ERM & Economic Concepts
Enterprise Risk Management (ERM) Framework
- Governance & Culture
- Strategy and Objective-Setting
- Performance
- Review & Revision
- Information, Communication, and Reporting
Gross Domestic Product (GDP) Expenditure Approach
Gross Domestic Product (GDP) is the total market value of all finished goods and services produced within a country's borders in a specific time period. The expenditure approach calculates GDP by summing all spending on these goods and services.
- C (Consumption): Personal Consumption Expenditures. This includes all spending by households on goods and services and is the largest component of GDP.
- I (Investment): Gross Private Domestic Investment. This represents business spending on capital, changes in inventory, and household purchases of new housing.
- G (Government Spending): Government Consumption Expenditures and Gross Investment. This is spending by all levels of government on goods and services. It does not include transfer payments.
- NX (Net Exports): The value of total exports (X) minus total imports
(M). This component
can be positive (trade surplus) or negative (trade deficit).
Formula: NX = X - M
COSO Internal Control Framework
The COSO framework is a model used to help organizations design, implement, and evaluate internal controls. It is comprised of five integrated components:
- Control Environment: The set of standards, processes, and structures that provide the basis for carrying out internal control across the organization. It includes the "tone at the top" regarding the importance of control and ethical values.
- Risk Assessment: The process of identifying and analyzing risks to the achievement of objectives, which forms a basis for determining how the risks should be managed.
- Control Activities: Actions established through policies and procedures that help ensure management's directives to mitigate risks are carried out.
- Information and Communication: The continual process of providing, sharing, and obtaining necessary information to enable personnel to carry out their responsibilities.
- Monitoring Activities: Ongoing or separate evaluations used to ascertain whether each of the five components of internal control is present and functioning effectively.
Risk & Return
Interest Rate Risk: Risk of loss due to changing interest rates.
Market/Systematic Risk: Risk inherent to the entire market (non-diversifiable).
Unsystematic/Firm-Specific Risk: Risk specific to a company (diversifiable).
Credit Risk: Risk that a borrower will default on a debt.
Liquidity Risk: Risk of being unable to sell an investment quickly.
Financial Calculations
Effective Interest Rate
$$ \frac{\text{Interest Paid}}{\text{Net Proceeds of Loan}} $$Annual Percentage Rate (APR)
$$ \text{Effective Periodic Rate} \times \text{\# Periods in Year} $$Effective Annual Rate (EAR)
$$ \left(1 + \frac{\text{Stated Rate}}{\text{\# Periods}}\right)^{\text{\# Periods}} - 1 $$Simple Interest
$$ \text{Principal} \times \text{Stated Rate} \times \text{\# of Periods} $$Compound Interest
$$ \text{Principal} \times (1 + \text{Effective Rate})^{\text{Total \# Periods}} $$Required Rate of Return
$$ \text{Nominal RF Rate} + \text{Risk Premiums} $$Supply & Demand Shifts
Factors that Shift Demand
- Tastes and Preferences: Changes in consumer tastes, trends, and preferences for a product.
- Prices of Related Goods: The price of substitutes (a good used in place of another) or complements (a good used together with another).
- Income: Changes in consumers' income, affecting demand for normal and inferior goods differently.
- Number of Buyers: An increase or decrease in the total number of consumers in the market.
- Expectations: Consumer expectations about future prices, income, or product availability.
Factors that Shift Supply
- Input Prices: Changes in the cost of resources used for production (e.g., labor, raw materials, energy).
- Technology: Advancements in production technology that can lower costs and increase output.
- Government Policies: The effect of taxes (which increase production costs) or subsidies (which decrease them).
- Number of Sellers: An increase or decrease in the number of firms producing the good.
- Expectations: Producer expectations about the future selling price of the good.
Elasticity Concepts
| Type | Formula | Interpretation |
|---|---|---|
| Price Elasticity of Demand | $$ \frac{\% \Delta \text{ Qty Demanded}}{\% \Delta \text{ Price}} $$ | > 1: Elastic (Revenue ↓ if Price ↑) < 1: Inelastic (Revenue ↑ if Price ↑) |
| Price Elasticity of Supply | $$ \frac{\% \Delta \text{ Qty Supplied}}{\% \Delta \text{ Price}} $$ | Measures sensitivity of supply to price changes. |
| Cross Elasticity | $$ \frac{\% \Delta \text{ Qty Demanded (X)}}{\% \Delta \text{ Price (Y)}} $$ | > 0: Substitutes < 0: Complements |
| Income Elasticity | $$ \frac{\% \Delta \text{ Qty Demanded}}{\% \Delta \text{ Income}} $$ | > 0: Normal Good < 0: Inferior Good |
Competitive Strategies & Porter's Five Forces
Competitive Strategies
- Cost Leadership: Lowest cost producer.
- Differentiation: Unique product/service.
- Best Cost: Combination of low cost and differentiation.
