Corporate Governance in Business
A: Corporate Governance
Rights, Duties, Responsibilities & Authority of Board and Officers
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Specific duties of directors include:
o Election, removal, and supervision of officers
o Adoption, amendment, and repeal of bylaws
o Setting management compensation, initiating fundamental changes, and declaration of distributions to owners
Critical role of the board is to manage any potential conflicts of interest between shareholders and senior management
Directors are fiduciaries of the corporation and must always act in the best interests of the corporation
o Fiduciaries must be independent and objective – duty of loyalty, disclose conflicts, due diligence
Officers are corporate agents and fiduciaries and must act in the best interest of the corporation
Officers are allowed to serve on the board of directors and are not required to be shareholders
o Okay to indemnify officers for good faith mistakes
Sarbanes-Oxley Act of 2002 (SOX)
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SOX has numerous provisions for expanded disclosures and specific representations by management
Title III – Corporate Responsibility
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Public companies must have an audit committee – comprises of board members that are independent
o CEO and CFO are required to sign off on published reports and represent that the report:
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Was reviewed by each party and doesn’t contain untrue statements or material omissions
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Contains financials that present fairly in all material respects
CEO and CFO are required to represent that they are responsible for internal controls – design and evaluated for effectiveness
o If CEO or CFO falsify information – penalties include repaying issuer any bonuses that are equity based or gains on sale of stock
Title IV – Enhanced Financial Disclosures
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Management must include the following enhanced disclosures in reports:
o Material correcting adjustments identified by auditors
o Disclosure of all material off-balance sheet transactions
o Conformity of pro-forma financial statements – reconciled with GAAP financial statements
o Use of “Special Purpose Entities” (SPEs) – related party transactions
Must disclose any parties that have direct or indirect ownership of more than 10% of any class of most equity securities
Management must assess organization’s internal controls and make disclosure of the assessment
Issuer must disclose whether or not senior officers have adopted a code of ethics (conduct)
o If not adopted the issuer must explain the reasons why
Audit committee should have a financial expert – must be disclosed
o Financial expert is an individual who has expertise developed through education or experience as an auditor or financial
officer for organization of similar complexity (should be combination)
Title VII – Corporate and Criminal Fraud Accountability
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Individuals who alter, destroy, conceal, or makes false entries in any record/document with intent to impede, obstruct, or influence an
investigation will be fined, imprisoned not >20 years, or both
Auditors of issuers should retain all audit and review workpapers for a period of 7 years
o Failure to do so = fine or imprisonment not >10 years or both
Statute of limitation for securities fraud is no later than the earlier of 2 years after discovery of facts or 5 years after the violation
Employee who lawfully provides evidence of fraud must be protected – whistleblower protection
Individual who executes or attempts to execute securities fraud will be fined, imprisoned not >25 years, or both
Title IX – White Collar Crime Penalty
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An individual who attempts or conspires to commit white-collar offense will be subject to penalties predetermined by US Sentencing
Commission – aggravating or mitigating circumstances could change the penalty
When an issuer files a report with SEC, it must include the following written statements (signatures):
1. Report fully complies with the Securities Exchange Act of 1934
2. Information in report fairly presents in all material respects the financial condition and operating results of the issuer
3. Above written statements must be signed by CFO and CEO or equivalent
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When a party of the issuers certified a report or its contents knowing that it does not satisfy all three requirements, they will be subject
to fines or imprisonment
Title XI – Corporate Fraud Accountability
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An individual who alters the integrity of, destroys, or conceals a document used in connection with an official proceeding shall be fined
and/or subject to not >20 year prison term
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As part of a cease-and-desist proceeding, the SEC may issue an order that prohibits a person from serving as an officer or director
Internal Control in Business
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The Committee of Sponsoring Organizations (COSO) issues Internal Control – Integrated Framework to assist organizations in developing
comprehensive assessments of internal control effectiveness
o Framework is regarded as an appropriate and comprehensive basis to document assessment of internal control
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Focus is on internal control for financial reporting
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COSO Framework has three categories of objectives:
1. Operating Objectives – effectiveness and efficiency of an entity’s operations
2. Reporting Objectives – relate to the reliability, timeliness, and transparency of entity’s reporting
3. Compliance Objectives – developed to ensure entity is adhering to existing laws and regulations
COSO Internal Control Framework
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COSO framework comprises five integrated components – all needed to achieve ORC objectives – with 17 principles
o Mnemonic “CRIME” is used for the 5 components
Framework is used by company management and its board or directors to obtain an initial understanding of what constitutes an
effective system of internal control and to provide insight as to when internal controls are being properly applied
o Provides confidence to external stakeholders that an organization has a system of internal control in place that is conducive to
achieving its objectives
Five Components of Framework:
1. Control Environment – referred to as “tone at the top”
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Compromised of “EBOCA” principles
2. Risk Assessment – identification and analysis of risks (SAFR)
3. Information & Communication – includes capturing and processing information
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Includes internal and external communication
4. Monitoring – monitoring the effectiveness of internal control
5. Existing Control Activities – policies and procedures in place to respond to risk assessment
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Selecting and developing control activities, developing IT controls, and put policy into action
COSO cube demonstrates that there is a direct relationship between an entity’s three framework objectives and its five integrated
internal control components, along with the organizational structure of the entity
Pass Key
Remember that it would be a CRIME if you forgot the five components of internal control:
1. Control Environment – tone at the top and ethics [EBOCA]
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Commitment to ethical values
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Board independence and oversight
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Organizational structure
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Commitment to competence
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Accountability
2. Risk Assessment – financial statement misstatements, not efficient controls, breaking law [SAFR]
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Specify objectives
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Identify and analyze risks
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Consider the potential for fraud
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Identify and assess changes
3. Information & Communication – fair, accurate, complete, timely [OIE]
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Obtain and use information
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Internally communicate information
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Communicate external parties
4. Monitoring – effectiveness of controls and report deficiencies [SO D]
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Ongoing and/or separate evaluations
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Communication of deficiencies
5. Existing Control Activities – policies/procedures to mitigate risks [CA T P]
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Select and develop control activities
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Select and develop technology controls
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Deploy through policies and procedures
Pass Key
An effective system of internal control requires more than adherence to policies and procedures by
management, the board of directors and the internal auditors
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It requires the use of judgement in determining the sufficiency of controls, in applying the
proper controls, and in assessing the effectiveness of the system
The principles-based approach of the framework supports the emphasis on the importance of
management judgement
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The framework is not a rules-based approach – only principle based
Effective (Ineffective) Internal Control - COSO
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The framework defines an effective internal control system as one that provides reasonable assurance that the entity’s objectives will be
achieved – framework general requirements include:
o Five components and 17 principles that are relevant are to be both present and functioning
o All components are operating together as an integrated system are means to reduce risk to an acceptable level
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Doesn’t eliminate risk entirely – only reasonable assurance
In order to be considered effective, senior management and the board must achieve reasonable assurance that the entity:
1. Understands when its operations are manages effectively and efficiently
2. Complies with applicable rules, regulations, and standards
3. Prepares reports that conform to the entity’s reporting objectives
When a major deficiency is identified or if the components do not operate together, the entity has an ineffective internal control system
under the COSO framework
o Major deficiency represents a deficiency that significantly reduces the likelihood that organization can achieve its objectives
Internal Control (Framework) Limitations
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Although internal control provides reasonable assurance that a firm will achieve its stated objectives, it does not prevent bad decisions
or eliminate all external events that may prevent the achievement of the entity’s operational goals
The following are inherent limitations that may exist even in an effective internal control system:
o Breakdowns in internal control due to errors or human failure
o Faulty or biased judgement in decision making
o Issues relating to the suitability of the entity’s objectives
o External events beyond the control of the entity
o Circumvention of controls through collusion
o Management override of internal controls
Enterprise Risk Management
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COSO issues Enterprise Risk Management (ERM) – Integrated Framework (“the framework”) to assist organizations in developing
comprehensive response to risk management
o The intent of ERM is to allow management to effectively deal with uncertainty, evaluate risk acceptance, and build value
The underlying premise of ERM is that every entity exists to provide value for stakeholders and that all entities face risk in the pursuit of
value for its stakeholders
o According to COSO, “Risk is the possibility that events will occur and affect achievement of strategy and business objectives”
ERM is defined by COSO as the culture, capabilities, and practices, integrated with strategy-setting and performance, that organizations
rely on to manage risk in creating, preserving, and realizing value
o Objective is that ERM evaluates risk within the context of strategy (hope to achieve) and objectives (mission/core purpose)
The five components of enterprise risk management follow in logical sequence using the mnemonic GO PRO
o Supported by the 20 principles memorized using the mnemonic DOVES SOAR VAPIR SIR TIP
Although ERM is an outstanding tool, its limitations include:
o Being subject to human judgement and management override
o Evaluations made in error
Themes of Enterprise Risk Management
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Management decisions will impact the development of value including its creation, preservation, erosion, and realization (CPER)
Mission, vision, and core values define what an entity strives to be and how it wants to conduct business
o Core values correlate with an organizations culture – mission and vision correlate with strategy and business objectives
Risk appetite represents the types and amounts of risk, on a broad level, that and organization is willing to accept in pursuit of value
o ERM seeks to align risk appetite and strategy – directly related – risk assumed (IV) and expected return (DV)
Application of ERM is intended to provide management with a reasonable expectation of success with:
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Enhancement of risk response decision – avoid, reduce, transfer, self-insure
Identification and management of multiple and cross-enterprise risks
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At a particular level – product line, geographic area, customer
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Portfolio view – entity-wide level (diversified)
o Seizing opportunities
o Improving the deployment of capital
Components & Principles of ERM
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Governance & Culture – tone at the top, core values, EBOCA
o Defines Desired culture – risk averse, risk neutral, risk aggressive
o Defined board Oversight
o Demonstrates commitment to core Values – code of conduct
o Attracts, develops, and retains capable individuals (Employees) – human resources
o Establishes operating Structure – how we carry out day-to-day operations
Strategy and Objective Setting – mission, vision, defining risk appetite
o Evaluates alternative Strategies – what is the mission
o Formulates business Objectives – what is the mission
o Analyzes business context – internal and external environment
o Defines Risk appetite
Performance – evaluate, identify and respond to risk using “ARTS”
o Develops portfolio View – parent level/entity-wide level
o Assesses severity of risk (likelihood and impact) – at multiple levels
o Prioritizes risk
o Identified risks (events)
o Implements risk Responses (accept, pursue, reduce, share, or avoid)
Review and Revision – review and revise procedures
o Assesses Substantial change – change in officers or change in competitors
o Pursues Improvement in enterprise risk management
o Reviews risk and performance – how they did at managing risks
Ongoing Information, Communications, and Reporting – “OIE”
o Leverages information and Technology
o Communicates risk Information
o Reports on risk culture and Performance
Economic Concepts and Analysis
A: Economic and Business Cycles
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Real GDP = measures the value of all final goods and services in constant prices, adjusted for changes in the price level (inflation)
Nominal GDP = measures the value of all final goods and services in current prices (not adjusted for inflation)
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 =
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𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑥 100
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟
Leading economic indicators tend to predict economic activity (ex: orders for goods, stock market, new housing)
o Lagging indicators follow economic activity (ex: consumer price index, interest rates, unemployment)
Coincident indicators change at generally the same time as the whole economy (ex: industrial production (GDP))
Aggregate Demand and Supply Curves
