Wiley CPAexcel Exam Review 2016 Focus Notes Business Environment and concepts

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Contents

Preface vii

About the Author ix

About the Contributor ix

Module 40: Corporate Governance, Internal Control, and Enterprise Risk Management 1

Module 41: Information Technology 15

Module 42: Economics, Strategy, and Globalization 52

Module 43: Financial Risk Management and Capital Budgeting 80

Module 44: Financial Management 99

Module 45: Performance Measures and Management Techniques 122

Module 46: Cost Measurement and Assignment 139

Module 47: Planning, Control, and Analysis 156

Index 171

v

Preface

This publication is a comprehensive, yet simplified study program. It provides a review of all the

basic skills and concepts tested on the CPA exam, and teaches important strategies to take

the exam faster and more accurately. This tool allows you to take control of the CPA exam.

This simplified and focused approach to studying for the CPA exam can be used:

• As a handy and convenient reference manual

• To solve exam questions

• To reinforce material being studied

Included is all of the information necessary to obtain a passing score on the CPA exam in a

concise and easy-to-use format. Due to the wide variety of information covered on the exam,

a number of techniques are included:

• Acronyms and mnemonics to help candidates learn and remember a variety of rules and

checklists

• Formulas and equations that simplify complex calculations required on the exam

• Simplified outlines of key concepts without the details that encumber or distract from learning

the essential elements

vii

Preface viii

• Techniques that can be applied to problem solving or essay writing, such as preparing a

multiple-step income statement, determining who will prevail in a legal conflict, or developing

an audit program

• Pro forma statements, reports, and schedules that make it easy to prepare these items by

simply filling in the blanks

• Proven techniques to help you become a smarter, sharper, and more accurate test taker

This publication may also be useful to university students enrolled in Intermediate, Advanced

and Cost Accounting; Auditing, Business Law, and Federal Income Tax classes; or Economics and

Finance classes.

Good luck on the exam,

Ray Whittington, PhD, CPA

About the Author

Ray Whittington, PhD, CPA, CMA, CIA, is the dean of the Driehaus College of Business at DePaul University. Prior to

joining the faculty at DePaul, Professor Whittington was the Director of Accountancy at San Diego State University. From

1989 through 1991, he was the Director of Auditing Research for the American Institute of Certified Public Accountants

(AICPA), and he previously was on the audit staff of KPMG. He previously served as a member of the Auditing

Standards

Board of the AICPA and as a member of the Accounting and Review Services Committee and the Board of Regents

of

the Institute of Internal Auditors. Professor Whittington has published numerous textbooks, articles, monographs,

and

continuing education courses.

About the Contributor

Kurt Pany, PhD, CPA, is a Professor of Accounting at Arizona State University. His basic and advanced auditing courses

provided the basis on which he received the Arizona Society of CPA’s Excellence in Teaching Award and an Arizona

CPA Foundation Award for Innovation in the Classroom for the integration

of computer and professional ethics applications.

His professional experience includes serving for four years on the AICPA’s Auditing Standards Board, serving as

an academic fellow in the Auditing Division

of the AICPA, and prior to entering academe, working as a staff auditor for

Deloitte and Touche.

ix

Focus on

Corporate Governance, Internal Control, and 1

Enterprise Risk Management—Module 40

Corporate Governance

and Enterprise Risk Management

Corporate Governance: Establish Incentives and Monitoring

• Owners separate from management

• Agency problem: Will managers act in owners’ interest?

Incentives to Defeat Agency Problem

Forms of Executive Compensation

• Base salary and profit: Usually based on accounting measures

• May lead to earnings manipulation or taking excessive risk

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Corporate Governance, Internal Control, and 2

Enterprise Risk Management—Module 40

Incentives to Defeat Agency Problem (continued)

• Stock options: align shareholders’ and managers’ interest in increasing share prices

• Differences in timing horizons (management short term?)

• Underwater options provide no incentive

• Restricted stock: force managers to think long term

Monitoring Devices

• Boards of directors

• Independent nominating/corporate governance committee

• Independent audit committee (AC) under Sarbanes-Oxley (SOX)

• At least one financial expert

• External auditors must report directly to AC

• AC appoints, determines compensation, and oversees external auditor

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Corporate Governance, Internal Control, and 3

Enterprise Risk Management—Module 40

Incentives to Defeat Agency Problem (continued)

• Stock exchange rules

• Majority independent directors

• Provide information to investors as to who is independent

• Have and make available code of conduct

• Have an independent AC (required by SOX)

• Have an independent compensation committee (required by Dodd-Frank)

• Clawback rules that require executives to pay back incentive compensation when there

is an accounting restatement (required by Dodd-Frank)

• Nonbinding shareholder votes on executive compensation and golden parachutes

(required by Dodd-Frank)

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Corporate Governance, Internal Control, and 4

Enterprise Risk Management—Module 40

Incentives to Defeat Agency Problem (continued)

• Internal auditors

• Provide assurance on risk management and internal control

• Should report at least indirectly to AC

• Independent and competent

• Chief IC officer reports directly to CEO

• Should adhere to Institute of Internal Auditors (IIA) professional and ethical standards.

These standards apply to both individual auditors and internal audit departments.

• External auditors

• Help assure users that financials are accurate and not fraudulent

• Must attest to management’s assessment of effective internal control as required by SOX

• The Jumpstart Our Business Startups (JOBS) Act exempted “emerging growth

companies” for a maximum of five years from the date of their initial public offering from

certain requirements that apply to larger public companies, including external reporting

on internal control

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Corporate Governance, Internal Control, and 5

Enterprise Risk Management—Module 40

Incentives to Defeat Agency Problem (continued)

• SEC and SOX

• CEO and CFO must certify accuracy and truthfulness with criminal penalties

• Fraud in sale or purchase of securities punishable by fine and/or prison

• Destruction or other damage to documentation to hinder investigation punishable by

fine and/or prison

• Retaliation on “whistleblowers” punishable by fine and/or prison

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Corporate Governance, Internal Control, and 6

Enterprise Risk Management—Module 40

Internal Controls

COSO: Internal Control Integrated Framework (Revised 2013)

Internal control is defined by COSO as a process, effected by the entity’s board of directors, management,

and other personnel, designed to provide reasonable assurance regarding the achievement

of objectives relating to operations, reporting, and compliance. It has five components and

16 principles.

1. The control environment is the set of standards, processes, and structures that provide

the basis for carrying out internal control across the organization. Principles include:

a. Commitment to integrity and ethical values.

b. The board of directors demonstrates independence from management and exercises

oversight.

c. Management establishes structures, reporting lines, and appropriate authorities and

responsibilities in the pursuit of objectives.

d. Commitment to attract, develop and retain competent individuals.

e. Hold individuals accountable for their internal control responsibilities.

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Corporate Governance, Internal Control, and 7

Enterprise Risk Management—Module 40

Internal Controls (continued)

2. Risk assessment is management’s process for identifying, analyzing, and responding to

risks. Principles include:

a. Specify objectives with sufficient clarity to enable the identification and assessment of

risks.

b. Identify risks to the achievement of its objectives and analyze risks as a basis for

determining how the risks should be managed.

c. Consider the potential for fraud.

d. Identify and assesses changes that could significantly impact internal control.

3. Control activities are policies and procedures that help ensure that management

directives are carried out. Principles include:

a. Select and develop control activities that contribute to the mitigation of risks.

b. Select and develop general control activities over technology to support the achievement

of objectives.

c. Deploy control activities through policies that establish what is expected and in

procedures that put policies into action.

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Corporate Governance, Internal Control, and 8

Enterprise Risk Management—Module 40

Internal Controls (continued)

Control activities to mitigate risks include:

a. Authorizations and approvals

b. Verifications

c. Physical controls

d. Controls over standing data

e. Reconciliations

f. Supervisory controls

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Corporate Governance, Internal Control, and 9

Enterprise Risk Management—Module 40

Internal Controls (continued)

4. The information and communication component of internal control supports all of the

other components. Principles include:

a. The organization obtains or generates and uses relevant, quality information to support

the functioning of internal control.

b. The organization internally communicates information, including objectives and

responsibilities for internal control.

c. The organization communicates with external parties regarding matters affecting the

functioning of internal control.

5. Monitoring activities assess whether each of the five components is present and

functioning. Principles include:

a. Select, develop, and perform ongoing and/or separate evaluations to ascertain whether

the components of internal control are present and functioning.

b. Evaluate and communicate internal control deficiencies in a timely manner to those

parties responsible for taking corrective action.

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Corporate Governance, Internal Control, and 10

Enterprise Risk Management—Module 40

Internal Controls (continued)

Monitoring may be considered as consisting of the following sequence of activities

(monitoring for change control continuum):

• Control baseline—Establishing a starting point that includes a supported understanding

of the existing internal control system.

• Change identification—Identifying through monitoring changes in internal control

that are either necessary because of changes in the operating environment or

have already taken place.

• Change management—Evaluating the design and implementation of the

changes, and establishing a new baseline.

• Control revalidation/update—Periodically revalidating control operation when

no known changes have occurred.

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Corporate Governance, Internal Control, and 11

Enterprise Risk Management—Module 40

Enterprise Risk Management: Eight Components

1. Internal environment (tone of the organization)

a. Effective board

b. Ethical management

c. Risk appetite: How much risk is organization willing to accept to achieve a goal?

d. Risk tolerance: How far above or below meeting objective is allowable?

2. Objective setting

a. Well-defined mission

b. Process to set objectives that align with goals

3. Event identification

a. Internal

1) Loss of key personnel

2) Damage to infrastructure (e.g., IS crash)

3) Key product/process becomes obsolete

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Corporate Governance, Internal Control, and 12

Enterprise Risk Management—Module 40

Enterprise Risk Management: Eight Components (continued)

b. External

1) Establish “trigger points” (e.g., competition increases market share above x

amount)

2) Process to assess demographic and economic changes

c. Black swan analysis: Evaluate negative events that were unforeseen to determine why

4. Risk assessment: What are the risks?

a. Assess impact and probability

b. Inherent risk: What if management does nothing in response to identified risk?

c. Residual risk: residual after management’s response

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Corporate Governance, Internal Control, and 13

Enterprise Risk Management—Module 40

Enterprise Risk Management: Eight Components (continued)

5. Risk responses

a. Avoidance

b. Reduction

c. Sharing

d. Acceptance

6. Control activities: Policies and procedures to insure that risk responses are implemented

7. Information and communication throughout organization

a. Organization’s objectives

b. Risk appetite and tolerance

c. Role of ERM in managing risk

8. Monitoring: Effective process to oversee ERM

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Corporate Governance, Internal Control, and 14

Enterprise Risk Management—Module 40

Enterprise Risk Management: Limitations

1. The future is uncertain

2. No absolute assurances

a. Human failure

b. System breakdown

c. Collusion across ERM

d. Management override

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Information Technology—Module 41 15

Information Technology

Attributes of Paper versus Electronic Systems

Difficulty of alteration—It is easier to change electronic data without detection

Prima facie credibility—The origin of paper documents is easier to determine

Completeness of documents—Paper documents typically include more information than electronic

documents

Evidence of approvals—Paper documents show approvals more obviously

Ease of use—Electronic data requires specialized knowledge to be accessed by the auditor

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Information Technology—Module 41 16

Benefits of IT

Consistency—Computers process data the same way every time.

Timeliness—Electronic processing and updating is normally more efficient.

Analysis—Data can be accessed for analytical procedures more conveniently (with proper

software).

Monitoring—Electronic controls can be monitored by the computer system itself.

Circumvention—Controls are difficult to circumvent when programmed properly, and exceptions

are unlikely to be permitted.

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Information Technology—Module 41 17

Risks of IT

Overreliance—Without clear output, IT systems are often assumed to be working when they are

not.

Access—Destruction and alteration of large amounts of data are possible if unauthorized access

occurs.

Changes in programs—Severe consequences without detection are possible if unauthorized

program changes occur.

Failure to change—Programs are sometimes not updated for new laws, rules, or activities.

Manual intervention—Knowledgeable individuals can sometimes alter files by bypassing the

appropriate programs.

Loss of data—Catastrophic data loss is possible if appropriate controls aren’t in place.

