for a good.

  • If the market price is $100, then the 30th unit will not sell because those who demand it are only willing to pay $60 for the good.
  • At $100, the 17th unit will sell because those who demand it are willing to pay up to $100 for the good.
  • At $100, the 5th unit will sell because those who demand it are willing to pay up to $133 for the good.

  • For all those goods under 17 units, people are willing to pay more than $100.
  • The area represented by the distance above the actual price paid and below the demand curve is called consumer surplus.
  • This area represents the net gains to buyers from market exchange.

Lower market prices increase the amount of consumer surplus in the market.

Producer Surplus

Producer surplus is the difference between the minimum supply price, represented by the supply curve, and the actual sales price.

  • It is measured by the area below the price and above the supply curve, up to the quantity sold.
  • It accrues to owners of firms and resource suppliers.

Example

The actual selling price of bananas is $9 per kg.

Now imagine that there are only 10,000 kg bananas being supplied at the moment. The marginal cost per kg is only $3 but the selling price is $9. So there is an additional $6 per kg being raised. This is the producer surplus per kg. The total producer surplus when 10,000 kg are produced is thus $60,000.

Due to the surplus, more producers enter the market and another 10,000 kg are produced, so there are now 20,000 kg of bananas on the market. The marginal costs of producing this additional 10,000 kg have risen to $4.

Producer surplus is not the same as profit. Remember that profit is the return that accrues to owners of a firm and is the difference between sales revenue and total (not marginal) costs of production.

Total Surplus

The following figure shows that a competitive market creates an efficient allocation of resources at equilibrium.

  • In equilibrium, the quantity demanded equals the quantity supplied.
  • At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity.
  • The sum of consumer and producer surplus is maximized at this efficient level of output. It is here that all potential gains from production and exchange are realized.
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Subject 6. Market Interference: The Negative Impact on Total Surplus
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-13-demand-and-supply-analysis-introduction
The equilibrium price set by the market mechanism is often deemed to be unfair: buyers complain that the price is too high, while sellers believe that it is too low. In such cases, the government may regulate the price of the good or service. This is known as price control. A price control is a government-mandated price that may either be greater or less than the market equilibrium price. Price ceilings and floors are two types of price controls.

A Price Ceiling

A price ceiling is a legal restriction that prohibits exchanges at prices greater than a designated price: the ceiling price. Price ceilings are usually imposed when the equilibrium price is considered too high to be fair. A typical price ceiling results in a lower price than market forces would produce. A shortage will result in a situation in which the quantity demanded by consumers exceeds the quantity supplied by producers at the existing price.

A typical example of a price ceiling is a "rent ceiling," implemented by over 200 U.S. cities. If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

If a rent ceiling is set below the equilibrium price P0, for example, at P1, there is a reduction in the quantity that producers are willing to supply qs and an increase in the quantity that consumers demand qd relative to the original equilibrium quantity q.

Because the legal price cannot eliminate the shortage, other mechanisms operate. For example, a black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. A shortage of housing creates a black market in housing. Illegal arrangements are made between renters and landlords at rents above the rent ceiling - and generally above what the rent would have been in an unregulated market.

A rent ceiling leads to an inefficient use of resources. The quantity of rental housing is less than the efficient quantity and there is a deadweight loss.

A rent ceiling decreases the quantity of rental housing, shrinks the total producer and consumer surplus by using resources such as search activity, and creates a deadweight loss. It also transfers part of the producer surplus from producers to consumers. The consumer surplus becomes the green area + the pink area.

A Price Floor

A price floor is a minimum price that can be legally charged. It usually fixes the price of a good or resource above the market equilibrium level. Price floors are usually imposed when the equilibrium price is considered too low to be fair. Agricultural price supports and minimum wage legislation are examples of price floors.

If a price floor is set above the equilibrium price, p0, for example, at p1, there is a reduction in quantity demanded from q0 to qd, whilst the quantity supplied increases from q0 to qs. The result is a surplus of qs-qd.

Example 1

Refer to the graph below. A price floor set by the government would be binding and cause the greatest distortion in the market if it were established at what price?

...
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Subject 7. Demand Elasticities
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-13-demand-and-supply-analysis-introduction
Elasticity means "responsiveness." The elasticity of demand measures the responsiveness of the quantity demanded of a product to changes in any of the factors that affect demand. Analysts are interested in knowing how much the quantity demanded will rise or fall for a given change in price or income.

Price elasticity of demand is the percentage change in the quantity of a product demanded divided by the percentage change in the price causing the change in quantity. It indicates the degree of consumer response to variation in price. Specifically, it tells the analyst the percentage change in the quantity demanded for a good caused by a 1% increase in the price of that good.

The change in price is expressed as a percentage of the average price - the average of the initial and new price, and the change in the quantity demanded is expressed as a percentage of the average quantity demanded - the average of the initial and new quantity. Using the average price and average quantity, the same elasticity value is obtained regardless of whether the price rises or falls.

The measure is units-free because it is a ratio of two percentage changes and the percentages cancel each other out. Changing the units of measurement of price or quantity leave the elasticity value the same.

Because a change in price causes the quantity demanded to change in the opposite direction, this ratio is always negative, although economists always ignore the sign and simply use the absolute value. It is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change.

Example 1

A Pizza Hut store can sell 50 pizzas per day at $7 each or 70 pizzas per day at $6 each. The price elasticity is: [(50 - 70)/60] / [(7 - 6) / 6.5] = -2.17.

Own-Price Elasticity of Demand

Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity. (Note: the negative sign is ignored.)

  • If the elasticity coefficient is greater than 1, demand is elastic. A small price change leads to a large change in the quantity demanded. The more elastic the demand, the flatter the demand curve over any specific range. Demands for goods with many substitutes (e.g., juice) are relatively elastic. If the demand curve of a good is completely horizontal, the demand is perfectly elastic. Consumers will buy all of that good at the market price.
  • When the elasticity coefficient is less than 1, demand is inelastic. The more inelastic the demand, the steeper the demand curve. Demands for goods with few substitutes (e.g., cigarettes) are relatively inelastic.
  • When the elasticity coefficient is equal to 1, demand is said to be unitary elastic.

Because elasticity is a relative concept, the elasticity of a straight-line demand curve will differ at each point along the demand curve. Specifically, a straight-line demand curve is more elastic when price is high. Note that the elasticity is not the slope of the demand curve. Elasticity is used since it is independent of the units of measure.

Example 2

Refer to the graph below. Which of the following is true?

A. Areas C and E are smaller than area A, so demand must be elastic between $10 and $30.
B. Areas C and E are smaller than area A, so demand must be inelastic between $10 and $30.
C. Area F is smaller than areas B and C, so demand must be inelastic between $10 and $30.

Answer: C. Since at $30 the demand is unit elas...
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Subject 1. Utility Theory
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-14-demand-and-supply-analysis-consumer-demand
Utility refers to the total satisfaction received by a person from consuming a good or service.

  • Completeness. A person can compare any two bundles, A and B, in such a way that it leads to one of the three following results: (i) A is preferred to B, (ii) B is preferred to A, or (iii) A and B are the same (they are indifferent).
  • Transitivity. Consider any three bundles A, B, and C. If a person prefers A to B and also prefers B to C, she or he must prefer A to C.
  • Nonsatiation. Consider two bundles, A and B. A has more than B in every commodity and yet all these commodities are not economic "bads"; then a person will rank A higher than B.

Utility theory is a quantitative model of consumer preferences and is based on the above axioms. Consumer preferences can be represented by an ordinal utility function:

This is a mathematical expression that shows the relationship between utility values and every possible bundle of goods.

This ordinal - not cardinal - utility captures only ranking and not strength of preferences.
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Subject 2. Indifference Curves
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-14-demand-and-supply-analysis-consumer-demand
An indifference curve shows the combination of two products that provide an individual with a given level of utility (satisfaction). It is a curve, convex from below, that separates the consumption bundles that are more preferred by an individual from those that are less preferred. The points on the curve represent combinations of goods that are equally preferred by the individual. For example, the bundle at point A of 10 apples and 3 fish provides the same satisfaction as the bundle at point B of 6 apples and 5 fish.

Indifference curves provide a diagrammatic picture of how an individual ranks alternative consumption bundles.

  • More goods are preferable to fewer goods. Thus, bundles on indifference curves lying farthest to the northeast of a diagram are always preferred. For example, the bundle at C is clearly preferred to those points along the indifference curve and the bundle at point D is clearly inferior to those points along the curve.

  • Goods are substitutable. Therefore, indifference curves slope downward to the right.

  • The value of a good declines as it is consumed more intensively. Therefore, indifference curves are always convex when viewed from below. The slope of the indifference curve is equal to the marginal rate of substitution: the amount of one good that is just sufficient to compensate the consumer for the loss of a unit of the other good.

  • Indifference curves are everywhere dense. That is, an indifference curve can be drawn through any point on the diagram; any two bundles of goods can be compared by the individual.

  • Indifference curves for one consumer cannot cross. If they did, rational ordering would be violated and the postulate that more goods are better than fewer goods would be violated.

If two consumers have different marginal rates of substitution, they can both benefit from the voluntary exchange of one good for the other.
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Subject 3. The Opportunity Set
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-14-demand-and-supply-analysis-consumer-demand
Assume a world with only two consumer goods, X and Y. Px is the price of good X. X is also the quantity of good X that is purchased by the consumer. Px x X is the consumer's expenditure on good X.

Total expenditure is Px x X + Py x Y.

M is the consumer's income or budget. The consumer cannot spend more than her budget allows. Px x X + Py x Y <= M is the consumer's budget constraint.

To draw a budget constraint, a line that shows the maximum amount of goods a buyer can purchase with her available funds, you need to know two things: 1) how much money she has, and 2) the prices of the two goods being considered.

Assume a consumer has an income of $24. The two goods are rice (price: $2) and beans (price: $3).

This is the basic budget line. Its slope is an indication of relative prices ($2/$3).

This is when the price of rice decreases and the consumer can purchase more rice.

When income doubles, the line will shifts outward, parallel to the original constraint.

Similarly, a company's production opportunity set represents the greatest quantity of one product that a company can produce for any given amount of the other good it produces. The investment opportunity set represents the highest return an investor can expect for any given amount of risk undertaken.
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Subject 4. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-14-demand-and-supply-analysis-consumer-demand #subject-4-consumer-equilibrium-maximizing-utility-subject-to-the-budget-contraint
The budget constraint line separates consumption bundles that are attainable from those that are unattainable. A consumer will maximise utility by consuming on the highest possible indifference curve (i.e., we assume all income is spent). This is where an indifference curve is tangent to the highest possible budget line.

A consumer could consume at G, for example, but would be on a higher indifference curve at H. This means that to maximise utility the consumer would consume Q1 of product A and Q2 of product B.

The consumer is maximising utility where the budget line and indifference curve are tangent, i.e., MUB/MUA = PB/PA.

An Increase in Income

An increase in income shifts the budget line out parallel. The new combinations of products that maximise utility can be identified.

If this is a normal good, an increase in income increases the quantity demanded.

Inferior goods have a negative income elasticity of demand. Demand falls as income rises.

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Subject 5. Revisiting the Consumer's Demand Function
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-14-demand-and-supply-analysis-consumer-demand #subject-5-revisiting-the-consumers-demand-function
Indifference curve analysis lies behind a demand curve. It can be used to examine the effect of price changes and income changes.

If the price of B now falls, the budget line will pivot. The consumer now maximises utility consuming Q3 of product A and Q4 of product B. The fall in the price of product B has led to an increase in the quantity demanded of Q2Q4. This can be shown on a demand curve.

There are two different phenomena underlying a consumer's response to a price drop:

  • As the price of a product declines, the lower opportunity cost will induce consumers to buy more of it since it becomes less expensive - even if they have to give up other products. This is called the substitution effect.

    To isolate this effect diagrammatically, we move the new budget line inwards and parallel until it is tangent to the old indifference curve. The new slope reflects the new relative prices but the utility is the same as it was originally. The substitution effect is Q2Q6. The substitution effect will always lead to more of the relatively cheaper product being demanded.

  • With a fixed amount of money income, a reduction in the price of a product will increase a consumer's real income - the amount of goods and services consumers are able to purchase. Typically, consumers will respond by purchasing more of the cheaper products (as well as other products). This is called the income effect. The income effect is identified by shifting the budget line back outwards again. In this case, this leads to an increase in the quantity demanded of Q6 Q4.

The substitution and income effects will generally work in the same direction, causing consumers to purchase more as the price falls and less as the price rises. The indifference curve can be used to separate these two effects.

In the case of a normal good, higher real income leads to an increase in quantity demanded; this complements the increase due to the substitution effect. This change is shown in the diagram below.

In the case of an inferior product, the income effect leads to a fall in the quantity demanded, which will work against the substitution effect. In the following diagram the substitution effect is Q2 Q5; the income effect is Q5 Q4. However, the substitution effect outweighs the income effect and overall the quantity demanded rises. The overall change in quantity demanded results in an increase of Q2 Q4. This means the demand curve is downward-sloping, because a price fall increases the quantity demanded.

When a good is inferior and the income effect outweighs the substitution effect, it is called a Giffen good. This is, however, unlikely, because the substitution effect is almost always stronger than the income effect.

Another exception is the case where an increase in price causes an increase in demand. This results in an upward-sloping demand curve, and...
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Subject 1. Types of Profit Measures
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
Accounting Profit

Accounting profit is the profit used by accountants to determine a firm's net income.

Accounting profit = Total revenue - Total accounting costs

Economic profit equals a firm's total revenue minus its total opportunity costs of production.

Economic profit = Total revenue - Total opportunity costs

The total opportunity costs include both explicit and implicit costs of all the resources used by a firm. Implicit opportunity cost is the unearned or nominal profit that the resource-owner did not make from investing in the next best alternative. As a result, you can have a significant accounting profit with little to no economic profit.

Example

Suppose a person uses his own resources, land, capital, and time in the production of goods. The opportunity costs of these resources are shown below:
Accounting Profit = $55,000
Entrepreneur's own forgone salary = $40,000
Foregone interest on capital = $1,000
Foregone rent = $2,000
Economic Profit = 55,000 - 40,000 - 1,000 - 2,000 = $12,000

For publicly traded corporations, economic profit is accounting profit - required return on equity capital.

When economic profit is zero, a firm's accounting profit becomes normal profit, which is effectively the total implicit opportunity cost.

Accounting profit = Economic profit + Normal profit

When a firm's total revenues are just equal to its total costs, its economic profit is zero, but it still makes accounting profit. Zero economic profit does not mean that the firm is about to go out of business. Instead, it just indicates that the owners are receiving exactly the market (normal) rate of return on their investment.

Economic Rent

The total income received by an owner of a factor of production is made up of its economic rent and its opportunity cost.

  • Economic rent is the income received by the owner of a factor of production over and above the amount required to induce that owner to offer the factor for use.
  • The opportunity cost of using a factor is the income required to induce its owner to offer the resource for use, which is the value of the factor in its next best use.

The following figure illustrates the division of a factor income into economic rent and opportunity cost.

The portion of income comprised of economic rent depends upon the elasticity of supply for the factor.

  • The less elastic the supply for a factor, the greater the share of income that is comprised by economic rent. When the supply is perfectly inelastic, all of the income is economic rent.

  • The more elastic the supply for a factor, the smaller the share of income that is economic rent. When the supply is perfectly elastic, none of the income is economic rent.

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Subject 2. Total, Average, and Marginal Revenue
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
Revenue is the income generated from the sale of output in product markets.

  • Total revenue (TR) is the sum of individual units sold multiplied by their respective prices:
  • Average revenue (AR) =
  • Marginal revenue (MR) is the change in revenue from selling one extra unit of output:

In a perfectly competitive market, each firm is a price taker. Since each unit of output sold by a price taker is sold at the market price, the MR for each unit is also equal to the market price, i.e., P = MR.

Under imperfect competition, a firm's marginal revenue is always less than the price of its good. Why? As the firm reduces price in order to expand output and sales, there will be two conflicting influences on total revenue.

  • The increase in sales due to the lower price will, by itself, add to the revenue of the monopoly.
  • The price reduction, however, also applies to units that would otherwise have been sold at a higher price. This factor itself will cause a reduction in total revenue.

These two conflicting forces will result in marginal revenue - the change in total revenue - that is less than the sales price of the additional units. Thus, the marginal revenue curve of the firm will always lie below the firm's demand curve, which is also the market's demand curve.

TR is maximized when MR = 0.
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Subject 3. Cost Measures
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
Factors of Production

A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. Such factors include land, labor, capital, and materials.

The total product curve shows how total product changes with the quantity of variable input employed.

As more and more units of a variable resource are combined with a fixed amount of other resources, employment of additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit.

The law of diminishing returns basically explains the old adage: "too many cooks spoil the broth," or too much of a good thing is bad.

Total, Average, Marginal, Fixed, and Variable Costs

To produce more output in the short run, the firm must employ more variable inputs, which means that it must increase its costs. In the short run, a firm's total costs (TC) can be broken down into two categories: fixed costs and variable costs (TC = TFC + TVC). Which costs are fixed and which costs are variable depends on the time horizon being dealt with. For a short time horizon, most costs are fixed. For a long time horizon, all costs are variable.

  • Total Fixed Cost. The sum of the costs that do not vary with output. They will be incurred as long as a firm continues in business and the assets have alternative uses. Examples of fixed costs include rent, property taxes and insurance premiums.

  • Average Fixed Cost. Total fixed cost divided by the number of units produced. It always declines as output increases.

  • Total Variable Cost. The sum of those costs that rise as output increases. Total variable costs are zero if output is zero. Examples are wages paid to workers and payments for raw materials.

  • Average Variable Cost. The total variable cost divided by the number of units produced.

  • Average Total Cost. Total cost divided by the number of units produced. It is sometimes called per unit cost.

    ATC is high at low levels of output, decreases as output increases (since fixed costs are spread across more units), and then increases as the firm's maximum capacity is approached (since marginal costs increase).

  • Marginal Cost. The change in total cost required to produce an additional unit of output.

    The law of diminishing returns implies that the marginal costs of producing each additional unit will increase by increasing amounts. Initially, as output expands, the cost of producing each additional unit of output falls, but then begins to rise as the firm approaches its maximum capacity (e.g., too many workers, congested production lines).

Over the output range with increasing marginal returns, marginal cost falls as output increases. Once a firm confronts diminishing returns, larger and larger additions of the variable factor are required to expand output by one unit. This will cause marginal cost (MC) to rise. As MC continues to increase, eventually it w...
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Subject 4. Shutdown Analysis
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
For a price taker (a firm in a perfectly competitive market):

Profit = Total Revenue - Total Cost = (Price - Average Total Cost) x Quantity

However, maximum profit is not always a positive economic profit. In the short run, the firm might break even (making a zero economic profit), make an economic profit, or incur an economic loss.

1. If the price equals minimum average total cost, the firm breaks even and makes a normal profit.

2. The ATC of producing each of q2 units is labeled as c1.

c1BAP indicates the economic profit being made by this firm. The firm is making a profit since the price per unit exceeds the ATC per unit and the total revenue exceeds the total costs.

3. What would happen to profits if the price fell to below the ATC curve?

The firm therefore will produce q1 units of output, as shown where MC = MR. At q1, the firm can only charge P per unit, and yet the ATC per unit is higher, at c2. This means that the firm is making a total economic loss equal to the shaded area, PBAc2, or the distance of c2 to P per unit.

If the firm's current sales revenues can cover its variable cost, and the firm anticipates that the lower market price is temporary, it will continue to operate and will face short-run economic losses. It will produce the quantity at which MC = P. This option is better than "shut down" since the firm is able to cover its variable costs and pay some of its fixed costs. If it were to shut down, the firm would lose the entire amount of its fixed costs.

The shutdown point is the output and price at which the firm just covers its total variable cost.

  • This point is where average variable cost is at its minimum.
  • It is also the point at which the marginal cost curve crosses the average variable cost curve.
  • At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action.

If the market price is below the firm's average variable cost, a temporary shutdown is preferable to short-run operation. If the firm continues to operate, operating losses merely add to losses resulting from the firm's fixed costs. Shutdown will reduce losses.

The Firm's Short-Run Supply Curve

The price taker that intends to stay in business will maximize profits (or minimize losses) when it produces the output level at which P = MC AND variable costs are covered. At this output level, the price taker can maximize its profits or minimizes its losses. Therefore, the portion of the firm's short-run marginal cost curve that lies above its average variable cost is the short-run curve of the firm.

In the above graph, if price is below P1, the firm should be shut down.
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Subject 5. Economies of Scale and Diseconomies of Scale
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
Short-Run Cost and Long-Run Cost

The short-run analysis relates costs to output for a specific size of plant. In the long-run, all resources used by the firm are variable.

For each plant size, there is a set of short-run, U-shaped costs curves for MC, AVC, and ATC. This diagram shows the ATC curves of three (of many) possible plant sizes: small, medium, and large.

Using this information, firms can plan, when in their blueprint stages, the optimal plant size they should be relative to the output they want to produce. For example, if a firm wanted to produce more than Q1 units of output, it would make sense to build a large firm, since costs per unit would be less than they would be with a small or medium firm.

Long-Run Average Cost Curve

To explain this process, imagine the output level Q2. Looking at the relevant costs on the vertical axis, the large firm is far cheaper per unit than both the small and medium-sized firms.

Thus, should a firm be planning for output in excess of Q1, a large firm should be built. For levels of output between Q0 and Q1, it would be cheaper per unit if the firm was of a medium size.

  • If a firm is planning to produce less than Q0 units, a small firm would be best.
  • For output between Q0 - Q1 units, a medium firm is preferable.
  • For output in excess of Q1 units, a large firm is preferable

The long-run average total cost curve is indicated in black.

It shows the minimum average cost of producing each output level when the firm is free to choose among all possible plant sizes. It can best be thought of as a planning curve, because it reflects the expected per-unit cost of producing alternative rates of output while plants are still in the blueprint stage. No single plant size could produce the alternative output rates at the costs indicated by the planning curve.

In reality, there are an infinite number of firm sizes:

Economies and Diseconomies of Scale

Economies of scale are reductions in the firm's per-unit costs that are associated with the use of large plants to produce a large volume of output. They are present over the initial range of outputs when the long-run ATC curve is falling. There are three reasons why economies of scale exist:

  • Mass production is more economical.
  • Specialization of labor and equipment improves productivity.
  • Workers at a larger firm tend to learn more from their experience.

Diseconomies of scale are situations in which the long-run average total costs are greater in larger firms than they are for smaller firms. They are possible: as a firm gets bigger and bigger, bureaucratic inefficiencies may result. Principal-agent problems grow; they are prese...
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Subject 6. Profit Maximization
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.

  • Total cost is the opportunity cost of production, which includes normal profit.
  • Under perfect competition, a firm's total revenue equals price, P, multiplied by quantity sold, Q, or P x Q.

Marginal revenue is the addition to total revenue earned by a firm when one more unit of output is sold: MR = ΔTR/ΔQ. Since each unit of output sold by a price taker is sold at the market price, the MR for each unit is also equal to the market price, i.e., P = MR.

MR plotted against quantity sold would thus yield the same curve as P plotted against quantity sold (i.e., the demand curve) for the price taker.


We say that the MR curve of a price taker lies on the demand curve of a price taker.

There are three approaches to calculating the point of profit maximization in the short run. All three approaches yield the same profit-maximizing quantity of output.

MC = MR Approach

Produce that quantity of output where: MC = P = MR

  • Each unit of output produced and sold by a price taker will generate revenue that equals the market price of the product (MR).
  • However, due to the law of diminishing returns, as output increases, costs per unit will eventually also begin to increase (MC).
  • The profit-maximizing quantity of output occurs where MC = MR = P.

Here are two familiar curves: the MC curve and the MR curve of a certain firm. Note that the MC curve clearly illustrates the Law of Diminishing Returns. Given this information, what quantity of output should this profit-maximizing price taker produce?

What about producing q1 units?

Can you see that at q1, MR exceeds MC by the distance shown by the arrow? This means that the revenue received from the sale of that unit would exceed the cost of its production, so it would be profitable for the firm to produce that unit. But would the firm be maximizing its profits, or should the firm produce more?

What about producing q2 units?

MR still exceeds MC, shown by the distance of the arrow. This means that the revenue received from the sale of unit q2 also exceeds its cost of production, so the firm would make even more profit if it produced that unit too.

But would the firm be maximizing its profits? Could the firm produce still more units?

At q3, the MR earned from the sale of the unit is equal to the MC involved in producing the unit, so unit q3 generates neither a profit nor a loss for the firm.

If the firm produced more than q...
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Subject 7. Productivity
#cfa #cfa-level #economics #has-images #microeconomics #reading-15-demand-and-supply-analysis-the-firm
Average product and marginal product, which are derived from total product, are key measures of a firm's productivity.

  • Total Product. The total output of a good associated with alternative utilization rates of a variable input. It increases as more and more units of the variable input are used.
  • Marginal Product. The increase in the total product as a variable input increases by one extra unit.
  • Average Product. The total product divided by the number of units of the variable input used in production.

Law of Diminishing Returns

The total product curve shows how total product changes with the quantity of variable input employed.

As more and more units of a variable resource are combined with a fixed amount of other resources, employment of additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit.

The law basically explains the old adage: "too many cooks spoil the broth," or too much of a good thing is bad. As a single resource is applied more intensively, the resource eventually tends to accomplish less and less. Essentially, this is a constraint imposed by nature.

Let's use labor as the input. Initially, hiring more laborers may mean more productive use of machines, which were underutilized. Output may thus initially increase. After a while, the firm may have hired too many laborers, given the number of machines. There may be overcrowding on the work floor and mistakes may result, causing productivity to fall whilst costs will increase.

As units of variable input are added to a fixed input, total product will increase, first at an increasing rate and then at a declining rate. This will cause both marginal and average product curves to rise at first and then decline. Note that the marginal product curve intersects the average product curve at its maximum. The smooth curves indicate that the input can be increased by amounts of less than a single unit.

Profit Maximization

Firms demand labor, amongst other factors, to produce goods and services. The Marginal Revenue Product (MRP) of labor is the change in the total revenue of a firm that results from the employment of one additional unit of labor. The marginal revenue product of an input is equal to its marginal product multiplied by the marginal revenue of the good or service produced: MRP = MP x MR, where

  • Marginal Product (MP) is the change in total output that results from the employment of one additional unit of labor.
  • Marginal Revenue (MR) is the change in a firm's total revenue that results from the production and sale of one additional unit of output.