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Aggregate Demand Curve – indicates the maximum quantity of all goods and services that households, business, and government are
willing and able to purchase at any given price level (Downward sloping because of wealth effect – as price increases, wealth of
economy declines in value as purchasing power of money falls, buys less goods. Interest Rate – as price level rises, households/firms
require more $ to handle their transactions (increased demand for money causes price of money, interest rate, to rise. Net Export – as
price level rises, foreign goods become cheaper so demand for imports increase, domestic price is also more expensive to foreign buyers
so demand for exports decrease. Net export decrease (real gdp declines)
o Aggregate Supply Curve – indicates the maximum quantity of all goods and services that producers are willing and able to
produce at any given price level
Real GDP (measured in quantity)
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While changes in the price level will impact the AD or AS along the AD/AS curves, there are other factors beyond price level that may
cause an inward or outward shift in their of the curves
Multiplier Effect on AD/AS
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Multiplier Effect – when an increase in consumer, business, or government spending generates a
multiplied increase in the level of economic activity
Economic Measures/Indicators
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Gross Domestic Product (GDP) = the measure of the output and performance of a nation’s economy that includes all final goods and
services produced by resources within a country, regardless of what country owns the resources
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Expenditure Approach to GDP (GICE)
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Government Purchases
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Gross Domestic Investment (Business Spending)
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Personal Consumption
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Net Exports (Exports – Imports)
Income Approach to GDP (I PIRATED)
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Income of Proprietors
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Profits of Corporations
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Interest (Net)
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Rental Income
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Adjustments for Net Foreign Income & Misc. Items
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Taxes (Government Income)
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Employee Compensation (Household Income)
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Depreciation
Gross National Product (GNP) = the measure of the market value of all final goods and services produced by residents of a country
o Regardless of whether or not the resident produces the goods/services domestically or abroad
Net National Product (NNP) = GNP – Depreciation
o National Income (NI) = NNP – Indirect Business Taxes
Disposable Income (DI) = Personal Income – Personal Taxes
o Personal income is income received by households and noncorporate businesses
Measuring Unemployment & Types of Unemployment
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Labor force is all individuals 16 years of age and older who are either working to actively seeking work
Types of unemployment:
1. Frictional Unemployment = normal unemployment due to turnover, etc.
2. Structural Unemployment = the jobs available do not match skills
3. Seasonal Unemployment = results from seasonal change in labor demand
4. Cyclical Unemployment = results from a decline in real GDP during contraction or recession
Natural rate of unemployment is equal to frictional unemployment + structural unemployment + seasonal unemployment (4%)
Phillips Curve demonstrates the inverse relationship between the rate of inflation and unemployment
o When unemployment is high (low), inflation tends to be low (high)
Inflation, Deflation & Consumer Price Index
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Inflation = sustained increase in general prices of goods and services
o Deflation = sustained decrease in general prices of goods and services
Consumer Price Index = overall cost of a basket of goods and services purchased by an
average household during a given period of time
Producer Price index = measures the overall cost of a basket of goods and services typically
purchased by businesses
Demand-Pull inflation is caused by increases in aggregate demand
o Cost-Push inflation is caused by reductions in short-run aggregate supply
Nominal & Real Interest Rates
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Nominal Interest Rate = the amount of interest paid or earned measured in current dollars (not adjusted for inflation)
o Nominal interest rates and inflation naturally move together
Real Interest Rate = nominal interest rate less the inflation rate
Money Supply & Effect on Fiscal Policy
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There are three levels of money in the money supply:
o M1 = coins, currency, checkable deposits, and traveler’s checks
o M2 = includes M1 plus CDs (<$100,000), money market deposits at banks, mutual fund accounts, and savings accounts
o M3 = includes M2 plus CDs of deposits of $100,000 or more
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Expansionary Fiscal Policy = Money Supply  (Monetary policy) Real GDP  Unemployment  Taxes  Government Spending 
o Purpose is to increase aggregate demand – usually used during recession
Contractionary Fiscal Policy = Money Supply  Real GDP  Unemployment  Taxes  Government Spending 
o Purpose is to decrease aggregate demand – usually used when inflation is high
The Fed controls the money supply through:
o Open Market Operations – buying and selling government securities
o Changes in the Discount Rate – interest rate for short-term loans to member banks
o Changes in the Required Reserve Ratio – fraction of bank deposits held in reserve
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The Money Supply & Interest Rates
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Increase in Money Supply = Decrease in Interest Rates (Expansionary)
o Purchasing government securities
o Lowering the discount rate
o Lowering the required reserve ratio
Decrease in Money Supply = Increase in Interest Rates (Contractionary)
o Selling government securities
o Increasing the discount rate
o Increasing the required reserve ratio
B: Market Influences on Business
Fundamental Law of Demand
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States that the price of a product/service and the quantity demanded of that product/service are inversely related due to:
o Substitution Effect = consumers tend to purchase more (less) when its price falls (rises) in relation to other goods
o Income Effect = change in consumption of goods based on income (higher Indifference curve as indicated on graph)
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Factors that shift the aggregate demand curve include changes in: (any components of real GDP)
o Consumer wealth
o Real interest rates
o Expectations of future economic outlook
o Exchange rates
o Government spending
o Consumer taxes (personal income tax)
Factors that shift demand curves include changes in:
o Wealth
o Price of related goods
o Consumer income
o Consumer tastes or product preferences
o Consumer expectations
o Number of buyers served the market
Fundamental Law of Supply
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Law of Supply states that price and quantity supplied are positively related
Factors that shift short-run aggregate supply include:
o Changes in input (resource) prices
o Supply shocks
Factors that shift supply curves include changes in:
o Price expectations of supplying firm
o Product costs
o Price or demand of other goods
o Subsidies or taxes
o Product technology
Market Equilibrium
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Market’s equilibrium price and quantity is the point on the graph where the supply and demand curves intersect
o Also called the market clearing price
Price Elasticity of Demand and Supply
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Price elasticity of demand is the impact of a change in price on quantity demanded
o Inelastic Demand = Price Elasticity of Demand < 1
o Elastic Demand = Price Elasticity of Demand > 1
o Unit Elastic Demand = Price Elasticity of Demand = 1
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Price elasticity of supply is the impact of a change in price on quantity supplied
o Inelastic Supply = Price Elasticity of Supply < 1
o Elastic Supply = Price Elasticity of Supply > 1
o Unit Elastic Supply = Price Elasticity of Supply = 1
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (𝑆𝑢𝑝𝑝𝑙𝑦) =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑(𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑)
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
Cross Elasticity of Demand/Supply
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Cross elasticity of demand is the impact of a change in price of another product on the quantity demanded of the original product
o Positive coefficient indicates substitute goods – negative indicates complement goods
𝐶𝑟𝑜𝑠𝑠 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (𝑆𝑢𝑝𝑝𝑙𝑦) =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 # 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑋 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 (𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑)
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
Income Elasticity of Demand/Supply
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Income elasticity is the impact of a change in income on the demand of a good
o Positive elasticity indicates the good is a normal good
o Negative elasticity indicates the good is an inferior good
𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (𝑆𝑢𝑝𝑝𝑙𝑦) =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 # 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑋 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 (𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑)
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
Production Costs in the Short/Long Run
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Production costs in the short run are both fixed and variable
Cost Functions:
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Average Fixed Cost = F C / Q
Average Variable Cost = VC / Q
Average Total Cost = FC + VC / Q
Marginal Cost = TC / Q, Marginal Revenue is a demand curve (horizontal for perfect competition), downward sloping for
monopolist. MC = MR maximum profit
All production costs in the long-run are variable with the long-run average total cost curve being U-Shaped
Market Structures of Firms
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Perfect Competition:
o A large number of firms in the market
o Very little product differentiation
o No barriers to entry
o Firms are price takers
Monopolistic Competition:
o A relatively large number of firms
o Differentiated products sold by the firms in the market
o Few barriers to entry
o Firm has control over quantity produced
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Price set by market
Oligopoly Structure:
o Very few firms selling differentiated products
o Fairly significant barriers to entry
o Firms are interdependent
o Firms face kinked demand curves – match price cuts
and ignore price increases
Monopoly Structure:
o A single firm in a market
o Significant barriers to entry
o No substitute products for the good
o Ability of a firm to set output and prices
Developing & Implementing Strategy
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Factors that influence strategy – SWOT Analysis
o Internal factors – strengths and weaknesses
o External factors – opportunities and threats
Porter’s five Forces – affecting competition and firm profitability:
1. Barriers to Market Entry
2. Market Competitiveness
3. Existence of Substitute Products
4. Bargaining Power of Consumers
5. Bargaining Power of Suppliers
Types of Competitive Strategies
1.
Cost Leadership Strategy
o Goal is to produce at the lowest cost possible
o Broad range of buyers or narrow range (niche) of buyers
o Successful in markets where buyers have large bargaining power and price competition exists
2.
3.
4.
Differentiation Strategies
o Goal is to make a “better” product than the competition
o Broad range of buyers or narrow range (niche) or buyers
o Successful in markets where customers see value in individual products
Best Cost Strategies
o Combines the cost leadership and differentiation strategies
o Successful when generic products are not considered acceptable but customers are sensitive to value
Focus/Niche Strategies
o Focus is on satisfying a particular customer segment (niche)
o Successful when niche is large enough so that firms can generate a profit
Value Chain Analysis
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Value chain analysis helps a company meet or exceed customer expectations
o Types of value chain analysis includes:
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Internal costs analysis
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Internal differentiation analysis
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Vertical linkage analysis
Steps in Value Chain Analysis include:
1. Identify the value chain activities (full range of activities needed to create a product/service) marketing/production.
2. Identify the cost drivers associated with each activity
3. Develop competitive advantage by either reducing cost (cost leadership) or adding value (differentiation)
Supply Chain Management (how much should we make to sell?)
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Supply chain operations reference the SCOR Model:
o Plan – consists of developing a way to properly balance demand and supply with goals and objectives of entity
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Determining the demand requirements
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Assessing the ability of the suppliers to supply resources
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Planning inventory levels and the distribution of inventory
o Source – procure the resources necessary to meet demand
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Selecting vendors and obtaining vendor feedback and certification
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Collecting and processing vendor payments
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Ordering, inspecting, and storing inputs to the production process
o Make – all activities that turn the raw materials into finished products that are produced to meet a planned demand
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Managing the production process
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Implementing changes in engineering – “reengineering”
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Manufacturing the product, testing the product, packaging the product
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Performing quality assurance measures, scheduling production runs, analyzing capacity availability
o Deliver – all activities of getting the finished product into the hands of the ultimate consumers to meet planned demand
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Managing of orders and transportation
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Forecasting and pricing
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Shipping and labeling of products
Benefits of supply chain management include:
o Reduced inventory, warehousing, and packaging costs
o Reduction of delivery and transportation costs
o Improved service and delivery times
o Management and integration of suppliers
o Cross-docking – minimization of handling and storage costs
o Enhanced revenues and strategic shipment consolidation
Types of Business Combinations
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Horizontal Combination = occurs when companies in the same industry that produce the same goods or same services join together
under single management/leadership (BMI combined with ASCAP)
o Benefits include reduced competition, economies of scale leading to reduced costs, expertise at various levels or production,
minimized overproduction, and maximized products – also apply to vertical combinations
Vertical Combination = involves the combination of companies at different stages of the production process (purchase to selling of
product linked i.e)
o Companies can be from the same industry or multiple industries
o Can assure the supply of raw materials (backward integration) or provide stable market for products sold (forward integration)
Circular Combination = firms engaged in different businesses and producing different products (cell phone business combines with car)
o Relationship could come from using similar distribution or advertising channels or requiring similar production processes