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Information Technology—Module 41 18

Systems Design and Process Improvement

A Seven-Step Process (PADDTIM)

1. Planning

a. Define system to be developed

b. Determine project scope

c. Develop project plan

2. Analysis

a. Meet with users and IS staff

b. Conduct needs assessment of users

c. Conduct gap analysis between needs and existing systems

3. Design (technical blueprint of new system)

4. Development: Build

a. Platform

b. Software

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Information Technology—Module 41 19

A Seven-Step Process (PADDTIM) (continued)

5. Testing

a. Unit tests (pieces of code)

b. System tests (Do units within a system integrate?)

c. Integration testing (Do separate systems integrate?)

d. User acceptance

6. Implementation: several strategies

a. Parallel implementation: run old and new

b. Plunge: Stop old, use new

c. Pilot

d. Phased

7. Maintenance

a. Monitor and support

1) Training

2) Help desk

3) Process and policies for authorizing changes

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Information Technology—Module 41 20

Hardware

Hardware is the actual electronic equipment. Common components include:

• Central processing unit or CPU—The principal hardware component that processes

programs

• Memory—The internal storage space or online storage, often referred to as random

access memory or RAM

• Offline storage—Devices used to store data or programs externally, including floppy disks,

magnetic tape, digital video discs (DVDs), and compact discs (CDs)

• File server—A computer with a large internal memory used to store programs and data

that can be accessed by all workstations in the network

• Input and output devices—Devices that allow for communication between the computer

and users and for the storage of data, such as a terminal with a screen and a keyboard,

scanners, microphones, wireless handheld units, barcode readers, point-of-sale registers,

optical character readers, mark sense readers, light guns, printers, speakers, CD and DVD

drives, magnetic tape drives, and magnetic disk drives

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Information Technology—Module 41 21

Size and Power of Computers

Hardware comes in various sizes, depending on the volume and complexity of users’ needs. In

declining order of power, computer hardware includes:

• Supercomputers—Common for massive scale needs by science and math departments

of universities and large governmental operations

• Mainframe computers—Until recently, often the only computer a large organization might

have, with several terminals having the ability to connect to it simultaneously

• Minicomputers—Until recently, a less expensive alternative to mainframes used by smaller

organizations as their primary computer with accessibility through multiple terminals

• Microcomputers—Personal computers designed for use by a single individual, including

desktops and laptops

• Personal digital assistants—Handheld computers with limited processing capabilities

that normally emphasize easy connection and transfer of data with the primary microcomputer

used by an individual

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Information Technology—Module 41 22

Storage Devices

Magnetic tape—Inexpensive form of storage used primarily for backup, since only sequential

access of data is possible.

Magnetic disks—Permanent storage devices inside a computer (including hard drives) that allow

random access to data without the need to move forward or backward through all intervening

data. Some systems use RAID (redundant array of independent disks), which includes multiple

disks in one system so that data can be stored redundantly and the failure of one of the disks won’t

cause the loss of any data.

Removable disks—Transportable forms of storage. In increasing order of capacity, these include:

• Compact discs (CDs)

• Optical discs (DVDs)

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Information Technology—Module 41 23

Data Entry Devices

Visual display terminal (keyboard and monitor)

Mouse (including joystick and light pen)

Touch-sensitive screen

Magnetic tape reader

Magnetic ink character reader

Scanner

Automatic teller machine

Radio frequency data communication

Point-of-sale register

Voice recognition

Electronic data interchange

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Information Technology—Module 41 24

Software

Software is either system software or application software.

• System software is made up of the programs that run the system and direct its operations.

It is comprised of the operating system and utility programs

• Utility programs are used for sorts, merges, and other routine functions to maintain and

improve the efficiency of a computer system

• Communication software handles transmission of data between different computers

• Specialized security software is a type of utility program used to control access to the

computer or its files

Programming languages:

• Source program is in the language written by the programmer (high-level languages

resemble English while assembly languages are closer to direct machine instructions)

• Object program is in a form the machine understands (on-off or 1-0)

• Compiler is a program that converts source programs into machine language

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Information Technology—Module 41 25

Data Structure

Bit—A single switch in a computer that is either in the on (1) or off (0) position

Byte—A group of eight bits representing a character

Character—A letter, number, punctuation mark, or special character

Alphanumeric—A character that is either a letter or number

Field—A group of related characters representing a unit of information (such as a phone number

or a city name)

Record—A group of logically related fields (such as the name, address, and telephone of one

employee)

File—A group of logically related records (such as the contact information for all the employees)

• Master file—A permanent source that is used as an ongoing reference and that is periodically

updated

• Detail file—A file listing a group of transactions that can be used to update a master file

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Information Technology—Module 41 26

Types of Computer Systems

Transaction processing systems—General record keeping and reporting needs

Management reporting systems—Assist in decision making within the organization

• Management information system—Provides information to management, which may utilize

it in decision making

• Decision support system—Combines models and data to help in problem solving but

with extensive user interpretation needed

• Expert system—Uses reasoning methods and data to render advice and recommendations

in structured situations where human interpretation isn’t necessary

• Executive information system—Systems designed specifically to support executive work

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Information Technology—Module 41 27

The Accounting Process in an IT Environment

The two primary approaches to the processing of data are batch processing and online processing.

1. Batch processing—Input data is collected over a period of time and processed periodically

2. Online processing—Individuals originating transactions process them from remote locations

in a batch, similar to batch processing, or immediately in an online, real-time system

Online, real-time systems update accounting records immediately as transactions occur, but result

in significant changes in internal control.

• Source documents are often not available to support input into the computer

• The audit trail is usually significantly reduced, requiring controls programmed into the

computer

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Information Technology—Module 41 28

Electronic Commerce

Electronic commerce using electronic data interchange or EDI adds to the complexity of auditing.

EDI enables:

• Communication without the use of paper

• Electronic funds transfers and sales over the Internet

• Simplification of the recording process using scanning devices

• Sending information to trading partners as transactions occur

EDI transactions are formatted using strict standards that have been agreed to worldwide, often

requiring companies to acquire translation software.

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Information Technology—Module 41 29

Risks of E-Commerce

Electronic commerce increases the risk of improper use of information. Controls might include:

• Data encryption

• Controls to prevent electronic eavesdropping

There is also the risk of improper distribution of transactions with information being electronically

transmitted to an inappropriate company. Controls might include:

• Routing verification procedures

• Message acknowledgement procedures

The reduction in the paper audit trail associated with EDI creates special challenges to the auditor.

• Detection risk may not be sufficiently reduced through substantive testing

• Control risk must be reduced adequately to achieve an acceptable level of audit risk

• Controls must be built into the system to insure the validity of information captured

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Information Technology—Module 41 30

Networks

In a computer network, computers are connected to one another to enable sharing of peripheral

devices, sharing data and programs stored on a file server, and communicating with one another.

Networks allow various user departments to share information files maintained in databases.

Databases should:

• Provide departments with information that is appropriate

• Prevent access to inappropriate information

A company may create its own value-added network or VAN.

• A local area network (LAN) is used when computers are physically near to one another

• A wide area network (WAN) uses high-speed, long-distance communications networks

or satellites to connect computers that are not near to one another

Cloud computing is the use and access of multiple server-based computational resources via a

digital network (WAN, Internet connection using the World Wide Web, etc.)

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Information Technology—Module 41 31

The Internet

The Internet is a worldwide network that allows virtually any computer system to link to it by way

of an electronic gateway. The Internet facilitates data communication services including:

• Remote login

• File transfer

• Electronic mail

• Newsgroups

• Videoconferencing

• Groupware systems

Intranets use Internet technology in closed networks.

Extranets use Internet technology to link businesses with suppliers, customers, and others.

Networks are part of a decentralized processing system applying distributed data processing.

Users share programs, peripheral devices, and data.

In client/server computing, smaller programs are distributed to the workstations, enabling the

user to communicate with the network. This is referred to as front-end processing.

In end user computing, a user department generates and uses its own information.

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Information Technology—Module 41 32

The Internet (continued)

To make use of the Internet more user-friendly, a framework for accessing documents was developed,

known as the World Wide Web

• Hypertext Transfer Protocol (HTTP)—The language commonly understood by different

computers to communicate via the Internet

• Document—A single file on any computer that is accessible through the Internet

• Page—The display that results from connection to a particular document on the Internet

• Uniform Resource Locator (URL)—The “address” of a particular page on the Internet

• Web browser—A program that allows a computer with a particular form of operating software

to access the Internet and that translates documents for proper display

• Server—The computer that is “sending” the pages for display on another computer

• Client—The computer that is “receiving” the pages and seeing the display

• Upload—Sending information from a client to a server computer

• Download—Sending information from a server to a client computer

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Information Technology—Module 41 33

The Internet (continued)

Web 2.0 is a 2nd generation of the web. Refers to era of web-based collaboration and community

generated content via web-based software tools such as

• Blog—An asynchronous discussion, or web log, led by a moderator that typically focuses

on a single topic

• Wiki—An information-gathering and knowledge-sharing website that is developed collaboratively

by a community or group

• Twitter—A micro-variation of a blog. Restricts input (tweets) to 140 characters

Many companies use software to monitor and manage their reputations in social media.

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Information Technology—Module 41 34

Networks and Control Risk

To minimize control risk, a network should have some form of security that limits access to certain

files to authorized individuals.

• Certain individuals may have read-only access to files

• Others will be authorized to alter the data in the files

A virus is a program that requests a computer to perform an activity that is not authorized by the

user. A worm is a program that duplicates itself over a network so as to infect many computers

with viruses.

A tool for establishing security is a firewall, which prevents unauthorized users from accessing

data.

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Information Technology—Module 41 35

Control Objectives for Information and Related Technology

(COBIT)

COBIT 5 is a framework for integrating IT with business strategy and governance. It incorporates

the following five principles:

1. Meeting stakeholder needs

2. Covering the enterprise end-to-end

3. Applying a single integrated framework

4. Enabling a holistic approach

5. Separating governance from management

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Information Technology—Module 41 36

Control Objectives for Information and Related Technology

(COBIT) (continued)

COBIT 5 enablers include:

• Processes—an organized set of practices to achieve objectives

• Organizational structures—the key decision-making entities in an organization

• Culture, ethics, and behavior of individuals and the organization

• Principles, policies and frameworks

• Information produced and used by the enterprise

• Services, infrastructure, and applications

• People, skills, and competencies required for successful completion of activities and making

accurate decisions

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Information Technology—Module 41 37

Organization of an IT Environment

Organization of the IT function is largely dependent on the size of the company and the number

of employees involved.

• Larger companies will have a separate IT department

• Others will have many IT functions performed by employees in the accounting department

and end users

One characteristic of an IT environment is a reduction in the segregation of duties. Although this

might appear to create a potential problem:

• A computer has no incentive to conceal its errors

• Functions can often be combined in an IT environment without weakening internal control

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Information Technology—Module 41 38

Organization in a Segregated Department

In a well-staffed IT department, systems, operations, and other technical services would be segregated.

Each of these segments would be under the supervision of the information systems manager,

who might report to the president of the company, one of the vice presidents, or the controller.

Systems Development and Maintenance

Systems might include:

• A systems analyst designs the information system using systems flowcharts and other

tools and prepares specifications for applications programmers.

• An application programmer writes, tests, and debugs programs that will be used in the

system. The programmer also develops instructions for operators to follow when running

the programs.

• A database administrator plans and administers the database to make certain that only

appropriate individuals have access to information in it.

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Information Technology—Module 41 39

Operations in an IT Function

Operations might include data entry, computer operations, program and file librarians, and data

control.

• A data entry clerk converts data into computer-readable form.

• A computer operator runs the programs on the computer.

• Program and file librarians are responsible for the custody of computer programs, master

files, transaction files, and other records.

• Data control is responsible for reviewing and testing input procedures, monitoring processing,

and reviewing and distributing outputs.

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Information Technology—Module 41 40

Other Technical Services

Other technical services might include telecommunications, systems programming or technical

support, and security administration.

• Telecommunications is responsible for maintaining and enhancing computer networks

and network connections.

• A systems programmer or technical support is responsible for updating and maintaining

the operating systems.

• Security administration is responsible for security of the system including control of

access and maintenance of user passwords.

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Information Technology—Module 41 41

Controls in an IT Environment

As a result of limited segregation of duties and a reduced paper audit trail, the auditor will often

have to rely more heavily on the ability to reduce control risk rather than detection risk in order to

keep audit risk at an acceptably low level.

The objectives of controls in an IT environment are:

• Completeness

• Accuracy

• Validity

• Authorization

• Timeliness

• Integrity

Controls will include general controls, application controls, input controls, processing controls, and

output controls.

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Information Technology—Module 41 42

General Controls

General controls ensure that the control environment is stable and well managed so that application

controls are effective. They relate to personnel policies, file security, contingency planning,

computer facilities, and access to computer files.

• Personnel policies provide for proper separation of duties and the use of computer

accounts that provide users with passwords or other means of preventing unauthorized

access.

• File security policies safeguard files from accidental or intentional errors or abuse.

Security controls involve internal and external file labels, creating backup copies of critical

files, lockout procedures, and file protection. These policies also incorporate contingency

planning.

• Hardware controls are built into the computer equipment to ensure proper functioning,

such as parity checks that verify all bytes of data are stored as an even number of bits (for

even-parity computers) and echo checks in which data that is transmitted is sent back to

verify that it was received correctly.

