4.3: International Trade Agreements and Organizations

4.3.1: The General Agreement on Tariffs and Trade (GATT)

Learning Objective

Outline the history of the creation of the General Agreement on Tariffs and Trade (GATT)

Key Points

• The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement regulating international trade, the purpose of which is the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis”.
• The failure to create the International Trade Organization (ITO) resulted in the GATT negotiation at the UN Conference on Trade and Employment.
• GATT was in place from 1947-1993, when it was replaced by the World Trade Organization (WTO) in 1995.
• GATT text is still in effect under the WTO framework, subject to modifications.
• During GATT’s eight rounds, countries exchanged tariff concessions and reduced tariffs.

Key Terms

multilateral

Involving more than one party (often used in politics to refer to negotiations, talks, or proceedings involving several nations).

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement regulating international trade. According to its preamble, its purpose is the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis. ” GATT was negotiated during the UN Conference on Trade and Employment and was the outcome of the failure of negotiating governments to create the International Trade Organization (ITO). GATT was signed in 1947 and lasted until 1993, when it was replaced by the World Trade Organization (WTO) in 1995. The original GATT text (GATT 1947) is still in effect under the WTO framework, subject to the modifications of GATT 1994.

GATT held a total of eight rounds, during which countries exchanged tariff concessions and reduced tariffs.

In 1993, the GATT was updated (GATT 1994) to include new obligations upon its signatories. One of the most significant changes was the creation of the WTO. The 75 existing GATT members and the European Communities became the founding members of the WTO on January 1, 1995. The other 52 GATT members rejoined the WTO in the following two years, the last being Congo in 1997. Since the founding of the WTO, 21 new non-GATT members have joined and 29 are currently negotiating membership. There are a total of 157 member countries in the WTO, with Russia and Vanuatu being new members as of 2012.

Of the original GATT members, Syria and SFR Yugoslavia (SFRY) have not rejoined the WTO. Because FR Yugoslavia (later renamed Serbia and Montenegro) is not recognized as a direct SFRY successor state, its application is considered a new (non-GATT) one. The General Council of WTO, on 4 May 2010, agreed to establish a working party to examine the request of Syria for WTO membership. The contracting parties who founded the WTO ended official agreement of the “GATT 1947” terms on 31 December 1995. Serbia and Montenegro are in the decision stage of the negotiations and are expected to become the newest members of the WTO in 2012 or in the near future.

WTO Membership, 2005

GATT was replaced by the World Trade Organization (WTO) in 1995. This map shows membership in the WTO in 2005.

4.3.2: The European Union

Learning Objective

Discuss the establishment of the European Union (EU) and the Euro

Key Points

• The European Union (EU) is an economic and political union made up of 27 member states that are located primarily in Europe.
• Members of the EU include Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.
• The EU operates through a system of supranational independent institutions and intergovernmental negotiated decisions by the member states.
• Within the Schengen Area (which includes EU and non-EU states) passport controls have been abolished.
• The creation of a single currency became an official objective of the European Economic Community (EEC) in 1969. On January 1, 2002 euro notes and coins were issued and national currencies began to phase out in the eurozone.
• The ECB is the central bank for the eurozone, and thus controls monetary policy in that area with an agenda to maintain price stability. It is at the center of the European System of Central Banks, which comprises all EU national central banks and is controlled by its General Council, consisting of the President of the ECB, who is appointed by the European Council, the Vice-President of the ECB, and the governors of the national central banks of all 27 EU member states.

Key Terms

European Union

A supranational organization created in the 1950s to bring the nations of Europe into closer economic and political connection. At the beginning of 2012, 27 member nations were Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, The Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom.

euro

The currency unit of the European Monetary Union. Symbol: €

transparency

Open, public; having the property that theories and practices are publicly visible, thereby reducing the chance of corruption.

Example

• The euro is designed to help build a single market by easing travel of citizens and goods, eliminating exchange rate problems, providing price transparency, creating a single financial market, stabilizing prices, maintaining low interest rates, and providing a currency used internationally and protected against shocks by the large amount of internal trade within the eurozone. It is also intended as a political symbol of integration.

The European Union

The European Union (EU) is an economic and political union or confederation of 27 member states that are located in Europe, including:

Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.

The EU operates through a system of supranational independent institutions and intergovernmental decisions negotiated by the member states. Important institutions of the EU include the European Commission, the Council of the European Union, the European Council, the Court of Justice of the European Union, and the European Central Bank. The European Parliament is elected every five years by EU citizens. The EU has developed a single market through a standardized system of laws that apply in all member states. Within the Schengen Area (which includes EU and non-EU states) passport controls have been abolished. EU policies aim to ensure the free movement of people, goods, services, and capital, enact legislation in justice and home affairs, and maintain common policies on trade, agriculture, fisheries, and regional development. A monetary union, the eurozone, was established in 1999, and as of January 2012, is composed of 17 member states. Through the Common Foreign and Security Policy the EU has developed a limited role in external relations and defense. Permanent diplomatic missions have been established around the world. The EU is represented at the United Nations, the WTO, the G8 and the G-20.

The Euro

The creation of a single European currency became an official objective of the European Economic Community in 1969. However, it was only with the advent of the Maastricht Treaty in 1993 that member states were legally bound to start the monetary union. In 1999 the euro was duly launched by eleven of the then fifteen member states of the EU. It remained an accounting currency until 1 January 2002, when euro notes and coins were issued and national currencies began to phase out in the eurozone, which by then consisted of twelve member states. The eurozone (constituted by the EU member states that have adopted the euro) has since grown to seventeen countries, the most recent being Estonia, which joined on 1 January 2011. All other EU member states, except Denmark and the United Kingdom, are legally bound to join the euro when the convergence criteria are met, however only a few countries have set target dates for accession. Sweden has circumvented the requirement to join the euro by not meeting the membership criteria.

The euro is designed to help build a single market by easing travel of citizens and goods, eliminating exchange rate problems, providing price transparency, creating a single financial market, stabilizing prices, maintaining low interest rates, and providing a currency used internationally and protected against shocks by the large amount of internal trade within the eurozone. It is also intended as a political symbol of integration. The euro and the monetary policies of those who have adopted it in agreement with the EU are under the control of the European Central Bank (ECB). The ECB is the central bank for the eurozone, and thus controls monetary policy in that area with an agenda to maintain price stability. It is at the center of the European System of Central Banks, which comprises all EU national central banks and is controlled by its General Council, consisting of the President of the ECB, who is appointed by the European Council, the Vice-President of the ECB, and the governors of the national central banks of all 27 EU member states. The monetary union has been shaken by the European sovereign-debt crisis since 2009.

European Union

European Union member countries

4.3.3: The North American Free Trade Agreement (NAFTA)

Learning Objective

Outline the stipulations of NAFTA

Key Points

• The North American Free Trade Agreement (NAFTA) is an agreement signed by the governments of Canada, Mexico, and the United States, creating a trilateral trade bloc in North America.
• NAFTA came into effect on January 1, 1994 and superseded the Canada – United States Free Trade Agreement.
• Within 10 years of the implementation of NAFTA, all U.S.-Mexico tariffs are to be eliminated except for some U.S. agricultural exports to Mexico which will be phased out within 15 years.
• Most U.S. – Canada trade was duty free before NAFTA.
• NAFTA also seeks to eliminate non-tariff trade barriers and to protect the intellectual property right of the products.
• When viewing the combined GDP of its members, as of 2010 NAFTA is the largest trade bloc in the world.

Key Terms

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

trade bloc

A trade bloc is a type of intergovernmental agreement, often part of a regional intergovernmental organization, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated among the participating states.

The North American Free Trade Agreement (NAFTA)

The North American Free Trade Agreement (NAFTA) is an agreement signed by the governments of Canada, Mexico, and the United States, creating a trilateral trade bloc in North America. The agreement came into force on January 1, 1994. It superseded the Canada – United States Free Trade Agreement between the U.S. and Canada.

In terms of combined GDP of its members, the trade bloc is the largest in the world as of 2010. NAFTA has two supplements: the North American Agreement on Environmental Cooperation (NAAEC) and the North American Agreement on Labor Cooperation (NAALC). The goal of NAFTA was to eliminate barriers to trade and investment among the U.S., Canada, and Mexico.

The implementation of NAFTA on January 1, 1994 brought the immediate elimination of tariffs on more than one-half of Mexico’s exports to the U.S. and more than one-third of U.S. exports to Mexico. Within 10 years of the implementation of the agreement, all U.S.–Mexico tariffs would be eliminated except for some U.S. agricultural exports to Mexico that were to be phased out within 15 years. Most U.S.–Canada trade was already duty free. NAFTA also seeks to eliminate non-tariff trade barriers and to protect the intellectual property right of the products.

The agreement opened the door for open trade, ending tariffs on various goods and services, and implementing equality between Canada, America, and Mexico. NAFTA has allowed agricultural goods such as eggs, corn, and meats to be tariff-free. This allowed corporations to trade freely and import and export various goods on a North American scale .

NAFTA countries

The members of NAFTA are the U.S., Canada, and Mexico.

4.3.4: The Asia-Pacific Economic Cooperation

Learning Objective

Explain the role The Asia-Pacific Economic Cooperation (APEC ) plays in ensuring free trade

Key Points

• Asia-Pacific Economic Cooperation (APEC) is a forum for 21 Pacific Rim countries that seeks to promote free trade and economic cooperation.
• APEC was established in 1989 in response to the growing interdependence of Asia-Pacific economies and the advent of regional economic blocs.
• APEC member countries include Australia, Brunei, Canada, Chile, China, Hong Kong (Hong Kong, China), Indonesia, Japan, South Korea, Mexico, Malaysia, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Taiwan (Chinese Taipei), Thailand, United States, and Vietnam.
• During the meeting in 1994 in Bogor, Indonesia, APEC leaders adopted the Bogor Goals which aim for free and open trade and investment in the Asia-Pacific by 2010, for industrialized economies and by 2020, for developing economies.

Key Term

bloc

A group of countries acting together for political or economic goals, an alliance (e.g., the eastern bloc, the western bloc, a trading bloc).

The Asia-Pacific Economic Cooperation (APEC) is a forum for 21 Pacific Rim countries (formally Member Economies) that seeks to promote free trade and economic cooperation throughout the Asia-Pacific region. Established in 1989 in response to the growing interdependence of Asia-Pacific economies and the advent of regional economic blocs (such as the European Union) in other parts of the world, APEC works to raise living standards and education levels through sustainable economic growth and to foster a sense of community and an appreciation of shared interests among Asia-Pacific countries.

Member countries are: Australia, Brunei, Canada, Chile, China, Hong Kong (Hong Kong, China), Indonesia, Japan, South Korea, Mexico, Malaysia, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Taiwan (Chinese Taipei), Thailand, United States, and Vietnam.

APEC member countries

APEC’s member countries border both the east and the west of the Pacific Ocean.

During the meeting in 1994 in Bogor, Indonesia, APEC leaders adopted the Bogor Goals that aim for free and open trade and investment in the Asia-Pacific by 2010, for industrialized economies and by 2020, for developing economies. In 1995, APEC established a business advisory body named the APEC Business Advisory Council (ABAC), composed of three business executives from each member economy. To meet the Bogor Goals, APEC carries out work in three main areas:

1. Trade and investment liberalization
2. Business facilitation
3. Economic and technical cooperation

APEC is considering the prospects and options for a Free Trade Area of the Asia-Pacific (FTAAP), which would include all APEC member economies. Since 2006, the APEC Business Advisory Council, promoting the theory that a free trade area has the best chance of converging the member nations and ensuring stable economic growth under free trade, has lobbied for the creation of a high-level task force to study and develop a plan for a free trade area. The proposal for a FTAAP arose due to the lack of progress in the Doha round of World Trade Organization negotiations, and as a way to overcome the “spaghetti bowl” effect created by overlapping and conflicting elements of the umpteen free trade agreements. There are approximately 60 free trade agreements, with an additional 117 in the process of negotiation in Southeast Asia and the Asia-Pacific region.

4.3.5: The World Bank

Learning Objective

Explain the role played by the World Bank in reducing poverty

Key Points

• The World Bank’s official goal is the reduction of poverty.
• According to the World Bank’s Articles of Agreement, all of its decisions must be guided by a commitment to promote foreign investment, international trade, and facilitate capital investment.
• The current President of the Bank, Jim Yong Kim, is responsible for chairing the meetings of the boards of directors and for overall management of the bank.
• Traditionally, the bank president has always been a U.S. citizen nominated by the United States, the largest shareholder in the bank. The nominee is subject to confirmation by the board of executive directors, to serve for a five-year, renewable term.
• For the poorest developing countries in the world, the bank’s assistance plans are based on poverty reduction strategies.

Key Terms

developing

Of a country: becoming economically more mature or advanced; becoming industrialized.

loan

A sum of money or other valuables or consideration that an individual, group, or other legal entity borrows from another individual, group, or legal entity (the latter often being a financial institution) with the condition that it be returned or repaid at a later date (sometimes with interest).

poverty

The quality or state of being poor or indigent; want or scarcity of means of subsistence; indigence; need.

World Bank

a group of five financial organizations whose purpose is economic development and the elimination of poverty

The World Bank is an international financial institution that provides loans to developing countries for capital programs. The World Bank’s official goal is the reduction of poverty. According to the World Bank’s Articles of Agreement (as amended effective February 16,1989), all of its decisions must be guided by a commitment to promote foreign investment, international trade, and facilitate capital investment.

The World Bank differs from the World Bank Group, in that the World Bank comprises only two institutions: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), whereas the former incorporates these two in addition to three more: International Finance Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and International Centre for Settlement of Investment Disputes (ICSID). The curent President of the Bank, Jim Yong Kim, is responsible for chairing the meetings of the boards of directors and for overall management of the bank. Traditionally, the bank president has always been a U.S. citizen nominated by the United States, the largest shareholder in the bank. The nominee is subject to confirmation by the board of executive directors, to serve for a five-year, renewable term.

The International Bank for Reconstruction and Development (IBRD) has 188 member countries, while the International Development Association (IDA) has 172 members.Each member state of IBRD should be also a member of the International Monetary Fund (IMF), and only members of IBRD are allowed to join other institutions within the Bank (such as IDA).

For the poorest developing countries in the world, the bank’s assistance plans are based on poverty reduction strategies; by combining a cross-section of local groups with an extensive analysis of the country’s financial and economic situation, the World Bank develops a strategy pertaining uniquely to the country in question. The government then identifies the country’s priorities and targets for the reduction of poverty, and the World Bank aligns its aid efforts correspondingly. Forty-five countries pledged $25.1 billion in “aid for the world’s poorest countries,” aid that goes to the World Bank International Development Association (IDA) which distributes the loans to 80 poorer countries.

World Bank Headquarters

Washington, DC headquarters of the World Bank

4.3.6: The International Monetary Fund (IMF)

Learning Objective

Explain how the International Monetary Fund (IMF) aids its 188 member countries

Key Points

• The International Monetary Fund (IMF) is an international organization that was created on July 22, 1944 at the Bretton Woods Conference.
• The IMF’s stated goal is to stabilize exchange rates and assist the reconstruction of the world’s international payment system after World War II.
• The IMF is run by country contributions. Money is pooled through a quota system from which countries with payment imbalances can borrow funds on a temporary basis.
• It works with developing nations to help them achieve macroeconomic stability and reduce poverty. The rationale for this is that private international capital markets function imperfectly and many countries have limited access to financial markets. Such market imperfections, together with balance of payments financing, provide the justification for official financing, without which many countries could only correct large external payment imbalances through measures with adverse effects on both national and international economic prosperity. The IMF can provide other sources of financing to countries in need that would not be available in the absence of an economic stabilization program supported by the Fund.
• Member countries of the IMF have access to information on the economic policies of all member countries, the opportunity to influence other members’ economic policies, technical assistance in banking, fiscal affairs, and exchange matters, financial support in times of payment difficulties, and increased opportunities for trade and investment. IMF conditionality is a set of policies that the IMF requires in exchange for financial resources. The IMF does not require collateral from countries for loans but rather requires the government seeking assistance to correct its macroeconomic imbalances in the form of policy reform. If the conditions are not met, the funds are withheld. Conditionality is perhaps the most controversial aspect of IMF policies.
• These loan conditions ensure that the borrowing country will be able to repay the Fund and that the country won’t attempt to solve their balance of payment problems in a way that would negatively impact the international economy. The incentive problem of moral hazard, which is the actions of economic agents maximizing their own utility to the detriment of others when they do not bear the full consequences of their actions, is mitigated through conditions rather than providing collateral; countries in need of IMF loans do not generally possess internationally valuable collateral anyway. Conditionality also reassures the IMF that the funds lent to them will be used for the purposes defined by the Articles of Agreement and provides safeguards that country will be able to rectify its macroeconomic and structural imbalances. In the judgment of the Fund, the adoption by the member of certain corrective measures or policies will allow it to repay the Fund, thereby ensuring that the same resources will be available to support other members.
• Voting power in the IMF is, like the money pool, based on a quota system. Each member has a number of “basic votes” (each member’s number of basic votes equals 5.502% of the total votes), plus one additional vote for each Special Drawing Right (SDR) of 100,000 of a member country’s quota. The Special Drawing Right is the unit of account of the IMF and represents a claim to currency. It is based on a basket of key international currencies. The basic votes generate a slight bias in favor of small countries, but the additional votes determined by SDR outweigh this bias.
• The IMF is mandated to oversee the international monetary and financial system and monitor the economic and financial policies of its 188 member countries. This activity is known as surveillance and facilitates international cooperation. Since the demise of the Bretton Woods system of fixed exchange rates in the early 1970s, surveillance has evolved largely by way of changes in procedures rather than through the adoption of new obligations. The responsibilities of the Fund changed from those of guardian to those of overseer of members’ policies.
• Some critics assume that Fund lending imposes a burden on creditor countries. However, countries receive market-related interest rates on most of their quota subscription, plus any of their own-currency subscriptions that are loaned out by the Fund, plus all of the reserve assets that they provide the Fund. Also, as of 2005 borrowing countries have had a very good track record of repaying credit extended under the Fund’s regular lending facilities with the full interest over the duration of the borrowing.

Key Terms

collateral

A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )

capital market

The market for long-term securities, including the stock market and the bond market.

moral hazard

The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

The International Monetary Fund (IMF) is an international organization that was created on July 22, 1944 at the Bretton Woods Conference and came into existence on December 27, 1945 when 29 countries signed the IMF Articles of Agreement. It originally had 45 members. The IMF’s stated goal was to stabilize exchange rates and assist the reconstruction of the world’s international payment system post-World War II. Countries contribute money to a pool through a quota system from which countries with payment imbalances can borrow funds on a temporary basis. Through this activity and others, such as surveillance of its members’ economies and policies, the IMF works to improve the economies of its member countries. The IMF describes itself as “an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty. “

The organization’s stated objectives are to promote international economic cooperation, international trade, employment, and exchange rate stability, including by making financial resources available to member countries to meet balance of payments needs. Member countries of the IMF have access to information on the economic policies of all member countries, the opportunity to influence other members’ economic policies, technical assistance in banking, fiscal affairs, and exchange matters, financial support in times of payment difficulties, and increased opportunities for trade and investment. Voting power in the IMF is based on a quota system. Each member has a number of “basic votes” (each member’s number of basic votes equals 5.502% of the total votes), plus one additional vote for each Special Drawing Right (SDR) of 100,000 of a member country’s quota. The Special Drawing Right is the unit of account of the IMF and represents a claim to currency. It is based on a basket of key international currencies. The basic votes generate a slight bias in favor of small countries, but the additional votes determined by SDR outweigh this bias.

The IMF works to foster global growth and economic stability. It provides policy advice and financing to members in economic difficulties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty. The rationale for this is that private international capital markets function imperfectly, and many countries have limited access to financial markets. Such market imperfections, together with balance of payments financing, provide the justification for official financing, without which many countries could only correct large external payment imbalances through measures with adverse effects on both national and international economic prosperity. The IMF can provide other sources of financing to countries in need that would not be available in the absence of an economic stabilization program supported by the fund.

The IMF is mandated to oversee the international monetary and financial system and monitor the economic and financial policies of its 188 member countries. This activity is known as “surveillance” and facilitates international cooperation. Since the demise of the Bretton Woods system of fixed exchange rates in the early 1970s, surveillance has evolved largely by way of changes in procedures rather than through the adoption of new obligations.The responsibilities of the fund changed from those of guardian to those of overseer of members’ policies. The fund typically analyzes the appropriateness of each member country’s economic and financial policies for achieving orderly economic growth, and assesses the consequences of these policies for other countries and for the global economy.

IMF conditionality is a set of policies or “conditions” that the IMF requires in exchange for financial resources. The IMF does not require collateral from countries for loans but rather requires the government seeking assistance to correct its macroeconomic imbalances in the form of policy reform. If the conditions are not met, the funds are withheld. Conditionality is the most controversial aspect of IMF policies. These loan conditions ensure that the borrowing country will be able to repay the fund and that the country won’t attempt to solve their balance of payment problems in a way that would negatively impact the international economy. The incentive problem of moral hazard, which is the actions of economic agents maximizing their own utility to the detriment of others when they do not bear the full consequences of their actions, is mitigated through conditions rather than providing collateral; countries in need of IMF loans do not generally possess internationally valuable collateral anyway. Conditionality also reassures the IMF that the funds lent to them will be used for the purposes defined by the Articles of Agreement and provides safeguards that country will be able to rectify its macroeconomic and structural imbalances. In the judgment of the fund, the adoption by the member of certain corrective measures or policies will allow it to repay the fund, thereby ensuring that the same resources will be available to support other members.

IMF Headquarters

Washington, DC headquarters of the IMF

4.3.7: Common Markets

Learning Objective

Explain the history of the European Economic Community (EEC)

Key Points

• A common market is the first stage towards a single market and may be limited initially to a free trade area, with relatively free movement of capital and of services. However, it is not to a stage where the remaining trade barriers have been eliminated.
• The European Economic Community (EEC) (also known as the Common Market in the English-speaking world and sometimes referred to as the European Community even before it was renamed as such in 1993) was an international organization created by the 1957 Treaty of Rome.
• The main aim of the EEC, as stated in its preamble, was to “preserve peace and liberty and to lay the foundations of an ever closer union among the peoples of Europe”.

Key Term

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

Example

• The European Economic Community was the first example of a both common and single market, but it was an economic union since it had additionally a customs union. The European Economic Community (EEC) was an international organization created by the 1957 Treaty of Rome. Its aim was to bring about economic integration, including a common market, among its six founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands. Upon the entry into force of the Maastricht Treaty in 1993, the EEC was renamed the European Community (EC) to reflect that it covered a wider range of policy. This was also when the three European Communities, including the EC, were collectively made to constitute the first of the three pillars of the European Union (EU). For the customs union, the treaty provided for a 10% reduction in custom duties and up to 20% of global import quotas. Progress on the customs union proceeded much faster than the twelve years planned.

A common market is a first stage towards a single market and may be limited initially to a free trade area with relatively free movement of capital and of services, but not so advanced in reduction of the rest of the trade barriers.

The European Economic Community (EEC) (also known as the Common Market in the English-speaking world and sometimes referred to as the European Community even before it was renamed as such in 1993) was an international organization created by the 1957 Treaty of Rome. Its aim was to bring about economic integration, including a common market, among its six founding members: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands.

It gained a common set of institutions along with the European Coal and Steel Community (ECSC) and the European Atomic Energy Community (EURATOM) as one of the European Communities under the 1965 Merger Treaty (Treaty of Brussels).

Upon the entry into force of the Maastricht Treaty in 1993, the EEC was renamed the European Community (EC) to reflect that it covered a wider range of policy. This was also when the three European Communities, including the EC, were collectively made to constitute the first of the three pillars of the European Union (EU), which the treaty also founded. The EC existed in this form until it was abolished by the 2009 Treaty of Lisbon, which merged the EU’s former pillars and provided that the EU would “replace and succeed the European Community. ” The main aim of the EEC, as stated in its preamble, was to “preserve peace and liberty and to lay the foundations of an ever closer union among the peoples of Europe. ” Calling for balanced economic growth, this was to be accomplished through:

• The establishment of a customs union with a common external tariff
• Common policies for agriculture, transport, and trade
• Enlargement of the EEC to the rest of Europe

For the customs union, the treaty provided for a 10% reduction in custom duties and up to 20% of global import quotas. Progress on the customs union proceeded much faster than the 12 years planned. However, France faced some setbacks due to its war with Algeria.

The six states that founded the EEC and the other two communities were known as the “inner six” (the “outer seven” were those countries who formed the European Free Trade Association). The six were France, West Germany, Italy, and the three Benelux countries: Belgium, the Netherlands, and Luxembourg. The first enlargement was in 1973, with the accession of Denmark, Ireland, and the United Kingdom. Greece, Spain, and Portugal joined in the 1980s. Following the creation of the EU in 1993, it has enlarged to include an additional 15 countries by 2007.

There were three political institutions that held the executive and legislative power of the EEC, plus one judicial institution and a fifth body created in 1975. These institutions (except for the auditors) were created in 1957 by the EEC but from 1967 on, they applied to all three communities. The council represents governments, the Parliament represents citizens, and the commission represents the European interest.

European Economic Community

Original member states (blue) and later members (green)

4.3.8: The Export-Import Bank of the United States

Learning Objective

Explain the purpose of the Export-Import Bank of the United States (Ex-Im Bank)

Key Points

• The mission of the Ex-Im Bank is to create and sustain U.S. jobs by financing sales of U.S. exports to international buyers.
• Ex-Im Bank provides financing for transactions that would otherwise not take place because commercial lenders are either unable or unwilling to accept the political or commercial risks inherent in the deal.
• The Export-Import Bank of the United States focuses much of its energy and resources on providing support to U.S. small businesses for export of American-made products.
• Export Credit Insurance from Export-Import Bank of the United States provides insurance policies to U.S. companies and banks to mitigate risks of non-collection from foreign buyers and borrowers.
• The Working Capital Guarantee program provides loan guarantees to banks willing to lend to exporting companies.

Key Terms

risk

To incur risk [of something].

guarantee

To assume responsibility for a debt.

credit agency

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.

Example

• The Ex-Im Bank provides two types of loans: direct loans to foreign buyers of American exports and intermediary loans to responsible parties, such as foreign government lending agencies that re-lend to foreign buyers of capital goods and related services (for example, a maintenance contract for a jet passenger plane).

The Export-Import Bank of the United States (Ex-Im Bank) is the official export credit agency of the United States federal government. It was established in 1934 by an executive order and made an independent agency in the Executive branch by Congress in 1945. Its purpose is to finance and insure foreign purchases of United States goods for customers unable or unwilling to accept credit risk.

The mission of the Ex-Im Bank is to create and sustain U.S. jobs by financing sales of U.S. exports to international buyers. Ex-Im Bank is the principal government agency responsible for aiding the export of American goods and services through a variety of loan, guarantee, and insurance programs. Generally, its programs are available to any American export firm regardless of size. The Bank is chartered as a government corporation by the Congress of the United States; it was last chartered for a five year term in 2006. Its Charter spells out the Bank’s authorities and limitations. Among them is the principle that Ex-Im Bank does not compete with private sector lenders, but rather provides financing for transactions that would otherwise not take place because commercial lenders are either unable or unwilling to accept the political or commercial risks inherent in the deal.

Export-Import Bank of the United States

Seal of the Export-Import Bank of the United States.

Ex-Im Bank provides the following services:

• The Export-Import Bank of the United States focuses much of its energy and resources on providing support to small American businesses for export of American-made products
• Export Credit Insurance provides insurance policies to U.S. companies and banks to mitigate risks of non-collection from foreign buyers and borrowers.
• The Working Capital Guarantee program provides loan guarantees to banks willing to lend to exporting companies.
• Two types of loans: direct loans to foreign buyers of American exports and intermediary loans to responsible parties, such as foreign government lending agencies that re-lend to foreign buyers of capital goods and related services (for example, a maintenance contract for a jet passenger plane).

4.4: The Money of International Business

4.4.1: Exchange Rates

The price of one country’s currency in units of another country’s currency is known as a foreign currency exchange rate.

Learning Objective

Summarize how exchange rates operate

Key Points

• An exchange rate between two currencies is the rate at which one currency will be exchanged for another.
• Currency may be free-floating, pegged or fixed, or a hybrid.
• A currency will tend to become more valuable whenever demand for it is greater than the available supply.
• Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money.

Key Terms

exchange rate

The amount of one currency that a person or institution defines as equivalent to another currency when either buying or selling it at any particular moment.

fixed exchange rate

Sometimes called a pegged exchange rate, a type of exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A floating or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market.

Example

• Suppose you plan to travel to France from the US. You will need to buy Euros for your stay there. You go to the local money changer and see a direct quote of 0.5 USD/EUR, which means that one US dollar will get you 0.5 Euros. You exchange $5,000 and get €2,500 to travel. Let us say a year later, you decide to go to France again. However, in this time, there is a lot of demand for European goods worldwide and people want more Euros to buy them. This increase in demand has made the Euro more expensive and now the exchange rate is 0.25 USD/EUR in your local money exchange. Your US$5,000 now only gets you €1,250. Because you want to still have €2,500 in your bank when you travel, you will need to spend an extra $5,000 for this. You realize that the Euro has become much more expensive than the previous year, and you need to spend double the amount of USD to get the same amount of Euro you had last year.

Exchange Rates

A foreign currency exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another’s. Exchange rates are determined in the foreign exchange market. The “forex” or “FX” market is the largest currency exchange market in the world today, where trading averages around 5.3 trillion US dollars per day (data from April, 2013).  

Exchange rates can be quoted in two ways: (1) A direct quote, is to state the number of domestic units of currency per one unit of foreign currency; (2) If an exchange rate is an indirect quote, the exchange rate is stated as the number of foreign units per one unit of domestic currency.

Foreign Exchange for Travelers

People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveler’s checks, or a travel-card. They can only buy foreign cash from a local money changer.

At the destination, travelers can buy local currency at the airport, at their hotel, a local money changer or dealer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser’s home currency at its prevailing exchange rate. If they have traveler’s checks or a travel card in the local currency, no currency exchange is necessary.

If a traveler has any foreign currency left over on his return home, he may want to sell it, which he may do at his local bank or money changer. The exchange rate, as well as fees and charges, can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next.

Fluctuations in Exchange Rates

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.25 means that one euro is exchanged for 1.25 US dollars.

Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. This currency is said to have a “floating exchange rate. ” Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1.00. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.

Still, some governments keep their currency within a narrow range. As a result, currencies become over-valued or under-valued, causing trade deficits or surpluses. A market-based exchange rate will change whenever the values of either of the two component currencies change.

A currency will tend to become more valuable whenever demand for it is greater than the available supply. Conversely, it will become less valuable whenever demand is less than available supply. Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money.

Transaction Demand vs. Speculative Demand

The transaction demand is highly correlated to a country’s level of business activity, gross domestic product (GDP), and employment levels. The more people who are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country’s interest rates, the greater the demand for its currency.

Exchange Rates

Example of exchange rates display in Thailand.

4.4.2: Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period.

Learning Objective

Define the balance of trade

Key Points

• A positive balance is known as a “trade surplus” if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
• Measuring the balance of trade can be problematic because of problems with recording and collecting data.
• The cost of production, the cost and availability of raw materials, and exchange rate movements are some factors that can affect the balance of trade.

Key Terms

trade credit

a form of debt offered from one business to another with which it transacts

trade surplus

A positive balance of trade.

balance of trade

The difference between the monetary value of exports and imports in an economy over a certain period of time.

trade deficit

A negative balance of trade.

Example

• Suppose the USA imported $1 billion worth of goods and services in 2008 and exported $750 million dollars worth of goods and services, then its trade deficit would be $1 billion minus $750 million, which equals a trade deficit of $250 million.

Balance of Trade

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports. A positive balance is known as a “trade surplus,” if it consists of exporting more than is imported; a negative balance is referred to as a “trade deficit” or, informally, a “trade gap.” The balance of trade is sometimes divided into a goods and a services balance. The trade balance is identical to the difference between a country’s output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world’s countries are added up, exports exceed imports by almost 1%; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely. Factors that can affect the balance of trade include:

• The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing economy
• The cost and availability of raw materials, intermediate goods and other inputs
• Exchange rate movements
• Multilateral, bilateral and unilateral taxes, or restrictions on trade
• Non-tariff barriers, such as environmental, health, or safety standards
• The availability of adequate foreign exchange with which to pay for imports
• Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand-led growth (as in the United States and Australia), the trade balance will worsen at the same stage in the business cycle as these economies will import additional raw materials and finished goods.

US Trade Balance

U.S. trade balance from 1980-2010

4.4.3: Balance of Payments

Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.

Learning Objective

Define the balance of payments (BOP) account

Key Points

• Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.
• Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items.
• Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.
• When all components of the BOP accounts are included they must equal zero with no overall surplus or deficit.

Key Terms

Capital Account

In macroeconomics and international finance, the capital account (also known as financial account) is one of two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation’s net income, the capital account reflects net change in national ownership of assets.

Current Account

In economics, the current account is one of the two primary components of the balance of payments (the other being the capital account). It is the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), times income (earnings on foreign investments minus payments made to foreign investors), and cash transfers.

balance of payments

an accounting record of all monetary transactions between a country and the rest of the world

Example

• Suppose in 2009 that (a) America exports $3 billion worth of goods (that money comes into the US when the goods are sold); (b) Saudi Arabia donates $1 billion to U.S. colleges in aid; (c) Iraq pays $500 million in interest payments for loans taken out from banks in the U.S.; (d) Chinese investors purchase $1 billion in U.S. Treasury bonds. All the activities listed above are sources of foreign exchange because foreigners are paying the U.S. so the total would be $4.5 billion. Also in 2009: (a) America imports $1.5 billion worth of goods from other countries; (b) It donates $2 billion for flood relief in Bangladesh; (c) McDonald’s makes $250 million dividend payments to German shareholders; (d) General Motors spends $250 million on a new plant in China. In all these cases, money is flowing out of the U.S. and we are losing its foreign exchange because the payments have to be made in foreign currency. So in 2009, $4 billion has flown out of the U.S. If we subtract the amount of money coming in and the money going out, the surplus would be $1.5 billion. It has to be kept in mind that the balance of payments accounts have different categories for these transactions called the Current Account and Financial Account.

Balance of Payments

Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. The BOP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included, they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter-balanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries.

While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank’s reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

The term balance of payments often refers to this example: a country’s balance of payments is said to be in surplus (balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country’s currency and other currencies. Then the net change per year in the central bank’s foreign exchange reserves is sometimes called the balance of payments surplus or deficit.

Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). The central bank does not intervene with a pure float to protect or devalue its currency, it allows the rate to be set by the market. The central bank’s foreign exchange reserves do not change.

Current Account Balance, 2006

Current Account balance, 2006, U.S. dollars, per capita

4.5: Types of International Business

4.5.1: Licensing

When considering strategic entry into an international market, licensing is a low-risk and relatively fast foreign market entry tactic.

Learning Objective

Identify the benefits and risks associated with licensing as a foreign market entry model

Key Points

• Foreign market entry options include exporting, joint ventures, foreign direct investment, franchising, licensing, and various other forms of strategic alliance.
• Of these potential entry models, licensing is relatively low risk in terms of time, resources, and capital requirements.
• Advantages of licensing include localization through a foreign partner, adherence to strict international business regulations, lower costs, and the ability to move quickly.
• Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign market, and lower returns due to lower risk.
• When deciding to license abroad, careful due diligence should be done to ensure that the licensee is a strong investment for the licensor and vice versa.

Key Terms

licensee

In a licensing relationship, the buyer of the produce, service, brand or technology being licensed.

licensor

In a licensing relationship, the owner of the produce, service, brand or technology being licensed.

When considering entering international markets, there are some significant strategic and tactical decisions to be made. Exporting, joint ventures, direct investment, franchising, licensing, and various other forms of strategic alliance can be considered as market entry modes. Each entry mode has different pros and cons, addressing issues like cost, control, speed to market, legal barriers, and cultural barriers with different degrees of efficiency.

Licensing

The 1933 Fiat 508 was manufactured under a license in Poland by Polski Fiat.

What is Licensing

A licensor (i.e. the firm with the technology or brand) can provide their products, services, brand and/or technology to a licensee via an agreement. This agreement will describe the terms of the strategic alliance, allowing the licensor affordable and low risk entry to a foreign market while the licensee can gain access to the competitive advantages and unique assets of another firm. This is potentially a strong win-win arrangement for both parties, and is a relatively common practice in international business.

Let’s consider an example. The licensor is a company involved in energy health drinks. Due to food import regulations in Japan, the licensor cannot sell the product at local wholesalers or retailers. In order to circumvent this strategic barrier, the licensor finds a local sports drink manufacturer to license their recipe to. In exchange, the licensee sells the product locally under a local brand name and kicks back 15% of the overall revenues to the licensor.

The Pros and Cons

Before deciding to use licensing as an entry strategy, it’s important to understand in which situations licensing is best suited.

Advantages

Licensing affords new international entrants with a number of advantages:

• Licensing is a rapid entry strategy, allowing almost instant access to the market with the right partners lined up.
• Licensing is low risk in terms of assets and capital investment. The licensee will provide the majority of the infrastructure in most situations.
• Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry.
• Cultural and linguistic barriers are also significant challenges for international entries. Licensing provides critical resources in this regard, as the licensee has local contacts, mastery of local language, and a deep understanding of the local market.

Disadvantages

While the low-cost entry and natural localization are definite advantages, licensing also comes with some opportunity costs:

• Loss of control is a serious disadvantage in a licensing situation in regards to quality control. Particularly relevant is the licensing of a brand name, as any quality control issue on behalf of the licensee will impact the licensor’s parent brand.
• Depending on an international partner also creates inherent risks regarding the success of that firm. Just like investing in an organization in the stock market, licensing requires due diligence regarding which organization to partner with.
• Lower revenues due to relying on an external party is also a key disadvantage to this model. (Lower risk, lower returns.)

4.5.2: Franchising

Franchising enables organizations a low cost and localized strategy to expanding to international markets, while offering local entrepreneurs the opportunity to run an established business.

Learning Objective

Examine the benefits of international franchising

Key Points

• A franchise agreement is defined as the franchiser granting an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products.
• Franchising is designed to enable large organizations rapid access to new markets with relatively low barriers to entry.
• Advantages of franchising (for the franchiser) include low costs of entry, a localized workforce (culturally and linguistically), and a high speed method of market entry.
• Disadvantages of franchising (for the franchiser) include loss of some organizational and brand control, as well as relatively lower returns than other strategic entry models (albeit, with lower risk).

Key Terms

franchisee

A holder of a franchise; a person who is granted a franchise.

franchiser

A franchisor, a company or person who grants franchises.

What is Franchising?

In franchising, an organization (the franchiser) has the option to grant an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products. 

In this arrangement, the franchisee will take the majority of the risk in opening a new location (e.g. capital investments) while gaining the advantage of an already established brand name and operational process. In exchange, the franchisee will pay a certain percentage of the profits of the venture back to the franchiser. The franchiser will also often provide training, advertising, and assistance with products.

Why Franchise

Lower Barriers to Entry

Franchising is a particularly useful practice when approaching international markets. For the franchiser, international expansion can be both complex and expensive, particularly when the purchase of land and building of facilities is necessary. With legal, cultural, linguistics, and logistical barriers to entry in various global markets, the franchising model offers and simpler, cleaner solution that can be implemented relatively quickly.

Localization

Franchising also allows for localization of the brand, products, and distribution systems. This localization can cater to local tastes and language through empowering locals to own, manage, and employ the business. This high level of integration into the new location can create significant advantages compared to other entry models, with much lower risk.

Speed

It is also worth noting that franchising is a very efficient, low cost and quickly implemented expansionary strategy. Franchising requires very little capital investment on behalf of the parent company, and the time and effort of building the stores are similar outsources to the franchisee. As a result, franchising can be a way to rapidly expand both domestically and globally.

Starbucks’ Expansion

Starbucks operates with a wide variety of strategic alliances, including a franchising program. 

A chart that shows how various forms of strategic alliance can rapidly increase rates of expansion.

Downsides to Franchising

Franchising has some weaknesses as well, from a strategic point of view. Most importantly, organizations (the franchisers) lose a great deal of control. Quality assurance and protection of the brand is much more difficult when ownership of the franchise is external to the organization itself. Choosing partners wisely and equipping them with the tools necessary for high levels of quality and alignment with the brand values is critical (e.g., training, equipment, quality control, adequate resources).

It is also of importance to keep the risk/return ratio in mind. While the risk of franchising is much lower in terms of capital investment, so too is the returns derived from operations (depending on the franchising agreement in place). While it is a faster and cheaper mode of entry, it ultimately results in a profit share between the franchiser and the franchisee.

4.5.3: Exporting

Exporting is the practice of shipping goods from the domestic country to a foreign country.

Learning Objective

Explain how exports are accounted for in international trade

Key Points

• This term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country.
• In national accounts “exports” consist of transactions in goods and services (sales, barter, gifts or grants) from residents to non-residents.
• Statistics on international trade do not record smuggled goods or flows of illegal services. A small fraction of the smuggled goods and illegal services may nevertheless be included in official trade statistics through dummy shipments that serve to conceal the illegal nature of the activities.

Key Terms

export

to sell (goods) to a foreign country

import

To bring (something) in from a foreign country, especially for sale or trade.

exporting

the sale of capital, goods, and services across international borders or territories

exporting

the act of selling to a foreign country

Example

• When individuals from Country A purchase goods from Country B, this process is known as exporting for Country B (since their goods are being sold) and importing for Country A (since they are buying the goods).

