BEC CPA Exam Review Course

Yeah. Hi, welcome to Bisk CPA Review online learning. My name is Jennifer Lewis, and I'm going to be walking you through corporate governance. A few tips before we start one tip is to make sure that you have your viewer's guide with you so that you can follow along as we discuss the topics. It's important for you to use it as an outline, but to make sure that you keep your own notes of things that you hear that strike a chord with you and things that you want to make sure that you remember.

You want to treat this CPA Review course, like you're taking a live CPA prep course, which means at the end, you want to make sure that after you've listened to the video and you've gone through and taken your CPA Exam notes, that you take a few moments to go through and review the outline and the notes that you took prior to moving on to the next topic.

The first thing that we're going to talk about is to go through an overview about what corporate governance is now. Corporate governance is going to be the manner in which an entity is managed and governed. Now, who is involved in this process, it's going to vary from entity to entity. Sometimes it's just management.

Other times it's management and other personnel that are appropriate to assist management within the organization. And it also may include those charged with governance, which may include the board of directors. Not all entities have boards of directors. Some of them will just have an executive managed committee management committee or a owner of the business that helps govern the organization.

But the ultimate goal is to make sure that there is some. Person or persons that operate to the benefit of the organization to make sure that they're running the operations effectively and efficiently, that there is controls over reliable financial reporting, that there is controls over governing the organization as far as compliance with laws and regulations and contracts and grant agreements.

And then they also need to make sure that there's somebody that is involved in overseeing the strategic direction of the organization. When you think about things from an audit perspective, mostly the auditors are concerned about internal controls over funding reporting and internal controls over financial reporting are a process that's effected by the company's board of directors management and other personnel.

So as you talked about who governance is, governance could be something that includes all three of those different components or elements of corporate governance. Internal controls over financial reporting are designed to provide reasonable assurance regarding the reliability of the financial statements.

Since we're dealing with financial statements, that's why generally auditors are interested in internal controls over financial reporting, because they're wanting to make sure that there's reasonable assurance, that the financial statements that they're giving opinions on are reliable. Those charged with governance is a unique term that has emerged in recent years.

And those chargers governance was a term that's a little bit broader than the board of directors. It encompasses the board of directors and an audit committee that you typically might see in some organizations where they have the nature, size, or complexity that really needs there to be a formal governance structure.

Other organizations, smaller organizations might just have an executive management committee that might be the person or persons that are charged with governance. So when we talk about those charter governance, it's really any appropriate body. That's responsible for overseeing the strategic direction of the organization and the obligations that are related to accountability, including financial reporting.

They may or may not. Include the responsibility for improve approving the entities, financial statements. So, as I mentioned, governance, when we talk about those charged with governance is going to vary from entity to entity, and it's going to be influenced by the size and the ownership characteristics.

Some members of those charged with governance may or may not have management responsibilities. The members of governance may or may not be an owner manager, but they could include those. If it's a smaller entity, say if there is only a sole business owner with no other ownership in the organization, then they're generally going to be that owner manager may be the only person that's charged with governance.

Whereas a larger organization that might be publicly traded would have a formal board of directors and a formal audit committee. But it doesn't matter if you're a sole trustee of an organization or whether or not there's a complete board, every organization, regardless of its nature, size and complexity is going to have a person or persons that's responsible for guns running that entity management.

Or, or those that are responsible for achieving the objectives of the entity. And they're the ones that have direct responsibility and authority to establish the policies and make decisions. About financial statements and financial reporting objectives. So they're the ones that will actually design and implement and maintain internal controls over financial reporting.

And then those charged with governance would be the ones that would oversee management to make sure that they're comfortable with what is being designed and implemented as it relates to financial reporting. So those charged with governance oversees management. And then management may oversee other personnel in the organization that are responsible for actually carrying out those financial reporting directors like processing payroll and recording acquisitions that would show up in in property plant and equipment.

And so everything would have a hierarchy within the organization with those charged with governance or the board of directors sitting at the top of the organizational structure. So boards of directors may be the formal representation of those charged with governance. And often when you hear that there's a board of directors, it's a group of people that are elected or appointed to oversee the activities of a company or an organization.

Other terms that you might hear related to boards of directors are going to be things like a board of trustees or a board of governors or a board of managers. Or it even could be referred to as an executive board. Any of those terms are very, are very similar in nature in referring to the elected or the appointed people that are assigned with the responsibility to jointly oversee the activities of the organization.

Now, what those activities specifically are, will depend a little bit as well. It all depends on what the powers are. The duties of the responsibilities are that are. Delegated to this group by an authority outside of itself. So when we talk about that, we mean that there would be perhaps corporate bylaws that would have been established for a publicly traded company.

That would say here's what the board of directors is supposed to do. And it would outline those responsibilities within the corporate bylaws. So typically as we're looking at the number of board members and how they are chosen and what their specific responsibilities are, it may include how many times a year that they're expected to meet and what types of reports that they generate as a result of these meetings.

Those are all going to be governed by the bylaws. As far as legal responsibilities for the board of directors, that's going to depend with the nature of the entity. So is it a publicly traded organization? Is it a not-for-profit organization? Is it a college or a university? Each different type of entity will have some rules that it has to follow.

That's convert on it by oftentimes. Regulatory or legal type things that they have to follow and then each jurisdiction. So each different state than an organization and operates in. We'll also generally have some legal responsibilities for the board of directors when there is a formal board of directors.

So often when we're thinking about responsibilities, if you have a board of directors, that's more of a formalized governance structure. There often are. Bylaws that are the corporate bylaws, or there might be laws or regulations within the state that the organization operates in that gives responsibilities and accountability to the board of directors.

But remember not every organization needs to have a formal board. So depending on the nature of the organization, it might be that those charge of governance, isn't a formal board of directors. It's just a management team, or it's just an owner of the business. There still will be responsibilities for that person or persons, but that's going to be less formalized and it's not necessarily going to be something that's governed by laws or regulations outside of the entity itself.

So the more than an entity has public accountability. Be it because it's a publicly traded organization or because they receive money through grants or they're for a not-for-profit organization or it's a college or university that also gets grant funding and operates perhaps within the confines of state rules, those types of organizations or.

Often going to have those boards of directors that are going to be appointed or they're, they're going to be voted on by a larger membership for them to represent and act on behalf of the entity as a whole. So some organizations are required to have boards of directors. And that's one of the things you have to make sure that you're aware of with publicly traded organizations that are regulated by the sec and are governed by the Sarbanes Oxley act.

Those types of entities are required by statutory and regulatory bodies to have a board of directors. A lot of times, these public companies, when they have this board of directors, the board of directors is representing the, all the shareholders of the organization, but they don't necessarily have power directly in order for them to make change.

It's more that. Everybody in the, in the full, all the shits shareholders would have responsibility for submitting and getting a vote, but oftentimes they have a proxy vote. And so they send in for major changes. They send in what they believe their proxy vote should be on a particular issue. And then the board in essence, they'll often.

It does have voting memberships. And a lot of times the board will have a voting block. They will have so many voting shares that a lot of times the boards for large public companies have what they call defacto power, which means while they don't have direct power and authority, they have defacto power because their voting block is so large that sometimes it's difficult to overcome.

Decisions that they desire to make, even if you had other shareholders sending in their proxy votes, as it relates to specific issues, small private companies on the other hand, generally have. A lot of times, it's the same people that are involved in managing and running the business. That also may be the ones that are sitting on these boards and, or it might be the ones that are assigned with these governance responsibilities.

And so sometimes there's no real division of power between the two. Oftentimes it's the management of the company that often sits on the board of directors. So a lot of times for these smaller private companies that don't have this outside regulatory requirement to have a board of directors still has a governance structure that is similar to a board, but they often will use the term, those charged with governance, as opposed to establishing a formal board of directors.

So on behalf of this education online, I'd like to thank you for listening to this section around just a general governance oversight responsibility section on understanding the definitions. And what I'd like you to ask you to do is to go back and read the notes that you took and look at the outline and make sure that you're comfortable with the foundational definitions of some of these areas that we discussed before you move on to the next section.

Hi, welcome back to the corporate governance section of online learning. I'm Jennifer Lewis. And we're going to talk a little bit more about the specific qualities, duties and responsibilities of the board of directors. If it's been awhile before, since you looked at the first section that dealt with definitions of what a board of directors is, I'd like you to go back and revisit that really briefly, just look through the outline, refresh yourself and remind yourself about what the definitions are for the different terminologies that you're going to be hearing as we go through this section and then come back and pick up this section.

So the qualities necessary for a board of directors is to make sure that they have what's necessary to oversee the organization. And particularly as we're thinking about from an audit perspective, it's the financial reporting expertise that becomes very critical. We want to make sure that they have somebody within the.

Governance structure that has an in-depth knowledge of how a business operates and make sure that they understand what generally accepted accounting principles are and understand the differences between some of the alternatives that you may be able to select, because we want them to have enough of an expertise to oversee the financial reporting mechanisms of the organization.

We also want to make sure that they have some of those soft skills that are important. And when I talk about soft skills, I'm talking about things like integrity and commitment and a sense of due care to carry out their responsibilities in a way that they're keeping in mind their obligations to the entity and the shareholders whose interests they're supposed to be keeping in the forefront.

So we want to make sure that they are using their authority for proper purpose and that they're acting in honesty and good faith when they're making some of these key decisions and authorizing certain things to be carried out. We also want to make sure that they are aware of where there might be some conflicts of interest and that they properly identify and consider those in how it is that they can carry out their duties with responsibility.

So for example, if they have access to in entities, assets, or access to information, they shouldn't be using that access for their own personal benefit or profit without the informed consent of the entity. They shouldn't conflict with compete with the organization by setting up a situation where perhaps they're acting as a director for a competing company with the organization that they also are acting as a board of directors on that's very similar in nature.

They want to make sure that they don't set up business that competes directly with the company that they're sitting on the board of directors of. They shouldn't enter into transactions with the company where it could create some sort of conflict and it could even be conflict and appearance because if, if somebody were to engage in a transaction with a company, say that they were looking to purchase something, then from the organization, there's a natural interest.

From the personal standpoint to want to get the best you can out of the transaction. And then from the responsibility of the person from the board of directors perspective, they have a duty to the company to try and get the most as possible for the, the company itself out of the transaction. So you can see.

I see that there would be some conflict there. Do I look out for my self interest or do I look out for the company? Self-interest and part of your responsibilities of being on a board of directors is to make sure that you're looking out for the best interests of the company and that you're looking out for the best interest of the stakeholders or the shareholders and that you're ensuring that you're maintaining a level of divide to ensure that you're not stepping over the boundaries of perhaps.

Focusing too much on yourself and your own profit as opposed to your responsibility for the company. So what's very important is sometimes there might be some transactions that are entered into as a, as a board member with a company. And it's not that that is. Never allowable what's important is to make sure that those, all of those types of transactions are done with the informed consent of the company and that management of the company that this board member is sitting on the board of directors up, that they ratify those transactions.

Make sure that they're fully disclosed and they may even need to be disclosed in the footnotes to the financial statements so that other financial statement users would know where there is a transaction, where there is a related party interest. When we talk about being objective and that's one of the things that's very important for a board to have board members on it, where there is a sense of objectivity is to try and build a critical, massive independent directors.

And when you see that term, what they're generally referring to is that there's at least two members that have a sense of independence. If possible, this is more important for a public company than it is for a non-public company, but for a public company, you want to make sure that there's a critical mass of preferably at least two independent objectives that can be objective in the advice and the counsel that they provide to the organization and that they can appropriately monitor and oversee what senior management of the company's doing.

So if they're independent, that means that they can perhaps have a greater sense of professional skepticism regarding what management's telling. And some of the judgements that are put into play as far as some of the decisions that management is, is making that they would like. The board to ratify.

So if they're adopting a significant accounting policy, or if they're going to go out and spend a large sum of money to make a capital acquisition of some amount of, by some big piece of equipment or to change the types of investments that they might invest in, and they want to start spending money on acquiring some higher risk, higher yield type investment securities.

Those are all types of things that typically, if you have a board of directors that they would be involved in that decision-making process, if it's something that's significant to the organization. And so the more that you have some. Independence and objectivity in who comprises the board of directors, the better that they're going to be able to maintain that appropriate level of skepticism.

And they're not going to feel intimidated about asking probing and challenging questions of management. So we want to make sure that that, that is considered that as much as we can have somebody that's. Financially literate, sitting on a board of directors, but also that they have a sense of independence and objectivity.

It's not that every board member has to have those qualities, but you want to make sure that you have at least one, preferably two people that have those qualities. And you also want to make sure that the entity has a process to periodically evaluate whether or not the directors continue to be independent because things change over time.

A board member that joined the board initially might have changed the affiliations or might've changed who they engage in in business with. And that change. May have may actually influence their ability to maintain independence. So somebody that is independence when they first join a board, things may happen where over the course of time, they no longer are considered independent.

And so it may be that they are asked to, to, they might be removed from that board, or they might just restructure the board to add additional members that help fulfill the criteria being financially literate and independent. So general responsibilities of whether you have a formal board of directors, or even if you just have those charged with governance.

So if you remember an earlier section, we talked about how some organizations don't have formal boards. They have a person or persons that might be the owner manager, or it might be an executive management committee. Somebody that is just really just charged with governance and all organizations, regardless of their nature, size and complexity should have those charged with governance.

Whereas only larger, more complex entities are going to have a formal board and a formal audit committee. So the responsibilities of a governance structure for small companies, big companies, publicly traded companies, not for profits. Doesn't really matter. Their responsibilities are to objectively review management, significant judgments, and to help management identify and evaluate any sort of unusual activity that might be occurring with transactions or events that might impact financial reporting.

So they're going to interact with the auditors, whether it's internal auditors or external auditors to really get a sense around what's the overall quality of the entities controls over financial reporting and to make suggestions, if they think that there needs to be improvements, it could be improvements in management and who is involved in.

Management, it might be improvements in how a system of internal controls is structured. They might make suggestions around hiring additional people so that they can improve segregation of duties. So governance. So the ones that are supposed to be a little bit removed from the organization, to the extent that they can look at the broader view and the broader perspective to say, what is it that we really need to accomplish in order to ensure that we have.

Reliable financial reporting, effective and efficient operations and compliance with laws and regulations. So we want to make sure that they are alert to where there might be management override. So if they're interested in all these things and they're separate from management, then. They want to make sure that they're overseeing management and making sure that management is not trying to manipulate the financial statements by short circuiting, a system of internal control.

So if there's lack of segregation of duties, it might be easier for management to go in and book fraudulent revenue transactions, for example. Governance and those charter governance by overseeing management's judgements and looking at the financial reports on a periodic basis, they're going to be looking for those types of situations where there might be signals or red flags that something like that might be occurring.

So they're going to look at performance reports like budget to actual analysis, or looking at gross profit margins or looking at trend analysis from period to period. And they're going to try and look for indicators or red flags of where something might be going on that significant or unusual. And then they'll follow up and ask questions to management to make sure that they're comfortable, that everything's being handled in an appropriate and aboveboard manner.

They also might be involved in making decisions around how to structure incentive compensation arrangements, which could include compensation of senior management of an organization. They will Often also, if there isn't audit, that's done of the organization, they will review the audit plan and the services that are being provided by the auditor.

And often they're the ones that will actually engage the external auditor. So they will interview the different firms that might be applying to be the external auditor for the company. And they're the ones that will establish the compensation arrangements with the external auditor and meet with the extra Lauder periodically throughout the process.

To ensure that everything's being handled correctly there on a periodic basis, going to do a periodic self-assessment of their own performance. So not just looking at what management's doing, what the auditors are doing, but how good of a job are they doing in fulfilling their oversight role of looking at the strategic direction of the company and ensuring that they're focusing on effective and efficient operations.

Reliable financial reporting. And compliance with laws and regulations. And so those three elements are very important for those charge of governance to periodically look at and make sure that they're doing the right things at the right time. And they're going to make sure that management is making changes as necessary.

Particularly if, for example, a new accounting standard comes out and this new accounting standard needs to be adopted by the company. Those charged with governance will. Be informed enough to know that there's a new standard coming out and they will ask management. W what did you decide to do? How did you decide to implement it?

Management would relate what their decisions were and then those charges governance would listen to what management said, and they would feel comfortable that the approach that was being taken by management seemed to be an appropriate way to handle the situation. So thanks for listening to this topic on qualities of a board of directors and some of the things that you want to make sure that the individual members are keeping attuned to as they carry out their responsible.

Hi, welcome back to the corporate governance section of our online learning. We're going to talk next about audit committees. Now, back when I was in public accounting, I worked for a large public accounting firm and we used to have to meet with the audit committees frequently about the financial statement audits.

And I also was the financial operational internal audit director for a very large not-for-profit in Washington, DC. And I also had the responsibility as the internal audit person to meet with the audit committee. So the audit committee has a very important role and function and, and their job is to actively oversee the entities, accounting and financial reporting policies and practices.

So the larger board, the board of directors would be responsible for many different objectives, including. Compliance with laws and regulations effective and efficient operations and reliable financial reporting. The audit committee really just takes one of those three objectives and focuses in on it more precisely.

So they assist the larger board with fulfilling their fiduciary responsibilities. So there needs to be a process where the audit committee is informed of significant judgments and issues that effect accounting and financial reporting so that they can deal with those issues on a timely basis. And often it's the internal audit group or the external audit group that would be involved in that process to come in and have those conversations with the audit committee.

In addition to the audit committee meeting with the senior management of the organization. So the audit committee needs to understand how it is that management actually identifies monitors and controls financial reporting risks that would affect the organization. So how do they make sure that the financial statements are complete and that all the assets exist and that accounts receivable is properly valued.

They're going to go through and think about what are the major things that could be wrong or misrepresented within the financial statements. And then their job is to know, well, what is this particular organization's greatest risks and how can we make sure that management is appropriately managing those risks?

So there's going to be a direct line of communication. That's going to be necessary in order for them to do that. And it's going to involve talking directly with management, but it also is going to involve a direct line of communication with internal and external auditors to discuss. Those types of relevant matters.

Now you'll notice I said direct line of communication. So what that means is that periodically the audit committee is going to meet with the internal and external auditors without management around. So that they're. If they want to say something that they don't feel comfortable saying in front of management directly, they have an opportunity to have these Eyeful offline conversations with the audit committee in order for them to make sure that they can discuss the reasonableness of the financial reporting process and significant comments and recommendations they might have as a result of doing audit type services.

And just being able to give that feedback in an open and free environment. The audit committee beyond just overseeing management is also responsible for overseeing. The auditor activities, whether it's an internal audit activity or whether it's an external audit activity, they have responsibility.

Understand what is it that these internal and external auditors are doing. And they're supposed to also, particularly with the external auditors to challenge whether or not there's any independence issues that might exist with who they have doing their, their financial statement audit, because that's one of the things that's important about a financial statement audit is that the external auditors.

Really should have no impediments for them to be able to. Judge and evaluate whether or not the financial statements are materially misstated. And so it's very important for them to be independent and objective. And over the course of time, for example, there might be a familiarity threat where the auditor has been the organization's auditor for 10 years.

And so the audit committee might make a judgment to say, well, maybe we should go out for bid to see if we should hire a different CPA firm to come in and do our financial statement audit in order to try and mitigate the risk of this familiarity threat that the auditors might be presuming that things are being done above board because they have such great, great relationships with management and the people that they're dealing with on a day-to-day basis, as it relates to the financial statement, audit.

So they do have a responsibility of making sure they're comfortable with the auditor, external auditor relationship with the firm, as well as overseeing what internal audit is doing and the results of their services. And then also monitoring it overseeing management. There also might be circumstances where there needs to be some interaction with outside regulators.

Say the sec, the sec might have a question about the financial reports and. The audit committee would often be involved in those interactions along with management, just to make sure that they're comfortable, that what's being represented to these outside third parties in this compliance type of arena is something that they're comfortable with because they're going to look at things from the viewpoint of preserving and protecting the best interest of the company.

Whereas management is probably going to be looking to preserve and protect their own best interests. So they may. Skew things. Management may skew things and dealing with outside regulators to try and preserve their job, to not make it look like they did anything wrong. So they may be coming from a more defensive posture.

Whereas the audit committee being on an oversight role could be the one that would be more of the mediator between the two and try and make sure that conversations are such, that they can objectively look at both viewpoints and try and bakes bring such issues to resolution. So they do have the authority to engage and replace and determine external auditors.

When they're hiring them, they have influence over making recommendations to compensation and performance evaluations for management. And they also have the authority to have influence over the internal audit department as well. So the audit committees purely have they, they clearly have a lot of influence over the organization, as it relates directly to ensuring reliable financial reporting.

The Sarbanes Oxley act is the act that came out and it's that it's applicable to organizations that are regulated by the sec. So if you're a publicly traded organization or an issuer as they're called, they have to follow the Sarbanes-Oxley act. The Sarbanes Oxley act actually has a requirement that publicly traded entities have a audit committee.

Now the audit committees are a subset. Of the board of directors. So usually it's the people that are sit on the audit committee, also sit on the full board of directors. And as they're looking at, who's sitting on the audit committee, the Sarbanes Oxley act says that more than half of the audit committee should be outside directors or they should be independent directors.

So that means that they can't be executive directors, meaning that they can't be a member of management and they can't be. Inside directors, meaning that they have a vested financial interest or other sort of conflict with the entity itself, they have to be truly outside directors that are independent and won.

At least one of these outside directors has to be financially literate. Now they don't give specific definitions around what financially literate means, but what they do is provide a list of here's some things that might make somebody. Qualified to be financially literate. And it includes things like their experience and their education and whether or not they've ever sat on a board before.

There's a whole laundry list of things that could qualify somebody to be financially literate, but it's important to have at least one outside director that qualifies as being financially literate on the audit committee of a publicly traded organization that follows the Sarbanes-Oxley act. In addition, Remember, at least half of the of the members of an audit committee of a publicly traded organization should be independent or outside directors.

The other thing that the Sarbanes-Oxley does as it relates to the audit committee is it says that the internal auditors are required to report directly to the audit committee. Now, generally, if there is an internal audit department, they do have a direct line of communication with the audit committee because that's.

Kind of the whole point of having an audit committee is to have that means that independence and objectivity it's optional for private companies to do that. It's just a best practice that they do. Whereas if it's a publicly traded organization, their internal auditors are required by law to have that direct line of reporting.

So by law, if you're a publicly traded organization, there has to be a direct line of. Reporting for internal audit, a direct line of reporting for. External auditors. And there has to be at least one outside director that's financially literate or determined to be a financial expert. And remember that financial expert determination can be made up of a lot of different factors.

It could be because they've had prior experience as a controller of a large organization, or they previously were in public accounting or they. Actually have been involved in preparing audited financial statements in the past, it could be that they were an internal auditor for another organization. The goal was to make sure that they have enough understanding and experience formally or informally, to be able to understand financial statements, generally accepted accounting principles, to be able to make judgment calls around the sufficiency and appropriateness of key decisions like selecting.

Alternatives that might be available within generally accepted accounting principles and they want to understand controls. And what does it mean to have a good sound system of controls over reliable financial reporting? So they need to be able to understand preparing financial statements, reading financial statements, the controls.

Over generating financial statements, and then they also need to understand what it means to be a member of the audit committee. So what are our duties and our responsibilities and why is it that we have to take these jobs so seriously? So in looking at. With an audit committee and trying to decide, well, who should sit on the audit committee?

It's very important that the board ensure that they have somebody that is sitting on that committee, that they feel comfortable has those skill sets necessary. So they're going to make sure that they do independent reference checks and that they look at the relationships that that individual might have.

So do they have any conflicts of interests or any other types of. Related party relationships that might impair their ability to really be considered an outside director, as opposed to an inside director. Sometimes companies use independent search firms to help find individuals to sit on the audit committee and that might be appropriate for a much larger publicly traded type organization.

In all cases, you should know enough about the individuals to feel confident about their financial literacy, their commitment. Their ability to be able to perform their, their responsibilities with, with due diligence and appropriate amount of professional skepticism. In some cases, the audit committee might be required to actually certify that they've complied with independence and ethics rules that the organization has established an often.

If there are these certifications, these certifications are updated periodically often once a year to make sure that somebody that. Sitting on the audit committee as circumstances change that they're, that they are able to identify where there might be some emerging issues with independence and ethics that might require them to change their relationship.

Perhaps they could no longer be on the audit committee or perhaps they can no longer be on the full board if the conflict of interest is, is large enough, but it's definitely something that needs to be periodically evaluated. So we've gone through and talked about the. Composition of the audit committee itself.

And so now would be a good time to go back and revisit the earlier sections that talk about what's the definitions of those charged with governance. What's the definition of a board? How is the board and audit committee differ? And what types of responsibilities is the audit committee have that the full board does not have.

Hi, welcome back to our corporate governance section on our online learning. And now we're going to talk about internal control over financial reporting. My name is Jennifer Lewis and I used to work in public accounting. And it's one of those things that you really need to ensure that you have a firm understanding around what does it mean to have internal controls over financial reporting?

A lot of times when you're in private accounting and you're working directly with. Companies in their accounting departments. You certainly, you get a sense around controls over financial reporting. But companies from a, from a broader perspective are also concerned about controls over operational effectiveness and efficiency and controls over compliance with laws and regulations.

Whereas from an audit perspective you're more directly related to internal controls just specifically over financial reporting. And there might be some overlap. There might be where a control that helps you ensure that you're running your business. Well also helps you ensure that you have accurate and timely and, and consistent financial statements.

So there can be where there's multiple objectives, but the primary objective that you're going to be focused on is to ensure that the financial statements are reasonably stated. And so when we talk about controls and we think about it from the context of financial reporting, we're looking at an integrated system of checks and balances that work together to reduce the risk.

That your financial statements are materially misstated. So you want to reduce the risk that there is a problem to an acceptably low level. Now who's involved in that responsibility where it's going to be management other personnel, and then those charged with governance, which could be the board of directors.

So when we talk about the board of directors in this segment, I'm automatically bringing in situations where maybe there's not a board of directors, but there's just an executive management committee or other group that's considered the governance structure of the organization. What's important to think about is when we talk about internal controls over financial reporting, that it involves multiple parties.

It's not just the people that are processing the transactions or management that is authorizing, approving those transactions. But it's also the governance structure, which may be the board of directors that's overseeing management and what they're doing as well. It's an integrated process that involves lots of different people and lots of different activities.

All of it designed to provide reasonable assurance regarding the reliability of financial statements. Now, one of the most widespread methods that's used to design and evaluate. The strength of the system of internal controls over financial reporting is what's called the COSO internal control integrated framework.

Now Kozo stands for the committee, a sponsoring organization. So they're a group that put together this gold standard of internal controls. And this gold standard is called the integrated framework and the integrated framework. Operates as a mechanism to show what are the most important components of a well-designed and effectively functioning system of internal controls that does not have material weaknesses in its system.

You notice I emphasized that there's not material weaknesses. If system of internal controls over financial reporting is never going to be perfect. You're never going to be able to design the perfect system. There's always going to be limitations that will exist because of the fact that there's people involved.

And so there can be collusion and there could be override. There could just be errors in judgment. It could be that somebody just wrote down the wrong number. So there's lots of things that could happen. It may be intentional or unintentional, but there's things that could go wrong in any system. Of internal controls.

And so the goal is to design your system in such a way that it is reducing risk, that you're going to have material fraud or material error. And so the people that are involved in this process are responsible for overseeing to make sure that the design of the system is set up in such a way that airs a chance and a pretty good chance that we're going to be able to identify all of those instances.

If you're talking about the COSO integrated framework, there's basically five key components that we're going to discuss that are critical to satisfy that objective. When we talk about the different components, we're assuming that each of those different components are all going to function together in.

Managing the risk that there's material misstatement in these financial statements, not all of the five different components are going to operate identically. Some of the components will be stronger than other components as you look at the different organizations. And so what I mean by that is that not every organization is going to have a system of internal controls.

That's designed exactly the same way. Depending on the nature and the size and the complexity of the organization, how many people they have that are involved in accounting, how many different types of locations they have, how many different products and services they offer, all of those things are going to come into play in designing a system of internal controls over financial reporting, to be able to manage risk it's appropriate to that organization.

Now not one component is so one single component out of the different components is not going to be in and of itself sufficient to make up for just totally ignoring another component. But what it can do is that it can mitigate risk. So the strength of one component could make up for some deficiencies in another component.

That we're going to talk about when we go through the different components, but they're all going to operate together in an integrated way to all limit the, the fact of things. So the different components that are in the COSO integrated framework starts with the foundational component of that framework, which is called the control environment.

The control environment is the first of the five components and it's the base of the whole. System of the integrated framework in that it sets the control consciousness of the organization. It's the foundation for the other four components of the COSO internal control, integrated framework. It's things like management's integrity and ethical values and how the organization is structured and how they hire people.

What types of training they provide to people. It's all the things that just set that foundational base. And set the tone of the organization around the fact that internal controls matter and ensuring reliable financial statements matters. The second component of the internal control integrated framework relates to risk assessment.

Now risk assessment is how does the company identify and evaluate and analyze the internal and external risks that could impact. The entities ability to create reliable financial statements. This is going to include how they record and process and summarize and report all the individual financial data transactions that go through a system of controls.

But it also is going to include things like how they accumulate all those individual transactions and get them into the set of financial statements. So how they present. Financial information, this set of financial statements, what types of disclosures are there in the set of financial statements and what the risk assessment component does is that somebody within the organization is responsible for looking at the financial statements and saying what could go wrong in this set of financial statements.

That actually might be something of concern to the users of the financial statements. So whatever the users of the financial statements care the most about those are the things that if there were to be a problem, it would be a much bigger deal. So when we talk about identifying and evaluating risk, we're talking about identifying, evaluating the areas where if there were to be something wrong, it would make a difference to the users and they may end up making a different economic choice.

So once they've identified all those things, then somebody needs to go through and decide how are we going to manage these risks? So the risk assessment is not just the identification of risk, the evaluation of how significant is that risk, but also trying to decide how are we going to manage that risk?

The third component of the COSO integrated framework has to do with information and communication. So as we are setting the foundational basis, Of the COSO integrated framework with our control environment. And as we go through and identify and evaluate and analyze risk within our financial statements, we also need to share important information.

So the information and communication component, which is the third component of the COSO integrated framework is the method of sharing knowledge and data throughout the organization. So it's not just making sure that pertinent information is identified and captured and communicated through some sort of formal accounting system or formal record keeping system.

But also that they're just communicating informal things that occur. So if I am making a change in my department, for example, that might influence the data and information that. Another department's getting that. I share that information across the organization that I communicate with my external auditors and my legal counsel that I.

Communicate downwards in the organization so that people at the upper levels of the organization let people at the lower level of the organization know what's critical and important for them to do their jobs appropriately. And, and people at the lower end of the organization have to communicate upwards to let upper management and those charged with governance know where they think there might be flaws in the system or where they're confused about what they're supposed to be doing, or they think that there might be some sort of fraud that might be perpetrated.

Communication has to flow up down, across, inside, outside. It has to flow in a free and robust manner throughout the entity in order to make sure that people have the information to make good decisions and to do their jobs well. And then remember this component also includes the actual information systems.

That produce the reports that can clay contain the operational financial and compliance related information. That's critical to people to be able to do their jobs. It also deals with the fact of just making sure that everybody, once again, is getting clear messaging from top management about the seriousness of fulfilling their roles and responsibilities, particularly internal control responsibilities in a thoughtful and diligent manner.

People need to understand how their jobs Interrail interrelate with them. Other people's jobs and how, what they do on a daily basis actually ultimately influences what ends up in the financial statements. So we need to make sure that if people are confused about what they're doing or why they're doing it, or how to do it, as it relates to financial reporting, that there is a mechanism in place that management and those charged with governance could.

Be alert to that and know that there might be some confusion or some misunderstanding, and then their job and responsibility is to make sure that there's clear messaging messaging out there to, to correct that issue. So we've talked about three of the five. Components of the COSO integrated framework.

So far, we've talked about the foundational control environment that just sets the tone of the organization around financial reporting. We've talked about assessing risk to figure out what might go wrong and how, and what is it that we need to manage and control. That might be the bigger issues. We talked about information and communication that makes sure that everybody has the data and the information and the knowledge to do their jobs well.

And then the fourth component is going to be control activities. And so the control activities are traditionally what people think about as being. Internal controls. It's the actual policies and procedures that make sure that management directives are carried out. And so what that means is those are the actual actions that are occurring in processing payroll or Paying your bills or getting deposits in the bank.

It's the activities that include the processing and recording and the authorization and approving and the reconciliations and all of those things that occur on a day to day routine basis throughout the organization at all levels and at all functions to get the transactions and events into the systems that actually create the financial statements themselves.

So the control activities are the specific policies and procedures that help ensure a management directors are carried out. And those include things like approvals, authorizations, verifications, reconciliations, matching of documents, anything that is an activity that would help ensure that the data and information that's getting into the system that ultimately is going to create the financial statements is handled properly.

The fifth and last component of the COSO integrated framework that we're going to talk about is called monitoring. And what monitoring is, is that it is the mechanism that management uses and that governance uses to ensure that internal controls is operating as intended over a period of time. So over the course of time, they want to make sure that all the controls and the systems that they've set up are happening as intended.

If there's changing circumstances we have a new employee that joins the organization. Monitoring is going to make sure that that changeover from the old employee to the new employee happens appropriately. And that the new employee seems to have a grasp on the roles and responsibilities that they're supposed to be fulfilling as it relates to internal controls over financial reporting.

So monitoring could be done. What you might hear two different things. There's ongoing monitoring. And then there's separate evaluations. Ongoing monitoring is things that management and governance does just in the course of doing their jobs on a day-to-day basis. So every day they might review a report that shows.

How many sales were generated during the course of the day, if they see where there's an anomaly, where sales are have are significantly higher than anticipated or significantly lower than anticipated, they're going to go and investigate to say, okay, what's happening? Is it because we're having a great day with our sales?

Or is there something perhaps that is a glitch within the system? So they try to identify through monitoring where there might be a problem. And they're going to investigate it and they may conclude that. No, it really isn't a problem. It's something that we anticipated and expected and should be occurring, or they may identify that there is a problem with the control activities and the other internal controls related to financial reporting.

That need to be remediated. Now you're going to hear this term. Remediated remediate is just a fancy word for fixed. So monitoring is going to identify where there might need to be corrective action taken of deficiencies in the system of internal controls over financial reporting, and they could identify deficiencies in how trust transactions are processed and recorded in the system.

Or they also might identify deficiencies in the control consciousness of the organization, or it could be deficiencies in, in assessing risk, or it could be deficiencies in information and communication. So monitoring really monitors the other four components of the COSO integrated framework to make sure that things are happening as intended over the course of time.

So when we talk about over the course of time, we're talking about there, these perhaps the need to have these separate evaluations. So periodically they may go through and have internal audit go in and do a. A project to go and look at a specific area like cash management, to make sure that things are happening as intended specific to cash management.

There may be a control self-assessment program that every department head goes through once a quarter or once a year. So separate of that  would be something that's very targeted and specific to a specific area. Of emphasis and it might be your higher risk areas that are more open to there being problems or issues.

And then ongoing monitoring is the monitoring. That's just done on a daily routine basis. As the, as everybody just goes through their regular roles and responsibilities, where they're constantly alert to where there might be issues. And if they do uncover an issue that they investigate it and determine what corrective action within the system needs to be.

Remediated or fixed to ensure that that issue isn't perpetuated and that it doesn't continue because the longer you let control deficiencies continue the greater likelihood that you're going to end up with a material misstatement because individual transactions might aggregate up to be problems over the course of time.

That might be a material misstatement. If you give it time enough for it to perpetuate. So understanding the COSO integrated framework and just the core elements and how they fit together is important for corporate governance because corporate governance is going to play a role in monitoring, and they're going to play a role in setting the control.

Consciousness of the organization with the control environment, and they're going to play a role in making sure that risk is assessed appropriately and that communications are free flowing and robust. So they're going to look at all these different elements and from an oversight, big picture perspective, they're going to make sure that all these different elements are properly designed and that they're looked at as an integrated system of controls that all work together to try and manage financial reporting risk.

Yeah. Hi, I'm Jennifer Lewis and welcome back to our corporate governance online module. Today, we're going to talk about enterprise risk management and. Enterprise risk management or erm, is a principle that's very similar in a lot of ways to the COSO internal control integrated framework. If you remember, we talked about that in an earlier module about the COSO integrated framework that had five components of.

Control environment, risk assessment, information and communication monitoring, and control activities. The enterprise risk management framework is also something that is based on COSO principles, Kozol being the committee of sponsoring organizations. And what it does is it takes that original COSO integrated framework and looks at it in a little bit of a, in a more broad context.

And the foundational principle of it is that. Every entity exists to provide value for its stakeholders. So what management's challenges is to figure out how much uncertainty or risk are we willing to accept in order to grow stakeholder value, enterprise risk management enables management to effectively deal with the uncertainty that's associated with.

Opportunity. Because every time you try to take advantage of opportunity, there's always a risk that the opportunity might not play out. So you want to figure out where's that delicate balance between accepting risk in order to take advantage of opportunities and create value, but not going to the extreme to the detriment of the organization.

So in going through this enterprise risk management process, It also helps ensure effective financial reporting, compliance with laws and regulations and operational effectiveness and efficiency. So there's other objectives that roll out of the enterprise risk management framework, enterprise risk management, or erm, if you would, to the actual definition is that it's a process.

That's affected by the entities board of directors management and other personnel. So you can tell that that part of the definition is very similar to the Kozel internal control, integrated framework definition, which is also a process that is affected by management and other personnel and an entities board of directors.

What's different about this is that it is applied in a. Strategic way. So the COSO framework or the integrated framework for internal controls thinks about operational process improvement, ensuring reliable financial statements and compliance with laws and regulations, where the erm, framework adds an additional objective of ensuring that you're able to fulfill the strategic.

Directions are the strategic objectives of the company as well. So what they do in the erm framework is they look at what are the things that could go wrong that may affect the entities ability to meet any of those risks. And then how do I manage that risk to be within the entities appetite and to assure that we can achieve those objectives, whether it's financial reporting, operational effectiveness and efficiency compliance, or the ability to fulfill strategic goals and objectives.

Key terms that you will hear as real as it relates to the enterprise risk management or erm, framework, is these concepts around aligning your risk appetite and your risk strategy. So your risk appetite is where you try to assess how much risk or uncertainty am I willing to take on. And then my risk strategy is going to be, how do I respond to that risk?

So, what it does is it helps. Design it helps creating a rigorous process of identifying your risk, selecting among different alternative risk responses to create a strategy for dealing with that risk. And the different risk responses are either going to be risk avoidance. Where I just choose not to engage in that activity to reduce my risk, or what's often it's risk reduction is the second option, which is I can try and put in some compensating or mitigating controls and activities to try and manage the risk.

I can do risk sharing where I try and share the risks with other organizations. For example, I might get involved in a joint venture as opposed to taking all the risk on myself. Or I might choose to do risk assessment at Rick's acceptance, which is where I just choose to to go ahead and assume the risk, because I think that the risk isn't going to be significant enough for me to have to try and deal with it.

So for responses that you might have to risk underneath the enterprise risk management framework are risk avoidance, risk reduction, risk sharing, and risk acceptance. The goal of each of those different responses or combinations responses is going to be to try and make sure that you are reducing any surprises.

And you want to try to make sure that as you identify potential events and, and trying to figure out how you're going to respond to those different events, that you do that in a robust manner in order to, for you to reduce surprises that might have. An outcome such as a unexpected cost or a loss. This might involve you looking at risk from a very large perspective, like how to manage risk across an enterprise that has multiple locations that might operate on an international basis.

And so part of it might be Going through and trying to look at risk at a big picture perspective, not just at the individual component perspective and trying to figure out how all those risks interrelate together and how to prioritize, how you're going to respond to risks, looking at things on an enterprise wide level.

The goal of all this is to help you seize opportunities where I have an opportunity where I think my risk appetite is such that I should take advantage of that opportunity and try to have a positive outcome. So I'm going to deploy my capital or delegate my resources to the areas where I think that there's this great opportunity for me to seize.

Chances in order for me to build shareholder value. So remember that all comes back to the very beginning when we talked about, erm, is that the ultimate goal is to take on risk. With the goal of building shareholder value, but I need to do that in a way that makes sense that I go through and I make conscious decisions around how can I provide reasonable assurance to the organization that I am actually moving towards my objectives of reliable financial statements, strategic objectives, operational objectives, compliance.

I'm moving towards all these objectives. In a way where we are accepting risk, but not doing it to the extent where there could be a detriment or a loss to the organization, because we've overextended ourselves with our risk appetite. Each of those different categories of risk, of strategic, operational reporting and compliance, all could overlap.

Just like we talked about with the COSO internal control integrated framework, you might have activities that crossover those different objectives. It's something that helps me be in compliance with the law regulation also might help me run my business better. So you might see where there's overlap between the four objectives, but you have to make sure.

That, during this process of using the enterprise risk management process, that you're looking at each of those different objectives and trying to thoughtfully deal with each of those different components. Now, how do you do that? If you remember, the COSO integrated framework had five components of internal controls, it had the control environment, risk assessment, information and communication monitoring, and control activities.

The enterprise risk management has. Eight components. Now, some of the components are very similar to what you heard in the COSO integrated framework, starting with the control environment. Erm, has a concept around that the internal environment has to encompass the tone of the entity and sets the consciousness around how risk is viewed and addressed.

And what's the general philosophy around the organization's risk appetite. And. What's management's integrity and ethical values. And so it's all those things that are very similar to that foundational basis of the COSO integrated framework, which is the control environment. Here's where it's a little different.

The COSO integrated framework has something called a risk assessment component. Whereas the erm framework actually takes that risk assessment component and it breaks it apart into three separate components. The first component is to. Establish what your objectives are. So you need to know what are the things that we're trying to accomplish with financial reporting and strategy and operations and compliance.

So that is a whole separate component of the framework. The second thing that you're going to do in that. In that risk assessment thing part of the component is to identify the internal and external events that might keep you from achieving those objectives. And then the next step is to say, how is it that I'm going to perhaps decide how I'm going to manage these risks?

So that includes looking at the likelihood and magnitude of these things that could go wrong. How likely is it that they would happen and what would be the magnitude if they did, and to go through the process of segregating out your lower level risks from your higher level risks. So, whereas the risk assessment component of the COSO integrated framework that we talked about in a previous module has just risk assessment.

The erm, framework has objective setting for your risk has identifying the internal and external events that could occur, and it could keep you from meeting those objectives and. Has a risk assessment component that involves looking at the likelihood and magnitude of risks and deciding how it is that those risks should be managed appropriately.

Then you're going to go through and set up the response itself. So you're going to go through and say, once I've looked at. The dip, the likelihood and magnitude of risk, and I've tried to put them into different buckets. Then I'm going to go through and say, how should I respond to these risks? I remember there was four different risks responses.

You could avoid the risk. You could share the risk, you could manage the risk or you, or you could decide, tried to manage the risk appropriately with some compensating or mitigating controls. So with your risk response, you're going to decide how it is that I'm going to deal with that risk, looking at my risk appetite, or how much risk I'm willing to tolerate.

And then I'm going to design control activities that will appropriately manage that risk. So the control activities are the policies and the procedures that are established and implemented to help ensure that your responses, that management's decided on how to respond to these risks are effectively carried out.

This is where things are going to start looking a little bit more similar to the COSO integrated framework because there isn't information and communication component where it talks about identifying and capturing and communicating information in a form and timeframe that enables people to carry out their job responsibilities.

And then there also needs to be a monitoring component that makes sure that things are happening as intended. So the erm, framework has eight different components to it. And so take the time now to go back to the outline and go back and revisit those eight different components of the enterprise risk management framework and think to yourself where there is some similarities to the COSO integrated framework and where there's some differences.

Hi, I'm Jennifer Lewis. And I'm going to be talking to you about the control environment as it relates to corporate governance. The control environment is the tone of the organization that influences the control consciousness of its people. So it's the foundation for all other aspects of internal control.

Okay. That's why it's so important for it to be a critical part of any corporate governance. It provides the discipline and the structure for people to do the right things at the right time. So it is important for a governing body, but be it a. Board of directors or a it executive management team or management or other appropriate people embody it within the organization.

It's it is important for them to make sure that they are focusing on the tone at the top and the messages that are being sent throughout the organization related to the control consciousness and the importance of reliable financial reporting. So how exactly do they go about doing that? There's a few key ways that governance can play an important role in this.

And one of them is to make sure that there's an emphasis on integrity and ethical values and competence. And this is going to be most important for top managers of the organizations, because they do set that. Tone at the top, they articulate the values that have to be developed and understood throughout the organization.

And they set the standard for conduct. If, if, if the employees of the organization see management operating in a way that demonstrates integrity and ethical values, they're going to be more apt to perform in that same manner. Should they have the, should the need arise for them to make some value judgments or some choices?

So it's important as it relates to integrity, ethical values and competence, that there are processes in place to monitor adherence to any principles that might be out there related to those foundational principles. And these monitoring processes should identify any deviations from sound, integrity, and ethics so that they can be responded to in a timely manner.

It's important to make sure that entity peop personnel are informed of any ethical violations that are identify and that they're informed of any actions that were taken to remediate or fix the problems. One of the biggest decisions of something like fraud is that it's the fear of getting caught.

And so if. You don't publicize the fact that the organization is alert to where there might be violations of integrity or ethical principles, then people aren't aware. That it is something that they need to place an emphasis on. So deviations need to be identified and communicated to appropriate people in a timely manner.

Corrective action needs to be taken. And we want to make sure that there's a constant messaging out there around the importance of integrity, ethics competence. The other critical element of the controlled environment is management's philosophy and operating style. So. The philosophy and operating style of management directly influences the attitudes that others in the organization are going to have around accounting principles, estimates, presentation, and disclosure, and other similar type tasks that are a part of generating financial statements, the philosophy and operating style that management has establishes.