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Information Technology—Module 41 43

Contingency Planning

Unanticipated interruptions are avoided through contingency planning that includes faulttolerant

systems and backup files. One approach to backup is the grandfather-parent-child procedure

in which three generations of files are retained.

A contingency plan will include a disaster recovery plan to prepare for the possibility of fires,

floods, earthquakes, or terrorist bombings. The plan should specify backup sites to be used for

alternate processing.

• A hot site is a location that includes a computer system that is already configured similarly

to the system regularly used by the company, allowing for immediate use.

• A cold site is a location where power and space are available allowing for the installation

of processing equipment on short notice.

Controls over computer facilities should include locating the facility in a safe place, limiting

access to appropriate employees, and maintaining insurance.

Passwords or other forms of identification should be used to limit access to computer files.

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Information Technology—Module 41 44

Application Controls

Application controls include:

• Preventive controls are designed to prevent errors and fraud.

• Detective controls and automated controls are designed to detect errors and fraud.

• User controls and corrective controls allow individual users to follow up on detected

errors and fraud.

In an IT environment, application controls relate to data input, data processing, and data output.

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Information Technology—Module 41 45

Input Controls

Input controls are designed to ensure the validity, accuracy, and completeness of data entered into

the system. Errors can be avoided through:

• Observational controls

• Use of point-of-sale devices, such as scanners, to gather and record data automatically

The use of preprinted recording forms can minimize errors.

Data transcription controls, such as preformatted screens, can minimize errors when converting

data to machine-readable form.

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Information Technology—Module 41 46

Edit Tests

Edit tests scrutinize data as it is input to determine if it is in an appropriate form. When not in

appropriate form, transactions will be rejected and an exception report will be created. Examples

include:

• Tests of numeric field content

• Tests of alphabetic field content

• Tests of alphanumeric field content

• Tests for valid codes

• Tests of reasonableness

• Tests of sign

• Tests of completeness

• Tests of sequence

• Tests of consistency

Other input controls include an unfound-record test, a check digit control procedure, or a selfchecking

digit.

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Information Technology—Module 41 47

Processing Controls

Once data has been input, processing controls ensure that the data is properly manipulated to

produce meaningful output.

• Systems and software documentation allows system analysts to verify that processing

programs are complete and thorough

• Computer programs can be tested using error testing compilers to ensure that they do not

contain programming language errors

• Test data exposes the program to one sample of each type of exception condition likely to

occur during its use

• System testing can be used to make certain that programs within the system are interacting

properly

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Information Technology—Module 41 48

Output Controls

Output controls ensure that the processing results are valid and monitor the distribution and use

of output. The completeness, accuracy, and validity of processing results can be checked using

activity listings.

The distribution and use of output can be monitored using numbered forms and, distribution lists

and by requiring signatures for certain reports.

When information is particularly sensitive, users might be instructed to use paper shredders to

dispose of reports after use.

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Information Technology—Module 41 49

Control Totals

When data is entered in batches, one way to verify the accuracy of the data is through the use of

control totals. Examples are:

• Record count—The total number of entries being made (such as the total number of

employees being entered into a payroll program)

• Financial total—The sum of a column of numbers expressed in dollar form (such as the

total value of all the checks)

• Nonfinancial total—The meaningful sum of a column of numbers expressed in some

type of unit other than dollars (such as the sum of the number of hours worked by the

employees)

• Hash total—The meaningless sum of a column of numbers (such as the sum of the

employee ID numbers)

Controls can immediately verify the accuracy of input or be used to ensure the accuracy of processing

calculations or output that is being posted to files. Discrepancies can generate an error

message or exception report.

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Information Technology—Module 41 50

Controls Over Microcomputers

Microcomputers present additional control risks since they are small and portable, making them

easier to steal or damage. Data and software are also more accessible in a microcomputer environment,

and individuals can more readily access unauthorized records and modify, copy, or

destroy data and software.

A variety of controls can be employed in a microcomputer environment:

• Maintain an inventory listing of all microcomputer equipment and the purposes for which

it is used

• Keyboard locks can be built into the CPUs of microcomputers so that unauthorized users

will not have access

• Microcomputers and monitors can be secured to desks or fixtures to discourage theft

• Passwords that are changed periodically limit the access of unauthorized users to sensitive

data

• Periodic backup of data on microcomputers enables recovery in the case of alteration or

destruction of data

• Sensitive information can be maintained in off-line storage kept in locked cabinets to prevent

unauthorized access

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Information Technology—Module 41 51

Flowcharts

Flowcharts diagram the design of internal controls.

Symbols used:

Manual operation Process Decision Input or Output

Document Manual input Magnetic tape Off-line storage

Magnetic disk storage On-page connector Off-page connector

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Economic Concepts

Demand Curve

As the price of a product increases, the quantity demanded by buyers decreases. This is reflected

by a demand curve that is plotted with quantity demands on the x-axis (horizontal) and price on

the y-axis (vertical):

P

Q

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Demand Curve Shifts

When some variables other than the price of the product causes demand to change, it is referred

to as a demand curve shift.

Positive shift—An increase in demand at each price (the line moves to the right)

Negative shift—A decrease in demand at each price (the line moves to the left)

This is an illustration of a positive demand curve shift:

P

Q

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Economics, Strategy, and Globalization—Module 42 54

Positive Demand Curve Shift

Certain factors have a direct relationship to the demand curve for a product (an increase in that

factor will cause the demand curve to have a positive shift to the right):

• The price of substitute goods—When another product may be an acceptable alternative,

an increase in its price will make the present product more attractive. For example, an

increase in the price of hamburgers will cause a positive shift in the demand for hot dogs.

• Expectations of price increases—Consumers are more likely to buy now if they think

prices will be going up in the future.

• Consumer income and wealth—For normal goods, the demand will increase if consumers

have more wealth to spend on goods.

• Size of the market—When new consumers are available to purchase a product, such as

when trade barriers between countries are removed, demand for the product will increase.

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Negative Demand Curve Shift

Certain factors have an inverse relationship to the demand curve for a product (an increase in that

factor will cause the demand curve to have a negative shift to the left):

• The price of complementary goods—When products are normally used together, an

increase in the price of one of the goods harms demand for the other. For example, an increase

in the price of hamburgers will cause a negative shift in the demand for hamburger buns.

• Consumer income and wealth—For inferior goods, the demand will decrease if consumers

have more wealth to spend on goods. For example, the demand for tire patches

will likely decrease as people become wealthier, since they are more likely to be able to

replace the tires rather than patch them.

• Group boycott—An organized boycott will, if effective, decrease the demand for a product.

Other factors affect the demand curve in significant but indeterminate ways, such as changes in

consumer tastes.

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Elasticity of Demand

Price Elasticity = Percentage change in quantity demanded / Percentage change in price

If elasticity is greater than 1, demand is considered elastic, and total revenue will decline if

the price is increased, since the percentage drop in demand exceeds the percentage increase

in price. A firm will be unable to pass on cost increases to consumers in these circumstances.

If elasticity is equal to 1, demand is considered unitary, and total revenue will remain the same if

the price is increased.

If elasticity is less than 1, demand is considered inelastic, and total revenue will increase if the

price is increased, since the percentage increase in price exceeds the decrease in demand. A firm

will be able to raise prices in these circumstances.

Income Elasticity = Percentage change in quantity demanded / Percentage change in income

This will be a positive number for normal goods and a negative number for inferior goods.

Cross-Elasticity = Percentage change in demand for product X / Percentage change in price of

product Y

This will be a positive number for substitute goods and a negative number for complements.

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Consumer Demand and Utility

Marginal utility—The satisfaction value to consumers of the next dollar they spend on a particular

product.

Law of diminishing marginal utility—The more a consumer has of a particular product, the less

valuable will be the next unit of that product. As a result, a consumer maximizes satisfaction when

the last dollar spent on each product generates the exact same amount of marginal utility.

Personal disposable income—The available income of a consumer after subtracting payment

of taxes or adding receipt of government benefits. The consumer will either spend (consume) or

save this income.

Marginal propensity to consume (MPC)—The percentage of the next dollar in personal disposable

income that the consumer would be expected to spend.

Marginal propensity to save (MPS)—The percentage of the next dollar in personal disposable

income that the consumer would be expected to save (MPC plus MPS must equal 100%, or 1).

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Supply Curve

As the price of a product increases, the quantity offered by sellers increases. This is reflected by a

supply curve that is plotted with quantity on the x-axis (horizontal) and price on the y-axis (vertical):

P

Q

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Supply Curve Shifts

When some variable other than the price of the product causes supply to change, it is referred to

as a supply curve shift.

Positive shift—An increase in supply at each price (the line moves to the right)

Negative shift—A decrease in supply at each price (the line moves to the left)

This is an illustration of a positive supply curve shift:

P

Q

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Factors Causing a Supply Curve Shift

Factors with a direct relationship on the supply curve include:

• Number of producers

• Government subsidies

• Price expectations

Factors with an inverse relationship on the supply curve include:

• Changes in production costs

• Prices of other goods

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Market Equilibrium

The price at which the quantity demanded and quantity offered intersect is the equilibrium price:

P

Q

When the government intervenes to impose price ceilings, setting the price below equilibrium, the

quantity demanded will exceed quantity offered, resulting in shortages of goods. When the government

intervenes to impose price floors, setting price above equilibrium, the quantity offered will

exceed quantity demanded, resulting in unsold surpluses of goods.

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Short-Run Costs of Production

Over short periods of time and limited ranges of production, costs include fixed and variable

components:

Fixed costs—Costs that won’t change even when there is a change in production. Average fixed

costs are total fixed costs divided by units produced. An example is rent paid on the production

facility.

Variable costs—Costs that will rise as production rises. Average variable costs are total variable

costs divided by units produced. An example is materials used in the manufacture of the product.

Total costs—The sum of fixed and variable costs. Average total costs are total costs divided by

units produced.

Marginal cost—The increase in cost that will result from an increase in one unit in production.

Only variable costs are relevant, since fixed costs won’t increase in such circumstances.

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Long-Run Costs of Production

In the long run, all costs are variable, since increasing production beyond certain levels will require

increases in capacity, causing even “fixed” costs to rise.

Return to scale is the increase in units produced (output) that results from an increase in production

costs (input).

Return to scale = Percentage increase in output / Percentage increase in input

When return to scale is greater than 1, we have increasing returns to scale. This will normally

occur up to a certain level for all firms because of economies of scale, or the increased efficiency

that results from producing more units of a product (such as the ability to have employees specialize

in different tasks and improve their abilities).

When return to scale is less than 1, we have decreasing returns to scale. This will normally

occur beyond a certain level for all firms because of diseconomies of scale, or the increased

inefficiencies that result from expanding production (such as the greater difficulty management

has in controlling the activities of larger numbers of employees and facilities).

Firms should not increase production beyond levels at which marginal revenue from output

exceeds marginal costs from inputs.

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Measures of Economic Activity

Gross domestic product (GDP)—The price of all goods and services produced by a domestic

economy for a year at current market prices.

Real GDP—GDP adjusted to remove the effect of price inflation in the goods and services. In

theory, real GDP growth above a certain level (called potential GDP) results in price inflation.

Gross national product (GNP)—The price of all goods and services produced by labor and

property supplied by the nation’s residents. It differs from GDP in two ways:

1. GNP includes income received by the nation’s resident from other countries for products

that are a part of foreign economies.

2. GNP excludes payments made to the residents of other countries for products that are a

part of the domestic economy.

GDP/GNP may be computed using one of two different approaches:

1. Income approach—National income plus depreciation (and a few small adjustments)

2. Expenditure approach—Consumption plus private investment plus government purchases

(and a few small adjustments)

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Aggregate Demand and Supply

Effects of Price Inflation

Just as there are demand and supply curves for individual products, aggregate curves can be

depicted for overall prices and production of goods and services of an entire economy. Price inflation

will shift the aggregate demand curve for several reasons:

• Interest rate effect—Price inflation causes an increase in interest rates and decreases the

willingness of consumers to borrow, causing a negative shift in the demand curve for items

whose purchase is typically financed, such as houses and automobiles.

• Wealth effect—Price inflation causes the value of fixed income investments (such as

bonds) to decrease, causing individuals to have less wealth and reducing their consumption

of normal goods. (The consumption of inferior goods will increase, but these are typically

a small part of the overall economy.)

• International purchasing power effect—Domestic price inflation makes domestic goods

and services more expensive relative to foreign goods and services, causing an increased

demand for foreign products and a negative shift in the demand curve for domestic goods

and services.

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Measuring Price Inflation

There are three common measures of price inflation:

1. Consumer price index (CPI)—This measures the price of a fixed basket of goods and

services that a typical urban consumer might purchase in relation to the price of the same

goods and services in an earlier base period.

2. Producer price index (PPI)—This measures a fixed basket of goods at the wholesale

cost to dealers (such as retail stores) rather than the price to consumers.

3. GDP deflator—This utilizes the total production of the economy as measured by GDP and

is used to convert GDP to real GDP.