This term “export” is derived from the concept of shipping goods and services out of the port of a country . The seller of such goods and services is referred to as an “exporter” who is based in the country of export whereas the overseas based buyer is referred to as an “importer”. In international trade, exporting refers to selling goods and services produced in the home country to other markets.

Oil Exports 2006

The map shows barrels of oil exported per day in 2006. Russia and Saudi Arabia exported more barrels than any other oil-exporting countries.

Export of commercial quantities of goods normally requires the involvement of customs authorities in both the country of export and the country of import. The advent of small trades over the internet such as through Amazon and eBay has largely bypassed the involvement of customs in many countries because of the low individual values of these trades. Nonetheless, these small exports are still subject to legal restrictions applied by the country of export. An export’s counterpart is an import.

In national accounts, exports consist of transactions in goods and services (sales, barter, gifts, or grants) from residents to non-residents.The exact definition of exports includes and excludes specific “borderline” cases. A general delimitation of exports in national accounts is as follows: An export of a good occurs when there is a change of ownership from a resident to a non-resident; this does not necessarily imply that the good in question physically crosses any border. However, in specific cases, national accounts impute changes of ownership even though in legal terms no change of ownership takes place (e.g. cross border financial leasing, cross border deliveries between affiliates of the same enterprise, goods crossing the border for significant processing to order or repair). Smuggled goods must also be included in the export measurement.

Export of services consist of all services rendered by residents to non-residents. In national accounts, any direct purchases by non-residents in the economic territory of a country are recorded as exports of services; therefore, all expenditure by foreign tourists in the economic territory of a country is considered part of the export of services of that country. International flows of illegal services must also be included.

National accountants often need to make adjustments to the basic trade data in order to comply with national accounts concepts; the concepts for basic trade statistics often differ in terms of definition and coverage from the requirements in the national accounts:

Data on international trade in goods is mostly obtained through declarations to customs services. If a country applies the general trade system, all goods entering or leaving the country are recorded. If the special trade system (e.g., extra-EU trade statistics) is applied, goods which are received into customs warehouses are not recorded in external trade statistics unless they subsequently go into free circulation in the country of receipt.

4.5.4: Importing

Imports are the inflow of goods and services into a country’s market for consumption.

Learning Objective

Explain the methodology behind the selection of products to import

Key Points

• A country specializes in the export of goods for which it has a comparative advantage and imports those for which it has a comparative disadvantage. By doing so, the country can increase its welfare.
• Comparative advantage describes the ability of a country to produce one specific good more efficiently than other goods.
• A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically.

Key Terms

import

To bring (something) in from a foreign country, especially for sale or trade.

comparative advantage

The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.

Example

• A country in certain tropical areas of the world has a comparative advantage at growing crops like sugar or coffee beans, but it would be much less efficient at growing wheat (due to the climate). Therefore, they should export their sugar/coffee beans and import wheat at a lower cost than trying to grow wheat themselves.

The term “import” is derived from the concept of goods and services arriving into the port of a country. The buyer of such goods and services is referred to as an “importer” and is based in the country of import whereas the overseas-based seller is referred to as an “exporter.” Thus, an import is any good (e.g. a commodity) or service brought in from one country to another country in a legitimate fashion, typically for use in trade. It is a good that is brought in from another country for sale.

Singapore

The Port of Singapore is one of the busiest ports in the world. Singapore has to import most of its food and consumer goods.

A large ship at the Port of Singapore.

Imported goods or services are provided to domestic consumers by foreign producers. An import in the receiving country is an export to the sending country. Imports, along with exports, form the basics of international trade. Import of goods normally requires the involvement of customs authorities in both the country of import and the country of export; those goods are often subject to import quotas, tariffs, and trade agreements. While imports are the set of goods and services imported, “imports” also means the economic value of all goods and services that are imported.

Imports are the inflow of goods and services into a country’s market for consumption. A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically. Comparative advantage is a concept often applied to importing and exporting. Comparative advantage is the concept that a country should specialize in the production and export of those goods and services that it can produce more efficiently than other goods and services, and that it should import those goods and services in which it has a comparative disadvantage.

4.5.5: Contract Manufacturing

In contract manufacturing, a hiring firm makes an agreement with the contract manufacturer to produce and ship the hiring firm’s goods.

Learning Objective

Compare the benefits and risks of employing a contract manufacturer (CM)

Key Points

• A hiring firm may enter a contract with a contract manufacturer (CM) to produce components or final products on behalf of the hiring firm for some agreed-upon price.
• There are many benefits to contract manufacturing, and companies are finding many reasons why they should be outsourcing their production to other companies.
• Production outside of the company does come with many risks attached. Companies must first identify their core competencies before deciding about contract manufacture.

Key Terms

Contract manufacturing

a business model where a firm hires another firm to produce components or products

Contract manufacturing

Business model in which a firm hires a contract manufacturer to produce components or final products based on the hiring firm’s design.

A contract manufacturer (“CM”) is a manufacturer that enters into a contract with a firm to produce components or products for that firm. It is a form of outsourcing. In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labor, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm.

Contract Manufacturing

Ness Corporation is a contract manufacturer in Seven Hills, Australia.

Benefits

Contract manufacturing offers a number of benefits:

• Cost Savings: Companies save on their capital costs because they do not have to pay for a facility and the equipment needed for production. They can also save on labor costs such as wages, training, and benefits. Some companies may look to contract manufacture in low-cost countries, such as China, to benefit from the low cost of labor.
• Mutual Benefit to Contract Site: A contract between the manufacturer and the company it is producing for may last several years. The manufacturer will know that it will have a steady flow of business at least until that contract expires.
• Advanced Skills: Companies can take advantage of skills that they may not possess, but the contract manufacturer does. The contract manufacturer is likely to have relationships formed with raw material suppliers or methods of efficiency within their production.
• Quality: Contract Manufacturers are likely to have their own methods of quality control in place that help them to detect counterfeit or damaged materials early.
• Focus: Companies can focus on their core competencies better if they can hand off base production to an outside company.
• Economies of Scale: Contract Manufacturers have multiple customers that they produce for. Because they are servicing multiple customers, they can offer reduced costs in acquiring raw materials by benefiting from economies of scale. The more units there are in one shipment, the less expensive the price per unit will be.

Risks

Balanced against the above benefits of contract manufacturing are a number of risks:

• Lack of Control: When a company signs the contract allowing another company to produce their product, they lose a significant amount of control over that product. They can only suggest strategies to the contract manufacturer; they cannot force them to implement those strategies.
• Relationships: It is imperative that the company forms a good relationship with its contract manufacturer. The company must keep in mind that the manufacturer has other customers. They cannot force them to produce their product before a competitor’s. Most companies mitigate this risk by working cohesively with the manufacturer and awarding good performance with additional business.
• Quality: When entering into a contract, companies must make sure that the manufacturer’s standards are congruent with their own. They should evaluate the methods in which they test products to make sure they are of good quality. The company has to ensure the contract manufacturer has suppliers that also meet these standards.
• Intellectual Property Loss: When entering into a contract, a company is divulging their formulas or technologies. This is why it is important that a company not give out any of its core competencies to contract manufacturers. It is very easy for an employee to download such information from a computer and steal it. The recent increase in intellectual property loss has corporate and government officials struggling to improve security. Usually, it comes down to the integrity of the employees.
• Outsourcing Risks: Although outsourcing to low-cost countries has become very popular, it does bring along risks such as language barriers, cultural differences, and long lead times. This could make the management of contract manufacturers more difficult, expensive, and time-consuming.
• Capacity Constraints: If a company does not make up a large portion of the contract manufacturer’s business, they may find that they are de-prioritized over other companies during high production periods. Thus, they may not obtain the product they need when they need it.
• Loss of Flexibility and Responsiveness: Without direct control over the manufacturing facility, the company will lose some of its ability to respond to disruptions in the supply chain. It may also hurt their ability to respond to demand fluctuations, risking their customer service levels.

4.5.6: Joint Ventures

In a joint venture business model, two or more parties agree to invest time, equity, and effort for the development of a new shared project.

Learning Objective

Outline the dynamics of a joint venture

Key Points

• Joint business ventures involve two parties contributing their own equity and resources to develop a new project. The enterprise, revenues, expenses and assets are shared by the involved parties.
• Since money is involved in a joint venture, it is necessary to have a strategic plan in place.
• As the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Key Term

joint venture

A cooperative partnership between two individuals or businesses in which profits and risks are shared.

Example

• Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony to develop cellular devices.

Joint Ventures

A joint venture is a business agreement in which parties agree to develop a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets.

Joint Venture

Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony.

When two or more persons come together to form a partnership for the purpose of carrying out a project, this is called a joint venture. In this scenario, both parties are equally invested in the project in terms of money, time and effort to build on the original concept. While joint ventures are generally small projects, major corporations use this method to diversify. A joint venture can ensure the success of smaller projects for those that are just starting in the business world or for established corporations. Since the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties must be committed to focusing on the future of the partnership rather than just the immediate returns. Ultimately, short term and long term successes are both important.To achieve this success, honesty, integrity and communication within the joint venture are necessary.

A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time contracts. The JV is dissolved when that goal is reached. Some major joint ventures include Dow Corning, MillerCoors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

4.5.7: Outsourcing

Outsourcing business functions to developing foreign countries has become a popular way for companies to reduce cost.

Learning Objective

Explain why companies outsource

Key Points

• Outsourcing is the contracting of business processes to external firms, usually in developing countries where labor costs are cheaper.
• This practice has increased in prevalence due to better technology and improvements in the educational standards of the countries to which jobs are outsourced.
• The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Key Terms

insourcing

The obtaining of goods or services using domestic resources or employees as opposed to foreign.

outsourcing

The transfer of a business function to an external service provider.

offshoring

The location of a business in another country for tax purposes.

Example

• Corporations may outsource their helpdesk or customer service functions to 3rd party call centers in foreign countries because these skilled laborers can do these jobs at a lesser cost than their equivalents in the domestic country.

Outsourcing

Overview

Outsourcing is the contracting out of a business process, which an organization may have previously performed internally or has a new need for, to an independent organization from which the process is purchased back as a service. Though the practice of purchasing a business function—instead of providing it internally—is a common feature of any modern economy, the term outsourcing became popular in America near the turn of the 21^st century. An outsourcing deal may also involve transfer of the employees and assets involved to the outsourcing business partner. The definition of outsourcing includes both foreign or domestic contracting , which may include offshoring, described as “a company taking a function out of their business and relocating it to another country. “

Outsourcing

Outsourcing is the process of contracting an existing business process to an independent organization. The process is purchased as a service.

Businessmen talk and shake hands.

The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Reasons for Outsourcing

Companies outsource to avoid certain types of costs. Among the reasons companies elect to outsource include avoidance of burdensome regulations, high taxes, high energy costs, and unreasonable costs that may be associated with defined benefits in labor union contracts and taxes for government mandated benefits. Perceived or actual gross margin in the short run incentivizes a company to outsource. With reduced short run costs, executive management sees the opportunity for short run profits while the income growth of the consumers base is strained. This motivates companies to outsource for lower labor costs. However, the company may or may not incur unexpected costs to train these overseas workers. Lower regulatory costs are an addition to companies saving money when outsourcing.

Import marketers may make short run profits from cheaper overseas labor and currency mainly in wealth consuming sectors at the long run expense of an economy’s wealth producing sectors straining the home county’s tax base, income growth, and increasing the debt burden. When companies offshore products and services, those jobs may leave the home country for foreign countries at the expense of the wealth producing sectors. Outsourcing may increase the risk of leakage and reduce confidentiality, as well as introduce additional privacy and security concerns.

4.5.8: Offshoring

Offshoring entails a company moving a business process from one country to another.

Learning Objective

Explain the benefits of offshoring

Key Points

• Offshoring is the relocation of certain business processes from one country to the other, resulting in large tax breaks and lower labor costs.
• Offshoring can cause controversy in a company’s domestic country since it is perceived to impact the domestic employment situation negatively.
• Offshoring of a company’s services that were previously produced domestically can be advantageous in lowering operation costs, but has incited some controversy over the economic implications.

Key Terms

offshoring

The location of a business in another country for tax purposes.

outsourcing

The transfer of a business function to an external service provider.

captive

held prisoner; not free; confined

“Offshoring” is a company’s relocation of a business process from one country to another. This typically involves an operational process, such as manufacturing, or a supporting process, such as accounting. Even state governments employ offshoring. More recently, offshoring has been associated primarily with the sourcing of technical and administrative services that support both domestic and global operations conducted outside a given home country by means of internal (captive) or external (outsourcing) delivery models.The subject of offshoring, also known as “outsourcing,” has produced considerable controversy in the United States. Offshoring for U.S. companies can result in large tax breaks and low-cost labor.

Worldwide Offshoring Business

The worldwide offshoring business is projected to equal $500 billion by 2020.

A chart that shows growth in the worldwide offshoring business.

Offshoring can be seen in the context of either production offshoring or services offshoring. After its accession to the World Trade Organization (WTO) in 2001, the People’s Republic of China emerged as a prominent destination for production offshoring. Another focus area includes the software industry as part of Global Software Development and the development of Global Information Systems. After technical progress in telecommunications improved the possibilities of trade in services, India became a leader in this domain; however, many other countries are now emerging as offshore destinations.

The economic logic is to reduce costs. People who can use some of their skills more cheaply than others have a comparative advantage. Countries often strive to trade freely items that are of the least cost to produce.

Related terms include “nearshoring,” “inshoring,” and “bestshoring,” otherwise know as “rightshoring.” Nearshoring is the relocation of business processes to (typically) lower cost foreign locations that are still within close geographical proximity (for example, shifting United States-based business processes to Canada/Latin America). Inshoring entails choosing services within a country, while bestshoring entails choosing the “best shore” based on various criteria. Business process outsourcing (BPO) refers to outsourcing arrangements when entire business functions (such as Finance & Accounting and Customer Service) are outsourced. More specific terms can be found in the field of software development; for example, Global Information System as a class of systems being developed for/by globally distributed teams.

4.5.9: Multinational Firms

With the advent of improved communication and technology, corporations have been able to expand into multiple countries.

Learning Objective

Explain how a multinational corporation (MNC) operates

Key Points

• Multinational corporations operate in multiple countries.
• MNCs have considerable bargaining power and may negotiate business or trade policies with success.
• A corporation may choose to locate in a special economic zone, a geographical region that has economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Key Term

Multinational corporation

A corporation or enterprise that operates in multiple countries.

Example

• McDonalds operates in over 119 different countries, making it a fairly large MNC by any standard

A multinational corporation (MNC) or multinational enterprise (MNE) is a corporation registered in more than one country or has operations in more than one country. It is a large corporation which both produces and sells goods or services in various countries . It can also be referred to as an international corporation. The first multinational corporation was the Dutch East India Company, founded March 20, 1602.

Ford 

Ford is a multinational corporation with operations throughout the world.

Corporations may make a foreign direct investment. Foreign direct investment is direct investment into one country by a company located in another country. Investors buy a company in the country or expand operations of an existing business in the country.

A corporation may choose to locate in a special economic zone, a geographical region with economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Multinational corporations are important factors in the processes of globalization. National and local governments often compete against one another to attract MNC facilities, with the expectation of increased tax revenue, employment and economic activity. To compete, political powers push toward greater autonomy for corporations. MNCs play an important role in developing economies of developing countries.

Many economists argue that in countries with comparatively low labor costs and weak environmental and social protection, multinationals actually bring about a “race to the top.” While multinationals will see a low tax burden or low labor costs as an element of comparative advantage, MNC profits are tied to operational efficiency, which includes a high degree of standardization. Thus, MNCs are likely to adapt production processes in many of their operations to conform to the standards of the most rigorous jurisdiction in which they operate.

As for labor costs, while MNCs pay workers in developing countries far below levels in countries where labor productivity is high (and accordingly, will adopt more labor-intensive production processes), they also tend to pay a premium over local labor rates of 10% to 100%.

Finally, depending on the nature of the MNC, investment in any country reflects a desire for a medium- to long-term return, as establishing a plant, training workers and so on can be costly. Therefore, once established in a jurisdiction, MNCs are potentially vulnerable to arbitrary government intervention like expropriation, sudden contract renegotiation and the arbitrary withdrawal or compulsory purchase of licenses. Thus both the negotiating power of MNCs and the “race to the bottom” critique may be overstated while understating the benefits (besides tax revenue) of MNCs becoming established in a jurisdiction.

4.5.10: Direct Investment

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other privileges in that foreign country.

Learning Objective

Explain the effects of foreign direct investment (FDI) for the investor and the host country

Key Points

• FDI is the flow of investments from one company to production in a foreign nation, with the purpose of lowering labor costs and gaining tax incentives.
• FDI can help the economic situations of developing countries, as well as facilitate progressive internal policy reforms.
• A major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions.

Key Term

Foreign direct investment

investment directly into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Example

• Intel is headquartered in the United States, but it has made foreign direct investments in a number of Southeast Asian countries where they produce components of their products in Intel-owned factories.

Foreign direct investment (FDI) is investment into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

FDI is done for many reasons including to take advantage of cheaper wages in the country, special investment privileges, such as tax exemptions, offered by the country as an incentive to gain tariff-free access to the markets of the country or the region. FDI is in contrast to portfolio investment which is a passive investment in the securities of another country, such as stocks and bonds.

One theory for how to best help developing countries, is to increase their inward flow of FDI. However, identifying the conditions that best attract such investment flow is difficult, since foreign investment varies greatly across countries and over time. Knowing what has influenced these decisions and the resulting trends in outcomes can be helpful for governments, non-governmental organizations, businesses, and private donors looking to invest in developing countries.

Sao Paulo, Brazil

Sao Paulo, Brazil, is home to a growing middle class and significant direct investments.

Paulista Avenue in Sao Paulo, Brazil.

A study from scholars at Duke University and Princeton University published in the American Journal of Political Science, “The Politics of Foreign Direct Investment into Developing Countries: Increasing FDI through International Trade Agreements,” examines trends in FDI from 1970 to 2000 in 122 developing countries to assess what the best conditions are for attracting investment. The study found the major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions. The researchers conclude that, while “democracy can be conducive to international cooperation,” the strongest indicator for higher inward flow of FDI for developing countries was the number of trade agreements and institutions to which they were party.

4.5.11: Countertrade

Countertrade is a system of exchange in which goods and services are used as payment rather than money.

Learning Objective

Explain the various methods of countertrading

Key Points

• Countertrade is the exchange of goods or services for other goods or services. This system can be typified as simple bartering, switch trading, counter purchase, buyback, or offset.
• Switch trading: Party A and B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
• Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
• Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
• Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Key Terms

Switch trading

Practice in which one company sells to another its obligation to make a purchase in a given country.

counter purchase

Sale of goods and services to one company in another country by a company that promises to make a future purchase of a specific product from the same company in that country.

barter

The exchange of goods or services without involving money.

Examples

• Bartering: One party gives salt in exchange for sugar from another party.
• Switch trading: Party A and Party B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
• Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
• Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
• Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Countertrade means exchanging goods or services which are paid for, in whole or part, with other goods or services, rather than with money. A monetary valuation can, however, be used in counter trade for accounting purposes. Any transaction involving exchange of goods or service for something of equal value.

Bartering

Bartering involves exchanging goods or services for other goods or services as payment.

A newspaper illustration in Harper’s Weekly where two men engaging in a barter. One man offers chickens in exchange for his yearly newspaper subscription.

There are five main variants of countertrade:

1. Barter: Exchange of goods or services directly for other goods or services without the use of money as means of purchase or payment.
2. Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.
3. Counter purchase: Sale of goods and services to one company in aother country by a company that promises to make a future purchase of a specific product from the same company in that country.
4. Buyback: This occurs when a firm builds a plant in a country, or supplies technology, equipment, training, or other services to the country, and agrees to take a certain percentage of the plant’s output as partial payment for the contract.
5. Offset: Agreement that a company will offset a hard currency purchase of an unspecified product from that nation in the future. Agreement by one nation to buy a product from another, subject to the purchase of some or all of the components and raw materials from the buyer of the finished product, or the assembly of such product in the buyer nation.

Countertrade also occurs when countries lack sufficient hard currency or when other types of market trade are impossible. In 2000, India and Iraq agreed on an “oil for wheat and rice” barter deal, subject to UN approval under Article 50 of the UN Persian Gulf War sanctions, that would facilitate 300,000 barrels of oil delivered daily to India at a price of $6.85 a barrel, while Iraq oil sales into Asia were valued at about $22 a barrel. In 2001, India agreed to swap 1.5 million tonnes of Iraqi crude under the oil-for-food program.

3.3: Social Responsibility

3.3.1: A Brief Definition of Corporate Social Responsibility

Learning Objective

Examine how social responsibility helps to sustain the equilibrium between economic development and the welfare of society and the environment

Key Points

• Corporate social responsibility is the expectation that a firm maintain a balance between making a profit and contributing to society.
• Socially responsible entities are conscious of the tradeoff between economic development and the welfare of society and the environment. They therefore refrain from socially harmful practices and contribute to activities that are socially beneficial.
• Companies can demonstrate social responsibility in a variety of ways, such as donating funds to education, arts, culture, and underprivileged children.

Key Terms

social responsibility

A voluntarily assumed obligation toward the good of society at large as opposed to the self alone.

not-for-profit

A company or organization that is not meant to make a profit.

Examples

• Companies that donate proceeds to charitable organizations are socially responsible. For example, many large corporations are major patrons of the arts and education.
• Companies that seek to make their products or their production process more environmentally friendly are socially responsible. This also makes the company’s consumers feel like they are behaving responsibly by supporting that brand.

A tradeoff always exists between material economic development and the welfare of society and the environment. Social responsibility is the idea that an organization or individual is obligated to act to benefit society at large—i.e., to maintain equilibrium between the economy and the ecosystem.

Social responsibility in business is also known as corporate social responsibility (CSR), corporate responsibility, corporate citizenship, responsible business, sustainable responsible business, or corporate social performance. This term refers to a form of self-regulation that is integrated into different disciplines, such as business, politics, economy, media, and communications studies.

The Conference Board of Canada, a not-for-profit organization that specializes in economic trends, organizational performance, and public policy, wrote a National Corporate Social Responsibility Report. In it they explain that corporate social responsibility is a way of conducting business through balancing the long-term objectives, decision making, and behavior of a company with the values, norms, and expectations of society.

Companies can demonstrate social responsibility in a myriad of ways. They can donate funds to education, arts and culture, underprivileged children, or animal welfare, or they can make commitments to reduce their environmental footprint, implement fair hiring practices, sponsor events, and work only with suppliers with similar values. CSR can be practiced passively, through refraining from committing socially harmful acts, or actively, through performing activities that directly advance social goals. The below diagram shows the various ways that a company can invest in being socially responsible and the value those actions can bring to the company.

The Value of CSR

This diagram shows the various ways that a company can invest in being socially responsible and the value those actions can bring to the company.

The Conference Board of Canada, a not-for-profit organization that specializes in economic trends, suggests that social responsibility is a way of conducting business through balancing the long-term objectives, decision-making, and behavior of a company with the values, norms, and expectations of society. Social responsibility can be a normative principle and a soft law principle engaged in promoting universal ethical standards in relationship to private and public corporations.

Companies can demonstrate social responsibility in a myriad of ways. They can donate funds to education, arts and culture, underprivileged children, animal welfare, or they can make commitments to reduce their environmental footprint, implement fair hiring practices, sponsor events, and work only with suppliers with similar values.

Social responsibility in business is also known as corporate social responsibility, corporate responsibility, corporate citizenship, responsible business, sustainable responsible business, or corporate social performance. This term refers to a form of self-regulation that is integrated into different disciplines, including business, politics, economy, media, and communications studies.

3.3.2: Early Efforts in Social Responsibility

Learning Objective

Recognize Andrew Carnegie’s business principles of charity and stewardship as the precursors to modern organizational social responsibility

Key Points

• Social responsibility as an ethical principle was first drawn from the business philosophy of Andrew Carnegie, the 19th century steel magnate who believed in charity and social stewardship.
• Economist Milton Friedman held that humans act in self-interest, to maximize profit, and social issues were the government’s issue.
• After recent significant corporate scandals and disasters, the relationship between society and corporations has been severely tested.

Key Terms

social audit

reporting on the societal and environmental effects of organizations’ economic actions to particular interest groups

charity

An organization, the objective of which is to carry out a charitable purpose.

social responsibility

A voluntarily assumed obligation toward the good of society at large as opposed to the self alone.

Example

• Carnegie’s philanthropic accomplishments included contributions to education by establishing many public libraries around the country.

Social responsibility is the idea that an entity needs to act in a way that balances its own gain with societal benefits. Entities include individuals as well as businesses. Companies do need to make a profit, but not at the expense of society or the environment. Businesses should use ethical decision-making practices to make responsible decisions and reduce the need for government involvement such as, for example, Environmental Protection Agency (EPA), which monitors business decisions and practices to prevent pollution.

The notion of social responsibility is far from new. Its roots are in economics and the writings of Andrew Carnegie (1835-1919), a Scottish-born businessman and founder of U.S. Steel. Carnegie’s business philosophy was based on two principles: charity (the more fortunate should assist those who are less fortunate) and stewardship (the rich hold their money “in trust” for the rest of society, using it for any purpose society deems appropriate).

Milton Friedman (1912-2006), an American economist and Nobel Laureate, later advocated that corporations exist only to maximize profit and behave in their own best self-interest. He argued that corporations’ attempts at social responsibility were “morally wrong,” as social issues and concerns were best dealt with by government. In the last half century, highly publicized corporate behavior like the handling of the Exxon Valdez oil spill, the financial scandal of Enron, and the more recent subprime mortgage crisis has undermined trust in corporations. Social responsibility has taken on heightened importance as a way of building trust in relationships .

Oil Spill

Oil spills and other environmental disasters show the need for social responsibility.

3.3.3: Modern Trends in Social Responsibility

Learning Objective

Explain how the advent of socially responsible investing, sustainability accounting, and social entrepreneurship has contributed to the modernization of social responsibility

Key Points

• Corporate social responsibility (CSR) guides individuals and companies to act in socially and environmentally responsible ways.
• Businesses that seek to be socially responsible are described as having a double or triple bottom line; they judge their success not only by profit but also by their social and environmental impact.
• Sustainable accounting is a method of financial disclosure that reveals a corporation’s activities and impact on the environment. This information is available to stakeholders, suppliers, and the government for the sake of transparency.
• Social entrepreneurship is the use of entrepreneurial principles to organize a business venture that addresses a certain social problem. Profit and return may still be important to social entrepreneurs, but a positive impact on society is their key measure of success.
• The adoption of CSR policy is sometimes perceived as “window dressing” to prevent future government oversight.

Key Term

corporate social responsibility

A form of corporate self-regulation integrated into a business model in which companies aim to embrace responsibility for their actions and encourage a positive impact through their activities on the environment, consumers, employees, communities and other stakeholders. Commonly abbreviated as CSR.

Example

• A social entrepreneur can be the founder or co-founder or a chief functionary (president, secretary, treasurer, CEO, or chairman) of a social enterprise or non-profit. Examples of some of social entrepreneurs based in India are Ramji Raghavan, founder and Chairman of the Agastya International Foundation; Harish Hande, founder of Selco India; Rippan Kapur of Child Rights; and You and Jyotindra Nath of Youth United.

Corporate Social Responsibility

Corporate social responsibility (abbreviated CSR; also called corporate conscience, corporate citizenship, social performance, or sustainable responsible business) is a form of self-regulation integrated into a business model. A socially responsible business monitors and ensures its active compliance with the spirit of the law, ethical standards, and international norms. The goal of CSR is for a company to take accountability for its actions and achieve and encourage a positive impact on the environment as well as its consumers, employees, communities, and other stakeholders.

CSR is designed to support an organization’s mission as well as to guide what the company stands for and will deliver to its consumers. ISO 26000 is the recognized international standard for CSR. Public sector organizations (e..g, the United Nations) adhere to the so-called triple bottom line (TBL): maximizing (1) profit, (2) social impact, and (3) environmental impact. The UN has developed the Principles for Responsible Investment as guidelines for investing entities. CSR adheres to similar principles but has no formal act of legislation.

The United Nations

The UN has developed the Principles for Responsible Investment as guidelines for investing entities.

Socially Responsible Investing

Socially responsible investing is the practice of investing funds only in companies deemed to be socially responsible according to a given set of criteria. It is a booming market in both the US and Europe. As of 2010, nearly one out of every eight dollars under professional management in the US is involved in socially responsible investing; this is 12.5% of the $25.2 trillion in total assets under management tracked by Thomson Reuters Nelson.

Sustainability Accounting

Sustainability accounting has increased in popularity over the past few decades. Many companies are adopting new methods and techniques in their financial disclosures that provide information about their core activities and their impact on the environment. As a result of this action, stakeholders, suppliers, and governmental institutions have a better understanding of how companies manage their resources to achieve sustainable development.

Sustainability accounting connects a company’s strategies to a sustainable framework by disclosing three dimensions of information: environmental, economic, and social. In practice, however, it is often difficult to put together policies that simultaneously promote environmental, economic, and social goals.

Social Entrepreneurship

Social entrepreneurship is the recognition of a social problem and the use of entrepreneurial principles to organize, create, and manage a social venture to achieve social change. While a business entrepreneur typically measures performance in profit and return, a social entrepreneur also cares about positive social, cultural, and environmental progress. Social entrepreneurs are commonly associated with the voluntary and not-for-profit sectors, but this doesn’t necessarily mean they don’t make a profit.

Social entrepreneurship practiced with a global perspective or embedded in an international context is called international social entrepreneurship.

One well-known contemporary social entrepreneur is Muhammad Yunus, founder and manager of Grameen Bank and its growing family of social venture businesses. He was awarded a Nobel Peace Prize in 2006. Yunus’ and Grameen Bank’s work supports the claims of modern-day social entrepreneurs regarding the enormous synergies and benefits achieved when business principles are unified with social ventures. In some countries—including Bangladesh and, to a lesser extent, the USA—social entrepreneurs have filled the spaces neglected by a relatively small state. In other countries, particularly Europe and South America, social entrepreneurs tend to work more closely with public organizations at both the national and local levels.

Today, non-profits, non-governmental organizations, foundations, governments, and individuals play a role in promoting, funding, and advising social entrepreneurs around the world.

3.3.4: Stakeholders: Consumers, Employees, and Shareholders

Learning Objective

Identify the importance of an organization recognizing the needs of its stakeholders

Key Points

• Corporations are motivated to become more socially responsible because their most important stakeholders expect them to understand and address the social and community issues that are relevant to them.
• The perspectives of stakeholders play a role in shaping the organization’s socially responsible activities, as the organization leadership should recognize the needs of its stakeholders in order to function effectively.
• It is the stakeholder theory that implies that all stakeholders (or individuals) must be treated equally regardless of the fact that some people will obviously contribute more than others to an organization.

Key Term

stakeholder

A person or organization with a legitimate interest in a given situation, action, or enterprise.

Example

• Suppose a corporation is engaging in environmentally harmful practices. This information comes to the attention of the local community near the production plants or the consumers who buy the products. Pressure from these stakeholders can force the corporation into adopting a corporate self-regulation policy that improves their environmental footprint.

Increasingly, corporations are motivated to become more socially responsible because their most important stakeholders expect them to understand and address the social and community issues that are relevant to them. Understanding what causes are important to employees is usually the first priority because of the many interrelated business benefits that can be derived from increased employee engagement (i.e. loyalty, improved recruitment, increased retention, higher productivity, and so on). Key external stakeholders include customers, consumers, investors (particularly institutional investors), communities in the areas where the corporation operates its facilities, regulators, academics, and the media .

Various Types of Stakeholders

This image shows the various internal and external stakeholders.

Branco and Rodrigues (2007) describe the stakeholder perspective of CSR (corporate social responsibility) as the inclusion of all groups or constituents (rather than just shareholders) in managerial decision making related to the organization’s portfolio of socially responsible activities. This normative model implies that the CSR collaborations are positively accepted when they are in the interests of stakeholders and may have no effect or be detrimental to the organization if they are not directly related to stakeholder interests. The stakeholder perspective suffers from a wheel and spoke network metaphor that does not acknowledge the complexity of network interactions that can occur in cross-sector partnerships. It also relegates communication to a maintenance function, similar to the exchange perspective.

Stakeholder and Other Theories

Whether it is a team, small group, or a large international entity, the ability for any organization to reason, act rationally, and respond ethically is paramount. Leadership must have the ability to recognize the needs of its members (or called “stakeholders” in some theories or models), especially the very basics of a person’s desire to belong and fit into the organization. It is the stakeholder theory that implies that all stakeholders (or individuals) must be treated equally regardless of the fact that some people will obviously contribute more than others to an organization.

Leadership not only has to place aside each of their individual (or personal) ambitions (along with any prejudices) in order to present the goals of the organization, but they also have to engage the stakeholder with the benefit of the organization in mind. Further, it is leadership that has to be able to influence the stakeholders by presenting the strong minority voice in order to move the organization’s members toward ethical behavior. Importantly, the leadership (or stakeholder management) has to have the desire, the will, and the skills to ensure that the other stakeholders’ voices are respected within the organization, and leadership has to ensure that those other voices are not expressing views that are not shared by the larger majority of the members (or stakeholders). Therefore, stakeholder management, as well as any other leadership of organizations, has to take upon themselves the arduous task of ensuring an “ethics system” for their own management styles, personalities, systems, performances, plans, policies, strategies, productivity, openness, and even risk(s) within their cultures or industries.

3.4: Consumer Rights

3.4.1: Basic Consumer Rights

Basic consumer rights ensure a level of protection for consumers owed by a supplier of goods or services.

Learning Objective

Summarize the Consumer Bill of Rights extolled by President John F. Kennedy and the United Nations

Key Points

• The Consumer Bill of Rights pushed for by John F. Kennedy established four basic rights; the right to safety, the right to be informed, the right to choose, and the right to be heard.
• In 1985, the United Nations added four more rights to protect consumers: the right to satisfaction of basic needs, the right to redress, the right to consumer education, and the right to a healthy environment.
• Consumer protection consists of laws and organizations designed to ensure the rights of consumers, as listed above.
• In 1985, the United Nations in 1985 added four more rights to protect consumers: the right to satisfaction of basic need, the right to redress, the right to consumer education, and the right to a healthy environment.
• Consumer protection is the duty of the laws, government agencies, and organizations created to ensure consumer rights.
• Competitive markets also promote the interests of consumers under the principle of economic efficiency.

Key Terms

Consumer

Someone who acquires goods or services for direct use or ownership rather than for resale or use in production and manufacturing.

right

A legal or moral entitlement.

consumer rights

The legal and moral duties of protection owed to a purchaser of goods or services by the supplier.

Example

• Regulatory bodies, such as the FDA, establish and maintain standards for goods and services. In the FDA’s case, drugs and foods are regulated to ensure consumer safety.

What is a Consumer?

A consumer is defined as “someone who acquires goods or services for direct use or ownership rather than for resale or use in production and manufacturing. ” Before the mid-twentieth century, consumers were without rights with regard to their interaction with products and producers. Consumers had little ground on which to defend themselves against faulty or defective products, or against misleading or deceptive advertising methods. By the 1950s, a movement called “consumerism” began pushing for increased rights and legal protection against malicious business practices. By the end of the decade, legal product liability had been established in which an aggrieved party need only prove injury by use of a product, rather than bearing the burden of proof of corporate negligence.

Consumer Bill of Rights

In 1962, President John F. Kennedy presented a speech to the United States Congress in which he extolled four basic consumer rights — later called, The Consumer Bill of Rights. In 1985, these rights were expanded to eight by the United Nations. These eight rights are the:

John F. Kennedy

President John F. Kennedy extolled four basic consumer rights, later called the “Consumer Bill of Rights. “

A painting of John F. Kennedy.

Right to Safety

The assertion of this right is aimed at the defense of consumers against injuries caused by products other than automobile vehicles, and implies that products should cause no harm to their users if such use is executed as prescribed. The Consumer Product Safety Commission (CPSC) has jurisdiction over thousands of commercial products, and powers that allow it to establish performance standards, require product testing and warning labels, demand immediate notification of defective products, and, when necessary, force product recall.

Right to Be Informed

This right states that businesses should always provide consumers with enough appropriate information to make intelligent and informed product choices. Product information provided by a business should always be complete and truthful. This right aims to achieve protection against misleading information in the areas of financing, advertising, labeling, and packaging.

Right to Choose

The right to free choice among product offerings states that consumers should have a variety of options provided by different companies from which to choose. The federal government has taken many steps to ensure the availability of a healthy environment open to competition through legislation, including limits on concept ownership through Patent Law, prevention of monopolistic business practices through Anti-Trust Legislation, and the outlaw of price cutting and gouging.

Right to Be Heard

This right asserts the ability of consumers to voice complaints and concerns about a product in order to have the issue handled efficiently and responsively. While no federal agency is tasked with the specific duty of providing a forum for this interaction between consumer and producer, certain outlets exist to aid consumers if difficulty occurs in communication with an aggrieving party. State and federal attorney generals are equipped to aid their constituents in dealing with parties who have provided a product or service in a manner unsatisfactory to the consumer in violation of an applicable law.

Right to Satisfaction of Basic Needs

To have access to basic, essential goods and services: adequate food, clothing, shelter, health care, education, public utilities, water, and sanitation.

The Right to Redress

To receive a fair settlement of just claims, including compensation for misrepresentation, shoddy goods or unsatisfactory services.

Right to Consumer Education

To acquire knowledge and skills needed to make informed, confident choices about goods and services, while being aware of basic consumer rights and responsibilities and how to act on them.

Right to a Healthy Environment

To live and work in an environment which is non-threatening to the well-being of present and future generations.

Consumer Protection

Even though consumers have these rights, they can easily be ignored. That’s where consumer protection comes in. Consumer protection consists of laws and organizations designed to ensure the rights of consumers, as well as fair trade competition and the free flow of truthful information in the marketplace. The laws are designed to prevent businesses that engage in fraud or specified unfair practices from gaining an advantage over competitors and may provide additional protection for the weak and those unable to take care of themselves.

Organizations that promote consumer protection include government organizations, individuals as consumer activism, and self-regulating business organizations, such as consumer protection agencies and organizations, the Federal Trade Commission, the Better Business Bureaus, etc.

Consumer interests can also be protected by promoting competition in the markets, which directly and indirectly serve consumers, consistent with economic efficiency.

3.4.2: Forces in Consumerism

The modern understanding of consumerism refers to an emphasis on the consumption of goods, often with a connotation of excess.

Learning Objective

Discuss the forces driving the evolution of consumerism as an economic order that encourages the purchase of goods and services in ever-greater amounts

Key Points

• The modern definition of consumerism, derived from the works of economist Thorstein Veblen, refers to the preoccupation with the acquisition of goods.
• Though consumerism is an international and historical phenomenon, it was magnified dramatically by the Industrial Revolution, which made mass production of consumer goods a reality.
• With the progression of mass production and consumption, some argue that materialism and desire for social status became more prominent in cultures around the world. Modern consumers are now able to emulate the wealthy and iconic through consumption of certain goods.
• Increasing awareness of environmental and social concerns has given rise to ethical consumerism. Consumers are becoming much more conscious of how their consumption behavior is impacting the world around them, and they are beginning to change their purchasing decisions accordingly.

Key Terms

consumerism

An economic theory that increased consumption is beneficial to a nation’s economy in the long run.

conspicuous consumption

A public display of acquisition of possessions with the intention of gaining social prestige; excessive consumerism in order to flaunt one’s purchasing power.

ethical consumerism

consumption of goods and services with a conscious awareness of ethical and environmental implications

Examples

• An example of ethical consumerism is consciously purchasing coffee from a cafe that buys fair trade coffee beans. Concern for the conditions of producers in developing countries and the environmental sustainability of their farming practices shapes the preferences of this ethical consumer.
• Example of ethical consumerism would be consciously purchasing coffee from a cafe that buys fair trade coffee beans. Concern for the conditions of producers in developing countries and the environmental sustainability of their farming practices shapes the preferences of this ethical consumer.

Consumerism

Consumerism is a social and economic order that encourages the purchase of goods and services in ever-greater amounts. The term is often associated with criticisms of consumption starting with Thorstein Veblen. While the term “consumerism” is also used to refer to the consumerists movement, consumer protection or consumer activism, the focus of this section relates to the first definition.

In economics, consumerism refers to economic policies that place emphasis on consumption. In an abstract sense, it is the belief that the free choice of consumers should dictate the economic structure of a society (cf. Producerism, especially in the British sense of term).

The term “consumerism” was first used in 1915 to refer to “advocacy of the rights and interests of consumers” (Oxford English Dictionary). Today the term consumerism more commonly refers to the, “emphasis on or preoccupation with the acquisition of consumer goods” (Oxford English Dictionary), a movement that emerged in the 1960s. This more modern conceptualization is based on the writings of sociologist and economist Thorstein Veblen who lived at the turn of the 20^th century. He coined the term “conspicuous consumption” to describe this apparently irrational and confounding form of economic behavior. Veblen’s scathing proposal was that unnecessary consumption is a form of status display .

Conspicuous Consumerism

Conspicuous consumption is when goods are consumed to enhance one’s social status.

History of Consumerism

Consumerism today is an international phenomenon. People purchasing goods and consuming materials in excess of their basic needs is as old as the first civilizations (e.g. Ancient Egypt, Babylon and Ancient Rome).

