Bookkeeping is the recording of financial transactions. Transactions include sales, purchases, income, receipts and payments by an individual or organization.

Bookkeeping is usually performed by a bookkeeper. Many individuals mistakenly consider bookkeeping and accounting to be the same thing. This confusion is understandable because the accounting process includes the bookkeeping function, but is just one part of the accounting process. The accountant creates reports from the recorded financial transactions recorded by the bookkeeper and files forms with government agencies. There are some common methods of bookkeeping such as the single-entry bookkeeping system and the double-entry bookkeeping system. But while these systems may be seen as "real" bookkeeping, any process that involves the recording of financial transactions is a bookkeeping process. A bookkeeper (or book-keeper), also known as an accounting clerk or accounting technician, is a person who records the day-to-day financial transactions of an organization. A bookkeeper is usually responsible for writing the "daybooks". The daybooks consist of purchases, sales, receipts, and payments. The bookkeeper is responsible for ensuring all transactions are recorded in the correct day book, suppliers ledger, customer ledger and general ledger. The bookkeeper brings the books to the trial balance stage. An accountant may prepare the income statement and balance sheet using the trial balance and ledgers prepared by the bookkeeper.

Process The bookkeeping process primarily records the financial effects of financial transactions only. The variation between manual and any electronic accounting system stems from the latency between the recording of the financial transaction
1

and its posting in the relevant account. This delay, absent in electronic accounting systems due to instantaneous posting into relevant accounts, is not replicated in manual systems, thus giving rise to primary books of accounts such as Sales Book, Cash Book, Bank Book, Purchase Book for recording the immediate effect of the financial transaction. In the normal course of business, a document is produced each time a transaction occurs. Sales and purchases usually have invoices or receipts. Deposit slips are produced when lodgments (deposits) are made to a bank account. Cheques are written to pay money out of the account. Bookkeeping involves, first of all, recording the details of all of these source documents into multicolumn journals (also known as a books of first entry or daybooks). For example, all credit sales are recorded in the sales journal, all cash payments are recorded in the cash payments journal. Each column in a journal normally corresponds to an account. In the single entry system, each transaction is recorded only once. Most individuals who balance their cheque-book each month are using such a system, and most personal finance software follows this approach. After a certain period, typically a month, the columns in each journal are each totaled to give a summary for the period. Using the rules of double entry, these journal summaries are then transferred to their respective accounts in the ledger, or book of accounts. For example the entries in the Sales Journal are taken and a debit entry is made in each customer's account (showing that the customer now owes us money) and a credit entry might be made in the account for "Sale of class 2 widgets" (showing that this activity has generated revenue for us). This process of transferring summaries or individual transactions to the ledger is called posting. Once the posting process is complete, accounts kept using the "T" format undergo balancing, which is simply a process to arrive at the balance of the account.
2

As a partial check that the posting process was done correctly, a working document called an unadjusted trial balance is created. In its simplest form, this is a three column list. The first column contains the names of those accounts in the ledger which have a non-zero balance. If an account has a debit balance, the balance amount is copied into column two (the debit column). If an account has a credit balance, the amount is copied into column three (the credit column). The debit column is then totaled and then the credit column is totaled. The two totals must agree this agreement is not by chance because under the double-entry rules, whenever there is a posting, the debits of the posting equal the credits of the posting. If the two totals do not agree, an error has been made either in the journals or during the posting process. The error must be located and rectified and the totals of debit column and credit column recalculated to check for agreement before any further processing can take place. Once the accounts balance, the accountant makes a number of adjustments and changes the balance amounts of some of the accounts. These adjustments must still obey the double-entry rule. For example, the "inventory" account asset account might be changed to bring them into line with the actual numbers counted during a stock take. At the same time, the expense account associated with usage of inventory is adjusted by an equal and opposite amount. Other adjustments such as posting depreciation and prepayments are also done at this time. These results in a listing called the adjusted trial balance. It is the accounts in this list and their corresponding debit or credit balances that are used to prepare the financial statements. Finally financial statements are drawn from the trial balance, which may include:

the income statement, also known as the statement of financial results, profit and loss account, or P&L
3

the balance sheet, also known as the statement of financial position the cash flow statement the statement of retained earnings, also known as the statement of total recognized gains and losses or statement of changes in equity Entry systems

Two common bookkeeping systems used by businesses and other organizations are the single-entry bookkeeping system and the double-entry bookkeeping system. Single-entry bookkeeping uses only income and expense accounts, recorded primarily in a revenue and expense journal. Single-entry bookkeeping is adequate for many small businesses. Double-entry bookkeeping requires posting (recording) each transaction twice, using debits and credits. Single-entry system The primary bookkeeping record in single-entry bookkeeping is the cash book, which is similar to a checking (cheque) account register but allocates the income and expenses to various income and expense accounts. Separate account records are maintained for petty cash, accounts payable and receivable, and other relevant transactions such as inventory and travel expenses. These days, single entry bookkeeping can be done with DIY bookkeeping software to speed up manual calculations.

Sample revenue and expense journal for single-entry bookkeeping [2]

Sales Servi Tax ces Office Suppl

No.

Date

Description

Revenue

Expense Sales

Inventory Advert. Freight

Misc

7/13

Balance forward

1,826.00

835.00

1,218. 00

98.00

510.0 0

295.00

245.00 150.00

83.50

61.50

1041

7/13

Printerflyers

Advert

450.00

450.00

1042

7/13

Wholesaler inventory

380.00

380.00

1043

7/16

office supplies

92.50

92.50

7/17

bank deposit

1,232.00

Taxable sales

400.0 0

32.00

Out-of-state sales

165.0 0

Resales

370.0 0

Service sales

265.0 0

bank

7/19

bank charge

23.40

23.40

1044

7/19

petty cash

100.00

100.00

TOTALS

3,058.00

1,880.90

2,153. 130.0 775.0 00 0 0

675.00

695.00 150.00

176.00

184.90

Double-entry system A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different nominal ledger accounts. The name derives from the fact that financial information used to be recorded using pen and ink in paper books hence "bookkeeping" (whereas now it is recorded mainly in computer systems) and that these books were called journals and ledgers (hence nominal ledger, etc.) and that each transaction was entered twice (hence "double-entry"), with one side of the transaction being called a debit and the other a credit. It was first codified in the 15th century by the Franciscan Friar, Luca Pacioli. In deciding which account has to be debited and which account has to be credited, the golden rules of accounting are used. This is also accomplished using the accounting equation: Equity = Assets Liabilities. The accounting equation serves as an error detection tool. If at any point the sum of debits for all accounts does not equal the corresponding sum of credits for all accounts, an error has occurred. It follows that the sum of debits and the sum of the credits must be equal in value. Double-entry bookkeeping is not a guarantee that no errors have been made for example, the wrong ledger account may have been debited or credited, or the entries completely reversed.

Debits and credits

6

Double-entry bookkeeping is governed by the accounting equation. If revenue equals expenses, the following (basic) equation must be true: Assets = liabilities + equity For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are made by debits and credits to the accounts. Note that the usage of these terms in accounting is not identical to their everyday usage. Whether one uses a debit or credit to increase or decrease an account depends on the normal balance of the account. Assets, Expenses, and Drawings accounts (on the left side of the equation) have a normal balance of debit. Liability, Revenue, and Capital accounts (on the right side of the equation) have a normal balance of credit. On a general ledger, debits are recorded on the left side and credits on the right side for each account. Since the accounts must always balance, for each transaction there will be a debit made to one or several accounts and a credit made to one or several accounts. The sum of all debits made in each day's transactions must equal the sum of all credits in those transactions. After a series of transactions, therefore, the sum of all the accounts with a debit balance will equal the sum of all the accounts with a credit balance. Debits and credits are numbers recorded as follows:

Debits are recorded on the left side of a T account in a ledger. Debits increase balances in asset accounts and expense accounts and decrease balances in liability accounts, revenue accounts, and capital accounts. Credits are recorded on the right side of a T account in a ledger. Credits increase balances in liability accounts, revenue accounts, and capital accounts, and decrease balances in asset accounts and expense accounts. Debit accounts are asset and expense accounts that usually have debit balances, i.e. the total debits usually exceeds the total credits in each debit account. Credit accounts are revenue (income, gains) accounts and liability accounts that usually have credit balances. Debit Asset Liability Credit

Increase Decrease Decrease Increase

7

Income (revenue) Decrease Increase Expense Capital Double entry example In this example the following will be used: Books of prime entry (Books of original entry)

Increase Decrease Decrease Increase

Sales Invoice Daybook (records customer invoices) Bank Receipts Daybook (records customer & non customer receipts) Cash book Return inwards day book Return outwards day book Purchase Invoice Daybook (records supplier invoices) Bank Payments Daybook (records supplier & non supplier payments)

The books of prime entry are where transactions are first recorded. They are not part of the double-entry system, but may be expanded by the computer as a debit to one account and a credit to another account. For example, a cash receipts transaction may cause a debit (increase) to a cash account and a credit (decrease) to an accounts receivable account. Ledger Cards

Customer Ledger Cards Supplier Ledger Cards General Ledger (Nominal Ledger) Bank Account Ledger Trade Creditors Ledger Trade Debtors Ledger
8

Purchase invoice daybook Purchase Invoice Daybook Date Supplier Name Reference Amount Electricity Widgets 10 July 2006 Electricity Company PI1 1000 1000 12 July 2006 Widget Company PI2 1600 1600 ------------------Total 2600 1000 1600 ==== ==== ==== Credit Debit Debit Trade Electricity Widgets control a/c a/c a/c Each individual line is posted as follows:

The amount value is posted as a credit to the individual supplier's ledger a/c The analysis amount is posted as a debit to the relevant general ledger a/c

From example above:

Line 1 Amount value 1000 is posted as a credit to the Supplier's ledger a/c ELE01-Electricity Company Line 2 Amount value 1600 is posted as a credit to the Supplier's ledger a/c WID01-Widget Company

The totals of each column are posted as follows:

Amount total value 2600 posted as a credit to the Trade creditors control a/c Electricity total value 1000 posted as a debit to the Electricity General Ledger a/c Widget total value 1600 posted as a debit to the Widgets General Ledger a/c

Double-entry has been observed because Dr = 2600 and Cr = 2600. Bank payments daybook The payments book is not part of the double-entry system. Bank Payments Daybook
9

Date Supplier Name Reference Amount Suppliers Wages 17 July 2006 Electricity Company BP701 1000 1000 19 July 2006 Widget Company BP702 900 900 28 July 2006 Owner's Wages BP703 400 400 ------- ------------Total 2300 1900 400 ==== ==== ==== Credit Debit Debit Bank Trade Wages Account Creditors control a/c control a/c Keys: PI = Purchase Invoice, BP = Bank Payment Each individual line is posted as follows:

The amount value is posted as a debit to the individual supplier's ledger a/c. The analysis amount is posted as a credit to the relevant general ledger a/c.

From example above:

Line 1 Amount value 1000 is posted as a debit to the Supplier's ledger a/c ELE01-Electricity Company. Line 2 Amount value 900 is posted as a debit to the Supplier's ledger a/c WID01-Widget Company.

The totals of each column are posted as follows:

Amount total value 2300 posted as a credit to the Bank Account. Trade Creditors total value 1900 posted as a debit to the Trade creditors control a/c. Other total value 400 posted as a debit to the Wages control a/c.

Double-entry has been observed because Dr = 2300 and Cr = 2300. The daybooks are the key documents (books) to the double entry system. From these daybooks we create the ledger accounts. Each transaction will be recorded in at least two ledger accounts.

10

Supplier ledger cards Supplier Ledger Cards A/c Code: ELE01 Electricity Company Date Details Reference Amount Date Details Bank 17 July 10 July Payments BP701 1000 Invoice 2006 2006 Daybook 31 July Balance c/d 0 2006 ------1000 ==== 1 August Balance 2006 b/d A/c Code: WID01 Widget Company Date Details Reference Amount Date Details Bank 19 July 12 July Payments BP702 900 Invoice 2006 2006 Daybook 31 July Balance c/d 700 2006 ------1600 ==== 1 August Balance 2006 b/d [edit] Sales/customers [edit] Sales daybook

Reference Amount PI1 1000

------1000 ==== 0 Reference Amount PI2 1600

------1600 ==== 700

11

Sales Invoice Daybook Date Customer Name Reference Amount Parts Service 2 July 2006 JJ Manufacturing SI1 2500 2500 29 July 2006 JJ Manufacturing SI2 3200 3200 ------------- ------Total 5700 2500 3200 ==== ==== ==== Debit Credit Credit Trade Sales Sales debtors Parts Service control a/c a/c a/c Each individual line is posted as follows:

The amount value is posted as a debit to the individual customer's ledger a/c. The analysis amount is posted as a credit to the relevant general ledger a/c.

From example above:

Line 1 Amount value 2500 is posted as a debit to the Customer's ledger a/c JJM01-JJ Manufacturing. Line 2 Amount value 3200 is posted as a debit to the Customer's ledger a/c JJM01-JJ Manufacturing.

The totals of each column are posted as follows:

Amount total value 5700 posted as a debit to the Trade debtors control a/c. Sales-parts total value 2500 posted as a credit to the Sales parts a/c. Sales-service total value 3200 posted as a credit to the Sales service a/c.

Double-entry has been observed because Dr = 5700 and Cr = 5700. Customer ledger cards

12

Customer Ledger cards are not part of the Double-entry system. They are for memorandum purposes only. They allow you to know the total amount an individual customer owes you. CUSTOMER LEDGER CARDS A/c Code: JJM01 JJ Manufacturing Date Details Reference Amount Date Sales 20 2 July invoice SI1 2500 July 2006 daybook 2006 Sales 31 29 July invoice SI2 3200 July 2006 daybook 2006 ------5700 ==== 1 August Balance 3200 2006 b/d General (nominal) ledger GENERAL (NOMINAL) LEDGER Sales parts Date Details Reference Amount Date 31 July Balance 2006 c/d 2500 ------2500 ==== 1 August Balance 2006 Sales service Date Details 31 May Balance 2006 Reference Amount Date c/d 3200 Details Sales 29 July invoice 2006 daybook b/d

Details Bank receipts daybook balance c/d

Reference Amount BR1 2500 3200 ------5700 ====

Details Sales 2 July invoice 2006 daybook

Reference Amount SDB 2500 ------2500 ==== 2500

Reference Amount SDB 3200

13

------3200 ==== 1 June Balance 2010 Electricity Date Details Reference Amount Date Details 10 May Electricity 30 May PDB 1000 Balance 2010 Co. 2010 ------1000 ==== 1 June Balance b/d 1000 2010 Widgets Date Details Reference Amount Date Details 12 May 31 May Widgets Co. Pdb 1600 Balance 2010 2010 ------1600 ==== 1 August Balance b/d 1600 2010 Other a/c Date Details Reference Amount Date Details 28 July Owner's 31 July BPDB 400 Balance 2006 Wages 2006 ------400 ==== 1 August Balance b/d 400 2006 Bank Control A/c Date Details Reference Amount Date Details 31 July Bank BRDB 2500 31 July Bank b/d

------3200 ==== 3200

Reference Amount c/d 1000 ------1000 ====

Reference Amount c/d 1600 ------1600 ====

Reference Amount c/d 400 ------400 ====

Reference Amount BPDB 2300

14

2006

receipts daybook

2006

payments daybook c/d 200 ------2500 ====

31 July Balance 2006 ------2500 ==== 1 August Balance b/d 200 2006 Trade Debtors Control A/c Date Details Reference Amount Date 1 July Balance 2006 Sales 31 July Invoice 2006 Daybook b/d SDB 0 5700 ------5700 ==== 1 August Balance b/d 3200 2006 Trade Creditors Control A/c Date Details Reference Amount Date Details Bank 31 July 1 July Payments BPDB 1900 Balance 2006 2006 Daybook 31 July 31 July Purchase Balance c/d 700 2006 2006 Daybook ------2600 ==== 1 Balance August

Details Bank 31 July receipts 2006 daybook 31 July Balance 2006

Reference Amount BRDB c/d 2500 3200 ------5700 ====

Reference Amount b/d PDB 0 2600 ------2600 ==== b/d 700

15

The customers ledger cards show the breakdown of how the trade debtors control a/c is made up. The trade debtors control a/c is the total of outstanding debtors and the customer ledger cards shows the amount due for each individual customer. The total of each individual customer account added together should equal the total in the trade debtors control a/c. The supplier ledger cards show the breakdown of how the trade creditors control a/c is made up. The trade creditors control a/c is the total of outstanding creditors and the suppliers ledger cards shows the amount due for each individual supplier. The total of each individual supplier account added together should equal the total in the trade creditors control a/c. Each Bank a/c shows all the money in and out through a bank. If you have more than one bank account for your company you will have to maintain separate bank account ledgers in order to complete bank reconciliation statements and be able to see how much is left in each account. [edit] Bank account Bank A/c Date Details Bank 20 July Receipts 2006 Day Book Reference Amount Date 17 BR1 2500 July 2006 19 July 2006 28 July 2006 31 July 2006 ------2500 ==== b/d 200 Details Bank Payments Daybook Bank Payments Daybook Bank Payments Daybook Balance Reference Amount BP701 BP702 BP703 c/d 1000 900 400 200 ------2500 ====

1 Balance August

16

Unadjusted trial balance Trial balance as at 31 July 2006 A/c description Debit Credit Sales-parts 2500 Sales-service 3200 Widgets 1600 Electricity 1000 Other 400 Bank 200 Trade Debtors Control A/c 3200 Trade Creditors Control A/c 700 ------- ------6400 6400 ===== ===== Both sides must have the same overall total Debits = Credits. The individual customer accounts are not to be listed in the trial balance, as the Trade debtors control a/c is the summary of each individual customer a/c. The individual supplier accounts are not to be listed in the trial balance, as the Trade creditors control a/c is the summary of each individual supplier a/c. Important note: this example is designed to show double entry. There are methods of creating a trial balance that significantly reduce the time it takes to record entries in the general ledger and trial balance. [edit] Profit-and-loss statement and balance sheet Profit and loss statement for the month ending 31 July 2006 Dr x Sales x Sales-parts 2500 x Sales-service 3200 x ------x 5700
17

x Widgets x x Gross Profit x Less expenses x Electricity x Other x x x x Net Profit x Balance sheet as at 31 July 2006 x Current Assets x Bank A/c x Trade Debtors x x x Current Liabilities x Trade Creditors x x x x Net Current Assets x x Capital & Reserves x Revenue Reserves a/c x x x

1600 ------4100 1000 400 ------1400 ------2700 ====

Dr 200 3200 ------3400 700 ------700 ------2700 ==== 2700 ------2700 ====

Daybooks
18

A daybook is a descriptive and chronological (diary-like) record of day-today financial transactions also called a book of original entry. The daybook's details must be entered formally into journals to enable posting to ledgers. Daybooks include:

Sales daybook, for recording all the sales invoices. Sales credits daybook, for recording all the sales credit notes. Purchases daybook, for recording all the purchase invoices. Purchases credits daybook, for recording all the purchase credit notes. Cash daybook, usually known as the cash book, for recording all money received as well as money paid out. It may be split into two daybooks: receipts daybook for money received in, and payments daybook for money paid out.

Petty Cash daybook, for recording small value purchases paid for by cash General Journal daybook, for recording journals

Petty cash book A petty cash book is a record of small value purchases usually controlled by imprest system. Items such as coffee, tea, birthday cards for employees, stationery for office working, a few dollars if you're short on postage, are listed down in the petty cash book. Journals Journals are recorded in the general journal daybook. A journal is a formal and chronological record of financial transactions before their values are accounted for in the general ledger as debits and credits. A company can maintain one journal for
19

all transactions, or keep several journals based on similar activity (i.e. sales, cash receipts, revenue, etc.) making transactions easier to summarize and reference later. For every debit journal entry recorded there must be an equivalent credit journal entry to maintain a balanced accounting equation.[3] Ledgers A ledger is a record of accounts. These accounts are recorded separately showing their beginning/ending balance. A journal lists financial transactions in chronological order without showing their balance but showing how much is going to be charged in each account. A ledger takes each financial transactions from the journal and records them into the corresponding account for every transaction listed. The ledger also sums up the total of every account which is transferred into the balance sheet and income statement. There are 3 different kinds of ledgers that deal with book-keeping. Ledgers include:

Sales ledger, which deals mostly with the accounts receivable account. This ledger consists of the financial transactions made by customers to the business. Purchase ledger is a ledger that goes hand and hand with the Accounts Payable account. This is the purchasing transaction a company does.

General

ledger

representing

the

original

main

accounts: assets, liabilities, equity, income, and expenses Abbreviations used in bookkeeping

A/C Account Acc Account A/R Accounts receivable

20

A/P Accounts payable B/S Balance sheet c/d Carried down b/d Brought down c/f Carried forward b/f Brought forward Dr Debit record Cr Credit record G/L General ledger; (or N/L nominal ledger) P&L Profit and loss; (or I/S income statement) P/R - Payroll PP&E Property, plant and equipment TB Trial Balance GST Goods and services tax VAT Value added tax CST Central sale tax TDS Tax deducted at source AMT Alternate minimum tax EBITDA Earnings before interest, taxes, depreciation and amortisation
21

EBDTA Earnings before depreciation, taxes and amortisation EBT Earnings before taxes EAT Earnings after tax PAT Profit after tax PBT Profit before tax Depr Depreciation Dep Depreciation

Financial accountancy
Financial decision accountancy (or financial makers, such accounting) is the field of accountancy concerned with the preparation of financial statements for as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.[1] The fundamental need for financial accounting is to reduceprincipalagent problem by measuring and monitoring agents' performance and reporting the results to interested users.

Financial accountancy is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company. Management accounting provides accounting information to help managers make decisions to manage the business.

In short, financial accounting is the process of summarizing financial data taken from an organization's accounting records and publishing in the form

22

of annual (or more frequent) reports for the benefit of people outside the organization.

Basic accounting concepts

Financial accountants produce financial statements based on generally accepted accounting principles of a respective country. In particular cases financial statements must be prepared according to the International Financial Reporting Standards. Financial accounting serves the following purposes:

producing general purpose financial statements producing information used by the management of a business entity for decision making, planning and performance evaluation

producing financial statements for meeting regulatory requirements.

Objectives of Financial Accounting

To know the results of the business To ascertain the financial position of the business To ensure control over the assets To facilitate proper management of cash To provide requisite information

Graphic definition The accounting equation (Assets = Liabilities + Owners' Equity) and financial statements are the main topics of financial accounting.
23

The trial balance which is usually prepared using the double-entry accounting system forms the basis for preparing the financial statements. All the figures in the trial balance are rearranged to prepare a profit & loss statement and balance sheet. Accounting standards determine the format for these accounts (SSAP, FRS, IFRS). Financial statements display the income and expenditure for the company and a summary of the assets, liabilities, and shareholders' or owners' equity of the company on the date to which the accounts were prepared. Expenses and withdrawals have normal debit balances, i.e., debiting these types of accounts increases them. Liabilities, revenues, and capital have normal credit balances, i.e., crediting these increases them.

0 = Dr Assets

Cr Owners' Equity

Cr Liabilities . . . . . .

_____________________________/\____________________________ . . . / Cr Retained Earnings (profit) Cr Common Stock \ . . _________________/\_______________________________ Cr Beginning Retained Earnings \ Cr Revenue . Dr Dividends

. / Dr Expenses

\________________________/ \______________________________________________________/ increased by debits increased by credits

Crediting a credit
24

Thus -------------------------> account increases its absolute value (balance) Debiting a debit

Debiting a credit Thus -------------------------> account decreases its absolute value (balance) Crediting a debit

When the same thing is done to an account as its normal balance it increases; when the opposite is done, it will decrease. Much like signs in math: two positive numbers are added and two negative numbers are also added. It is only when there is one positive and one negative (opposites) that you will subtract.

Financial statement
A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. In British English including United Kingdom company lawa financial statement is often referred to as an account, although the term financial statement is also used, particularly by accountants. For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, are called the financial statements. They typically include four basic financial statements, accompanied by a management discussion and analysis:[1]

25

1.

Statement of Financial Position: also referred to as a balance sheet, reports on a company's assets, liabilities, and ownership equity at a given point in time. Statement of Comprehensive Income: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. A Profit & Loss statement provides information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state.

2.

3.

Statement of Changes in Equity: explains the changes of the company's equity throughout the reporting period

4.

Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements[2] and explanation of financial policies and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

financial statements by business entities

"The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions." [3] Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to an organization's financial position. Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who
26

are willing to study the information diligently." [3] Financial statements may be used by users for different purposes:

Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders. Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings. Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions. Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loanor debentures) to finance expansion and other significant expenditures. Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company. Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business. Media and the general public are also interested in financial statements for a variety of reasons.

