Flashcards in From MCQs Deck (14)
"XBRL: An IT Opportunity to Improve Financial Reporting
a. Until recently, disseminating financial and nonfinancial information electronically was a cumbersome, inefficient process because:
(1) recipients had different requirements for the way information was delivered to them. As a result, organizations spent a great deal of time and incurred significant expense to format the same information a number of different ways.
(2) the organizations that received the data had to manually reenter much of it into their own information systems.
The problem is caused by the way information is displayed on the Internet. HTML code specifies how data is displayed; it does not provide information about data content. Extensible business reporting language (XBRL) was developed to provide a way to communicate the content of data. XBRL uses tags to identify the contents of each data item. For example, an XBRL tag might indicate that a data item represents accounts receivable.
b. There are several benefits to creating and electronically disseminating financial data using XBRL:
(1) Organizations can publish information once, using XBRL tags, in a format that anyone can use as they see fit.
(2) Information systems and analysis tools can interpret the XBRL tags. Recipients do not need to manually reenter data they obtain electronically. Instead, they can be fed directly into any information system or analysis tool that understands XBRL.
(3) XBRL tags result in more efficient and accurate Internet searches."
"HTML is a programming language that defines the format and display of text and graphics when viewing a website.
Transmission Control Protocol/Internet Protocol (TCP/IP) is the basic communication language or protocol of the Internet that may also be used as a communications protocol in private networks such as intranets. The messages of a file are assembled into smaller packets that are sent over the Internet and received by the TCP layer that reassembles the packets into the original message."
"Information systems are documented using the following methods:
a. Narrative documentation is a written, step-by-step explanation of system components and interactions.
b. A flowchart graphically describes an information system in a clear, concise, and logical manner. Flowcharts use a standard set of input/output, processing, storage, and data flow symbols to pictorially describe the system.
(1) A document flowchart graphically describes the flow of documents and information among areas of responsibility (or departments) within an organization. Document flowcharts trace a document from its cradle to its grave. They show where each document originates, its distribution, the purposes for which it is used, its ultimate disposition, and everything that happens as it flows through the system.
(2) An internal control flowchart is particularly useful in analyzing the adequacy of control procedures in a system, such as internal checks and segregation of duties. It can reveal weaknesses or inefficiencies in a system, such as inadequate communication flows, unnecessary complexity in document flows, or procedures responsible for causing wasteful delays.
(3) A system flowchart graphically describes the relationship among the input, processing, and output functions of an AIS. A system flowchart begins by identifying both the inputs that enter the system and their origins. The input is followed by the processing portion of the flowchart; that is, the steps performed on the data. The logic the computer uses to perform the processing task is shown on a program flowchart. The resulting new information is the output component, which can be stored for later use, displayed on a screen, or printed on paper. In many instances, the output from one process is an input to another.
c. Diagrams. A data flow diagram (DFD) graphically describes the source of data, the flow of data in an organization, the processes performed on the data, where data is stored in the organization, and the destination of data. It is used to document existing systems and to plan and design new ones.
d. Dictionaries. A data dictionary contains a description of all data elements, stores, and flows in a system. Typically, a master copy of the data dictionary is maintained to ensure consistency and accuracy throughout the development process.
e. Other written material that explains how a system works
f. Operating documentation is all information required by a computer operator to run a program, including the equipment configuration used, variable data to be entered on the computer console, and descriptions of conditions leading to program halts and related corrective actions."
Billing and Accounts Receivable
"a. The primary objectives of the billing and accounts receivable functions are to ensure that:
(1) customers are billed for all sales,
(2) invoices are accurate, and
(3) customer accounts are accurately maintained.
b. There are two steps in the Billing and Accounts Receivable Activity.
(1) Bill customers. After goods are shipped, a sales invoice is sent to customers to let them know how much they owe and where to send payment. EDI and EFT technology is often used to reduce billing costs and the time required to send invoices and receive payment.
(2) Update accounts receivable. Sales invoice information is used to update customer accounts.
(a) There are different ways to maintain accounts receivable depending on when customers remit payments, how payments are updated on the accounts receivable master file, and monthly statement format.
