Understanding an entity and its environment Flashcards
(14 cards)
A company currently sells 100,000 units of product A at $10 per unit. The company also sells 100,000 units of product B at the same price. The company raises the price of both products by 10%. Product A has an elasticity of 1.5. Product B has an elasticity of 3.0. Which of the following effects will the price increase most likely have on company revenues?
A. Company revenues will increase for both products.
B. Company revenues will decrease for both products.
C. Company revenues will increase for product A but not product B.
D. Company revenues will increase for product B but not product A.
B. Company revenues will decrease for both products.
In economics, elasticities measure the sensitivity of one thing (eg, quantity demanded) to changes in something else (eg, price). There are various types of elasticity, including price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity of demand.
The price elasticity of demand (Ed) measures how responsive the quantity demanded of a good or service is to a change in its price. If Ed is greater than 1, demand is elastic, and total revenue will decline if the price is increased. Conversely, if Ed is less than 1, demand is considered inelastic, and total revenue will increase if the price is increased. Unit elasticity exists when Ed is exactly equal to 1.
Given that Product A’s Ed = 1.5 and Product B’s Ed = 3.0 (ie, both are greater than 1), company revenues will decrease for both products when prices for both products increase by 10% (Choices A, C, and D).
Things to remember:
The price elasticity of demand (Ed) measures how responsive the quantity demanded of a good or service is to a change in its price. If Ed is greater than 1, demand is elastic, and total revenue will decline if the price is increased. Conversely, if Ed is less than 1, demand is considered inelastic, and total revenue will increase if the price is increased.
According to the Sarbanes-Oxley Act of 2002, the audit committee of an issuer is responsible for each of the following activities, except
A. Evaluating and reporting on the effectiveness of the company’s internal control over financial reporting.
B. Preapproving all audit and nonaudit services provided by the company’s auditor.
C. Establishing procedures for the receipt, retention, and treatment of complaints received by the company regarding accounting, internal control, and auditing matters.
D. The appointment, compensation, and oversight of the work of the registered public accounting firm employed by the company.
A. Evaluating and reporting on the effectiveness of the company’s internal control over financial reporting.
An audit committee (A/C) is part of an entity’s governance and consists of independent members of the entity’s board of directors. A/C members are not employed by the entity, are not shareholders, and have no financial relationship with the entity (Choice D).
An A/C member may receive compensation such as director fees, retainers, and meeting fees for serving on the board and/or committees but may not:
accept any other consulting, advisory, or compensatory fees, or
be affiliated with the company.
The A/C is responsible for overseeing the:
Financial reporting process, making certain that reliable information useful to stakeholders is available on a timely basis.
Appointment and compensation of the entity’s auditors (Choice B).
Establishment of appropriate internal controls, including programs for the prevention and detection of fraud.
Creation and publication of a code of ethics for senior financial officers.
Establishment of a process for employees to anonymously report concerns (ie, whistleblowing), accounting matters, and/or fraud (Choice C).
Engagement of independent counsel as deemed necessary.
Evaluating and reporting on the effectiveness of the company’s internal control is the responsibility of the CEO and CFO, not the audit committee.
Things to remember
An audit committee (A/C) consists of independent members of an entity’s board of directors. They are not employed by the entity, are not shareholders, and have no financial relationship with the entity. Evaluating and reporting on the effectiveness of the company’s internal control is the responsibility of the CEO and CFO, not the A/C.
A company has a policy of frequently cutting prices to increase sales. Product demand is significantly elastic. What impact would this have on the company’s situation?
A. Quantity increases proportionally more than the price declines.
B. Quantity increases proportionally less than the price declines.
C. Price increases proportionally more than the quantity declines.
D. Price increases proportionally less than the quantity declines.
A. Quantity increases proportionally more than the price declines.
Barring shifts in the demand curve, a firm expects the quantity demanded for its product to decrease as the price increases, and vice versa. The price elasticity of demand (Ed) measures how responsive the quantity demanded is to a change in price, as follows:
If Ed is greater than 1, then demand is elastic; the change in quantity demanded (ie, revenue) is proportionally more than the change in price.