o Having one management group over the combined units reduces overall administrative and other operational costs
Diagonal Combination = when a company that engages in an activity integrates with another company that provides ancillary (primary)
support for that primary activity. LoL (bot + support)
o Purpose is to ensure that the ancillary support is delivered in a timely and effective manner
Types of Significant Business Transactions




Merger = two or more entities combine to form a single new corporation, with the stocks of all merging companies surrendered and
replaced with new stock in the name of the new company. Arthur + Anderson = EY
o Mergers often involve the combination of like-sized companies
Acquisition = when one company takes over another company and involves no new company being created
o Only the acquirer remains after the acquisition
o The acquired firm is generally smaller than the acquiring firm and may retain its legal structure and name or it may be
subsumed by the acquirer and cease to exist
Tender Offer = a company makes an offer directly to shareholders to buy the outstanding shares of another company at a specified price
o Offer may be in the form of cash or securities of the acquiring corporations
o Shareholders of the target company have the option of accepting or rejecting the offer
Purchase of Assets = occurs when a portion (or all) of the selling company’s assets are purchased by the acquiring company, which may
result in the dissolution of the selling company
o Shareholder approval must be obtained
Types of Business Divestures



Sell-Off = an outright sale of a subsidiary because of, for example, the subsidiary’s core competencies do not align with the overall
company’s or because there is a lack of synergy between the company and its subsidiary
o Legal action stemming from anticompetitive or antitrust practices may also require a sell-off
Spin-Off = creates a new, independent company by separating a subsidiary business from a parent company
o Can be completed by distributing stock in the new entity as a stock dividend to existing shareholders or by offering
shareholders stock in the new company in exchange for their stock in the parent company

Typically occur when a unit is less profitable and/or unrelated to the core parent business
o Assumption is that the operations of the unit after a spin-off are expected to have more value than they did as part of the
larger (parent) operation
Equity Carve-Out = occurs when a subsidiary is made public through an initial public offering (IPO), thereby creating a new public co.
o The sale of shares in the new company generates cash for the parent company as well as providing the parent with a
controlling interest in the subsidiary

Hope is that this strategy will unlock the independent value of the subsidiary
C: Financial Risk Management
Risk Definitions – Exposure to Loss





Market Risk = losses in trading value of asset or liability in markets – risk for investors
o Market risk is a non-diversifiable risk – it is a systematic risk
Credit Risk = inability to secure debt financing in a timely and affordable manner – risk for borrower
Default Risk = possibility that a debtor may not repay the principle or interest due on their debt obligation on a timely basis
o Default risk is a risk for a creditor/lender
Liquidity Risk = investor desires to sell a security but cannot do so on a timely basis or without material price concessions
o Liquidity risk is a risk that investors face
Interest Rate (Yield) Risk = losses in underlying asset value or increases in underlying liability value as a result of changes in market
interest rates – risk for investors
Pass Key
It is important to be able to classify risk into two broad categories:
1. Diversifiable Risk – unsystematic risk (nonmarket/firm-specific)
2. Non-diversifiable Risk – systematic risk (market risk)
Risk Preferences of Managers

Three basic risk preference behaviors exist:
o
o
o
Risk-Indifferent = an increase in the level of risk does not result in an increase in management’s required rate or return

Managers are seeking the highest return period – don’t care about the associated risks
Risk-Averse = attitude towards risk in which an increase in the level of risks results in an increase in required return

This is the general rule – the other preferences are exceptions
Risk-Seeking = an increase in the level of risk results in a decrease in management’s required rate of return

Managers are willing to settle for lower expected returns as the level of risk increases
Computation of Return





Stated Interest Rate = rate of interest charged before adjustments for compounding or market factors
Effective Interest Rate = the actual finance charge associated with a borrowing
o After reducing the loan proceeds for charges and fees
Simple Interest Rate = the amount of interest paid on the original principle without including compounding
o Formula for calculating simple interest – SI = P0(i)(n)
Compound Interest = amount of interest earnings or expense that is based on the original principal plus unpaid interest earnings or
expense – FVn = P0 (1+i)n
Required Rate of Return = rate computed starting with the risk-free rate and adding the market risk premium, inflation premium,
liquidity risk premium, and default risk premium
Financial Decisions Using Probability & Expected Value


Probability represents a chance that an event will occur, with a zero being assigned when there is no chance the event will occur
o A one is assigned if there is complete certainty that an event will occur
Expected value is the weighted average of the probability assigned to each expected outcome of occurrence
Exchange Rate Fluctuations


Exchange rate fluctuations are generally caused by two factors:
o Trade Factors

Inflation Rates

Income Levels

Government Controls
o Financial Factors

Interest Rates

Capital Flows
A higher demand currency will lead to a higher exchange rate – a lower demand currency will have a lower exchange rate
Risk Exposures Implied by Exchange Rate Fluctuations
1.
2.
3.
Transaction Exposure – dealing in foreign currencies exposes the parties involved to potential economic loss or gain upon settlement of
a transaction in a foreign currency
o This is either a purchase transaction resulting in a payable or sales transaction resulting in a receivable
Translation Exposure – the potential that the consolidation of the financial statements of domestic parents with foreign subsidiaries will
result in changes in account balances and income as a result of exchange rate fluctuations
o Increases as the degree of involvement by the parent with international subsidiaries increases
o Exposure is also affected by the stability of a foreign currency vs. the stability of the parent currency
Economic Exposure – possibility that the value of cash flows could fluctuate up or down as a result of changes in the exchange rate
Hedging to Mitigate Exchange Rate Transaction Exposure


Hedging = a financial risk management technique in which an entity acquires a financial instrument that behaves in the opposite manner
from the hedged item – firm is attempting to mitigate the risk fluctuations in exposure
o There are several hedging transactions that can be used to mitigate transaction exposure from both an accounts payable and
accounts receivable application basis
Hedging transactions/techniques include:
o Futures Hedge = entitles holder to either purchase or sell a number of currency units for a negotiated price on a stated date

Futures hedges are used for smaller amounts
o Forward Hedge = entitles owner of the contract to buy or sell volumes of currency at a point in time

Forward contracts identify groups of transactions for larger amounts
Money Market Hedge = uses foreign money markets to meet future cash flow needs and mitigate exchange rate risks by
investment in financial institutions of the foreign economy

May be executed with either excess cash discounted and invested in the foreign economy or through simultaneous
borrowing and reinvesting in the foreign economy
o Currency Option Hedge = owner has the option (and not the obligation) to execute the hedge transaction

Acquisition of an option requires payment of consideration (a premium)

Owner of the option must consider the cost of the premium as part of determining the value of exercising option
o Currency Swap = firms agree to swap their currencies received at a future date for a negotiated exchange rate

Can be used to mitigate transaction exposure for longer term transactions
Long-term forward contracts can be used to hedge long-term purchase contracts – works like any other forward contract
o

Hedging to Mitigate Economic and Translation Exposure


Economic and translation exposure to exchange rate fluctuations involved overall business planning and design which create potential
exposures to cash flow (economic) or financial reporting (translation) risks related to exchange rate fluctuations
o Economic exposure can be mitigated by restructuring the sources of income and expense to the consolidated entity
Downside to restructuring is that it is usually more difficult to manage than ordinary hedges
Transfer Pricing


Primary reason for transfer pricing arrangements between domestic parents and foreign subsidiaries is to minimize local taxation
Intercompany cash transfers are often managed through the use of:
o “Leading” transfer policy – subsidiaries with strong cash position
o “Lagging” transfer policy – subsidiaries with weak cash position
Financial Management in Business
A: Capital Structure
Factors Affecting ST and LT Financing



Short-term financing anticipates higher levels of temporary working capital – as CA increase, more liquid, higher turnover
o Advantages of short-term financing:

Increased liquidity

Higher profitability

Lower financing costs
o Disadvantages of short-term financing:

Higher interest rate risk

Reduced capital availability
Short-term cost of borrowing is usually less than the long-term cost of borrowing
Long-term financing anticipates higher levels of “permanent” working capital – PPE and noncurrent assets increase, less liquid
o Advantages of long-term financing:

Lower interest rate risk

Increased capital availability
o Disadvantages of long-term financing:

Reduced profitability

Decreased liquidity

Higher financing costs
Methods of Short-Term Financing
1.
2.
3.
Working Capital Financing – entails current assets being financed with trade accounts payable and accrued liabilities
o Typically involved spontaneous financing of inventory
Letter of Credit – a third party guarantee
o Often required by vendor before they extend credit
o Makes the borrower more creditworthy and lowers the cost of borrowing
Line of Credit – a revolving line of short-term borrowing with a financial institution (ex: bank loan)
Methods of Long-Term Financing
1.
2.
3.
4.
5.
6.
Operating Leases – the balance sheet of the lessee will reflect a right of use asset and a lease liability
o On the income statement, lease expense will be recognized each year over the lease term
Finance Leases – lessee will recognize a right of use asset and a lease liability on the balance sheet
o Interest expense will be recognized each year on the income statement
Debentures – unsecured bonds that are backed by the full faith and credit of the issuer
o Subordinated Debentures – unsecured obligations that rank behind senior fixed-income securities at liquidation
o Exposes lender to greater risk which increases the cost of borrowing
Bonds – form of indebtedness that obligates the borrower to pay an agreed coupon payment over a period of years
o Income Bonds – fixed-income securities that pay interest only upon achievement of target income levels
o Mortgage Bonds – long-term loans that are secured by residential or commercial real property
Preferred Stock – hybrid security with similar features to both debt and equity
o Shareholders usually receive a fixed dividend and rank higher than common stockholders
Common Stock – basic equity ownership of a corporation – may receive capital gains from holding stock
o They have a residual last claim to issuer’s assets in the event of a liquidation
Debt Covenants for Protection


Creditors use debt covenants in their lending agreements to protect their interests by limiting or prohibiting the action of the debtor
(borrower) that might negatively affect the position of the creditors
o Protects value of investor’s bonds by requiring the borrower to protect credit rating
Debt covenants can be either:
o Positive – ex: the issuer must provide periodic financial statements
o Negative – ex: restrictions on asset sales
o Financial – ex: minimum interest coverage ratio
Operating & Financial Leverage


Operating Leverage = the degree to which a firm uses fixed operating costs as opposed to variable operating costs (labor intensive)
o Firm with significant operating leverage must have sufficient sales revenues to cover high fixed operating costs

High operating leverage can be very capital intensive (con)
o Beyond breakeven, firms with higher F.C.s will retain a higher percentage of additional revenues as operating revenue (pro)
Financial Leverage = the degree to which a firm uses debt (as opposed to equity) in its capital structure
o Firm with significant financial leverage must have sufficient operating income (EBIT) to cover fixed interests costs (con)
o Once interest costs are covered, additional EBIT goes straight to net income and EPS (pro)
Cost of Capital Computations
1.
Cost of Long-Term Debt – cheapest source of capital – assume least risk and interest is tax deductible
𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑥 ( 1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 )
2.
Cost of Preferred Stock – often greater than cost of debt because dividends are not tax deductible and more risky
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 =
3.
Cost of Common Equity – discounted cash flow method
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 =
4.
𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑥 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 𝑖𝑛 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒
Cost of Retained Earnings – capital asset pricing model (CAPM)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 + 𝐵𝑒𝑡𝑎( 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑎𝑡𝑒 − 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 )
5.
Weighted Average Cost of Capital = the sum of the weighted percentage of each form of capitalization used by a business
o Optimal cost of capital of the combination of debt and equity securities that produces the lowest WAAC
𝑊𝐴𝐶𝐶 =
𝐸
𝑃
𝐷
(𝑅 ) + (𝑅𝑝 ) + (𝑅𝑑 )(1 − 𝑇)
𝑉 𝑒
𝑉
𝑉
B: Working Capital Ratios & Management
Debt Ratios – Solvency

Solvency is a measure of security for long-term creditors/investors
o Can be used for interest-bearing, negotiated, or financing debt
Working Capital Management & Ratios




Goal of working capital management is to maximize shareholder wealth
o Want to balance both profitability and risk – want adequate working capital reserves that mitigate risk
Liquidity measures a firm’s short-term ability to meet its current obligations – current ratio and quick ratio
Current ratio is not the best measure of business health/value – there are limitations and it can be misleading
o Deteriorating Current Ratio – Risk Increases
o Improving Current Ratio – Risk Decreases
Quick ratio is a better measure – more conservative and rigorous
Cash Management Strategies