Government financial statements

The rules for the recording, measurement and presentation of government financial statements may be different from those required for business and even for nonprofit organizations. They may use either of two accounting methods:
27

accrual accounting, or cash accounting, or a combination of the two (OCBOA). A complete set of chart of accounts is also used that is substantially different from the chart of a profit-oriented business Financial statements of not-for-profit organizations The financial statements that not-for-profit organizations such as charitable organizations and large voluntary associations publish tend to be simpler than those of for-profit corporations. Often they consist of just a balance sheet and a "statement of activities" (listing income and expenses) similar to the "Profit and Loss statement" of a for-profit. Charitable organizations in the United States are required to show their income and net assets (equity) in three categories: Unrestricted (available for general use), temporarily Restricted (to be released after the donor's time or purpose restrictions have been met), and Permanently Restricted (to be held perpetually, e.g., in an Endowment). Personal financial statements Personal financial statements may be required from persons applying for a personal loan or financial aid. Typically, a personal financial statement consists of a single form for reporting personally held assets and liabilities (debts), or personal sources of income and expenses, or both. The form to be filled out is determined by the organization supplying the loan or aid. Audit and legal implications Although laws differ from country to country, an audit of the financial statements of a public company is usually required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. Results of the audit are summarized in an audit report that either provide an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. The audit opinion on the financial statements is usually included in the annual report. There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the United, they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting
28

language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have unlimited liability. In the United States, especially in the post-Enron era there has been substantial concern about the accuracy of financial statements. Corporate officers (the chief executive officer (CEO) and chief financial officer (CFO)) are personally liable for attesting that financial statements "do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by th[e] report." Making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability. For example Bernie Ebbers (former CEO of WorldCom) was sentenced to 25 years in federal prison for allowing WorldCom's revenues to be overstated by billion over five years. Standards and regulations Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. To ensure uniformity and comparability between financial statements prepared by different companies, a set of guidelines and rules are used. Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide the basis in the preparation of financial statements, although many companies voluntarily disclose information beyond the scope of such requirements.[4] Recently there has been a push towards standardizing accounting rules made by the International Accounting Standards Board ("IASB"). IASB develops International Financial Reporting Standards that have been adopted by Australia, Canada and the European Union (for publicly quoted companies only), are under consideration in South Africa and other countries. The United States Financial Accounting Standards Board has made a commitment to converge the U.S. GAAP and IFRS over time. Inclusion in annual reports To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a "marketing brochure" of sorts. Usually the company's chief executive will

29

write a letter to shareholders, describing management's performance and the company's financial highlights. In the United States, prior to the advent of the internet, the annual report was considered the most effective way for corporations to communicate with individual shareholders. Blue chip companies went to great expense to produce and mail out attractive annual reports to every shareholder. The annual report was often prepared in the style of a coffee table book. Moving to electronic financial statements Financial statements have been created on paper for hundreds of years. The growth of the Web has seen more and more financial statements created in an electronic form which is exchangeable over the Web. Common forms of electronic financial statements are PDF and HTML. These types of electronic financial statements have their drawbacks in that it still takes a human to read the information in order to reuse the information contained in a financial statement. More recently a market driven global standard, XBRL (Extensible Business Reporting Language), which can be used for creating financial statements in a structured and computer readable format, has become more popular as a format for creating financial statements. Many regulators around the world such as the U.S. Securities and Exchange Commission have mandated XBRL for the submission of financial information. The UN/CEFACT created, with respect to Generally Accepted Accounting Principles, (GAAP), internal or external financial reporting XML messages to be used between enterprises and their partners, such as private interested parties (e.g. bank) and public collecting bodies (e.g. taxation authorities). Many regulators use such messages to collect financial and economic information.

Financial statement analysis

Financial statement analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports. Financial statement analysis consists of 1) reformulating reported financial statements, 2) analysis and adjustments of measurement errors, and 3) financial
30

ratio analysis on the basis of reformulated and adjusted financial statements. The two first steps are often dropped in practice, meaning that financial ratios are just calculated on the basis of the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation. 1) Financial statement analysis typically starts with reformulating the reported financial information. In relation to the income statement, one common reformulation is to divide reported items into recurring or normal items and nonrecurring or special items. In this way, earnings could be separated in to normal or core earnings and transitory earnings. The idea is that normal earnings are more permanent and hence more relevant for prediction and valuation. Normal earnings are also separated into net operational profit after taxes (NOPAT) and net financial costs. The balance sheet is grouped, for example, in net operating assets (NOA), net financial debt and equity. 2) Analysis and adjustment of measurement errors question the quality of the reported accounting numbers. The reported numbers can for example be a bad or noisy representation of invested capital, for example in terms of NOA, which means that the return on net operating assets (RNOA) will be a noisy measure of the underlying profitability (the internal rate of return, IRR). Expensing of R&D is an example when such investment expenditures are expected to yield future economic benefits, suggesting that R&D creates assets which should have been capitalized in the balance sheet. An example of an adjustment for measurement errors is when the analyst removes the R&D expenses from the income statement and put them in the balance sheet. The R&D expenditures are then replaced by amortization of the R&D capital in the balance sheet. Another example is to adjust the reported numbers when the analyst suspects earnings management.
31

3) Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability: 3.1) Analysis of risk typically aims at detecting the underlying credit risk of the firm. Risk analysis consists of liquidity and solvency analysis. Liquidity analysis aims at analyzing whether the firm has enough liquidity to meet its obligations when they should be paid. A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful. Solvency analysis aims at analyzing whether the firm is financed so that it is able to recover from a loss or a period of losses. A usual technique to analyze insolvency risk is to focus on ratios such as the equity in percentage of total capital and other ratios of capital structure. Based on the risk analysis the analyzed firm could be rated, i.e. given a grade on the riskiness, a process called synthetic rating. Ratios of risk such as the current ratio, the interest coverage and the equity percentage have no theoretical benchmarks. It is therefore common to compare them with the industry average over time. If a firm has a higher equity ratio than the industry, this is considered less risky than if it is above the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk. 3.2) Analysis of profitability refers to the analysis of return on capital, for example return on equity, ROE, defined as earnings divided by average equity. Return on equity, ROE, could be decomposed: ROE = RNOA + (RNOA - NFIR) * NFD/E, where RNOA is return on net operating assets, NFIR is the net financial interest rate, NFD is net financial debt and E is equity. In this way, the sources of ROE could be clarified.

32

Unlike other ratios, return on capital has a theoretical benchmark, the cost of capital - also called the required return on capital. For example, the return on equity, ROE, could be compared with the required return on equity, kE, as estimated, for example, by the capital asset pricing model. If ROE < kE (or RNOA > WACC, where WACC is the weighted average cost of capital), then the firm is economically profitable at any given time over the period of ratio analysis. The firm creates values for its owners. Insights from financial statement analysis could be used to make forecasts and to evaluate credit risk and value the firm's equity. For example, if financial statement analysis detects increasing superior performance ROE - kE > 0 over the period of financial statement analysis, then this trend could be extrapolated into the future. But as economic theory suggests, sooner or later the competitive forces will work and ROE will be driven toward kE. Only if the firm has a sustainable competitive advantage, ROE - kE > 0 in "steady state". CORPORATE FINANCING: Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value.
[1]

Although it is in principle different from managerial finance which studies the

financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short
33

term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers). The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms corporate finance and corporate financier may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses

Capital investment decisions

Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision. The investment decision Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting.[3] Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.
34

Project valuation In general, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams Theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See financial modeling. The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate often termed, the project "hurdle rate is critical to making an appropriate decision. The hurdle rate is the minimum acceptable return on an investmenti.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix.
[6]

Managers

use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.) In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR,Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include Residual
35

Income

Valuation, MVA / EVA (Joel

Stern, Stern

Stewart

&

Co)

and APV(Stewart Myers). Valuing flexibility In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach, Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers).[8][9] Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.[10] Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the flexible and staged nature of the investment is modeled, and hence "all" potential payoffs are considered. See further under Real options valuation. The difference between the two valuations is the "value of flexibility" inherent in the project. The two most common tools are Decision Tree Analysis (DTA)[11][12] and Real options valuation (ROV); they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" each scenario must be modeled
36

separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this knowledge of the events that could follow, and assuming rational decision making, management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory Choice under uncertainty.

ROV is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an appropriate valuation technique is then employed usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) See also Option pricing approaches under Business valuation.

Quantifying uncertainty
37

Given the uncertainty inherent in project forecasting and valuation,[12][14] analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": NPV / Factor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface",[15] (or even a "value-space",) where NPV is then a function of several variables. See also Stress testing. Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (product,
exchange,

commodity prices, etc...) as well as for company-specific

factors (unit costs, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario the NPV for the project is then the probability-weighted average of the various scenarios. See First Chicago Method. A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of
38

variables

and

their

realizations." [16] is

to

construct stochastic

or probabilistic financial models as opposed to the traditional static and deterministic models as above.[14] For this purpose, the most common method is to use Monte Carlo simulation to analyze the projects NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or trials, "covering all conceivable real world contingencies in proportion to their likelihood;" [18] see Monte Carlo Simulation versus What If Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment as well as its volatility and other sensitivities is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value). Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly incorporating this correlation so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV)
39

will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs. The financing decision

Domestic credit to private sector in achieving the goals of corporate finance requires that any corporate investment be financed appropriately. [19] The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt andequity (and hybrid- or convertible securities). As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term financial management decisions). There are two interrelated considerations here:

Management must identify the "optimal mix" of financingthe capital structures those results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.) Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of
40

success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity (see CAPM and APT) is also typically higher than the cost of debt which is, additionally, a deductible expense - and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.[21]

Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap entails matching the assets and liabilities respectively according to maturity pattern ("Cash flow") or duration ("immunization"); managing this relationship in the short-term is a major function of working capital management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate risk.

Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their decisions. However economists have developed a set of alternative theories about financing decisions. One of the main alternative theories of how firms make their financing decisions is the suggests that firms avoid external
Pecking

(Stewart Myers), which they have internal

financing while

financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance
41

investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One of the more recent innovations in this are from a theoretical point of view is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity. The dividend decision Whether to issue dividends, and what amount, is calculated mainly on the basis of the company's inappropriate profit and its earnings prospects for the coming year. The amount is also often calculated based on expected free cash flows i.e. cash remaining after all business expenses, and capital investment needs have been met. If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then finance theory suggests management must return excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider investment flexibility / potential payoffs and decide to retain cash flows; see above and Real options. Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends"
42

from stock rather than in cash; see Corporate action. Today, it is generally accepted that dividend policy is value neutral i.e. the value of the firm would be the same, whether it issued cash dividends or repurchased its stock (see Modigliani-Miller theorem). Working capital management Decisions relating to working capital and short term financing are referred to as working capital management; These involve managing the relationship between a firm's short-term assets and its
short.

In general this is as follows: As above, the

goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA). Decision criteria Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term, decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although
43

some constraints such as those imposed by loan covenants may be more relevant here).

Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).

The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.) In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

Management of working capital

44

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets(generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and hence increases cash flow. Note that "inventory" is usually the realm of operations management: given the potential impact on cash flow, and on the balance sheet in general, finance typically "gets involved in an oversight or policing way". See Supply chain management; Just In Time (JIT); Economic production order quantity (EOQ); Dynamic Lot lot size model; Economic quantity(EPQ); Economic Scheduling

Problem; Inventory control problem; Safety stock.

Debtors management. There are two inter-related roles here: Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances. Implement appropriate Credit scoring policies and techniques such that the risk of default on any new business is acceptable given these criteria.

Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by

45

the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring". Relationship with other areas in finance Investment banking Use of the term corporate finance varies considerably across the world. In the United States it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a companys finances and capital. In the United Kingdom and Commonwealth countries, the terms corporate finance and corporate financier tend to be associated with investment banking i.e. with transactions in which capital is raised for the corporation.[26] These may include

Raising seed, start-up, development or expansion capital Mergers, demergers, acquisitions or the sale of private companies Mergers, demergers and takeovers of public companies, including public-toprivate deals

Management buy-out, buy-in or similar of companies, divisions or subsidiaries typically backed by private equity

Equity issues by companies, including the flotation of companies on a recognized stock exchange in order to raise capital for development and/or to restructure ownership

Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses

Financing joint ventures, project finance, infrastructure finance, publicprivate partnerships and privatizations
46

Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above.

Raising debt and restructuring debt, especially when linked to the types of transactions listed above

Financial risk management Risk management is the process of measuring risk and then developing and implementing strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk). It will also play an important role in short term cash-and treasury management; see above. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for small firms to have a formal risk management function, many still apply risk management informally. See also Enterprise risk management. The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives; see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because company specific, "over the counter" (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or exchanges are often preferred. These standard derivative instruments include options, futures contracts, forward contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related

47

transactions

will

attract

their

own accounting treatment:

see Hedge

accounting, Mark-to-market accounting, FASB 133, IAS 39. This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. There is a fundamental debate [28] relating to "Risk Management" and shareholder value. Per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firmspecific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress. A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of bankruptcy in that market. See Fisher separation theorem.

Personal and public finance Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations have broad application to entities other than corporations, for example, to partnerships, sole proprietorships, not-forprofit organizations, governments, mutual funds, and personal wealth management. But in other cases their application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money
48

much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from personal and public finance. Alternate Approaches A standard assumption in corporate finance is that shareholders are the residual claimants and that the primary goal of executives should be to maximize shareholder value. Recently, however, legal scholars (e.g. Lynn Stout [29]) have questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous assumption.

Cash flow statement

In financial accounting, a cash flow statement, also known as statement of cash flows,[1] is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the Standard that deals with cash flow statements. People and groups interested in cash flow statements include:

Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
49

Potential lenders or creditors, who want a clear picture of a company's ability to repay

Potential investors, who need to judge whether the company is financially sound

Potential employees or contractors, who need to know whether the company will be able to afford compensation

Shareholders of the business.

Purpose
Statement of Cash Flow - Simple Example for the period 01/01/2011 to 12/31/2012 Cash flow from operations Cash flow from investing Cash flow from financing Net cash flow $4,000 ($1,000) ($2,000) $1,000

Parentheses indicate negative values The cash flow statement was previously known as the flow of Cash statement. The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only
50

inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are usually reported in footnotes. The cash flow statement is intended to
1.

provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances

2. provide additional information for evaluating changes in assets, liabilities and equity
3.

improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods

4. indicate the amount, timing and probability of future cash flows The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets. History and variations Cash basis financial statements were very common before accrual basis financial statements. The "flow of funds" statements of the past were cash flow statements. In 1863, the Dowlais Iron Company had recovered from a business slump, but had no cash to invest for a new blast furnace, despite having made a profit. To explain why there were no funds to invest, the manager made a new financial statement
51

that was called a comparison balance sheet, which showed that the company was holding too much inventory. This new financial statement was the genesis of Cash Flow Statement that is used today. In the United States in 1971, the Financial Accounting Standards Board (FASB) defined rules that made it mandatory under Generally Accepted Accounting Principles (US GAAP) to report sources and uses of funds, but the definition of "funds" was not clear."Net working capital" might be cash or might be the difference between current assets and current liabilities. From the late 1970 to the mid-1980s, the FASB discussed the usefulness of predicting future cash flows. [7] In 1987, FASB Statement No. 95 (FAS 95) mandated that firms provide cash flow statements.[8] In 1992, the International Accounting Standards Board issued International Accounting Standard 7 (IAS 7), Cash Flow Statement, which became effective in 1994, mandating that firms provide cash flow statements.[9] US GAAP and IAS 7 rules for cash flow statements are similar, but some of the differences are:

IAS 7 requires that the cash flow statement include changes in both cash and cash equivalents. US GAAP permits using cash alone or cash and cash equivalents.[5] IAS 7 permits bank borrowings (overdraft) in certain countries to be included in cash equivalents rather than being considered a part of financing activities.[10]

IAS 7 allows interest paid to be included in operating activities or financing activities. US GAAP requires that interest paid be included in operating activities.[11]

52

US GAAP (FAS 95) requires that when the direct method is used to present the operating activities of the cash flow statement, a supplemental schedule must also present a cash flow statement using the indirect method. The IASC strongly recommends the direct method but allows either method. The IASC considers the indirect method less clear to users of financial statements. Cash flow statements are most commonly prepared using the indirect method, which is not especially useful in projecting future cash flows.

Cash flow activities The cash flow statement is partitioned into three segments, namely: 1) cash flow resulting from operating activities; 2) cash flow resulting from investing activities; and 3) cash flow resulting from financing activities. The money coming into the business is called cash inflow, and money going out from the business is called cash outflow.

Operating activities Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product. Under IAS 7, operating cash flows include:[11]

Receipts from the sale of goods or services

53

Receipts for the sale of loans, debt or equity instruments in a trading portfolio

Interest received on loans Payments to suppliers for goods and services. Payments to employees or on behalf of employees Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)

buying Merchandise

Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:

Depreciation (loss of tangible asset value over time) Deferred tax Amortization (loss of intangible asset value over time) Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement)

Investing activities Examples of investing activities are

Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
54

Loans made to suppliers or received from customers Payments related to mergers and acquisitions. Dividends Received.

Financing activities Financing activities include the inflow of cash from investors such

as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement. Under IAS 7,

Proceeds from issuing short-term or long-term debt Payments of dividends Payments for repurchase of company shares Repayment of debt principal, including capital leases For non-profit organizations, receipts of donor-restricted cash that is limited to long-term purposes

Items under the financing activities section include:

Dividends paid Sale or repurchase of the company's stock Net borrowings Payment of dividend tax
55

Disclosure of non-cash activities Under IAS 7, non-cash investing and financing activities are disclosed in footnotes to the financial statements. Under US General Accepted Accounting Principles (GAAP), non-cash activities may be disclosed in a footnote or within the cash flow statement itself. Non-cash financing activities may include,

Leasing to purchase an asset Converting debt to equity Exchanging non-cash assets or liabilities for other non-cash assets or liabilities

Issuing shares in exchange for assets

Preparation methods The direct method of preparing a cash flow statement results in a more easily understood report. The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method. Direct method The direct method for creating a cash flow statement reports major classes of gross cash receipts and payments. Under IAS 7, dividends received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities. Generally Accepted Accounting Principles (GAAP) vary from International Financial Reporting Standards in that
56

under GAAP rules, dividends received from a company's investing activities is reported as an "operating activity," not an "investing activity." Sample cash flow statement using the direct method Cash flows from (used in) operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations (sum) Interest paid Income taxes paid Net cash flows from operating activities 9,500 (2,000) 7,500 (2,000) (3,000) 2,500

Cash flows from (used in) investing activities Proceeds from the sale of equipment Dividends received 7,500 3,000

57

Net cash flows from investing activities Cash flows from (used in) financing activities Dividends paid Net cash flows used in financing activities . Net increase in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year (2,500)

10,500

(2,500)

10,500

1,000

$11,500

Indirect method The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.[15]
58

Rules (operating activities) To from Find Operating Cash Flows Activities

using the Balance Sheet and Net Income For Increases in Current Assets (Non-Cash) Current Liabilities For All Non-Cash... *Expenses (Decreases in Fixed Assets) Increase Net Inc Adj Decrease Increase

*Non-cash expenses must be added back to NI. Such expenses may be represented on the balance sheet as decreases in long term asset accounts. Thus decreases in fixed assets increase NI. The following rules can be followed to calculate Cash Flows from Operating Activities when given only a two year comparative balance sheet and the Net Income figure. Cash Flows from Operating Activities can be found by adjusting Net Income relative to the change in beginning and ending balances of Current Assets, Current Liabilities, and sometimes Long Term Assets. When comparing the change in long term assets over a year, the accountant must be certain that these changes were caused entirely by their devaluation rather than purchases or sales (i.e. they must be operating items not providing or using cash) or if they are non operating items.

Decrease in non-cash current assets are added to net income Increase in non-cash current asset are subtracted from net income
59

Increase in current liabilities are added to net income Decrease in current liabilities are subtracted from net income Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period)

Revenues with no cash inflows are subtracted from net income Non operating losses are added back to net income Non operating gains are subtracted from net income

The intricacies of this procedure might be seen as,

For example, consider a company that has a net income of $100 this year, and its A/R increased by $25 since the beginning of the year. If the balances of all other current assets, long term assets and current liabilities did not change over the year, the cash flows could be determined by the rules above as $100 $25 = Cash Flows from Operating Activities = $75. The logic is that, if the company made $100 that year (net income), and they are using the accrual accounting system (not cash based) then any income they generated that year which has not yet been paid for in cash should be subtracted from the net income figure in order to find cash flows from operating activities. And the increase in A/R meant that $25 of sales occurred on credit and has not yet been paid for in cash. In the case of finding Cash Flows when there is a change in a fixed asset account, say the Buildings and Equipment account decreases, the change is added back to Net Income. The reasoning behind this is that because Net Income is calculated by,
60

Net Income = Rev - Cogs - Depreciation Exp - Other Exp then the Net Income figure will be decreased by the building's depreciation that year. This depreciation is not associated with an exchange of cash; therefore the depreciation is added back into net income to remove the non-cash activity. Rules (financing activities) Finding the Cash Flows from Financing Activities is much more intuitive and needs little explanation. Generally, the things to account for are financing activities:

Include as outflows, reductions of long term notes payable (as would represent the cash repayment of debt on the balance sheet) Or as inflows, the issuance of new notes payable Include as outflows, all dividends paid by the entity to outside parties Or as inflows, dividend payments received from outside parties Include as outflows, the purchase of notes stocks or bonds Or as inflows, the receipt of payments on such financing vehicles.[citation needed]

In the case of more advanced accounting situations, such as when dealing with subsidiaries, the accountant must

Exclude intra-company dividend payments. Exclude intra-company bond interest.[citation needed]

A traditional equation for this might look something like,

61

Example: cash flow of XYZ: XYZ co. Ltd. Cash Flow Statement

(all numbers in millions of Rs.) Period ending Net income 03/31/2010 03/31/2009 03/31/2008 21,538 24,589 17,046

Operating activities, cash flows provided by or used in: Depreciation and amortization Adjustments to net income Decrease (increase) in accounts receivable Increase (decrease) in liabilities (A/P, taxes payable) Decrease (increase) in inventories Increase activities Net cash flow from operating activities (decrease) in other operating 2,790 4,617 12,503 2,592 621 17,236 2,747 2,910 --

131,622

19,822

37,856

--

--

--

(173,057) (33,061)

(62,963)

13

31,799

(2,404)

Investing activities, cash flows provided by or used in:

62

Capital expenditures Investments Other cash flows from investing activities Net cash flows from investing activities

(4,035)

(3,724)

(3,011) (75,649) (571) (79,231)

(201,777) (71,710) 1,606 17,009

(204,206) (58,425)

Financing activities, cash flows provided by or used in: Dividends paid Sale (repurchase) of stock Increase (decrease) in debt Other cash flows from financing activities Net cash flows from financing activities Effect of exchange rate changes Net increase (decrease) in cash and cash equivalents (9,826) (5,327) 101,122 120,461 206,430 645 (9,188) (12,090) 26,651 27,910 33,283 (1,840) (8,375) 133 21,204 70,349 83,311 731

2,882

4,817

2,407

63

Income statement
Income statement (also referred to as profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of taxes. The purpose of the income various assets) statement is and to

show managers and investors whether the company made or lost money during the period being reported. The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time. Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments. This statement is commonly referred to as the statement of activities. Revenues and expenses are further categorized in the statement of activities by the donor restrictions on the funds received and expended. The income statement can be prepared in one of two methods. [2] The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement
64

(as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Usefulness and limitations of income statement

Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through report of the income and expenses. However, information of an income statement has several limitations:

Items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty). Some numbers depend on accounting methods used ( e.g. using FIFO or LIFO accounting to measure inventory level).

Some

numbers

depend

on

judgments

and

estimates

(e.g. depreciation expense depends on estimated useful life and salvage value).

- INCOME STATEMENT GREENHARBOR LLC For the year ended DECEMBER 31 2012 Debit Revenues GROSS REVENUES (including INTEREST income) 296,397 Credit

65

-------Expenses: ADVERTISING BANK & CREDIT CARD FEES BOOKKEEPING SUBCONTRACTORS ENTERTAINMENT INSURANCE LICENSES RENT MATERIALS TELEPHONE UTILITIES TOTAL EXPENSES -------NET INCOME 100,885 750 1,575 320 632 13,000 74,400 1,000 1,491 -------(195,512) 2,350 88,000 5,550 6,300 144

LEGAL & PROFESSIONAL SERVICES PRINTING, POSTAGE & STATIONERY

Guidelines for statements of comprehensive income and income statements of business entities are formulated by the International Accounting Standards Board and numerous country-specific organizations, for example the FASB in the U.S... Names and usage of different accounts in the income statement depend on the type of organization, industry practices and the requirements of different jurisdictions.
66

If applicable to the business, summary values for the following items should be included in the income statement:[3] Operating section

Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.[4]

Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations.

Cost of Goods Sold (COGS) / Cost of Sales - represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandizing). It includes material costs, direct labour, and overhead costs (as in absorption costing), and excludes operating costs (period costs) such as selling, administrative, advertising or R&D, etc.

Selling, General and Administrative expenses (SG&A or SGA) consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labour.

Selling expenses - represent expenses needed to sell products (e.g. salaries of sales people, commissions and travel expenses,
67

advertising, freight, shipping, depreciation of sales store buildings and equipment, etc.).

General and Administrative (G&A) expenses - represent expenses to manage the business (salaries of officers / executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc.).

Depreciation / Amortization - the charge with respect to fixed assets / intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.