1. With the open-invoice method, customer payments are applied against specific invoices. Two invoice copies are mailed to the customer. One serves as a remittance advice and is returned with the payment.
2. With the balance-forward method, customers pay the balance shown on a monthly statement that lists all sales and payment transactions that occurred during the past month.
Cycle billing can be used to spread out billing and cash receipts. Monthly statements are prepared and mailed at different times for subsets of customers. For example, the master file could be divided into four parts, and each week monthly statements sent to one-fourth of the customers.
(b) As part of the update process, adjustments to customer accounts are sometimes needed due to:
1. items that are returned.
2. allowances for damaged goods.
3. customer's accounts that must be written off.
In such cases, the credit manager fills out a credit memo. When the credit memo is for damaged or returned goods, the customer is sent a copy."
Theories Explaining Business Cycles
"a. There are several competing theories that economists have developed that try to explain the causes for the business cycle. While there is no universal agreement as to the exact combination of factors that cause business cycles, a brief review of some of the more accepted theories helps to potentially explain how changes at the firm level might affect the economy at the macroeconomic level.
b. The real business cycle model is based on the premise that fluctuations in output and employment result from real supply shocks that periodically hit the economy, and that markets adjust rapidly to the shock and always remain in equilibrium.
1. Monetary policy is assumed to have no real effect on the business cycle.
2. Toward the end of the expansionary phase of the business cycle, employment is high and jobs are easy to find. The supply of labor is highly elastic with respect to temporary changes in wages as workers are very willing to substitute work for leisure on a short-term basis because wages are high.
3. The most important shock that can impact the economy is a productivity shock that often results from technological change and leads to an increased level of output from the given amount of inputs. Workers will be willing to work more hours to take advantage of the higher wages caused by the higher productivity.
4. In the absence of an increase in aggregate demand, the necessary level of output could be produced by a smaller level of inputs, thus increasing unemployment until aggregate expenditures increase. Rising productivity also increases the incentive for business investment.
5. Illustration: Assume that productivity declines significantly because of a supply shock that raises the price of crude oil. This would lead to a dramatic increase in the cost of energy. This in turn would lead to an increase in operating costs for most firms. The cost increases would reduce society's ability to produce real output. At the same time, the increased cost of energy would reduce consumer purchasing power and expenditures on consumer goods. This would further reduce the incentive for businesses to invest.
c. The political business cycle model explains the business cycle as resulting from interactions between economic policy decisions and political decisions designed to influence voter behavior.
1. Economic policy choices often represent trade-offs between unemployment and inflation.
2. Surveys indicate the voters are worried about both issues and perceive rising unemployment to be a problem. Voters are also concerned about the rate of inflation, the rate of increase in the inflation rate, and the effect that inflation could have on their buying power.
3. Politicians desire to have the economy “moving in the right direction” as an election approaches.
4. Politicians tend to run restrictive fiscal policies early in their terms and to blame the previous administration for current economic problems.
5. Fiscal policy tends to become more expansionary as an election year approaches.
6. There is little doubt that most administrations tend to pursue certain policies; however, it is very difficult for any administration to “fine-tune” fiscal policy since the executive branch does not control the major policy tools. Monetary policy is controlled by the Federal Reserve and fiscal policy measures are enacted by the legislative branch.
d. The insufficient aggregate expenditure model is based on the premise that a business cycle is caused by inadequate spending. The key components of aggregate expenditure are personal consumption (C), business investment (I), government expenditures (G), and the net difference between exports (X) and imports (M). It is represented by the formula:
GDP = C + I + G + (X - M)
Each of these expenditure categories is assumed to be a function of other economic variables:
1. The level of personal consumption depends primarily on consumer disposable income and wealth. In addition, the demand for consumer durable goods such as housing and automobiles is influenced by the impact of interest rate changes on monthly payments.
2. Business investment depends primarily on the level of interest rates and business expectations concerning the net present value of the cash flows from potential projects. (See section 5312 on capital budgeting.)