A decline in general price levels is known as deflation.

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Demand-Pull Inflation

When aggregate spending increases, the demand curve moves to the right, causing the market

equilibrium to occur at higher price levels:

Q

P

Notice that the equilibrium point occurs at a higher level of prices AND quantity. This is the basis for

the historical theory that higher inflation results in higher productivity and, therefore, lower unemployment.

The trade-off between inflation and unemployment is known as the Phillips curve.

Many modern economists reject this theory, or believe that increases in inflation cause only a

temporary decline in unemployment.

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Cost-Push Inflation

When production costs increase, the supply curve moves to the left, causing the market equilibrium

to occur at higher price levels:

Q

P

Notice that the equilibrium occurs at a higher level of prices but at a lower quantity. This means

that prices are rising but output is declining, usually resulting in higher unemployment. This effect

directly contradicts the theory of the Phillips curve.

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Multiplier Effect

There will be a positive shift in the demand curve when there is an increase in spending by consumers,

businesses, or governments. The size of the shift will be significantly larger than the

amount spent, due to the multiplier effect of increased spending increasing the income of suppliers,

who in turn will spend more, increasing the income of other suppliers, and so on.

The size of the multiplier effect depends on the percentage of increased income that is expected

to be spent, or the marginal propensity to consume, and the related percentage of increased

income that is expected to be saved, or the marginal propensity to save. (These two must add

up to 1 for the overall economy just as they did for each individual consumer.)

The increase in the equilibrium GDP that results from an injection of new spending is:

Change in spending / Marginal propensity to save

For example, if those making up the economy overall are likely to spend 75% of increased income

and save the other 25%, then a change in spending of $100 will raise GDP by $400:

$100 / 25% = $400

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Business Cycle

Expansion—Periods of increased aggregate spending will cause a positive shift in the demand

curve to the right and result in a higher equilibrium GDP. Technological advances will cause a positive

shift in the supply curve and also result in a higher equilibrium GDP.

Contraction—Periods of decreased aggregate spending will shift the demand curve to the left

and result in a lower equilibrium GDP. Trade wars between nations (and wars in general) cause a

negative shift in the supply curve and also cause a decline in GDP.

Recession—Two consecutive quarters of negative GDP growth.

Depression—A contraction of GDP that continues for a long period of time. (there is no formal

agreement as to the length of time a recession must continue to be called a depression, but it will

usually be multiple years.)

Panic—A severe contraction of GDP occurring within a very short time frame (generally lasting

less than a year).

Recovery—The term used to refer to the period of expansion that follows the end of a contraction.

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Indicators of Business Cycles

Leading indicator—A measure that is being used to try to predict recoveries and recessions.

These indicators will normally start moving up months before an actual recovery begins and start

moving down months before an actual recession beings. There are many such indicators with variable

success in predicting the business cycle. One of the most useful is changes in stock market

prices.

Coincident indicator—A measure that normally moves up and down simultaneously with economic

recoveries and recessions, respectively, and is used to determine if the economy is expanding

or contracting at the present time. One example is industrial production.

Lagging indicator—A measure that normally starts moving up months after a recovery has begun

and starts declining months after a recession has begun. It is used to confirm evidence that the

economy has been expanding or contracting over the past few months. A commonly used lagging

indicator is the average prime rate for bank loans.

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Unemployment

The unemployment rate is the percentage of those people who are looking for work who are currently

not employed. There are three types of unemployment:

1. Frictional—This represents the time period during which people are unemployed as a

result of changing jobs or newly entering the workforce. Because of the mobility of society,

there is always some level of this type of unemployment, even in a society that effectively

has “full” employment.

2. Structural—This represents potential workers whose job skills do not match the needs

of the workforce as a result of changing demand for goods and services of technological

advances that reduce or eliminate the need for the skills they possess. Such unemployment

normally requires retraining in order for these individuals to be employable again.

3. Cyclical—This represents the unemployment caused by variations in the business cycle,

when real GDP fails to grow at the pace necessary to employ all willing workers.

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Interest Rates

This term refers to the price that borrowers must pay for the use of money.

• Nominal interest rate—The rate as measured in terms of the nation’s currency

• Real interest rate—The rate adjusted for inflation

• Risk-free interest rate—The rate that would be charged to a borrower if the lender had

an absolute certainty of being repaid (The rate paid on United States Treasury securities is

often considered to be a useful measure of the risk-free interest rate.)

• Discount rate—The rate set by the Federal Reserve System at which a bank can borrow

from a Federal Reserve bank

• Prime rate—The rate that banks charge their most creditworthy customers on short-term

loans from the bank

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Government Involvement in the Economy

Fiscal policy—By the manner in which it collects taxes and spends, the government may try to

aid certain industries or the economy as a whole. A common technique is known as fiscal expansion

or deficit spending, which involves raising spending levels without an equivalent increase in

taxes or lowering taxes without an equivalent decrease in spending. The goal is to increase aggregate

spending in the economy and benefit from the multiplier effect.

Monetary policy—The Federal Reserve System (or “Fed”) is charged with control over the money

supply. By taking actions that increase (known as expansionary policies) or decrease (known as

contractionary policies) the total amount of money in circulation, the fed has a major impact on

total spending. It has various techniques at its disposal:

• Reserve requirements—The Fed sets requirements on banks as to the percentage of

checking deposit money received from customers that may not be loaned out.

• Open-market operations—The Fed can buy or sell government securities on the open

market and thereby increase or decrease the money supply outstanding.

• Discount rate—The Fed can change the cost of money to banks and thereby cause a

change in interest rates throughout the economy.

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International Trade

Because of differences in resources, climate, and specific skills, countries that trade goods and

services with each other normally raise the standard of living of the people in both nations. Each

country will focus on its advantages:

• Absolute advantage—This exists when the country can produce the goods at a lower

cost than the other country.

• Comparative advantage—This exists when the cost of producing those goods relative to

the cost of producing other goods is lower in that country than in the other country.

Even if one country has an absolute advantage over the other with respect to all goods, there

will be trade benefits to both from each focusing on its comparative advantage. (On an individual

level, a skilled CPA who is able to type 80 words per minute would still benefit from having word

processing performed by a secretary who can type only 40 words per minute and who has no

accounting skills.)

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Obstacles to Free Trade

Free trade is restricted by tariffs (taxes on the importing of goods) and quotas (limits on the quantity

that may be imported). When restrictions are imposed, their direct effects are:

• Domestic producers: Positive. Their demand curve shifts to the right as the availability of

substitute goods has been reduced. They sell more goods at higher prices. Usually the

managements and unions of these producers sought the restrictions.

• Domestic users: Negative. Their supply curve is being shifted to the left. As a result, they

end up paying higher prices and acquiring fewer goods overall.

• Foreign producers: Negative. Their demand curve shifts to the left because the number of

potential buyers has been reduced. They sell fewer goods at lower prices.

• Foreign users: Positive. Their supply curve shifts to the right, as their producers will have to

do more selling in their own market. They buy more goods at lower prices.

A crucial indirect effect of trade restrictions is retaliation by other countries. The World Trade

Organization (WTO) was formed to encourage all countries to maintain free trade policies and

to prevent trade wars. The North American Free Trade Agreement (NAFTA) was signed by the

United States, Mexico, and Canada in order to remove trade restrictions existing between those

countries.

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Balance of Payments

This is an account summary of the transactions of a nation with others.

Current account—The flow of goods and services and government transfers during a specific

period of time:

• Balance of trade—The difference between the goods exported and good imported. If

exports are higher, then a trade surplus exists; if imports are higher, a deficit exists.

• Balance of goods and services—The same comparison, but with services included

Capital account—The flow of investments in fixed and financial assets

Balance of payments—The combined surplus or deficit from the current and capital accounts

Official reserve account—The total of gold and foreign currency held by the nation

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Foreign Exchange Rates

The value of the currencies of different nations will fluctuate relative to one another based on the

supply and demand for these currencies. Exchange rates between currencies include:

• Spot rate—The exchange rate for currencies that will be immediately delivered

• Forward rate—The rate at which two parties agree they will exchange the currencies at a

specific future date (called the settlement date)

Forward rates differ from spot rates based on expectations that the relative values of the two currencies

will change between now and then. Factors affecting foreign exchange rates:

• Inflation—The currency with higher inflation will fall in value relative to the other.

• Interest rates—The currency in the nation with higher interest rates will rise in value.

• Balance of payments—The currency of the country that is a net exporter will rise in value.

• Government intervention—The currency will rise if official reserves are used to buy it.

• Political and economic stability—The currency will fall when there are threats to stability.

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Strategic Planning

Strategic planning involves identifying an organization’s long-term goals and determining the best

approaches to achieving those goals.

• Develop mission

• Develop vision

• Perform situational analysis to identify internal and external forces that may affect the organization’s

performance and choice of strategies and assess the organization’s strengths,

weaknesses, opportunities, and threats (a SWOT analysis)

Generic Strategies

• Product differentiation

• Cost leadership

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Financial Risk Management

Expected Returns

The total return of an investment includes cash distributions (interest, dividends, rents) and the

change in the value of the asset. For example, an investment of $100 that pays a dividend of $3

and then grows in value to $107 at the end of the year has a total return of 10%.

Gordon equation: Total return = Current dividend rate + Annual rate of dividend increase

Expresses total return only in terms of future cash distributions by assuming increased value will

allow future distributions. For example, 3% current dividend rate + 7% expected rate of dividend

increase = 10%. The effect is identical to adding dividend and value growth.

A group of investments in similar types of assets is known as a portfolio. The expected return on

a portfolio is a weighted average of the expected return of the individual investments.

For example, if a portfolio is invested 60% in Asset A, which is expected to return 10%, and 40%

in Asset B, which is expected to return 5%, the expected portfolio return is 8%, as follows:

60% × 10% + 40% × 5% = 6% + 2% = 8%

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Average Returns

When measuring average returns, there are two different measures:

1. Arithmetic average returns—The result of adding different returns and dividing by the

number of periods

2. Geometric average returns—The consistent return that would grow to the same final

result as the actual returns of several different periods

For example, if an investment grew by 44% in one year and 0% in the next, then $100 would have

grown to $144 in the first year and remained there in the second.

Arithmetic average return = 22% (the average of 44% and 0%)

Geometric average return = 20% (An investment of $100 earning a consistent 20% each year

would grow to $120 after one year and $144 after two years.)

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Standard Deviation

The most common measure of investment risk is standard deviation (SD), which is a measure of

the volatility of an investment. To calculate the SD, take the following steps:

1. Determine the arithmetic average return.

2. Calculate the difference from the average for each individual period.

3. Square the differences.

4. Determine the average of the squared values.

5. Calculate the square root of this average.

In general, since most investors are risk averse, an investment with a higher standard deviation

(such as common stocks) would have a higher expected return, and an investment with a lower

standard deviation (such as bonds) would have a lower expected return.

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Standard Deviation (continued)

As an example, assume an investment has returned 7%, 15%, and 8% in three different periods.

1. (7% + 15% + 8%) / 3 = 10% arithmetic average return.

2. –3%, +5%, –2% are the differences from average in the three periods.

3. 9%, 25%, 4% are the squares of the differences.

4. (9% + 25% + 4%) / 3 = 12.67% average of the squared values.

5. SQR of 12.67% = 3.56%

Notice that the SD of 3.56% is slightly higher than the straight average of the differences:

(3% + 5% + 2%) / 3 = 3.33%

This is because the calculation of the SD gives disproportionate weight to bigger differences.

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Portfolio Risk

The SD of a portfolio of investments will generally be much smaller than the SD of the individual

investments, because different investments don’t move up and down at the exact same time. The

measure of the degree to which different investments move together is covariance or correlation.

Covariance = 1.00. When one investment goes up, the other always goes up. When one goes

down, the other always goes down.

Covariance = 0. There is no relationship between the two investments; whether one goes up or

down has no relationship to whether the other goes up or down.

Covariance = −1.00. When one investment goes up, the other always goes down. When one goes

down, the other always goes up.

Whenever the covariance between two investments is less than 1.00, the SD of the portfolio will be

lower than the average SD of the individual investments. This is because the differences in movement

will somewhat offset each other.

By combining investments that have low covariances with each other, an investor can eliminate

unsystematic (unique) risk. The unavoidable risk that remains is systematic risk.

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Loan Risks

Creditors face certain business risks when they make loans:

• Credit or default risk—The risk that the borrower will default on interest or principal

payments.

• Sector risk—The credit risk associated with conditions in the borrower’s industry.

• Concentration of credit risk—The credit risk associated with lending to a small number

of borrowers or borrowers with common sector risks. This is an unsystematic risk that can

be eliminated through adequate diversification of loan portfolios.

• Market risk—The risk that the value of a bond or loan will decline due to a decline in the

aggregate value of all the assets in the economy.