Research & Development (R&D) expenses - represent expenses included in research and development.

Expenses recognized in the income statement should be analyzed either by nature (raw materials, transport costs, staffing costs, depreciation, employee benefit etc.) or by function (cost of sales, selling, administrative, etc.). (IAS 1.99) If an entity categories by function, then additional information on the nature of expenses, at least, depreciation, amortization and employee benefits expense must be disclosed. (IAS 1.104) The major exclusive of costs of goods sold, are classified as operating expenses. These represent the resources expended, except for inventory purchases, in generating the revenue for the period. Expenses often are divided into two broad sub classicifications selling expenses and administrative expenses.[4] Non-operating section

68

Other revenues or gains - revenues and gains from other than primary business activities (e.g. rent, income from patents). It also includes unusual gains that are either unusual or infrequent, but not both (e.g. gain from sale of securities or gain from disposal of fixed assets)

Other expenses or losses - expenses or losses not related to primary business operations, (e.g. foreign exchange loss).

Finance costs - costs of borrowing from various creditors (e.g. interest expenses, bank charges).

Income tax expense - sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/ tax payable) and the amount of deferred tax liabilities (or assets).

Irregular items They are reported separately because this way users can better predict future cash flows - irregular items most likely will not recur. These are reported net of taxes.

Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.

Cumulative effect of changes in accounting policies (principles) is the difference between the book value of the affected assets (or liabilities) under the old policy (principle) and what the book value would have been if the new principle had been applied in the prior periods. For example, valuation of inventories using LIFO instead of weighted average method. The changes should
69

be applied retrospectively and shown as adjustments to the beginning balance of affected components in Equity. All comparative financial statements should be restated. (IAS 8) However, changes in estimates (e.g. estimated useful life of a fixed asset) only require prospective changes. (IAS 8) No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. [Note: natural disaster might not qualify depending on location (e.g. frost damage would not qualify in Canada but would in the tropics).] Additional items may be needed to fairly present the entity's results of operations. (IAS 1.85) Disclosures Certain items must be disclosed separately in the notes (or the statement of comprehensive income), if material, including:[3] (IAS 1.98)

Write-downs of inventories to net realizable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring

Disposals of items of property, plant and equipment Disposals of investments Discontinued operations

70

Litigation settlements Other reversals of provisions

Earnings per share Because of its importance, earnings per share (EPS) are required to be disclosed on the face of the income statement. A company which reports any of the irregular items must also report EPS for these items either in the statement or in the notes.

There are two forms of EPS reported:

Basic: in this case "weighted average of shares outstanding" includes only actual stocks outstanding. Diluted: in this case "weighted average of shares outstanding" is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

Sample income statement The following income statement is a very brief example prepared in accordance with IFRS. It does not show all possible kinds of items appeared a firm, but it

71

shows the most usual ones. Please note the difference between IFRS and US GAAP when interpreting the following sample income statements. Fitness Equipment Limited INCOME STATEMENTS (in millions) Year Ended March 31, Revenue Cost of sales Gross profit SGA expenses Operating profit 2012 $ 14,580.2 (6,740.2) 7,840.0 (3,624.6) $ 4,215.4 2011 2010 $ 8,290.3 (4,524.2) 3,766.1 (3,034.0) $ 732.1 (142.8) 589.3 (235.7) $ 353.6 ---------------------------------------------------------------------------------$ 11,900.4 (5,650.1) 6,250.3 (3,296.3) $ 2,954.0 46.3 (124.1) 2,829.9 (1,132.0) $ 1,697.9 -

------------- ------------ ------------------------ ------------ ------------------------ ------------ ------------------------ ------------ -----------Gains from disposal of fixed assets Interest expense Profit before tax Income tax expense Profit (or loss) for the year (119.7) 4,142.0 (1,656.8) $ 2,485.2

------------- ------------ ------------------------ ------------ ------------------------ ------------ -----------DEXTERITY INC. AND SUBSIDIARIES

72

CONSOLIDATED STATEMENTS OF OPERATIONS (In millions) Year Ended December 31, Revenue Cost of sales Gross profit Operating expenses: Selling, general and administrative expenses (4,142.1) Depreciation Amortization Impairment loss Total operating expenses Operating profit (or loss) Interest income Interest expense Profit (or loss) from continuing operations before tax, share of profit (or loss) from associates and non-controlling interest $ (5,665.0) $ 8,778.9 $ 4,481.5 ----------- ----------- -----------73

2012

2011

2010

---------------------------------------------------------------------------------------------$ 36,525.9 $ 29,827.6 $ 21,186.8 (18,545.8) (15,858.8) (11,745.5) ----------- ----------- -----------17,980.1 13,968.8 9,441.3 ----------- ----------- -----------(3,732.3) (562.3) (111.8) (4,172.7) (3,498.6)

(602.4) (209.9) (17,997.1)

(584.5) (141.9)

----------- ----------- -----------(22,951.5) (4,458.7) ----------- ----------- -----------$ (4,971.4) $ 9,510.1 $ 5,268.6 ----------- ----------- -----------25.3 (718.9) 11.7 (742.9) 12.0 (799.1)

----------- ----------- ------------

Income tax expense Profit (or loss) from associates, net of tax

(1,678.6)

(3,510.5) (20.8)

(1,789.9) 0.1 (37.3)

Profit (or loss) from non-controlling interest, net of tax (5.1) (4.7) (3.3) $ (7,348.7) $ 5,263.8 $ ----------- ----------- -----------Profit (or loss) from continuing operations 2,651.0 ----------- ----------- -----------Profit (or loss) from discontinued operations, net of tax Profit (or loss) for the year (1,090.3) (802.4) 164.6 ----------- ----------- -----------$ (8,439.0) $ 4,461.4 $ 2,815.6

Bottom line "Bottom line" is the net income that is calculated after subtracting the expenses from revenue. Since this forms the last line of the income statement, it is informally called "bottom line." It is important to investors as it represents the profit for the year attributable to the shareholders. After revision to IAS 1 in 2003, the Standard is now using profit or loss for the year rather than net profit or loss or net income as the descriptive term for the bottom line of the income statement. Requirements of IFRS
74

On 6 September 2007, the International Accounting Standards Board issued a revised IAS 1: Presentation of Financial Statements, which is effective for annual periods beginning on or after 1 January 2009. A business entity adopting IFRS must include:

a Statement of Comprehensive Income or two separate statements comprising:

1.

an Income Statement displaying components of profit or loss and

2. a Statement of Comprehensive Income that begins with profit or loss (bottom line of the income statement) and displays the items of other comprehensive income for the reporting period. (IAS1.81) All non-owner changes in equity (i.e. comprehensive income) shall be presented in either in the statement of comprehensive income (or in a separate income statement and a statement of comprehensive income). Components of comprehensive income may not be presented in the statement of changes in equity. Comprehensive income for a period includes profit or loss (net income) for that period and other comprehensive income recognized in that period. All items of income and expense recognized in a period must be included in profit or loss unless a Standard or an Interpretation requires otherwise. (IAS 1.88) Some IFRSs require or permit that some components to be excluded from profit or loss and instead to be included in other comprehensive income. (IAS 1.89) Items and disclosures
75

The statement of comprehensive income should include:[3] (IAS 1.82)

1. 2.

Revenue Finance costs (including interest expenses)

3. Share of the profit or loss of associates and joint ventures accounted for using the equity method
4. 5.

Tax expense A single amount comprising the total of (1) the post-tax profit or loss of discontinued operations and (2) the post-tax gain or loss recognised on the disposal of the assets or disposal group(s) constituting the discontinued operation

6. Profit or loss
7.

Each component of other comprehensive income classified by nature

8. Share of the other comprehensive income of associates and joint ventures accounted for using the equity method
9.

Total comprehensive income

The following items must also be disclosed in the statement of comprehensive income as allocations for the period: (IAS 1.83)

Profit or loss for the period attributable to non-controlling interests and owners of the parent Total comprehensive income attributable to non-controlling interests and owners of the parent

76

No items may be presented in the statement of comprehensive income (or in the income statement, if separately presented) or in the notes as extraordinary items.
E-ACCOUNTING

E-accounting or

online

accounting,

is

the

application

of

online

and Internet technologies to the business accounting function. Similar to email being an electronic version of traditional mail, e-accounting is "electronic enablement" of lawful accounting and traceable accounting processes which were traditionally manual and paper-based. E-accounting involves performing regular accounting functions, accounting research and the accounting training and education through various computer based /internet based accounting tools such as digital tool kits, various internet resources, international web-based materials, institute and company databases which are internet based, web links, internet based accounting software and electronic financial spreadsheet tools to provide efficient decision making. Online accounting through a web application is typically based on a simple monthly charge and zero-administration approach to help businesses concentrate on core activities and avoid the hidden costs associated with traditional accounting software such as installation, upgrades, exchanging data files, backup and disaster recovery. E-accounting does not have a standard definition but merely refers to the changes in accounting due to computing and networking technologies. [1] Most e-accounting services are offered as SaaS; software as a service, i.e. as a cloud service.

77

Uses

Accounts payable Accounts receivable Job costing Financial write-up and reporting Bank and account reconciliations Quarterly tax reporting Compliance reporting Tax return preparation Internal financial consultant Establish the control system Inform those concerned of financial condition Supply the business with adequate information Maintain contact with government agencies, bankers, etc. Provide insight, courses of action Facilitate future planning and growth

Accounts payable
Accounts payable is money owed by a business to its suppliers and shown on its Balance Sheet as a liability. An accounts payable is recorded in the Account
78

Payable sub-ledger at the time an invoice is vouchered for payment. Vouchered, or vouched, means that an invoice is approved for payment and has been recorded in the General Ledger or AP sub ledger as an outstanding, or open, liability because it has not been paid. Payables are often categorized as Trade Payables, payables for the purchase of physical goods that are recorded in Inventory, and Expense Payables, payables for the purchase of goods or services that are expensed. Common examples of Expense Payables are advertising, travel, entertainment, office supplies and utilities. A/P is a form of credit that suppliers offer to their customers by allowing them to pay for a product or service after it has already been received. Suppliers offer various payment terms for an invoice. Payment terms may include the offer of a cash discount for paying an invoice within a defined number of days. For example, 2%, 30 Net 31 terms mean that the payor will deduct 2% from the invoice if payment is made within 30 days. If the payment is made on Day 31 then the full amount is paid. In households, accounts payable are ordinarily bills from the electric dish service,

company, telephone company, cable

television or satellite

newspaper subscription, and other such regular services. Householders usually track

and pay on a monthly basis by hand using cheques, credit cards or internet banking. In a business, there is usually a much broader range of services in the A/P file, and accountants or bookkeepers usually use accounting software to track the flow of money into this liability account when they receive invoices and out of it when they make payments. Increasingly, large firms are using specialized Accounts Payable automation solutions (commonly called ePayables) to automate the paper and manual elements of processing an organization's invoices. Commonly, a supplier will ship a product, issue an invoice, and collect payment later, which describes a cash conversion cycle, a period of time during which the
79

supplier has already paid for raw materials but hasn't been paid in return by the final customer. When the invoice is received by the purchaser it is matched to the packing slip and purchase order, and if all is in order, the invoice is paid. This is referred to as the three-way match. [1] The three-way match can slow down the payment process, so the method may be modified. For example, three-way matching may be limited solely to large-value invoices, or the matching is automatically approved if the received quantity is within a certain percentage of the amount authorized in the purchase order.

Expense administration
Expense administration is usually closely related to accounts payable, and sometimes those functions are performed by the same employee. The expense administrator verifies employees'expense reports, confirming that receipts exist to support airline, ground transport, meals and entertainment, telephone, hotel, and other expenses. This documentation is necessary for tax purposes and to prevent reimbursement of inappropriate or erroneous expenses. Airline expenses are, perhaps, the most prone to fraud because of the high cost of air travel and the confusing nature of airline-related documentation, which can consist of an array of reservations, receipts, and actual tickets.

Internal controls A variety of checks against abuse are usually present to prevent embezzlement by accounts payable personnel. Segregation of duties is a common control. Nearly all companies have a junior employee process and print a cheque and a senior employee review and sign the cheque. Often, the accounting software will limit
80

each employee to performing only the functions assigned to them, so that there is no way anyone employee even the controller can singlehandedly make a payment. Some companies also separate the functions of adding new vendors and entering vouchers. This makes it impossible for an employee to add himself as a vendor and then cut a cheque to himself without colluding with another employee. This file is referred to as the master vendor file. It is the repository of all significant information about the company's suppliers. It is the reference point for accounts payable when it comes to paying invoices.[3] In addition, most companies require a second signature on cheques whose amount exceeds a specified threshold. Accounts payable personnel must watch for fraudulent invoices. In the absence of a purchase order system, the first line of defense is the approving manager. However, A/P staff should become familiar with a few common problems, such as "Yellow Pages" rip-offs in which fraudulent operators offer to place an advertisement. The walking-fingers logo has never been trademarked, and there are many different Yellow Pages-style directories, most of which have a small distribution. According to an article in the winter 2000 American Payroll Association's Employer Practices, "Vendors may send documents that look like invoices but in small print they state "this is not a bill." These may be charges for directory listings or advertisements. Recently, some companies have begun sending what appears to be a rebate or refund check; in reality, it is a registration for services that is activated when the document is returned with a signature." In accounts payable, a simple mistake can cause a large overpayment. A common example involves duplicate invoices. An invoice may be temporarily misplaced or still in the approval status when the vendors calls to inquire into its payment status.
81

After the A/P staff member looks it up and finds it has not been paid, the vendor sends a duplicate invoice; meanwhile the original invoice shows up and gets paid. Then the duplicate invoice arrives and inadvertently gets paid as well, perhaps under a slightly different invoice number.

Audits of accounts payable Auditors often focus on the existence of approved invoices, expense reports, and other supporting documentation to support cheques that were cut. The presence of a confirmation or statement from the supplier is reasonable proof of the existence of the account. It is not uncommon for some of this documentation to be lost or misfiled by the time the audit rolls around. An auditor may decide to expand the sample size in such situations. Auditors typically prepare an aging structure of accounts payable for a better understanding of outstanding debts over certain periods (30, 60, 90 days, etc.). Such structures are helpful in the correct presentation of the balance sheet as of fiscal year end.

Accounts receivable
Accounts receivable also known as Debtors, is money owed to a business by its clients (customers) and shown on its balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered.

82

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically established executed by generating called credit an invoice and either mailing terms. or electronically delivering it to the customer, who, in turn, must pay it within an timeframe, terms or payment

The accounts receivable departments use the sales ledger, this is because a sales ledger The The amount sales of money normally a business received for has goods or records [2]: made. services.

- The amount of money owed at the end of each month varies (debtors). The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the accounts receivable department. While the collection's department seeks the debtor, the cashiering team applies the monies received.

Payment terms
An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date; businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60 and 30 days end of month. Booking a receivable is accomplished by a simple accounting transaction; however, the process of maintaining and collecting payments on the accounts
83

receivable subsidiary account balances can be a full-time proposition. Depending on the industry in practice, accounts receivable payments can be received up to 10 15 days after the due date has been reached. These types of payment practices are sometimes developed by industry standards, corporate policy, or because of the financial condition of the client. Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts[3] which appears on the balance sheet as a contra account that offsets total accounts receivable. When accounts receivable are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action. Outstanding advances are part of accounts receivable if a company gets an order from its customers with payment terms agreed upon in advance. Since billing is done to claim the advances several times, this area of collectible is not reflected in accounts receivables. Ideally, since advance payment occurs within a mutually agreed-upon term, it is the responsibility of the accounts department to periodically take out the statement showing advance collectible and should be provided to sales & marketing for collection of advances. The payment of accounts receivable can be protected either by a letter of credit or by Trade Credit Insurance Accounts Receivable Age Analysis The Accounts Receivable Age Analysis Printout, also known as the Debtors Book is divided in categories for current, 30 days, 60 days, 90 days, 120 days, 150 days and 180 days and overdue that are produced in Modern Accounting Systems. The printout is mostly known as an Aged Trial Balance or ATB for short. The printout is done in the order of the Chart of Accounts for the Accounts Receivable and/or
84

Debtors Book. The option to include Zero Balances outstanding or to specifically leave it out is also possible in the printout features.

Special uses
Companies can use their accounts receivable as collateral when obtaining a loan (asset-based lending). They may also sell them through factoring or on an exchange. Pools or portfolios of accounts receivable can be sold in capital markets through securitization. For tax reporting purposes, a general provision for bad debts is not an allowable deduction from profit[4] - a business can only get relief for specific debtors that have gone bad. However, for financial reporting purposes, companies may choose to have a general provision against bad debts consistent with their past experience of customer payments, in order to avoid over-stating debtors in the balance sheet.

Management accounting
Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions. In contrast to financial accountancy information, management accounting

information is:

primarily forward-looking, instead of historical; model based with a degree of abstraction to support decision making generically, instead of case based;

designed and intended for use by managers within the organization, instead of being intended for use by shareholders, creditors, and public regulators;
85

usually confidential and used by management, instead of publicly reported;

Computed by reference to the needs of managers, often using management information systems, instead of by reference to general financial accounting standar

IFAC Definition of enterprise financial management embracing three broad areas: cost accounting; performance evaluation and analysis; planning and decision support.[1] Copyright July 2009, International Federation of Accountants According to the Institute of Management Accountants (IMA): "Management accounting is a profession that involves partnering in management decision making, devising planning and performance management systems,and providing

86

expertise in financial reporting and control to assist management in the formulation and implementation of an organization's strategy".[2] The American Institute of Certified Public Accountants (AICPA) states that management accounting as practice extends to the following three areas:

Strategic managementadvancing the role of the management accountant as a strategic partner in the organization. Performance managementdeveloping the practice of business decisionmaking and managing the performance of the organization.

Risk

managementcontributing

to

frameworks

and

practices

for

identifying, measuring, managing and reporting risks to the achievement of the objectives of the organization. The Institute of Certified Management Accountants (ICMA), states "A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking" . Management accountants therefore are seen as the "value-creators" amongst the accountants. They are much more interested in forward looking and taking decisions that will affect the future of the organization, than in the historical recording and compliance (score keeping) aspects of the profession. Management accounting knowledge and experience can therefore be obtained from varied fields and functions within an organization, such as information management, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc.

87

Traditional vs. innovative practices

Managerial costing time line. Within the area of management accounting there are almost an infinite number of tools, methods, techniques and approaches floating around.
88

The

distinction

between traditional and innovative accounting

practices

is

perhaps best illustrated with the visual timeline (see sidebar) of managerial costing approaches presented at the Institute of Management Accountants 2011 Annual Conference. Traditional standard costing (TSC), used in cost accounting dates back to the 1920s and is a central method in management accounting practiced today because it is used for financial statement reporting for the valuation of income statement and balance sheet line items such as cost of goods sold (COGS) and inventory valuation. Traditional standard costing must comply with generally accepted accounting principles (GAAP ) and actually aligns itself more with answering financial accounting requirements rather than providing solutions for management accountants. Traditional approaches limit themselves by defining cost behavior only in terms of production or sales volume. In the late 1980s, accounting practitioners and educators were heavily criticized on the grounds that management accounting practices (and, even more so, the curriculum taught to accounting students) had changed little over the preceding 60 years, despite radical changes in the business environment. In 1993, the Accounting Education Change Commission Statement Number 4 calls for faculty members to come down from their ivory towers and expand their knowledge about the actual practice of accounting in the workplace. Professional accounting institutes, perhaps fearing that management accountants would increasingly be seen as superfluous in business organizations, subsequently devoted considerable resources to the development of a more innovative skills set for management accountants. Variance analysis is a systematic approach to the comparison of the actual and budgeted costs of the raw materials and labor used during a production period.
89

While some form of variance analysis is still used by most manufacturing firms, it nowadays tends to be used in conjunction with innovative techniques such as life cycle cost analysis and activity-based costing, which are designed with specific aspects of the modern business environment in mind. life-cycle costing recognizes that managers' ability to influence the cost of manufacturing a product is at its greatest when the product is still at the design stage of its product life-cycle (i.e., before the design has been finalized and production commenced), since small changes to the product design may lead to significant savings in the cost of manufacturing the products. Activity-based costing (ABC) recognizes that, in modern factories, most manufacturing costs are determined by the amount of 'activities' (e.g., the number of production runs per month, and the amount of production equipment idle time) and that the key to effective cost control is therefore optimizing the efficiency of these activities. Both lifecycle costing and activity-based costing recognize that, in the typical modern factory, the avoidance of disruptive events (such as machine breakdowns and quality control failures) is of far greater importance than (for example) reducing the costs of raw materials. Activity-based costing also deemphasizes direct labor as a cost driver and concentrates instead on activities that drive costs, As the provision of a service or the production of a product component. Other approach that can be viewed as innovative to the U.S. is the German approach, Grenzplankostenrechnung (GPK). Although it has been in practiced in Europe for more than 50 years, neither GPK nor the proper treatment of 'unused capacity' is widely practiced in the U.S. Thus GPK and the concept of unused capacity is slowly becoming more recognized in America, and "could easily be considered 'advanced' by U.S. standards".[4]
90

One of the more innovative accounting practices available today is resource consumption accounting (RCA). RCA has been recognized by the International Federation of Accountants (IFAC) as a"sophisticated approach at the upper levels of the continuum of costing techniques"[7] because it provides the ability to derive costs directly from operational resource data or to isolate and measure unused capacity costs. RCA was derived by taking the best costing characteristics of the German management accounting approach Grenzplankostenrechnung (GPK), and combining the use of activity-based drivers when needed, such as those used in activity-based costing. With the RCA approach, resources and their costs are considered as "foundational to robust cost modeling and managerial decision support, because an organization's costs and revenues are all a function of the resources and the individual capacities that produce them".[7] Role within a corporation Consistent with other roles in today's corporation, management accountants have a dual reporting relationship. As a strategic partner and provider of decision based financial and operational information, management accountants are responsible for managing the business team and at the same time having to report relationships and responsibilities to the corporation's finance organization. The activities management accountants provide inclusive of forecasting and planning, performing variance analysis, reviewing and monitoring costs inherent in the business are ones that have dual accountability to both finance and the business team. Examples of tasks where accountability may be more meaningful to the business management team vs. the corporate finance department are the development of new product costing, operations research, business driver metrics, sales management score carding, and client profitability analysis. (See financial modeling.) Conversely, the preparation of certain financial reports, reconciliations
91

of the financial data to source systems, risk and regulatory reporting will be more useful to the corporate finance team as they are charged with aggregating certain financial information from all segments of the corporation. In corporations that derive much of their profits from the information economy, such as banks, publishing houses, telecommunications companies and defense contractors, IT costs are a significant source of uncontrollable spending, which in size is often the greatest corporate cost after total compensation costs and property related costs. A function of management accounting in such organizations is to work closely with the IT department to provide IT cost transparency. Given the above, one widely held view of the progression of the accounting and finance career path is that financial accounting is a stepping stone to management accounting. Consistent with the notion of value creation, management accountants help drive the success of the business while strict financial accounting is more of a compliance and historical endeavor. An alternative view A very rarely expressed alternative view of management accounting is that it is neither a neutral or benign influence in organizations, rather a mechanism for management control through surveillance. This view locates management accounting specifically in the context of management control theory. Stated differently, management accounting information is the mechanism which can be used by managers as a vehicle for the overview of the whole internal structure of the organization to facilitate their control functions within an organization. Specific methodologies Activity-based costing (ABC)

92

Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. Grenzplankostenrechnung (GPK) Grenzplankostenrechnung is a German costing methodology, developed in the late 1940s and 1950s, designed to provide a consistent and accurate application of how managerial costs are calculated and assigned to a product or service. The term Grenzplankostenrechnung, often referred to as GPK, has best been translated as either marginal planned cost accounting or flexible analytic cost planning and accounting.[10] The origins of GPK are credited to Hans Georg Plaut, an automotive engineer and Wolfgang Kilger, an academic, working towards the mutual goal of identifying and delivering a sustained methodology designed to correct and enhance cost accounting information. GPK is published in cost accounting textbooks, notably Flexible Plankostenrechnung und Deckungsbeitragsrechnung and taught at German-speaking universities today. Lean accounting (accounting for lean enterprise) In the mid- to late-1990s several books were written about accounting in the lean enterprise (companies implementing elements of the Toyota Production System). The term lean accounting was coined during that period. These books contest that traditional accounting methods are better suited for mass production and do not support or measure good business practices in just-in-time manufacturing and
93

services. The movement reached a tipping point during the 2005 Lean Accounting Summit in Dearborn, Michigan, United States. 320 individuals attended and discussed the merits of a new approach to accounting in the lean enterprise. 520 individuals attended the 2nd annual conference in 2006. Resource consumption accounting (RCA) Main article: Resource Consumption Accounting Resource consumption accounting (RCA) is formally defined as a dynamic, fully integrated, principle-based, and comprehensive management accounting approach that provides managers with decision support information for enterprise optimization. RCA emerged as a management accounting approach around 2000 and was subsequently developed at CAM-I the Consortium for Advanced ManufacturingInternational, in a Cost Management Section RCA interest group in December 2001. Throughput accounting The most significant recent direction in managerial accounting is throughput accounting; which recognizes the interdependencies of modern production processes. For any given product, customer or supplier, it is a tool to measure the contribution per unit of constrained resource. Transfer pricing Management accounting is an applied discipline used in various industries. The specific functions and principles followed can vary based on the industry. Management accounting principles in banking are specialized but do have some common fundamental concepts used whether the industry is manufacturing based or service oriented. For example, transfer pricing is a concept used in manufacturing but is also applied in banking. It is a fundamental principle used in
94

assigning value and revenue attribution to the various business units. Essentially, transfer pricing in banking is the method of assigning the interest rate risk of the bank to the various funding sources and uses of the enterprise. Thus, the bank's corporate treasury department will assign funding charges to the business units for their use of the bank's resources when they make loans to clients. The treasury department will also assign funding credit to business units who bring in deposits (resources) to the bank. Although the funds transfer pricing process is primarily applicable to the loans and deposits of the various banking units, this proactive is applied to all assets and liabilities of the business segment. Once transfer pricing is applied and any other management accounting entries or adjustments are posted to the ledger (which are usually memo accounts and are not included in the legal entity results), the business units are able to produce segment financial results which are used by both internal and external users to evaluate performance. Resources and continuous learning There are a variety of ways to keep current and continue to build one's knowledge base in the field of management accounting. Certified Management Accountants (CMAs) are required to achieve continuing education hours every year, similar to a Certified Public Accountant. A company may also have research and training materials available for use in a corporate owned library. This is more common in "Fortune 500" companies who have the resources to fund this type of training medium. There are also numerous journals, on-line articles and blogs available. The journal Cost Management (ISSN 1092-8057)[12] and the Institute of Management Accounting (IMA) site are sources which includes Management Accounting Quarterly and Strategic Finance publications. Indeed, management accounting is needed in an organization.
95

Tasks/ services provided Listed below are the primary tasks/ services performed by management accountants. The degrees of complexity relative to these activities are dependent on the experience level and abilities of any one individual.