Cash Management Strategies include fee reduction, expediting deposits, and fraud protection
Fee reduction can be accomplished by compensating balances
o Bank fees are waived when the customer maintains minimum account balances
Trade credit is a type of fee reduction that maximizes the availability of funding with no or reduced charges
o Largest source of short-term funding – stretch it out and take full advantage of interest-free grace period
Commercial paper is a source of short-term financing by the issuer and an investment of idle cash by the buyer – examples of
commercial paper include notes, drafts, checks, CDs
Expedite Deposits – increases cash inflows and cash balances
o Zero-balance accounts – checking account that transfers funds just in time to cover checks presented

Maintains a zero balance at all times

Its use reduces the elapsed time for transfers between accounts and maximizes availability of idle cash
o Electronic fund transfers allow for direct deposits of funds which increases cash balances
o Lockbox system – customers send payments to a PO box or a location accessible by the bank
Fraud Protection – official bank checks (a.k.a. depository transfer checks) are designed to insulate the company from fraudulent checks
and simplify bookkeeping
Cash Discounts Used in Credit Terms



General Rule: Take full advantage of interest-free grace period unless a cash discount is offered to pay early
o The opportunity cost of not taking this discount is huge
o On flip side, this is a very expensive way to expedite cash receipts from your customers
Cash discounts are often offered to early payment of accounts payable or receivable
To compute the cost of discounts not taken:
1. Compute the number of times the discount forgone period occurs in a year
2. Compute the effective interest rate associated with the discount forgone
3. Annualize by multiplying the effective rate by the number of times the discount foregone period occurs in a year
Operating & Cash Conversion Cycle






Operating Cycle = the length of time from the initial expenditure until the time the cash is collected from the customer
o Calculated by adding days in inventory to the days sales in accounts receivable
Inventory Turnover Ratio = measures the number of times over an accounting period that inventory is sold
o Days in Inventory = the average number of days inventory is held before it is sold
Receivables Turnover = measures the number of times receivables are collected over an accounting period
o Days Sales in A/R = average number of days after a typical credit sale is made until the firm receives payment

Strict credit policy increases the number of to sell, but decreases the days to collect and write-offs

Lax credit policy decreases the number of days to sell, but increases the days to collect and write-offs
Cash Conversion Cycle = adjusts the operating cycle for the time in which vendors are paid by the firm for the initial expenditure
o Takes the operating cycle and subtracts the days of payables outstanding
Accounts Payable Turnover = measures the number of times payable are paid by the firm over an accounting period
o General rule is to not pay too quickly unless given an incentive (i.e. discount)
Days of Payables Outstanding = average number of days a firm takes to pay its vendors for purchases made on credit
Accounts Receivable


Accounts receivable can be sold (factored) to expedite cash collections
o Factors will typically charge a fee on all receivables purchased, as well as interest on cash given in advance to the seller prior
to the factor collecting from the seller’s customers
Want accounts receivable turnover to be greater than or equal to the standard – want to collect quickly
Inventory Management Techniques



Inventory management techniques focus on maintaining the minimum quantities on hand necessary to meet current needs
o Too much inventory (surplus) leads to increase carrying costs
o Too little inventory (shortage) leads to lost sales
Just-In-Time inventory management system reduces the lag time between inventory arrival and inventory use
o It assumes zero defects – pull approach of inventory management
o Reduces the number of units in inventory and extra coordination between manufacturer and supplier is required
Economic Order Quantity formulates the order size that will minimize both ordering costs and carrying costs
o Ordering costs are primarily driven by frequency of orders
o EOQ assumes that demand is known and constant throughout the year
C: Financial Valuation Methods
Valuation Methods and Calculating PV of an Annuity


Traditional financial valuation is based on the formula for the present value of an annuity
o Alternative valuation methods use variation of the Price Earnings (P/E) Ratio
Key assumptions include:
o Recurring amount of the annuity
o Appropriate discount rate
o Duration of the annuity
o Timing of the annuity
Perpetuities – Zero Growth Stock



When a company is expected to pay the same dividend each period, the perpetuity formula can be used to determine stock value
o Formula implies that the stock price will not increase because the dividend does not increase – no growth potential
Used for preferred stock – fixed return but no maturity
Key assumptions include:
o The dividend (and assume it will never change)
o The required return
𝑃𝑉 𝑜𝑓 𝑎 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑/𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
Constant Growth – Dividend Discount Model


If dividends are assumed to grow at a constant rate, the Gordon (constant) growth model can be used to determine the intrinsic (true)
value of the company’s stock
Key assumptions include:
o Calculation of dividends one year beyond the year in which you are determining the price
o A required rate of return
o A constant dividend growth rate
o Formula implies that the stock price will grow at the same rate as the dividend
𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝐷𝑡+1 / (𝑅 − 𝐺)
Price Multiples & Ratios

Price/Earnings (P/E) Ratio = can be applied to expected earnings (E1) in order to determine the current stock price
o It requires that earnings be greater than 0 – focuses on relationships that can be used to forecast stock price

Stock price = “certain multiple” of EPS, SPS, CFPS, BVPS
o If trading at “high” multiple – infers high growth rate – if trading at “low” multiple it infers low growth rate
𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = 𝑃0 /𝐸1

PEG Ratio = a measure that demonstrates the effect of earnings growth on a company’s P/E, assuming a linear relationship between P/E
and growth – often times given PEG and solving for other component
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑃0 ) = 𝑃𝐸𝐺 𝑥 𝐸1 𝑥 𝐺

Price-to-Sales Ratio = price multiple can be used to determine the intrinsic value of stock
o Rationale for using this multiple is that the sales are less subject to manipulation than earnings and sales can be used to
generate a meaningful multiple even when companies earnings are negative

This ratio is good for start-up companies that may not have earnings yet
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑃0 ) = (𝑃0/𝑆1 ) 𝑥 𝑆1

Price-to-Cash Flow Ratio = another multiple that can be used to calculate the stock’s intrinsic value
o This multiple may be preferred over P/E because cash flows are more difficult to manipulate than earnings and its more stable
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑃0) = (𝑃0 /𝐶𝐹1 ) 𝑥 𝐶𝐹1

Price-to-Book Ratio = can be used to value a stock’s intrinsic value – focus is on the balance sheet (common shareholders’ equity)
o Balance sheet is a cumulative financial statement so there is less volatility
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑃0) = (𝑃0 /𝐵0 ) 𝑥 𝐵0


Price multiple ratios have similar assumption requirements, which can be influenced by management behaviors including:
o Future cash earnings
o Future cash flows
o Future sales
o Future growth rate (compounded)
o Duration of sales or earnings trends
If P/E is provided on exam with no growth rate, assume earnings are already E1
Discounted Cash Flow Analysis (DCF)



Discounted cash flow analysis attempts to determine the intrinsic value of a stock by determining the present value of its expected
future cash flows (involves the time value of money)
o More rigorous analysis than multiples and multiple ratios
DCF models used by analysts to perform an absolute valuation on an equity security include:
o Dividend Discount Model (DDM)
o Free Cash Flow to Equity (FCFE) Model
o Free Cash Flow to Firm (FCFF) Model
DCF = Value of Asset = Sum of PV of Future Cash Flows
Evaluating Assumptions Used in Valuations

Forecasting methods have numerous subjective elements that are subject to behavioral influences including:
o
Generalized Rules of Thumb – distort objective evaluation of evidence

Tendency to use “stereotyped characterizations” – historical relationships

Use adjustments from presumed baselines

Use of intuition rather than analysis
o
Behavior Biases – distort user’s judgement

Excessive optimism – overestimating positive results

Confirmation bias – only use data that confirms forecast

Overconfidence – believes they are so smart the forecast must be correct

Illusion of control – actions of financial managers will cause equity to increase
o
Effect of Loss Aversion – behaviors related to losses

Losses are more distracting than gains – risky behaviors increase as losses increase (double down)

Managers are generally averse to sure losses – even though the probability of reversing loss is low they will not sell
stock – need to cut realized losses
Models for Valuing Options



A number of different factors enter into the determination of the value of an option – common method is Black-Scholes Model
Accountants may use this method in valuing options when accounting for share-based payments
o Need for matching principle – accrue for expense over vesting period given estimated option value
Black-Scholes Model Inputs – determinants of option value:
o Current price of underlying stock (higher price = higher option value)
o Option exercise price – “strike price” (exercise price decreases, rate increases)
o Risk-Free interest rate (higher rate = higher option value)
o Current time until expiration (longer time = higher option value)
o Some measure of risk for the underlying stock (higher risk = higher option value)

If stock price is more volatile, the option value increases
o Dividend on the optioned stock (higher dividend = higher option value)

Assumptions of Model:
o Stock prices behave randomly
o The risk-free rate and volatility of the stock prices are constant over the option’s life
o There are no taxes or transaction costs
o The stock pays no dividends – model can be adapted to dividend-paying stock though
o The options are European-Style (exercisable only at maturity)
o An option may or may not have value

Limitations of Black-Scholes Model – only an estimate based on a lot of assumptions
o Due to the model’s assumptions, results generated from the model may differ from real prices
o It assumes instant, cost-less trading, which is unrealistic in today’s markets
o Model tends to underestimate extreme price movements
o Model is not applicable to pricing American-Style options
C: Financial Decision Models
Net Present Value (NPV) Method




Net present value approach is generally thought to be the best technique to evaluate capital projects
Characteristics of NPV Method:
o Computations are based upon amounts (not percentages)
o Method displays the net amount by which the present value of cash inflows exceeds (or doesn’t exceed) the invested amount
Positive NPV indicates that the proposed investment exceeds the hurdle rate and the investment should be considered
o Investments that have a negative NPV should be rejected
A zero NPV indicates that the proposed investment is expected to yield the exact hurdle rate of return
Capital Rationing & Profitability Index



Unlimited Capital – pursue all investments with a positive NPV
Limited Capital – allocate capital to the combination of projects with the maximum NPV
Profitability Index – a means of ranking projects based on NPV
o
The higher the profitability index is, the higher the expected NPV
Pass Key
Discounted cash flow is the basis for net present value methods:
1. Calculate after-tax cash flows = annual net cash flow x (1-Tax Rate)
2. Add depreciation tax shield = depreciation x tax rate
3. Multiply result by appropriate present value factor
4. Subtract the initial cash outflow
Discounted Cash Flow


Discounted cash flow method is a technique that uses time value of money concepts to measure the present value of cash inflows and
cash outflows expected from a project
o Includes the net present value and internal rate of return methods
Factors of the method – the following elements must be known:
o Dollar amount of initial investment
o Rate of return desired for the project (discount/hurdle rate)
o Dollar amount of future cash inflows and outflows (after-tax)
Internal Rate of Return (IRR)


Internal rate of return method computes the percentage rate of return on a specific investment for comparison to a company’s target
(hurdle) rate of return
o IRR produces a NPV equal to zero
Limitation of IRR Method:
o Computations are less reliable than NPV computations when the investment alternative has variable cash flows
o Computation assumes the reinvestment of earnings at the IRR – a rate that may be unrealistic
Payback Methods – Undiscounted & Discounted



Payback methods compute the number of years it will take to recoup the initial investment
o Methods can use either a discounted or undiscounted approach
Payback methods are based upon periods of time – not dollar amounts or percentage returns
Limitation of undiscounted payback method is that it ignores profitability and the time value of money
o Discounted payback method accounts for time value of money by discounting after-tax cash flows
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑣𝑒. 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 (𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥)
Information Technology in Business
A: Information Technology (IT) Governance
Information Technology (IT) Governance




IT Governance = a formal structure for how organizations align IT and business strategies
o IT governance framework should align key questions, metrics, and returns to the business
IT governance is concerned with the strategic alignment between goals and objectives of the business and the utilization of its IT
resources to effectively achieve the desired results
Five areas of focus in IT governance:
1. Strategic Alignment
2. Value Delivery
3. Resource Management
4. Risk Management
5. Performance Measures
IT strategies should intersect with the corporate-level, business-level and functional-level strategies of the corporation
Principles of Technology-Driven Strategy Development