• Interest rate risk—The risk that the value of a bond or loan will decline due to an increase

in interest rates.

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Yield Curve

The interest rate charged on loans (and paid on bonds) varies based on the term of the loan. This

is often charted with the x-axis (horizontal) being the term of the loan and the y-axis (vertical)

being the interest rate. This chart is known as the yield curve:

• Normal yield curve—An upward-sloping curve with rates rising as time gets longer

• Inverted yield curve—A downward curve with rates on long-term loans being lower

• Flat yield curve—A curve with rates being about the same regardless of length

Theories on the reason for differences in yields include:

• Liquidation preference—Since long-term loans are less liquid and subject to more interest

rate risk, they ought to normally offer higher yields.

• Market segmentation—Different lenders will dominate in different loan lengths: banks favor

short-term loans, savings and loans favor intermediate-term loans, and life insurance companies

favor long-term loans. Rates depend on the demands of lenders in those segments.

• Expectations—Long-term rates reflect expected changes in future short-term rates, with

inflation expectations playing a major part in determining such rates.

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Derivatives

A contract whose value derives from another contract or asset is a derivative if:

• Settlement of the contract will involve transfers of cash or other liquid assets.

• There is an underlying index that will be used to settle the contract and there is a specific

notional amount (quantity) of that index to calculate the settlement.

• No payment is made at origination (other than an option premium, if applicable).

Specific types of derivatives include:

• Option—Contract allowing (but not requiring) the holder to buy (call) or sell (put) a commodity

or financial instrument. The holder pays some premium to the other party.

• Forward—Negotiated contract to purchase and sell a commodity, financial instrument, or

foreign currency at a future date at terms set at the origination of the contract.

• Future—Standardized forward-based contract trading on a public market.

• Currency swap—Forward-based contract to swap different currencies.

• Interest rate swap—Forward-based contract to swap interest payment agreements.

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Financial Risk Management and Capital Budgeting—Module 43 88

Risks Associated with Derivatives

Derivatives are used in two different ways:

1. Speculation—An investment intended to profit from price changes in the underlying

2. Hedge—An attempt to mitigate some business risk faced by the firm

Various business risks are associated with the use of derivatives:

• Credit risk—The risk that the counterparty to the contract will fail to honor its obligations.

• Market risk—The risk that the adverse changes will affect the fair value of the derivative.

This risk is applicable only to derivatives used for speculation.

• Legal risk—The risk that legal or regulatory action will invalidate the derivative.

• Basis risk—The risk that the index used in connection with a derivative hedge will not

fluctuate by the same amount as the contract or asset that is being hedged.

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Financial Risk Management and Capital Budgeting—Module 43 89

Using Derivatives as Hedges

There are three types of derivative hedges:

1. Fair value hedge—A hedge against a recognized asset or liability or a firm purchase or

sale commitment.

2. Cash flow hedge—A hedge against possible variations in future expected cash flows.

3. Foreign currency hedge—A hedge against the effects of fluctuations in the value of a

foreign currency. Most of these are forms of fair value or cash flow hedge.

Derivatives are always measured at fair value. Unrealized gains and losses are reported as follows:

• Fair value hedge—Changes in fair value are reported in earnings, offset by the changes

in the asset, liability, or commitment being hedged. There will be a net effect on earnings

only to the extent the hedge was ineffective.

• Cash flow hedge—Changes in fair value are reported in other comprehensive income to

extent the hedge is effective with the remainder reported in earnings.

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Financial Risk Management and Capital Budgeting—Module 43 90

Valuing Derivatives

For derivatives that trade on public markets, determining fair value is straightforward. For others,

pricing models may be needed.

Options may be valued using mathematical models such as:

• Black-Scholes model

• Monte Carlo simulation

• Binomial trees

Interest rate swaps are usually valued using the zero-coupon method.

The calculations used in these various models are generally complex and require specialized

knowledge or access to computer programs.

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Financial Risk Management and Capital Budgeting—Module 43 91

Time Value of Money

Many decisions require adjustments related to the time value of money:

• Present value of amount—This is used to examine a single cash flow that will occur at a

future date and determine its equivalent value today.

• Present value of ordinary annuity—This refers to repeated cash flows on a systematic

basis, with amounts being paid at the end of each period. (It may also be known as an

annuity in arrears.) Bond interest payments are commonly made at the end of each period

and use these factors.

• Present value of annuity due—This refers to repeated cash flows on a systematic basis,

with amounts being paid at the beginning of each period. (It may also be known as an

annuity in advance or special annuity.) Rent payments are commonly made at the beginning

of each period and use these factors.

• Future values—These look at cash flows and project them to some future date, and

include all three variations applicable to present values.

• Interest rates—Usually, two components:

1. Expected inflation/deflation rates

2. Inflation-adjusted return for the investment (risk adjusted)

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Financial Risk Management and Capital Budgeting—Module 43 92

Capital Budgeting

Used to evaluate capital expenditures—uses two equations

Cash inflows before tax

– Depreciation on investment

= Increase in taxable income

– Tax

= Increase in accounting net income

Cash inflows before tax or Increase in accounting net income

– Tax + Depreciation on investment

= After-tax net cash inflows = After-tax net cash inflows

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Financial Risk Management and Capital Budgeting—Module 43 93

Payback Method

Initial investment

÷ After tax net cash inflows

= Payback period

Payback period is compared to target period

• If shorter, investment is acceptable

• If longer, investment is unacceptable

Traditional payback method does not take into account time value of money

Present value payback method considers the time value of money

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Financial Risk Management and Capital Budgeting—Module 43 94

Accounting Rate of Return

Increase in accounting net income

÷ Investment

= Accounting rate of return

Investment may be

• Initial investment

• Long-term average − (Initial investment + Salvage value) / 2

• Short-term average − (Beginning carrying value + Ending carrying value) / 2

Return compared to target rate

• If greater, investment is acceptable

• If lower, investment is unacceptable

Accounting rate of return does not consider the time value of money

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Financial Risk Management and Capital Budgeting—Module 43 95

Internal Rate of Return

Initial investment

÷ After tax net cash inflows

= Present value factor (same as payback period)

Present value factor is compared to factors for same # of periods (life of investment) to determine

effective interest rate

• Factor may be equal to amount at specific interest rate

• If factor falls between amounts, rate is estimated

Resulting rate compared to target rate

• If greater, investment is acceptable

• If lower, investment is unacceptable

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Financial Risk Management and Capital Budgeting—Module 43 96

Net Present Value

After-tax net cash inflows

× Present value factor for annuity at target rate

= Present value of investment

– Initial investment

= Net present value

If positive, investment is acceptable—if negative, investment is unacceptable

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Financial Risk Management and Capital Budgeting—Module 43 97

Special Analyses for Decision Making

Sensitivity analysis used to evaluate results of decisions under various conditions

Probability Analysis

Long-term average result (expected value) of decision is estimated

1. Each possible outcome of decision is assigned a probability

2. Total of probabilities is 100%

3. Profit or loss under each possible outcome is determined

4. Profit or loss for outcome multiplied by probability

5. Total of results is added

6. Result is long-term average result

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Financial Risk Management and Capital Budgeting—Module 43 98

Relevant Costing

Increase or decrease in profits or costs resulting from decision is analyzed

1. Determine increase or decrease in revenues that will result from decision

2. Determine increase or decrease in variable costs that will result from decision

3. Determine if decision will affect fixed costs

4. Net of change in revenues, variable costs, and fixed costs is relevant cost of making

decision

Lease versus Buy: Compare Both Options Using Discounted Cash Flow

1. Leasing may require lower initial investment

2. Operating leases off balance sheet

3. Capital leases shift risk of ownership from lessor to lessee

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Financial Management—Module 44 99

Financial Management

Five functions:

1. Financing—Raising capital to fund the business

2. Capital budgeting—Selecting the best long-term projects based on risk and return

3. Financial management—Managing cash flow so that funds are available when needed at

the lowest cost

4. Corporate governance—Ensuring behavior by managers that is ethical and in the best

interests of shareholders

5. Risk management—Identifying and managing the firm’s exposure to all types of risk

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Financial Management—Module 44 100

Working Capital Management

Inventory conversion period (ICP)—The average number of days required to convert inventory

to sales

• ICP = Average inventory / Cost of sales per day

• Average inventory = (Beginning inventory + Ending inventory) / 2

• Assume 365 days in a year unless told otherwise

Receivables collection period (RCP)—The average number of days required to collect accounts

receivable

• RCP = Average receivables / Credit sales per day

Payables deferral period (PDP)—The average number of days between the purchase of inventory

(including materials and labor for a manufacturing entity) and payment for them

• PDP = Average payables / Purchases per day

Cash conversion cycle (CCC)—The average number of days between the payment of cash to

suppliers of material and labor and cash inflows from customers

• CCC = ICP + RCP – PDP

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Financial Management—Module 44 101

Cash Management

Cash balances are maintained by a firm for:

• Operations—To pay ordinary expenses

• Compensating balances—To receive various bank services, fee waivers, and loans

• Trade discounts—Quick payment of bills for early payment discounts

• Speculative balances—Funds to take advantage of special business opportunities

• Precautionary balances—Amounts that may be needed in emergency situations

Float refers to the time it takes for checks to be mailed, processed, and reflected in accounts.

Management techniques try to maximize float on payments and minimize it on receipts.

• Zero-balance accounts—The firm is notified each day of checks presented for payment

and transfers only the funds needed to cover them.

• Lockbox system—Customers send payments directly to bank to speed up deposits.

• Concentration banking—Customers pay to local branches instead of main offices.

• Electronic funds transfers—Customers pay electronically for fastest processing.

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Financial Management—Module 44 102

Marketable Securities

To maximize earnings on free cash, a firm may utilize various investments. Investments that are

available through the federal government include:

• Treasury bills—Short-term obligations backed by the United States with original lives

under 1 year that can be bought and sold easily from issuance to maturity date. These are in

zero-coupon form and pay no formal interest, so they trade at a discount to maturity value.

• Treasury notes—Obligations with initial lives between 1 to 10 years. Formal interest payments

are made semiannually.

• Treasury bonds—Same as notes but with original lives over 10 years.

• Treasury Inflation-Protected Securities (TIPS)—Treasury notes and bonds that pay a

fixed rate of interest but with principal adjusted semiannually for inflation.

• Federal agency securities—Offerings that may or may not be backed by the full faith and

credit of the United States and don’t trade as actively as Treasuries but pay slightly higher

rates.

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Financial Management—Module 44 103

Marketable Securities (continued)

Other possible investments with free cash include:

• Certificates of deposit—Time deposits at banks that have limited government insurance.

• Commercial paper—Promissory notes from corporations with lives up to 9 months.

• Banker’s acceptance—A draft drawn on a bank but payable at a specific future date (not

on demand, as checks would be), usually 30 to 90 days after being drawn. These are usually

generated by corporations to pay for goods, and may trade in secondary markets prior

to the due date for payment at a discount.

• Money market fund—Shares in a mutual fund that invests in instruments with an average

maturity date under 90 days, and which generally maintains a stable value for investors.

• Short-term bond fund—Shares in a mutual fund that invests in instruments with an average

life over 90 days but under 5 years, generating higher returns than a money market

fund but with some fluctuation in the principal value of the fund.

• Equity and debt securities—Individual stocks and bonds with substantially higher potential

returns but also greater risk, including the risk of default. Should consider purchasing

credit default insurance.

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Financial Management—Module 44 104

Inventory Management

Economic Order Quantity (EOQ)

Minimizes total of order cost and carrying cost:

• Order cost—Cost of placing an order or starting a production run

• Carrying cost—Cost of having inventory on hand

EOQ = √2AP/S

A = Annual demand in units

P = Cost of placing an order or beginning a production run

S = Cost of carrying one unit in inventory for one period

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Financial Management—Module 44 105

Reorder Point and Safety Stock

Reorder point

• Units in inventory when order should be placed

• Average daily demand × Average lead time = Reorder point

Safety stock

• Extra units in inventory when placing order in case demand or lead time is greater than

average

• Avoids costs associated with running out of stock

• Maximum daily demand × Maximum lead time – Reorder point = Safety stock

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Financial Management—Module 44 106

Just-in-Time (JIT) Purchasing

Costs reduced through:

• Reduction in inventory quantities

• Elimination of non-value-adding operations

• Most appropriate when order cost low and carrying cost high

Requires high-quality control standards

• Efficient system minimizing defective units

• Corrections made as defects occur

• Fewer vendors and suppliers

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Financial Management—Module 44 107

Just-in-Time (JIT) Purchasing (continued)

Problems of JIT system:

• Difficult to find suppliers able to accommodate

• High shipping costs due to smaller orders

• Potential problems due to delays in deliveries

May use backflush approach

• All manufacturing costs charged to cost of goods sold (COGS)

• Costs allocated from COGS to inventories at reporting dates

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Financial Management—Module 44 108

Receivables Management

A company sets credit policies for the granting and monitoring of receivables, including:

• Credit period—The time allowed for payment (typically 30 days)

• Discounts—Percentage reduction for early payment (such as 2% for payment in 10 days)

• Credit criteria—Financial strength requirements for customer to be granted credit

• Collection policy—Methods used to collect slow-paying accounts

In utilizing receivables to generate immediate cash, a firm’s receivables may be:

• Pledged—A loan is obtained with the receivables offered as collateral for the loan.