The seeds of modern day consumerism grew out of the Industrial Revolution. In the nineteenth century, capitalist development and the industrial revolution were primarily focused on the capital goods sector and industrial infrastructure. For example, after observing the assembly lines in the meat packing industry, Frederick Winslow Taylor brought his theory of scientific management to the organization of the assembly line in other industries; this unleashed incredible productivity gains and reduced the costs of all commodities produced on assembly lines. Henry Ford and other leaders of industry understood that mass production presupposed mass consumption.

In the agrarian economy, the working classes labored long hours and had little time for consumption. While previously the norm had been the scarcity of resources, the Industrial Revolution created a new economic situation. After the Industrial Revolution, products were available in outstanding quantities, at low prices, being thus available to virtually everyone. Access to credit, in the form of installment payments aided further consumption.

Modern Consumerism

Beginning in the 1990s, the reason most frequently given for attending college had changed. Making a lot of money outranked previous reasons such as becoming an authority in a field or helping others in difficulty. This rationale correlates with the rise of materialism, specifically the technological aspect: the increasing prevalence of mp3 players, digital media, tablets and smartphones. Madeline Levine criticized what she saw as a large change in American culture; “a shift away from values of community, spirituality, and integrity, and toward competition, materialism and disconnection.”

Businesses have realized that wealthy consumers are the most attractive targets of marketing. Consequently, upper class tastes, lifestyles, and preferences trickle down to become the standard for all consumers. The not so wealthy consumers then “purchase something new that will speak of their place in the tradition of affluence”. A consumer can have the instant gratification of purchasing an expensive item to improve social status.

Emulation is also a core component of 21^st century consumerism. As a general trend, regular consumers seek to emulate those who are above them in the social hierarchy. The poor strive to imitate the wealthy and the wealthy imitate celebrities and other icons. The celebrity endorsement of products can be seen as evidence of the evocation of the desire of modern consumers to purchase products partly or solely to emulate people of higher social status. This purchasing behavior may co-exist in the mind of a consumer with an image of oneself as being an individualist.

Ethical Consumerism

The rise in popularity of ethical consumerism over the last two decades can be linked to the rise of the Corporate Social Responsibility (CSR) movement. As global population increases, so does the pressure intensify on limited natural resources required to meet rising consumer demand. Industrialization of developing countries, facilitated by technology and globalization is further straining these resources. Consumers are becoming more and more aware of the environmental and social implications of their day-to-day consumer decisions and are therefore beginning to make purchasing decisions based on environmental and ethical implications. However, the practice of ethical consumerism is in its nascent stages and far from universal.

2.3: Measuring Economic Performance

2.3.1: The Business Cycle

Learning Objective

Summarize the phases and turning points inherent in the business cycle

Key Points

• The business cycle reflects economy-wide shifts and therefore is measured with close consideration of trends in Gross Domestic Product.
• Business cycles consist of two phases and two turning points.
• Although termed a cycle, the business cycle does not follow a predictable pattern.
• More recently, economists describe this phenomenon as economic fluctuations, where the long-run expansionary trend of an economy experiences shocks to the system that create short-term departures.

Key Terms

gross domestic product

Gross Domestic Product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period.

fluctuation

A motion like that of waves; a moving in this and that direction.

recession

a period of reduced economic activity

business cycle

(economics) A long-term fluctuation in economic activity between growth and recession

Example

• The boom in economic activity from about 2002 until 2008 is an example of the expansion characteristic of the upswing portion of the business cycle. Just before 2008, the business cycle peaked, and the economy began to contract.

Business Cycle Defined

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and they typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom) and periods of relative stagnation or decline (a contraction or recession).

The Phases and Turning Points of Business Cycles

Business cycles are composed of two phases and two turning points.

Phases

• Expansion: The period of time in which real GDP rises and unemployment declines. It is sometimes called recovery.
• Contraction: The period of time in which real GDP declines and unemployment rises. A recession is six consecutive months of decrease. A “severe recession” is called a depression. There is no official definition of severe (length and depth).

Turning Points

• Peak: A peak occurs when the real GDP reaches its maximum, stops rising, and begins to decline. It is determined after the fact.
• Trough: A trough occurs when the real GDP reaches its minimum, stops declining, and begins to rise. It is determined after the fact.

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.

The Development of the Theory

The first systematic exposition of periodic economic crises, in opposition to the existing theory of economic equilibrium, was the 1819 Nouveaux principes d’économie politique by Jean Charles Léonard de Sismondi. Prior to that point, classical economics had denied the existence of business cycles; blamed them on external factors, notably war; or only studied them in a long-term context.

Sismondi found vindication in the Panic of 1825, which was the first international economic crisis occurring in peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less systematic thoughts in the 1817 Report to the Committee of the Association for the Relief of the Manufacturing Poor, both identified the cause of economic cycles as overproduction and underconsumption. These believed these problems were caused in particular by wealth inequality, and they advocated government intervention and socialism, respectively, as the solution.

This work did not generate interest among classical economists, although underconsumption theory developed as a heterodox branch in economics until being systematized in Keynesian economics in the 1930s.

Sismondi’s theory of periodic crises was developed into a theory of alternating cycles by Charles Dunoyer, and similar theories, showing signs of influence by Sismondi, were developed by Johann Karl Rodbertus.

Periodic crises in capitalism formed the basis of the theory of Karl Marx, who further claimed that these crises were increasing in severity and would lead to a Communist revolution. Marx devoted hundreds of pages of Das Kapital to crises.

Cycles or Fluctuations?

In recent years, economic theory has moved towards the study of economic fluctuation rather than the study of business cycles. However, some economists use the phrase “business cycle” as a convenient shorthand.

For Milton Friedman, the term “business cycle” is a misnomer because of its noncyclical nature. Friedman believed that for the most part, excluding very large supply shocks, business declines are more of a monetary phenomenon.

Rational expectations theory leads to the efficient-market hypothesis, which states that no deterministic cycle can persist, because it would consistently create arbitrage opportunities.

Much economic theory also holds that the economy is usually at or close to equilibrium. These views have led to the formulation of the idea that observed economic fluctuations can be modeled as shocks to a system.

In the tradition of Slutsky, business cycles can be viewed as the result of stochastic shocks that on aggregate form a moving average series. However, the recent research employing spectral analysis has confirmed the presence of business (Juglar) cycles in the world GDP dynamics at an acceptable level of statistical significance.

Long Term Growth

Deviations from the long term growth trend, US 1955–2005

A purple line moving up and down show trends from 1955-2005.

2.3.2: Economic Indicators

Learning Objective

Identify the major economic indicators and what economic factors they measure

Key Points

• Many different economic indicators are tracked in order to evaluate the economy in different ways or from different perspectives.
• Government agencies, such as the Bureau of Labor Statistics, and private entities, such as the National Bureau of Economic Research, report and compile many useful economic indicators.
• Economic indicators are used to evaluate the past performance of the economy as well as predict future economic conditions.

Key Terms

economic indicator

An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance.

Lagging indicators

Lagging indicators are indicators that usually change after the economy as a whole does.

leading indicator

Leading indicators are indicators that usually change before the economy as a whole changes.

Example

• The National Bureau of Economic Research analyzes and interprets many different trends in economic indicators, including GDP (gross domestic product), to identify business cycle dates.

Economic Indicators

An economic indicator is a statistic that provides valuable information about the economy. One application of economic indicators is the study of business cycles.

There is no shortage of economic indicators, and trying to follow them all would be an overwhelming task. Thus, economists and businesspeople track only a select few, including those that we’ll now discuss including:

• Indices
• Earnings reports
• Economic summaries

Examples within these categories include:

• Unemployment rate “”
• Quits rate
• Housing starts
• Consumer price index (a measure for inflation)
• Consumer leverage ratio
• Industrial production
• Bankruptcies
• Gross domestic product
• Broadband Internet penetration
• Retail sales
• Stock market prices
• Money supply changes

The leading business cycle dating committee in the United States of America is the National Bureau of Economic Research (private). The Bureau of Labor Statistics is the principal fact-finding agency for the U.S. government in the field of labor economics and statistics. Other producers of economic indicators includes the United States Census Bureau and United States Bureau of Economic Analysis.

Lagging Indicators and Leading Indicators

Statistics that report the status of the economy a few months in the past are called lagging economic indicators. One such lagging indicator is the average length of unemployment. If unemployed workers have remained out of work for a long time, we may infer that the economy has been slow.

Indicators that predict the status of the economy three to twelve months into the future are called leading economic indicators. If such a leading indicator rises, the economy is likely to expand in the coming year. If it falls, the economy is likely to slow down.

To predict where the economy is headed, we obviously must examine several leading indicators. It’s also helpful to look at indicators from various sectors of the economy (which might include labor, manufacturing, and housing).

One useful indicator of the outlook for future jobs is the number of new claims for unemployment insurance. This measure tells us how many people recently lost their jobs. If the number of claims is rising, it signals trouble ahead because unemployed consumers can’t buy as many goods and services as they could if they were working and had paychecks coming in.

To gauge the level of goods to be produced in the future (which will translate into future sales) economists look at a statistic called average weekly manufacturing hours. This measure tells us the average number of hours worked per week by production workers in manufacturing industries. If the average numbers of hours is on the rise, the economy will probably improve.

The number of building permits issued is often a good way to assess the strength of the housing market. An increase in this statistic—which tells us how many new housing units are being built—indicates that the economy is improving because increased building brings money into the economy not only through new home sales but also through sales of furniture and appliances to furnish these homes.

Finally, if you want a measure that combines all these economic indicators, as well as others, a private research firm called the Conference Board publishes a U.S. leading index.

To get an idea of what leading economic indicators are telling us about the state of the economy today, go to the “Business” section of the CNN Money website (CNNMoney.com), and click first on “Economy” and then on “Leading Indicators.”

Consumer Confidence Index

The Conference Board also publishes a consumer confidence index based on results of a monthly survey of 5,000 U.S. households. The survey gathers consumers’ opinions on the health of the economy and their plans for future purchases. It’s often a good indicator of consumers’ future buying intent.

For information on current consumer confidence, go to the CNN Money website (CNNMoney.com), click on the “Business” section, and click on “Economy” and on “Consumer Confidence.”

2.3.3: Gross Domestic Product

Learning Objective

Differentiate the product, income, and expenditure approaches to calculating GDP

Key Points

• GDP per capita is often considered an indicator of a country’s standard of living.
• The product approach sums the outputs of every class of enterprise to arrive at total GDP.
• The expenditure approach works on the principle that all products must be bought by a consumer; therefore, the value of the total product must be equal to consumers’ total expenditures.
• The income approach measures GDP by adding the incomes that firms pay households for factors of production — i.e., wages for labor, interest for capital, rent for land and profits for entrepreneurship.

Key Terms

per capita

per person

GDP

Gross Domestic Product (Economics). A measure of the economic production of a particular territory in financial capital terms over a specific time period.

GDI

gross domestic income; the total income received by all sectors of an economy within a nation.

Example

• The value of all the goods and services produced in the United States in 2011 (GDP) was around $15 trillion.

What is Gross Domestic Product (GDP)?

GDP is the value of all the final goods and services produced in a country during a given time period. Intermediate goods are not counted because they would cause double-counting to occur. GDP only refers to goods produced within a particular country. For instance, if a firm is located in one country but manufactures goods in another, those goods are counted as part of the manufacturing country’s GDP, not the firm’s home country. BMW is a German company, but cars manufactured in the U.S. are counted as part of the U.S. GDP. GDP is a measure used by economists to determine how productive a country is on the whole.

GDP per capita is often considered an indicator of a country’s standard of living. Under economic theory, GDP per capita exactly equals the gross domestic income (GDI) per capita.

GDP Categories – United States

Components of U.S. GDP

Chart showing the categories of product and the amount of money for each in the years 2009 and 2010.

How Is GDP Determined?

GDP can be determined in three ways:

• the product (or output) approach;
• the income approach; and
• the expenditure approach.

The product approach is the most direct, summing the outputs of every class of enterprise to arrive at the total. The expenditure approach works on the principle that all products must be bought by a consumer; therefore, the value of the total product must be equal to consumers’ total expenditures. The income approach works on the principle that the incomes of the productive factors must be equal to the value of their products. This approach determines GDP by finding the sum of all producers’ incomes.

Example: the Expenditure Approach

The expenditure approach only measures products that are intended to be sold. If you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Components of GDP by expenditure are:

consumption + gross investment + government spending + (exports − imports)

Note: In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports).

Consumption is normally the largest GDP component in the economy. Consumables fall under one of the following categories: durable goods, non-durable goods and services. Examples include food, rent, jewelry, gasoline and medical expenses.

Examples of investment include the construction of a new mine, purchase of software, or purchase of equipment for a factory. Spending by households on items like new houses is also included in investment. Buying financial products is classed as saving, as opposed to investment.

Government spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments like social security or unemployment benefits.

Example: the Production Approach

The production approach is also known as the Net Product or Value Added method. This method consists of three stages:

1. Estimating the gross value of domestic output in various economic activities;
2. Determining the intermediate consumption — i.e., the cost of material, supplies and services used to produce final goods or services; and
3. Deducting intermediate consumption from Gross Value to obtain the Net Value of Domestic Output.

For measuring gross output of domestic product, economic activities (i.e. industries) are classified into various sectors. After classifying economic activities, the gross output of each sector is calculated by either of the following two methods:

1. By multiplying the output of each sector by their respective market price and adding them together, or
2. By collecting data on gross sales and inventories from the records of companies and adding them together.

Example: the Income Approach

Another way of measuring GDP is to measure total income. If GDP is calculated this way, it is sometimes called Gross Domestic Income (GDI). GDI should provide the same amount as the expenditure method. However, in practice, measurement errors will make the two figures slightly off when reported by national statistical agencies.

This method measures GDP by adding the incomes that firms pay households for factors of production — i.e., wages for labor, interest for capital, rent for land and profits for entrepreneurship. The U.S. “National Income and Expenditure Accounts” divide incomes into five categories:

• Wages, salaries and supplementary labor income
• Corporate profits
• Interest and miscellaneous investment income
• Farmers’ income
• Income from non-farm unincorporated businesses

These five income components sum to net domestic income at factor cost. Two adjustments must then be made to get GDP:

1. Indirect taxes minus subsidies are added to get from factor cost to market prices.
2. Depreciation (or capital consumption allowance) is added to get from net domestic product to gross domestic product.

Map of world showing GDP per capita, 2011

GDP per capita 2011 for the world economy; with the darkest reds being the highest, and the lighter yellows to white being the lowest.

2.3.4: Employment Levels

Learning Objective

Differentiate between cyclical, structural and frictional unemployment

Key Points

• Full employment is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment.
• The Phillips curve tells us that there is no single unemployment number that one can single out as the full employment rate. Instead, there is a trade-off between unemployment and inflation.
• Cyclical unemployment occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Structural unemployment occurs when a labor market is unable to provide jobs for everyone who wants to work because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs.
• Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another.

Key Terms

structural unemployment

A type of unemployment explained by a mismatch between the requirements of the employers and the properties (such as skills, age, gender, or location) of the unemployed.

Macroeconomics

the study of the entire financial system in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices

cyclical unemployment

A type of unemployment explained by the demand for labor going up and down with the business cycle.

frictional unemployment

A type of unemployment explained by people being temporarily between jobs, searching for new ones. A labor market is regarded as being in the state of full employment if no frictional unemployment is present.

unemployment rate

the percent of the total labor force without a job

Example

• One kind of frictional unemployment is called wait unemployment: it refers to the effects of the existence of some sectors where employed workers are paid more than the market-clearing equilibrium wage. Not only does this restrict the amount of employment in the high-wage sector, but it attracts workers from other sectors who wait to try to get jobs there. The main problem with this theory is that such workers will likely wait while having jobs, so they are not counted as unemployed. In Hollywood, for example, those who are waiting for acting jobs also wait on tables in restaurants for pay (while acting in Equity Waiver plays at night for no pay). However, these workers might be seen as underemployed.

Employment Levels

Full Employment Defined

Employment levels are one of the most important economic indicators available. Full employment, in macroeconomics, is the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation, which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Governments that follow NAIRU are attempting to keep unemployment at certain levels (usually over 4%, and as high as 10% or more) by keeping interest rates high. The majority of mainstream economists mean NAIRU when speaking of full employment.

What most economists mean by full employment is a rate somewhat less than 100%, considering slightly lower levels desirable. For example, the 20^th century British economist, William Beveridge, stated that an unemployment rate of 3% was full employment. Other economists have provided estimates between 2% and 13%, depending on the country, time period, and the various economists’ political biases. However, rates of unemployment substantially above 0% have also been attacked by prominent economists, such as John Maynard Keynes:

“The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts… J.M. Keynes, in a pamphlet to support Lloyd George in the 1929 election.

Ideal Unemployment

An alternative, more normative, definition describes full employment as the attainment of the ideal unemployment rate, where the types of unemployment that reflect labor-market inefficiency (such as structural unemployment) do not exist. Only some frictional unemployment would exist, where workers are temporarily searching for new jobs. For example, Lord William Beveridge defined full employment as where the number of unemployed workers equaled the number of job vacancies available. He preferred that the economy be kept above that full employment level in order to allow maximum economic production.

The Phillips curve tells us that there is no single unemployment number that one can single out as the full employment rate. Instead, there is a trade-off between unemployment and inflation: a government might choose to attain a lower unemployment rate but would pay for it with higher inflation rates. Ideas associated with the Phillips curve questioned the possibility and value of full employment in a society: this theory suggests that full employment—especially as defined normatively—will be associated with positive inflation.

NAIRU-SR-and-LR

Short-run Phillips curve before and after Expansionary Policy, with long-run Phillips curve (NAIRU).

A chart where unemployment rate is the x-axis and inflation rate is the y-axis. A red vertical line represents NAIRU or Long-Run Phillips Curve, and two blue lines are curving down and across the red line: New Short-Run Phillips Curve and Initial Short-Run Phillips Curve.

There are three important categories of unemployment levels that should be understood in order to evaluate the effect of employment levels on overall economic performance: cyclical unemployment, structural unemployment, and frictional unemployment.

Cyclical Unemployment

Cyclical unemployment occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. When demand for most goods and services falls, less production is needed, consequently fewer workers are needed; wages are sticky and do not fall to meet the equilibrium level and mass unemployment results. With cyclical unemployment, the number of unemployed workers exceeds the number of job vacancies, so that even if full employment was attained and all open jobs were filled, some workers would still remain unemployed.

Structural Unemployment

Structural unemployment occurs when a labor market is unable to provide jobs for everyone who wants to work because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs. Structural unemployment may be encouraged to rise by persistent cyclical unemployment: if an economy suffers from long-lasting low aggregate demand, many of the unemployed may become disheartened and their skills (including job-searching skills) become rusty and obsolete. The implication is that sustained high demand may lower structural unemployment. Seasonal unemployment may be seen as a kind of structural unemployment, since it is a type of unemployment that is linked to certain kinds of jobs (construction work or migratory farm work).

Frictional Unemployment

Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment is always present in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment. Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to any of the following reasons:

• Skills
• Payment
• Work-time
• Location
• Seasonal industries
• Attitude
• Taste

There can be a multitude of other factors, too. New entrants (such as graduating students) and re-entrants (such as former homemakers) can also suffer a spell of frictional unemployment. Workers as well as employers accept a certain level of imperfection, risk, or compromise, but usually not right away; they will invest some time and effort to find a better match. This is in fact beneficial to the economy, since it results in a better allocation of resources.

2.3.5: Productivity

Learning Objective

Explain how productivity is modeled on the company and national level, and how productivity is driven

Key Points

• Productivity is considered a key source of economic growth and competitiveness and, as such, is basic statistical information for many international comparisons and country performance assessments.
• The performance of production measures production’s ability to generate income.
• Labour productivity is a revealing indicator of several economic factors, as it offers a dynamic measure of economic growth, competitiveness, and living standards within an economy.
• Factors driving productivity growth include: investment, innovation, skills, enterprise, and competition.
• Productivity growth means more value is added in production, and this means more income is available to be distributed.

Key Terms

productivity

Productivity is a measure of the efficiency of production and is defined as total output per one unit of a total input.

efficiency

The extent to which time is well used for the intended task.

Example

• When the moving assembly line when integrated into the production of automobiles, it became possible to produce many more autos with the same number of factory workers. Said another way, the productivity of labor in the auto manufacturing business increased dramatically.

Productivity Defined

Production is the act of creating output, which is a good or service that has value and contributes to the utility of individuals. Productivity is the ratio of what is produced to what is required to produce it. In other words, productivity is a measure of production efficiency, and its level has major results on overall economic performance. Productivity is considered a key source of economic growth and competitiveness and, as such, is basic statistical information for many international comparisons and country performance assessments.

Production Performance

The performance of production measures production’s ability to generate income. There are two components in income growth due to performance: the income growth caused by an increase in production volume and the income growth caused by an increase in productivity. The income growth caused by increased production volume is determined by moving along the production function graph. The income growth corresponding to a shift of the production function is generated by the increase in productivity. The change of real income signifies a move from Point 1 to Point 2 on the production function. When we want to maximize the production performance, we have to maximize the income generated by the production function.

The Production Function

Growth in income due to production are due to an increase in production volume or an increase in productivity.

Diagram showing how production performance works. Dotted lines labeled T1, T2, P1, and P2 cross over lines labeled 1 and 2.

Productivity Models

With the help of productivity models, it is possible to calculate the performance of the production process. The starting point is a profitability calculation, using surplus value as a criterion of profitability. The surplus value calculation is the only valid measure for understanding the connection between profitability and productivity. A valid measurement of total productivity necessitates considering all production inputs, and the surplus value calculation is the only calculation to conform to that requirement.

Surplus Value Calculation

This is an example of a model calculating surplus value, and thus measuring productivity.

This chart shows the quantity, price, and value for different production inputs over two periods.

The results of the above model are easily interpreted and understood. We see that the real income has increased by 58.12 units, of which 41.12 units came from the increase of productivity growth. The other 17.00 units came from the production volume growth. Based on these changes in productivity and production volume values, we can explicitly locate the production on the production.

There are two parts of the production function. The first is called “increasing returns” and occurs when productivity and production volume increase or when productivity and production volume decrease. The second, “diminishing returns”, occurs when productivity decreases and volume increases or when productivity increases and volume decreases.

In the above example, the combination of volume growth (+17.00) and productivity growth (+41.12) reports explicitly that the production is classified as “increasing returns” on the production function. This model demonstration reveals the fundamental character of total productivity. Total productivity is that part of real income change which is caused by the shift of the production function. Accordingly, any productivity measure is valid only when it indicates this kind of income change correctly.

National Productivity

In order to measure the productivity of a nation or an industry, it is necessary to operationalize the same concept of productivity as in a production unit or a company. However, the object of modelling is substantially wider and the information more aggregate. There are different measures of national productivity, and the choice between them depends on the purpose of the productivity measurement and/or data availability.

One of the most widely used measures of productivity is Gross Domestic Product (GDP) per hour worked. Another productivity measure is known as multi-factor productivity (MFP). It measures the residual growth that cannot be explained by the rate of change in the services of labour, capital and intermediate outputs, and is often interpreted as the contribution to economic growth made by factors such as technical and organizational innovation.

Labor productivity is a revealing indicator of several economic factors, as it offers a dynamic measure of economic growth, competitiveness, and living standards within an economy. Labor productivity is equal to the ratio between a volume measure of output (gross domestic product or gross value added) and a measure of input use (the total number of hours worked or total employment). The volume measure of output reflects the goods and services produced by the workforce. The measure of input use reflects the time, effort, and skills of the workforce.

Drivers Of Productivity Growth

Certain factors are critical for determining productivity growth. These include:

1. Investment: The more capital workers have at their disposal, generally the better they are able to do their jobs.
2. Innovation: For example, better equipment works faster and more efficiently, or better organization increases motivation at work.
3. Skills: These are needed to take advantage of investment in new technologies and organisational structures.
4. Enterprise: This is the seizing of new business opportunities by both start-ups and existing firms.
5. Competition: Improves productivity by creating incentives to innovate and ensures that resources are allocated to the most efficient firms.

Importance Of Productivity Growth

Productivity growth is a crucial source of growth in living standards. Productivity growth means more value is added in production, and this means more income is available to be distributed. At a firm or industry level, the benefits of productivity growth can be distributed in a number of different ways:

1. to the workforce through better wages and conditions;
2. to shareholders through increased profits and dividend distributions;
3. to customers through lower prices;
4. to the environment through more stringent environmental protection; and
5. to governments through increases in tax payments.

At the national level, productivity growth raises living standards because more real income improves people’s ability to purchase goods and services, enjoy leisure, improve housing and education and contribute to social and environmental programs. Over long periods of time, small differences in rates of productivity growth compound — like interest in a bank account — and can make an enormous difference to a society’s prosperity. Nothing contributes more to reduction of poverty, to increases in leisure, and to the country’s ability to finance education, public health, environment and the arts.

2.3.6: Stability Through Fiscal Policy

Learning Objective

Outline the economic objectives of fiscal policy

Key Points

• Governments use fiscal policy to influence the level of aggregate demand in an economy.
• The effectiveness of fiscal policy in general played an important role in recent discussions surrounding the appropriateness of various government responses to recessions.
• Different factions of economic thought offer different theoretical perspectives on fiscal policy.
• Tight fiscal policy, resulting from increasing taxes and reducing government spending, can keep inflation down at the expense of increasing unemployment.
• Loose fiscal policy, resulting from increasing government spending and reducing taxes, can decrease the unemployment level at the risk of increasing inflation.

Key Term

fiscal policy

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

Example

• A recent fiscal policy initiative in the United Sates was the American Recovery and Reinvestment Act of 2009, which was aimed at stimulating economic activity through various channels, such as job creation and federal tax credits.

The Debate Around Fiscal Policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of:

• Price stability
• Full employment
• Economic growth

Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending and increasing taxes after the economic boom begins.

Keynesians argue that this method may be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment.

In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things:

• To slow the pace of strong economic growth
• To stabilize prices when inflation is too high

Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

AS + AD graph

The “aggregate supply” and “aggregate demand” curves for the AS-AD model.

Economists debate the effectiveness of fiscal stimulus.

The argument mostly centers on crowding out, a phenomenon where government borrowing leads to higher interest rates that offset the stimulative impact of spending.

When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

Neoclassical economists generally emphasize crowding out, while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal, while Austrians argue against almost any government distortion in the market.

Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View, which Keynesian economics rejects.

The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes’ call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.

Austrians say that Fiscal Stimulus, such as investing in roads and bridges, does not create economic growth or recovery, pointing to the case that unemployment rates don’t decrease because of fiscal stimulus spending, and that it only puts more debt burden on the economy. Many times, they point to the American Recovery and Reinvestment Act of 2009 as an example.

In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income.

When government borrowing increases interest rates, it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return.

In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return.

To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases.

The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country cost more to foreigners than they did before, and foreign goods cost less than they did before. Consequently, exports decrease, and imports increase.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand.

In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand, while labor supply remains fixed, leading to wage inflation and, therefore, price inflation.

2.3.7: Growth Through Monetary Policy

Learning Objective

Explain how monetary policy theoretically promotes growth

Key Points

• Monetary policy refers to actions taken by a central bank, such as the Federal Reserve in the United States, which seek to influence the overall level of economic activity in an economy by targeting interest rates or the money supply.
• Expansionary monetary policy seeks to lower interest rates or increase the money supply, allowing money to be acquired more easily, increasing economic activity in an economy.
• Contractionary monetary policy will increase interest rates or reduce the money supply, making money (loans, etc.) more difficult to acquire and, thus, reducing (or at least reducing the growth rate of) economic activity in an economy.
• The Federal Reserve System (the Fed) can initiate monetary policy through open market operations, or by changing reserve requirements or the discount window lending interest rate.

Key Terms

Federal Reserve

the central banking system of the United States

monetary policy

The process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Example

• By adjusting monetary policy in favor of low interest rates and a large monetary base, the Fed is taking expansionary actions designed to help the United States recover from the recession.

Influencing Economic Activity Through Policy

In every country, the government takes steps to help the economy achieve the goals of growth, full employment, and price stability.

In the United States, the government influences economic activity through two approaches:

• Monetary policy
• Fiscal policy

Through monetary policy, the government exerts its power to regulate the money supply and level of interest rates. Through fiscal policy, it uses its power to tax and to spend.

Monetary Policy and the Fed

Monetary policy is exercised by the Federal Reserve System (“the Fed”), which is empowered to take various actions that decrease or increase the money supply and raise or lower short-term interest rates, making it harder or easier to borrow money.

When the Fed believes that inflation is a problem, it will use contractionary policy to decrease the money supply and raise interest rates. In theory, when rates are higher, borrowers have to pay more for the money they borrow, and banks are more selective in making loans. Because money is “tighter”more expensive to borrow–demand for goods and services will go down, and so will inflation.

To counter a recession, the Fed uses expansionary policy to increase the money supply and reduce interest rates. With lower interest rates, it’s cheaper to borrow money, and banks are more willing to lend it. We then say that money is “easy. ” Attractive interest rates encourage businesses to borrow money to expand production and encourage consumers to buy more goods and services.

The Tools of Monetary Policy

Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Fed in the United States, the Bank of England, and the European Central Bank) exist which have the task of executing the monetary policy, often independently of the executive. In general, these institutions are called “central banks” and often have other responsibilities, such as supervising the smooth operation of the financial system. The beginning of monetary policy as such comes from the late nineteenth century, where it was used to maintain the gold standard.

Monetary policy rests on the relationship between the rates of interest in an economy (the price at which money can be borrowed) and the total money supply. Monetary policy uses a variety of tools to control one or both of these in order to influence economic growth, inflation, exchange rates, and unemployment.

Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and, thus, influence the interest rate (to achieve policy goals).

Monetary Policy Tools

There are several monetary policy tools available to achieve these ends:

• Increasing interest rates by fiat
• Reducing the monetary base
• Increasing reserve requirements

All have the effect of contracting the money supply and, if reversed, expand the money supply.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually, the short-term goal of open market operations is to achieve a specific short-term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold.

For example, in the case of the United States, the Fed targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include:

• Discount window lending (lender of last resort)
• Fractional deposit lending (changes in the reserve requirement)
• Moral suasion (cajoling certain market players to achieve specified outcomes)
• “Open mouth operations” (talking monetary policy with the market)

Types of Monetary Policy

A policy is referred to as “contractionary,” if it reduces the size of the money supply or increases it only slowly or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly or decreases the interest rate.

Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight, if intended to reduce inflation.

MB, M1 and M2 aggregates from 1981 to 2012

These are the aggregates for MB, M1, and M2, as taken from the St. Louis Federal Reserve’s aggregate graph generator.

Years are on the x-axis and dollar amounts are on the y-axis. Three differently colored lines representing MB, M1, and M2 move up the graph.

2.4: Businesses Under Socialist Systems

2.4.1: Socialism and Planned Economies

Socialism is characterized by social ownership of the means of production.

Learning Objective

Distinguish between economic planning in socialist versus capitalist economic systems

Key Points

• A planned economy is a type of economy consisting of a mixture of public ownership of the means of production and the coordination of production and distribution through state planning.
• Socialism has many variations, depending on the level of planning versus market power, the organization of management, and the role of the state.
• In a socialist system, production is geared towards satisfying economic demands and human needs. Distribution of this output is based on individual contribution.
• Socialists distinguish between a planned economy, such as that of the fomer Soviet Union, and socialist economies. They often compare the former to a top-down bureaucratic capitalist firm.

Key Terms

planned economy

An economic system in which government directly manages supply and demand for goods and services by controlling production, prices, and distribution in accordance with a long-term design and schedule of objectives.

socialism

Any of various economic and political philosophies that support social equality, collective decision-making, distribution of income based on contribution and public ownership of productive capital and natural resources, as advocated by socialists.

Example

• There are few clear examples of purely socialist economies; nonetheless, many of the industrialized countries of Western Europe experimented with one form of social democratic mixed economies or another during the twentieth century, including Britain, France, Sweden, and Norway. They can be regarded as social democratic experiments, because they universally retained a wage-based economy and private ownership and control of the decisive means of production. Variations range from social democratic welfare states, such as in Sweden, to mixed economies where a major percentage of GDP comes from the state sector, such as in Norway, which ranks among the highest countries in quality of life and equality of opportunity for its citizens.

Planned Economy

A planned economy is a type of economy consisting of a mixture of public ownership of the means of production and the coordination of production and distribution through state planning.

Planned Socialist Economy

Economic planning in socialism takes a different form than economic planning in capitalist mixed economies. In socialism, planning refers to production of use-value directly (planning of production), while in capitalist mixed economies, planning refers to the design of capital accumulation in order to stabilize or increase the efficiency of its process. While many socialists advocate for economic planning as an eventual substitute for the market for factors of production, others define economic planning as being based on worker-self management, with production being carried out to directly satisfy human needs. Enrico Barone provided a comprehensive theoretical framework for a planned socialist economy. In his model, assuming perfect computation techniques, simultaneous equations relating inputs and outputs to ratios of equivalence would provide appropriate valuations in order to balance supply and demand.

Hierarchy of Needs

Worker self-management and production to satisfy human needs are key.

The command economy is distinguished from economic planning. Most notably, a command economy is associated with bureaucratic collectivism, state capitalism, or state socialism.

Socialism

Socialism is an economic system characterized by social ownership, control of the means of production, and cooperative management of the economy. A socialist economic system would consist of an organization of production to directly satisfy economic demands and human needs, so that goods and services would be produced directly for use instead of for private profit driven by the accumulation of capital. Accounting would be based on physical quantities, a common physical magnitude, or a direct measure of labor-time. Distribution of output would be based on the principle of individual contribution.

There are many variations of socialism and as such there is no single definition encapsulating all of socialism. They differ in:

• The type of social ownership they advocate;
• The degree to which they rely on markets versus planning;
• How management is to be organised within economic enterprises; and
• The role of the state in constructing socialism.

2.4.2: The Benefits of Socialism

Socialism has a number of theoretical benefits, based on the idea of social equality and justice.

Learning Objective

Demonstrate how the nationalization of key industries, redistribution of wealth, social security schemes and minimum wages are beneficial in socialist economies

Key Points

• Advantages of socialism relating to social equality include a focus on reducing wealth disparities, unemployment and inflation (through price controls).
• Advantages of socialism related to economic planning include an ability to make good use of land, labor and resources, as well as avoiding excess or insufficient production.
• Additional benefits of Socialism: Nationalization of key industries, redistribution of wealth, social security schemes, minimum wages, employment protection and trade union recognition rights.

Key Terms

Public Benefit

A payment made in accordance with an insurance policy or a public assistance scheme.

redistribution

The act of changing the distribution of resources

Example

• Socialist systems have a number of policy tools to help them achieve these goals. Nationalization of key industries such as mining, oil, and energy allows the state to invest directly, set prices and production levels, publicly fund research, and avoid exploitation. Wealth redistribution can occur through targeted, progressive taxation and welfare policies such as free/subsidized education and access to housing. Social security schemes also provide security in old age, while minimum wages, employment protection, and other labor rights ensure a fair wage and safety at work.

How Economies Can Benefit From Socialism

Socialist economics entails the following:

Socialism

A graphical illustration of socialism.

1. Nationalization of key industries, such as mining, oil, steel, energy and transportation. A common model includes a sector being taken over by the state, followed by one or more publicly owned corporations arranging its day-to-day running. Advantages of nationalization include: the ability of the state to direct investment in key industries, distribute state profits from nationalized industries for the overall national good, direct producers to social rather than market goals, and better control the industries both by and for the workers. Additionally, nationalization enables the benefits and burdens of publicly funded research and development to be extended to the wider populace.
2. Redistribution of wealth, through tax and spending policies that aim to reduce economic inequalities. Social democracies typically employ various forms of progressive taxation regarding wage and business income, wealth, inheritance, capital gains and property. On the spending side, a set of social policies typically provides free access to public services such as education, health care and child care. Additionally, subsidized access to housing, food, pharmaceutical goods, water supply, waste management and electricity is common.
3. Social security schemes in which workers contribute to a mandatory public insurance program. The insurance typically includes monetary provisions for retirement pensions and survivor benefits, permanent and temporary disabilities, unemployment and parental leave. Unlike private insurance, governmental schemes are based on public statutes rather than contracts; therefore, contributions and benefits may change in time, and are based on solidarity among participants. Its funding is done on an ongoing basis, without direct relationship to future liabilities.
4. Minimum wages, employment protection and trade union recognition rights for the benefit of workers. These policies aim to guarantee living wages and help produce full employment. While a number of different models of trade union protection have evolved throughout the world over time, they all guarantee the right of workers to form unions, negotiate benefits and participate in strikes. Germany, for instance, appointed union representatives at high levels in all corporations, and as a result, endured much less industrial strife than the UK, whose laws encouraged strikes rather than negotiation.

The benefits of socialism also include the following:

• In theory, based on public benefits, socialism has the greatest goal of common wealth;
• Since the government controls almost all of society’s functions, it can make better use of resources, labors and lands;
• Socialism reduces disparity in wealth, not only in different areas, but also in all societal ranks and classes. Those who suffer from illnesses or are too old to work are still provided for and valued in by the government, assuming that the government is more compassionate that the individual’s family;
• Excess or insufficient production can be avoided;
• Prices can be controlled in a proper extent;
• Socialism can tackle unemployment to a great extent.

2.4.3: The Disadvantages of Socialism

Despite the theoretical benefits of socialist economic systems, there are also disadvantages that may arise in application.

Learning Objective

Evaluate how key components of socialism, such as state ownership of the means of production and the centralization of capital, can be disadvantageous to an economy

Key Points

• Disadvantages of socialism include slow economic growth, less entrepreneurial opportunity and competition, and a potential lack of motivation by individuals due to lesser rewards.
• Critics of socialism claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.
• Economic liberals and pro-capitalist libertarians see private ownership of the means of production and the market exchange as natural entities or moral rights, which are central to their conceptions of freedom and liberty.

Key Terms

socialism

Any of various economic and political philosophies that support social equality, collective decision-making, distribution of income based on contribution and public ownership of productive capital and natural resources, as advocated by socialists.

economy

The system of production and distribution and consumption. The overall measure of a currency system.

Example

• Austrian school economists, such as Friedrich Hayek and Ludwig Von Mises, have argued that the elimination of private ownership of the means of production would inevitably create worse economic conditions for the general populace than those that would be found in market economies. Without the price signals of the market, they state that it is impossible to calculate rationally how to allocate resources.

The Disadvantages of Socialism

Economic liberals and pro-capitalist libertarians see private ownership of the means of production and the market exchange as natural entities or moral rights which are central to their conceptions of freedom and liberty. They, therefore, perceive public ownership of the means of production, cooperatives and economic planning as infringements upon liberty. Some of the primary criticisms of socialism are claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.

Critics from the neoclassical school of economics criticize state-ownership and centralization of capital on the grounds that there is a lack of incentive in state institutions to act on information as efficiently as capitalist firms because they lack hard budget constraints, resulting in reduced overall economic welfare for society. Economists of the Austrian school argue that socialist systems based on economic planning are unfeasible because they lack the information to perform economic calculations in the first place, due to a lack of price signals and a free-price system, which they argue are required for rational economic calculation.

Thus, Socialism can have several disadvantages:

Socialism

Some of the primary criticisms of socialism are claims that it creates distorted or absent price signals, results in reduced incentives, causes reduced prosperity, has low feasibility, and that it has negative social and political effects.

• The national economy develops relatively slowly;
• There is an inability to obtain the upmost profit from the use of resources, labors and land;
• Places that have a geographical advantage lose chances to develop better and people who have intelligence and wealth lose chances to make their businesses become bigger and more powerful; and
• People lose initiative to work and enthusiasm to study as doing more isn’t rewarded.

2.5: Businesses Under Communist Systems

2.5.1: The Communist Economic System

The communist economic system is one where class distinctions are eliminated and the community as a whole owns the means to production.

Learning Objective

Explain how a communist economic system is representative of a command planned economy

Key Points

• Karl Marx and Freidrich Engels wrote the Communist Manifesto in 1848, in response to poor working conditions for workers across Europe. The goal was to establish a system where class distinctions were eliminated and the means of production were owned by the masses.
• Recent attempts at creating political economic systems have led to state-driven authoritarian economies with unaccountable political elites, further driving power away from the hands of the masses.
• A Command Economy is characterized by collective ownership of capital: property is owned by the State, production levels are determined by the State via advanced planning mechanisms rather than supply and demand, and prices are regulated and controlled.

Key Terms

proletariat

The proletariat (from Latin proletarius, a citizen of the lowest class) is a term used to identify a lower social class, usually the working class; a member of such a class is proletarian. Originally it was identified as those people who had no wealth other than their children.

Command Economy

Most of the economy is planned by a central government authority and organized along a top-down administration where decisions regarding production output requirements and investments are decided by planners from the top, or near the top, of the chain of command.

bourgeoisie

In sociology and political science, bourgeoisie (Fr.: [buʁ.ʒwa’zi] | Eng.: /bʊrʒwɑziː/) and the adjective bourgeois are terms that describe a historical range of socio-economic classes. Since the late 18th century in the Western world, the bourgeoisie describes a social class that is characterized by their ownership of capital and their related culture. In contemporary academic theories, the term bourgeoisie usually refers to the ruling class in capitalist societies. In Marxist theory, the abiding characteristics of this class are their ownership of the means of production.

Examples

• The former USSR (or Soviet Union) is the typical example of a communistic, command economy. It was formed in 1922 by the Bolshevik party of the former Russian Empire. In 1928, Joseph Stalin achieved party leadership and introduced the first Five Year Plan, ending the limited level of capitalism that still existed. In 1991, under Mikhael Gorbachev, the Soviet Union was dissolved.
• A modern day example is China, particularly in the 70s, 80s and 90s. Today, China is seen to be more of an authoritarian capitalist rather than communistic command economy.