- Niche/Focus: Target a specific market segment.
Porter's Five Forces
- Barriers to Entry
- Market Competitiveness
- Existence of Substitute Products
- Bargaining Power of Customers
- Bargaining Power of Suppliers
SWOT Analysis
A strategic planning tool used to identify internal and external factors for achieving an objective.
Internal Factors
- Strengths: Internal attributes that help achieve the objective.
- Weaknesses: Internal attributes that harm achieving the objective.
External Factors
- Opportunities: External conditions that are helpful to achieving the objective.
- Threats: External conditions that are harmful to achieving the objective.
Value Chain Analysis
A strategic tool used to analyze internal firm activities to create value and competitive advantage.
Primary Activities
- Inbound Logistics: Receiving, storing, and distributing inputs.
- Operations: Transforming inputs into the final product.
- Outbound Logistics: Collecting, storing, and distributing the product to buyers.
- Marketing & Sales: Inducing buyers to purchase the product.
- Service: Providing service to enhance or maintain the product's value.
Support Activities
- Procurement: Function of purchasing inputs.
- Human Resource Management: Recruiting, hiring, training, and compensating personnel.
- Technology Development: Improving the product and processes.
- Infrastructure: General management, planning, finance, accounting, etc.
Macroeconomic Concepts
Business Cycles
- Expansion: GDP is rising, unemployment is falling.
- Peak: GDP stops rising, hits its highest level.
- Contraction: GDP is falling, unemployment is rising.
- Trough: GDP stops falling, hits its lowest level.
Economic Indicators
- Leading: Predict future economic activity (e.g., stock market).
- Lagging: Follow economic activity (e.g., unemployment rate).
- Coincident: Change at the same time as the economy (e.g., industrial production).
Unemployment Types
- Frictional: Normal unemployment from workers changing jobs.
- Structural: Mismatch between job skills and employer needs.
- Cyclical: Caused by downturns in the business cycle.
Government Policy
- Fiscal Policy: Government spending and taxation.
- Monetary Policy: Actions by a central bank to control the money supply and credit conditions.
Foreign Currency Hedging Strategies
Use these derivative strategies to mitigate foreign currency exchange risk:
Hedging an A/R (Asset)
If you are due to receive foreign currency, you fear it will weaken (go down). You need to lock in a sales price.
- Sell a Forward or Futures Contract
- Buy a Put Option
Hedging an A/P (Liability)
If you are due to pay foreign currency, you fear it will strengthen (go up). You need to lock in a purchase price.
- Buy a Forward or Futures Contract
- Buy a Call Option
Foreign Currency Transactions & Remeasurement
This applies when a company buys or sells goods/services in a currency other than its functional currency. The key is that transaction gains and losses are always reported in Net Income.
- Transaction Date: Record the accounts receivable or payable using the exchange rate (spot rate) on this date.
- Balance Sheet Date: Remeasure the receivable/payable using the current spot rate. The difference creates an unrealized gain or loss, which is reported in current period income.
- Settlement Date: Remeasure the receivable/payable using the spot rate on the settlement date. A further gain or loss is calculated and reported. The transaction is then settled.
Market Structures
- Perfect Competition: Many small firms, identical products, no barriers to entry. Firms are price takers.
- Monopolistic Competition: Many firms, differentiated products, few barriers to entry. Firms have some control over price.
- Oligopoly: A few large firms dominate the market, significant barriers to entry. Firms are interdependent.
- Monopoly: Single firm, unique product, significant barriers to entry. Firm is a price setter.
Financial Management
Weighted Average Cost of Capital (WACC)
WACC Formula
$$ WACC = \left(\frac{E}{V}\right) R_e + \left(\frac{D}{V}\right) R_d (1 - T) $$
Where:
E = Market Value of Equity
D = Market Value of Debt
V = E + D
Rₑ = Cost of Equity
Rₔ = Cost of Debt
T = Tax Rate
Cost of Debt (Rₔ)
Use the effective interest rate on new debt. Remember to use the after-tax cost of debt in the WACC formula.
Cost of Preferred Stock (Rₚₛ)
$$ R_{ps} = \frac{\text{Dividend per share}}{\text{Net proceeds per share}} $$Cost of Common Equity (Rₑ)
Can be calculated using CAPM, DCF (Gordon Growth), or Bond Yield Plus Risk Premium.
Economic Order Quantity (EOQ) Model
The EOQ model calculates the ideal order size to minimize the sum of ordering costs and carrying costs. The formula is:
Opposing Costs
- Ordering Costs: Costs of placing and receiving an order (e.g., purchase order processing, receiving department costs). Decrease as order size increases.
- Carrying (Holding) Costs: Costs of holding inventory (e.g., storage, insurance, obsolescence). Increase as order size increases.
Key Assumptions
- Demand is known and constant.
- Lead time is reliable and does not vary.
- Ordering costs are fixed per order.