And. Helps articulate what it is. That's important about the financial reporting objective. So if management is. Absolutely focused on making sure that the financial statements are fairly presented, that they're consistently presented that they're completely presented. Then if they emphasize those types of things, as part of their financial reporting objectives, that tone of the organization, that tone is going to is going to travel down through the organization.

And it's going to start establishing a role of internal control over financial reporting within the. Organization as a whole. So you need to make sure that that with the management's philosophy and operating style, that they emphasize the importance of minimizing risks, that financial statements are misstated.

So all of their interactions with others throughout the organization, as well as interactions with those outside of the organization and the tone and the attitude that they take around accounting principles and estimates are critical in establishing this. Core foundational principle around having the right control consciousness.

So beyond making sure that integrity and ethical values and competence are something that's emphasized that management's philosophy and operating style is something that sets the right tone of the organization. Another component of the control environment is how is it that management assigns authority and responsibility within the organization?

There has to be clearly defined responsibilities at appropriate levels in the organization to facilitate effective internal control, which includes. Where are the limitations of things that I'm not allowed to do? So not just one of my authorized to do, but what am I not authorized to do so that it's clear, particularly with things like segregation of duties that they're not stepping over those boundaries.

So position descriptions, job descriptions. They need to be set to the degree that it reinforces who's responsible for what, within the organization. This is going to include what management's responsible for and what those charged with governance are responsible for. If it's a board of directors, the owner, the an executive management team, whoever the governing body is, they need to know what they're accountable for as well.

And then those charter governance also need to make sure that they're reviewing managements. Job descriptions and levels of assigned at the wordy so that they can strengthen and improve those as necessary. So there is a hierarchy. That is important as it relates to designing the foundational control environment, which includes management, looking at the job descriptions and roles and responsibilities of people at the operational level within the organization.

And then those chargers governance looking at management's job descriptions and responsibilities and authorizations as well to make sure that everybody is doing something that's appropriate within the confines of their job. So there's always going to be a balance. That's an out there that's necessary to look at what does it need we need to do to get the job done.

And then what is it that we need to do in order to maintain adequate internal controls? And sometimes particularly in. Smaller organizations that becomes a little bit more difficult because they have fewer people. And so sometimes the, there is an inability to have proper segregation of duties because they just don't have enough people to enable that to happen.

And so sometimes there becomes, it becomes even more important for management and those charger governance to look at how job responsibilities are assigned to make sure that they've mitigated that risk as much as they possibly can. This gets into the next component of the control environment is around organizing and developing its people and entity needs to make sure that they have a proper lines of financial reporting established such that there is appropriate lines of communication and oversight.

So what different business units. How were they, how were they described within an organization chart? And how does responsibilities line up as far as who oversees, what business unit and who is ultimately responsible for managing the organization, including. Overseeing reliable financial reporting. So there needs to be some sort of formalized organization structure.

Now, when I say formalized organization structure, it could be an organization chart that's created, but in smaller, less complex entities that don't have that many people. They may not need an org chart, but what really becomes more critical if they don't have a formal org chart is to have job descriptions.

So that at least everybody knows who is responsible for what within. The financial reporting system itself, and there needs to be some identification around what core competencies do I need these individuals to have so that we can make sure that the organization is employing or otherwise retaining individuals who possess the require competence related to financial reporting.

We want to make sure that everybody has the skill sets in order to do the job adequately. Those charged with governance. Are they form a critical role in establishing a control environment that's conducive to ensuring reliable financial reporting, because they're the ones that are going to monitor management and they're particularly going to monitor any risks of management override.

Of internal control. And so it's important that governance has at least one or more members that have some financial reporting expertise that has a greater opportunity for them to be able to oversee the effective of internal controls over financial reporting and the financial statement, preparation process.

They need to be able to oversee the relationship with they make with internal and external auditors and interact with regulatory auditors as deemed necessary. It's important, even if they don't have a formal board that there'll be some person or persons that are charged with governance or overseeing the strategic direction of the company, including the reliability of financial reports in order to make sure that there isn't that risk of management override.

Human resources is another important element of the control environment and human resources is the policies and procedures that are designed and implemented to facilitate effective internal control, because it they're looking for ways to demonstrate a commitment to. Competence integrity and sound ethical behavior.

So it's going to be the training that is put into place, but it's also going to be how it is that we go about recruiting and hiring key people in these key financial reporting positions and making sure that we hire the right people. That have the greatest potential of being successful in their jobs, but that you're also providing tools and training for them to continue to perform those financial reporting roles on a recurring basis.

There needs to be performance evaluation and compensation practices like raises and bonuses should reflect the importance of achieving. Financial reporting objectives. So compensation plans should not be excessively tied to short-term results because then there's going to be this motivation maybe for people to overstate earnings.

In order to, for example, if their bonuses is tied to, to net income or to revenue growth, then there might be a short term motivation for them to misstate those things in order to get the bonus. And then later they may need, they might not be able to keep up the fraud scheme any longer and ultimately things will catch up with them.

And then you could have a misstatement in the financial statements that's going to result from that. So the control environment as part of corporate governance is important because it does establish the tone and the foundational principles that are critical to establishing a sound control consciousness around internal controls over financial reporting.

Yeah. Hi, I'm Jennifer Lewis. And we're going to talk a little bit more about financial reporting oversight and how that's a critical part of corporate governance. Financial reporting oversight has a lot of important elements to it, including making sure that an entity does properly understand what are the financial reporting risks to our organization.

So the organization needs to have a risk identification process. That includes consideration of all the operational processes that impact the financial statement, accounts and disclosures, risk identification, and assessment considers things like. Are my entities personnel competent enough and dedicated enough to support our ability to meet these financial reporting objectives and does my information, technology, infrastructure and processes support in entities ability to meet financial reporting objectives.

And is the organization has it, has it designed its operations in a way where there are appropriate mechanisms for management to. Deal with risks. So as risk changes and evolves, is there a mechanism in place for them to identify those changing circumstances, such that they can modify the it infrastructure, the processes, the training of its people and other relevant matters in order for them to respond to these risks?

So risk identification is important to make sure that they're looking at, at all the factors that could create a risk that the financial statements might not be correct. This is going to include both internal and external factors, things that the organization can control and things that the organization can't control.

So when we talk about internal factors, it's things like. The it systems that are put in place but that, that are, that are running and generating and capturing the data that's being put into the financial statements. It's going to be the number of people that you decide to hire in the accounting department.

Those are all things that are directly in the control of the entity itself. But there's also going to be external factors that might create risk of misstatement in the financial statements, changes in the economy, changes in interest rates, changes in regulations that that organizations have to comply with.

Those are things are outside of the organization's control, but yet they still create circumstances that need to be managed to ensure that financial statements are properly stated. So from a financial reporting risk standpoint, that's why it's so critical for governance being management. Those charged with governance, the board and other appropriate personnel that they're all looking for, identifying these things that could go wrong and then analyzing them through a process that goes through and says, how likely is it that this will have an impact on my financial statements?

That even if it does impact my financial statements, to what degree or magnitude would it likely occur and then D and then. What they can do is use that information to decide what risks need to be managed, what risks need to have some controls in place to keep it from being a big deal. So this, this risk assessment process requires an initial evaluation.

And, and, and, and analysis of risk, but it also requires management to periodically reassess their conclusions to look for things that have changed that might ultimately need some changes to be made to the internal controls over financial reporting themselves. So financial reporting risks are the risks that something could go wrong.

In the financial reporting information. So financial reporting information is all of the information that is pertinent to the financial statements themselves. So it's all the information that's identified, captured and used at all levels in order to put together your set of financial statements. So it's the actual data that's undermined the financial statements and the financial reporting.

System makes sure that it's captured completely and accurately and timely. It makes sure that all transactions and events are put through some sort of mechanism. Of capturing that data. So things that are routine and in the ordinary course of business, as well as things that are non routine in nature, say a related party transaction or something that happens through journal entry.

Only it doesn't get processed through the system itself. These are all things that you need to make sure that. All transactions events have some means whether they're something that's through the formal processing system or outside of the routine processing system, to make sure that there is everything that needs to be included in the financial statements is included.

This includes things like estimates. So if we have to make an adjusting journal entry to change the allowance for doubtful accounts, then that estimate needs to make sure that that gets recorded into the system. It includes looking at. Any operating information that is used to develop accounting and financial reporting information.

Like it could be your cash management and looking at your collections of amounts that were on bills that you sent out to your customers. There's an overlapping degree there. There's an overlap. In the fact that yes, I need to make sure that what is still receivable that has not been collected yet is shown as an accounts receivable my books.

But we also want to know what customers are paying their bills on a timely basis for us to be able to manage cash flow and decide what customers we really should be looking to sell more products or services to. So when we talk about financial information, financial reporting information, it is sometimes things that directly.

Influence the financial statements. And then it also may include things that are indirectly a part of the financial statements. There needs to be policies that are established for reliable financial reporting. And these policies should be communicated throughout the organization to make sure that management's directives are properly being carried out.

People need to know what it is that they should be doing and when they should be doing it so that they are comfortable, that they're properly fulfilling management's directives and their objectives that they established with financial reporting. Part of this is going to be the control activities that are built into the day-to-day processes and that are out there.

How do I collect cash on a daily basis and get it in the bank? How do I pay my payroll? How often do I pay it? How do I pay my vendors? How do I book sales? How do I show that inventory has been relieved after shipments are, are, are made of a particular product. All of those things of whatever happens on a day to day.

Business level, there is going to be an impact on the financial reporting system as well, to get those transactions and events captured into the financial reporting system. So people need to know what their responsibility is and their accountability is for those policies and procedures and management as the one that needs to establish those policies and procedures.

So there is something for people to follow. And it needs to include the timeliness of it. Not just that I want somebody to perform bank recs, but how often do I want an individual to perform bank reconciliations? Do I want them to do it monthly? Do I want them to do it weekly? You know, how often is my expectation for the performance of those procedures?

Other important aspects around policies and procedures for financial reporting is that senior management needs to be involved in the development of these policies and procedures. And as the importance of those policies and procedures increases the level of oversight and approval of those policies and procedures needs to increase.

So if I have a board of directors, for example, they're going to be involved in approving any significant accounting policies and procedures that might be material to the financial statements as a whole. So there needs to be somebody that is establishing the policies and procedures, and then somebody else that's reviewing and approving it.

Now, who is that? Somebody else it's generally going to be those charged with governance, whoever that is for an organization. There also needs to be a mechanism to make sure that financial policies and procedures are periodically reviewed for their continued relevance and to make sure that they are adapted for changing conditions and circumstances.

So just to review for financial reporting oversight, we want to make sure that that the organization is aware of what the financial reporting risks are. We want to make sure that they're aware of how financial reporting information is generated, generated, and captured within the system. And we want to make sure that there's appropriate policies and procedures that are in existence to ensure reliability of the financial reporting process as a whole.

Yeah.

Hi, I'm Jennifer Lewis. And we're going to talk a little bit about the purpose and benefits of monitoring and control effectiveness. As it relates to corporate governance. The primary purpose of monitoring is to provide comfort on whether controls continue to operate effectively over the course of time.

That concept is critical to governance because you're looking at whether or not there isn't any deterioration of controls, because if you're not monitoring those controls, then they tend to deteriorate over the course of time, which could lead to misstatement in the financial statements. And so governance be it management and the board of directors and executive management teams and other appropriate parties.

They are the ones that. Need to set the standard to say that we are looking over each other's shoulder to ensure that we're all doing the right things in the right way in a timely manner. So monitoring as a foundational premise is the gathering of all the important information that needs to be accumulated in order for.

Appropriate people to make that evaluation around whether or not controls are continuing to operate effectively over the course of time, monitoring should include all the important elements of internal control. Which generally is going to be the components of the COSO integrated framework that you've heard me talk about multiple times.

Now, if you've been watching all these different segments, and if you remember the five important components are the control invited the risk assessment, the information and communication, the company control activities themselves, and then monitoring. So monitoring is the fifth component of the COSO.

Internal control, integrated framework that monitors the other remaining four components of a well-designed and operating effectively effectively operating system of controls. So it looks at the relative strength of all those other components and evaluates whether or not there's any deficiencies in the system that needed to be fixed.

Now, monitoring can happen through manual processes or automated processes. So a manual. Monitoring example would be if somebody. Physically takes a check package that was written and looks at the supporting check package and decides whether or not it was properly categorized, whether it was properly authorized, whether it was put into the right reporting period for the right amount, somebody going through and maybe taking a sample of those check disbursements and making sure that everything was treated properly.

You also could have an automated monitoring mechanism over cash disbursements. And that could be that perhaps the system automatically rejects any checks that are written over a certain dollar amount, or maybe it matches, checks up with the vendor invoice file that shows all. Vendor invoices that have been approved for payment.

And so it check can't be cut for a vendor unless it's in this authorized vendor listing. So there's ways that, that that systems can be used automated systems that can be used to help mitigate the risk that there's something going wrong with the day-to-day processing and, and what it might be even is to generate these exception reports that could be.

Something that's listed, for example, run me a list of all disbursements that were authorized and processed after hours. And so somebody could go take that exception listing and look to see whether or not it appears as if these are valid transactions. This concept of monitoring has two folds to it. One of them is that it looks at.

Where there might be actual errors in the system or where somebody might be overriding controls or perpetrating fraud, but it also looks at the effectiveness of the system because it identifies any internal control breakdowns, which may reduce efficiency and the system as a whole. So part of monitoring is to make sure that the entity is producing accurate and reliable information to be used in decision-making, including.

Creating accurate and timely financial statements that are used by outside third parties, perhaps, but it also is identifying and correcting internal control problems on a timely basis. So it's looking at. At how things are processed over the course of time, not just a set period of time, but over the course of time.

And so you want to make sure that monitoring is done periodically, not just once a year, that there should be monitoring that is built into to some degree ongoing monitoring that happens on a, on a, on a routine daily basis. Because you don't want issues and problems with things like controls or misstatements in the financial statements to linger out there for too long of a period of time, because they could aggregate up to be something that's material as time passes.

Ultimately the goal of monitoring that would be a benefit to an organization is to be more proactive in identifying deficiencies in internal controls, over financial reporting, and to identify any misstatements so that they can be dealt with on a timely basis. So what are some important foundational elements of monitoring?

Those elements are going to include a proper tone at the top. Regarding the importance of monitoring. So those that are most directly involved in monitoring management, senior management. The board or others that might be part of governance to make sure that they're taking the process seriously, that they are communicating with people at lower levels of the organization.

If they do find deficiencies to let them know that we found a deficiency, here's how we're going to fix it. And to put people on alert that. That they need to make sure that they're doing their, their jobs and their responsibilities appropriately. Otherwise somebody's going to notice, and they're going to take action.

So an effective organization structure that assigns these monitoring roles to people with appropriate capabilities, objectivity and authority is important. So not just assigning roles and responsibilities and how to process individual transactions and events throughout a financial reporting system.

But also who's going to be monitoring what, within that process, all the way up to what is. Those charged with governance or the board of directors going to monitor in their role and responsibility, another critical element beyond setting the right tone and having an appropriate organization structure that assigns roles and responsibilities to those that are going to be doing monitoring is to make sure that those doing the monitoring have a baseline in order for them to monitor against.

They have to know what is the starting point that I'm dealing with or what is the. Desired baseline that we want to operate against to compare to. So what do I compare against what are we doing now compared to what we should be achieving and being able to identify the differences that might exist in that point in time.

So they want to make sure that they're using persuasive information about key controls that. Might address some of these meaningful risks that are out there with the financial reporting objectives. So you want to make sure that, that those doing the monitoring have a means of identifying and knowing what it is that they're looking for as far as risks that could be out there.

And they also want to make sure that they know what are the controls that we're using to monitor or manage those risks. To keep them from being something that is considered to be material. So they need to know what the relative severity of any problems are. And what are the points in time where I need to remediate or fix those problems.

There's some points in time where there could be a deficiency or a problem in the system that's identified, but we can let it go for a little while before we have to deal with it because it's, it's really more of a less consequential. Issue so I can let less consequential things build up over the course of time before I have to deal with them, as opposed to I come across an issue in my monitoring, that's a major, big deal, and I need to fix it right away because it's going to have an immediate impact on my financial statements.

So those doing the monitoring need to have the capability to be able to differentiate the varying levels of severity of the problems and issues that they come across and be able to prioritize their responses to those problems and issues for timely action and follow up as necessary who gets. The information about any identified deficiencies is going to be those that are at an appropriate level to fix the problem, as well as one level up from that, that should be aware that there is a potential issue here for the longterm.

And so what that might mean is that what that might mean is that a monitoring might happen at a, at a level closer to the identified deficiency for a period of time until. Everybody gets comfortable that the problem has been fixed and then maybe monitoring could be loosened up a little bit and performed at a less periodic level until because they're comfortable that, that, that, that the system is working as intended again.

Okay. So when we talk about with monitoring, it's important for those charter, that responsibility, to know what their responsibilities are, to know who's all involved in the monitoring process to be able to understand financial reporting risks and to be able to understand materiality so that as they're going through and they're identifying deficiencies and potential problems, they can go through the process of evaluating.

What needs to be done and when, so that they can allocate resources appropriately and communicate issues appropriately throughout the organization, to make sure that the most important things aren't being dealt with first and that other issues that may have been encountered are being dealt with on a, on a, on a future basis.

Hi, I'm Jennifer Lewis. And we're going to talk about practical applications of monitoring concepts. If you need to go back and refresh on what monitoring is, go back to the internal controls over financial reporting section, and read a little bit about monitoring and how it fits into the. Internal controls of our financial reporting framework.

And then also look at the sections that dealt with the benefits of monitoring. So the monitoring is something that's critical to ensure during that there's reliable financial statements that are generated from a system and there's different types of monitoring that could occur. One of them is to have internal audit or other appropriate parties.

Go and periodically evaluate and test the operating effectiveness of controls that are in the internal control and are in the financial reporting process. So a periodic evaluation or a separate test of controls is something that's called a separate evaluation. There also could be ongoing monitoring and ongoing monitoring as the continuous monitoring of information that's built into a system.

And so this can be something that's done on an automated basis, or it could be something that's done on a manual basis. So on a manual basis, for example, there might be some operating reports or some performance metrics that are generated from the system that tells us. The tells management or other appropriate parties about the financial information that's being generated.

And they can look at that financial information and they can look to see if there's anything that looks odd or funny or what you might hear called an anomaly. So if there's an anomaly, it's that, there's something that's not expected. There's something that is unusual. And so if there's a trend, let's say if I'm looking at my.

Expenses from last period to this period. And all of a sudden there's certain expense areas that really jumped up significantly from the prior period that might be an anomaly or something that's unusual that could be integrate indicative of a control failure, or it could be that we just spent more money and that increase in expenses is actually something that's valid.

It also could be that perhaps there's items that are miscategorize, that something's getting charged to a particular expense line item that doesn't really belong there, or it could be that things that. Should be recorded in the next period or being recognized too early, or it could be that somebody stealing from the company and they're trying to cover it up.

And so they're hiding the other side of the entry into expenses. So monitoring is going to include looking at these re these reports that are generated with financial information. And they're going to look to see whether there might be things that are significant or unusual, or those. Anomalies in order for them to identify possible issues.

And then the job of the people that are doing the monitoring then is to actually follow up on those issues and ask the questions to see, is it truly a problem or not? If it does end up being a problem, then they need to correct the problem. Make sure that the, that the amounts end up being correct in the financial statements, but then they also need to correct.

The system to make sure that this whatever deficiency, what in a system that existed that allowed this misstatement or this error to occur, that, that, that, that gets fixed as well. So the ultimate goal of monitoring is to make sure that the numbers are right in the financial statements at the end of the day.

And the presentation is appropriate and the disclosures are appropriate. But also that the system that's generating all this information is also a strong, accurate, reliable system. Part of the monitoring could be through. Supervisory review that occurs in the course of business. So for example, looking at reconciliations, if somebody is preparing a bank reconciliation, and then somebody else is reviewing the bank reconciliation, The person reviewing the bank, reconciliation is looking at it from the perspective of was the bank rec done.

And does it tick and tie and agree, but they're also looking for things like, are there any unusual reconciling items that might indicate that there is an error in the financial statements or an index or an internal control failure? They're going to look at. Was the reconciliation able to perform timely.

If it wasn't able to be done timely, then maybe there's a system problem that needs to be fixed. Or perhaps there are unusual transactions or events that need to be further analyzed and addressed. So the rec the review of the reconciliations is a control activity over the financial statement amount of cash, but it also is a monitoring control over the processing of cash and the management of cash and, and looking at it from a systems perspective as well.

So self assessment needs to be done. By management, if they're the ones that are performing some of these controls. So if management is the one in a smaller organization that is preparing the bank reconciliation, who should be reviewing the bank reconciliation to look for the appropriateness of financial reporting and looking to see if there's any red flags or indicators of deficiencies in the system.

So. Those charged with governance are the ones that might be the appropriate party to look at bank reconciliations. In that situation, if management is preparing the bank rec, then an executive management committee or the owner of a business, or a board of directors needs to be the one that's reviewing the bank reconciliation, there always should be some sort of oversight function.

To set the right tone in the organization around the importance of generating reliable financial statements. Monitoring is also going to include things that is, that is built into the interactions that those charged with governance has with internal and external auditors. So internal and external auditors are going to bring potential issues to the table around things that they think may be areas of concern.

That need to be looked at in more detail or possibly could end up in material misstatement down the road. So internal and extra waters are supposed to throw up the red flag to say, Hey, I think there potentially could be an issue. And then. Management is the one that's responsible for taking the corrective action and making the changes in the system to make sure that that problem does not continue or end up being something that is a much larger deal that could end up in a misstatement of the financial statements, or maybe even having to restate financial statements for the information that's already been generated.

So how, how do we prioritize monitoring? It's going to depend on risk. And so somebody has to make the decision around. As problems are identified. Let's say that maybe we find a transaction that is miscategorized or we find a disbursement that was made too soon, or we find a cash receipt that was coded to the wrong customer.

As we find these problems, somebody has to make a judgment call to say, well, How big of a problem is this, what's the likelihood and the magnitude of this issue. And is this something that we need to fix now today? Or is this something that could wait a period of time before we end up fixing it? They have to look at the inherent risks associated with issues that are identified through monitoring.

So they have to look and see what's the nature of the problem. What is the. Complexity of the problem, how much subjectivity is involved with this particular area? They have to look at how many processes could be impacted by this problem. How, how much could it perhaps trickle out throughout the organization?

So there needs to be an instance where somebody is able to prioritize. Ha, not just the monitoring efforts, but prioritizing the response that is necessary for any problems that are identified. Having said that there also is an inherent risk that things may change and that controls may not. Modify or adapt appropriately to deal with these changing circumstances.

So in an earlier section, we talked about the need to have a control baseline. So the control baseline is giving the, those that are doing monitoring a starting point, that to, for them to be able to compare against, to say, okay, what is the ideal situation that I should be looking for? And now, where do I have variances from that situation that I need to perhaps investigate and resolve.

It's important to make sure that, that those doing monitoring realize that the control baseline may need to change because it's circumstances change as the business grows as our. Products and services evolve as the economy changes. There's things that change that require the baseline to change, because what might be reasonable and expected in one month might not be what's reasonably accepted in the next month.

For example, with the downturn in the economy, it might not be expected that revenues should be consistent with the prior period. You actually might expect a decline in those revenues. So the control baseline of what you're looking for to identify those significant and unusual events or anomalies might be, if it is the same as last year, I want to know what's going on.

So it's important to make sure that, that those doing monitoring are aware of changing circumstances and they're aware of changing risks and they're aware of where numbers are expected to change and should change, and where controls might need to be modified in order for them to best address the risk.

So using a change management process might be one means of verifying that. Any necessary changes to controls are being appropriately made and that a new control baseline is actually created when appropriate. And then finally somebody needs to periodically can reconfirm that changed controls the new baseline, that, that things that evolved that is we made changes to our systems that those are.

Operating from that point forward at an appropriate level. So there may, so there needs to be monitoring of the new set of controls or the new processes or systems. Okay. A couple areas to emphasize that. I think we've talked about several times now throughout the corporate governance modules, but I know it's an important concept that is likely going to be addressed in the CPA Exam is the concept between there's a difference between ongoing monitoring and separate evaluations.

Ongoing monitoring is the monitoring that's done in the ordinary course of operation. So these are the things that are going to potentially happen daily, weekly, monthly, quarterly. So depending on the frequency of the operation of control, there's going to be different levels of monitoring of that control.

So if I have a daily control, I have to make an assessment of how often do I need to monitor the daily control what's happening. If I have a. Weekly something that happens weekly, or how often do I need to monitor that weekly control? So the extent of operation of the control that's being monitored plays into determining the timing of monitoring the control to make sure that it's happening as intended.

So a lot of times these things are built into the regular. Processes the regular management and supervisor activities. So if I know that I want to do monthly bank reconciliations, I know I want to do quarterly budget to actual analysis. Those are things that are going to be built into the normal policies and procedures.

And they're going to be set at a timeframe where it's real time enough to be able to identify potential internal control issues before they aggregate to be a material issue. Because that's the goal of monitoring to keep problems from building up to end up being a material misstatement in the financial statements, separate evaluations are going to be things that happen at a point in time.

It might be that. Separate evaluations might occur once every other year. It could be dependent on an internal audit and what internal audit establishes as what it is that they want to look at. It might be that it's the same thing that we do on a ongoing basis, but we do it less periodically with a very, very specific focus.

Let me explain what I mean by that. I mean, if I do. Monthly budget to actual analysis, just through the course of a business. And it might be that the controller does that maybe every quarter, the board of directors looks at the results of the budget to actual analysis and they do their own investigation of things that might look significant or unusual.

So it might be that it's the same thing. We're doing budgets, actual analysis. It's just that it's done at one level. On an ongoing basis and it's done at a higher level at a basis that happens less often throughout the process. So monitoring is important to make sure that you're building it into a good sound system of governance.

And it needs to make sure that everybody's thinking about as they're designing, monitoring as part of governance, that there's an identification of all the people that are involved in monitoring. What are the different procedures that we're doing? What are the things that we're doing that are part of ongoing monitoring and what are the things that are part of separate evaluations that might be done by internal audit or through control self-assessment or through using outside resources or using the board of directors or a higher level of management?

Hi, I'm Jennifer. And we're going to discuss the importance of making sure that you're using quality information in the monitoring process. That's a part of corporate governance. So corporate governance and monitoring requires information that's generated from the system in order for them to perform the analysis of whether or not things are operating as intended.

And so it's important for that information to be persuasive. And when we talk about persuasive information, it's the degree to which the information provides support for the conclusions that. They're coming too. And so when we talk about persuasive information, it really is going to be contingent on two key aspects.

One of them is that the information is suitable and the other is that it's sufficient. Now suitability has three components to it. It has to be relevant. It has to be reliable and it has to be timely in order for it to be suitable. So relevant information, relevant information, provide something that's actually meaningful about the operation of the underlying controls or the control component itself.

And so it's fit for its intended purpose. Or there actually is relevance to what it is that we're accumulating to monitoring the next aspect, being reliability. Reliable information means that it is not only accurate, but that it's also verifiable and comes from an objective source that is suitable to generate the information.

And then the final part of having information that is suitable is that it also needs to be timely. So suitable information is relevant, it's reliable and it's timely. And timely information is produced in used in an appropriate timeframe to make it possible, to prevent or detect control weaknesses before they become significant.

And that's an important concept about. The T the suitability of financial information, it's emphasizes that we need to do it in a timely manner that will prevent or detect and correct control weaknesses before they become significant. So it's not that we have to prevent or detect every single misstatement it's that we have to prevent or detect problems before they aggregate up to be significant.

So that means that there could be inconsequential deficiencies in our internal control system that we could let lapse for a period of time and that they won't aggregate to be significant until a month out a quarter out, even a whole year out. And so the relativity of monitoring is going to depend on, on how timely do I need the information to be.

And my. Assessment of that around the time, these information is going to depend on how quickly could my problems. I grew up to be aggregate up to be something that significant. So ways of information is going to be both suitable and sufficient suitable information is relevant, reliable, and timely, and sufficient information means that I've gathered.

I've gathered it in enough quantity in order for me to form a reasonable conclusion. Both suitability and sufficiency are really a matter of judgment. That's going to be based on the relative risk of what it is that's being monitored and the relative importance of the control. The other decision that has to be made around information that's used in monitoring is whether or not the information needs to be gathered directly, or can it be gathered indirectly direct information is obtained.

Directly it's obtained through observing controls in their actual operation, like observing somebody, opening up the mail and, and accumulating the cash and checks for deposit. It could be repo re-performing. The control. So that's a direct information. So to re-perform a bank reconciliation, for example, to make sure that you're comfortable with the process and that you're comfortable with the information that's being accumulated within the reconciliation itself.

You also could do some other direct testing of controls, like going through and pulling a sample of cash disbursements and looking at the supporting check package and making sure that it's coded to the right account and in the right period. And then it pu it appeared to have all the proper sign-offs that were required in order for the disbursement to be made.

Each of those are examples of monitoring where monitoring is being performed with direct information and direct information tends to be pretty persuasive information because it provides an unobstructed view of the operation, right? That control. So direct information is something that is probably most of them appropriate for monitoring controls that have the greatest level of importance to them.

Indirect information is going to be less persuasive than direct information because it's indirect. It doesn't tell the evaluator explicitly, explicitly what the underlying controls that the underlying controls are operating effectively, but it gives you some indicator as to whether or not things are going askew or something.

Doesn't quite make sense. So a lot of times these, the, the, the monitoring that's done with indirect information is using reports. And analyses that are summarizations of individual transactions that are generated from the system, like looking at operating statistics, looking at my accounts, receivable aging, or my AR has percentage of sales or looking at my gross profit margin trends are looking at my expenses compared to last period of this period.

Those are all things that it's an aggregation of data and information that is probably done on in a. In a manner that might be weekly, monthly, quarterly, annually, it's often done and on a basis that that's, that's less periodic than my direct information. So it's important that even if we're using indirect information that we think about how timely we need that information to be, should I be monitoring budget to actual.

Once a week, once a month, once a quarter, what would be appropriate for me to look for those anomalies? And remember we said, anomalies are the things that look odd that are significant or unusual, and that we're looking at those anomalies to be able to address them in a timely manner that would allow me to prevent or detect and correct any problems before they aggregate too, these significant.

So whether I'm using. Direct information or indirective information. It's important to think about the timing of those monitoring controls and looking to see, you know, what is it that needs to be there in order for this information that's being used to, to be persuasive information for me to be able to conclude that the systems and the processes and the controls are operating as intended.

Which in effect means that I could have a better sense of comfort that my financial statements that are being produced are reliable when you're looking at indirect information, it's important to realize that the absence of any anomalies does not mean that the underlying controls are operating effectively.

It just means that they could be that the Controls are failing, but yet the data information that's being produced, isn't, isn't reflecting anomaly for some reason. So the absence of thing of things looking significant, unusual does not mean the underlying controls are operating effectively.

Whereas direct testing generally is going to give you better information about the operating effectiveness of controls. So in order for monitoring to be something that is useful, In a governance type environment. It does need to be based on information that is, has a sense of high quality to it and, and is, is appropriate to the monitoring that's being performed.

So when we talk about persuasive information, we have to remember it. Persuasive information needs to be both suitable and sufficient. Suitable means that it's relevant, reliable, and timely. And the information that's being used can either be direct information, meaning that I'm actually observing the controls or re performing them or getting them through some other direct means, or they could be indirect information that evolves from the processes in which the underlying control actually resides like budget to an actual analysis or looking at a trend.

Reports or other types of key performance metrics, but whether it's direct information or indirect information, it still needs to be suitable and sufficient. So the concepts of relevant, reliable, timely, and sufficient to the extent that I need to have it, they, those concepts still hold true. Whether it's direct or indirect information.

Hi, I'm Jennifer Lewis. And we're going to talk about the change control process as it relates to corporate governance. Now change control process is. Basically the formal process that's used to ensure that any necessary changes to internal controls over financial reporting are that are identified through the monitoring process are done in a coordinated and controlled manner.

So when we talk about governance and when we've been talking a lot about the importance of establishing the right tone of the organization about, about Generating reliable financial statements and the importance of internal controls over financial reporting and identifying financial reporting risks and designing procedures to manage those risks and making sure that we're monitoring to ensure that that things are happening as intended.

I mean, all of that is I meant to look for where there isn't for change either things aren't happening as intended. And so we need to reinforce that with individuals to tell them you need to do this. Role and responsibility and activities that were assigned to you. And perhaps they're not doing them and they're not doing them appropriately, perhaps they're not doing them right.

Timely perhaps they're not doing them as robust and thoughtfully. So where is it that we need to modify existing controls, but also where is it that we need to perhaps add control activities to the process, that, to the internal controls over financial reporting that we need to modify and change thing because of changes that have been happening with.

Internal external factors like changes in the scope of our business or changes in the ability for our customers to pay their bills or changes in interest rates on our variable rate debt, which is. Having us pay more every month on our, on our, on our debt, which leaves us less money to reinvest in the business.

So all of those types of things, we also need to take into account with change control, to ensure that necessary changes are made when they're needed and where changes to existing things are done as well. So what's new and what needs to just be tweaked or clarified or enhanced? So identification and communication of these changes needs to be done in a timely manner to those parties, responsible for taking corrective action.

And that's going to include management and those charged with governance when it's appropriate. It needs to meet. You need to make sure as we're thinking about what needs to change, that it's going to come from information from a lot of sources. It could come directly from internal sources through our monitoring of, of, of how things are done in our business.

But it also could come from external sources, perhaps external auditors bring to management's attention that there's a deficiency in, in the processing of. Cash receipts, or maybe it comes from a regulator that has identified where there might be a flaw in how certain transactions or events are being treated within the internal control system.

So deficiencies can be identified either from internal or external sources and all deficiencies that are identified need to be considered. Okay. For what's their implications on our financial reports so that we can prioritize and take timely corrective action to fix the problems that we've identified.

And then once we've made corrections to the system, we need to make sure that the corrected systems. Are designed and are operating effectively a well, so there needs to be ongoing sense of monitoring just because we monitor it and make corrections to systems at one point in time. Does it mean that we can now ignore that?

We need to make sure that we're constantly and continuously looking for improvements to the process to strengthen our internal controls over financial reporting. So there's different tools that can be used to help us in, in this process. And there are some formalized process manage management tools that are out there that could be purchased and, and installed in a information technology type environment.

And they might make mom tree more efficient and something that's more sustainable for the long-term, particularly if we have to replicate the monitoring activities over a period of time, maybe every month or every quarter. So the automation could help us not only identify problems, but it also could help the organization assess and prioritize risks by assigning some sort of key that would help me, we figure out is this something thing that is of a low priority?

Is this something that's at a moderate priority or is this something that needs to be fixed in court corrected right away? So it helps us identify risks. Assess risks. And then also look for the controls that are linked to the problems that we found. So if I found that something got coded, a vendor payment got coded to the wrong expense line item, it went to telephone instead of rent.

Then what I would need to do is to say, well, what controls failed that enabled that to happen? And. How can I, and who do I need to communicate those problems to so that we can appropriately fix the system. So these process management tools are the things that provide the structure to consistently keep track of our monitoring efforts, to link them to the specific controls that need to be fixed and to follow up on that process by communicating to the appropriate people, what needs to be fixed as well as to follow up on controls that have supposedly been remediated to make sure that they really have been fixed too.

To the degree that we wanted them to be. So it's a repository for all of these pieces of information, and it allows us to document our thought process and our rationale and our thinking around the. Change control process. It helps us roll up information. So if I have lots of deficiencies that were identified related to my cash, receipts processing, I might've had five different deficiencies that I identified in my internal control process that needed to be fixed and governance might want to roll all the deficiencies up.

And to think, to look at cash receipts as a whole, as opposed to maybe just opening the mail or depositing the cash in the bank or relieving the receivable from the system. So you could look at things at a very finite level, or you can look at things at a very aggregated level. And these process management tools allow governance to look at the items that were identified at varying levels throughout the organization and throughout the process.

So the goal ultimately is to try and make the process simple too, to figure out a way where there can be a dashboard of metrics that will focus time and effort into fixing the problems that carry the highest degree of severity. And risk to the financial reports themselves and to make sure that they get fixed first and then trying to roll out any remaining resources to fix the problems that are of the next level severity, and then the next level of severity and, and moving that through the process and, and keeping track of as things get fixed, to remove them from the, from the, the, the dashboard of metrics.

Management and other personnel, obviously you're going to be capturing this information and doing the initial input into some sort of process management tool. But those charged with governance, people that are at the board of directors level or executive management team level, they also need to be involved in the process because they need to hold management accountable for.

Aggregating this information and taking corrective action and following through, if management says that they're going to make some sort of corrective fixed by the end of the month, then somebody needs to hold them accountable for following through with that action step in that plan. And so those charter governance.

Plays that role in monitoring senior management to make sure that they're doing what they've committed to and that they are properly remediating identify control deficiencies in a timely manner to prevent or detect and correct misstatements. Those charts of governance are the ones that are best positioned to objectively.

Look to see whether or not management has implemented effective monitoring procedures and taken corrective necessary action, because hopefully they don't have a direct vested interest in it. They're not the ones that are the doers, so they can be the ones that are the overseers. So this may involve.

Those charge of governance, having to do some inquiry of management and to get updates from them. But it also is going to include the conversations that they have with internal audit, external audit. If there's a specialist that's brought in to correct a particular problem or issue, they should be involved in having robust and open dialogue with all appropriate parties that might.

Give some red flag signals around the quality of the job that management's doing in managing the process of enacting change. As it's been deemed appropriate, this should include. Looking at necessary changes that because of problems that were identified, that could be leading to fraud or to error. So remembering that management could have an intent to deceive and they could even be intentionally deceiving, those charged with governance.

And so particularly when there's a deficiency that relates to a potential fraud risk that needs to be. Given a higher level of priority of looking to see what needs to be done. And so they may need to actually physically do some direct testing. So remember, in another module, we talked about the persuasiveness of information, and so those charter governance may need to get some direct information about whether or not there could be some potential fraud problems going on as opposed to relying on indirect information.

So. Ultimately, as we look at governance and we've looked through the whole process of different elements of governments, we've talked about, who is. The parties that are involved with governance, we've talked about the important qualities of governance, not just the board of directors, but the audit committee, if it's appropriate of an executive management team, if that's who the governance structure is.

And then all the different elements of what it is that governance is doing the, the importance of them being involved in all the different elements of the COSO integrated framework, that includes the components of the control environment and risk assessment. And. Control activities and monitoring and information and communication.

And, and also thinking about the objectives of, of these systems of internal controls, how, yes, we're really heavily focused on the reliability of financial information because that teams to be the thing that carries the greatest risk in an organization. But also we need to think about operational effectiveness and efficiency and compliance with laws and regulations and.

Particularly, if we're thinking about the enterprise risk management framework, that we're thinking about strategic objectives as well, and emphasizing the points in those, in those components of the COSO framework, that really requires governance to be most heavily involved with establishing the control environment.

With ensuring proper information and communication with assessing risk appropriately and then monitoring to make sure that things are happening as intended. So there's a critical role for governance throughout the process of financial reporting to ensure that they're generating accurate, complete, timely, and reliable financial information where the risk of material misstatement has been reduced to a relatively low level.

Hopefully you've learned a lot as we've gone through talking about the corporate governance section, I encourage you to go back and look at. The outlines that were associated with the viewer's guide to look at any notes that you took and to reevaluate, if there's any areas where you need to go back and, and revisit, because it doesn't look as familiar to you as, as you thought you would remember things the first time through, because sometimes these segments are done.

All at once. And sometimes they're broken into multiple days, so go back and revisit and make sure that there's nothing that you want to review. And I encourage you to continue to study and to take this process in, in a way that, that you're. It's like it's a career choice in a way, is that you're moving forward and you're treating this processes as a job to ensure that you're setting yourself up for success and passing the CPA exam.

So I wish you all the best of luck and here for all of us here at Bisk CPA Review, online learning, we really hope that you pass that exam.

Hello and welcome. My name is Kevin Kammer. I'll be your instructor for today's topic. Of economics before we get into our coverage today, what I'd like to talk to you about for just a minute or two is some key factors that will help you in succeeding in passing the CPA exam. One of the most important things that you'll need and preparing for the CPA exam is a good plan.

So I hope you've thought it out about. How much are you going to study? And how long are you going to study when you're going to study? And that you've really thought it out about how much you have to study. One of the things that I find when candidates are not passing the BEC CPA Exam is they didn't put in the time they need to.

Now as part of that time and studying, preparing for the exam, one really critical factor in my opinion is doing a lot of questions. You can do a lot of reading in textbooks and, and you could watch videos. You, you can go to all kinds of sources for help, but in the end, on the CPA exam, you are answering questions.

And so you need to get used to answering questions. You see, when, when you read something, for example, you're a little bit passive. It's not really coming out of you or through your mind. It's more of a recognition kind of thing. You're seeing it on, on paper. But when you're doing questions, you are actively involved in that and you can learn things by doing other questions and lots of questions.

You can see the curves that can be thrown into problems. You can learn to identify what items are irrelevant to the question, but it's just a, it's just an incredible amount of advantages. From actually doing questions. And I don't think that really any candidates can really pass the CPA exam without doing questions.

So if I had just one major piece of advice for you, it would be to do as many questions as you can. And I tell my CPA review students, you ought to do them. Then you go around and you do them again. And again and particular. When you miss a question, you check that answer and see why you missed it. And when you do that, I know it hurts some people's egos or feelings when they get a question wrong.

But when you recognize what you did wrong and realize the correct answer, that's a learning opportunity for you. So do a lot of questions and experience a little bit of pain, but then you get that gain, that gain of experience, that gain of knowledge, that will help you in your efforts on the exam. But with that, let's get into our material.

Let's start with the definition of economics. Now, economics is the study of the allocation of scarce resources among alternatives. Again, economics is a study of the allocation of scarce resources among alternatives. And as you can see from that definition, resources are scarce. That's an, that's a. Great big assumption here in economics is that resources are limited.

Another assumption that we tend to make in economics is that we have unlimited desires and consuming those resources. So we have a problem. There's a limited amount of resources to go around. Everybody wants it. How do we allocate those resources? Well, typically we can talk about two major fields. And economics, we've talked about microeconomics and macroeconomics.

And what I'd like to start with is micro economics. Now, micro economics, and you think of the word microscope, you're looking at really small stuff. And that's what micro economics does is it looks at the small stuff. It looks down to the details. Micro economics deals with the economic decisions of individuals.

The buyers, the consumers and the firms. These are the sellers in pursuit of maximizing satisfaction. Again, micro economics deals with the economic decisions of individuals and firms in pursuit of maximizing satisfaction.

No, in microeconomics, the first area we need to really get into is the law of demand. Now. The quantity purchased of a good or service is inversely related to the price. All other things being equal. That's the law of demand. The quantity purchased of a good or service is inversely related to the price.

In other words, if prices go up, then demand goes down and if prices go down, then demand is going to go up. It's going to increase. Now what could influence demand. We have several factors that could affect demand that you need to be aware of. The first is closely related goods, closely related goods can influence demand.

And when we talk about closely related goods, what we're going to talk about later, we'll give it a name, cross elasticity of demand. But for right now, we'll just think of cross excuse me, closely related goods. Now the more closely that two goods are related, then the greater, the influence on the change in van of the other product, it's going to be, again, the more closely the two are related.

Then when you have a change of demand of one product, it's going to have even a greater influence. Okay. As opposed to when they're not so closely related, more closely related the art, the greater, the influence. Now one kind of closely related, good is referred to as substitute goods. It's just like, it sounds we're able to substitute one.

Good for another good. For example, margarine and butter. How about Manet's and Coolah? How about movies at the theater versus movie rentals, chicken and Turkey. Okay. These are substitute goods. If for some reason the price of margin goes up, maybe I'll decide to buy butter because it's a substitute or if Manet's gets too expensive, I might buy Kula.

Okay. So with substitutes, when the price of one good goes up, the demand for that product tends to decrease as consumers like us, turn around and purchase the substitute. Good. Again, with the price of one, good goes up demand for the product tends to decrease and that's because we're turning around and buying the substitute.

Good. Other closely related goods are known as compliments. The compliments are closely related goods. These are goods that tend to go together like hot dogs and hot dog buns, you know, who can eat a hot dog without it being a hot dog bun. I hope you don't like these hot dogs and just bread. Okay. I got to have a hot dog, but peanut butter and jelly, you know, I have no reason to just have a jelly sandwich.

I'm going to make sure I have peanut butter to go with it. Cameras and rolls of film, go together, razor and razorblades. And one of my favorites, surf and turf. It's nothing likes good prime rib and lobster. Now, when we talk about compliments, When the price of one of the goods goes up, the demand for that product, as well as its compliment is going to decrease.

Okay. When the price of one of the good goes up, the demand for that product and its compliment, it's going to go up. You know, if the price of New Zealand lobster goes from say $25 to $50, the next time I go out there and eat, I'm not going to buy that lobster. And I'm also not going to buy that prime rep together.

Okay. I'm not going to get that surf and turf. Other factors can also affect the demand for goods. For example, income as personal income increases, the demand for normal goods will also increase. Okay. Let me say that again. As personal income increases, the demand for normal goods are going to increase.

When I talk about normal goods was talking about things like steaks. An airline tickets, brand new Armani suits. Okay. As our income increases, we're going to buy more of those items. On the other hand, some goods are inferior goods. For example, potatoes, a lot of times as personal income increases, the demand for potatoes tends to go down.

Another example of an inferior. Good might be. How about public transportation as. Your income increases the demand to ride the bus is going to go down because more people will be buying cars. True about clothing, you know, instead of an Armani suit. How about use clothing as personal income increases?

The demand for used clothing is going to decrease that's because it's considered an inferior. Good. Another factor that affects demand for goods is future price expectations. If consumers expect future prices to be higher if consumer consumers expect future prices to be higher, what's going to happen to the demand.