• Factored—The receivables are actually sold to a financing company, which accepts the

risk of noncollection and charges a percentage fee for accepting that risk (based on an

estimate of the uncollectibles rate) as well as an interest rate based on the funds advanced

prior to the date collection of the receivables is due.

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Financial Management—Module 44 109

Capital Structure

Long-Term Debt

Private debt—Loans obtained from banks and other financial institutions or from syndicates of

lenders. Virtually all such loans have variable interest rates that are tied to an index:

• Prime rate—This is the rate that the lender charges its most creditworthy customers.

Loans to other customers would include a fixed amount above this (e.g., prime plus 2%).

• London Interbank Offered Rate (LIBOR)—When the borrower and lender are in different

countries, the base used will typically be the LIBOR rather than the prime rate.

Public debt—To bypass institutional lenders, a corporation may sell bonds directly to investors

as a means of borrowing, with fixed interest rates and maturity dates for the securities, which can

then trade on the open market.

• SEC registered bonds—To be sold on U.S. markets, bonds must satisfy the stringent

registration and disclosure requirements of the SEC.

• Eurobonds—Bonds denominated in U.S. dollars can be sold on the European exchanges,

which have less stringent requirements.

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Financial Management—Module 44 110

Debt Covenants

Borrowers often must agree to obey restrictions, or debt covenants.

Positive covenants might include:

• Providing annual audited financial statements to the lender

• Maintaining minimum ratios of current assets to current liabilities or financial measures

• Maintaining life insurance policies on key officers or employees of the company

Negative covenants might include:

• Not borrowing additional sums during the time period from other lenders

• Not selling certain assets of the business

• Not paying dividends to shareholders

• Not exceeding certain compensation limits for executives

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Financial Management—Module 44 111

Secured and Unsecured Bonds

Debt obligations may be secured by certain collateral or may specifically be placed behind other

forms of debt in the priority of repayment. In roughly declining order of safety (and increasing order

of interest rate), there are:

• Mortgage bonds—Secured by certain real estate owned by the borrower

• Collateral trust bonds—Secured by financial assets of the firm

• Debentures—Unsecured bonds

• Subordinated debentures—Unsecured bonds that will be repaid after all other creditors

in the event of a liquidation of the corporation

• Income bonds—Bonds whose interest payments will be made only out of earnings of the

corporation

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Financial Management—Module 44 112

Provisions Affecting Repayment of Bonds

The repayment of bonds may be affected by various provisions:

• Term bonds—Principal will be repaid on a single maturity date.

• Serial bonds—Principal repayment will occur in installments.

• Sinking funds—Regular deposits will be made by the borrower into an account from

which repayment of the bonds will be made.

• Convertible bonds—The bondholder may convert the bonds to the common stock of the

company as a form of repayment instead of holding them to maturity for cash.

• Redeemable bonds—The bondholder may be able to demand repayment of the bonds

in advance of the normal maturity date should certain events occur (such as the buyout of

the company by another firm).

• Callable bonds—The borrowing firm may force the bondholders to redeem the bonds

before their normal maturity date (usually there is a set premium above the normal redemption

price to compensate them for this forced liquidation).

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Financial Management—Module 44 113

Bond Interest Rates

There are three interest rates relevant to bonds:

1. Stated rate—The fixed interest payment calculated from the face value of the bond. It is

also known as the coupon rate, face rate, or nominal rate.

2. Current yield—The fixed interest payment divided by the current selling price of the

bond. When the bond is trading at a discount, this rate will be higher than the stated rate,

and when the bond is trading at a premium, this rate will be lower than the stated rate. This

rate can be somewhat misleading, since it reports the interest payment as a percentage of

the current price but doesn’t take into account the fact that the principal repayment of the

bond will not be the current selling price but the face value.

3. Yield to maturity—The interest rate at which the present value of the cash flows of interest

and principal will equal the current selling price of the bonds. For a bond selling at a

discount, it will be even higher than the current yield, since it accounts for the “bonus”

interest payment reflected in the discount. For a bond selling at a premium, this rate will

be even lower than the current yield, since it reflects the loss of the premium when the

principal is repaid. This rate is also known as the effective rate or market rate.

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Financial Management—Module 44 114

Variations on Bond Interest

Zero-coupon bond—This bond makes no interest payments at all and only pays the face value

on the date of maturity. Short-term U.S. Treasury bills are a common example. A zero-coupon bond

will always sell at a discount, since the interest is represented entirely by the difference between

the price at which it is bought and the face value paid at maturity.

Floating rate bond—The interest payment is not fixed but fluctuates with some general index of

interest rates. A reverse floater actually pays more interest when the general index goes down

and less interest when the index goes up. Such an unusual bond might be used to hedge against

the risk associated with floating rate bonds that the firm has issued.

Registered bond—The bondholder’s name is registered with the firm, and interest payments are

sent directly to the registered owner. In such cases, an actual bond certificate usually will not be

issued.

Junk bond—This bond pays much higher than normal interest, since it was issued by a firm that

has a poor credit rating and is more likely to default on its obligations. Bonds with a credit rating by

Moody’s Investors Service lower than Baa are usually considered junk bonds.

Foreign bond—This simply refers to a bond in which interest and principal is paid in another

currency.

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Financial Management—Module 44 115

Common Stock

Common stock shareholders are entitled to the residual (or leftover) assets and income after all

creditors and preferred shareholders are paid.

Advantages to firm:

• The firm has no specific obligation to pay investors, increasing financial flexibility.

• Increased equity reduces the risk to lenders and reduces borrowing costs.

Disadvantages to firm:

• Issuance costs are greater than for debt.

• Ownership and control must be shared with all the new shareholders.

• Dividends are not tax-deductible.

• Shareholders ultimately receive a much higher return than lenders if the business is successful,

so the long-run cost of capital obtained this way is typically much higher.

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Financial Management—Module 44 116

Preferred Stock

Preferred stock shareholders receive a stipulated dividend and priority over common shareholders

in the event of liquidation of the business. Additional features preferred stock may include:

• Cumulative dividends—If stipulated dividends are not declared in a particular year, the

amount becomes dividends in arrears and must be paid in later years before the common

shareholders can receive any distribution.

• Redeemability—The shareholders may demand repayment of the face value at a specific

date. In some cases, redemption is automatic. Such shares more closely resemble debt

and are often presented before equity in the balance sheet.

• Callability—The firm may force the shareholders to redeem the shares.

• Convertibility—Shareholders can convert these shares to common stock.

• Participation—Preferred shareholders will receive a dividend that is higher than the stipulated

rate when the common shareholders receive a higher rate.

• Floating rate—The dividend is variable based on some interest or inflation index.

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Financial Management—Module 44 117

Leverage

Operating leverage—The degree to which a firm has built fixed costs into its operations

• Higher fixed costs mean more risk when revenues are below expectations

• Profit grows rapidly relative to revenue increases due to lower variable costs

• % change in operating income / % change in unit volume = Degree of operating leverage

Financial leverage—The degree to which a firm uses debt financing in its business

• Higher debt means higher interest and principal obligations for repayment, increasing risk

if performance is not up to expectations

• Debt financing costs less than equity financing and doesn’t increase with greater performance,

so overall profit and asset growth potential is greater

• % change in earnings per share / % change in earnings before interest and taxes = Degree

of financial leverage

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Financial Management—Module 44 118

Cost of Capital

Debt—The cost of debt financing is the after-tax cost of interest payments, as measured by the

yield to maturity. It can be calculated in two ways:

1. Yield to maturity × (1 – Effective tax rate)

2. (Interest expense – Tax deduction for interest) / Carrying value of debt

Preferred stock—The cost of preferred stock financing is the stipulated dividend divided by the

issue price of the stock.

Common stock—The cost of common stock financing represents the expected returns of the

common shareholders and is difficult to estimate. Some techniques:

• Capital asset pricing model (CAPM)—Volatility of stock price relative to average stock.

This model assumes the expected return of a particular stock depends on its volatility

(beta) relative to the overall stock market. CAPM = Beta × Excess of normal market return

over risk-free investments + Normal return on risk-free investments

• Arbitrage pricing model—This model is a more sophisticated CAPM with separate

excess returns and betas for each component making up the stock characteristics

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Financial Management—Module 44 119

Cost of Capital (continued)

• Bond yield plus—This uses the normal historical relationship between equities and debt

and simply adds 3% to 5% to the interest rate on the firm’s long-term debt

• Dividend yield plus growth rate—This takes the current dividend as a percentage of the

stock price and adds the expected growth rate in earnings

Weighted-average cost of capital—This is a calculation of a firm’s effective cost of capital, taking

into account the portion of its capital that was obtained by debt, preferred stock, and common

stock. For example, if 40% of capital was obtained through long-term debt at an effective cost of

6%, 10% of capital was obtained by issuing preferred stock with an effective cost of 8%, and 50%

of capital was obtained by issuing common stock expected to return 11% to shareholders, the

weighted-average cost of capital is:

40% × 6% + 10% × 8% + 50% × 11%

= 2.4% + 0.8% + 5.5%

= 8.7%

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Financial Management—Module 44 120

Mergers

Horizontal merger—When a firm acquires another in the same line of business (a competitor)

Vertical merger—When a firm acquires another in the same supply chain (a supplier or customer)

Conglomerate merger—When a firm acquires another in an unrelated line of business

In valuing a potential merger target, the company may use:

• Discounted cash flow analysis—The present value of the cash flows expected from the

acquisition of the company, discounted at the cost of equity capital

• Market multiple method—The current earnings of the company multiplied by the priceearnings

ratio that is appropriate to that company (based on factors such as the typical

ratio in that industry)

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Financial Management—Module 44 121

Asset and Liability Valuation

Three major valuation models for financial instruments assets in order of reliability:

1. Market values from active markets for identical assets

a. Assumes sufficient volume

2. Active markets for similar assets

a. Must adjust for differences in instruments, for example,

1) Block sales

2) Credit risks

3) Maturity/exercise dates

3. Valuation models

a. In absence of active markets, assume hypothetical seller/buyer

b. Generally use discounted cash flow

c. Must use assumptions that are reasonable and consistent with existing general market

information

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Performance Measures and Management Techniques—Module 45 122

Performance Measures AND

MANAGEMENT TECHNIQUES

Measurement Frameworks

Balanced scorecards attempt to translate an organization’s goals into specific measures with

four perspectives:

1. Financial—Return on investment and related financial measures

2. Customer—Nonfinancial measures of customer satisfaction and retention

3. Internal business processes—Measures of operating effectiveness and efficiency

including financial measures, such as cost variances, and nonfinancial measures, such as

number of defects in production

4. Learning and growth—Measures of employee satisfaction, training, and advancement

Value-based management examines all aspects of a company with the intention of identifying the

amount of economic value added (EVA) by different activities. In effect, it attempts to translate all

activities into their financial value to the firm, and is comparable to a financial scorecard focus.

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Performance Measures and Management Techniques—Module 45 123

Balanced Scorecard

The components of a balanced scorecard include:

• Strategic objectives—A statement of the goals of the firm and necessary elements

• Performance measures—Identification of quantitative methods that can be used to track

success in fulfilling the strategic objectives

• Baseline performance—The current level of performance for each measure

• Targets—The level or improvement in performance being sought

• Strategic initiatives—Programs that will help achieve the targets and objectives

Cause-and-effect linkages identify which performance measures are performance drivers

(leading indicators) and which are outcome performance measures (lagging indicators). This

allows the firm to focus on those drivers that are critical to strategic objectives.