- No quantity discounts are available.
Cost of Equity (Rₑ) & Growth Rate (g)
CAPM Formula
Where: R𝒻=Risk-Free Rate, β=Beta, Rₘ=Market Return
Sustainable Growth Rate (g)
Where: Retention Rate = 1 - Dividend Payout Ratio
Optimal Capital Structure & Leverage
The optimal capital structure is the mix of debt and equity that minimizes the WACC and maximizes the value of the firm.
Operating Leverage
Measures the degree to which a firm uses fixed operating costs.
Degree of Operating Leverage (DOL)
$$ \frac{\% \text{ Change in EBIT}}{\% \text{ Change in Sales}} $$Financial Leverage
Measures the degree to which a firm uses debt financing.
Degree of Financial Leverage (DFL)
$$ \frac{\% \text{ Change in EBT}}{\% \text{ Change in EBIT}} $$Inventory Management
- Reorder Point: Safety Stock + (Lead Time x Sales during Lead Time).
- SCOR Model: A framework for supply chain management: Plan, Source, Make, Deliver.
Internal Rate of Return (IRR)
The discount rate at which the Net Present Value (NPV) of a project's cash flows equals zero.
Decision Rule: Accept the project if the IRR is greater than the company's required rate of return (hurdle rate).
IRR is generally less reliable than NPV when comparing mutually exclusive projects or projects with unconventional cash flows.
Working Capital Management
Key Formulas
| AR Turnover | $$ \frac{\text{Net Credit Sales}}{\text{Avg. AR}} $$ |
| Inventory Turnover | $$ \frac{\text{COGS}}{\text{Avg. Inventory}} $$ |
| AP Turnover | $$ \frac{\text{COGS}}{\text{Avg. AP}} $$ |
Cash Conversion Cycle
Advanced Working Capital & Inventory
APR for Quick Payment Discounts
Methods to Delay Disbursements
- Centralized payables with zero-balance accounts
- Use of drafts (checks payable by a bank)
- Lines of credit
Inventory Techniques
- Just-in-Time (JIT): Reduces inventory by receiving goods only as they are needed in the production process.
- Kanban: A visual system to manage and control JIT workflow.
Valuation Models
Dividend Discount Models (DDM)
Gordon Growth: $$ P_0 = \frac{D_1}{r - g} $$
Zero Growth: $$ P_0 = \frac{D}{r} $$
Relative Valuation Models
P/E Ratio: $$ \frac{P_0}{E_1} $$
PEG Ratio: $$ \frac{(P_0 / E_1)}{g} $$
Price-to-Sales: $$ \frac{P_0}{S_1} $$
Price-to-Cash-Flow: $$ \frac{P_0}{CF_1} $$
Price-to-Book: $$ \frac{P_0}{B_0} $$
Asset & Intangible Valuation
Tangible: Cost Method, Liquidation Value, Market Value, Appraisal.
Intangible: Market Approach, Cost Approach, Income Approach.
Debt & Options
Debt Instruments: Valued at the Present Value of future cash flows (interest payments and principal) discounted at the market rate.
Options: Can be valued using models like Black-Scholes.
Capital Budgeting Techniques
- Net Present Value (NPV): Present value of inflows minus present value of outflows. Accept if NPV > 0.
- Payback Period: Time to recover initial investment. Ignores time value of money and cash flows after payback.
- Profitability Index: PV of Future Cash Flows / Initial Investment. Accept if PI > 1.
Marginal Analysis & Relevant Costs
- Special Order Decisions: Accept if incremental revenue > incremental costs. Consider opportunity cost if there is no excess capacity.
- Sell or Process Further: Process further if incremental revenue from processing > incremental processing costs. Joint costs are sunk costs and irrelevant.
- Lease vs. Buy: Compare the NPV of the cash flows for each option.
Capital Budgeting: NPV vs. IRR
Net Present Value (NPV) and Internal Rate of Return (IRR) are the two primary discounted cash flow methods for evaluating capital projects.
| Metric | Description | Decision Rule |
|---|---|---|
| Net Present Value (NPV) | The present value of a project's future cash inflows minus the present value of its cash outflows. Measures the absolute dollar value added to the firm. | Accept if NPV > 0. |
| Internal Rate of Return (IRR) | The discount rate at which the NPV of a project equals zero. Measures the percentage return of the project. | Accept if IRR > Hurdle Rate (WACC). |
Which is Better?
NPV is generally considered superior to IRR for capital budgeting decisions, especially when ranking mutually exclusive projects. NPV assumes cash flows are reinvested at the firm's cost of capital, which is more realistic than IRR's assumption of reinvestment at the IRR itself.
Operations Management
Cost Accounting Systems
Job Costing
For custom orders; costs are tracked by individual job.
Process Costing
For mass-produced, homogeneous products; costs are averaged over all units.
Activity-Based Costing (ABC)
Assigns overhead based on activities (cost drivers) rather than a single plant-wide rate.