Because of the law of diminishing returns, the marginal product of labor will fall as employment of the labor expands, and thus the marginal revenue product of labor will also fall as employment expands.

The firm has two equivalent conditions for maximizing profit. They are:

  • Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals the wage rate (W).
  • Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC).

Why?

MRP = W => MP x MR = W => MR = W/MP, since W/MP = MC => MR = MC.

This relationship indicates why wage differences across skill categories will tend to reflect product...
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Subject 1. Characteristics of Different Market Structures
#cfa #cfa-level #economics #microeconomics #reading-16-the-firm-and-market-structures
A financial analyst must understand the characteristics of market structures to better forecast a firm's future profit stream.

We focus on those characteristics that affect the nature of competition and pricing. They are:

  • The number of firms (including the scale and extent of foreign competition).
  • The extent of product differentiation (which affects cross-price elasticity of demand).
  • The pricing power of seller(s). Can a firm influence the market price?
  • Barriers to entry. Exit costs should also be considered.
  • Non-price competition such as product differentiation.

The characteristics of each market structure will be discussed in subsequent subjects of this reading.
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Subject 2. Perfect Competition
#cfa #cfa-level-1 #economics #has-images #microeconomics #reading-16-the-firm-and-market-structures
An industry with perfect competition displays the following characteristics:

  • All the firms in the market are producing an identical product (e.g., wheat of the same grade).
  • No barriers limit the entry or exit of firms in the market.
  • A large number of firms exist in the market. Established firms have no advantages over new ones.
  • Sellers don't have market-pricing power.
  • There is no non-price competition.

Perfect competition arises:

  • When a firm's minimum efficient scale is small relative to market demand so there is room for many firms in the industry, and
  • When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don't care which firm they buy from.

The demand analysis in perfectly competitive markets is covered in Reading 13.

The supply analysis, optimal price and output, and long-run equilibrium in perfectly competitive markets are covered in Reading 15.

In perfect competition, each firm is a price taker. Price takers are sellers who must take the market price in order to sell their products.

  • There is no price decision to make: they will merely attempt to choose the output level that will maximize profit.
  • Each price taker's output is small relative to the total market: the output of a firm exerts little or no effect on the market price.

This diagram represents the market demand and supply curve for a certain product - for example, eggs.

As usual, the intersection of the demand and supply curve creates the market price (P) per egg. Now remember that a firm that is a price taker can sell all it wants to at that price, but can sell nothing at a higher price.

Price takers can sell all their output at the market price, but they are unable to sell any of their output at a price higher than the market price. That is, a price taker faces a horizontal demand curve. Each firm's output is a perfect substitute for the output of the other firms, so the demand for each firm's output is perfectly elastic.

  • They can sell as much as they would like at the going market price.
  • There is no need for them to reduce their price in order to sell more.
  • Moreover, at any price above the market price there is no demand; their sales would be zero (nobody would buy from that firm because there are so many other firms from which to obtain the product at the market price).
  • This reflects the fact that perfectly competitive firms have no control over their price.

When a perfectly competitive market is in long-run equilibrium:

  • Quantity supplied and quantity demanded must be equal in the market.
  • Firms in the market must earn zero economic profit at the prevailing market price (that is, firms are earning the "normal rate of return"). This occurs when market price = marginal revenue = marginal cost = minimum ATC. Note that accounting profits may still be positive.

Why do firms earn zero economic profit in the long-run equilibrium?

  • If firms earn positive economic profit in the long-run equilibrium, these firms will have an incentive to expand their capacity, and new firms will enter the market. This will lead to an increase in supply, forcing the market price down
...
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Subject 3. Monopolistic Competition
#cfa #cfa-level #economics #has-images #microeconomics #reading-16-the-firm-and-market-structures
A monopolistic market is also called a competitive price searcher market.

Characteristics are:

  • A large number of firms. This is due to low entry barriers and causes intense competition in these markets. Firms face competition from existing firms and potential entrants to the market.

  • Firms produce differentiated products. This means that each firm makes a product that is slightly different from the products of competing firms. This is the most distinctive characteristic of such a market.

  • Low entry barriers. Entry into and exit from the market are relatively easy. Sellers in competitive price searcher markets face competition both from firms already producing in the market and from potential new entrants into the market. If profits are present, firms can expect that new rivals will be attracted. Because of the low entry barriers, competitive forces will be strong in monopolistic markets, and firms cannot earn an economic profit in the long run.

  • Competition on quality, price, and marketing. Demand is not simply given for a monopolistic competitor. The firm has some pricing power and can alter the demand for its products by changing product quality (design, reliability and service), location and by advertising. The firm faces a downward-sloping demand curve. This demand curve is highly elastic because good substitutes for a firm's output are readily available from other suppliers.

Consider two hamburger companies: McDonald's and Burger King.

  • Both firms are producing burgers but customers view them as differentiated.
  • If McDonald's increases the price of its burger, it will not lose all its customers, as some will continue to pay the higher price, preferring McDonald's.
  • Thus, differentiation explains the downward-sloping demand curve. The more firms producing burgers (substitutes), the more elastic McDonald's demand curve will be, since the greater the decrease in quantity demanded as price increases.

The Firm's Short-Run Output and Price Decision

As with price takers, monopolistic competitors maximize profits by expanding output to where MR = MC.

A firm in monopolistic competition operates much like a single-price monopolist.

According to the demand curve, the firm can charge P1 per unit.

  • The total revenue earned is the shaded area 0P1AQ1.
  • The total cost is the shaded area 0CBQ1.
  • It earns an economic profit (as in this example) when P > ATC. The total profit is thus the difference between total revenue and total costs, and is given by the shaded area CP1AB.

A firm might incur an economic loss in the short run when P < ATC.

Long Run: Zero Economic Profit

Whenever firms can freely enter and exit a market, profits and losses play an important role in determining the size of the industry. Economic profits will attract new competitors to the market and economic losses will cause competitors to exit from the market. In the short run, a price searcher may make either economic profits or losses, depending on market conditions. As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward.

The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell...
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Subject 4. Oligopoly
#cfa #cfa-level #economics #has-images #microeconomics #reading-16-the-firm-and-market-structures

Literally, oligopoly means "few sellers." This market structure is characterized by:

  • A small number of rival firms. The firms are interdependent because each is large relative to the size of the market. The decisions of a firm often influence the demand, price, and profit of rivals, and an oligopolist must consider the potential reaction of rivals.

  • High entry barriers into the market. Either natural or legal barriers to entry can create oligopoly.

    • Economies of scale are probably the most significant entry barrier here. Achieving minimum per-unit cost is required, and thus a small number of large-scale firms will be able to produce the entire market demand for the product. This is what distinguishes an oligopoly from a monopolistic competitive market.
    • A legal oligopoly might arise even where demand and costs leave room for a larger number of firms.

In short, an oligopoly is competition among the few.

Pricing Strategies

  • Like a monopolist, an oligopolist faces a downward-sloping demand curve and seeks to maximize profit, not price.
  • Unlike a monopolist, an oligopolist cannot determine the product price that will deliver maximum profit simply by estimating market demand and cost conditions.

A key factor here is the pricing behavior of close rivals, or interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market when making pricing decisions. Because the reactions of those rivals cannot be determined, the precise price and output that will emerge under an oligopoly cannot be determined. Only a potential range of prices can be indicated.

There are three basic pricing strategies.

1. The assumption of pricing interdependence is that firms will match a price reduction and ignore a price increase. The idea is that if a firm raises prices, other firms won't follow, because they won't worry about losing market share to a firm that is raising its prices. However, if the firm lowers its prices, other firms will respond by lowering their prices also, since they don't want to lose market share.

The demand curve that a firm believes it faces has a kink at the current price P and quantity Q.

The kinked demand curve can be thought of as two demand curves.

  • Above the price P, an individual firm is afraid of putting up prices. A price increase would, it assumes, not be matched by competitors, hence the demand curve above P is elastic. It will be remembered that if demand is elastic and price rises, revenue falls.
  • Similarly, a price fall has the same effect on revenue. This time the firm imagines that dropping its own price leads to others dropping theirs. Overall, quantity demand increases as the demand curve slopes down, but the increase is less than proportionate. That is the demand curve below price P is inelastic.

The kink in the demand curve means that the MR curve is discontinuous at the current quantity - shown by the gap AB in the figure.

Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.

For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit-maximizing price and quantity would not change.

The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact. If MC increases enough, all firms raise their prices and the kink vanishes.

2. The assumption of the Cournot...
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Subject 5. Monopoly
#cfa #cfa-level #economics #has-images #microeconomics #reading-16-the-firm-and-market-structures
Literally, monopoly means "single seller." It is a market structure characterized by:

  • High entry barriers.
  • A single seller of a well-defined product for which there are no good substitutes.

Barriers to entry include legal or natural constraints that protect a firm from potential competitors.

  • Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a:

    • Public franchise. The U.S. Postal Service franchises to deliver first-class mail.
    • Government license. Licensing is a requirement that one obtain permission from the government in order to perform certain business activities or work in various occupations. It limits entry and restricts the right to buy and sell goods. Sometimes these licenses cost little and are designed to ensure certain minimum standards. In other cases, they are expensive and designed primarily to limit competition. For example, in many U.S. states a license is required for operating a taxi.
    • Patent and copyright. The entry barrier created by the grant of a patent generally leads to higher consumer prices for products that have already been developed. On the other hand, the absence of patent protection might well lead to a slowdown in the pace of technological innovation.

  • Natural barriers to entry (for example, economies of scale) create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. In some industries, larger firms will always have lower unit costs. It will be difficult for small firms to enter the market, build a reputation, and compete effectively. Economies of scale tend to eventually result in the market being dominated by one large firm.

  • Other barriers, such as strong brand loyalty or the increasing returns associated with network effects.

Demand and Supply Analysis

A monopoly faces no competition, and as a result there is no product differentiation. It is a price setter, not a price taker like a firm in perfect competition. Because the monopoly is the only seller in the market, the demand for its product is the market demand curve. It is downward-sloping because demand will decline as price increases.

Marginal Revenue and Price

A monopoly must choose between lower prices with larger quantities sold and higher prices with smaller sales. Although a monopoly can set the price for its products, market forces will determine the quantity sold at alternative prices. To maximize profit, a monopoly must estimate the relationship between price and the quantity of its products demanded.

As the monopoly reduces price in order to expand output and sales, there will be two conflicting influences on total revenue.

  • The increase in sales due to the lower price will, by itself, add to the revenue of the monopoly.
  • The price reduction, however, also applies to units that would otherwise have been sold at a higher price. This factor will cause a reduction in total revenue.

These two conflicting forces will result in marginal revenue - the change in total revenue - that is less than the sales price of the additional units. Thus, the marginal revenue curve of the monopoly will always lie below the firm's demand curve, which is also the market's demand curve:

MR < P

The following example illustrates this concept.

Portico produces beauty soaps.

  • If Portico charges $10 for each bar of soap, the demand will be only 1
...
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Subject 6. Price Discrimination
#cfa #cfa-level #economics #has-images #microeconomics #reading-16-the-firm-and-market-structures
Price discrimination is a practice whereby a seller charges different consumers different prices for the same product or service. It converts consumer surplus into economic profit.

  • In first-degree price discrimination each consumer is charged the maximum he is willing to pay. Consumer surplus is nil, while producer surplus is maximized. The output is the same as in a competitive market.
  • In second-degree price discrimination, prices vary across units but not people. Consumers self-select into consumption groups and seek the largest surplus.
  • In third-degree price discrimination, consumers are segregated by demographic or other traits. Prices are determined by the demands of each group.

When sellers can segment their market (at a low cost) into groups with differing price elasticities of demand, price discrimination can increase profits. For each group, the seller will maximize profit by equating marginal cost and marginal revenue. The number of units sold also increases because the discounts provided to price-sensitive groups increase the quantity sold more than the higher prices charged the less price-sensitive groups reduce sales.

Imagine that the MC per unit for a monopoly is constant at $60, producing a horizontal MC curve, as shown below.

The firm produces where MC = MR. It thus produces 100 units and charges $200 per unit. Total revenue (price x quantity) for the firm is thus: $200 x 100 = $20,000. Total costs (cost per unit x quantity) are: $60 x 100 = $6,000. Total profit is thus: $20,000 - $6,000 = $14,000.

Imagine that this firm is an airline and that it now decides to increase its profits using price discrimination. It identifies two groups of people: businessmen, who are fairly price-inelastic, and students, who are fairly price-elastic (responsive to changes in price). By increasing the price of businessmen's tickets and decreasing the price of student's tickets, it can increase its total revenue and thus increase its profit.

The airline starts by doubling the price of businessmen's tickets to $400. By equating the businessmen's MR curve to the MC curve (for simplicity, the MR curve is not shown), the airline finds that the quantity demanded decreases, but by relatively little, given the large increase in price, to 60 tickets.

Next, it equates MC to the students' MR curve and finds that it can decrease the price of students' tickets from $200 to $150, whilst the quantity demanded increases to 150 tickets. (Note: for simplicity, the students' MR curve is not shown).

Therefore, the total revenue is as follows: $400 x 60 + $150 x 150 = $46,500.
Total costs are: $60 x 60 + $60 x 150 = $12,600.
Total profits are thus: $46,500 - $12,600 = $33,900.

This is more than the $14,000 profit the firm made in the absence of price discrimination.

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Subject 7. Identification of Market Structure
#cfa #cfa-level #economics #microeconomics #reading-16-the-firm-and-market-structures
Measuring market power is complicated. Ideally, econometric estimates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elasticity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures.

The N-firm concentration ratio is the percentage of market output generated by the N largest firms in the industry. The ratio is used as an indicator of the relative size of firms in relation to the industry as a whole. It may also assist in determining the market form of the industry. The larger the measure of market concentration, the less competition exists in the industry.

The concentration ratio is simple to compute. However, it does not directly quantify market power, meaning it does not take the possibility of entry into account. Another disadvantage is that it ignores mergers among the top market players.

The Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman index is the sum of the squared market shares of the top N largest firms in the industry.

H = M12 + M22 + M32 + ... + MN2

where Mi is the market share of an individual firm.

Suppose there are a total of four firms in a specific industry. Three firms have a 20% share each and one has a 40% market share, H = 0.202 + 0.202 + 0.202 + 0.402 = 0.28.

The advantages of the Herfindahl index are that it reflects more firms in the industry and it gives greater weight to the companies with larger market shares.

Properties of the Herfindahl index:

  • It is always smaller than or equal to 1. In a monopoly, the HHI is 1.
  • One can classify the competition structure of a market based on this ratio. For example,

    • An H below 0.1 indicates a competitive market.
    • An H of 0.1 to 0.18 indicates moderate competitive.
    • An H above 0.18 indicates uncompetitive.

  • If all firms have an equal share, H = N x (1/N)2 = 1/N. Note that the reciprocal of the index shows the number of firms in the industry.
  • When the firms have unequal shares in the industry, the reciprocal of the index indicates the "equivalent" number of firms in the industry. Using the above example, the market structure is equivalent to having 1/0.28 = 3.57 firms of the same size.

Limitations: HHI fails to consider barriers to entry and firm turnover. For example, for some industries, few firms may be currently operating in the market but competition might be fierce, with firms regularly entering and exiting the industry. Even potential entry might be enough to maintain competition.
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Subject 1. Gross Domestic Product
#cfa #cfa-level-1 #economics #macroeconomics #reading-17-aggregate-output-and-economic-growth
Gross Domestic Product (GDP) is the total market value of all domestically produced final goods and services for a particular year. Its five key factors are: market value, final goods and services, produced, within a country, during a specific time period.

  • Only final goods and services count; GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded, to avoid double-counting. Their value is embodied in the value of the goods purchased by the end user.

  • GDP is a flow variable; it measures the market value of production that flows through the economy.

  • Financial transactions and income transfers (e.g., social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production.

  • GDP counts only goods and services produced domestically, whether by citizens or foreigners.

  • It includes only goods produced during the current period. Thus, sales of used goods are not counted in GDP. However, sales commissions count toward GDP because they involve services provided during the period.

Government services and household production are estimated and included in the GDP. Activities occurring in the underground economy, although sometimes productive, are not included in GDP.

Nominal and Real GDP

When comparing GDP across time periods, we confront a problem: the nominal value of GDP may increase as the result of either expansion in the quantities of goods produced or higher prices. Since the former will improve our living standards, we have to adjust the nominal values (nominal GDP, or money values) for the effects of inflation to get real values (real GDP).

A price index is used for the adjustment. It measures the cost of purchasing a market basket or bundle of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference period (e.g., a base year).

Consumer price index (CPI) (not included in the required reading) is an indicator of the general level of prices. It attempts to compare the cost of purchasing the market basket bought by a typical consumer during a specific period with the cost of purchasing the same market basket during an earlier period. The CPI is better at determining how rising prices affect the money income of consumers. The CPI is more widely used for price changes over time.

The GDP deflator is a price index that reveals the cost during the current period of purchasing the items included in GDP relative to the cost during a base year. Because the base year is assigned a value of 100, as the GDP deflator takes on values greater than 100, it indicates that prices have risen. It is a broader price index than the CPI since it is better at giving an economy-wide measure of inflation. It is designed to measure the change in the average price of the market basket of goods included in GDP. In addition to consumer goods, the GDP deflator includes prices for capital goods and other goods and services purchased by businesses and governments. The GDP deflator also allows the basket of goods to change as the composition of GDP changes, while the CPI is computed using a fixed basket of goods.

We can use the GDP deflator together with nominal GDP to measure the real GDP (GDP in dollars of constant purchasing power).

Real GDPi = Nominal GDPi x (GDP Deflator for base year/ GDP Deflator for year i)

Suppose the nominal GDPs in 1992 and 2010 were $6244 and $8509 billion dollars, respectively. This amount has increased by 36.3%. The GDP deflator for 1992 and 2010 was 100 and 112.7, respectively. The re...
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Subject 2. The Components of GDP and Related Measures
#cfa #cfa-level-1 #economics #macroeconomics #reading-17-aggregate-output-and-economic-growth
GDP is a measure of both output and income. The revenues that firms derive from the sale of goods and services are paid directly to resource suppliers in the form of wages, self-employment income, rents, profits, and interest.

There are two ways of measuring GDP. GDP derived by these two approaches will be equal.

The expenditure approach totals the expenditures spent on all final goods and services produced during the year. Under this approach, GDP is a measure of aggregate output. There are four components of GDP under this approach:

  • GDP = C + I + G + (X - M)
  • C (personal consumption expenditures): This is the largest component with this approach: durable goods, non-durable goods, and services.
  • I (gross private domestic investment): The flow of private sector expenditures on durable assets plus the addition to inventories during a period. It is the production or construction of capital goods that provide a flow of future service. It indicates the economy's future productive capacity.
  • G (government consumption and gross investment): Government purchases, not including transfer payments. It includes both (1) expenditures on such items as office supplies, law enforcement, and the operation of veteran hospitals and (2) the capital purchase of long-lasting capital goods such as missiles, highways, and dams for flood control. Government expenditures, which include transfer payments like social security, are not equal to government consumption.
  • E - M (net exports to foreigners): This is exports minus imports. Exports are domestically produced goods and services sold to foreigners. Imports are foreign-made goods and services purchased by domestic consumers, investors and governments. When measuring GDP using the expenditure approach, we must add exports and subtract imports. Net exports may be either positive or negative.

GDP can be measured either from the value of the final output or by summing the value added at each stage of the production and distribution process. The sum of the value added by each stage is equal to the final selling price of the good.

Under the income approach, GDP is a measure of aggregate income. It is calculated by summing the income payments to resource suppliers and the other costs of producing those goods and services. It includes employee compensation (wages and salaries), self-employment income, rents, profits and interest, etc. Employee compensation is the largest source of income generated by the production of goods and services.

Personal income is the total income received by domestic households and non-corporate businesses. It is available for consumption, saving, and payment of personal taxes. Personal disposable income is an individual's available income, after personal taxes are paid, that can be either consumed or saved.
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Subject 3. Aggregate Demand
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-17-aggregate-output-and-economic-growth
Aggregate demand (AD) is the quantity of goods and services that households, businesses, and foreign customers want to buy at any given level of prices.

The IS Curve

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

  • Consumption (C) is a function of disposable income. Consumption increases when income(Y) increases and/or taxes decrease.

    The marginal propensity to consume (MPC) is defined as additional current consumption divided by additional current disposable income. The marginal propensity to save (MPS) = 1 - MPC.

  • Investment spending depends on the interest rate (i) and output/income level.

  • Government purchases are assumed to be unrelated to both interest rates (i) and income (Y). Although tax policy is also considered an exogeneous variable, the actual taxes collected depend on income (Y) and are therefore endogenous. The government's deficit (G - T) increases as income decreases and vice versa.

  • Net exports (X - M) depends on relative income and prices between the domestic country and the rest of the world.

We can also derive the following equation, which shows that domestic saving has three uses: investment, government deficits, and trade surplus:

S = I + (G - T) + (X - M), where S is domestic saving.

If we combine these relationships together we can derive the IS curve: the combination of GDP (Y) and the real interest rate (i) such that aggregate income/output equals planned expenditures.

Note that there is an inverse relationship between income and the real interest rate. For example, when interest rates are high, investment falls and therefore Y must fall as well.

Note that changes in Y caused by changes in i are reflected as movements along the IS curve. On the other hand, changes in Y that are brought about by factors other than interest rates will cause Y to change, regardless of the level of interest rates in the economy. For example, changes in government purchases will not change the slope but will change the intercepts; in other words, they will cause the IS curve to shift.

The LM Curve

The IS curve depicts combinations of interest rates and output that clears markets for goods and services. The IS curve by itself does not pin down the interest rate that prevails in the economy. In order to do so, we look at the money market. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply.

The quantity theory of money: MV = PY, where V is the velocity of money.

  • When interest rates (i) are high, the demand for money is low because money pays no interest; the opportunity cost of holding money rises.
  • When Y is high, the demand for money is high; richer people buy more goods and are likely to hold more money.
  • When P is hig,h the demand for money is high because we need more money to buy goods.

When the money market is in equilibrium, money supply = money demand. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply. It is an upward-sloping relationship between i and Y.

Intuitively, we can explain the upward-sloping LM curve as follows: Let's consider some combination of income and interest rates that equates money demand with the money supply set by the Fed. Now suppose there is ...
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Subject 4. Aggregate Supply
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-17-aggregate-output-and-economic-growth
The aggregate quantity of goods and services supplied depends on three factors: labor (L), capital (K), and the state of technology (T).

Y = F (L, K, T)

The aggregate supply curve (AS) represents the relationship between the quantity of goods and services supplied and the price level. It is important to distinguish between long-run aggregate supply and short-run aggregate supply.

The short-run aggregate supply curve typically slopes upward to the right. In the short run, some prices (e.g., rents, wages) are temporarily fixed as the result of prior commitments. Therefore, firms will expand outputs as the price level increases because higher prices will improve profit margins. Short-run equilibrium occurs when the aggregate quantity of goods and services demanded is equal to the aggregate quantity supplied.

The long-run aggregate supply curve is vertical. In the long run, people have sufficient time to alter their behavior to adjust fully to price changes. The sustainable level of output is determined by a nation's resource base, technology, and the efficiency of its institutional factors. The price level has no effect on a nation's long-run aggregate supply. In long-run equilibrium, current output (Yfull) will equal the economy's potential GDP, the economy is operating at full employment, and the actual rate of unemployment will equal the natural rate of unemployment.

Aggregated demand and supply determine the level of real GDP and the price level of a nation.

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Subject 5. Shifts in Aggregate Demand and Supply
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-17-aggregate-output-and-economic-growth
Factors that Shift Aggregate Demand

At each price level, the AD curve shifts to the right due to changes in C, I, G, and X.

  • An increase in real wealth: greater wealth increases the demand for all goods.
  • Increased optimism about the future: both current consumption and investment increase.
  • High capacity utilization: companies have to increase investment spending to expand production.
  • Expanding fiscal policy: higher government spending and lower taxes will increase G and C.
  • An increase in money supply: higher income and expenditure.
  • A lower interest rate - when borrowing is cheaper, investment increases; consumption is cheaper with a lower interest rate.
  • A decrease in exchange rate: increases export demand.
  • Growth in the global economy: increases export demand.

And vice versa.

Factors that Shift Aggregate Supply

We need to differentiate between the long-run and short-run effects.

Increases in short-run aggregate supply (SRAS) that don't affect long-run aggregate supply are caused by:

  • A decrease in resource prices/production costs (e.g., nominal wages, input prices). Unless the lower prices of resources reflect a long-term increase in the supply of resources, they will not alter LRAS.
  • A reduction in the expected rate of inflation. If high inflation is expected, suppliers would like to reduce supplies now to sell them at higher prices later but consumers would like to spend more money now.
  • Lower business taxes and higher government subsidies.
  • Favorable exchange rates for importers of raw materials.

And vice versa.

Long-run supply refers to the economy's long-run production possibilities (maximum rate of sustainable output). Increase in long-run aggregate supply (LRAS) is caused by:

  • An increase in the supply of resources. This will expand the economy's sustainable rate of output. Note that an economy's resource base includes physical capital, natural resources and human capital.
  • An improvement in technology and productivity. This will increase the average output per unit of resources.

And vice versa.
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Subject 6. Equilibrium GDP and Prices
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Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve. If real GDP is below equilibrium GDP, firms increase production and raise prices, and if real GDP is above equilibrium GDP, firms decrease production and lower prices. These changes bring a movement along the SAS curve towards equilibrium.

In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP - when the economy is on its LAS curve.

Note two things:

  • At the price chosen by suppliers (P), the aggregate demand (AD) is exactly equal to the amount suppliers are willing to supply (SAS).
  • This equilibrium between SAS and AD coincides with the maximum capacity of the economy, as indicated by the LAS curve. The level of output produced is labeled as Yf, indicating full employment of resources.

Long-run equilibrium thus occurs where LAS, AD, and SAS coincide.

Economic Growth and Inflation

Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances, all of which increase potential GDP and bring a rightward shift of the LAS curve. The following figure illustrates economic growth and inflation.

Inflation occurs because the quantity of money grows faster than potential GDP, which increases aggregate demand by more than long-run aggregate supply. The AD curve shifts rightward faster than the rightward shift of the LAS curve.

The Business Cycle

The business cycle occurs because aggregate demand and short-run aggregate supply fluctuate.

  • A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. The amount by which potential GDP exceeds real GDP is called a recessionary gap.
  • Long-run equilibrium is an equilibrium in which potential GDP equals real GDP.
  • An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP is called an inflationary gap.