Strategy maps are diagrams that identify cause-and-effect linkages:

On-time

delivery rate

Customer

satisfaction

Return on

investment

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Performance Measures and Management Techniques—Module 45 124

Value-Based Management

Return on Investment (based on assets) = Net income / Total assets

DuPont return on investment (ROI) analysis: ROI = Return on sales × Asset turnover

• Return on sales = Net income / Sales

• Asset turnover = Sales / Total assets

Residual income = Operating profit – Interest on investment

• Interest on investment = Invested capital × Required rate of return

Economic Value Added: EVA = Net operating profit after taxes (NOPAT) – Cost of financing

• Cost of financing = (Total assets – Current liabilities) × Weighted-average cost of capital

Free Cash Flow = NOPAT + Depreciation + Amortization – Capital expenditures – Net increase

in working capital

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Performance Measures and Management Techniques—Module 45 125

Business Process Management: Focus on Continuous

Improvement in Processes to Meet Customers’ Needs

Business Processes: Assets in Themselves

1. Design: Identify existing processes/possible improvements

2. Modeling: What-if analyses

3. Execution

a. Install new software

b. Test

c. Train employees

d. Implement new processes

4. Monitor with performance statistics

5. Optimize

a. Use performance statistics to identify bottlenecks

b. Consider strategies (e.g., outsourcing) to remove bottlenecks

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Performance Measures and Management Techniques—Module 45 126

Business Process Management: Focus on Continuous Improvement

in Processes to Meet Customers’ Needs (continued)

6. Other techniques

a. Reengineer

b. Lean manufacturing (shorten time by eliminating waste)

c. Theory of constraints: Increase throughput contribution margin by decreasing

investment and operating costs. Must identify and remediate:

1) Bottleneck resources: capacity is less than demand

2) Non-bottleneck resources: capacity greater than demand

7. Workflow analysis: Focus on eliminating non-value-added activities

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Performance Measures and Management Techniques—Module 45 127

Profitability Ratios

Gross Margin = Gross profit / Net sales

Operating Profit Margin = Operating profit / Net sales

Return on Assets = Net income / Average total assets

• Average total assets = (Beginning total assets + Ending total assets) / 2

Return on Equity = Net income / Average common stockholders’ equity

• Common stockholders’ equity = Stockholders’ equity – Preferred stock liquidation value

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Performance Measures and Management Techniques—Module 45 128

Asset Utilization Ratios

Receivable Turnover = Net credit sales / Average accounts receivable

• Average accounts receivable (A/R) = (Beginning A/R + Ending A/R) / 2

• Remember to use net credit sales, not net sales

Receivables Collection Period = Average accounts receivable / Average credit sales per day

• Use 365-day year unless told otherwise

Inventory Turnover = Cost of goods sold / Average inventory

• Remember to use cost of goods sold, not sales

Inventory Conversion Period = Average inventory / Average cost of goods sold per day

Fixed Asset Turnover = Sales / Average net fixed assets

• Remember that net fixed assets is after subtraction of accumulated depreciation

Total Asset Turnover = Sales / Average total assets

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Performance Measures and Management Techniques—Module 45 129

Liquidity Ratios

Current Ratio = Current assets / Current liabilities

Quick (or Acid Test) Ratio = Quick assets / Current liabilities

• Quick assets = Cash + Marketable securities + Accounts receivable

Debt Utilization Ratios

Debt to Total Assets = Total liabilities / Total assets

Debt to Equity Ratio = Total debt / Total equity

Times Interest Earned Ratio = Earnings before interest and taxes / Interest expense

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Performance Measures and Management Techniques—Module 45 130

Market Ratios

Price/Earnings (PE) Ratio = Common stock price per share / Earnings per share

Book Value per Share = Common stock equity / Common stock shares outstanding

• Common stock equity = Stockholders’ equity – Preferred stock liquidation value

Market Capitalization = Common stock price per share × Common stock shares outstanding

Market/Book Ratio can be calculated in two ways:

1. Common stock price per share / Book value per share

2. Market capitalization / Common stock equity

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Performance Measures and Management Techniques—Module 45 131

Benchmarking

Measures of performance need to be compared with expected or desired results. In selecting an

approach benchmark, the firm may utilize any or all of the following:

• Internal benchmarking—Similar operations within the organization

• Competitive benchmarking—Direct competitors

• Functional benchmarking—Industry averages

• Generic benchmarking—Overall averages of all business enterprise

Benchmarks may represent average performance results or optimal results (best practices).

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Performance Measures and Management Techniques—Module 45 132

Quality Control

ISO Quality Standards—A series of standards established by the International Organization of

Standards.

• ISO 9000 Series—Standards consisting of five parts (9000 to 9004) that focus on the

quality of products and services provided by firms

• ISO 14000 Series—Standards focused on pollution reduction and other environmental goals

Pareto Principle—An attempt to focus on the small number of significant quality issues, based on

an estimate that 80% of all problems come from only 20% of all causes.

Six Sigma Quality—A statistical measure of the percentage of products that are in acceptable

form, based on standard deviation measures. One sigma means that approximately 68% of products

are acceptable. Six sigmas would indicate 99.999997% of products meet quality standards,

and constitute a hypothetical goal of perfection in manufacturing.

Kaizen—Japanese art of continuous improvement. This theory emphasizes identification by all

members of a company of small potential improvements rather than searching for big breakthroughs.

Delphi—Separate consultation with multiple experts and tabulation of recommendations.

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Performance Measures and Management Techniques—Module 45 133

Cost of Quality

The costs related to quality rise the later in the process the firm deals with it. There are four different

stages at which costs can be addressed:

1. Prevention costs—Prevent product failure

• Use high-quality materials

• Inspect production process

• Train employees

• Maintain machines

2. Appraisal or detection costs—Detect product failure before production is complete

• Inspect samples of finished goods

• Obtain information from customers

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Performance Measures and Management Techniques—Module 45 134

Cost of Quality (continued)

3. Internal failure costs—Detect product failure after production but before shipment to

customer

• Scrap resulting from wasted materials

• Reworking units to correct defects

• Reinspection and retesting after rework

4. External failure costs—Defective product sent to customer

• Warranty costs

• Dealing with customer complaints

• Product liability

• Marketing to improve image

• Lost sales

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Performance Measures and Management Techniques—Module 45 135

Project Management

A project is a series of activities and tasks that

• Have specific definable objectives

• Have defined start and end dates

• Are subject to funding constraints

• Consume resources, people, equipment, etc.

• Cut across various functional areas of the organization

Effective project management: Four basic elements

1. Resources

2. Time

3. Money

4. Scope

Focus on

Performance Measures and Management Techniques—Module 45 136

Project Management (continued)

Effective project management: Five processes/cycles

1. Project initiation

a. Support of management

b. Project manager with authority

c. Project charter

2. Project planning

a. Define scope

b. Identify resources needed

c. Schedule tasks

d. Identify risks

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Performance Measures and Management Techniques—Module 45 137

Project Management (continued)

3. Project execution

a. Managing work

b. Directing team

4. Project monitoring and control

a. Tracking progress

b. Comparing actual outcomes to predicted outcomes (variances)

5. Project closure

Project Management Tools

1. Life-cycle approach: Define and assess each phase of project

2. Gantt chart—bar chart that illustrates the scheduled start and finish of elements of a project

over time

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Performance Measures and Management Techniques—Module 45 138

Project Management (continued)

3. Program Evaluation and Review Technique (PERT): Focus on the interdependency of

activities

and the time required to complete an activity to schedule and control the project

a. Critical path: The shortest amount of time necessary to accomplish the project.

1) Optimistic

2) Most likely

3) Pessimistic

4. PERT used where there is a high variability of completion time, such as R&D

5. ABC analysis: Categorize tasks into three groups:

a. Tasks that are perceived as being urgent and important

b. Tasks that are important but not urgent

c. Tasks that are neither urgent nor important

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Cost Measurement and Assignment—Module 46 139

Cost Measurement and assignment

Cost Classifications

Product and Period Costs

Product Period

Direct materials (DM) x

Direct labor (DL) x

Manufacturing overhead (MOH) x

Selling, general, and administrative expenses (SG&A) x

Prime and Conversion Costs

Prime Conversion

DM x

DL x x

MOH x

Focus on

Cost Measurement and Assignment—Module 46 140

Cost Classifications (continued)

Variable and Fixed Costs

Variable Fixed

DM x

DL x

MOH x x

SG&A x x

Focus on

Cost Measurement and Assignment—Module 46 141

Costing Methods

DM used

Work-in-process inventory (WIP)

Cost of complete units

Cost of units sold

Cost of good sold

Finished goods

+ DL incurred

+ MOH applied

Focus on

Cost Measurement and Assignment—Module 46 142

Manufacturing Overhead

1. Calculate the predetermined overhead rate (POHR)

Estimated variable MOH for period

+ Estimated fixed MOH for period

= Estimated total MOH for period

÷ Estimated # of units for period (cost driver)

= Predetermined overhead rate (POHR)—often split into fixed and variable rates

2. Apply MOH to WIP

Actual # of units for period (cost driver)

× POHR

= MOH Applied

Focus on

Cost Measurement and Assignment—Module 46 143

Manufacturing Overhead (continued)

3. Determine under-applied or over-applied MOH

• Actual MOH > MOH applied: MOH under-applied

• Actual MOH < MOH applied: MOH over-applied

4. Dispose of under-applied or over-applied MOH

• Generally added to or deducted from cost of good sold (COGS)

• May be charged or credited directly to income

• May be allocated to WIP, finished goods, and COGS

Focus on

Cost Measurement and Assignment—Module 46 144

Job Order Costing

Used when units are relatively expensive and costs can be identified to units or batches

• DM, DL, and MOH applied charged to WIP

• Cost of completed units removed from WIP and charged to finished goods

• Cost of units sold removed from finished goods and charged to COGS

Focus on

Cost Measurement and Assignment—Module 46 145

Process Costing

Used when units are relatively inexpensive and costs cannot be identified to units or batches

• DM, DL, and MOH applied charged to WIP

• Calculates average cost of equivalent units produced during period

• Average costs used to transfer from WIP to finished goods and from finished goods to COGS

Calculating equivalent units

• Costs incurred at beginning of process—Equivalent units = Units × 100%

• Costs incurred at end of process—Equivalent units = Units × 0%

• Costs incurred uniformly—Equivalent units = Units × % complete

• Costs incurred at particular point

• If units reached that point—Equivalent units = Units × 100%

• If units haven’t reached that point—Equivalent units = Units × 0%

Focus on

Cost Measurement and Assignment—Module 46 146

Process Costing (continued)

Process costing—weighted-average

1.

+=

Costs in beginning WIP

Costs incurred during period

Total costs to be allocated

2. Units completed during period

+=

Equivalent units in ending WIP

Total equivalent production

3. Total costs to be allocated

÷

=

Total equivalent production

Average cost per equivalent unit

4.

×

=

Units completed during period

Average cost per equivalent unit

Amount allocated to finished goods

5.

×

=

Equivalent units in ending inventory

Average cost per equivalent unit

Amount allocated to ending WIP

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Cost Measurement and Assignment—Module 46 147

Process Costing (continued)

Process costing—FIFO

1. Determine costs incurred during period

2. Units in beginning WIP

– Equivalent units in beginning WIP

= Equivalent units required to complete beginning WIP

3. Equivalent units required to complete beginning WIP

÷ Units started and completed during period × 100%

+ Equivalent units in ending WIP

= Total equivalent production

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Cost Measurement and Assignment—Module 46 148

Process Costing (continued)

4. Costs incurred during period

÷ Total equivalent production

= Average cost per equivalent unit

5. Costs in beginning WIP

+ Units started and completed × Average cost per equivalent unit

= Amount allocated to finished goods

6. Equivalent units in ending WIP

× Average cost per equivalent unit

= Amount allocated to ending WIP

Focus on

Cost Measurement and Assignment—Module 46 149

Spoilage and Scrap

Different types of unused units or materials have different accounting treatments:

Normal spoilage—Product cost (added to cost of good units)

Abnormal spoilage—Period cost (charged against income in period)

Scrap—Generally charged to cost of goods manufactured

Proceeds from sale of scrap:

• Additional income

• Reduce cost of sales

• Reduce manufacturing overhead

• Reduce cost of specific job

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Cost Measurement and Assignment—Module 46 150

Activity Based Costing (ABC)

Method of analyzing and reducing MOH

• MOH segregated into pools

• Cost driver identified for each pool

• MOH applied using multiple rates

Identifies costs that are nonvalue adding

• Can be used to reduce overhead

• Identify and minimize nonvalue adding costs

Also used to allocate service department costs

Under step allocation method

• Services departments allocated beginning with those serving most other departments

• Allocation based on that department’s cost driver

• Costs allocated to all remaining service departments and production departments

• Costs not charged back to service departments already allocated

• Process complete when only production departments remain

Focus on

Cost Measurement and Assignment—Module 46 151

Activity Based Costing (ABC) (continued)

Service departments Production departments

#1 #2 #3 #4 #1 #2

Costs $ $ $ $ $ $

Allocation ($) $ $ $ $ $

Subtotal 0 $ $ $ $ $

Allocation ($) $ $ $ $

Subtotal 0 $ $ $ $

Allocation ($) $ $ $

Subtotal 0 $ $ $

Allocation ($) $ $

Total 0 $ $

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Cost Measurement and Assignment—Module 46 152

Cost Estimation

Calculating Total Costs

Total costs = Fixed costs + Variable costs

y = a + bx

y = Total cost (dependent variable)

a = Total fixed costs

b = Variable cost per unit

x = # of units (independent variable)

Various methods are used to determine the variable cost per unit and total fixed costs