Flow of Inventory Costs
Raw Materials
Work-in-Process
+ DL, + OH Applied
Finished Goods
(Cost of Goods Mfd)
Cost of Goods Sold
Cost of Goods Manufactured (COGM)
COGM represents the total cost of goods completed and transferred from WIP to Finished Goods inventory during a period.
+ Direct Materials Used
+ Direct Labor Incurred
+ Manufacturing Overhead Applied
- End. WIP Inventory
= Cost of Goods Manufactured
Cost of Quality
Costs of quality are categorized as either conformance or non-conformance costs. The goal is to invest in conformance costs to minimize non-conformance costs.
Conformance Costs (Good)
Costs incurred to prevent or detect defects before they reach the customer.
- Prevention Costs: Costs to prevent defects from occurring (e.g., employee training, quality control).
- Appraisal Costs: Costs to identify defective products before shipment (e.g., testing, inspection).
Non-Conformance Costs (Bad)
Costs incurred because defects were produced.
- Internal Failure Costs: Costs of defects found before the product reaches the customer (e.g., rework, scrap).
- External Failure Costs: Costs of defects found after the product reaches the customer (e.g., warranty costs, returns, lost sales).
Joint & By-Product Costing
- Joint Products: Two or more products generated from a common input. Joint costs are allocated to these main products.
- By-Products: Products with a low sales value relative to the main product. Revenue from by-products can be used to reduce the joint costs allocated to the main products.
- Split-off Point: The point in the production process where joint products can be individually identified.
- Separable Costs: Costs incurred after the split-off point that are assignable to specific products.
Joint Cost Allocation Methods
Joint costs are incurred in a single process that yields multiple products. These costs must be allocated to the main (joint) products at the split-off point.
1. Relative Sales Value Method
Allocates joint costs based on each product's share of total sales value at the split-off point. This is the preferred method.
2. Net Realizable Value (NRV) Method
Used when products cannot be sold at split-off. Allocation is based on final sales value minus identifiable costs incurred after split-off (separable costs).
3. Physical Unit Method
Allocates joint costs based on a physical measure (e.g., pounds, gallons) of the units produced. This method does not consider the revenue-generating power of products.
Accounting for By-Products
By-products have a low sales value. Any proceeds from their sale are typically used to reduce the costs of the main products, either as a credit to joint costs or to cost of goods sold.
Process Costing: Equivalent Units
Weighted-Average
FIFO
Absorption vs. Contribution Margin
The only difference is the treatment of Fixed Factory Overhead.
- Absorption Costing (GAAP): Fixed OH is a product cost (inventoried).
- Contribution/Variable Costing: Fixed OH is a period cost (expensed immediately).
If Production > Sales → Absorption Income > Variable Income.
If Sales > Production → Variable Income > Absorption Income.
Break-Even & CVP Analysis
BE Point (Units)
BE Point ($)
Sales for Target Profit (Units)
Margin of Safety
Business Process Management
- Plan-Do-Check-Act (PDCA): A cycle for continuous improvement.
- Lean Manufacturing: Focuses on waste reduction and efficiency.
- Six Sigma: A data-driven approach for quality control and eliminating defects.
- Theory of Constraints: Identifies and improves the most significant bottleneck in a process.
Responsibility Centers
A responsibility center is a segment of a business for which a manager has control and accountability.
- Cost Center: Manager responsible for costs only (e.g., production department).
- Revenue Center: Manager responsible for revenues only (e.g., sales department).
- Profit Center: Manager responsible for both revenues and costs (e.g., a specific product line).
- Investment Center: Manager responsible for revenues, costs, and invested capital (e.g., a subsidiary).
Investment Center Performance Metrics (ROI, RI, EVA)
These metrics are used to evaluate the performance of an investment center manager, who is responsible for revenues, costs, and the capital invested in the unit.
1. Return on Investment (ROI)
Measures the income of a division as a percentage of the assets invested.
(Can also be calculated as: Profit Margin × Asset Turnover)
- Advantage: Simple and widely used metric for profitability.
- Disadvantage: Can lead to underinvestment. A manager might reject a profitable project if it lowers the division's overall ROI.
2. Residual Income (RI)
Measures the income earned in excess of a required minimum return on the division's assets. This dollar amount encourages investment in any project that earns more than the required return.
- Advantage: Promotes goal congruence; managers are motivated to make any investment that is profitable for the company as a whole.
- Disadvantage: It's an absolute measure, making it difficult to compare divisions of different sizes.
3. Economic Value Added (EVA)
A specific type of residual income that measures the economic profit of a division by using the weighted-average cost of capital (WACC) as the charge for capital.
- Advantage: Aligns manager decisions with shareholder wealth maximization by incorporating the true cost of capital.
Balanced Scorecard
- Financial: Financial performance (e.g., ROI, profit).
- Internal Business Processes: Efficiency and quality (e.g., defect rate).