Technology is a core input to the development of strategy


Technology plays an important role in enabling the flow of information in an organization
o Including information directly relevant to enterprise risk management across strategy setting and the whole organization
Strategy development must be a continual process – due to the speed technology changes at
Organization of IT Governance Structure

The governance structure must encompass the following aspects - Tone at the Top, Key Stakeholders, Governance Objectives , and IT
Strategies and Oversight

Tone at the Top – selecting technologies to support an organization reflects the:
o Entity’s approach to risk management
o Types of events affecting the entity
o Entity’s overall information technology architecture
o Degree of centralization of supporting technology

Stakeholders – key stakeholders or participants in business process design include:
o Management – most important role is to provide support and encouragement
o Accountants – may be users and should help determine system requirements
o Information Steering Committee – executive level project steering committee
o Project Development Team – responsible for development, technical implementation, and user acceptance
o External Parties – major customers or suppliers

Governance Objectives – the five governance objectives align with the IT Governance Institute’s five areas of focus:
1. Strategic Alignment – defining, maintaining, and validating the IT value proposition
2. Value Creation – provision by IT of promised benefits to the organization
3. Resource Management – optimization of knowledge and infrastructure
4. Risk Management – risk awareness of senior management and the organization
5. Performance Measurement – tracking and monitoring strategic initiatives, milestones, and deliverables throughout projects
Risk Assessment Process

Organizations develop a risk assessment through the following steps:
1. Prepare a Business Impact Analysis

Identification of business units, departments, and processes essential to the survival of an entity
2. Identify Information Resources

Identification of hardware, software, systems, services, people, databases, and related important resources
3. Categorize Information Resources by Impact

Identify information resources either as high, medium, or low impact in relation to the effect on daily operations

High-Impact = department cannot operate without this resource

Medium-Impact = department could work around the loss of the resource for a limited amount of time

Low-Impact = department can operate without this resource for an extended period
4. Identify and Categorize Risks by Likelihood

Identify and categorize information resource risks or threats either as high, medium, or low likelihood of occurrence

High = risk/threat is highly motivated and preventative controls in place to mitigate the risk are ineffective

Medium = risk is motivated but preventative controls may impede successful exercise of the vulnerability

Low = risk lacks motivation or preventative controls will prevent or significantly impede successful exercise
of the vulnerability
5. Information Resources, Associated Risks, and Corrective Actions

Align the high-impact information resources with the appropriate risks and indicate the action decision needed by
the team to mitigate each risk

High action = corrective action needed immediately

Medium action = corrective action will be implemented in reasonable time frame

Low action = no corrective action is needed
6. Recommendations for Mitigating Risks

Document a recommendation or plan for mitigation of each risk for all high and medium risks associated with highimpact information resources
B: Role of Information Technology in Business
Big Data and Data Analytics in Business

Big Data = a constantly evolving concept in data management and information technology that incorporates four dimensions:


1. Volume – the volume of data is large
2. Velocity – the flow of data is continuous
3. Variety – big data comes from a variety of sources
4. Veracity – biases must be mined from big data
Three main data analytical processes used with big data include:
1. Descriptive Analytics – describing events that have already occurred
2. Predictive Analytics – predicting what could happen
3. Prescriptive Analytics – using optimization and simulation algorithms to affect future decisions
Four top uses of data analytics include:
1. Customer Analytics
2. Operational Analytics
3. Risk and Compliance Analytics
4. New Products and Services Innovation Analytics
Role of Information Systems in Key Business Processes within Entity







Business information systems process detailed data, and provide information for decision making and strategy development
o Allow a business to collect, process, store, transform, and distribute data
Management information System (MIS) = provide comprehensive processing and summarizing of data and enable organizations to use
data as part of strategic planning and tactical execution
o Decision Support Systems (DSS) = assist with analytics and presentation of data for specific decisions
o Executive Information System (EIS) = summarize data for executive management’s needs

Assists with strategy only – no decision-making capabilities
Accounting Information System = a type of MIS that creates an audit trail for accounting transactions
o May be partly a transaction processing system and partly a knowledge system
o Objectives of an organizations AIS include:

Recording valid transactions and properly classifying those transactions

Recording transactions at their proper value and in the proper accounting period

Properly presenting the transactions and information in the financial statements
Inventory Management Systems = track quantities of items and trigger orders when quantities fall below predetermined levels
Customer Relationship Mngt. (CRM) System = provide sales force automation and customer services to manage customer relationships
o Objective of a CRM system is to increase customer satisfaction which can lead to increased revenue and profitability
Enterprise Resource Planning System (ERP) = cross-functional enterprise systems that integrate and automate many business processes
and systems working together
o Work together in the manufacturing, logistics, distribution, accounting, finance, and human resources functions of a business
Supply Chain Management Systems = the integration of business processes from the original supplier to the customer
o Includes purchasing, materials handling, production planning and control, logistics and warehousing, inventory control, and
production distribution and delivery
E-Commerce Technologies







E-Commerce = the electronic completion of buying and selling (exchange) transactions
o Can use a private network or the Internet
Electronic funds transfer systems are a major form of electronic payment for the banking and retailing industries
o EFT security is normally provided through various types of data encryption
o A third-party vendor acts as an intermediary between the user company and the banking system
Application service providers supply access to application programs on a rental basis – allows smaller companies to avoid the extremely
high cost of owning and maintaining application systems
o The application service providers own and host the software
Many smaller companies have stand-alone web stores that are not integrated with larger accounting systems
Dynamic content is any content that changes frequently and includes videos, audio, and animation
Cloud computing involves virtual servers over the internet
o If can offer other professional management of hardware and software
o Cloud providers must have sophisticated backup procedures as well as high-level security for customer data
Mashups are web pages that are collages of other web pages and other information (ex: Google Maps)
C: Information Security & Availability
Protection of Information – Security Policies

Security Policy = a document that states how an organization plans to protect its tangible and intangible information assets





o The goal of a good information security policy is to require people to protect information
The information security policy may include:
o Management instructions
o High-level statements that provide guidance to workers
o Generalized requirements that must be written down and communicated to certain groups
Computer security policies start out at a high level and become more specific
Types of security policies include:
o Program-Level Policy
o Program-Framework Policy

Issue-Specific Policy

System-Specific Policy
A three level model can be used to develop a comprehensive set of security policies:
1. Define Security Objectives – based on system functionality or mission requirements
2. Operational Security – define the way a specific data operation would remain secure
3. Policy Implementation – enforced through technical and/or traditional management methods
Documents that support policies include: regulations, standards, baselines, guidelines, and procedures
Logical Access Controls in Information Security





Logical Controls = controls that use software and data to monitor and control access to information and computing systems
o User accounts are the first target of hacker – need procedures for creating accounts and granting access to information
Password Management – a password management policy must address the following characterisitcs:
o Password length – should require at least 8 characters
o Password complexity – should feature at least three of the following four characteristics

Upper case, lower case, number, ASCII characters (ex: ! $ % *)
o Password age – should be changed at least every 90 days
o Password reuse – passwords should not be reused for a significant amount of time

Goal is to prevent users from alternating between two or three passwords
o Two-Factor Authorization – allows for a second authentication key from a secondary device
Network & Host-Based Firewalls:
o Default-deny policy (more secure)
o Default-allow policy (easier)
Access Control Lists – these lists specify which users or system processes are granted access to objects
o Also what operations are allowed on the given objects
Data Encryption – scrambling information to make it unreadable without an access code (key)
o Encryption methods include:

Encryption keys – used to scramble and unscramble the data – longer the better – 128 bits is popular

Digital certificates – an electronic document that is digitally signed by a trusted party

Digital signatures – a signature in electronic form to identify sender

Ensures that the message has not been changed

E-Signatures – a legally binding imprint of a persons name applied to an electronic document
o None of the encryption methods are foolproof – hackers are always trying to find ways around them
Physical Access Controls in Information Security


Physical Controls = monitor and control the environment of the workplace and computing facilities
Examples of physical controls:
o Segregation of Duties – ensuring that an individual cannot complete a critical task by himself
o Monitoring and Control of Access to and From the Facilities

Ex: door locks with retina, separating the network and workplace into functional areas, etc.
o Backup Files – store copies of key master files and records off-site with copies of files kept on-site in fireproof areas
o Uninterrupted Power Supply (UPS) – device that maintains continuous supply of power – battery backup
o Program Modification Controls – prevent changes by unauthorized personnel and to track program changes

Creates a record of what version of a program is running in production at a given point in time
o Malware Detection – software that detects the threat of viruses, worms, and file infectors
General & Application Controls

General Controls = controls designed to make sure an organization’s control environment is stable and well-managed
o Important general controls include:

System development standards

Security management controls and change management procedures

Software acquisition, development, operations, and maintenance controls

Application Controls = controls that prevent, detect, and correct transaction error and fraud
o Concerned with accuracy, completeness, validity, and authorization of the data captures, entered into the system, processed,
stored, transmitted to other systems, and reported
Disaster Recovery / Business Continuity Plans







Disaster Recovery = consists of plans for continuing operations in the event of destruction of programs, data, and processing capability
o Depending on the organization, the plan may be limited to the restoration of functions in end-user areas

This is sometimes called a business continuity or business recovery plan
Major players in disaster recovery include:
o The organization itself
o Application software vendors – may need to provide replacement application software
o IT and Business area personnel – to do the work after the ability to process data is restored
o Disaster recovery service provider – provides disaster recovery services for a fee
o Provisions/hardware vendors – replacement hardware or supplies may be needed
o Senior management – must support the disaster recovery plan or nothing will happen
Steps in Disaster Recovery:
1. Assess Risks
2. Identify Mission-Critical Applications
3. Determine Responsibilities of Personnel
4. Develop a Plan
5. Test the Plan
Split-Mirror Backup = backup that uses a remote server to back up large amounts of data offline that can be restored in disaster
Some organizations contract with outside providers for disaster recovery services
o Major factor under consideration is available hardware and telecommunication services
Some organizations that require instantaneous resumption of processing after a disaster (banks, brokerage houses) provide their own
duplicate facilities in separate locations
Multiple data centers – organizations with multiple data centers plan to use one data center to back up another
o Several types of backups can be used to recover lost data:

Full Backup = an exact copy of the entire database

Partial Backup – two types of partial data backups

Incremental Backup = copying only the data items that have changed since the last backup

Differential Backup = copies all changes made since the last full backup
Alternative Processing Facilities



Cold Site = a disaster recovery facility that does not have equipment and operating system software available
o All that is provided is the infrastructure – organization provides everything else
Hot Site = a facility that does have equipment and operating system software available
o Client must provide its application software and its data
Warm Site = a facility that is already stocked with all the hardware necessary to create a reasonable facsimile of the primary data center
D: Processing Integrity in Information Technology
Role of Input, Processing & Output Controls




Input Controls = verify that transaction data is valid, complete and accurate
o May include data validation at the field level, prenumbered forms, and well-defined source data preparation procedures
Processing Controls = verify that all transactions are processing correctly during file maintenance
o Key processing controls include:

Data Matching and Use of File Labels

Recalculation of Batch Totals

Cross-Footing and Zero-Balance Tests

Write-Protection Mechanisms

Data Processing Integrity Procedures
Output Controls = verify the accuracy and integrity of reports
o Output controls include:

Review of Output and Reconciliation Procedures

External Data Reconciliation

Output Encryption
Correctly functioning controls are designed to ensure completeness, accuracy and continuous processing integrity
Information Technology Controls

IT controls related to the use of information technology resources should be established including:
o Appropriate segregation of duties
o Procedures that include design and use of adequate documents and records
o Limit access to assets
o Effective performance management
o Information processing controls
o Design and use of electronic and paper documents
o Implementation of security measures and contingency plans
Effectiveness of Control Policies



To minimize failures and reduce cost overruns, while substantially improving system efficiency and effectiveness, the following
principles of control should be applied to systems development:
o Strategic Master Plan – developed and updated yearly