Let's look at the inflation gap.

An economic boom may be the result of an increase in AD. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward.

The prices of goods and services increase, which in turn induces suppliers to expand output to a level that is unsustainable in the long run (which is why a boom is followed by an economic contraction). That is, firms increase output and prices - a movement along the SRAS curve.

Since prices are currently high (P1) and the situation is moving into the long run, people will expect prices to continue to be high. There is an inflationary gap.

Stagflation

In the resource market, a supply shock such as a drought or high oil prices is reflec...
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Subject 7. Economic Growth and Sustainability
#cfa #cfa-level-1 #economics #macroeconomics #reading-17-aggregate-output-and-economic-growth
Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. The economic growth rate is the annual percentage change of real GDP. It tells us how rapidly the total economy is expanding.

The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. It grows only if real GDP grows faster than the population grows.

The Production Function and Potential GDP

Y = A F(L, K)

The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of capital, K, and the state of technology, A (total factor productivity).

This equation shows that output depends on inputs and the level of technology.

  • More inputs mean more output. That is, the marginal product of labor (the increase in output generated by increased labor) and the marginal production of capital (the increase in output generated by increased capital) are both positive.
  • The higher the level of technology, the more output is produced for a given level of inputs.

The law of diminishing returns: As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments. As capital per hour of labor rises, output rises (the marginal product of capital is positive) but output rises less at high levels of capital than at low levels. This is the key explanation of why the economy reaches a steady state rather than growing endlessly.

Convergence is the process of one economy catching up with another economy. According to the neoclassical growth theory, countries with a low level of capital would have a higher marginal product of capital because of diminishing returns and hence attract more investment and grow faster.

Growth in Y = Growth in technology + WL (growth in labor) + WC (growth in capital)

where WL and WC = 1 - WL are the shares of labor and capital in GDP.

Sources of Economic Growth

There are five important sources of growth for an economy:

  • Labor supply is the quantity of the work force. It is determined by population growth, the labor force participation rate, and net immigration.
  • Human capital measures the quality of the labor force. Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of economic growth. It is the source of increased labor productivity and technological advance.
  • Physical capital results from saving and investment decisions. The accumulation of new capital increases capital per worker and labor productivity.
  • Technology. Technological change - the discovery and the application of new technologies and new goods - has contributed immensely to increasing labor productivity. It is the main factor affecting economic growth in developed countries.
  • Natural resources account for some of the differences in growth among countries.

Measures of Sustainable Growth

Labor productivity is the quantity of real GDP produced by an hour of labor. The growth of labor productivity depends on physical capital growth, human capital growth, and technology advances.

Potential GDP = Aggregate hours worked x Labor productivity

Potential growth rate = Long-term growth rate of labor force + Long-term labor productivity growth rate
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Subject 1. The Business Cycle and its Phases
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-18-understanding-business-cycles
The business cycle is the fluctuations in the general level of economic activity as measured by such variables as the rate of unemployment and changes in real GDP. Periods of growth in real output and other aggregate measures of economic activity followed by periods of decline are distinguishing characteristics of business cycles. A complete business cycle is represented by A to G in the diagram below:

  • Peak

    When most businesses are operating at capacity level and real GDP is growing rapidly, a business peak or boom is present.

  • Contraction

    Aggregate business conditions are slow, real GDP grows at a slower rate or even declines, and the unemployment rate increases. This indicates that the economy begins the contraction, or recessionary, phase of a business cycle.

    • Firms start to cut hours and freeze hiring, followed by outright layoffs.
    • As final demand starts to fall off the downturn in investment spending usually occurs abruptly.
    • Inventories accumulate involuntarily, and firms cut production below even reduced sales levels to let their inventories decline. This eventually accelerates the economic downturn.

  • Trough

    The bottom of the contraction phase is referred to as the recessionary trough. When a contraction is prolonged and characterized by a sharp decline in economic activity, it is called a depression.

  • Expansion

    After the downturn reaches bottom and economic conditions begin to improve, the economy enters the expansion phase of the cycle. Here business sales rise, GDP grows rapidly, and the rate of unemployment declines.

    • Hiring new workers is a costly process. Firms will wait until it's clear that the economy is in this phase. They will then start full-time rehiring as overtime hours rise.
    • As inventories dwindle, businesses ultimately find themselves short of inventory. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate.
    • Changes in sales can result in magnified percentage changes in investment expenditures. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates.

      Orders for new equipment are early signals of recovery. Since it usually takes longer to plan and complete large construction projects than for equipment orders, construction projects may be less influenced by business cycles.

    The expansion eventually blossoms into another peak.
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Subject 2. Theories of the Business Cycle
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We consider a few fundamentally different theories of the business cycle.

Neoclassicial and Austrian Schools - Self-Correcting Economy

The neoclassical economists assumed that the economy would not operate with real GDP (Y) away from the level of natural real GDP (YN) for any length of time; if Y < YN, then firms would be producing below capacity, and would tend to cut nominal wages and prices, which would continue until YN was again reached. If Y > YN, then above-capacity production could support hikes in nominal wages and prices, until real output fell back to YN. The consequence was no business cycle in real GDP.

The Austrian school economists argued that business cycles are caused by governments as they try to increase GDP and employment.

Keynesian School - No Self-Correction

It is the changes in output and employment, not price changes, that restores equilibrium in the Keynesian model.

  • Aggregate demand fluctuations. Demand is the driving force of the economy. Expectations are the most significant influence on aggregate demand.
  • Aggregate supply response. Wages and prices are highly inflexible, particularly in a downward direction. With a sticky price level, the short-run aggregate supply curve is horizontal at a fixed price level.
  • Policy response is needed. When aggregate expenditures are deficient, there are no automatic forces capable of assuring full employment. Recessions and depressions result when total spending falls because businesses reduce production. Therefore, government intervention is required to keep the economy at full employment capacity without inflation.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed.

Monetarist School

The economy is self-regulating and it will normally operate at full employment if monetary policy is properly timed and the pace of money growth is kept steady. The quantity of money is the most significant influence on aggregate demand.

The New Classical Model - Policy Ineffectiveness

Real business cycle theory assumes that real shocks to the economy are the primary cause of business cycles.

  • Adverse cost shocks lead to a recession, as individuals should spend less time working because it is not profitable.
  • Favorable cost shocks lead to a boom period because it is advantageous to produce as much as possible.

Production fluctuates because of the changing value of output and the changing productivity of the economy. Government intervention is generally not necessary because it may exacerbate this fluctuation or delay the convergence to equilibrium.

The Neo-Keynesian school assumes that the prices of most goods don't change daily (sticky price, or menu cost), as the cost of changing prices may outweigh the benefits of changing prices. Therefore, markets do not reach equilibrium quickly.
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Subject 3. Unemployment
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-18-understanding-business-cycles
The U.S. Census Bureau conducts monthly surveys to determine the status of the labor force in the U.S.

To be counted as unemployed, a person must be actively seeking employment but currently without work.

The unemployment rate is the percentage of persons in the labor force who are unemployed. This is a key parameter of conditions in the aggregate labor market.

There are special categories of unemployment, such as:

  • Long-term unemployed: people who are unemployed because they do not have the skills required by the openings or reside far from the jobs.
  • Frictionally unemployed: people who are not working because they are in between jobs.

Unemployment rate tends to be a lagging instead of a leading indicator of the economy, confirming but not foreshadowing long-term market trends. It tends to peak after the trough of the business cycle and bottom after the peak of the business cycle. This is because:

  • The employment data is compiled afterwards.
  • Employers are reluctant to lay people off when the economy turns bad. For large companies, it can take months to put together a layoff plan. Companies are even more reluctant to hire new workers until they are sure the economy is well into the expansion phase of the business cycle.

Underemployed is a measure of employment and labor utilization in the economy. It looks at how well the labor force is being utilized in terms of skills, experience, and availability to work.

Discouraged workers believe that continuing the job search is fruitless and thus give up looking for a job. They wish to work but because they are not actively searching for work they are excluded from the labor force and are not counted in the unemployment rate. The unemployment rate may fall during recessions as discouraged workers leave the labor force.

Voluntary unemployment refers to the number of persons in an economy without jobs because they choose to be unemployed.

Analysts also use other measures to get a better picture of the employment cycle. These measures include the size of payrolls, hours worked, and the use of temporary workers.
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Subject 4. Inflation
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-18-understanding-business-cycles
Inflation is a continuing rise in the general level of prices of goods and services. It can also be defined as a decline in the value (the purchasing power) of the monetary unit. There is too much money chasing too few goods.

  • It is a rise in the price level, not in the price of a particular commodity. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs.
  • It is an ongoing process, not a one-time jump in the price level.

There are different types of inflation.

  • Deflation is a decrease in the general price level of goods and services.
  • Disinflation is a slowing in the rate of increase in the general price level.
  • Hyperinflation indicates a very high and increasing rate of inflation.

The annual inflation rate is simply the percentage change in the price index (PI) from one year to the next:

For example, the CPI is 115 for 2010 and 120 for 2011. The inflation rate during 2011 is: (120 - 115)/115 = 4.35%.

The Laspeyres index uses the same group of commodities purchased in the base period.

  • Advantages: It requires quantity data from only the base period. This allows a more meaningful comparison over time. The changes in the index can be attributed to changes in the price.
  • Disadvantages: It does not reflect changes in buying patterns over time. It may also overweight goods when prices increase.

The Paasche index uses the current composition of the basket. It tends to understate inflation.

The Fisher index is the geometric mean of the two indices.

Many countries use their own consumer price indices to track domestic inflation. These indices have different names and baskets.

Inflation is not simply a matter of rising prices. In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, there are endemic and perhaps diverse reasons for causes at the root of inflation.

Inflation can result from either an increase in aggregate demand (demand-pull inflation) or a decrease in aggregate supply (cost-push inflation).

  • Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production (itself a result of different factors). It basically means that prices have been "pushed up" by increases in the costs of any of the production factors (money wage rate and money price of raw materials) when companies are already running at full production capacity. Increased costs are passed on to consumers, causing a rise in the general price level (inflation).

    • The non-accelerating inflation rate of unemployment (NAIRU), or the natural rate of unemployment (NARU), is defined as the rate of unemployment when the rate of wage inflation is stable.
    • The unit labor cost (ULC) indicator is calculated as total compensation per worker divided by total output per worker. Higher labor costs may pass through to prices.

  • Demand-pull inflation occurs when total demand for goods and services exceeds total supply. Buyers, in essence, "bid prices up" and cause inflation. This excessive demand usually occurs in an expanding economy.

    The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, the authorities may allow the money supply to grow faster than the ability of the economy to supply goods and services, so there is "too much money chasing too f
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Subject 5. Economic Indicators
#cfa #cfa-level-1 #economics #macroeconomics #reading-18-understanding-business-cycles
Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle an economy is in. Economic indicators can be leading, lagging, or coincident, which indicates the timing of their changes relative to how the economy as a whole changes.

  • Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and improves before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

  • Lagging: A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagging economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

  • Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

No single indicator is able to forecast accurately the future direction of the economy. In the U.S., economists often refer to the Conference Board's diffusion index when judging the moves in the leading index. The diffusion index can measure the breadth of a move in any BCI index, showing how many of an index's components are moving together with the overall index. The index generally turns down prior to a recession and turn up before the beginning of a business expansion.

However, there are two problems with the index.

  • There has been significant variability in the lead time of the index. For example, a downturn in the index is not always an accurate indicator of the future.
  • The index has often given false alarms. For example, a recession forecasted by a decline in the index does not materialize.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going.
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Subject 1. What is Money?
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals. Monetary policy refers to central bank activities to control the supply of money. Their goals are maximum employment, stable prices, and moderate long-term interest rates.

The Functions of Money

Money performs three basic functions.

  • It serves as a medium of exchange to buy and sell goods and services. Money simplifies and reduces the costs of transactions.

    In the absence of money, a barter economy would exist. Acquiring a belt, for example, would entail finding a belt maker who happened to want what you had to offer in exchange, making transactions tedious, enormously costly, and inefficient.

    Money permits us to realize the enormous gains from the specialization, division of labor, and mass-production processes that underlie our modern standard living.

  • It is used as an accounting unit to compare the value and cost of things. As a unit of measurement, like a centimeter, money is used by people to post prices and keep track of revenues and costs.

  • It provides a way of storing value to allow the movement of purchasing power from one period to another. Although it is not the only way of storing value, it is the most liquid of all assets, due to its function as the medium of exchange. However, many methods of holding money do not yield an interest return and the purchase power of money will decline during a time of inflation.

The Money Creation Process

Reserves are the cash in a bank's vault and deposits at Federal Reserve Banks. Under the fractional reserve banking system, a bank is obligated to hold a minimum amount of reserves to back up its deposits. Reserves held for that purpose, which are expressed as a percentage of a bank's demand deposits, are called required reserves. Therefore, the required reserve ratio is the percentage of a bank's deposits that are required to be held as reserves.

Banks create deposits when they make loans; the new deposits created are new money.

Example

Suppose the required reserve ratio in the U.S. is 20%, and then suppose that you deposit $1,000 cash with Citibank. Citibank keeps $200 of the $1,000 in reserves. The remaining $800 of excess reserves can be loaned out to, say, John. After the loan is made, the money supply increases by $800 (your $1,000 + John's $800). After getting the loan, John deposits the $800 with Bank of America (BOA). BOA keeps $160 of the $800 in reserves and can now loan out $640 to another person. Thus, BOA creates $640 of money supply. The process goes on and on. With each deposit and loan, more money is created. However, the money creation process does not create an infinite amount of money.

The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the money supply. Money Multiplier = 1/b, where b is the required reserve ratio. In our example, b is 0.2, so money multiplier = 1/0.2 = 5.

Definitions of Money

There are different definitions of money. The two most widely used measures of money in the U.S. are:

  • The M1 Money Supply: cash, checking accounts and traveler's checks. This is the narrowest definition of the money supply. This definition focuses on money's function as a medium of exchange.
  • The M2 Money Supply: M1 + savings + small time deposits + retail money funds. This definition focuses on money's function as a medium of exchange and store of value.

Credit cards are not purchasing power, but instead are a convenient means of arranging a loan. Credit is a liability acquired when one borrows funds, while money is a financial asset that provides the holder with future purchasing power. However, the wid...
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Subject 2. The Demand for and Supply of Money
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-19-monetary-and-fiscal-policy
At any given interest rate, the amount of wealth that households and businesses desire to hold in the form of money balances, either as cash or any other highly liquid form of value (such as checking accounts), is called the demand for money.

People hold (demand) money to conduct transactions, to deal with emergencies (precautionary motive), and for speculative activities.

There is an inverse relationship between the demand for money and interest rates when all other influences on the amount of money that people wish to hold remain the same.

A rise in the interest rate brings a decrease in the quantity of money demanded. A fall in the interest rate brings an increase in the quantity of money demanded.

The money supply schedule is vertical since domestic supply of money is determined by the central bank and reserve requirements. The supply of money is not affected by changes in the interest rate.

Money market equilibrium occurs when people are willing to hold all the money supplied by the monetary authorities at the prevailing interest rate; the supply of money equals the demand for money. It occurs at ie in the diagram.

However, disequilibrium exists at the interest rate i2.

People are not willing to hold all the money supplied by the monetary authorities as money balances. Instead, they demand high-interest earning assets such as bonds. This will increase the price of bonds, which in turn reduces their interest yield, driving i2 down towards ie and eventually restoring equilibrium.

Disequilibrium also exists at the interest rate i3.

People would like to hold more money balances than the monetary authorities are willing to supply. The resultant low demand for bonds reduces their prices, thus increasing their interest rate (yield), and slowly restores equilibrium at ie.

The Fisher Effect

Rnom = Rreal + Rinflation + risk premium

The nominal rate of interest is comprised of three components:

  • A real required rate of return.
  • A component to compensate lenders for future inflation.
  • A risk premium to compensate lenders for uncertainty.
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Subject 3. The Roles of Central Banks
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Central banks all have similar roles:

  • Issue currency
  • The government's bank, and bank of the banks
  • Lender of last resort to the banking sector
  • Regulator and supervisor of the payments system
  • Set monetary policy
  • Regulate banking system
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Subject 4. The Objectives of Monetary Policy
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A nation's monetary policy objectives and the framework for setting and achieving those objectives stems from the relationship between the central bank and the government. Central banks in different countries have a variety of objectives, such as maximum employment, stable prices, and moderate long-term interest rates. In the long run, these objectives are in harmony and reinforce each other, but in the short run, they might be in conflict.

The key objective is price stability. It is the source of maximum employment and moderate long-term interest rates.

The Costs of Inflation

Unanticipated inflation is an increase in the general level of prices that was not expected by most decision makers. It is a surprise to most individuals. For example, if someone anticipates an inflation rate of 3% but the actual inflation rate turns out to be 10%, it will catch that person off guard.

Unanticipated inflation redistributes income, creates uncertainty, and can have a potentially destabilizing impact on the economy.

Monetary Policy Tools

Central banks manipulate the money base that creates the change in the money supply. When following an expansionary monetary policy, they increase the growth rate of the money supply. Conversely, when following a restrictive monetary policy, they reduce the growth rate of the money supply.

Central banks have three major means of controlling the money stock.

Open Market Operations. Since it can be undertaken easily and quietly, this is the most common tool used by a central bank to alter the money supply. For example, to increase the money supply, the central bank buys government securities from commercial banks. This increases the money supply.

The Central Bank's Policy Rate. Sometimes banks find themselves in a position where they are not holding enough bank reserves relative to the value of the deposits they hold (i.e., they have extended too many loans!). As a result, they may need to acquire a short-term loan from the central bank to cover this shortage of required reserves. They may apply to the central bank for a loan; the interest charged on the loan is known as repo rate (in the U.S. it is called the discount rate).

An increase in the policy rate is restrictive on money supply - it tends to discourage banks from shaving their excess reserves to a low level.

In the U.S., borrowing from the Fed amounts to less than one-tenth of 1% of the available loanable funds of banks. A bank can go to the federal funds market to borrow to meet its reserve requirements. The market is where banks with excess reserves extend short-term loans to those banks seeking additional reserves. The interest rate in this market is called the federal funds rate. The federal funds rate and the discount rate tend to move together.

Reserve Requirements. The central bank sets the rules. Since banking institutions will want to hold interest-earning assets rather than excess reserves, an increase in the reserve requirements will reduce the supply of money, and vice versa. However, the central banks of developed countries have seldom used their regulatory power over reserve requirements to alter the supply of money, due to its disruptive impact on banking operations - small changes in reserve requirements can sometime lead to large changes in the money supply.

The Transmission Mechanism

When a central bank lowers its official interest rate:

  • Other short-term interest rates fall. Short-term rates move closely together and follow the official interest rate.
  • The exchange rate falls. The exchange rate responds to changes in the domestic interest rate relative to the interest
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Subject 5. Monetary Targeting Rules
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Inflation Targeting

Price stability is the primary goal of inflation-targeting monetary policy strategy. Inflation is usually defined as a range of permissible values (e.g., 1%-3%) rather than as a point value (e.g., 2.4%). The definition of inflation also varies from country to country.

There are three key concepts:

Central bank independence. Central bank independence exists on two dimensions. Goal independence is the freedom that the central bank has to select the objectives of monetary policy, whether they are low inflation, the target rate of unemployment, the level of GDP, etc. Instrument independence is the freedom that the central bank has to pick appropriate policies to produce a certain outcome in the economy. Most inflation-targeting countries only lay out the goals and not the operating procedures; the central bank does have operational independence.

Credibility. Central bankers who are unable to credibly convince the public that they are serious about fighting inflation will be faced with a high inflation rate as a result.

Transparency. It is well known that credibility requires transparency. The benefits of transparency are obvious: it improves the efficiency of monetary policy, allows for a more effective management of expectations, and promotes the discussion and evaluation of monetary policy.

Exchange Rate Targeting

Many countries have viewed pegging their nominal exchange rate to a stable, low-inflation foreign currency as a means of achieving domestic price stability. In a sense, countries that target their exchange rates against an anchor currency attempt to "borrow" the foreign country's monetary policy credibility. However, this monetary policy deprives the central bank of its ability to respond to idiosyncratic domestic shocks. Such countries can become prone to speculation against their currencies.
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Subject 6. Contractionary and Expansionary Monetary Policies and the Neutral Rate
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An expansionary monetary policy decreases the interest rate in order to increase the size of money supply. A contractionary monetary policy increases the interest rate to reduce the size of money supply.

The idea behind the concept of neutral rate of interest is that there might be a rate of interest that neither deliberately seeks to stimulate aggregate demand and growth nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be one that encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP.

The neutral rate is a useful method of measuring the stance of monetary policy. It has two components:

Neutral rate = Trend growth + Inflation target

When the neutral rate is reached, the state of equilibrium is attained, implying that the economy is now well-balanced and the price level is stable.

Certainly there can be no such thing as an exact measure of the neutral rate, and it will differ from country to country.

A demand shock is a sudden surprise event that increases or decreases demand. If inflation is caused by an unexpected increase in aggregate demand, a contractionary monetary policy might be appropriate, to cause inflation to fall. However, if inflation is caused by a supply shock such as a sudden increase in oil price, a contractionary monetary policy might make the situation worse.

Limitations of Monetary Policy

Central banks cannot control the money supply. This is because:

  • They cannot control the amount of money that households and corporations put in banks on deposit.
  • They cannot control the willingness of banks to create money by expanding credit.

In quantitative easing (QE), a central bank buys any financial assets to inject money into the economy. It is different from the traditional policy of buying or selling government bonds to keep market interest rates at a specified target value. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional money in order to increase their capital reserves.
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Subject 7. Fiscal Policy: Roles, Objectives, and Tools
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals, including the overall level of aggregate demand in an economy (and hence the level of economic activity), the distribution of income and wealth among different segments of the population, and, ultimately, the allocation of resources between different sectors and economic agents.

Government expenditures include transfer payments, the purchase of goods and services (current government spending), and capital expenditure.

Government revenues are generated through taxes. There are direct and indirect taxes. Direct taxes are difficult to change without considerable notice. Indirect taxes can be adjusted almost immediately.

The four desirable attributes of a tax policy are simplicity, efficiency, fairness, and revenue sufficiency.

A budget is the annual statement of the government's expenditures and tax revenues. A balanced budget implies that current government revenue is equal to current government expenditures.

A budget deficit exists when total government spending exceeds government revenue. A budget deficit is financed through the issuance of government securities. Such issuance of securities adds to the national debt.

A budget surplus occurs when revenues exceed spending. Under a budget surplus, excess revenue is applied to the total outstanding debt accumulated during prior periods, therefore reducing it by the amount of the surplus.

There are arguments for and against being concerned with the size of a fiscal deficit.

The arguments against being concerned about national debt:

  • The debt is owed internally by fellow citizens.
  • Some borrowed money may have been used for capital investment projects or enhancing human capital.
  • Large deficits require tax changes which may be desirable.
  • Richardian equivalence: the timing of any tax change does not affect consumers' change in spending.
  • Debt could improve employment.

The arguments for being concerned about national debt:

  • Higher deficits -> higher tax rates -> less incentive to work and invest -> lower long-term growth
  • The central bank may have to print money to finance a deficit. This may lead to high inflation.

The crowding-out effect is the reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the capital market. It suggests that budget deficits will exert less impact on aggregate demand than the basic Keynesian model implies. Because financing the deficit pushes up interest rates, budget deficits will tend to retard private spending, particularly spending on investment. This reduction will at least partially offset additional spending emanating from the deficit.

Multipliers

As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income. This is reflected in the marginal propensity to consume (MPC), which is less than one.

Marginal propensity to save (MPS) is defined as additional savings divided by additional current disposable income.

MPC + MPS = 1
If we add tax rate t, then:

MPC + MPS = 1 - t
An expenditure multiplier is the ratio of the change in equilibrium output relative to the independent change in consumption, investment, and government spending or spending on net exports that brings about the change.

The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. It exists because government purchases are a component of aggregate expenditure; an increase in government purchases incre...
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Subject 8. Active and Discretionary Fiscal Policy
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
Fiscal policy actions seek to stabilize the business cycle by changing aggregate demand. These policy actions can be:

  • Discretionary. Discretionary fiscal policy is a policy action that is initiated explicitly by the government.
  • Automatic. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed. For example, during an economic downturn, a government uses expansionary fiscal policy to stimulate aggregate demand. Suppose, by the time the expansionary fiscal policy starts to exert its primary impact, the economy's self-corrective mechanism has restored full employment capacity. Therefore, the stimulus injected by expansionary fiscal policy will result in excessive demand and inflation, causing more economic instability.

The use of discretionary fiscal policy is hampered by three time lags:

  • Recognition lag. There is usually a time lag between when a change in policy is needed and when its need is widely recognized by policymakers. Forecasting a forthcoming recession or boom is a highly imperfect science.
  • Action lag. There is generally a lag between the time when the need for a fiscal policy change is recognized and the time when it is actually instituted. The time required to change tax laws and government expenditure programs is quite lengthy.
  • Impact lag. Even after a policy is adopted, it may be 6 to 12 months before its major impact is felt.

Changes in fiscal policy must be timed properly if they are going to exert a stabilizing influence on an economy. However, the use of fiscal policy to calm the business cycle is very difficult; it may accentuate the corrective action of the economy rather than correct the problem for which it was intended. In the real world, a discretionary change in fiscal policy is like a double-edged sword - it has the potential to do harm as well as good. If timed correctly, it will reduce economic instability. If timed incorrectly, however, the fiscal change will increase rather than reduce economic instability.

Automatic Stabilizers

Automatic stabilizers apply stimulus during a recession and restraint during a boom even though no legislative action has been taken. Their major advantage is that they institute counter-cyclical fiscal policy without the delays associated with policy changes that require legislative action. During a recession, they trigger government spending without the authorization of Congress (unemployment compensation and welfare programs). During inflationary overheating, they take spending power out of the economy without the delays caused by legislative actions, thereby minimizing the problem of proper timing.

Income taxes and transfer payments are automatic stabilizers.

When the economy starts to fall into a recession, unemployment increases. Government payments for unemployment compensation will increase while government receipts from the employment tax that finances unemployment benefits will decline. As a result, the unemployment compensation program automatically promotes a budget deficit. Similarly, when the economy expands into an inflationary boom, the program promotes a budget surplus.