- Customer Satisfaction: How customers view the organization (e.g., satisfaction surveys).
- Growth: Human capital and innovation (e.g., employee training).
Comprehensive Variance Analysis
Cost Variances
Direct Materials
Price Variance
$$ \text{AQ Purchased} \times (\text{AP} - \text{SP}) $$Quantity Variance
$$ \text{SP} \times (\text{AQ Used} - \text{SQ Allowed}) $$Direct Labor
Rate Variance
$$ \text{AH} \times (\text{AR} - \text{SR}) $$Efficiency Variance
$$ \text{SR} \times (\text{AH} - \text{SH Allowed}) $$Variable Overhead
Spending Variance
$$ \text{AH} \times (\text{AR} - \text{SR}) $$Efficiency Variance
$$ \text{SR} \times (\text{AH} - \text{SH Allowed}) $$Fixed Overhead
Budget (Spending) Variance
$$ \text{Actual FOH} - \text{Budgeted FOH} $$Volume Variance
$$ \text{Budgeted FOH} - \text{Applied FOH} $$Sales & Profit Variances
Sales Price Variance
$$ (\text{Actual SP} - \text{Budgeted SP}) \times \text{Actual Units Sold} $$Sales Volume Variance
$$ (\text{Actual Units} - \text{Budgeted Units}) \times \text{Std. CM per Unit} $$Market Size Variance
$$ (\text{Actual Size} - \text{Budgeted Size}) \times \text{Budgeted Share} \times \text{Budgeted CM} $$Market Share Variance
$$ (\text{Actual Share} - \text{Budgeted Share}) \times \text{Actual Size} \times \text{Budgeted CM} $$Master Budget Components
The Master Budget is a comprehensive plan for an organization, typically for one year. It is composed of operating and financial budgets.
Operating Budgets
Describe the income-generating activities of a firm. Based on the Sales Budget.
- Sales Budget
- Production Budget
- Direct Materials, Direct Labor & OH Budgets
- COGS Budget
- Selling & Administrative Expense Budget
Financial Budgets
Detail the inflows and outflows of cash and the overall financial position.
- Capital Expenditures Budget
- Cash Budget
- Budgeted Balance Sheet
- Budgeted Statement of Cash Flows
Advanced Accounting
Employee Stock Options Accounting
Compensation for stock options is recognized as an expense in the financial statements.
- Measurement: Compensation expense is measured at the fair value of the options on the grant date, using a pricing model like Black-Scholes.
- Allocation: The total compensation cost is allocated on a straight-line basis over the vesting period (the period during which the employee earns the right to the options).
- Journal Entry: Each period, the entry to record the expense is:
DR: Compensation Expense
CR: APIC - Stock Options - Expiration: If vested options expire, the APIC - Stock Options balance is reclassified to APIC - Expired Stock Options. No reversal of previously recognized expense is permitted.
Revenue Recognition 5-Step Model
The framework for recognizing revenue under ASC 606 is based on the following five-step process:
- Identify the contract(s) with a customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Earnings Per Share (EPS)
Basic EPS
Diluted EPS
Considers the effect of all potential dilutive common shares (e.g., stock options, convertible bonds). Uses the if-converted method for convertible securities and the treasury stock method for options and warrants.
Acquisition: Goodwill vs. Bargain Purchase
In a business combination, Goodwill is recognized if the purchase price exceeds the fair value of the net assets acquired. The calculation is as follows:
- If the result is positive, it is Goodwill, which is capitalized as an intangible asset and tested for impairment.
- If the result is negative, it is a Bargain Purchase Gain. This gain is recognized immediately in the acquirer's current earnings.
Variable Interest Entities (VIE)
A VIE is an entity where control is not based on majority voting rights. The primary beneficiary must consolidate the VIE. A company is the primary beneficiary if it meets the criteria below:
- Recipient: The company is the recipient of the VIE's profits and losses.
- Variable Interest: The company has a financial stake in the VIE.
- Characteristics: The VIE lacks the basic characteristics of a normal company (e.g., insufficient equity at risk).
Partnership Accounting Basics
- Formation: Assets contributed are recorded at their fair market value.
- New Partner Admission: Can be done by purchasing an interest from existing partners or by investing new assets into the partnership.
- Bonus Method: When a new partner's capital account differs from their investment, the difference is allocated as a bonus to/from the existing partners' capital accounts based on their P&L ratio.
- Liquidation: All liabilities are paid first, then loans to partners, and finally capital balances are distributed.
Consolidation Elimination Entry
This journal entry eliminates the subsidiary's equity and the parent's investment account:
- DR: Common Stock - Sub
- DR: APIC - Sub
- DR: Retained Earnings - Sub
- DR: Balance Sheet FV Adjustments
- DR: Intangibles FV
- DR: Goodwill (or CR: Gain)
- CR: Investment in Sub
- CR: Noncontrolling Interest
Consolidation: Intercompany Transactions
All intercompany transactions must be eliminated during consolidation. Any unrealized profits on assets that remain within the consolidated entity at year-end must be deferred.