Shows the projects that must be completed to achieve long-range company goals

Addresses the company’s hardware, software, personnel, and infrastructure requirements
o Data Processing Schedule – to maximize the use of scarce computer resources

All data processing tasks should be organized according to a data processing schedule
o Steering Committee – should be formed to guide and oversee systems development and acquisition
o System Performance Measurements – for a system to be evaluated properly, it must be assessed using system performance
measurements
Controls can be manual or automated
Controls can be either:
o Preventative – security awareness training, firewalls
o Detective – anti-virus system monitoring
o Corrective – backup data restore
Roles & Responsibilities of IT Professionals






Roles and responsibilities of IT professionals are defined by individual organizations, and job titles and responsibilities can vary widely
Executive roles include – Chief Information Officers (CIO) and Chief Technology Officers (CTOs)
Management includes senior executives, directors, and managers who usually report to the CIO or CTO
o Titles in the real world can vary widely and do not necessarily indicate specific functions
Programmers, Administrators, and Analysts
o System Analysts – designs or purchases IT system, responsible for flowcharts, liaison between users and programmers
o Application Programmers
o System Administrator – controls database access
o System Programmers – writes, updates, maintains, and tests software, systems, and compliers

In mainframe environments, they maintain the operating system

In non-mainframe environments operating system maintenance may be done by a system administrator

Control – system programmer can't also have application programming duties or be an operator
o Security Administration
o Database Administrators

Are different from data administrators
Segregation of duties should divide responsibilities of portions of a transaction – authorization, recording, and custody
o Segregated IT roles – operators (administrators), programmers (engineers), and librarians (custodians)
Within an IT department the following duties should be kept separate:
o System Analysts and Computer Programmers
o Computer Operators
o Security Administrators
E: Systems Development and Maintenance
Risks Related to Systems Development & Maintenance


Risks can be assessed and to some extent managed
o Access, data, and procedural controls are all important tools of risk management
Technology Risk – four general types of risks associated with IT Systems
1.
2.
3.
4.
Strategic Risk = risk of choosing an inappropriate technology
Operating Risk = risk of doing the right things in the wrong way
Financial Risk = risk of having financial resources lost, wasted, or stolen
Information Risk = risk of loss of data integrity, incomplete transactions, or hackers
Managing Information Technology (IT) Risk


IT Risk = the business risk associated with the use, ownership, operation, involvement, influence, and adoption of IT within an enterprise
o ISACA sorts IT risk into three categories:

IT Benefit/Value Enablement Risk

IT Program and Project Delivery Risk

IT Operations and Service Delivery Risk
ISACA developed the Risk IT Framework to achieve three objectives:
1. Integrate management of IT risk into the overall risk management of the enterprise
2. Make well-informed decisions about the nature and extent of the risk, the risk appetite, and risk tolerance
3. Develop a response to the risk
Risk Assessment Procedures/Process

Before risks can be managed, they must be assessed – steps in risk assessment are to:
1. Identify the threats
2. Evaluate the probability that the threat will occur
3. Evaluate the exposure in terms of potential loss from each threat
4. Identify the controls that could guard against the threats
5. Evaluate the costs and benefits of implementing controls
6. Implement controls that are deemed to be cost effective
Risks Related to New Technology

AICPA published lessons learned that stressed the following points when implementing new technology:
o Define the integration points to the governance processes
o Define and manage planning data
o Define and publicize the planning calendar
o Realize that timing is essential
o Clearly define roles and responsibilities
o Communicate data and messages well
Risks Related to Legacy Systems



Reasons for Persistence of Legacy Systems include:
o Investment in deployment and training
o Dependencies on supportive technology
o Dependencies built on the legacy product
o Risk over reward
Risks of Legacy Systems include:
o Lack of vendor support
o Old “Threatscape”
o Code reutilization
o Educated Hackers & Evolving Hacker Tools
o Patch Lag
o Dependency on Insecure Platform
Mitigating risks related to legacy systems can be accomplished either through isolating the system and/or virtual patches
Information System Testing Strategies


Software testing is intended to find defects created during development, determine the level of quality, and ensure that the end
product meets business and user requirements
o An effective testing strategy includes automated, manual, and explanatory tests to efficiently reduce risk, including unit tests
and integration tests – both bottom-up and top-down integration testing approaches
Guidelines for successful testing:
o Specify testing objectives explicitly
o Identify categories of users for the software – develop a profile for each
o Build robust software that is designed to test itself
o Use effective formal reviews as a filter prior to testing
o
o
Conduct formal technical reviews to assess the test strategy and test cases
Develop a continuous improvement approach for the testing process
Operations Management in Business
A: Performance Management
Financial and Nonfinancial Performance Measures



Financial and nonfinancial performance measures motivate behavior
o Businesses should link measures, incentives, and goals for most effectiveness
Financial measures of performance includes:
o Profit – the amount of income generated after expenses
o Return on Investment – the income generated based on a given investment (ex: total assets employed, stockholders’ equity)
o Variance Analysis – compares actual performance to expected performance
o Balance Scorecard – a framework used to convert an entity’s strategic objectives into a set of performance measures
Nonfinancial Measures (benchmarking/best practices) include:
o Total Factor Productivity Ratios (TFPs)

Reflect the quantity of all output produced relative to the costs of all inputs used
o Partial Productivity Ratios (PPRs)

Reflect the quantity of output produced relative to the quantity of individual inputs used
Internal Benchmarks & Techniques

Internal benchmarks and techniques can be used for finding and analyzing problems
o Control Chart = a graphical tool used to plot a comparison of actual results by batch to an acceptable range to determine
improvement or deterioration of quality conformance

Determine zero defects

Keep deviations in an acceptable “Goal Post” conformance range
o Fishbone Diagrams = cause and effect diagrams used to identify recurring and costly defects and then break down the
problems that led to the individual defects

Consists of tracing back to the problem causing the defects
o Pareto Diagram = used to plot the frequency of defects from the highest to lowest frequency
Characteristics of Effective Performance Measures


Effective performance measures promote the achievement of goals and motivate the entity
Characteristics of effective performance measures include:
o Relate to the goals of the organization
o Balance long-term and short-term issues
o Reflect management of key activities – sometimes referred to as critical success factors in the balanced scorecard (“FECH”)

Financial

Efficient/Effective

Customer Satisfaction

Human Resources
o Are under the control or influence of and understood by the employee
o Are used to both evaluate and reward the employee or otherwise constructively influence behavior
o Are objective and easily measures
o Are used consistently
Return on Investment (ROI) & Return on Assets (ROA)

Return on Investment = provides for the assessment of a companies percentage return relative to its capital investment risk
𝑅𝑂𝐼 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑅𝑂𝐼 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑥 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑅𝑂𝐼 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠
𝑥
𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Return on Assets = similar to return on investment, except that ROA uses average total assets in the denominator rather than invested
capital in the denominator
𝑅𝑂𝐴 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Return on Equity (ROE) & DuPont Ratios

Return on Equity = a measure of profitability equal to the amount of net income returned as a percentage of shareholders’ equity
𝑅𝑂𝐸 =

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
DuPont Ratio is a means of breaking down ROE into three components:
𝐷𝑢𝑃𝑜𝑛𝑡 𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑥
𝑥
𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑢𝑃𝑜𝑛𝑡 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑥 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒

Extended DuPont Ratio breaks down ROE into five components:
𝐸𝑥𝑡𝑒𝑛𝑑𝑒𝑑 𝐷𝑢𝑃𝑜𝑛𝑡 𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑒𝑡𝑎𝑥 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝐼𝑇
𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑥
𝑥
𝑥
𝑥
𝑃𝑟𝑒𝑡𝑎𝑥 𝐼𝑛𝑐𝑜𝑚𝑒
𝐸𝐵𝐼𝑇
𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑥𝑡𝑒𝑛𝑑𝑒𝑑 𝐷𝑢𝑃𝑜𝑛𝑡 𝑅𝑂𝐸 = 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐵𝑢𝑟𝑑𝑒𝑛 𝑥 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐. 𝑀𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑥 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
Residual Income & Economic Value Added

Residual Income = the excess of a firm’s net income over its required rate of return
o The hurdle rate used is the cost of equity – can be established by management or calculated using CAPM, DCF, BYRP
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑓𝑟𝑜𝑚 𝐼𝑆) − 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 (𝐸𝑞𝑢𝑖𝑡𝑦) 𝑥 𝐻𝑢𝑟𝑑𝑙𝑒 𝑅𝑎𝑡𝑒

Economic Value Added = a firm’s net operating profit after taxes, less its after-tax cost of capital
o Cost of capital used is typically the weighted average cost of capital (WAAC)
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 𝐴𝑑𝑑𝑒𝑑 = 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠 − 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
B: Cost Accounting in Business
Cost Objects in Cost Accounting

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Cost Objects = resources or activities that serve as the basis for management decisions – cost control
o Could be products, departments, or geographic areas
Product Costs = comprises all costs related to the manufacturing of a product
o Components of product costs include:

Direct Material

Direct Labor

Manufacturing Overhead Applied
o Product costs are inventoriable and traceable (WIP inventory, FG inventory, and cost of goods sold)
Period Costs = costs that are expensed in the period which they are incurred and are not inventoriable
o Examples: selling, general, and administrative expenses
Manufacturing Costs = includes all costs associated with the manufacturing of a product (DM, DL, MOH)
o Includes both direct and indirect manufacturing costs

Indirect Materials

Indirect Labor

Factory Costs
Nonmanufacturing Costs = costs that do not relate to the manufacturing of a product
o Includes advertising costs and salaries of sales personnel
o Nonmanufacturing costs are expensed in the period incurred
Tracing Costs to Cost Objects


Direct Costs = costs that can be identified with or traced to a given cost object in an economical manner
o Usually relevant to a costing decision – variable costs are usually direct costs
o Direct costs include direct raw materials and direct labor

Direct raw materials includes freight-in and normal scrap

Direct labor includes downtime, setting up, training, and breaks
Indirect Costs = costs that are not easily traced to the cost object or cost pool
o Also known as manufacturing overhead, indirect costs include indirect materials and labor, and other indirect costs
o Indirect costs are allocated to the cost pools/objects using cost drivers that have a significant relationship to the incurrence of
these costs – “high correlation”

Assign overhead to cost of goods manufactured “estimate”
o In-factory indirect costs are product costs while in-office indirect costs are period costs
Pass Key
A cost driver is a factor that has the ability to change total costs

Cost drivers could include nonfinancial or statistical measurements of
activities such as sales or production volume

Cost drivers are identified by activity based costing and are related to one
of multiple cost pools for cost allocation
Cost Behaviors & Characteristics




Variable Costs – varies in total as production volume increases or decreases
o Remains constant on a per-unit basis
o Direct materials and direct labor are variable costs
Fixed Costs – remains constant in total, regardless if the production volume increases or decreases
o Fixed costs vary on a per-unit basis
o Depreciation would be classified as a fixed cost
o Over a long-run time horizon, any cost can be considered variable
Semi-Variable (Mixed) Costs – costs that contain both fixed and variable components
o Example: utilities where there is a fixed monthly charge plus a variable rate
Relevant Range – the graphical range for which the assumptions of a cost driver are valid
o Any cost driver activity that is outside the relevant range cannot be used to allocate costs to objects
Cost Accumulation Systems

Cost accumulation systems are used to assign costs to production
o Use job order costing when the cost object is a custom order
o Use process costing when the cost object is a mass-produced homogenous product
Pass Key
Although the most commonly tested cost accumulation systems are job-order costing and process costing,
there are many variations of cost accumulation systems that may appear on the exam:

Operations Costing = uses components of both job-order costing and process costing

Backflush Costing = accounts for certain costs at the end of the process in circumstances in which
there is little need for in-process inventory valuation

Life-Cycle Costing = seeks to monitor costs throughout the product’s life cycle and expand on the
traditional costing systems that focus only on the manufacturing phase of a product’s life
Cost of Goods Manufactured & Sold

Cost of Goods Manufactured = accounts for the manufacturing costs of the products
completed during the period
o COGM is used as part of the cost of goods sold computation
o Factory overhead is applied based on a predetermined rate

Predetermined OH rate in traditional costing is the estimated total
OH costs divided by the estimated cost driver (DL Hours, etc.)