Rate and volume analysis Business metrics development Price modeling Product profitability Geographic vs. industry or client segment reporting Sales management scorecards Cost analysis Costbenefit analysis Cost-volume-profit analysis Life cycle cost analysis Client profitability analysis IT cost transparency Capital budgeting Buy vs. lease analysis Strategic planning Strategic management advice
96

Internal financial presentation and communication Sales forecasting Financial forecasting Annual budgeting

Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest. The Securities and Exchange Commission (SEC) designated the FASB as the organization responsible for setting accounting standards for public companies in the U.S. It was created in 1973, replacing the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA).

Mission statement
The FASB's mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information."[1] To achieve this, FASB has five goals:

Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability, and on the qualities of comparability and consistency.

97

Keep standards current to reflect changes in methods of doing business and in the economy.

Consider promptly any significant areas of deficiency in financial reporting that might be improved through standard setting.

Promote international convergence of accounting standards concurrent with improving the quality of financial reporting.

Improve common understanding of the nature and purposes of information in financial reports.

Description
The FASB is not a governmental body. The SEC has legal authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, Commission policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest. The FASB is part of a structure that is independent of all other business and professional organizations. Before the present structure was created, financial accounting and reporting standards were established first by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants (19361959) and then by the Accounting Principles Board, also a part of the AICPA (195973). Pronouncements of those predecessor bodies remain in force unless amended or superseded by the FASB. The FASB is subject to oversight by the Financial Accounting Foundation (FAF), which selects the members of the FASB and the Governmental Accounting
98

Standards Board and funds both organizations. The Board of Trustees of the FAF, in turn, is selected in part by a group of organizations including:

American Accounting Association American Institute of Certified Public Accountants CFA Institute Financial Executives International Government Finance Officers Association Institute of Management Accountants National Association of State Auditors, Comptrollers and Treasurers Securities Industry Association

The FASB's structure is very different from its predecessors in many ways. The board consists of seven full-time members.[2] These members are required to sever all ties to previous firms and institutions that they may have served prior to joining the FASB. This is to ensure the impartiality and independence of the FASB. All members are selected by the FAF. They are appointed for a five-year term and are eligible for one additional five-year term. [1] The current members are (with current term end dates indicated)[1]:

Leslie F. Seidman, Chairman (2013) Daryl E. Buck (2015) Russell G. Golden (2012) Thomas J. Linsmeier (2016)
99

R. Harold Schroeder (2015) Marc A. Siegel (2013) Lawrence W. Smith (2012)

In additional to the full-time members, there are approximately 68 staff members. These staff is, "professionals drawn from public accounting, industry, academe, and government, plus support personnel."[1] In 1984, the FASB formed the Emerging Issues Task Force (EITF). [1] This group was formed in order to provide timely responses to financial issues as they emerged. This group includes 15 people from both the private and public sectors coupled with representatives from the FASB and an SEC observer. [2] As issues emerge, the task force considers them and tries to reach a consensus on what course of action to take. If that consensus can be reached, they issue an EITF Issue and FASB doesn't get involved. An EITF Issue is considered just as valid as a FASB pronouncement and is included in the GAAP.

Creation of the Codification

On July 1, 2009, the FASB announced the launch of its Accounting Standards Codification, declaring it to be "the single source of authoritative nongovernmental U.S. generally accepted accounting principles." The Codification organizes the many pronouncements that constitute U.S. GAAP into a consistent, searchable format.[3] The Codification is not to be confused with the FASB's Conceptual Framework, a project begun in 1973 to develop a sound theoretical basis for the development of accounting standards in the United States.

Norwalk Agreement

100

FASB is pursuing a convergence project with the International Accounting Standards Board (IASB) and International Financial Reporting Standards (IFRS). On Sept. 18, 2002, in Norwalk, Connecticut, FASB and IASB met and issued a Memorandum of Understanding.[4] This document outlined plans to converge IFRS and US GAAP into one set of high quality and compatible standards. As part of the project, FASB has begun moving from the principle of historical cost to fair value.

Independence
In June 2009, FASB was criticized by an advisory panel of investors after making changes on mark-to-market accounting in response to political pressure. Lobbyists had obtained its permission for banks to apply a special accounting treatment for toxic assets.

FASB pronouncements
In order to establish accounting principles, the FASB issues pronouncements publicly, each addressing general or specific accounting issues. These pronouncements are:

Statements of Financial Accounting Standards Statements of Financial Accounting Concepts FASB Interpretations FASB Technical Bulletins EITF Abstracts

FASB 11 Concepts
101

Money measurement Entity Going concern Cost Dual aspect Accounting period Conservation Realization Matching Consistency Materiality

Accounting software
Accounting software is application software that balance. It records functions and as

processes accounting transactions within functional modules such as accounts payable, accounts receivable, payroll, and trial an accounting information system. It may be developed in-house by the company or organization using it, may be purchased from a third party, or may be a combination of a third-party application software package with local modifications. It varies greatly in its complexity and cost.[1]

102

The market has been undergoing considerable consolidation since the mid 1990s, with many suppliers ceasing to trade or being bought by larger groups.

Modules
Accounting software is typically composed of various modules, different sections dealing with particular areas of accounting. Among the most common are Core modules

Accounts receivablewhere the company enters money received Accounts payablewhere the company enters its bills and pays money it owes

General ledgerthe company's "books" Billingwhere the company produces invoices to clients/customers Stock/inventorywhere the company keeps control of its inventory Purchase orderwhere the company orders inventory Sales orderwhere the company records customer orders for the supply of inventory

Bookkeepingwhere the company records collection and payment

Non-core modules

Debt collectionwhere the company tracks attempts to collect overdue bills (sometimes part of accounts receivable) Electronic payment processing

103

Expensewhere employee business-related expenses are entered Inquirieswhere the company looks up information on screen without any edits or additions

Payrollwhere the company tracks salary, wages, and related taxes Reportswhere the company prints out data Timesheetwhere professionals (such as attorneys and consultants) record time worked so that it can be billed to clients

Purchase requisitionwhere requests for purchase orders are made, approved and tracked

Reconciliationcompares records from parties at both sides of transactions for consistency

Different vendors will use different names for these modules.

Implementations In many cases, implementation (i.e. the installation and configuration of the system at the client) can be a bigger consideration than the actual software chosen when it comes down to the total cost of ownership for the business. Most midmarket and larger applications are sold exclusively through resellers, developers and consultants. Those organizations generally pass on a license fee to the software vendor and then charge the client for installation, customization and support

104

services. Clients can normally count on paying roughly 50-200% of the price of the software in implementation and consulting fees. Other organizations sell to, consult with and support clients directly, eliminating the reseller. Categories Personal accounting Mainly for home users that use accounts payable type accounting transactions, managing budgets and simple account reconciliation at the inexpensive end of the market. Low end At the low end of the business markets, inexpensive applications software allows most general business accounting functions to be performed. Suppliers frequently serve a single national market, while larger suppliers offer separate solutions in each national market. Many of the low end products are characterized by being "single-entry" products, as opposed to double-entry systems seen in many businesses. Some products have considerable functionality but are not considered GAAP or IFRS/FASB compliant. Some low-end systems do not have adequate security nor audit trails.

Mid market The mid-market covers a wide range of business software that may be capable of serving the needs of multiple national accountancy standards and allow accounting in multiple currencies.

105

In addition to general accounting functions, the software may include integrated or add-on management information systems, and may be oriented towards one or more markets, for example with integrated or add-on project accounting modules. Software applications in this market typically include the following features

Industry-standard robust databases Industry-standard reporting tools Tools for configuring or extending the application (e.g. an SDK), access to program code.

High end The most complex and expensive business accounting software is frequently part of an extensive suite of software often known as Enterprise resource planning or ERP software. These applications typically have a very long implementation period, often greater than six months. In many cases, these applications are simply a set of functions which require significant integration, configuration and customization to even begin to resemble an accounting system. The advantage of a high-end solution is that these systems are designed to support individual company specific processes, as they are highly customizable and can be tailored to exact business requirements. This usually comes at a significant cost in terms of money and implementation time. Vertical market Some business accounting software is designed for specific business types. It will include features that are specific to that industry.

106

The choice of whether to purchase an industry-specific application or a generalpurpose application is often very difficult. Concerns over a custom-built application or one designed for a specific industry include:

Smaller development team Increased risk of vendor business failing Reduced availability of support

This can be weighed up against:

Less requirement for customization Reduced implementation costs Reduced end-user training time and costs

Some important types of vertical accounting software are:

Banking Construction Medical Nonprofit Point of Sale (Retail) Daycare accounting (a.k.a. Child care management software)

Hybrid solutions As technology improves, software vendors have been able to offer increasingly advanced software at lower prices. This software is suitable for companies at
107

multiple stages of growth. Many of the features of Mid Market and High End software (including advanced customization and extremely scalable databases) are required even by small businesses as they open multiple locations or grow in size. Additionally, with more and more companies expanding overseas or allowing workers to home office, many smaller clients have a need to connect multiple locations. Their options are to employ software-as-a-service or another application that offers them similar accessibility from multiple locations over the internet. Comparison of accounting software The following comparison of accounting software documents the various features and differences between different professional accounting software and personal finance packages. Free and open source software
Packag e License Windows Mac OS Linux Market focus Type Structure Language

A1 ERP

ATPL

Yes

Yes

Yes

Mid-Large market

ERP , CRM, Human Capital Management, Performance management, Contract management, Web Campus Management, based Records Management, Supply Chain Management, Warehouse Management, Business Intelligence

Java on JBoss, GlassFish, PostgreSQL

108

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

Adempier GPL e

Yes

Yes

Yes

ERP , CRM, POS, Busines s Intelligence, General Ledger, Acco unts Web Mid-market Receivable, P based ayable, Inventory, Manufacturin g, Payroll & HR, ecomme rce connectiv ity

Java on JBoss, Glassfish, PostgreSQL

GPL2, Compiere other Yes proprietary

Yes

Yes

ERP, CRM, Web Mid-market POS, WMS, based MES

Java EE

FrontAcc GPLv3 ounting

Yes

Yes

Yes

Low to Mid- ERP, CRM, Web Market POS, GL, Do based uble-Entry Accounting, Accounts Receivable, Accounts Payable, Inve ntory management, Manufacturin g, SCM, Multicompany, Multi-user, Multi-

PHP

109

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

currency

GnuCash GPL

Yes

Yes

Yes

GL; DoubleEntry Accounting; Stock/Bond/ Personal and Mutual Fund Stand small Accounts; alone enterprise SmallBusiness Accounting; etc.

C, Scheme

GNU Enterpris GPL e

Yes

Yes

Yes

Mid to high ERP end market

Web based stand alone

Python

Grisbi

GPL

Yes

Yes

Yes

Personal

stand alone

Home Bank

GPL

Yes

Yes

Yes

Personal

stand alone

C, GTK+

JFire

GPL

Yes

No

Yes

Web ERP, CRM, based, All Markets POS, WMS Stand alone

Java

JGnash

GPL

Yes

Yes

Yes

Personal

Double-Entry stand Accounting, alone multi-

Java

110

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

currency

KMyMon GPL ey

Yes

Yes

Yes

Personal

Double-Entry Accounting, multicurrency, stand Stock/Bond/ alone Mutual Fund Accounts, on line banking

C++

LedgerS MB

GPL

Yes

Yes

Yes

ERP, POS, G eneral Ledger, Acco unts Receivable, Accounts Payable, Dou ble-Entry Accounting, SaaS,Invento Web Mid-market ry control, based Light Manufacturin g, Multi-user, Multicompany, Multicurrency| Multilanguage (40),

Perl

Apache OFBiz

Apache License

Yes

Yes

Yes

Mid-market ERP, CRM, Web POS, Busines based s

Java

111

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

Intelligence, GL, Account s Receivable, Accounts Payable, Inve ntory control, Manufacturin g, SCM, HR, Shopping Cart/Catalog/ ecommerce, SaaS, Calendar, Webmail

Openbrav MPL o

Yes

Yes

Yes

ERP, CRM, POS, Busines s Intelligence, General Ledger, Acco unts Low to midWeb Receivable, P market based ayable, Inventory, Manufacturin g, Payroll & HR, ecomme rce connectiv ity

Java

OpenERP GPL

Yes

Yes

Yes

Mid-market ERP, CRM, Web Python POS, Busines based and s ClientIntelligence, server GL, Double112

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

Entry Accounting, Accounts Receivable, Accounts Payable, Inve ntory control, Manufacturin g, SCM, HRM (Human Resource Management ), Shopping Cart/Catalog/ ecommerce ( both built-in or external integration/c onnectivity), SaaS, Calendar, Webmail, Multicompany, Multi-user, Multicurrency

Post books

CPAL

Yes

Yes

Yes

Low to mid- ERP, CRM, Clientmarket POS, Busines server s Intelligence, General Ledger, Dou ble-Entry Accounting, Receivable,

C++, Qt

113

Packag e

License

Windows

Mac OS

Linux

Market focus

Type

Structure Language

Accounts, In ventory control, Manufacturin g, Distribution, Professional Services, eco mmerce connectivity, MultiCurrency

SQLLedger

GPL

Yes

Yes

Yes

ERP, Double Web Mid-market -Entry based Accounting

Perl

Tryton

GPL

Yes

Yes

Yes

ERP, GL, Do uble-Entry Accounting, Thin Accounts Client Low to mid- Receivable, Server or Python market Accounts Stand Payable, SC alone M, WMS, multicurrency

TurboCA GPL SH

Yes

No

No

Low to mid- Double-Entry Stand market Accounting alone

Delphi

webERP

GPL

Yes

Yes

Yes

Low to midERP Market

Web based

PHP

114

Proprietary software Packa ge Mac Wind Linu Marke OS Type ows x t focus X Struct ure

License

24Seven Software as Yes Office a Service

Low to ERP, CRM, e-mail, collabora Web Yes Yes Mid- tion, Project Management, based Market Integrated VoIP Financials, Customer Relationship Management, Manufacturing MidStand , Job Market alone Costing, POS, Inventory control, ERP, Business Intelligence, CIS, Payroll Stand alone and Web based

The Access Group

Proprietary Yes

No No

Proprietary Acumati and Softwa Yes ca re as a service

No No

MidERP, Accounting software Market

AME Accounti Proprietary Yes ng Software

No No

Payroll, General Ledger, Accounts Low to Receivable, Accounts Stand MidPayable, Double-entry alone Market Accounting, Small Business Accounting Stand alone and web
115

Baan

Proprietary Yes

Yes Yes Mid to ERP LowMarket

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

based Double-Entry Accounting, Small Business Accounting, Inventory Low to control, Order Web Yes Yes Mid Entry/Tracking,General based Market Ledger, Accounts Receivable, Accounts Payable, ERP, ecommerce, P OS Double-Entry Accounting, Small Business Accounting, Bookkeeping, Multi-Currency, Inventory control, Order Low to Entry/Tracking, General Web Yes Yes Mid Ledger, Accounts based Market Receivable, Accounts Payable, ERP,ecommerce, P OS, Retail, CRM, Reporting, Integration, Quota tions, Invoices, Scheduler Yes Yes Low to Financials; ERP; CRM;Manu Stand Mid facturing; Multicompany; alone Market Multicurrency; Payroll; contr ol; Accounts; Accounts Payable; General Ledger

Software as BIG4boo a Yes ks Service or Freeware

Bright pearl

Software as Yes a Service

CGram Proprietary Yes Enterpri se

116

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X MidMarket No Yes ERP to High End

Struct ure

COA Proprietary Yes Solutions

Stand alone

CODA

Proprietary Yes

Stand Mid- GL; AP; AR; Analytics; Inte alone/ No Yes Market gration; etc. Web Access ERP; GL; Bookkeeping, Multi-Currency, MultiStand Low to Language, Double-entry alone / Mid- Accounting, AP; AR;Analyti Web Market cs; Integration; CRM; BI; eAccess commerce; Workflow; Retail ; POS Stand Low to Business Accounting, POS alone Mid Retail, Nonprofit, Inventory and Market Control Web based Low to Business Accounting Mid Invoicing Market and Stand Alone/ Web Access

Comarc Proprietary Yes h Altum

No No

Cougar Mountai Proprietary Yes n Software

No No

Express Proprietary Yes Accounts fromNC H Software

Yes No

117

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

Financia Software as lForce.co Yes a Service m

ERP, Ordering & Billing, Accounts Receivable, MidAccounts Payable, Cash Market Management, General Web Yes Yes to Ledger, Reporting & based Enterpr Dashboarding, Multiise Currency, Multi-Company, Global Tax, Analytics Stand Mid to ERP, Manufacturing, alone High Intercompany, and End Multicurrency, Budgeting, Web Market Reporting, Analysis Based

Flex Proprietary Yes Account

No No

Fortora Fresh Proprietary Yes Finance

Yes No

Person ? al

Stand alone

FreshBo Software as Yes oks a Service

Small Busine sses Cloud accounting specialist Web Yes Yes (Small for small business owners. based Busine sses) Stand alone and Mobile
118

iBank

Proprietary No

Yes No

Person ? al

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

invoiceit Proprietary Yes

No No

Small Business Accounting, single entry, accounts receivable, accounts Low to payable, Contact StandMid Management alone Market System, Inventory Management, Purchasing, Qu otations, Invoices, Scheduler, Marketing

Intact

Software as Yes a Service

Custom Reporting, DoubleEntry Accounting, Employee Expenses, ERP, Inventory Mid Web Yes Yes Control, Order Market based Entry/Tracking, Payroll, ecommerce, POS, Revenue Recognition, VSOE Payroll, General Ledger, Multi-currency, Cashbook, Stand Sales and Purchase Ledgers, alone eBanking, MRP, Stock Multi Mid- Forecasting, Project Costing, No Yes User Market Job Costing, Time Termin Costing, CRM, Business al Intelligence, Microsoft Server Excel Integration, Report Writer No No Mid- Payroll, General Stand Market Ledger, POS, Payroll, Doubl Alone
119

IRIS Exchequ Proprietary Yes er

Jonas Proprietary Yes Software

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

e-Entry Accounting, Analytic to and ,Accounts Highweb Receivable, Accounts Market based Payable Accounts Receivable, Accounts Payable, Double-Entry Low to Accounting, Small Business Web Yes Yes Mid- Accounting, Multi-currency, based Market standard business reporting, management reporting, fixed asset depreciation, inventory items ERP, SCM, CRM, WMS, Project mgmt, Stand Manufacturing, alone Mid Intercompany, and Market Multicurrency, Cost Web Accounting, Reporting & based Analysis services Mid ERP, SCM, manufacturing, Stand Market Cost Accounting, Double- alone Entry Accounting, project accounting, Payroll, General Ledger, Analytic, Accounts Receivable, Accounts Payable

KashFlo Software as Yes w a Service

Microsof t Proprietary Yes Dynamic s AX

No No

Microsof Proprietary Yes t Dynamic s GP

No No

120

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

Microsof t Proprietary Yes Dynamic s NAV

No No

ERP, CRM, Intercompany, Mid Multicurrency, Cost Stand Market Accounting, Reporting & alone Analysis services Stand alone and Web based Stand alone

Microsof t Proprietary Yes Dynamic s SL

No No

Mid ? Market

Microsof Proprietary Yes t Money Microsof t Office Proprietary Yes Accounti ng Mint.co Software as Yes m a Service Money dance

No No

Person Product is Discontinued al

No No

Low Product is Discontinued Market

Stand alone

Yes Yes

Person Account aggregation al Person Double-Entry al multi-currency

Web based

Proprietary Yes

Yes Yes

Accounting, Stand alone

MYOB Proprietary Yes Account Right

Yes No

Low to Small business and Stand High commercial accounting. alone End Payroll and POS
121

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X Market

Struct ure

MYOB EXO Proprietary Yes Business

No No

Larger, more complex Stand businesses. Fully customized alone, ERP with multiMid to Accounting/General ledger, user/lo High CRM, Job & Project Costing, cation, End POS, Asset Management and termin Market Intercompany Reporting. al Integrated Payroll & HR server, available through MYOB remote EXO Employer Services access Real-time, ecommerce, Integrated, MultiStand user, Payroll, General Low to alone Ledger, AR, AP, MultiMid and/or Currency, Small Business Market Web Accounting, Inventory Access Control, Order Entry, Job Costing Private AR, AP, GL, Double-entry Stand Enterpr Accounting, Sales and alone ises, Contracts, Inventory Control, and/or Public Order Entry/Tracking, Job Web Sectors Costing, Integrated, Inter- based and Company, Multi-Currency, Accoun Multi-Language. ting Firms
122

NewVie Proprietary Yes ws

No No

NOSA XP

Proprietary Yes

No No

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X Mid CRM, ERP, ecommerce Market

Struct ure

Net Suite

Software as Yes a Service

Yes Yes

Web based

Software as a NolaPro Yes Service or Freeware

Double-Entry Accounting, Stand Low to Small Business Accounting, alone High Inventory Control, Order Yes Yes and End Entry/Tracking, Web Market Payroll, ERP, ecommerce, P based OS Windo ws remote connec t client

Yes Yes (Lin Low to Openda Proprietary (client No ux Mid CRM, ERP QX ) serve Market r) Open Systems Accounti Proprietary Yes ng Software Outright Software as Yes a service

Low to ERP, SCM, ecommerce, Stand Yes Yes Mid Reporting & Business Alone Market Intelligence

Yes Yes Entrepr Bookkeeping, Taxes, ecomm Web eneurs, erce, Reporting & Business based freelan Intelligence cers, Contra ctors, Consult ants,
123

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X Small busines ses Low Market

Struct ure

Passport Software Proprietary Yes , Inc.