Intercompany Inventory
- Profit Deferral: Defer 100% of the gross profit on inventory that remains unsold to outsiders at year-end.
- Subsequent Period: When the inventory is sold to an outsider in the next period, the deferred profit is recognized.
Intercompany Fixed Assets
- Gain/Loss Deferral: Defer 100% of any gain or loss on the intercompany sale in the year of the sale.
- Restore Basis: The asset must be restored to its original cost basis on the consolidated books.
- Correct Depreciation: "Excess" depreciation (depreciation on the gain) must be reversed in all subsequent periods until the asset is sold externally.
Statement of Cash Flows (Commercial)
Summarizes the cash inflows and outflows over a period.
- Operating Activities: Cash effects of transactions that determine net income (e.g., cash from customers, payments to suppliers). Can be presented using the direct or indirect method.
- Investing Activities: Cash flows from making and collecting loans and acquiring/disposing of investments and long-lived assets.
- Financing Activities: Cash flows from issuing debt and equity, paying dividends, and repurchasing stock.
Foreign Currency Accounting
| Method | When to Use | B/S Monetary Items | B/S Non-Monetary Items | I/S Items | Gain / Loss Location |
|---|---|---|---|---|---|
| Remeasurement | Sub's functional currency is the parent's currency (e.g., highly integrated). | Current Rate | Historical Rate | Weighted-Avg (Historical for B/S related items) | Net Income |
| Translation | Sub's functional currency is their local currency (self-contained). | Current Rate | Current Rate | Weighted-Avg Rate | OCI (CTA) |
Derivatives & Hedging
No Hedge Designation
Gains/Losses are recognized in current earnings.
Fair Value Hedge
Hedges exposure to changes in FV of an asset or liability. G/L is recognized in current earnings, offsetting the G/L on the hedged item.
Cash Flow Hedge
Hedges exposure to variability in future cash flows. Effective portion of G/L is reported in OCI until the hedged transaction affects earnings.
Hedge Accounting: Fair Value vs. Cash Flow
The goal of hedge accounting is to match the timing of gain/loss recognition on a hedging instrument with the gain/loss on the item it hedges.
Fair Value Hedge
- Purpose: Hedges exposure to changes in the Fair Value of a recognized asset or liability (e.g., hedging the value of inventory or a fixed-rate investment).
- Accounting: Gains/Losses on both the derivative and the hedged item are recognized immediately in current earnings.
- Result: Creates an offsetting effect in the income statement, smoothing earnings.
Cash Flow Hedge
- Purpose: Hedges exposure to variability in expected future cash flows (e.g., hedging a future purchase or a variable-rate loan).
- Accounting (Effective Portion): The effective portion of the gain/loss on the derivative is reported in Other Comprehensive Income (OCI) until the hedged transaction affects earnings.
- Accounting (Ineffective Portion): Any ineffective portion of the hedge is reported in current earnings immediately.
Common Derivative Instruments
Derivatives are financial instruments whose value is derived from an underlying asset. Common types include:
Defined Benefit Pension Expense
The components of net periodic pension cost are:
- Service Cost: The present value of benefits earned by employees in the current period. (Increases expense)
- Interest Cost: The interest accrued on the Projected Benefit Obligation (PBO). (Increases expense)
- Expected Return on Plan Assets: The anticipated earnings on the pension fund's investments. (Decreases expense)
- Amortization of Prior Service Cost: The allocation of the cost of retroactive benefits from plan amendments. (Increases expense)
- Amortization of Gains and Losses: The amortization of actuarial gains (which decrease expense) or losses (which increase expense).
Revenue Recognition for Long-Term Contracts (ASC 606)
Under ASC 606, revenue recognition is determined by when control of a good or service transfers to the customer, which can occur either over time or at a point in time.
Revenue Recognized Over Time
An entity recognizes revenue over time if certain criteria are met (e.g., the customer controls the asset as it is created). Progress toward completion is measured using either input or output methods.
- Input Method (e.g., Cost-to-Cost): Revenue is recognized based on the proportion of costs incurred to date relative to total estimated costs.
- Output Method: Revenue is recognized based on direct measurements of the value transferred to the customer (e.g., milestones achieved).
Anticipated losses on the contract are recognized in full immediately.
Revenue Recognized at a Point in Time
If the criteria for recognizing revenue over time are not met, revenue is recognized in full at the point in time when the customer obtains control of the completed asset. Costs are capitalized and expensed upon completion. Anticipated losses are still recognized immediately.
Lease Classification & Accounting (ASC 842)
Lease classification determines the accounting treatment for both the lessee and the lessor, and it is based on a universal set of criteria that assess whether the lease effectively transfers control of the underlying asset.