Well, current demand is going to increase and the reason being is because they don't want to pay those higher prices in the future. They'd rather go ahead and buy the goods or services now and enjoy them at the lower price. Instead of paying the higher price later. So future price expectations. If we have increases expected in the future, demand will decrease increase.

Excuse me. Now, on the other hand, if consumers expect for prices to go down in the future, then demand is going to decrease. They're gonna defer their purchases and they're going to wait until the prices go up.

Okay. Other factors also affecting demand would include things like consumer preferences. Market size and group actions like boycotts. For example, with consumer preferences, sometimes consumers are more interested in, let's say the girls want to buy miniskirts. Well, then the fad sort of changes people aren't buying miniskirts anymore.

So consumer preferences change over time. During one period of time, demand might be higher. Another period of time demand might be lower. Market size also affects demand. Typically, if population is growing, most of the time demand also grows. Okay. Things like boycotts. Well, that's going to eliminate demand completely because when people boycott, they're not going to buy any of the products.

And what I'd like to do at this time is to look at a graph of the demand curve for video conferencing time. If you were to look in your viewers guide, you'll find that graph. And I wanted to go over this at this point. So I want to make sure that you're comfortable in looking at graphs. A lot of times in economics, we use graphs and some people, when they're in school, we're a little bit confused or intimidated by them.

And I don't want any of my students to be intimidated by these graphs because they're really not that difficult. If you look at that graph in your viewers guide, labeled demand curve for video conferencing time. I want you to notice that there's a vertical line on the left part of the graft and a horizontal line going across on the bottom.

The vertical line is also known as your Y axis. Typically what we put on the Y axis and economics is a price. And so here we have the prices for video conferencing, time up at the top, you see a dollar $90 80 going on down. On the Y axis the horizontal line there at the bottom where it goes zero one, two, three, four, that's the quantity of goods.

And here for the video conferencing time, I have that in thousands of hours. Now, the curve that you see in the graph, there is obviously a demand curve. And one of the things I like to point out right away about this demand curve is that you're notice going to notice this demand curve is downward sloping.

So you can remember the D in demand stands for downward sloping. I remember what, as a student, I used to always get confused between demand and supply, and it's really pretty easy when you use a little technique like that, the for demand downward sloping. Now, if you look at the y-axis, you'll notice that I have two lines drawn from the Y axis over to the demand curve.

If you look at the price of a dollar 50. You can follow that line over the horizontal line from a dollar 50 over to the demand curve. And then where that intersects the demand curve. I have a line going down to the X axis to indicate the quantity. And what that says is that at a price of a dollar 50 consumers demand, approximately 4,000 hours of video conferencing time.

Now we can go down or a long, this demand curve. And what it will do is represent the changes in demand due to changes in prices. So the other line that I have goes from the price of a dollar 30 over to the demand curve, and then you followed that over and then followed the horizontal line from the demand curve.

I'm sorry, from dollar 30 over to the demand curve, and then follow the vertical line down to the X axis where quantity is. And you'll notice that at a dollar 30 consumers are demanding 6,000 hours. So, what we can say here is that if the price goes from a dollar 50 to a dollar 30, the manned, what consumers demand, they would go from 4,000 hours, demand it to 6,000 hours.

And that goes along with what we said about the law of demand. That demand is inversely related to price. As price goes down, demand goes up, as price goes up, the man will go down. Let's look at the. Next graph in your viewers guide. This is also demand curves for video conferencing time, but instead of just having one curve on here, I have three and they're labeled D diesel blond and the sup two let's start with the line labeled D okay.

The demand curve labeled D I have a line going over there from the price of a dollar 45. Over to the demand curve and down to five, 5,000 hours, that would be the demand at the price of a dollar 50 on the demand curve. Well, the sub one is an entirely separate demand curve. In other words, at a dollar 45, if you followed the horizontal line demand under DC of one is 7,000 hours.

Now, why would it. In one curve, there'd be demand 5,000 hours and another demand curve there'd be demand for 7,000 hours all at the same price. Well, what's happened here is that a factor has occurred that has caused an increase in demand from the five to 7,000. So we have an complete shifting from the left to the right of the demand curve.

Some of the things that might cause that shift in demand to the right would include things like. An increase in the price of a substitute. Let's just assume that airlines tickets would be a substitute for video conferencing time. Because if people are using video conferencing, they're wanting to meet their customers or clients face to face.

And that's why they're using video conferencing. And they might use that because they don't want to fly. It's too expensive to fly. Well, if there's an increase in the price of a substitute, if airline tickets go up. Then companies will be less inclined to send their employees to meet the clients face to face, and there would rather use video conferencing.

And that would cause an increase in the demand for video conferencing time. Another potential explanation for a shift to the right would be a decrease in the price of compliments, a decrease in the price of compliments. If there's something that went along with this, I have trouble thinking about that for video conferencing.

So let me go back to my a surf and turf example. If this were actually a demand curves for prime rib and the price of lobster decreased. Okay. It's the price of lofter decreased. That's going to result and. An increase in the demand for lobster and an increase in demand for prime rib. And so the line is going to shift or the demand curve is going to shift to the right.

Also, if we had an increase in consumer income, the more income consumers have, the more they'll tend to spend on an item. So we'd have an increase also to the right in contrast. We could have gone from the demand curve D to the demand curve diesel, to. And here what we have as a shift to the left or a decrease in demand and a decrease in demand could occur for just the opposite reasons that a shift to the right occurred, an increase in current the opposite.

For example, a decrease in the price of a substitute would result in a shift to the left, an increase in the price of a compliment would cause a shift to the left or a decrease in demand and a decrease in consumer income would also cause a. Shift to the left or a decrease in income.

What I'd like to talk about now is talk about supply supplies, the quantity of a good or service that sellers are prepared to sell at a given price at a given point in time. Again, supply simply represents the quantity. That of good or a service that sellers are prepared to sell at a given price at a given point in time.

And the law of supply says that the quantity of a good or service sold is directly tied directly related to the price. All other things being equal. Again, the quantity of a good or service sold is directly related to the price, all other, the things being equal. And what that means is that when the price goes up, Supply is going to increase.

And when the price goes down, supply is going to decrease and you stop and think about it. We said all other things being equal. If the price of a good goes up and all of the things were being equal, including the cost to produce that good. Aren't the companies that produce the good one going to want to sell more since it's at a higher price, it has higher profit margin.

Absolutely. And that's why when the price goes up, the supply increases. When the price goes down, the supply is going to decrease. Now, there are several factors that can affect the amount of supply. The first we'll talk about is production costs. If production costs were going to increase. For example, let's say that there are taxes that are now enacted.

They're slapped on video conferencing time. What is the effect of taxes on our video conferencing time going to have to do have on our supply? What's going to end up happening is all of the things being equal with the production costs being higher. There's going to be a decrease in supply. Why? Because if the price hasn't changed, Remember all of the things being equal.

If the price has not changed and there's an increase in the cost to produce that product, then the profit margin is going to be less. And so there's going to be less reason or less incentive for the company to supply that. So they'll decrease the supply of the goods. Conversely any decreases in production costs due to things like lower wages to our employees lower supply costs, Navy subsidies, all of these things would result in a reduction in our production costs.

And if you keep everything equal, including the price. Then that's going to result in higher profit margins for the company, and they're going to be willing to supply more at a higher profit margin. So any decreases in costs are going to result in an increase in supply technology also affects supply. If we experienced technological improvements in the production, then that will result in an increase in supply because typically the technology improvements.

Is going to decrease the cost where we're going to be able to produce more for the same cost overall. So the average cost of production is going to go down and that's going to increase profit margins. Nobody's going to be willing to supply more. A third factor affecting supply is the prices of other goods.

Let's say that both goods, X and Y are made with the same inputs, the same materials. But the price of Y has gone up. Now, if the price of Y goes up, then producers are going to want to produce more of why, because as long as the costs haven't changed, but the price of Y goes up higher profit margins and the less of good X that they're going to produce, because if the price of the materials have not changed, Then the supplier will make a higher profit margin on why, so the prices of other goods as those prices change could impact what the supplier is going to produce.

A fourth factor affecting supply would be price, expectations, and anticipated increase in the price of a good will cause a firm to supply less. Now. And more later when that anticipated price increase arrives again, because they can sell it later at a higher profit margin, if they're anticipating a price increase.

So price, expectations affect supply. If you'll go back to your viewers guide, like for you to look at another graph, I have a graph in there that's titled supply curves for video conferencing time and it has three supply curves. And you'll notice right away that, in that graph. That the supply curves are all upward sloping.

They're all Oprah sloping, which pretty much reflects the flat facts. Excuse me, that for supply, when the price goes up, suppliers are willing to supply more. So I sort of remember the supply is an upward sloping because the UPP and supply and the UPN upward, so demand is downward sloping. The supply curve is upward sloping.

Now, let's look at the middle curve here. The one that's just labeled S at a price of a dollar 45 cents per hour, suppliers are willing to supply 7,000 hours of video conferencing time. Again, all I have to do is follow the line going from a dollar 45 on the Y axis until it intersects the S demand curve, and then follow the.

Intersection going down to the X axis and we follow that line down. We come to 7,000 hours. Okay. Well, what happens if we go from S to say S to why would there be a change here? I think I want to point out we're not moving up and down the same curve what's happening here is you go from S to S to you're experiencing an increase in supply.

Y we'll follow that dollar 45 cents. Line over until it reaches S two and then you go down to the x-axis and you'll see that at dollar 45 on the  supply curve, suppliers are willing to supply 9,000 hours as opposed to the 7,000 hours they were willing to supply the demand curve, just labeled S so what would cause that increase in supply from 7,000 to 9,000 hours?

Well, one reason might be a decrease in production costs. If the company is able to produce those video conferencing hours for a cheaper price, whether it's due to an improvement in technology or some other production costs, then they're willing to supply more because they now have a higher profit margin.

Again, we're holding everything else. Equal the price being equal. We have a lower production costs. That's going to be a higher profit margin. Suppliers will be willing to supply more. Another reason why there might be a shift from the S demand curve to  an example would be a decrease in the price of other goods if other goods decrease in price.

Okay. Then the profit margin is not as good. And so it will shift. What about shifting from S to S one what's happening there? We have the decrease and the supply, and that could be caused because of an increase in production costs. If our costs are going up, whether it's because wage increases or just supply costs are going up, or subsidies have been discontinued, all of those would result in higher production costs.

And if we have higher production costs, but the price that we sell it, that doesn't change. What happens to your profit margin? It goes down and so suppliers don't want to sell it at a lower profit margin, so they'd be willing to supply less. So there would be a shift from 7,000 hours to 5,000 hours.

There's one more graph that I'd like for you to take a look at and I've titled it demand, supply and market price for video conferencing time. And what I've done here is I put both a demand curve and. The supply curve on this graph. And this is important to us because when we put the demand curve and the supply curve on a graph, we'll be able to determine what the equilibrium point is in a free market.

What is the quantity of goods that will be supplied and at what price. And so what we would do is find the intersection of the demand curve and the S curve there, this demand curve and supply curve. And I've labeled that point E and I've drawn a line, a horizontal line over to the Y axis. So you can see what the price is.

A dollar 30 and I've drawn a vertical line down to the x-axis six. And you see that at a price of a dollar 30 per hour suppliers and buyers they'll have an equal Librium exchange of 6,000 video conferencing hours.

What I'd like to talk about now is the concept of elasticity. They last to city is the measure of the sensitivity or the responsiveness of quantity demanded or supplied to a change in a determinant of that demand or supply. The reason why say demand or supply is because there are different measures of elasticity.

And the first one that I'd like to talk about is the price elasticity of demand. So, if we're talking about the price elasticity of demand, we're talking about measuring the sensitivity or responsiveness of quantity, demanded to a change in the price of the goods. Again, the price elasticity of demand is a measure of the responsiveness or the quantity demanded to a change in price.

So if prices change, how does the demand change? Well, there's a couple of approaches that we, you can determine how elastic the demand is. And the first way that we could go about it is by using a formula approach. Now, the measure of sensitivity or responsiveness of quantity demanded and using a formula.

What we have to do is we have to look at the responsiveness of the change in demand, and that's going to be. One measure. And then we're going to divide that by the percentage change in price, which is in the denominator and then put those two together. So it's, it's a sort of a large formula and we actually have two different formulas.

There's two different methods of approaching the formula for the price elasticity of demand. So let's begin with the simple method and just like, it sounds, it's simple. It's easier. What you're looking at is the response on this. The quantity demanded the percentage change in demand. We're going to take the demand after the price change, subtract out the demand before the price change and divide it by your starting point, the demand before the price change.

And so that gives you the percentage change in demand. That will be your numerator for the price elasticity of demand. Then in your denominator, you're going to look at the percentage change in price. So prices are going to change from P one to P two. You're going to look at the change in price that will be peak to minus piece of bond or P one.

And then you'll divide that difference by the original price, the starting price. So it's very simple in that, in your. Little calculations, the little denominators, if you will, are just the starting points. So when you look at the percentage change in demand, you're using the original demand. When you look at the change in price, the percentage change in price, you're looking at the original price.

And one thing that I need to comment on here in doing the computing, the price elasticity of demand, is that right? We use absolute values. So if price goes down, say from a dollar to 75 cents, you actually have a decrease in price. And when you take that change in price, it will be minus 0.25. Well, for price elasticity of demand, we'll take the absolute value.

And instead, just use 0.25 instead of using the minus.

Well, let's look at an example, using this simple formula. Let's assume that we have a hot dog vendor and every day at the rush lunch hour, the hot dog vendor sells his hotdogs for a dollars per hot dog, $1 per hot dog. And in the normal lunch hour, when he has that price of a dollar, the vendor is able to sell 100 hotdogs.

Let's say the supplier, the vendor wants to change the price and see what happens to demand. And the vendor decides to reduce the price to 75 cents per hotdog. And when the vendor changes the price of the hotdogs to 75 cents results in 150 hot dogs being sold well, let's compute the price elasticity of demand for the hot dogs using the simple formula.

Now again, the simple formula is the percentage change in demand, divided by the percentage change in price. So let's do our percentage change in demand. First, the demand originally was a hundred, went up to 150. So to get the change, we take the 150. After the price change subtract out the starting point of a hundred.

So 150 minus a hundred. We'll give you 50. And then we have to divide that by what our starting point simple formula using just that one starting point and the starting demand was 100. So we've got a 50 unit change divided by a hundred that's 50%. Now let's do the denominator. That's looking at the percentage change in price.

Price went from. $1 to 75 cents. So we're going to take D to R to make P to the price after the change that was 75 cents subtract the starting price of a dollar . And you're going to get minus 0.25. Again, we, the absolute value. So make sure you just, just use 25 cents here. And then in the denominator, we're going to divide that by the starting point, the original price, which was a dollar.

So we've got 25 cents divided by a dollar. And that's going to give you 25%. So we've got 50% in the numerator. Twenty-five percent. The denominator, the price elasticity of demand for hotbox here is two. Now what that number tells us is how elastic demand is. And as a rule, when the coefficient is greater than one, then we say that that demand is elastic.

In other words, it's responsive to price changes.

well now let's look at the computing, the price. You've asked to see the man using the arc method. Now the arc method, instead of using one starting point, in other words, the original demand or the original price, depending which part of the formula, and you actually want to use an average. So. The formula for price elasticity of demand would be the change in demand D two minus D one divided by the average demand.

Well, the average demand is D one plus D two divided by two. So now in the denominator for that part of our formula, we've got a lot more than just that original Dijuan. We'll do the same thing in the percentage change in price. Part of the formula, we'll take P two minus P one and we'll divide that by the average price.

In other words, P one plus P two divided by two. So if we use go back to our same example with the hotdog vendor, a dog vendor was selling a hundred hot dogs. And the lunch hour at a dollar each. And when the vendor reduced the price to 75 cents, the demand went to 150 hot dogs. Let's fill in our numbers here for formula using the arc method.

We're going to have 150 hotdogs minus a hundred hundred. So we have a 50 hot dog increase. And yeah, we're going to divide that by the average demand or the average demand. A hundred plus 150 divided by two is 125. That's going to give us 40% as the percentage change in demand for hotdogs 40%. Now let's look at the denominator part of the formula.

Let's look at the percentage change in price. That's going to be the new price peak, which is 75 cents minus the starting price. The one, which is a dollar we're going to have minus 25 cents. And again, we take the absolute value. So we're going to have 25 cents in the numerator here for the percentage change in price.

We're going to divide that by the average price. Well, we had a dollar plus 75 cents divide that by two, and you're going to get about 87 and a half cents. So the percentage change in price comes out to be about 0.2857. Well, Now we have our numerator 40% divided by our denominator of almost 0.29. And the price elasticity of demand using the arc method would be 1.4.

So even though we're using a different method, we still come up with the coefficient that is elastic because it's greater than one. So again, this indicates that this demand of hotdogs is very responsive to changes in prices. No. What I'd like for you to do is to look in your viewers guide. And I have a graph there that I've entitled demand curve showing different elasticities, and you'll find three curves actually on this graph one's labeled D once the sub one, once these two let's look at the middle.

A line here, that's labeled D and it says that it's unit elastic. Well, what is that? And how do we, how do we know? Well, the man is unitary elastic or unit elastic. If the price the coefficient is equal to exactly one. Well, how are we going to compute that? Well, let's look at that D demand curve. You'll notice that I have a line drawn from the Y axis, which is where we have the price.

And we have a price there equal to 10 and draw the line over from 10 over to the demand curve and then down to the X axis. And we see that it intersects at a quantity of 1,600. So at that point on the demand curve at a price of 10, there's a demand of 1,600. Now, if we want to get the price elasticity of demand for this demand curve, we have to pick out another point that we're interested in.

Well, let's say that we dropped the price to $8 again, go to the Y axis where the price is eight and nine for all line over to the, the demand curve and then down to the X axis. And you see that. The quantity demanded on the curve there at the price of $8 is 2000 units. So by dropping the price from $10 to $8, demand goes from 1,600 to 2000.

So it is responsive to the price change. And the question is, how responsive is it now in coming up with this graph, I've assumed that we're going to use. The arc method in computing, the price elasticity. So let's compute the price elasticity using the arc method. As we change from the price of $10 to the price of eight,

what's our formula. We want the percentage change in demand. Well, we've got an increase in demand of 400 units, and we're going to divide that by the average. Demand the average would be 1,800 because we have the 1600 plus the 2005 by two. So we've got four excuse me, 400 divided by 1800. As the percentage change in price.

Let's look at the percentage percentage change in advance. Excuse me. Now let's look at the percentage change in price. We went from 10 to eight. That's a decrease of two. Of course, since we're dealing with the price elasticity demand, we're gonna use the absolute value. We're just going to worry about the difference, which is to not worry about that the price went down.

So it's a price of two price change of two. We're gonna divide that by the average price. Well, 10 plus eight divided by two is going to give you nine. So we have in the percentage change in price, $2 divided by $9 and 400 divided by 1800. Then divide that by two divided by nine and you have 1.0. So that demand curve is indeed unit elastic using the arc method.

What about diesel? One diesel one is labeled elastic demand and elastic demand. As I mentioned previously means that the coefficient must be greater than zero. And we can compute that if we looked at. Use the art method you're going to find. And I encourage you to do that on your own that the coefficient will be greater than a one.

If you were to look at diesel too, as the price changes from 10 to eight and compute the coefficient of the price elasticity of demand, you're going to get a number that is less than one. And when the coefficient is less than one, that indicates that demand is in elastic. Now in looking at this graph with these three different curves, we've come up with three different types of elasticity, elastic, unit elastic, and inelastic.

But one of the things that I want to make you aware of is just because you look at the change from one price to another price on a demand curve. That doesn't mean that prices all along that curve are the same elasticity. In other words, the sub one, when we looked at here is elastic, but only from the price of 10 to eight, if you go to your viewers guide, I have another graph also called demand curve, showing different elasticities, and it's simply one curve.

And again, if you were to compute the price elasticity of demand, as you go from the price of 10 down to the price of five, You'll find that demand is elastic as we go through that price change. As we go through the price change of five down to zero, you'll find that demand is in elastic so we can have one demand curve and different parts of that demand curve will represent different levels of elasticity.

Now what goods tend to be elastic and what goods tend to be any lasting. Why did he give you some example of goods that have a tendency to have a price elasticity of demand that we would consider Lastic? In other words, greater than one luxury items tend to be elastic, large expenditures, durable goods, you know, refrigerators, cars, substitute goods tend to be elastic and goods that have multiple uses.

Yeah, last it goods include luxuries, large expenditure items, durable goods, substitute goods, and multiple use items. Goods that tend to be inelastic include necessities, small expenditures, perishable goods, complimentary goods, and those that have limited uses yeah. Goods that tend to be inelastic include necessities, small expenditures, perishable goods.

Complimentary goods. And those with limited uses, I have another set of graphs in your viewers guide. I'd like for you to take a look at, just to sort of give you almost all the different possibilities. If you go to the graph in your viewers guide, that's entitled three demand curves showing different elasticities.

You'll see that it has three, three graphs in there. We actually have a graph, a graph B and graph C graph, a simply represents a demand curve. That is completely horizontal. In other words, at the same price, we would have various demands, various quantities demanded that demand curve is perfectly elastic.

In other words, there's no changes isn't priced yet. We have a great response on this and the quantity demanded graph B, you have a vertical line for a demand curve. And this demand curve is perfectly any Lastic. In other words, we can change the price a lot, but it's not going to change. The quantity.

Demand is not responsive to changes in price. In the last example, in section C, there you have a curve that represents perfectly unit elasticity. Now another approach to. Determining elasticity would be using the total revenue approach. Remember revenue, total revenue is simply price times quantity. So since in looking at elasticity, we're wondering how does demand change with changes in price?

What we can do is look at the change and total revenues, and we have a number of possible situations here. If prices were to increase and total revenues were going down. Demand would set to be elastic. Remember the coefficient is the responsiveness to the changes in demand to the changes in price. Okay.

So if prices increase in total revenues, go down, we're having a bigger impact on quantity than the change in price. If prices increase and total revenues remain the same, this is an example of unitary elastic. In other words, we have exactly the same per tenant percentage change in demand. As we have change in price, if prices increase and total revenues go up, then demand is any Lastic.

Well, we've looked at three situations where price increase. How about if prices decrease? If prices decrease in total revenues, go down. Then the man said to the inelastic, because consumers are not responding to the change in price. They're not, they're not. The demand is not as responsive as to the change in price.

If prices decrease and total revenues remain the same. Again, we have unitary elasticity. It's unit elastic. If prices decrease and total revenues go up. Then the coefficient is going to be greater than one. It's going to be elastic.

Let's talk about some other measures of elasticity. Let's talk about the price elasticity of supply. This is the measure of the sensitivity or responsiveness of the quantity supply to a change in the price. Again, this is the measure of the sensitivity or responsiveness of the quantity supplied. To a change in the price of the gun.

So in our numerator, we're going to be having the percentage change in quantity supply. That's going to be the quantity supplied after the price change, minus the quantity supplied before the price change divided by either you're starting. Supply, if you're using the simple method or by the average supply, if you're using the arc method, then we would divide that by the percentage change in price T2 minus P one, divided by either your T1 or your average price.

Depending again, if you're using the simple method or the arc method example, we might be interested in looking at. How a 5% increase in the price of regular unleaded, gasoline would affect the quantity supplied. So we could measure that with the price elasticity of supply and determine how elastic the quantity supplied is to changes in price.

The next measure of elasticity is the cross elasticity of demand and what this measures is the responsiveness of the quantity demanded for a particular good. Relative to a change in price of a different good. In other words, our formula is the percent of change in the quantity. Demanded for good. Let's say X divided by the percentage change in price of good.

Y we have a different good in the numerator and a different good. And the denominator, for example, this would be like looking at how the price of. Filet mignon changes how that price change would affect the quantity demanded for hamburger. So with Philemon, yawn prices went up by 20%. How responsive would the quantity demanded for hamburger B?

Now, one of the things I want to warn you about here with the cross elasticity of demand, we don't want to use absolute values. Here, we're going to come up with numbers that are either positive or negative. And we're going to use those coefficients to identify whether the goods are substitutes, compliments or unrelated.

So by not using absolute values, we could come up with negative numbers. Well, if we compute this cross elasticity of demand and the coefficient is greater than zero. We consider these goods substitutes. If the coefficient ends up being negative and we consider these goods to be compliments. And if it's exactly equal to zero, that means these goods are unrelated.

The final measure of elasticity that I like to talk about is the income elasticity of demand. And the income elasticity of demand measures the sensitivity or the responsiveness of the quantity demanded to change as an income. So we're going to have to present a change in quantity, demanded, divided by the percentage change in income.

For example, let's say we have a 10% increase in income and an 8% increase in steak. Well, we have more income. We have more steak, which is. What we would normally think of? Well, when we compute this coefficient again, we're not going to use absolute values. If the coefficient ends up being greater than zero, then we know the good is a normal good.

And we know before that stake is a normal good. So if we have a 10% increase in income and an 8% increase in steak, we know the coefficient is going to be positive. It's going to be greater than zero and steak is indeed a normal good. Let's look at another example, let's say that we had a 12% increase in income and it resulted in a 5% decrease in potatoes.

In other words, consumers are making more money. They're buying less potatoes. Well, when we compute the coefficient for the income and plasticity of demand, we're going to end up with a negative number because remember we're not using absolute values and any coefficient, that's less than zero for the incoming elasticity of demand.

Indicates that the good is an inferior. Good. Let's talk a little bit about the market. The market is the interaction between buyers and sellers of a good, so you can have a market for airline tickets. You can have a market for potatoes, and as we've discussed previously, the point at which the demand and supply curves meet is called the equilibrium point.

Okay. The price at which that equilibrium point occurs is called the equilibrium price for the market price. So you can sort of think of the market as sort of an automatic system of allocating resources. Essentially what happens is we end up allocating resources and the goods to those that are willing to pay for them in the market.

If there's a shortage of goods, we know that the market price is going to increase. And once the market increases, we know the quantity demanded will decrease. So there's going to be a shifting here. There's going to be a moving around and eventually that shortage will be eliminated. We'll find a new equilibrium point.

Conversely, if there's a surplus, the price is going to decrease resulting in an increase in demand. Eliminating the surplus.

Well, The market, as we just talked about, it is a free market. However, sometimes the market's not always so free governments sometimes intervene and they set mandatory or artificial prices. They can utilize price, floors, or price ceilings. Now a price floor is a government mandated minimum price that can be charged for a good, a service.

Yeah, price floor is a government mandated minimum price. The floor is as low as you can go as the floor, right? It's the minimum price that can be charged for a good a service. And we have a little bit of a problem if the government sets that floor above the market, or in other words, above the equilibrium point above the market price.

And if the floor is set above the market or the equilibrium price, a surplus will develop. Let's look at the figure in your viewers guy titled surplus of video conferencing time.

you look at the figure we have the demand curve and the supply curve, and I've marked the original equilibrium point. You'll notice where E. Is that that's the intersection of a price of a dollar 30 and 6,000 hours. So that was the original equilibrium price. Now, if the government comes in and mandates a floor of a dollar 50, now a dollar 50 is above that equilibrium point of a dollar 30.

If they mandate a floor of a dollar 50, what's going to be the impact. Well, what I've done is I've drawn a line. Over from a dollar 50 over to both the supply and the demand curves. And if you follow that line across, until it reaches the demand curve, then we can see that at a price of a dollar 50, the demand is only going to be 5,000 units.

But how much are the suppliers willing to supply? If you follow the line from a dollar 50 over to the supply curve, you'll notice it intersects the supply curve where the quantity is equal to 8,000 units or 8,000 hours. So at a price of a dollar 50 suppliers will be willing to supply 8,000, but consumers are only demanding 5,000 hours.

That's going to result in the surplus of video conferencing time of 3000 hours. What if the government set a floor of a dollar 20, well, a dollar 20 would be underneath the equilibrium or the market price. And therefore that's not really going to have any impact at all because the market is already above that price.

The floor is a minimum, not a maximum, that's not going to cause a problem.

Well, what about price? Ceilings? A price ceiling. Is a government mandated, maximum price that can be charged for a good or service. Again, a price ceiling is a mandated, maximum price that can be charged. And here we're going to run into problems. If the government sets a ceiling that is below the market equilibrium, if the government sets a ceiling price that is below the market equilibrium, a shortage will develop.

Again, if you would look in your viewers guide, I have the figure titled shortage of video conferencing time. Again, we start with an equilibrium point where we have at the price of a dollar 36,000 hours being exchanged. Both the government comes in and they set a price ceiling of a dollar 10, which means no prices can go above that.

That means the market can't be at a dollar 30 because the dollar 10 is the maximum. So if you draw a line from a dollar 10 over to your supply and demand curves, let's look at how that price change would influence or affect the demand and the supply. Well, the first curve it hits is the supply. So let's look at that.

When that dollar 10 price comes over, we intersect the supply curve. That's at about 3,500 hours. So suppliers have video conferencing time. We're willing to supply about 3,500 hours. But if you continue the line across from a dollar 10, all the way over to the demand curve, you'll notice that the quantity demanded by consumers will be equal to about 8,500 hours.

So what we have here is a shortage. We have 8,500 hours being demanded. We have 3,500 being supplied. We have a shortage of 5,000 hours.

Let's talk a little bit about how shifts in the supply and the demand curves, interact with each other and their impact on price and an output. We have a lot of different possible combinations here. I'm going to start with looking at changes in demand and holding the supply. Constant. If demand increases and supply is held constant, what's going to happen to the price.

Well, you've got more people demanding the goods, but there's not additional supply. It's the same amount of supply. The price is going to increase. If demand decreases, however, and supply remains constant, then it's going to result in a decrease in price because suppliers aren't getting rid of all the goods that they would like to.

So they're going to have to lower the price in order to reach a new equilibrium. Let's look at changes in supply and let's hold the man constant. If we were to increase supply, but hold demand constant. What would be the impact on price? Well, if you increase supply and decrease excuse me, and hold the demand constant, there's going to be a resulting decrease in price.

Why? Because there's more goods out there in the market, but demand hasn't changed in order for the people, the suppliers to get rid of those goods. They're going to have to lower their price. If we have a decrease in supply. And demand remains constant. Then we're going to have to increase our price, or they're not going to have to increase the price is going to increase because there's less supply.

What if both increase? Yeah. Supply and demand increase. We know that more goods would be demanded. More goods are available and therefore we know output is going to increase. But we don't really know what the effect is on the market price. It really depends upon what the slope of the demand and the supply curves are.

Same is true with decreasing supply and demand. And that we really don't know what the effect on the market price is going to be. If you have a decrease in supply and a decrease in demand, the only thing that we know is that the output is going to decrease, but we don't know the change in the price.

Again, that's dependent upon what are the slopes of the demand and supply curves? A couple more possibilities. What if we have a decrease in income? I'm sorry. A increase in demand, a decrease in demand and a decrease in supply. If there's an increase in demand and a decrease in supply, it will result in an increase in the market price.

Let's think about it. If demand increases. If you didn't do anything to supply, that's going to increase the price if supply decreased and you didn't do anything with demand, the price is going to increase. So the combination of the two is also going to result in an increase in market price. However, we wouldn't be able to figure out whether output is going to increase or decrease, that would be dependent upon the slope.

So the curves, what is it? There is a decrease in demand and an increase in supply. Well, if there's a decrease in demand and you didn't change anything else, what would happen? The decrease in demand would result in a decrease in market prices. One, if there's an increase in supply supply increases and everything was held constant, there would be a decrease in market prices.

So when you combine the two, there has to be a decrease in market prices. But the effect on the quantity of output is going to be indeterminable.

I hope you tried. These let's go over them together. The first question says if a law establishes a maximum price for product Y in a competitive market and the ceiling price is above the market or equilibrium price for product X, what? Let's stop thinking about it before we read any of the answers.

Remember ceiling price is a maximum price that the, so the price cannot go above it. And a floor would be a minimum price here, or the ceiling price is set above the market. So what we're saying is that you can't go any higher than that ceiling. Well, the market is not higher than that ceiling, so there's not a problem.

Is there. So look at my answer. A says the law has no effect on the market of good why it's not going to have any effect because it does not. It does not cause a problem that would cause a problem. If the ceiling was below the equilibrium price, only when the ceiling is below, whether it be an effect and that would result in a shortage.

Look at the second question. The demand for cigars in Miami is relatively elastic and Miami imposes high taxes on cigars that result in higher cigar prices. Then in Miami, a, the quantity of cigars demanded would increase. No it's cigar prices go up. The demand is going to decrease. So a is not correct.

The, the demand for cigars with increase. No, that may have cigars is not going to increase. It would decrease. See the demand curve for cigars would become vertical. In other words, that's perfectly inelastic. Why would it change in price? Because the demand curve to become vertical about D expenditures on cigars would fall.

And that's the correct answer. If you remember, when we talked about the total revenue approach to measuring elasticity, we said that when prices go up, if total revenues or in this case expenditures go down, Dan. The elasticity of demand is elastic. It is elastic demand. Number three, if the coefficient of elasticity is two, then the consumer demand for the product is said to be what?

Well, we said that when we have a coefficient that is greater than one, then demand is elastic. And so the answer is letter B. Now you might want to make a little bit of notes here. Letter a says unit elastic, or remember that is where the coefficient is equally. Excuse me, exactly. Equal to one letter C says any Lastic.

Well remember any lasting city or being inelastic, the coefficient would be less than one D says perfectly inelastic. Well, in that situation, the coefficient would be zero because demand is constant at all prices. So again, the answer to number three is B. The next question says if the average household income decreases and there's no change in the price of a normal good and normal is important here, because that's going to have the opposite effect than an inferior.

Good. Then the, what letter a says, supply curve will shift to the right. Well, when income decreases supply, that has no effect necessarily on supply curve, that would impact the quantity demanded. It would cause the demand curve to shift. So A's not right. B. The quantity demanded will move farther up the demand curve.

But when there's an increase in income or a decrease in income, as in this case, there's a shift of the curve. It's not moving up or down the curve, but an actual shift of the curve to the left of the right. So B is not correct. See, demand will shift to the right. Well, demand will shift to the right if income increases not decreases, because if we had more income, we could buy more, but income here decreases.

So the answer is letter D demand curve will shift to the left. Number five. This is an increase in the price of a complimentary good we'll do what? Well member complimentary goods, they tend to move in the same direction. And if you have an increase in the price of a complimentary good, then what's going to happen to the demand for that.

Good. Well, the demand for that good is going to decrease, right? So it's also going to have an effect on the joint commodity or the compliment commodity let's read through the answers, see what we have, let her ACEs shift the demand curve of the joint commodity to the right. No, that that means that we would be demanding more well, if the price of a complimentary good has increased would be demanding less.

So a is not correct. They will decrease the price paid for a substitute. Good. Now we're talking about complimentary goods, not substitutes. See a shift, the supply curve of the joint commodity to the right. Okay. The supply curve to the right. Well, an increase in the price of a complimentary good. It's not necessarily going to have a determinable impact on the supply curve, the shift, the demand curve of the joint commodity to the left.

Yes, that's going, there's going to be a decrease in the demand for the complimentary goods. Or for the complimentary goods, because there's an increase in the price of one. Good. There'll be a decrease for that. Decreased demand for that. Good. As well as its compliment. Number six, if shoes are part of the consumer's basket of goods and the consumer price index increased by 6% for the year, while the price of shoes increased by 2% than what.

You know, if you don't read the whole question, you might get misled here. If you just looked at the price of shoes increasing by 2%, you might be thinking, Oh, well the prices are going up. So the demand is going to go down. Well, what you have to understand is that we are given the consumer price index, which is for basket of all goods and all goods went up in price by 6% in overall.

But the price of shoes individually. Just as a type of good increased by only 2%. So relative to all the other goods, it did not, the price did not go up as much as the other. So it affect that sort of like a decrease in price. And what that really means is that now shoes are more attractive than that.

That relatively speaking, the price is less. So the demand curve will actually shift to the right. The answer is letter C.

Next question says X and Z or I'm sorry. Y and Z are substitute guts. What would cause a shift in the supply curve to the right for Y which happens to be a normal good, not an inferior. Good. So what's going to cause a shift in the supply curve to the right, which means that suppliers are going to be willing to supply more at the same price.

Well, they're usually going to do that. If you recall our discussion earlier, they will be willing to supply more. At the same price, if their costs decrease, if technology causes improvement wages go down. And if you look at answer D it says cost savings, technological improvements in the production process for Y.

And that will cause a shift in the supply curve to the right. So the answer to number seven is letter D. Next question says the market for product a is elastic. And purely competitive. If the market price of product a increases, what is the effect on total revenue? Well, we said that if a product is elastic, that the demand for that product is elastic using the total revenue approach.

Total revenues would actually decrease if the price of that product increase. So the answer is a decreases. The next question, we have a demand schedule for Kendall tomatoes and apparently Kendall tomatoes has three customers, Michael Kevin and Gabriel. And we have the demand for Kendall tomatoes at different price levels.

And it says, assuming that these three are the only customers of Kendall tomatoes, which of the following sets of prices and levels of output would be on the market demand curve. Well, let's look at it. Letter a one set data point is $4 and three units. Well, if you go up to the table at a price of $4, Michael's demand is one Kevin's is two and Gabriel's a zero.

So the total demand is three. So that first data point would be on the demand curve. Let's look at the second data point in letter, a. $3 and 12. Well, if we go to the price, the tomatoes, when it's $3, Michael will demand three, Kevin will demand six and Gabriel will demand two, well, three and six and two that's 11, not 12.

So a is not the correct answer because one of those data points, the second one does not fit on the curve. Look at letter B, letter B says $4 and 10 units. Well, we already determined in letter a that $4 at $4. The demand would be three units, Michael, Juan and Kevin too. So that we know that in be the first data point is wrong.

So that can't be the correct answer. Let's go to let her see, let her see. The first data point is $3 and 11. Well, when we analyzed letter a, that's what we came up with the demand for $3. Again, if you go to the price of $3, Michael demands, three. Kevin demands, six Gabriel to three plus six and two is 11.

So that data point fits. How about the second data point in letter C $4 and three? Yeah, that's the same correct. One that we did and let her a price of $4. My goal will demand one and Kevin will demand two and Gabriel zero. So that's $4 and three letter C is the correct answer there. So D should be wrong.

Shouldn't have to go through it, but sometimes a good idea to make sure that the other answers are wrong. Let's real quick. Take a look at it. Two 50 and 17, well, $2 and 50 cents. Michael demands for Kevin eight and Gabriel five. That is 17. How about the second data $0.40 and 10. Now we said $4 and 10 wasn't right at $4.

The demand is three. So D is wrong. The answer to this question is letter C. The next question asks an improvement in technology that in turn leads to improved worker productivity would most likely result in a wage decreases the wage increases, see if shift to the right of the supply curve and a lowering of the price of the output or D a shift to the left and the supply curve and the lowering of the price of the output.

Well, if we have an improvement in technology that leads to improve worker productivity, we said that results usually in lower costs and a shift to the right and supply curve. And the only one that has that in the answer is C a shift to the right and supply curve and a lowering of the price of the output.

Now, why would the price of the output lower? Well, because usually when you have technology increases, increased worker productivity, you're able to manufacture the units at a lower price. And so C does fit with the question here with a and B w you know, just because we have improved technology and improve worker productivity that can't tell us in what direction wages might go.

Okay. And these wrong, because it's a shift to the left, as opposed to the shift in the right, the supply curve. The next question says an increase in the market supply of coffee would result in. Hey, an increase in the price of coffee. Well, supply went up, prices normally would go down, right? So A's not right.

B decrease in the demand for coffee. Well, just because there's an increase in the supply, you don't really know whether or not there would be a decrease in the demand. Why, why would that impact it? Other than an increase in the market supply of coffee would usually result in a decrease. And the price of the coffee.

But how does that pack the demand for, for, for coffee? How's it going to decrease it? Well, if the increase in market supply of coffee, that would result in a lower price that would result in an increased demand, right? Because it was price goes down, demand is inversely related to that. And so answer D is the correct answer because quantity of coffee demanded will indeed increase because of the decrease in price.

C is wrong, says increase in the price of tea coffee and tea. I guess the assumption here is that they, they might be substitutes. There's an increase in the market supply of coffee. There would be a lower price for coffee, which means more people would buy coffee and less people would buy tea. And if less people were buying tea, then there would be a decrease in the price.

So C can't be right. It isn't the letter D the next question it says. In any competitive market, an equal decrease in both demand and supply can be expected to always what, well, if there's an increase in demand and in supply, we said that we would know what the effect would be on prices. So a, B and C all tell you a change in prices, but we can't determine that.

The only thing that we do know is that with an N excuse me, a decrease in demand and supply, there will be a decrease in the number of. Units that are exchanged, then that would be, see a decrease in the market. Clearing quantity. Number 13, it says if a legal price floor of $5 is declared in the diagram below what will be the result?

Well, if we look at that diagram, we can see that where the demand and supply curves intersect the equilibrium price was $3 and 50 cents and the quantity was 70,000. But if there's a law that establishes a price minimum, a price floor of $5, we need to draw a line going from $5 over. And when it connects the demand curve, you can see that demand is only going to be 60,000 units.

And if you extend the line from $5 on over to the supply curve, you'll see that. Suppliers would be willing to supply 80,000 units. So supplies 80,000 demand is only 60,000 and therefore there's going to be a surplus of 20,000 gallons. So the answer to number 13 is a yeah.

Reuse in terms utility is the satisfaction derived from a good or service. This is totally a subjective kind of concept. So from the consumer's perspective, their utility might be different from another user's utility, but it's simply the amount of satisfaction that they get from buying a good or a service.

Now marginal utility is the additional utility obtained from one more unit. Now. You want to make sure that you understand this concept of marginal, because we're going to use marginal the term marginal many times marginal. If you remember from like cost accounting is similar to incremental, it's the increase.

It's the difference? It's the, the amount from that next unit. So again, marginal utility is the additional utility, not total, but the additional utility obtained from one more unit. So if I already have 10 units of something, the marginal utility of the 11th unit is just the utility that I derive from that 11th unit that don't include any of the utility from the previous 10 units.

The concept of diminishing marginal utility says that each additional unit provides less satisfaction. Again, diminishing, marginal utility. This says that each additional unit provides less satisfaction. You know, when I go out and I get my New Zealand lobster tail, that first New Zealand lobster tail is just absolutely magnificent and I really enjoy it.

And that second one is really good too, but it's not quite as good as the first. And by the time I get to that fifth lobster tail. I'm not getting that much satisfaction from it. I'm just getting way too stuffed. I think you understand the concept of diminishing marginal utility a little bit less satisfaction from each additional unit.

Now an individual's objective under this utility theory is to maximize their utility, given that individual's income. Okay. And individual's objective. Under utility theory is to maximize their utility. What do they want to make themselves as happy as they can given their available income? Now, the objective is achieved and this is important.

The objective is achieved when the utility obtained from the last dollar spent on each commodity purchased is the same. So we're going to derive equal satisfaction from each of the last. Dollars that we spend on each commodity. Okay. Let's say that again. The objective is achieved. We've maximized our utility.

When the utility obtained from the last dollar that we've spent on each commodity purchased is the same. One of the ways that we can represent this utility is through the use of something called indifference curves. Now an indifference curve is a curve on a graph. Various combinations of X and Y or whatever the two goods or services are, which is use X and Y it's a combination.

It's the various combinations of those two goods that give equal utility. Okay. So it's a curve and some of the characteristics of that curve, it's, non-linear, it's not a straight line. It is curved, and we have a lot of indifference curves. And all the indifference curves that an individual have are parallel to each other.

So they're not going to intersect at all. Each indifference curve is negatively sloped with the convex to the origin, and then each curve represents a difference level of utility. So the further to the right and up that we go represents a higher level of utility. Now, what are we going to use? These indifference curves or utility curves for?

Well, we're going to try to do is eventually we're going to figure out where the utility is maximized by looking at the indifference curves and when the highest possible indifference curve becomes tangent to the budget constraint lines. Talk about that budget constraint line. The budget constraint line consists of all the possible combinations of two commodities for X and Y that an individual can purchase given a set level of income and that given prices again, the budget constraint line, it consists of all the possible combinations, zero of X.

So many of Y one of X, so many of Y, et cetera, all these possible different combinations that an individual can purchase. Given their level of income and given prices for X and Y, as I mentioned a minute ago, an individual's utility is maximized where that budget constraint line is tangent to the highest possible indifference curve.

Then you're going to know exactly how many X and Y you should buy based upon your income to maximize your utility. Like turn on now, two different factors of production. You should be aware that there are four factors of production in economics. Land is a factor. Labor is a factor. Capital is a factor and management or entrepreneurial activity is a factor.

So we've got four factors, land, labor, capital, and management activity or entrepreneurial activity. Each of these factors can sort of be measured by their return or their costs land, the return or the cost. There is rent for labor it's wages for our capital it's interest and for management or entrepreneurial activity.

It's profits.

Don't worry. We're going to talk about now is various cost classifications. And it seems like there's just so many terms here, but it's really important that you have an understanding of each of these terms. And that's why I have them in the presentation. I want to make sure that you understand these and that you're prepared and taste when you get to the exam.

You come across questions that include these in the questions. Let's start with fixed costs. Now remember what fixed costs are when we talk about a cost being fixed or variable for that matter, what we're talking about is the total amount of costs. Okay. Six costs are fixed because the total fixed costs remain exactly the same, regardless of how much output there is, regardless of the activity.

And again, total fixed costs are fixed because the amount of fixed costs don't change. The amount of fixed cost is not change as output or the quantity changes. Now, what about fixed cost per unit or average fixed costs? Well, to get average fixed costs, you would take the total fixed costs and divide it by your quantity by your output.

Now that is going to change. It's the total fixed cost doesn't change, but the average fixed cost or the fixed cost per unit does change without output, because what you're doing is spreading the same amount of total fixed costs over a different number of units. So as we go up the X axis as, as X increases, excuse mirrors, Q the quantity increases, the average fixed cost is going to decrease.