Focus on

Cost Measurement and Assignment—Module 46 153

Cost Drivers

Units represent volume of cost driver

• Cost driver can be any variable that has greatest influence on cost

• Examples include volume of production, hours worked, miles driven, or machine hours

High-Low Method

Four steps in estimating variable cost per unit and total fixed costs

1. Highest volume Total cost # of units

Lowest volume Total cost # of units

Difference Cost # of units

2. Variable cost per unit = Difference in cost ÷ Difference in # of units

3. Total variable costs (at either level) = Variable cost per unit × # of units

4. Fixed costs (at either level) = Total costs – Total variable costs

Focus on

Cost Measurement and Assignment—Module 46 154

Regression Analysis

Coefficient of correlation (R) indicates relationship between dependent and independent variable:

• R = 1 Strong direct relationship

• 1 > R > 0 Direct relationship, not as strong

• R = 0 No relationship

• 0 > R > −1 Indirect relationship, not as strong

• R = −1 Strong indirect relationship

Company will use cost driver with strongest direct or indirect relationship

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Cost Measurement and Assignment—Module 46 155

Variable and Absorption Costing

Absorption Costing

• Used for financial statements

• Inventory includes DM + DL + Variable MOH + Fixed MOH

Variable Costing

• Used for internal purposes only

• Inventory includes DM + DL + Variable MOH

Sales Sales

– Cost of sales

= Gross pro t

– SG&A expenses

= Operation income

– Variable costs

= Contribution margin

– Fixed costs

= Operation income

Difference = Change in inventory × Fixed overhead per unit

Absorption costing Variable costing

Focus on

Planning, Control, and Analysis—Module 47 156

Planning, Control, and Analysis

Flexible Budgeting

Used to estimate revenue, costs, a group of costs, or profits at various levels of activity

• Applies when operating within a relevant range

• Total fixed costs remain the same at all levels within range

• Variable costs per unit of activity remains the same within range

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Planning, Control, and Analysis—Module 47 157

Master and Static Budgets

Static budget—Budget as specific level of activity

• Can be for division of company

• Can be for company as a whole

Master budget—Static budget for company as a whole

Master budget generally includes:

• Operating budget

• Budgeted cash flows

• Budgeted financial statements

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Planning, Control, and Analysis—Module 47 158

Preparing a Master Budget

1. Estimate sales volume

2. Use sales volume to estimate revenues

3. Use collection history to estimate collections

4. Estimate cost of sales based on units sold

5. Use current finished goods inventory, budgeted ending inventory, and cost of sales to estimate

units to be manufactured

6. Use units manufactured to estimate material needs, labor costs, and overhead costs

7. Use material needs, current raw materials inventory, and budgeted ending inventory to

budget purchases

8. Use purchase terms to estimate payments

9. Analyze expense and payment patterns to complete operating and cash flow budgets

Focus on

Planning, Control, and Analysis—Module 47 159

Budgeting Material Purchases and Payments

Units sold

+ Budgeted increase in finished goods

– Budgeted decrease in finished goods

= Units to be manufactured

× Units of raw material per unit of finished goods

= Units of raw material required for production

+ Budgeted increase in raw materials

– Budgeted decrease in raw materials

= Budgeted raw material purchases

+ Budgeted decrease in accounts payable

– Budgeted increase in accounts payable

= Budgeted payments for raw materials

Focus on

Planning, Control, and Analysis—Module 47 160

Standard Costing

Material Variances

Standard cost (Units produced × Std qty per unit × Std cost per unit)

– Actual material cost

= Total material variance

Material price variance (MPV)

+ Material usage variance (MUV)

= Total material variance

MPV = Act qty × (Std pr – Act pr) MUV = Std pr × (Std qty – Act qty)

Focus on

Planning, Control, and Analysis—Module 47 161

Standard Costing (continued)

Labor Variances

Standard cost (Units produced × Std hrs per unit × Std rate per hr)

– Actual labor cost

= Total labor variance

Labor rate variance (LRV)

+ Labor efficiency variance (LEV)

= Total labor variance

LRV = Act qty × (Std rate – Act rate) LEV = Std rate × (Std hrs – Act hrs)

Focus on

Planning, Control, and Analysis—Module 47 162

Standard Costing (continued)

Overhead Variances

Overhead applied (Std hrs × Total POHR)

– Actual overhead cost

= Total overhead variance

Overhead volume variance (OVV)

+ Overhead efficiency variance (OEV)

+ Overhead spending variance (OSV)

= Total overhead variance

Std hrs × POHR (xed)

– Budgeted xed OH

= OVV

Std hrs × POHR (Variance)

– Act hrs × POHR (Variance)

= OEV

Act hrs x POHR (total)

+ Budgeted xed OH

– Act OH

= OSV

Focus on

Planning, Control, and Analysis—Module 47 163

Responsibility Accounting and Performance Evaluation

Company divisions may be:

• Cost centers—manager responsible for costs incurred

• Profit centers—manager responsible for costs and revenues

• Investment centers—manager responsible for costs, revenues, and capital investments

Focus on

Planning, Control, and Analysis—Module 47 164

Transfer Pricing

Transfer price—price at which products are transferred from one department to another within the

same company

Possible transfer prices:

• Actual cost

• Market value

• Cost + profit

• Negotiated amount

• Standard cost

Transfer from cost center to profit center—generally use standard variable cost

• Cost center evaluated based on comparing standard variable cost to actual cost

• Profit center not affected by performance of cost center

Focus on

Planning, Control, and Analysis—Module 47 165

Cost-Volume-Profit Analysis

Sales price per unit Contrib margin per unit

– Variable cost per unit ÷ Sales price per unit

= Contrib margin per unit = Contrib margin ratio

Units Dollars

Breakeven

Fixed costs Fixed costs

÷ Contrib margin per unit ÷ Contrib margin ratio

= Breakeven in units = Breakeven in dollars

Profit as fixed amount

Fixed costs + Desired profit Fixed costs + Desired profit

÷ Contrib margin per unit ÷ Contrib margin ratio

= Units required to earn desired profit = Sales dollars required to earn desired profit

Profi t as percentage of sales

Fixed costs Fixed costs

÷ Contrib margin – Profit per unit ÷ (Contrib margin – Profit) ÷ Sales price

= Units required to earn profit ratio = Sales required to earn profit ratio

Focus on

Planning, Control, and Analysis—Module 47 166

Graphical Approach to Breakeven

D

F C

B G

E

Volume

A

AC = Pro t for product at various levels of production

B = Breakeven point

OA = Fixed costs

DE = Loss at production point D (below breakeven)

FG = Pro t at production point G (above breakeven)

OA OB = Contribution margin

FG BG = Contribution margin

O

$

Focus on

Planning, Control, and Analysis—Module 47 167

Joint Products and By-products

Joint Product Costing

Joint products—two or more products resulting from same process

• Joint product costs—costs incurred before products separated

• Split-off point—earliest point at which products can be separated

• Sales value—amount each product can be sold for at earliest point of sale

• Separable costs—costs incurred after split-off point before products can be sold

• Relative sales value—Sales value—Separable costs

Separable costs

Joint process

A

B

C

Split-off point

Focus on

Planning, Control, and Analysis—Module 47 168

Joint Product Costing (continued)

Allocating joint product costs—relative sales value method

1. Calculate relative sales value for each joint product

2. Add together to calculate total relative sales value

3. Calculate ratio of relative sales value for each joint product to total relative sales value

4. Multiply ratio for each product by joint product costs

5. Result is amount of joint product costs to be allocated to each product

Focus on

Planning, Control, and Analysis—Module 47 169

Accounting for By-Products

Revenues from sale of by-product generally reduce cost of other products

1. Determine revenues from sale of by-products

2. Reduce by separable costs, if any, and costs of disposal

3. Net amount reduces cost of primary product or joint costs

Focus on

Planning, Control, and Analysis—Module 47 170

Product and Service Pricing

Factors that affect price of product or service:

• Cost of manufacturing and delivering product or cost of delivering service

• Quality of product or service

• Life of product

• Customers’ preferences as to quality or price

Pricing Models

Profit based on sales price Profit based on cost

Sales price 100% Sales price 100% + Profit %

Cost 100% – Profit % Cost 100%

Gross profit Profit % Gross profit Profit %

Index

Accounting for By-Products, 169

Accounting Process In An IT Environment, 27

Accounting Rate of Return, 94

Activity Based Costing, 150

Aggregate Demand and Supply, 65

Application Controls, 44

Asset Utilization Ratios, 128

Attributes of Paper vs Electronic Systems, 15

Average Returns, 81

Balance of Payments, 77

Balanced Scorecard, 123

Benchmarking, 131

Benefits of IT, 16

Bond Interest Rates, 113

Budgeting Material Purchases and

Payments, 159

Business Cycle, 70

Calculating Total Costs, 152

Capital Budgeting, 92

Capital Structure, 109

Cash Management, 101

Common Stock, 115

Components of Enterprise Risk

Management, 11–13

Consumer Demand and Utility, 57

Contingency Planning, 43

Control Totals, 49

Controls in an IT Environment, 41

Controls Over Microcomputers, 50

Corporate Governance and Enterprise Risk

Management, 1, 2

Cost Classifications, 139

Cost Drivers, 153

Cost Estimation, 152

Cost Measurement, 139

Cost of Capital, 118

171

Index 172

Cost of Quality, 133

Costing Methods, 141

Cost-push inflation, 68

Cost-Volume-Profit Analysis, 165

Data Entry Devices, 23

Data Structure, 25

Debt Covenants, 110

Debt Utilization Ratios, 129

Demand Curve, 52

Demand Curve Shifts, 53

Demand-Pull Inflation, 67

Derivatives, 87

Economic Concepts, 52

Edit Tests, 46

Effects of Price Inflation, 65

Elasticity of Demand, 56

Electronic Commerce, 28

Expected Returns, 80

Factors Causing a Supply Curve Shift, 60

Financial Management, 99

Flexible Budgeting, 156

Flowcharts, 51

Foreign Exchange Rates, 78

General Controls, 42

Government Involvement in the

Economy, 74

Graphical Approach to Breakeven, 166

Hardware, 20

High-Low Method, 153

Incentives to Defeat Agency Problem, 1–5

Indicators of Business Cycles, 71

Information Technology, 15

Input Controls, 45

Interest Rates, 73

Internal Controls, 6–10

COSO definition of, 6

Index 173

Internal Rate of Return, 95

International Trade, 75

Internet, 31–33

Inventory Management, 104

Job Order Costing, 144

Joint Product Costing, 167, 168

Joint Products & By-Products, 167

Just-In-Time (JIT) Purchasing, 106, 107

Leverage, 117

Limitations of Enterprise Risk

Management, 14

Liquidity Ratios, 129

Loan Risks, 85

Long-Run Costs of Production, 63

Long-Term Debt, 109

Manufacturing Overhead, 142, 143

Market Equilibrium, 61

Market Ratios, 130

Marketable Securities, 102

Master and Static Budgets, 155

Measurement Frameworks, 122

Measures of Economic Activity, 64

Measuring Price Inflation, 66

Mergers, 120

Multiplier Effect, 69

Negative Demand Curve Shift, 55

Net Present Value, 96

Networks, 30

Networks and Control Risk, 34

Obstacles to Free Trade, 76

Operations in an IT Function, 39

Organization in a Segregated

Department, 38

Organization of an IT Environment, 37

Other Technical Services, 40

Output Controls, 48

Index 174

Payback Method, 93

Performance Measures, 122

Planning, Control, & Analysis, 156

Portfolio Risk, 84

Positive Demand Curve Shift, 54

Preferred Stock, 116

Preparing a Master Budget, 158

Probability Analysis, 97

Process Costing, 145

Processing Controls, 47

Product and Service Pricing, 170

Profitability Ratios, 127

Provisions Affecting Repayment of

Bonds, 110

Quality Control, 132

Receivables Management, 108

Regression Analysis, 154

Relevant Costing, 98

Reorder Point & Safety Stock, 105

Responsibility Accounting, 163

Risk Management, 78

Risks Associated with Derivatives, 88

Risks of E-Commerce, 29

Risks of IT, 17

Secured and Unsecured Bonds, 111

Short-Run Costs of Production, 62

Size and Power of Computers, 21

Software, 24

Special Analyses for Decision

Making, 97

Spoilage and Scrap, 149

Standard Costing, 160

Standard Deviation, 82

Storage Devices, 22

Supply Curve, 58

Supply Curve Shifts, 59

Index 175

Time Value of Money, 91

Transfer Pricing, 164

Types of Computer Systems, 26

Unemployment, 72

Use of Microcomputers, 21

Using Derivatives as Hedges, 89

Value-Based Management, 124

Valuing Derivatives, 90

Variable and Absorption Costing, 155

Variations on Bond Interest, 114

Working Capital Management, 100

Yield Curve, 86

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