When the economy expands into an inflationary boom, personal income will grow sharply. As a result, more people will fall into the "tax due" category, and others will be pushed into higher tax brackets. Therefore, income tax revenues will rise more rapidly than income, reducing the momentum of consumption growth. In addition, higher tax revenues will promote a budget surplus.
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Subject 9. Interrelationships between Fiscal and Monetary Policy
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Governments use fiscal and monetary policies to respond to changes in the business cycle. Although both fiscal and monetary policy can alter aggregate demand, they work through different channels. Consider the effects of using monetary or fiscal policy to increase aggregate demand:

  • Central banks can respond with lower interest rates and an expanded money supply. This will lead to an increase in investment and consumer spending. Since investment spending results in a large capital stock, incomes in the future will also be higher. However, inflation may result.
  • Keynes argued that the government should boost spending but that if this is financed by higher borrowing, it may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in aggregate demand. However, since investment spending is lower, the capital stock is lower than it would have been and future incomes will be lower.

Monetary policy and fiscal policy are not interchangeable. When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree; they argue that changes in monetary policy can impact consumer and business behaviour quite quickly and strongly.

However, there may be factors which make fiscal policy ineffective aside from the usual crowding-out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals "undo" government fiscal policy through changes in their own behaviour - for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this.

Monetary and fiscal policies also differ in the speed with which each takes effect. The time lags are variable and they can conceivably work against one another unless the government and central bank coordinate their objectives.
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Subject 1. GDP vs. GNP
#cfa #cfa-level-1 #economics #economics-in-a-global-context #reading-20-international-trade-and-capital-flows
GDP is the total market value of all domestically produced final goods and services for a particular year. Its five key factors are: market value, final goods and services, produced, within a country, during a specific time period.

  • Only final goods and services count: GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded, to avoid double-counting. Their value is embodied in the value of the goods purchased by the end user.

  • GDP is a "flow" variable; it measures the market value of production that flows through the economy.

  • Financial transactions and income transfers (e.g., social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production.

  • GDP counts only goods and services produced domestically, whether by citizens or foreigners.

  • It includes only goods produced during the current period. Thus, sales of used goods are not counted in GDP. However, sales commissions count toward GDP because they involve services provided during the period.

GNP is the total market value of all final goods and services produced by the citizens of a country. It measures the output that is produced by the "nationals" of a country. This figure is the output generated by the labor and capital owned by the citizens of the country, regardless of whether that output is produced domestically or abroad. Consider the case of the United States. GNP is the income earned by Americans, regardless of whether that income is earned in the United States or abroad. It omits the income foreigners earn in the United States, but counts the income that Americans earn abroad. It is equal to GDP minus the net income of foreigners.

GNP = GDP + Income received by citizens for factors of production supplied abroad - Income paid to foreigners for the contribution to domestic output

In short, GNP measures the worldwide output of a nation's citizens while GDP measures the domestic output of the nation.

  • In general, the bulk of output is produced domestically using resources owned by nationals of the country. Thus, GDP often differs only slightly from GNP.
  • These two measures differ substantially only when a country attracts a large number of foreign workers or investments (the country's GDP will exceed its GNP).
  • If a relatively large number of a country's citizens work abroad, or its citizens have made substantial investments abroad, the country's GNP will exceed its GDP.
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Subject 2. International Trade
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Benefits and Costs

Here are the benefits:

  • International trade and specialization result in lower prices and higher domestic consumption for imported products, and higher prices and lower domestic consumption for exported products.
  • International trade permits the residents of each nation to concentrate on the things they do best (produce at a low cost) while trading for those they do least well.
  • Industries experience greater economies of scale.
  • Households and firms have greater product variety.
  • Resources are allocated more efficiently.

Costs:

  • International trade may result in the loss of jobs in developed countries.
  • The potential for greater income inequality increases.

Countries have different resource endowments. Some have an abundance of labor whilst others possess fertile lands. Differences in resource endowments result in countries incurring different opportunity costs of production for the same products.

Comparative advantage is the ability to produce a good at a lower opportunity cost than others can produce it. Relative costs determine comparative advantage.

If each country has a comparative advantage in producing a specific good, international trade will lead to mutual gain because it allows the residents of each country to:

  • Specialize more fully in the production of those things that they do best (i.e., at a lower opportunity cost).
  • Import goods when foreigners are willing to supply them at a lower cost than domestic producers.

A nation can have a comparative advantage in producing a good even if it has no absolute advantage in producing any good. As long as the relative costs of producing two goods differ in two countries, comparative advantage exists and gains from specialization and trade will be possible. When this is the case, each country will find it cheaper to trade for goods that can be produced only at a high opportunity cost.

We are going to start with some simplifying assumptions:

  • Only two countries exist: X and Y.
  • Only two products are produced in each country: wine and fish.
  • The only resource in each country is labor.

Country X has an absolute advantage in producing both products (i.e., country X's laborers are more efficient than those in country Y).

  • Each worker in X is able to produce either 5 fish or 10 bottles of wine per day. The opportunity cost of 1 fish produced in X is 2 bottles of wine.

    A production possibilities frontier (PPF) represents the various maximum combinations of outputs of the two products that a country is able to produce given its current resources.

    Any point on the PPF represents an attainable combination of fish and wine. The slope of the PPF represents the opportunity cost of wine relative to fish. For example, if X was consuming 250 million fish and no wine at point A, the cost of increasing wine consumption to 250 million bottles would be that 125 million fish would have to be sacrificed (i.e., it would move to point B).

  • In Y, each worker can produce either 2 fish or 1 bottle of wine per day. One bottle of wine costs 2 fish.

In the absence of trade, a country's consumption possibilities are constrained by the country's production possibilities frontier (i.e., country X could not consume 125 million fish and more than 250 million bottles of wine).

...
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Subject 3. International Trade Restrictions and Agreements
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Governments restrict international trade to protect domestic producers from competition by using many trade policies. All trade restriction policies result in higher prices and higher domestic production (more producer surplus) but lower domestic consumption (less consumer surplus).

For purposes of international trade policy and analysis:

  • A small country cannot affect the world price of traded goods. In a small country, trade barriers always generate a net welfare loss arising from distortion of production and consumption decisions and the associated inefficient allocation of resources.
  • A large country's production and/or consumption decisions do alter the relative prices of traded goods. Trade barriers can generate a net welfare gain in a large country if it imposes an even larger welfare loss on its trading partners.

Tariffs

A tariff is a tax levied on goods imported into a country. It benefits domestic producers and the government at the expense of consumers.

Let's illustrate the impact of a tariff on automobiles. Without a tariff, the world market price (Pw) would prevail in the domestic market. U.S. consumers purchase Q1 units while U.S. producers supply Qd1 units. When the U.S. imposes a tariff (t) on imports of automobiles, U.S. consumers now pay (Pw + t) to purchase automobiles from foreigners. Due to the higher price, U.S. consumers will reduce demand from Q1 to Q2, while U.S. producers will increase supply from Qd1 to Qd2. Imports from foreigners will reduce from Q2 to Qd2.

The tariff benefits domestic producers and the government. It protects domestic producers from foreign competition. Consequently, domestic producers can supply goods at a higher price. Domestic producers gain the area S in the form of additional revenue. The government gains the area T in the form of tax revenues collected on imports.

The tariff harms domestic consumers as they have to pay a higher price for fewer goods. They lose the area S + U + T + V. Note that areas U and V are a deadweight loss (loss of efficiency) for the economy since they do not benefit either producers or the government.

In effect, a tarrif acts as a subsidy to domestic producers. Potential gains from specialization and trade go unrealized.

Quotas

An import quota is a specific limit or maximum quantity (or value) of a good permitted to be imported into a country during a given period. It is designed to restrict foreign goods and protect domestic industries.

Assume that a quota limits imports of automobiles to (Q2 - Qd2), a quantity below the free trade level of imports (Q1 - Qd1). Since the quota reduces foreign supply, domestic price will be pushed up to P2. Due to the higher price, U.S. consumers will reduce demand from Q1 to Q2, while U.S. producers will increase supply from Qd1 to Qd2. Like a tariff, an import quota benefits domestic producers but harms domestic consumers.

However, different from a tariff, an import quota benefits foreign producers at the expense of the government; with a quota, foreign producers who are granted permission to sell in the domestic market can charge premium prices for the limited supply of foreign goods. The area T represents the gains of those foreign producers. Under a tariff, the government would gain the area T in the form of tariff revenues. This po...
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Subject 4. The Balance of Payments
#cfa #cfa-level-1 #economics #economics-in-a-global-context #reading-20-international-trade-and-capital-flows
When we buy something from another country, we use the currency of that country to make the transaction. We record international transactions in the balance of payments accounts.

A country's balance of payments accounts records its international trading, borrowing, and lending.

  • It summarizes the transactions of the country's citizens, businesses, and government with foreigners.
  • Its accounts reflect all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).

Balance-of-payments accounts are recorded using the regular bookkeeping method.

  • Any transaction that creates a financial inflow is recorded as a credit. That is, if a country has received money, this is known as a credit. Exports are an example of a credit item.
  • Any transaction that creates a financial outflow is recorded as a debit. That is, if a country has paid or given money, the transaction is counted as a debit. Imports are an example of a debit item.

The main categories of the balance of payments are:

  • Current account

    It records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments).

    When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports.

  • Capital account

    This is where is where all international capital transfers are recorded. It also includes net sales of non-produced, non-financial assets. Capital inflow transactions are recorded as credits and capital outflow transactions are recorded as debits.

  • Financial account

    This documents all international monetary flows related to investment in financial assets such as bonds and stocks. Also included are government-owned assets such as foreign reserves, gold, and special drawing rights (SDRs) held with the International Monetary Fund.

Analysts often lump financial account and capital account into one category named "capital account," which consists of portfolio investment flows (short-term) and foreign direct investment (long-term).

Example

A U.S. citizen purchases a rug from India for $100. The U.S. debits its current account for $100. Now the Indian rug-maker has two options:

  • Deposit the $100 into a U.S. bank. The U.S. asset (a bank deposit) will show up as a credit to the U.S. capital account.
  • Convert the $100 to rupees. The Indian bank then has 2 options.

    • Lend the $100 to a customer for the purchase of U.S. goods. This is to credit the U.S. current account.
    • Purchase U.S. government bonds. This is to credit the U.S. capital account.

In each case the balance of payments will balance.

The balance of payments must balance, meaning the balances of these three components must sum to zero. A deficit in one area implies an offsetting surplus in other areas. A current-account deficit implies a capital-account surplus (and vice versa).

What do these balances mean in economic terms? A country that runs a current account deficit is spending more than it produces, making up the difference between how much a country saves and how much it invests. A rising current account deficit could imply rising investment or falling saving, or both.

CA = Sp + Sg - I
To reduce a current account deficit, a country must save more and/or invest less. Higher saving can come from the private sector or from the government through a smaller budget deficit.

Net exports are ...
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Subject 5. Trade Organizations
#cfa #cfa-level-1 #economics #economics-in-a-global-context #reading-20-international-trade-and-capital-flows
Created after WWI, the International Monetary Fund, the World Bank, and the World Trade Organization are the three major international organizations that provide necessary stability to the international monetary system and facilitate international trade and development.

The IMF's mission is to ensure the stability of the international monetary system, the system of exchange rates and international payments which enables countries to buy goods and services from each other. The IMF helps keep country-specific market risk and global systemic risk under control.

The World Bank's mission is to help developing countries fight poverty and enhance environmentally sound economic growth. It helps create the basic economic infrastructure essential for the creation and maintenance of domestic financial markets and a well-functioning financial industry in developing countries.

The WTO provides the legal and institutional foundation of the multinational trading system and is the only international organization that regulates cross-border trade relations among nations on a global scale. Its mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules. Without such global trade rules, today's global transactional corporations would be hard to conceive.
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Subject 1. The Foreign Exchange Market
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An exchange rate is the current market price at which one currency can be exchanged for another. The convention used in the reading is the number of units of one currency (price currency) that one unit of another currency (base currency) will buy.

Let's say a:b = S.

  • a is the price currency.
  • b is the base currency.
  • S is the cost of one unit of currency b in terms of currency a.

For example, US$ : £ = 1.5 indicates that £1 is priced at US$1.5.

The exchange rate above is referred to as the nominal exchange rate. The real exchange rate is the nominal rate adjusted somehow by inflation measures.

For example, if country A has an inflation rate of 10%, country B an inflation rate of 5%, and no changes in the nominal exchange rate took place, then country A now has a currency whose real value is higher than before.

Market Functions and Participants

A foreign exchange market is a place where foreign exchange transactions take place. Measured by average daily turnover, the foreign exchange market is by far the largest financial market in the world. It has important effects, either directly or indirectly, on the pricing and flows in all other financial markets.

There is a wide diversity of global FX market participants that have a wide variety of motives for entering into foreign exchange transactions. Commercial companies undertake FX transactions during cross-border purchases and sales of goods and services. Hedge funds trade FX currencies for hedging or even speculative purposes. Central banks use their FX reserves to stabilize the market and control the money supply. Large dealing banks provide FX price quotes to their clients. With so many different market participants, motives, and strategies, it is very difficult to describe the FX market adequately with simple characterizations.
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Subject 2. Exchange Rate Quotations
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Most countries use a system of direct quotation. A direct exchange rate quote gives the home (domestic) currency price of a certain quantity of the foreign currency quoted (Domestic Currency/Foreign Currency, or DF/FC). In this case, the home currency is the price currency and the foreign currency is the base currency.

For example, the price of foreign currency is expressed in yen in Japan and pesos in Mexico. Direct quotation is used in most countries. For an American investor, a quote €:$ = 1.25 is a direct quote; he is expected to pay $1.25 for a €. Note that when there are two currencies, the base currency is always mentioned first, the opposite order of the actual ratio (price currency / base currency).

Indirect quotation (FC/DC) is also used in some markets. It is just the opposite of a direct quote; they are reciprocals of each other. For example, a bank in London will quote the value of the pound sterling (GBP) in terms of the foreign currency (i.e., £:$ = 1.4410).

Example

For a U.S. resident, ¥:$ = 0.0085 is the direct quote for Japanese yen and $:¥ = 119.46 is the indirect quote for Japanese yen.

In a direct quote, an appreciation of the foreign currency (a depreciation of the domestic currency) causes an increase in the direct quote.

  • The domestic currency moves in the opposite direction of the exchange rate.
  • The foreign currency moves in the same direction as the exchange rate.

The opposite is true for an indirect quote: the domestic (foreign) currency moves in the same(opposite) direction as the exchange rate.

Bid-Ask (Offer) Quotes and Spreads

Dealers (e.g., banks) do not normally charge a commission on their currency transactions but they profit from the spread between the buying and selling rates on both spot and forward transactions. Quotes are always in pairs: the first rate is the buy, or bid, price (for a dealer); the second is the sell, or ask, offer (for a dealer). The ask rate is usually higher than that bid rate, so the dealer can make a profit. The average of the bid and ask price is known as the midpoint price: midpoint price = (Ask + Bid) / 2.

When direct quotations are converted to indirect quotations, bid and ask quotes are reversed. That is:

  • The direct ask price is the reciprocal of the indirect bid price.
  • The direct bid price is the reciprocal of the indirect ask price.
  • No matter how the quote is made, dealers will always buy low and sell high.

For example, here is a direct quote for the Japanese yen from the U.S. perspective: ¥:$ = 0.0081-83. That is, the dealer is willing to buy ¥ at $0.0081 (direct bid price) and sell them at $0.0083 (direct ask price). The indirect bid price is (1/0.0083) $:¥ = 120.48 and the indirect ask price is (1/0.0081) = $:¥ = 123.45.

The bid-ask spread is the spread between bid and ask rates for a currency: Bid-ask spread = ask price - bid price. It is usually stated as a percentage of the ask price:

For example, with GBP quoted at £:$ = 1.4419 - 28, the percentage spread is: (1.4428 - 1.4419) x 100 / 1.4428 = 0.062%.

Note that the percentage spread is the same irrespective of whether the exchange rate is expressed in direct or indirect quotations.

The bid-ask spread is based on the breadth and depth of the market for that currency as well as on the currency's volatility.
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Subject 3. Cross-Rate Calculations
#cfa #cfa-level-1 #economics #economics-in-a-global-context #reading-21-currency-exchange-rates
A cross rate is the exchange rate between two countries computed from each country's exchange rate against a third country. For example, since most currencies are quoted against the U.S. dollar, sometimes we need to work out the cross rates for currencies other than the U.S. dollar.

If we interpret a:b as a "divide" sign, then a:b is actually b/a. Assume we have currencies a, b and c. If a:b and b:c are both known, then a:c = a:b x b:c. For example, if the Mexico peso (MXN) is selling for $0.0923 (MXN:USD = 0.0923) and the buying rate for the EUR is $0.7928 (USD:EUR = 0.7928), then the MXN/EUR cross rate is MXN:EUR = 0.0923 x 0.7928 = 0.0732.

Cross-Rate Calculations with Bid-Ask Spreads

Example

The rate between Japanese ¥ and the U.S. $ is $:¥ = 119.05 - 121.95 and the rate between the euro and the U.S. $ is $:€ = 0.7920 - 0.7932. The direct quote between the yen and the euro in Japan will be: (¥119.05/$)/(€0.7932/$) = ¥150.0883/€, and (¥121.95/$)/(€0.7920/$) = ¥153.9773/€.

The lower rate is the bid, and the higher rate is the ask. Therefore, the rate between yen and euro is €:¥ = 150.0883 - 153.9773.

In fact, each cross-currency transaction is the combination of two trades:

  • The bid price: a bank will buy U.S. dollars with yen low ($:¥ = 119.05), and sell U.S. dollars for euro high ($:€ = 0.7932). Thus, the bid price is €:¥ = 150.0883.
  • The ask price: a bank will sell U.S. dollars for yen high ($:¥ = 121.95), and buy U.S. dollars with euro low ($:€ = 0.7920). Thus, the ask price is €:¥ = 153.9773.

Note that in calculating the cross rates you should always assume that you have to sell a currency at the lower (or bid) rate and buy it at the higher (or ask) rate, giving you the worst possible rate. This method of quotation is how dealers make money in foreign exchange.

Similarly, the direct quote in France or Germany is ¥:€ = 0.006494 - 0.006663
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Subject 4. Forward Calculations
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Spot and Forward Exchange Rates

In the spot market, currencies are traded for immediate delivery. In the forward market, contracts are made to buy or sell currencies for future delivery.

In a typical forward transaction, a U.S. company buys textiles from England with payment of £1 million due in 90 days. The importer is thus short £ - that is, it owes £ for future delivery. Suppose the present price of £ is $1.71. Over the next 90 days, however, £ might rise against the U.S. dollar, raising the U.S. dollar cost of the textiles. The importer can guard against this exchange risk by immediately negotiating a 90-day forward contract with a bank at a price, say, £:$ = 1.72. In 90 days the bank will give the importer £1 million and the importer will give the bank 1.72 million U.S. dollars. By going long in the forward market, the importer is able to convert a short underlying position in £ to a zero net exposed position.

Three points are worth noting:

  • The gain or loss on the forward contract is unrelated to the current spot rate of £:$ = 1.71.
  • The forward contract gain or loss exactly offsets the change in the U.S. dollar cost of the textile order that is associated with movements in the GBP's value.
  • The forward contract is not an option contract. Both parties must perform the agreed-on behavior.

Forward exchange rates are often quoted as a premium, or discount, to the spot exchange rate. A base currency is at a forward discount if the forward rate is below the spot rate, whereas a forward premium exists if the forward rate is above the spot rate.

For example, if the one-month forward exchange rate is $:€ = 0.8020 and the spot rate is $:€ = 0.8000, the $ quotes with a premium of 0.0020 €/$. In the language of currency traders, the $ is "strong" relative to the €.

Consequently, when a trader announces that a currency quotes at a premium (discount), the premium (discount) should be added to (subtracted from) the spot exchange rate to obtain the value of the forward exchange rate.

Occasionally, forward rates are presented in terms of percentages relative to the spot rate:

Interest Rate Parity

According the interest rate parity (IRP) theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. In an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential.

The exact relationship between the forward rate and the spot rate of two currencies is as follows:

  • The exchange rate is d:f = S for the spot rate and F for the forward rate.
  • Both id and if are periodic interest rates, which should be computed as i = annual interest rate x number of days till the forward contract expires / 360.
  • It is assumed that there are no transaction costs.

Example

Suppose that the annual interest rate in the U.S. is 5%. The spot exchange rate £:$ = 1.50 and the 180-day forward rate is £:$ = 1.45. The U.S. periodic interest rate (180) is: 0.05 x 180 / 360 = 0.025. If interest rate parity holds:

(1.45 - 1.5)/1.5 = (0.025 - iUK)/(1+iUK) => iUK = 6%

Therefore, the annual UK interest rate is approximately 12%.

Similarly, you can calculate the forward rate based on the two interest rates and ...
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Subject 5. Exchange Rate Regimes
#cfa #cfa-level-1 #economics #economics-in-a-global-context #reading-21-currency-exchange-rates
The exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market.

An ideal currency regime would have three properties:

  • The exchange rate between any two currencies would be credibly fixed.
  • All currencies would be fully convertible.
  • Each country would be able to undertake fully independent monetary policy in pursuit of domestic objectives, such as growth and inflation targets.

However, these conditions are not consistent. A country cannot have a fixed exchange rate and fully convertible currency without giving up its ability to implement independent monetary policy.

In a flexible exchange rate regime, the exchange rate is determined by the market forces of supply and demand, and therefore fluctuates freely in the market. The central bank intervenes in the foreign exchange market only to smooth temporary imbalances. The advantages are that the exchange rate reflects economic fundamentals at a given point in time and governments are free to adopt independent monetary and fiscal policies. However, exchange rates can be extremely volatile in this regime.

A fixed exchange rate is an exchange rate that is set at a determined amount by government policy. The distinguishing characteristic of a fixed rate, unified currency regime is the presence of only one central bank with the power to expand and contract the supply of money. Those linking their currency at a fixed rate to the U.S. dollar or the euro are no longer in a position to conduct monetary policy. They essentially accept the monetary policy of the nation to which their currency is tied. They also accept the exchange-rate fluctuations of that currency relative to other currencies outside of the unified zone.

In practice, most regimes fall between these extremes. The type of exchange rate regime used varies widely among countries and over time.

No Separate Legal Tender

In this regime a country does not have its own legal tender. There are two sub-types:

  • Dollarization. The country uses another country's currency as its domestic currency. The benefit is the elimination of exchange rate fluctuations. However, this leads to the loss of monetary policy autonomy.
  • Monetary union. In this case a group of countries share a common currency, e.g., the European Union and the euro.

Currency Board System

The monetary authority is required to maintain a fixed exchange rate with a foreign currency. Its foreign currency reserves must be sufficient to ensure that all holders of its own currency can convert them into the reserve currency. That is, the monetary authority will only issue one unit of local currency for each unit of foreign currency it has in its vault.

The major benefit is currency stability and the main drawback is the loss of ability for the country to set its own monetary policy.

Fixed Parity

The country tries to keep the value of its currency constant against another country but it has no legal obligation to do so. This is also known as the pegged exchange rate system. There can be a very small percentage allowable deviation (band) on both sides of the rate.

Target Zone

This is a fixed parity with a somewhat wider band.

Crawling Peg

In this case, the exchange rate is fixed and then adjusted periodically to keep pace with the inflation rate.

Crawling Band

This is initially a fixed parity, followed by widening band around the central parity. It is used to gradually exit from the fixed parity.

Managed Float

A country's exchange rate is adjusted based on the country's internal or external targets.

Independently Float

In this case, the market determines the ...
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Subject 6. Exchange Rates, International Trade, and Capital Flows
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-21-currency-exchange-rates

Countries that attract a net inflow of foreign capital tend to run current account deficits. The U.S. is an example. In general, a trade deficit (surplus) has to be offset by a capital account surplus (deficit). That is, a current account deficit implies a capital account surplus.

X - M = (S - I ) + (T - G)

This relationship shows that a trade surplus is equal to the sum of public and private savings. A country saves more than enough to fund its investment (I) in plants and equipment. If a country runs a trade deficit, it has to rely on foreign capital to finance its investment (a capital surplus).

Now we analyze the impact of the exchange rate on trade and capital flows.

The Elasticities Approach

This approach emphasizes price changes as a determinant of a country's balance of payments and exchange rate.

The exchange rate is an important price in an economy. When a country's currency depreciates, domestic goods become relatively cheaper and foreign goods relatively more expensive in the global market. Hence, we would expect exports to rise and imports to decline. The elasticities approach considers the responsiveness of imports and exports to a change in the value of a country's currency.

For example, if import demand is highly elastic, a depreciation of the domestic currency will cause a disproportionate decline in the country's imports.

The Marshall-Lerner condition states that a depreciation of domestic currency can improve a country's balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds unity.

The J-Curve is an observed phenomenon.

What is observed is that, following a depreciation or devaluation, a country's balance of payments worsens before it improves. This is because, in the short-run, exports and imports volume does not change that much, so that the price effect dominates, leading to a worsening of the current account.

Absorption Approach

This approach assumes that prices remain constant and emphasizes changes in real domestic income. Hence, the absorption approach is a real-income theory of the balance of payments.

Absorption refers to the total goods and services taken off the market domestically. In other words, absorption equals the sum of consumption plus investment.

Whether a currency depreciation can improve the current account (then the balance of payments) depends on its effect on national income and on domestic expenditure (absorption).

  • On the supply side, effective depreciation requires idle resources in the economy.
  • On the demand side, effective depreciation requires the Marshall-Lerner condition to be met.

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Subject 1. The Roles of Financial Reporting and Financial Statement Analysis
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction
The role of financial reporting is to provide information about a company's financial position and performance for use by parties both internal and external to the company. Financial statements are issued by management, who is responsible for their form and content.

The role of financial statement analysis, on the other hand, is to take these financial statements and other information to evaluate the company's past, current, and prospective financial position and performance for the purpose of making rational investment, credit, and similar decisions.

The primary users of financial statements are equity investors and creditors.

  • Equity investors are primarily interested in the company's long-term earning power, growth, and ability to pay dividends.
  • Short-term creditors (e.g., banks and trade creditors) are more interested in the company's immediate liquidity, because they seek an early payback of their investment.
  • Long-term creditors (e.g., corporate bond owners such as insurance companies and pension funds) are primarily concerned with the company's long-term asset position and earning power.
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Subject 2. Major Financial Statements
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #introduction
Financial statements are the most important outcome of the accounting system. They communicate financial information gathered and processed in the company's accounting system to parties outside the business.