We're spreading the same amount of fixed costs over an increasing number of quantity of units. Resulting in decreasing fixed costs as fixed excuse me. As activity decreases, the fixed cost per unit is going to increase as activity increases that denominator gets larger and larger fixed costs. The average fixed cost, excuse me, is going to decrease.

How about variable costs or variable costs? Again, our variable. We talk about the total cost of these and the total variable cost will vary as activity changes or as output changes as queue changes. But the average variable cost is usually constant. The average variable costs. In other words, take total variable cost and divided by the quantity of output.

And that is a constant figure. I used to really love to confuse my students and say fixed costs are fixed and variable is variable and sometimes fixed or variable, variable fixed. And that's because it depends if you're looking at the total or if you're looking at the per unit again, total fixed costs are constant they're fixed, but the fixed cost per unit varies total variable costs vary, but the variable cost per unit or average variable cost there.

How about total costs? Well, total costs course would be the sum of the variable cost and the fixed cost. That's all we have to do to get total cost. We'd sum up the variable cost and the fixed. Another term you need to know is the average total costs. What you do here is take the sum of the variable and the fixed and divided by the output member.

The average variable cost is constant, but the average fixed costs decreases with activity. So your average total cost is going to decrease with activity as long as activities increasing. Your average total cost will also decrease because you're spreading those fixed costs over more and more units. Now, one way that economists look at costs is by talking about costs in the short run versus the long run.

Costs in the short run. What we're assuming here is that at least one input is fixed. In other words, short run is such a short period of time that there's a cost that can't be changed. It's fixed. On the other hand, when we talk about cost in the long run, we're talking about such an extended period of time that we have enough time to vary all the inputs.

In such a way that all the costs are variable. So in the short run, we have variable antics costs. We have variable and at least one in the short run in the long run, all costs are considered to be variable. Other ways of classifying costs, we have explicit costs, explicit meaning straight out Obvious.

These are actual expenditures. Okay. Explicit cost or actual expenditures, as opposed to implicit costs. Now implicit costs are not actual expenditures, but there are amounts that would have been received or are paid. If resources have been used for other purposes, it's sort of like an opportunity cost it's amounts that would have been received.

If resources had been used for other purposes. In other words, implicit costs is because you've given up something, you use the resource for one thing. So you gave up the use of that asset, or excuse me, resource for something else. Some more costs terms. Let's talk about opportunity costs to give a good formal definition of opportunity costs.

Opportunity costs are costs that are forgone by not engaging in an alternative activity. Yeah, it sounds very similar to those implicit costs. Say opportunity costs or costs for gone by not engaging in an alternate tentative activity. Economic costs is the income and entity must provide to attract resource suppliers.

The definition of economic cost is the income and entity must provide to attract resource. Suppliers. Well, what about economic profit? How do we determine economic profit? Not accounting, profit, not a cruel basis. Profit, but economic profit economic profit is equal to total revenue minus all economic costs number.

We gave factors of production. While in Dell, we said land labor capital. Okay, these are factors of production. Okay. So these are all economic costs. Economic profit is total revenue minus all economic costs. That's cost of land. Remember that's rent, labor, that's wages, capital that's interest. I want to point out here the difference between economic profits and accounting profits.

And the difference is that in accounting, accountants did not subtract out the cost. Of investors capital. Oh yeah. We'll subtract out the cost of the land and labor, but not the cost of investors' capital.

Now let's talk about more marginal concepts, have a number of marginal concepts. I want to make sure you're aware of again, remember marginal is incremental. It's an increase. Let's start with marginal revenue. Marginal revenue is the revenue that's provided by selling an additional unit of product.

Okay. What is the revenue from selling one more unit of product that's marginal revenue. Marginal cost is the cost of producing one more unit. Again, it's incremental concept. It's marginal cost of producing an additional unit of output. One more unit. So your marginal profit is the difference between your marginal revenue and your marginal costs.

We just can take marginal revenue minus marginal costs. How about marginal product what's marginal product marginal product is additional output obtained by adding one more unit of an input. So if we added one more cook to the kitchen, How many more meals could we put out an hour? That's the additional output obtained by adding one more unit of input, marginal revenue, product, not marginal product, but marginal revenue product.

I know there's just a ton of terms here and you're going to should be able to know what these are. You should be able to identify these marginal revenue product is the additional revenue. Provided by using one more unit of input, similar to the marginal product, marginal product was additional output.

It was in terms of units like meals, but marginal revenue product is actually revenue. Additional revenue provided by using one more unit of input, marginal resource cost what's marginal resource costs. The marginal resource costs is the change in total cost of a resource from using one more unit of resource.

So these last three terms, marginal product, marginal revenue, product, marginal resource costs. We're talking about adding one more unit of input. One more unit of resources. Now. Need to be aware of the term diminishing returns, diminishing returns are experienced when additional units of variable inputs contribute less and less to total production.

So even though we're adding one more unit, we're not getting the same amount of output out of that additional unit. It's it's diminishing returns, we're getting less for each additional input. In other words, marginal production is declining. Diminishing returns is where marginal production marginal product is declining.

As we add more and more units. Let me give you an example. If we have a 100 units of input results and an increase in output of 150. Okay. Let me see, let's try this again. Here. We have 100 units of input. And with those 100 units, we get out 150 units of output, but then we add one more unit and that one more unit results in an increase that is less than the previous unit resulted in say 145.

We're experiencing less output for each unit. Again, if we have 100 units, if the 100 unit. Make sure. I said this properly, it's 100th unit, just the one unit, the 100th results in an increase of output of 150. Okay. One unit of input gives us 150 output. Then the next unit, if I put in a hundred and first unit and that results in an increase of only 145 more units, I have diminishing returns.

Okay. So you're getting less for each unit of input. A couple of sort of just overall things that you need to know, just statements that you really ought to memorize. First thing that I really want you to make sure that you have in your notes and you spend time on in case it comes up in questions.

When do we maximize profits? Well, maximization of profits occurs. Re re when marginal revenue is equal to marginal cost. Again, we will maximize profits when marginal revenue is equal to marginal costs. In other words, increase in one more unit sold that revenue is equal to the cost of that. One more unit sold at that point will be maximizing profits.

Does it not, or what the market structure is? It doesn't matter. We haven't talked about market structure, but if it's a monopoly or a monopolistic competition, doesn't matter, we're going to maximize profits when marginal revenue is equal to marginal costs. Awesome. Another sort of statement here that I'd like for you to make sure you know, case you see this a firms should demand additional resources until the marginal revenue product is equal to the marginal resource costs.

Okay. You should demand additional resources until you reach the point that marginal revenue product is equal to marginal resource costs.

Okay, let's talk about long run costs in the long run, the cost curve, the long run cost curve it's U shaped. And what that shape represents is that initially companies experience economies of scale. In other words, the average costs are decreasing over time. Again, they're spreading out those fixed costs over more and more units, but eventually.

They experienced this economies of scale, which results in the average cost increasing. And that's what makes it a U shape. You start out going down and then the average cost start to increase because of this economies of scale. Why would the economies of scale exist? Three reasons. I want you to make sure you're aware of increased specialization and division of labor that are used in specialization of management and more efficient machinery.

Now this economies of scale tend to result from the difficulty associated with managing a large scale entity. One last blanket statement. I want to make sure that, you know, it's one of these things I want you to memorize. We talked about marginal and average cost curves. Whenever the average total cost is that a minimum or a maximum that average total cost will be equal to the marginal cost.

Okay. So hopefully you can take all these blanket statements. I know it's a lot, which I got to spend a little bit of time of, of memorizing these come in handy when you're answering questions and preparing for the exam. Yeah. About market structures. There are four major market structures that I want to spend some time talking about the first being pure competition, and really it's going to help if you understand.

A lot of the assumptions about pure competition. When we talk about pure competition, we have a large number of buyers and sellers, large number of buyers and sellers, and all these competitors are selling a homogenous or in other words, they standardized product. So all these lots of buyers and sellers, and they're all buying and selling a standard product.

And then. Purely competitive environment like that. There's free entry and exit into the market. Also, we assume in pure competition that there's perfect information that there's no price controls, no ceilings, no floors. There's no non-price competition. In other words, no advertising your brands now in a pure competition in the short run, the producer is a price taker.

They take whatever price they can get for their products. And in the long run, they're not going to make any economic profits at all. Okay. It's in pure competition. There's no economic profits and the allocation of the resources and pure competition is completely optimal. It's the best that they can be.

And that's because the price is equal to the marginal cost. Again, here in the long run, the company's not gonna make any economic profits. And the allocation of resources is considered to be optimal because price is equal to marginal costs. Now in a pure competitive environment like this companies are going to produce a quantity such that the average cost is at its lowest point, okay.

Production is going to occur. And the quantity where the average cost is at its lowest point and the market price. Is going to be equal to the marginal revenue, which is equal to the average revenue. Again, in a purely competitive market. The market price will be equal to the marginal revenue, which will be equal to the average revenue.

Okay. This is the best possible situation. Resources are optimally allocated. No one's making any economic profits. And this is going to result in the largest quantity of goods of all the market structures. It's the largest quantity of goods that are going to be produced. Let's talk about pure monopoly, for example at one point in time, telephone service in the United States used to be a monopoly.

There was one seller of telephone service, and that's the first assumption of a pure monopoly is that there's only one. Single seller. And that monopolist has a unique product also in a pure monopoly. There's blocked entry. Okay. It's hard to get in or almost impossible to get in. There's perfect information.

Like we assumed in pure competition and with a monopoly, there are significant price controls. As opposed to pure competition, pure competition, there was no price controls, but with a pure monopoly, there are significant price controls. And we also assume that there's Goodwill advertising. Remember we said in pure competition, there is no real advertising or brand competition.

Okay. So again, the assumptions for pure monopoly, single seller, unique product blocked entry into the marketplace. Perfect information, significant price controls and Goodwill advertising. Now to maximize profits in a pure monopoly, the producer will produce it point where the marginal revenue is equal to the marginal cost.

Remember I said that previously, I have said that to maximize profits. This is one of the things that you ought to just memorize to maximize profits. Marginal revenue should be equal to marginal cost at that point. Profits will be maximized. Doesn't matter what structure profits we maximize there. Of course there are pure competition.

There are no profits. So it's hard to maximize no profits that are pure monopoly. There are profits they're maximized where marginal revenue is equal to marginal costs, except one condition. The marginal revenue can be equal to the marginal cost, but if the price of the product is less than the average cost, then we're going to stop production.

Okay. Yeah. And if price is less than the average cost there, we're going to stop production. Cause we're, we're not making any profits at all. Okay. If the price is less than the average cost, in terms of the short run at a pure monopoly, the demand is negatively sloped and the marginal revenue curve is less than the demand and it's negatively sloped in the long run.

In a pure monopoly, blocked entry allows an entity to earn an economic profit. Okay. So there is economic profits and a pure monopoly. Also in a pure monopoly. The price is going to be greater than the marginal cost. Again, the prof excuse me, the price is going to be greater than the marginal cost. And this is going to result in an under allocation of resources.

Remember in a pure competition, it was, it was optimal allocation of resources, but in a pure monopoly, there's only one, one seller resources are going to be under allocated. Also in a pure monopoly production is less than ideal. The output is less than ideal. Remember in a pure competition kind of market the production or the output was, was the maximum.

It was best. It was ideal. It was often. Okay, pure monopoly. It's less than ideal. Also it a pure monopoly. The price is higher. And output, like I said, is, is lower than in the competitive market. Okay. The price will be higher than in pure competition and the output is going to be lower.

The next concept that I want to talk about, excuse me. The next market structure here is monopolistic competition. Now in monopolistic competition, we assume that there are a large number of firms and the products are differentiated. Again, there's large number firms and the products are different. It's relatively easy to enter the market.

There are some price controls and there is considerable non-price competition. In other words, brands and advertising. Again, the assumptions for monopolistic competition, a large number of firms. They're differentiated products. It's relatively easy to enter into the market. There's some price controls and considerable non-price competition.

What about profit maximization? What else he told you earlier? Profits are maximized when, when marginal revenue is equal to marginal cost, unless. The price was less than the average cost. We have the same exception here. If the price is less than the average cost, we're going to see production in terms of the short run, the demand is negatively sloped, but it's not as negatively sloped as it is in a pure monopoly.

In other words, demand here in a monopolistic competition. It's more elastic than it. Isn't a monopoly also here in the short run. Marginal revenue is less than demand and it's negatively sloped. Okay. So in the short run demand is negatively slope, less than it is in pure monopoly. And therefore demand is more elastic and marginal revenue is less than demand is negatively slope.

What about the long run? Well with monopolistic competition in the long run they're limited entry allows an entity to earn a normal profit, not an economic profit. But a normal profit. And in this situation, the long run, the price will be greater than the marginal costs. So again, we have an under allocation of resources.

The only time that you really have the proper optimal allocation of resources is under pure competition. Okay. With pure monopoly monopolistic competition, you have under allocation of resources. The production is less than ideal. Okay. The price is higher than pure competition, and the output is lower than pure competition, but they're still better than in a monopoly.

In other words, the price in monopolistic competition is lower than a monopoly. The output is higher than an, a monopoly. The fourth structure that I want to emphasize is oligopoly. Okay. A good example of oligopoly is airline services. In an oligopoly, you have few sellers, just a few sellers, and there are barriers to entering the market.

And these could be natural barriers or they could be created barriers. And when I say natural barriers, they just mean there's a cost advantage to them. They're just better able to control those costs by created barriers, talking about things like advertising and patents. Okay. So in an oligopoly, we have few sellers and we have some barriers to entering the market.

Somewhat more natural summer created in an oligopoly, rivals actions are observed, okay. They watch each other, but the products can be differentiated or standardized. Okay. They can be differentiated or standardized. Remember with a pure monopoly, they were unique with monopolistic competition. They were differentiated.

Okay. And purely competitive environment. There were standardized. Okay. Now it could be differentiated or standardized. The one other characteristic of oligopoly that you ought to know is they have sticky prices. What does that mean? Well, there's price leadership occurring here. In other words, if one airline lowers their prices than the other airlines also tend to lower their.

Airline prices, ticket prices w these firms are so closely related to the competition and that's why they call it sticky prices. Okay. They follow the leaders for the most part. Now there's another market structure that that's not as, as major, and it's really a more specific and, and detail.

It's a monopsony and I just wanted to let you know what a monopsony was. Okay. And that's where one buyer. Exists for all sellers. Okay. Usually it's because of like geographic location. There's only one buyer for all of them. You could talk about Munis monopsony mystic demand for in employment, where there could be just one employer in an area and everyone gets their job at the local Walmart or whatever that one employer is.

Let's look at this group of questions together. The first question says in the economic theory of production and cost, the short run is defined to be a production process. A which spans a time period of less than three months in length. I wouldn't say anything about less than three months in length.

What we did say was that in the short run, there was at least one fixed cost. Let's look at B. In which all inputs employed are variable. Now that's definition of a long run C that is subject to economies of scale. Well, that may be the case that may not, it may be in the long run or not D in which both fixed and variable inputs are employed.

Yes. With at least one fixed input. That's definition of the short run. The next question says all the following are true. About perfect competition, except that you've got to always watch out for words like accept and always and never and button, Hey firms are price takers. Well, is that true about perfect competition?

Yes. B there are a large number of buyers and sellers. That's true about perfect competition. See, there's a standardized product. Yeah, we sit in perfect competition. All the products are the same. They're standardized D in the long run and increase in profits will have no effect on the number of firms in the market.

Well, that's not true. Remember we said in perfect competition in the long run, there, there would be no real economic profits. If there's any profit at all in the short term, then there will be an increase in the number of firms in the market, because they're going to went in to try to get into that profit.

And eventually. In the long run, there will be no profit. So D is the exception and the answer next one says all of the following are characteristics of monopolistic competition, except that, okay. So three of these are characteristics of monopolistic competition, and one is not let's start with old letter D says price is higher than pure competition.

That's true. That's true and pure competition. The price is the lowest monopolistic competition. It's higher. That's the true answer. It's not an exception. See, firms tend to earn normal profits. Yeah, we said that's true. Novelistic competition firms do earn normal profits B the firms tend not to recognize the reaction of competitors when determining prices.

That's true. W we really don't. Don't look at that. Remember that was an oligopoly. When they do look, that was sticky prices, oligopoly, but B is true of monopolistic competition. Hey, the firms sell a homogeneous product. Now that's pure competition where they sell a homogeneous product, novelistic competition.

They sell a differentiated product. So the answer is a, that is the exception.

The next question. An industry that is oligopoly listic would be best characterized by what a many firms selling unique products. No, we said not oligopoly that there would be few sellers be a single firm selling a unique product. No, that's not correct either. It could be a differentiated or a unique product.

C significant barriers to entry. Yeah, there are significant barriers to entry in an oligopoly. Okay. They could be natural or created D horizontal or flat demand curve. So the output of individual firms now that that's not the characteristics of an oligopoly and the answer is C. And the next question, they're asking this about the law of diminishing returns and which of those four possible answers is.

Best description of law of diminishing recurrence. Let's remember what diminishing returns are. We said that diminishing returns are experienced when additional units of variable inputs, additional use of input contribute less and less to total production. Let's say a, a small furnaces is less efficient than a large furnace.

Well, going from small to large, that is. An economy of scale kind of thing. That is, that is an increasing return. The small furnace is less efficient. The large furnace is more efficient. That's good. That's not the right answer B manufacturing company purchases, its supplier of materials. Now that would result in economies of scale, not diminishing returns C at the no place like home restaurant four cooks can prepare 160 meals in the evening while three cooks.

Can prepare 150 meals. Well on w we can't do, we don't see the difference between two cooks and three cooks, but three cooks can prepare 150 meals on average. That's about 50 meals, a cook, but four cooks can only prepare 160 meals. On average, that's 40 meals per cook. So overall we seem to be getting less out of that.

Fourth cook C is an example of the law of diminishing returns. Let's look real quick at D just make sure it's not a correct answer. John's landscaping can mow an acre and 10 minutes and two acres in 15 minutes. So by adding just five more minutes, John's landscaping is able to do twice as much. Twice as many acres.

Okay. For the first 10 minutes they mowed one acre. And for five more minutes, going up to 15, they, Oh, they mowed an additional acre. So it took them less time to do one more acre than it took to do the first taker that's economies of scale, not dimensioning return. So the answer is C the next question reads a corporation's net income as presented on its income statement is usually.

A less than a Sikh anomic profits, because opportunity costs are considered in calculating net income. No, we don't consider opportunity costs and calculating that income. So a can't be the right answer B the net income is more than its economic profits because economists consider interest payments to be costs.

Well, both accountants and. Economists consider interest payments to be costs. That's not going to cause a difference between economic profits and net income. So B's not right. C equal to its economic profits. Well, usually that's not going to be the case it, and it's, it shouldn't be the case. The difference between accounting income and economic profits is that economic profits.

They also subtract out the cost of the capital. Look at letter D says, net income is higher than its economic profits because opportunity costs are not considered in calculating net income. And that is the correct answer and accounting. We do not consider opportunity costs the cost of the capital.

Next question, the competitive model of supply and demand predicts a long run shortage. Only when. Well, the one situation that we came across, where there was a shortage was where the maximum price was set below the equilibrium price and that's letter B. Okay, good. Whenever the maximum price, the max is below the market, there's going to be a shortage.

Next question says Clegg company's average costs is decreasing over a range of increased output. What is Clegg experiencing? Well, this is just the definition of economies of scale. We said that economies of scale is when average cost is decreasing. The answer is B next question deals with the monopolist.

This is a monopolist tends to and comparison with firms in a perfectly competitive market produce. Say more or less sell at a higher price for a lower price. Or remember. In a monopoly, there's an under allocation of resources and the amount of output the production is, is less. So we can immediately eliminate a and B because monopolous will produce less.

Now, what about prices where they sell at a higher or lower price? Well, they're going to sell at a higher price. Remember they're the only ones in the market. They can sell at a higher price. They don't have any competition. So the answer is D. The next question to ask, how does a company maintain a natural monopoly?

Well, this is really asking them difference between a natural and a created one. When you create one, you can create it by things like advertising and patents. But a natural monopoly just exists typically because you are the best at doing it, or it's only cost efficient for one to do it. And if you look at letter C, it says technological or economic conditions permit only one efficient supplier.

So C is the answer. The next question says companies and monopolist and monopolistic, competitive markets maximize profits. When, well, I told you this, I said, this is one of those blanket statements. You just got to memorize it. Maximize profits when marginal revenue is equal to marginal costs. So it didn't matter what market structure you were in.

That's the answer. Let her be marginal costs is equal to marginal revenue. That's I have a fact pattern that goes with the following three questions. We have information regarding the number of units produced and the average selling price for different levels of workers. If we have 20 workers, 21 workers or 22 workers, the first question for this fact pattern asks about the marginal physical product.

It says, what is the marginal physical product? When one worker's added to a team of 20 workers. So if we add one worker to a team of 20, that would give us 21. So we're obviously looking at the first two lines of this. What happens when we go from 20 workers to 21? Now this is where it's important that you remember.

I used all those terms we talked about previously, and that is. The marginal revenue, marginal product, et cetera. What is marginal product, which is what they're asking about the marginal physical product is the additional output is the additional output obtained by adding one more unit of an input. So by going from 20 workers to 21 workers, how many more units did we produce?

Well with 21 workers, we produce 45 where with 20, we had only produced 40 units. So we were producing. Five additional units. Based upon that, one more input that one more worker, the answer is C five units. The next question deals with marginal revenue per unit says, determine the marginal revenue per unit.

When one worker is added to a team of 21 workers, not from going from 20 to 21, but adding two 21 worker. So we're going to go from 21 to 22. And again, recall what is the marginal revenue product here? It's the additional revenue provided by using one more unit of input. So by using one more worker, how much more revenue are we going to get?

So we need to use the average marginal revenue product over three units. Because if you look from 21 to 22, we're going up three units, not one unit. So we can't really get the exact. Marginal revenue per unit from going from 47 to 48, but we can get the information from going from 45 to 48, determining what the marginal revenue product is over those three units and just average it out.

So what we need to do is figure out what is the selling price at 21 units, or excuse me, I'm sorry. 21 workers. We produce 45 units. Well at 45 units. We are able to sell them at an average selling price of $69. So if you sell 45 units at $69, that's 3,105. Well what's how much sales revenue do you have when you produce 48 units?

When you have the 22nd worker there? Well, you're selling those 48 units at an average price of $67 and 50 cents. So the revenue. For those 48 units would be 3000, $240. All we have to do is take the difference between the revenues for 48 units of product subtract out the revenues for 45 units of product.

In other words, the 3,240 minus the 3,105. We know that the increase in revenue is $135, but remember that's over three units, not one unit. It's over one unit of workers, but not one unit of product. Okay. So if we take the 48 and minus the 45, that gives us 335 divided by three is $45. Okay.

Next question asks about the marginal revenue product. Okay. The marginal revenue product. And remember the marginal revenue product is the additional revenue by using one more unit of input. And one more unit of input is the 22nd worker. So here, all we're looking for is the difference between the 32 40 and the 3,105 that we computed in the last question, in other words, $135.

So the answer is letter C again, it's just the additional revenue by using one more unit of input. Which is the 22nd worker. And we have another, the fact pattern that goes with the next two questions. We have the total units of a product they're six, seven, eight, nine, an average fixed cost and average variable costs.

And then the average total, and the first question for this pattern, it says the total cost of producing seven units is what well remember total cost is what it's average. Plus variable. Well, we could really do this two ways here. We have the average fixed cost and we have the average variable costs, but we also have the average total cost.

The average total cost. All we really have to do is take the seven units of product, multiply it by the average total cost of $39 and 29 cents. And we're going to get the cost of producing those seven units is $275 and 3 cents. That's letter C. Of course we could've taken a longer way and added the average fixed cost.

The 1429, excuse me, not added it that multiply that 1429 times seven and then add it to the average variable cost of 25 times the seven units. But why take the long way? Just take the average total cost of 39 29. Multiply by seven. The next question asks us for the marginal cost of producing the ninth unit.

Again, marginal means the increase. The increase in cost marginal cost to producing the ninth unit. In other words, as you go from unit eight to unit nine, what's the extra amount of cost in order for us to figure that out, we would have to know what the cost of producing eight is, and then compare that to the cost of producing that nine units subtract, not the cost of producing all nine.

From, excuse me, where you can subtract from the cost of producing all nine, we can subtract the cost of producing eight to figure out what the cost of producing that ninth unit is. So what's the cost of producing eight units? Well, eight units, times $37 of average. Total cost is $296. For nine units, we had an average cost of $35 and 36 cents.

And that would result in total cost of $318 and 24 cents for the nine units subtracting the cost of producing eight from the cost of producing nine units. And we're gonna get the difference of $22 and 24 cents. The answer is C.

Macro economics. Remember we say macro economics. We're talking about the big picture as opposed to micro economics, which looks at the small picture, the individuals and the firms with macro economics. We're talking about dealing with aggregates, looking at the big picture, allocating resources to maximize social welfare.

Again, macro economics deals with the aggregates and allocating resources to maximize social welfare. And we'll look at things like total production and total employment. These aggregate kinds of numbers need to discuss a number of measures that are used in macro economics. And you're going to notice that there is a progression here.

We're going to start at the very top with a very big number, and we're going to go through various other measures that start with that bigger number. And continue to subtract things away. And sometimes some things were added, but the numbers tend to get smaller. As we go through these, this progression of measures, the first measure, the start of it all is GDP or the gross domestic product.

Now the gross domestic product is equal to the total market value of all final goods and services produced within a country. Again, GDP is equal to the total market value of all the final goods and services produced within a country. Say the U S for example, now I emphasize the final goods and services because something like an automobile engine is not a final good.

And therefore it's not counted, at least not until it becomes part of the automobile finished car. And that way we avoid double counting. So it's just the total market value of all final goods and services. The other thing I wanted to emphasize is that it's all produced within a country. So if we're talking about us GDP, then this would include goods are produced by foreign companies, as well as United States companies.

As long as those goods are produced within the us borders, doesn't matter. Who the manufacturer is, as long as it's being produced within the U S it's part of the U S GDP. The next measure is GNP the gross national product. Now the gross national product is equal to the total market value of all final goods or services, goods, and services that are produced with resources from a specified country.

It's a little bit different than the GDP. Okay. All the goods and services produced with resources from a specified country. So this is going to include goods and services produced outside the United States, but using us resources. And this is not as common of a measure. As in years, past GDP is a little bit more common of a measure, a macro measure.

The next macro measure we need to talk about is net domestic product. As I said, we typically are going down through a progression here. The net domestic product and DP is equal to the gross domestic product minus depreciation. Okay, so MVP is equal to GDP minus depreciation. Sounds like we're mixing up a bunch of alphabet soup here, but it is important that you have an understanding of all these measures.

So you're going to have to spend some times effort making sure that you can identify compute all of these measures. Again, we start with GDP next basically is NDP. We're going to take GDP and subtract out depreciation. Okay. The next measure in the progression is national income. So we're going to start with the previous measure net domestic product, and we have to make some adjustments to get to national income.

National income is equal to NDP the net domestic product. Plus us net income earned abroad minus indirect business taxes. Okay. Again, national income is equal to NDP net domestic product, plus the U S debt income earned abroad minus indirect business taxes. What are indirect business taxes and things like sales taxes are indirect business.

the next measure and the progression is personal income. And of course, to obtain personal income, we're going to start with the previous measure. And that was national income. Personal income is equal to national income minus corporate income tax and undistributed profits. Minus social security contributions, plus transfer payments.

Now, what do I mean by transfer payments, transfer payments. I'm talking about things like social security, benefits, not contributions, but social security benefits that are received and dividends. So again, personal income is equal to national income minus corporate income tax and undistributed profits, minus social security contributions.

Plus these transfer payments. Then we get to disposable income, which again, starts with the previous measure. That's personal income. The disposable income is personal income minus personal income taxes. Okay, disposable income is equal to personal income minus personal income taxes. And basically what disposable income measures is.

It's what people have left over that they can use to consume on goods and services, make interest payments, and save money. So basically we were spending or saving, consuming, or saving, and you sort of think of the making interest payments as spending. But that's what disposable income is used for consumption.

And savings. One final macro measure is the real per capita output and real per capita output is equal to GDP divided by the population and then adjusted for inflation. So there's quite a few measures there and you're going to need to take some time and learn how to compute all of those next. I like to talk about business cycles.

And when we talk about business cycle, it really would help for us to look at a graph. And so if you go to your viewers guide, I have a graph in there that's labeled the phases of the business cycle. And you'll notice that has sort of a squiggly line that looks sort of a little bit like a cursive N. And what we want to do is look at this business cycle.

This. Curved curvy line here and talk about the different parts of that business cycle. The first part that I like to highlight, if you go down to the bottom where the line first starts towards the origin, and you go up as you reach that top, as you reached the top of the mountain there, so to speak, that's the peak, that's the highest level of economic activity in a particular cycle.

Okay. Again, that peak there is literally called the peak of the business cycle and this involves the highest level of economic activity. And this is where pretty much the full use of resources is taking place. Now, as you go over that peak and start heading down. Okay. Sort of think about over the peak, but not down to the very bottom in between there on that way down.

Is the part of cycle there's called a re contraction or a recession. And basically during this period of time, we noticed a drop in the level of business activity. Employment is, is decreasing and inventories typically grow. Okay. So we have a recession area or contraction contractual kind of period of time.

Again, we have a drop in business activity. Employment is decreasing. And inventories are typically growing as you reach that very bottom, that's called a trough. And that trough is the lowest level of business activity at a particular business cycle. And obviously way down here, not as much as going on, therefore we're not really utilizing our resources.

We have under use of our resources. And then we start to go back up again and as we head back up. The last part of that curve, the end, so to speak, that's called the expansion or recovery. And this is a period of time where we have rising level of economic activity. Let's go back and describe some of these areas in a little bit more detail.

Let's start with, with the trough. I'd like to give you a number of characteristics about that trough part of the cycle. The very bottom. Okay. Remember I said that this was a low level of business activity, so there's a lot of things that are occurring at low points here in the trough. You have low level of outputs.

Employment is low. Income is low. Prices tend to be low. Costs are low. Profits are low and investment is low. So we have low output, low employment income prices costs. Profits and investment, but the one thing that's high at this point in time is pessimism because everything's looking sort of bad business activity.

Is that a real low and people aren't feeling very good. And so pessimism is, is high. At that point. Let's talk about the recovery or the expansion period of the cycle what's happening here? Well, during the recovery, we usually have low interest rates. A lot of times the interest rates are low trying to spur.

Honor or activate some of that recovery, get some business activity going also during the expansion recovery period of time. We're replacing depleted inventories and investment starts to increase. Demand also starts to increase as well as employment and income. A lot of the things that were at Lowe's at the trough.

Are starting to now increase. So in the expansion period, we have low interest rates that the replacement of depleted inventories, investment demand, employment, and income are all increasing. What about the peak, which is just the opposite of the trough. It was trough was the lowest point. He was the highest point.

So if you can remember a lot of the characteristics for the trough or the peak, then you can just do the reverse for the other. Okay. At the peak. Well, a number of things we're at highs. Output is at a high employment is at a high income prices, profits and investment. They're all at highs. And of course, if all these things were at highs, what's that a low pessimism, is it a low, but on the other hand, you can look at it this way.

Be optimistic. Optimism is at a high we're at the peak. Things are going really well. So people are optimistic at the peak. In the final section of this business cycle that I want to give a little bit more detail on is the contraction or the recessionary period what's happening during the recession?

Well, during the recession, output, employment and income are all at their peak or reached their peak already. And at this point, consumer demand begins to taper off. And because the man begins to taper off prices began to level out. They're no longer at that high and inventories are beginning to increase because the demand has tapered off.

Not as much as being purchased. Also during the recession costs tend to increase and the profit margins diminish because the costs are increasing. The demand is tapering off businesses. Aren't willing to pass on increased costs to the customer. Because they'll just lose more, more sales. So the profit margins diminished during this period of time.

Also during the recession, the man slackens, I mentioned the consumer demand, Tapper tapering off in firms reduce their excess inventories output begins to become cut. And therefore, so is income and employment. Also during the recession, investments are discouraged and the outlook becomes pessimistic in nature.

The next area of macro economics that I'd like to discuss with you is indicators. And there are two kinds of indicators we typically talk about, and you may hear in the news, if you're ever listening to the one of the business channels or the nightly news or reading the wall street journal, leading indicators are used to forecast future trends.

Again, leading indicators are used to forecast future trends. They're trying to give us an indication about what's to happen. What's coming up. You may be familiar with a private research group called the conference board and the conference board computes a number of composite indices that use these leading indicators.

I don't want to try to give you an exhaustive list. Cause there's, there's, there's a lot of them that are used, but I'd like to give you an idea of some of the leading indicators that are used by the conference board and others. Some leading indicators would include the average hours worked per week by manufacturers workers.

Now the leading indicators, the weekly initial unemployment claims. Stock prices of 500 common stocks, new housing permits, new orders for durable goods changes in the money supply. Again, these leading indicators include average hours worked by per week by manufacturer workers, weekly initial unemployment claims stock prices of 500 common stocks, new housing permits, new orders for durable goods.

And changes in the money supply. There are also a number of trailing indicators. Obviously they're not doing any predictions, they're not forecasting trailing indicators or indicators that change after the change in the phase of the cycle, as we're moving from the peak down. Or from the trough up and starting to expand.

Okay. These are going to give you the indication after the change in the phase. Some examples of trailing indicators include average prime rate charged by banks. The average length of unemployment in terms of weeks and the change in CPI for services. And again, three examples of trailing indicators. The average prime rate charged by banks, the average length of unemployment and weeks.

And the change in CPI for services.

What I'd like to discuss with you now, or a couple of the major models of economic analysis. Let's begin by talking about the classical model under the classical model. Equilibrium occurs only at full employment. And if it's not at full employment, it's assumed that the market will correct itself. Again, equilibrium is assumed to occur only at full employment and full employment doesn't exist in the market is assumed to correct itself.

Well, how does the market go about correcting itself? Well, the driving force behind the market, it seemed to be as competition competition. We'll move the economy towards equilibrium point. For example, if there's any unsold inventory, then prices will be decreased so that the inventory can be sold. But also assume that the competition eliminates any unemployment because of the competition between workers in contrast the Keynesian model of economics.

Assumes that the market can reach an equilibrium point. The economy can reach an equilibrium point with significant levels of unemployment, not full employment, but unemployment with some unemployment. And it's also, so the economy cannot take care of itself. It's not self-regulating as it is in the classical model.

And therefore the government needs to come in and act in order to pull the economy out of recessions. Now two very important variables that exist in these economic models are consumption and savings. You'll recall in previous parts of the class, that disposable income is income to the consumer that the consumer can either spend or save.

As disposable income increases, you have more money. So what can you do with it? Well, you can spend it or save it. Well, do you always spend everything that you get an income increases? No, we're going to assume that some of it is going to be saved. So we have the economists use are two measures of the changes and disposable income and their impact on consumption and savings.

The first measure, let's talk about the marginal propensity to consume and PC marginal propensity to consume. And what that measure is, is simply a ratio of the change in consumption, spending to the change in disposable or after tax income. Again, the marginal propensity to consume is the ratio of the change in consumption, spending to the change in disposable or after tax income.

So the ratio. It's going to fall between zero and one, for example, let's assume that we have an MPC of 0.4. What that says is that for every dollar of increases in disposable income, we're going to take 40 cents of that and consume it. We're going to spend it on something. So what are we going to do with the other 60 cents, right?

We're going to save it. And that leads us to the next measure, which is the marginal propensity to save. Marginal propensity to save is the ratio of the change in plan saving to the change in disposable income. And as you probably have already realized when you have a dollar increase of disposable income and 40 cents of it is going to be spent 60 cents of it's going to be saved.

That's all there is. So the sum of the marginal propensity to consume and the marginal propensity to save must be equal to one. So, if you ever know one of those ratios, one of those measures and you don't know the other, you can always subtract that other measure from one to get the measure. You don't know.

So for example, if you don't know what Marshall propensity to consumers, you can simply subtract the marginal propensity to say from one,

let's talk a little bit about savings and their viewpoints and the different economic models. Now on the classical model, it's assumed that savings depends entirely on the interest rate, but Kings, please believe that savings habits were based primarily on consumers income. Again, under the classical model, the assumption was that savings dependent upon interest rates under the Keynesian model.

Consumer savings depends on what about vestments? Well, classical economics economists believe that the most important determinant of planned investment spending is the interest rate Kings. On the other hand, argued that profit experts patients are the most important determinant of investment spending by businesses.

The next item we need to talk about is the multiplier effect you see, as expenditures are made it results in a larger impact on the national output or national income. Again, this multiplier effect. What it does is it measures the relationship between the change in the aggregate expenditure and the resulting larger change in national output.

The way that we compute the multiplier effect is simply to take one and divide it by the marginal propensity to save. Of course, if you don't know the marginal propensity to save, you could mult you could compute this multiplier effect by taking one divided by one minus the marginal propensity to consume.

Now the larger this multiplier excuse me, the larger, the marginal propensity to consume. Then the larger, the multiplier or another way to look at it is the smaller, the marginal propensity to save the larger the multiplier. So the marginal propensity to consume and the marginal propensity to save, have opposite effects on that multiplier.

Remember they're equal to one minus the other measure. So they're going to have opposite effects when they get into that denominator of the multiplier effect.

Let's talk about money. Supply money supply can be measured and different ways. The first measure is M one and one is the most liquid definition of money. And in M one will include currency travelers, checks and checkable deposits. Let's talk about currency. Of course, I'm referring to paper, money and coins.

When I talk about checkup with deposits and talking about checking accounts at banks, I'm talking about now accounts automated transfer service accounts and share draft accounts. M two is equal to M one, but it includes more variables. So to get them to what we'll do is we'll take M one and we'll also add savings accounts.

Well, that's small time deposits. These are deposits less than a hundred thousand dollars, and we'll also add in money market funds. So the M two is equal to M one. Plus the second deposits, the small time deposits less than a hundred thousand the money market accounts. Now, when I refer to savings deposits or savings accounts, I'm talking about interest bearing accounts that do not allow for automatic transfer services.

You have a savings account that allows for automatic transfer services. That's part of the  supply time deposits or the small time deposits I was talking about. I'm talking about CDs here. Certificates of deposits. These are funds that earn a fixed rate of interest. It must be held for a specific period of time.

Money market funds are deposits, held and accounts invested in a broad range of financial assets. Okay. So M to include saving deposits, time deposits like CDs and money market funds, and three is the largest measure of money supply. It's going to include . Plus we're going to add in large negotiable CDs.

These are the CDs that are over a hundred thousand dollars, and we'll also include Euro dollars and the M three measures. Now you're a dollars are simply us dollars that are deposited in foreign banks. And therefore they're really outside the jurisdiction of the United States. Again, Euro dollars are U S dollars.

They're deposited in foreign banks. And therefore they're out of the jurisdiction of the United States. Well, how does money get created? Well, first somebody takes some new money and they deposited it in the bank. Now when a customer deposits money in the bank, the bank must retain a certain percentage in reserve.

This is known as the reserve ratio. So for example, if I deposit a thousand dollars and the reserve ratio is 20%, then the bank is going to have to maintain or keep on hand $200 of that $1,000 deposit. Okay. The rest, the difference, the $800 are considered excess reserves and that money can be loaned out.

Now when a bank loans out money from its sexist reserves, it's creating money. It's increasing the money supply. Now the effect of this increase on the money supply as measured through what we call the money multiplier. Now the money multiplier. Is very easy to compute. It's simply the reciprocal of the reserve ratio.

So the money multiplier is equal to one divided by the reserve ratio. So let's look at it. A little example. Let's say that we have an increase in deposits at a bank of a thousand dollars. The reserve ratio is let's say 10%. Then we can measure the effect that this deposit has on the overall money supply in the banking system.

What we can do is get the money multiplier compute the money multiplier. And, but that's one divided by the reserve ratio. The reserve ratio is 10%. One divided by 10% would be 10. So if we have an increase in deposits of a thousand dollars, we can multiply that by the money multiplier of 10. And that would result in an overall money supply increase in the banking system of $10,000.

Well, who controls the money supply? I hope, you know, it's the federal reserve federal reserve board. They control the money supply. Now the federal reserve. Has general controls that affect the overall supply of money. They also use some selective control that we'll talk about now, the most important, all the controls that the federal reserve uses are open market operations.

And what I'm talking about here is when the federal reserve buys and sells government securities, and by buying and selling government securities, they're impacting the money supply. When they purchase securities, it encourages the expansion of the money supply. They're putting more money into the banking system.

And of course that gets impacted by that money multiplier. When they sell securities that leads to a contraction of the money supply. They're taking money out of the money supply. So for example, if the federal open market committee buys $50,000 of securities, They're putting $50,000 into the bank and supply, but the money multiplier, if we assume that the reserve ratio is 10% say, then the money multiplier member is 10, 10 times.

So by putting $50,000 in there buying $50,000 of securities, then they're going to increase the money supply by 500,000, $50,000 times the money multiplier of 10.

So you see there's an importance to these excess reserves, the effectiveness of the federal reserve board's efforts to either limit or expand the money supply, depending on the status of these excess reserves. Again, if they purchase securities in the open market, they're trying to expand the money supply, and if they sell they're reducing the money supply.

What is the discount rate you may have heard of the discount rate before? Well, the discount rate is the interest rate at which depository institutions can borrow funds from the federal reserve banks. Okay. This candle rate is an interest rate that reserve banks can borrow from the federal reserve from, from each other.

Okay. This is usually very short term, kind of barring like overnight. Now the federal reserve can affect these discount rates and if they lower the discount rate, then the fed is signaling that they want to encourage the expansion of the money supply. If the federal reserve raises the discount rate gives the opposite signal.

In other words, they're trying to contract the money supply.

Some other rates that you might ought to be familiar with include commercial loans and federal funds rates. Okay. You've probably, I'm sure you've heard of the prime rate and make sure you know, what the prime rate is. The prime rate is the rate at which individuals and firms with the best credit can borrow.

Okay. Prime rate is the rate at which the individuals and firms with the best credit ratings can borrow the federal funds market rate. The federal funds market, excuse me, is a fairly well-organized market where the banks borrow. And again, we've talked about the federal funds rate a little bit earlier.

That's the rate at which each of these federal funds banks can borrow from each other.

let's talk about price indexes. Now price index is simply a, a number or a method that we can compute that allows us to compare the average price of anything in one period of time with it's price. At another point in time. In other words, we can compare, let's say, for example, how much loaf of bread costs today.

To how much a loaf of bread cost one year ago. So price index just measures the average the price for a good, in one period relative to a base period, and you can develop price indices or price indexes for a variety of items. We could group goods together. We could group goods and services together and compare prices in one period, two prices and another period.

Now the way that you determine the price index is you simply take the price of whatever, good or goods that you're interested in any a given year, divide that by the price of goods and the base period. And then if you want to, you can multiply it by a hundred. Some people do some don't. Let me give you a numerical example.

Just to make sure that you're following me here, if the price of goods or a good in one year. This year is $1,200. And if we'd bought the same good, let's say one year ago, our base period, and that good would have cost us $1,000. Then what would be the price index for the current year? Well, we would be comparing the price of that good 1,202, the base period price of a thousand.

So we have 1,200 divided by 1000 and we would get 1.2. If we multiplied it by a hundred, we would get 120, but either way it gives us the same information. If we don't multiply it by the 100, when we just have 1.2 or 1.20, what you can do is to practice one. That's what you start with. And the difference 0.2 or 20% indicates how prices have changed.

In other words, from our base year to the current year, there's been a 20% increase. If you had multiplied it by a hundred, you would be comparing, or you would have a price index of 120 to figure out how prices have changed since the base period, you would subtract out a hundred. So 120 minus a hundred would be 20.

And that indicates that prices went up by 20%. So you really can compute that using the 100 in there or not. It's up to you now. Price index, a commonly used price index. In our economy is the CPI, the consumer price index. Now the consumer price index compares the price of a group of basic goods and services as purchased by urban residents.

Again, the CPI is an index that basically compares the price of a group of basic goods and services as purchased by urban residents today. Compare that to some base period. Now you might be interested in as to what goes into the CPI. I don't think the exam's going to ask you any percentages, but some of the things that go into the computations, CPI include food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication, as well as some other items.

Now the CPI does have some limitations that you ought to be aware of. Basically what the CPI does, measures the relative change in the cost of living, how of price has changed from relative to some base period. And so, and by doing that, what it does not measure is the actual cost of living. It does tell us how the cost of living has changed, but not what the actual cost of living is.

It's really not a completely pure index. In fact, it's recognized that there's usually a little bit of upward bias in there each year. Now the other common index that you probably ought to be aware of for the CPA Exam is the producer price index. The producer price index or PPI is a measure of the average prices received by producers and wholesalers.

So the consumer price index is looking at how price has changed for consumers. The producer price index is looking for how prices change for the producers, what they're able to receive for their products.

The first four questions relate to this fact pattern for Nidek and in these questions were asked to compute a number of these macro economic measures that we've previously discussed. The first question asks us to compute the net domestic product. You recall that the net domestic product is equal to GDP minus depreciation.

So all that we have to do here is take the 4,500,000 talents of GDP. So practice appreciation of 500,000 talents and we'll get 4 million talents. The answer is D the next question we are requested to compute national income. You'll recall that national income is defined as net domestic product plus, plus any income earned abroad minus any indirect business taxes.

So what we're going to do is we'll start off with the net domestic product we got in the previous question, the 4 million talents we're going to subtract out a hundred thousand dollars of income earned abroad. Excuse me. I'm sorry. We're going to add the a hundred thousand talents of income earned abroad.

We're going to subtract out the 175,000 talents of indirect business taxes, and we get our answer of 3,925,000 talents. The third question in this pattern Aspers to compute personal income. You'll recall that personal income is defined as the national. Excuse me, personal income is defined as the national income minus the corporate income taxes minus any undistributed corporate profits minus any retirement contributions and plus any transfer payments.

