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:
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:
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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:
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.
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.
The arithmetic mean has the following disadvantages:
Geometric Mean
![]() The geometric mean has three important properties:
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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#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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#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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#obgyn
Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia
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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:
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.
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.
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.
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.
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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 be classified as one of two types:
There are also many different methods for auctioning items:
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.
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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.
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.
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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.)
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.
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.
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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:
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.
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![]() 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.
Economic profit equals a firm's total revenue minus its total opportunity costs of production.
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.
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.
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.
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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.
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.
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.
![]() 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):
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.
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.
![]() 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:
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.
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
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.
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
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:
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 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:
Perfect competition arises:
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.
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.
When a perfectly competitive market is in long-run equilibrium:
![]() Why do firms earn zero economic profit in the long-run equilibrium?
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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:
Consider two hamburger companies: McDonald's and Burger King.
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.
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:
In short, an oligopoly is competition among the few. Pricing Strategies
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.
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:
Barriers to entry include legal or natural constraints that protect a firm from potential competitors.
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.
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:
The following example illustrates this concept.
![]() Portico produces beauty soaps.
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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.
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.
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:
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.
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 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)
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 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).
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
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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.
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:
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:
And vice versa. |
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Subject 6. Equilibrium GDP and Prices
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-17-aggregate-output-and-economic-growth
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:
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.
![]() ![]() 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
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.
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:
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 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:
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Subject 2. Theories of the Business Cycle
#cfa #cfa-level-1 #economics #macroeconomics #reading-18-understanding-business-cycles
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.
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.
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:
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:
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.
There are different types 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.
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).
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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.
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.
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.
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:
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
The nominal rate of interest is comprised of three components:
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Subject 3. The Roles of Central Banks
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
Central banks all have similar roles:
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Subject 4. The Objectives of Monetary Policy
#cfa #cfa-level-1 #economics #has-images #macroeconomics #reading-19-monetary-and-fiscal-policy
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:
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Subject 5. Monetary Targeting Rules
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
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
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
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:
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:
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 arguments for being concerned about national debt:
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.
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:
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:
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
#cfa #cfa-level-1 #economics #macroeconomics #reading-19-monetary-and-fiscal-policy
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:
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.
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.
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Subject 2. International Trade
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-20-international-trade-and-capital-flows
Benefits and Costs
Here are the benefits:
Costs:
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:
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:
Country X has an absolute advantage in producing both products (i.e., country X's laborers are more efficient than those in country Y).
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
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-20-international-trade-and-capital-flows
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:
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.
Balance-of-payments accounts are recorded using the regular bookkeeping method.
The main categories of the balance of payments are:
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:
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.
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
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-21-currency-exchange-rates
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.
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
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-21-currency-exchange-rates
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 $:¥ = 119.46 is the indirect quote for Japanese yen. In a direct quote, an appreciation of the foreign currency (a depreciation of the domestic currency) causes an increase in the direct quote.
The opposite is true for an indirect quote: the domestic (foreign) currency moves in the same(opposite) direction as the exchange rate. Bid-Ask (Offer) Quotes and Spreads Dealers (e.g., banks) do not normally charge a commission on their currency transactions but they profit from the spread between the buying and selling rates on both spot and forward transactions. Quotes are always in pairs: the first rate is the buy, or bid, price (for a dealer); the second is the sell, or ask, offer (for a dealer). The ask rate is usually higher than that bid rate, so the dealer can make a profit. The average of the bid and ask price is known as the midpoint price: midpoint price = (Ask + Bid) / 2. When direct quotations are converted to indirect quotations, bid and ask quotes are reversed. That is:
For example, here is a direct quote for the Japanese yen from the U.S. perspective: ¥:$ = 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:
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
#cfa #cfa-level-1 #economics #economics-in-a-global-context #has-images #reading-21-currency-exchange-rates
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:
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:
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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:
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:
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.
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).
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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.
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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:
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.
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:
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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
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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:
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:
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:
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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:
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:
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.
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
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
Owners' Equity Equity represents the source of financing provided to the company by the owners.
Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.
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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:
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:
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.
Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.
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.
The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:
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.
2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.
3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.
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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.
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:
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.
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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.
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.
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:
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Subject 2. Financial Reporting Standard-Setting Bodies and Regulatory Authorities
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
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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 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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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:
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:
Presentation requirements:
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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:
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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:
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
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
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?
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:
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:
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:
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:
The standard introduces new, increased requirements for disclosure of revenue in a reporter's financial statements. |
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Subject 5. Expense Recognition
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
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.
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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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.
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:
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:
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:
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:
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).
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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:
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.
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.
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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:
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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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 liabilities:
Measured at cost or amortized cost: Financial assets:
Financial liabilities:
Accounting for Gains and Losses on Marketable Securities
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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:
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.
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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.
Solvency ratios measure a company's ability to meet long-term and other obligations.
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:
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:
Financing Activities These involve liability and owner's equity items, and include:
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:
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.
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.
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:
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![]() Additional information:
Direct Method:
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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:
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 to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.
Example Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):
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:
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:
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.
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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:
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:
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.
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:
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.
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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:
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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.
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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.
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.
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:
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.
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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).
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:
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
Now assume NRV increases from $3,000 to $4,000 and the market cost increases from $2,000 to $3,000.
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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.
![]() Financial Analysis: FIFO versus LIFO The advantages of LIFO are:
The disadvantages of LIFO:
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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:
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:
Therefore, the total interest cost incurred during the accounting period has two parts:
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:
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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.
Financial Statement Analysis Considerations
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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:
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
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:
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:
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:
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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:
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:
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:
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.
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:
Here are key terms based on financial reporting:
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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.:
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.
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:
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.
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:
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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:
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.
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)
Items that give rise to taxable temporary differences are:
Deductible Temporary Differences (DTD)
Items that give rise to deductible temporary differences are:
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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.
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.
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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:
Uncertain tax positions:
Initial recognition exemption:
Recognition of deferred tax assets:
Calculation of deferred asset or liability:
Classification of deferred tax assets and liabilities in balance sheet:
Recognition of deferred tax liabilities from investments in subsidiaries or joint ventures (JVs) (often referred to as outside basis differences):
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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, Decision-Useful, but Sustainable?
Biased Accounting Choices
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
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality
Motivations for managers to issue less than high quality financial reports:
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:
Mechanisms that discipline financial reporting quality:
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Subject 4. Detection of Financial Reporting Quality Issues
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality
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:
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:
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