The four principal financial statements are:

  • Income statement (statement of earnings)
  • Balance sheet (statement of financial position)
  • Cash flow statement
  • Statement of changes in owners' or stockholders' equity

These four financial statements, augmented by footnotes and supplementary data, are interrelated. In addition, there are other sources of financial information, such as management discussion and analysis, auditor's reports, etc.

Income Statement

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies. The following is a generic sample:

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings. As operating expenses do not include financing costs such as interest expenses, operating income (EBIT) is independent of the company's capital structure.

In the typical income statement this means segregating the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.

Balance Sheet

A balance sheet provides a "snapshot" of a company's financial condition. Think of the balance sheet as a photo of the business at a specific point in time. It reports major classes and amounts of assets, liabilities, stockholders' equity, and their interrelationships as of a specific date.

Assets = Liabilities + Stockholders' Equity

  • Assets are the economic resources controlled by the company.
  • Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
  • Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

Cash Flow Statement

The primary purpose of the cash flow statement is to provide information about a company's cash receipts and cash payments during a period. It reports the cash receipts and cash outflows classified according to operating, investment, and financing activities.

The cash flow statement is useful because it provides answers to the following simple yet important questions:

  • Where did the cash come from during the period?
  • What was the cash used for durin
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Subject 3. Other Financial Information Sources
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction
Financial Notes and Supplementary Schedules

Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Auditor's Reports

See next subject for details.

Other Sources of Information

  • Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

  • Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

  • Companies' websites, press releases, and conference calls.
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Subject 4. Auditor's Reports
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction
The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

  • Whether the financial statements are presented in accordance with generally accepted accounting principles.
  • It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
  • Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

  • An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
  • A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
  • An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

  • A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on In...
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Subject 5. Financial Statement Analysis Framework
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction

The financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

  • Articulate the purpose and context of the analysis.

    What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?

    The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

  • Collect input data.

    Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

  • Process data.

    Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

  • Analyze / interpret the processed data.

    Interpret the output to support a conclusion (e.g., a buy decision).

  • Develop and communicate conclusions and recommendations.

    Communicate the conclusion or recommendation in an appropriate format.

  • Follow up.

    Periodic review is required to determine if the original conclusions and recommendations are still valid.

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Subject 1. The Classification of Business Activities
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
Business activities can be classified into three groups:

  • Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:

    • Selling goods and services
    • Employing managers and workers
    • Buying goods and services
    • Paying taxes

  • Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:

    • Buying resources such as land, buildings, and equipment needed in the operation of the business.
    • Selling these resources when no longer needed.

    Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

  • Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:

    • Issuing stock
    • Paying dividends to stockholders
    • Obtaining loans from creditors
    • Repaying amounts plus interest to creditors

    Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

In Reading 27 [Understanding the Cash Flow Statement] a more detailed discussion of different business activities and their impact on cash flows will be provided.
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Subject 2. Financial Statement Elements and Accounts
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
An account is a label used for recording and reporting a quantity of almost anything. It is the:

  • Means by which management keeps track of the effects of transactions.
  • Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

  • An asset is usually listed on the balance sheet.
  • It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

  • Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
  • Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
  • Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
  • Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

  • Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
  • Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

  • Contributed capital is the amount invested in the busines
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Subject 3. Accounting Equations
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

  • Dividends and expenses decrease owners' equity.
  • Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

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Subject 4. Effects of Transactions on the Accounting Equation
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets=Liab.Owners' Equity
CashA/RSuppliesLandBuilding A/PCommon StockRetained Earnings
1$50,000 $50,000
A = $50,000 L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets=Liab.Owners' Equity
CashA/RSuppliesLandBuilding A/PCommon StockRetained Earnings
1$50,000 $50,000
2-35,000 $10,000$25,000 $50,000
bal$15,000 $10,000$25,000 $50,000
A = $50,000 L + OE = $50,000
This transaction only affects one side of the accounting equation: assets.
Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets=Liab.Owners' Equity
CashA/RSuppliesLand
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Subject 5. Accruals and Valuation Adjustments
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

  • A balance sheet must list all assets and liabilities at the end of the accounting period.
  • An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

  • Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

  • Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

  • Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

  • Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

  • If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
  • If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other com
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Subject 6. Financial Statements
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
Here are financial statements based on previous transactions for ABC Realty.

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Subject 7. Flow of Information in an Accounting System
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

  • General journal is the simplest and most flexible.
  • A separate journal entry records each transaction.
  • Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

  • For every amount debited, an equal amount must be credited.
  • The total of debits and credits for all the T-accounts must be equal.
  • A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
  • It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.
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Subject 1. The Objective of Financial Reporting
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
An awareness of the reporting framework underlying financial reports can assist in security valuation and other financial analysis. This framework describes the objectives of financial reporting, desirable characteristics for financial reports, the elements of financial reports, and the underlying assumptions and constraints of financial reporting. An understanding of the framework that is broader than knowledge of a particular set of rules offers an analyst a basis from which to infer the proper financial reporting, and thus security valuation implications, of any financial statement element transaction.

The objective of financial reporting:

  • The objective of financial statements is to provide information about a company's financial position, performance, and any changes in financial position; this information should be useful to a wide range of end-users for the purpose of making economic decisions.
  • Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to attempt to ensure some type of consistency in these judgments.
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Subject 2. Financial Reporting Standard-Setting Bodies and Regulatory Authorities
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Private sector standard-setting bodies and regulatory authorities play significant but different roles in the standard-setting process. In general, standard-setting bodies make the rules and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdictions.

International Accounting Standards Board (IASB)

This is essentially the international equivalent of the Financial Accounting Standards Board (FASB).

  • It was preceded by the International Accounting Standards Committee (IASC), which was established in 1973.
  • It is comprised of 14 members (12 full-time, 2 part-time); seven members are liaisons with a national board.
  • It works toward harmonization of international accounting standards.
  • The standard development process is open.
  • Standards are principles-based.
  • Since the establishment of the IASB, the focus is on global standard-setting rather than harmonization per se.

International Organization of Securities Commissions (IOSCO)

This is essentially the international equivalent of the U.S. Securities and Exchange Commission (SEC).

  • It works to achieve improved market regulation internationally.
  • It works to facilitate cross-border listings.
  • It advocates for the development and adoption of a single set of high-quality accounting standards.

Financial Accounting Standards Board (FASB)

The FASB is a non-governmental body that sets accounting standards for all companies issuing audited financial statements. All FASB pronouncements are considered authoritative; new FASB statements immediately become part of GAAP.

U.S. Securities and Exchange Commission (SEC)

In the U.S., the form and content of the financial statements of companies whose securities are publicly traded are governed by the SEC through its regulation S-X. Although the SEC has delegated much of this responsibility to the FASB, it frequently adds its own requirements. The SEC functions as a highly effective enforcement mechanism for standards promulgated in the private sector.

Audited financial statements, related footnotes, and supplementary data are presented in both annual reports sent to stockholders and those filed with the SEC. These filings often contain other valuable information not presented in stockholder reports.

Convergence of Global Financial Reporting Standards

As capital markets become more international in scope, the need for global accounting standards and the demand for multiple listings has grown. The IASB and FASB, along with other standard-setters, are working to achieve convergence of financial reporting standards.

Pros:

  • Expedite the integration of global capital markets and make the cross-listing of securities easier.
  • Facilitate international mergers and acquisitions.
  • Reduce investor uncertainty and the cost of capital.
  • Reduce financial reporting costs.
  • Allow for easy adoption of high-quality standards by developing countries.

Cons:

  • Significant differences in standards currently exist.
  • The political cost of eliminating differences.
  • Overcoming nationalism and traditions.
  • Will cause "standards overload" for some firms.
  • Diverse standards for diverse places are acceptable.

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Subject 3. The International Financial Reporting Standards Framework
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
The IFRS Framework sets forth the concepts that underlie the preparation and presentation of financial statements for external end-users, provides further guidance on the elements from which financial statements are constructed, and discusses the concepts of capital and capital maintenance.

Objectives of Financial Statements

The Framework identifies the central objective of financial statements as providing information about a company that is useful in making economic decisions. Financial statements prepared for this purpose will meet the needs of most end-users. Users generally want information about a company's financial performance, financial position, cash flows, and ability to adapt to changes in the economic environment in which it operates.

The Framework identifies end-users as investors and potential investors, employees, lenders, suppliers, creditors, customers, governments, and the public at large.

Qualitative Characteristics of Financial Statements

The Framework prescribes a number of qualitative characteristics of financial statements. The key characteristics are relevance and reliability. Preparers can face a dilemma in satisfying both criteria at once. For example, information about the outcome of a lawsuit may be relevant, but the financial impact cannot be measured reliably.

Financial information is relevant if it has the capacity to influence an end-user's economic decisions. Relevant information will help users evaluate the past, present, and most importantly, future events in a company.

To be reliable, financial information must represent faithfully the effects of the transactions and events that it reflects. The true impact of transactions and events can be compromised by the difficulty of measuring transactions reliably.

  • Financial information faithfully represents transactions and events when accounted for in accordance with their substance and economic realityand not merely their legal form. Commonly, a legal agreement will purport that a company has "sold" assets to a third party. However, an analysis of the substance of the arrangement indicates that the company retains control over the future economic benefits and risks embodied in the asset, and should continue to recognize it on its own balance sheet.
  • Financial information is reliable if it is free from material error and is complete. Information is material if its omission or misstatement could influence decisions that end-users make on the basis of the financial statements. Information is reliable when it is neutral or free from bias and prudence. A degree of prudence when preparing financial information enhances its reliability. However, a company should not use prudence as the basis for the recognition of, for example, excessive provisions.

Financial information must be easily understandable in addition to being relevant and reliable. Preparers should assume that end-users have a reasonable knowledge of business and economic activities, and an ability to comprehend complex financial matters.

End-users must be able to compare a company's financial statements through time in order to identify trends in financial performance (comparability). Hence, policies on recognition, measurement, and disclosure must be applied consistently over time. Where a company changes its accounting for the recognition or measurement of transactions, it should disclose the change in the Basis of Accounting section of its financial statements and follow the guidance set out in IFRS.

The application of qualitative characteristics and accounting standards usually results in financial statements that show a true and fair view, or fairly present a company's financial position and performance.

The Elements of Financial Statements

The Framework outlines definition and recognition criteria fo...
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Flashcard 1418088025356

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Question
You need a [...] ​to have FHR variability
Answer
functional autonomic nervous system

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Subject 4. General Requirements for Financial Statements
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
The objective of IAS No. 1 is to prescribe the basis for the presentation of general-purpose financial statements, to ensure comparability both with the company's financial statements of previous periods and with the financial statements of other entities. To achieve this objective, this Standard sets out overall requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.

Components of Financial Statements

A complete set of financial statements comprises:

  • a balance sheet
  • an income statement
  • a statement of changes in equity showing either:

    • all changes in equity, or
    • changes in equity other than those arising from transactions with equity-holders acting in their capacity as equity-holders

  • a cash flow statement
  • notes, comprising a summary of significant accounting policies and other explanatory notes

Fundamental Principles Underlying the Preparation of Financial Statements

A company whose financial statements comply with IFRS shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRS unless they comply with all the requirements of IFRS.

Underlying principles:

  • Fair presentation. Financial statements shall present fairly the financial position, financial performance, and cash flows of a company. In virtually all circumstances, a fair presentation is achieved by compliance with applicable IFRS.

  • Going concern. A business is presumed to be a going concern. If management has significant concerns about the company's ability to continue as a going concern, the uncertainties must be disclosed.

  • Accrual basis. IAS No. 1 requires that a company prepare its financial statements, except for cash flow information, using the accrual basis of accounting.

  • Consistency. The presentation and classification of items in the financial statements shall be retained from one period to the next unless a change is justified either by a change in circumstances or requirements of new IFRS.

  • Materiality and Aggregation. Each material class of similar items must be presented separately in the financial statements. Dissimilar items may be aggregated only if they are individually immaterial.

Presentation requirements:

  • No offsetting. Assets and liabilities, and income and expenses, may not be offset unless required or permitted by IFRS.

  • Classified balance sheet. A business must normally present a classified balance sheet, separating current and non-current assets and liabilities. Only if a presentation based on liquidity provides information that is reliable and more relevant may the current/non-current split be omitted.

  • Minimum information on the face of the financial statements. IAS No. 1 specifies the minimum line item disclosures on the face of, or in the notes to, the balance sheet, the income statement, and the statement of changes in equity.

  • Minimum information in the notes. IAS No. 1 specifies disclosures about information to be presented in the financial statements.

  • Comparative information. Comparative information shall be disclosed in respect of the previous period for all amounts reported in the financial statements, both on the face of financial statements and in notes.
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Flashcard 1418091695372

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Question
If a baby doesn't react to scalp scratching, worry about [...]
Answer
hypoxemia

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Flashcard 1418094841100

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Question
Although decreased FHR variability can be an ominous sign indicating a seriously compromised fetus, decreased variability in the absence of fetal decelerations is unlikely due to [...]
Answer
fetal hypoxia

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Subject 5. Comparison of IFRS with Alternative Reporting Systems
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards

A significant number of the world's listed companies report under either IFRS or U.S. GAAP. Although these standards are moving toward convergence, there are still significant differences in the framework and individual standards. Frequently, companies provide reconciliations and disclosures regarding the significant differences between reporting bases. These reconciliations can be reviewed to identify significant items that could affect security valuation.

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Subject 1. Components and Format of the Income Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement

The income statement presents information on the financial results of a company's activities over a period of time. The format of the income statement is not specified by U.S. GAAP and the actual format varies across companies.

Here are common components:

  • Sales or revenue: amount charged for the delivery of goods or services.

    • Follows the revenue recognition rule: Revenue is recognized even though cash may not be collected until the following accounting period.
    • Net sales = gross sales - sales returns and allowances - discounts.
    • Amount of sales and trends in net sales over time are used to analyze a company's progress.

  • Cost of goods sold is the amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period.

  • Gross margin = net sales - costs of goods sold. Also called gross profit.

    Management is interested in both:

    • The amount of gross margin; and
    • The percentage of gross margin (gross margin/net sales).

    Both are useful in planning business operations.

  • Operating expenses are expenses other than the cost of goods sold that are incurred in running a business.

    • These expenses are grouped into categories: selling expenses, general and administrative expenses, and other revenues and expenses.
    • Careful planning and control of operating expenses can improve a company's profitability.

  • Income from operations (also called operating income) is the difference between gross margin and operating expenses. It represents the income from a company's normal, or main, business. It is used to compare the profitability of companies or divisions within a company.

  • Other revenues and expenses are not part of a company's operating activities. These include:

    • Revenues or expenses from investments (e.g., dividends and interest).
    • Interest and other expenses from borrowing.
    • Any other revenue or expense not related to the company's normal business operations.

    They are also called non-operating revenues and expenses.

  • Income before income taxes is the amount a company has earned from all activities - operating and non-operating - before taking into account the amount of income taxes the company incurred.

    This is used to compare the profitability of two or more companies or divisions within a company. Comparisons are made before income taxes are deducted because companies may be subject to different income tax rates.

  • Income taxes (also called provision for income taxes) represent the expense for federal, state, and local taxes on corporate income.

    The income taxes account is shown as a separate item on the income statement. Tax rates are substantial (usually 15-38%) and have a significant effect on business decisions. Most other types of taxes are shown among operating expenses.

  • Net income is what remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted. It is the final figure, or "bottom line," of the income statement.

    Net income = Income before income taxes - income taxes

    Net income is an important performance measure.

    • It represents the amount of business earnings that accrue to stockholders.
    • It is the amount transferred to retained earnings from all income generating activities during the year.
    • It is often used to determine whether a business has been operating successfully.

The...
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Flashcard 1418099035404

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Question
[...] and [...] during labour can decrease FHR variability
Answer
maternal acidemia (diabetic ketoacidosis); analgesic drugs

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Flashcard 1418100870412

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Question
FHR Variability tends to [increase/decrease] ​with increasing fetal tachycardia.
Answer
decrease

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Flashcard 1418104016140

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Question
What is a normal EFM tracing baseline?
Answer
110-160 bpm

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Subject 2. Revenue Recognition
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
There are two revenue and expense recognition issues when accrual accounting is used to prepare financial statements:

  • Timing: when should revenue and expense be recognized?
  • Measurement: how much revenue and expense should be recognized?

Revenue is generally recognized when it is (1) realized or realizable, and (2) earned.

The general rule for revenue recognition includes the "concept of realization." Two conditions must be met for revenue recognition to take place:

1. Completion of the earnings process

The company must have provided all or virtually all the goods or services for which it is to be paid, and it must be possible to measure the total expected cost of providing the goods or services. No remaining significant contingent obligation should exist. This condition is not met if the company has the obligation to provide future services (such as warranty protection) but cannot estimate the associated expenses.

2. Assurance of payment

The quantification of cash or assets expected to be received for the goods or services provided must be reliable.

These conditions are typically met at the time of sale, but there are many exceptions, which will be discussed next.
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Subject 3. Revenue Recognition in Special Cases
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In limited circumstances, specific revenue recognition methods may be applicable.

Long-term Contracts

A long-term contract is one that spans multiple accounting periods. How should a company apportion the revenue earned under a long-term contract to each accounting period?

  • If the outcome of a long-term contract can be reliably measured, both IFRS and U.S. GAAP require the use of the percentage-of-completion method.
  • If the outcome of a long-term contract can NOT be reliably measured:

    • Under IFRS, revenue is only reported to the extent of contract costs incurred. Costs are expensed in the period incurred.
    • Under U.S. GAAP, no revenue is reported until the contract is finished. This is called the completed contract method.

  • If a loss is expected on a contract, the loss is reported immediately, regardless of the method used.

Percentage-of-completion

Revenues and expenses are recognized each period in proportion to the work completed. This is used for a long-term project if all of the following conditions are met:

  • There is a contract.
  • There are reliable estimates of revenues, costs, and progress towards completion.
  • The buyer can be expected to pay the full contract price on schedule.

It recognizes profit corresponding to the percentage of cost incurred to total estimated costs associated with long-term construction contracts. It is the preferred method because it provides a better measure of operating activities and a more informative disclosure of the status of incomplete contracts. It also facilitates the forecast of future performance and cash flows. This method highlights the relationship among the income statement (revenues), the balance sheet (resulting receivables), and the cash flow statement (current collections).

The percentage-of-completion is equal to actual cost/estimated total cost, or it can be determined by an engineering estimate. Using the first approach:

  • Percent completed = Costs incurred to date / Most recent estimate of total costs.
  • Revenue to be recognized to-date = Percent complete x Estimated total revenue.
  • Current period revenue = Revenue to be recognized to date - revenue recognized in prior periods.

To date, the most recent estimate of the total cost is used in computing the progress toward completion. It means that if cost estimates are revised as the project progresses, that effect is recognized in the period in which the change is made. Costs and revenues of prior periods are not restated.

Completed Contract

This method does not recognize revenue and expense until the contract is completed and the title is transferred. All profits are recognized when the contract is completed. The completed contract method is used when:

  • There is no contract; or
  • Estimates of revenues, costs, or progress towards completion are unreliable; or
  • The ability to collect revenues from the buyer is uncertain.

This method is more conservative than the percentage-of-completion method. Analysts may need to rely on the statement of cash flows to assess the contribution of long-term contracts to a company's profitability.

Installment Sales

This method is used if the costs to provide goods or services are known but the collectability of sales proceeds cannot be reasonably determined. It recognizes both revenue and the associated cost of goods sold only when cash is received. Gross profit (sales - costs of goods sold) reflects the proportion of cash received. This method is sometimes used to report income from sales of noncurrent assets and real estate transactions.

Cost Recovery

This method is similar to the installment sales method but is more conservative. It ...
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Subject 4. Revenue Recognition Accounting Standards Issued May 2014
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
In May 2014, the IASB and FASB each issued a converged standard for revenue recognition. The standards are effective for reporting periods beginning after 1 January 2017 under IFRS and 15 December 2016 under U.S. GAAP.

Key aspects of the converged accounting standards:

The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services.

Companies under contract to provide goods or services to a customer will be required to follow a five-step process to recognize revenue:
  1. Identify contract(s) with a customer
  2. Identify the separate performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the separate performance obligations
  5. Recognize revenue when the entity satisfies each performance obligation
There is new guidance on whether revenue should be recognized at a point in time or over time. The standard provides detailed guidance on various issues such as identifying distinct performance obligations, accounting for contract modifications, and accounting for the time value of money. Detailed implementation guidance is included on topics such as sales with a right of return, customer options for additional goods or services, etc. The standard also introduces new guidance on costs of fulfilling and obtaining a contract and specifying the circumstances in which such costs should be capitalized. Costs that do not meet the criteria must be expensed when incurred.

The standard introduces new, increased requirements for disclosure of revenue in a reporter's financial statements.
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Subject 5. Expense Recognition
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The matching principle states that operating performance can be measured only if related revenues and expenses are accounted for during the same period ("let the expense follow the revenues"). Expenses are recognized not when wages are paid, when the work is performed, or when a product is produced, but when the work (service) or the product actually makes its contribution to revenue. Thus, expense recognition is tied to revenue recognition.

Expenses incurred to generate revenues must be matched against those revenues in the time periods when the revenues are recognized.

  • If the revenues are recognized in the current period, the associated expenses should be recognized in the current period and appear in the income statement.
  • If revenues are expected to be recognized in future periods, the associated expenses are capitalized (appearing on the balance sheet of the current period as an asset). When the revenues are recognized in future periods, the asset is converted to expenses in those periods.

The problem of expense recognition is as complex as that of revenue recognition. For costs that are not directly related to revenues, accountants must develop a "rational and systematic" allocation policy that will approximate the matching principle. However, matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.

The Matching of Inventory Costs with Revenues

Please refer to Reading 29 [Inventories] for details.

Some issues in expense recognition:

Doubtful Accounts

Account receivables arise from sales to customers who do not immediately pay cash. There are always some customers who cannot or will not pay their debts. The accounts owed by these customers are called uncollected accounts. Therefore, accounts receivables are valued and reported at net realizable value - the net amount expected to be received in cash, which is not necessarily the amount legally receivable. The chief problem in recording uncollectible accounts receivable is establishing the time at which to record the loss.

Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless. No entry is made until a specific account has definitely been established as uncollectible. This method is easy and convenient to apply. However, it usually does not match costs with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.

Advocates of the allowance method believe that bad debt expense should be recorded in the same period as the sale to obtain a proper matching of expenses and revenues and to achieve a proper carrying value for accounts receivable. In practice, the estimate of bad debt is made either on the percentage-of-sales basis (income statement approach) or outstanding-receivables basis (balance sheet approach).

Warranties

Warranty costs are a classic example of a loss contingency. Although the future cost amount, due date, and customer are not known for certain, a liability is probable and should be recognized if it can be reasonably estimated.

Depreciation and Amortization

Please refer to Reading 30 [Long-Lived Assets] for details.

Financial Analysis Implications

In expense recognition, choice of method (i.e., the depreciation method and the inventory method) as well as estimates (i.e., uncollectible accounts, warranty expenses, assets' useful life, and salvage value) affect a company's reported income. An analyst should identify differences in companies' expense-recognition methods and adjust r...
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Flashcard 1418111880460

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Question
If abnormal FHR strip and resuscitation interventions ([...]) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
Answer
change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).







Flashcard 1418113453324

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to [...] if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
Answer
c/s

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).







Flashcard 1418115026188

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~[...] cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
Answer
3

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Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).







Flashcard 1418116599052

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~[...]cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
Answer
8

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Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).







Flashcard 1418118171916

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, [...] can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
Answer
fetal scalp sampling

statusnot learnedmeasured difficulty37% [default]last interval [days]               
repetition number in this series0memorised on               scheduled repetition               
scheduled repetition interval               last repetition or drill

Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).







Flashcard 1418120531212

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have [...].
Answer
assisted vag delivery (forceps/vacuum)

statusnot learnedmeasured difficulty37% [default]last interval [days]               
repetition number in this series0memorised on               scheduled repetition               
scheduled repetition interval               last repetition or drill

Open it
l FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have <span>assisted vag delivery (forceps/vacuum).<span><body><html>







Subject 6. Non-Recurring Items and Non-Operating Items
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
The goal of analyzing an income statement is to derive an effective indicator to predict future earnings and cash flows. Net income includes the impact of non-recurring items, which are transitory or random in nature. Therefore, net income is not the best indicator of future income. Recurring pre-tax income from continuing operations represents the company's sustainable income and therefore should be the primary focus of analysis.

Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring," especially those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring," regardless of their accounting labels.

There are four types of non-recurring items in an income statement.

1. Discontinued operations

Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized.

  • Subsidiaries and investees also qualify as separate components.
  • Disposal of a portion of a business component does not qualify as discontinued operations. Instead, this is recorded as an unusual or infrequent item.

2. Extraordinary items

Extraordinary items are BOTH unusual in nature AND infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax.

Common examples are:

  • Expropriations by foreign governments.
  • Uninsured losses from earthquakes, eruptions, and tornadoes.

Note that gains and losses from the early retirement of debt used to be treated as extraordinary items; SFAS No. 145 now requires them to be treated as part of continuing operations.

3. Unusual or infrequent items

These are either unusual in nature OR infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations.

Common examples are:

  • Gains or losses from disposal of a portion of a business segment.
  • Gains or losses from sales of assets or investments in affiliates or subsidiaries.
  • Provisions for environmental remediation.
  • Impairment, write-offs, write-downs, and restructuring costs (such as those costs related to the integration of acquired companies).

4. Changes in accounting principles

Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on...
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Subject 7. Earnings per Share
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Earnings per share (EPS) is a measure that is widely used to evaluate the profitability of a company.

A company's capital structure is simple if it consists of only common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. Companies with simple capital structures only need to report basic EPS.

A complex capital structure contains securities that could have a dilutive effect on earnings per common share. Dilutive securities are securities that, upon conversion or exercise, could dilute earnings per share. These securities include options, warrants, convertible bonds, and preferred stocks.

Companies with complex capital structures must report both basic EPS and diluted EPS. Calculation of diluted EPS under a complex capital structure allows investors to see the adverse impact on EPS if all diluted securities are converted into common stock.

Basic EPS

To calculate EPS in a simple capital structure:

The current year's preferred dividends are subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Since the number of common shares outstanding may change over the year, the weighted average is used to compute EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. Analysts need to find the equivalent number of whole shares outstanding for the year.

Three steps are used to compute the weighted average number of common shares outstanding:

  • Identify the beginning balance of common shares and changes in the common shares during the year.
  • For each change in the common shares:

    • Compute the number of shares outstanding after each change in the common shares. Issuance of new shares increases the number of shares outstanding. Repurchase of shares reduces the number of shares outstanding.
    • Weight the shares outstanding by the portion of the year between this change and next change: weight = days outstanding / 365 = months outstanding / 12

  • Sum up to compute the weighted average number of common shares outstanding.