Well, here, we're going to take the national income that we computed in the previous question. The 3,925,000 talents. We're going to subtract out a hundred thousand talents for the corporate income taxes. We're going to subtract out 50,000 in undistributed corporate profits. We're going to subtract out 300,000 and the retirement and the retirement.

Contributions. And we'll add the 600,000 talents of transfer payments, and we'll get the answer of 4,075,000 talents. The last question, the pattern asks us to compute disposable income. Recall that disposable income is defined as the personal income that we just computed minus any personal income taxes.

So we're going to take the 4,075,000 talents of personal income. It will subtract out the personal income taxes of 150,000 talents. Sorry, the answer is B 3,925,000. Talent's the next question? It says the recessionary phase of a business cycle is characterized by what. But a high levels of economic activity.

No. In a recessionary phase, remember that economic activity is decreasing. Be shortages of resources. No, here we're actually going to have beginning to have increases in and supplies of resources because we're not operating at full capacity. See potential national income will exceed actual national income or D the reverse situation.

Well, it's going to be, see the potential national income is going to exceed the actual national income again, because not all our resources are being used. So we're not operating at full capacity. Therefore we're not realizing the full potential. The full potential is greater than actually what's occurring.

Answer is C. The next question asks us about the multiplier effect. What does it explain? Well, remember we said the multiplier effect is basically explaining how a change and an investment can impact the larger number that the national output. Well that's letter a, a small change in investment can have a much larger impact on gross domestic product.

For the next two questions. We have another fact pattern and this is deals with gross domestic product. Wait, you have to remember about gross domestic product is that it's a measure of all the final members, a market value of all the final goods and services produced in a country. Well consumption investment represents what's being Done in that country, but it also includes net exports because you're exporting from our country or whatever the national country is into another country.

So GDP, the equilibrium GDP occurs when consumption investment and net exports all add up to be the real GDP. So the first question asks us, what is the equal equilibrium point for gross domestic product. And if we look at the data we have to go through and see where consumption investment added to net exports is equal to the real GDP at that level.

And when we go through that list, go down to 420 real GDP. You'll notice that the consumption and investment is 412 and the net exports are eight. When you add that together, you get the real GDP, a 420. So the answer is letter B. In the next question, it says, what is the equilibrium real GDP? If net exports are increased by $6 at each level, well, we have to go back to this data and we're going to have to add $6 to the net exports, which is going to break all those negative net export equal to 14.

Then we'll add for each level, the consumption and investment and see where that equals the real. Gross domestic product. And we're going to come up with 460 because at 460, we have consumption investment of four 46, plus the net exports now a 14. So again, the answer is C the next question it asks if the marginal propensity to consume is 0.3, five, a $30 increase in net exports will cause an increase.

An equilibrium, real GDP of what? Remember net exports is a part of real GDP. And when you increase expenditures, then that's going to increase or have a bigger impact. So what is the impact of this? Remember marginal propensity to consume being 1.35 that makes the marginal propensity to save 0.6, five.

And so we're going to get the multiplier. We'll take one divided by the 0.65, the marginal propensity to save, multiply that by the $30 and that's $46 rounded. So the answer is letter D. The next question asks about what action would the federal reserve board take to implement an expansionary monetary policy?

Well, if they want to expand. I have an expansionary monetary policy. They want to increase the money supply. Let's look at the choices. Letter a says, increase the reserve requirement and decrease the discount rate. Well, if you increase the reserve requirement, remember what that does. That money multiplier.

You're going to have one divided by a larger reserve ratio. Well, that's going to make that multiplier smaller, so that's not expansionary. Hey is not correct. We look at big. He says, purchase us government, securities and decrease the discount rate. Well, when the federal reserve purchases us government securities, they're putting in money into the money supply.

That's going to be expansionary. What about the discount rate? It says and decrease the discount rate. Well, federal reserve, when they, when they decrease the discount rate, they're trying to expand. Monetary policy. You're trying to expand the money supply. So that's correct. Letter B is the answer. If you look at C and D it's usually a good idea to make sure, make sure they're wrong.

I feel pretty good about B let's look at C real quick. It says increase the reserve requirement and the discount rate. Well, we sent a letter, a increase in the reserve requirements. Gonna not have an expansionary monetary effect is going to decrease the monetary supply. So C is wrong and D it says increase the discount rate.

Well, if you increase the discount rate, that's not expansionary. That's contractionary. It's going to contract the money supply. So the answer is big. Next question. Also deals with money in the banking system. This is a banking system with the reserve ratio, excuse me, of 25% and a change in reserves of 750,000 can increase its total demand deposits by how much?

Well, again, you use the multiplier. We're going to take one divided by the reserve ratio of 25%. Your multiplier is four. So you take four times the change of reserves of 750,000 and you get $3 million. The answer is C. The next question deals with Carlton bank. This is Carlton bank has deposit liabilities of a hundred thousand dollars.

It has reserves a 45,000. And a required reserve ratio of 25%. Let's stop and think about that. If they have a hundred thousand dollars of deposits on hand and a required reserve ratio of 25%, the only amount that they are required to keep on hand is the 25% of the a hundred thousand, which is $25,000.

So they have $20,000 of excess reserves. Let's read what the question says is therefore Carlton bank and the banking system can increase loans respectively, by how much? Well, since Carleton has $20,000 of excess reserves, they can loan that money out. So that immediately cancels out B and D. They can't be right because they say 45,000 and 50,000 as the increase in loans by Carlton, they could only loan out $20,000.

So it's gotta be a or C. Well, what's the effect on the banking system? Well, again, the multiplier one divided by 25% is four when they loan $20,000 out, that has an impact on the banking system before times that mountain was, which is $80,000. So the answer is, Hey,

Let's talk about economic, ah, excuse me, international economics. One of the issues that we're interested in in this area is what should we be producing for exchange with other countries? And there are a couple of concepts for us to look at. One is called the absolute advantage. The absolute advantage is the ability to produce a good or a service using fewer resources than other producers use.

Again, the absolute advantage is the ability to produce a good or service using fewer resources than other producers use. Another concept that we talk about is comparative advantage. This is the ability to produce a good or service. At a lower opportunity cost than other producers. Again, conflict of advantage is the ability to produce a good or service at a lower opportunity cost than other producers.

Ideally, parties should produce the good in which it has the lower opportunity cost. If you go to your viewers guy, I have an example of two nations. And their ability to produce cotton and wheat. We have countries Southland and Northland. Now, if you look at the data for Southland, South end is able to use three units of resources to produce 30 bales of cotton, and they can use two units of resource and produce 60 bushels of wheat Northland.

Using three units of resource can only produce 15 bales of cotton. And using two units of resource is able to produce 40 bushels of wheat. So at all, with both countries using six units of resources to produce cotton, they get 45 bales of cotton and producing wheat using four units of resource. They're able to produce a hundred bushels of wheat.

Well, let's look at these concepts of absolute advantage in concert of advantage. With relation to this data, let's start with absolute advantage. Let's figure out who has the absolute advantage in producing cotton. Remember, the absolute advantage is the ability to produce a good or service using fewer resources than other producers.

Let's look at Southland. Southland can produce 30 bales of cotton using three units of resource, but we need to know how much they can produce using one unit of resource to take the 30 bales of cotton divided by the three units of resource they're able to produce 10 bales of cotton for each unit of resource.

What about North Linden producing cotton? They produce 15 bales of cotton using three units of resource. So per unit, they're only able to produce five bales of cotton. So Southland has the absolute advantage. They're able to produce 10 bales of cotton per unit of resource. Whereas Northland could only produce five units of resource.

Again, South end has the absolute advantage over Northland and producing cotton. How about the absolute advantage in producing wheat? Okay. Let's start with Southland. Southland's able to produce 60 bushels of wheat when they utilize two units of resource. So per unit, that would be 30 bushels of wheat.

Northland is capable of producing 40 bushels of wheat when they use two units of resource. So per unit of resource that's 2020 per unit of resource. So Southland has the absolute advantage over Northland and producing weight. They're able to produce 30 bushels of wheat compared to Northlands 20 bushels of wheat.

So Southland has the absolute advantage in producing both cuts. And we, and that's a little bit problem because we want to have company, excuse me, countries producing what they're best at, but some countries are better producing a lot of goods. They're more efficient. So, what we can do is look at the competition advantage.

Ideally, what we'll do is have the countries produce those goods, that they have a competition advantage in. And when we look at competition advantage, only one country will have a competitive advantage and a resource. When we're looking at a two resource situation like this, and then the other country will have the conflict of advantage and the other resource.

So under competetive advantage, The parties will produce the good in which it has the lowest or lower opportunity cost. So what we're going to have to do is compute the opportunity costs of these countries in producing cotton and wheat. Well, let's look at producing cotton and what we really need to do.

It's a lot easier if you look at the output based upon just one unit of resource. So for Southland.

When we talk about cotton, they were able to produce 30 bales of cotton using three units of resource. So that translated into 10 bales of cotton per unit. Well, they could also use that unit of resource to produce a Bush bushels of wheat, how much we could Southland use, because if we're going to talk about the opportunity cost of cotton, remember that's the cost of not producing wheat?

Well with wheat. They're able to produce 60 bushels using two units of resource or 30 bushels per unit of resource. So for Southland using one unit of resource, they could either produce 10 bales of cotton, or they could produce 30 bushels of wheat. We wanted to express this in terms of the opportunity cost of producing cotton.

Get the opportunity costs of producing cotton. The cost of producing cotton is 30 bushels of wheat to 10 bales of cotton because that's what happens if they use one unit of resource, they could make 30 bushels of wheat or 10 bales of cotton. So the cost, the opportunity cost of producing cotton is three it's, 30 divided by 10.

What about the opportunity? Cost of Northland to produce cotton? Well, again, let's put this cotton and wheat production in terms of one unit, how many bales of cotton can Northland produce using one unit of resource? They had 15 bales of cotton when they use three units of resource. So that translated to five bales of cotton using one unit of resource when they produce wheat.

That was 20 bushels of wheat for one unit of resource. It was the 40 divided by two units. So how do we compute the opportunity cost of producing cotton for Northland? Again, we're going to take the. 20 bushels of weight that we could, they could produce using a unit of resource divided by the five bales of cotton that they could produce using the one unit of resource and the opportunity cost to produce in cotton or less as for so who has the lower opportunity cost of cotton?

Southland Southland has an opportunity cost of cotton three compared to Northlands four. So Southland should produce cotton. We said that the parties should produce the good in which they had the lowest opportunity cost. So South wind will produce cotton. Therefore Northland must have a comprehensive advantage in producing, but let's make sure let's figure out the opportunity costs of producing wheat for both the countries.

Let's start with Southwest. What's the opportunity cost to producing wheat? Well, in that case, They would have to give up the 10 bales of cotton they could produce in order to produce the 30 bushels of wheat using one unit of resource. So the opportunity cost is one over three. With respect to Northland, the opportunity cost of wheat would be the five bales of cotton divided by the 20 bushels of wheat.

They could produce using one unit of resource that's one fourth. Which one of those opportunity costs a smaller one over three or one or four, one over four is the smaller number. So Northland has the lowest opportunity cost to producing wheat. So Northland should produce the wheat. So you can see that competitive advantage is good and identifying who has, who should produce what unit, because there's only one country that will have a conflict of advantage in a particular product.

Well, If we use that conflict to the advantage and Southland produces cotton and Northland produces wheat, and they use all their resources for producing those items. How much cotton, how much we will be the result. Well, Southland produces nothing but cotton. Remember they were able to produce 10 bales of cotton for every unit of resource.

If they were say, have five units of resource. Because remember they had three units, they were using for cotton and two for wheat. They had five units of resource before. Now they can take those five units of resource. Instead of doing some cotton wheat, they can produce all cotton. They would get 10 bales of cotton for each unit of resource.

They would make 50 bales of cotton Northland. On the other hand, had a conflict of that vantage and producing wheat. So they got to take all their resources and. Make wheat. And in the original data Northern was using three units of resources for cotton and two for wheat. Now they're going to take all five of those resources and make wheat well, they were able to produce 20 bushels of wheat for every resource.

So using all five units of resource, they'll make a hundred bushels. So how many bales of cotton and bushels of wheat are there after the companies? Excuse me, countries begin to specialize. Well, now they're making 50 bales of cotton and a hundred bushels of wheat. So overall there's more production when the countries produce you, the item that they have a conflict of advantage in.

So using conflict of advantage, it's better for everyone because there's more units being produced

of countries are making products, hand working with each other, and they're, they're exchanging, there has to be a way of.  Making that exchange easier. In other words, it needs to be some foreign ex common medium of exchange. And if countries are using different currencies, then we need to come up with an exchange rate.

And the exchange rate is the rate at which one currency can exchange for another currency. Now when a currency can buy more of another currency. For example, if the us dollar can buy more Swiss francs or any other Mexican pesos, if they can buy more with one us dollar than the us dollar is said to have appreciated.

From the other hand, the U S dollar can buy less pesos. That dollar is said to have depreciated. Well, where do the exchange rates come from? Well, we have different kinds of exchange rates. Floating exchange rates is where the market determines what that exchange rate should be. Okay. A floating exchange rate is where the market itself determines what that rate should be.

On the other hand, a fixed exchange rate is an exchange rate. That's fixed by a particular government. Again, a fixed exchange rate, this fixed by a particular government. Now we could have some sort of cross between these two systems and have what they call a managed float, managed, float, and manage float.

The market is the primary, primary determinant of the exchange rate, but sometimes governments intervene to maintain stability.

Well talking about foreign exchange. We have more rates to talk about. We have spot rates and Ford exchange rates. What is a spot rate? A spot rate is the exchange rate paid for currency right now on the spot. Again, a spot rate is the rate of exchange for currency right now. So if I went out right, this moment it's changed us dollars for pesos that would be done using the spot rate.

The forward exchange rate is a rate agreed upon to be paid at a specified point in the future. If I knew I was going to have a transaction. And I would have to pay a certain amount of pesos in the future. I could owner enter into a Ford contract using a Ford exchange rate, and we could agree. I would agree with the bank or wherever I was getting.

The pace was from at a certain rate at a certain period of time. That's the Ford exchange rate, the amount that will be exchanged at a specified period of time. And these two usually are not the same. Usually they. The Ford rate and the spot rate are different. What happens if the Ford rate is greater than the spot rate?

Again, the Ford rate is greater than the spot rate. Well, in this case, the currency is said to be at a premium. The Ford rate is at a premium that's more than the spot rate. And what that says is that they're expecting the value of that currency to increase again, if we have Ford rate greater than a spot rate, Then is that a premium?

And the value is expected to increase and the opposite would be where the Ford rate is less than a spot rate. And that currency, the Ford exchange rate would be at a discount to the spot rate. In other words, investors are expecting the currency to decline in value. Now, these exchange rates are affected by interest rates.

Whether these Ford rates are less than, or more than the spot rate is often determined by the relationship between interest rates in one country to that of the other country. So what kind of relationships exist there? If the domestic rate is greater than the foreign interest rate? Again, the domestic interest rate is greater than the foreign countries interest rate.

Then this Ford exchange rate is going to be at a premium. And the opposite is true. The domestic rate is less than the foreign interest rate. Then it's going to be at a discount. Some other items of importance here in the area of international economics is the balance of payments. We're talking about exchanging between these countries.

Sometimes some countries import more than. They export. And so we have a difference and the accounts, there's a difference how much the countries owe each other. There's a couple of accounts that we need to talk about. One is called the current account. Now the current account includes the balance of goods and services net of any interest in dividends and any unilateral transfers.

Again, the current account. Includes the balance of goods or services and services, the net interest and dividends and net unilateral transfers. So what is the balance of goods and services? Well, the way you need to look at balance of goods and services is this it's the imports, which you can say that their debits less exports, which are credits.

In other words, the imports that's, what's coming in. Exports that's what's going out now. There is a difference between this balance of goods and services and something else called balance of tray. Remember, the current account is the balance of goods and services and the net of interest in dividends and net of unilateral transfers.

But the balance of trade is a little bit different and you may come across that term. It's the same thing as the balance of goods and services, except it excludes the services. So if you come across a question and it says the balance of trade, then you're going to just look at the imports minus the exports, not including the services, just goods, but in the current account, we typically are using the balance of goods and services.

So you want to include the services in the imports and exports. What about the interest in dividend? Okay. How do we handle that? Well, if interest is. Being paid out because for example, you're paying interest on a foreign loan. Well, that's like an export. That's that's going out. What we're really looking at in this current account is where's the money going?

Is it coming in or is it going out? So if you're making payments for interest in dividends going out overseas, then that is basically a credit. If it's coming in, then that's a debit. Same with the unilateral transfers. These were things like four and eight. When the United States sends aid to foreign countries, we're exporting our money.

If we're sending pension payments overseas, for some reason, that's an export, that's a credit. Now the capital account is another account that deals with the balance between countries and what the capital account looks at. Is a result of the exchange and fixed or financial assets. In other words, things like equipment and securities.

Next topic that we need to talk about with international economics is trade barriers and control strategies. And I just want to mention a few here, some of the relationships that exist between countries and this balance of trade. Some countries will have import quotas. In other words, this is a limit on the imports, and this is a strategy to try to keep the difference for the balancing trade.

More balanced countries will use these import quotas. And for example, if the us imports more goods from like Japan than they're exporting United States might decide to use import quotas and limit the number of imports coming in from Japan. Tariffs is another control strategy for what a tariff is. It's simply a tax on imports.

Okay. So it's a tax on imports, which means that the imports are going to cost more to the consumer in this country. So if there's a tariff say on Japanese automobiles, then that's going to increase the price that us citizens pay on those Japanese automobiles. Another control strategy is export incentives.

Things like subsidies, sometimes a country like the United States may make payments to producers in the United States to send goods overseas. They'll pay them a little bit of money to add onto the price because the price overseas isn't large enough and that's considered a subsidy.

Let's do this group of questions together. We have a fact pattern here for the first three questions that deals with North Korea and South Korea and their ability to produce corn and potato chips. You using one unit of resource we're told that North Korea could produce five bushels of corn or they could produce 1000 units of potato chips.

South Korea. On the other hand can produce 10 bushels of corn using one unit of resource or 1,500 units of potato chips. Well, let's just do a little bit of analysis on our own. Before we get into the questions let's look at, who has the absolute advantage in producing corn? And who has the absolute advantage in producing potato chips.

Remember absolute advantages, how much you can produce using one unit of resource, whoever can produce more using one unit of resource has the absolute advantage. North Korea is able to produce five bushels of corn using one unit of resource, but South Korea can produce 10. So South Korea has the absolute advantage in producing corn.

They also have the absolute. Advantage in producing potato chips because they're able to produce 1,500 potato chips compared to North Korea is 1000 units. We're a little bit luckier in this particular problem because the data is already given to us on a per unit basis. I've seen other problems, like the example we've done previously, where it wasn't based upon the one unit of resource.

And you had to figure out what the amount of production would be for one unit of resource. What about the competition advantage? Who has the competition advantage and producing potato chips? Well, remember the country that has the competitive advantage of producing potato chips has the lowest opportunity cost of producing the chips and the compute, the opportunity cost of producing chips.

You have to compare the bushels of corn. You would have to give up to the number of units of chips that you would be able to produce. So looking at North Korea, they would give up five bushels of corn in order to produce the thousand units of potato chips. In other words, that's an opportunity cost of one over 200 for South Korea, South Korea would have to give up 10 bushels of corn in order to produce 1,500 units of potato chips.

So 10 divided by 1,500 would be one over 150. And of course one over 200, the opportunity costs for North Korea is lower than the opportunity cost for South Korea of one over 200, a one over 150. So North Korea has the comprehensive advantage in producing potato chips. What about producing corn? Well, again, the country that has the conflict of advantage and producing corn, it's going to have the lowest opportunity cost, which means if you're going to produce core and you're going to give up producing potato chips.

So what is the opportunity cost for North Korea? Well, North Korea would give up a thousand units of potato chips in order to produce five bushels of corn. That's an opportunity cost of 200. Okay. For South Korea, they would have to give up 1,500 units of potato chips in order to produce 10 bushels of corn.

1,500 divided by 10 would be 150. So South Korea has the lowest opportunity cost, and therefore has the competence advantage in producing corn? Well, knowing this, we should be able to answer these questions. The first question it says in trade between North Korea and South Korea. What? Well, we already saw that South Korea has a confident advantage in producing corn.

And that is the answer in B. Let's look at the other answers to make sure that they were wrong. ACEs North Korea has an absolute advantage in producing corn. We said that South Korea had the absolute advantage and producing both corn and chips. So a is not right. C. North Korea has confident vantage of producing corn.

Well, no, that's the opposite of the correct answer, which is letter B, which we've already computed. The South Korea has a competitive advantage in producing chips. Now we said that North Korea had the conflict of advantage of producing chips. So these is the only correct answer in that question. And the next question it says, if there are free trade between the two countries, which one of the following statements would be true.

Hey. Only North Korea will gain from free trade. Now, theoretically, everyone is going to gain from free trade because then we're going to have the maximum amount of output you saw. In our previous example that after specialization, there was more bushels of of cotton bales of cotton and wheat being produced.

Okay, so specialization is going to benefit everybody. It would be more output B South Korea would specialize in the production of both chips and corn. No South Korea is going to just produce the corn because they have the comfort of advantage in corn. North Korea had this competitive of advantage and ships will be, is not correct.

See South Korea will export ships to North Korea. No South Korea has a conflict of advantage in core, and they're not going to be exporting any chips to North Korea. North Korea can produce chips a better than North Korea is going to specialize in the chips. The answer must be D North Korea will specialize in the production of chips.

Now the third question is a little bit more difficult. This is assuming free trade between the. South Korea, North Korea, the relative prices of the corn and the chips would be what? Well, the answer here is going to be big. It's going to be between 150 and 200 chips for one bushel of corn. Now, why is that correct?

Or he call that North Korea is opportunity cost to produce one bushel of corn is 200 units of chips. South Korea is opportunity costs producing one bushel of corn is 150 units of chip chips. That's the lowest price that South Korea would charge would be 150 and North Korea wouldn't pay more than excuse me.

The North Korea would only be willing to pay around 200. So the answer is B. Next question says, what is the consequence of tariffs on imports of a product? Remember we said that tariffs is a tax sort of on these imports, and that makes the cost of the final consumer higher. And the answer is C a higher cost for the consumer.

The important product is not correct because it's not going to result in higher consumption. The cost is going to be higher. And because the cost is higher, we know that there would be less demand. So a is not correct B there would be lower profits on rivaled domestic products. Well, the tax on imports is not really going to affect the domestic products.

In fact, by taxing or providing a tariff on these imports that makes the domestic products a little bit more competitive and that they don't have to reduce the price in order to compete with. The imports. So the profits are not going to be affected on rivaled domestic products. These are lower cost for the consumer on rival domestic products.

No, it's not going to result in any lower costs. It's still going to be charging the same price. So the answer is C. The next question says, given a spot exchange rate for the us dollar against the Euro dollar of 1.209 in a 90 day Ford rate of 1.1956. Well, well, we said that when the Ford rate is lower than the spot rate, that that Ford rate was at a discount.

And that's the answer to see the Ford Euro dollar. Is it a discount against the dollar?

The next question says if the us dollar British pound exchange rate. Was $1 for 0.5, eight British pounds, a product priced at 45 pounds will cost us consumer. How much we have to do is convert the pounds in the U S dollars. And the exchange rate is $1 4.58 British pounds. All we're going to have to do is multiply the 45 pounds times $1 divided by 0.58 British pounds.

The pounds will council cancel out, leaving us 77. Dollars and 58 cents. The answer is B

the next question. What would be the likely result of a decline in the value of the U S dollar relative to the currencies of the trading partners of the U S well, the value of the U S dollars declining. That means that the foreign currencies are getting stronger. And what that means is that U S. Exports to other countries will become cheaper for those foreign countries because their dollar is stronger.

They're able to buy more items of us exports. So the U S exports will increase. The answer is C

the last question. Says generally how our balance of payment deficits and surpluses eliminated. Well, we have typically in the currency markets, flexible exchange rates or floating exchange rates, and just by the market mechanism of the floating exchange rates, this is how balance of payment depths and surpluses are eliminated.

The answer is C a says by adopting a common monetary unit. Well, that's not going to help. Reduce any deficit surpluses because some countries will still import more or export more to certain countries be said by adopting PYP monetary policies. Well, that's not going to necessarily affect the opera.

The exchanges between countries. It might impact a little bit in this country though, of the change, but not necessarily in the other country. D says by taxing imports is necessary for import and export quantities to match not a really great thing to do. Usually tariffs and other control strategies, sometimes backfire and don't work the way that they're intended to.

It's not really the best way to do it. C is the best answer. Just let the market reach its own equilibrium. Well, that's the end of our discussion on economics. On behalf of all of us here at Bisk, I'd like to encourage you to study to lots and lots of questions. There's a very high correlation between doing lots of questions and doing well on the exam.

We'd like to wish you the best of luck.

Okay. Hello. Welcome to the financial management review. My name is Ron Harris and I'm the chief financial officer of high-tech POS a startup software company. That's based in Raleigh, North Carolina. Over the past 25 years, I've been involved in various aspects of financial management. I was a finance leader at GE and GE capital.

I started the investor relations function and ran it for a company called convergence corporation, which is one of the largest BPO companies in the world. In addition to being the CFO at high-tech POS I'm a consultant and instructor of finance for the university of Florida is leadership development Institute.

My academic training and finance included an MBA. In from Washington university in St. Louis, where I was consortium for graduate study and management fellow

phase review, we're going to focus on time value of money. We'll talk about concepts such as present value and future value. We'll look at time value interest factors, and we'll see the importance of compounding in a lot of financial management problems.

One of the primary principles in time value of money is the fact that a dollar today is worth more than a dollar tomorrow. And that's a fact because the dollar today can be invested immediately to start earning interest. If someone gave you the option of getting $373 and 38 cents today. Or $300 and $373 and 83 cents in the future, but said you could not earn any interest on that money.

You would pretty much be indifferent whether to get the $300 today or get the $373 in the future. Now, if they said you could earn 7% interest per year, And then you would say, I'll take that $373 and 83 cents right now, because a year from now it'll, it would be worth $400. And that's the power of the time value of money.

One way to look at it is to say that discounting from future value back to the present value is like moving along a timeline. Where you would go from one value to the other. And the difference would be the amount of interest that you can earn. If for example, you had $79 and 30 sense, and the interest rate was 8% over three year period.

That's $79 and 38 cents. We grow to a hundred dollars. Conversely, if you were going to be given a hundred dollars, three years from now, And the interest rate was 8%. You could discount that back to the present value of $79 and 38 cents. So a dollar today is much more important and more valuable than a day in the future.

As you prepare for the CPA exam, you're going to find that there's going to be several types of time value problems that you're going to be asked to solve. You can be asked to solve the present value of a single sum in the future. Some problems are going to be include uneven cash flows over multiple future periods.

You may find problems that have even levels of cash flow for a specified number of future periods, and that's called and annuity. And then there's a special type of annuity where you've got even level of cash flows forever. And that would be called a perpetuity. And of course you can get a problem. That would be a combination of all the above.

And just as you could use, you'll see these problems asking you to find the present value. These same problems could give you the present value and ask you to find the future value. And so we'll be working on each one of these types of problems as we help you prepare for the BEC CPA Exam. So, what do you need to know re relating to time value of money?

Historically, the CPA exam has provided an assortment of time value factors rather than giving you a complete table. Candidates must determine the correct factor to use in a given situation. And the selection manipulation and use of correct factors will be tested. Now the CPA Exam will supply you with a present value interest factor, which will show up as P V I F parentheses in periods, which is the number of periods at some interest rate that will be given.

And that number will show up as a zero point X X, X. So that that number will always be less than one. Conversely, the future value interest factor, which is F V I F will include the number of periods and the interest rate. And it will equal some number that's greater than one. It will always be greater than one.

Now there is a. Couple of formulas that I, that we're going to go over, but don't worry. You're not going to have to memorize these formulas. the BEC CPA Exam will provide you with the interest factors. You won't have to look it up in a table. You will not have to calculate it by memorizing these formulas, but you will have to be able to determine which interest factor you're going to use, because they may give you multiple interest factors and you'll have to select the correct one.

So let's start with the present value interest factor. The P V I F is equal to one divided by one plus R raised to the T if R is 8% and T is three years, that becomes one plus one plus 0.03, raised to the three. The present value interest factor. Then once you do the math actually becomes 0.79383 a number that's less than one.

And I told you the present value interest factor will always be less than one. Conversely, the future value interest factor is the reciprocal of the present value factor. So that F V I F future value interest factor. Is one plus R raised to the T remember present value was one over one, plus R raised to the T.

So again, if R equals 8% and T equals three years, the future value interest factor equals one plus 0.08, raise to the third. And when you do that math, you get the number 1.259, seven. A number that's greater than one. And, and future value interest factor will always be greater than one. So as you saw in the, in the example we just talked about, there were several variables that you were given.

There are four variables that will be included in every time value of money. Problem. You will get a S you will see the number C which represent cash inflows or outflows. Excuse me, you'll see the letter C, which would represent cash inflows or outflows T will repre represent time period. Our interest rate.

And then you'll get interest factor. If the question is asking for a present value, you'll get a PVI F which the present value interest factor. If it's asking for a future value, you'll get an F V I F, which is future value interest factor for every single problem, you will be given three of the four variables.

It will be up to you to solve for one of the missing variables. Let's look at cash flows for a moment cash inflows T to the T represent benefits, receipts, cost savings, expected, future payoffs or borrowings while cash outflows, which would normally show up as a negative C to some time period represent expected.

Future cost payments. Investments or lending

interest rates, which are shown with the letter R can be looked at and actually will, would include various different names like yield discount rate, hurdle rate, effective rate, and it represents a reward for delayed payment. You may hear them, someone, the question may ask you opportunity costs the capital, find the opportunity cost of capital.

Well that also could be referred to are, and what that opportunity costs the capital is, is the return for gone by investing in the project rather than investing in some securities. And lastly, you may hear rate of return offered by a comparable investment alternative, all of which. Would be used as the interest rate in a particular time value of money, money problem.

So don't just think you're going to see interest rate. You could see any of these terms and you have to understand that it represents that interest rate or discount rate that you use in your problem. Now, compounding is one of the most fantastic concepts in finance. And it represents the fact that each interest payment is reinvested in to your investment.

So for example, you will see annual compounding, which means only one compounding period. And that will be usually the quoted rate or the average percentage rate. And the number of compounding periods when it's annual is in now, a lot of problems. We'll ask you to figure out the interest rate when it's semi-annual quarterly, monthly, or even daily.

In that case, you take the APR, the annual percentage rate and you divide it by two. If it's semi-annual for, if it's quarterly. 12 bits if it's monthly and either three 65 or 360, if it's daily at the same time, as you adjust the interest rate, you also have to adjust the compounding periods. So if it's a semi-annual compounding, you will adjust the APR by dividing by two, but also you would multiply the number of periods by that two.

Which represents the semi-annual compounding period.

Another concept around interest rates is effective annual rate and the effective annual rate equals one. Plus the annual percentage rate divided by N, which is the number of periods and that number raised to the N minus one. Again, N being the number of compounding periods and assuming let's look at an example, if you assume semi-annual compounding with a 10% average percentage rate, the effective annual rate would therefore be one plus 0.10 divided by two raise to the two or squared.

And that would be subtracted from that would be the number one. So. 1.05 squared is 1.1025. And when you subtract one, the effective rate now becomes 10.25% versus the annual percentage rate of 10%. And that's because of the, the, of the convention of compounding the effective annual rate will always. Be greater than the annual percentage rate, unless there's only one compounding period, as you add more and more compounding periods, the effective annual rate exceeds the annual percentage rate.

Now that we know about the variables included in a time value problem. And we know how to find the interest factor. Let's look at a problem, a present value problem. So the present value equals the present value interest factor times, future cashflow. So if the future cash flow is $100 and the time period equals three years, and we can earn 8% annually over that three-year period, it becomes a simple problem.

Present value equals the present value interest factor at 8%, for three years, times $100. That interest factors we calculated earlier is 0.79383. I'm not showing you the formula here or talking about the formula only because in, in the CPA exam, you're going to be given an interest factor, not a formula.

So 0.79383 is the present value interest factor that we would multiply by 100 to get a present value of $79 and 38 cents sound familiar. Let's look at future value. The future value of a number equals the present value of cash flows. So the value of cash that you have right now. Times of future value interest factor.

So let's say if the present value of the cashflow is $79 and 38 cents, and that the number of periods that you're going to have it for is three years, and you're going to earn 8% annually. The future value would therefore equal the present value, which is 79, 38 times the future value interest factor.

Which is 1.2597, and that will be given to you. And that when you do that multiplication, you get the number of $100. So as you can see, the future value is the present value times the future value interest factor. So let's look at a couple of problems now from each of the different types of. Present value or future value problems that you could expect on the exam.

Let's start with the net present value of uneven cash flows. So if you have a project, let's call it project a and it's a three-year project that requires an initial investment of $50,000. The hurdle rate don't be surprised. Remember the hurdle rate interest rate the herd awake for the project is 8%.

You could be asked to calculate the net present value of project. A so some additional assumptions would be because there are uneven cash flows that the cash flows occur in year one at $20,000 year to $30,000. And your three $40,000. Now the present value interest factor for three years at 8%. We would actually look at the present value interest factor for each year and use it to discount that cash flow back to the present.

So the present value interest factor for year one is 0.9259 for year two is 0.8573. And for year three is 0.7938. So when you have a series of uneven cash flows, you multiply that cashflow. By the present value interest factor for that time period. And because of the additive principle where you can add present values to come up with the net present value.

In this case, the formula would be a minus cash flow today, or investment of 50,000 plus. The present value of each one of those cash flows. And when you plug in the present value interest factors and multiply it by the uneven cash flows for each of those years, you come up with $25,900 as a net present value.

And that, again, what you've done is you've taken the present value of those, the sum of the present values of those uneven cash flows. Subtracted it again from it the $50,000 that you had to invest now at time period zero, and you come up with 25,900 net present value. Let's look at one where we've got a lump sum.

Jennifer wants to is deposit enough money in a CD at the bank of Wyoming at 4%. To have $3,000 in three years. Well, the future value interest factor for three years at 4% is 1.1249. The present value interest factor for three years at 4% is one divided by 1.249, the reciprocal or 0.88, nine zero. What amount will Jennifer need to deposit now?

I purposely gave you the future value interest factor and the present value interest factor in this problem, because the CPA Exam may give you multiple interest factors and you'll be required to select the appropriate one now, because we're trying to figure out how much Jennifer needs to deposit. Right now, we're trying to find the present value of some amount.

That, what is the present value of $3,000 that she's going to want three years from now? So present value equals the future value times the present value interest factor, which in this case is 0.8, eight, nine zero. PVI F is always going to be less than one times, the $3,000, which is the future value three years from now.

And you get. $2,667. So Jennifer will have to invest 2000, excuse me, $2,667 today earning 4% over the next three years, two to have $3,000, three years from now. Now we can look at a future value of a lump sum problem. And let's say for example, David deposits, $7,500 in a CD. At a bank for four years at 6%, the future value interest factor for four years at 6% is 1.262477.

That number will be provided to you in the problem. And again, they may even show you in the CPA exam, additional interest factors, so that you'll be required to select the right one. So in this case, we know that. Future value interest factor for four years at 6% is 1.262477. So what will the total of the CDB at maturity?

Well, this is a future value problem. And so we'll take the present value of the cash flow, which is $7,500 times the future value interest factor to come up with $9,468 and 58 cents. So over four years at 6%. Your seventy-five hundred dollars CD will grow to over to almost $9,500. Let's make it a little bit more interesting.

And let's introduce the concept of quarterly compounding. Well, now let's say Jennifer wants to deposit enough money in a CD at 4% to have $3,000 in three years. But now the Wyoming bank is offering a product with quarterly compounding. Let's say the problem gives you a future value interest factor for three years at 4%, which we saw as 1.1, two, four nine, or you'll have a future value interest factor for 12 periods at 1%, which is 1.126, eight.

Additionally. We'll have a present value interest factor of 3%, excuse me. A 4% for three periods, which is 0.8, eight, nine zero, or we'll have a present value interest factor of 1% over 12 periods. And that number is 0.8, eight, seven four. You can see both present value. Interest factors are less than one, and both future value interest factors are greater than one.

So what amount will Jennifer need to deposit? Now, if she goes to the Wyoming bank and, and agrees to purchase the CD that's has quarterly compounding. Well, first of all, we would use the present value interest factor times the future value and the interest factor that we would select would actually be the.

Present value interest factor over 12 period periods at 1%. The reason why is because of the quarterly compounding, we would take the number of periods and multiply it times three. To me, times four. So three periods, times quarterly or four compounding periods equal to 12, and we would actually divide the discount rate or interest rate.

By four. And so we would get 1% and that's why we selected the present value interest factor 12 periods. At 1%, when you do that math, you get $2,662 and 20 cents as the present value that you would need to deposit to get $3,000 at 8% at 4% with quarterly compounding. Now let's look at the future value of an amount with semi-annual compounding David deposits, 7,500 in the CDA Wyoming bank for four years, at 6% interest is compounded semi-annually.

That means that you and reinvest the interest at the six month period. And then you reinvest it again at the end of 12 months. So you've got. Four years, 6% compounded semi-annually the future value interest factor of four years at 6% is 1.262477. Whereas the future value interest factor for eight periods and 3% you multiplied the number of periods by two divided the interest factor by two because of semi-annual compounding and you get a slightly different.

Future value interest factor of 1.26677. Well, what is the total of the CD at maturity at the Wyoming bank in this problem, while you take your $7,500 times your future value interest factor eight periods at 3%, and you get 1.26677. And the answer is $9,500 and 78 cents. So you see here that your $7,500 grows to slightly over $9,500 over that period.

The concept of time value of money is a foundational aspect to financial management.

Yeah. Welcome back to the financial management review. I'm Ron Harris. We're going to continue our CPA review on time value of money by focusing on the topic of annuities and annuity is an asset that pays a fixed sum each year for a specified number of years, examples of annuities would be a house mortgage, a mortgage loan with equal payments, or it could be an installment credit agreement, but the.

Key there is that there's a fixed sum of payments for each period specify. And they're actually two types of annuities that we're going to look at. There's the ordinary annuity and the payment occurs at the end of the year or the end of the period. And, and this is known as annuities in a rear or annuity in arrears.

Annuities do is the other type of annuity. And in that annuity payments occur in advance, AKA annuities in advance. Let's start by looking at ordinary annuities or annuities in arrears, as we saw in our discussion about present value in the, in our earlier time value of management review. We, we look at the same thing.

We have to find an interest factor. For an annuity. So we look at present value, interest factor. P V I F a for an annuity. The formula would be one minus one, plus R raised to the T and that divided by R where T again is the number of payments are, is the discount rate. Now what you're going to see on the exam, you won't see this formula.

You will see PVI F a, the number of periods represented by T and R the discount rate, and then you'll get some number and again, on present values for annuities here, the number will be greater than one and will vary in size depending upon how many years the annuity goes out for. So in the present value.

Of of uneven or the present value of a lump sum. You had the interest actor was always less than one that will not be the case in the present value of annuities interest factor. So again, to come up with the present value, you take the present value of an annuity and the rears equals the payment, which is a lump sum, which would be the same amount each period.

Times of present value interest factor. P V I F a for a certain number of periods at a certain rate. So let's look at a problem on present value of an ordinary annuity. Let's go back to Jennifer. Some of, you might know Jennifer, I know Jennifer, so that's why I continue to go back to Jennifer. Jennifer just received a four year automobile loan and this was her first car loan.

The terms of the agreement require monthly payments, excluding taxes and insurance and so forth. But the monthly payments is $450. The annual percentage rate that's the rate that's quoted on the loan is 12%. Some additional information that you need to know is that the payments are due at the end of each month.

So it's an ordinary annuity. The present value interest factor is for four periods. At 12% equals 3.0373. The present value interest factor of annuity for 48 periods at 1%. And that equals 37.9740. Or you have the present value interest factor for 48 periods at 1%. And that equals 0.553676. What is the starting balance of the loan?

So to solve this problem, first of all, you have to select the correct present value interest factor because this loan is, has monthly payments. What we have to do first is we have to take the APR and divided by 12 to come up with the adjusted interest rate or discount factor that we're going to use.

And at the same time, we have to multiply the number of periods by 12 to come up with the adjusted number of periods. So the present value interest factor of an annuity. That we're going to be using. We'll be 48 periods at 1%. And all you do is the same thing as you had done on other present value problems.

You multiply the, the payment or cash flow in this case, $450 times the 37.9740 to come up with 17,888. And that's the amount of starting amount of the loan that Jennifer is going to take out. In order to have a $450 payment for four years now, the future value of annuity works similarly, but the formulas of course, slightly different.

The future value interest factor of annuity that F V I F a equals one, plus R raised to the T minus one. And that divided by R. Where again T equals the number of payments are equals the interest rate and you will see F V I F a for T periods at our interest rate. The formula for that would be future value of an annuity in a rears would be the payment times, the F F B I F a future value interest factor of an annuity at T periods.

Raised to an our interest rate. The other way you would see this little bit of a twist on solving. The problem is first, you would take the payment and you would find the present value interest factor of annuity. And then you would take that and discount it back to the out to the future. So you would first find the present value of that stream of flows, then multiply it by a future value interest factor to come up with the future value of the annuity.

The first way was one step where you use the future value interest factor of an annuity factor. The other way is you do two steps. First, you find the present value of those of that annuity stream. Then you multiply it by the future value interest factor. And, and you come up with the future value of that annuity.

Let's look at a problem on future value of an ordinary annuity. David invest $502 at the end of the next nine years at an interest rate of 13%. How much will he have at the end of the period? Well, the problem, like you'll see it in the CPA exam, you might get multiple or, or several interest factors and you have to select the correct one.

In this case, we know that the interest rate is 13%. We know that it's nine periods and we're trying to find the future value of an ordinary annuity. So the F V I F a for nine periods at 13% is 15.4157. So you take the payment of $502. Multiply it by. The future value interest factor of annuity for nine periods at 13% or the 15.4157, and you get $7,738 and 68 cents.

And so that's how much the future value of that annuity is the alternative approach. Again, you would find the present value of nine annual payments. And then calculate the future value of that amount at 13%. So in that case, you would use the present value interest factor of an annuity for nine periods, 13%, and then multiply it by the future value interest factor.

And that's how you would get the same $7,738 and 68 cents. You can solve the problem either way. Your job will be to figure out what's the best way given the information that's provided. Now let's make a slight modification to our annuity, and let's say that the payments occur in advance. So now we'll be looking at an annuity due, which is a nudity in advance.

So the first step would be. To modify the present value factor use for an ordinary annuity. So the present value interest factor of an ordinary annuity you adjusted by instead of having T periods and R as your interest rate, you go T minus one periods. So the present value interest factor of an annuity in advance, or an annuity do P V I F a.

Equals your present value interest factor of an ordinary annuity, but you adjusted to T minus one periods and the interest rate continues to be our, so the present value of annuity in advance, the formula looks like payment. Time's present value, interest factor of annuity T minus one, with our, as your interest rate, plus you add a payment on the end.

Or you can look at it as the present value of an ordinary annuity times one plus R times one plus R. So that would be one plus the interest rate. So there's two approaches. And again, which approach you use will depend upon what information is provided to you in the problem. One thing to remember is that the present value interest factor of annuity is always greater than the present value.

Excuse me. The present value interest factor of an annuity in advance is always greater than the present value interest factor of an annuity. This is always true because money received sooner. You getting your payments in advance is more valuable than money received later in the future. When you get in your payments.

In arrears or at the end of the period. Okay. Let's look at a problem for present value of an annuity. You do. Mr. Smith can make annual mortgage payments, not including taxes and insurance of $4,800. A month, the interest rate is 8% and the mortgage term is 20 years. The other assumptions that you're giving is the present value interest factor of an annuity.

For 20 periods at 8%, which is 9.8181. You're also given the present value interest factor of an annuity at 19 periods at 8%. And that equals a slightly lower number of 9.6036. How much can Mr. Smith borrow making 20 equal payments at the beginning of the year? I had mentioned monthly payments in the question, but it's actually annual payments.

So how much can Mr. Smith borrow making 20 equal payments at the beginning of the year? Well, the solution is we have to find the present value of an annuity in advance, which equals the payment. And in this case, 4,800 times, the present value interest factor of annuity advance. And we know that we have to adjust the present value interest factor of annuity to PVI F a one period, fewer to, in order to come up with the PVI F a and then at the end, we add an additional payment.

So when you go through that exercise, you get 4,000 times 9.60369. You use the present value interest factor of annuity for 19 periods, not 20 periods. Plus you add to that one extra payment of 4,800 and you get 50,008 97, 28. So that is the beginning amount that Mr. Smith has to borrow. If he wants 4,800 payment, $4,800 payments once a year at 8% interest.

Let's look at a future value of an annuity due and to come up with the future value of an annuity due in advance, you modify the future value factor for an ordinary annuity. So you get F V I F a, which is the future value of an annuity due or a future value of annuity in advance. You take the future value interest factor.

F V I F a. And you add a period to it. So instead of taking it for T periods, you take it for T plus one periods at the interest rate of R. So the future value of an annuity in advance is the payment times, the future value interest factor of annuity, the FEI F a adjusted for an additional period. So T plus one at, at the, at the quoted rate, And then you subtract the payment off of the end of that.

So let's look at a problem on future value of an annuity. Do Mr. Jones plans to save $300 a year for three years and he's going to be making $25 payments at the beginning of each month. The savings plan yields 24%. We're given the future value interest factor of annuity for 36 periods at 2%. And that equals 51.9949.