The Communist Economic System

A communist economic system is an economic system where, in theory, economic decisions are made by the community as a whole. In reality, however, attempts to establish communism have ended up creating state-driven authoritarian economies and regimes which benefit single party political élite who are not accountable to the people or community.

Communist theory was developed by a German philosopher in the 1800s named Karl Marx . He thought that the only way to have a harmonious society was to put workers in control. This idea was established during the Industrial Revolution when many workers were treated unfairly in France, Germany, and England.

Communist Ideology

The Hammer and Sickle represents the communion of the peasant and the worker.

Marx did not want there to be a difference in economic classes and he wanted class struggle to be eliminated. His main goal was to abolish capitalism (an economic system ruled by private ownership). Marx abhorred capitalism because the proletariat was exploited and unfairly represented in politics, and because capitalism allows the bourgeoisie to control a disproportionate amount of power. Therefore, he thought that if everything was shared and owned by everyone, a worker’s paradise or Utopia could be achieved.

Together with Friedrich Engel, a German economist, Marx wrote a pamphlet called the Communist Manifesto. This was published in 1848 and it expressed Marx’s ideas on communism. However, it was later realized that communism did not work. Most interpretations or attempts to establish communism have ended up creating state-driven authoritarian economies and regimes which benefit single party political élite who are not accountable to the people at all.

Command Planned Economy

An economy characterized by Command Planning is notable for several distinguishing features:

1. Collective or state ownership of capital: capital resources such as money, property and other physical assets are owned by the State. There is no (or very little) private ownership.
2. Inputs and outputs are determined by the State: the State has an elaborate planning mechanism in place that determines the level and proportions of inputs to be devoted to producing goods and services. Local planning authorities are handed 1 year, 5 year, 10 year or, in the case of China, up to 25-year plans. The local authorities then implement these plans by meeting with State Owned Enterprises, whereby further plans are developed specific to the business. Inputs are allocated according to the plans and output targets are set.
3. Labor is allocated according to state plans: in a command planning economy, there is no choice of profession; when a child is in school (from a very early age), a streaming system allocates people into designated industries.
4. Private ownership is not possible: under a command planning system an individual cannot own shares, real estate, or any other form of physical or non-physical asset. People are allocated residences by the State.
5. Prices and paying for goods and services: prices are regulated entirely by the State with little regard for the actual costs of production. Often a currency does not exist in a command planning economy and when it does, its main purpose is for accounting. Instead of paying for goods and services when you need to buy them, you are allocated goods and services. This is often also called rationing.

In western democratic and capitalist societies, the price mechanism is a fundamental operator in allocating resources. The laws of demand and supply interact, the price of goods (and services) send signals to producers and consumers alike to determine what goods and quantities are produced, and helps determine what the future demands and quantities will be.

The law of demand states that the higher the price of a good or service, the less the amount of that good or service will be consumed. In other words, the quantity of a good or service demanded, rises when the price falls and falls when the price increases.

2.5.2: The Benefits of Communism

Communism ideology supports widespread universal social welfare, including improvements in public health and education.

Learning Objective

Explain how the theoretical benefits of communism may lead to a more equitable society

Key Points

• The theoretical advantages of communism are built around equality and strong social communities.
• Communist ideology advocates universal education with a focus on developing the proletariat with knowledge, class consciousness, and historical understanding.
• Communism supports the emancipation of women and the ending of their exploitation.
• Communist ideology emphasizes the development of a “New Man”—a class-conscious, knowledgeable, heroic, proletarian person devoted to work and social cohesion, as opposed to the antithetic “bourgeois individualist” associated with cultural backwardness and social atomisation.

Key Terms

Communism

a political philosophy or ideology advocating holding the production of resources collectively

bourgeois

Of or relating to capitalist exploitation of the proletariat.

antithetic

Diametrically opposed.

proletariat

The working class or lower class.

Examples

• In theory, Communism seems to have some very desirable characteristics. In practice, however, it has many drawbacks, and historically it seems that only the most corrupt members of Communist governments have gained advancement within systems. When a system depends on an entire community but is controlled by a few corrupt bureaucrats, it cannot be successful.
• However, this is not to say that state run enterprises in certain areas are a bad idea. Publically owned utilities such as water, electricity, and postal services have proven to be beneficial in countries, even when no communist system exists.

The Benefits of Communism

Theoretically, there are many benefits that can be achieved through a communist society. Communist ideology supports widespread universal social welfare. Improvements in public health and education, provision of child care, provision of state-directed social services, and provision of social benefits will, theoretically, help to raise labor productivity and advance a society in its development. Communist ideology advocates universal education with a focus on developing the proletariat with knowledge, class consciousness, and historical understanding. Communism supports the emancipation of women and the ending of their exploitation. Both cultural and educational policy in communist states have emphasized the development of a “New Man”—a class-conscious, knowledgeable, heroic, proletarian person devoted to work and social cohesion, as opposed to the antithetic “bourgeois individualist” associated with cultural backwardness and social atomization.

Other theoretically beneficial ideas characteristic of communist societies include:

1. People are equal. In a communist regime, people are treated equally in the eyes of the government regardless of education, financial standing, et cetera. Economic boundaries don’t separate or categorize people, which can help mitigate crime and violence.
2. Every citizen can keep a job. In a communist system, people are entitled to jobs. Because the government owns all means of production, the government can provide jobs for at least a majority of the people. Everyone in a communist country is given enough work opportunities to live and survive. Every citizen, however, must do his or her part for the economy to receive pay and other work benefits.
3. There is an internally stable economic system. In communism, the government dictates economic structure; therefore, economic instability is out of the question. Every citizen is required to work in order to receive benefits, and those who don’t have corresponding sanctions. This creates an incentive to participate and to encourage economic growth.
4. Strong social communities are established. In communism, there are certain laws and goals which determine resource and responsibility allocation. If the citizens abide by these laws, this leads to a harmonious spirit of sharing one goal. Consequently, this builds stronger social communities and an even stronger economy.
5. Competition doesn’t exist. In communist societies, everyone can work harmoniously without stepping on each other’s toes. Work, responsibility, and rewards are shared equally among the citizens. If people have no sense of envy, jealousy or ambitions that counter the goals of the state, then a harmonious economic development can be maintained .
6. Efficient distribution of resources. In a communist society, the sense of cooperation allows for efficiency in resource distribution. This is very important, especially in times of need and in emergency situations.

2.5.3: The Disadvantages of Communism

Businesses under Communist system have very strict limitations as to what they can and cannot do, which can hamper productivity and innovation.

Learning Objective

Summarize how the strict rules placed on businesses in a communist economic system can lead to social unrest

Key Points

• In a Communist system, the central authority dictates the means and quantity of production, and places strict rules on businesses.
• Since there is no competition amongst firms, each is given the same amount of money and each worker is paid the same, with the same expectations of each.
• All businesses are ultimately owned by the government.
• Populations tend to be treated homogeneously, meaning that common goals or sets of rules will not apply to different segments of the population and community.
• Without a price mechanism, supply and demand are difficult to balance perfectly over time.

Key Term

Price mechanism

An economic term that refers to the buyers and sellers who negotiate prices of goods or services depending on demand and supply. A price mechanism or market-based mechanism refers to a wide variety of ways to match up buyers and sellers through price rationing.

Example

• Ho Chi Minh raised a guerrilla army in Vietnam, promising them a Utopian communist future of rule by the people and a communal country. However, what transpired was a nation ruled by corrupt Party officials, with no rights or civil liberty. The theory peddled by Ho Chi Minh was far removed from the practice of Communism once he was successfully elected. There are many other examples of how Communism has failed the people of a country. Whether this is down simply to corrupt leaders, or to a deeper flaw in the nature of Communism is a subject debated by many scholars.

Disadvantages of Communism

The economic and political system of Communism effectively dictates what can and cannot be done in the realm of business. There are defined limitations for the amount a business can produce and how much money it can earn.

In addition to directly controlling the means of production, Communism places strict rules as to how businesses operate in such a way that a classless society is born. No matter what field a business specializes in, the same amount of funds will be allocated to each, and each worker will receive the same amount of money. This can cause emotional unrest between workers who wish to be specially recognized for their work. It can serve to create uncomfortable conditions for workers in a society without rank or varying specialty. Finally, it can be stifling to entrepreneurial spirit, which is key to a country’s economic growth and development. The U.S., a capitalistic nation, has greatly benefited from that small business and entrepreneurial atmosphere, a backdrop for the American dream.

More specifically, in Communism:

• The government owns all the businesses and properties (the means of production).
• There is no freedom of speech.
• Large or geographically-broad populations tend to be diverse, making it difficult to maintain a common goal or set of rules for shared effort and resources.
• Central planning is difficult to achieve.
• Consumers’ needs are not taken into consideration.
• Productivity and efficiency are difficult to achieve without profit motive for the workers.
• It is difficult to achieve internal balances between supply and demand without a price mechanism.

The Kremlin

Only the government has a say in production planning under a Communist system.

2.6: Businesses under Mixed Economic Systems

2.6.1: Mixed Economies

A Mixed Economy exhibits characteristics of both market and planned economies, with private and state sectors providing direction.

Learning Objective

Outline the plan behind and what governments provide in a mixed economy

Key Points

• The term Mixed Economy is very broadly defined and has been used to describe economies as diverse as the United States and Cuba.
• The means of production are privately owned, and markets remain the dominant form of economic coordination. However, governments wield significant influence over the economy through monetary and fiscal policy and regulation.
• Characteristics of mixed economies include welfare systems, employment standards, environmental protection, publicly owned enterprises, and antitrust policies.
• Keynesian economics advocates the presence of a mixed economy. This line of thought subsided between 1970 and 2000, but has regained considerable popularity after the financial crisis of 2008.

Key Terms

mixed economies

a system in which both the state and private sector direct the way goods and services are bought and sold

mixed economy

An economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.

welfare state

A social system in which the state takes overall responsibility for the welfare of its citizens, providing health care, education, unemployment compensation and social security.

Keynesian Economics

The group of macroeconomic schools of thought based on the ideas of 20th-century economist John Maynard Keynes. Advocates of Keynesian economics argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes that require active policy responses by the public sector, particularly monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle.

Examples

• The American School (also known as the National System) is the economic philosophy that dominated United States national policies from the time of the American Civil War until the mid-twentieth century, and is an example of a mixed economy. It consisted of a three core policy initiative: protecting industry through high tariffs (1861–1932), government investment in infrastructure through internal improvements, and a national bank to promote the growth of productive enterprises. During this period the United States grew into the largest economy in the world, surpassing the UK (though not the British Empire) by 1880.
• Dirigisme is an economic policy initiated under Charles de Gaulle of France designating an economy where the government exerts strong directive influence. It involved state control of a minority of the industry, such as transportation, energy and telecommunication infrastructures, as well as various incentives for private corporations to merge or engage in certain projects. Under its influence, France experienced what is called Thirty Glorious Years of profound economic growth.
• Social market economy is the economic policy of modern Germany that steers a middle path between the goals of socialism and capitalism within the framework of a private market economy and aims at maintaining a balance between a high rate of economic growth, low inflation, low levels of unemployment, good working conditions, public welfare and public services by using state intervention.

Mixed Economies

What is a Mixed Economy?

A mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies. Most mixed economies can be described as market economies with strong regulatory oversight, in addition to having a variety of government-sponsored aspects.

A mail truck

Restrictions are sometimes placed on private mail systems by mixed economy governments. For example, in the United States, the USPS enjoys a government monopoly on nonurgent letter mail as described in the Private Express Statutes.

While there is not one single definition for a mixed economy, the definitions always involve a degree of private economic freedom mixed with a degree of government regulation of markets.

The Plan Behind a Mixed Economy

The basic plan of the mixed economy is that:

• The means of production are mainly under private ownership;
• Markets remain the dominant form of economic coordination; and
• Profit-seeking enterprises and the accumulation of capital would remain the fundamental driving force behind economic activity. However, the government would wield considerable indirect influence over the economy through fiscal and monetary policies designed to counteract economic downturns and capitalism’s tendency toward financial crises and unemployment, along with playing a role in interventions that promote social welfare. Subsequently, some mixed economies have expanded in scope to include a role for indicative economic planning and/or large public enterprise sectors.

The relative strength or weakness of each component in the national economy can vary greatly between countries. Economies ranging from the United States to Cuba have been termed mixed economies. The term is also used to describe the economies of countries which are referred to as welfare states, such as Norway and Sweden.

What do Governments Provide?

Governments in mixed economies often provide:

• Environmental protection,
• Maintenance of employment standards,
• A standardized welfare system,
• Maintenance of competition.

Who Supports the Ideal of Mixed Economies?

As an economic ideal, mixed economies are supported by people of various political persuasions, typically center-left and center-right, such as social democrats or Christian democrats. Supporters view mixed economies as a compromise between state socialism and laissez-faire capitalism that is superior in net effect to either of those.

Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector. It also served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the tax surcharge in 1968 and the stagflation of the 1970s. The advent of the global financial crisis in 2008 has caused a resurgence in Keynesian thought.

2.6.2: The Benefits of Mixed Economies

A mixed economy allows private participation in production while ensuring that society is protected from the full swings of the market.

Learning Objective

Outline the characteristics of a mixed economy that help to maintain a stable economy

Key Points

• Mixed economies allow many more freedoms than command economies, such as the freedom to possess the means of production; to participate in managerial decisions; to buy, sell, fire, and hire as needed; and for employees to organize and protest peacefully.
• Mixed economies have a high level of state participation and spending, leading to tax-funded libraries, schools, hospitals, roads, utilities, legal assistance, welfare, and social security.
• Various restrictions on business are made for the greater good, such as environmental regulation, labor regulation, antitrust and intellectual property laws.
• The ideal combination of these freedoms and restrictions is meant to ensure the maximum standard of living for the population as a whole.

Key Terms

Social Security

A system whereby the state either through general or specific taxation provides various benefits to help ensure the wellbeing of its citizens.

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

monopoly

An exclusive control over the trade or production of a commodity or service through exclusive possession.

Example

• The US economy is best described as a mixed economy, because even though it strongly advocates free market principles, it relies on the government to deal with matters that the private sector overlooks, ranging from education to the environment. The government has also helped nurture new industries and has played a role in protecting American companies from competition abroad. An example of this is the heavily subsidized agriculture industry in the US. Overall, the US has benefited from this combination.

Overview: The Advantages of a Mixed Economy

A mixed economy permits private participation in production, which in return allows healthy competition that can result in profit. It also contributes to public ownership in manufacturing, which can address social welfare needs.

Marketplace

Private investment, freedom to buy, sell, and profit, combined with economic planning by the state, including significant regulations (e.g., wage or price controls), taxes, tariffs, and state-directed investment.

The advantage of this type of market is that it allows competition between producers with regulations in place to protect society as a whole. With the government being present in the economy it brings a sense of security to sellers and buyers. This security helps maintain a stable economy.

Overall, businesses, as well as consumers, in mixed economies have freedoms that are important to both. And while government is actively involved and provides support, its control is limited, which is good for structure.

The Details: The Advantages of a Mixed Economy

• In a mixed economy, private businesses can decide how to run their businesses (e.g. what to produce, at what price, who to employ, etc.).
• Consumers also have a choice in what they want to buy.
• In this system, there is also less income inequality.
• Monopolies, market structures that are the only producer of a certain product, are allowed under government watch so they do not make it impossible for entrepreneurs in the same industry to succeed.

More specifically:

The elements of a mixed economy have been demonstrated to include a variety of freedoms:

• to possess means of production (farms, factories, stores, etc.)
• to participate in managerial decisions (cooperative and participatory economics)
• to travel (needed to transport all the items in commerce, to make deals in person, for workers and owners to go to where needed)
• to buy (items for personal use, for resale; buy whole enterprises to make the organization that creates wealth a form of wealth itself)
• to sell (same as buy)
• to hire (to create organizations that create wealth)
• to fire (to maintain organizations that create wealth)
• to organize (private enterprise for profit, labor unions, workers’ and professional associations, non-profit groups, religions, etc.)
• to communicate (free speech, newspapers, books, advertisements, make deals, create business partners, create markets)
• to protest peacefully (marches, petitions, sue the government, make laws friendly to profit making and workers alike, remove pointless inefficiencies to maximize wealth creation).

They provide tax-funded, subsidized, or state-owned factors of production, infrastructure, and services:

• libraries and other information services
• roads and other transportation services
• schools and other education services
• hospitals and other health services
• banks and other financial services
• telephone, mail, and other communication services
• electricity and other energy services (e.g. oil, gas)
• water systems for drinking, agriculture, and waste disposal
• subsidies to agriculture and other businesses
• government-granted monopoly to otherwise private businesses
• legal assistance
• government-funded or state-run research and development agencies

Such governments also provide some autonomy over personal finances, but include involuntary spending and investments, such as transfer payments and other cash benefits, including:

• welfare for the poor
• social security for the aged and infirm
• government subsidies to business
• mandatory insurance (e.g. automobile)

They also impose regulation laws and restrictions that help society as a whole, such as:

• environmental regulation (e.g. toxins in land, water, air)
• labor regulation, including minimum wage laws
• consumer regulation (e.g. product safety)
• antitrust laws
• intellectual property laws
• incorporation laws
• protectionism
• import and export controls, such as tariffs and quotas
• taxes and fees written or enforced with manipulation of the economy in mind

2.6.3: The Disadvantages of Mixed Economies

The disadvantages of mixed economies can be understood through examining criticisms of social democracy.

Learning Objective

Examine the criticisms of social democracy as a vessel to understanding the disadvantages of mixed economies.

Key Points

• One disadvantage of mixed economies is that they tend to lean more toward government control and less toward individual freedoms.
• While most modern forms of government are consistent with some form of mixed economy, the mixed economy is most commonly associated with social democratic parties or nations run by social democratic governments.
• Some critics of contemporary social democracy argue that when social democracy abandoned Marxism it also abandoned socialism and has become, in effect, a liberal capitalist movement.
• Marxian socialists argue that because social democratic programs retain the capitalist mode of production they also retain the fundamental issues of capitalism, including cyclical fluctuations, exploitation and alienation.
• The democratic socialist critique of social democracy states that capitalism could never be sufficiently “humanized” and any attempt to suppress the economic contradictions of capitalism would only cause them to emerge elsewhere.
• Market socialists criticize social democracy for maintaining a property-owning capitalist class, which has an active interest in reversing social democratic policies and a disproportionate amount of power over society to influence governmental policy as a class.

Key Terms

regulation

A law or administrative rule, issued by an organization, used to guide or prescribe the conduct of members of that organization.

social democracy

a moderate political philosophy or ideology that aims to achieve socialistic goals within capitalist society such as by means of a strong welfare state and regulation of private industry

mixed economy

Mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.

Example

• Many pubs in Britain are suffering due to drinking and smoking regulations imposed by the government for the good of society. As a result, many question whether pubs have a future.

One disadvantage of mixed economies is that they tend to lean more toward government control and less toward individual freedoms. Sometimes, government regulation requirements may cost a company so much that it puts it out of business. In addition, unsuccessful regulations may paralyze features of production. This, in return, can cause the economic balance to shift.

Another negative is that the government decides the amount of tax on products, which leads to people complaining about high taxes and their unwillingness to pay them. Moreover, lack of price control management can cause shortages in goods and can result in a recession.

Disadvantages of Social Democratic Policy In a Mixed Economy

While most modern forms of government are consistent with some form of mixed economy, given the broad range of economic systems that can be described by the term, the mixed economy is most commonly associated with social democratic parties or nations run by social democratic governments. In contemporary terms, “social democracy” usually refers to a social corporatist arrangement and a welfare state in developed capitalist economies.

Critics of contemporary social democracy argue that when social democracy abandoned Marxism it also abandoned socialism and has become, in effect, a liberal capitalist movement. They argue that this has made social democrats similar to center-left, but pro-capitalist groups, such as the U.S. Democratic Party .

The Democratic Party Logo

The Democratic party in the United States is seen by some critics of contemporary social democracy (and mixed economies) as a watered-down, pro-capitalist movement.

Marxian socialists argue that because social democratic programs retain the capitalist mode of production they also retain the fundamental issues of capitalism, including cyclical fluctuations, exploitation and alienation. Social democratic programs intended to ameliorate capitalism, such as unemployment benefits or taxation on profits and the wealthy, create contradictions of their own through limiting the efficiency of the capitalist system by reducing incentives for capitalists to invest in production.

Others contrast social democracy with democratic socialism by defining the former as an attempt to strengthen the welfare state and the latter as an alternative socialist economic system to capitalism. The democratic socialist critique of social democracy states that capitalism could never be sufficiently “humanized” and any attempt to suppress the economic contradictions of capitalism would only cause them to emerge elsewhere. For example, attempts to reduce unemployment too much would result in inflation, and too much job security would erode labor discipline. In contrast to social democracy, democratic socialists advocate a post-capitalist economic system based either on market socialism combined with workers self-management, or on some form of participatory-economic planning.

Social democracy can also be contrasted with market socialism. While a common goal of both systems is to achieve greater social and economic equality, market socialism does so by changes in enterprise ownership and management, whereas social democracy attempts to do so by government-imposed taxes and subsidies on privately owned enterprises. Market socialists criticize social democracy for maintaining a property-owning capitalist class, which has an active interest in reversing social democratic policies and a disproportionate amount of power over society to influence governmental policy as a class.

3: Business Ethics and Social Responsibility

1.3: Trends in American Business

1.3.1: Productivity Gains in Agriculture

Learning Objective

Outline agricultural advances that have resulted in productivity gains

Key Points

• Between 1950 and 2000, during the so called “second agricultural revolution of modern times,” U.S. agricultural productivity rose fast, especially due to the development of new technologies.
• Avoiding losses of agricultural products to spoilage, insects, and rats contribute greatly to productivity.
• Additional innovations include the pasteurization of milk, which allow it to be shipped long distances without spoiling.

Key Terms

revolution

A sudden, vast change in a situation, a discipline, or the way of thinking and behaving.

pasteurize

To heat food for the purpose of killing harmful organisms, such as bacteria, viruses, protozoa, molds, and yeasts.

agriculture

The art or science of cultivating the ground, including the harvesting of crops, and the rearing and management of livestock; tillage; husbandry; farming.

Examples

• During the second agricultural revolution, the average amount of milk produced per cow increased from 5,314 pounds to 18,201 pounds per year (+242%), the average yield of corn rose from 39 bushels to 153 bushels per acre (+292%), and each farmer in 2000 produced on average 12 times as much farm output per hour worked as a farmer did in 1950.
• The amount of feed required to produce a kilogram of live weight chicken fell from 5 in 1930 to 2 by the late 1990s and the time required fell from three months to six weeks. 
•  

Huge productivity gains in agriculture were recorded in the twentieth century. Avoiding losses of agricultural products to spoilage, insects, and rats contributes significantly to productivity. Large amounts of hay stored outdoors were traditionally lost to spoilage before indoor storage or other means of coverage became more common. Pasteurization of milk allowed it to be shipped by railroad. (It was noted that calves fed pasteurized milk were less likely to develop tuberculosis, and soon it was found that pasteurization reduced the incidences of several other diseases in humans. ) Keeping livestock indoors in winter reduces the amount of feed needed. Also, feeding chopped hay and ground grains, particularly corn (maize), was found to improve digestibility. The amount of feed required to produce a kilogram of live weight chicken fell from 5 in 1930 to 2 by the late 1990s and the time required fell from 3 months to 6 weeks.

Between 1950 and 2000, during the so called “second agricultural revolution of modern times,” U.S. agricultural productivity rose fast, especially due to the development of new technologies (the greatest period of agricultural productivity growth in the U.S. occurred from World War 2 until the 1970s). For example, the average amount of milk produced per cow increased from 5,314 pounds to 18,201 pounds per year (+242%), the average yield of corn rose from 39 bushels to 153 bushels per acre (+292%), and each farmer in 2000 produced on average of 12 times as much farm output per hour worked as a farmer did in 1950.

1.3.2: Productivity Gains in Manufacturing

Learning Objective

Discuss the various factors that impact productivity in manufacturing, alongside trends in jobs and production

Key Points

• Manufacturing plays a vital role in the overall health of the U.S. economy.
• As of 2016, manufacturing accounts for over 12 million US jobs. This number is down from the 1980’s, but is still a significant aspect of the workforce.
• Globalization has a somewhat mixed impact on manufacturing, as it offers access to more markets (growth) while also offering access to cheaper production elsewhere (outsourcing).
• Technology has a great impact on manufacturing as well, with machines drastically lowering costs and increasing efficiency. However, this too may ultimately cost jobs while increasing production.

Key Term

GDP

Or gross domestic product, this economic indicator measures the total amount of products and services produced over a specific time frame.

Manufacturing in the United States is important both economically and politically. As a potential source of gross domestic product (GDP) and jobs across various skill levels, manufacturing plays a vital role in the overall health of the U.S. economy.

Trends in Manufacturing

Jobs and overall contributions to GDP from manufacturing are impacted by a number of factors, most importantly trends in outsourcing, changes in skilled labor (domestically), and advances in technology. 

Over the past few decades, there have been drastic changes in the overall number of manufacturing jobs in the United States. As of October 2016, the United States employed over 12 million people in the manufacturing industries. At its highest in the 1980s, the United States had nearly 20 million manufacturing employees in the country. 

Total US Manufacturing Employment

This chart illustrates the changes in overall manufacturing employment from the 1940s onward. The peak of manufacturing employment was in the 1980s, though it’s worth noting that this is not normalized as a percentage of population (i.e., population growth would impact this assessment).

Population is shown on the y-axis and years are shown on the x-axis. A blue line moves up and down, showing the changes in employment over the years.

Globalization

With globalization and the availability of affordable labor and real estate overseas, there has been a trend towards outsourcing manufacturing over the past few decades. This trend has had some clear effects on the overall number of manufacturing jobs domestically and the GDP.

2014 U.S. Exports

This is a graphic diagram depicting the most common U.S. exports, including a number of manufactured goods.

This diagram is split into differently colored and shaped boxes, each showing a different export and percentage per export.

On the other side of things, globalization has opened more markets than ever before. U.S. manufactured goods are sold across the world, which offers great potential for expanding upon production levels of manufacturing. The United States manufacturers more goods than any other country excepting China and the EU as of 2014, indicating that trends in decreasing manufacturing employment may be a result of complex factors such as technological evolution.

Technology Advances

Similarly, technology has increased the efficiency of manufacturing significantly over time. This increase in efficiency often results in less labor required for a higher volume of output. As this trend continues, and robotics (and even AI) continues to evolve, some jobs may be lost to technology while gross output should increase (or, at least maintain).

Conclusion

Manufacturing is a significant aspect of the U.S. economy, and will maintain its importance in the near future. Outsourcing of jobs and technological advances are a threat to the availability of jobs in this sector, while access to global markets and a political focus on creating jobs offers growth opportunities.

1.3.3: Productivity Gains from Technology

Learning Objective

Identify the fundamental factors that have led to technological evolution over the centuries

Key Points

• Technologies that improve productivity date back to antiquity, with rather slow progress until the late Middle Ages.
• Technological progress was aided by literacy and the diffusion of knowledge that accelerated after the spinning wheel spread to Western Europe in the 13th century.
• However, technological and economic progress did not proceed at a significant rate until the English Industrial Revolution in the late 18th century.
• Even then productivity only grew about 0.5% annually, with high productivity growth only beginning during the late 19th century in the Second Industrial Revolution.
• Productivity gains were not just the result of inventions, but also of continuous improvements to those inventions which greatly increased output in relation both capital and labor compared to the original inventions.

Key Terms

internal combustion

The process where fuel is burned within an engine such as a diesel engine, producing power directly as opposed to externally such as in a steam engine.

electromagnetism

A unified fundamental force that combines the aspects of electricity and magnetism and is one of the four fundamental forces. (technically it can be unified with weak nuclear to form electroweak) Its gauge boson is the photon.

automation

The act or process of converting the controlling of a machine or device to a more automatic system, such as computer or electronic controls.

Examples

• The Spinning Jenny and Spinning Mule greatly increased the productivity of thread manufacturing compared to the spinning wheel.
• Mining and metal refining technologies played a key role in technological progress. Much of our understanding of fundamental chemistry evolved from ore smelting and refining, with De Re Metallica being the leading chemistry text for 180 years. Railroads evolved from mine carts and the first steam engines were designed specifically for pumping water from mines.
• Mining and metal refining technologies played a key role in technological progress. Much of our understanding of fundamental chemistry evolved from ore smelting and refining, with De Re Metallica being the leading chemistry text for 180 years. Railroads evolved from mine carts and the first steam engines were designed specifically for pumping water from mines.

Productivity Gains from Technology

In 1889, David Ames Wells described the economic events and technologies that created the great productivity growth during 1870-1890:

“The economic changes that have occurred during the last quarter of a century -or during the present generation of living men- have unquestionably been more important and more varied than during any period of the world’s history.”

Technologies that improve productivity date back to antiquity, with rather slow progress until the late Middle Ages. Technological progress was aided by literacy and the diffusion of knowledge that accelerated after the spinning wheel spread to Western Europe in the 13^th century. The spinning wheel increased the supply of rags used for pulp in manufacturing paper, and the technology reached Sicily sometime in the 12^th century. Cheap paper was a factor in the development of the moveable type printing press, ca. 1440, which lead to a large increase in the number of books and titles published.

Books on science and technology eventually began to appear, such as the mining technical manual, De Re Metallica. Mining and metal refining technologies played a key role in technological progress. Much of our understanding of fundamental chemistry evolved from ore smelting and refining, with De Re Metallica being the leading chemistry text for 180 years. Railroads evolved from mine carts and the first steam engines were designed specifically for pumping water from mines.

Later, near the beginning of the Industrial Revolution, came publication of the Encyclopédie, written by numerous contributors and edited by Denis Diderot and Jean le Rond d’Alembert (1751–72). It contained many articles on science and was the first general encyclopedia to provide in depth coverage on the mechanical arts, but far more celebrated for its presentation of thoughts of the Enlightenment.

Important mechanisms for the transfer of technical knowledge were scientific societies. The Royal Society of London for Improving Natural Knowledge is one example, though they were better known as the Royal Society and technical colleges. The École Polytechnique is one example. Probably the first period in history in which an economic progress was observable during one generation was the British Agricultural Revolution in the 18^th century.

However, technological and economic progress did not proceed at a significant rate until the English Industrial Revolution in the late 18^th century, and even then productivity grew about 0.5% annually. High productivity growth began during the late 19^th century in what is sometimes called the Second Industrial Revolution. Most major innovations of the Second Industrial Revolution were based on the modern scientific understanding of chemistry, electromagnetism theory, and thermodynamics.

Productivity gains were not just the result of inventions, but also of continuous improvements to those inventions which greatly increased output in relation to both capital and labor compared to the original inventions.

Technology and productivity

Technology has had a profound effect on productivity.

A picture of a cable engine.

Since the beginning of the Industrial Revolution, some of the major contributors to productivity have been as follows:

• Replacing human and animal power with water and wind power, steam, electricity and internal combustion, and greatly increasing the use of energy;
• Energy efficiency in the conversion of energy to process heat or chemical energy in the manufacture of materials;
• Infrastructures: canals, railroads, highways, and pipelines;
• Mechanization, both production machinery and agricultural machines;
• Work practices and processes: the American system of manufacturing, Taylorism (scientific management), mass production, assembly line, and modern business enterprise;
• Materials handling of bulk materials, palletization, and containerization;
• Scientific agriculture: fertilizers and the green revolution, and livestock and poultry management;
• New materials for new processes of production and dematerialization;
• Communications: telegraph, telephone, radio, satellites, fiber optic networks, and the Internet;
• Home economics: public water supply, household gas, and appliances;
• Automation and process control;
• Computers and software for data processing.

Example: The Spinning Jenny and Spinning Mule greatly increased the productivity of thread manufacturing compared to the spinning wheel

1.3.4: Service Economy Growth

Learning Objective

Identify the characteristics of the service sector that have led to its growing prevalence

Key Points

• The growth of the service sector is a response to the change of traditional manufacturing industries into services.
• Many modern services combine both products and services, and the distinction between the two has blurred.
• Service producing sectors include a clear focus on knowledge and ICT, ever-changing business processes, and unique financial, regulatory, and investment structures.
• Service industries also cover a large variety of business types.

Key Terms

services

That which is produced, then traded, bought or sold, then finally consumed and consists of an action or work.

manufacture

The action or process of making goods systematically or on a large scale.

productivity

Productivity is a measure of the efficiency of production and is defined as total output per one unit of a total input.

Example

• Many products are being transformed into services. For example, IBM treats its business as a service business. Although it still manufactures computers, it sees the physical goods as a small part of the “business solutions” industry.

As shown below, most of the U.S. economy is classified as services. Agriculture accounts for 1.2%, industry makes up 22.1%, and services contribute 76.7% (2011 est.).

Hospital equipment

Health care is part of the service economy

In fact, the current list of Fortune 500 companies contains more service companies and fewer manufacturers than in previous decades.

A “service” can be described as all intangible effects that result from a client interaction that creates and captures value. Services are everywhere in today’s world. The sector ranges from common “intangible” goods, such as health and education, to newer goods, such as modern communications and IT. Services are said to be essential to increase productivity and growth and are considered salient to the development of knowledge-based economies.

Many products are being transformed into services. For example, IBM treats its business as a service business. Although it still manufactures computers, it sees the physical goods as a small part of the “business solutions” industry.

The growth of the service sector is, in part, a response to the change of traditional manufacturing industries into services. Many modern services combine both products and services, and the distinction between the two has blurred. However, still a number of typically shared characteristics distinguish services from goods-producing sectors. These include a clear focus on knowledge and ICT, ever-changing business processes, and unique financial, regulatory, and investment structures. Service industries also cover a large variety of business types, from travel to highly knowledge-intensive services, such as global communication networks and specialized financial services. In general, knowledge-intensive services encompass both professional services (e.g., financial, legal), and science and technology-linked services (e.g., environmental, mining, health).

1.4: Introduction to Entrepreneurship

1.4.1: The Goals of Entrepreneurs

The goals of entrepreneurs are varied and individualized but can include the achievement of independence, financial success, or social change.

Learning Objective

Discover the factors that lead individuals to entrepreneurship

Key Points

• Entrepreneurship is the act of being an entrepreneur or “one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods.”
• An individual may start a new organizations or may be part of revitalizing mature organizations in response to a perceived opportunity.
• The most obvious form of entrepreneurship is that of starting new businesses (referred as Startup Company).
• In recent years, startup has been extended to include social and political forms of entrepreneurial activity.
• When entrepreneurship is describing activities within a firm or large organization it is referred to as intra-preneurship.

Key Terms

entrepreneur

A person who organizes and operates a business venture and assumes much of the associated risk.

seniority

A measure of the amount of time a person has been a member of an organization, as compared to other members, and with an eye towards awarding privileges to those who have been members longer.

intra-preneurship

When entrepreneurship is describing activities within a firm or large organization it is referred to as intra-preneurship.

Examples

• Most new entrepreneurs help the local economy. A few—through their innovations—contribute to society as a whole. One example is entrepreneur Steve Jobs, who co-founded Apple in 1976, and ignited the subsequent revolution in desktop computers.
• Entrepreneurship offers a greater possibility of achieving significant financial rewards than working for someone else.
• Entrepreneurs are their own bosses. They make the decisions. They choose whom to do business with and what work they will do. They decide what hours to work, as well as what to pay and whether to take vacations.

Entrepreneurship is the act of being an entrepreneur or “one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods”. This may result in new organizations or may be part of revitalizing mature organizations in response to a perceived opportunity. The most obvious form of entrepreneurship is that of starting new businesses (referred as a startup company); however, in recent years, the term has been extended to include social and political forms of entrepreneurial activity. When entrepreneurship is describing activities within a firm or large organization it is referred to as intra-preneurship and may include corporate venturing, when large entities spin-off organizations.

What leads a person to strike out on his own and start a business? Sometimes it is a proactive response to a negative situation. Perhaps a person has been laid off once or more. Sometimes a person is frustrated with his or her current job and doesn’t see any better career prospects on the horizon. Sometimes a person realizes that his or her job is in jeopardy. A firm may be contemplating cutbacks that could end a job or limit career or salary prospects. Perhaps a person already has been passed over for promotion. Perhaps a person sees no opportunities in existing businesses for someone with his or her interests and skills. Some people are actually repulsed by the idea of working for someone else. They object to a system where reward is often based on seniority rather than accomplishment, or where they have to conform to a corporate culture. Other people decide to become entrepreneurs because they are disillusioned by the bureaucracy or politics involved in getting ahead in an established business or profession. Some are tired of trying to promote a product, service, or way of doing business that is outside the mainstream operations of a large company.

In contrast, some people are attracted to entrepreneurship simply for the sake of the advantages of starting a business. These include:

• Entrepreneurs are their own bosses. They make the decisions. They choose whom to do business with and what work they will do. They decide what hours to work, as well as what to pay and whether to take vacations.
• Entrepreneurship offers a greater possibility of achieving significant financial rewards than working for someone else.
• It provides the ability to be involved in the total operation of the business, from concept to design and creation, from sales to business operations and customer response.
• It offers the prestige of being the person in charge.
• It gives an individual the opportunity to build equity, which can be kept, sold, or passed on to the next generation.
• Entrepreneurship creates an opportunity for a person to make a contribution. Most new entrepreneurs help the local economy. A few—through their innovations—contribute to society as a whole. One example is entrepreneur Steve Jobs, who co-founded Apple in 1976, and ignited the subsequent revolution in desktop computers.

Some people evaluate the possibilities for jobs and careers where they live and make a conscious decision to pursue entrepreneurship.

No one reason is more valid than another; none guarantee success. However, a strong desire to start a business, combined with a good idea, careful planning, and hard work, can lead to a very engaging and profitable endeavor.

Entrepreneurship history

Notable persons and their works in entrepreneurship history. Figure created by Mikko Ohtamaa.

1.4.2: Benefits of a Small Organization

In general, small firms have greater flexibility than larger firms and capacity to respond promptly to industry or community developments.

Learning Objective

Discuss how flexibility, adaptation, independence, and the involvement of high skilled personnel in small organizations bring about benefits

Key Points

• A small firm has the ability to modify its products or services in response to unique customer needs.
• The average entrepreneur or manager of a small business knows his customer base far better than one in a large company.
• The participants in small firms, such as the entrepreneur, partners, advisers, and employees, have a passionate, almost compulsive, desire to succeed. This entrepreneurial spirit makes them work harder and better.
• Small business is also well suited to Internet marketing because it can easily serve specialized niches, something that would have been more difficult prior to the Internet revolution which began in the late 1990s.

Key Terms

startup

a new organization or business venture

entrepreneur

A person who organizes and operates a business venture and assumes much of the associated risk.

bureaucracy

Structure and regulations in place to control activity. Usually in large organizations and government operations.

Example

• When entrepreneur William J. Stolze helped start RF Communications in 1961 in Rochester, New York, three of the founders came from the huge corporation General Dynamics, where they held senior marketing and engineering positions. In the new venture, the marketing expert had the title “president” but actually worked to get orders. The senior engineers were no longer supervisors; instead, they were designing products. As Stolze said in his book, Start Up, “In most start-ups that I know of, the key managers have stepped back from much more responsible positions in larger companies, and this gives the new company an immense competitive advantage. “

Benefits of Small Business

Greater Flexibility

In general, small start-up firms have greater flexibility than larger firms and the capacity to respond promptly to industry or community developments. They are able to innovate and create new products and services more rapidly and creatively than larger companies that are mired in bureaucracy. Whether reacting to changes in fashion, demographics, or a competitor’s advertising, a small firm usually can make decisions in days, not months or years.

Small business is also well suited to Internet marketing because it can easily serve specialized niches, something that would have been more difficult prior to the Internet revolution, which began in the late 1990s. Adapting to change is crucial in business and particularly small business; not being tied to any bureaucratic inertia, it is typically easier to respond to the marketplace quickly. Small business proprietors tend to be intimate with their customers and clients which results in greater accountability and maturity.

A small firm has the ability to modify its products or services in response to unique customer needs. The average entrepreneur or manager of a small business knows his customer base far better than one in a large company. If a modification in the products or services offered, or even the business’s hours of operation, would better serve the customers, it is possible for a small firm to make changes. Customers can even have a role in product development.

Entrepreneurial Spirit

Another strength comes from the involvement of highly skilled personnel in all aspects of a startup business. In particular, startups benefit from having senior partners or managers working on tasks below their highest skill level. For example, when entrepreneur William J. Stolze helped start RF Communications in 1961 in Rochester, New York, three of the founders came from the huge corporation General Dynamics, where they held senior marketing and engineering positions. In the new venture, the marketing expert had the title “president” but actually worked to get orders. The senior engineers were no longer supervisors; instead, they were designing products. As Stolze said in his book, Start Up, “In most start-ups that I know of, the key managers have stepped back from much more responsible positions in larger companies, and this gives the new company an immense competitive advantage. ” Another strength of a startup is that the people involved–the entrepreneur, any partners, advisers, employees, or even family members–have a passionate, almost compulsive, desire to succeed. This makes them work harder and better. Finally, many small businesses and startup ventures have an intangible quality that comes from people who are fully engaged and doing what they want to do. This is “the entrepreneurial spirit,” the atmosphere of fun and excitement that is generated when people work together to create an opportunity for greater success than is otherwise available. This can attract workers and inspire them to do their best.