Mid to General ledger, Accounts Stand No Yes Low- Receivable, Accounts alone Market payable, ERP Accounting, ERP, CRM, Fin Lowancials, Business end to Intelligence, POS,Small High Stand business accounting,MidEnd alone sized enterprise Market accounting,Large enterprise s accounting, Payroll, HR

Proprietary Softline and Softwa Yes Pastel re as a service

Yes No

Oracle EProprietary Yes Business Suite

Yes Yes

High ERP Market

Web based

Peachtre e by Proprietary Yes Sage

No No

Lowend to Business management. High end Newsa POS gency

Stand alone

POS Proprietary Yes Solutions

No No

Stand
124

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X pharma cy

Struct ure

alone

QuickBo oks Proprietary Yes Online QuickBo oks Proprietary Yes Pro/Pre mier QuickBo oks Enterpri Proprietary Yes se Solutions

Yes Yes

Low Financial Market Payroll

management, Web Based

Yes No

Low to Financial Mid Inventory Market Payroll

management, Stand Management, alone

Yes No

Mid Business Market Payroll

management, Stand alone

Quicken Proprietary Yes

Yes No

Person Personal Cash Management, Stand al Investment Management alone Low to Payroll, General Stand Mid- Ledger, Accounts alone Market Receivable, Accounts Payable, Accounting, Fund, Inventory Management, Procurement, Order Entry/Tracking, Small Business Accounting
125

Red Proprietary Yes Wing Software

No No

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X Accoun ting CRM, payroll Firms

Struct ure

Sage

Proprietary Yes

No No

Stand alone

Sage 300 Proprietary Yes ERP

ERP, Multicurrency, Intercompany, Reporting & Stand Analysis Alone MidYes Yes services, Project & costing, and Market General, Accounts Web Receivable, Accounts based Payable, Inventory control Lowmarket ? (for S ME)

Sage Line 50

Proprietary Yes

No No

Stand alone

Sage Pastel Proprietary Yes Evolutio n

No No

Small, Mediu Financials, Inventory, Manuf m to acturing, Job MidStand Costing, POS, Procurement, size alone CRM, Business Enterpr Intelligence, Payroll, HR ises (SME)

Sage PFW ERP

Proprietary Yes

No Yes Mid- ERP, Process Manufacturing Stand market alone

126

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X Small & Midsiz e ERP, e-Commerce Enterpr ises (SME) Small & Midsiz e ERP, e-Commerce Enterpr ises (SME)

Struct ure

SAP Business Proprietary Yes One

No No

Stand alone

SAP Business Proprietary Yes ByDesig n

No No

Web based

SAP ERP

Proprietary Yes

ERP, CRM, SCM, SRM, PL Stand Midsiz M, Global Trade Services alone e to Yes Yes (GTS), e-commerce, Busines and Highs Intelligence, Mobile Web end Business based

Simply Accounti Proprietary Yes ng

No Yes

Lowend

Business Accounting, Retail, Stand Inventory Control alone

Tally

Proprietary Yes

No No

Business Accounting, Mid- Inventory Management, Stand market Taxation, Payroll, Remote alone Access
127

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

TRAVE Proprietary Yes RSE

No No

ERP, CRM, SCM, Intercompany, Low to Multicurrency, Manufacturin Stand Mid g, Distribution, ecommerce, Alone Market Mobile Business Solutions, Reporting & Business Intelligence

Wave Software as accounti Yes a Service ng

Entrepr eneurs, freelan cers, Accounts contrac Receivable, Accounts tors, Payable, Double-Entry consult Accounting, Small Business Web Yes Yes ants, Accounting, Multi-currency, based small automatic bank feeds, small busines business reporting, payroll ses integration Low Market ) Yes Yes Low to Accounts Web Mid- Receivable, Accounts based Market. Payable, Double-Entry Small Accounting, Small Business & Accounting, Multi-currency, Midsiz automatic bank feeds, e standard business reporting, Enterpr management reporting, fixed ises asset depreciation, payroll,
128

Xero

Software as Yes a Service

Packa ge

License

Mac Wind Linu Marke OS Type ows x t focus X (SME) inventory items

Struct ure

You Need a Proprietary Yes Budget (YNAB)

Personal spending Person Stand Yes Yes management, with an al alone emphasis on budgeting

Package Licence Further details

Mac Wind Linu Marke OS Type ows x t focus X

Struct ure

Packa ge

First Programmi Latest Stable public Developme Supported ng stable release Database release nt Status languages Language release date date

October 5 - Oracle, +10: English, Adempi 12, 3.6.0L Jun 14, J2EE, JBoss Production PostgreSQ Spanish, ere 2006 TS 2010 / Stable L French, ... 23:46 5 Production any / Stable

Apache Java OFBiz

9.04

April 2009

Multilingual

CGram C, Java Softwar

1982

5.0.0

August 5 - PostgreSQ English Production

129

Packa ge

First Programmi Latest Stable public Developme Supported ng stable release Database release nt Status languages Language release date date 2009 / Stable L

Oracle, Advance +10: English, 5 Compie June 8, October Server, Germany, J2EE, JBoss 3.2.0s Production re 2001 , 2008 MS SQL, Spanish, French, / Stable PostgreSQ Indonesia,... L XML Register (Compres C 80%, ed: 5 - sed), software: 33 GnuCas Scheme / July 14, [1] 1999- 2.4.11 Production SQLite3, languages; webs h Lisp 13%, 2012 11-08 / Stable MySQL, ite: 8 languages Perl 7%? 23:59 PostgreSQ L GNU Python Enterpr 100% ise Grisbi C Novem 5 PostgreSQ 2: English, ber 19, Production L 8.1+ German, 2008 / Stable May 19, 2010 5 Production / Stable German, Spanish, French, Italian, Dutch, Polish, Portuguese, Romanian, Russian, Chinese, Hebrew, Bulgarian.
130

June 28, 1.4 2002

0.6.0

Packa ge

First Programmi Latest Stable public Developme Supported ng stable release Database release nt Status languages Language release date date 35: English, 5 Spanish, French, Production XML file Russian, Greek, / Stable Hebrew, ...

Home Bank

January 4.0.4 2, 1998

June 10, 2009

IntarS

Objective-C 1999

6.1

Septem 5 ber 11, Production ? 2012 / Stable

German

JFire

J2EE, JBoss, Eclipse RCP, JDO

1.0.1

March 20, 2010

MS SQL, English, German, Derby, ... Thai, ...

JGnash Java

200301-01

2.8.0

March 5 XML, 10, Production db4o 2012 / Stable

English

KMyM C++ oney

Register 4.6.2 ed: 200004-15 19:16

Februar 5 - XML file 19: English, y 4, Production Spanish, German, 2012 / Stable Catalan, Czech, French, Galician, Italian, Dutch, Polish, Portuguese, Russian, Chinese, ...

131

Packa ge

First Programmi Latest Stable public Developme Supported ng stable release Database release nt Status languages Language release date date October 5 - Proprietar 2.24.1 29, Production y, Object English 2012 / Stable Oriented

New Views

C++, Tcl/T 1985 k

LedgerS Perl MB

+40:English Septem 5 development, Nov 21, PostgreSQ ber 6, 1.3.24 Production Multilingual (.po 2012 L 8.3+ 2006 / Stable files Gettext#Tran slating ) 5 - Oracle, Production PostgreSQ Multilingual / Stable L

Openbr J2EE, JBoss ? avo

2.50

April 2009

OpenE Python, RP XML

6.0.2

PostgreSQ L (any 5 - through April 2, Production SQLAlche +10 2011 / Stable my in SAServer branch) April 15, 2012 ? PostgreSQ 30: English, ... L

SQLPerl Ledger

3.0.2

Tryton Python

Novemb 2.6 er 17, 2008

October 5 - PostgreSQ English, Catalan, 22, Production L, SQLite French, German, 2012 / Stable Italian, Russian,
132

Packa ge

First Programmi Latest Stable public Developme Supported ng stable release Database release nt Status languages Language release date date Spanish 5 January January mySQL 3.11.2 Production Multilingual 2003 2010 innodb / Stable

webER PHP P

Mathematical finance Mathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical or numerical models without necessarily establishing a link to financial theory, taking observed market prices as input. Thus, for example, while a financial economist might study the structural reasons why a company may have a certain share price, a financial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the fair value of derivatives of the stock (see: Valuation of
133

options; Financial modeling). The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance, while the Black Scholes equation and formula are amongst the key results. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modeling and derivation (see: Quantitative analyst), often by help of stochastic asset models. In general, there exist two separate branches of finance that require advanced quantitative techniques: derivatives pricing on the one hand, and risk- and portfolio management on the other hand. These are discussed below. History: Q versus P There exist two separate branches of finance that require advanced quantitative techniques: derivatives pricing on the one hand, and risk and portfolio management on the other hand. One of the main differences is that they use different probabilities, namely the risk-neutral probability, denoted by "Q", and the actual probability, denoted by "P". Derivatives pricing: the Q world

The goal of derivatives pricing is to determine the fair price of a given security in terms of more liquid securities whose price is determined by the law of supply and demand. The meaning of "fair" depends, of course, on whether one considers buying or selling the security. Examples of securities being priced are plain vanilla and exotic options, convertible bonds, etc.

134

Once a fair price has been determined, the sell-side trader can make a market on the security. Therefore, derivatives pricing is a complex "extrapolation" exercise to define the current market value of a security, which is then used by the sell-side community. Derivatives pricing: the Q world Goal Environmen t "extrapolate the present"

risk-neutral probability

Processes

continuous-time martingales low Ito calculus, PDEs calibration sell-side

Dimension Tools Challenges Business

Quantitative derivatives pricing was initiated by Louis Bachelier in The Theory of Speculation (published 1900), with the introduction of the most basic and most influential of processes, theBrownian motion, and its applications to the pricing of options. Bachelier modeled the time series of changes in the logarithm of stock prices as a random walk in which the short-term changes had a finite variance. This
135

causes longer-term changes to follow a Gaussian distribution. Bachelier's work, however, was largely unknown outside academia.[citation needed] The theory remained dormant until Fischer Black and Myron Scholes, along with fundamental contributions by Robert C. Merton, applied the second most influential process, the geometric Brownian motion, to option pricing. For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. Black was ineligible for the prize because of his death in 1995. The next important step was the fundamental theorem of asset pricing by Harrison and Pliska (1981), according to which the suitably normalized current price P0 of a security is arbitrage-free, and thus truly fair, only if there exists a stochastic process Pt with constant expected value which describes its future evolution: ( 1 ) A process satisfying (1) is called a "martingale". A martingale does not reward risk. Thus the probability of the normalized security price process is called "risk-neutral" and is typically denoted by the blackboard font letter " ". The relationship (1) must hold for all times t: therefore the processes used for derivatives pricing are naturally set in continuous time. The quants who operate in the Q world of derivatives pricing are specialists with deep knowledge of the specific products they model. Securities are priced individually, and thus the problems in the Q world are low-dimensional in nature. Calibration is one of the main challenges of the Q world: once a continuous-time parametric process has been calibrated to a set of

136

traded securities through a relationship such as , a similar relationship is used to define the price of new derivatives. The main quantitative tools necessary to handle continuous-time Q-processes are Itos stochastic calculus and partial differential equations (PDEs). Risk and portfolio management: the P world Risk and portfolio management aims at modeling the probability distribution of the market prices of all the securities at a given future investment horizon. This "real" probability distribution of the market prices is typically denoted by the blackboard font letter " ", as opposed to the "risk-neutral" probability " " used in derivatives pricing. Based on the P distribution, the buy-side community takes decisions on which securities to purchase in order to improve the prospective profit-and-loss profile of their positions considered as a portfolio. Risk and portfolio management: the P world Goal Environment Processes Dimension Tools "model the future" real probability discrete-time series large multivariate statistics

137

Challenges Business

estimation buy-side

The quantitative theory of risk and portfolio management started with the mean-variance framework of Harry Markowitz (1952), who caused a shift away from the concept of trying to identify the best individual stock for investment. Using a linear regression strategy to understand and quantify the risk (i.e. variance) and return (i.e. mean) of an entire portfolio of stocks, bonds, and other securities, an optimization strategy was used to choose a portfolio with largest mean return subject to acceptable levels of variance in the return. Next, breakthrough advances were made with the Capital (CAPM) and the Arbitrage Pricing Theory (APT) developed by Trey nor (1962), Mossin (1966), William Sharpe (1964), Lintner (1965) and Ross (1976). For their pioneering work, Markowitz and Sharpe, along with Merton Miller, shared the 1990 Nobel Memorial Prize in Economic Sciences, for the first time ever awarded for a work in finance. The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the "black art" of investment management. With time, the mathematics has become more sophisticated. Thanks to Robert Merton and Paul Samuelson, one-period models were replaced by continuous time, Brownian-motion models, and the quadratic utility function implicit in meanvariance optimization was replaced by more general increasing, concave utility functions.[1] Furthermore, in more recent years the focus shifted toward estimation risk, i.e., the dangers of incorrectly assuming that advanced time
138

series analysis alone can provide completely accurate estimates of the market parameters [2] Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics. Criticism Over the years, increasingly sophisticated mathematical models and derivative pricing strategies have been developed, but their credibility was damaged by the financial crisis of 20072010. Contemporary practice of mathematical finance has been subjected to criticism from figures within the field notably by Nassim Nicholas Taleb, a professor of financial engineering at Polytechnic Institute of New York University, in his book The Black Swan[3] and Paul Wilmot. Taleb claims that the prices of financial assets cannot be characterized by the simple models currently in use, rendering much of current practice at best irrelevant, and, at worst, dangerously misleading. Wilmott and Emanuel Derman published the Financial Modelers' Manifesto in January 2008 which addresses some of the most serious concerns. Bodies such as the Institute for New Economic Thinking are now attempting to establish more effective theories and methods . In general, modeling the changes by distributions with finite variance is, increasingly, said to be inappropriate.[6] In the 1960s it was discovered
139

by Benot Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Levy alpha-stable distributions. The scale of change, or volatility, depends on the length of the time interval to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation.[3] See also Financial models with long-tailed distributions and volatility clustering. Mathematical finance articles Mathematical tools

Asymptotic analysis

Mathematical models

Stochastic calculus Brownian motion Levy process Stochastic equations differential

Calculus Copulas Differential equations

Monte method

Carlo

Numerical analysis

Expected value

Real analysis Partial differential equations

Stochastic volatility Numerical partial

differential equations

Ergodic theory

Probability Probability distributions

Crank Nicolson method

Feynman Kac formula

Finite difference method

Fourier transform

Binomial

Value at risk
140

Gaussian copulas

distribution Log-normal distribution

Volatility ARCH model GARCH model

Girsanov's theorem

Quantile functions Heat equation

It's lemma Martingale representation theorem

RadonNikodym derivative Risk-neutral measure

Derivatives pricing

Interest derivatives

rate

Black model caps and floors swaptions

Bond options Short-rate

141

models

Rendlem an-Bartter model

Vasicek model

Ho-Lee model

Hull White model

Cox IngersollRoss model

Black Karasinski model

Black DermanToy model

Kalotay WilliamsFabozzi model

Longstaff Schwartz model

142

Chen model

Forward based models

rate-

LIBOR market model (Brace GatarekMusiela Model, BGM)

Heath JarrowMorton Model (HJM)

Throughput accounting
Throughput Accounting (TA) is a principle-based and comprehensive

management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash
143

focused and does not allocate all costs (variable and fixed expenses, including overheads) to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output (see definition of T below for TVC) e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC).[3] It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput (see definition of T below) is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

History

When cost accounting was developed in the 1890s, labor was the largest fraction of product cost and could be considered a variable cost. Workers often did not know how many hours they would work in a week when they reported on Monday morning because time-keeping systems were rudimentary. Cost accountants, therefore, concentrated on how efficiently managers used labor since it was their most important variable resource. Now however, workers who come to work on Monday morning almost always work 40 hours or more; their cost is fixed rather than variable. However, today, many managers are still evaluated on their labor
144

efficiencies, and many "downsizing," "rightsizing," and other labor reduction campaigns are based on them. Goldratt argues that, under current conditions, labor efficiencies lead to decisions that harm rather than help organizations. Throughput Accounting, therefore, removes standard cost accounting's reliance on efficiencies in general, and labor efficiency in particular, from management practice. Many cost and financial accountants agree with Goldratt's critique, but they have not agreed on a replacement of their own and there is enormous inertia in the installed base of people trained to work with existing practices. Constraints accounting, which is a development in the Throughput Accounting field, emphasizes the role of the constraint, (referred to as the Archimedean constraint) in decision making

The concepts of Throughput Accounting

Goldratt's alternative begins with the idea that each organization has a goal and that better decisions increase its value. The goal for a profit maximizing firm is easily stated, to increase profit now and in the future. Throughput Accounting applies to not-for-profit organizations too, but they have to develop a goal that makes sense in their individual cases.

145

Throughput Accounting also pays particular attention to the concept of 'bottleneck' (referred to as constraint in the Theory of Constraints) in the manufacturing or servicing processes. Throughput Accounting uses three measures of income and expense:

The chart illustrates a typical throughput structure of income (sales) and expenses (TVC T=Sales less TVC and NP=T less OE.

and

OE).

Throughput (T) is the rate at which the system produces "goal units." When the goal units are money [5] (in for-profit businesses), throughput is net sales (S) less totally variable cost (TVC), generally the cost of the raw materials (T = S 146

TVC). Note that T only exists when there is a sale of the product or service. Producing materials that sit in a warehouse does not form part of throughput but rather investment. ("Throughput" is sometimes referred to as "throughput contribution" and has similarities to the concept of "contribution" in marginal costing which is sales revenues less "variable" costs - "variable" being defined according to the marginal costing philosophy.)

Investment (I) is the money tied up in the system. This is money associated with inventory, machinery, buildings, and other assets and liabilities. In earlier Theory of Constraints (TOC) documentation, the "I" was interchanged between "inventory" and "investment." The preferred term is now only "investment." Note that TOC recommends inventory be valued strictly on totally variable cost associated with creating the inventory, not with additional cost allocations from overhead.

Operating expense (OE) is the money the system spends in generating "goal units." For physical products, OE is all expenses except the cost of the raw materials. OE includes maintenance, utilities, rent, taxes and payroll.

Organizations that wish to increase their attainment of The Goal should therefore require managers to test proposed decisions against three questions. Will the proposed change: 1. Increase throughput? How?
2.

Reduce investment (inventory) (money that cannot be used)? How?

3. Reduce operating expense? How? The answers to these questions determine the effect of proposed changes on system wide measurements:
147

1. Net profit (NP) = throughput - operating expense = T-OE

2. 3.

Return on investment (ROI) = net profit / investment = NP/I TA Productivity = throughput / operating expense = T/OE

4. Investment turns (IT) = throughput / investment = T/I These relationships between financial ratios as illustrated by Goldratt are very similar to a set of relationships defined by DuPont and General Motors financial executive Donaldson Brown about 1920. Brown did not advocate changes in management accounting methods, but instead used the ratios to evaluate traditional financial accounting data. Throughput Accounting [6] is an important development in modern accounting that allows managers to understand the contribution of constrained resources to the overall profitability of the enterprise. See cost accounting for practical examples and a detailed description of the evolution of Throughput Accounting.

Trade credit
Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders.[1] For many borrowers in the developing world, trade credit serves as a valuable source of alternative data for personal and small business loans.[citation needed] There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of
148

businesses to make efficient use of capital to accomplish various business objectives.

Example

The operator of an ice cream stand may sign a franchising agreement, under which the distributor agrees to provide ice cream stock under the terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10 days. This means that the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a check for all or part of the invoice, and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days. The ice cream distributor can do the same thing. Receiving trade credit from milk and sugar suppliers on terms of Net 30, 2% discount if paid within ten days, means they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First, they have a substantial markup on the ingredients and other costs of production of the ice cream they sell to the operator. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be wellcapitalized either from the owners' investment or from accumulated profits, and may be looking to expand his markets. They may be aggressive in attempting to locate new customers or to help them get established. It is not on their interests for customers to go out of business from cash flow instabilities, so their financial terms aim to accomplish two things:
1.

Allow startup ice cream parlors the ability to mismanage their investment in inventory for a while, while learning their markets, without having a
149

dramatic negative balance in their bank account which could put them out of business. This is in effect, a short term business loan made to help expand the distributor's market and customer base. 2. By tracking who pays, and when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit he extends to prospering or exposure to losses from customers going bankrupt who would never pay for the ice cream delivered.

Treasury stock
A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including insiders' holdings). Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands, rather than paying dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat. Limitations of treasury stock

Treasury stock does not pay a dividend Treasury stock has no voting rights

150

Total treasury stock cannot exceed the maximum proportion of total capitalization specified by law in the relevant country

When shares are repurchased, they may either be canceled or held for reissue. If not canceled, such shares are referred to as treasury shares. Technically, a repurchased share is a company's own share that has been bought back after having been issued and fully paid. A company cannot own itself. The possession of treasury shares does not give the company the right to vote, to exercise pre-emptive rights as a shareholder, to receive cash dividends, or to receive assets on company liquidation. Treasury shares are essentially the same as unissued capital and no one advocates classifying unissued share capital as an asset on the balance sheet, as an asset should have probable future economic benefits. Treasury shares simply reduce ordinary share capital. Buying back shares Benefits In an efficient market, a company buying back its stock should have no effect on its price per share valuation. If the market fairly prices a company's shares at $50/share, and the company buys back 100 shares for $5,000, it now has $5,000 less cash but there are 100 fewer shares outstanding; the net effect should be that the underlying value of each share is unchanged. Additionally, buying back shares will improve price/earnings ratios due to the reduced number of shares(and unchanged earnings) and improve earnings per shareratios due to fewer shares outstanding (and unchanged earnings).

151

If the market is not efficient, the company's shares may be underpriced. In that case a company can benefit its other shareholders by buying back shares. If a company's shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock. Incentives One other reason for a company to buy back its own stock is to reward holders of stock options. Call option holders are hurt by dividend payments, since, typically, they are not eligible to receive them. A share buyback program may increase the value of remaining shares (if the buyback is executed when shares are under-priced); if so, call option holders benefit. A dividend payment short term always decreases the value of shares after the payment, so, for stocks with regularly scheduled dividends, on the day shares go ex-dividend, call option holders always lose whereas put option holders benefit. This does not apply to unscheduled (special) dividends since the strike prices of options are typically adjusted to reflect the amount of the special dividend. Finally, if the sellers into a corporate buyback are actually the call option holders themselves, they may directly benefit from temporary unrealistically favorable pricing. A company does not benefit by helping call stock options holder so this is not an incentive. A company will not do it for this reason except for the case in which the decision makers for the company have the incentive of profiting which is indeed illegal. After buyback The company can either retire (cancel) the shares (however, retired shares are not listed as treasury stock on the company's financial statements) or hold the shares
152

for later resale. Buying back stock reduces the number of outstanding shares. Accompanying the decrease in the number of shares outstanding is a reduction in company assets, in particular, cash assets, which are used to buy back shares. Accounting for treasury stock On the balance sheet, treasury stock is listed under shareholders' equity as a negative number. The accounts may be called "Treasury stock" or "equity reduction". One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively. Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market, the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market the entry in the books will be the same as the cost method. In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased, not retained earnings. In auditing financial statements, it is a common practice to check for this error to detect possible attempts to "cook the books."

Trial balance
153

A trial balance is a list of all the General ledger accounts (both revenue and capital) contained in the ledger of a business. This list will contain the name of the nominal ledger account and the value of that nominal ledger account. The value of the nominal ledger will hold either a debit balance value or a credit balance value. The debit balance values will be listed in the debit column of the trial balance and the credit value balance will be listed in the credit column. The profit and loss statement and balance sheet and other financial reports can then be produced using the ledger accounts listed on the trial balance. The name comes from the purpose of a trial balance which is to prove that the value of all the debit value balances equal the total of all the credit value balances. Trialing, by listing every nominal ledger balance, ensures accurate reporting of the nominal ledgers for use in financial reporting of a business's performance. If the total of the debit column does not equal the total value of the credit column then this would show that there is an error in the nominal ledger accounts. This error must be found before a profit and loss statement and balance sheet can be produced. The trial balance is usually prepared by a bookkeeper or accountant who has used daybooks to record financial transactions and then post them to the nominal ledgers and personal ledger accounts. The trial balance is a part of the double-entry bookkeeping system and uses the classic account format for presenting values.

Trial balance limitations

A trial balance only checks the sum of debits against the sum of credits. That is why it does not guarantee that there are no errors. The following are the main classes of error that are not detected by the trial balance.
154

An error of original entry is when both sides of a transaction include the wrong amount.[1] For example, if a purchase invoice for 21 is entered as 12, this will result in an incorrect debit entry (to purchases), and an incorrect credit entry (to the relevant creditor account), both for 9 less, so the total of both columns will be 9 less, and will thus balance. An error of omission is when a transaction is completely omitted from the accounting records.[1] As the debits and credits for the transaction would balance, omitting it would still leave the totals balanced. A variation of this error is omitting one of the ledger account totals from the trial balance.[2]

An error of reversal is when entries are made to the correct amount, but with debits instead of credits, and vice versa. [1] For example, if a cash sale for 100 is debited to the Sales account, and credited to the Cash account. Such an error will not affect the totals.

An error of commission is when the entries are made at the correct amount, and the appropriate side (debit or credit), but one or more entries are made to the wrong account of the correct type.[1] For example, if fuel costs are incorrectly debited to the postage account (both expense accounts). This will not affect the totals.

An error of principle is when the entries are made to the correct amount, and the appropriate side (debit or credit), as with an error of commission, but the wrong type of account is used.[1]For example, if fuel costs (an expense account), are debited to stock (an asset account). This will not affect the totals.

Compensating errors are multiple unrelated errors that would individually lead to an imbalance, but together cancel each other out.[1]

155

A Transposition Error is an error caused by switching the position of two adjacent digits. Since the resulting error is always divisible by 9, accountants use this fact to locate the misentered number. For example, a total is off by 72, dividing it by 9 gives 8 which indicates that one of the switched digits is either more, or less, by 8 than the other digit. Hence the error was caused by switching the digits 8 and 0 or 1 and 9. This will also not affect the totals.

Accounting ethics
Accounting ethics is primarily a field of applied ethics, the study of moral values and judgments as they apply to accountancy. It is an example of professional ethics. Accounting ethics were first introduced by Luca Pacioli, and later expanded by government groups, professional organizations, and independent companies. Ethics are taught in accounting courses at higher education institutions as well as by companies training accountants and auditors. Due to the diverse range of accounting services and recent corporate collapses, attention has been drawn to ethical standards accepted within the accounting profession.[2] These collapses have resulted in a widespread disregard for the reputation of the accounting profession.[3] To combat the criticism and prevent fraudulent accounting, various accounting organizations and governments have developed regulations and remedies for improved ethics among the accounting profession.