We're also given the future value interest factor of annuity for 37 periods at 2%. And that equals 54.03 for three. So how much will Mr. Jones have at the end of three years? Okay. He plans to save $300 a year by making $25 payments. So when we look at this problem, we say, what is the future value of annuity in advance?

If our payment is $25. We take the future value interest factor of annuity. We adjust it by adding one period. So instead of T periods, it's T plus one periods, and at the end we subtract $25. So that becomes the $25 times the 54.0343, which is the future value interest factor of annuity for 37 periods, not for the 36 periods.

But 37 periods. And the reason why it was 37 periods, it's again, we, we have monthly payments. We were looking at three years, which was 12 periods times. The 12 payments per year, which gets us to the 36, but we have to add an extra period minus the $25, that extra payment. And when you do the math, you get $1,325 and 86 cents.

So the future value of annuity in advance in this case would be 1003, 25, 86. No, there's a special type of annuity that you'll see on the exam, which is called a perpetuity and a perpetuity is a security or asset. That offers a fixed income or cashflow for each year, but it goes out indefinitely. And so the perpetuity formula through, through calculations turns out to be the present value of a perpetuity is C, which is the fixed cashflow divided by R, which is the, the rate of return that you're going to receive on that perpetuity.

Now, if you don't have the rate of return, but they tell you. What the present value is. You can figure out the rate of return by saying the rate of return on a perpetuity is just C divided by present value. So expect to be asked how to calculate the present value of a perpetuity or how to calculate the return of a perpetuity.

Let's look at a problem. Jennifer wishes to endow a chair in counseling at a school of social administration. The rate of interest is 7%. And her aim is to provide $50,000 a year in perpetuity. What amount will she need to set aside today in order to have the $50,000 a year into perpetuity? Well, we know our formula is the present value of a perpetuity will be the amount of cash flows that we expect year over year, over year into, into the future.

Which is 50,000 and we divided by the 7%, which is the interest rate that they, we expect to earn. And you get 7,700, excuse me, $714,285 and 71 cents. And that is how much Jennifer will need to put right now in order to generate $50,000 a year, perpetuity, Jennifer, you better start saving. Now there's a special type of annuity also, which would be a growing perpetuity and a growing perpetuity is a security or asset that offices series of cash flows that increase each compounding period at a constant rate forever.

So if we look at our perpetuity formula that we just discussed, the present value of a growing perpetuity equals the cash flow in the next period. Divided by R minus G, where G is the growth rate. And so if you know C zero, you can calculate C1 by just taking C zero times one plus G. So don't be surprised or alarmed if they give you see zero and you're trying to solve for a perpetuity that has constant growth.

Because you could calculate C1 by multiplying one. Plus the growth rate times C zero let's look at a problem. The present value of a growing perpetuity. In this case, Jennifer wishes to endow a chair in counseling at the school of social administration. The rate of ventures has 7% and our aim is to provide 50,000 a year into perpetuity.

The only difference this time is that she wants to cover inflation. So the payment must grow by 4% a year. If you expected, inflation is 4%. What amount will Jennifer need to set, set aside today in order to have $50,000 into a year into perpetuity? When you know that inflation is going to be 4% a year, well, this is a perpetuity with growth problem.

You take the CA the cashflow of 50,000 divided by 7% growth rate. Excuse me, interest rate minus the 4% growth rate. And you get 50,000 divided by 0.03. And that equals 1,000,006 six six six six 6.70. So $1,666,667 and 70 cents. Is the amount that Jennifer would need to set aside today to D to complete the endowment.

Oh, let me illustrate annuities in a different way. And I'm going to show it to you graphically. When you think of annuities you can look at annuities being a certain the difference between perpetuities. If you have a perpetuity, a less say that starts at period zero, and obviously runs into infinity.

That formula we talked about is just the cashflow over R and it would go from now into infinity. But now if you look at another perpetuity, but it doesn't start until period T what you first have to do is you have to find. The formula for perpetuity, which is C over R and, but then you have to discount that back to the present by taking one over one, plus art race to the T and multiplying it by that perpetuity to get it into present value terms.

Remember that that perpetuity didn't start until time T the annuity on the other hand. Let's say it starts in time, zero and runs the period. T what you can do is you can take the difference between the two perpetuities to come up with the annuity. Let's look at a problem. Rick won $160,000 in a state lottery.

He will receive an immediate payment of $30,000. Then they'll get three annual payments of $30,000 at the end of each year and a payment of $40,000 at the end of the fourth year. Now, Rick only has the following time value factors. That would be he be given the ordinary annuity factor with 3%, three periods.

At 8%. He might be given an ordinary annuity factor at 4%, four periods at 8%. He could also be given a annuity due, which is the present value interest factor of annuity and advance at 4% for periods at 8%, or he might be given the present value interest factor of annuity in advance, but five periods at 8%, he has to select the appropriate one for this problem, because Rick is trying to determine what is the present value of the payments discounted at a rate of 8%.

And see you've only been given annuity due factors. So this makes you really think about how do I select or how do I select the appropriate factors while to solve this problem? You have to look at it as the combination of the present value of an annuity, plus the present value of a single sum combined, because you're going to be looking at payments from periods one through five.

And in this case, that will be $30,000 occur in each of those five periods times the present value interest factor of annuity and advance for five periods at 8%, you're going to add to that the payment in period, five times the present value interest factor of annuity and advance. Mine is the present value interest factor of annuity and advance for four periods.

And the reason why you do that is because you're trying to find out what a present value interest factor would be for period five. And you can do that by subtracting the two present value interest factors of an annuity for five periods. And from and take from that, the present value interest factor of annuity and advanced for four periods.

So let's go through the math. If you take 30,000 times the present value interest factor of annuity and advance for five periods at 8%, that's 4.312127. That number becomes 129,003 64. You add to that, the present value of that lump sum of $10,000, and you multiply that times. The difference between the present value interest factor of annuity and advance for five years at 8% and the present value interest factor of an annuity and advance for four periods at 8%.

And you get. Point seven three five zero three. And if you had the table, you would see that's the present value interest factor for four periods for five periods at 8%, that number becomes $7,350. When you add the two present values together, which you know, we can do because of the additive principle, you get $136,741.

So, as I mentioned before in the CPA exam, you're going to be provided with the time value factors. You're going to be provided with information on interest rates and, and cash flows. And your job will be the selection, manipulation and use of the correct factors. Good luck. Welcome back to the financial management review.

My name is Ron Harris. We're going to talk about bonds. We're going to look at a description of bonds and we're going to see how they've been priced or how they're valued. We'll look at yield to maturity and we'll also look at a special type of bond. The zero coupon bond bonds represent the right to receive any interest payments specified in the bond.

And the return of principle upon maturity related topics that you need to be aware of. When you're talking about a discussion on bonds is par or face value. You have to know what the coupon rate is yield to maturity, which also could be referred to as internal rate of return coupon payments, which is the face value times that coupon rate.

And maturity date or term to maturity. These are terms that you have to be familiar with. Cash flows of a bond are fixed that issue. So when the bonds are sold, issued the cash flows that will occur are fixed. And the value of the bond is inversely related to interest rate. That investors demand for that bond.

So this inverse relationship with say, as interest rates rise, the value of the bond falls and as interest rates fall, the value of the bond rises when you're pricing bonds, the value of bond is the present value of the expected future cash flows on that bond. Discounted at the interest rate that is appropriate for the riskiness of the bond.

So let's look at a formula for the present value or price of a bond. The price of a bond is the present value of the sum of coupon payments. Plus the present value of the face value, because there are actually two cash flows that you get when you have a bond. You get periodic coupon payments, plus you get the return of your principle at maturity.

So the formula looks like this. It's the sum of coupon payments divided by one plus R raised to the T plus the face value divided by one plus R raised to the T. How you will see that on the CPA exam, it will be P V I F a of at the T periods at our percent. Plus the present value interest factor of a lump sum for T periods at our percent and coupon equals the coupon expected in period T face value.

Is that the value of your bond normally in denominations of 1000 are as the discount rate for your cash flows and T represents the number of coupon payments, the best way to illustrate this would be with the problem. Now, the price bonds are normally priced where they pay semi-annual coupon payments.

So we're going to look at a problem that has semi-annual payments. At the end of 2012, David invested a 4% invested in a 4% 2018 us treasury bond. That's a treasury bond. That's maturing in 2018. The bond has a face value of $1,000. The short-term us treasury bonds rate at in late 2012 was offering a return of 6%.

So. The return on a, on a comparable asset is different than the coupon rate on the bond that David is buying. So the coupon payments are made. Semi-annually, you'll get a couple of different interest factors, but expect to get something like the present value interest factor of an annuity for six periods at 4%.

The present value interest factor of annuity for 12 periods at 3%, the present value interest factor for six periods at 4%, or maybe even the present value interest factor for 12 periods at 3% on the exam, you can expect to get multiple interest factors because you'll be required to select the correct.

One B again, let's look at the problem. David is investing in a 4%. Bond that's going to mature in 2018. So the coupon rate is 4%. The face value is 1000, but the yield on comparable securities that are being issued now is 6%. So what is the price that David has to pay for the bond while the appropriate Present value interest factor that he should use to multiply by his coupon payments will be the one that's for 12 periods at 3% 12 periods at 3%.

The face value will be multiplied prior present value interest factor for 12 periods at 3%. So when you do the math, you take $20 as the coupon payment. And you say, why $20 you take the 1000. Times 4%, you get $40 and you divide that by two for semi-annual. So $20 times the present value interest factor of annuity for 12 periods, 9.9540.

Plus the present value of the lump sum $1,000 at 0.7014. And you get a price of $948. So you see that this bond is selling for less than face value. And the reason why it is no investor would pay the full $1,000 for that bond when they could go out and get an interest rate higher than the rate that that bond is paying.

So the bond ends up selling at a discount. Let's look at another semi-annual bond. This time, Jennifer is considering investing in a 7%. 10 year, us treasury bond. The bond has a face value of $10,000 short term, us treasury bonds currently yield 5%. So we look at this problem, we say, okay, what are the coupon payments that are going to have to be made annually?

We also look at what is the correct present value interest factor. Of an annuity that we should select, or should we select the present value interest factor, not an annuity, but just the present value interest factor. Remember a bond has two cash flows, an annuity, which represents the coupon payments and a lump sum, which represents the return of the maturity at maturity.

So what is the price that Jennifer will have to pay? Well, in this case, Jennifer is going to take the coupon payments, which is $350. How did we get to $350? We took the $10,000 face value time, 7%. And we multiplied it, which is $700. But we multiplied that by two for 20 periods because we have semi-annual payments.

So $350 times the present value interest factor of annuity for 20 periods. At 2.5%, we took the 5% coupon rate and we divided it by two to get 2.5. Then the lump sum component is the $10,000 face value times the present value interest factor, because we want to get the present value of a lump sum for 20 periods at 2.5%.

And when we look at that, we come up with $5,456 and 21 cents, which represents the present value of that annuity. And we take $6,102 and 71 cents. When we calculate the present value of the lump sum for a total of 11,005, 58 92. You have to be mindful that we use the 5% yield as our discount rate, because it's the current rate being paid in the market.

And you see that the price of this bond is actually higher than the face amount, because the bond is yielding and higher amount than the yield that's on. That's currently being offered in the market. So the seller of this bond would not sell it to you for less. Because you have, because it's more valuable because it has a higher return.

So therefore you end up paying a premium for this bond. Now let's look at yield to maturity and that is the discount rate, which causes the price of the bond to equal the present value of its cash flows. It reflects where interest rates are in the economy today. So when the price of the bond is less than the face value, then that yield to maturity is greater than the coupon rate.

And we saw that in the last in the last problem, the yield to maturity will always be expressed as an annual value. Now I mentioned earlier that we were going to look at zero coupon bonds. Now zero coupon bonds have priced a little differently. Zero coupon bonds. The present value of future cash flows represent the price of the bond, just like in a normal bond.

However, there's only a single cash flow for a zero coupon bond. And that cash flow is return is the return of the face value at maturity. The price is always less than the face value. So it's always going to be selling at a discount. And the interest that you earn will be the difference between the maturity value, the face value at maturity and the purchase price there on there's.

No annuity, just a single cashflow. Again, the interest is the difference between the price paid for the bond and the face value. So the formula for that will be face value divided by one plus R to the T. And that becomes the face value times the present value interest factor for T periods at our percent.

It's just like figuring out the lump sum component of a normal bond. So how are bonds quoted? Bonds are quoted either as discount par or premium. And we looked at two examples that show bonds that would pay that were priced at a premium and a discount. And on the discount, remember the price was less than the face value.

So on a thousand dollars bond, It might be priced at $900 and that would represent a discount if it was selling at par that's where the price equals the face value and that purchase price would be $1,000. And then lastly, as a premium, the price would be greater than the face value. Thank you for your interest.

That ends the first section on bonds. Thank you.

Welcome back to the financial management review. My name is Ron Harris. We're going to continue our CPA review of bonds. We're going to cover several topics related to bonds, including interest rate, risk duration, which is a measure of the interest rate risk. We're going to look at the types of bonds and we'll wrap it up by looking at the term structure of interest rates.

The value of a straight bond is determined by the level of, and the changes in interest rates. As I mentioned before, there's an inverse relationship between interest rates and bond values. As interest rates rise, the value of the bond will decrease as interest rates decrease. The value of the bonds will increase any increase in interest rates.

We'll lower. The present value of the stream of expected cash flows. And remember there are two cash flows related to bonds, most bonds there's the stream of coupon payments. And then there's the lump sum return of principle at the maturity in zero coupon bonds. There's just a single. Cash flow, which is the return of interest of, of the principal at maturity.

The effective interest rate changes on bond prices on bond prices will vary and there they'll vary because of three main factors, one the maturity of the bond to coupon rate of the bond and three, the yield to maturity. Now bond sensitivity will vary depending upon which of these factors you're looking at.

So for example, the longer the maturity of a bond, the more sensitive it is to change as an interest rate, conversely, the shorter, the maturity, the less sensitivity exists with respect to coupon rates, the lower the coupon rate, the more sensitive the bond is to changes. And the higher the coupon rate, the less sensitive it is to changes.

And then lastly, the yield to maturity, the lower, the yield to maturity, the more sensitive the bond is to changes in interest rates. And finally, the higher, the yield to maturity, the less sensitive bonds are to changes in interest rates. So instead of having to look at each one of those factors individually and determining.

You know, w is it more or less sensitive? There's a measure called duration that could be used to determine and measure the sensitivity of the bond price to changes in interest rates. And it consolidates all three of those factors, maturity coupon rate yield to maturity, all into one measurement. A way to, and it's a way to maturity of cash flows on the bond.

The weights are based on two things, the timing and the magnitude of those cash flows and the formula is actually called the Macaulay duration. And it really just is based on yield to maturity as it's, it's very variable. Now, the larger and earlier cashflows are weighted more than the smaller and later cash flows.

The higher duration of a bond, the more sensitive it is to changes in interest rates. Other duration factors would include for coupon bonds. Duration is less than maturity for zero coupon. Bonds duration equals maturity. So again, one measure duration to measure the sensitivity of the price of the bond to changes in interest rates.

Now some bonds have special features and these features can be added to make the bonds either more or less valuable. Two of those features would be convertible, witty, and call ability. Now a convertible bond can be converted into a predetermined number of shares of stock. At the option of the bond holder, that's a critical point to remember it's the option of the bond holder on a convertible bond.

And as a result of this option, being given to the bond holder, the conversion options will help lower the interest rate paid on the bond. So the issuer is able to issue those bonds at a lower rate because they're offering this special feature. Of comfortability to the bond holders or the buyer convertible bond years, therefore are less than the yields on non-convertible bonds.

The conversion becomes a more attractive option as stock prices increase and the value conversion, excuse me, becomes a more attractive option as stock prices become greater than the value of the bond. Now the conversion ratio is a measure of the number of shares of stock for which each bond may be exchanged.

The market conversion value equals the current value of the shares for which the bonds can be exchanged. So there's a conversion premium. If there is a conversion premium, it would equal the ESSA excess of the bond value over the conversion value of the bond. Bond value will be greater than conversion value when the issuer does poorly.

So if the issuer is performing poorly, it stock price, isn't going to increase and you probably will never get conversion. Let's look at an example of convertible bonds. Now you've got a convertible bond with a par value of 1000. The market value of that bond is $1,300. And the current stock price is $25.

The company will establish a conversion ratio and that will be done upfront. And let's say it was 50 shares. So you can convert your bonds into 50 shares of the company. And let's say the conversion price is $20. Well, the way you get that conversion price is you take the par value. And you divided by the conversion ratio.

So in this case, you take $1,000 divided by 50. So the conversion price becomes $20. Next, you take that conversion ratio and you multiply it by your current stock price. So you take the $20 times the current stock price. Of $25 and you get a market conversion value of $1,250. Make sure you're familiar with how convertible bonds have conversion prices.

They have conversion ratios and how to come up with the market conversion value by taking the conversion ratio times the current stock price. So the, but the price of a convertible bond. Is a combination of the same way we priced the straight bond. But the only difference is there's a value to that conversion option.

Now you're not going to be expected to calculate the conversion of the version conversion option, but the value of the conversion option is the value of the bond. If converted immediately. Again, the conversion value is the value of the bond. If, if the holder converts it immediately, the value of that conversion option is estimated using what's called the black Shoals pricing options pricing model, which is beyond the scope of this review.

But just remember that that component, that conversion option is a part of the price of a convertible bond. Now let's look at callable bonds, a bond that gives the issue of the right to call back the bond and pay a fixed price for it at the issuers option. This one is at the issuer's option. The convertible bond was at the purchases option.

The bond holders option. The callable bond is at the issuer's option. If interest rates decline, the firm can refund the bond at the fixed price. Which will usually be below market value. Initial, the initial period is normally called protected. So for a certain amount of time, you are not able, the issuer is not able to call the bonds that gives protection to the bond holder.

Now, how do you value a callable bond? Again, you look at the value of a straight bond and that is the present value of the coupon payment cash flows. Plus the present value of the face value at maturity. But in this case, you subtract the value of the call feature. So in with a convertible bond, you added the call premium to the straight bond value.

In the case of callable bonds, you subtract the value of the call feature. Some characteristics of a callable bond would be the yield is greater than that. Then that yield of a non callable bond and the call feature can be valued using an option pricing model. So you will not have to calculate the value of the call feature.

Just be aware that it's subtracted from the straight bond value in order to get the, the value of a callable bond. So when would bonds be called? If interest rates fall, you'll see bonds calling because then the company can reissue new bonds at a lower rate. If your bond rating increases, that means your ability to repay those bonds has increased and therefore you'll be able to issue at a lower.

At a lower rate. So you may see the bonds being called then. And then lastly, the bonds may be called if you tried to remove some unattractive covenants that are part of the bond indenture. So three reasons why you can expect a bond to be called. You should know each one of those three. One of the important things about understanding bond and bond valuation is understanding what determines interest rates.

And there are three primary factors that determine interest rates. There's the default premium, which relates to the default risk of the bond issuer. There's the maturity premium, which says there's a difference between longer and shorter term default free rates. Usually the longer the maturity, the higher the rate and vice versa.

And lastly, short-term default free rate, and this is captured in every bond pricing. And it looks at the overall rates level of rates in the economy. One of the ways that we look at that is through what's called the term structure of interest rates, which relates the time to maturity, to the yield of maturity and the shape of the yield curve, which actually is a collection of all the yields of bonds of similar grade across time.

And at various yields to maturity. And what you'll see is there's either a upward sloping yield curve, which is considered a normal yield curve, a flat yield curve, or an inverted yield curve. You will sell them, see an inverted yield curve, but the shape of the yield curve is determined by the yield curve is determined by a couple of factors.

And one is determined by the expectations. Future short-term interest rates and inflation. If there's expected inflation, you're going to see a yield curve. That's got more of a normal shape. If we've got a situation of deflation, you're going to see a yield curve where short-term rates are actually higher than long-term rates.

And you'll see an inverted yield curve. The yield curve is also influenced by supply and demand for short-term and long-term money. And then lastly, It's influenced by the greater risk of long-term lending and, and the liquidity premium that gets added to a longer term loan. Thank you for your interest and we'll continue our CPA review of financial management in our next session.

Thank you.

Welcome back to the financial management review. I'm Ron Harris. We're going to continue our CPA review of bonds by looking at how bonds have quoted. We'll look at a bond indenture w and we'll talk about bond ratings and reviews. How are bonds sold? Well, there's three markets for bond, three main markets for bond.

There's the primary, the secondary, and then there's auctions. And the primary market bonds are sold are issued for the first time. And bonds have brought to market by an underwriter who is the one that actually sells the bonds. You'll hear the term, a bond underwriter. These are usually large investment banks.

The secondary market is where bonds that have been previously issued are resold again, after the initial offering the secondary market. Bonds are sold through a huge network of independent dealers. And then lastly, the auctions are primarily used for federal government bonds and they are sold to dealers and to individuals through that auction process, when bonds are quoted, there's usually a bid price and I ask price, the bid price is the price that the dealer is willing to pay for the bond.

Where the ask price is the price of which the dealer will sell a bond. It's an important measure to look at the spread between the bid and the offer or ask. And that spread is a function of liquidity. So the bid price is the price of dealers willing to pay. The ask price is the price. The dealer is willing to sell a bond for bonds are sold.

Purchased and sold over the counter. So there's no central exchange or place where you could go and walk into a store or a bank or an investment firm and buy the bonds over the counter like that, excuse me directly. Through a teller, the bonds are bought and sold over the counter. There's no central place or exchange for bonds.

Now bonds, because they, you normally pay semi-annual interest. Sometimes when you're pricing the bond, you have to include the accrued interest from the last interest payment. And when that happens, the price is considered to be a dirty price. So that price would include a crude interest from the last interest payment date.

When you get a clean price quote, that's when the price of the bond. Excludes any accrued interest since the last payment, but payment date. So there'll be a clean price and a dirty place. Nice prices of bonds are normally quoted as a percentage of face value. And we've mentioned that briefly earlier. So if a bond is quoted as if it's a par value, then the bond would be quoted at a hundred percent or maybe 100.

Even though most bonds are sold in denominations of when thousand you'll still see the 100, which would be 100%. If it's par, if the bonds are sold at a premium, you may see 105% or the bonds being priced at one Oh five. And then lastly, it, if it's sold at a discount, you would say 95%. If the bond sold for $950, or it would go at 95, But again, most bonds are sold in denominations of 100, but the bonds are quoted as a percentage of face.

If you saw the headline that read the two year us treasury jumped eight percentage points to, excuse me, eight basis points to 2.1, 2%. You may wonder. Well, what does that all mean? Well, Bond quotes are many times expressed as yields and that's so that they could have easy comparisons. So in the case of this headline, the two year us treasury jumped eight basis points to 2.1, 2% would tell you that the two year treasury bond is the bond being traded and it jumped eight basis points.

And in bond speak a basis point is one over 100. Or 0.0001, which is 0.01%. And so a point is 1%. So the bond going up eight basis points to 12.1, 2% says that the yield to maturity has gone up eight basis points and it's, and again, it's the yield to maturity. Now at 2.1, 2%. Now, how does, how do they keep it all together?

How do they know what the, what the price is? What the coupon payments should be? The maturity? Well, there's a document that's required by law called the bond indenture. And that bond. Indenture is a legal document that provides the coupon rate, the maturity date. It includes covenants either positive or negative, and that can include financial covenants, which would require you to have certain levels of working capital or certain levels of equity compared to debt.

And also it would name a trustee who is really the overseer for the bond holders. So that's a bond indenture. Now bonds get ratings and the rate, it represents the ability that the issuer has to meet in denture terms. And the, there are three primary rating agency Moody's standard and Poor's and Fitch, and there are others, but these would be the primary three rating companies.

And let's look at how Moody's and standard and Poor's would rate both have. Have five categories of ratings going from triple a to double B in the case of Moody's it would be B excuse me, B a in the case of standard and Poor's, it would be double B and each one of those ratings in between and the ones at the top and at the bottom can be modified to give a level of level of, of intensity to that rating.

So for example, if you're a trip away one, then that rating is a lot strong, is a little bit stronger than a triple a three under the Moody's ratings, under the S and P ratings. Your triple a will be a triple a plus or a triple a minus, or just a trip away, which gives a level of intensity. Or comfort to the, to the bond holder.

If you've got a, a plus versus a minus in one of the ratings, the top four ratings for either one, either Moody's or S and P represent investment grade ratings versus the bottom rating for Moody's or S and P represent non-investment grade ratings. Or in, in terms you may have heard or junk bonds. So a BA for the Moody's rating would be considered non-investment grade of BB and below would be considered a non-investment grade for standard.

And Poor's the lower, the rating, the higher, the probability of default. And from time to time during the life of the bond, there could be periodic reviews by these rating agencies to either upgrade the rating or to downgrade the rating. All of this is for the protection of the bond hall. Thank you.

Welcome back to the financial management review. I'm Ron Harris. We're going to cover in this session. Inflation. And how the impact of inflation will determine how you do your longterm or retirement planning. Inflation represents the drop in purchasing power, and it's most often measured by a change in the consumer price index or CPI.

When you're calculating the impact of inflation, you are actually looking at a future value calculation. Let's look at a quick example. If we have 4% inflation or expected 4% inflation over the next 10 years, we would set up a future value problem. That would say, let's say if we had a hundred dollars that the future value equals the $100 times one, plus the expected inflation rate raised to the 10th.

Cause we're talking about over a 10 year period. So in the problem that you'll see in the exam, you'll be given the future value interest factor for certain periods of time. In this case, you would look at the future value interest factor for 10 periods at a rate of 4%. You multiply that times 100 and you get $148.

So $100 of goods today. Will cost $148, 10 years from now at 4% inflation. Whenever you try to understand inflation and its impacts, they're really 14 terms. You must know if you get this right, you'll have no problem working on solving inflation related problems. First, you have to know the nominal cash flows.

And nominal cash flows represent the actual dollars to be received, not purchasing power, but actual number of dollars received real cash flows on the other hand are expressed in terms of time, zero or today, and it represents purchasing power. At time. Zero nominal cash flows will equal real cash flows.

The third term that's important. Is nominal interest rates and that represents unadjusted rates, unadjusted for inflation, real interest rates are adjusted for inflation. So those four key terms, you must have a good understanding of let's look at an example on inflation, where David wants to purchase a special laptop and he wants to purchase it one year from today.

He has $1,000 to invest for a year at 7%. And inflation is expected to be 3%. So the price of the laptop today is 1000. But with that 3% inflation in one year, that laptop price is going to go up to $130 excuse me, $1,030. So it's the 1000 times 1.03 now. Will he be able to pay for that laptop since he only has a thousand dollars today?

Well, if he invested today at 7%, he will end up with $1,070 one year from now, but that will be in nominal cash terms. That will be the number of dollars he has. But in terms of purchasing power, what he will have is a little less than that. And the way you come up with the real interest rate. Is you actually take the equation, which is called the Fisher equation and you, which is one.

Plus the real rate equals one. Plus the nominal rate divided by one plus inflation rate. So when you do that math and you have one, plus the nominal rate or 1.07 divided by one, plus the inflation rate of 1.03. And then you subtract the one to isolate real rate. And the answer is 3.8, 8%. So when you try to figure out what your purchasing power is, you say your present value of $1,000 times your real rate of 1.0388, and you come up with 1030 $8 and 80 cents.

And that's your real purchasing power. And you will, David will have enough. To buy that special laptop a year from now, when you're talking about retirement planning, inflation has a major impact in how much money you have to save now in order to have enough to, to hit you up investment goals in the future.

So let's look at an example where we've got a young lady named Jennifer and she's twenty-five years old, and she wants to retire at age 65 and at 65. She wants a lifestyle that's based on $60,000 per year, $60,000 of purchasing power per year. Now Jennifer hopes to live to be 100. So that means that she will have to have $60,000 a year for 35 years, which would be 100 minus the 65.

Inflation is expected to be at 2% over that time. And the nominal rate. Is expected to be 7%. One thing to keep in mind as we go through this problem, we're going to avoid mixing nominal and real when we're dealing with the inflation problem. And you'll, I'll remind you of that as we go. So step one, I have to calculate the real interest rate and we're going back to the Fisher formula and we know we have to take the nominal interest rate divided by the inflation.

And then subtract one from that. And we come up with 4.9% using the Fisher equation and that's going to be the real interest rate. So now we want to calculate the amount in real dollars purchasing power that Jennifer's is going to need at retirement. So the, our problem here is an annuity problem. And so we learned during the time value of.

Money sessions, how to calculate the present value of an annuity. In this case, we're looking at a 35 year annuity for $60,000 of cash flow in real dollars per year. And so that problem, we structure it by saying present value equals $60,000 times the present value interest factor of an annuity. For 35 years at the real rate of 4.9%.

When you do the math, you end up with $994,973 and 73 cents.

Next step that we may want to do is find the nominal dollars needed to get that $994,997 and 73 cent in real dollars. In time of retirement. So what are the number of dollars that we need right now that will grow into our retirement number? And that becomes a future value that would say not. And I, I made a mistake there.

I said that it would be the dollars we need right now, but it's actually the dollars we're going to need in the future in nominal terms that will be equated to the $994. $994,997 of real dollars. And that becomes a future value problem. So all you do there is you say future value equals your present value times the inflation rate raised to the T.

And in this case, we're talking about over 40 years. So if we have 994,976, $3 and 73 cents today, we multiply that by the future value interest factor for 40 years at 2%, and we get 2 million, $196, $96,941 and 46 cents. That represents nominal dollars that we would have to invest in order to get. 994,973 73, which would give us our $60,000 a year.

Now let's talk a little bit about savings and as it relates to that 2.19 million that we just identified, how much does Jennifer have to save annually? To have 2 million, $196,941 when she retires in 40 years. Now, remember that number is a nominal number. So this again is a future value of an annuity problem where R equals 7% T equals 40 years.

The formula is future value equals your cash flow or your present value times your future value interest factor of annuity. Over that time period. And at that nominal rate. So to solve this problem, we already know what the future value is, is 2 million, 196, nine 41. What we're solving for is C because the factor is going to be given to us.

And that future value interest factor happens to be 199.6351. So when you do the math and software C. Jennifer's going to need to invest in nominal dollars, $11,004 and 79 cents. Now, when you're younger, I'm trying to invest $11,000 a year may be a little difficult when your income levels really isn't that high.

So if we look at this and we'd say, well, if we know inflation is going to be 2%, maybe. We should try to invest a smaller amount. At first, it's going to grow at 2%. Every year. We'll increase our savings by 2%, every year to come up with what will be the real dollars needed. And it spread the pain over a longer period of time.

Instead of us having to save the $11,000 every year. Starting from year one, because I'm going to assume that Jennifer will make more money in year two and three and four and so on. And so let's see how we could cut her savings down in the early years and just grow it at the inflation rate. So if Jennifer needed to save $994,973 in real dollars, when she retires in 40 years, What could she invest it at?

What could she invest every year to get her there? Well, this is another future value of an annuity problem. This time we'll use the real interest rate, which is 4.9% over 40 years with the future value being 994,009 73, we will multiply the cashflow that we need every year times. 117,000, excuse me, $117

one 17.89224. And we get $8,493 and 69 cents. So instead of saving 11,000 and nominal dollars, if Jennifer saves $8,439 and 69 cents this year, And then increases that amount each year. By 2% in 40 years, she will be up to the 994,973 in real dollars that she needs savings. Doesn't have to be as overburdening as you would think.

If you just take it a little at a time and if you never mix real and nominal, thank you.

Okay, welcome back to the financial management review. I'm Ron Harris. We're going to talk about stocks during this session. One of the things we need to start off with is some basic definitions, and then we'll go into the beginning discussions around how you value stocks. So how do you price a stock common stock?

Sometimes referred to as just stock and also its equity represents ownership, shares in a corporation. Now the ownership can be in a publicly held company like a GE or Apple or Microsoft, or it could be shares in a closely held or private company like high-tech POS my company dividends. Represent the cash distributions from the corporation to the shareholders usually distributed quarterly.

But for, for this lesson, we'll assume the annual dividends have paid and that's for simplicity. Although the calculations still remain the same and dividends really represent one part of shareholders return retained earnings are the corporate earnings not distributed as dividends. They represent the cumulative earnings or losses over the life of the quarter operation.

Now capital gains or losses will be either realized or unrealized the gain or loss represents the current stock price minus the price you bought it from. Or if the stock sold, you'll have a realized gain and loss. On the other hand, if the stock is held, you have an unrealized gain or loss, but for our calculations, it really doesn't make a difference for tax purposes.

It's a big difference, but not for calculating the values that we're going to be calculating in this lesson. Remember in our case, market value equals current price. So when we talk about the market value of a stock or the current value of the current price of a stock, They're both the same shares.

Outstanding are the total number of shares of a company stock that's been issued. For example, if you own 500 shares of stock in a company that has 10,000 shares outstanding, you own 5% of the company that 5% ownership entitles you to 5% of the profits. And if you were to liquidate the company, 5% of the proceeds upon liquidation,

the price earnings ratio sometimes referred to as a PE multiple or just PE illustrates really the expensiveness of a stock. And it says, how many, how much am I willing to pay per dollar of earnings? The way you calculate that is you take your stock price per share. And divided by the earnings per share.

Now, when you're calculating the PE ratio, you can either use forward earnings, which would be projections that are usually supplied by wall street analysts. And they go out for four quarters. The average of the four quarters forward earnings, or you can use past earnings, which take into consideration actual earnings over the past four quarters.

There's a concept relating to stock call. And it's a, it's a strategy that some investors use quite often called short sale. Now a short sale is when you borrow a stock, then sell it at a later time and then buy it back and returning the stock to the owner and then return the stock to the owner. So you buy the stock, you sell it.

And then you see what kind of movement the stock price is going to have over that time that you're holding it during the holding period. And then you sell it back to the owner. Now the objective is to make money from the decline of the value of the stock while you have an open position in the short sale.

So you're betting that ABC company's stock is going to go down in price. So you'll, you'll borrow it, sell it, watch the stock price, go down, hopefully, and then make profit. By selling it by, by selling it, by buying it back at the lower price, but selling it at a predetermined price. Any dividends paid while in your possession must be paid to the owner of the stock.

That's a risk that you have to keep in mind when you're doing a short sale. So let's look at an example. You borrow shares and you sell them at $100. Let's say the stock price falls to 95. And then you repurchase at the new price at 95, you returned to shares to the original owner at the $100. And so you've made money 100 minus 95 equals a realized profit of $5.

Now there's a lot of risk associated with the short sale, because what if the price doesn't go down? If the price continues to increase, there's really no limit to the potential loss. You lose more and more money as the price of the stock continues to increase. If you were to just, if you just bought the stock out, right.

And let's say you paid a hundred dollars, that would be the extent of your, your risk of $100 if it went to zero. But if the price continued to go up and tripled and quadrupled, you would be faced with higher and higher losses.

so let's look at stock price. And how do you value a stock price? Well, like any other financial asset, the price equals the present value of all future cash flows. And there are actually two cash flows. When you're talking about a stock related to a stock, you've got dividends and then you've got capital gains.

So if you look at. The return on, on stock, the return or R represents the dividends plus P one minus P zero, which actually equals the capital gain or capital loss divided by the original purchase price. So dividends is your first cash flow. Plus the capital gain. Is your second cash flow divided by your original investment.

And that's how you calculate return on stock. If you're uncertain, what the actual stock price will be.

Okay. You look at the dividend and the return for the next period. Let's look at this as an example. If you made an investment in high tech company, let's say you paid $80 today for of stock in high-tech company. The expected price at price. One is $85. You don't know with certainty, but you expected to go up to $85 and the dividend, the next period is $3.

Your return would be $3, which is the current dividend payment. With next period's dividend payment, plus the capital gain, $85 minus $80 divided by your original investment of $80. And you get a return of 10%, $8, which is combination of cap, total gain and, and dividend payment divided by $80 investment equal 10%.

So if you break down the components and where's my return coming from how much of it is from dividend yield and how much of it is from capital gain yield, you can take your dividend $3 and divided by your investment of $80 and you get a 3.7, 5% dividend yield. And if you take the $5 of capital gain divided by your $80 investment, you get a 6.2, 5%.

Expected capital gains yield, combine the two, and you've got your 10% yield. So now let's solve for price for high-tech company. So if P O equals dividend one plus price in period, one divided by one plus R so you know what you expect, you haven't expected price in mind. You know what the dividend payment's going to be next year.

That'd be $3, plus your $85 of your expected price. And that will be $88 divided by one plus R or 1.1. And you get your price of $80. Now this is the price that you need in order for you to earn the 10% that you're expecting. If you don't think the price is going to be $85, and someone wants you to pay some different.

Initial price. You may have to rethink whether or not you want to invest because you're trying to get that expected return of 10%. So now if you extend this and you say, okay, if at 0.0 at time, zero P O equals price at 0.0 is dividend one, plus price, one divided by one plus R then a year from now the price one is this.

Dividend and year two plus price at year two, divided by one plus R and so on and so on into infinity. And that becomes the basis for what's called the dividend discount model. The dividend discount model model says the price. The price of a stock equals dividends in period one discounted at one plus R plus dividends expected in period two plus one plus R two squared.

Plus dividends in period three, divided by one plus R cubed and so on. This is the most common way to calculate stock price, but you know, it's difficult to project dividends indefinitely. You can't always assume that a company is going to pay dividends indefinitely, nor can you project it with any real accuracy.

So what you have to do is assume a terminal value at some point in time. And so to calculate a terminal value, you, your first thought is that the dividends of Kern into perpetuity really would represent your terminal price. So if you look at price at time T that equals your dividends, plus your dividends and period T plus one, one period ahead.

Divided by R so, so the same concept that you use to come up with the price in a particular period, you come up with a price for all future periods. Now, if dividends continue as a growing perpetuity, you adjust that terminal value equation, and you say price T or terminal price equals dividend at period T plus one divided by R minus G.

Does that look familiar to you? Like a growing perpetuity. The Gordon growth model says that the present value at time zero equals dividend one divided by R minus G. And if you do a little bit of math, you can actually figure out the return and say return equals dividend one, divided by price at times zero plus G.

Thank you for your interest. And I look forward to our next session.

Welcome back to the financial management review. I'm Ron Harris. Let's continue our study on stock. The dividend discount model is the simplest method used and probably the most popular method used for calculating the price of a stock. Let's look at an example of how you can use the dividend discount model.

Let's look at high-tech company and let's assume that it expects annual dividends over the next five years to be $3 in year one and year two, $4 in period three or year, year three, $3 and 50 cents in period four and $5 in period five and thereafter, let's assume that there's going to be a steady growth of 6% into perpetuity.

Now the investors expect a return of 10% on the high-tech POS stock. Well, looking at the dividend discount model, the current price of the stock equals the present value of future dividends. So we know what the dividend is in period one through five. And as we learned at the end of the last review on stock, Was, you cannot always assume that you can forecast dividends into perpetuity.

And so you have to come up with the terminal value. So the dividend stream represents one stream of cash flows, and then the other stream is the present value of the terminal value. And which is the price of the stock and period five discounted by the present value interest factor. At, for five periods at 10%.

So let's put that into the, our formula. The dividend in period one is $3 and it's discounted back at the present value interest factor of 1.1. The second period, the dividend is $3 and is discounted at 1.1 squared. The fourth. The third is $4 and it's discounted back at 1.1 cube and so on until you get to the, the terminal value and you have to say, well, what is the pricing year five.

I have to figure that out before I can come up with the present value of that terminal value. And to do that, I know I have to figure out what's the dividend in period six. Actually six through infinity because it's all contained in the price at period five. So the price that period five is the $5 dividend in period, five times 1.06, which represents the growth rate in dividends.

And that's divided by the return of 10% minus your growth, right. Raise to the second power. So let's look at it again. It's $5 times, 1.06 divided by the difference between the return and the growth rate squared. And that number is $132 and 50 cents. So now we can take that terminal value and plug it into the dividend discount model and discount it back to the present by taking the 1.1.

Raised to the fifth and we could come up with the present value of that terminal value. So when you do all that, you get a stream of present values that you can add together. And the present value of the one 32 50 stock price five years from now is $82 and 27 cents. Add that to the present values of the dividend in period one, the present value of dividends and period two.

Period three period four and period five. And you come up with a price of $95 and 98 cents. So in summary, this, this investor would be willing to pay $95 and 98 cents. If it would get it as expected dividend stream and earn 10%, which is required rate of return. And that's the dividend discount model used to come up with the price of a stock.

Now there's another way to calculate the price of a stock, because again, dividends may be too difficult to forecast and companies may not offer a continuous stream of dividends. So another way to calculate the price of a stock or the value of a stock is to forecast free cashflow and cashflow available to stockholders and creditors.

And it's the, and what it represents is the earnings before interest, but after taxes, but it's available to stockholders and creditors. No. How do you get there? Well, first of all, you discount off future free cash flows at the weighted average cost of capital. And we'll talk about the weighted average, average cost of capital in a later session.

And from that you take out the total market value of debt. To come up with free cash flow. That's available for stockholders and creditors. Once you have that number, you divided by the number of shares outstanding so that you can get an equity price per share. So that's your second method of calculating the price per share of stock.

The last way that, that an analyst would value a firm would be by using comparables. There are two comparables that are commonly used. Excuse me, you can use the PE, which we mentioned earlier as the share price divided by earnings per share, or you could use a market to book calculation to come up with a comparable, actually the share price and the market value are both the same.

The difference is you're using earnings per share in the denominator of the PE versus you're using the book value of the company's assets in the market to book. Most people use the PE multiple as a valuation methodology. Now, how do you use it while you find the appropriate ratio by observing comparable companies and comparable companies could be.

Some industry peers, or they could be financial peers, financial peers, being those companies that have similar growth, similar size, either in asset size or revenue size similar operating leverage. Those would be examples of financial peers. And so what you would do is you would multiply the appropriate ratio by actual earnings per share, or book value per share to get the price.

So if you've got a 15 P E and your earnings per share is $1, your stock price would be 15 times the $1 or $1 per share. That's how you use comparables. Now let's look at for a minute. At preferred stock preferred stock works like a perpetuity because it provides a continuous cash flow. And it's a consistent cashflow indefinitely, usually preferred stock is non-voting versus common stock has voting rights and shareholders have control preferred stock.

Doesn't provide its owners with that, that benefit. Now the dividends on preferred stock, however, not guaranteed. However, they usually are cumulative. Which means any dividends that are not paid in a particular year on preferred stocks must be paid before common stock holders can receive any dividends.

So dividends in arrears must be paid up before a common stockholder can get any dividends. Preferred stock, therefore is less risky than common stock. But it's still more risky than debt because debt holders are able to drive a company into bankruptcy and will have priority over preferred stockholders and common stock holders in the event of it liquidation.

But preferred stock does have less risks than common stock. Thank you.

Welcome back to our financial management review and our discussion around capital budgeting. I'm Ron Harris. We're going to look at corporate finance in general, and then we would look at some capital budgeting tools. That's going to help you to solve problems that will come up as you try to plan for your capital expenditures.

And we'll look at a problem, which looks at the net present value of a, of a realistic project. Corporate finance really has two major and separate decisions that have to be made. We look at capital budgeting, which really is the project selection process. You've got a portfolio of projects that you want to do, and you may not be able to do every single one of them for whatever reason, but you want to.

Select the projects that provide the most value to the firm. So that's the capital budgeting process selection process. And then the second question is after you've decided what projects to do now, you have to figure out how do I pay for those seems a little strange, but this assumption here is that companies will have enough sources of capital.

That if they've got projects that are going to create value, they'll be able to finance those. Those those projects. I wouldn't try that for your personal budget, but, but this is how most companies manage their capital budgeting and financing decisions. When you're thinking about looking at projects that create value, there's a couple of different measures that, that most companies are interested in.

First of all, the project has to make money. Secondly, the sooner the money can come in, the better. And thirdly, they want to minimize the risks. So make money, make it faster and do it without as much risk. Do it with less risk. Now, any project evaluation tool that you use needs to be able to measure all three of those perf preferences that companies have.

We're going to look at five different capital budgeting tools that are used in industry, business and industry today. First is net present value, which actually is the best. And I've, I've listed this in the order of preference, net present value, then internal rate of return, profitability index accounting rate of return and payback period.

When I worked at general electric, one of my primary jobs was to manage the investment planning. For general electric lighting, GE lighting. And so we had millions and millions of dollars of budget that we had available for capital projects. We used four of the tools that we have fab listed here. The only one we really didn't pay a lot of attention to was accounting rate of return, but net present value, IRR profitability index and payback were all used in practice at GE.

If you look at which ones are used the most, I would say net present value is the one that I would pick out of any of these others. If I could only select one, but internal rate of return is good as well as profitability index is very good. Now, always will projects get selected based on the results of using these tools.

Sometimes there'll be strategic considerations. Past actions by management, some management gut feel or intuition will drive some investment decisions. And in some cases there won't be enough quantitative data available, or there may be legal or regulatory requirements, like some of the requirements around disability.

Where you have to make some capital investments. And lastly there may be some asset replacements that are caused by natural disasters, but those aside, these tools are the tools that should be used in capital budgeting. Let's look at net present value. Well in net present value, we look at projected cash flows minus the present value of cash outflows.

So cash inflows. Mine is the present value of the cash outflows. Now we discount those cash flows at the firm's cost of capital, which is also referred to as the opportunity cost of capital or the hurdle rate. The variables that are included in any present value analysis would be, you have to estimate the cash outflows or costs.

You have to estimate the cash inflows or benefits. You've got to take the tax rate into consideration because there is a tax shield on depreciation that you have to take into consideration. You have to look at inflation rates, the cost of capital or discount rate, which is our, and you got to look at the project life.

And then lastly, in some cases, you'll assume that there's some value to the asset. That you've invested in at the end of its usefulness and its determined terminal value that also has to be considered in your net present value analysis. Now the opportunity costs the capital is the rate of return that could be earned on alternative investments of similar risks.