Independence

Independence is another advantage of owning a small business. One survey of small business owners showed that 38% of those who left their jobs at other companies said their main reason for leaving was that they wanted to be their own bosses. Freedom to operate independently is a reward for small business owners. In addition, many people desire to make their own decisions, take their own risks, and reap the rewards of their efforts. Small business owners have the satisfaction of making their own decisions within the constraints imposed by economic and other environmental factors. However, entrepreneurs have to work very long hours and understand that ultimately their customers are their bosses. Additionally, the startup cycle of initial financing can be daunting, and entrepreneurs have to act responsibly and intelligently so as not to end up in the “Valley of Death. ” Several organizations in the United States provide help for the small business sector, such as the Internal Revenue Service’s Small Business and Self-Employed One-Stop Resource.

Start-up financing cycle

Diagram of the typical financing cycle for a start-up company.

1.4.3: Entrepreneurship and the Economy

Creativity and entrepreneurship are needed to combine inputs in profitable ways, resulting in large scale economic growth/development.

Learning Objective

Identify the characteristics of an entrepreneurial economy and the factors that lead to it

Key Points

• Entrepreneurship drives economic resources to work efficiently, which positively impacts long-term economic development and growth.
• The entrepreneur is a factor in microeconomics, and the study of entrepreneurship reaches back to the work of Richard Cantillon and Adam Smith in the late 17th and early 18th centuries.
• In the 20th century, the understanding of entrepreneurship owes much to the work of economist Joseph Schumpeter in the 1930s and other Austrian economists such as Carl Menger, Ludwig von Mises and Friedrich von Hayek.
• An entrepreneur is a person willing and able to convert a new idea or invention into a successful innovation.
• They employ what is called “the gale of creative destruction” to replace in whole or in part inferior innovations, creating new products including new business models.

Key Terms

entrepreneur

A person who organizes and operates a business venture and assumes much of the associated risk.

business model

The particular way in which a business organization ensures that it generates income, one that includes the choice of offerings, strategies, infrastructure, organizational structures, trading practices, and operational processes and policies.

microeconomics

the study small-scale financial activities such as that of the individual or company

creative destruction

Refers to the linked processes of the accumulation and annihilation of wealth under capitalism.

Example

• Schumpeter’s initial example of entrepreneurship and long-term economic growth was the combination of a steam engine and then current wagon making technologies to produce the horseless carriage. In this case the innovation, the car, was transformational but did not require the development of a new technology, merely the application of existing technologies in a novel manner.

Entrepreneurial Economics

Entrepreneurial economics is the study of the entrepreneur and entrepreneurship within the economy. The accumulation of factors of production per se does not explain economic development. They are necessary inputs in production, but they are not sufficient for economic growth. Human creativity and productive entrepreneurship are needed to combine these inputs in profitable ways, and hence an institutional environment that encourages free entrepreneurship becomes the ultimate determinant of economic growth. Thus, the entrepreneur and entrepreneurship should take center stage in any effort to explain long-term economic development. Early economic theory, however did not pay proper attention to the entrepreneur. As William J. Baumol observed in the American Economic Review, “The theoretical firm is entrepreneurless—the Prince of Denmark has been expunged from the discussion of Hamlet.” The article was a prod to the economics profession to attend to this neglected factor. If entrepreneurship remains as important to the economy as ever, then the continuing failure of mainstream economics to adequately account for entrepreneurship indicates that fundamental principles require re-evaluation. The characteristics of an entrepreneurial economy are high levels of innovation combined with high level of entrepreneurship which result in the creation of new ventures as well as new sectors and industries. Entrepreneurship is difficult to analyze using the traditional tools of economics e.g. calculus and general equilibrium models.

Startup financing cycle

Diagram of the typical financing cycle for a startup company

Equilibrium models are central to mainstream economics, and exclude entrepreneurship. Joseph Schumpeter and Israel Kirzner argued that entrepreneurs do not tolerate equilibrium.

Studies about entrepreneurs in Economics, Psychology and Sociology largely relate to four major currents of thought. Early thinkers such as Max Weber emphasized its occurrence in the context of a religious belief system, thereby suggesting that some belief systems do not encourage entrepreneurship. This contention has, however, been challenged by many sociologists. Some thinkers such as K Samuelson believe that there is no relationship between religion, economic development and entrepreneurship. Karl Marx considered the economic system and mode of production as its sole determinants. Weber suggested a direct relation between the ethics and economic system as both intensively interacted. Another current of thought underscores the motivational aspects of personal achievement. This overemphasized the individual and his values, attitudes and personality. This thought, however, has been severely criticized by many scholars such as Kilby (1971) and Kunkel (1971).

Economists of the 1930s and the Acknowledgement of Entrepreneurship

Entrepreneurship is a factor in microeconomics, and its study reaches back to the work of Richard Cantillon and Adam Smith in the late 17th and early 18th centuries. It was ignored theoretically until the late 19th and early 20th centuries and empirically until a profound resurgence in business and economics in the last 40 years. In the 20th century, the understanding of entrepreneurship owes much to the work of Joseph Schumpeter in the 1930s and other Austrian economists such as Carl Menger, Ludwig von Mises and Friedrich von Hayek. To Schumpeter, an entrepreneur is a person willing and able to convert a new idea or invention into a successful innovation. Entrepreneurship employs what Schumpeter called “the gale of creative destruction” to replace in whole or in part inferior innovations across markets and industries, simultaneously creating new products and business models. In this way, creative destruction is largely responsible for the dynamism of industries and long-run economic growth. The supposition that entrepreneurship leads to economic growth is an interpretation of the residual in endogenous growth theory and as such is hotly debated in academic economics. An alternate description posited by Israel Kirzner suggests that the majority of innovations may be much more incremental improvements such as the replacement of paper with plastic in the construction of a drinking straw.

For Schumpeter, entrepreneurship resulted in new industries but also in new combinations of currently existing inputs. Schumpeter’s initial example of this was the combination of a steam engine and then current wagon-making technologies to produce the horseless carriage. In this case the innovation, the car, was transformational but did not require the development of a new technology, merely the application of existing technologies in a novel manner. It did not immediately replace the horsedrawn carriage, but in time, incremental improvements which reduced the cost and improved the technology led to the complete practical replacement of beast drawn vehicles in modern transportation. Despite Schumpeter’s early 20th-century contributions, traditional microeconomic theory did not formally consider the entrepreneur in its theoretical frameworks (instead assuming that resources would find each other through a price system). In this treatment the entrepreneur was an implied but unspecified actor, but it is consistent with the concept of the entrepreneur being the agent of x-efficiency. Different scholars have described entrepreneurs as, among other things, bearing risk. For Schumpeter, the entrepreneur did not bear risk: the capitalist did.

1.5: Learning Business Topics

1.5.1: Context and Current Events

There are two main ways to learn business topics: problem-based and team-based learning.

Learning Objective

Discover how problem-based learning leads to a more effective and fulfilling experience for students learning business topics

Key Points

• Problem-based learning is a student-centered pedagogy in which students learn about a subject in the context of complex, multifaceted, and realistic problems.
• PBL is a learning method that can promote the development of critical thinking skills –students learn how to analyze a problem, identify relevant facts and generate hypotheses, identify necessary information/knowledge for solving the problem and make reasonable judgments about solving the problem.
• The goals of PBL are to help the students develop flexible knowledge, effective problem solving skills, self-directed learning, effective collaboration skills and intrinsic motivation.
• In the workplace, employers use team-based learning to teach and develop their employees.

Key Terms

critical thinking

The application of logical principles, rigorous standards of evidence, and careful reasoning to the analysis and discussion of claims, beliefs, and issues.

self-directed

Directed independently by oneself without external control or constraint.

workshop

A brief intensive course of education for a small group; emphasizes interaction and practical problem solving

Problem-based learning (PBL) is a student-centered pedagogy in which students learn about a subject in the context of complex, multifaceted, and realistic problems. The goals of PBL are to help the students develop flexible knowledge, effective problem solving skills, self-directed learning, effective collaboration skills, and intrinsic motivation. Working in groups, students identify what they already know, what they need to know, and how and where to access new information that can lead to resolution of the problem. In PBL, students are encouraged to take responsibility for their group and organize and direct the learning process with support from a tutor or instructor. The role of the instructor is to provide appropriate scaffolding and support for the process, modelling of the process, and monitoring the learning. The tutor must build the students’ confidence to take on the problem and encourage them, while also stretching their understanding.

The six core characteristics of PBL are as follows:

• PBL consists of student-centered learning.
• Learning occurs in small groups.
• Teachers act as facilitators or tutors.
• A problem forms the basis for organized focus and stimulus for learning.
• Problems stimulate the development and use of problem solving skills.
• New knowledge is obtained through means of self-directed learning.

Advocates of PBL claim it can be used to enhance content knowledge while simultaneously fostering the development of communication, problem-solving, critical thinking, collaboration, and self-directed learning skills.

PBL may position students in a simulated real-world working and professional context that involves policy, process, and ethical problems that will need to be understood and resolved to some outcome. By working through a combination of learning strategies to discover the nature of a problem, understanding the constraints and options to its resolution, defining the input variables, and understanding the viewpoints involved, students learn to negotiate the complex sociological nature of the problem and how competing resolutions may inform decision making.

Current Issues

Accountants must stay up to date with current issues in reporting and disclosure.

PBL can also promote the development of critical thinking skills. In PBL learning, students learn how to analyze a problem, identify relevant facts, generate hypotheses, identify necessary information/knowledge for solving the problem, and make reasonable judgments about solving the problem.

Principles

• Problem-based learning: Use problems encountered in the course of work as the context for learning.
• Point of the Wedge: Push responsibility combined with support to the most junior person possible
• Teach, Don’t Tell: Use inquiry (i.e., Socratic Method) to teach rather than just giving the answer or solving the issue
• Owning the Client or Project: Individuals have a heightened sense of accountability and motivation because they have their own client or project with support from more experienced team members

Routines

• Rounds: Meetings where a less-experienced team member presents an issue or challenge and recommends a course of action.
• Team Workshops: A team member leads a developmental event for other members focusing on a specific technical or service topic.
• Shadowing: Less-experienced team members accompany a more experienced member to a meeting that he or she would not normally attend.
• Observation and Feedback: A specific activity is observed, and coaching is given using the Socratic Method.
• Lessons Learned Forum: A thorough review and discussion using mistakes and successes as a situation to learn from. This is similar to an After Action Review.

Making It Work

The mission of a teaching hospital is to develop doctors. While businesses earnestly espouse a desire to develop their people, such activities are too often seen as separate from work and something that interferes with getting work done. Businesses are not as motivated as teaching hospitals to develop people on the job. For that reason, the transfer of approaches used in teaching hospitals to a business context might have failed if not for the fact that the new processes create side benefits that motivate the business team members.

1.5.2: Business Cases and Examples

The teaching approach of presenting students with a case and putting them in the role of a decision maker is known as the case method.

Learning Objective

Identify how case studies can lead students to a deeper understanding of business topics

Key Points

• The case method is similar to the case study method, but the two teaching approaches are not identical.
• The length of a business case study may range from two or three pages to thirty pages or more.
• Typically, information is presented about a business firm’s products, markets, competition, financial structure, sales volumes, management, employees, and other factors affecting the firm’s success.
• Students are expected to scrutinize the case study and prepare to discuss strategies and tactics that the firm should employ in the future.

Key Terms

dilemma

A circumstance in which a choice must be made between two or more alternatives that seem equally undesirable.

case method

A teaching approach that consists of presenting the students with a case, and putting them in the role of a decision-maker facing a problem.

case study

An intensive analysis of an individual unit (e.g., a person, group, or event) stressing developmental factors in relation to context; also called a case report.

Case Method

The case method is a teaching approach that presents the students with a case and puts them in the role of a decision maker facing a problem (Hammond 1976). The case method overlaps with the case study method, but the two are not identical. “Case studies recount real life business or management situations that present business executives with a dilemma or uncertain outcome. The case describes the scenario in the context of the events, people and factors that influence it and enables students to identify closely with those involved. ” — European Case Clearing House, Case studies. “

Business Case Discussion

A lot can be learned from the contents of a business case.

Typically, information is presented about a business firm’s products, markets, competition, financial structure, sales volumes, management, employees, and other factors affecting the firm’s success. The length of a business case study can range from two or three pages to 30 pages or more.

Business schools often obtain case studies published by the Harvard Business School, INSEAD, the Ross School of Business at the University of Michigan, the Richard Ivey School of Business at the University of Western Ontario, the Darden School at the University of Virginia, IESE, other academic institutions, or case clearing houses (such as European Case Clearing House). Harvard’s most popular case studies include Lincoln Electric Co. and Google, Inc.

Students are expected to scrutinize the case study and prepare to discuss strategies and tactics that the firm should employ in the future. Three different methods have been used in business case teaching:

• Prepared case-specific questions to be answered by the student. This is used with short cases intended for undergraduate students. The underlying concept is that such students need specific guidance to be able to analyze case studies.
• Problem-solving analysis. This method, initiated by the Harvard Business School is by far the most widely used method in MBA and executive development programs. The underlying concept is that with enough practice (that is, hundreds of case analyses) students develop intuitive skills for analyzing and resolving complex business situations. Successful implementation of this method depends heavily on the skills of the discussion leader.
• A generally applicable strategic planning approach. This third method does not require students to analyze hundreds of cases. A strategic planning model is provided, and students are instructed to apply the steps of the model to between six and twelve cases during a semester. This is sufficient to develop their ability to analyze a complex situation, generate a variety of possible strategies, and select the best ones. In effect, students learn a generally applicable approach to analyzing cases studies and real situations. This approach does not make any extraordinary demands on the artistic and dramatic talents of the teacher. Consequently, most professors are capable of supervising application of this method.

History of Business Cases

When Harvard Business School was founded, the faculty realized that there were no textbooks suitable to a graduate program in business. Their first solution to this problem was to interview leading practitioners of business and to write detailed accounts of what these managers were doing. Of course, the professors could not present these cases as practices to be emulated because there were no criteria available for determining what would succeed and what would not succeed. So the professors instructed their students to read the cases and to come to class prepared to discuss the cases and to offer recommendations for appropriate courses of action. The basic outlines of this method are still present in business school curricula today.

1.5.3: Application of Knowledge

A business game (also called business simulation game) refers to a simulation game that is used as an educational tool for teaching business.

Learning Objective

Justify the use of business simulation games in the process of applying business knowledge

Key Points

• Business games may be carried out for various business training such as general management, finance, organizational behavior, and human resources.
• In business simulation games, players receive a description of an imaginary business and an imaginary environment and make decisions (on price, advertising, production targets, and so on) about how their company should be run.
• There are several important steps to a business game, including: the theoretical instruction; the introduction to the game, where the participants are told how to operate the computer; and debriefing, which is the most important part of the simulation and gaming experience.

Key Terms

debriefing

The report of a mission or project, or the information so obtained.

distribution

The process by which goods get to final consumers over a geographical market, including storing, selling, shipping, and advertising.

simulation

Something which simulates a system or environment in order to predict actual behavior.

Examples

• The Beer Distribution Game is a simulation game created by a group of professors at MIT Sloan School of Management in early 1960s to demonstrate a number of key principles of supply chain management. The game is played by teams of at least four players, often in heated competition, and takes from one to one and a half hours to complete. A debriefing session of roughly equivalent length typically follows to review the results of each team and discuss the lessons involved.
• The purpose of the game is to understand the distribution side dynamics of a multi-echelon supply chain used to distribute a single item, in this case, cases of beer. The aim is to meet customer demand for cases of beer through the distribution side of a multi-stage supply chain with minimal expenditure on back orders and inventory. Players can see each other’s inventory but only one player sees actual customer demand. Verbal communication between players is against the rules so feelings of confusion and disappointment are common. Players look to one another within their supply chain frantically trying to figure out where things are going wrong. Most of the players feel frustrated because they are not getting the results they want. Players wonder whether someone in their team did not understand the game or assume customer demand is following a very erratic pattern as backlogs mount and/or massive inventories accumulate. During the debriefing, it is explained that these feelings are common and that reactions based on these feelings within supply chains create the bullwhip effect.
• For a complete understanding, the game is played not only within a supply chain, but two or three supply chains are set up (when there are enough players and volunteers to help). In real life, more than the understanding one gets by playing as different entities in a single supply chain, it is the learning when supply chains compete with each other that the real strategic intent is made clear. The team or supply chain which turns up with the least total costs when played over 12-15 cycles is the winner.

Applying Knowledge Through Games

Business games (also called business simulation games) refer to simulation games that are used as an educational tool for teaching business. Business games may be carried out for various business trainings such as general management, finance, organizational behavior, and human resources. Often the term business simulation is used with the same meaning.

Business Game

Business game (also called business simulation game) refers to simulation games that are used as an educational tool for teaching business.

An exterior view of a street business called GAME.

Business strategy games are intended to enhance the decision-making skills of students, especially under conditions defined by limited time and information. They vary in focus from how to undertake a corporate takeover to how to expand a company’s share of the market. Typically, the player feeds information into a computer program and receives back a series of optional or additional data that are conditional upon the player’s initial choices. The game proceeds through several series of these interactive, iterative steps. As can be noted, this definition does not consider continuous (real-time) processing an alternative.

In business simulation games, players receive a description of an imaginary business and an imaginary environment and make decisions – on price, advertising, production targets, and so on – about how their company should be run. A business game may have an industrial, commercial or financial background (Elgood, 1996). Ju and Wagner mention that the nature of business games can include decision-making tasks, which pit the player against a hostile environment or hostile opponents. These simulations have a nature of strategy or war games, but usually are very terse in their user interface. Other types of managerial simulations are resource allocation games, in which the player or players have to allocate resources to areas such as plant, production, marketing, and human resources, in order to produce and sell goods.

The Simulation Gaming Process

Business simulation game developers regard their artefacts to be learning environments. When arguing for this, they most often refer to David A. Kolb’s influential work in the field of experiential learning. During the last decades, ideas from constructivism have influenced the learning discussion within the simulation gaming field. The activities carried out during a simulation game training session are:

• Theoretical instruction: The teacher goes through certain relevant aspects of a theory and participants can intervene with questions and comments.
• Introduction to the game: The participants are told how to operate the computer and how to play the game.
• Playing the game: Participants get the opportunity to practice their knowledge and skills by changing different parameters of the game and reflecting on the possible consequences of these changes. Permanent contact with the participants is advisable, as well as keeping the training going to maintain a positive atmosphere and to secure that the participants feel engaged.
• Group discussions: Each of the participants is given a possibility to present and compare their results from the game with the results of others. The participants are encouraged to present their results to others. The teacher should continually look for new ways of enriching the discussions and to help the participants find the connection between the game results and the problems in the real world. The quality of this group discussion plays a relevant role in the training as it will affect the participants’ transfer of knowledge and skills into the real world.

The last phase in the list above is usually called debriefing. Debriefing is the most important part of the simulation and gaming experience. We all learn from experience, but without reflecting on this experience the learning potential may be lost. Simulation gaming needs to be seen as contrived experiences in the learning cycle, which require special attention at the stages of reflection and generalization.

16.3: Ratio Analysis Overview

16.3.1: Classification

Learning Objective

Classify a financial ratio based on what it measures in a company

Key Points

• Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis.
• A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements.
• The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one method an investor can use to gain that understanding.

Key Terms

liquidity

Availability of cash over short term: ability to service short-term debt.

ratio

A number representing a comparison between two things.

ratio analysis

the use of quantitative techniques on values taken from an enterprise’s financial statements

shareholder

One who owns shares of stock.

Classification

Financial statements are generally insufficient to provide information to investors on their own; the numbers contained in those documents need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one of three methods an investor can use to gain that understanding.

Business analysis and profitability

Financial ratio analysis allows an observer to put the data provided by a company in context. This allows the observer to gauge the strength of different aspects of the company’s operations.

Financial statement analysis is the process of understanding the risk and profitability of a firm through analysis of reported financial information. Ratio analysis is a foundation for evaluating and pricing credit risk and for doing fundamental company valuation. A financial ratio, or accounting ratio, is derived from a company’s financial statements and is a calculation showing the relative magnitude of selected numerical values taken from those financial statements.

There are various types of financial ratios, grouped by their relevance to different aspects of a company’s business as well as to their interest to different audiences. Financial ratios may be used internally by managers within a firm, by current and potential shareholders and creditors of a firm, and other audiences interested in understanding the strengths and weaknesses of a company, especially compared to the company over time or compared to other companies.

Types of Ratios

Most analysts think of financial ratios as consisting of five basic types:

• Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
• Liquidity ratios measure the availability of cash to pay debt.
• Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s use of resources, or assets.
• Debt, or leverage, ratios measure the firm’s ability to repay long-term debt.
• Market ratios are concerned with shareholder audiences. They measure the cost of issuing stock and the relationship between return and the value of an investment in company’s shares.

16.4: Using Financial Ratios for Analysis

16.4.1: Limitations of Financial Statement Analysis

Financial statement analyses can yield a limited view of a company because of accounting, market, and management related limitations of such analyses.

Learning Objective

Describe the limitations associated with using ratio analysis

Key Points

• Ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios.
• Proponents of the stronger forms of the efficient-market hypothesis, technical analysts, and behavioral economists argue that fundamental analysis is limited as a stock valuation tool, all for their own distinct reasons.
• Ratio analysis can also omit important aspects of a firm’s success, such as key intangibles, like brand, relationships, skills and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.
• Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers that may not provide adequate context or be comparable across time or industry.

Key Term

valuation

The process of estimating the market value of a financial asset or liability.

Limitations of Financial Statement Analysis

Ratio analysis using financial statements includes accounting, stock market, and management related limitations. These limits leave analysts with remaining questions about the company.

First of all, ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios. While accounting measures may have more external standards and oversights than many other ways of benchmarking companies, this is still a limit.

Ratio analysis using financial statements as a tool for performing stock valuation can be limited as well. The efficient-market hypothesis (EMH), for example, asserts that financial markets are “informationally efficient. ” In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. While the weak form of this hypothesis argues that there can be a long run benefit to information derived from fundamental analysis, stronger forms argue that fundamental analysis like ratio analysis will not allow for greater financial returns.

In another view on stock markets, technical analysts argue that sentiment is as much if not more of a driver of stock prices than is the fundamental data on a company like its financials. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These audiences also see limits to ratio analysis as a predictor of stock market returns.

At the management and investor level, ratio analysis using financial statements can also leave out a number of important aspects of a firm’s success, such as key intangibles, like brand, relationships, skills, and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.

Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers. Also, changes in the information underlying ratios can hamper comparisons across time and inconsistencies within and across the industry can also complicate comparisons.

16.4.2: Trend Analysis

Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events.

Learning Objective

Analyze the benefits and challenges of using trend analysis to evaluate a company

Key Points

• Trend analysis is the practice of collecting information and attempting to spot a pattern or trend in the same metric historically, either by examining it in tables or charts. Often this trend analysis is used to predict or inform decisions around future events.
• Trend analysis can be performed in different ways in finance. Fundamental analysis relies on historical financial statement analysis, often in the form of ratio analysis.
• Trend analysis using financial ratios can be complicated by changes to companies and accounting over time. For example, a company may change its business model and begin to operate in a new industry or it may change the end of its financial year or the way it accounts for inventories.

Key Terms

sentiment

A general thought, feeling, or sense.

forecast

An estimation of a future condition.

In addition to using financial ratio analysis to compare one company with others in its peer group, ratio analysis is often used to compare the company’s performance on certain measures over time. Trend analysis is the practice of collecting information and attempting to spot a pattern, or trend, in the information. This often involves comparing the same metric historically, either by examining it in tables or charts. Often this trend analysis is used to forecast or inform decisions around future events, but it can be used to estimate uncertain events in the past .

Trend Analysis

Determining the popularity and demand for specific subject over time through trend analysis.

Trend analysis can be performed in different ways in finance. For example, in technical analysis the direction of prices of a particular company’s public stock is calculated through the study of past market data, primarily price, and volume. Fundamental analysis, on the other hand, relies not on sentiment measures (like technical analysis) but on financial statement analysis, often in the form of ratio analysis. Creditors and company managers also use ratio analysis as a form of trend analysis. For example, they may examine trends in liquidity or profitability over time.

Trend analysis using financial ratios can be complicated by the fact that companies and accounting can change over time. For example, a company may change its business model so that it begins to operate in a new industry or it may change the end of its financial year or the way it accounts for inventories. When examining historical trends in ratios, analysts will often make adjustments to the ratios for these reasons, perhaps performing some ratio analysis in which they segment out business segments that are not consistent over time or they separate recurring from non-recurring items.

16.4.3: Benchmarking

Comparing the financial ratios of a company to those of the top performer in its class is a type of benchmarking.

Learning Objective

Describe how benchmarking can be used to assess the strength of a company

Key Points

• Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one’s business to that of relevant others or of the same company at a different point in time processes on a specific indicator or series of indicators.
• Benchmarking can be done in many ways and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data.
• Benchmarking using ratio analysis can be useful to various audiences; for example, investors and managers interested in incorporate quantitative comparisons of a company to peers.

Key Terms

benchmark

A standard by which something is evaluated or measured.

ratio

A number representing a comparison between two things.

Benchmarking

Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one’s business to that of others or of the same company at a different point in time. In many cases, benchmarking involves comparisons of one company to the best companies in a comparable peer group or the average in that peer group or industry. In the process of benchmarking, an analyst or manager identifies the best firms in their industry, or in another industry where similar processes exist, and compares the results and processes of those studied to one’s own results and processes on a specific indicator or series of indicators.

Benchmarking Measures Performance

Results are the paramount concern to a transactional leader.

Benchmarking can be done in many ways, and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data. In benchmarking as a whole, benchmarking can be done on a variety of processes, meaning that definitions may change over time within the same organization due to changes in leadership and priorities. The most useful comparisons can be made when metrics definitions are common and consistent between compared units and over time.

Benchmarking using ratio analysis can be useful to various audiences. From an investor perspective, benchmarking can involve comparing a company to peer companies that can be considered alternative investment opportunities from the perspective of an investor. In this process, the investor may compare the focus company to others in the peer group (leaders, averages) on certain financial ratios relevant to those companies and the investor’s investment style. From a management perspective, benchmarking using ratio analysis may be a way for a manager to compare their company to peers using externally recognizable, quantitative data.

16.4.4: Industry Comparisons

While ratio analysis can be quite helpful in comparing companies within an industry, cross-industry comparisons should be done with caution.

Learning Objective

Describe how valuation methodologies are used to compare different companies in different sectors

Key Points

• One of the advantages of ratio analysis is that it allows comparison across companies. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, cross-industry comparisons may not be helpful and should be done with caution.
• An industry represents a classification of companies by economic activity, but “industry” can be too broad or narrow a definition for ratio analysis comparison. When comparing ratios, companies should be comparable in terms of having similar characteristics in the statistics being analyzed.
• Valuation using multiples only reveals patterns in relative values. For multiples to be useful, the statistic involved must bear a logical, meaningful relationship to the market value observed, which is something that can vary across industry.

Key Terms

metric

A measure for something; a means of deriving a quantitative measurement or approximation for otherwise qualitative phenomena.

valuation

The process of estimating the market value of a financial asset or liability.

One of the advantages of ratio analysis is that it allows comparison across companies, an activity which is often called benchmarking. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, comparing ratios of companies across different industries may not be helpful and should be done with caution .

Industry

Comparing ratios of companies within an industry can allow an analyst to make like to like (apples to apples) comparisons. Comparisons across industries may be like to unlike (apples to oranges) comparisons, and thus less useful.

An industry represents a classification of companies by economic activity. At a very broad level, industry is sometimes classified into three sectors: primary or extractive, secondary or manufacturing, and tertiary or services. At a very detailed level are classification systems like the ISIC (International Standard Industrial Classification).

However, in terms of ratio analysis and comparing companies, it is most helpful to consider whether the companies being compared are comparable in the financial metrics being evaluated in the ratios. Different businesses will have different ratios for different reasons. A peer group is a set of companies or assets which are selected as being sufficiently comparable to the company or assets being valued (usually by virtue of being in the same industry or by having similar characteristics in terms of earnings growth and return on investment). From the investor perspective, peers can include companies that are not only direct product competitors but are subject to similar cycles, suppliers, and other external factors.

Valuation using multiples involves estimating the value of an asset by comparing it to the values assessed by the market for similar or comparable assets in the peer group. A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – whether earnings, cash flow, or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value. The price to earnings ratio, for example, is a common multiple but can differ across companies that have different capital structures; this could make it difficult to compare this particular ratio across industries.

Additionally, there could be problems with the valuation of an entire industry, making ratio analysis of a company relative to an industry less useful. The use of multiples only reveals patterns in relative values, not absolute values such as those obtained from discounted cash flow valuations. If the peer group as a whole is incorrectly valued (such as may happen during a stock market “bubble”), then the resulting multiples will also be misvalued.

16.4.5: Evaluating Financial Statements

With a few exceptions, the majority of the data used in ratio analysis comes from evaluation of the financial statements.

Learning Objective

Differentiate between recurring and non-recurring items in financial reports

Key Points

• Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used for comparison. With a few exceptions, the majority of the data used in ratio analysis comes from the financial statements.
• Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies.
• In terms of reformulation, earnings might be separated into recurring and non-recurring items. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

Key Terms

valuation

The process of estimating the market value of a financial asset or liability.

earnings management

A euphemism, such as creative accounting, to refer to fraudulent accounting practices that manipulate reporting of income, assets or liabilities with the intent to influence interpretations of the income statements.

Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used as ratios for comparison over time or across companies. Financial statements are used as a way to discover the financial position and financial results of a business. With a few exceptions, such as ratios involving stock price, the majority of the data used in ratio analysis comes from the financial statements. Ratios put this financial statement information in context.

Putting Numbers in Order

Evaluating financial statements involves getting the numbers in order and then using these figures to perform ratio analysis.

Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies. In terms of reformulation, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items. In this way, earnings could be separated into normal or core earnings and transitory earnings with the idea that normal earnings are more permanent and hence more relevant for prediction and valuation. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

The evaluation of a company’s financial statement analysis is a form of fundamental analysis that is bottoms up. While analysis of a company’s prospects can include a number of factors, including understanding the economic situation or the industry or sentiment about the company or its products, ratio analysis of a company relies on the specific company financials.

16.4.6: Selected Financial Ratios and Analyses

Financial ratios and their analysis provide information on a firm’s profitability and allow comparisons between the firm and its industry.

Learning Objective

Summarize how an interested party would use financial ratios to analyze a company’s financial statement

Key Points

• When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals from one period to the next or for the timeframe presented is referred to as horizontal analysis.
• Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.
• Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company’s financial statements. Ratios can identify various financial attributes, such as solvency and liquidity, profitability, and return on equity.
• An example of a financial ratio is the current ratio, used to determine a company’s liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other.
• Often a financial ratio, which is a relative magnitude of two selected numerical values taken from a company’s financial statements is used to find out a specific piece of information such as the quality of income.

Key Terms

solvency

The state of having enough funds or liquid assets to pay all of one’s debts; the state of being solvent.

comparative

Comparable; bearing comparison.

trend

an inclination in a particular direction

Analyzing the Financial Statements

Analyzing a company’s financial statements allows interested parties (investors, creditors and company management) to get an overall picture of the financial condition and profitability of a company. There are several ways to analyze a company’s financial statements.

Horizontal vs. Vertical Analysis

Two main methods for analysis are horizontal and vertical analysis. When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals over time is horizontal analysis. This analysis detects changes in a company’s performance and highlights trends.

Vertical analysis is usually performed on a single financial statement (i.e., income statement): each item is expressed as a percentage of a significant total. Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

Using Ratios

Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company’s financial statements. Ratios can identify various financial attributes of a company, such as solvency and liquidity, profitability (quality of income), and return on equity. A company’s financial ratios can also be compared to those of their competitors to determine how the company is performing in relation to the rest of the industry.

Financial ratios may be used by managers within a firm, by current and potential shareholders (owners), and by a firm’s creditors. For example, financial analysts compute financial ratios of public companies to evaluate their strengths and weaknesses and to identify which companies are profitable investments and which are not. Changes in financial ratios can impact a public company’s stock price, depending on the effect the change has on the business. A publicly traded company’s stock price can also be a variable used in the computation of certain ratios, such as the price/earnings ratio.

Examples of Ratios

The following are some examples of financial ratios that are used to analyze a company. For example, the quality of income ratio is computed by dividing cash flow from operating activities (CFOA) by net income:

Quality of income = CFOA / Net income

This ratio indicates the proportion of income that has been realized in cash. As with quality of sales, high levels for this ratio are desirable. The quality of income ratio has a tendency to exceed 100% because depreciation expense decreases net income and cash outflows to replace operating assets (part of cash flow from investing activities) is not subtracted when calculating the numerator.

Capital

Acquisition Ratio = (cash flow from operations – dividends) / cash paid for acquisitions.

The capital acquisition ratio reflects the company’s ability to finance capital expenditures from internal sources. A ratio of less than 1:1 (100 %) indicates that capital acquisitions are draining more cash from the business than they are generating revenues.

Current Ratio = Current Assets/Current

Liabilities

The current ratio is used to determine a company’s liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other. However, it is important to note that determination of a company’s solvency is based on various factors and not just the value of the current ratio.

16.5: Liquidity Ratios

16.5.1: Current Ratio

Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Learning Objective

Use a company’s current ratio to evaluate its short-term financial strength

Key Points

• The liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
• The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.

Key Terms

working capital management

Decisions relating to working capital and short term financing are referred to as working capital management [19]. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities.

current ratio

current assets divided by current liabilities

Liquidity Ratio

Liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means it is fully covered .

Liquidity

High liquidity means a company has the ability to meet its short-term obligations.

Liquidity ratio may refer to:

• Reserve requirement – a bank regulation that sets the minimum reserves each bank must hold.
• Acid Test – a ratio used to determine the liquidity of a business entity.

The formula is the following:

LR = liquid assets / short-term liabilities

Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. It is expressed as follows:

Current ratio = current assets / current liabilities

• Current asset is an asset on the balance sheet that can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash, cash equivalents, short-term investments, accounts receivable, inventory, and the portion of prepaid liabilities that will be paid within a year.
• Current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

The current ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management. In such a situation, firms should consider investing excess capital into middle and long term objectives.

Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, low values do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable do, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

If all other things were equal, a creditor, who is expecting to be paid in the next 12 months, would consider a high current ratio to be better than a low current ratio. A high current ratio means that the company is more likely to meet its liabilities which fall due in the next 12 months.

16.5.2: Quick Ratio (Acid-Test Ratio)

The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.

Learning Objective

Calculate a company’s quick ratio

Key Points

• Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.
• Acid Test Ratio = (Current assets – Inventory) / Current liabilities.
• Ideally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. In general, the higher the ratio, the greater the company’s liquidity.

Key Term

Treasury bills

Treasury bills (or T-Bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.

Quick ratio

In finance, the Acid-test (also known as quick ratio or liquid ratio) measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than 1 cannot pay back its current liabilities.

Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence. They mature within 3 months, whereas short-term investments are 12 months or less and long-term investments are any investments that mature in excess of 12 months. Another important condition that cash equivalents need to satisfy, is the investment should have insignificant risk of change in value. Thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.

Cash

Cash is the most liquid asset in a business.

Acid test ratio

Acid test often refers to Cash ratio instead of Quick ratio: Acid Test Ratio = (Current assets – Inventory) / Current liabilities.

Note that Inventory is excluded from the sum of assets in the Quick Ratio, but included in the Current Ratio. Ratios are tests of viability for business entities but do not give a complete picture of the business’ health. A business with large Accounts Receivable that won’t be paid for a long period (say 120 days), and essential business expenses and Accounts Payable that are due immediately, the Quick Ratio may look healthy when the business could actually run out of cash. In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy.

The acid test ratio should be 1:1 or higher, however this varies widely by industry. The higher the ratio, the greater the company’s liquidity will be (better able to meet current obligations using liquid assets).

16.6: Debt-Management Ratios

16.6.1: Times-Interest-Earned Ratio

Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company’s ability to honor its debt payments.

Learning Objective

Use a company’s index coverage ratio to evaluate its ability to meet its debt obligations

Key Points

• Times interest earned (TIE) or Interest Coverage ratio is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.
• Interest Charges = Traditionally “charges” refers to interest expense found on the income statement.
• EBIT = Revenue – Operating expenses (OPEX) + Non-operating income.
• EBITDA = Earnings before interest, taxes, depreciation and amortization.
• Times Interest Earned or Interest Coverage is a great tool when measuring a company’s ability to meet its debt obligations.

Key Term

Non-operating income

Non-operating income, in accounting and finance, is gains or losses from sources not related to the typical activities of the business or organization. Non-operating income can include gains or losses from investments, property or asset sales, currency exchange, and other atypical gains or losses.

Times interest earned (TIE), or interest coverage ratio, is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA, divided by the total interest payable.

Times-Interest-Earned = EBIT or EBITDA / Interest charges

Interest

Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

Times-Interest-Earned = EBIT or EBITDA / Interest charges

• Interest Charges = Traditionally “charges” refers to interest expense found on the income statement.
• EBIT = Earnings Before Interest and Taxes, also called operating profit or operating income. EBIT is a measure of a firm’s profit that excludes interest and income tax expenses. It is the difference between operating revenues and operating expenses. When a firm does not have non-operating income, then operating income is sometimes used as a synonym for EBIT and operating profit.
• EBIT = Revenue – Operating Expenses (OPEX) + Non-operating income.
• Operating income = Revenue – Operating expenses.
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization. The EBITDA of a company provides insight on the operational profitability of the business. It shows the profitability of a company regarding its present assets and operations with the products it produces and sells, taking into account possible provisions that need to be done.

If EBITDA is negative, then the business has serious issues. A positive EBITDA, however, does not automatically imply that the business generates cash. EBITDA ignores changes in Working Capital (usually needed when growing a business), capital expenditures (needed to replace assets that have broken down), taxes, and interest.

Times Interest Earned or Interest Coverage is a great tool when measuring a company’s ability to meet its debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations. The Company would then have to either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when interest coverage falls below 2.5x.

16.6.2: Total Debt to Total Assets

The debt ratio is expressed as Total debt / Total assets.

Learning Objective

Use a company’s debt ratio to evaluate its financial strength

Key Points

• The debt ratio measures the firm’s ability to repay long-term debt by indicating the percentage of a company’s assets that are provided via debt.
• Debt ratio = Total debt / Total assets.
• The higher the ratio, the greater risk will be associated with the firm’s operation.

Key Terms

goodwill

Goodwill is an accounting concept meaning the value of an asset owned that is intangible but has a quantifiable “prudent value” in a business for example a reputation the firm enjoyed with its clients.

debt to total assets ratio

after tax income divided by liabilities

Example

• For example, a company with 2 million in total assets and 500,000 in total liabilities would have a debt ratio of 25%.

Financial Ratios

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures.

Financial ratios allow for comparisons:

• Between companies
• Between industries
• Between different time periods for one company
• Between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.

Debt ratios

Debt

Debt ratio is an index of a business operation.

Debt ratios measure the firm’s ability to repay long-term debt. It is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. It is the ratio of total debt (the sum of current liabilities and long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as ‘goodwill’).

• Debt ratio = Total debt / Total assets

Or alternatively:

• Debt ratio = Total liability / Total assets

The higher the ratio, the greater risk will be associated with the firm’s operation. In addition, high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm’s financial flexibility. Like all financial ratios, a company’s debt ratio should be compared with their industry average or other competing firms.

Total liabilities divided by total assets. The debt/asset ratio shows the proportion of a company’s assets which are financed through debt. If the ratio is less than 0.5, most of the company’s assets are financed through equity. If the ratio is greater than 0.5, most of the company’s assets are financed through debt. Companies with high debt/asset ratios are said to be “highly leveraged,” not highly liquid as stated above. A company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand repayment of debt.

16.7: Profitability Ratios

16.7.1: Basic Earning Power (BEP) Ratio

The Basic Earning Power ratio (BEP) is Earnings Before Interest and Taxes (EBIT) divided by Total Assets.

Learning Objective

Calculate a company’s Basic Earning Power ratio

Key Points

• The higher the BEP ratio, the more effective a company is at generating income from its assets.
• Using EBIT instead of operating income means that the ratio considers all income earned by the company, not just income from operating activity. This gives a more complete picture of how the company makes money.
• BEP is useful for comparing firms with different tax situations and different degrees of financial leverage.

Key Terms

EBIT

Earnings before interest and taxes. A measure of a business’s profitability.

Return on Assets

A measure of a company’s profitability. Calculated by dividing the net income for an accounting period by the average of the total assets the business held during that same period.

BEP Ratio

Another profitability ratio is the Basic Earning Power ratio (BEP). The purpose of BEP is to determine how effectively a firm uses its assets to generate income.

The BEP ratio is simply EBIT divided by total assets . The higher the BEP ratio, the more effective a company is at generating income from its assets.

Basic Earnings Power Ratio

BEP is calculated as the ratio of Earnings Before Interest and Taxes to Total Assets.

This may seem remarkably similar to the return on assets ratio (ROA), which is operating income divided by total assets. EBIT, or earnings before interest and taxes, is a measure of how much money a company makes, but is not necessarily the same as operating income:

EBIT = Revenue – Operating expenses+

Non-operating

income

Operating income = Revenue – Operating expenses

The distinction between EBIT and Operating Income is non-operating income. Since EBIT includes non-operating income (such as dividends paid on the stock a company holds of another), it is a more inclusive way to measure the actual income of a company. However, in most cases, EBIT is relatively close to Operating Income.

The advantage of using EBIT, and thus BEP, is that it allows for more accurate comparisons of companies. BEP disregards different tax situations and degrees of financial leverage while still providing an idea of how good a company is at using its assets to generate income.

BEP, like all profitability ratios, does not provide a complete picture of which company is better or more attractive to investors. Investors should favor a company with a higher BEP over a company with a lower BEP because that means it extracts more value from its assets, but they still need to consider how things like leverage and tax rates affect the company.