Cost of Goods Sold = the amount matched against sales revenue as part of income determination
o If overhead applied is greater than the total actual overhead costs incurred,
we say overhead is overapplied

If the applied overhead is less than the actual, we have
underapplied overhead
o Overapplied overhead is closed to cost of goods sold account as a credit to
the expense to reduce it
o Underapplied overhead is closed to COGS as a debit it the expense
Job Order Costing




Job Order Costing = a cost accumulation of product costing method that involved unique or easily identifiable units
o This method is used when manufacturing custom products such as customized cars, boats, and houses
Costs are allocated to a specific job as it moves through the manufacturing process – “sequentially”
Job cost records or job orders accumulate all costs for a specific job with data obtained from material requisitions and labor time cards
o Prime Costs = Direct Materials + Direct Labor
o Conversion Costs = Direct Labor + Overhead Applied
Once the job is complete, the total cost is readily available on the job cost record
Process Costing – Average Costs





Process Costing = costing method that accumulates costs by department or process
o Two methods are used in process costing – FIFO and Weighted Average
Process costing is used in those instances in which homogenous units of output are produced and average costing is appropriate
o Applications include fuel refining, chemical processing, and paper production
Transfers in from other departments are always considered 100% complete and included in the cost
Direct materials added at the beginning of or during a second or later process may either be 100% complete or “partially complete”
o Depending on how much work has been done on that component of the process
Any material added at the very end of a process will not be in work in process inventory at the month end
Equivalent Units – FIFO & Weighted Average

Equivalent Unit = the amount of direct material, direct labor, or conversion costs necessary to complete one unit of production
o FIFO approach specifically accounts for work to be completed during a period
o Weighted average approach account for work completed during the period as well as work performed last period on this
period’s beginning inventory
Spoilage – Abnormal & Normal


Equivalent units added to production for a month are usually less than the actual units added during the month as a result of problems
with the production process
o This is the result of spoilage or shrinkage
There are two different types of spoilage:
o Normal Spoilage = occurs under regular operating conditions and is charged to factory overhead (inventory cost)

Included in inventoriable costs on the balance sheet
o Abnormal Spoilage = doesn’t occur under normal operating conditions and its treated as a period expense

Not included in inventoriable costs – included in expenses on the income statement

Examples: floods, fire damage, and spoilage materially in excess or standard caused by inefficient production
Activity-Based Costing (ABC)

Activity-Based Costing = a costing system that divides production into activities where costs are accumulated (cost pools) and allocated
to the product based on the level of activity demanded by the product
o Multiple cost pools – by department


o Multiple overhead rates from each department
ABC tends to increase both the number of cost pools and allocation bases – traditional uses one cost pool and one allocation base
When using ABC, companies may allocate service department costs to production – may be allocated using:
o Direct Method – each service department’s total costs are allocated to the production departments directly without
recognizing that service departments themselves may also use the services from other service department

Most commonly used method – less complex than step-down method
o Step-Down Method – service department costs are allocated to production departments as well as other service departments
that use a given service department’s services

Allocation to other service departments is done through a step-down allocation process
Joint Product & By-Product Costing

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


Joint Product Costing = two or more products are produced from the same common raw material
o Costing methods are used to segregate costs associated with each product jointly produced by the same process
Assigns joint (common) costs up to split-off point to the joint (main) products
There are three methods to allocating joint costs:
1. Relative Sales Value at Split-Off Approach

Joint costs are allocated to joint products based on their relative sales value at the split-off point
2. Net Realizable Value Approach

Costs added after the split-off point (separable costs) must be subtracted from the final selling price to arrive at the
net realizable value

Used when there is no sales values at the split-off point – must finish the products
3. Service Department Cost Allocation to Joint Products

Service costs are allocated to joint products based on the joint products proportional unit-volume relationship
By-Products = represent outputs of minor value incidental to a manufacturing process
Accounting for by-products can take one of two forms:
1. Revenue applied to the main product as a cost reduction – reduction from joint costs
2. Included in miscellaneous income
C: Process Management in Business
Business Process Management

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
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Business Process Management – promotes continuous improvement in business processes (ongoing process)
o There are many generic BPM methodologies – most recognized is PDCA
PDCA method of business process management:
o Plan – design process improvements
o Do – implement the designed process improvements
o Check – check and monitor the improvements
o Act – continuously commit to the process and reassess effectiveness
Measures can be either financial or nonfinancial and should correlate directly to the managed process to determine progress toward the
expectations/goals
Benefits of process management include improved efficiency, effectiveness, and agility for the organization
Shared Services, Outsourcing & Offshore Operations


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Shared Services = a consolidation of redundant services in an organization or group of affiliates
o While consolidation of redundant services leads to efficiency, it may result in service flow disruption or failure demand
o Shared services is an “in-house” solution – but it may be ineffective
Outsourcing Services = involves contracting with a third party to provide a service
o Risks pertaining to outsourcing include inferior quality of service and the security of information – may be compromised
Offshore Operations = the outsourcing of services to providers outside of the country
o All outsourcing risks plus lack of control caused by proximity issues and language barriers are potential risks
Selecting & Implementing Improvement Initiatives


Selecting and implementing improvement initiatives is a key component of process management
Rational and irrational methods may be used to select improvement initiatives
o Rational assessments are structured and systematic
o Irrational methods are intuitive and emotional
Business Process Reengineering


Business Process Reengineering = seeks radical change by entirely changing the design and operation of business processes
o Different from business process management

Business process management seeks incremental change not radical change
The basic idea behind BPR is to create a fresh start by effectively “wiping the slate clean” and reassessing the business processes from
the ground up
Management Philosophies & Techniques for Performance Improvements
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Just-In-Time System = an inventory system where resources will be introduced to the manufacturing process only as they're needed
o Item is produced only when it is requested further downstream in the production cycle
o Serve to make organizations efficient and better managed – want to avoid a surplus
o Assumes that maintaining inventory does not add value
Quality Control = a product’s ability to meet or exceed customer expectations
o Cost of quality is classified into two components:
1. Conformance Costs
2. Non-Conformance Costs
o Total quality management is an organizational commitment to customer-focused performance that stresses both quality and
continuous improvement

Never satisfied – always want to improve

Quality audits – find strengths and weaknesses

GAP analysis – actual practices vs. best practices
Lean Manufacturing = a management style that uses only those resources that are necessary to meet customer requirements or that
add value to the production process – focus is on waste reduction and efficiency
o Kaizen – refers to continuous improvement efforts that improve efficiency and effectiveness through operational control

Occurs at the manufacturing stage where the ongoing search for cost reductions takes the form of analysis of
production processes to ensure that resource uses stay within target costs
o An organization may implement process improvement by using activity-based costing and activity-based management
Demand Flow = seeks to reduce waste by bringing resources into production as they are demanded rather than as they are scheduled
for production – not mere forecasts – demanded by customers
o Blends the efficiencies of JIT with the effectiveness (customer-focused, value-added) goals of lean manufacturing
Conformance Costs

Conformance Costs = costs ensuring conformance with quality standards and are classified as prevention and appraisal costs
o Prevention Costs = costs incurred to prevent the production of defective units

Employee training

Inspection expenses

Preventative maintenance

Redesign of product or processes

Search for high quality suppliers
o Appraisal Costs = costs incurred to discover and remove defective parts before they are shipped to the customer

Statistical quality checks

Testing and inspection

Maintenance of the laboratory

Non-Conformance Costs = costs to fix quality problems related to nonconformance with quality standards
o Internal Failure Costs = costs to cure a defect discovered before the product is sent to the customer

Rework costs and scrap

Tooling changes and downtime

Costs to dispose and cost of the lost unit
o External Failure Costs = costs to cure a defect discovered after the product is sent to the customer

Warranty costs and liability claims

Costs of returning the good

Lost customers

Reengineering and external failure
Theory of Constraints


Theory of Constraints = a management philosophy that says organizations are impeded from achieving objectives by the existence of
one or more constraints
o The organization must be consistently operated in a manner that either works around or leverages the constraint
There are five steps to applying the theory of constraints – maximize throughput by:
1. Identification – use process charts or interview results in identification of constraint that produces suboptimal performance
2. Exploitation – planning around the constraint uses capacity that is potentially wasted
3. Subordinate – subordinate everything else to the above decisions

Management directs its efforts to improving the performance of the constraint
4. Elevate Constraint – add capacity to overcome the constraint
5. Return to First Step – reexamine the process to optimize the results
Six Sigma & Quality Improvement



Six Sigma = recommends the use of rigorous metrics in the evaluation of goal achievement and logically anticipates methodologies to
improve current processes and develop new processes
o Focus is on continuous quality improvement in current and new processes
Existing Product and Business Process Improvements (DMAIC)
o Define the problem
o Measure key aspects of the current process
o Analyze data
o Improve or optimize current process
o Control
New Product or Business Process Development (DMADV)
o Define design goals
o Measure CTQ – critical to quality issues
o Analyze design alternatives
o Design optimization
o Verify the design
D: Budgeting & Analysis in Businesses
Types of Budgets – Master & Flexible


Master Budget = a budget for all of the planned activities of a firm – budget at one level of activity (“static budget”)
o Generally includes operating budgets and financial budgets

Operating budget includes a sales budget, a production budget, and a SG&A expense budget

Financial budget includes a cash budget and pro forma financial statements
o The annual plan anticipates the coming year’s activities that will contribute to the accomplishment of the long-term and shortterm goals outlined in the company’s strategic plan
Flexible Budgets = budgets produced at several levels of activity – adjusted to changes in sales or production volumes
o Flexible budgets are normally designed for a period of one year or less to accommodate the potential changing relationship
between per unit revenues and costs

Include consideration of revenue per unit, variable costs per unit, and fixed costs over the relevant range
Operating vs. Financial Budgets


Operating budgets consist of the following budgets:
o Sales Budgets
o Production Budgets

Direct Materials Budget

Direct Labor Budget

Factory Overhead Budget

Cost of Goods Sold Budget
o Selling and Administrative Budgets
Financial budgets consist of the following budgets:
o Pro Forma Financial Statements
o Cash Budgets
Variance Analysis in Business


Variance Analysis = involves differences between budgeted (targeted or standard) and actual performance
o Actual cost lower than standard produces a favorable variance
o Actual cost higher than standard produces an unfavorable variance
Expense variances are calculated for:
o Direct Material and Direct Labor

Price and Quantity Variance

Rate and Efficiency Variance
o Manufacturing Overhead
Manufacturing Overhead Variances

Overhead variances represent the analysis of any balance in the overhead account after overhead has been applied
o
o

Overapplied overhead (more credit) is favorable
Underapplied overhead (more debit) is unfavorable
VOH Rate (Spending) Variance – tells managers whether more or less was spend on variable overhead than what was expected
𝑉𝑂𝐻 𝑅𝑎𝑡𝑒 (𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔) 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐻𝑜𝑢𝑟𝑠 𝑥 (𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 − 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑅𝑎𝑡𝑒)

VOH Efficiency (Usage) Variance – isolates the amount of total VOH variance that is due to using more/fewer hours than budgeted
𝑉𝑂𝐻 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 (𝑈𝑠𝑎𝑔𝑒)𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑅𝑎𝑡𝑒 𝑥 (𝐴𝑐𝑡𝑢𝑎𝑙 𝐻𝑜𝑢𝑟𝑠 − 𝑆𝑡𝑑 𝐻𝑜𝑢𝑟𝑠 𝐴𝑙𝑙𝑜𝑤𝑒𝑑 𝑓𝑜𝑟 𝐴𝑐𝑡. 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑉𝑜𝑙𝑢𝑚𝑒)