If Ed is less than 1, then demand is inelastic; the change in quantity demanded is proportionally less than the change in price.
If elasticity is equal to 1, then demand is unit elastic (unitary); quantity demanded will not proportionally change.
For example, assume that the price of a pound of corn decreased 45% due to a surplus crop, and the Ed for corn is 3.2 (elastic). Using the formula above, the change in demand would be 144%, determined as follows:
3.2 = percentage change in quantity demanded
45%
Percentage change in quantity demanded = 144%
For elastic products, a 45% change in price resulted in a proportionally greater 144% change in demand. Here, the quantity demanded increased proportionally more than the price decline.
Things to remember:
The price elasticity of demand (Ed) measures how responsive the quantity demanded is to a change in price. If Ed is greater than 1, then demand is elastic; the change in quantity demanded is proportionally greater than the change in price. If Ed is less than one, then demand is inelastic, and the change in quantity demanded is proportionally less than the change in price.
Which of the following statements is correct regarding an economy at the peak of the business cycle?
A. The economy will be in a static equilibrium.
B. The economy will be at the natural rate of unemployment.
C. Incomes will be stable.
D. The rate of inflation will decrease.
B. The economy will be at the natural rate of unemployment.
A business cycle is a fluctuation in economic production generally lasting several years. Variations in business cycles depend on supply and demand, the availability of capital for investment, and consumer confidence. A full cycle consists of an expansion, peak, contraction (ie, recession), and trough.
During the peak phase, the economy is becoming overheated, with both growth (ie, GDP) and inflation surpassing their “target” ranges (Choices A and D). Businesses are no longer able to meet consumer demand, with unemployment reaching its natural rate. Natural unemployment is the rate of unemployment that will exist even when labor supply meets labor demand (ie, labor market is in equilibrium). It is the result of frictional, structural, and cyclical unemployment. When unemployment rates fall particularly low, income (ie, salaries and wages) tends to increase as bidding wars begin for available labor (Choice C).
Eventually, inflation drive prices to the point at which consumer demand begins to decrease, production declines, unemployment increases, and the contractionary phase of the business cycle has begun.
Things to remember:
A business cycle is a fluctuation in economic production generally lasting several years. A full cycle consists of an expansion, peak, contraction (ie, recession), and trough. During the peak phase, businesses can no longer meet excessive consumer demand, prices rise, and unemployment falls, reaching its natural rate.
Pursuant to the Sarbanes-Oxley Act of 2002, an accountant who destroys documents to impede an investigation by a U.S. agency can be
A. Suspended or barred from being associated with a registered public accounting firm or can be required to end such association.
B. Temporarily or permanently limited on the activities, functions, or operations conducted on behalf of a registered public accounting firm.
C. Fined and/or imprisoned not more than 20 years.
D. Fined and/or imprisoned not more than 10 years.
C. Fined and/or imprisoned not more than 20 years.
Which of the following actions is the acknowledged preventive measure for a period of deflation?
A. Increasing interest rates.
B. Increasing the money supply.
C. Decreasing interest rates.
D. Decreasing the money supply.
B. Increasing the money supply.
Deflation occurs when prices fall, usually from a long-term drop in aggregate demand. Consumers and businesses begin to defer purchases and/or investments in anticipation of a better deal. This forces manufacturers to continually lower prices, leading to lower wages and less investment spending. Deflation often signals an impending recession.
To combat deflation and a potential recession, the Federal Reserve Bank (the Fed) (D5004) typically implements monetary policy, designed to increase the money supply and stimulate demand (Choice D). This in turn leads the economy into an expansionary phase of the business cycle. Expansionary policy tools include buying U.S. Treasury securities, lowering the interest rate the Fed charges banks for short-term loans (eg, discount rate), and decreasing reserve requirements for member banks.