16.7.2: Return on Common Equity

Return on equity (ROE) measures how effective a company is at using its equity to generate income and is calculated by dividing net profit by total equity.

Learning Objective

Calculate the Return on Equity (ROE) for a business

Key Points

• ROE is net income divided by total shareholders’ equity.
• ROE is also the product of return on assets (ROA) and financial leverage.
• ROE shows how well a company uses investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE is better.

Key Term

equity

Ownership, especially in terms of net monetary value, of a business.

Return on Equity

Return on equity (ROE) is a financial ratio that measures how good a company is at generating profit.

ROE is the ratio of net income to equity. From the fundamental equation of accounting, we know that equity equals net assets minus net liabilities. Equity is the amount of ownership interest in the company, and is commonly referred to as shareholders’ equity, shareholders’ funds, or shareholders’ capital.

In essence, ROE measures how efficient the company is at generating profits from the funds invested in it. A company with a high ROE does a good job of turning the capital invested in it into profit, and a company with a low ROE does a bad job. However, like many of the other ratios, there is no standard way to define a good ROE or a bad ROE. Higher ratios are better, but what counts as “good” varies by company, industry, and economic environment.

ROE can also be broken down into other components for easier use. ROE is the product of the net margin (profit margin), asset turnover, and financial leverage. Also note that the product of net margin and asset turnover is return on assets, so ROE is ROA times financial leverage.

Return on Equity

The return on equity is a ratio of net income to equity. It is a measure of how effective the equity is at generating income.

Breaking ROE into parts allows us to understand how and why it changes over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm’s capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm’s ROE only if the matching return on assets (ROA) of that debt exceeds the interest rate on the debt.

16.7.3: Return on Total Assets

The return on assets ratio (ROA) measures how effectively assets are being used for generating profit.

Learning Objective

Calculate a company’s return on assets

Key Points

• ROA is net income divided by total assets.
• The ROA is the product of two common ratios: profit margin and asset turnover.
• A higher ROA is better, but there is no metric for a good or bad ROA. An ROA depends on the company, the industry and the economic environment.
• ROA is based on the book value of assets, which can be starkly different from the market value of assets.

Key Terms

net income

Gross profit minus operating expenses and taxes.

asset

Something or someone of any value; any portion of one’s property or effects so considered.

Return
on Assets

The return on assets ratio (ROA) is found by dividing net income by total assets. The higher the ratio, the better the company is at using their assets to generate income. ROA was developed by DuPont to show how effectively assets are being used. It is also a measure of how much the company relies on assets to generate profit.

Return on Assets

The return on assets ratio is net income divided by total assets. That can then be broken down into the product of profit margins and asset turnover.

Components of ROA

ROA can be broken down into multiple parts. The ROA is the product of two other common ratios – profit margin and asset turnover. When profit margin and asset turnover are multiplied together, the denominator of profit margin and the numerator of asset turnover cancel each other out, returning us to the original ratio of net income to total assets.

Profit margin is net income divided by sales, measuring the percent of each dollar in sales that is profit for the company. Asset turnover is sales divided by total assets. This ratio measures how much each dollar in asset generates in sales. A higher ratio means that each dollar in assets produces more for the company.

Limits of ROA

ROA does have some drawbacks. First, it gives no indication of how the assets were financed. A company could have a high ROA, but still be in financial straits because all the assets were paid for through leveraging. Second, the total assets are based on the carrying value of the assets, not the market value. If there is a large discrepancy between the carrying and market value of the assets, the ratio could provide misleading numbers. Finally, there is no metric to find a good or bad ROA. Companies that operate in capital intensive industries will tend to have lower ROAs than those who do not. The ROA is entirely contextual to the company, the industry and the economic environment.

16.7.4: Profit Margin

Profit margin measures the amount of profit a company earns from its sales and is calculated by dividing profit (gross or net) by sales.

Learning Objective

Calculate a company’s net and gross profit margin

Key Points

• Profit margin is the profit divided by revenue.
• There are two types of profit margin: gross profit margin and net profit margin.
• A higher profit margin is better for the company, but there may be strategic decisions made to lower the profit margin or to even have it be negative.

Key Terms

gross profit

The difference between net sales and the cost of goods sold.

net profit

The gross revenue minus all expenses.

Profit Margin

Profit margin is one of the most used profitability ratios. Profit margin refers to the amount of profit that a company earns through sales.

The profit margin ratio is broadly the ratio of profit to total sales times 100%. The higher the profit margin, the more profit a company earns on each sale.

Since there are two types of profit (gross and net), there are two types of profit margin calculations. Recall that gross profit is simply the revenue minus the cost of goods sold (COGS). Net profit is the gross profit minus all other expenses. The gross profit margin calculation uses gross profit and the net profit margin calculation uses net profit . The difference between the two is that the gross profit margin shows the relationship between revenue and COGS, while the net profit margin shows the percentage of the money spent by customers that is turned into profit.

Net Profit Margin

The percentage of net profit (gross profit minus all other expenses) earned on a company’s sales.

Gross Profit Margin

The percentage of gross profit earned on the company’s sales.

Companies need to have a positive profit margin in order to earn income, although having a negative profit margin may be advantageous in some instances (e.g. intentionally selling a new product below cost in order to gain market share).

The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses’ operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure. Comparing one business’ arrangements with another has little meaning. A low profit margin indicates a low margin of safety. There is a higher risk that a decline in sales will erase profits and result in a net loss or a negative margin.

16.7.5: Operating Margin

The operating margin is a ratio that determines how much money a company is actually making in profit and equals operating income divided by revenue.

Learning Objective

Calculate a company’s operating margin

Key Points

• The operating margin equals operating income divided by revenue.
• The operating margin shows how much profit a company makes for each dollar in revenue. Since revenues and expenses are considered ‘operating’ in most companies, this is a good way to measure a company’s profitability.
• Although It is a good starting point for analyzing many companies, there are items like interest and taxes that are not included in operating income. Therefore, the operating margin is an imperfect measurement a company’s profitability.

Key Term

operating income

Revenue – operating expenses. (Does not include other expenses such as taxes and depreciation).

Operating Margin

The financial job of a company is to earn a profit, which is different than earning revenue. If a company doesn’t earn a profit, their revenues aren’t helping the company grow. It is not only important to see how much a company has sold, it is important to see how much a company is making.

The operating margin (also called the operating profit margin or return on sales) is a ratio that shines a light on how much money a company is actually making in profit. It is found by dividing operating income by revenue, where operating income is revenue minus operating expenses .

Operating margin formula

The operating margin is found by dividing net operating income by total revenue.

The higher the ratio is, the more profitable the company is from its operations. For example, an operating margin of 0.5 means that for every dollar the company takes in revenue, it earns $0.50 in profit. A company that is not making any money will have an operating margin of 0: it is selling its products or services, but isn’t earning any profit from those sales.

However, the operating margin is not a perfect measurement. It does not include things like capital investment, which is necessary for the future profitability of the company. Furthermore, the operating margin is simply revenue. That means that it does not include things like interest and income tax expenses. Since non-operating incomes and expenses can significantly affect the financial well-being of a company, the operating margin is not the only measurement that investors scrutinize. The operating margin is a useful tool for determining how profitable the operations of a company are, but not necessarily how profitable the company is as a whole.

16.8: Market-Value Ratios

16.8.1: Price/Earnings Ratio

Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies.

Learning Objective

Calculate a company’s Price to Earnings Ratio

Key Points

• P/E ratio = Market price per share / Annual earnings per share.
• The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies; for example, a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more expensive than one with a lower P/E ratio.
• Different types of P/E include: trailing P/E or P/E ttm, trailing P/E from continued operations, and forward P/E or P/Ef.

Key Terms

time value of money

The value of money, figuring in a given amount of interest, earned over a given amount of time.

inflation

An increase in the general level of prices or in the cost of living.

Example

• As an example, if stock A is trading at 24 and the earnings per share for the most recent 12 month period is three, then stock A has a P/E ratio of 24/3, or eight.

Price/Earnings Ratio

In stock trading, the price-to-earnings ratio of a share (also called its P/E, or simply “multiple”) is the market price of that share divided by the annual earnings per share (EPS).

The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies; a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more “expensive” than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years. The price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings that would be required to pay back the purchase price, ignoring inflation, earnings growth, and the time value of money.

Price-Earning Ratios as a Predictor of Twenty-Year Returns

The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Note that over the last century, as the P/E ratio has decreased, annualized returns have increased.

P/E ratio = Market price per share / Annual earnings per share

The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator may vary depending on the type of P/E. The types of P/E include the following:

• Trailing P/E or P/E ttm: Here, earning per share is the net income of the company for the most recent 12 month period, divided by the weighted average number of common shares in issue during the period. This is the most common meaning of P/E if no other qualifier is specified. Monthly earnings data for individual companies are not available, and usually fluctuate seasonally, so the previous four quarterly earnings reports are used, and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
• Trailing P/E from continued operations: Instead of net income, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), and accounting changes. Longer-term P/E data, such as Shiller’s, use net earnings.
• Forward P/E, P/Ef, or estimated P/E: Instead of net income, this uses estimated net earnings over the next 12 months. Estimates are typically derived as the mean of those published by a select group of analysts (selection criteria are rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.

By comparing price and earnings per share for a company, one can analyze the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (or more certain) forecast earnings growth will usually have a higher P/E, and those expected to have lower (or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks; for example, if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading. P/E ratio in general is useful for comparing valuation of peer companies in a similar sector or group.

The P/E ratio of a company is a significant focus for management in many companies and industries. Managers have strong incentives to increase stock prices, firstly as part of their fiduciary responsibilities to their companies and shareholders, but also because their performance based remuneration is usually paid in the form of company stock or options on their company’s stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders). The stock price can increase in one of two ways: either through improved earnings, or through an improved multiple that the market assigns to those earnings. In turn, the primary driver for multiples such as the P/E ratio is through higher and more sustained earnings growth rates.

Companies with high P/E ratios but volatile earnings may be tempted to find ways to smooth earnings and diversify risk; this is the theory behind building conglomerates. Conversely, companies with low P/E ratios may be tempted to acquire small high growth businesses in an effort to “rebrand” their portfolio of activities and burnish their image as growth stocks and thus obtain a higher P/E rating.

16.8.2: Market/Book Ratio

The price-to-book ratio is a financial ratio used to compare a company’s current market price to its book value.

Learning Objective

Calculate the different types of price to book ratios for a company

Key Points

• The calculation can be performed in two ways: 1) the company’s market capitalization can be divided by the company’s total book value from its balance sheet, 2) using per-share values, is to divide the company’s current share price by the book value per share.
• A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal.
• Technically, P/B can be calculated either including or excluding intangible assets and goodwill.

Key Term

outstanding shares

Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.

Price/Book Ratio

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company’s current market price to its book value. The calculation can be performed in two ways, but the result should be the same either way.

In the first way, the company’s market capitalization can be divided by the company’s total book value from its balance sheet.

• Market Capitalization / Total Book Value

The second way, using per-share values, is to divide the company’s current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).

• Share price / Book value per share

As with most ratios, it varies a fair amount by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for example, consulting firms. P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values.

A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal (and/or that the market value of the firm’s assets is significantly higher than their accounting value). P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, P/B should also be calculated on a “diluted” basis, because stock options may well vest on the sale of the company, change of control, or firing of management.

It is also known as the market-to-book ratio and the price-to-equity ratio (which should not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market ratio.

Total Book Value vs Tangible Book Value

Technically, P/B can be calculated either including or excluding intangible assets and goodwill. When intangible assets and goodwill are excluded, the ratio is often specified to be “price to tangible book value” or “price to tangible book”.

16.9: Considering Inflation’s Distortionary Effects

16.9.1: Deflation

Deflation is a decrease in the general price level of goods and services and occurs when the inflation rate falls below 0%.

Learning Objective

Explain how deflation can effect a business

Key Points

• In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand.
• In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it. This can produce a liquidity trap.
• In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation.
• In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money; specifically the supply of money going down and the supply of goods going up.
• The effects of deflation are: decreasing nominal prices for goods and services, increasing buying power of cash money and all assets denominated in cash terms, possibly decreasing investment and lending if cash holdings are seen as preferable, and benefiting recipients of fixed incomes.

Key Terms

liquidity trap

A liquidity trap is a situation in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause.

In economics, deflation is a decrease in the general price level of goods and services. This occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. In turn, this allows one to buy more goods with the same amount of money over time.

Economists generally believe that deflation is a problem in a modern economy because they believe it may lead to a deflationary spiral .

US historical inflation rates

Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004

In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly with a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Since this idles the productive capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral.

An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply; or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce a liquidity trap. A central bank cannot normally charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adherence to a gold standard or to other external monetary base requirements.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically: the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

The effects of deflation are thus: decreasing nominal prices for goods and services, increasing buying power of cash money and all assets denominated in cash terms, possibly decreasing investment and lending if cash holdings are seen as preferable (aka hoarding), and benefiting recipients of fixed incomes.

16.9.2: Disinflation

Disinflation is a decrease in the inflation rate; a slowdown in the rate of increase of the general price level of goods, services.

Learning Objective

Describe what causes disinflation

Key Points

• Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a very short period of time.
• The causes of disinflation may be a decrease in the growth rate of the money supply. If the central bank of a country enacts tighter monetary policy, the supply of money reduces, and money becomes more upscale and the demand for money remains constant.
• Disinflation may result from a recession. The central bank adopts contractionary monetary policy, goods, and services are more expensive. Even though the demand for commodities fall, the supply still remains unaltered.Thus, the prices would fall over a period of time leading to disinflation.

Key Terms

recession

A period of reduced economic activity.

business cycle

A long-term fluctuation in economic activity between growth and recession.

Disinflation is a decrease in the rate of inflation–a slowdown in the rate of increase of the general price level of goods and services in a nation’s gross domestic product over time. Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a very short period of time. Disinflation takes place only when an economy is suffering from recession.

Disinflation

Disinflation is a decrease in the rate of inflation as illustrated in the yellow region of this graph.

If the inflation rate is not very high to start with, disinflation can lead to deflation–decreases in the general price level of goods and services. For example if the annual inflation rate for the month of January is 5% and it is 4% in the month of February, the prices disinflated by 1% but are still increasing at a 4% annual rate. Again, if the current rate is 1% and it is -2% for the following month, prices disinflated by 3% (i.e., 1%-[-2]%) and are decreasing at a 2% annual rate.

The causes of disinflation are either a decrease in the growth rate of the money supply, or a business cycle contraction (recession). If the central bank of a country enacts tighter monetary policy, (i.e., the government start selling its securities) this reduces the supply of money in an economy. This contraction of the monetary policy is known as a “quantitative tightening technique. ” When the government sell its securities in the market, the supply of money reduces, and money becomes more upscale and the demand for money remains constant. During a recession, competition among businesses for customers becomes more intense, and so retailers are no longer able to pass on higher prices to their customers. The main reason is that when the central bank adopts contractionary monetary policy, its becomes expensive to annex money, which leads to the fall in the demand for goods and services in the economy. Even though the demand for commodities fall, the supply of commodities still remains unaltered. Thus the prices fall over a period of time leading to disinflation.

When the growth rate of unemployment is below the natural rate of growth, this leads to an increase in the rate of inflation; whereas, when the growth rate of unemployment is above the natural rate of growth it leads to a decrease in the rate of inflation also known as disinflation. This happens when people are jobless, and they have a very small portion of money to spend, which indirectly implies reduction in the supply of money in an economy.

16.9.3: Impact of Inflation on Financial Statement Analysis

General price level changes creates distortions in financial statements. Inflation accounting is used in countries with high inflation.

Learning Objective

Discuss how inflation can impact a company’s financial statements

Key Points

• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company’s ongoing operations.
• Future earnings are not easily projected from historical earnings. Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.

Key Terms

Financial Accounting Standards Board

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

hyperinflation

In economics, this occurs when a country experiences very high, accelerating, and perceptibly “unstoppable” rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses real value.

historical cost basis

Under this type of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values. Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.

Inflation’s Impact on Financial Statements

In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices. Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s .

Hyperinflation Graph

German Hyperinflation Data

General price level changes in financial reporting creates distortions in financial statements such as:

• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two identical numbers.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company’s ongoing operations.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.
• Future earnings are not easily projected from historical earnings.
• The impact of price changes on monetary assets and liabilities is not clear.
• Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• When real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior).

Inflation accounting, a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation, is a solution to these problems. This type of accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries such as these the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.

16.10: The DuPont Equation, ROE, ROA, and Growth

16.10.1: Assessing Internal Growth and Sustainability

Sustainable– as opposed to internal– growth gives a company a better idea of its growth rate while keeping in line with financial policy.

Learning Objective

Calculate a company’s internal growth and sustainability ratios

Key Points

• The internal growth rate is a formula for calculating the maximum growth rate a firm can achieve without resorting to external financing.
• Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy.
• Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.

Key Terms

sustainable growth rate

the optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations

retention ratio

retained earnings divided by net income

retention

The act of retaining; something retained

Example

• A company’s net income is 750,000 and its total shareholder equity is 5,000,000. Its earnings retention rate is 80%. What is its sustainable growth rate? Sustainable Growth Rate = (750,000/5,000,000) x (1-0.80). Sustainable Growth Rate = 3%

Internal Growth and Sustainability

The true benefit of a high return on equity arises when retained earnings are reinvested into the company’s operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing. It’s essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets), or conceptually as the total amount of internal capital available compared to the current size of the organization.

We find the internal growth rate by dividing net income by the amount of total assets (or finding return on assets) and subtracting the rate of earnings retention. However, growth is not necessarily favorable. Expansion may strain managers’ capacity to monitor and handle the company’s operations. Therefore, a more commonly used measure is the sustainable growth rate.

Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy, such as target debt to equity ratio, target dividend payout ratio, target profit margin, or target ratio of total assets to net sales.

We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention. While the internal growth rate assumes no financing, the sustainable growth rate assumes you will make some use of outside financing that will be consistent with whatever financial policy being followed. In fact, in order to achieve a higher growth rate, the company would have to invest more equity capital, increase its financial leverage, or increase the target profit margin.

Optimal Growth Rate

Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy. The concept of optimal growth rate was originally studied by Martin Handschuh, Hannes Lösch, and Björn Heyden. Their study was based on assessments on the performance of more than 3,500 stock-listed companies with an initial revenue of greater than 250 million Euro globally, across industries, over a period of 12 years from 1997 to 2009.

Revenue Growth and Profitability

ROA, ROS and ROE tend to rise with revenue growth to a certain extent.

Due to the span of time included in the study, the authors considered their findings to be, for the most part, independent of specific economic cycles. The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates. Furthermore, the authors attributed this profitability increase to the following facts:

1. Companies with substantial profitability have the opportunity to invest more in additional growth, and
2. Substantial growth may be a driver for additional profitability, whether by attracting high performing young professionals, providing motivation for current employees, attracting better business partners, or simply leading to more self-confidence.

However, according to the study, growth rates beyond the “profitability maximum” rate could bring about circumstances that reduce overall profitability because of the efforts necessary to handle additional growth (i.e., integrating new staff, controlling quality, etc).

16.10.2: Dividend Payments and Earnings Retention

The dividend payout and retention ratios offer insight into how much of a firm’s profit is distributed to shareholders versus retained.

Learning Objective

Calculate a company’s dividend payout and retention ratios

Key Points

• Many corporations retain a portion of their earnings and pay the remainder as a dividend.
• Dividends are usually paid in the form of cash, store credits, or shares in the company.
• Cash dividends are a form of investment income and are usually taxable to the recipient in the year that they are paid.
• Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends.
• Retained earnings can be expressed in the retention ratio.

Key Term

stock split

To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.

Dividend Payments and Earnings Retention

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. On the other hand, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year with losses offsetting earnings. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. Retained earnings are shown in the shareholder equity section in the company’s balance sheet–the same as its issued share capital.

Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a “special dividend” to distinguish it from the fixed schedule dividends. Dividends are usually paid in the form of cash, store credits (common among retail consumers’ cooperatives), or shares in the company (either newly created shares or existing shares bought in the market). Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

Cash dividends (most common) are those paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense but rather a deduction of retained earnings. Dividends paid do not show up on an income statement but do appear on the balance sheet.

Example Balance Sheet

Retained earnings can be found on the balance sheet, under the owners’ (or shareholders’) equity section.

Stock dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield five extra shares). If the payment involves the issue of new shares, it is similar to a stock split in that it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held.

Dividend Payout and Retention Ratios

Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:

The part of the earnings not paid to investors is left for investment to provide for future earnings growth. These retained earnings can be expressed in the retention ratio. Retention ratio can be found by subtracting the dividend payout ratio from one, or by dividing retained earnings by net income.

Dividend Payout Ratio

The dividend payout ratio is equal to dividend payments divided by net income for the same period.

16.10.3: Relationships between ROA, ROE, and Growth

Return on assets is a component of return on equity, both of which can be used to calculate a company’s rate of growth.

Learning Objective

Discuss the different uses of the Return on Assets and Return on Assets ratios

Key Points

• Return on equity measures the rate of return on the shareholders’ equity of common stockholders.
• Return on assets shows how profitable a company’s assets are in generating revenue.
• In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
• Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production. Rising capital intensity pushes up the productivity of labor.

Key Terms

return on common stockholders’ equity

a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage

quantitatively

With respect to quantity rather than quality.

Example

• A company has net income of 500,000. It has total assets valued at 3,000,000. Its retention rate is 80%, and its shareholder equity is equal to $1,500,000. What is the company’s ROA and internal growth rate? What is the company’s ROE and sustainable growth rate? ROA = 500,000/3,000,000 = 17% Internal growth rate = 17% x 80% = 13% ROE = 17% x (3,000,000/1,500,000) = 34% Sustainable growth rate = 34% x 80% = 27.2%

Return On Assets Versus Return On Equity

In review, return on equity measures the rate of return on the ownership interest (shareholders’ equity) of common stockholders. Therefore, it shows how well a company uses investment funds to generate earnings growth. Return on assets shows how profitable a company’s assets are in generating revenue. Return on assets is equal to net income divided by total assets.

Return On Assets

Return on assets is equal to net income divided by total assets.

This percentage shows what the company can do with what it has (i.e., how many dollars of earnings they derive from each dollar of assets they control). This is in contrast to return on equity, which measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on assets is, however, a vital component of return on equity, being an indicator of how profitable a company is before leverage is considered. In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.

ROA, ROE, and Growth

In terms of growth rates, we use the value known as return on assets to determine a company’s internal growth rate. This is the maximum growth rate a firm can achieve without resorting to external financing. We use the value for return on equity, however, in determining a company’s sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio.

Capital Intensity and Growth

Return on assets gives us an indication of the capital intensity of the company. “Capital intensity” is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor. The underlying concept here is how much output can be procured from a given input (assets!). The formula for capital intensity is below:

The use of tools and machinery makes labor more effective, so rising capital intensity pushes up the productivity of labor. While companies that require large initial investments will generally have lower return on assets, it is possible that increased productivity will provide a higher growth rate for the company. Capital intensity can be stated quantitatively as the ratio of the total money value of capital equipment to the total potential output. However, when we adjust capital intensity for real market situations, such as the discounting of future cash flows, we find that it is not independent of the distribution of income. In other words, changes in the retention or dividend payout ratios can lead to changes in measured capital intensity.

16.10.4: The DuPont Equation

The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.

Learning Objective

Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst

Key Points

• By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
• As profit margin increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
• As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
• Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.

Key Term

competitive advantage

something that places a company or a person above the competition

Example

• A company has sales of 1,000,000. It has a net income of 400,000. Total assets have a value of 5,000,000, and shareholder equity has a value of 10,000,000. Using DuPont analysis, what is the company’s return on equity? Profit Margin = 400,000/1,000,000 = 40%. Asset Turnover = 1,000,000/5,000,000 = 20%. Financial Leverage = 5,000,000/10,000,000 = 50%. Multiplying these three results, we find that the Return on Equity = 4%.

The DuPont Equation

DuPont Model

A flow chart representation of the DuPont Model.

The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.

The DuPont Equation

In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.

Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time.

Components of the DuPont Equation: Profit Margin

Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.

Components of the DuPont Equation: Asset Turnover

Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.

Components of the DuPont Equation: Financial Leverage

Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity.

The DuPont Equation in Relation to Industries

The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company’s return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important.

High margin industries, on the other hand, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin. For high end fashion and other luxury brands, increasing sales without sacrificing margin may be critical. Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity. While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company’s return on equity.

16.10.5: ROE and Potential Limitations

Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.

Learning Objective

Calculate a company’s return on equity

Key Points

• Return on equity is an indication of how well a company uses investment funds to generate earnings growth.
• Returns on equity between 15% and 20% are generally considered to be acceptable.
• Return on equity is equal to net income (after preferred stock dividends but before common stock dividends) divided by total shareholder equity (excluding preferred shares).
• Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.

Key Term

fundamental analysis

An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.

Example

• A small business’ net income after taxes is $10,000. The total shareholder equity in the business is $50,000. What is the return on equity? ROE = 10,000/50,000 ROE = 20%

Return On Equity

Return on equity (ROE) measures the rate of return on the ownership interest or shareholders’ equity of the common stock owners. It is a measure of a company’s efficiency at generating profits using the shareholders’ stake of equity in the business. In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better. Returns on equity between 15% and 20% are generally considered to be acceptable.

The Formula

Return on equity is equal to net income, after preferred stock dividends but before common stock dividends, divided by total shareholder equity and excluding preferred shares.

Return On Equity

ROE is equal to after-tax net income divided by total shareholder equity.

Expressed as a percentage, return on equity is best used to compare companies in the same industry. The decomposition of return on equity into its various factors presents various ratios useful to companies in fundamental analysis.

ROE Broken Down

This is an expression of return on equity decomposed into its various factors.

The practice of decomposing return on equity is sometimes referred to as the “DuPont System. “

Potential Limitations of ROE

Just because a high return on equity is calculated does not mean that a company will see immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity. Earnings per share is the amount of earnings per each outstanding share of a company’s stock. EPS is equal to profit divided by the weighted average of common shares.

Earnings Per Share

EPS is equal to profit divided by the weighted average of common shares.

The true benefit of a high return on equity comes from a company’s earnings being reinvested into the business or distributed as a dividend. In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.

16.11: Asset-Management Ratios

16.11.1: Fixed Assets Turnover Ratio

Fixed-asset turnover is the ratio of sales to value of fixed assets, indicating how well the business uses fixed assets to generate sales.

Learning Objective

Calculate the fixed-asset turnover ratio for a business

Key Points

• Fixed asset turnover = Net sales / Average net fixed assets.
• The higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.
• Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash.

Key Term

IAS

International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Fixed Assets

Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets, such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed.

Moreover, a fixed/non-current asset also can be defined as an asset not directly sold to a firm’s consumers/end-users. As an example, a baking firm’s current assets would be its inventory (in this case, flour, yeast, etc.), the value of sales owed to the firm via credit (i.e., debtors or accounts receivable), cash held in the bank, etc. Its non-current assets would be the oven used to bake bread, motor vehicles used to transport deliveries, cash registers used to handle cash payments, etc. Each aforementioned non-current asset is not sold directly to consumers.

These are items of value that the organization has bought and will use for an extended period of time; fixed assets normally include items, such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets. According to International Accounting Standard (IAS) 16, Fixed Assets are assets which have future economic benefit that is probable to flow into the entity and which have a cost that can be measured reliably.

The primary objective of a business entity is to make a profit and increase the wealth of its owners. In the attainment of this objective, it is required that the management will exercise due care and diligence in applying the basic accounting concept of “Matching Concept.” Matching concept is simply matching the expenses of a period against the revenues of the same period.

The use of assets in the generation of revenue is usually more than a year–that is long term. It is, therefore, obligatory that in order to accurately determine the net income or profit for a period depreciation, it is charged on the total value of asset that contributed to the revenue for the period in consideration and charge against the same revenue of the same period. This is essential in the prudent reporting of the net revenue for the entity in the period.

Fixed-asset Turnover

Fixed-asset turnover is the ratio of sales (on the profit and loss account) to the value of fixed assets (on the balance sheet). It indicates how well the business is using its fixed assets to generate sales.

Turn Tables

Turn tables should help you remember turnover. Fixed-asset turnover indicates how well the business is using its fixed assets to generate sales.

Fixed asset turnover = Net sales / Average net fixed assets

Generally speaking, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.

16.11.2: Total Assets Turnover Ratio

Total asset turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue.

Learning Objective

Calculate the total assets turnover ratio for a business

Key Points

• Total assets turnover = Net sales revenue / Average total assets.
• Net sales are operating revenues earned by a company for selling its products or rendering its services.
• Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset.
• Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.

Key Term

profit margins

Profit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue.

Example

• Examples of intangible assets are goodwill, copyrights, trademarks, patents, computer programs, and financial assets, including such items as accounts receivable, bonds and stocks.

Total assets turnover

This is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company.

Assets

Asset turnover measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company.

Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio due mainly to cut-throat and competitive pricing.

Total assets turnover = Net sales revenue / Average total assets

• “Sales” is the value of “Net Sales” or “Sales” from the company’s income statement”.
• Average Total Assets” is the average of the values of “Total assets” from the company’s balance sheet in the beginning and the end of the fiscal period. It is calculated by adding up the assets at the beginning of the period and the assets at the end of the period, then dividing that number by two.

Net sales

• In bookkeeping, accounting, and finance, Net sales are operating revenues earned by a company for selling its products or rendering its services. Also referred to as revenue, they are reported directly on the income statement as Sales or Net sales.
• In financial ratios that use income statement sales values, “sales” refers to net sales, not gross sales. Sales are the unique transactions that occur in professional selling or during marketing initiatives.

Total assets

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value, and that is held to have positive economic value, is considered an asset. Simply stated, assets represent value of ownership that can be converted into cash (although cash itself is also considered an asset).

The balance sheet of a firm records the monetary value of the assets owned by the firm. It is money and other valuables belonging to an individual or business.

Two major asset classes are tangible assets and intangible assets.

• Tangible assets contain various subclasses, including current assets and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.
• Intangible assets are non-physical resources and rights that have a value to the firm because they give the firm some kind of advantage in the market place.

16.11.3: Days Sales Outstanding

Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.

Learning Objective

Calculate the days sales outstanding ratio for a business

Key Points

• Days sales outstanding is a financial ratio that illustrates how well a company’s accounts receivables are being managed.
• DSO ratio = accounts receivable / average sales per day, or DSO ratio = accounts receivable / (annual sales / 365 days).
• Generally speaking, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm’s credit policy is too rigorous, which may be hampering sales.

Key Terms

days in inventory

the average value of inventory divided by the average cost of goods sold per day

average collection period

365 divided by the receivables turnover ratio

outstanding check

a check that has been written but has not yet been deposited in the receiver’s bank account

business cycle

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years.

Days Sales Outstanding

In accountancy, days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period. It is a financial ratio that illustrates how well a company’s accounts receivables are being managed. The days sales outstanding figure is an index of the relationship between outstanding receivables and credit account sales achieved over a given period.

Typically, days sales outstanding is calculated monthly. The days sales outstanding analysis provides general information about the number of days on average that customers take to pay invoices. Generally speaking, though, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm’s credit policy is too rigorous, which may be hampering sales.

Days sales outstanding is considered an important tool in measuring liquidity. Days sales outstanding tends to increase as a company becomes less risk averse. Higher days sales outstanding can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company’s bad debt reserve.

A DSO ratio can be expressed as:

• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)

For purposes of this ratio, a year is considered to have 365 days.

Days sales outstanding can vary from month to month and over the course of a year with a company’s seasonal business cycle. Of interest, when analyzing the performance of a company, is the trend in DSO. If DSO is getting longer, customers are taking longer to pay their bills, which may be a warning that customers are dissatisfied with the company’s product or service, or that sales are being made to customers that are less credit worthy or that sales people have to offer longer payment terms in order to generate sales. Many financial reports will state Receivables Turnover defined as Net Credit Account Sales / Trade Receivables; divide this value into the time period in days to get DSO.

However, days sales outstanding is not the most accurate indication of the efficiency of accounts receivable department. Changes in sales volume influence the outcome of the days sales outstanding calculation. For example, even if the overdue balance stays the same, an increase of sales can result in a lower DSO. A better way to measure the performance of credit and collection function is by looking at the total overdue balance in proportion of the total accounts receivable balance (total AR = Current + Overdue), which is sometimes calculated using the days’ delinquent sales outstanding (DDSO) formula.

16.11.4: Inventory Turnover Ratio

Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.

Learning Objective

Calculate inventory turnover and average days to sell inventory for a business

Key Points

• Inventory turnover = Cost of goods sold/Average inventory.
• Average days to sell the inventory = 365 days /Inventory turnover ratio.
• A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
• Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Key Term

holding cost

In business management, holding cost is money spent to keep and maintain a stock of goods in storage.

Inventory Turnover

In accounting, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year. The equation for inventory turnover equals the cost of goods sold divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

Inventory Turnover Equation

• The formula for inventory turnover:

Inventory turnover = Cost of goods sold/Average inventory

• The formula for average inventory:

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

• The average days to sell the inventory is calculated as follows:

Average days to sell the inventory = 365 days / Inventory turnover ratio

Application in Business

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.

Inventory

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.

Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of cost of sales. Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded. Sales are generally recorded at market value (i.e., the value at which the marketplace paid for the good or service provided by the firm). In the event that the firm had an exceptional year and the market paid a premium for the firm’s goods and services, then the numerator may be an inaccurate measure. However, cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms “cost of sales” and “cost of goods sold” are synonymous.

An item whose inventory is sold (turns over) once a year has a higher holding cost than one that turns over twice, or three times, or more in that time. Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.

• Increasing inventory turns reduces holding cost. The organization spends less money on rent, utilities, insurance, theft, and other costs of maintaining a stock of good to be sold.
• Reducing holding cost increases net income and profitability as long as the revenue from selling the item remains constant.
• Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of obsolete items. This is a major concern in fashion industries.

When making comparison between firms, it’s important to take note of the industry, or the comparison will be distorted. Making comparison between a supermarket and a car dealer, will not be appropriate, as a supermarket sells fast moving goods, such as sweets, chocolates, soft drinks, so the stock turnover will be higher. However, a car dealer will have a low turnover due to the item being a slow moving item. As such, only intra-industry comparison will be appropriate.

16.12: Other Distortions

16.12.1: Extraordinary Gains and Losses

Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.

Learning Objective

Define what makes a gain or loss extraordinary

Key Points

• Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.
• No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) The amount of each of these gains or losses, net of the income tax effect, is reported separately in the income statement.
• Examples of extraordinary items are casualty losses, losses from expropriation of assets by a foreign government, gain on life insurance, gain or loss on the early extinguishment of debt, gain on troubled debt restructuring, and write-off of an intangible asset.

Key Terms

extraordinary items

unusual (abnormal) and infrequent things that impact the company

non-operating

Non-operating in accounting and finance is not related to the typical activities of the business or organization.

Extraordinary Gains and Losses

Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. It is notable that a natural disaster might not qualify depending on location (e.g., frost damage would not qualify in Canada but would in the tropics).

Extra gains or losses are the result of unforeseen and atypical events. They are nonrecurring, onetime, unusual, non-operating gains, or losses that are recorded by a business during the period.

No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) The amount of each of these gains or losses, net of the income tax effect, is reported separately in the income statement. Net income is reported before and after these gains and losses. As a result, extraordinary gains or losses don’t skew the company’s regular earnings. These gains and losses should not be recorded very often but, in fact, many businesses record them every other year or so, causing much consternation to investors. In addition to evaluating the regular stream of sales and expenses that produce operating profit, investors also have to factor into their profit performance analysis the perturbations of these irregular gains and losses reported by a business.

Income statement in accordance with IFRS

This income statement is a very brief example prepared in accordance with IFRS; no extraordinary items are presented.

Examples of extraordinary items are casualty losses, losses from expropriation of assets by a foreign government, gain on life insurance, gain or loss on the early extinguishment of debt, gain on troubled debt restructuring, and write-off of an intangible asset. Write down and write off of receivables and inventory are not extraordinary, because they relate to normal business operational activities.They would be considered extraordinary, however, if they resulted from an Act of God (e.g., casualty loss arising from an earthquake) or governmental expropriation.

16.12.2: Discrepancies

Accounting discrepancies are unintentional mistakes in the delivery of financial statements.

Learning Objective

Recognize the various reasons a discrepancy may occur, and how to prevent them

Key Points

• Mistakes happen. Being aware of common pitfalls is the best way to avoid accounting discrepancies, though.
• Discrepancies shouldn’t be confused with irregularities, which are generally assumed to be intentional mistakes to misrepresent data.
• Data errors, software issues, late payments, and shrinkage may all contribute to potential discrepancies in the tracking of organizational finances.
• Preventing discrepancies is best, but if a mistake occurs, it is best to address it as soon as possible (as opposed to waiting for an audit to catch it).

Key Terms

accounting irregularity

An intentional misrepresentation of accounting data.

discrepancies

Accidental misrepresentations of accounting data.

Nobody’s perfect, including accountants. From time to time, discrepancies will arise on financial statements, for a wide variety of reasons. Accounting errors that are not intentional are described as discrepancies (as opposed to an accounting irregularity, which is distinguished from a discrepancy by an intention to defraud). Accounting requires meticulous eye for detail and a strong sense of accuracy and accountability, and financial professionals and internal stakeholders must be careful of errors which could be mistaken for intentional fraud.

Common Discrepancies

Data Errors

All accounting relies heavily on input data from various sources, including accurate inventory counts, revenue reports, sales figures, asset valuations, and a wide variety of other relevant aspects of income statements, balance sheets, and statements of cash flows. Any error from input data points will thus be reflected in the final financial statements, for public companies these are released externally. Catching these errors through careful confirmation of all receipts and cash flows is a central responsibility of both management and the accounting and finance teams.

Late Payments

If a large client is late in providing capital for a service or product provided, this can impact the accuracy of a financial release. Accounts receivable, by their nature, are timed payments with specific deadlines. If an accountant assumes a receivable will be timely, they may potentially create a discrepancy. As a result, all reporting should be done on what actually is, rather than what’s expected to be.

Shrinkage

Particularly relevant for retail outlets is the concept of shrinkage. Shrinkage is the lost inventory/sales that occurs over an operational period. This can be due to petty theft, mismanaged inventory, perishable goods going unrecorded, and a wide variety of other factors. Ensuring that inventory is carefully managed and shrinkage is built into any current financial calculations is important to maintain accuracy and avoid discrepancy.

Bank Reconciliation

While rarely an issue in the long term, bank transfer and capital movements sometimes take time. Taking into account bank reconciliation when viewing the amount shown in a current account and the amount that should be shown is an occasionally cause of temporary discrepancy.

Technology

Modern accounting is largely a software endeavor. Utilizing complex software incurs the potential for complex, hard to catch errors. Having a strong IT team, and accountants familiar with the world of software coding are important assets in modern financial reporting. 

Addressing Discrepancies

While perhaps common sense, amending a discrepancy as soon as it is identified is important. Waiting to be audited is not a good tactic, as this will likely result in fees or penalties for inaccurate reporting. Double and triple checking financial statements inputs before building them into public releases is particularly important for this field of work.

16.13: Next Steps in Financial Statement Analysis

16.13.1: Interpreting Ratios and Other Sources of Company Information

Financial statement analysis uses comparisons and relationships of data to enhance the utility or practical value of accounting information.

Learning Objective

Explain how a company would use one of the four financial statement analysis methods to interpret their data

Key Points

• In financial statement analysis, comparisons and relationships can be shown in the following ways: vertical analysis, horizontal analysis, trend percentages, and ratios.
• The vertical method is used on a single financial statement, such as an income statement, and involves each item being expressed as a percentage of a significant total.
• The horizontal method is comparative, and shows the same company’s financial statements for one or two successive periods in side-by-side columns. The side-by-side display reveals changes in a company’s performance and highlights trends.
• Trend percentages make comparisons to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they disclose changes and trends occurring through time.
• Ratios are expressions of logical relationships between items in the financial statements from a single period. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g.balance sheet and income statement).

Key Terms

trend

an inclination in a particular direction

ratio

A number representing a comparison between two things.

analysis

a process of dismantling or separating an object of inquiry into its constituent elements in order to study the nature, function, or meaning of the object

Financial Statement Analysis

Financial statement analysis, also known as financial analysis, is the process of understanding the risk and profitability of a company through the analysis of that company’s reported financial information. This information includes annual and quarterly reports, such as income statements, balance sheets, and statements of cash flows.

All financial analysis relies on comparing or relating data in a way that enhances the utility or practical value of the information. For example, when analyzing a particular company, it is helpful to know that they had a net income of $100,000 for the year, but it is even more helpful to know that, in a previous year, they only had $25,000 in net income. As more information is added, such as the total amount of sales, the number of assets, and the cost of goods sold, the initial information becomes increasingly valuable, and a more complete picture of a company’s financial activity can be derived.

In financial statement analysis, comparisons and relationships can be shown in the following ways:

• Absolute increases and decreases for an item from one period to the next
• Percentage increases and decreases for an item from one period to the next
• Percentages of single items to an aggregate total
• Trend percentages
• Ratios

Methods for Financial Statement Analysis

There are four methods for making these types of comparisons: vertical analysis, horizontal analysis, ratios, and trend percentages.

The vertical method is used on a single financial statement, such as an income statement. In a vertical analysis, each item is expressed as a percentage of a significant total. This type of analysis is especially helpful in analyzing income statement data .