3. Government expenditures are determined by the fiscal policy that is developed by the executive and legislative branches of government.
4. Exports are driven by consumer income and wealth in foreign nations as well as foreigners' tastes and preferences for foreign (in this case U.S.) goods. The demand for imports depends primarily on the same factors as personal consumption plus the tastes and preferences U.S. citizens have for foreign goods.
e. The accelerator model assumes that the business cycle is caused by the volatility of investment spending.
1. Expenditures on capital goods and investment in inventory are related to the rate of change in GDP.
2. It assumes that a given level of capital goods is required to produce a given level of output. Also, firms desire a given level of inventory at a given level of demand.
3. If the economy is operating at full capacity and there is an increase in aggregate demand, then there would be an increase in the demand for capital goods, which stimulates increases in aggregate demand, causing a secondary increase in the demand for capital goods.
4. With the increase in aggregate demand, inventory levels will fall below desired levels and firms will increase their investment in inventory which will cause an increase in production and employment at the wholesale level."
Weighted-Average Cost of Capital
"a. The cost of capital is an important element in making investment decisions, as projects with a higher rate of return than the firm's cost of capital will increase the value of the firm. The relevant cost of capital is the firm's long-term cost of capital, since we are evaluating long-term projects or investments.
b. The Weighted-Average Cost of Capital is the weighted average of the cost of debt and the various equity components of the firm's capital structure. It is preferable to use weights based on the market value of the items or the firm's target capital structure.
(1) The cost of debt for the issuing firm is based upon the required rate of return for debt holders and the marginal tax rate for the issuing company. Due to the tax shield associated with interest-bearing debt, the effective cost of the debt is lower than the interest rate paid due to the reduction in the taxes paid.
Cost of debt = kd (1 - T)
• kd = Cost of debt
• T = Marginal tax rate
(2) Preferred stock provides the investor with a constant stream of dividends; however, these dividends do not provide a tax shield since they are not a deductible expense for the issuing company. The cost of preferred stock to the issuing company can be calculated by dividing the annual return (interest payment) by the net issuance price for the preferred stock.
k = ------
• kp = Cost of preferred stock
• Dp = Preferred dividend
• Pp = Price of preferred stock
Generally, however, when looking at the cost of issuing new preferred stock, the company would have to pay flotation costs to an investment house; thus, the proceeds received by the company would be less than the issue price. This would increase the cost of this form of financing. Taking flotation costs into consideration, the formula to calculate the cost of preferred stock to the issuing company would be:
k = ----------
p (1 - f) P
• kp = Cost of preferred stock
• Dp = Preferred dividend
• Pp = Price of preferred stock
• f = Flotation costs
(3) The cost of retained earnings is the opportunity cost that stockholders of a firm could earn elsewhere if they made investments of comparable risk. This figure would need to be imputed.
(4) The cost of equity (ke) is more expensive than the cost of debt since stockholders are subject to more risk than debt holders. There are a number of ways to estimate the cost of equity, and one commonly used method to obtain the estimate is the dividend growth model. The formula used is:
k = (D / (P (1 - F))) + g
e 1 o
This formula assumes that the firm pays a dividend equal to D1, would issue new stock at price Po, and would pay a flotation cost (F) that is equal to some percentage of the value of the stock being issued. It is assumed that the firm's dividend will grow at a constant rate (g). The result is the cost of using internally generated equity. If new stock is going to be issued, the cost of new equity would be the result obtained for internally generated equity divided (1 - Percent of flotation costs).