(Choice A) Increasing interest rates discourages current consumption and investment and increases savings rates. This is a preventative measure for inflation, not deflation.
(Choice C) Lowering interest rates generally tends to increase the money supply, However, during a deflationary period, interest rates are already exceeding low, often near zero. Reducing rates further will not have a noticeable effect on the money supply.
Things to remember:
Deflation occurs when prices decline, usually from a decrease in aggregate demand, often signaling an impending recession. To stimulate the economy, particularly aggregate demand, the Federal Reserve will implement expansionary monetary policy (ie, increase the money supply) to promote consumer and business spending.
To ensure that the audit report for an issuer is prepared in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, the report must
A. Be prepared within 60 days of the end of the issuer’s fiscal year end unless extenuating circumstances, as outlined in the act, are publicly disclosed.
B. Attest to and report on the internal control assessment made by the management of the issuer.
C. Be prepared within 60 days of the issuer’s fiscal year end, be certified by the Public Company Accounting Oversight Board, and be publicly disclosed.
D. Attest to, and report on, the efficiency and effectiveness of the issuer’s system of internal control.
B. Attest to and report on the internal control assessment made by the management of the issuer.
In the wake of several accounting scandals at public companies, Congress passed the Sarbanes-Oxley Act (SOX). Some key requirements of the Act are designed to shore up investor confidence in financial reporting by increasing the reliability of internal control (I/C) over that reporting.
SOX requires each issuer to include in its Form 10-K an assessment of the effectiveness of, and a statement that management is responsible for, I/C. SOX requires auditors to report on management’s assessment by evaluating the design and operating effectiveness of I/C. This involves understanding I/C, assessing the risk that a material weakness exists, and executing tests of controls based on that risk.
(Choices A and C) Although SOX Section 404 doesn’t specify a due date for the auditor’s report, it is submitted with an issuer’s Form 10-K. Not all Forms 10-K are due within 60 days. Large accelerated filers report within 60 days of year end, but accelerated and nonaccelerated filers have 75 and 90 days, respectively.
(Choice D) The effectiveness of I/C is a measure of how well it prevents material misstatements and is of concern to both auditors and management. The efficiency of I/C is a measure of how little waste is involved in maintaining it and will be of concern to management, but not auditors. Auditors report on the effectiveness, not the efficiency, of I/C.
Things to remember:
Managers of issuers must acknowledge their responsibility for, and assess the effectiveness of, internal control over financial reporting. Auditors attest to and report on management’s assessment.
The Federal Reserve wishes to reduce interest rates. Which of the following approaches will be the most successful?
A. Sell government securities.
B. Reduce reserve requirements.
C. Decrease government spending.
D. Increase regulation of banks.
B. Reduce reserve requirements.
One of the Fed’s monetary tools involves manipulating reserve requirements. Reserves are funds that banks hold to cover customer withdrawals. Because supply and demand for money determines interest rates, lowering the reserve requirement creates excess reserves. Banks use the additional reserves to make loans, resulting in an increase in the money supply. Increases in the money supply should put downward pressure on interest rates.
(Choice A) The sale of government securities by the Fed is a contractionary monetary policy and is likely to put upward pressure on interest rates.
(Choice C) A decrease in government spending is an example of fiscal, not monetary, policy. Although this decrease would tighten the money supply for businesses and consumers, it would not necessarily impact the interest rates charged by banks.
(Choice D) Regulations are designed to protect bank customers and are not an example of monetary policy.
Things to remember:
A reduction in the reserve requirement creates excess cash reserves in the banking system. Banks are likely to use this excess to make business and consumer loans, leading to an increase in the money supply and downward pressure on interest rates.
Which of the following types of unemployment typically results from technological advances?
A. Cyclical.
B. Frictional.
C. Structural.
D. Short-term.
C. Structural.
Unemployment will never be zero as there is a natural rate of unemployment. In the U.S., that rate is considered to be between 4.5 and 5 percent. There are four types of unemployment: cyclical, frictional, seasonal, and structural.