Lease Classification Criteria
The classification hinges on the following two sets of criteria:
- Criteria for Transfer of Control:
- Ownership of the asset transfers to the lessee by the end of the lease term.
- A written purchase option exists that the lessee is reasonably certain to exercise.
- The Net Present Value of lease payments is 90% or more of the asset's fair value.
- The economic life of the asset is primarily consumed during the lease term (75% or more).
- The asset is specialized with no alternative use to the lessor at the end of the term.
- Additional Lessor-Only Criteria:
- The present value of the sum of lease payments, lessee-guaranteed residual value, and third-party guaranteed residual value is equal to or substantially exceeds the asset's fair value.
- Collection of the lease payments is probable.
Lessee Accounting
- Finance Lease: If any one of the five criteria for transfer of control is met. The lessee recognizes a Right-of-Use (ROU) asset and a lease liability, and records both interest and amortization expense separately on the income statement.
- Operating Lease: If none of the criteria for transfer of control are met. The lessee recognizes an ROU asset and a lease liability, but records a single, straight-line lease expense on the income statement.
Lessor Accounting
- Sales-Type Lease: If any one of the five criteria for transfer of control is met. The lessor derecognizes the asset and recognizes a net investment in the lease, along with any profit or loss on the "sale" at commencement.
- Direct Financing Lease: If none of the criteria for transfer of control are met, but both of the additional lessor-only criteria are met. The lessor derecognizes the asset and recognizes a net investment in the lease, but defers any profit.
- Operating Lease: If the lease meets none of the criteria for transfer of control and fails to meet at least one of the additional lessor-only criteria. The lessor keeps the asset on its books and recognizes lease income over time.
Segment Reporting
A segment is reportable if it meets the 10% "Size" Test for:
- Combined Revenue (internal & external)
- Absolute value of Profit or Loss
- Identifiable Assets
75% Reporting Sufficiency Test: Total external revenue of all reportable segments must be at least 75% of total consolidated revenue.
Other Advanced Topics
- Software Costs: Expense costs incurred before technological feasibility. Capitalize costs incurred after.
- Pension Plans: Defined Contribution (risk on employee) vs. Defined Benefit (risk on employer).
Goodwill Impairment Test
Goodwill is tested for impairment at the reporting unit level. Under US GAAP, this is a one-step quantitative test:
- Compare the Fair Value (FV) of the reporting unit with its Carrying Value (CV), including goodwill.
- If the CV > FV, an impairment loss is recognized for the difference.
- The loss cannot exceed the carrying amount of goodwill.
Governmental Accounting
Major Fund Reporting
A governmental or enterprise fund is considered a "major fund" and must be reported in a separate column if it meets both parts of a two-step test:
- 10% Test: The fund's assets, liabilities, revenues, or expenditures/expenses are at least 10% of the corresponding total for all funds of that category (i.e., all governmental or all enterprise funds).
- 5% Test: The fund's assets, liabilities, revenues, or expenditures/expenses are at least 5% of the corresponding total for all governmental AND enterprise funds combined.
The General Fund is always considered a major fund.
Interfund Activity
Flows of resources between a government's funds.
Reciprocal (Exchange-like)
- Interfund Loans: Temporary extensions of credit, expect repayment.
- Interfund Services: Sales and purchases of goods/services between funds at market-based prices.
Nonreciprocal
- Interfund Transfers: Flows of assets without an expectation of repayment (e.g., annual transfer from General Fund to Debt Service Fund).
- Interfund Reimbursements: Repayments from a fund that is ultimately responsible for an expenditure to a fund that initially paid for it.
Governmental Fund Accounting Overview
Governmental Funds
Modified Accrual, Current Resources
- General Fund
- Special Revenue Funds
- Capital Projects Funds
- Debt Service Funds
- Permanent Funds
Proprietary Funds
Full Accrual, Economic Resources
- Internal Service Funds
- Enterprise Funds
Fiduciary Funds
Full Accrual, Economic Resources
- Custodial Funds
- Investment Trust Funds
- Private Purpose Funds
- Pension/ Other Employee Benefits Trust Funds
Proprietary Fund Statement of Cash Flows
This statement uses four distinct categories, different from commercial accounting:
- Operating Activities: Includes cash flows from sales, services, and payments to suppliers/employees.
- Noncapital Financing Activities: Includes grants and subsidies, and cash paid/received to other funds (not for capital purposes).
- Capital and Related Financing Activities: Includes issuing debt for capital assets, purchasing capital assets, and capital grants. Interest expense is reported here.
- Investing Activities: Includes interest and dividends received, and sales/purchases of investment securities.