Illustration: The firm's dividend was $1.50 and is expected to grow 6% per year. They expect to be able to sell new stock at a price $30 per share and flotation costs are expected to be 10% of the value of the stock issue. What is the firm's cost of equity?
k = ($1.50 / ($30(1 - 0.10))) + 6.0%
= ($1.50 / $27.00) + 6.0%
= 5.56% + 6.0%
c. Most analysts use the CAPM (Capital Asset Pricing Model) to estimate the required return on a firm's cost of equity. The basic equation for estimating the required return on equity (Ri) is:
R = R + Beta (R - R )
i F i m F
The beta coefficient is the amount of risk that an individual stock contributes to the market portfolio and is a measure of the correlation between the volatility of the price of the individual stock and the volatility of the stock market. The market risk premium (Rm - RF) is the premium that common stocks have returned over time in excess of the risk-free rate (RF). Generally the current Treasury bill rate is used as the risk-free rate. Some analysts would use the 10-year Treasury Bond rate for the risk-free rate when evaluating long-term capital projects.
d. The primary conclusion of the capital-asset pricing model (CAPM) is that the relevant risk on any security is its contribution to the risk of a well-diversified portfolio. A commonly used benchmark portfolio for the market portfolio is the S & P 500.
e. Illustration: Assume that the current T-bill rate is 3.35% and the market risk premium is 7% for a diversified market portfolio.
R = R + Beta (R - R )
i F i m F
= 3.35% +1.0(7.0%)
Under this scenario, investors would expect to earn 10.35% on a diversified market portfolio. (Note: The beta coefficient for the diversified market portfolio is 1.0.)
Given the information in the example above and assuming that the beta coefficient for an individual security is 1.4, what return would investors require to hold this security?
Solution: Using the formula from (c) above, that is, Ri = RF + Beta i (Rm - RF), the return required by investors would be 13.15%. Again, this is the cost of internally generated equity. The cost of issuing new stock would be the cost of internally generated equity divided by (1 - Percentage of flotation costs).
R = R + Beta (R - R )
i F i m F
= 3.35% +1.4(7.0%)
f. The weighted-average cost of capital can be computed as follows:
WACC = (wt x k ) + (wt x k ) + (wt x k )
d d pf pf e e
Example: Assume that the firm can issue new debt at 5% and that the marginal tax rate is 40%. The firm has $1,000 par preferred stock that pays a dividend of 4%. Using the CAPM, it is estimated that investors require a 16% return on equity investments. The firm has a target capital structure of 30% debt, 10% preferred stock, and 60% equity. What is the firm's WACC?
WACC = (.30 x (.05 x (1 - .40))) + (.10 x .04) + (.60 x .16)
= .009 + .004 + .096
= .109 or 10.9%"
Various Interest Rate Formulas and Their Uses
"Short-term debt is that debt that will be repaid within one year. Interest rates on short-term bank debt are calculated in a number of ways, including:
a. Basic interest is calculated on an annual basis using the stated rate of interest.
Illustration: The customer takes out a $10,000 loan with a 1-year maturity and a 10% interest rate. The basic interest is:
Basic interest rate = Interest paid / Amount borrowed
= $1,000 / $10,000 = 10%
b. Interest is discounted (discounted interest) when the amount of interest to be collected during the life of the loan is subtracted from the loan proceeds, with the customer repaying the loan principal amount.
Illustration: The customer takes out a $10,000 loan with a 1-year maturity and a 10% interest rate. The interest for the year is $1,000 and the individual receives $9,000. The effective interest rate on the loan is 11.11% ($1,000 ÷ $9,000).
The add-on interest method is one where interest is calculated on the full amount of the original principal. The calculated interest is added to the principal and the payment is determined by dividing the sum of principal plus interest by the number of payments to be made. The add-on interest rate can be calculated as follows using the following example:
Approximate add-on annual rate = Interest paid / (Amount received / 2)
= $1,000 / ($10,000 / 2)
= $1,000 / $5,000
Add-on effective rate = (1 + i) - 1
= (1 + .0167) - 1
= 1.2199 - 1
(If the approximate annual rate is 20%, then the monthly rate is 1.67% (or 20% ÷ 12).)
Simple interest is computed on the remaining outstanding balance using the daily periodic rate times the number of days since the prior payment.
c. Under certain situations with add-on loans where interest is paid according to the Rule of 78s, the monthly payment is allocated first to the payment of interest and then to principal. If the amount of interest due is greater than the amount of the payment, the difference would be added on to the loan principal and is termed negative amortization. This can commonly occur on longer term loans such as on 15-year mobile home loans.