Importance of ethics

156

The nature of the work carried out by accountants and auditors requires a high level of ethics. Shareholders, potential shareholders, and other users of the financial statements rely heavily on the yearly financial statements of a company as they can use this information to make an informed decision about investment. They rely on the opinion of the accountants who prepared the statements, as well as the auditors that verified it, to present a true and fair view of the company.[5] Knowledge of ethics can help accountants and auditors to overcome ethical dilemmas, allowing for the right choice that, although it may not benefit the company, will benefit the public who relies on the accountant/auditor's reporting. Most countries have differing focuses on enforcing accounting laws. In Germany, accounting legislation is governed by "tax law"; in Sweden, by "accounting law"; and in the United Kingdom, by the "company law". In addition, countries have their own organizations which regulate accounting. For example, Sweden has the Bokfringsnmden (BFN - Accounting Standards Board), Spain the Instituto de Comtabilidad y Auditoria de Cuentas (ICAC), and the United States the Financial Accounting Standards Board (FASB). History

157

Luca Pacioli, here in a 1495 portrait by an unknown Renaissance artist, wrote on accounting ethics in 1494. Luca Pacioli, the "Father of Accounting", wrote on accounting ethics in his first book Summa de arithmetica, geometria, proportioni, ET proportionalita, published in 1494.[8] Ethical standards have since then been developed through government groups, professional organizations, and independent companies. These various groups have led accountants to follow several codes of ethics to perform their duties in a professional work environment. Accountants must follow the code of ethics set out by the professional body of which they are a member. United States accounting societies such as the Association of Government Accountants, Institute of Internal Auditors, and the National Association of Accountants all have codes of ethics, and many accountants are members of one or more of these societies.[9] In 1887, the American Association of Public Accountants (AAPA) was created; it was the first step in developing professionalism in the United States accounting industry. By 1905, the AAPA's first ethical codes were formulated to educate its members. During its twentieth anniversary meeting in October 1907, ethics was a major topic of the conference among its members. As a result of discussions, a list of professional ethics was incorporated into the organization's bylaws. However, because membership to the organization was voluntary, the association could not require individuals to conform to the suggested behaviors.[10] Other accounting organizations, such as the Illinois Institute of Accountants, also pursued discussion on the importance of ethics for the field. The AAPA was renamed several times throughout its history, before becoming the American Institute of Certified Public Accountants (AICPA) as its named today. The AICPA developed five divisions of ethical principles that its members should follow: "independence, integrity, and objectivity"; "competence and technical standards"; "responsibilities to clients";
158

"responsibilities to colleagues"; as well as "other responsibilities and practices". Each of these divisions provided guidelines on how a Certified Public Accountant (CPA) should act as a professional. Failure to comply with the guidelines could have caused an accountant to be barred from practicing. When developing the ethical principles, the AICPA also considered how the profession would be viewed by those outside of the accounting industry. Teaching ethics Universities began teaching business ethics in the 1980s. Courses on this subject have grown significantly in the last couple of decades. Teaching accountants about ethics can involve role playing, lectures, case studies, guest lectures, as well as other mediums. Recent studies indicate that nearly all accounting textbooks touch on ethics in some way. In 1993, the first United States center that focused on the study of ethics in the accounting profession opened at State University of New York at Binghamton. Starting in 1999, several U.S. states began requiring ethics classes prior to taking the CPA exam. Seven goals of accounting ethics education

Relate accounting education to moral issues. Recognize issues in accounting that have ethical implications. Develop "a sense of moral obligation" or responsibility. Develop the abilities needed to deal with ethical conflicts or dilemmas. Learn to deal with the uncertainties of the accounting profession. "Set the stage for" a change in ethical behavior.

159

Appreciate and understand the history and composition of all aspects of accounting ethics and their relationship to the general field of ethics. Stephen E. Loeb

In 1988, Stephen E. Loeb proposed that accounting ethics education should include seven goals (adapted from a list by Daniel Callahan). To implement these goals, he pointed out that accounting ethics could be taught throughout accounting curriculum or in an individual class tailored to the subject. Requiring it be taught throughout the curriculum would necessitate all accounting teachers to have knowledge on the subject (which may require training). A single course has issues as to where to include the course in a student's education (for example, before preliminary accounting classes or near the end of a student's degree requirements), whether there is enough material to cover in a semester class, and whether most universities have room in a four-year curriculum for a single class on the subject.[9] There has been debate on whether ethics should be taught in a university setting. Supporters point out that ethics are important to the profession, and should be taught to accountants entering the field. In addition, the education would help to reinforce students' ethical values and inspire them to prevent others from making unethical decisions. Critics argue that an individual is ethical or not, and that teaching an ethics course would serve no purpose. Despite opposition, instruction on accounting ethics by universities and conferences, has been encouraged by professional organizations and accounting firms. The Accounting Education Change Commission (AECC) has called for students to "know and understand the ethics of the profession and be able to make value-based judgments." Phillip G. Cottel argued that in order to uphold strong ethics, an accountant "must have a strong sense of values, the ability to reflect on a situation to determine the ethical implications, and a commitment to the well-being of others." Iris Stuart
160

recommends an ethics model consisting of four steps: the accountant must recognize that an ethical dilemma is occurring; identify the parties that would be interested in the outcome of the dilemma; determine alternatives and evaluate its effect on each alternative on the interested parties; and then select the best alternative. Accounting scandals

Accounting ethics has been deemed difficult to control as accountants and auditors must consider the interest of the public (which relies on the information gathered in audits) while ensuring that they remained employed by the company they are auditing. They must consider how to best apply accounting standards even when faced with issues that could cause a company to face a significant loss or even be discontinued. Due to several accounting scandals within the profession, critics of accountants have stated that when asked by a client "what does two plus two equal?" the accountant would be likely to respond "what would you like it to be?". This thought process along with other criticisms of the profession's issues with conflict of interest, have led to various increased standards of professionalism while stressing ethics in the work environment. The role of accountants is critical to society. Accountants serve as financial reporters and intermediaries in the capital markets and owe their primary obligation to the public interest. The information they provide is crucial in aiding managers, investors and others in making critical economic decisions. Accordingly, ethical improprieties by accountants can be detrimental to society, resulting in distrust by the public and disruption of efficient capital market operations.
161

"Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse. ... In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting." Ian Griffiths in 1986, describing creative accounting From the 1980s to the present there have been multiple accounting scandals that were widely reported on by the media and resulted in fraud charges, bankruptcy protection requests, and the closure of companies and accounting firms. The scandals were the result of creative accounting, misleading financial analysis, as well as bribery. Various companies had issues with fraudulent accounting practices, including Nugan Hand Bank, Phar-Mor, WorldCom, and AIG. One of the most widely-reported violations of accounting ethics involved Enron, a multinational company that for several years had not shown a true or fair view of their financial statements. Their auditor Arthur Andersen, an accounting firm considered one of the "Big Five", signed off on the validity of the accounts despite the inaccuracies in the financial statements. When the unethical activities were reported, not only did Enron dissolve but Arthur Andersen also went out of business. Enron's shareholders lost $25 billion as a result of the company's bankruptcy. Although only a fraction of Arthur Anderson's employees were involved with the scandal, the closure of the firm resulted in the loss of 85,000 jobs.

Causes
162

Fraudulent accounting can arise from a variety of issues. These problems usually come to light eventually and could ruin not only the company but also the auditors for not discovering or revealing the misstatements. Several studies have proposed that a firm's corporate culture as well as the values it stresses may negatively alter an accountant's behavior. This environment could contribute to the degradation of ethical values that were learned from universities. Until 1977, ethics rules prevented accounting and auditing firms from advertising to clients. When the rules were lifted, spending by the largest CPA firms on advertisements rose from US$4 million in the 1980s to more than $100 million in the 2000s. Critics claimed that, by allowing the firms to advertise, the business side overstepped the professional side of the profession, which led to a conflict of interest. This focus allowed for occurrences of fraud, and caused the firms, according to Arthur Bowman, "... to offer services that made them more consultants and business advisers than auditors." As accounting firms became less interested in the lower-paying audits due to more focus on higher earning services such as consulting, problems arose. This disregard for the lack of time spent on audits resulted in a lack of attention to catching creative and fraudulent accounting. A 2007 article in Managerial Auditing Journal determined the top nine factors that contributed to ethical failures for accountants based on a survey of 66 members of the International Federation of Accountants. The factors include (in order of most significant): "self-interest, failure to maintain objectivity and independence, inappropriate professional judgment, lack of ethical sensitivity, improper leadership and ill-culture, failure to withstand advocacy threats, lack of competence, lack of organizational and peer support, and lack of professional body support." The main factor, self-interest, is the motivation by an accountant to act in his/her best interest or when facing a conflict of interest. [2] For example, if an
163

auditor has an issue with an account he/she is auditing, but is receiving financial incentives to ignore these issues, the auditor may act unethically. Principles- vs. rules-based "When people need a doctor, or a lawyer, or a certified public accountant, they seek someone whom they can trust to do a good job not for himself, but for them. They have to trust him, since they cannot appraise the quality of his 'product'. To trust him they must believe that he is competent, and that his primary motive is to help them." John L. Carey, describing ethics in accounting The International Financial Reporting Standards (IFRS) are standards and interpretations developed by the International Accounting Standards Board, which are principle-based.[35] IFRS are used by over 115 countries including the European Union, Australia, and Hong Kong. The United States Generally Accepted Accounting Principles (GAAP), the standard framework of guidelines for financial accounting, is largely rule-based. Critics have stated that the rules-based GAAP is partly responsible for the number of scandals that the United States has suffered. The principles-based approach to monitoring requires more professional judgment than the rules-based approach. There are many stakeholders in many countries such as The United States who report several concerns in the usage of rules-based accounting. According to recent studies, many believe that the principles-based approach in financial reporting would not only improve but would also support an auditor upon dealing with clients pressure. As a result, financial reports could be viewed with fairness and transparency. When the U.S. switched to International accounting standards, they are composed that this would bring change. However, as a new chairperson of the
164

SEC takes over the system, the transition brings a stronger review about the pros and cons of rules- based accounting. While the move towards international standards progresses, there are small amount of research that examines the effect of principle- based standards in an auditors decision- making process. According to 114 auditing experts, most are willing to allow clients to manage their net income based on rules- based standards. These results offers insight to the SEC, IASB and FASB in weighing the arguments in the debate of principles- vs. rules basedaccounting. IFRS is based on "understandability, relevance, materiality, reliability, and comparability". Since IFRS has not been adopted by all countries, these practices do not make the international standards viable in the world domain. In particular, the United States has not yet conformed and still uses GAAP which makes comparing principles and rules difficult. In August 2008, the Securities (SEC) proposed that the United States switch from GAAP to IFRS, starting in 2014. Responses to scandals Since the major accounting scandals, new reforms, regulations, and calls for increased higher education have been introduced to combat the dangers of unethical behavior. By educating accountants on ethics before entering the workforce, such as through higher education or initial training at companies, it is believed it will help to improve the credibility of the accounting profession. Companies and accounting organizations have expanded their assistance with educators by providing education materials to assist professors in educating students. New regulations in response to the scandals include the Corporate Law Economic Reform Program Act 2004 in Australia as well as the Sarbanes-Oxley Act of 2002, developed by the United States. Sarbanes-Oxley limits the level of work which can
165

be carried out by accounting firms. In addition, the Act put a limit on the fee which a firm can receive from one client as a percentage of their total fees. This ensures that companies are not wholly reliant on one firm for its income, in the hope that they do not need to act unethically to keep a steady income. The act also protects whistleblowers and requires senior management in public companies to sign off on the accuracy of its company's accounting records. In 2002, the five members of the Public Oversight Board(POB), which oversaw ethics within the accounting profession, resigned after critics deemed the board ineffective and the SEC proposed developing a new panel, the Public Company Accounting Oversight Board (PCAOB). The PCAOB was developed through the Act, and replaced the POB. In 2003, the International Federation of Accountants (IFAC) released a report entitled Rebuilding Public Confidence in Financial Reporting: an International Perspective. By studying the international company collapses as a result of accounting issues, it determined areas for improvement within organizations as well as recommendations for companies to develop more effective ethics codes. The report also recommended that companies pursue options that would improve training and support so accountants could better handle ethical dilemmas. [2] A collaborative effort by members of the international financial regulatory community led by Michel Prada, Chairman of the French Financial Markets Authority, resulting in establishment of the Public Interest Oversight Board (PIOB) on 1 March 2005. The PIOB provides oversight of the IFAC standards-setting boards: the International Auditing and Assurance Standards Board (IAASB), the International Accounting Education Standards Board (IAESB) and the International Ethics Standards Board for Accountants (IESBA).

166

The most recent reform came into effect in July 2010 when President Obama signed "The Dodd-Frank Wall Street Reform and Consumer Protection Act". The act covers a broad range of changes. The highlights of the legislation are consumer protections with authority and independence, ends too big to fail bail outs, advance warning system, transparency and accountability for exotic instruments, executive compensation and corporate governance, protects investors, and enforces regulations on the books. The legislation also resulted in the Office of the Whistleblower, which was established to administer the SEC's whistleblower program. Congress authorized the SEC to provide monetary awards to whistleblowers who come forward with information that results in a minimum of a $1,000,000 sanction. The rewards are between 10% and 30% of the dollar amount collected. Whistleblowers help identify fraud and other unethical behaviors early on. The result is less harm to investors, quickly holding offenders responsible, and to maintain the integrity of the U.S. markets.

167

Accounting information system

An accounting information system (AIS) is a system of collection, storage and processing of financial and accounting data that is used by decision makers. An accounting information system is generally a computer-based method for tracking accounting activity in conjunction with information technology resources. The resulting statistical reports can be used internally by management or externally by other interested parties including investors, creditors and tax authorities. The actual physical devices and systems that allows the AIS to operate and perform its functions 1. Internal controls and security measures: what is implemented to safeguard the data 2. Model Base Management

History Initially, accounting information systems were predominantly developed inhouse as legacy systems. Such solutions were difficult to develop and expensive to maintain. Today, accounting information systems are more commonly sold as prebuilt software packages from vendors such as Microsoft, Sage Group, SAP and Oracle where it is configured and customized to match the organizations business processes. As the need for connectivity and consolidation between other business systems increased, accounting information systems were merged with larger, more centralized systems known as enterprise resource
168

planning (ERP). Before, with separate applications to manage different business functions, organizations had to develop complex interfaces for the systems to communicate with each other. In ERP, a system such as accounting information system is built as a module integrated into a suite of applications that can include manufacturing, supply chain, human resources. These modules are integrated together and are able to access the same data and execute complex business processes. With the ubiquity of ERP for businesses, the term accounting information system has become much less about pure accounting (financial or managerial) and more about tracking processes across all domains of business.

Software architecture of a modern AIS Modern AIS typically follows a multitier architecture separating the presentation to the user, application processing and data management in distinct layers. The presentation layer manages how the information is displayed to and viewed by functional users of the system (through mobile devices, web browsers or client application). The entire system is backed by a centralized database that stores all of the data. This can include transactional data generated from the core business processes (purchasing, inventory, and accounting) or static, master data that is referenced when processing data (employee and customer account records and configuration settings). As transaction occurs, the data is collected from the business events and stored into the systems database where it can be retrieved and processed into information that is useful for making decisions. The application layer retrieves the raw data held in the database layer, processes it based on the configured business logic and passes it onto the presentation layer to display to the users. For example, consider the accounts payable department when processing an
169

invoice. With an accounting information system, an accounts payable clerk enters the invoice, provided by a vendor, into the system where it is then stored in the database. When goods from the vendor are received, a receipt is created and also entered into the AIS. Before the accounts payable department pays the vendor, the systems application processing tier performs a three-way matching where it automatically matches the amounts on the invoice against the amounts on the receipt and the initial purchase order. Once the match is complete, an email is sent to an accounts payable manager for approval. From here a voucher can be created and the vendor can ultimately be paid. Advantages and implications of AIS A big advantage of computer-based accounting information systems is that they automate and streamline reporting. Reporting is major tool for organizations to accurately see summarized, timely information used for decisionmaking and financial reporting. The accounting information system pulls data from the centralized database, processes and transforms it and ultimately generates a summary of that data as information that can now be easily consumed and analyzed by business analysts, managers or other decision makers. These systems must ensure that the reports are timely so that decision-makers are not acting on old, irrelevant information and, rather, able to act quickly and effectively based on report results. Consolidation is one of the hallmarks of reporting as people do not have to look through an enormous number of transactions. For instance, at the end of the month, a financial accountant consolidates all the paid vouchers by running a report on the system. The systems application layer provides a report with the total amount paid to its vendors for that particular month. With large corporations that generate large volumes of transactional data, running reports with even an AIS can take days or even weeks.
170

After the wave of corporate scandals from large companies such as Tyco International, Enron and WorldCom, major emphasis was put on enforcing public companies to implement strong internal controls into their transaction-based systems. This was made into law with the passage of the Sarbanes Oxley Act of 2002 which stipulated that companies must generate an internal control report stating who is responsible for an organizations internal control structure and outlines the overall effectiveness of these controls. [2] Since most of these scandals were rooted in the companies' accounting practices, much of the emphasis of Sarbanes Oxley was put on computer-based accounting information systems. Today, AIS vendors tout their governance, risk management, and compliance features to ensure business processes are robust and protected and the organization's assets (including data) are secured. How to effectively implement AIS As stated above, accounting information systems are composed of six main components: When AIS is initially implemented or converted from an existing system, organizations sometimes make the mistake of not considering each of these six components and treating them equally in the implementation process. This results in a system being "built 3 times" rather than once because the initial system is not designed to meet the needs of the organization, the organization then tries to get the system to work, and ultimately, the organization begins again, following the appropriate process. Following a proven process that works, as follows, results in optimal deployment time, the least amount of frustration, and overall success. Most organizations, even larger ones, hire outside consultants, either from the software publisher or consultants who understand the organization and who work to help the organization select and implement the ideal configuration, taking all components
171

into consideration. Certified Public Accountants (CPAs) with careers dedicated to information systems work with small and large companies to implement accounting information systems that follow a proven process. Many of these CPAs also hold a certificate that is awarded by the American Institute of CPAsthe Certified Information Technology Professional (CITP). CITPs often serve as coproject managers with an organization's project manager representing the information technology department. In smaller organizations, a co-project manager may be an outsourced information technology specialist who manages the implementation of the information technology infrastructure.[4] The steps necessary to implement a successful accounting information system are as follows: Detailed Requirements Analysis Where all individuals involved in the system are interviewed. The current system is thoroughly understood, including problems and complete documentation of the current systemtransactions, reports, and questions that need to be answered are gathered. What the users need that is not in the current system is outlined and documented. Users include everyone, from top management to data entry. The requirements analysis not only provides the developer with the specific needs, it also helps users accept the change. Users who have the opportunity to ask questions and provide input are much more confident and receptive of the change, than those who sit back and don't express their concerns. Systems Design (synthesis) The analysis is thoroughly reviewed and a new system is created. The system that surrounds the system is often the most important. What data needs to go into the system and how is this going to be handled? What
172

information needs to come out of the system, and how is it going to be formatted? If we know what needs to come out, we know what we need to put into the system, and the program we select will need to appropriately handle the process. The system is built with control files, sample master records, and the ability to perform processes on a test basis. The system is designed to include appropriate internal controls and to provide management with the information needed to make decisions. It is a goal of an accounting information system to provide information that is relevant, meaningful, reliable, useful, and current. To achieve this, the system is designed so that transactions are entered as the occur (either manually or electronically) and information is immediately available on-line for management to use. Once the system is designed, an RFP is created detailing the requirements and fundamental design. Vendors are asked to respond to the proposal and to provide demonstrations of the product and to specifically respond to the needs of the organization. Ideally, the vendor will input control files, sample master records, and be able to show how various transactions are processed that result in the information that management needs to make decisions. An RFP for the information technology infrastructure follows the selection of the software product because the software product generally has specific requirements for infrastructure. Sometimes, the software and the infrastructure is selected from the same vendor. If not, the organization must ensure that both vendors will work together without "pointing fingers" when there is an issue with either the software or the infrastructure. Documentation As the system is being designed, it is documented. The documentation includes vendor documentation of the system and, more importantly, the procedures, or detailed instructions that help users handle each process
173

specific to the organization. Most documentation and procedures are on-line and it is helpful if organizations can add to the help instructions provided by the software vendor. Documentation and procedures tend to be an afterthought, but is the insurance policy and the tool that is used during testing and trainingprior to launch. The documentation is tested during the training so that when the system is launched, there is no question that it works and that the users are confident with the change. Testing

Prior to launch, all processes are tested from input through output, using the documentation as a tool to ensure that all processes are thoroughly documented and that users can easily follow the procedures so that you know it works and that the procedures will be followed consistently by all users. The reports are reviewed and verified, so that theres not a garbage ingarbage out. This is all done in a test system not yet fully populated with live data. Unfortunately, most organizations launch systems prior to thorough testing, adding to the end-user frustration when processes don't work. The documentation and procedures may be modified during this process. All identified transactions must be tested during this step in the process. All reports and on-line information must be verified and traced through the "audit trail" so that management is ensured that transactions will be handled consistently and that the information can be relied upon to make decisions.

Training

174

Prior to launch, all users need to be trained, with procedures. This means, a trainer using the procedures to show each end user how to handle a procedures. The procedures often need to be updated during training as users describe their unique circumstances and the "design" is modified with this additional information. The end user then performs the procedure with the trainer and the documentation. The end user then performs the procedure with the documentation alone. The end-user is then on his or her own with the support, either in person or by phone, of the trainer or other support person. Data Conversion

Tools are developed to convert the data from the current system (which was documented in the requirements analysis) to the new system. The data is mapped from one system to the other and data files are created that will work with the tools that are developed. The conversion is thoroughly tested and verified prior to final conversion. Of course, theres a backup so that it can be restarted, if necessary. Launch

The system is implemented only AFTER all of the above is completed. The entire organization is aware of the launch date. Ideally, the current system is retained and oftentimes run in "parallel" until the new system is in full operation and deemed to be working properly. With the current "massmarket" software used by thousands of companies and fundamentally proven to work, the "parallel" run that is mandatory with software tailor-made to a company is generally not done. This is only true, however, when the above
175

process is followed and the system is thoroughly documented and tested and users are trained PRIOR to launch.

Tools

Online resources are available to assist with strategic planning of accounting information systems. Information Systems and Financial Forms aid in determining the specific needs of each organization, as well as assign responsibility to principles involved. [5] Support

The end-users and managers have ongoing support available at all times. System upgrades follow a similar process and all users are thoroughly apprised of changes, upgraded in an efficient manner, and trained. Many organizations chose to limit the amount of time and money spent on the analysis, design, documentation, and training, and move right into software selection and implementation. It is a proven fact that if a detailed requirements analysis is performed with adequate time being spent on the analysis, that the implementation and ongoing support will be minimal. Organizations who skip the steps necessary to ensure the system meets the needs of the organization are often left with frustrated end users, costly support, and information that is not current or correct. Worse yet, these organizations build the system 3 times instead of once.

Audit
176

The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, water management, and energy conservation

Accounting
Auditing is a vital part of accounting. Traditionally, audits were mainly associated with gaining information about financial systems and the financial records of a company or a business. Financial audits are performed to ascertain the validity and reliability of

information, as well as to provide an assessment of a system's internal control. The goal of an audit is to express an opinion of the person / organization / system (etc.) in question, under evaluation based on work done on a test basis. Due to constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Hence, statistical sampling is often adopted in audits. In the case of financial audits, a set of financial statements are said to be true and fair when they are free of material misstatements a concept influenced by both quantitative (numerical) and qualitative factors. But recently, the argument that auditing should go beyond just True and fair is gaining momentum. And the US Public Company Accounting Oversight Board has come out with a concept release on the same. Cost accounting is a process for verifying the cost of manufacturing or producing of any article, on the basis of accounts measuring the use of material, labor or other items of cost. In simple words, the term, cost audit means a systematic and
177

accurate verification of the cost accounts and records, and checking for adherence to the cost accounting objectives. According to the Institute of Cost and Management Accountants of Pakistan, a cost audit is "an examination of cost accounting records and verification of facts to ascertain that the cost of the product has been arrived at, in accordance with principles of cost accounting. An audit must adhere to generally accepted standards established by governing bodies. These standards assure third parties or external users that they can rely upon the auditor's opinion on the fairness of financial statements, or other subjects on which the auditor expresses an opinion. The Definition for Audit and Assurance Standard AAS-1 by the Institute of Chartered Accountants of India(ICAI): "Auditing is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon. Integrated audits In the United States, audits of publicly traded companies are governed by rules laid down by the Public Company Accounting Oversight Board (PCAOB), which was established by Section 404 of the Sarbanes-Oxley Act of 2002. Such an audit is called an integrated audit, where auditors, in addition to an opinion on the financial statements, must also express an opinion on the effectiveness of a company's internal control over financial reporting, in accordance with PCAOB Auditing Standard No. 5. There are also new types of integrated auditing becoming available that use unified compliance material (see the unified compliance section in Regulatory compliance). Due to the increasing number of regulations and need for operational
178

transparency, organizations are adopting risk-based audits that can cover multiple regulations and standards from a single audit event. This is a very new but necessary approach in some sectors to ensure that all the necessary governance requirements can be met without duplicating effort from both audit and audit hosting resources. Assessments The purpose of an assessment is to measure something or calculate a value for it. Although the process of producing an assessment may involve an audit by an independent professional, its purpose is to provide a measurement rather than to express an opinion about the fairness of statements or quality of performance. As a general rule, audits should always be an independent evaluation that will include some degree of quantitative and qualitative analysis whereas an assessment implies a less independent and more consultative approach. Auditors Auditors of financial statements can be classified into two categories:

External auditor / Statutory auditor is an independent firm engaged by the client subject to the audit, to express an opinion on whether the company's financial statements are free of material misstatements, whether due to fraud or error. For publicly-traded companies, external auditors may also be required to express an opinion over the effectiveness of internal controls over financial. External auditors may also be engaged to perform other agreed-upon procedures, related or unrelated to financial statements. Most importantly, external auditors, though engaged and paid by the company being audited, are regarded as independent auditors.