Budgetary Accounting & Encumbrances
Budgetary Journal Entry (Beginning of Year)
DR Estimated Revenue Control
CR Appropriations Control
DR/CR Budgetary Control (Plug for surplus/deficit)
Encumbrance Journal Entries
To record a purchase order:
DR Encumbrances, CR Budgetary Control
To reverse and record actual expenditure:
DR Budgetary Control, CR Encumbrances
DR Expenditures, CR Vouchers Payable
Fund Balance (Governmental) vs. Net Position (Proprietary/Gov-Wide)
Fund Balance Categories (Governmental Funds)
Presented in a hierarchy of spending constraints:
- Nonspendable: Amounts not in spendable form (e.g., inventory, prepaids) or legally required to be maintained intact (e.g., corpus of a permanent fund).
- Restricted: Amounts constrained for specific purposes by external parties (creditors, grantors) or by law.
- Committed: Amounts constrained for specific purposes by the government's highest level of decision-making authority (e.g., a city council ordinance).
- Assigned: Amounts the government intends to use for a specific purpose, without a formal commitment.
- Unassigned: The residual classification for the General Fund. It is the only category that can have a negative balance.
Net Position Categories (Gov-Wide & Proprietary)
(Assets + Def. Outflows) - (Liab. + Def. Inflows)
- Net Investment in Capital Assets: Capital assets, net of accumulated depreciation and related outstanding debt.
- Restricted: Net position subject to externally imposed constraints by creditors, grantors, or law.
- Unrestricted: The residual amount of net position that does not meet the other two definitions.
Non-Exchange Revenue
In Governmental Funds (Modified Accrual), revenue is recognized when it is measurable and available. "Available" means collectible in the current period or soon enough thereafter to pay current liabilities.
| Type | Example | Revenue Recognition |
|---|---|---|
| Derived Tax Revenue | Sales Tax, Income Tax | When underlying exchange transaction occurs. |
| Imposed Non-Exchange | Property Taxes, Fines | When an enforceable legal claim arises (when billed). |
| Government-Mandated | Federal grant requiring a state to perform an action. | When all eligibility requirements are met. |
| Voluntary Non-Exchange | Unrestricted grants, donations. | When all eligibility requirements are met. |
Government-Wide Financial Statements
Presents a consolidated overview of the government's financial position. Uses Full Accrual and the Economic Resources measurement focus.
- Statements: Statement of Net Position & Statement of Activities.
- Key Features: Includes capital assets and long-term debt. Fiduciary funds are excluded. Internal Service Fund activity is allocated.
- Reconciliation: A reconciliation from the governmental fund financial statements to the government-wide statements is required.
Gov-Wide Reconciliation
This reconciliation is needed to adjust the Governmental Fund Balance (Modified Accrual basis) to the Government-Wide Net Position (Full Accrual basis).
Reconciliation Summary:
- Total Governmental Fund Balance
- + Capital assets
- + Internal service fund net position
- - Accumulated depreciation
- - Non-current liabilities
- = Net Position from Governmental Activities
Explanation of Adjustments:
- Capital Assets: Add the value of capital assets, which are expensed as expenditures in governmental funds but capitalized and depreciated in government-wide statements.
- Accumulated Depreciation: Subtract the accumulated depreciation related to those capital assets.
- Non-current Liabilities: Subtract long-term liabilities (like bonds payable), which are not recorded in governmental funds but are on the government-wide statements.
- Service Fund Net Position: Add the net position of internal service funds, which are proprietary funds but are typically consolidated with governmental activities.
Other reconciling items include differences in revenue recognition (e.g., property taxes not "available") and recognizing expenses like depreciation and interest accruals.
Annual Comprehensive Financial Report (ACFR)
The ACFR is the official annual report of a government. It has three main sections:
- Introductory Section: Includes a letter of transmittal, organizational chart, and list of principal officers. (Unaudited)
- Basic Financial Statements: Includes government-wide F/S, fund F/S, notes to the F/S, and the auditor's report. (Audited)
- Statistical Section: Presents multi-year data (e.g., 10-year trends) on financial, economic, and demographic information. (Unaudited)
Modified Approach for Infrastructure
This is an alternative to depreciating eligible infrastructure assets (e.g., roads, bridges) in the government-wide financial statements.
Instead of recording depreciation, expenditures to maintain and preserve the assets are expensed in the period incurred. To use this approach, two requirements must be met:
- An asset management system is in place.
- Documentation shows the infrastructure assets are being preserved at or above a disclosed condition level.
Not-for-Profit (NFP) Financial Statements
NFP entities have a unique set of financial statements that focus on the organization as a whole.
- Statement of Financial Position: Shows Assets, Liabilities, and Net
Assets. Net assets are broken into two classes:
- Net Assets with Donor Restrictions: Subject to donor-imposed stipulations that are temporary or perpetual.
- Net Assets without Donor Restrictions: No donor-imposed restrictions.
- Statement of Activities: Reports revenues and expenses, showing the change in each net asset class. Expenses must be reported by functional classification (e.g., program services, management & general).
- Statement of Cash Flows: Can use either the direct or indirect method. Financing activities include donor-restricted contributions for long-term purposes.