(In the Rule of 78s, 78 is equal to the sum of the digits from 1 to 12. For an annual installment loan, 12/78ths or 15.4% of the interest due on the loan would be charged to the first payment before anything was credited to principal. This concept can be applied to installment loans of any maturity by summing the digits of the number of payments. For example, a 15-year loan with monthly payments would sum the digits from 1 to 180.)
d. Miscellaneous Considerations:
(1) Compound interest involves the paying or charging interest on interest. The most common usage relates to the effective return on deposits. Federal legislation in 1991 (Truth-in-Savings) was designed to provide consumers with information that would allow them to be able to compare the effective yield on alternative instruments.
Illustration: Assume that an individual deposits $10,000 in a 1-year certificate of deposit paying 6% interest. If interest is compounded annually, he would receive $600 in interest. If the interest were compounded semi-annually, there would be two payments received. The first payment would be $300 and the second payment would also include interest on that $300 and the consumer would receive $609. Quarterly compounding would result in interest earnings in the amount of $614, and daily compounding $618.
(2) 360-day vs. a 365-day year. Many credit card issuers compute the daily periodic rate using a 360-day as opposed to a 365-day year, yet charge interest for 365 days. This has the result of increasing the effective annual rate on a loan. (The effective annual interest rate is the investment's annual rate of interest when compounding occurs more often than once a year.)
Illustration: Assume that you have an 18% loan. With a 365-day year, the daily periodic rate would be 0.0493%, while with a 360-day year, the daily periodic rate would be 0.05%.
a. Effective interest rate using a 365-day year with a 365-day daily periodic rate:
((1 + 0.000493)365 - 1) = 19.71%
b. Effective interest rate using a 365-day year with a 360-day daily periodic rate:
((1 + 0.0005) 365 - 1) = 20.02%"
IT Control terms
"A check digit is a specific type of input control, consisting of a single digit at the end of an identification code that is computed from the other digits in a field. If the identification code is mis-keyed, a formula or algorithm will reveal that the check digit is not correct, and the field will not accept the entry.
Hash totals are nonsense totals; for example, the sum of the digits of an invoice number. A hash total is similar to a control total and is used to verify processing (or output) compared to input. It is not an input control.
A parity check (bit) is an extra bit added to a string of bits as a hardware control. It is a control over the accuracy of data transmission, but since it is a hardware control, it is not an input control.
In encryption, data is processed through a formula that substitutes other characters for the original characters. Data may be encrypted so that it can be transmitted between computers to prevent interception of the data or to store data so that others cannot read it. Encryption does not attempt to show the original value has not been altered"
Source Data Controls
"The following controls make sure source documents and other input data are authorized, accurate, complete, accounted for properly, entered into the system, and sent to their intended destination in a timely manner. They should also make sure the data has not been suppressed, duplicated, or otherwise improperly changed.
a. Design source documents such that they minimize errors and omissions.
b. Prenumber all documents and have the system identify and report any missing or duplicate numbers.
c. Restrict source document preparation to authorized personnel.
d. Require all source documents, where required, to be properly authorized before processing them.
e. Use machine-readable turnaround documents (company data sent to an external party and returned to the system as input) to reduce data input time, effort, expense, and errors.
f. Cancel documents that have been entered into the system so they cannot be reused.
(1) Deface paper documents by marking them paid or perforating them.
(2) Flag electronic documents to show they have been canceled.
g. Retain original source documents long enough to satisfy legal requirements.
h. Use check digit verification.
(1) ID numbers can have a check digit computed from the other digits. For example, a six-digit account number can have a seventh digit, which is the check digit.
(2) Data entry devices verify the check digit each time the ID number is entered by using the six digits to recalculate the seventh check digit.
(3) The verification calculation will not match the check digit if an error is made in entering the six digits or the check digit.
i. Use key verification.
(1) An employee rekeys data entered through a keyboard.
(2) The system compares the two sets of keystrokes.
(3) Discrepancies are highlighted for correction.
(4) Key verification is used for crucial input such as customer numbers and amounts."