179

Cost auditor / Statutory Cost auditor is an independent firm engaged by the client subject to the Cost audit, to express an opinion on whether the company's Sheet are free of material misstatements, whether due to fraud or error. For publicly-traded companies, external auditors may also be required to express an opinion over the effectiveness of internal controls over Cost reporting. These are Specialized Person called Cost Accountants in India & CMA globally either Cost & management Accountant or Certified management Accountants.

The most used external audit standards are the US GAAS of the American Institute of Certified Public Accountants; and the ISA International Standards on Auditing developed by the International Auditing and Assurance Standards Board of the International Federation of Accountants.[citation needed]

Internal auditors are employed by the organization they audit. They perform various audit procedures, primarily related to procedures over the effectiveness of the company's controls over financial reporting. Due to the requirement of Section 404 of the Sarbanes Oxley Act of 2002 for management to also assess the effectiveness of their internal controls over financial reporting (as also required of the external auditor), internal auditors are utilized to make this assessment. Though internal auditors are not considered independent of the company they perform audit procedures for, internal auditors of publiclytraded companies are required to report directly to the board of directors, or a sub-committee of the board of directors, and not to management, so to reduce the risk that internal auditors will be pressured to produce favorable assessments.

180

The most used Internal Audit standards are those of the Institute of Internal Auditors.

Consultant auditors are external personnel contracted by the firm to perform an audit following the firm's auditing standards. This differs from the external auditor, who follows their own auditing standards. The level of independence is therefore somewhere between the internal auditor and the external auditor. The consultant auditor may work independently, or as part of the audit team that includes internal auditors. Consultant auditors are used when the firm lacks sufficient expertise to audit certain areas, or simply for staff augmentation when staff are not available.

Quality auditors may be consultants or employed by the organization.

Performance audits Safety, security, information systems performance, and environmental concerns are increasingly the subject of audits. There are now audit professionals who specialize in security audits and information. With nonprofit organizations and government agencies, there has been an increasing need for performance audits, examining their success in satisfying mission objectives. Quality audits

Quality audits are performed to verify conformance to standards through review of objective evidence. A system of quality audits may verify the effectiveness of a quality management system. This is part of certifications such as ISO 9001. Quality audits are essential to verify the existence of objective evidence showing conformance to required processes, to assess how successfully processes have been
181

implemented, for judging the effectiveness of achieving any defined target levels, providing evidence concerning reduction and elimination of problem areas and are a hands-on management tool for achieving continual improvement in an organization. To benefit the organization, quality auditing should not only report nonconformance and corrective actions but also highlight areas of good practice and provide evidence of conformance. In this way, other departments may share information and amend their working practices as a result, also enhancing continual improvement. Project management

Regular Health Check Audits: The aim of a regular health check audit is to understand the current state of a project in order to increase project success. Regulatory Audits: The aim of a regulatory audit is to verify that a project is compliant with regulations and standards. Best practices of NEMEA Compliance Center describe that, the regulatory audit must be accurate, objective, and independent while providing oversight and assurance to the organization.

Energy audits An energy audit is an inspection, survey and analysis of energy flows for energy conservation in a building, processor system to reduce the amount of energy input into the system without negatively affecting the output. Operations audit An operations audit is an examination of the operations of the client's business. In this audit the auditor thoroughly examines the efficiency, effectiveness and
182

economy of the operations with which the management of the entity (client) is achieving its objective. The operational audit goes beyond the internal controls issues since management does not achieve its objectives merely by compliance of satisfactory system of internal controls. Operational audits cover any matters which may be commercially unsound. The objective of operational audit is to examine Three E's, namely: Effectiveness doing the right things with least wastage of resources. Efficiency performing work in least possible time. Economy balance between benefits and costs to run the operations .

Big Four (audit firms) The Big Four are the four largest international professional services

networks in accountancy and professional services, offering services including Audit, Assurance, Tax, Consulting, Advisory, Actuarial, Corporate Finance and Legal. They handle the vast majority of audits for publicly traded companies as well as many private companies, creating an oligopoly in auditing large companies. It is reported that the Big Four audit all but one of the companies that constitute the FTSE 100, and 240 of the companies in the FTSE 250, an index of the leading mid-cap listing companies.[1] The Big Four firms are shown below, with their latest publicly available data. Firm PwC Deloitte Revenues $31.5bn $31.3bn Employees 180,000 193,000 Fiscal Year 2012 2012 Headquarters United Kingdom United States Source
[2]

[3]

183

Firm Ernst Young KPMG &

Revenues

Employees

Fiscal Year

Headquarters

Source

$24.4bn

167,000

2012

United Kingdom

[4]

$22.1bn

145,000

2011

Netherlands

[5]

This group was once known as the "Big Eight", and was reduced to the "Big Five" by a series of mergers. The Big Five became the Big Four after the demise of Arthur Andersen in 2002, following its involvement in the Enron scandal. Legal structure None of the Big Four accounting firms is a single firm - rather, they are accounting networks. Each is a network of firms, owned and managed independently, which have entered into agreements with other member firms in the network to share a common name, brand and quality standards. Each network has established an entity to co-ordinate the activities of the network. In one case (KPMG), the coordinating entity is Swiss, and in three cases (Deloitte Touch Tohmatsu, PricewaterhouseCoopers and Ernst & Young) the co-coordinating entity is a UK limited company. Those entities do not themselves practice accountancy, and do not own or control the member firms. They are similar to law firm networks found in the legal profession. In many cases each member firm practises in a single country, and is structured to comply with the regulatory environment in that country. In 2007 KPMG announced a merger of four member firms (in the United Kingdom, Germany, Switzerland and Liechtenstein) to form a single firm.

184

Ernst & Young also includes separate legal entities which manage three of its four areas: Americas, EMEIA (Europe, The Middle East, India and Africa), and AsiaPacific. (Note: the Japan area does not have a separate area management entity). These firms coordinate services performed by local firms within their respective areas but do not perform services or hold ownership in the local entities.[6] The figures in this article refer to the combined revenues of each network of firms. Mergers and the Big Auditors Since 1989, mergers and one major scandal involving Arthur Andersen have reduced the number of major accountancy firms from eight to four. Big 8 The firms were called the Big 8 for most of the 20th century, reflecting the international dominance of the eight largest accountancy firms (presented here in alphabetical order):

Arthur

Andersen (Until

its

destruction

in

2002

for

its

part

in

the Enron scandal.)

Arthur Young & Co. Coopers & Lybrand (until 1973 Cooper Brothers in the UK and Lybrand, Ross Bros., & Montgomery in the US)

Ernst & Whinney (until 1979 Ernst & Ernst in the US and Whinney Murray in the UK)

Deloitte Haskins & Sells (until 1978 Haskins & Sells in the US and Deloitte & Co. in the UK)

Peat Marwick Mitchell (later Peat Marwick, then KPMG)

185

Price Waterhouse Touche Ross

Most of the Big 8 originated in alliances formed between British and US accountancy firms in the 19th or early 20th centuries. Price Waterhouse was a UK firm which opened a US office in 1890 and subsequently established a separate US partnership. The UK and US Peat Marwick Mitchell firms adopted a common name in 1925. Other firms used separate names for domestic business, and did not adopt common names until much later: Touche Ross in 1960, Arthur Young (at first Arthur Young, McClelland Moores) in 1968, Coopers & Lybrand in 1973, Deloitte Haskins & Sells in 1978 and Ernst & Whinney in 1979. The firms' initial international expansion was driven by the needs of British and US based multinationals for worldwide service. They expanded by forming local partnerships or by forming alliances with local firms. Arthur Andersen had a different history. The firm originated in the United States, and expanded internationally by establishing its own offices in other markets, including the United Kingdom. In the 1980s the Big 8, each now with global branding, adopted modern marketing and grew rapidly. They merged with many smaller firms. One of the largest of these mergers was in 1987, when Peat Marwick merged with the Klynveld Main Goerdeler (KMG) group to become KPMG Peat Marwick, later known simply as KPMG. Big 6 Competition among these public accountancy firms intensified and the Big 8 became the Big 6 in 1989 when Ernst & Whiney merged with Arthur Young to
186

form Ernst & Young in June, and Deloitte, Haskins & Sells merged with Touch Ross to form Deloitte & Touch in August. Confusingly, in the United Kingdom the local firm of Deloitte, Haskins & Sells merged instead with Coopers & Lybrand. For some years after the merger, the merged firm was called Coopers & Lybrand Deloitte and the local firm of Touch Ross kept its original name. In the mid 1990s however, both UK firms changed their names to match those of their respective international organizations. On the other hand, in Australia the local firm of Touch Ross merged instead with KPMG. It is for these reasons that the Deloitte & Touch international organization was known as DRT International (later DTT International), to avoid use of names which would have been ambiguous (as well as contested) in certain markets. Elsewhere, the local firm in Malaysia merged with Arthur Andersen. Big 5 The Big 6 became the Big 5 in July 1998 when Price Waterhouse merged with Coopers & Lybrand to form PricewaterhouseCoopers. Big 4 The Enron collapse and ensuing investigation prompted scrutiny of their financial reporting, which was audited by Arthur Andersen, which eventually was indicted for obstruction of justice for shredding documents related to the audit in the 2001 Enron scandal. The resulting conviction, since overturned, still effectively meant the end for Arthur Andersen. Most of its country practices around the world have been sold to members of what is now the Big Four, notably Ernst & Young globally, Deloitte & Touche in the UK, Canada, Spain and Brazil, andPricewaterhouseCoopers(now known as PwC) in China and Hong Kong.

187

The Big 4 are sometimes referred to as the "Final Four" due to the widely held perception that competition regulators are unlikely to allow further concentration of the accounting industry and that other firms will never be able to compete with the Big 4 for top-end work, as there is a market perception that they are not credible as auditors or advisors to the largest corporations. 2002 saw the passage of the SarbanesOxley Act into law, providing strict compliance rules to both businesses and their auditors. In 2010 Deloitte with its 1.8% growth was able to beat PricewaterhouseCoopers with its 1.5% growth to gain first place and become the largest accounting firm in the industry. In 2011, PwC re-gained the first place with 10% revenue growth. [10] Mergers and developments

(2001) Arthur Andersen Developed from Andersen, Delany Ernst & Young (1989)

Arthur Young (1968) Ernst & Whiney (1979) Ernst & Ernst (US) Whiney Murray (UK) Whiney, Smith & Whiney

PwC (2010) PricewaterhouseCoopers (1998)

188

Coopers & Lybrand (1973) Cooper Brothers (UK) Lybrand, Ross Bros, Montgomery (US) Price Waterhouse

Deloitte Touche Tohmatsu Deloitte & Touche (1989)

Deloitte Haskins & Sells (1978) Deloitte & Co. (UK) Haskins & Sells (US) Touche Ross (1960) Touche, Ross, Bailey & Smart Ross, Touche (Canada) George A. Touche (UK) Touche, Niven, Bailey & Smart (US) Touche Niven Bailey A. R. Smart

Tohmatsu & Co. (Japan) KPMG (1987)

189

Peat Marwick Mitchell (1925) William Barclay Peat (UK) Marwick Mitchell (US) KMG Klynveld Main Goerdeler Klynveld Kraayenhof (Netherlands) Thomson McLintock (UK) Main Lafrentz (US) Deutsche Treuhand Gesellschaft (Germany)

A year at the end indicates year of formation through merger or adoption of single brand name. A year in the beginning indicates date of closure of functioning or going out of prominence. Policy issues concerning industry concentration In the wake of industry concentration and individual firm failure, the issue of a credible alternative industry structure has been raised. The limiting factor on the growth of additional firms is that although some of the firms in the next tier have become quite substantial, and have formed international networks, effectively all very large public companies insist on having a "Big Four" audit, so the smaller firms have no way to grow into the top end of the market. Documents published in June 2010 show that some UK companies' banking covenants require them to use one of the Big Four. This approach from the lender prevents accounting firms in the next tier from competing for audit work for such
190

companies. The British Bankers' Association said that such clauses are rare.
[12]

Current discussions in the UK consider outlawing such clauses.

In 2011, The UK House of Lords completed an inquiry into the financial crisis, and called for an Office of Fair Trading investigation into the dominance of the Big Four. It is reported that the Big Four audit all but one of the companies that constitute the FTSE 100, and 240 of the companies in the FTSE 250, an index of the leading mid-cap listing companies. In Ireland, the Director of Corporate Enforcement, in February 2011 said, auditors "report surprisingly few types of company law offences to us", with the so-called "big four" auditing firms reporting the least often to his office, at just 5pc of all reports. Global member firms additionalcitations for verification. (April 2012) Deloitte Touche Tohmatsu Ernst Young & Co. Ernst Young & &

Country

PwC

KPMG

Argentina

Deloitte & Co. Pricewaterhouse S.R.L Hoda Vasi S.R.L.

KPMG

Bangladesh Chowdhury Co. Brazil Deloitte

& A. Qasem & Co. (AQC)

S. F. Ahmed Rahman & Co. Rahman Huq

PwC

Ernst

& KPMG
191

Country

Deloitte Touche Tohmatsu

PwC

Ernst Young

&

KPMG

Young Terco Ernst Young Ming Allied Egypt Kamel Saleh Mansour & Co. for Hazem Hassan & Hua

China

Deloitte Yong

Hua PricewaterhouseCoopers Zhong Tian

KPMG Hua Zhen

Accounting and Auditing (Emad Ragheb) Ernst PricewaterhouseCoopers El Young Salvador Salvador, S.A. de C.V. & El

DTT El Salvador Salvador, de C.V.

El S.A.

KPMG, S.A.

India

Deloitte Haskins Price Waterhouse, Price S.R.Batliboi BSR & Co & Sells, P C Waterhouse Chokshi & Co, Dalal & Shah S.B. Billimoria, M.Pal & Co., & Co., & Co., Hansotia, C C Lovelock & Lewes, and S.R.Batliboi & Associates, S.V.Ghatalia & Associates
192

Country

Deloitte Touche Tohmatsu Fraser & Ross and Touche Ross & co and A.F Ferguson

PwC

Ernst Young

&

KPMG

KAP Indonesia KAP Osman KAP Tanudiredja, Purwantono, Suherman & Surja Kost, Deloitte Israel Brightman Almagor Zohar Kesselman & Kesselman, PwC Israel Gabbay Kasierer (Ernst Young Israel) Italy Deloitte Touche PricewaterhouseCoopers Tohmatsu Forer, Bing Satrio Wibisana & Rekan

KAP Sidharta dan Widjaja

& KPMG Somekh & Chaikin

Reconta Ernst KPMG & Young Financial Business Advisors

193

Young

SpA, Ernst &

Country

Deloitte Touche Tohmatsu

PwC

Ernst Young SpA, Ernst Young

&

KPMG

& KPMG AZSA KPMG AZSA Co.) Houjin & & LLC (formerly

Deloitte Touche Japan Tohmatsu Kansa Tohmatsu Houjin

PricewaterhouseCoopers Aarata Aarata Kansa Houjin

ShinNihon LLC ShinNihon YugenHoujin

sekinin Kansa Azsa Kansa

Jordan

Deloitte Touche(M.E) Deloitte Touche (E.A) Deloitte Touche(M.E) Deloitte KassimChan &

PwC

Ernst Young Ernst Young Ernst Young Ernst Young

KPMG

Kenya

PwC

&

KPMG

Lebanon

PwC

&

Malaysia

PricewaterhouseCoopers

& KPMG

194

Country

Deloitte Touche Tohmatsu Galaz,

PwC

Ernst Young

&

KPMG

Mexico

Yamazaki, Ruiz Urquiza, S.C. Deloitte Touche(M.E) Akintola

PricewaterhouseCoopers Mxico

KPMG Mancera S.C. Crdenas Dosal, S.C. Ernst Young &

Morocco

PwC

KPMG

Nigeria

Williams Deloitte

PwC Nigeria

Ernst Young

&

KPMG

Ernst Pakistan M. Yousuf Adil Saleem & Co. A. F. Ferguson & Co. Young Hyder Deloitte Touche(M.E) Ernst Young

& Ford

KPMG Taseer Hadi & Co.

Rhodes Sidat

Palestine

PwC

&

none

Philippines Navarro Amper Isla Lipana & Co. & Co (formerly Manabat Delgado Amper

Sycip Gorres Manabat Velayo & Co. Sanagustin & Co.

195

Country

Deloitte Touche Tohmatsu & Co.) Deloitte Touche & Bakr

PwC

Ernst Young

&

KPMG

Saudi Arabia

PricewaterhouseCoopers LLP

Ernst Arabia Ernst Young Hanyoung LLC Ernst Young

& KPMG Sadhan &

Al

Young Saudi Fozan & Al

Abulkhair & Co Deloitte Touche Tohmatsu

South Africa South Korea

PwC

KPMG

Anjin LLC

Samil LLC

Samjong LLC &

Sri Lanka

PwC

KPMG

Sweden

Deloitte Touche hrlings Tohmatsu Deloitte(M.E)Nassir Tamimi Chartered Accountant PricewaterhouseCoopers Pricewaterhousecoopers

KPMG

Syria

Abdul Kader Mejanni partners

&

Hussarieh and Co. Charted Accountants and Consultants

196

Country

Deloitte Touche Tohmatsu

PwC

Ernst Young

&

KPMG

LLC PricewaterhouseCoopers Taiwan Ernst Young Gney Basaran Nas Bagimsiz Bagimsiz Denetim Denetim ve SMMM A.S. &

Taiwan

Deloitte.

KPMG

DRT Turkey

Bagimsiz ve

Akis Bagimsiz ve Denetim ve

Denetim S.M.M. A.S.

S.M.M. A.S. S.M.M. A.S.

Uzbekistan.

Deloitte Touche ASC Tohmatsu PricewaterhouseCoopers Espieira Asociados (PricewaterhouseCoopers) Pacheco y

Evan Young

Venezuela

Lara Marambio & Asociados

197

Investment
Investment is putting money into something with the expectation of gain, usually over a longer term. This may or may not be backed by research and analysis. Most or all forms of investment involve some form of risk, such as investment in equities, property, and even fixed interest securities which are subject, inter alia, to inflation risk. In contrast putting money into something with a hope of short-term gain, with or without thorough analysis, is gambling or speculation. This category would include most forms of derivatives, which incorporate a risk element without being longterm homes for money, and betting on horses. It would also include purchase of e.g. a company share in the hope of a short-term gain without any intention of holding it for the long term. Under the efficient market hypothesis, all investments with equal risk should have the same expected rate of return: that is to say there is a trade-off between risk and expected return. But that does not prevent one from investing in risky assets over the long term in the hope of benefiting from this trade-off. The common usage of investment to describe speculation has had a effect in real life as well: it reduced investor capacity to discern investment from speculation, reduced investor awareness of risk associated with speculation,

198

increased capital available to speculation, and decreased capital available to investment.

In economics or macroeconomics

In economic theory or in macroeconomics, investment is the amount purchased per unit time of goods which are not consumed but are to be used for future production (i.e. capital). in human Examples include railroad or factory construction. costs of additional schooling or Investment on-the-job capital includes

training. Inventory investment is the accumulation of goods inventories; it can be positive or negative, and it can be intended or unintended. In measures of national income and output, "gross investment" (represented by the variable I) is also a component of gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government

spending, and NX is net exports. Thus investment is everything that remains of total expenditure after consumption, government spending, and net exports are subtracted (i.e. I = GDP C G NX). Non-residential fixed investment (such as new factories) and residential investment (new houses) combine with inventory investment to make up I. "Net investment" deducts depreciation from gross investment. Net fixed investment is the value of the net increase in the capital stock per year. Fixed investment, as expenditure over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock that is, accumulated net investment to a point in time (such as December 31). Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an
199

investment, the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest. In finance In finance, investment is the application of funds to hold assets over a longer term in the hope of achieving gains and/or receiving income from those assets. It generally does not include deposits with a bank or similar institution. Investment usually involves diversification of assets in order to avoid unnecessary and unproductive risk. In contrast, dollar (or pound etc) cost averaging and market timing are phrases often used in marketing of collective investments and can be said to be associated with speculation. Investments are often made indirectly through intermediaries, such as pension funds, banks, brokers, and insurance companies. These institutions may pool money received from a large number of individuals into funds such as investment trusts, unit trusts, SICAVs etc to make large scale investments. Each individual investor then has an indirect or direct claim on the assets purchased, subject to charges levied by the intermediary, which may be large and varied.

Foreign direct investment

Foreign direct investment (FDI) is direct investment into production or business in a country by a company in another country, either by buying a company in the target country or by expanding operations of an existing business in that country. . Foreign direct investment is in contrast to portfolio investment which is a passive investment in the securities of another country such as stocks and bonds.

200

As a part of the national accounts of a country, and in regard to the national income equation Y=C+I+G+(X-M), I is investment plus foreign investment, FDI refers to the net inflows of investment (inflow minus outflow) to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. [1] It is the sum of equity capital, other long-term capital, and short-term capital as shown the balance of payments. It usually involves participation in management, joint-venture, transfer of technology and expertise. There are two types of FDI: inward and outward, resulting in a net FDI inflow (positive or negative) and "stock of foreign direct investment", which is the cumulative number for a given period. Direct investment excludes investment through purchase of shares.[2] FDI is one example of international factor movements. Importance and barriers to FDI The rapid growth of world population since 1950 has occurred mostly in developing countries. This growth has not been matched by similar increases in per-capita income and access to the basics of modern life, like education, health care, or - for too many - even sanitary water and waste disposal. FDI has proven, when skillfully applied, to be one of the fastest and highest means of development. However, given its many benefits for both investing firms and hosting countries, the level possible to meet potential and needs has been difficult. Recently, research and practice are finding ways to clarify the local situation and to suggest contractual and policy tools the make FDI more assured and beneficial. Foreign direct investment and the developing world A recent meta-analysis of the effects of foreign direct investment on local firms in developing and transition countries suggests that foreign investment robustly
201

increases

local

productivity

growth.[3] The Commitment

to

Development

Index ranks the "development-friendliness" of rich country investment policies. Difficulties limiting FDI Foreign direct investment may be politically controversial or difficult because it partly reverses previous policies intended to protect the growth of local investment or of infant industries. When these kinds of barriers against outside investment seem to have not worked sufficiently, it can be politically expedient for a host country to open a small "tunnel" for FDI. To secure greater benefits for lesser costs, this tunnel need be focused on a particular industry and on a closely negotiated, specific term. These terms define the trade offs of certain levels and types of investment by a firm, and specified concessions by the host country. Of course, there are (like many segmented marriage markets) 'match-making' implicit markets, and unpredictable "courtships" with rapidly shifting terms. Because local circumstances and the global economy vary so rapidly, not only is the value of FDI with some industries, some companies, and some countries much greater than with others, but the valuations can shift dramatically in short times and at time quite irrationally. These uncertainties can make negotiating and planning FDI even more irrational. The risk premiums involved have been major barriers for FDI in many countries. The investing firm needs sufficient cooperation and concessions to justify their business case in terms of lower labor costs, and the opening of the country's or even regional markets at a distinct advantage over (global) competitors. The hosting country needs sufficient contractual promises to politically sell uncertain benefits -- versus the better-known costs of concessions or damage to local interests.

202

The benefits to the host may be: creation of a large number of more stable and higher-paying jobs; establishing in lagging areas centers of new economic development that will support attracting or strengthening of many other firms without so costly concessions; hastening the transfer of premium-paying skills to the host country's work force; and encouraging technology transfer to local suppliers. Concessions or "cooperation" commonly offered include: tax exemptions or reductions; construction or cheap lease-back of site improvements or of new building facilities; and large local infrastructures such as roads or rail lines; More politically difficult (certainly for less-developed regions)are concessions which change policies for: reduced taxes and tariffs; curbing protections for smallerbusiness from the large or global; and laxer administration of regulations on labor safety and environmental preservation.