Stock Dividends and Splits

In computing the weighted average number of shares, stock dividends and stock splits are only changes in the units of measurement, not changes in the ownership of earnings. A stock dividend or split does not change the shareholders' total investment (i.e., it means more pieces of paper for shareholders).

When a stock dividend or split occurs, computation of the weighted average number of shares requires restatement of the shares outstanding before the stock dividend or split. It is not weighted by the portion of the year after the stock dividend or split occurred.

Specifically, before starting the three steps of computing the weighted average, the following numbers should be restated to reflect the effects of the stock dividend/split:

  • The beginning balance of shares outstanding;
  • All share issuance or purchase prior to the stock dividend or split.
  • No restatement should be made for shares issued or purchased after the date of the stock dividend or split.

If a stock dividend or split occurs after the end of the year but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated.

Example

1. 01/01/15 - 100...
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Subject 8. Analysis of the Income Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Common-Size Analysis of the Income Statement

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Income Statement Ratios

The following operating profitability ratios measure the rates of profit on sales (profit margins).

  • Net Profit Margin shows how much profit is generated on every dollar of sales.

    Net income is earnings after tax but before dividends (EBIT - interest - taxes). It should be based on earnings from the company's continuing operation because the analysis is to forecast the company's future performance. Thus analysts should not consider earnings from discontinued operations, gains or losses from the sale of discontinued operations, and non-recurring income or expenses.

  • Gross Profit Margin equals percent of sales available after deducting cost of goods sold.

    This percentage is available to cover selling, general and administrative costs, and also earn a profit. It indicates the basic cost structure of a company and shows the company's cost-price position. Comparing this ratio with the industry average over time shows the company's relative profitability within the industry.

    • A declining gross profit may indicate increasing costs of production or declining prices.
    • The ratio can be affected by changes in the company's product mix: a change toward items with higher (lower) margin raises (reduces) the gross profit margin.
    • A small change in gross profit can result in a much larger change in profit margin if the company has high fixed costs.
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Subject 9. Comprehensive Income
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation.

Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available-for-sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.

The following table is from the Statement of Stockholders' Equity section of the 3M's 2001 annual report.

This section describes the composition of comprehensive income. It begins with net income and then includes those items affecting stockholders' equity that do not flow through the income statement. For 3M, these items include:

  • Cumulative translation adjustment.
  • Minimum pension liability adjustment.
  • Unrealized gains (losses) on available-for-sale investments.
  • Unrealized gains (losses) on derivative investments.

FASB has taken the position that income for a period should be all-inclusive comprehensive income. Comprehensive income may be reported on an income statement or separate statement, but is usually reported on a statement of stockholders' equity.
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Subject 1. Components and Format of the Balance Sheet
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-balance-sheets
The starting place for analyzing a company is typically the balance sheet. Think of the balance sheet as a photo of the business at a specific point in time. It presents the assets, liabilities, and equity ownership of a company as of a specific date.

  • Assets are the economic resources controlled by the company.
  • Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
  • Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

The balance sheet provides users, such as creditors and investors, with information regarding the sources of finance available for projects and infrastructure. At the same time, it normally provides information about the future earnings capacity of a company's assets as well as an indication of cash flow implicit in the receivables and inventories.

The balance sheet has many limitations, especially relating to the measurement of assets and liabilities. The lack of timely recognition of liabilities and, sometimes, assets, coupled with historical costs as opposed to fair value accounting for all items on the balance sheet, implies that the financial analyst must make numerous adjustments to determine the economic net worth of the company.

The analyst must understand the components, structure, and format of the balance sheet in order to evaluate the liquidity, solvency, and overall financial position of a company.

Balance Sheet Format

Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The table below indicates the general format of balance sheet presentation:

This format is referred to as the account format, which follows the pattern of the traditional general ledger accounts, with assets at the left and liabilities and equity at the right of a central dividing line. A report format balance sheet lists assets, liabilities, and equity in a single column.

Balance Sheet Components

Current Assets

These are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between the acquisition of materials and supplies and the realization of cash through sales of the product for which the materials and supplies were acquired. The cycle operates from cash through inventory, production, and receivables back to cash. Where there are several operating cycles within one year, the one-year period is used. If the operating cycle is more than one year, the longer period is used.

Long-Term Investments

Often referred to simply as investments, these are to be held for many years and are not acquired with the intention of disposing of them in the near future.

  • Investments in securities such as bonds, common stock, or long-term notes that management does not intend to sell within one year.
  • Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
  • Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. The cash surrender value of life insurance is included here.
  • Investments in non-consolidated subsidiaries or affiliated companies.
...
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Flashcard 1418139667724

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#obgyn
Question
What is an atypical EFM tracing baseline?
Answer
-bradycardia 100-110bpm
-tachy >160bpm for >30 but <80 min
-rising baseline

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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scheduled repetition interval               last repetition or drill






Flashcard 1418144386316

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#obgyn
Question
What is an abnormal EFM tracing baseline?
Answer
-brady <100bpm
-tachy >160bpm for >80min
-erratic baseline

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Subject 2. Measurement Bases of Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Asset and liability values reported on a balance sheet may be measured on the basis of fair value or historical cost. Historical cost values may be quite different from economic values. The balance sheet must be evaluated critically in light of accounting policies applied in order to answer the question of how the values relate to economic reality and to each other.

Current Assets

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section are:

  • Cash. Valued at its stated value. Cash restricted for purpose other than payment of current obligations or for use in current operations should be excluded from the current asset section.
  • Marketable securities. Valued at cost or lower of cost and market value.
  • Accounts receivables. Amounts owed to the company by its customers for goods and services delivered. Valued at the estimated amount collectible.
  • Inventories. Products that will be sold in the normal course of business. They should be measured at the lower of cost or net realizable value. Refer to Reading 29 [Inventories] for details.
  • Pre-paid expenses. These are expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. Typical examples are pre-paid rent, advertising, taxes, insurance policies, and office or operating supplies. They are reported at the amount of un-expired or unconsumed cost.

Current Liabilities

Current liabilities are typically paid from current assets or by incurring new short-term liabilities. They are not reported in any consistent order. A typical order is: accounts payable, notes payable, accrued items (e.g., accrued warranty costs, compensation and benefits), income taxes payable, current maturities of long-term debt, unearned revenue, etc.

Tangible Assets

These are carried at their historical cost less any accumulated depreciation or accumulated depletion. See Reading 30 [Long-Lived Assets] for details.

Intangible Assets

Intangible assets are long-term assets that have no physical substance but have a value based on rights or privileges that belong to their owner. Generally, identifiable intangible assets are recorded only when purchased (at acquisition costs). The cost of internally developed identifiable intangible assets is typically expensed when incurred. For example, R&D costs are not in themselves intangible assets. They should be treated as revenue expenditures and charged to expense in the period in which they are incurred. One exception is that IFRS allows costs in the development stage to be capitalized if certain criteria (including technological feasibility) are met.

A company should assess whether the useful life of an intangible asset is finite or infinite and, if finite, the length of its life. The straight-line method is typically used for amortization.

Goodwill is an example of an unidentifiable intangible asset which cannot be acquired singly and typically possesses an indefinite benefit period. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally hig...
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Flashcard 1418147532044

Tags
#obgyn
Question
What is normal EFM tracing variability?
Answer
- 6-25bpm
- =/< 5bpm for <40 min

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Subject 3. Financial Instruments: Financial Assets and Financial Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Financial instruments are contracts that give rise to both a financial asset of one company and a financial liability of another company. Financial instruments come in a variety of forms which include derivatives, hedges, and marketable securities.

Measured at fair market value:

Financial assets:

  • Financial assets held for trading.
  • Available-for-sale financial assets.
  • Derivatives (whether stand-alone or embedded in non-derivative instruments).
  • Non-derivative instruments with fair value exposures hedged by derivatives.

Financial liabilities:

  • Derivatives.
  • Financial liabilities held for trading.
  • Non-derivative instruments with fair value exposures hedged by derivatives.

Measured at cost or amortized cost:

Financial assets:

  • Unlisted instruments (there is no reliable valuation measure).
  • Held-to-maturity investments (bonds).
  • Loans and receivables.

Financial liabilities:

  • All other liabilities (such as bonds payable or notes payable).

Accounting for Gains and Losses on Marketable Securities

  • Held-to-maturity securities. Debt securities that management intends to hold to their maturity dates. At year-end, they are reported at cost adjusted for the effect of interest (debit the securities account and credit the interest income account) and unrealized holding gains and losses are not recognized.

  • Trading securities. Debt and equity securities bought and held mainly for sale in the short term to generate income on price changes. At year-end, they are reported at their fair market value. Any unrealized holding gains or losses are recognized on the company's income statement as part of net income. When they are sold, the realized gains or losses will also appear on the income statement. Realized gains and losses are not affected by any unrealized gains or losses recognized before.

  • Available-for-sale securities. Debt and equity securities not classified as held-to-maturity or trading securities. Unrealized gains and losses are reported as part of other comprehensive income (in contrast, the unrealized gains or losses of trading securities are reported in the income statement as part of net income). Other than that, they are accounted for in the same way as trading securities.
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Flashcard 1418151726348

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Question
What is atypical EFM tracing variability?
Answer
- =/< 5bpm for 40-80 min

statusnot learnedmeasured difficulty37% [default]last interval [days]               
repetition number in this series0memorised on               scheduled repetition               
scheduled repetition interval               last repetition or drill






Flashcard 1418153561356

Tags
#obgyn
Question
What is abnormal EFM tracing variability?
Answer
- =/< 5bpm for >80 min
- =/> 25 bpm for > 10 min
- sinusoidal

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418155396364

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Question
What is normal EFM tracing decels?
Answer
- none
- occasional uncomplicated variables
- early decels

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418157231372

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Question
What are atypical EFM tracing decels?
Answer
- repetitive (3+) uncomplicated variable decels
- occasional late decels
- single prolonged decel >2 but <3 min

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418159066380

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#obgyn
Question
What are abnormal EFM tracing decels?
Answer
- repetitive (3+) complicated variables (decels to <70 bpm for >60 sec; loss of variability in trough or in baseline; biphasic decels; overshoots; slow return to baseline; baseline lower after decel; baseline tachy/brady)
- late decels >50% of contractions
- single prolonged decel >3 but <10 min

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418160901388

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#obgyn
Question
What are features of complicated variables seen in abnormal EFM?
Answer
- decels to <70 bpm for >60 sec
- loss of variability in trough or in baseline
- biphasic decels
- overshoots
- slow return to baseline
- baseline lower after decel
- baseline tachy/brady

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418162736396

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Question
What are normal EFM tracing accels?
Answer
- spontaneous accels present
- FHR increases >15 bpm lasting > 15 sec (>10 bpm for >10 sec if <32 wk)
- accels present w/ fetal scalp stimulation

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418164571404

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Question
What are atypical EFM tracing accels?
Answer
absence of accel w/ fetal scalp stimulation

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418166406412

Tags
#obgyn
Question
What are abnormal EFM tracing accels?
Answer
usually absent (but if present, doesn't change classification of tracing)

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418168241420

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Question
What action can you take for normal EFM tracing?
Answer
EFM can be interrupted for periods up to 30 min if maternal-fetal condition stable and/or oxytocin infusion rate stable

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418170076428

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Question
What actions can you take for atypical EFM tracing?
Answer
further vigilant assessment required (especially when combined features present)

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418171911436

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Question
What action is required for abnormal EFM tracing?
Answer
ACTION REQUIRED
- review overall clinical situation
- obtain scalp pH if appropriate
- prepare for delivery

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418173746444

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#obgyn
Question
What are the 10 steps of managing an abn fetal tracing?
Answer
1 . Reposition patient to increase uteroplacental perfusion or alleviate cord compression
2 . Check maternal vitals
3 . Correct maternal hypovolemia, if present, by increasing IV fluids
4 . Stop oxytocin if applicable
5 . Administer oxygen at 8 to 10 L/min
6 . Rule out fever, dehydration, drug effect, prematurity
7 . Consider initiation of electronic fetal monitoring to clarify and document components of FHR
8 . If external monitor already in place, consider applying an internal fetal scalp electrode
9 . Consider fetal scalp sampling if appropriate
10. If abnormal findings persist despite corrective measures and other tests are not available (like fetal scalp pH) or desirable, the delivery should be considered

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Flashcard 1418175581452

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Question
fetal scalp blood sampling (FBS) is done when?
Answer
in pts with abn FHR patterns

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Flashcard 1418177416460

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Question
If fetal scalp pH is 7.25+ what should you do?
Answer
- continue w/ labour
- FBS (fetal scalp blood sampling) should be repeated if abnormality persists

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418179251468

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#obgyn
Question
If fetal scalp pH 7.21 - 7.24, what should you do?
Answer
- continue w/ labour
- repeat FBS in 30 min or consider delivery if rapid fall since last sample

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418181086476

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#obgyn
Question
If fetal scalp pH is =/< 7.20, what should you do?
Answer
delivery is indicated

statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418182921484

Tags
#obgyn
Question
What are the 6 steps to interpreting a FHR tracing?
Answer
1 . What is the uterine contraction frequency? (check the paper speed)
2 . What is the baseline fetal heart rate?
3 . What is the baseline variability?
• Absent
• Minimal
• Moderate/average
• Excessive
4 . Periodic changes noted on this tracing are:
• Accelerations
• Early decelerations
• Late decelerations
• Variable decelerations
5 . This tracing is classified as:
• Normal
• Atypical
• Abnormal
6 . What would be your management?

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Flashcard 1418184756492

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Question
meconium aspiration syndrome is more likely to occur in:
Answer
- post-term pregnancy
- pregnancies complicated by IUGR

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Flashcard 1418188426508

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Flashcard 1418192620812

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#has-images #obgyn





statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418195504396

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statusnot learnedmeasured difficulty37% [default]last interval [days]               
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Flashcard 1418199698700

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Flashcard 1418210708748

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Question
Meconium aspiration may cause both [...] and chemical pneumonitis, in addition to severe pulmonary hypertension.
Answer
mechanical obstruction of the airways

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.







Flashcard 1418212281612

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Question
Meconium aspiration may cause both mechanical obstruction of the airways and [...], in addition to severe pulmonary hypertension.
Answer
chemical pneumonitis

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.







Flashcard 1418213854476

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Question
Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to [...].
Answer
severe pulmonary hypertension

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.







Flashcard 1418216738060

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Question
List 5 predisposing factors to cord prolapse
Answer
- malpresentation
- prematurity
- abn fetus
- mult pregnancy
- polyhydramnios
- premature ROM
- AROM
- high presenting part
- obstetric procedures (ECV)

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Flashcard 1418218573068

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Question
If infant is vigorous and crying immediately after birth, [...] is not necessarily recommended in the presence of meconium
Answer
suctioning the mouth and nares

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If infant is vigorous and crying immediately after birth, suctioning the mouth and nares is not necessarily recommended in the presence of meconium







Flashcard 1418221456652

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Question
If infant is depressed at birth, [...] and suctioning of meconium from the lower airway should be done.
Answer
tracheal intubation

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If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.







Flashcard 1418223029516

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Question
If infant is depressed at birth, tracheal intubation and [...] should be done.
Answer
suctioning of meconium from the lower airway

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If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.







Flashcard 1418225913100

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Question
What should you do when a multip is fully dilated and delivering and the cord pops out?
Answer
push cord back in and try to deliver quickly

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Flashcard 1418227748108

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Question
What is the management of cord prolapse on delivery? (3 main steps + components of each)
Answer
1. assess fetal viability
- check for cord pulsations
- if fetus already dead/too immature to survive/lethal anomaly, intervention for fetal reasons are inappropriate (allow vag deliv or c/s if transverse lie)
2. relieve cord compression
- if cord outside introitus, gently replace in vagina
- with hand in vagina, cradle cord in palm & use tips of fingers to elevate presenting part off of cord
- adjust maternal position to trendelenberg (head lower than pelvis) or knee-chest
3. method of delivery
- if cervix fully dilated & present part low, do assisted vag deliv
- if cervix not fully dilated/vag deliv dangerous, do immediate CS

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Flashcard 1418229583116

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Question
[#] ​ high-risk HPV types responsible for development of most cancers
Answer
13

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Subject 4. Equity
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Equity is a residual value of assets which the owner has claim to after satisfying other claims on the assets (liabilities). There are five potential components that comprise the owner's equity section of the balance sheet:

  • Contributed capital. The amount of money which has been invested in the business by the owners. This includes preferred stocks and common stocks. Common stock is recorded at par value with the remaining amount invested contained in additional paid-in capital.

  • Minority interest.

  • Retained earnings. These are the total earnings of the company since its inception less all dividends paid out.

  • Treasury stock. This is a company's own stock that has

    • Already been fully issued and was outstanding;
    • Been reacquired by the company; and
    • Not been retired.

    It decreases stockholder's equity and total shares outstanding.

  • Accumulated comprehensive income. This includes items such as the minimum liability recognized for under-funded pension plans, market value changes in non-current investments, and the cumulative effect of foreign exchange rate changes. Refer to Reading 25 [Understanding the Income Statement] for details.

Statement of Changes in Shareholders' Equity

This statement reflects information about increases or decreases to a company's net assets or wealth. It reveals much more about the year's stockholders' equity transactions than the statement of retained earnings.

  • The statement of shareholders' equity is a financial statement that summarizes changes that occurred during the accounting period in components of the stockholders' equity section of the balance sheet. For example, it includes capital transactions with owners (e.g., issuing shares) and distributions to owners (i.e., dividends).
  • The shareholders' equity section of the balance sheet lists the items in contributed capital and retained earnings on the balance sheet date.
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Subject 5. Uses and Analysis of the Balance Sheet
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-balance-sheets
Common-Size Analysis of Balance Sheets

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Balance Sheet Ratios

Liquidity ratios measure the ability of a company to meet future short-term financial obligations from current assets and, more importantly, cash flows. Each of the following ratios takes a slightly different view of cash or near-cash items.

  • Current Ratio is a measure of the number of dollars of current assets available to meet current obligations. It is the best-known liquidity measure. A current ratio of less than 1 indicates the company has negative working capital.

  • Quick Ratio (Acid-Test Ratio) eliminates less liquid assets, such as inventory and pre-paid expenses, from the current ratio. If inventory is not moving, the quick ratio is a better indicator of cash and near-cash items that will be available to meet current obligations.

  • Cash Ratio is the most conservative liquidity ratio, determined by eliminating receivables from the quick ratio. As with the elimination of inventory in the quick ratio, there is no guarantee that the receivables will be collected.

Solvency ratios measure a company's ability to meet long-term and other obligations.

  • Long-Term Debt-Equity Ratio is an indicator of the degree of protection available to the creditors in the event of insolvency of a company. Higher debt-equity ratio indicates higher financial risk.

  • Debt-Equity Ratio includes short-term debt in the numerator.

    The total debt includes all liabilities, including non-interest-bearing debt such as accounts payables, accrued expenses, and deferred taxes. This ratio is especially useful in analyzing a company with substantial financing from short-term borrowing.

  • Total Debt Ratio =

  • Financial Leverage Ratio =

Financial statement analysis aims to investigate a company's financial condition and operating performance. Using financial ratios helps to examine relationships among individual data items from financial statements. Although ratios by themselves cannot answer questions, they can help analysts ask the right questions in financial statement analysis. As analytical tools, ratios are attractive because they are simple and convenient. However, ratios are only as good as the data upon which they are based and the information with which they are compared.

Fr...
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Subject 1. Classification of Cash Flows and Non-Cash Activities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-cashflow-statements
The cash flow statement provides important information about a company's cash receipts and cash payments during an accounting period as well as information about a company's operating, investing and financing activities. Although the income statement provides a measure of a company's success, cash and cash flow are also vital to a company's long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company's liquidity, solvency, and financial flexibility.

Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities:

Operating Activities

These involve the cash effects of transactions that enter into the determination of net income and changes in the working capital accounts (accounts receivable, inventory, and accounts payable). Cash flows from operating activities (CFOs) reflect the company's ability to generate sufficient cash from its continuing operations. CFOs are derived by converting the income statement from an accrual basis to a cash basis. For most companies, positive operating cash flows are essential for long-run survival.

The major operating cash flows are (1) cash received from customers, (2) cash paid to suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5) income taxes paid.

Special items to note:

  • Interest and dividend revenue, and interest expenses, are considered operating activities, but dividends paid are considered financing activities. Note that interest expense is reported on the income statement while dividends flow through the retained earnings statement.

    Remember that an interest/dividend item is an operating activity if it appears on the income statement. For example, payments of dividends do not appear on the income statement, and thus are not classified as operating activities.

  • All income taxes are considered operating activities, even if some arise from financing or investing.

  • Indirect borrowing using accounts payable is not considered a financing activity - such borrowing would be classified as an operating activity.

Investing Activities

These include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plants, and equipment. In general, these items relate to the long-term asset items on the balance sheet. Investing cash flows reflect how a company plans its expansions.

Examples are:

  • Sale or purchase of property, plant and equipment.
  • Investments in joint ventures and affiliates and long-term investments in securities.
  • Loans to other entities or collection of loans from other entities.

Financing Activities

These involve liability and owner's equity items, and include:

  • Obtaining capital from owners and providing them with a return on (and a return of) their investments.
  • Borrowing money from creditors and repaying the amounts borrowed.

In general, the items in this section relate to the debt and the equity items on the balance sheet. Financing cash flows reflect how the company plans to finance its expansion and reward its owners.

Examples:

  • Dividends paid to stockholders (not interest paid to creditors!). Note that the cash outflow caused by dividends is determined by dividends paid, not dividends declared. Dividends paid are not reflected in the retained earnings account. The amount is provided in the supplementary information.
  • Issue or repurchase of the company's stocks.
  • Issue or retirement of long-term debt (including the current portion of long-term debt).

Purchase of debt and equity securities fro...
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Subject 2. Preparing the Cash Flow Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-cashflow-statements
The beginning and ending cash balances on the statement of cash flows tie directly to the Cash and Cash Equivalents accounts listed on the balance sheets at the beginning and end of the accounting period.

Net income differs from net operating cash flows for several reasons.

  • One reason is non-cash expenses, such as depreciation and the amortization of intangible assets. These expenses, which require no cash outlays, reduce net income but do not affect net cash flows.
  • Another reason is the many timing differences existing between the recognition of revenue and expense and the occurrence of the underlying cash flows.
  • Finally, non-operating gains and losses enter into the determination of net income, but the related cash flows are classified as investing or financing activities, not operating activities.

There are two methods of converting the income statement from an accrual basis to a cash basis. Companies can use either the direct or the indirect method for reporting their operating cash flow.

  • The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.

    • It adjusts each item in the income statement to its cash equivalent.
    • It shows operating cash receipts and payments. More cash flow information can be obtained and it is more easily understood by the average reader.

  • The indirect method reconciles net income to net cash flow from operating activities by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.

    • It shows why net income and operating cash flows differ.
    • It is used by most companies.

  • The direct and indirect methods are alternative formats for reporting net cash flows from operating activities. Both methods produce the same net figure (dollar amount of operating cash flow).

  • Under IFRS and U.S. GAAP, both the direct and indirect methods are acceptable for financial reporting purposes. However, the direct method discloses more information about a company. Partly because companies want to limit information disclosed, the indirect method is more commonly used.

  • The reporting of investing and financing activities is the same for both direct and indirect methods. Only the reporting of CFO is different.

Direct Method

Under the direct method, the statement of cash flows reports net cash flows from operations as major classes of operating cash receipts and cash disbursements. This method converts each item on the income statement to its cash equivalent. The net cash flows from operations are determined by the difference between cash receipts and cash disbursements.

Assume that Bismark Company has the following balance sheet and income statement information:

Additional information:

  • Receivables relate to sales and accounts payable relates to cost of goods sold.
  • Depreciation of $5,000 and pre-paid expense both relate to selling and administrative expenses.

Direct Method:

  • Cash sales: sales on the accrual basis are $242,000. Since the receivables have decreased by $8,000, the ca
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Subject 3. Cash Flow Statement Analysis
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-cashflow-statements
Evaluation of the Sources and Uses of Cash

Analysts should assess the sources and uses of cash between the three main categories and investigate what factors drive the change of cash flow within each category. For example, if operating cash flow is growing, does that indicate success as the result of increasing sales or expense reductions? Are working capital investments increasing or decreasing? Is the company dependent on external financing? Answers to questions like these are critical for analysts and can help form a foundation for evaluating the financial health of an industry or company.

Please refer to the textbook for specific examples.

Common-Size Analysis of the Statement of Cash Flows

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Free Cash Flow to the Firm and Free Cash Flow to Equity

From an analyst's point of view, cash flows from operation activities have two major drawbacks:

  • CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO.
  • CFO does not include cash outlays for replacing old equipment.

Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business.

The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity.

Free cash flow = CFO - capital expenditure

Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

  • NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.
  • NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.
  • Int (1 - Tax rate): After-tax interest expense. Add this back to net income because:

    • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and
    • Interest expense net of the related tax savings was deducted in arriving at net income.

    The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.
  • FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets.
  • WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities.

Example

Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):

  • Net income: $250
  • Interest expense: $50
  • Depreciation: $130
  • Investment in working capital: $20
  • Investment in fixed capital: $100
  • Tax rate: 30%
  • Net borrowing: $180
  • Proust has launched a new product in the market. It has capitalized $200 as an intangible asset out of a product launch expense of $240.
  • During the year, Proust has written down restructuring non-cash charges amounting to $30.
  • The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

NCC = Depreci...
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Subject 1. Analysis Tools and Techniques
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
Financial analysis techniques are useful in summarizing financial reporting data and evaluating the performance and financial position of companies. The results of financial techniques provide important inputs into security valuation.

Ratios

Ratios express one quantity in relation to another. As analytical tools, ratios are attractive because they are simple and convenient. They can provide a profile of a company, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics.

Ratio analysis is essential to comprehensive financial analysis. However, analysts should understand the following aspects when dealing with ratios:

  • A ratio is not "the answer." A ratio is an indicator of some aspect of a company's performance in the past. It does not reveal why things are as they are. Also, a single ratio by itself is not likely to be very useful. For example, a current ratio of 2:1 may be viewed as satisfactory. If, however, the industry average is 3:1, such a conclusion may be questionable.
  • Differences in accounting policies can distort ratios (e.g., inventory valuation, depreciation methods).
  • Not all ratios are necessarily relevant to a particular analysis. Analysts should know the questions for which they want to find answers and know the questions that particular ratios can help answer.
  • Ratio analysis does not stop with computation; interpretation of the result is also important.