And this is the rate of return that's given up by the fact that you decide to do the project, as opposed to just taking those, that those dollars and invest them in some security of similar risk. So we're always going to be using as our discount rate, a risk adjusted rate of return. And the formula. If you look at it is someone that we looked at earlier and it's just the net present value equals the cash invested, which is represented by C O and has a negative sign.

Plus the cash inflows, each one discounted at its respective present value, interest factor for that period. Now the decision criteria. Would be if the net present value is greater than zero, except the project. If the net present value is less than zero rejected because you'll destroy value. If you do go ahead and do the project, and then if the net present value equals zero, you're really indifferent.

Should I do the project or should I invest the proceeds in something else? That's going to give me the same required return. Let's look at a problem in net present value. Let's assume that you you're doing a project and its initial capital investment is a hundred thousand dollars. And let's also assume that the operational cash flows would be in period one $25,000.

And then in periods two through five $30,000. So for periods of $30,000 of cash flows, inflows. These cash flows come at the end of the period. When I think about that, I think about an ordinary annuity when you've got, where you've got fixed cash flows over a specific period of time. And that occurs at the end of the period, the weighted average cost of capital or the rate that we're going to use to discount our cash flows is 6%.

So if we look at our formula. We can see that cash flows of negative 100,000 in period zero or now 25,000 in period, one 30,000. At the end of periods, two through five will be given present value interest factors for each one of those periods. And what we'll do is we'll multiply the present value interest factors for those periods.

By the cash flows for that period. And we'll come up with a present value number from that we'll subtract. We'll add those present values of those cash in flows together. And then we'll subtract the initial investment of a hundred thousand. And in this case you get 20 1006 55 as your net present value.

Now there's an alternative way that you could solve this same problem. If you look at the cash flows, you see that the 25,000 in year one is the present value of a lump sum. And so you just use the present value interest factor for period one at 6% to discount that first flow, but the present value of the next four cash flows, which are there all 30,000 would say that that's an annuity.

So there you could use the present value interest factor of an annuity, ordinary annuity because the cash flows at the end, right? The period for four years at 6%. And then the annuity starts in period. At the end of period two, you really have to discount it back. Excuse me, the period one, you have to discount it back to its present value by taking the present value interest factor.

For one period at 6%. So you would take your $25,000 times 0.9434 that's its interest factor for period one at 6%. And then you would add to that the present value of an annuity, which is the $30,000 times 3.4651, discount it back using the present value interest factor of 0.94, three, four. And you will get $21,654 and 26 cents.

The same answer that you got using the other approach. So should you do this project? I think absolutely. Do this project. Not only does the project return you, your required return of 6%, it also gives you an additional. $21,654 and 26 cents. So value has been created by this project accepted remember projects that increase the value of the firm.

This project increases the value of the firm by almost $22,000. Versus if you had invested in a return in an asset that gave you your required return, you would have just gotten the sixth, do the project. Thank you. Welcome back to the financial management review and our discussion around capital budgeting.

I'm Ron Harris. In the last discussion, we looked at net present value as the primary tool used in capital budgeting. Now we're going to turn and look at internal rate of return. Profitability index accounting rate of return and payback periods, and learn a little bit about how they're used in capital budgeting and which ones are preferred versus the ones which aren't as preferred internal rate of return is the percentage rate of return on your investment project.

If you recall, in net present value, it gave you a dollar amount. Well, internal rate of return actually gives you a percentage or return number. And the, and the decision criteria is usually to accept the project. If their internal rate of return is greater than the cost of capital or the hurdle rate. Now there are some complications with internal rate of return, but for the most part, it's a very reliable capital budgeting measurement tool.

For example, the internal rate of return. There could be situations when you have more than one IRR. And the reason why, or when that happens is when you have more than one change in the directions of your cash flows. So if you have an outflow and then a series of inflows and then an outflow in a later year, When you do the invest internal rate of return calculation, you'll get multiple answers and you will not know which one represents the real return on the project.

Additionally, I R can be misleading are mutually exclusive projects because you can't tell which project to accept. Now, a mutually exclusive, exclusive project says, you can do one or you can do the other, but you can't do both. For example, if you wanted to build a plant in Ohio and also build a plant in North Carolina to produce the same product, the same capacity.

Well, IRR won't tell you which one to do because you can't do both. You can only do one or the other. Now let's look at an IRR problem. Let's assume we had a project that we needed to spend up front $10,000 and we had cash close in years. One through five of $3,000 a year. The cost of capital is 10%. So let's figure out what the IRR is on this project.

Well, when you look at the net present value equation, we already know that the IRR is the discount rate. That makes the net present value zero. So when you substitute zero for net present value, and then you look at the rest of the equation, what you do is you, instead of having our, as your discount rate, you substitute IRR and I R becomes the unknown.

Now in reality, you could use calculators or go to a IRR table and find out the IRR for, for various time periods. But. In in, in for our purposes and for the BEC CPA Exam, you really going to have to use trial and error to find IRR. So let's start for this purpose. Let's start with 17% as our discount rate or assume that that's our IRR.

So when we take zero, put zero in for net present value, put in negative 10,000 for our initial cash or cash outflow or investment. And then we look at a $3,000 annuity over five years at an IRR. And we put in 17%, we find that the present value interest factor of annuity for five periods at 17% is 3.1993.

We multiply that by our $3,000, our annuity payment over the five periods. We subtract from that $10,000, which was our initial investment. And we end up with a negative net present value of $402 and 10 cents. So what that says is you would reject this project because 17% is too high, a hurdle rate. So the IRR in this case is not 17% because if it were the, the net present value would have been zero.

So step two, what you do is you, you, through trial and error, you put in 16%. So when you put in 16% and go through the exercise, you find the present value interest factor of annuity. It's 16%, four or five periods. Multiply that by your $3,000 annuity payment, subtract out to $10,000 initial investment.

And you get a negative $177 and 10 cents. So you see that you're getting closer, but you're still not there. So through continued trial and error, you put in 50% go through the same exercise and voila, you get a positive $56 and 60 cents. So now, you know, at 16% you were at a negative $177 and 10 cents at 15%.

Discount rate you're at $56. So you know that your IRR is somewhere between 15 and 16% on the exam. This most likely would be the answer that the IRR is between 15 and 16%. You've done your trial and error and you've narrowed it down. The actual IRR on this project is 15.238, 3%. The next tool that we use for capital budgeting is profitability index.

And this is best used when you're faced with capital rationing. In other words, you've got a budget constraint, the more acceptable projects that there are more acceptable projects than are available. And so you have to draw the line and you have to force rank your projects. It's similar to net present value because in denominator, which is the present value of all the cash flows from the cash inflows, from the project divided by the denominator, the cash flows as the initial investment.

If, if that answer comes out to be greater than one, then you would except the project similar. If net present value is greater than zero. You accept the project, but there's one stipulation because you've got budget constraints. You can't do every project. When I was at GE, one of the things we used to do was we would use the profitability index and we would draw a line once all the money was gone.

So if we had net present value, if we had investments of $10 million and we had budget. Of $8 million. We would force rank each project based on the profitability index. Once we used up the 8 million, $8 million, we would draw the line and the projects that were we're below the line, the additional $2 million of projects just wouldn't get done unless we could change some assumptions, realistically.

But, but it, it provided us with a method for force ranking projects. Because we had budget constraints. The next method is not one of the preferred methods and, and it's, and it's called the accounting rate of return method in this accounting rate of return method. We actually look say that the average book rate of return is the average annual income divided by average annual investment.

And we would compare this project return to the company's rate of return or hurdle rate. It's good to know, but we are not really that useful in practice because there are a couple of drawbacks. One, the accounting rate of return uses net income rather than cash flow and net income can be manipulated.

Secondly, it ignores time value of money, and we know. That a dollar today is worth more than a dollar tomorrow.

Last method is called the payback period, and this is a popular method used in industry, but it's not a preferred method because the payback period considers the time it takes for the cash flows for the project to recover its initial investment. What the firm has to do is it actually has to accept an arbitrary cutoff date.

So let's say if it's three year cutoff, we want to pay back within three years. Well, what if the cash flows from that project? See the larger cash flows occur beyond year three. And so that you are not able to recover your initial investment in periods. One through three. It would not make the cut off.

Although what if it had huge cash flows coming in in year four or five and six from a net present value perspective in IRR perspective, it very well could be great projects, but you would reject it because it didn't meet the cashflow. It didn't meet the cutoff period. I will say though, that the payback period is a useful method.

When you're under financial distress, we used it at GE. When we were looking at productivity projects because we needed to get a certain amount of cost reductions every year. And we got those reductions through implementing productivity projects. So that's one that if you could get us a payback within 12 months, you had a good chance of getting it approved.

Although it may not be the highest net present value decision. The drawbacks, I think, and I mentioned some of them, the drawbacks of this method is it gives equal weights to all cash flows that occur before the payback cut off. And it gives no weight to cash flows that occur after the cut-off period.

And also it ignores time value of money. So the preferred capital budgeting methods are net present value. Internal rate of return and profitability index and net present value is the King of all capital budgeting methods. Thank you. Yeah. Welcome back to the financial management review. I'm Ron Harris.

We're going to turn our attention to cash flow. We learned earlier that net present value is the preferred method for evaluating capital projects. And then using that present value, you have to discount the future cash flows of the project to come up with the net present value. Well, what our cash flows in this session, we're going to review just, we're going to answer that question and we're going to look at an actual project to show you how to come up with cash flows.

Well, cashflow is C or FCF or free cash flow. You'll see any one of those terms in the CPA exam when we're talking about cashflow and cashflow is what's available for stockholders and bondholders, as well as any other creditors of the firm. So it's the cash that's available. For stockholders and bondholders.

There's some rules you really need to remember when thinking about free cash flow. First of all, we discount cash flows, not accounting earnings. And when we discount cash flows, it has to be incremental cash flows associated with doing the project. If you've already spent money on a project and you try to include that cost in a new analysis, you've made a mistake because that cost is irrelevant.

Anytime you have sunk costs, you exclude it from your analysis because sunk costs is irrelevant. Incremental cash flows are only relevant because they only occur. If you do the project, if you don't do the project, you won't have the cashflow. It won't be incremental. So relative free cash flows include opportunity costs.

For example, if I want to build a factory or sell the property, if I build a factory, then my opportunity cost is the loss. Cash inflow from selling the property that should be included as a relevant cashflow in your capital budgeting analysis. Let's say for example, you're opening a new retail store and you have to build up inventory as a result of adding this new store.

Well, that incremental or change in working capital. Would be added to your cash flows. It would be a cash outflow at the start of the project, and then it will revert into, or convert into a cash inflow at the end of the project life. One of the things you have to be mindful of is that you exclude financial costs from your free cashflow.

And I know you wanted reduce. Your cashflow by interest expense, but do not include interest payments in, in your free cash flow. It's covered within your cost of capital.

a couple of relevant cash flows. Let's just go down the list so that we can make them more understandable and make it more clear. What's included in a cashflow new asset purchase represents a cashflow, a new lease payment. Would be cashflow installation costs, training setup, and maintenance. Like we mentioned earlier, incremental working capital operating, other operating costs, all would be considered cash outflows.

Now cash inflows would be incremental revenue. Less the cost associated. Yeah, like new scrap rework, spoilage, labor inspections, handling inventory, carrying terms, no value cost avoidance. If you're able to avoid some costs because you do do a project that would be a relevant, that would be a, a cash inflow ignore sunk costs can see or only incremental cash inflows and outflows.

You could summarize all of those examples of cash flows that I just spoke about into three categories. There could be the initial investment, which is an outflow, and then there could be changes in net working capital, which is an outflow at 0.0 and an inflow at time, sometime in the future. And lastly cashflow from operations, which represents your cash inflows between time zero and time, sometime at the end of the project in the future.

When you think about cash flows and projects, they normally fall into several categories, but the type of projects that you normally going to be looking for cash flows from are replacement projects, which would be the acquisition of new machinery and buildings. And that's driven by cost savings or sometimes tax consequences, expansion projects would be another category and that's driven by market expansion or entering new markets.

And your objective there is you're trying to increase profits and cash flow improvement projects. They're generally strategic and they're trying to improve existing products. And then there are safety and environmental projects that. Really may not be provide you with the best returns, but you have to do them anyway because they're normally driven by regulations.

So how do you get the cash flow from those projects? Well, there are two, actually two methods of calculating cash flow. You could start with a top down method or you can use what's called a depreciation tax shield method, and we'll review both of those. The top-down method. You start with incremental revenue.

And you subtract from that cost. And those costs of both, both variable costs and fixed costs. You further reduce that number by depreciation. So you come up with a number that's called earnings before interest in taxes. EBIT. Now you may say to yourself, wait a minute, depreciation is a non-cash item. So why am I subtracting it?

Well, you'll see in a moment. To that EBIT number. You're able to use that number to calculate your tax liability. And so you want it to reduce EBIT because the depreciation is a deductible expense, and now you can calculate the appropriate tax liability. So from EBIT, you calculate tax liability and you come up with your, your income from operations that you're going to use.

In your tops down method, add back depreciation because it is a non-cash item, but you needed it earlier to calculate the right tax number. And therefore you come up with a new number called cashflow from opera. That's the top-down method. Okay. Now the depreciation tax shield method is a little bit different, but you'll get the same answer.

You start with revenue and you subtract both your variable and fixed costs. And then you adjust that number, this the difference between revenue and all costs. You adjusted by your tax rate, which is one minus your tax rate. Additionally, you add back your tax shield on depreciation. So you take depreciation times your tax rate, and you come up with your tax shield.

So you add that, which is a benefit to the previous number and you get cashflow from operations. Let's look at that. By looking at a critical project and evaluate what we should do. Well, unit sales have forecasted at 50,000 units and the unit price that we think we can sell it for is $4 per unit. We have variable costs of $2 and 50 cents a unit fixed cost of $12,000 a year.

And the company is expecting a required return of 20%. That's the hurdle rate. And the life of the project is three years. So the capital investment for this project is going to be $90,000. We're going to use straight line depreciation and the marginal tax rate is 34%. And this project is going to require some incremental working capital.

Let's say $20,000 a year. So using a top down approach to evaluate this critical project. We start with revenue. So the 50,000 units, times $4, and we get $200,000 as the anticipated revenues for this project, the variable costs would be the $2 and 50 cents, times 50,000 units that we manufacture. And that will be 125,000 fixed costs.

Like we mentioned is $12,000. And then the depreciation is going to be $30,000 a year. The initial 90,000. For the investment divided by three years gives us $30,000 a year. So when you start with your 200,000 of incremental revenue and you subtract out your variable costs, fixed costs and depreciation expense, you get an EBIT of our earnings before interest in taxes of $33,000.

You take that number and you multiply it by your tax rate and you get a tax expense of 11,220. Dollars you do that math and subtract down. You get an income of $21,780. Now you add back your depreciation. Why? Because it's a non-cash expense. And so when you add that back, you get $51,780 as cash from operations.

Let's try that, looking at that depreciation tax shield method and see what if, what we come up with for operating income. Again, revenues are Oregon. $200,000. Your cost, you combine your variable cost plus your fixed cost and you get $137,000. Your earnings before interest taxes and depreciation is $63,000.

And, and so you do your tax adjustment on your depreciation and you get an earnings, you do your taxes, excuse me, you do your tax adjustment, which is one minus 0.3, four times your $63,000. And you end up with $41,580. Now to that number, you add your tax shield, which is your depreciation. Times 0.34, and that should depreciation tax shield of $10,200.

And when you add that to the 40 1005 80, you have an operating income of 51,780, and that's your cashflow. So when we look at it on a year by year basis, we can see that operating cashflow starting in year one is 51,780. In year two, you have 50 1007 80. And in year three you have 50 1007 80 and period.

Yes, zero. You have the incremental outflow, which is your increase in net working capital of 20,000. And you have your initial investment of 90,000. That's an outflow. In year three, you did that. Networking capital returned to you at the end of the project, which becomes a cash inflow of 20,000. Therefore your project cash flows are 110,000 in period, zero 50, $1,780 in period one and two and $71,780 in period three.

So we know our net present value formula. And when we, we discount the, the, the cash flows in periods, one through three by their respective present value interest factors for period one at 20% period, too, with 20% discount rate and period three at 20% discount rate. Okay. And you get $10,647 and 69 cents.

You accept that critical project. Now, now let's figure out what the IRR is on that same project, because you can see that the net present value gave us a dollar figure that the imp the IRR is going to give us a rate. So when we go through the process and we look to solve for IRR, because I R R is the net present value is the discount rate that makes our net present value zero and through trial and error.

We find out that the IRR is between 25% and 26%. And the actual IRR is actually 25.76. And with a cost of capital or hurdle rate of 20%, we would accept that critical project on an IRR basis as well. So I R R and MPV both tell us. That we should accept the project because we made sure in this case that we got our cashflow.

Right. Thank you. Welcome back to the financial management review. I'm Ron Harris. We're going to now turn our attention to the capital asset pricing model. So what is cap M it's a model that represents a simple theory that says the only reason and investors should earn more. On average by investing in one stock rather than another is that one stock is riskier.

So if both stocks had the same risk, there should be no expectations to get a higher return. The model also assumes that the standard deviation of past returns is a perfect proxy for the future risk associated with a given security. Shareholders require rate of return on equity capital. That is a function of three things.

The risk-free rate of return, the rate of return earned on stocks in general, we'll call it the market portfolio or market return and the riskiness of a particular stock in which the investor may be considering investing this cap in can also be applied to. Capital projects. So it's not just used to come up with the cost of equity for a stock or portfolio stocks, but also for the cost of equity for a particular project.

Now you can use a rule of thumb to estimate the cost of capital by using the capital asset pricing model. You can use it to calculate the expected return of a risky asset. And like I mentioned, you can use it to find the discount rate for a new capital project or a new capital investment to really understand the cap capital asset pricing model.

You really have to break down the formula and the formula for expected return for equity is the risk-free rate. Plus a risk premium. Where the risk-free rate is, is shown as RF. And it's the rate of return on long-term us T bonds. And those T bonds typically would be 10 years or longer. The risk premium would be the rate of return on a market portfolio, which would be our M minus the risk-free rate.

And the difference between the two represents the risk premium and beta, which is multiplied by that risk premium. It measures the tendency of stocks to change with the market changes.

Now there are a couple of assumptions that any investor or anybody evaluating a project trying to calculate the cost of equity would have to use in order to apply the capital asset pricing model. And they would be investors aim to maximize economic utilities. The capital asset pricing model also assumes that investors are rational and they're risk averse.

They assume that there's, they're brought that their portfolios have broadly diversify. So they've eliminated all of the risk associated with concentration into one investment that they're price takers and that him, so therefore investors are able to influence prices. They're not able to influence prices, but they can lend and borrow unlimited amounts of money under the risk-free rate of interest.

They can trade without transaction or taxation costs. They can deal with securities that are divisible into small parcels and they assume market efficiency, which means that all information is available at the same time to all investors. W with all those insulations less focus our attention on beta because beta is the riskiness of an individual stock and it gauges the tendency of a securities return to move in tandem with the overall market.

So if beta is one, stock has the same volatility as the market. However, if, if beta is greater than one. You have what's called high systematic risk. And that means the stock is more volatile than the market. And if beta is less than one, you have low systematic risk, which means that it is less volatile.

Then the market

beta is estimated by regressing stock prices against a level of some broad market index. And beta is therefore. The slope of that regression line and it measures a company's systematic risk, no matter how much, but you try to diversify your portfolio. It's impossible to get rid of all risk. So investors require a rate of return that compensates it for taking on risks.

The capital asset pricing model is used to calculate investment risk and the appropriate return to expect. So let's look at market or systematic risks. And then we look at company risk or unsystematic risks. Market risks can not be eliminated by diversification and it's caused by changes in the market at large.

And it includes interest rate risk company risk. On the other hand is risk that the company will suffer losses in the future. And it can be eliminated by holding a diversified portfolio. So it's unsystematic risk. So let let's look at a company called McDonald's. We all know about McDonald's. Well, if you look at McDonald's, you'll see that using the capital asset pricing model that they actually have an expected return of about 9.8, 4%.

The way you get that is you just take the numbers and include it in and enter them into the capital asset pricing model. So the beta right now for McDonald's is at one point to the risk-free rate or the rate on treasury bills are about 3%. And the market rate in general is somewhere around 8.7%. So therefore the risk premium is the market rate minus the risk-free rate.

And it's 5.7%. So when you plug into the formula, the risk-free rate of 3% plus beta of 1.2 times the risk premium of 5.7. That's how you come up with your 9.84% for the expected return on McDonald's stock. Now you can graph the capital asset model pricing model on what's known as the security market line.

And that line shows the relationship between beta and expected returns. Every investment must plot along the security market line. So if you have a beta of one, then your return is the market return. If you. Have a beta of two, then your return is going to be somewhere North of the market return. And conversely, if you have a beta of less than one, let's say 0.5, your return is going to be half the return of the market return because there is a direct relationship between beta and the expected return on stocks.

Thank you. Welcome back to the financial management review. My name is Ron Harris so far, we've looked at present value problems and future value problems. And we recently finished going over some capital budgeting problems. And in each case we were given the discount rate or the interest rate to use to solve those problems.

Now that's okay. When, because when you're in your early part of your financial management career, you'll usually be given a hurdle rate or discount rate to use when you're trying to solve these types of problems. However, as you move up into the executive ranks in finance, that I know each one you have we'll have the opportunity to do in roles like the treasurer's role or the CFO's role.

You're going to have to be the one to determine what is the actual weighted average cost of capital that we should use when we evaluating projects jacks. Now, before we start, let me just quickly review what we'll cover in this review. We're going to look at weighted average cost of capital. What is that?

We're going to look at capital structure so that we can understand how do we come up with an appropriate capital structure, and then we'll actually look at. How you calculate the cost of capital. So the weighted average cost of capital is the average of the cost of various sources of financing. Each of which is weighted by its respective use in the given situation, the cost of equity.

When you're looking at capital structure, management is always going to be greater than the cost of debt. And so you need to keep in mind that investors are averse to risk. And as a result of that adverse aversion investors demand a higher rate of return on equity than on debt. And that's because invest in equity is riskier than invest in debt.

So when you're talking about weighted average cost of capital, before you go right into the calculations, first of all, you got to determine how much. Debt, should I use and financing the company versus how much equity should I use? So capital structure management focuses on finding the appropriate combination of debt and equity such that combined weighted average cost of capital is optimized.

Now I wish I can just give you a formula that says, use this formula and it will be give you the exact. Capital structure and weighted average cost of capital that you're looking for. But unfortunately there's no model to determine unequivocally what a proper debt to equity mix is for any entity.

And, and that's, that's important to know because you changes to capital structure weights can change the cost of capital. So really understanding how much debt versus how much equity you use. Becomes important, not only in determining the cost of capital, but also in determining what projects get accepted.

And also the overall riskiness of the firm. Now the optimal capital structure maximizes the price of the stock by balancing risk and returns. And in this case, the stock stock price of the stock represents the value of the company. Optimal capital structure is where the marginal tax shelter and the benefits of that tax shelter are equal to the marginal bankruptcy costs.

So when you use debt, you actually get a tax shelter benefit because interest expense is tax deductible. If you, if you draw a graph and on the X axis, you use various. Debt to equity ratios. And on the Y axis, you used interest rates, and then you plotted a line of what is the cost of equity at each one of those debt to equity ratios.

And what is the cost of debt at each one? What you'll see is the average cost of capital capital. The combination of debt and equity will actually decline as you add more debt. But it will plateau at some level. And for short range will bottom out before it starts reversing upward. And the reason for that is as you add more debt, there's a marginal diminishing return to the benefit of adding debt.

And then ultimately, as you increase the riskiness of the company and the default risk, the actual cost of capital, the total average cost of capital will increase. And so there's a continuous balancing act between how much that to use versus how much equity. So when you're trying to do Turman the capital structure, there are several factors that you have to consider.

I'm going to talk about six of those factors. First you have risk and risk falls under both business and financial risk business risk is one of the most important factors in determining an appropriate capital structure because business risks looks at the uncertainty inherited inherent in the projections of your earnings or your net income or cash flows.

The next one is the financial risks and financial risks comes about because the entity decides to carry debt. So as you add additional debt, you're adding additional risk to the company. Next, you would look at the degree of operating leverage and the degree of financial leverage. Well operating leverage as measured by contribution margin divided by.

EBIT or earnings before interest and taxes, and you would be considered to have a high degree of operating leverage if a small change in sales results in a large change in operating income with respect to financial leverage, you calculate that by taking earnings before interest in taxes, divided by the earnings before interest in taxes, minus interest.

And you will be considered to have a high degree of financial leverage. If a small change in earnings before interest in taxes, results in a large change in common shareholders. Turn the next factors that are, that go into determining the capital structure of a firm would be stock valuation factors, analysis factors, and dividend policy.

Well, I've talked a little bit about the stock valuation factors. When I mentioned that you're always balancing the interest tax shield versus the risk of bankruptcy, but analysis factors. There are several different things you have to think about. You have to look at the sales stability. You have to look at profitability of your asset structure.

You'd look at your growth rates, even management point of view, because some management teams are more conservative than other management teams look at borrowing capacity and you look at the control of owners. And then lastly, you look at your dividend policy. If you when you look at what's called a payout rate if your payout rate is high, where you pay out a high percentage of your, of your earnings in dividends, that actually reduces the uncertainty for stockholders versus the plow back says, maybe I want to return or, or keeping the business a large percentage of my earnings, because I have high expectations for growth of the projects that I'm considering.

So now once you've determined what your targeted capital structure is, then you can start calculating the actual cost of capital. Well, let's look at the cost of each one of your sources of capital. So the cost of debt. Well, that equals interest rates, excuse me, interest expense times one, minus your tax rate to get your after-tax interest expense.

And then you divide that by the average market value of debt. Next you turn to, if you have it, you look at the cost of preferred stock while the cost of preferred stock equals your preferred dividends divided by the average market value of preferred stock. Next, you look at the cost of common stock, which is determined by the dividends on your common stock.

Divided by your average market value of the common stock and two that if there's growth, you add your expected dividend growth rate. And then lastly, the, the sources of capital that's generated internally, which is retained earnings equals one minus the marginal tax rate times the cost of common stock.

So combined. That those are your four different sources of capital and the costs, how you calculate the cost of that capital. Now, determining the, depending on your, your, your target capital structure, you're going to have a certain amount of your, the value of your firm represented by debt and a certain amount represented by common stock.

So the value of the firm equals the market value of equity. Plus the market value of debt. And we use the letter E for equity and the letter D for debt. And so you to come up with the weight for debt, which is WD you just take your total debt and divided by your, the value of the firm V and then to come up with your weight for common stock, which is w common stock WCS that equals.

The value of equity divided by the total value of your firm. So when you take the weights, plus the cost of capital that you've calculated, you can put it into a formula that's known as the weighted average cost of capital. So the weighted average cost to capital is the weight of debt times R which is the R D, which is the cost of debt times one minus T.

So that you get your after-tax weighted average cost of debt. Then you take your weight for preferred stock times are, or the, or the cost of preferred stock, and you multiply them together to get your overall cost of preferred stock. Your weighted cost of preferred stock. Plus the, the comp the product of.

The weighted cost of stock, which is represented by w subscripts CS times R subscripts, griot, subscripts CS, which is the required return on your cost on common stock. So you take the three, the after-tax weighted cost of debt. Plus the weighted cost of preferred stock, plus the weighted cost of common stock.

And that's how you get your weighted average cost of capital.

Now you must be mindful that there are a few things, mistakes that you need to avoid, or I like to call them the four don'ts when you're trying to calculate your weighted average cost of capital first, never use or don't use the coupon rate on existing debt. Rather use current interest rates on new debt.

Don't use book values to estimate weights. When I was going over the targeted capital structure, we always used the current market values for, for, for that source of capital, not book values. Next don't subtract current long-term bond rate from the historical average return on common stock to calculate the risk premium.

Use expected future returns on stocks. And lastly don't include non investor funds as a source of capital. And example of a non investor funds would be when you extend your payables to actually fund your receivables. That's not an, that's not a capital source that so only use capital. That's a capital source, but it's not provided by investors.

Only use capital from investors. The best way to illustrate the weighted average cost of capital would be to let's look at a problem and let's look at high tech company. High tech company has 1 million shares outstanding of common stock. And currently their common stock is trading at $60 and 60 cents per share bank debt is 10 million at an 8% fixed rate.

And the long-term bond, which is another source of debt is 10 million and it's trading at one Oh two. So the fact that it's trading at one Oh two tells me that it's trading at a premium and the coupon rate is 8%. So I'm not surprised that when you look at this, you'll have to be able to understand that we've got bank debt and long-term bonds debt that we have to consider.

And, and, and the long-term bond matures in 12 years. So if you look at this problem, you have to also look at what's the beta of the firm. What's the risk-free rate. And in this case is 3%. The beta is 1.1. The market rate is 8.7% represented by RM. And so your market premium, which is RM minus RF or your risk-free rate, and that's 8.7 minus 3.0.

And the market premium is 5.7%. And, and high-tech company has a corporate tax rate of 35%. So what is the weighted average cost of capital? Let's do it in steps. Let's calculate it in steps. Step one. First you calculate the value of the firm. And as I mentioned earlier, the value of the firm equals the value of debt, plus the value of market value of equity.

So to calculate the value of debt, you add your bank debt. Plus the market value of the bonds bank debt was 10 million. The market value of the bonds is actually 1.02 times. 10%. Remember it was trading at 102%. So it was trading at a premium. So 1.02 times the 10 million. And when you add the two, you get 20.2 million.

The market value of common stock, which is represented by E equals the current price of the stock, $60 and 60 cents times the 1 million common shares. Outstanding. So it's 60.6 million. So when you add the, the market value of common stock, 60.6 million, plus the market value of the sources of debt, 20.2 million, you get the value of the firm of 80.8 million.

So now that you've got the value of the firm, what you do in step two, you calculate the weights for each capital source. And so the weight of debt, which is represented by w subscript D. Equals your 20.2 million, which is your market value of your debt divided by the market value of the firm 80.8 million.

And you get 25%. Then when you turn to your weighted, your weights for, for equity, you take. The 60.6 million, which is the market value of equity divided by the total market value of your firm of 80.8. And you get 75%. So our target capital structure for high-tech company is 25% debt. 75% equity. Step three, we calculate the expected return on common stock and the expected return on common stock.

What do we do? We turned to the capital asset pricing model that we talked about in an earlier review. So R E R F equity equals the risk-free rate. Plus beta times the market premium and the market premium is RM minus RF. So if the risk-free rate is 3% and the beta for high-tech company is 1.1. And the market premium is 5.7.

When you plug those numbers into the capital asset pricing model, you get 3% plus 1.1 times 5.7, the market premium. And when you do that math, you get the number 9.27%. So our weighted average cost of equity using the cap M is 9.27%. Next we have to calculate the required rate of return on debt. In this case, it's a two step process because we have two different types of debt.

We've got your bank loan and we've got your bonds. And so when you look at the formula that's used for calculating the price of bonds, we go back to what we learned on how you price bonds, and you would see that. The formula would become, and you don't have to memorize this formula, but the formula really looks at the two cash flows that come from a bond and you've got your cashflow.

That's coming from the dividend payments and it's coming from, and the cashflow, excuse me, from your coupon payments and the cashflow that's coming from the return of your principal. But what you're trying to do is you're trying to solve for our. So when you, you will be get, you will always be given the tools to calculate this.

You will not be responsible for calculating this, but when you put it in the formula that's given, you'll see that the yield on for art on the price of the bonds is 3.8, 7%. And that's R but the yield to maturity, it turns out to be 7.7, 4%. So your costs, your actual cost of debt will be 7.7, 4%. You don't use the coop.

You don't use the effective coupon rate. You actually use your yield to maturity. Next, you look at the weighted average cost of debt. And in this case, you say half of my debt is at 8%, which is the rate on the loan. And half of my debt is that. 7.7, 4%, which is, which is the the weighted average cost of the bonds.

And so when you add them, when you add it together, you get the weighted average cost of debt, which is 7.87%. Last step is you calculate the overall weighted average cost of capital. And the weighted average cost of capital is again, though. Cost of the component times it's respective weight. So we remember that the cost, the, the w the weight use for debt in our capital structure is 25%.

So we take our weighted average cost of debt, which is 7.8, 7% one minus 0.35, which is our after tax. D after tax rate so that we come up with our weighted average after tax cost of debt, plus the 75% weight that we have in our targeted capital structure for equity times 9.27%, which is the cost of equity, which we calculated using the capital asset pricing model.

So when you add those two together, weighted average cost of capital is 8.2, 3%. So a couple of observations. What you see is that the stockholders are requiring a higher return than the creditors. And the reason for that is debt debt holders get paid. First also there's less risk to debt holders because debt holders actually could drive a company into bankruptcy if they default on those payments.

And then lastly, stockholders get a required rate of return. Based on what the return that we calculate using the capital asset pricing model. Thank you very much for your attention.

Yeah. Welcome to the financial management review. My name is Ron Harris in this session. We're going to talk about working capital. We're going to look at and get an understanding of what is working capital and how do you manage two of the components of working capital cash and accounts receivables working capital equals current assets.

So that would be cash marketable, securities accounts, receivables and inventory networking capital would be current assets minus current liabilities. When you're trying to manage the first component of working capital cash, there's a couple of different ways to manage the balances. There's an approach called the transaction balances that are, that represent the associated routine payments and collections of cash.

While you start by developing a cash budget of inflows and outflows, and that would include the payments of. Capital asset purchases, inventory, and expenses. And then as you're building your Mo your cashflow budget, what you have to do is consider the timing and collections from customers, collections from debtors and the, and the collection of cash from capital assets sales.

In addition to forecasting your transaction balances, you have to, you have to forecast your compensate and balance needs. And compensating balances are specific minimum balances required by banks to improve yields on lines of credits that they may provide to you. And to offset the associated service costs.

Usually a minimum monthly weighted average balance must be held on deposit. In addition to transaction balances and compensating balances, you also could have a need for precautionary balances of cash and speculative balances. The precautionary balances are to help you. When you have uncertainty around the timing of your collections and outflows, and the speculative balances would be, if you just want to have something extra in case a unique opportunity occurs.

And you want to take advantage of that opportunity. You'll have the cash. Now, there are several, there's a couple of them different tools that you can use when you're trying to manage your cash. And the first approach is synchronization and that would be arranging your collections and your payments so that the receipts coincide with the hours flows.

Additionally. And in addition to making sure you have the The the flow synchronized, you can actually impact the timing of the flows. You could speed up collections, or you can slow down payments. You speed up collections by using lockbox service from a bank and as well along with electronic funds transfer.

Versus you try to slow down the payments by using an account call control disbursement account. There was really popular in the, in the eighties and nineties, not as popular today because the fed system, the clearing system has improved so dramatically is really difficult to get any advantage from having an account in a remote location that you would call a control disbursement.

Now what you're trying to do. With synchronization and the speeding up and slowing down of payments, it's really trying to generate some float and float is the difference between. The amount on the depositors' books and the balance, according to the bank, if the balance, according to the bank is greater than the balance on your books, you actually have additional funds that you have use of that you weren't expecting, and you actually have positive float.

Now, if the, if the alternative exists where the depositors' books are, are lower. Then the balance in the bank are higher than the balance in the bank. Then you actually have an overdraft and that's not, that's not good. That's a problem

from time to time, you're going to have seasonal needs for cash. And so you hold marketable securities during Slack periods and you sell them doing peak periods. Alternatively, you could use short term borrowings from your line of credit at your bank to cover the peak period to cover the peak periods.

And you can repay those when you don't have the cash needs or an alternative strategy would be to combine the management of your marketable securities and use some short term borrowings. One of the tools that are used. To manage cash, actually the optimized cash is called the Beaumont model and, and it is actually utilizing the similarities between the economic order quantity model that's used for managing inventory and it's applied for cash management.

It does have some, some simplifying assumptions that include stable, predictable cash flows, and it doesn't allow for too much seasonality. Or cyclical trends. So if you look at the variables that are included in the economic order, quantity model that's used for inventory and the Beaumont model that's used for managing cash, you see that you each has three primary variables.

You have fixed costs, demand for the period and opportunity costs. So let's look a little bit deeper into these components. So the optimal or ideal level of cash is represented by C C star CEI strictest. Plus F is the fixed cost of selling securities to replenish cash or the fixed costs of borrowing money.

T is the total amount of new cash needed for transaction purposes. Over a relative period of relevant period, which could be a year, a quarter or a month, and RS the interest rate on the marketable securities. So when you put those together, there's a formula that says the ideal level of cash represents the square root of two times T times F divided by R you can use that formula to calculate your ideal level of cash.

Let's look at a couple of diff a couple of different problems that may have, they may appear on the BEC CPA Exam relating to cash management or, or accounts receivable management. Let's start with cash management. The Brooks company's treasury is considering purchasing a lockbox service from Wyoming bank daily cash receipts are $400,000.

If he utilizes this service, he'll be able to reduce his collection time. By two days, the expected return on the collections is 8% and the monthly lockbox fee is $2,000. So what will be the annual increase? The earnings before taxes from using this lockbox service? Well, first you start by calculating the pre-tax interest on collections.

So that would be the $400,000 of daily collections. Times two days, times your 8% return and that's $64,000. Next you calculate real simply the annual lockbox cost, which will be 2000 per month, times, 12 months or $24,000. So your annual net benefit of using the lockbox service would be your $64,000. Of pretax interests on collections Monisha 25, $24,000 of annual lockbox costs to give you a total of four $40,000 64,000 minus 24,000 gives you $40,000.

Let's turn our attention to accounts receivables. Now outstanding accounts, receivables will equal your credit sales times. The average time between sales and collections. Now the optimal credit policy tries to match credit costs with profits from the related sales volume that occurs by offering terms easing credit policy stimulates sales, but it also increases your costs.

Now there's several variables that are associated with credit policies, they would include, you have to look at the credit standards of your customer, the credit quality of your customer, the credit period, which is the length of time that credit is going to be extended. You have to decide, am I going to offer cash discounts or not?

You have to look at your collection policy. How am I going to handle those past due accounts? Interest core interest income could come into play. If you're able to charge a carrying charge of carrying charge on accounts receivable, and also you can use a tool called aging schedule so that you can highlight any overdue accounts receivables.

The final variable that you really have to look at is you have to perform an incremental analysis that really looks at what's the reaction. To the new policy, the reaction of the customers, as well as the reaction of your competitors. Now, the impact of a credit period increase that really is the incremental sales that occurs from the period, increase times the contribution margin associated with those sales.

Now remember you get more sales, but they're also some costs. So you have to subtract from that to get the impact. You have to subtract the cost of carrying new accounts, receivables, plus incremental bad debt losses that may occur. Plus incremental fixed costs from the increased pile in in the credit period.

Now the carrying cost of carrying new accounts receivables. That equals your incremental investment in accounts.

let's look at credit policy because that's a big component of your accounts receivable management. You look at, if you had policy where you were offering a 3% discount for anybody that pays their, their, their accounts receivable off in 10 days. And no discount if you pay beyond 10 days, but you have to pay by 30 days.

Well, that's represented by three slash 10 net, 33%. If paid in 10 days with the net receivable being due in 30 days. Now, some customers will pay on day 10 and take the discount. In this case, if you had a thousand dollars receivable. And they took the discount. They would only pay, they would have to pay within 10 days and they would only pay $970.

Now others are going to pay on day 30 and forego the discount. So by day 30, they're going to pay the full $1,000 to find out just how much is it costing you for this credit policy is really a present value or future value problem. And so if you want it to calculate. How much is it costing me? You would actually take the $1,000 and divided by one plus R raised to the 20th, over three 60 power.

And that will equal $970. So if you rearrange the formula using algebra, you would get one plus R raised to the 20, over three 65 power. Equals 1000 over nine 70, then you would see that R equals 3.09278%. So doesn't seem like a lot, but over 20 days it doesn't seem like a lot, but if you actually looked at our and annualized it so that you, again, manipulate the formula, so R equals 1000 divided by $970.

Raised to the three 65 over 20, not 20, over three 65, but three 65 over 20 minus one. You would say that the annual interest rate is 0.743, five or 74.35%. That seems like a high price to pay. So what you really have to do is look at the additional sales from the extended credit. And see if those more favorable terms provide a greater return in terms of higher sales, because you have to offset that opportunity costs for those new terms, which is paying 74.35%.

Let's look at another problem that is associated with managing receivables. And let's say we have a credit policy change where we lengthen the average collection period. Okay. Stiff stiffening company is evaluating a proposed credit policy change. The changes include increasing the collect, decreasing the collection period from what it is currently 60 days to 27 days.

Some of the assumptions that we have is we forecast total sales next year of $128 million. That's assuming we don't change the policy. If we change the policy and shortening credit. The collection period. Total sales next year will only be 75% of what they otherwise would have been. So 75% of the one 28 there will be credit sales under the current policy will be 128 million times 0.7, five or 75% of the sales will be credit.

And then the number of calendar days that we're going to use for calculating this problem in this problem is 360 days. So what is the potential decrease in average accounts receivable balance of implementing the proposed policy. First, we want to calculate the accounts receivables using under the current policy.

So we would take our 128 million times 0.75. Divide that by three 60 times, 60 days, the current collection period, and we get $16 million of accounts receivables under the current policy with total sales of 128 million credit sales under the current policy, which is 75% of total sales is 96 million credit sales.

The credit sales reduction under the new policy. It's going to be $32 million. So our credit sales under the new policy will be the $96 million of credit sales under the current policy, minus $32 million of credit sales reduction because of the shortened collection period two. And that will equal $64 million of credit sales under the new policy.

So finally, what is the potential decrease in average accounts receivable balance of implementing the proposed policy? Well, accounts receivable reduction due to the new policy equals $64 million divided by three 60 times 27 days. And that equals $4.8 million. So. Our accounts receivables with the new policy, we take the 16 million minus the 4 million reduction in accounts, receivables of 4.8 million and our accounts receivables.

Our average accounts receivable decrease as a result of those policy will be $11.2 million. Thank you for your attention.

welcome back to the financial management review. I'm Ron Harris. We're going to continue our CPA review of working capital working capital management requires the balancing of profitability with liquidity. Working capital has a fluctuating layer and a permanent layer generally. The fluctuating layer of working capital is financed with short-term borrowings while based, because of conservative management, the working capital that's permanent is financed with longer-term debt, and sometimes they use a combination of short term and long-term to finance the variable and the fixed working capital requirements.

When you're looking at your overall working capital policy, you can have a flexible policy or you can have a more restrictive policy. The flexible policy would say that you have large cash and Mark marketable security balances. You would have large inventory investments, a very liberal credit terms as well as a high level of accounts receivables.

A more restrictive working capital policy would have low cash and marketable security balances. Small inventory investment would not allow any credit sales and therefore wouldn't have any accounts receivables. One of the biggest components of working capital depending upon your company is inventory.

And the goal of inventory management is to minimize the total cost of holding the inventory. And there's two components to that. Holding costs, it's carrying costs and shortage costs. And what you're really trying to do is you're trying to balance the cost of having a shortage, not having enough inventory available to either produce your product or to sell the product, to meet demand.

Right. Against the carrying cost. So the cost of actually having and holding that inventory, and you're trying to minimize the total cost by balancing carrying costs with short term costs with shortage costs. And if you look at a graph, you would see that the optimal carrying costs. Would be the the optimal investment in, in, in inventory would be your investment in inventory, on the X axis with your cost of caring or cost of shortage being represented on the Y axis.

And you're looking at the, trying to find the point where the two. CROs were carrying costs and shortage costs cross. And that will give you your minimum or optimal total cost of inventory of carrying inventory. Now inventory carrying costs includes opportunity costs because you could get a greater return.

There's a possibility that you get a greater return on using the dollars. That you've got invested in inventory and into some other areas or into maybe some other projects. It also includes the cost of maintaining the economic value of that inventory, such as warehousing costs and refrigeration costs.

It's important to remember that if carrying costs decrease, it's cheaper to hold inventory, and that will result in fewer but larger orders of inventory. Now shortage costs include ordering costs. So the cost of placing an order for more inventory you have to balance that with having more inventory.

It also looks at the cost related to safety reserves. So for example, lost sales may occur. If you don't have enough safety stock or enough inventory to begin with, it may be the customer Goodwill that you lose. If you don't have inventory on hand, when they want to buy it. And from a production standpoint it may disrupt your production schedules so that you cannot meet the customer requirements.

Now if ordering costs decrease, there's going to be little incentive to minimize your orders. And that's going to result in more orders, but of smaller quantities. There's a tool that you can use to help you manage inventory. And it also can be used to manage production scheduling. But in this case, we're going to look at the tool of economic order quantity, which is.

The purchase order size that minimizes the total inventory order costs and inventory carrying costs. So when you look at the economic order quantity model there's three main components to it. There's audit, audit, ordering costs, which is a fixed cost. There's the total dollars of sales, which is demand for periods.

And then there's the per unit inventory carrying costs, which is your opportunity costs. What I did for you, because you could get a question on the CPA Exam that looks at production related quantities. And so I've actually shown here where you've got the setup costs, which is your fixed cost necessary for a production run, your unit demand, which is the band for the period.

And then you've got your per unit carrying costs. Now looking at the actual formula. Economic order quantity equals the square root of two times. Your ordering costs times your average demand divided by carrying costs per unit what's included in ordering costs would be things like quantity, discounts, loss, shipping costs, purchasing costs.

And if you were talking about production, it would be set up. Cost for a manufacturer. Your Andrew demand is influenced by inventory usage rates. So if you're turning your inventory faster, if demand is high, that's going to actually increase your economic order quantity. And then lastly carrying cost per unit.

And that again, includes handling insurance interests on invested capital storage costs and spoilage and obsolescence. Let's say, for example, we had. Ordering costs of $100 and we had annual demand or some period demand of 10,000 units. And that our costs are carrying cost per unit was $2 while you would just plug those numbers into the economic order quantity model.