The horizontal method is a comparative, and presents the same company’s financial statements for one or two successive periods in side-by-side columns. This comparative display shows dollar changes or percentage changes in the statement items or totals across given periods of time. Horizontal analysis detects changes in a company’s performance and highlights various other trends.

The trend percentages method is the same as horizontal analysis, except that in the former, comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they reveal changes and trends occurring over time.

Ratios are expressions of logical relationships between items in financial statements from a single period. It is possible to calculate a number of ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g.balance sheet and income statement). The only limiting factor in choosing ratios is that the items used to construct a ratio must have a logical relationship to one another.

Analyzing the Income Statement

In vertical analysis each item is expressed as a percentage of a significant total.

15.3: Lease Accounting

15.3.1: Overview of Lease Accounting

Learning Objective

Summarize how a company would account for a lease

Key Points

• A lease allows a company to get a major piece of equipment with no large expenditure of cash.
• A capital lease is a form of debt-equity financing in which the lease acts like loan.
• An operating lease lets a company obtain equipment with virtually no upfront capital outlay and with the lease payments treated as a deductible cost of business.

Key Terms

monetary

Of, pertaining to, or consisting of money.

capital lease

a financial arrangement where the borrower uses an asset and pays regular installments plus interest

lessor

The owner of property that is leased.

expenditure

An amount expended; an expense; an outlay.

What is a Lease

A lease is a contract calling for the lessee (user) to pay the lessor (owner) for use of an asset for a specified period.

Why Do Some Companies Lease

For many companies the decision is monetary. A lease allows a company to get a major piece of equipment with no large expenditure of cash. In addition, some companies who are in the financial position to buy equipment still prefer to lease because they would not benefit from the depreciation on the equipment.

Equipment Lease

An equipment lease allows a company to get a piece of equipment without a large expenditure.

Types of Leases

There are two types of leases capital leases and operating leases.

Capital equipment is financed either with debt or equity. A capital lease is a form of debt-equity financing in which the lease acts like loan. To that end, a capital lease must be recorded as liability on the company’s balance sheet, it is important to note that the IRS treats capital leases as a liability.

On the other hand, an operating lease lets a company obtain equipment with virtually no upfront capital outlay and with the lease payments treated as a deductible cost of business.

Accounting for the Lease-Leasee

Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be registered as an expense on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset’s economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

Note: For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.

Accounting for the Lease-Lessor

Under an operating lease, the lessor records rent revenue (credit) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor’s books as an owned asset. The lessor records depreciation expense over the life of the asset. Under a capital lease, the lessor credits owned assets and debits a lease-receivable account for the present value of the rents. The rents are an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future. With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.

Other Lease Items

• Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property and revert to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life. If the life of the leasehold improvement extends past the life of the initial term of the lease and into an option period, normally that option period must be considered part of the life of the lease.
• Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.
• Security Deposits: Nonrefundable security deposits:deferred by the lessor as unearned revenue; capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned. Refundable security deposits: treated as a receivable by the lessee; treated as a liability by the lessor until the deposit is refunded to the lessee.

15.4: Making Changes and Correcting Errors

15.4.1: Overview of Statement Changes and Errors

Despite best efforts, occasionally an error is made on the financial statement and must be corrected.

Learning Objective

Explain why a previously issued financial statement would have an error and how to correct it

Key Points

• These errors are most usually caused by mathematical mistakes, mistakes in applying generally accepted accounting principles, or through the oversight of facts existing when the financial statements were prepared.
• In order to properly correct an error, it is necessary to retrospectively restate the prior period financial statements.
• A counterbalancing error occurs when an an error is made that cancels out another error.
• It makes no difference whether the books are closed or still open; a correcting journal entry is necessary.

Key Terms

offset

Anything that acts as counterbalance; a compensating equivalent.

cumulative

Incorporating all data up to the present

retrospectively

In a retrospective manner.

Changes and Errors on the Financial Statements

Despite best efforts, occasionally an error is made on the financial statement. Most often, the error is in the recognition, measurement, presentation, or disclosure of an item in financial statements. These errors are usually caused by mathematical mistakes, mistakes in applying generally accepted accounting principles, or the oversight of facts existing when the financial statements were prepared.

Please note: an error correction is the correction of an error in previously issued financial statement; it is not an accounting change.

How to Correct an Error

In order to properly correct an error, it is necessary to retrospectively restate the prior period financial statements. In order to restate the financials the company must:

• Reflect the cumulative effect of the error on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period presented; and
• Make an offsetting adjustment to the opening balance of retained earnings for that period; and
• Adjust the financial statements for each prior period presented, to reflect the error correction.

If the financial statements are only presented for a single period, then reflect the adjustment in the opening balance of retained earnings.

Counterbalancing vs. Non-counterbalancing Errors

A counterbalancing error has occurred when an error is made that cancels out another error. An example of a counterbalancing error is expenses charged to year X that should have been charged to year Y. The result is year X has an overstated expense and an understated profit and year Y has an expense understated and the profit overstated. Yet when retained earning for year Z is correct, because the two previous errors cancelled each other out. While the effects of the error are corrected over a period of two years, the yearly net income figures for year X and year Y were still misstated.

Accounting for a counterbalancing error is made by determining if the books for the current year are closed or not. If the current year books are closed-no entry is necessary if the error has already counterbalanced. If the error has not counterbalanced then an entry must be made to retained earnings.

If the books are not closed for the current year, the company is in the second year, and the error hasn’t already counterbalanced then it is necessary to correct the current period and adjusted beginning retained earnings. If the error has not counterbalanced, an entry is necessary to adjusted beginning retained earnings and correct the current period.

Keep in mind the financial statements need to be re-run no matter what.

Non-counterbalancing errors are those that will not be automatically offset in the next accounting period. It makes no difference whether the books are closed or still open, a correcting journal entry is necessary.

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

15.5: Additional Notes on Disclosures

15.5.1: Mechanics of a Disclosure

Disclosures provide additional information about the specific data on the company’s financial statements.

Learning Objective

Summarize why a company would have a disclosure on the financial statement

Key Points

• All relevant information must be disclosed. “Relevant” means any context that may impact a financial statement’s reliability.
• The disclosures can be required by generally accepted accounting principles or voluntary per management decisions.
• Types of disclosures include, accounting changes, accounting errors, asset retirement, insurance contract modifications, and noteworthy events.

Key Terms

contingent

An event which may or may not happen; that which is unforeseen, undetermined, or dependent on something future; a contingency.

disclosure

The act of revealing something.

Purpose of Disclosures

While a company’s financial statements contain all the relevant financial data about the company, that data is often in need of further explanation. That is where the disclosures on the financial statement come into play.

A financial statement disclosure will communicate relevant information not captured in the statement itself to a company’s stakeholders. The disclosures can be required by generally accepted accounting principles or voluntary per management decisions.

What Is Disclosed: Materiality and Impact

All relevant information must be disclosed. “Relevant” means any context that may impact a financial statement’s reliability. This may include information about accounting methods, dependencies, or changes in amounts or estimates.

Types of Financial Disclosures

Accounting Changes

If a company makes a significant change to their accounting policies, such as a change in inventory valuation, depreciation methods, or application of GAAP, they must disclose it. Such disclosures alert the financial statement’s users as to why the company’s financial information may suddenly look different.

Accounting Errors

Accounting errors can result for a variety of reasons including transposition, mathematical computation, and incorrect application of GAAP or failing to revalue assets using fair market value. When an error is discovered, it must be corrected. This often means correcting prior period financial statements. This information must be noted in the disclosure. Keep in mind, significant accounting errors can result in financial audits and possible bankruptcy by the company.

Asset Retirement

Companies retire assets once the asset provides no future benefits to the company. The procedure for retiring an asset requires the company to obtain both a fair market value and salvage value for the asset. Usually, the difference between the sale price and the asset’s salvage value results in a net loss. The net loss is then included on the company’s income statement, which is then explained via a disclosure.

Insurance Contract Modifications

Insurance contract modifications affect a company’s balance sheet. Since companies use the balance sheet to determine the total economic value added by their company’s operations. A financial disclosure is necessary to explain why the insurance contract was modified and what current or future implications may occur. Examples of insurance contracts include the business owner’s life insurance policy or the general liability insurance for business operations.

Other items

Other items requiring disclosure are noteworthy events and transactions. These events are infrequent but made a significant impact on the current financial period.

Credit Cards Represent Debt

Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).

Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).

Methods of Making a Disclosure

Disclosures may be simple statements regarding the change or provide a lengthy explanation for the reason to change the company’s accounting policies and procedures.

Voluntary disclosure in accounting is the provision of information by a company’s management beyond requirements, such as generally accepted accounting principles and Securities and Exchange Commission rules, where the information is believed to be relevant to the decision making of users of the company’s annual reports.

Voluntary disclosure benefits investors, companies, and the economy; for example, it helps investors make better capital allocation decisions and lowers firms’ cost of capital, the latter of which also benefits the general economy. Chau and Gray (2002) also found support for the theory that voluntary disclosure helps reduce conflicts of interest in widely held firms. Firms, however, balance the benefits of voluntary disclosure against the costs, which may include the cost of procuring the information to be disclosed, and decreased competitive advantage.

Structure of Disclosures

Disclosures can span several pages at the end of the financial statements.

13.3: Expense Recognition

13.3.1: Expense Recognition

Learning Objective

Calculate the ending balance of an income statement account and discuss how the proper recognition of expenses affects a company’s income

Key Points

• Expenses are outflows of cash or other assets from a person or company to another entity.
• Expenses can either take the form of a decrease in a business’ cash or assets, or an increase in its liabilities. It is important to note that cash or property distributions to a business owner do not count as expenses.
• The accounting method the business uses determines when an expense is recognized.
• If the business uses cash basis accounting, an expense is recognized when the business pays for a good or service.
• Under the accrual system, an expense is recognized once it is incurred.

Key Terms

accrual basis accounting

A method of accounting where income is not recorded until earned and expenses are not recorded until incurred.

cash-basis accounting

A method of accounting where income is recorded when cash is received and expenses are recorded when cash is paid.

expense

In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

Recognition of Expenses

Expenses are outflows of cash or other valuable assets from a person or company to another entity. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners’ equity.

A Sample Income Statement

Expenses are listed on a company’s income statement.

The International Accounting Standards Board defines expenses as follows: “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. “

An important issue in accounting is when to recognize expenditures. When a business recognizes an expenditure, it records the amount in its financial records. The expenditure offsets the income the business earned and is used to calculate the business’s profit.

This makes the timing of expenses and revenues very important. By shifting the timing of when expenses are recognized, a company can artificially make its business appear more profitable. Therefore, the accounting standards institute has established clear guidelines to minimize any subjective judgment regarding when to recognize expenses. Thus, the accounting method the business uses depends on when an expense is recognized.

Cash Basis Accounting

If the business uses cash basis accounting, an expenditure is recognized when the business pays for a good or service. Generally, cash basis accounting is reserved for tax accounting, not for financial reports.

Accrual Basis Accounting

Most financial reporting in the US is based on accrual basis accounting. Under the accrual system, an expense is not recognized until it is incurred. This means it is unimportant with regard to recognition when a business pays cash to settle an expense.

13.3.2: Current Guidelines for Expense Recognition

Learning Objective

Explain how accrual accounting uses the matching principle for expense recognition

Key Points

• An expense is incurred when the underlying good is delivered or service is performed.
• If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.
• If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed.
• If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred.

Key Terms

consigned good

a good sent to another person where the seller still retains ownership until ownership is transferred or the good is sold

matching principle

An accounting principle related to revenue and expense recognition in accrual accounting.

Since most businesses operate using accrual basis accounting, expense recognition is guided by the matching principle. For an expense to be recognized, the obligation must be both incurred and offset against recognized revenues.

Revenues and Expenses

This graph shows the growth of the revenues, expenses, and net assets of the Wikimedia Foundation from june 2003 to june 2006.

Incurred

An expense is incurred when the underlying good is delivered or service is performed. For example, assume a company enters into a contract with a supplier for the delivery of 1,000 units of raw material that will be used to produce the goods it sells. Two weeks later, the raw material is delivered to the company’s warehouse. Two weeks after that, the company pays the outstanding obligation. Under the matching principle, the expense related to the raw material is not incurred until delivery.

Offset Against Recognized Revenues

Generally, an expense being incurred is insufficient for it to be recognized. If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.

Using the same example from above, the delivery of the raw material is insufficient to cause the cost of those goods to be recognized as an expense. The raw material will be used to make items that will be sold to the public. When the items that used the raw materials are sold, then the costs related to the raw material are recognized.

No Cause and Effect

The matching principle assumes that every expense is directly tied to a revenue generating event, such as a production of a good or service. This is not always the case. When these expenses are recognized depends on what goods or services are related to the cost in question.

If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed. So if a business produced substandard goods that it could not sell or the good becomes spoiled, the production costs would be expensed as soon as it became clear that the item could not be sold.

If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred. Examples of such costs include general administration and research and development.

13.3.3: Differences Between Accrued and Deferred Expenses

Learning Objective

Explain the difference between accrued expenses and deferred expenses

Key Points

• An accrued expense is a liability that represents an expense that has been recognized but not yet paid.
• A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred.
• Oftentimes an expense is not recognized at the same time it is paid. This difference requires a business to record either an asset or liability on its balance sheet to reflect this difference in timing.

Key Terms

matching principle

Expenses should be matched with revenues.

deferred expense

A deferred expense or prepayment, prepaid expense, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.

accrued expense

Accrued expense is a liability with an uncertain timing or amount, the reason being no invoice has been received yet.

accrued revenue

income recognized before cash is received

Expenses

Accrued expenses and deferred expenses are two examples of mismatches between when expenses are recognized under the matching principle and when those expenses are actually paid. Both are represented on the company’s balance sheet .

Balance Sheet

Accrued and deferred expenses are both listed on a company’s balance sheet.

Accrued Expense

An accrued expense is a liability that represents an expense that has been recognized but not yet paid. Not every transaction requires an immediate exchange of cash for goods and services. Sometimes, especially when there is a prolonged history of ongoing transactions between two parties, formal invoicing and payment requirements can occur after the expense associated with the transaction has been recognized.

For example, assume a reseller receives goods from a supplier that it is able to immediately resell. However, the billing for those goods does not require payment for another month. Since the supplier delivered the goods and the reseller already generated revenues from the sale of those goods, it must recognize the associated expense. So the associated expense must be listed as a liability to be paid at some point in the future.

Deferred Expense

A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred. Deferred expense is generally associated with service contracts that require payment in advance.

For example, assume a company enters into a legal services contract that requires an upfront payment of $12,000 for a year of services. The service has not yet been delivered, so the business cannot recognize the expense yet. So the business will record a $12,000 deferred expense asset. The provider then delivers on his service each month, requiring the business to recognize the associated expense. As a result, the business must recognize $1000 in expenses each month and decrease the value of the deferred expense asset by that amount.

13.4: Additional Income Statement Considerations

13.4.1: Impact of the Operating Cycle on the Income Statement

The accrual method ensures proper reporting on the income statement because the operating cycle doesn’t coincide with the accounting cycle.

Learning Objective

Differentiate between the accounting cycle and the operating cycle

Key Points

• A company’s income statement shows profit (or loss) for a given period of time.
• A company’s operating cycle is the length of time necessary to convert inventory into a sale, plus the length of time to receive payment from receivables, plus the length of time to pay the accounts payable.
• The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding.
• The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating financial statements.
• The accounting cycle is often different from the operating cycle.

Key Terms

income statement

A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

profitability

The capacity to make a profit.

operating cycle

The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale.

Income Statement

The income statement is one component of the financial statements for a company. It can also be referred to as an earnings statement, profit and loss statement, or operating statement . The income statement reports the profitability of a business organization for a stated period, such as a month or a year. These time periods are usually of equal length so that statement users can make valid comparisons of a company’s performance from period to period. Profitability is measured by comparing the revenues earned with the expenses incurred to produce the revenue.

The company’s income statement

The income statement shows a company’s profit or loss.

An example of revenue is cash received from the sale of products or services. Expenses are the costs involved in producing revenue, such as cash spent to purchase materials or pay bills or employees. If the revenues for a period exceed the expenses for the same period, net income results (Net income = Revenues – Expenses). If expenses exceed revenues for the period, then the result is a net loss.

Accounting Cycle vs. Operating Cycle

Information enters the income statement via the accounting cycle. The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating the financial statements. This includes analyzing items to determine if they are a business transaction, as well as classifying and recording the transactions as journal entries in the proper journal. After that, the items are posted from the journals to the general ledger, which is used to prepare the financial statements. Companies choose the length of their accounting cycle by how long it takes to carry out the required accounting—not when the individual business transactions take place.

Often, companies have a separate operating cycle for their business. The operating cycle reflects the length of time it takes a company to convert its inventory purchase to sales revenue. A typical operating cycle includes the length of time to convert inventory into a sale, length of time to receive payment from receivables, and length of time to pay the accounts payable.

The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding and may occur several times in one period. It is very rare that the accounting cycle and operating cycle coincide with each other. That is why each business transaction during the operating cycle is analyzed to determine which accounting cycle to record it in. When companies fail to follow this procedure, the current accounting cycle records do not accurately reflect the business transactions in each of the operating cycles. In that case, the financial statements, including the income statement, will not be accurate.

Accrual Basis of Accounting

To allow for the fluctuations in the operating cycle, many companies choose to use the accrual basis of accounting. In accrual accounting, companies recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. However, the matching principle necessitates the preparation of adjusting entries. Adjusting entries are journal entries made at the end of an accounting period, or at any time financial statements are to be prepared, to bring about a proper matching of revenues and expenses.

The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. The matching principle is one of the underlying principles of accounting. This matching of expenses and revenues is necessary for the income statement to present an accurate picture of the profitability of a business.

13.4.2: Reporting Irregular Items

Irregular items are reported separately from the income statement proper so that users can better predict future cash flows. 

Learning Objective

Differentiate among discontinued operations, extraordinary items, and changes in accounting principles

Key Points

• Irregular items are shown separately from the income statement proper because they are unlikely to recur. This helps the reader more accurately predict future cash flows
• There are three types of irregular items: discontinued operations, extraordinary items, and changes in accounting principles.
• Discontinued operations, the most common category of irregular items, are a component of an enterprise that either has been disposed of or is classified as “held for sale.”
• Extraordinary items are unexpected, abnormal, and infrequent occurrences—for example, sudden natural disaster or new regulations.
• Changes in accounting principles are when a company adopts a new accounting method that has an impact on the book value of the affected assets or liabilities.

Key Term

irregular item

An unusual occurrence reported separately from the standard income statement because it is unlikely to recur.

Irregular items, which are by definition unlikely to recur, are reported separately from the income statement proper so that users can better predict future cash flows. Irregular items are reported net of taxes.

Discontinued Operations

Discontinued operations are the most common type of irregular items and must be shown separately. A discontinued operation is a component of an enterprise that either has been disposed of or is classified as “held for sale,” and:

• represents a separate major line of business or geographical area of operations; and
• is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or
• is a subsidiary acquired exclusively with a view to resale.

Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Any gain or loss from sale of assets should be recognized in the statement of comprehensive income.

Extraordinary Items

Extraordinary items are unexpected, abnormal, and infrequent—for example, sudden natural disaster, expropriation, or new prohibitions due to changes in regulations.

Changes in Accounting Principles

The effect of changes in accounting principles is the difference between the book value of the affected assets (or liabilities) under the old policy (i.e. principle) vs. what the book value would have been had the new principle been applied. An example, if a company switched from using a weighted-average method to using a LIFO method of valuating inventories, both values for the same time period should be calculated and compared. These changes should be applied retrospectively and shown as adjustments to the beginning balance of affected components in Equity. All comparative financial statements should be restated.

13.4.3: Special Reporting

Irregular items require special reporting procedures, and include discontinued operations, extraordinary items, and the reporting of the resultant EPS.

Learning Objective

Summarize how a company reports extraordinary items, discontinued operations, intraperiod tax allocations, retained earnings and earnings per share.

Key Points

• Discontinued operation pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division.
• Extraordinary items are both unusual (abnormal) and infrequent — for example, unexpected natural disasters, expropriation, and prohibitions under new regulations.
• If a company reports any irregular items on its income statement, then it must report earnings per share for the irregular items.
• With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax applied.

Key Terms

income statement

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 various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.

retained earnings

Retained earnings are the portion of net income that is retained by the corporation rather than distributed to its owners as dividends.

dilute

To cause the value of individual shares to decrease by increasing the total number of shares.

Special Reporting Issues

Special, or irregular, items appear on single step or multi-step income statements, and require special reporting procedures. They are reported separately, and net of taxes, so that stakeholders can better predict future cash flows. Two examples of irregular items are discontinued operations and extraordinary expenses.

Discontinued operation is the most common type of irregular item. It pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations.

Extraordinary items are both unusual (abnormal) and infrequent — for example, unexpected natural disasters, expropriation, and prohibitions under new regulations. If an item is unique, but does not fit the criteria of being unusual and infrequent, it must remain in the main section of the income statement. No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP.

Other special reporting issues include Earnings per Share, Retained Earnings and Intraperiod Tax Allocation.

Earnings per Share: If a company reports any irregular items on its income statement, then it must report earnings per share for those items. The earnings per share can appear on the income statement or in the notes to the income statement. Earnings per share measures the dollars earned by each share of common stock. Earnings per share are calculated as net income, with preferred dividends/weighted number of shares outstanding. There are two forms of earnings per share that are reported: basic and diluted. For basic earnings per share, the weighted average of shares outstanding includes only actual stocks outstanding. In diluted, the 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. Diluted earnings per share are considered a more reliable way to measure earnings per share.

Retained Earnings: The statement of retained earnings explains the changes in a company’s retained earnings over the reporting period. It is required by the U.S. Generally Accepted Accounting Principles (U.S. GAAP) whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income and changes in retained earnings statement, or as a separate schedule. In essence, the statement of retained earnings uses information from the income statement and provides information to the balance sheet. The statement breaks down changes in the owners’ interest in the organization, and also in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses from operations, dividends paid, the issue or redemption of stock, and any other items charged or credited to retained earnings.

Intraperiod Tax Allocation: With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax amount applied. Income tax is allocated to income from continuing operations before tax, discontinued operations and extraordinary items.

13.5: Reporting and Analyzing the Income Statement

13.5.1: Preparation of the Income Statement

An income statement includes detail on operating and non-operating activities.

Learning Objective

Explain the difference between the operating and non-operating section of the income statement

Key Points

• 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 fall under the revenue category of the income statement.
• 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 appear under the expenses section of the income statement.
• 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.
• Certain items must be disclosed separately in the notes, if material, including write-downs of inventories to net realizable value or of property, and restructuring of the activities of an entity and reversal of any provisions for the costs of restructuring; and more.

Key Terms

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

expense

In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

disclosure

The act of revealing something.

Income Statement

An income statement 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 various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

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 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.

A Sample Income Statement

Expenses are listed on a company’s income statement.

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 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 merchandising). It includes material costs, direct labor, 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 labor. Selling expenses represent expenses needed to sell products (e.g., salaries of sales people, commissions and travel expenses, 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 is 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.

Non-operating Section

• Other revenues or gains include those from other than primary business activities (e.g., rent, income from patents). They also includes unusual gains that are either unusual or infrequent, but not both (e.g., gains from the sale of securities or gain from disposal of fixed assets)
• Other expenses or losses not related to primary business operations (e.g., foreign exchange loss).
• Finance costs are costs of borrowing from various creditors (e.g., interest expenses, bank charges).
• Income tax expense is the 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

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.Disclosures

Certain items must be disclosed separately in the notes (or the statement of comprehensive income), if material, including:

• 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
• 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 that 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.

13.5.2: Income Statement Analyses

The income statement indicates how the revenue is transformed into net income and can provide many insights to a company’s performance.

Learning Objective

Explain how the different formulas are used on the income statement to show a company’s performance

Key Points

• Net income is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.
• In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies.
• The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share.
• The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads.
• Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments.

Key Terms

ratio

A number representing a comparison between two things.

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

net income

Gross profit minus operating expenses and taxes.

The 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 various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported .

A Sample Income Statement

Expenses are listed on a company’s income statement.

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.

Basic Equations

Revenues – Expenses = Net Income

• In business, net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.

Earnings per Share = (Net Income –

Preferred

Dividends) / Shares of Stock Outstanding

• Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock.

Price to Earnings Ratio = Market Value of Stock / Earnings per Share

• In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies. A higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more “expensive” than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years. The price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation, earnings growth and the time value of money.

Dividend Yield = (Dividends per Share / Market Value of Stock) x 100

• The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.
• Dividend yield is used to calculate the earnings on investment (shares) considering only the returns in the form of total dividends declared by the company during the year.

Operating Expense Ratio = Operating Expense / Net Sales

• The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads. In railroading, an operating ratio of 80 or lower is considered desirable.
• The operating ratio can be used to determine the efficiency of a company’s management by comparing operating expenses to net sales. It is calculated by dividing the operating expenses by the net sales. The smaller the ratio, the greater the organization’s ability to generate profit should revenues decrease. The ratio does not factor in expansion or debt repayment.

Times Interest Earned = Net Income / Annual Interest Expense

• Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.

12.3: Rules and Rights of Common and Preferred Stock

12.3.1: Claim to Income

Learning Objective

Describe the rights preferred stock has to a company’s income

Key Points

• Common stock and preferred stock are both forms of equity ownership but carry different rights and claims to income.
• Preferred stock shareholders will have claim to assets over common stock shareholders in the case of company liquidation.
• Preferred stock also has first right to dividends.

Key Terms

Common stock

Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the line when it comes to dividends and receiving compensation in the case of bankruptcy.

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Preferred and common stock have varying claims to income which will change from one equity issuer to another. In general, preferred stock will be given some preference in assets to common assets in the case of company liquidation, but both will fall behind bondholders when asset distribution takes place. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, these investors often receive nothing after a bankruptcy. Preferred stock also has the first right to receive dividends. In general, common stock shareholders will not receive dividends until it is paid out to preferred shareholders. Access to dividends and other rights vary from firm to firm.

1903 stock certificate of the Baltimore and Ohio Railroad

Preferred and common stock both carry rights of ownership, but represent different classes of equity ownership.

Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.

Both types of stock can have a claim to income in the form of capital appreciation as well. As company value increases based on market determinants, the value of equity held in this company also will increase. This translates to a return on investment to shareholders. This will be different to common stock shareholders and preferred stock shareholders because of the different prices and rewards based on holding these different kinds of shares. In turn, should market forces decrease, the value of equity held will decrease as well, reflecting a loss on investment and, therefore, a decrease on the value of any claims to income for shareholders.

12.3.2: Voting Right

Learning Objective

Summarize the voting rights associated with common and preferred stock

Key Points

• Common stock shareholders can generally vote on issues, such as members of the board of directors, stock splits, and the establishment of corporate objectives and policy.
• While having superior rights to dividends and assets over common stock, generally preferred stock does not carry voting rights.
• Many of the voting rights of a shareholder can be exercised at annual general body meetings of companies. An annual general meeting is a meeting that official bodies, and associations involving the general public, are often required by law to hold.

Key Terms

Voting rights

Rights which are generally associated with common stock shareholders in regards to business entity matters ( such as electing the board of directors or establishing corporate policy)

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Common stock

Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the line when it comes to dividends and receiving compensation in the case of bankruptcy.

Voting Rights

Common stock can also be referred to as a “voting share. ” Common stock usually carries with it the right to vote on business entity matters, such as electing the board of directors, establishing corporate objectives and policy, and stock splits. However, common stock can be broken into voting and non-voting classes. While having superior rights to dividends and assets over common stock, generally preferred stock does not carry voting rights.

The matters that a stockholder gets to vote on vary from company to company. In many cases, the shareholder will be able to vote for members of a company board of directors and, in general, each share gets a vote as opposed to each shareholder. Therefore, a single investor who owns 300 shares will have more say in a voting matter than a single shareholder that owns 30.

Exercising Voting Rights

Many of the voting rights of a shareholder can be exercised at annual general body meetings of companies. An annual general meeting is a meeting that official bodies and associations involving the general public (including companies with shareholders) are often required by law (or the constitution, charter, by-laws, etc., governing the body) to hold. An AGM is held every year to elect the board of directors and inform their members of previous and future activities. It is an opportunity for the shareholders and partners to receive copies of the company’s accounts, as well as reviewing fiscal information for the past year and asking any questions regarding the directions the business will take in the future. Shareholders also have the option to mail their votes in if they cannot attend the shareholder meetings. In 2007, the Securities and Exchange Commission voted to require all public companies to make their annual meeting materials available online. Shareholders with the right to vote will have numerous options in how to make their voice heard with regards to voting matters should they choose to.

Shareholder Meeting

This scene from “The Office” humorously illustrates a shareholder meeting, where the shareholder can exercise their right to vote on company issues or question company directors.

12.3.3: Provisions of Preferred Stock

Learning Objective

Describe in detail the different types of provisions for preferred stock

Key Points

• If a preferred share has cumulative dividends, then it contains the provision that should a company fail to pay out dividends at any time at the stated rate, then the issuer will have to make up for it as time goes on.
• Convertible preferred stock can be exchanged for a predetermined number of company common stock shares.
• Often times companies will keep the right to call or buy back preferred shares at a predetermined price.
• Participating preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals.
• Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index.

Key Terms

Callable shares

Shares which can be bought back by the issuer at a predetermined price.

Convertible preferred stock

Convertible preferred stock can be exchanged for a predetermined number of company common stock shares.

Cumulative Dividends

Condition where owners of certain shares will receive accumulated dividends in the case a company cannot pay out dividends at the stated rate at the stated time.

Preferred stock may be entitled to numerous rights, depending on what is designated by the issuer. One of these rights may be the right to cumulative dividends. Preferred stock shareholders already have rights to dividends before common stock shareholders, but cumulative preferred shares contain the provision that should a company fail to pay out dividends at any time at the stated rate, then the issuer will have to make up for it as time goes on.

Historical dividend information for Franklin Automobile Company

Dividends are one of the privileges of stock ownership, and preferred shares get more rights to them than common shares do.

Convertible preferred stock can be exchanged for a predetermined number of company common stock shares. Generally, this can occur at the discretion of the investor, and he or she may pick any time to do so and, therefore, take advantage of fluctuations in the price of common stock. Once converted, the common stock cannot be converted back to preferred status.

Often times companies will keep the right to call or buy back preferred shares at a predetermined price. These shares are callable shares.

There is a class of preferred shares known as “participating preferred stock. ” These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance (assuming the company does well enough to make its annual dividend payments). If the company achieves predetermined sales, earnings, or profitability goals, the investors receive an additional dividend.

Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index or floating rate. An example of this would be tying the dividend rate to LIBOR.

12.3.4: Purchasing New Shares

Learning Objective

Discuss the process and implication of purchasing new shares by a shareholder that already holds shares in a company

Key Points

• New share purchase is an important indicator of current shareholder belief in the health of the company and long term prospects for growth.
• Current Shareholders will often have preemptive rights that give them the right to purchase newly issued company shares before they go on sale to the general public.
• New shares can be purchased on exchanges, which offer a platform for the financial marketplace.

Key Terms

Stock Exchange

A form of exchange that provides services for stock brokers and traders to trade stocks, bonds and other securities.

Preemption

The right of a shareholder to purchase newly issued shares of a business entity before they are available to the general public so as to protect individual ownership from dilution.

New share purchases are an important action by share shareholders, since it requires a further investment in a business entity and is a reflection of a shareholder’s decision to maintain an ownership position in a company, or a potential investor’s belief that purchasing equity in a company will be an investment that grows in value.

Current shareholders may have preemptive rights over new shares offered by the company. In practice, the most common form of preemption right is the right of existing shareholders to acquire new shares issued by a company in a rights issue, a usually but not always public offering. In this context, the pre-emptive right is also called “subscription right” or “subscription privilege. ” This is the right, but not the obligation, of existing shareholders to buy the new shares before they are offered to the public. In this way, existing shareholders can maintain their proportional ownership of the company, preventing stock dilution.

New shares may be purchased over the same exchange mechanisms that previous stock was acquired. A stock exchange is a form of exchange which provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events, including the payment of income and dividends. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets are driven by various factors that, as in all free markets, affect the price of stocks.

Exchanges

New shares can be traded on exchanges such as the Nasdaq, but will usually be offered to current shareholders before being put on sale to the general public.

12.3.5: Preferred Stock Rules and Rights

Learning Objective

List the rights that preferred stock generally has

Key Points

• Preferred stock generally does not carry voting rights, but this may vary from company to company.
• Preferred stock can gain cumulative dividends, convertibility to common stock, and callability.
• The rights that come with ownership of preferred stock are detailed in a “Certificate of Designation”.

Key Terms

liquidation

liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Designation. “

VOC stock

Preferred stock is a security ( a little more modern that this stock from the VOC or Dutch East India Company) that carries certain rights which designate it from common stock or debt.

Preferred stock is a special class of shares that may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock: Preference in dividends preference in assets, in the event of liquidation, convertibility to common stock, callability, and at the option of the corporation. Some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors, but, once again, most preferred shares have no voting rights associated with them. Some preferred shares gain voting rights when the preferred dividends are in arrears for a substantial time.

Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital which was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index. Preferred stock may also have rights to cumulative dividends.

12.3.6: Comparing Common Stock, Preferred Stock, and Debt

Learning Objective

Differentiate between the rights of common shareholders, preferred shareholders, and bond holders

Key Points

• Common stock and preferred stock fall behind debt holders as creditors that would receive assets in the case of company liquidation.
• Common stock and preferred stock are both types of equity ownership. They receive rights of ownership in the company, such as voting and dividends.
• Debt holders often receive a bond for lending and while this does not give the ownership rights of being a stockholder, it does create a superior claim to a company’s assets in the case of liquidation.

Key Terms

Common stock

Common stock is a form of corporate equity ownership, a type of security.

bond

A bond is an instrument of indebtness of the bond issuers toward the bond holders.

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Equity

Common Stock and Preferred Stock are both methods of purchasing equity in a business entity.

Common stock generally carries voting rights along with it, while preferred shares generally do not.

Preferred shares act like a hybrid security, in between common stock and holding debt. Preferred stock can (depending on the issue) be converted to common stock and have access to accumulated dividends and multiple other rights. Preferred stock also has access to dividends and assets in the case of liquidation before common stock does.

However, both common and preferred stock fall behind debt holders when it comes to claims to assets of a business entity should bankruptcy occur. Common shareholders often do not receive any assets after bankruptcy as a result of this principle. However, common stock shareholders can theoretically use their votes to affect company decision making and direction in a way they believe will help the company avoid liquidation in the first place.

Debt

Debt can be “purchased” from a company in the form of a bond.

A bond from the Dutch East India Company

A bond is a financial security that represents a promise by a company or government to repay a certain amount, with interest, to the bondholder.

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest and/or to repay the principal at a later date, termed the maturity. Therefore, a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas, bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

12.4: Additional Detail on Preferred Stock

12.4.1: Dividend Preference

A corporation may issue two basic classes or types of capital stock, common and preferred, both of which can receive dividends.

Learning Objective

Explain the difference between common stock and preferred stock dividends

Key Points

• A corporation may issue two basic classes or types of capital stock, common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights.
• Common stock is a form of corporate equity ownership. Common stock holders cannot be paid dividends until all preferred stock dividends are paid in full. On the other hand, common shares on average perform better than preferred shares or bonds over time.
• Preferred stock is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim.

Key Terms

dividend in arrears

an omitted dividend on cumulative preferred stock

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Common stock

Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

Dividends

A corporation may issue two basic classes or types of capital stock—common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights. Common stock is usually the residual equity in the corporation, meaning that all other claims against the corporation rank ahead of the claims of the common stockholder. Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features.

Companies issue preferred stock in order to avoid the following:

• Using bonds with fixed interest charges that must be paid regardless of the amount of net income.
• Issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years.
• Diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

1903 stock certificate of the Baltimore and Ohio Railroad

Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

Details on Common Stock

Common stock is a form of corporate equity ownership, a type of security. The terms “voting share” or “ordinary share” are also used in other parts of the world; common stock is primarily used in the United States. It is called “common” to distinguish it from preferred stock. If both types of stock exist, common stock holders cannot be paid dividends until all preferred stock dividends (including payments in arrears) are paid in full. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, such investors often receive nothing after a bankruptcy. On the other hand, common shares on average perform better than preferred shares over time.

Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors. However, a company can have both a “voting” and “non-voting” class of common stock. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company’s board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering. There is no fixed dividend paid out to common stock holders and so their returns are uncertain, contingent on earnings, company reinvestment, and efficiency of the market to value and sell stock. Additional benefits from common stock include earning dividends and capital appreciation.

Details on Preferred Stocks

Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to stock holders’ share of company assets). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock upon liquidation, and in the payment of dividends. Terms of the preferred stock are stated in a “Certificate of Designation. “

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds, and because they are junior to all creditors.

12.4.2: Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to satisfy claims in the manner and order prescribed by law.

Learning Objective

Summarize how the liquidation preference determines which claims will be paid if a company becomes insolvent

Key Points

• The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law.
• Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims.
• Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance.
• Most preferred stocks are preferred as to assets in the event of liquidation of the corporation.

Key Terms

creditor

A person to whom a debt is owed.

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

liquidation

The selling of the assets of a business as part of the process of dissolving it.

Example

• A party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance and compel the liquidator to transfer title to the land to them, upon tender of the purchase price. After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.

Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law. The liquidator must determine the company’s title to property in its possession. Property which is in the possession of the company, but which was supplied under a valid retention of title clause will generally have to be returned to the supplier. Property which is held by the company on trust for third parties will not form part of the company’s assets available to pay creditors.

Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims. Security by way of floating charge may be postponed to the preferential creditors.

Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance and compel the liquidator to transfer title to the land to them, upon tender of the purchase price. After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.

Plane Liquidation

Planes are an example of liquidated items when companies “go under. ” They are generally auctioned off to the highest bidder.

Priority of Claims

Generally, the priority of claims on the company’s assets will be determined in the following order:

• Liquidators costs
• Creditors with fixed charge over assets
• Costs incurred by an administrator
• Amounts owed to employees for wages/superannuation (director limit $2,000)
• Payments owed in respect of workers’ injuries
• Amounts owed to employees for leave (director limit $1,500)
• Retrenchment payments owing to employees
• Creditors with floating charge over assets
• Creditors without security over assets
• Shareholders (Liquidating distribution) – Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.
• Unclaimed assets will usually vest in the state as bona vacantia.

12.4.3: Accounting for Preferred Stock

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock.

Learning Objective

Differentiate between preferred to dividends, noncumulative, cumulative and convertible preferred stock

Key Points

• Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to preferred stockholders as a return for the use of their money.
• Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year.
• Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.
• All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.

Key Terms

Common stock

Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

cumulative dividend

a payments by the company to shareholders that accumulate if a previous payment was missed

Preferred Stock

Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features. Companies issue preferred stock to avoid:

1903 stock certificate of the Baltimore and Ohio Railroad

Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

1. using bonds with fixed interest charges that must be paid regardless of the amount of net income;
2. issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years; and
3. diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

Types of Preferred Stock

When a corporation issues both preferred and common stock, the preferred stock may be:

• Preferred as to dividends. It may be noncumulative or cumulative.
• Preferred as to assets in the event of liquidation.
• Convertible or nonconvertible.
• Callable.

Preferred as to Dividends

Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend is the amount paid to preferred stockholders as a return for the use of their money.

For no-par preferred stock, the dividend is a specific dollar amount per share per year, such as USD 4.40. For par value preferred stock, the dividend is usually stated as a percentage of the par value, such as 8% of par value; occasionally, it is a specific dollar amount per share. Most preferred stock has a par value.

Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends only if they have retained earnings (income that has been retained in the business) at least equal to the dividend declared.

Noncumulative Preferred Stock

Noncumulative preferred stock is preferred stock in which a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.

Cumulative Preferred Stock

Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock. For example, assume a company has cumulative, USD 10 par value, 10% preferred stock outstanding of USD 100,000, common stock outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years) before paying any dividends to the common stockholders.

Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote.

Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.

Convertible Preferred Stock

Convertible preferred stock is preferred stock that is convertible into common stock of the issuing corporation. Convertible preferred stock is uncommon, most preferred stock is nonconvertible. Holders of convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common stock of the same corporation.

Preferred Stock and the Balance Sheet

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.

12.5: Dividend Policy

12.5.1: Impact of Dividend Policy on Clientele

Change in a firm’s dividend policy may cause loss of old clientele and gain of new clientele, based on their different dividend preferences.

Learning Objective

Describe how the clientele effect can influence stock price

Key Points

• The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change.
• Current clientele might choose to sell their stock if a firm changes their dividend policy and deviates considerably from the investor’s preferences. Changes in policy can also lead to new clientele, whose preferences align with the firm’s new dividend policy.
• In equilibrium, the changes in clientele sets will not lead to any change in stock price.
• The real world implication of the clientele effect lies in the importance of dividend policy stability, rather than the content of the policy itself.

Key Terms

clientele effect

The theory that changes in a firm’s dividend policy will cause loss of some clientele who will choose to sell their stock, and attract new clientele who will buy stock based on dividend preferences.

clientele

The body or class of people who frequent an establishment or purchase a service, especially when considered as forming a more-or-less homogeneous group of clients in terms of values or habits.

dividend clientele

Sets of investors who are attracted to certain types of dividend policy.

Example

• Suppose Firm A had been in a growth stage and did not offer dividends to its shareholders, but their policy changed to paying low cash dividends. Clientele interested in long term capital gains might be alarmed, interpreting this decision as a sign of slowing growth, which would mean less stock price appreciation in the future. This set of clientele could choose to sell the stock. On the other hand, dividend payments could appeal to investors who are interested in regular additional income from the investment, and they would buy Firm A’s stock.