Limitations: There are a significant number of estimates and subjective information that go into financial statements and therefore it is imperative that the analyst understands the numbers before calculating and relying on ratio analyses based on these numbers. An analyst needs to ask questions like:

  • How homogeneous is the company? Are the ratios comparable between divisions within a company? It is critical to derive comparable industry ratios. However, many companies have multiple lines of business, making it difficult to identify the appropriate industry to use in comparing companies. Companies are required to provide segmented information that allows the user to see the impact of various segments on the overall company.

  • Are the results of the ratio analysis consistent? An analyst needs to look at several ratios in conjunction in order to form a sensible conclusion. The total portfolio of the company should be used instead of only one set of ratios. A company must be viewed along all these lines since the company may have strengths and/or weaknesses in different areas. For example, a highly profitable company may have very poor short-term liquidity.

  • Is the ratio within a reasonable range for the industry? Analysts must look at a range of values for a particular ratio because a ratio can be too high or too low.

  • Are alternative companies' accounting treatments comparable? In comparsons companies, even within the same industry, companies may be using different accounting treatments and/or different estimates to capture the same event. Companies can use different estimates to calculate depreciation or bad debt expenses. Companies can use different inventory methods and may have operating versus capital leases in the financial statements. All of these accounting choices and estimates affect financial statements. Alternative treatments can cause a difference in results for the same events, especially when dealing with non-U.S. companies.

Common-size Analysis

Raw numbers hide relevant information that percentages frequently unveil. Common-size statements normalize balance sheet, income statement, and cash flow statement items to allow easier comparison of different-sized companies. They reduce all the dollar am...
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Subject 2. Common Ratios
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
The ratios presented in the textbook are neither exclusive nor uniquely "correct." The definition of many ratios is not standardized and may vary from analyst to analyst, textbook to textbook, and annual report to annual report. The analyst's primary focus should be the relationships indicated by the ratios, not the details of their calculations.

Activity Ratios

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

  • Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.

    This ratio provides a better level of detail than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over very slowly, these ratios would not be a good measure of liquidity. The same applies for the inventory turnover below.

    This ratio also implies an average collection period (the number of days it takes for the company's customers to pay their bills):

    Remember, as with all ratios, these ratios are industry specific. The nature of the industry dictates a higher or lower receivables or inventory turnover. For receivables turnover, analysts don't want to derive too much from the norm, since a low number indicates slow-paying customers that cause capital to be tied up in receivables and bad debt and a high number indicates overly stringent credit terms that hurt sales. If a company's credit policy is 30 days and the days of sales outstanding is 45 days, then the credit policy needs to be reviewed.

  • Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.

    An abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.

  • Payable turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.

    The following measures the number of days it tak
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Subject 3. The DuPont System
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
The breakdown of ROE into component ratios to assess the impact of those ratios is generally referred to as the DuPont Model.

Traditional DuPont equation:

  • ROE = net income / common equity
  • ROE = (net income / net sales) x (net sales / common equity). Therefore, ROE = (net profit margin) x (equity turnover).
  • ROE = (net income / net sales) x (net sales / total assets) x (total assets / common equity)

Each of these components impacts the overall return to shareholders. An increase in profit margin, asset turnover, or leverage can all increase the return. There is a downside as well. If a company loses money in any year, the asset turnover or financial leverage multiplies this loss effect.

This implies that to improve its return on equity, a company should become more:

  • Profitable (increase net profit margin, e.g., pricing and expense control).
  • Efficient (increase total asset turnover, e.g., efficiency of asset use).
  • Leveraged (increase its financial leverage ratio).

A company's over- or underperformance on ROA is due to one or both of these causes, or "drivers."

The extended DuPont model takes the above three factors and incorporates the effect of taxes and interest based on the level of financial leverage. It takes the profit margin and backs up to see the effect of interest and taxes on the overall return to shareholders. Therefore the extended model starts with EBIT (Earnings Before Interest and Taxes) rather than net income.

  • EAT = EBT (1 - t), where t is the company's average tax rate. Substituting EBT(1 - t) for EAT in the expanded ROE equation gives us ROE = (EBT / sales)(sales / assets)(assets / equity)(1 - t).
  • EBT = EBIT - I, where I equals the company's total interest expense. Substituting (EBIT - I) into the ROE equation for EBT gives us ROE = [(EBIT / sales)(sales / assets) - (interest expense / assets)] (assets / equity) (1 - t).
  • Restated in accounting terms:

    ROE = [(operating profit margin) x (total asset turnover) - (interest expense rate)] x (financial leverage multiplier) x (tax retention rate)

High financial leverage does not always increase ROE; higher financial leverage will lead to a higher interest expense rate, which may offset the benefits of higher leverage.

This breakdown will help an analyst understand what happened to a company's ROE and why it happened.
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Subject 4. Ratios Used in Equity Analysis, Credit Analysis, and Segment Analysis
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis
Equity Analysis

Analysts need to evaluate a company's performance in order to value a security. One of their valuation methods is the use of valuation ratios.

Some common valuations ratios are:

  • P/E: Price per share / Earnings per share.

    P/E is widely recognized and used by investors. Earning power is a chief driver of investment value, and EPS is perhaps the chief focus of security analysts' attention.

  • P/CF: Price per share / Cash flow per share.

    Cash flow is less subject to manipulation by management than earnings. Thus, P/CF ratios can be used to compare companies with different degrees of accounting aggressiveness. Moreover, cash flow is generally more stable than earnings, so P/CF ratios are more stable than P/Es. When EPS is abnormally high, low, or volatile, P/CF ratios are more reliable than P/Es.

  • P/S: Price per share / Sales per share.

    • Sales growth is the driving force for the growth of earnings and cash flows.
    • Sales are positive even when EPS is negative.
    • Sales are generally less subject to distortion or manipulation than are other fundamentals.

  • P/BV: Price per share / Book value per share.

    Similarly, book value is generally positive even when EPS is negative. Since book value per share is more stable than EPS, P/B may be more meaningful than P/E when EPS is abnormally high or low, or is highly variable.

These price multiples and dividend-related quantities are discussed in more detail in Study Session 14 (Equity Analysis and Valuation).

Credit Analysis

Credit analysis is the evaluation of credit risk.

How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? Somehow, the analyst must relate the ratio to the likelihood that a borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default). For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other factors being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.

Many credit analysts conduct their ratio analyses within ranking frameworks established by their employers. In the securities field, bond ratings provide a structure for analysis. Credit rating agencies such as Moody's and Standard & Poor's use financial ratios when assigning a credit rating to a company's debt issues. For example, credit ratios used by Standard & Poor's include EBIT interest coverage, funds from operations to total debt, total debt to EBITDA, and total debt to total debt plus equity.

Much research has been performed on the ability of ratios to assess the credit risk of a company (including the risk of bankruptcy) and predict bond ratings and bond yields.

Segment Analysis

A company may be involved in many different businesses, may do business in many different geographic areas, or may have significant number of customers. It is difficult to analyze a company with multiple business lines because of the inherent differences in financial structures, risk characteristics, etc,. amount the different lines. Aggregation of financial results for all the lines tends to obscure the true picture.

A company must disclose information related to various subdivisions of its business.

  • Under IAS 14 (Segment Reporting), disclosures are required for reportable segments.
  • U.S. GAAP requirements are similar to IFRS but less det
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Subject 5. Model Building and Forecasting
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis
The results of financial analysis provide valuable inputs into forecasts of future earnings and cash flow. An analyst can build a model to forecast future performance of a company. Techniques that can be used include:

  • Sensitivity Analysis. This is the study of how the variation in the output of a model can be apportioned to different sources of variation. (e.g., what will be the net income if more debt is issued?)

  • Scenario Analysis. This considers both the sensitivity of financial outcome to changes in key financial variables and the likely range of variable values. The least "reasonable" set of circumstances (low unit sales, high construction costs, etc.) and the most "reasonable" set are specified first. The financial outcomes under the bad and good conditions are then calculated and compared to the expected, or base-case, outcome. Even though there are an infinite number of possibilities, scenario analysis only considers a few discrete outcomes.

  • Monte Carlo Simulation. This is a risk analysis technique in which a computer is used to simulate probable future events and thus estimate the profitability and risk of a project. Random values of input variables are generated on a computer. The mean of the target variable is computed to measure the expected value. Standard deviation (or coefficient of variation) is computed to measure risks.
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Subject 1. Cost of Inventories
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
There are two basic issues involved in inventory accounting:

1. Determine the cost of goods available for sale: Beginning Inventory + Purchases.

2. Allocate the cost of total inventory costs (cost of goods available for sale) between two components: COGS on the income statement and the ending inventory on the balance sheet. Note that COGS = (Beginning Inventory + Purchases) - Ending Inventory. The cost flow assumption to be adopted includes specific identification, average cost, FIFO, LIFO, etc. This issue will be discussed in subsequent subjects.

Determination of Inventory Cost

IFRS and SFAS No. 151 provide similar treatment of the determination of inventory costs.

The cost of inventories, capitalized inventory costs, includes all costs incurred in bringing the inventories to their present location and condition.

  • It includes production costs, invoice price (net of discount), transportation costs, taxes, part of fixed production overhead, etc.
  • It does not include all abnormal costs incurred due to waste of materials, abnormal waste incurred for labor and overhead conversion costs from the production process, any storage costs, or any administrative overhead and selling costs. These costs are typically expensed in the accounting period instead of being considered inventory costs.
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Subject 2. Inventory Valuation Methods
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
In some cases, it's possible to specifically identify which inventory items have been sold and which remain. Using the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold; Credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items. In most cases, companies may be unable to determine exactly which items are sold and which items remain in ending inventory.

The remaining three methods are referred to as cost flow assumptions under GAAP and cost formulas under IFRS. They should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory.

Weighted Average Cost

Using the weighted average cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

  • Average cost = (beginning inventory + purchases) / units available for sale
  • Ending inventory = average cost x units of ending inventory
  • COGS = cost of goods available for sale - ending inventory

FIFO

FIFO is the assumption that the first units purchased are the first units sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold.

LIFO

LIFO is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

LIFO is not allowed under IFRS. In the U.S., however, LIFO is used by approximately 36 percent of U.S. companies because of potential income tax savings.

Comparison of Inventory Accounting Methods

Inventory data is useful if it reflects the current cost of replacing the inventory. COGS data is useful if it reflects the current cost of replacing the inventory items to continue operations.

During periods of stable prices, all three methods will generate the same results for inventory, COGS, and earnings.

During periods of rising prices and stable or growing inventories, FIFO measures assets better (the most useful inventory data) but LIFO measures income better.

  • Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, the cost of inventory may be decades old and almost useless for analysis purposes. However, the cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement costs. As a result, LIFO provides a better measurement of current income and future profitability.

  • Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement costs. The gain is actually holding gain or inventory profit. It is debatable whether this should be considered income; at least, analysts can say the underestimated COGS leads to inflated net income.

In an environment of declining inventory unit costs and constant or increasing inventory quantitie...
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Subject 3. Periodic versus Perpetual Inventory System
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The perpetual inventory system updates inventory accounts after each purchase or sale. Inventory quantities are updated continuously. When there is a sale, inventory is reduced and COGS is calculated.

The periodic inventory system records inventory purchase or sale in the "Purchases" account. The "Inventory" account is updated on a periodic basis, at the end of each accounting period (e.g., monthly, quarterly). Cost of goods sold or cost of sale is computed from the ending inventory figure.

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system, we cannot wait until the end of the year to determine the last cost. An entry must be recorded at the time of the sale in order to reduce the Inventory account and increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in lower income taxes than perpetual LIFO.

Example

Date....................................Units....Price
12.31.2008........Beginning Inventory....1.......85
1.1.2009..........Purchase...............1.......87
2.1.2009..........Purchase...............2.......89
6.1.2009..........Sales..................1.......89
12.1.2009.........Purchase...............1.......90

Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited from Cost of Goods Sold. If that was the only item sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351 ($85 + $87 + $89 + $90).

Under periodic LIFO we assign the last cost of $90 to the one item that was sold. (If two items were sold, $90 would be assigned to the first item and $89 to the second item.) The remaining $350 is assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to the item that was sold is permanently gone from inventory.
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Subject 4. The LIFO Method
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
In the U.S., firms that use LIFO must report a LIFO reserve. The LIFO reserve is the difference between the inventory balance shown on the balance sheet and the amount that would have been reported had the firm used FIFO. That is:

InventoryFIFO = InventoryLIFO + LIFO Reserve

It represents the cumulative effect over time of ending inventory under LIFO vs. FIFO.

When adjusting COGS from LIFO to FIFO: COGSFIFO = COGSLIFO - Change in LIFO Reserve.

LIFO Liquidations

So far, discussions have been based on the assumptions of rising prices and stable or growing inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO reserves can decline for either of the two reasons listed below. In either case, the COGS will be smaller and the reported income will be higher relative to what they would have been if the LIFO reserve had not declined. However, the implications of a decline in the LIFO reserve on financial analysis vary, depending on the reason for the decline.

  • Liquidation of inventories. When a firm reduces its inventory, the old assets flow into income. The COGS figure no longer reflects the current cost of inventory sold. This is called LIFO liquidation. Gross profit margin will be abnormally high and unsustainable ("phantom" gross profits). To defer taxes indefinitely, purchases must always be greater than or equal to sales. A LIFO liquidation may signal that a company is entering an extended period of decline (and needs the "profit" to show as income). Analysts should exclude this profit from recurring earnings, as it is not operating in nature; the reported COGS should be restated by adding back the decline in the LIFO reserve to remove the artificial boost to net income.

  • Price declines. The lower-cost current purchases enter reported LIFO COGS when purchase prices fall, reducing the cost differences between LIFO and FIFO ending inventories. As a result, the LIFO reserve declines. Such a decline is not considered a LIFO liquidation. Amounts on the balance sheet are still outdated but those on the income statement are still current. However, the tax benefits are lost under LIFO. For analytical purposes, no adjustment is required for declining prices, since price decreases are a normal business situation.
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Subject 5. Measurement of Inventory Value
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Under IFRS, inventories are reported at the lower of cost or net realizable value (NRV).

  • If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.
  • A reversal (up to the amount of original write-down) is required if the inventory value goes up later.
  • The amount of any reversal is recognized as a reduction in the cost of sales.
  • This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price inventory on an item-by-item basis.

IFRS does not apply to the measurement of inventories held by producers of agricultural and forest products, mineral products, or commodity brokers and dealers. Their inventories are measured at net realizable value (above or below cost) in accordance with well-established practices in those industries.

Similarly, GAAP requires the use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value defined as replacement cost. Reversal is prohibited, however. The LCM valuation basis follows the principle of conservatism (on both the balance sheet and income statement) since it recognizes losses or declines in market value as they occur, whereas increases are reported only when inventory is sold.

Here are some relevant terms:

  • Net realizable value: Estimated selling price less estimated costs of completion necessary to make the sale.
  • Historical cost: The cash equivalent price of goods or services at the date of acquisition.
  • Market value (Replacement cost): The cost that would be required to replace an existing asset.
  • Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Example

Historical cost: $5,000
Market cost: $2,000
Estimated selling price: $4,000
Estimated costs to complete sale: $1,000
Net realizable value: $4,000 - $1,000 = $3,000

  • Inventory Valuation under IFRS: $3,000 (the lower of historical cost and NRV).
  • Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost).

Now assume NRV increases from $3,000 to $4,000 and the market cost increases from $2,000 to $3,000.

  • Under IFRS, $1,000 of original write-down may be recovered to bring NRV up from $3,000 to $4,000. Note that reversals are limited to the amount of the original write-down ($2,000).
  • Under U.S. GAAP, the value of inventory is $2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited.
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Subject 6. Financial Analysis of Inventories
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company's inventory management.

Presentation and Disclosure

Consistency of inventory accounting policy is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively and there is no retrospective adjustment to the financial statements.

Inventory Ratios

Inventory turnover measures how fast a company moves its inventory through the system.

This ratio can be used to measure how well a firm manages its inventories. The lower the ratio, the longer the time between when the good is produced or purchased and when it is sold.

  • An abnormally high inventory turnover and a short processing time could mean either effective inventory management or inadequate inventory, which could lead to outages, backorders, and slow delivery to customers (which would adversely affect sales). Revenue growth should be compared with that of the industry to assess which explanation is more likely.
  • An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory. Again, the analyst should compare the firm's revenue growth with that of the industry to assess the situation.

Financial Analysis: FIFO versus LIFO

The advantages of LIFO are:

  • Matching. Current costs are matched against revenues and inventory profits are thereby reduced.
  • Tax benefits. These are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting."
  • Improved cash flow. This is related to tax benefits, because taxes must be paid in cash.
  • Future earnings hedge. With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline.

The disadvantages of LIFO:

  • Reduced earnings. Many managers would just rather have higher reported profits than lower taxes. However, non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street.
  • Inventory understated. LIFO may have a distorting effect on a company's balance sheet. It makes the working capital position of the company appear worse than it really is.
  • Physical flow. LIFO does not approximate the physical flow of the inventory items except in particular situations.
  • Current cost income not measured. LIFO falls short of measuring current cost (replacement cost) income, though not as far as FIFO. Using replacement cost is referred to as the next-in, first-out method; it is not acceptable for purposes of inventory valuation.
  • Inventory liquidation. If the base or layers of old costs are elim
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Subject 1. Capitalizing versus Expensing
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets

The costs of acquiring resources that provide services over more than one operating cycle should be capitalized and carried as assets on the balance sheet. All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs. Costs of the long-lived asset should be allocated over current and future periods. In contrast, if these assets are expensed, their entire costs are written off as expense on the income statement in the current period.

Accounting rules on capitalization are not straightforward. As a result, management has considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The choice of capitalization or expensing affects the balance sheet, income and cash flow statements, and ratios both in the year the choice is made and over the life of the asset.

Here is a summary of the different effects of capitalization versus expensing:

  • Income variability. Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income. Firms that expense those costs as incurred tend to have higher variability of net income.

  • Profitability. In the early years expensing lowers profitability because the entire cost of the asset is expensed. In later years expensing results in higher net income because no more expense is charged in those years. This results in higher ROA and ROE because these expensing firms report lower assets and equity.

  • CFO. The net cash flow remains the same, but the compositions of cash flows differ. Cash expenditures for capitalized assets are included in investing cash flows and are never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFOand are never classified as investing cash flows. Capitalization results in higher CFO but lower investing cash flows, and the cumulative difference increases over time.

  • Leverage ratios. Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities.

Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged. Therefore, the carrying amount of a self-constructed asset depends on the firm's financial decisions. The capitalized interest cost is added to the value of the asset being constructed.

The amount of interest cost to be capitalized has two components:

  • Any interest on borrowed funds made specifically to finance the construction of the asset. The interest rate applicable is the interest rate on each borrowing.
  • The interest on other debt of the firm, up to the amount invested in the construction project. The interest rate applicable is the weighted-average interest rate on all outstanding debt not specifically borrowed for the asset under construction.

Therefore, the total interest cost incurred during the accounting period has two parts:

  • Capitalized interest cost, which is reported as part of the asset on the balance sheet. Payments for capitalized interest cost are classified as an investing cash outflow and never as CFO.
  • Other interest cost, which is charged to expense on the income statement. Payments for such non-capitalized interest cost are reported as CFO.

The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements.

Once the construction is complete, capitalized interest costs will be written off as part of depreciation over the useful life of the asset. From ...
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Subject 2. Intangible Assets
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Intangible assets are identifiable nonmonetary resources controlled by firms. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, property rights, and organization costs.

Accounting for the Acquisition of Long-Lived Intangible Assets

Accounting for an intangible asset depends on how it is acquired.

1. Intangible Assets Purchased in Situations Other than Business Combinations

These are accounted for at acquisition costs. "Cost" includes purchase price, legal fees, and other expenses that make the intangibles ready for use. For example, fees paid to obtain a license or franchise are capitalized. Another example: expenditures on patents and copyrights purchased from another party are capitalized. They are amortized over their remaining legal lives or 40 years, whichever is less. The straight-line method is typically used for amortization.

2. Intangible Assets Developed Internally

For internally generated intangible assets, it is difficult to measure costs, benefits, and economic lives. Generally, internally generated assets (such as costs of R&D, patents and copyrights, brands and trademarks, and advertising and secret processes) must be expensed in the period incurred.

One exception is research and development (R&D) expenditures which add risk to investment with uncertain future economic benefits. As a result, they must be expensed as incurred in most countries (including the U.S.). SFAS 86 requires that all R&D costs to establish the technological and/or economic feasibility of software must be expensed. Subsequent costs that are beyond the point of technological feasibility can - but don't have to - be capitalized as part of product inventory and amortized based on revenues or on a straight-line basis. The point of technological feasibility is the point when a software prototype has been proven to be technologically feasible, as evidenced by the existence of a working model of the software.

IFRS also requires research costs be expensed but allows development costs to be capitalized under certain conditions.

As you can see, managers have considerable discretion in making decisions, such as whether or when to capitalize these costs and by how much. For software development costs, one particular risk is that capitalized costs will not be realized and a future write-down may be needed.

If companies apply different approaches to capitalizing software development costs, adjustments can be made to make the two comparable.

3. Intangible Assets Acquired in a Business Combination

Business combinations are accomplished when one entity (investor) acquires "control" over the net assets of another entity. The transaction is accounted for using the purchase method of accounting, in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value.

Any excess of cost over fair value of net assets acquired is recorded as goodwill.

U.S. GAAP requires that in-process R&D (IPRD) of the target company should be expensed at the date of acquisition, which results in a large one-time charge. IFRS requires identifying IFRD as a separate asset with a finite life or including it as part of goodwill.

Amortizing Intangible Assets with Finite Useful Lives

An intangible asset with a finite useful life is amortized over its useful life. The estimates required for amortization calculations are: original valuation amount, residual value at the end of useful life, and the length of useful life.

Example

Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 17 y...
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Subject 3. Depreciation Methods
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
For accountants, depreciation is an allocation process, not a valuation process. It is important for analysts to differentiate between accounting depreciation and economic depreciation. Two factors affect the computation of depreciation: depreciable cost (acquisition cost - salvage or residual value) and estimated useful life (depreciable life). Note that it is depreciable cost, not acquisition cost, that is allocated over the useful life of an asset.

The different depreciation methods are:

  • Straight Line Depreciation (SLD)

    This is the dominant method in the U.S. and most countries worldwide. It is based on the assumption that depreciation depends solely on the passage of time. The amount of depreciation expense is computed as:

    If income is constant, SLD will cause the asset base to decline, causing ROA to increase over time. For assets whose benefit may decline over time, the matching principle supports using an accelerated depreciation method.

  • Accelerated Depreciation Methods

    Accelerated depreciation methods are consistent with the matching principle because benefits from most depreciable assets are higher in the earlier years as the assets wear out. Therefore, more depreciation should be allocated to earlier years than to later years.

    Under the sum-of-the-years' digits (SYD) method, depreciation expense is based on a decreasing fraction of depreciable cost. The numerator decreases year by year but the denominator remains constant. As a result, this method applies higher depreciation expense in the early years and lower depreciation expense in later years.

    Where sum of years = (1 + 2 + 3 + ... + n) = n x (n + 1)/2, and years remaining = n - t + 1 (n: the estimated useful life. t: the index for current year).

    Double decline balance (DDB):

    Note that cost minus accumulated depreciation is the book value at the beginning of the year and that salvage value is not shown in the formula. For each year, however, depreciation is limited to the amount necessary to reduce book value to salvage value.

    With SYD and DDB methods, book value, net income, tax expense, and equity will be lower than with SLD in the earlier years of an asset's life. The percentage effect on net income is usually greater than the effects on assets and shareholders' equity. Consequently:

    • Profit margin is lower as net income is lower.
    • Asset turnover ratio is higher as assets are lower.
    • Debt-to-equity ratio is higher as equity is lower.
    • Return on assets ratio is lower; both net income and total assets are lower, but net income is lower by a larger percentage.
    • Return on equity ratio is lower; both net income and equity are lower, but net income is lower by a larger percentage.

    In later years the situation will reverse and income and book values will increase. This is true for individual assets. For a firm with stable or rising capital expenditures, however, the early-year impact of newly-acquired assets dominates. Therefore, an accelerated depreciation method will continuously result in lower reported earnings and tax expenses for these firms.

  • Units of Production (UOP) and Service Hours Method

    This method assumes that d
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Subject 4. The Revaluation Model
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Under U.S. accounting standards, it is compulsory to account for impairment in long-lived assets (downward revaluation). However, upward revaluation of long-lived assets to reflect fair market values is not allowed.

The balance sheet is more informative when assets and liabilities are stated at market value rather than historical cost. IASB and some other non-U.S. GAAP do permit upward revaluations. The purpose of a revaluation is to bring into the books the fair market value of long-lived assets.

  • If an asset revaluation initially decreases the asset's carrying value, the decrease is recognized as a loss. Later, if there is an increase in the carrying value, the increase is recognized as a profit (up to the amount of the original decrease).
  • If an asset revaluation initially increases its carrying value, the increase bypasses the income statement and goes to equity (revaluation surplus). Later, if there is a decrease, it first decreases the revaluation surplus, then goes to income.

Financial Statement Analysis Considerations

  • The leverage motivation. An upward revaluation may improve a firm's leverage.
  • Income manipulation. Revaluations are subjective in nature. For example, a downward revaluation will reduce ROE in the current period but make the firm more profitable in future years, since total assets and shareholders' equity will be lower.
  • Revaluation has no impact on cash flows.
  • What is the true value of the firm's long-lived assets? Why is the revaluation necessary? Who does the appraisal? How often is it done?
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Subject 5. Impairment of Assets
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Sometimes a long-term asset may lose some of its revenue-generating ability prior to the end of its useful life. (e.g., a significant decrease in the market value, physical change, or use of the assets). If the carrying amount of the asset is determined not to be recoverable, an asset impairment occurs and the carrying value should be written down. The amount of the write-down is recorded as a loss.

GAAP and IFRS differ as to the methodology used to determine impairment.

The GAAP methodology of determining impairment uses a two-step recoverability test. Occurrence of an impairment differs from recognition of an impairment. An impairment, whether recognized in financial reports or not, occurs as long as an asset's carrying value cannot be fully recovered in the future. However, only impairments that meet certain conditions are recognized in financial reports. SFAS 121 provides a two-step process:

  • Recoverability test. Impairment must be recognized when the carrying value of the assets exceeds the undiscounted future cash flows from their use and disposal.