FOH Budget (Spending) Variance – focuses at a high level whether more or less was spend on fixed overhead costs than budgeted
𝐹𝑂𝐻 𝐵𝑢𝑑𝑔𝑒𝑡 (𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔) 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐹𝑂𝐻 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐹𝑂𝐻

FOH Volume Variance – when actual volume produced differs from the amount used to calculate the FOH application rate
o Budgeted FOH = Budgeted Production x Standard Rate
o Standard FOH Cost Allocated = Actual Production x Standard Rate
𝐹𝑂𝐻 𝑉𝑜𝑙𝑢𝑚𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐹𝑂𝐻 − 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐹𝑂𝐻 𝐶𝑜𝑠𝑡 𝐴𝑙𝑙𝑜𝑐𝑎𝑡𝑒𝑑 𝑡𝑜 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Sales Variance Analysis

Sales Price Variance – measures the aggregate impact of a selling price different from the budget
o Also known as sales revenue flexible budget variance
𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑃 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑃 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡) 𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑜𝑙𝑑 𝑈𝑛𝑖𝑡𝑠

Sales Volume Variance – a flexible budget variance that distills volume activity from other sales performance components
𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑) 𝑥 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐶𝑀 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡


Actual sales prices higher than budgeted sales prices produce a favorable variance
o Actual sales prices lower than budgeted sales prices produce an unfavorable variance
Actual units sold higher than the budgeted units sold produces a favorable variance
o Actual units sold lower than the budgeted units sold produces an unfavorable variance
Responsibility Segments – SBUs


Responsibility Segment – highly effective in establishing accountability for financial dimensions of the business
o Responsibility segments are sometimes referred to as strategic business units – SBUs

Performance reporting for each SBU measures financial responsibility

SBUs are often subdivided into additional categories including product lines, geographic areas, or customers
Specific SBU classifications include:
o Cost SBU – managers are held responsible for controlling costs within a cost SBU
o Revenue SBU – managers are held responsible for generating revenues within a revenue SBU
o Profit SBU – managers are held responsible for producing a target profit within a profit SBU

Accountable for both revenues and costs to produce a profit
o Investment SBU – managers are held responsible for the return on the assets invested within an investment SBU

The return must be equal to or greater than management’s minimum required rate of return
Balanced Scorecards for Businesses


Balanced Scorecard = a control mechanism that gathers information on multiple dimensions of an organization’s performance defined
by critical success factors necessary to accomplish firm strategy
o Generally is a senior management or executive tool in organizations
Critical success factors can be classified within various categories and are commonly displayed as:
o Financial Performance – includes critical financial performance measures

Examples: current ratio or gross margin
o Internal Business Processes – includes critical business process measures

Example: through-put time (efficiency and effectiveness)
o Customer Satisfaction – includes critical customer satisfaction measures

Example: customer retention
o Innovation and Human Resources – includes critical learnings and grown measures

Examples: employee retention, innovations, suggestions made and accepted
E: Forecasting and Projection Methods
Absorption (Full) vs. Variable (Direct) Costing


Absorption costing method is a US GAAP basis calculation of gross profit, while variable costing develops contribution margin
compatible with breakeven analysis
o Variable costing is not allowed for financial reporting purposes under US GAAP
General assumptions of cost-volume-profit (CVP) analysis include:
o Costs are either variable or fixed, with volume the only relevant factor affecting cost
o In relation to production volume, all costs behave in a linear fashion
o Over the relevant range of production volume, cost behaviors will remain constant
o The longer (shorter) the time period, the greater the percentage of variable (fixed) costs
Absorption (Full) Costing Approach

Absorption costing capitalized fixed factory overhead as part of inventory in accordance with GAAP
o Absorption costing includes:

Direct Materials

Direct Labor

Fixed Overhead

Variable Overhead
Variable (Direct) Costing Approach


In variable costing, only variable manufacturing costs are included in inventory:
o Direct Materials
o Direct Labor
o Variable Factory Overhead
Fixed factory overhead is excluded from inventory and treated as a period cost
Pass Key
Examiners frequently ask about the difference between variable costing net income and absorption costing
net income. Follow these steps below to compute the difference:
1. Compute fixed cost per unit (fixed MOH/units produced)
2. Compute the change in income (change in inventory units x fixed cost per unit)
3. Determine the impact of the change in income
-No Change in Inventory – Absorption Net Income = Variable Net Income
-Increase in Inventory – Absorption Net Income > Variable Net Income
-Decrease in Inventory – Absorption Net Income < Variable Net Income
Breakeven Analysis & Formulas



Breakeven Analysis = determined the sales required (in dollars or units) to result in zero profit or
loss from operations
o After breakeven has been achieved, each additional unit sold will increase net income
by the amount of the contribution margin per unit
Breakeven in units can be found by dividing total fixed costs by the contribution margin per unit
Breakeven point in dollars can be found by using the breakeven in units or the contribution
margin approach
o Contribution margin ratio is equal to the contribution margin divided by sales
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 $ = 𝑈𝑛𝑖𝑡 𝑃𝑟𝑖𝑐𝑒 𝑥 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 𝑖𝑛 𝑈𝑛𝑖𝑡𝑠
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 (𝑈𝑛𝑖𝑡𝑠) =
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 $ =
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
Required Sales for a Desired Profit

Breakeven analysis can be extended to calculate the required sales to produce a desired pretax income by treating the desired profit as
another fixed cost
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 (𝑈𝑛𝑖𝑡𝑠) =
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 ($) =
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
Margin of Safety

The margin of safety is the excess of sales over breakeven sales
o Can be calculated/expressed in dollars or as a percentage of sales
Target Costing


Target costing is used to establish the product cost allowed that ensures both total sales volume and profitability per unit
o The target cost will be equal to the market price less the required profit
With target pricing, the selling price of the product determine the production costs allowed
Transfer Pricing – Non-Global & Global Perspectives


Non-Global Perspective Transfer Pricing
o A transfer price is the price charged for the sale/purchase of a product internally

Between two divisions within one overall company
o Prices are based on the following strategies: negotiated price, market price, and cost
Global Perspective Transfer Pricing
o Transfer pricing is a methodology for allocating profits or losses among related entities within the same corporation or legal
group in different tax jurisdictions

Transfer prices should approximate the prices for comparable transactions between unrelated parties
Special Order Decisions



Special Order Decisions = generally infrequent opportunities that require firm to decide if a special order should be accepted or rejected
o Generally most direct and variable costs are considered as well as incremental costs

General Decision Rule: Accept if selling price > relevant costs
Presumed Excess Capacity
o Compare the incremental (additional) costs of the order to the incremental revenue generated by the order

This process compares the variable cost per unit to the revenue generated per unit
o Provided the selling price per unit is greater than the variable cost per unit, the contribution margin will increase and the order
should be accepted
o Fixed costs are sunk costs and will not be relevant to this decision
Presumed Full Capacity
o Extend the analysis above to include opportunity costs

Relevant Cost = Variable Cost per Unit + Opportunity Cost per Unit
o The opportunity cost will be the contribution margin that would have been produced if the special order were not accepted
o The production that is forfeited to produce the special order is referred to as the next best alternative use of the facility
Make or Buy Decisions




Similar to accepting or rejecting a special order, managers must consider capacity and opportunity costs
o General Decision Rule: make if relevant costs < outside purchase price
If there is excess capacity, the cost of making the product internally is the cost that will be avoided or saved if the product is not made
o This will be the maximum outside purchase price

Compare variable costs to the purchase price and select the cheapest alternative
If there is no excess capacity, the cost of making the product internally is the cost that will be avoided (saved) if the product is not made
plus the opportunity cost associated with the decision
o Compare the variable costs plus opportunity cost to the purchase price and select the cheapest alternative
Make or buy decisions attempt to use existing capacity as efficiently as possible before purchasing from an outside supplier
Sell or Process Further Decisions

Management’s decision as to whether to sell at the split-off point involves comparing the incremental costs generated after split-off
o Separable costs incurred after split-off are relevant, while joint costs incurred prior to split-off are not relevant

Decision rules for sell or process further decisions:
o Sell: Incremental Costs > Incremental Revenues
o Process Further: Incremental Revenues > Incremental Costs
Keep or Drop Segment Decisions



Decision to keep or drop a segment involves comparing the lost contribution margin to avoidable fixed costs of the segment is dropped
o Avoidable fixed costs go away if the segment is dropped and are therefore relevant
Unavoidable fixed costs will be reallocated to other products and continue to be incurred by the company even if the segment is
dropped, therefore making them irrelevant
Decision rules for keeping or dropping a segment:
o Keep: Lost Contribution Margin > Avoidable Fixed Costs
o Drop: Avoidable Fixed Costs > Lost Contribution Margin
Regression Analysis




Linear Regression = a method for studying the relationship between two or more variables
o Using regression analysis, variation in the dependent variable is explained using one or more independent variables
The dependent variable is specified to be a linear function of one or more independent variables
Simple regression involves only one independent variable
o Multiple regression analysis involves more than one independent variable
The simple linear regression model takes the following form:
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑅𝑎𝑡𝑒 (𝑈𝑛𝑖𝑡𝑠)
Statistical Measures Used to Evaluate Regression Analysis


Coefficient of Correlation (r) = measures strength of the linear relationship between the independent variable and dependent variable
o In standard notation, the coefficient of correlation is r – range from -1.0 to 1.0

-1.0 indicates a perfect negative correlation and a value of 1.0 indicates a perfect positive correlation
Coefficient of Determination (R2) = the portion of the total variation in the dependent variable explained by the independent variable
o Its value lies between zero and one
o The higher the R2 the greater the proportion of the total variation in y that is explained by the variation in x

The higher the R2 the better fit of the regression line
Learning Curve Analysis

Learning curve analysis is based on the idea that per-unit labor hours will decline as workers become more familiar with a specific task
or production process
o Based on the idea that experience = efficiency
High-Low Point Method


The high-low point method is used to estimate the fixed and variable portions of cost
o It assumes that the differences between costs at the highest and lowest production levels are due directly to variable costs
Variable and fixed costs are calculated as follows:
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡 =
𝐶𝑜𝑠𝑡 𝐻𝑖𝑔ℎ − 𝐶𝑜𝑠𝑡 𝐿𝑜𝑤
𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝐶𝑜𝑠𝑡𝑠
=
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 𝑎𝑡 𝐻𝑖𝑔ℎ − 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 𝑎𝑡 𝐿𝑜𝑤
𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 − (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡 𝑥 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦)
Sales (net)
Accounts receivable
turnover
Average accounts receivable (net)
Sales (net)
Asset turnover
Average total assets
Income available to common shareholders
Basic earnings per share
Cash conversion cycle
Weighted-average common shares
outstanding
Days sales in accounts receivable + Days in inventory — Days of payables outstanding
Current assets
Current ratio
Current liabilities
Ending inventory
Days in inventory
Cost of goods sold / 365
Days of payables
outstanding
Ending accounts payable
Cost of goods sold / 365
Ending accounts receivable (net)
Days sales in accounts receivable
Sales (net) / 365
Total liabilities
Debt to equity
Total equity
Cash dividends
Dividend payout
Net income
Total assets
Equity multiplier
Gross margin
(Gross profit margin)
Total equity
Sales (net) — Cost of goods sold
Sales (net)
Cost of goods sold
Inventory turnover
Average inventory
Cash flow from operations
Operating cash flow ratio
Ending current liabilities
Price earnings ratio
Price per share
Basic earnings per share
Net income
Profit margin
Sales (net)
Quick ratio
Cash and cash equivalents + Short-term marketable
securities + Receivables (net)
Current liabilities
Net income
Return on assets
Average total assets
Net income
Return on equity
Average total equity
Return on sales
Income before interest income, interest
expense, and taxes
Sales (net)
Income before interest expense and taxes
Interest expense
Times interest earned
OR
Earnings before interest and taxes
Interest expense
Total liabilities
Total debt ratio
Total assets