The Clientele Effect

The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change. These investors are known as dividend clientele. For instance, some clientele would prefer a company that doesn’t pay dividends at all, but instead invests their retained earnings toward growing the business. Some would instead prefer the regular income from dividends over capital gains. Of those who prefer dividends over capital gains, there are further subsets of clientele; for example, investors might prefer a stock that pays a high dividend, while another subset might look for a balance between dividend payout and reinvestment in the company.

Clientele Type Example

Retirees are more likely to prefer high dividend payouts over capital gains since this provides them with cash income. Therefore, if a company discontinued paying dividends, the clientele effect may cause retiree shareholders to sell the stock in favor of other income generating investments.

Clientele may choose to sell their stock if a firm changes its dividend policy, and deviates considerably from its preferences. On the other hand, the firm may attract a new clientele group if its new dividend policy appeals to the group’s dividend preferences. These changes in demographics related to a stock’s ownership due to a change of dividend policy are examples of the “clientele effect. “

This theory is related to the dividend irrelevance theory presented by Modigliani and Miller, which states that, under particular assumption, an investor’s required return and the value of the firm are unrelated to the firm’s dividend policy. After all, clientele can just choose to sell off their holdings if they dislike a firm’s policy change, and the firm may simultaneously attract a new subset of clientele who like the policy change. Therefore, stock value is unaffected. This is true as long as the “market” for dividend policy is in equilibrium, where demand for such a policy meets the supply.

The clientele effect’s real world implication is that what matters is not the content of the dividend policy, but rather the stability of the policy. While investors can always choose to sell shares of firms with undesirable dividend policy, and buy shares of firms with attractive dividend policy, there are brokerage costs and tax considerations associated with this. As a result, an investor may stick with a stock that has a sub-optimal dividend policy because the cost of switching investments outweighs the benefit the investor would receive by investing in a stock with a better dividend policy.

Although commonly used in reference to dividend or coupon (interest) rates, the clientele effect can also be used in the context of leverage (debt levels), changes in line of business, taxes, and other management decisions.

12.5.2: Stock Dividends vs. Cash Dividends

Investors’ preference for stock or cash depends on their inclinations toward factors such as liquidity, tax situation, and flexibility.

Learning Objective

Assess whether a particular shareholder would prefer stock or cash dividends

Key Points

• Cash dividends provide steady payments of cash that can be used to reinvest in a company, if the shareholder desires.
• Holders of stock dividends can sell their stock for (hopefully) high capital gains in the future, or they can sell it off immediately to get cash, much like a cash dividend. This flexibility is seen by some as a benefit of stock dividend.
• Cash dividends are immediately taxable as income, while stock dividends are only taxed when they are actually sold by the shareholder.
• If an investor is interested in long-term capital gains, he or she will likely prefer stock dividends. If an investor needs a regular source of income, cash dividends will provide liquidity.
• Firms can choose to issue stock dividends if they would like to direct their earnings toward the development of the firm but would still like to appease stockholders with some form of payment.
• Established firms with little more room to grow do not have pressing needs for all their cash earnings, so they are more likely to give cash dividends.

Key Terms

cash dividend

a payment by the company to shareholders paid out in currency, usually via electronic funds transfer or a printed paper check

stock dividends

Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.

cash dividends

Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check.

If a firm decides to parcel out dividends to shareholders, they have a choice in the form of payment: cash or stock. Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check. This is the most common method of sharing corporate profits with the shareholders of a company. Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.Cash dividends provide investors with a regular stream of income. Stock dividends, unlike cash dividends, do not provide liquidity to the investors; however, they do ensure capital gains to the stockholders. Therefore, if investors are not interested in a long-term investment, they will prefer regular cash payments over payments of additional stock.

Income from Dividends

When choosing between cash or stock dividends, the trade-off is between liquidity in the short-term or income from capital gains in the long-term.

Costs of taxes can also play a role in choosing between cash or stock dividends. Cash dividends are immediately taxable under most countries’ tax codes as income, while stock dividends are not taxable until sold for capital gains (if stock was the only choice for receiving dividends). This can be seen as a huge benefit of stock dividends, particularly for investors of a high income tax bracket. A further benefit of the stock dividend is its perceived flexibility. Shareholders have the choice of either keeping their shares in hopes of high capital gains, or selling some of the new shares for cash, which is somewhat like receiving a cash dividend.

If the payment of stock dividends involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization of the shares held. It has the same effect as a stock split: the total value of the firm is not affected. If the payment involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held. As such, receiving stock dividends does not increase a shareholder’s stake in the firm; by contrast, a shareholder receiving cash dividends could use that income to reinvest in the firm and increase their stake.

For the firm, dividend policy directly relates to the capital structure of the firm, so choosing between stock dividends and cash dividends is an important consideration. A firm that is still in its stages of growth will most likely prefer to retain its earnings and put them toward firm development, instead of sending them to their shareholders. The firm could also choose to appease investors with stock dividends, which would still allow it to retain its earnings. Conversely, a firm that is already quite stable with low growth is much more likely to choose payment of dividends in cash. The needs and cash flow of the firm are necessary points of consideration in choosing a dividend policy.

12.5.3: Investor Preferences

The significance of investors’ dividend preferences is a contested topic in finance that has serious implications for dividend policy.

Learning Objective

Identify the criteria that define a company’s dividend policy

Key Points

• Elements of dividend policy include: paying a dividend vs reinvestment in company, high vs low payout, stable vs irregular dividends, and frequency of payment.
• Some are of the opinion that the future gains are more risky than the current dividends, so investors prefer dividend payments over capital gains. Others contend that dividend policy is ultimately irrelevant, since investors are indifferent between selling stock and receiving dividends.
• Assuming dividend relevance, coming up with a dividend policy is challenging for the firms because different investors have different views on present cash dividends and future capital gains.
• Importance of the content and the stability of a dividend policy are subject to much academic debate.

Key Terms

capital gains

Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).

dividend policy

A firm’s decisions on how to distribute (or not distribute) their earnings to their shareholders.

The role of investor preferences for dividends and the value of a firm are pieces of the dividend puzzle, which is the subject of much academic debate. Assuming dividend relevance, coming up with a dividend policy is challenging for the directors and financial manager of a company because different investors have different views on present cash dividends and future capital gains. Investor preferences are first split between choosing dividend payments now, or future capital gains in lieu of dividends. Further elements of the dividend policy also include:1. High versus low payout, 2. Stable versus irregular dividends, and 3. Frequency of payment. Cash dividends provide liquidity, but the bonus share will bring capital gains to the shareholders. The investor’s preference between the current cash dividend and the future capital gain has been viewed in kind.

Many people hold the opinion that the future gains are more risky than the current dividends, as the “Bird-in-the-hand Theory” suggests. This view is supported by both the Walter and Gordon models, which find that investors prefer those firms which pay regular dividends, and such dividends affect the market price of the share. Gordon’s dividend discount model states that shareholders discount the future capital gains at a higher rate than the firm’s earnings, thereby evaluating a higher value of the share. In short, when the retention rate increases, they require a higher discounting rate.

In contrast, others (see Dividend Irrelevance Theory) argue that the investors are indifferent between dividend payments and the future capital gains. Therefore, the content of a firm’s dividend policy has no real effect on the value of the firm.

Investor preferences play an uncertain role in the “dividend puzzle,” which refers to the phenomenon of companies that pay dividends being rewarded by investors with higher valuations, even though according to many economists, it should not matter to investors whether or not a firm pays dividends. There are a number of factors, such as psychology, taxes, and information asymmetries tied into this puzzle, which further complicate the matter.

Stock Market

Different kinds of investors are active in stock market.

12.5.4: Accounting Considerations

Accounting for dividends depends on their payment method (cash or stock).

Learning Objective

Describe the accounting considerations associated with dividends

Key Points

• Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is transferred into a separate dividends payable account and this is debited on payment day.
• Accounting for stock dividends is essentially a transfer from retained earnings to paid-in capital.
• Unlike cash dividends, stock dividends do not come out of the firm’s income, so the firm is able to both maintain their cash and offer dividends. The firm’s net assets remain the same, as does the wealth of the investor.

Key Terms

paid-in capital

Capital contributed to a corporation by investors through purchase of stock from the corporation.

retained earnings

The portion of net income that is retained by the corporation rather than distributed to its owners as dividends.

declaration date

the day the Board of Directors announces its intention to pay a dividend

Example

• Cash dividend example: Firm A’s Board of Directors declared a dividend on December 1, 2011 of $100,000 payable to shareholders of record on Feb 1, 2012 and payable on Feb 29, 2012. This $100,000 goes down as a liability on the firm’s accounting sheet.

Accounting for dividends depends on their payment method (cash or stock). On the declaration day, the firm’s Board of Directors announces the issuance of stock dividends or payment of cash dividends. Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is placed in a separate dividends payable account.

The accounting equation for this is simply:

Retained Earnings = Net Income − Dividends

Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity (shareholders’ equity). ” It is mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners/stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

On the date of payment, when dividend checks are mailed out to stockholders, the dividends payable account is debited and the firm’s cash account is credited.

Stock dividends are parsed out as additional stocks to shareholders on record. Unlike cash dividends, this does not come out of the firm’s income. The firm is able to both maintain their cash and give dividends to investors. Here, the firm’s net assets remain the same. If a firm authorizes a 15% stock dividend on Dec 1st, distributable on Feb 29, and to stockholders of record on Feb 1, the stock currently has a market value of $15 and a par value of $4. There are 150,000 shares outstanding and the firm will issue 22,500 additional shares. The value of the dividend is (150,000)(15%)(15) = $337,500.

The declaration of this dividend debits retained earnings for this value and credits the stock dividend distributable account for the number of new stock issued (150,000*.15 = 22,500) at par value. We must also consider the difference between market value and par (stated) value and record that as credit for additional paid-in-capital . On the day of issuance, the stock dividends distributable account is debited and stock is credited $90,000.

12.5.5: Signaling

Dividend decisions are frequently seen by investors as revealing information about a firm’s prospects; therefore firms are cautious with these decisions.

Learning Objective

Describe what information a shareholder can obtain from a company issuing dividends

Key Points

• Signaling is the idea that one agent conveys some information about itself to another party through an action. It took root in the idea of asymmetric information; in this case, managers know more than investors, so investors will find “signals” in the managers’ actions to get clues about the firm.
• For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Investors will notice this and choose to sell their share of the firm.
• Investors can use this knowledge about signal to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations.
• Firms are aware of this signaling effect, so they will try not to send a negative signal that sends their stock price down.

Key Terms

dividend decision

A decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company’s stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.

information asymmetry

In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.

signalling

Action taken by one agent to indirectly convey information to another agent.

A dividend decision may have an information signalling effect that firms will consider in formulating their policy. This term is drawn from economics, where signaling is the idea that one agent conveys some information about itself to another party through an action.

Signaling took root in the idea of asymmetric information, which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services . An information asymmetry exists if firm managers know more about the firm and its future prospects than the investors.

A company’s dividend decision may signal what management believes is the future prospects of the firm and its stock price.

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm’s future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information in actions like the firm’s dividend policy. For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers’ behavior to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

12.6: Cash Dividend Alternatives

12.6.1: Dividend Reinvestments

Dividend reinvestment plans (DRIPs) automatically reinvest cash dividends in the stock.

Learning Objective

Describe a dividend reinvestment plan

Key Points

• DRIPs help shareholders reinvest their dividends in the underlying stock without having to wait for enough money to buy a whole number of shares. It also may allow them to avoid some brokerage fees.
• DRIPs help stabilize stock prices by inherently encouraging long-term investment instead of active-management, which may cause volatility.
• DRIPs are generally associated with programs offered by the company. However, brokerage firms may offer similar reinvestment programs called “synthetic DRIPs”.

Key Term

reinvest

To invest cash again, instead of holding it as cash.

In some instances, a company may offer its shareholders an alternative option to receiving cash dividends. The shareholder chooses to not receive dividends directly as cash; instead, the shareholder’s dividends are directly reinvested in the underlying equity. This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).

The purpose of the DRIP is to allow the shareholder to immediately reinvest his or her dividends in the company. Should the shareholder choose to do this on his or her own, s/he would have to wait until enough cash accumulates to buy a whole number of shares and s/he would also incur brokerage fees .

Charles Schwab

Brokerage firms like Charles Schwab earn money by charging a brokerage fee for executing transactions. Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.

Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder. Some DRIPs are free of charge for participants, while others do charge fees and/or proportional commissions.

DRIPs have become popular means of investment for a wide variety of investors as DRIPs enable them to take advantage of dollar-cost averaging with income in the form of corporate dividends that the company is paying out. Not only is the investor guaranteed the return of whatever the dividend yield is, but s/he may also earn whatever the stock appreciates to during his or her time of ownership. However, s/he is also subject to whatever the stock may decline to, as well.

There is an advantage to the the company managing the DRIP, too. DRIPS inherently encourage long-term investment in the shares, which helps to mitigate some of the volatility associated with active-trading. DRIPs help to stabilize the stock price.

The name “DRIP” is generally associated with programs run by the dividend-paying company. However, some brokerage firms also offer similar plans where shareholders can choose to have their cash dividends reinvested in stocks for little or no cost. This is called a synthetic DRIP.

12.6.2: Stock Dividends

Stock dividends are when a company gives each shareholder additional stock in lieu of a cash dividend.

Learning Objective

Create a journal entry to record a stock dividend and a stock split

Key Points

• Stock dividends are no different than stock splits in practice. They simply increase the number of shares outstanding, but not the market capitalization or the total value of the shareholders’ assets.
• Stock dividends may be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).
• Cash dividends are taxed while stock dividends are not.
• The journal entry to record the stock dividend is a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

Key Terms

stock split

To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.

stock dividend

a payment to a shareholder paid out in the form of additional stock shares of the issuing corporation, or another corporation (such as its subsidiary corporation)

In lieu of cash, a company may choose to pay its dividend in the form of stock. Instead of each shareholder receiving, say $2 for each share, they may receive an additional share. A stock dividend (also known as a scrip dividend) can be the economic equivalent of a stock split.

When a stock dividend is paid, no shareholder actually increases the values of his or her assets. The total number of shares outstanding increases in proportion to the change in the number of shares held by each shareholder. If a 5% stock dividend is paid, the total number of shares outstanding increases by 5%, and each shareholder will receive 5 additional shares for each 100 held. As a result, each shareholder has the same ownership stake as before the stock dividend.

In addition, the value of the shares held does not change for each shareholder. As the number of shares outstanding increases, the price per share drops because the market capitalization does not change. Therefore, each shareholder will hold more shares, but each has a lower price so the total value of the shares remains unchanged.

The stock dividend is not, however, exactly the same as a stock split. A stock split is paid by switching out old shares for a greater number of new shares. The company is essentially converting to a new set of shares and asking each shareholder to trade in the old ones.

A stock dividend could be paid from shares not-outstanding. These are the company’s own shares that it holds: they are not circulating in the market, but were issued just the same. The company may have gotten these shares from share repurchases, or simply from them not being sold when issued.

Stock dividends may also be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).

The company would record the stock dividend as a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

An advantage of paying stock dividends instead of cash dividends to the shareholder is due to tax considerations. Cash dividends are taxed, while stock dividends are not . Of course, stock dividends don’t actually change the asset value of the shareholders so, in effect, nothing of substance has occurred.

Supreme Court Seal

The Eisner vs. Macomber case was a US Supreme Court Case that helped determine the differences in taxation of cash and stock dividends.

12.6.3: Drawbacks of Repurchasing Shares

Share repurchases often give an advantage to insiders and can be used to manipulate financial metrics.

Learning Objective

Discuss the drawbacks of a share repurchase

Key Points

• Insiders are more likely to know if a firm is undervalued, and are therefore more likely to know whether they should sell their shares in an open-market repurchase.
• Financial ratios that use the number of shares outstanding change when shares are repurchased. Executives and management whose compensation is tied to these metrics have an incentive to manipulate them through share repurchases.
• Share repurchases are often not completed. It is tough to value the effect of a share repurchase announcement because it is unknown whether it will occur in full.

Key Terms

Earnings Per Share

The amount of earnings per each outstanding share of a company’s stock.

insider

A person who has special knowledge about the inner workings of a group, organization, or institution.

There are a number of drawbacks to share repurchases. Both shareholders and the companies that are repurchasing the shares can be negatively affected.

Shares may be repurchased if the management of the company feels that the company’s stock is undervalued in the market. It repurchases the shares with the intention of selling them once the market price of the shares increase to accurately reflect their true value. Not every shareholder, however, has a fair shot at knowing whether the repurchase price is fair. The repurchasing of the shares benefits the non-selling shareholders and extracts value from shareholders who sell. This gives insiders an advantage because they are more likely to know whether they should sell their shares to the company .

Martha Stewart

Martha Stewart was convicted of insider trading, which is not the same as insiders choosing whether to sell their shares in a share repurchase. Insiders are still at an advantage because they will know not to sell during the share repurchase.

Furthermore, share repurchases can be used to manipulate financial metrics. All financial ratios that include the number of shares outstanding (notably earnings per share, or EPS) will be affected by share repurchases. Since compensation may be tied to reaching a high enough EPS number, there is an incentive for executives and management to try to boost EPS by repurchasing shares. Inaccurate EPS numbers are not good for investors because they imply a degree of financial health that may not exist.

From the investor’s standpoint, one drawback of share repurchases is that it’s hard to judge how it will affect the valuation of the company. Companies often announce repurchases and then fail to complete them, but repurchase completion rates increased after companies were forced to retroactively disclose their repurchase activity. It is difficult for shareholders, especially relatively uninformed ones, to judge how the announcement will affect the value of their holdings if there is no guarantee that the full announced repurchase will occur.

12.6.4: Reverse Splits

Reverse splits are when a company reduces the number of shares outstanding by offering a number of new shares for each old one.

Learning Objective

Define a reverse split

Key Points

• In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.
• A reverse split boosts the share price, so there is a stigma attached. Some investors have rules against trading shares below a certain value, so a company in financial trouble may issue a reverse split to keep their share price above that threshold.
• A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment.

Key Terms

outstanding shares

Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.

outstanding stock

all the stock of a corporation or financial asset that have been authorized, issued and purchased by investors and are held by them

By owning a share, the shareholder owns a percentage of the company whose share s/he owns. A share, however, does entitle the shareholder to a specific percentage ownership; the amount of the company that the shareholder owns is dependent of the number of shares owned and the number of shares outstanding. If Jim owns 10 shares of Oracle, and there are 1,000 shares outstanding, Jim effectively owns 1% of Oracle. If the number of shares outstanding were to double to 2,000, Jim’s 10 shares would now correspond to a 0.5% ownership stake. In order for Jim’s ownership stake to remain constant, the number of shares he holds must change in proportion to change in outstanding shares: he must own 20 shares if there are 2,000 shares outstanding.

That is the premise behind a reverse stock split. In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.

The reduction in the number of issued shares is accompanied by a proportional increase in the share price. A company with a market capitalization of $1,000,000 from 1,000,000 shares trading at $1 chooses to reduce the number of outstanding shares to 500,000 through a reverse split. This leads to a corresponding rise in the stock price to $2.

There is a stigma attached to doing a reverse stock split, so it is not initiated without very good reason and may take a shareholder or board meeting for consent. Many institutional investors and mutual funds, for example, have rules against purchasing a stock whose price is below some minimum. In an extreme case, a company whose share price has dropped so low that it is in danger of being delisted from its stock exchange, might use a reverse stock split to increase its share price. For these reasons, a reverse stock split is often an indication that a company is in financial trouble.

A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment. If the number of shareholders drops, the company may be placed into a different regulatory categories and may be governed by different laws .

SEC

The Securities and Exchange Commission is the department that sets the different regulations regarding stock trading and splitting.

12.6.5: Benefits of Repurchasing Shares

Share repurchases are beneficial when the stock is undervalued, management needs to meet a financial metric, or there is a takeover threat.

Learning Objective

Discuss the benefits of a company repurchasing its shares

Key Points

• If management feels the company is undervalued, they will repurchase the stock, and then resell it once the price of the shares increases to reflect the accurate value of the firm.
• A member of management may have to meet earnings per share (EPS) metrics which can be increased by increasing earnings or lowering the number of outstanding shares. Share repurchases decrease the number of outstanding shares, and thus increase EPS.
• To prevent a firm from acquiring enough of a company’s stock to take it over, the takeover target may buy back shares, often at a price above market value.

Key Terms

Earnings Per Share

EPS. (Net Income – Dividends on Preferred Stock) / Outstanding Shares

hostile takeover

An attempted takeover of a company that is strongly resisted by the target company’s management.

A company may seek to repurchase some of its outstanding shares for a number of reasons. The company may feel that the shares are undervalued, an executive’s compensation may be tied to earnings per share targets, or it may need to prevent a hostile takeover.

For shareholders, the primary benefit is that those who do not sell their shares now have a higher percent ownership of the company’s shares and a higher price per share. Those who do choose to sell have done so at a price they are willing to sell at – unless there was a ‘put’ clause, in which case they had to sell because of the structure of the share, something they would have already known when they bought the shares.

Undervaluation

Repurchasing shares may also be a signal that the manager feels that the company’s shares are undervalued. In this event, it will choose to repurchase shares, and then resell them in the open market once the price increases to accurately reflect the value of the company.

Executive Compensation

In some instances, executive compensation may be tied to meeting certain earnings per share (EPS) metrics. If management needs to boost the EPS of the company to meet the metric, s/he has two choices: raise earnings or reduce the number of shares. If earnings cannot be increased, there are a number of ways to artificially boost earnings (called earnings management), but s/he can also reduce the number of shares by repurchasing shares . Strictly speaking, this is a benefit to the management and executives, not the company or the shareholders. -Thwart.

Marc Benioff

CEOs, like Marc Benioff of Salesforce.com, may have to meet certain financial targets in order to earn his or her bonus. If one of these targets is EPS, they may have an incentive to try to increase EPS artificially.

Hostile Takeovers

A company can take over another firm if it holds enough of the other takeover target’s shares (the buyer of the shares is called the bidder, and the company it is trying to buy is called the takeover target). The bidder is buying the takeover target’s shares in an attempt to purchase enough to own it. Assuming the firm does not want to be taken over this way, the takeover attempt is called hostile. In order to prevent this from happening, the takeover target needs to prevent the bidder from purchasing enough of the shares. To do this, the takeover target will repurchase its own shares from the unfriendly bidder, usually at a price well above market value. Furthermore, it can prevent future takeover attempts. Companies with a lot of cash on their balance sheets are more attractive takeover targets because the cash can be used to pay down the debt incurred to carry out the acquisition. Share repurchases are one way of lowering the amount of cash on the balance sheet.

12.6.6: Stock Splits

A stock split increases the number of shares outstanding without changing the market value of the firm.

Learning Objective

Describe a stock split

Key Points

• A stock split is executed by offering several new shares in exchange for old ones. This may be a 3-for-1 split, for example: each share could be traded in for three new ones.
• A stock split does not change the market capitalization of the firm, it merely changes the number of shares outstanding. Therefore the price per share decreases as the number of shares outstanding increases.
• Each shareholder retains his or her same ownership stake because the number of share s/he holds changes in proportion to the change in the total number of shares outstanding.

Key Term

market capitalization

The total market value of the equity in a publicly traded entity.

A stock split or stock divide increases the number of shares in a public company. Suppose a company has 1,000 shares outstanding. The company may want to increase this number to 2,000 shares without issuing new shares. They would split their stock 2-for-1. That means that every shareholder trades in one old share and gets two new shares in return.

The ownership stake for each shareholder remains constant because the number of shares held changes in proportion to the number of shares outstanding. They own the same percentage of the outstanding shares, though the nominal number of shares increases.

The price of the shares, however, changes. Since the market value of the company remains the same, the price of the new shares adjusts to reflect the new number of outstanding shares. For example, a company that has 100,000 shares outstanding that trade at $6 has a market capitalization of $600,000. After a 3-for-1 stock split the market capitalization of the company remains unchanged at $600,000, but there are not 300,000 shares trading at $2.

Lowering the price per share is attractive to some companies. Berkshire Hathaway Class A shares have never been split, so the price has followed the company’s growth over time . Since the price of a Class A share was over $121,000 on May 2, 2012, smaller investors may have chosen not to invest in Berkshire Hathaway Class A shares because of cash-flow or liquidity concerns. There are, however, Class B shares that trade at a lower value.

Berkshire Hathaway

Berkshire Hathaway has famously never had a stock split, and has never paid a dividend. As a result its Class A shares traded at $121,775.00 as of May 2, 2012, making them the highest-priced shares on the New York Stock Exchange.

12.6.7: Repurchasing Shares

A share repurchase is when a company buys its own stock from public shareholders, thus reducing the number of shares outstanding.

Learning Objective

Describe the different ways a company may repurchase its stock

Key Points

• Since the market capitalization is unchanged and the number of shares outstanding drops, a share repurchase will lead to a corresponding increase in stock price.
• The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase.
• There are a number of methods for repurchasing shares, the most popular of which is open-market: the company buys back shares at the market dictated price if the price is favorable.

Key Term

Repurchase

To buy back a company’s own shares. The issuing company pays public shareholder for their shares.

An alternative to cash dividends is share repurchases. In a share repurchase, the issuing company purchases its own publicly traded shares, thus reducing the number of shares outstanding. The company then can either retire the shares, or hold them as treasury stock (non-circulating, but available for re-issuance).

When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase. Repurchasing shares when a company’s share price is undervalued benefits non-selling shareholders and extracts value from shareholders who sell.

Repurchasing shares will lead to a corresponding increase in price of the shares still outstanding. The market capitalization of the company is unchanged, meaning that a reduction in the number of shares outstanding must be accompanied by an increase in stock price.

There are six primary repurchasing methods:

1. Open Market: The firm buys its stock on the open market from shareholders when the price is favorable. This method is used for almost 75% of all repurchases.
2. Selective Buy-Backs: The firm makes repurchase offers privately to some shareholders.
3. Repurchase Put Rights: Put rights are the right of the seller to purchase at a certain price, set ahead of time. If the company has put rights on its shares, it may use them to repurchase shares at that price.
4. Fixed Price Tender Offer: The firm announces a number of shares it is looking for and a fixed price they are willing to pay. Shareholders decide whether or not to sell their shares to the company.
5. Dutch Auction Self-Tender Repurchase: The company announces a range of prices at which they are willing to repurchase. Shareholder voluntarily state the price at which they individually are willing to sell. The company then constructs the supply-curve, and then announces the purchase price. The company repurchases shares from all shareholders who stated a price at or below that repurchase price .
6. Employee Share Scheme Buy-Back: The company repurchases shares held by or for employees or salaried directors of the company.

12.7: Reporting and Analyzing Equity

12.7.1: Reporting Stockholders’ Equity

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Learning Objective

Explain how a company would report changes in stockholder’s equity

Key Points

• The book value of equity will change relative to changes in the firm’s assets (liabilities, depreciation, new issue, and stock repurchase).
• The book value of equity will change as there are changes in the firm’s assets. This includes changes to liabilities, depreciation, new issue, and stock repurchase.
• The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements.

Key Term

share repurchase

Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.

Reporting Stockholders’ Equity

In financial accounting, owner’s equity consists of an entity’s net assets. Net assets are the difference between the total assets of the entity, and all its liabilities. Equity appears on the balance sheet of financial position, one of the four primary financial statements. “”

Balance Sheet

Shareholders’ equity in a balance sheet.

A statement of shareholder’s equity provides investors with information regarding the transactions that affected the stockholder’s equity accounts during the period.

The book value of equity will change in the case of the following events:

• Changes in the firm’s assets relative to its liabilities. For example, a profitable firm may receive more cash for its products than the cost at which it produced the goods, and so in the act of making a profit, it increases its assets.
• Depreciation. For example, equity will decrease when machinery depreciates. Depreciation is registered as a decline in the value of the asset, and as a decrease in shareholders’ equity on the liabilities side of the firm’s balance sheet.
• Issue of new equity in which the firm obtains new capital and increases the total shareholders’ equity.
• Share repurchases, in which a firm gives back money to its investors, reducing its financial assets, and the liability of shareholders’ equity. For practical purposes (except for its tax consequences), share repurchasing is similar to a dividend payment, as both consist of the firm giving money back to investors. Rather than giving money to all shareholders immediately in the form of a dividend payment, a share repurchase reduces the number of shares, thereby increasing the percent of future income and distributions garnered by each remaining share.

The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements. Stock valuations, which are often much higher, are based on other considerations related to the business’s operating cash flow, profits, and future prospects. Some factors are derived from the accounting statements.

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Dirty Surplus Accounting

Dirty surplus accounting involves the inclusion of other comprehensive income or unusual items in net income, which will consequently flow into retained earnings. These items can skew net income and provide information that could be misleading. A prime example of dirty surplus accounting is the inclusion of unrealized gains or losses on treasury stocks, or securities they are holding for sale.

The main problem with dirty surplus accounting is that unusual items that affect shareholders equity can be easily hidden. Employee stock options are a good example of expenses that may not explicitly show up on the income statement. ESOs can, in actuality, cost shareholders a large sum; therefore, it is important for investors to realize the magnitude of these costs in order to correctly value a firm’s equity.

12.7.2: Earnings per Share

Earnings per share (EPS) is the amount of a company’s earnings per each outstanding share of a company’s stock.

Learning Objective

Explain how a company would calculate their earnings per share

Key Points

• Companies’ income statements must report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.
• The EPS formula does not include preferred dividends for categories outside of continued operations and net income.
• EPS (basic formula) = Profit / Weighted Average Common shares. EPS (net income formula) = Net income / Average Common shares. EPS (continuing operations formula) = Income from continuing operations / Weighted Average Common shares.
• Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted shares outstanding (i.e. including the impact of stock option grants and convertible bonds).

Key Term

discontinued operations

A discontinued operation is a component of an enterprise that has either been disposed of, or is classified as “held for sale”, and also represents a separate major line of business or geographical area of operations; and is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or is a subsidiary acquired exclusively with a view to resale.

Earnings Per Share

Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock. In the United States, the Financial Accounting Standards Board (FASB) requires that companies’ income statements report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.

The EPS formula does not include preferred dividends for categories outside of continued operations and net income. Earnings per share for continuing operations and net income are more complicated; any preferred dividends are removed from net income before calculating EPS. This is because preferred stock rights have precedence over common stock. If preferred dividends total $100,000, then that money is not available to distribute to each share of common stock.

Earnings Per Share (Basic Formula): “”

Earnings Per Share

Basic formula

Earnings Per Share (Net Income Formula): “”

Earnings Per Share

Net income formula

Earnings Per Share (Continuing Operations Formula): “”

Earnings Per Share

Continuing operations formula

Only preferred dividends actually declared in the current year are subtracted. The exception is when preferred shares are cumulative, in which case annual dividends are deducted regardless of whether they have been declared or not. Dividends in arrears are not relevant when calculating EPS.

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted outstanding shares (i.e. including the impact of stock option grants and convertible bonds). Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock without purchasing it directly for the full market value did so.

To find diluted EPS, basic EPS is first calculated for each of the categories on the income statement. Then each of the dilutive securities are ranked based on their effects, from most dilutive to least dilutive and antidilutive. Then the basic EPS number is diluted one by one by applying each, skipping any instruments that have an antidilutive effect.

Calculations of diluted EPS vary. Morningstar reports diluted EPS “Earnings/Share $” (net income minus preferred stock dividends divided by the weighted average of common stock shares outstanding over the past year). This is adjusted for dilutive shares. Some data sources may simplify this calculation by using the number of shares outstanding at the end of a reporting period.

12.7.3: Dividend Yield Ratio

The dividend-price ratio is a company’s annual dividend payments divided by market capitalization, or dividend per share divided by the price per share.

Learning Objective

Explain how a company would use the dividend yield ratio

Key Points

• Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.
• Preferred share dividend yield is the dividend payments on preferred shares are set out in the prospectus.
• Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings.
• Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield may be evidence that a stock is under priced or that the company has fallen on hard times, and future dividends will not be as high as previous ones.

Key Term

preferred share

Preferred stock (also called “preferred shares,” “preference shares,” or simply “preferreds”) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Designation. “

The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.

Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.

Preferred share dividend yield is the dividend payments on preferred shares, which are set out in the prospectus. The name of the preferred share will typically include its yield at par. For example, a 6% preferred share. However, the dividend may, under some circumstances, be passed or reduced. The yield is the ratio of the annual dividend to the current market price, which will vary.

Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings. There is no guarantee that future dividends will match past dividends or even be paid at all. The historic yield is calculated using the following formula:

Current dividend yield

Current dividend yield = Most recent Full-Year Dividend / Current Share Price

For example, take a company which paid dividends totaling 1 per share last year and whose shares currently sell for $20. Its dividend yield would be calculated as follows: 1/20 = 0.05 = 5%.

The yield for the S&P 500 is reported this way. U.S. newspaper and Web listings of common stocks apply a somewhat different calculation. They report the latest quarterly dividend multiplied by 4 divided by the current price. Others try to estimate the next year’s dividend and use it to derive a prospective dividend yield. Such a scheme is used for the calculation of the FTSE UK Dividend+ Index. Estimates of future dividend yields are by definition uncertain.

Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly, a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher. Some investors may find a higher dividend yield attractive, for instance, as an aid to marketing a fund to retail investors, or maybe because they cannot get their hands on the capital, which may be tied up in a trust arrangement. In contrast, some investors may find a higher dividend yield unattractive, perhaps because it increases their tax bill.

12.8: Additional Topics in Stockholders’ Equity

12.8.1: Other Comprehensive Income

Accumulated Other Comprehensive Income (AOCI) is all the changes in equity other than transactions from owners and distributions to owners.

Learning Objective

Summarize the purpose of the comprehensive income section on the financial statement

Key Points

• Other comprehensive income is comprised of several gains and losses that are not disclosed in the income statement and which relate to available for sale securities, foreign currency translation, derivatives, pension plans, and revaluation of assets.
• The AOCI balance is presented as a line item in the stockholder’s equity section of the balance sheet.
• The individual components of AOCI can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Key Terms

hedge

Contract or arrangement reducing one’s exposure to risk (for example, the risk of price movements or interest rate movements).

IFRS

International Financial Reporting Standards; designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Definition of Other Comprehensive Income

Other comprehensive income, disclosed in the stockholder’s equity section, is the total non-owner change in equity for a reporting period or all the changes in equity other than transactions from owners and distributions to owners. Most changes to equity, such as revenues and expenses, appear in the income statement. A few gains and losses are not shown in the income statement since they are not closed to retained earnings. They are disclosed in the shareholder equity section of the balance sheet known as “accumulated other comprehensive income” .

Stakeholders that use financial statements.

Other comprehensive income can be reported in its own statement of comprehensive income or in a separate section within the income statement.

Components of Other Comprehensive Income

Other comprehensive income is comprised of the following items:

• Unrealized gains and losses on available for sale securities (debt and equity)
• Gains and losses on the effective portion of derivatives held as cash flow hedges
• Gains and losses resulting from the translation of the financial statements of foreign subsidiaries from the foreign currency to the reporting currency
• Actuarial gains and losses on recognized defined benefit pension plans (minimum pension liability adjustments)
• Changes in the revaluation surplus account (this account records changes between the market and book value of fixed assets on the balance sheet)

The accumulated other comprehensive income balance is presented as a line item in the stockholder’s equity section of the balance sheet. The individual components of the balance can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Other Comprehensive Income and IFRS

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. Some IFRSs (international financial reporting standards) require or permit that some components be excluded from the income statement and instead be included in other comprehensive income.

12.8.2: Convertible Stock

A convertible security, such as convertible preferred stock, is any security that can be converted into another.

Learning Objective

Explain why a company would offer convertible stocks

Key Points

• Convertible preferred stock has an embedded option that allows the stock to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.
• The conversion feature in convertible stock adds an option of acquiring common shares, which has certain advantages, such as voting rights and unlimited access to company earnings.
• Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

Key Terms

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

liquidation

The selling of the assets of a business as part of the process of dissolving it.

Definition of Convertible Securities

This refers to any security that can be converted into another security. Convertible securities can include bonds that pay interest or preferred stocks that pay dividends. This type of stock has an embedded option that allows it to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.

The conversion can also be based on the occurrence of certain conditions, such as the stock’s market price appreciating to a predetermined level, or the requirement that the conversion take place by a certain date. The conversion is exercised at the security holder’s discretion. The shareholder can also sell the original security and use the conversion feature as a favorable selling point .

Allied Paper Corp. Common Stock Certificate

A public company’s preferred stock is designated as convertible if it can be exchanged for common stock.

Convertible Preferred Stock

Preferred stock (also called preferred shares) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid. Preferred shares rank higher to common stock during earnings distributions, such as dividends; however, they are subordinate to bonds in terms of their claim to company assets in the event of a business liquidation. Unlike common stock, preferred shares usually have no voting rights. The shares may also be cumulative or non-cumulative. A cumulative preferred stock accumulates unpaid prior period dividends into the future, while a non-cumulative preferred loses rights to any dividends not paid in prior periods. The conversion feature adds an option of acquiring common shares, which has certain advantages, such as voting rights.

Convertible Stock and Stockholder’s Equity

Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. Preferred stock is reported in the stockholder’s equity section as the number of shares outstanding, multiplied by the stock’s market price. The result is divided between the value of the shares that fall under “common stock – par value” and the excess value over par is reported as “common stock – additional paid-in-capital”. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

12.8.3: Stock Warrants

A stock warrant entitles the holder to buy the underlying stock of the issuer at a fixed exercise price until the expiration date.

Learning Objective

Summarize why a company would issue a stock warrant

Key Points

• Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer.
• Stock warrants have several features that should be evaluated: premium, expiration date, leverage, and restrictions on exercise option.
• No matter the type of warrant, all are reported in the stockholder’s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of shares the warrant provides.

Key Terms

contributed capital

Refers to capital contributed to a corporation by investors through purchase of stock from the corporation (primary market) (not through purchase of stock in the open market from other stockholders (secondary market)). It includes share capital (i.e. capital stock) as well as additional paid-in capital.

exercise price

The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.

yield

The current return as a percentage of the price of a stock or bond.

Definition of Stock Warrants

A stock warrant is similar to a stock option in that it entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer. They benefit the warrant issuer by allowing the company to pay lower interest rates or dividends. They can be used to enhance the yield of the bond and make them more attractive to potential buyers. Warrants can also be used in private equity deals .

Sears Roebuck & Co. Bond Certificate

Public companies can offer company bonds for sale with stock warrants attached.

Stock Warrant Features

Since warrants are typically attached to other securities, in certain cases it is possible to detach them and sell them independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Therefore, it is sometimes beneficial to detach and sell a warrant as soon as possible. Stock warrants have several features that can make them more or less attractive investments:

• Premium (the extra amount paid for the shares when exercising the warrant as compared to the market price paid when acquiring the stock through the open market)
• Leverage (risk exposure to the underlying shares acquired through the warrant as compared to the risk exposure of shares purchased in the open market)
• Expiration Date (the date the warrant expires; the longer the time frame involved until expiration the greater the opportunities for stock price appreciation, which increases the price of the stock warrant until its value diminishes to zero on the expiration date)
• Restrictions on Exercise (American-style warrants must be exercised before the expiration date and European-style warrants can only be exercised on the expiration date.

Stock Warrants and Stockholder’s Equity

There are many types of stock warrants — equity, callable, putable, covered, basket, index, wedding, detachable, and naked warrants. No matter the type of warrant, all are reported in the stockholder’s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of common shares the warrant provides.

12.8.4: Calculating Diluted Earnings per Share

Diluted earnings per share (EPS) takes the basic EPS formula and accounts for the effect of dilutive shares on earnings.

Learning Objective

Explain why a company would calculate diluted earning per share for its stock

Key Points

• Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator (weighted average number of common shares outstanding), which decreases the value of earnings per share.
• Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.
• Basic EPS, based on net income and reported on the face of the income statement, is followed by diluted earnings per share, also reported on the income statement.

Key Terms

dilutive

Describing something that dilutes or causes dilution (reduces value).

weighted average

An arithmetic mean of values biased according to agreed weightings.

Example

• Sun Microsystems, Inc. has 3,417,000,000 weighted-average common shares outstanding with income available to common shareholders of USD 922,590,000 during a recent year. Stock warrants can be exercised for 1,000,000,000 common shares. Basic EPS = USD 922,590,000 / 3,417,000,000 = USD .27 per share. Diluted EPS = USD 922,590,000 / 3,417,000,000 + 1,000,000,000 = USD .20 per share.

Diluted Earnings Per Share

Definition

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted common shares outstanding (i.e. which includes the impact of instruments such as stock option grants and convertible bonds). Fully diluted common shares consider securities with features that will increase the number of common shares outstanding and reduce (dilute) earnings per share. Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock did so without purchasing shares directly for the full market value.

Earnings per share shows the amount of income applicable to each share of common stock.

Diluted earnings per share includes shares of common stock from dilutive securities, such as convertible debt or stock options, in its calculation.

Calculation

The basic earnings per share formula involves taking the income available for common shareholders (net income minus preferred stock dividends), divided by the weighted average number of common shares outstanding. Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator (weighted average number of shares outstanding), which decreases the ending result of earnings per share. So, basic earnings per share tends to have a higher value than diluted earnings per share. Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.

Disclosure

Public companies calculate and disclose EPS for each major category on the face of the income statement. In other words, they make an EPS calculation for income from continuing operations, discontinued operations, extraordinary items, changes in accounting principle, and net income. Basic EPS, based on net income, is followed by diluted earnings per share and and both figures are reported on the income statement.