Structural unemployment is a result of technological change that displaces workers. For example, manual workers in the automobile manufacturing industry were displaced when production lines became automated (ie, computerized). Structural unemployment also results when consumers change their demands for certain goods and services (eg, on-demand streaming rather DVD players). Retraining workers will normally help alleviate this type of unemployment, although that is usually a long-term process (Choice D).
(Choice A) Cyclical unemployment involves job losses resulting from business cycle fluctuations. It is considered temporary; once the recessionary phase is over, many workers will be reemployed.
(Choice B) Frictional unemployment is caused by workers who are unemployed due to normal turnover. Some workers may voluntarily leave their employment to search for something better. This category of unemployment also includes new entrants (eg, recent college graduates) to the job market.
Things to remember:
There are four types of unemployment: structural, frictional, cyclical, and seasonal. Only structural unemployment is caused by technological changes or changes in consumer demand. Retraining, a long-term solution, is often required.
In addition to increasing the demand for loanable funds, government borrowing to finance large deficits has which of the following effects?
A. It decreases the rate of inflation.
B. It puts upward pressure on interest rates.
C. It increases the supply of loanable funds.
D. It exerts downward pressure on interest rates.
B. It puts upward pressure on interest rates.
The federal deficit is the amount by which federal government expenditures exceed tax revenues within a period. Deficit spending involves increasing federal spending without increasing tax revenues by an equivalent amount. To finance the deficit, the government borrows funds by selling government securities (T-bills, T-notes, and T-bonds) to individuals, businesses, federal agencies, and state and local governments.
When the government sells (ie, issues) securities, the supply increases. Graphically, the supply curve shifts to the right, resulting in equilibrium at higher quantities and lower security prices. Because prices are inversely related to the bond’s rate of return (ie, interest rates), interest rates increase.
(Choice A) Deficit spending is inflationary. Furthermore, government borrowing to finance deficits reinforces inflation. By issuing debt, the private sector has more wealth in financial assets (eg, government bonds). The increase in monetary wealth increases people’s willingness to spend money. Higher demand raises the prices of goods (inflation).
(Choice C) The government must borrow to pay for a large deficit. This increases the demand, but not the supply, for loanable funds.
(Choice D) Increasing the supply of bonds by the federal government reduces bond prices. This puts upward, not downward, pressure on interest rates.
Things to remember:
To finance deficit spending without raising tax revenues, the government sells U.S. Treasuries (ie, bonds). The supply of bonds increases, lowering the equilibrium price. Bond prices and interest rates are inversely related, resulting in upward pressure on interest rates.
The demand curve for a product reflects which of the following?
A. The impact of prices on the amount of product offered.
B. The willingness of producers to offer a product at alternative prices.
C. The impact that price has on the amount of a product purchased.
D. The responsiveness of the quantity demanded for one good to a change in the price of another good.
C. The impact that price has on the amount of a product purchased.
Demand is the quantity of a good or service that consumers are willing and able to purchase at a particular price and time. The demand curve shows the inverse (negative) relationship between price and quantity demanded. As prices increase, the quantity demanded decreases. Demand is commanded by the consumer; supply is determined by the supplier.
In the illustration, the quantity demanded is high at 90 widgets for $2. Conversely, when the price of the goods increases to $10, the quantity demanded decreases to 10 widgets.
(Choices A and B) The amount of product offered and the impact that price has on that amount d is determined by the supply curve, not the demand curve.
(Choice D) Cross-elasticity of demand measures the responsiveness of the quantity demanded for one good to a change in the price of another good. Cross-elasticity is used to determine if two different goods are substitutes, complements, or unrelated.
Things to remember:
Demand is commanded by the consumer; supply is determined by the supplier. The downward sloping demand curve shows the inverse relationship between demand and price and the quantity of goods that consumers are willing to purchase.