Fair value vs Fair Market Value
Fair market value is probably the most common standard of value used in business valuation engagements. The International Glossary of Business Terms defines fair market value as “the price, expressed in terms of the cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
The International Glossary of Business Terms defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
The differences between fair market value and fair value are quite substantial:
Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing.
Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value.
Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.
Other Standards of Value
"a. In a valuation engagement, a standard of value is the identification of the type of value being utilized. It is important that this standard be defined before the engagement begins since different standards lead to potentially different estimated values. Common standards include fair market value, fair value, intrinsic value, replacement value, and investment value. No matter how the standard of value is defined, the potential exists to use any of the three generally accepted valuations approaches (asset-based, market, or income) in preparing the valuation.
b. Fair market value is probably the most common standard value used in business valuation work. In the International Glossary of Business Valuation Terms, it is defined as “the price, expressed in terms of the cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
c. The differences between fair market value and fair value are quite substantial:
(1) Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing.
(2) Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value.
(3) Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.
d. Per the International Glossary of Business Valuation Terms, intrinsic value is defined as “the value that an investor considers, on the basis of an evaluation of available facts, to be the ‘true’ or ‘real’ value that will become the market value when other investors reach the same conclusion.”
e. Per the International Glossary of Business Valuation Terms, replacement cost new is defined as “the current cost of a similar new property having the nearest equivalent utility to the property being valued.” And, reproduction cost new is defined as “the current cost of an identical new property.”
f. Per the International Glossary of Business Valuation Terms, investment value is defined as “the value to a particular investor based on individual investment requirements and expectations.”"
Threats and Controls in General Ledger and Reporting System
"1. Threat: An error in updating the General Ledger produces incorrect information, which can result in:
a. misleading reports and
b. poor decisions.
a. Input controls, such as:
(1) Making sure summary journal entries represent actual reporting period activity
(2) Validity checks to make sure a general ledger account exists for each journal entry account number
(3) Field checks to make sure amount fields in a journal entry contain only numeric data
(4) Zero-balance checks in journal entries to make sure total debits journal entries equal total credits
(5) Completeness tests to make sure all pertinent journal entry data is entered
(6) Closed-loop verification tests to make sure account numbers match account descriptions, so that the correct general ledger account is accessed
(7) Adjusting entry files for standard recurring adjusting entries, such as depreciation expense
(a) Because the entries are not keyed in each time, this improves input accuracy.
(b) Because the entries are not forgotten, this improves input completeness.
(8) Signing checks on general ledger account balances to make sure the balance is of the appropriate nature (debit or credit)
(9) Run-to-run totals to verify batch processing accuracy. Run-to-run controls for an online system are able to accumulate separate totals for all transactions processed during the day and then agree the totals to the total of items accepted for processing.
(a) Calculate new general ledger account balances, based on beginning balances and total debits and credits applied to the account.
(b) Compare that total with the actual account balance in the updated general ledger.
(c) Investigate any discrepancies, as they indicate a processing error that must be corrected.
b. Reconciliations and controls that help detect general ledger updating errors.
(1) Compare total debit balances to total credit balances in a trial balance to determine if a posting error has occurred.
(2) Determine if clearing and suspense accounts have end-of-period zero balances.
(3) Determine if general ledger control account balances agree to corresponding subsidiary ledger totals.
(4) Examine end-of-period transactions to make sure they are recorded in the proper time period.
c. An audit trail provides the information needed to:
(1) trace transactions from source documents to the general ledger and any report or document using that data,
(2) trace items on reports back through the general ledger to the original source document, and
(3) trace general ledger account changes from their beginning to their ending balance."
"Off-balance-sheet financing is a term used to describe a use of lease financing that did not meet all of the requirements of a capital lease (formerly called a financing lease). The present value of the commitment (liability and asset) was not recorded and did not appear on the lessee's balance sheet or accompanying footnotes. (See Operating Lease.) FASB ASC 840-10 generally reduces this practice.
This term also refers to a form of financial arrangement associated with some leveraged leases in which the lender of the funds has no recourse against the lessor and agrees to look solely to the lessee and the leased asset for repayment of the debt."