Types 1. Horizon FDI arises when a firm duplicates its home country-based activities at the same value chain stage in a host country through FDI.[4] 2. Platform FDI 3. Vertical FDI takes place when a firm through FDI moves upstream or downstream in different value chains i.e., when firms perform value-adding activities stage by stage in a vertical fashion in a host country.[4] Horizontal FDI decreases international trade as the product of them is usually aimed at host country; the two other types generally act as a stimulus for it. Methods
203

The foreign direct investor may acquire voting power of an enterprise in an economy through any of the following methods:

by incorporating a wholly owned subsidiary or company anywhere by acquiring shares in an associated enterprise through a merger or an acquisition of an unrelated enterprise participating in an equity joint venture with another investor or enterprise

Foreign direct investment incentives may take the following forms

low corporate tax and individual income tax rates tax holidays other types of tax concessions preferential tariffs special economic zones EPZ Export Processing Zones Bonded Warehouses Maquiladoras investment financial subsidies soft loan or loan guarantees free land or land subsidies relocation & expatriation
204

infrastructure subsidies R&D support derogation from regulations (usually for very large projects)

Country attractiveness There are multiple factors determining host country attractiveness in the eyes of large foreign direct institutional investors, notably pension funds and sovereign wealth funds. Research conducted by the World Pensions Council (WPC) suggests that perceived legal/political stability over time and medium-term economic growth dynamics constitute the two main determinants. Some development economists believe that a sizeable part of Western Europe has now fallen behind the most dynamic amongst Asias emerging nations, notably because the latter adopted policies more propitious to long-term investments: Successful countries such as Singapore, Indonesia and South Korea still remember the harsh adjustment mechanisms imposed abruptly upon them by the IMF and World Bank during the 1997-1998 Asian Crisis [] What they have achieved in the past 10 years is all the more remarkable: they have quietly abandoned the Washington consensus [the dominant Neoclassical perspective] by investing massively in infrastructure projects []: this pragmatic approach proved to be very successful.[6] Foreign direct investment by country

Global overview of foreign direct investment The United Nations Conference on Trade and Development said that there was no significant growth of global FDI in 2010. In 2011 was $1,524 billion, in 2010 was
205

$1,309 billion and in 2009 was $1,114 billion. The figure was 25 percent below the pre-crisis average between 2005 and 2007.[7] Foreign direct investment in the United States Broadly speaking, the U.S. has a fundamentally open economy and very small barriers to foreign direct investment. The United States is the worlds largest recipient of FDI. U.S. FDI totaled $194 billion in 2010. 84% of FDI in the U.S. in 2010 came from or through eight countries: Switzerland, the United Kingdom, Japan, France, Germany, Luxembourg, the Netherlands, and Canada.[9] Research indicates that foreigners hold greater shares of their investment portfolios in the United States if their own countries have less developed financial markets, an effect whose magnitude decreases with income per capita. Countries with fewer capital controls and greater trade with the United States also invest more in U.S. equity and bond markets.[10] White House data reported in June 2011 found that a total of 5.7 million workers were employed at facilities highly dependent on foreign direct investors. Thus, about 13% of the American manufacturing workforce depended on such investments. The average pay of said jobs was found as around $70,000 per worker, over 30% higher than the average pay across the entire U.S. workforce. President Barack Obama has said, "In a global economy, the United States faces increasing competition for the jobs and industries of the future. Taking steps to ensure that we remain the destination of choice for investors around the world will help us win that competition and bring prosperity to our people." Foreign direct investment in China FDI in China, also known as RFDI (renminbi foreign direct investment), has increased considerably in the last decade reaching $85 billion in 2010. [11] China is
206

the second largest recipient of FDI globally. FDI into China fell by over one-third in 2009 due the global financial crisis (global macroeconomic factors) but rebounded in 2010. In the first six months of 2012 China received more foreign direct investment than the United States ($59.1 billion and $57.4 billion, respectively). Foreign direct investment in India Starting from a baseline of less than $1 billion in 1990, a recent UNCTAD survey projected India as the second most important FDI destination (after China) for transnational corporations during 20102012. As per the data, the sectors that attracted higher inflows were services, telecommunication, construction activities and computer software and hardware. Mauritius, Singapore, US and UK were among the leading sources of FDI. According to Ernst & Young, FDI in India in 2010 was $44.8 billion and in 2011 experienced an increase of 13% to $50.8 billion.[14] India has seen an eightfold increase in its FDI in March 2012. India disallowed overseas corporate bodies (OCB) to invest in India.[16] 2012 FDI reforms On 14 September 2012, Government of India allowed FDI in aviation up to 49%, in the broadcast sector up to 74%, in multi-brand retail up to 51% and in singlebrand retail up to 100%. The choice of allowing FDI in multi-brand retail up to 51% has been left to each state. In its supply chain sector, the government of India had already approved 100% FDI for developing cold chain. This allows non-Indians to now invest with full ownership in India's burgeoning demand for efficient food supply systems. [18] The need to reduce waste in fresh food and to feed the aspiring demand of India's fast

207

developing population has made the cold supply chain a very exciting investment proposition. Foreign investment was introduced by Prime Minister Manmohan Singh when he was finance minister (1991) by the government of India as FEMA (Foreign Exchange Management Act). This has been one of the top political problems for Singh's government, even in the current (2012) election.

List of countries by received FDI

2007 List by the UNCTAD2010 List by the CIA World Factbook Rank 1 2 Country United States United Kingdom FDI (millions of USD) 2,093,058 1,347,688

208

Rank 3 4 5 6 7 8 9 10 11 12 13 14 15

Country Hong Kong SAR France Belgium Netherlands Germany Spain Canada Italy Brazil China (PRC) Russian Federation Australia Switzerland

FDI (millions of USD) 1,184,471 1,026,081 748,110 673,430 629,711 537,455 520,737 364,839 328,455 327,087 324,065 312,275 278,155
209

Rank 16 17 18 19 20 21 22 23 24 25 26 27 28

Country Mexico Sweden Singapore Ireland Denmark Turkey Poland Japan Austria South Korea Portugal Chile Czech Republic

FDI (millions of USD) 265,736 254,459 249,667 187,184 146,632 145,556 142,110 132,851 126,895 119,630 114,192 105,558 101,074
210

Rank 29 30 31 32 33 34 35 36 37 38 39 40 41

Country Hungary Norway South Africa Thailand Finland Malaysia India Saudi Arabia New Zealand Cayman Islands Argentina Nigeria British Virgin Islands

FDI (millions of USD) 97,397 93,688 93,474 85,749 85,237 76,748 76,226 76,146 71,312 69,784 66,015 62,791 61,578
211

Rank 42 43 44 45 46 47 48 49 50 51 52 53 54

Country Romania Israel Indonesia Colombia United Arab Emirates Greece Egypt Taiwan Croatia Venezuela, Bolivarian Republic of Kazakhstan Slovakia Viet Nam

FDI (millions of USD) 60,921 59,952 58,955 56,189 54,786 52,838 50,503 48,640 44,630 43,957 43,381 40,702 40,235
212

Rank 55 56 57 58 59 60 61 62 63 64 65 66 67

Country Ukraine Bulgaria Morocco Luxembourg Tunisia Peru Lebanon Pakistan Philippines Cyprus Estonia Serbia and Montenegro Lithuania

FDI (millions of USD) 38,059 36,508 32,516 30,176 26,223 24,744 21,121 20,086 18,952 18,414 16,594 15,681 14,679
213

Rank 68 69 70 71 72 73 74 75 76 77 78 79 80

Country Panama Jordan Sudan Trinidad and Tobago Serbia Bahrain Iceland Angola Algeria Equatorial Guinea Latvia Slovenia Ecuador

FDI (millions of USD) 14,611 14,549 13,828 13,475 13,204 12,947 12,269 12,207 11,815 10,745 10,493 10,350 10,310
214

Rank 81 82 83 84 85 86 87 88 89 90 91 92 93

Country Brunei Darussalam Syrian Arab Republic Costa Rica Macao Jamaica Dominican Republic Bahamas Malta Qatar Azerbaijan Libyan Arab Jamahiriya Guatemala Bosnia and Herzegovina

FDI (millions of USD) 10,045 9,684 8,803 8,606 8,580 8,269 8,268 7,457 7,250 6,598 6,575 6,506 5,990
215

Rank 94 95 96 97 98 99 100 101 102 103 104 105 106

Country United Republic of Tanzania El Salvador Oman Cte d'Ivoire Myanmar Zambia Bolivia Iran, Islamic Republic of Georgia Chad Uruguay Belarus Bangladesh

FDI (millions of USD) 5,942 5,911 5,878 5,702 5,433 5,375 5,323 5,295 5,259 5,085 5,069 4,500 4,404
216

Rank 107 108 109 110 111 112 113 114 115 116 117 118 119

Country Honduras Turkmenistan Namibia Cambodia Congo Cameroon Ghana Ethiopia Sri Lanka Mozambique Macedonia Nicaragua Uganda

FDI (millions of USD) 4,328 3,928 3,822 3,821 3,819 3,796 3,634 3,620 3,456 3,216 3,084 3,083 2,909
217

Rank 120 121 122 124 125 126 127 128 129 130 131 132 133

Country Montenegro Armenia Yemen Liberia Albania Paraguay Antigua and Barbuda Mauritania Kenya Madagascar Moldova Saint Lucia Uzbekistan

FDI (millions of USD) 2,478 2,448 2,389 2,278 2,264 2,003 1,986 1,905 1,892 1,830 1,813 1,669 1,648
218

Rank 134 135 136 137 138 139 140 141 142 143 144 145 146

Country Congo Zimbabwe Fiji Gibraltar

FDI (millions of USD) 1,512 1,492 1,464 1,406

Korea, Democratic People's Republic of 1,378 New Caledonia Mongolia Mali Botswana Bermuda Mauritius Guyana Aruba 1,360 1,326 1,326 1,300 1,291 1,249 1,244 1,184
219

Rank 147 148 149 150 151 Rank

Country Lao People's Democratic Republic Iraq Saint Kitts and Nevis Afghanistan Tajikistan Country

FDI (millions of USD) 1,180 1,162 1,120 1,116 1,046 Stock of FDI at home Date (USD) information 2008 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. of

1 2 3 4

World United States France United Kingdom Germany Hong Kong SAR

16,360,000,000,000 2,581,000,000,000 1,207,000,000,000 1,169,000,000,000 1,057,000,000,000 962,200,000,000

220

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est.

of

5 6 7 8 9 10 11 12 13 14 15 16

Belgium Netherlands Spain China Canada Switzerland Italy Brazil Australia Mexico Sweden Russia

741,700,000,000 687,800,000,000 668,500,000,000 574,300,000,000 528,700,000,000 514,000,000,000 405,100,000,000 349,200,000,000 329,100,000,000 328,400,000,000 321,400,000,000 306,800,000,000

221

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est.

of

17 18 19 20 21 22 23 24 25 26 27 28

Singapore Ireland Saudi Arabia Japan Poland India Austria Denmark Chile Norway Czech Republic Thailand

274,600,000,000 228,000,000,000 204,300,000,000 199,400,000,000 198,800,000,000 191,100,000,000 154,000,000,000 149,600,000,000 136,300,000,000 132,800,000,000 130,400,000,000 117,900,000,000

222

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2008 est. 2009 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est.

of

29 30 31 32 33 34 35 36 37 38 39

South Korea Taiwan Portugal

112,100,000,000 111,100,000,000 105,700,000,000

Trinidad and Tobago 102,000,000,000 Tajikistan Angola Finland Argentina Colombia Turkey Kazakhstan South Africa 1,003,000 91,550,000,000 87,990,000,000 86,800,000,000 84,620,000,000 84,450,000,000 83,300,000,000 83,080,000,000

223

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est.

of

40 41 42 43 44 45 46 47 48 49 50 51

Hungary Indonesia Romania Vietnam Malaysia

82,070,000,000 81,210,000,000 80,160,000,000 77,950,000,000 77,440,000,000

United Arab Emirates 76,380,000,000 Egypt Nigeria New Zealand Israel Ukraine Slovakia 72,410,000,000 67,230,000,000 67,180,000,000 64,820,000,000 52,310,000,000 52,200,000,000

224

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2009 est.

of

52 53 54 55 56 57 58 59 60 61 62 63

Bulgaria Greece Peru Morocco Venezuela Croatia Tunisia Pakistan Cyprus Qatar Philippines Serbia

51,280,000,000 48,100,000,000 43,470,000,000 42,190,000,000 37,710,000,000 34,630,000,000 33,560,000,000 30,090,000,000 29,360,000,000 26,380,000,000 24,500,000,000 23,520,000,000

225

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2008 est.

of

64 65 66 67 68 69 70 71 72 73 -

Jordan Kosovo

22,190,000,000 21,200,000,000

Dominican Republic 19,450,000,000 Algeria Libya Estonia Iran Bahrain Slovenia Lithuania Costa Rica Macau 19,340,000,000 18,640,000,000 17,530,000,000 16,820,000,000 15,770,000,000 15,730,000,000 14,110,000,000 13,920,000,000 13,600,000,000

226

Rank

Country

Stock of FDI at home Date (USD) information 2010 est. 2010 est. 2010 est. 2009 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2010 est. 2008 est.

of

74 75 76 77 78 79 80 81 82 83 84

Ecuador Latvia Azerbaijan Malta El Salvador Bangladesh Macedonia Moldova Kenya Kuwait Paraguay

12,300,000,000 11,710,000,000 8,918,000,000 8,240,000,000 7,522,000,000 6,720,000,000 3,739,000,000 2,649,000,000 2,337,000,000 1,281,000,000 2,153,000

227

Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituent. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation.

Examples

The simplest example of diversification is provided by the proverb " Don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, even if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types (such as some growth stocks and some value stocks) it is still less likely. Further diversification can be obtained by investing in stocks from different countries, and in different asset classes such as bonds, real estate, private equity, infrastructure and commodities [2]such as heating oil or gold.[3]
228

Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America. Return expectations while diversifying If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better than others; but since one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification needs not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return. Maximum diversification Given the advantages of diversification, many experts recommend maximum diversification, also known as buying the market portfolio. Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes

229

from buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of economic footprint, such as total underlying assets or annual cash flow.[7] Risk parity is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.[8] Effect of diversification on variance One simple measure of financial risk is variance. Diversification can lower the variance of a portfolio's return below what it would be if the entire portfolio were invested in the asset with the lowest variance of return, even if the assets' returns are uncorrelated. For example, let asset X have stochastic return have stochastic return , with respective return variances and asset Y . If the

and

fraction of a one-unit (e.g. one-million-dollar) portfolio is placed in asset X and the fraction If is of is and are is placed in Y, the stochastic portfolio return is uncorrelated, the variance of portfolio . return

. The variance-minimizing value , which is strictly between and . Using this value of
230

in the expression for the variance of portfolio return gives the latter as , which is less than what it would be at either of the and (which respectively give portfolio return

undiversified values variance of and

). Note that the favorable effect of diversification on portfolio and were negatively correlated but diminished

variance would be enhanced if

(though not necessarily eliminated) if they were positively correlated. In general, the presence of more assets in a portfolio leads to greater diversification benefits, as can be seen by considering portfolio variance as a function of , the number of assets. For example, if all assets' returns are mutually uncorrelated and have identical variances the equals monotonically decreasing in . The latter analysis can be adapted to show why adding uncorrelated risky assets to a portfolio,[10][11] thereby increasing the portfolio's size, is not diversification, which involves subdividing the portfolio among many smaller investments. In the case of adding of the is assets investments, the portfolio's return is instead equal , portfolio variance is minimized by holding all assets in .[9] Then the portfolio = return's = variance , which is

proportions

and the variance of the portfolio return if are which uncorrelated

is increasing in n rather than decreasing. Thus, for example, when an insurance company adds more and more uncorrelated policies to its portfolio, this expansion does not itself represent diversificationthe diversification occurs in the spreading

231

of the insurance company's risks over a large number of part-owners of the company.

Diversifiable and non-diversifiable risk The Capital Asset Pricing Model introduced the concepts of diversifiable and nondiversifiable risk. Synonyms for diversifiable risk are idiosyncratic risk, unsystematic risk, and security-specific risk. Synonyms for non-diversifiable risk are systematic risk, beta risk and market risk. If one buys all the stocks in the S&P 500 one is obviously exposed only to movements in that index. If one buys a single stock in the S&P 500, one is exposed both to index movements and movements in the stock based on its underlying company. The first risk is called non-diversifiable, because it exists however many S&P 500 stocks are bought. The second risk is called diversifiable, because it can be reduced it by diversifying among stocks. Note that there is also the risk of over diversifying to the point that your performance will suffer and you will end up paying mostly for fees. The Capital Asset Pricing Model argues that investors should only be compensated for non-diversifiable risk. Other financial models allow for multiple sources of non-diversifiable risk, but also insist that diversifiable risk should not carry any extra expected return. Still other models do not accept this contention[12] An empirical example relating diversification to risk reduction In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over
232

all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n30. Number Stocks Portfolio 1 2 4 6 8 10 20 30 40 50 of Average in Deviation of Portfolio Returns 49.24% 37.36 29.69 26.64 24.98 23.93 21.68 20.87 20.46 20.20 Standard Ratio of Portfolio Standard

Annual Deviation to Standard Deviation of a Single Stock 1.00 0.76 0.60 0.54 0.51 0.49 0.44 0.42 0.42 0.41
233

400 500 1000

19.29 19.27 19.21

0.39 0.39 0.39

Corporate diversification strategies In corporate portfolio models, diversification is thought of as being vertical or horizontal. Horizontal diversification is thought of as expanding a product line or acquiring related companies. Vertical diversification is synonymous with integrating the supply chain or amalgamating distributions channels. Non-incremental diversification is a strategy followed by conglomerates, where the individual business lines have little to do with one another, yet the company is attaining diversification from exogenous risk factors to stabilize and provide opportunity for active management of diverse resources.

History Diversification is mentioned in the Bible, in the book of Ecclesiastes which was written in approximately 935 B.C. But divide your investments among many places, for you do not know what risks might lie ahead.[15]
234

Diversification is also mentioned in the Talmud. The formula given there is to split one's assets into thirds: one third in business (buying and selling things), one third kept liquid (e.g. gold coins), and one third in land (real estate). Diversification is mentioned in Shakespeare[16] (Merchant of Venice): My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year: Therefore, my merchandise makes me not sad. The modern understanding of diversification dates back to the work of Harry Markowitz in the 1950s. [edit]Diversification with an equally-weighted portfolio The expected return on a portfolio is a weighted average of the expected returns on each individual asset:

where

is the proportion of the investor's total invested

wealth in asset . The variance of the portfolio return is given by:

Inserting in the expression for

235

Rearranging:

where and

is the variance on asset is the covariance between In an equally-

assets and . weighted portfolio, The portfolio

. variance then

becomes:

236

Where

is the average of the for .

convariances

Simplifying we obtain

As the number of assets grows we get the asymptotic formula:

Thus, in an equallyweighted portfolio, the portfolio variance tends to the average of covariances of securities between becomes

securities as the number arbitrarily large. Co integration and

Correlation in Finance Within the framework of the financial industry, when relationships assets, representing between is correlation

typically used. However,

237

academics since method

have due to

long this the

questioned

plethora of issues that plague it. Indeed, it is thought that co integration is a natural replacement in some of the cases as it is able to represent the physical reality of these assets better. However, despite this general academic consensus, financial practitioners refuse to accept co integration as a better tool, or even, the lesser of two evils. This interesting bias has led to the creation of the mathematical referred a hybrid model to model

as Cointelation which is between correlation and cointegration.

238

Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business, a corporation or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year. A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities.[3] Another way to look at the same equation is that assets equal liabilities plus owner's equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner's money (owner's equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections "balancing."
239

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.

Types
A balance sheet summarizes an organization or individual's assets, equity and liabilities at a specific point in time. We have two forms of balance sheet. They are the report form and the account form. Individuals and small businesses tend to have simple balance sheets.[4] Larger businesses tend to have more complex balance sheets, and these are presented in the organization's annual report.[5] Large businesses also may prepare balance sheets for segments of their businesses. [6] A balance sheet is often presented alongside one for a different point in time (typically the previous year) for comparison.[7][8] Personal balance sheet A personal balance sheet lists current assets such as cash in checking accounts and savings accounts, long-term assets such as common stock and real estate, current liabilities such as loan debt and mortgage debt due, or overdue, long-term liabilities such as mortgage and other loan debt. Securities and real estate values are listed at market value rather than at historical cost or cost basis. Personal net worth is the difference between an individual's total assets and total liabilities.

240

US small business balance sheet Sample Small Business Balance Sheet[10] Assets Cash Liabilities and Owners' Equity $6,600 Liabilities $5,000

Accounts Receivable $6,200 Notes Payable

Tools and equipment $25,000 Accounts Payable $25,000 Total liabilities Owners' equity Capital Stock $7,000 $30,000

Retained Earnings $800 Total owners' equity Total $37,800 Total $7,800 $37,800

A small business bump that balance sheet lists current assets such as cash, accounts receivable, and inventory, fixed assets such as land, buildings, and
241

equipment, intangible assets such as patents, and liabilities such as accounts payable, accrued expenses, and long-term debt. Contingent liabilities such as warranties are noted in the footnotes to the balance sheet. The small business's equity is the difference between total assets and total liabilities. [11]

Public Business Entities balance sheet structure Guidelines for balance sheets of public business entities are given by the International Accounting Standards Board and numerous country-specific organizations/companys. Balance sheet account names and usage depend on the organization's country and the type of organization. Government organizations do not generally follow standards established for individuals or businesses.[12][13][14][15] If applicable to the business, summary values for the following items should be included in the balance sheet:[16] Assets are all the things the business owns, this will include property, tools, cars, etc. Assets Current assets 1. Cash and cash equivalents 2. Accounts receivable 3. Inventories 4. Prepaid expenses for future services that will be used within a year Non-current assets (Fixed assets)

242

1.

Property, plant and equipment

2. Investment property, such as real estate held for investment purposes

3.

Intangible assets

4. Financial assets (excluding investments accounted for using the equity method, accounts receivables, and cash and cash equivalents)
5.

Investments accounted for using the equity method

6. Biological assets, which are living plants or animals. Bearer biological assets are plants or animals which bear agricultural produce for harvest, such as apple trees grown to produce apples and sheep raised to produce wool.[17] Liabilities 1. Accounts payable
2. 3.

Provisions for warranties or court decisions Financial liabilities (excluding provisions and accounts payable), such as promissory notes and corporate bonds

4. Liabilities and assets for current tax

5.

Deferred tax liabilities and deferred tax assets

6. Unearned revenue for services paid for by customers but not yet provided Equity The net assets shown by the balance sheet equals the third part of the balance sheet, which is known as the shareholders' equity. It comprises:

243

1. Issued capital and reserves attributable to equity holders of the parent company (controlling interest) 2. Non-controlling interest in equity Formally, shareholders' equity is part of the company's liabilities: they are funds "owing" to shareholders (after payment of all other liabilities); usually, however, "liabilities" is used in the more restrictive sense of liabilities excluding shareholders' equity. The balance of assets and liabilities (including shareholders' equity) is not a coincidence. Records of the values of each account in the balance sheet are maintained using a system of accounting known as double-entry bookkeeping. In this sense, shareholders' equity by construction must equal assets minus liabilities, and are a residual. Regarding the items in equity section, the following disclosures are required: 1. Numbers of shares authorized, issued and fully paid, and issued but not fully paid
2.

Par value of shares

3. Reconciliation of shares outstanding at the beginning and the end of the period 4. Description of rights, preferences, and restrictions of shares
5. 6.

Treasury shares, including shares held by subsidiaries and associates Shares reserved for issuance under options and contracts

7. A description of the nature and purpose of each reserve within owners' equity

244

Sample balance sheet The following balance sheet is a very brief example prepared in accordance with IFRS. It does not show all possible kinds of assets, liabilities and equity, but it shows the most usual ones. Because it shows goodwill, it could be a consolidated balance sheet. Monetary values are not shown, summary (total) rows are missing as well. Balance Sheet of XYZ, Ltd. As of 31 December 2009 ASSETS Current Assets Cash and Cash Equivalents Accounts Receivable (Debtors) Less : Allowances for Doubtful Accounts Inventories Prepaid Expenses Investment Securities (Held for trading) Other Current Assets Non-Current Assets (Fixed Assets) Property, Plant and Equipment (PPE)

245

Less : Accumulated Depreciation Investment Securities (Available for sale/Held-to-maturity) Investments in Associates Intangible Assets (Patent, Copyright, Trademark, etc.) Less : Accumulated Amortization Goodwill Other Non-Current Assets, e.g. Deferred Tax Assets, Lease Receivable LIABILITIES and SHAREHOLDERS' EQUITY LIABILITIES Current Liabilities (Creditors: amounts falling due within one year) Accounts Payable Current Income Tax Payable Current portion of Loans Payable Short-term Provisions Other Current Liabilities, e.g. Unearned Revenue, Deposits Non-Current Liabilities (Creditors: amounts falling due after more than one year) Loans Payable Issued Debt Securities, e.g. Notes/Bonds Payable Deferred Tax Liabilities Provisions, e.g. Pension Obligations Other Non-Current Liabilities, e.g. Lease Obligations SHAREHOLDERS' EQUITY Paid-in Capital Share Capital (Ordinary Shares, Preference Shares) Share Premium
246

Less: Treasury Shares Retained Earnings Revaluation Reserve Accumulated Other Comprehensive Income

247