Historically, the duration of most expansions and recessions has been
A. Several decades and several years, respectively.
B. Several years and several months, respectively.
C. Several months and several years, respectively.
D. Several years each.
B. Several years and several months, respectively.
A business cycle is a fluctuation in economic production that generally lasts several years. Some business cycles are shorter (barely a couple of years) and others longer (over a decade). A full cycle consists of a peak, contraction (ie, recession), trough, and expansion.
Variations in business cycles depend on the length of the cycle (ie, duration) and the degree of fluctuation (ie, intensity of change) in the economy. Supply and demand, the availability of capital, and consumer confidence also contribute to cycle fluctuations.
Expansions, often lasting years, are typically longer than recessions. Recessions tend to have shorter durations than expansions, typically lasting several months or only a few years. Government intervention is more likely with a recession than an expansion, thus shortening the length of the phase.
Things to remember:
A business cycle is a fluctuation in economic production that generally lasts several years. A full cycle consists of a peak, contraction (ie, recession), trough, and expansion. Expansions, often lasting several years, typically run longer than recessions. Recessions tend to have shorter durations than expansions, lasting several months or only a few years.
Which of the following best describes stagflation?
A. A business cycle phase of low economic growth (stagnation) and falling prices (deflation).
B. A business cycle phase of high unemployment and high inflation.
C. A business cycle phase that can be addressed through lower interest rates to reduce unemployment.
D. A business cycle phase that can be addressed through higher interest rates to reduce inflation.
B. A business cycle phase of high unemployment and high inflation.
Natural unemployment (ie, full employment) is the rate of unemployment when all workers who want to be employed are employed. Whenever actual unemployment is significantly greater than the natural level, a recession is likely to occur. If these conditions are coupled with inflation, stagflation (also known as cost-push inflation) is the result.
Stagflation is the combination of high inflation (ie, high growth rates with rising prices) and high unemployment (Choice A). It is caused by increases in the costs of production (eg, labor and energy), which pushes the aggregate supply (AS) to the left in the graph above. Although aggregate demand (AD) does not shift, the market equilibrium will shift to higher prices (ie, inflation) but lower output (ie, increased unemployment).
Generally, the government implements contractionary fiscal policies to mitigate stagflation. Fiscal policies include higher taxes and lower government spending. Monetary policies could also be enacted, including increasing interest rates, which would slow excessive growth (Choice C).
Although higher interest rates are designed to reduce consumer spending and investment, they have the potential to backfire by reducing growth too much, causing a significant decline in GDP (Choice D). The more effective solution is to focus on supply-side policies, which increase productivity and shift the AS1 curve back to AS0 (ie, back to initial equilibrium).
Things to remember:
Stagflation is the combination of high inflation (ie, high growth rates) and high unemployment. Typically, it is caused by an increase in the costs of production (eg, labor and energy). The long-term solution is to focus on supply-side policies, which increase productivity and shift the supply curve back to its initial equilibrium position.
The controller of Gray, Inc. has decided to use ratio analysis to analyze business cycles for the past two years in an effort to identify seasonal patterns. Which of the following formulas should be used to compute percentage changes for account balances for year 1 to year 2?
A. (Prior balance - current balance) / current balance.
B. (Prior balance - current balance) / prior balance.
C. (Current balance - prior balance) / current balance.
D. (Current balance - prior balance) / prior balance.
D. (Current balance - prior balance) / prior balance.
Choice D (Correct): A change in account balances will always be measured as the current balance minus the prior balance, with a positive result indicating an increase and a negative result a decrease. To determine the percentage change, the increase or decrease in the balance will be divided by the beginning, or prior, balance.
Choices A, B, C (Incorrect): A change in account balances will always be measured as the current balance minus the prior balance, with a positive result indicating an increase and a negative result a decrease. To determine the percentage change, the increase or decrease in the balance will be divided by the beginning, or prior, balance.