  • Loss measurement. The excess of the carrying amount over the fair value of the assets. If the fair value is not available, the present value of future cash flows discounted at the firm's incremental borrowing rate should be used. That is:

    Impairment Loss = Book Value - Either Fair Value or Present Value of Future Cash Flows

Conversely, IFRS methodology uses a one-step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell, or 2) value in use (i.e., the present value of future cash flows including disposal value).

Impairment of Intangible Assets

  • Similar accounting treatment if the intangible asset has a finite life.
  • Tested annually for impairment for an intangible asset with an indefinite life.

Among the most interesting intangible assets is goodwill. Goodwill is the present value of future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified.

Under U.S. GAAP SFAS 142, goodwill is not amortized, but is tested annually for impairment. Goodwill impairment for each reporting unit should be tested in a two-step process at least once a year.

1. The fair value of a reporting unit is compared to its ...
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Subject 6. Derecognition
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
For accounting purposes, an asset may be disposed of in three different ways. It may be:

  • sold for cash
  • exchanged for another asset
  • abandoned

When plant assets are disposed of, depreciation should be recorded on the date of disposal. The cost is then removed from the asset account and the total recorded depreciation is removed from the accumulated depreciation account. Normally an asset's market value at the time of sale or disposal will most likely be different than the asset's book value (its original historical cost minus all accumulated depreciation on that asset). The sale of a plant asset at a price above or below book value results in a gain or loss to be reported in the income statement.

Because different depreciation methods are used for income tax purposes, the gain or loss reported on income tax returns may differ from that shown in the income statement. It is the gain or loss shown in the financial statement that is recorded in the company's general ledger accounts.

To illustrate each of these methods consider this. A machine was purchased on 1 January Year 1 for $1,000. The depreciation method was straight-line with a useful-life of 5 years and an estimated residual value of $200. On 31 July Year 3 the firm decides to dispose of the asset. The firm has a December year-end.

The first step irrespective of the method of disposal is to calculate the depreciation up to the date of sale:

Depreciation per year = (Cost - residual value) / Useful life = (1,000 - 200) / 5 = $160
Depreciation for year 1 = $160
Depreciation for year 2 = $160
Depreciation for year 3 = $93 (160 x 7/12)
Total: $413

Remember that the depreciation for year 3 is only for 7 months, as the asset is disposed of on 31 July Year 3.

Sale of Long-Lived Assets

The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying value of the asset at the time of sale. Assume that the machinery is sold for cash in three scenarios:

a. Sold for $587 cash (Sale of machinery for carrying value)
Debit: Cash (B/S) $587
Debit: Accumulated depreciation (B/S) $413
Credit: Machinery (B/S) $1000

b. Sold for $600 cash (Sale of machinery for above carrying value)
Debit: Cash (B/S) $600
Debit: Accumulated depreciation (B/S) $413
Credit: Machinery (B/S) $1000
Credit: Profit on sale of machinery (I/S) $13

c. Sold for $500 cash (Sale of machinery for below carrying value)
Debit: Cash (B/S) $500
Debit: Accumulated depreciation (B/S) $413
Debit: Loss on sale of machinery (I/S) $87
Credit: Machinery (B/S) $1000

In summary, when disposing of an asset, entries are prepared to:

  • eliminate the cost of the asset from the books.
  • eliminate the accumulated depreciation from the books.
  • record the proceeds on the sale. This is reported as cash from investing activities on the statement of cash flows.
  • record the profit or loss on the sale (if applicable). This amount is excluded from net income when the indirect method is used to calculate cash flows from operating activities.

Exchange of Long-Lived Assets

If an asset is exchanged for another asset, the basic accounting is similar to the accounting for sales of plant assets for cash. If the trade-in allowance received is greater than the carrying value of the asset surrendered, there has been a gain. If the allowance is less, there has been a loss.

Level II will cover some special rules for recognizing these gains and losses, depending on the nature of the assets exchanged:

Abandoned

If an a...
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Subject 7. Presentation and Disclosures
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Property, Plant, and Equipment (PP&E)

IAS 16 provides a long list of disclosure requirements for PP&E. For each class of PP&E, the financial statements must disclose the following:

  • the measurement bases used for determining the gross carrying amount.
  • the depreciation methods and rates or useful lives.
  • the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period.
  • the detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, depreciation, impairment losses, revaluation information, foreign currency translation impacts, and so on).

U.S. GAAP require a company to disclose the depreciation expense for the period, the balances of assets, accumulated depreciation and a general description of the depreciation method(s) used.

Intangible Assets

IAS 38 provides a considerable set of disclosure requirements for intangible assets. For each class of intangibles, and distinguishing between internally generated and other assets, the financial statements must disclose:

  • whether the useful lives are indefinite or finite and, if finite, the length of the useful lives or the amortization rates used.
  • the amortization methods used for intangible assets with finite useful lives.
  • the gross carrying amount and any accumulated amortization (aggregated with accumulated impairment losses) at the beginning and end of the period.
  • the line item(s) of the statement of comprehensive income in which any amortization of intangible assets is included.
  • detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, amortization, impairment losses, revaluation information, foreign currency translation impacts, and so on).

Under U.S. GAAP, a company is required to disclose the gross carrying amounts and accumulated amortization, the aggregated amortization expense for the period, and the estimated amortization expense for the next 5 years.

Impairment of Assets

As with most other standards, IAS 36 provides a long list of disclosure requirements. To begin with, for each class of assets, the financial statements must disclose:

  • the amount of impairment losses and reversals recognized in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses and reversals are included.
  • the amount of impairment losses and reversals on revalued assets recognized in other comprehensive income during the period.

U.S. GAAP require a company to disclose a description of the impaired asset, what caused impairment, the method of determining fair value, the amount of impairment loss, and where the loss is recognized on the financial statements.
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Subject 8. Investment Property
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rental income, capital appreciation, or both.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model.

  • The cost model is identical to the cost model used for property, plant, and equipment (PP&E).
  • The fair value model differs from the revaluation model used for PP&E. All changes in the fair value of investment property affect income.

Under U.S. GAAP, there is no specific definition of investment property. Investment properties are generally measured using the cost model.
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Subject 1. Key Terms
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The computation of income taxes poses problems in financial reporting. The major problems arise because current period taxable income is measured using different rules than those used in accounting for pretax income.

Taxes are paid based on tax reporting, but from a financial reporting standpoint, the tax expense in the income statement (IS) is based on the matching principle and is computed on pretax accounting income. In order to achieve matching between taxes based on taxable income and taxes based on pretax income for accounting purposes, deferred tax entries are put through the accounting books.

The differences between the tax expense for tax and the accounting tax expense create deferred tax liabilities (credits) and deferred tax assets (debits or prepaid taxes).

Here are key terms based on tax return:

  • Taxable income: Income subject to tax based on the tax code.

  • Taxes payable: Tax return liability resulting from current period taxable income. (U.S.) SFAS 109 calls this "current tax expense or benefit."

  • Income tax paid: Actual cash flow for income taxes, including payments (refunds) for other years.

  • Tax loss carry forward: Tax return loss that can be used to reduce taxable income in future years.

  • The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

Here are key terms based on financial reporting:

  • Pretax income or accounting profit: Income before income tax expense.

  • The carrying amount is the amount at which the asset or liability is valued according to accounting principles.

  • Income tax expense: Expense resulting from current period pretax income; this includes taxes payable (from the tax return) and deferred income tax expense. It is reported in the income statement.

  • Deferred income tax expense: Accrual of income tax expense expected to be paid (or recovered) in future years (difference between taxes payable and income tax expense). Under (U.S.) SAAS 109, this results from changes in deferred tax assets and liabilities.

  • Deferred tax asset: Balance sheet item that results from a temporary excess of taxes payable over income taxes expense. It is expected to be recovered from future operations; it is not created if the excess is a permanent difference.

  • Deferred tax liability: Balance sheet item that results from a temporary excess of income taxes expense over taxes payable. It is expected to result in future cash outflows; it is not created if the excess is a permanent difference.

  • Valuation allowance: Reserve against deferred tax assets based on likelihood that those assets will be realized.

  • Timing difference: The result of the tax return treatment (timing or amount) of a transaction that differs from the financial reporting treatment.

  • Temporary difference: Difference between tax reporting and financial reporting that will affect taxable income when those differences reverse. This is similar to but slightly broader than timing difference. It also considers other events that result in differences between the tax bases of assets and liabilities and their carrying amounts in financial statements.

  • Permanent difference: Differences between tax reporting and financial reporting that will not reverse in the future.
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Subject 2. Deferred Tax Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Tax reporting and financial reporting are based on two different sets of assumptions. This is particularly true in the U.S. because financial reporting does not have to conform to tax reporting, as it does in Japan, Germany, and Switzerland. Numerous items create differences between accounting profit and taxable income. As a result, the taxes payable for the period are often different from the tax expenses recognized in the financial statements.

In the U.S.:

  • Tax reporting is based on the Internal Revenue Code (the tax code).

    • The modified cash basis of accounting is used in tax reporting to determine the periodic liability from currently taxable events.
    • Revenue and expense recognition methods used in tax reporting often differ from those used in financial reporting.

  • Financial reporting is based on GAAP.

    • Accrual accounting is used in financial reporting to provide maximum information to allow evaluation of a firm's financial performance and cash flows.
    • Management is allowed to select revenue and expense recognition methods. A firm has a strong incentive to use methods that allow it to minimize taxable income.

Because of the differences between tax accounting and financial accounting, the financial statements may include tax liabilities or assets - allowances that have been made in the financial statements for taxes that have not yet been or have already been paid.

Deferred tax liabilities generally arise when tax relief is provided in advance of an accounting expense, or when income is accrued but not taxed until received. Deferred tax liabilities on an individual transaction are expected to be reversed when these liabilities are settled, causing future cash outflows.

A typical example is depreciation: a company uses the Accelerated Cost Recovery System for tax reporting but uses straight-line depreciation for financial reporting.

  • Recall that taxes payable is calculated based on taxable income, and tax expense is calculated based on accounting profit.
  • Lower depreciation expense in financial reporting results in accounting profit that is higher than taxable income, and tax expense that is higher than taxes payable.
  • Deferred tax liabilities are thus created.

Deferred tax assets generally arise when tax relief is provided after an expense is deducted for accounting purposes. Deferred tax assets on an individual transaction are expected to be reversed when these assets are recovered, causing future cash inflows. Different treatments of warranty expenses in tax reporting and financial reporting are a common cause of deferred tax assets:

  • For tax reporting, warranty expenses cannot be recognized until they have been incurred. For financial reporting, warranty expenses are recognized each year using accrual accounting, regardless of whether they are incurred or not.
  • Lower warranty expense in tax reporting results in taxable income that is higher than accounting profit, and tax payable that is higher than tax expense.
  • Deferred tax assets are thus created.

In the U.S., deferred tax assets/liabilities are classified on the balance sheet as current or non-current based on the classification of the underlying asset or liability. However, deferred tax assets/liabilities are always classified as non-current under IFRS.

A deferred tax item cannot be created if it is doubtful that the company will realize economic benefits in the future.

Example

A company purchases an asset for $1,000 at the beginning of Year 1. It depreciates the asset at 33% per annum (straight-line) for financial reporting. The tax depreciation is 50% per annum (straight-line). The pretax income and taxable income are $2,0...
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Subject 3. Determining the Tax Base of Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The Tax Base of an Asset

An asset's tax base is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the asset's carrying amount. It is the amount that would be tax deductible if the asset was sold on the balance sheet date.

For example, a firm has total accounts receivable of $100,000. At the end of the year, management recognized a specific doubtful debt division of $3,000 for financial reporting. However, provisions for doubtful debts are not allowed for tax purposes in the firm's tax jurisdiction. A tax deduction is received when the receivable is written off as bad debt.

The carrying amount of the accounts receivable becomes $97,000. The tax base of the asset still remains $100,000. The firm has a deductible temporary difference of $3,000. Management should recognize a deferred tax asset in respect to the deductible temporary difference.

If the economic benefit will not be taxable, the tax base of the asset will be equal to the carrying amount of the asset. An example is dividends receivable from a subsidiary. If it is not taxable, the tax base and the carrying amount of the dividends receivable are equal.

The Tax Base of a Liability

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes with respect to that liability in future periods.

  • An unearned revenue item is treated as a liability for financial reporting but tax authorities often recognize it as taxable income. The tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in the future. Examples are prepaid rent, prepaid subscriptions, etc.
  • If an item has already been expensed, then its tax base and carrying amount are both zero. One example is interest paid on long-term loans.

Example

At the beginning of the year a firm received a lump sum of $5 million for rent from a lessee. The rent was for the use of an office building for the next 5 years. Local tax authorities require 70% of rent received in advance to be taxable income.

At the end of the year, $4 million should be treated as a liability for financial reporting purposes. That's the carrying amount. The tax base of the liability is $1.2 million (30% of $4 million) and $2.8 million should be treated as taxable income.

Changes in Income Tax Rates

When tax rates change, the deferred tax liability or asset has to be adjusted immediately to the new amount that is now expected, based upon the new expected tax consequences. The effect of this change in estimate will be included in the income from continuing operations.

The effect of an income tax rate increase:

  • It raises deferred tax liabilities and thus increases tax expense.
  • It raises deferred tax assets and thus decreases tax expense.
  • If deferred tax liabilities exceed deferred tax assets, the net effect is to increase tax expense, and vice versa.
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Subject 4. Temporary versus Permanent Differences
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Numerous items create differences between accounting profit and taxable income. These differences can be divided into two types.

Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:

  • is recognized for tax reporting but never for financial reporting, or
  • is recognized for financial reporting but never for tax reporting.

Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.

  • In the U.S., for example, interest income on tax-exempt bonds, premiums paid on officer's life insurance, and amortization of goodwill (in some cases) are included in financial statements but are never reported on tax returns.
  • Similarly, certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements.
  • Tax credits are another type of permanent difference. Such credits directly reduce taxes payable and are different from tax deductions that reduce taxable income.

These differences are permanent because they will not reverse in future periods.

No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates.

Example

A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond.

Solution

The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized.

Temporary differences result in deferred tax liabilities or assets. Different depreciation methods or estimates used in tax reporting and financial reporting are a common cause of temporary differences.

There are two categories of temporary differences.

Taxable Temporary Differences (TTD)

  • These will result in taxable amounts when an asset is recovered or a liability is settled.
  • Hence, these result in deferred tax liabilities. This means the company will pay more tax in the future.

Items that give rise to taxable temporary differences are:

  • Receivables resulting from sales.
  • Prepaid expenses.
  • Tax depreciation rates > accounting rates.
  • Development costs capitalized and amortized.

Deductible Temporary Differences (DTD)

  • These will result in deductible amounts when an asset is recovered or a liability is settled.
  • Hence, these result in deferred tax assets. This means the company will pay less tax in the future.

Items that give rise to deductible temporary differences are:

  • Accrued expenses.
  • Unearned revenue.
  • Tax depreciation rates < accounting rates.
  • Tax losses.

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Flashcard 1418357247244

Tags
#obgyn
Question
Subtypes [...] ​& [...] ​responsible for ~70% of cases of invasive disease
Answer
16 ; 18

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Subject 5. Recognition and Measurement of Current and Deferred Tax
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Deferred tax assets and liabilities are re-assessed on each balance sheet date.

  • They are measured against the criteria of probable future economic benefits.
  • The tax rate used to calculate them should be the one that is expected to apply when the asset is realized or liability settled.
  • They are not discounted to present value although they are related to amounts at some future date.

Valuation Allowance

Deferred tax assets are reduced by a valuation allowance to amounts that are "more likely than not" to be realized, taking into account all available positive and negative evidence about the future. For determining whether deferred tax assets must be reduced by a valuation allowance, all available positive and negative evidence must be considered. Information concerning recent pretax accounting earnings generally is critical. For example, if a firm has been recording material cumulative losses recently, it will be hard to justify a conclusion that tax credits can be realized in the near future. This will be evidence supporting the use of a valuation allowance ("negative evidence"). It is not necessary to quantify positive evidence for the conclusion that a valuation allowance is not required unless significant negative evidence exists. Where both positive and negative evidence exist, judgment must be used in evaluating what evidence is more persuasive. More weight should be given to objectively verifiable evidence.

Recognition of Current and Deferred Tax Charged Directly to Equity

A firm's deferred tax liability during an accounting period represents the portion of income tax expense that has not been paid. Therefore, from a pure accounting perspective, deferred tax liabilities are an accounting liability. However, from a financial analyst's perspective, whether deferred tax liabilities should be considered liabilities or not depends on whether they will reverse in the future. If they will, resulting in a cash outflow, then they should be treated as liabilities. If not, then they should be treated as equity! As deferred tax liabilities are created by temporary differences, reversal of a deferred tax liability depends on the reversal of the temporary difference that created it.

Changes in a firm's operations or tax law may result in deferred taxes that are never paid or recovered. For example, the use of accelerated depreciation methods for tax reporting creates a temporary difference. Normally, when there is less depreciation in later years, the deferred tax liability created by more depreciation in earlier years will be reversed. However, for firms with high growth rates, increased investments in fixed assets result in ever-increasing new deferred tax liabilities, which replace the reversing one. That is, a firm's growth may continually generate deferred tax liabilities. In this case, the deferred taxes are unlikely to be paid. Therefore, for such high-growth firms, deferred tax liabilities will not reverse and should be treated as equity.

Deferred tax liabilities are recorded at their stated value. Even if deferred taxes are eventually paid, payments typically occur far in the future. The present value of those payments is considerably lower than the stated amounts. Thus, the deferred tax liability should be discounted at an appropriate interest rate and the difference should be treated as equity.

In some cases, financial statement depreciation understates the value of economic depreciation. Instead, the accelerated depreciation in tax reporting is a better measure. Examples of such cases include equipment obsolescence due to technology innovation and rising price levels. Deferred tax liabilities are neither liabilities nor equity if they are not expected to reverse, and should be ignored by financial analysts.

  • They are not liabilities since they will not reverse.
  • They are not equity since adding the entire tax liabilities
...
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Flashcard 1418359606540

Tags
#obgyn
Question
Subtype 18 related often to [...]
Answer
adenocarcinoma

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Flashcard 1418362752268

Tags
#obgyn
Question
Pap tests should not be performed < [...] ​ weeks apart
Answer
6

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Subject 7. Comparison of IFRS and U.S. GAAP
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Similarities

FAS 109 Accounting for Income Taxes and IAS 12 Income Taxes provide the guidance for income tax accounting under U.S. GAAP and IFRS, respectively. Both pronouncements require entities to account for both current tax effects and expected future tax consequences of events that have been recognized (that is, deferred taxes) using an asset and liability approach. Further, deferred taxes for temporary differences arising from non-deductible goodwill are not recorded under either approach and the tax effects of items directly accounted for as equity during the current year are also allocated directly to equity. Finally, neither principle permits the discounting of deferred taxes.

Significant Differences and Convergence

Below we discuss the significant differences in the current literature.

Tax basis:

  • U.S. GAAP: Tax basis is a question of fact under the tax law. For most assets and liabilities there is no dispute on this amount; however, when uncertainty exists, it is determined in accordance with FIN 48 Accounting for Uncertainty in Income Taxes.
  • IFRS: Tax basis is generally the amount deductible or taxable for tax purposes. The manner in which management intends to settle or recover a carrying amount affects the determination of tax basis.

Uncertain tax positions:

  • U.S. GAAP: FIN 48 requires a two-step process, separating recognition from measurement. A benefit is recognized when it is "more likely than not" to be sustained based on the technical merits of the position. The amount of benefit to be recognized is based on the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement. Detection risk is precluded from being considered in the analysis.
  • IFRS: There is no specific guidance; IAS 12 indicates tax assets/liabilities should be measured at the amount expected to be paid. In practice, the recognition principles on provisions and contingencies in IAS 37 are frequently applied. Practice varies regarding consideration of detection risk in the analysis.

Initial recognition exemption:

  • U.S. GAAP: No similar exemption for non-recognition of deferred tax effects for certain assets or liabilities.
  • IFRS: Deferred tax effects arising from the initial recognition of an asset or liability are not recognized when the amounts did not arise from a business combination and, upon occurrence, the transaction affects neither accounting nor taxable profit (for example, acquisition of nondeductible assets).

Recognition of deferred tax assets:

  • U.S. GAAP: Recognized in full (except for certain outside basis differences), but valuation allowance reduces assets to the amount that is more likely than not to be realized.
  • IFRS: Amounts are recognized only to the extent it is probable (similar to "more likely than not" under U.S. GAAP) that they will be realized.

Calculation of deferred asset or liability:

  • U.S. GAAP: Enacted tax rates must be used.
  • IFRS: Enacted or "substantively enacted" tax rates (as of the balance sheet date) must be used.

Classification of deferred tax assets and liabilities in balance sheet:

  • U.S. GAAP: Current or non-current classification, based on the nature of the related asset or liability, is required.
  • IFRS: All amounts are classified as non-current in the balance sheet.

Recognition of deferred tax liabilities from investments in subsidiaries or joint ventures (JVs) (often referred to as outside basis differences):

  • U.S. GAAP: Recognition is not required for investment in foreign subsidiary or corporate JVs that are essentially permanent in duration, unless it becomes apparent that the difference will reverse
...
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Subject 1. Reporting Quality and Results Quality
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality

Financial reporting quality: a subjective evaluation of the extent to which financial reporting is free of manipulation and accurately reflects the financial condition and operating success of a company. It pertains to the information disclosed.

Earnings are considered to be high quality if they exhibit persistence and are unbiased. Sustainable earnings enable better forecasts of future cash flows or earnings. This is referred to as results quality or earnings quality.

Financial reporting quality is different from earnings quality. The two concepts are, however, interrelated because a correct assessment of earnings quality is possible only if we have some basic level of financial reporting quality. Low financial reporting quality makes it hard to assess earnings quality.
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Subject 2. Quality Spectrum of Financial Reports
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality
Financial reporting quality varies across companies.

GAAP, Decision-Useful, Sustainable, and Adequate Returns

  • GAAP compliance.
  • Useful: helpful in decision-making. Relevant, faithful representation and material.
  • Sustainable earnings indicate an adequate level of return on investment.

GAAP, Decision-Useful, but Sustainable?

  • GAAP compliance and useful.
  • But not sustainable earnings.

Biased Accounting Choices

  • Within GAAP.
  • Biased choices such as aggressive/conservative accounting, income smoothing, hidden reserves, and earnings management.

Departures from GAAP

It is difficult or impossible to assess earnings quality. Engaging in fraudulent financial reporting provides no quality of earnings.

Conservative and Aggressive Accounting

An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. "Aggressive" typically refers to choices that aim to enhance a company's reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period or by decreasing the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet.

Conservatism in financial reports can result from either (1) accounting standards that specifically require a conservative treatment of a transaction or an event or (2) judgments necessarily made by managers when applying accounting standards that result in more or less conservative results.

An example of conservatism in the oil and gas industry is the revenue recognition accounting standard. This standard permits recognition of revenue only at the time of shipment rather than closer to the time of actual value creation (which is the time of discovery).

Big Bath Accounting

The strategy of manipulating a company's income statement to make poor results look even worse. The big bath is often implemented in a bad year to artificially enhance next year's earnings. The big rise in earnings might result in a larger bonus for executives.

Cookie Jar Reserve Accounting

Companies shift earnings around by creating overly large reserve accounts in good years then drawing them down in bad years.
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Subject 3. Context for Assessing Financial Reporting Quality
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Motivations for managers to issue less than high quality financial reports:

  • Mask poor performance
  • Boost stock price
  • Improve incentive compensation
  • Meet debt covenants

Management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters.

Conditions conductive to issuing low-quality financial reports:

  • Opportunity is generally provided through weaknesses in internal controls.
  • Motivation can be imposed due to personal financial problems or unrealistic deadlines and performance goals.
  • Rationalization occurs when an individual develops a justification for fraudulent activities.

Mechanisms that discipline financial reporting quality:

  • The free market. A company seeking to minimize its long-term cost of capital should aim to provide high-quality financial reports.
  • Enforcement by market regulatory authorities, which plays a central role in encouraging high-quality financial reporting.
  • Auditors. An audit is intended to provide assurance that a company's financial reports are presented fairly. There are, however, inherent limitations. Auditors are only able to offer "reasonable assurance" of the truth and fairness of financial statements rather than absolute assurance.
  • Private contracts. External parties such as lenders and investors are motivated to ensure the quality of financial reports is high.
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Flashcard 1418373762316

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Question
What is the LSIL rule of 3rds?
Answer
- 1/3 will go away on their own
- 1/3 will stay as is
- 1/3 will progress

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Subject 4. Detection of Financial Reporting Quality Issues
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There is really nothing new in this reading, just a review of the previous material. A lot of the accounting practices are highlighted elsewhere in the curriculum but are reiterated here.

Presentation Choice

If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the company is required to provide a reconciliation between the non-GAAP measure and the equivalent GAAP measure.

Similarly, IFRS require that any non-IFRS measures included in financial reports must be defined and their potential relevance explained. The non-IFRS measures must be reconciled with IFRS measures.

Accounting Choices and Estimates

Managers' considerable flexibility in choosing their companies' accounting policies and formulating estimates provides opportunities for aggressive accounting.

Examples include:

  • Revenue recognition policies.
  • Inventory cost flow assumptions.
  • Capitalization policies.
  • Estimates of uncollectible account receivable.
  • Estimated realizability of deferred tax assets.
  • Depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.

Cash flow, especially operating cash flow and free cash flow, are always at the heart of any discussion of financial performance and valuation. Investors, creditors, and analysts are all interested in whether a firm is generating cash flow and where that cash flow can be expected to recur.

Operating cash flow is usually unaffected by estimates and judgments. However, firms can still create the perception that sustainable operating cash flow is greater than it actually is. One technique is to misrepresent a firm's cash-generating ability by classifying financing activities as operating activities and vice versa. Additionally, management has discretion over the timing of cash flows and where to report cash flows.

Warning Signs

Analysts should pay attention to:

  • Revenue. Check revenue recognition policies and revenue relationship.
  • Inventories. Look at inventory relationships.
  • Capitalization policies and deferred costs.
  • The relationship of cash flow and net income.
  • Other warning signs.
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Flashcard 1418376121612

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Question
[...] + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer
Answer
evasion of host immune system

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evasion of host immune system + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer







Flashcard 1418377694476

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#obgyn
Question
evasion of host immune system + [...] → cervical cancer