And you would get two times, 100 times, 10,000, divide that by two and your optimal order size or your economic order quantity would equal 1000. Now, in addition,  concerning yourself with your order size. You also have to know some other things about managing inventory. And first of all, safety stock safety stock is extra inventory to cover demand uncertainty.

So if the demand has some variability and there's some uncertainty around it, you, you may have to have some safety stock to prevent stock outs. You also have to understand what's the lead time, which is the time lag between placing an order and the receipt of the goods, because that will determine what your reorder point is.

And that is again, the estimated demand during your lead time. Now, if you have safety stock, that reorder point changes a little bit, because it then equals the anticipated demand during the lead time. Plus the level of safety stock to get your reorder point, let's say, look at an inventory management problem, to try to understand some of the concepts we've just gone over the pickle pharmacy company wants to determine the optimal safety stock level for drug alpha.

The total cost of safety stock, which equals the carrying costs plus expected stockout costs. Also the annual carrying cost is 25% of inventory. Investment inventory. Investment average is about $10 per unit. Stockout costs is $2 per unit and pickup orders, alpha product 20 times annually. Now. If Picco has 100 units of safety stock, and there's a 15% probability of a 30 unit stockout per order cycle.

So the question becomes, and there's a lot of information here, but the question is what is the annual cost of the 100 units of alpha safety stock?

so to, to get the solution, let's, let's take this step by step. Step one first you calculate the annual safety stock carrying costs average, and that equals your average inventory investment times, your annual carrying cost percentage, times the units. And so it's $10 per unit, your average inventory, investment times, your annual carrying cost percentage, which is 25% per unit.

Times 100 units and you get $250 as your annual safety stock carrying costs. Then step number two, you calculate the number of expected stock outs. Well, the probability of a stockout times, your number of order cycles. So 15% is the probability of a stockout times. 20 order cycles equals three times. Step three would be to calculate the stockout costs per occurrence and annually.

So there you take your units per stockout, which we said is 30 times your safety stock per unit, which is $2 per unit and you get $60 of costs per occurrence. And we just saw where we have three. Stockouts per per year. So our cost is $180 annually for a stockout. Now to get the total annual costs, you say your $250 of carrying costs.

Plus $180. Stockout costs gives you a total cost of safety stock of $430. Thank you for your attention.

Welcome back to the Bisk CPA review for business environment and concepts in this cpa review course class, we're going to begin our discussion of planning and measurement. My name is Bob Monette. I'll be your instructor for this section. And I think, you know that in planning and measurement problems, what we are dealing with primarily is manufacturing companies.

And of course, Any discussion of manufacturing companies will lead inevitably to a discussion on cost accounting. But before we get into cost accounting, I want to start with something a little bit more basic than that. I want to start with some absolutes. I want to start with some concepts that will always be true in any manufacturing company problem, regardless of the cost accounting system that's being used.

For example, In all of these manufacturing problems, you're always going to be dealing with the same basic flow of activity. It's never going to change. So let's go over it. In all these problems, we are dealing with companies that buy raw material, hire labor, to work on the raw material, to produce the finished goods.

That is always the flow of activity. They buy raw material. They hire labor to work on the raw material to produce a finished goods. And if you stop and think about it, that flow of activity naturally leads to three inventories. If you buy raw material, hire labor to work on the raw material to produce a finished good.

You naturally end up with reinvents. You end up with an inventory of raw material. You end up with an inventory of work in process. These are partially completed goods, goods. You haven't had time to finish. And of course, You have an inventory of finished goods. So you always look for those three inventories.

It doesn't matter which cost accounting system is being used. Now, one more absolute in all these manufacturing problems, you will always be dealing with the same three basic elements of production. Let's go over them. Number one would be direct material, direct material. Represents raw material costs applied directly to units.

In other words, what your units are made of essentially number two would be direct labor direct labor represents labor costs applied directly to units. There are people who work on the assembly line. There are people that work on units that's direct labor, and then the third element of production. Is everything else and we call everything else.

Factory overhead factory overhead represents all the indirect manufacturing costs, depreciation on the factory insurance on the factory property taxes on the factory supervisors, salary supplies for the factory utilities. What we do is lump all the indirect manufacturing costs under one heading.

Factory overhead. So those will always be your three basic elements of production, and they're never going to change in any one of these problems. Now, the first type of problem we're going to look at together is a problem. the CPA Exam has always liked, and that is how a manufacturing company develops its cost of goods sold.

And what you have to remember is that if you're trying to develop cost of goods, sold for a manufacturing company, This schedule has three separate and distinct sections. And basically the three sections follow the three inventories. The three sections are basically going to follow raw material work and process finished goods.

It just follows the three inventories. Let me show you what I mean. Hopefully you've already downloaded the file for this class and if you've printed out the problems, we're going to do problems one and two. Notice in problem. Number one, they want to know the amount of direct materials that were purchased.

Well, let's think about how we develop cost of goods sold for manufacturing company. The first section is called cost of materials used. And of course, when I say cost of materials used, I mean, cost of direct materials used not indirect materials like supplies. Remember that's part of factory over here.

That's not what this first section is about. If I'm going to do costs of direct materials used, I start. With the beginning inventory of raw material, then I add the raw material purchases for the period that gives me material available for use. Then I back out the ending inventory of raw material, and that gives me what I need cost of direct materials used, but the period it's pretty logical section.

Now let's fill it in. As far as we can. We know the beginning inventory of raw material, 15,000. We don't know the purchases that's missing. So we don't know available, but we do know the ending inventory of raw material, 20,000. And of course the key to this whole thing is in the problem they gave us cost of direct materials used for the period 95,000.

Now I can start working backwards. If cost of direct materials use was 95,000 and the ending inventory of direct material was 20,000. I just added up available. Must've been 115,000. And now I can solve it. If the beginning inventory of direct material was 15,000 and the available was 115,000, we must have purchased a hundred thousand of direct material during the period.

So the answer to number one is D. Now the second section is called cost of goods manufactured. And in fact, some textbooks call this whole statement. He cost of goods, manufactured statement. But the middle section is called cost of goods manufactured. And of course, because it's the middle section. I deal with the middle inventory.

Remember the three sections, just follow the three inventories. So I'm going to start with the beginning work in process inventory, which in this case was $7,500. Remember these are partially completed goods, goods. I didn't have time to finish. Then I add in the current production cost for the period what's current direct materials used.

95,000. I got that from the schedule above. Remember the schedules are connected that 95,000, we just calculated above in the first section. Now direct labor that's. We don't know that we have to. That's what we have to work out in question number two. Now how about the overhead? Would I use the actual overhead costs?

72,000 or the applied 75,000. the CPA Exam loves giving you this choice. You're going to pick up applied anytime you're doing this cost of goods, manufactured statement, put in the overhead, applied to units. Remember the difference between your actual overhead costs and your applied overhead. That's your overhead variance.

We're going to talk about that. In another class, but that overhead variance, some of that overhead variance would be allocated to cost of goods sold. Some of that overhead variance would be allocated inventory. You don't deal with that now. So if they give you a choice between actual overhead costs, And overhead applied in this schedule, you should always put in the overhead applied to units.

So that's 75,000. Now, if you add all of that up, that's going to give you your total production costs, which right now I do not know. I do know the ending inventory of work and process 10,000. And of course notice what's given here is cost of goods. Manufactured cost of goods. Manufactured is 257,500. Now again, I can start working backwards.

If cost of goods manufactured was two 57, five. And the ending inventory of work in process was 10,000. My total production cost just added up. It must've been 267,500. Now I can plug the direct labor costs for the period. Must have been 90,000. And the answer to number two is C let's carry through to the third section.

The third section is called cost of goods sold. And if you're going to work out cost of goods sold. You start now with the third inventory, which has finished goods. Remember the three sections follow the three inventories. So you start with the beginning inventory finished goods, 32,500. Then you add the cost of goods manufactured that you just figured out above.

Remember the three sections are connected, so that was 257,500. That gives you goods available for sale 290,000. Back out the ending inventory of finished goods, 25,000. And that would give you a cost of goods sold 265,000, which they did not ask for in this set, but they do fairly often. Just remember, just make sure you know how to do that entire statement.

All three sections. Now I want to show you a couple of shortcuts. If you're in the exam, you get a problem like this, and they asked you for costs of goods sold. There's a quick way to work out cost for goods sold. You don't have to do all three sections. I show you all three sections because as you've already seen, they can be something missing somewhere in any of the sections.

You have to find it and plug it somehow. But if they just want to know cost of good soul, there's a fast way to get it. If you just want to quickly get the answer, start by adding up all the beginning inventories you'd add up. Beginning inventory of direct material. Beginning inventory of work in process, beginning inventory of finished goods.

They add up to 55,000. Just add up the beginning inventories, then add in what happened in the current period. Current raw material purchases, a hundred thousand current direct labor. Remember that came out to 90,000 current overhead applied, not actual costs, overhead applied 75,000. If you add that up, notice, all I've done to this point is add.

That gives me a total of 320,000 of costs. Then I just back out the total of all my ending inventories, I add up the ending inventories of raw material work in process, finished goods. And oddly enough, they also add up to 55,000, but that would also give you cost of goods sold 265,000. Sometimes it's good to know that shortcut, if you just want to quickly figure out cost of goods sold, also that little shortcut will work for you.

If you want to quickly figure out cost of goods manufactured. If, if you're trying to figure out cost of goods manufactured, the shortcut also works, but now you just deal with the first two inventories. In other words, you'd add up the beginning of inventory of direct mail and work in process. Only they add up to 22,500.

Just add up the beginning inventory for just direct material and work in process. As it's 20 to five, then you add in the current. Period costs current raw material purchases, a hundred thousand current direct labor, 90,000 current overhead, 75,000. You add it up that it gives you a total costs of 287,500.

Then back out the total of ending direct material and work in process, which adds up to 30,000. And that gives you a cost of goods manufactured to 50 75. So this is a couple of shortcuts that might come in handy. Now, also, when you. Downloaded the file for this cpa review course and you printed out the problems.

You'll notice that there are three more problems for this class. Let's do three, four and five, three, four, and five. Also require you to think about how a manufacturing company develops the cost of goods sold in question number three, they want us to work out prime costs. We'll remember what prime costs are.

Prime costs are direct material and direct labor. Those are your prime costs, direct material and direct labor costs. Well, we know the direct labor costs are 30,000 that's given, but you had to work out is the cost of direct materials used for the period not purchased used. So let's work out our section.

We're going to take the beginning inventory of direct material, 18,000. Plus the raw material purchases with a period 42,000, that gives you material available 60,000 back out the ending inventory of direct material, 15,000. And that gives you what you need cost of direct materials used 45,000. If I take the cost of direct materials used 45,000 and the direct labor costs for the period 30,000, that gives me my prime costs of 75,000, which is answer date.

But prime costs are defined as direct materials used, not purchased used, and direct labor costs for the period. Those are your prime costs. Now in question number four, they want to know conversion costs. Conversion costs are defined as direct labor and factory overhead, direct labor and factory overhead.

So. We know the labor payroll that's given that's 30,000. What you had to work out is the overhead applied and notice overhead is applied at $10 per direct labor hour. So you had to work out how many hours they must've worked. If you take the payroll, which is $30,000 divided by the hourly rate, $7 and 50 cents.

We know that they must've worked. 4,000 hours. And if they're applying overhead at $10 per direct labor hour, you take that $10 times, 4,000 hours. The overhead applied must've been 40,000. The payroll was 30,000 conversion cost. Must've been 70,000, which is answer B conversion costs are defined as direct labor and notice overhead applied, not actual overhead costs, overhead applied.

Now in question number six, excuse me, question number five. We have to work out cost of goods manufactured. And once again, it helps if you know the three sections and we know that when you developing cost of this old for manufacturing company, the three sections, just follow the three inventories. So because cost of goods manufactured is the middle section.

We deal with the middle inventory. We're going to start with beginning work in process, which was $9,000. Then you add in the current production costs, what was current direct materials used 45,000. We work that out in question number three. Remember that the sections are connected. Current direct labor payroll, 30,000 that was given overhead applied.

Remember that was $10 an hour times, 4,000 hours work 40,000. If you add that up, total manufacturing costs come out to 124,000. Then it's just a matter of backing out, ending work in progress, which is 6,000 that gives you what you need. Cost of goods manufactured 118,000, which is answer D but of course my main point is don't win that exam and not know how to develop cost of goods sold for manufacturing company.

And the big thing to remember is the schedule takes three sections and the three sections follow the three inventories. I will look to see you in our next class. Keep studying don't fall behind,

come back to our discussion on planning and measurement. And what we're going to get into next is the type of problems the CPA Exam can ask on decision-making before we get into decision-making problems, I want to step back and go back to variances for just a moment. Remember in our class on variances, we said that direct material and direct labor are considered purely variable costs.

Why is that? Because the amount of costs we incur is directly related to the number of units produced or the number of hours worked. But we also said in that class, that factory overhead, our third basic element of production. Is really both variable and fixed. And I'm sure you remember why factory overhead represents all the indirect manufacturing costs.

And the fact is some of those indirect manufacturing costs we throw under factory overhead would be variable like supplies. Some of the indirect manufacturing costs that we throw under factory overhead would be fixed like depreciation. So bottom line is. Factory overhead. Our third element of production is variable and fixed.

And what we're going to get into next in the area of decision-making is mixed costs. A mixed cost is a cost element that is considered partly variable and partly fixed. For example, supervisor salaries. That would be a classic mixed cost. Why is that? Because no matter how low production falls, you always need some level of supervision.

It's really hard to eliminate supervision. There's always some level of supervision, no matter how low production falls. So some part of it is fixed. On the other hand, if production skyrockets supervision would go up. So there's a part of it. It's variable maintenance is another good one. Hey, no matter how low production falls.

There's always some level of maintenance. So some part of it is fixed, but if production skyrockets maintenance would eventually go up. So some part of it is variable. And what you have to know for the CPA Exam is the high, low method of breaking down a mixed cost into its fixed and variable parts. Let's go to question number one, Matt company.

Notice that Matt, when that handles 80,000 kilos. Matt spends $160,000 on handling costs. But when Matt handles 60,000 kilos, Matt spends 132,000 on handling costs. The question is what would handling cost be if Matt handles 75,000 kilos? God only knows what Matt is dealing with here with these kilos. We don't have to get into that, but what does it really cost Matt to handle 75,000 kilos?

Well, as I've already said, which you have to know for the CPA Exam is the high, low method of breaking down a mixed cost into its fixed and variable parts. Here's the key to it. In the high, low method you take. The change in cost. Take the change in cost and divide by the change in activity. That's the secret to it.

It's the change in cost and you divide by the change in activities. Let's put this in. We know that when Matt handles 80,000 kilos, Matt spends $160,000 on handling costs. When that handles 60,000 kilos, Matt spends 132,000 on handling costs. The point is when kilos went up 20,000. Handling costs went up 28,000.

Again, you're going to take the change in costs and you're going to divide by the change in activity. If you take the change in cost $28,000 divided by the change in activity on additional 20,000 kilos, what that tells you is that a dollar 40 of every KIBO must be purely variable handling costs. When you take the change in costs and divide by the change in activity, what you're isolating is the variable part of the cost.

Now here's the point. Once you have the variable part of the cost, now you can plug the fixed. All you have to do to get the fixed is go to any level of activity they gave you the problem I'll use 80,000 kilos. What do we now know happens at 80,000 kilos? Well, at 80,000 kilos, we now know from the last question that a dollar 40, every KIBO is purely variable handling.

So you multiply that out at that level. They're spending 112,000 on variable handling. Well, 48,000 must be fixed. Why? Because that gets you back to the 160,000. They spent in total on handling cost at that level, just to show you, it doesn't matter what level you test. Let's go to 60,000 kilos at 60,000 kilos.

We now know a dollar 40, every kilos, purely variable handling costs. You multiply that out at that level. They're spending $84,000 on. Variable variable handling. Well, 48,000 must be fixed. That gets you back to the 132,000. They spent on that level. Notice once you have the variable part of the, of the cost, then you can plug the fixed.

All right. Now we can answer the question. What does it really cost Matt to handle 75,000 kilos? Well, if Manny handles seventy-five thousand kilos, we know that a dollar 40, every kilo is. Purely variable handling. And you multiply that out at that level, that is spending 105,000 on purely variable handling 105,000.

What's fixed. It's gotta be 48,000. Fixed is fixed. It's set in a mound. It's not going to rise and fall with activity. That's the nature of fixed cost. So fixed would still be 48,000 and that spends 153,000 at that level. And the answer is B make sure, you know, the high, low method of breaking down a mixed cost.

Now, another thing about our classes on cost accounting, I want to make sure that you're aware that when we went through cost accounting together, when we went through job order costing and process costing and standard costing in all those areas, what we were talking about. Was absorption costing. Let me define that.

Under absorption costing the units that are produced, absorb all manufacturing costs, both the variable and the fixed that's what's meant by absorption costing the units you produce absorb all manufacturing costs, both the variable and the fixed. In other words, in absorption costing both the variable and the fixed manufacturing costs.

Are considered part of unit cost, both the variable and the fixed manufacturing costs are considered inventorial. They find a way to inventory. I bring this up because when you get into decision-making, then you're introduced to another way of costing units. It's called direct costing, or variable costing under direct costing, or variable costing.

Only the variable manufacturing costs are considered part of UNICOM. Only the variable unit, only the variable manufacturing costs are considered. Part of unit cost. The fixed manufacturing costs, the fixed part of factory overhead. The fixed manufacturing costs in direct costing are going to get treated as a period expenditure an expense of the period, not a product cost.

Let's go right to a set of problems. Let's go to two and three in question, number two, they ask what would operating income be under direct costing, and question three, they ask what's finished goods under absorption costing. Well, I want to start with absorb. I'm going to start with question number three first.

Let's do absorption costing. And let me say this to you again. If you're in the BEC CPA Exam and they ask you anything about absorption costing, just go back in your mind. So what we did in cost accounting, because that's, that's what absorption costing is all about. So in this, in this problem, let's work out with finished goods would be under absorption costing.

First of all, if you read the introduction, notice they produced a hundred thousand units, they sold 80,000. So they must be 20,000 units in finished goods. And they did say there's no beginning inventory to worry about. So all we know is. They produced a hundred thousand units. They sold 80,000. So we know there were 20,000 units in finished goods.

Let's work out the unit cost under absorption, costing and absorption costing. Would you pick up the $4 of material? Of course you would. Would you pick up the $2 and 50 cents of direct labor? Of course you would. Would you pick up the dollar 50 of purely variable overhead? Absolutely. You pick that up. How about the variable selling $2 per unit?

No. No, that's a selling expense belongs below gross profit. It's not a manufacturing cost. It's not an inventory item. So don't fall for that. Now that $2 that's a selling expense belongs below gross profit. That's not an inventory of item. It's not a manufacturing cost. And of course, same thing with the fixed, knowing not a manufacturing cost.

It's a selling expense belongs below gross profit, but in absorption, We would take that 240,000 to fixed factory overhead divided by a hundred thousand units of production and put $2 and 40 cents of fixed factory overhead on every unit you produce. The unit cost under absorption comes out to $10 and 40 cents.

Notice the units that are produced, absorb all manufacturing costs, both the variable, and also the fixed that fixed back for your overhead is part of unit cost and absorption. So if I take that unit cost $10 and 40 cents. Times, but 20,000 units in finished goods, they produced a hundred thousand units.

They sold 80 is 20,000 units and finished goods and absorption they're valued at $10 and 40 cents. Each finished goods is valued at 208,000. So the answer to question number three is B. So we've got that one. Now question number two asks about direct cost. And before we answer question number two, What if I, what if they had asked me for finished goods inventory under direct costs in AskPat here, but let's do an analysis here.

What if they'd asked for finished goods inventory on the direct costing? Well, if I'm using direct costing, remember only the variable manufacturing costs are part of unit cost. Only the variable manufacturing costs. Find a way to inventory. So in direct cost, can I pick up the $4 of direct material?

That's purely variable. I'd pick up the $2 of direct labor. That's purely variable. I would pick up the dollar 50 part of overhead. That's purely variable. Again, the variable selling no email. It's variable. You don't pick it up because it's not a manufacturing cost. It's not inventorial fixed selling. Of course not.

Don't pick that up. It's not a manufacturing cost. It's a selling expense belongs below gross profit and the fixed factor overhead. No. The fixed factory overhead will be treated just like the fixed selling and expense of the period, not a product cost. So notice that they added up the unit cost under direct costing or variable costing would come out to $8.

So if they'd asked me for ending inventory under direct costing, I would take the 20,000 units and finished goods, times $8. The answer would be 160,000. They didn't ask that, but that would be finished goods under direct costing. Now this. A couple of relationships that I think ultimately you just memorize because I think these relationships always help you in the exam.

All else being equal. If you produce more units than you sell, if you produce more units than you sell absorption will give you more profit than direct. I think I'd memorize that if you produce more units than you sell absorption gives you more profit than direct. For example, in this problem, didn't they produce a hundred thousand units sell 80.

So what did you, what did you do if you produce a hundred thousand units and you sell 80,000, didn't you add 20,000 units to finish goods and in absorption there'd be $2 and 40 cents of fixed overhead. And every one of those units. So what you're doing is taking. $48,000, 20,000 units, times $2 and 40 cents.

You're taking 48,000 to fixed overhead costs. You incurred this period, which you're deferring it. You're putting it on the balance sheet and inventory. So the expenses under absorption of $48,000 less, the profit is 48,000 higher under absorption. So all else being equal. If you produce more units than you sell absorption gives you more profit than direct all else being equal.

If you produce less units than you sell. If you produce less units than you sell absorption gives you less profit than direct notice the Moore's lessons go together. That's why I'm phrasing it the way I am. If you produce more than you sell absorption gives you more profit. If you produce less than you sell absorption gives you less profit.

And if you produce the same number of units that you sell, absorption gives you the same profit as direct. I would know those relationships. Now let's handle question number two, question number two says, all right, what is operating income? Under direct costing or variable costs then? Well, of course the tempting thing is to sit in the BEC CPA Exam and try to do our whole income statement.

I would not do that. There's a little shortcut. Don't do out a whole income statement, the fast way to do a problem like this. If they want to know the operating profit under direct costing, which is a very typical question in a decision-making the question the key to answering it is to figure out contribution margin per unit.

What does the sale of each unit contribute to the recovery fixed cost? That's a very powerful piece of information. That's what you want to focus in on contribution margin per unit. What does the sale of each unit contribute to the recovery fixed cost? Well, let's work it out. I know the selling price per unit here is $20.

Now, what do I back out of there to get contribution margin variable costs. So I'm going to take out. The $8 a variable manufacturing cost. Remember that $8. That's what would go to inventory under direct costing. Those are all your variable manufacturing costs, the $4 a material, the $2 and 50 cents of labor, the dollar 50 a variable over you remember that's that $8.

That's what goes to inventory under direct costing. It's all variable. So take out the variable manufacturing costs of eight. What I back out the variable selling of two, I would, because. There's no contribution to fixed costs till you cover all your variable costs, even that variable selling. So I'll back out that variable selling also of $2 per unit.

The contribution margin per unit comes out to $10. That's the definition of contribution. Margin contribution margin is defined as selling price minus all variable costs, not just the variable manufacturing, which goes inventory $8. You'd also pick up the $2 of variable selling. Cause again, You have no contribution to the recovery fixed costs until you cover all your variable costs, including that variable selling.

So you take the selling price per unit 20 minus all the variable costs, the $8, the variable manufacturing, the $2 variable selling. You've got $10 a variable cost. So the contribution margin per unit is $10. Now I know every time they sell a unit, it contributes $10 to the recovery of fixed costs. How many units did they sell?

They sold 80,000 times 10. There's your total contribution margin? 800,000. Now, just back out your fixed costs. Once I know that sales contributed 800,000 to the recovery fixed cost. Now I just back out the fixed cost, fixed factory overhead 240,000 a year fixed selling 140,000. That gives me a profit of 420,000.

So the answer to number two is B that's a quick way to work out profit under direct. Or variable costing the key is to work out that contribution margin per unit. That's the way you want to start to think. Let's do another question. Let's go to question number four, under variable costing, which costs are assigned to inventory.

How about am I going to assign variable factory overhead? Yes. I remember in variable costs from a direct costing. Only the variable manufacturing costs are considered. Part of unit cost. Only the variable manufacturing costs are considered inventory level. So the variable part of overhead, that's a variable manufacturing costs.

We pick that up. How about variable selling? No, that's a no, that's a selling expense belongs below gross profit. That's not an inventory item. And the answer is D no. Yes. Question number five. Kay had fixed back the overhead of a hundred thousand dollars variable selling of 80,000 under direct costing under variable costing.

What's a product cost. What's a period cost. Well remember, the key point is in variable costing or direct costing, you're going to treat the fixed factory overhead, just like the fixed selling. It's not a product cost. It's a period cost. It's an expense of the period. The answer is D you want all hundred 80,000 under period cost nothing on the product cost because that's the whole point of direct costing variable costing, direct costing, or variable costing treats the fixed factory over here, just like the fixed Ellen and expense of the period, not a product cost.

So it's all of it. Under period cost nothing on the product cost to date, question number six. They want to know the unit cost, the inventory will unit costs under direct or variable costing. Well, you know, on a direct costing only the variable manufacturing costs are considered part of unit cost. So I'm going to pick up the direct material and direct labor of 200,000.

I'm going to pick up the 45,000 of purely variable overhead. That's a variable manufacturing costs, the fixed factory of head. No that's going to be treated as a period expenditure, not a product cost. The variable selling? No, that's a selling expense belongs below gross profit. It's not an inventory bill item.

If you added up the total cost, I'm going to assign to inventory 245,200,000 of material and labor 45,000 a variable overhead 245,000. If I take that 245,000 divided by the 10,000 units produced, the unit cost under direct costing is $24 and 50 cents. Answer a.

Question number seven, they say operating income under direct costs compared to absorption costing would be higher. They're asking you when would absorption be lower than direct? Right. That's the, that's the question. When is income under absorption lower than direct? Well, that's why I think it's good to memorize those relationships.

Remember all else being equal. If you produce more units than you sell absorption gives you more profit. If you produce less units than you sell absorption gives you less profits. I'm looking for an answer here. Once. I know that absorption is less than the direct, then I know they produced less than they sold, and if they produce less than they sold.

Inventory is going down. I'm looking for an answer where inventory's going down. And the answer is B. If beginning inventory is greater than ending, inventory is going down. Answer be beginning of it towards greater than ending inventory is going down. And why is inventory going down? They produced less than they sold.

And if you produce less than you sell absorption gives you less profit than direct. I would know those relationships keep studying. Don't fall behind. Keep up with your homework. I'll see you in the next class.

Welcome back to our discussion of the kind of problems that you can get in the CPA Exam on decision-making. And if you look at your viewers guide, you know that the first two questions for this section, I wanted you to get done. Before watching the class, let's do the first two questions in question number one, they want to know what finished goods inventory would be under direct or variable costing.

And I'm sure you noticed that in this year they produce 10,000 units, but they sold 9,000. If you produce 10,000 units and you sell 9,000, given that there are no beginning inventories, there must be a thousand units in finished goods. And now we're going to value that finished goods inventory under director variable costing, and we know under direct or variable costing only the variable manufacturing costs are considered part of unit cost.

Only the variable manufacturing costs are considered inventorial. So let's go through it. We know that the direct material of 20,000, that is a purely variable manufacturing cost. So we'll divide by the. 10,000 units produced and put $2 of direct material. Whenever unit produced the direct labor of 10,000, we know that that's a purely variable manufacturing cost.

We divide by the 10,000 units produced, put a dollar of direct labor on every unit, the variable factory overhead of $6,000. That is a variable manufacturing cost. So we divide by the 10,000 units produced and put 60 cents of variable overhead on every unit produced. The unit costs under direct or variable costing is $3 and 60 cents.

Notice that the 12,500 of fixed factory overhead, that's not part of unit cost, not under direct or variable costing the 12,500 fixed factory overhead. That's going to be treated as a period expenditure, just like fixed selling, fixed administrative costs. We're not going to treat that as an inventory.

Bill costs. So the unit costs under direct or variable costing is $3 and 60 cents. And if there's a thousand units in finished goods, times $3 and 60 cents, the answer is a finished goods is valued at 3,600 question. Number two says which method absorption or variable costing would give you the highest income.

And by what amount? Well, first of all, If you remember the relationships we talked about in our last class, if you produce 10,000 units and sell 9,000, if you produce more than you sell absorption gives you more profit right away. You know that, so it has to be a or C because absorption is going to give you more profit, but they also want to know by what amount?

Well remember in absorption, They're going to take that 12,500 of fixed factory overhead. They're going to divide by 10,000 units produced. And in absorption, they're going to put a dollar 25, a fixed factory overhead on every unit produced because that's the whole point of absorption costing the units that are produced.

Absorb all manufacturing costs, both the variable as well as the fixed. So if you produce 10,000 units and sell 9,000. You're adding a thousand units for finished goods and an absorption. They'd be a dollar 25, a fixed overhead on every one of those units. So what you're really doing is taking 1002 50, a fixed overhead.

You incurred this period, but you're deferring it. You're putting it on the balance sheet. So the expenses on the income statement are 1002 50 less. Profit is 1000, two 50 higher under absorption. The answer is, Hey, now. What I want to do next is look at a couple of relationships that turn up a lot in questions in the exam.

Let me just mention a hypothetical. Let's say that a company sells units for $8. Each their variable cost per unit $2. Their fixed costs are $10,000 a year. Now, we're going to look at this situation under two levels of activity. First let's assume that they produce and they sell one unit. Let's go through some categories if they produce and they sell one unit at that level, what's total fixed costs would still be 10,000.

Wouldn't it still be 10,000? 'cause fixed is fixed. It's set in a mound. That budget does not rise and fall with activity. So as far as we know, they produce one unit total fixed cost would still be 10,000. What about fixed cost per unit? The next category? Well, I've got to take 10,000. The fixed costs divided by one unit.

Wouldn't the fixed cost per unit. Also be 10,000. That's simply taking the 10,000 fixed costs, dividing by one unit fixed cost per unit, which would also be 10,000. What about variable costs per unit? That would still be $2 that hasn't changed total variable costs. Well, I produce in sold one unit there's $2 variable costs in each unit would be also $2.

How about total costs or my total costs? I've got 10,000 to fixed. $2. The variable total cost would be 10,002, $10,002 sales at the level would just be sold. One unit for $8 sales would be $8. And then the last category, what's the ratio of variable cost to sales? Well, if I take the total variable cost, $2 over the total sales, $8 25%.

Now let's look at the same categories if they produce and they sell 10,000 units. If they produce them, they sell 10,000. Yeah. Units what's total fixed costs, still 10,000 fixed this fixed it's set in a mound. What's fixed cost per unit. Well, that's gone down to a dollar because now I'm taking my total fixed cost.

10,000 dividing by 10,000 units produced fixed cost per unit has gone down. So notice something notice fixed costs in total. Stay the same fixed cost per unit fluctuate. Notice as production rises, fixed costs per unit go down the CPA Exam plays a lot of word games with these kinds of concepts. Yeah, fixed costs in total.

Stay the same fixed cost per unit fluctuate as production rises, fixed cost per unit goes down as production falls, fixed cost per unit rises. So fixed costs per unit does fluctuate. How about my variable cost per unit would still be $2 at any level. So variable costs per unit stays the same. How about total variable costs?

Well, now I've produced 10,000 units, times two. Would be $20,000. Notice variable costs are exactly the opposite of fixed in the sense variable costs in total fluctuate, variable variable costs per unit stays the same. It's really the exact opposite fixed costs in total. Stay the same variable costs in total fluctuate.

Fixed cost per unit fluctuates. Variable cost per unit stays the same. You have to get used to these relationships. Now, of course, total costs that would always fluctuate. Depending on the level of activity. Now, my total costs, I've got 20,000 of variable, 10,000 fixed 30,000. You know, total costs are going to fluctuate with activity.

How about my sales? I sold 10,000 units at $8 each 80,000. And then my final category, the ratio of variable cost to sales. If I take the total variable cost 20,000 over sales, 80,000, it's still 25%. That does not change at any level that has remained the same. I'll show you just one way they could hit something like this.

Look at question number three. It says when production is increasing, it's all we know production is increasing within the relevant range. A flexible budget is used. What is the anticipate? What is the anticipated result on each of the following? Well, if production is rising, what's going to happen to fixed cost per unit strapping.

Fixed cost per unit goes down. I think a lot of people in the CPA Exam go too fast and they just like, Oh, fixed costs were always the same, not per unit, not per unit. Like in the example, you just went through at one unit. My fixed cost per unit were 10,000 at 10,000 units. Fixed cost per unit would be a dollar fixed cost per unit is going down at productions rising.

How about variable cost per unit? No change stays the same. Let's go to question number four, in question number four, we're asked what is the break even point in units? And this gives me a chance to say that one formula you would definitely memorize for the exam. Just flat out memorize. Is the formula for determining the break, even point in units.

You know what break even point is break. Even point is the point of sales where there's no profits and there's no losses. And you cannot go into that exam and not have memorized the formula for the break, even point in units, let's go over it to figure out the break, even point in units in the numerator you put total fixed costs.

You want to put fixed factory overhead, fixed selling, fixed administrative costs. You want your total fixed costs in the numerator. Remember you don't break even until you cover all your fixed costs, not just your fixed factory overhead. You've got to cover your fixed factory overhead and your fixed selling your fixed administrative costs.

So that's what goes into the numerator total fixed costs. You're going to divide by our old friend contribution margin per unit. As we sat in another class, one of the critical questions in the CPA Exam is what does the sale of each unit contribute to the recovery fixed costs? You can do a lot with that.

You want to figure out contribution margin per unit. That's the formula total fixed costs divided by contribution margin per unit. We'll give you break even point in units. So let's get to work here. First of all, what's total fixed costs. Well notice that's the fixed factory overhead. Is applied at $7. A unit, the fixed selling an admin is applied at $3, a unit they're applying $10 a fixed overhead on every unit.

And that's based on this current level, which is 900,000 of sales. The selling price is $20 a unit. So if you take 900,000 sales divided by 20, they must've sold 45,000 units. And if they're applying $10 of fixed overhead on every unit, again, that's $7, a fixed factory, overhead $3, a fixed selling an admin.

If they're applying $10, a fixed overhead, and every unit they produced and that's based on 45,000 units of activity, total fixed costs must be 450,000. So that gives me my numerator total fixed costs. Notice that's both the fixed factory overhead to fix selling. The fixed admin has got to add up to 450,000.

Now I want to divide by contribution margin per unit. How do I get that? What contribution margin is defined as the selling price minus all variable costs. So I'm going to take the selling price 20. I'm going to back out the prime costs of six, you know, prime costs are direct material, direct labor. I'm going to back out the variable, overhead a dollar.

How about the variable selling that's right back it out. It's not that that variable selling would go to inventory. It wouldn't, but if I'm analyzing break, even I have no contribution to fixed costs until I cover all my variable costs. Remember the definition of contribution margin is selling price minus all variable costs, not just what goes to inventory minus all variable costs.

So I'm going to take the selling price 20 minus the prime cost direct material, direct labor of six minus the variable overhead of one, minus the variable, selling an admin of one. My contribution margin per unit is 12. Every time they sell a unit, it contributes $12 to the recovery fixed costs. So now I can solve it.

If I take the 450,000 to fixed costs divided by 12 breakeven point units is 37,500 answers. See if they sell 37,500 units, they'll hit the break. Even point that point of sales with is no profits, no losses. Let's go to question number five, question five says, what is the most likely strategy to reduce the break even point what's going to, what's going to have you reduce that breakeven point.

We'll look at answers. See, first of all, if you decrease fixed costs, that makes sense, right? Because that's the numerator roommate or goes down, that's going to, that's certainly going to. Lower your breakeven point enough if nothing else changes, but also an answer is C you increase contribution margin. I increase the denominator, lower fixed costs, the numerous, and I increase the denominator contribution margin per unit.

I've definitely lowered the break even point. I've reduced it without question. And the answer is C let's go to question number six, six, and seven are also a set on breakeven. Six says how many radios must SL to earn an operating income of 35,000? So notice I've got to work out how many radios I have to sell to generate this profit of 35,000?

Well, this formula that you really have to memorize is very useful because you can use it here. Also, all you have to do in this case is take the total fixed costs. Which are 15,000 add the profit that you want to generate 35,000. That adds up to 50,000 and divide by good old contribution margin per unit.

We know the selling price here is $30. A unit variable costs are 20. The contribution margin per unit is 10. Now I have everything I need. If I take the total, if I take the total fixed costs of 15,000 plus the profit before tax that I want to generate 35,000, that adds up to 50,000 divided by contribution margin per unit.

I know every time they sell a unit, it contributes $10 to the recovery of fixed cost. That's the selling price, 30 minus variable cost money. If I sell 5,000 radios answer a I'll generate a $35,000 profit before tax seven says what's spring, even pointing dollars. Let's figure out break even point. We know that formula that's the total fixed cost.

15,000 divided by contribution margin per unit, which is $10. If they sell 1500 radios, they'll hit the break. Even point, they sell radios for $30 each notice here. They don't want it in units. They want it in dollars. Don't forget that the formula that I had, you memorize fixed cost divided by contribution margin per unit.

That gives you break even point in units that tells you how many units you have to sell to break even. But sometimes the exam, the CPA Exam doesn't cooperate. They want breakeven point in dollars. Well, it's still a useful formula because if I can figure out break, even point in units. That's the fixed cost, 15,000 divided by contribution margin per unit 10.

If I know they have to sell 1500 radios to break, even if they want it in dollars, I just multiply by the selling price. I sell radios for $30. Each breakeven point in dollars is 45,000 answer. See, now that now there's another way to get that I'm going to do, because sometimes it comes in handy. One way you can get breakeven point in dollars is to do what I just did.

Figure out that breakeven point units multiplied by the selling price, but there's another way you can get breakeven point in dollars. And sometimes this comes in handy. We know that they sell units for $30. Each variable costs are 20 notice variable costs are two thirds of selling price. Contribution margin is $10 a one-third.

Contribution margin per unit is $10, 10 over 30 or 33 and a third percent that 33 and a third percent that's called the contribution margin per ratio. That's the contribution margin ratio. The other way to get the breakeven point in dollars is simply to divide your fixed costs 15,000 by that contribution margin ratio, which is 33%.

That'll also give you 45,000. So one more time, you want to get breakeven point in dollars. You can either figure out the breakeven point in units multiplied by the selling price, or if you don't have that kind of information, just take the total fixed costs. In this case, 15,000 divided by the contribution margin selling price is 30 days.

Think of it as a hundred percent. Variable costs are 20, which is two-thirds of that 66 and two thirds percent contribution margin per unit. It's 10 over 30. Or 33 and a third percent. If you take the fixed costs, 15,000 divided by 33 and a third percent, the contribution margin ratio you'll get 45,000 break, even point in dollars.

That's the other way to, to get breakeven point in sales and question number eight, they want to know the break even point in dollars. Now, all we know in this problem is that their sales are 800,000. And again, think of that as a hundred percent, we know variable expenses are 160,000 notice variable costs are 20% of sales.

Well, if variable costs are 20% of sales contribution, margin ratio is 80% of sales. Remember that's always a function of a hundred. If variable expenses are 10% of sales contribution margin ratio is 90% of sales and that's always a function of a hundred. So here we know that the variable expenses are 160,000 over sales, 800,000.

Variable expenses are 20% of sales. So contribution margin ratio is 80% of sales. All right, now I can, now I can solve this in a couple of different ways. Once I know that first I could do trial and error. If I wanted to, I could say, how do I get breakeven point in sales? Well, is it a, let's say the answer is a it's 200,000.

I know the contribution margin ratio is 80%, so I multiply by 80%, the contribution margin for. Answer a is a 160,000 back out the fixed cost 40,000. Now there's 120,000 of profit and answer a that's not the break even point. How about SIG? What if the sales are 50,000? Contribution margin ratio is 80% of that.

So total contribution margin would be 40,000. That's just enough to cover the fixed cost. 40,000. Yes, I do break. Even in answer C you could just, you could just do trial and error there, or go back to the formula. If I take the total fixed costs, 40,000 divided by the contribution margin ratio, which is 80%.

That'll also give me 50,000. Remember that little trick you take total fixed costs divided by that contribution margin ratio, which in this case is 80%. That'll also give you the break even point in dollars, which is 50,000 in question number nine, question number nine. They want to know what the fixed costs are.

How do we, you figure out fixed costs? Well, we know that the sales. Our 200,000 and we know that the margin of safety is 80,000. Well, you have to know what margin of safety means. It's a definition you have to be aware of. Margin of safety is defined as how far the sales would have to drop. Before you incur a loss, how far your sales would have to drop before you incur a loss that's margin of safety.

So if right now sales are 200,000 and there's a margin of safety of 80. Then the break even sales must be 120,000. Again, margin of safety is how far the sales would have to drop before you start incurring losses. So of sales at 200,000 in margin of safety is 80,000. Then back out the 80 breakeven sales must be 120,000 margin of safety is really how far above break even you are.

So now I can solve it. If I know break even sales are 120,000, they said that. My contribution margin ratio is 20%. So if I take 20% of 120,000

notice that comes out to 24,000, my country fusion margin must be at that level 24,000. And remember at break, even my contribution margins just enough to cover my fixed cost, which must also be 24,000. And the answer is B. So remember that definition of margin of safety. It's how far your sales would have to drop before you incur a loss since it's how far above break even you are.

So in this case, sales are 200,000 margin of safety is 80 we'll break. Even sales must be 120,000. And if the contribution margin ratio is 20%, that at that level at breakeven, 120,000 sales contribution margin must be 24,000. And it break even that contribution margin is just enough to cover my fixed costs.

Fixed cost must be 24,000. As I say, answer B question number 10, question number 10 says Lake increased their direct labor wage rates. So direct labor is going up is direct labor, a variable or fixed costs. You know, it's a variable cost. So one of my variable manufacturing costs is going up. That's all I know.

Direct labor wage rates are going up. All of the costs remain the same. All of the revenues remain the same. Well, first of all, what's going to happen to your budget at break even point. Well, if my sales price remains the same and all that's happened is one of my variable cost is increased. Then my contribution margin has shrunk contribution margin per unit is going down.

I have to, I have to sell more units to break even. So you want increase under that first column is going to be an increase in my budget of break, even point. My selling price is staying the same, but one of my variable cost is going up. So contribution margin per unit is going down. I'm generating less profit out of each unit.

I have to sell more units to break. Even. How about my margin of safety? Lamar's to safety is how far my sales would have to drop before I incur losses. How far above break even I am? Well, if my break, if my break even point is going up, then my margin of safety. I'm not as safe as I was. It is shrinking.

And the answer is being, please continue with your homework. Don't fall behind. I will look to see you in the next class. Welcome back to our discussion on decision-making. And our next topic is really the heart and soul of decision-making. And that is profit analysis. And the CPA exam tends to get you into profit analysis in a couple of different ways.

First, they may give you a problem on a special order. You know, they'll say, you know, a factory normally sells units for $75. Each a special order comes in. Someone's willing to buy 10,000 units for $62 each. Should the company accept the offer? So that's very often how you will see a profit analysis problem laid out as some sort of special offer.

Another thing the BEC CPA Exam likes make or buy decisions. I'm sure you've seen these kinds of problems before. It costs so much to make a motor so much to buy a motor. What's the best thing for the company to do. What's the best thing for the bottom line? Should they make it or should they buy it and why?

These are classic problems that come up. On profit analysis. And before we do a couple, I just want to give you one quick point. And that is the key to all of these problems, whether it's a special offer or a make or buy decision is you only look at what changes. If you accept a given proposal, that's the key to all of these problems.

The analysis is just look at what changes. If you accept a given proposal. In other words, you only look at variable items, fixed costs are irrelevant through a decision like this. Why? Because the fixed costs, Guan, whatever I do, right? If costs are fixed, if they're set in amount, I'm going to incur the same amount of costs.

Whether I accept the special offer or reject it, I'm going to incur those same fixed costs. Whether I make the part or buy the part, therefore. They have no bearing on the decision. And that's really the key to these problems only look at what changes if you accept a given proposal, which is to say only look at variable items.

Let's look at questions. One and two questions. One and two are about golden company, golden company manufacturers, 5,000 units of part 10, five 41. And in question number one, They say in deciding whether to make or buy the part, what does it really cost to make it? What is the relevant cost to make the part?

Well, let's look at what it costs to really make this, you know, I'm going to have to pick up the $2 of direct material. I'm going to have to pick up the $8 of direct labor. I'm going to have to pick up the $4 of purely variable overhead. You know, I have to pick up that first $14 because those costs are all variable.

I only incur those $14 of costs if I make a part. So of course I have to consider that. And what you learn very quickly from doing problems like this is you have to read very carefully what they say about the fixed let's read what they say about the fixed. It says golden has also determined that if they buy the part from Brown two-thirds of the fixed overhead applied.

We'll continue. Two thirds of that fixed overhead applied to the part will continue. Even if the part is purchased from Brown. So think about it. The fixed overhead, that's applied to each part here, $6. They're saying two thirds, four of the six will continue regardless of what they do well at four of the six are fixed.

We'll continue. Regardless of what decision they make, it has no bearing on the decision. You're stuck with it. It's a fixed cost, but isn't that another way of saying that one-third of the sixth, two of $2 of the $6 of fixed won't continue. If I go out and buy the part only will continue. If I make the part, say that again.

One third of the sixth, $2 of the $6 of fixed overhead applied to each unit. Won't continue if I go out and buy the part so only will continue if I make the part. So it becomes another relevant cost to make the part. What does it really cost to make a part? It costs $2, a material, $8 of labor, $4, a variable overhead, and $2 a fixed that won't continue.

If I go out buy the part only will continue. If I make the part I got to consider, it really cost me $16 to make the part $16 times 5,000 parts. What it really costs to make the part is 80,000. Answer B. Now in number two, they say should golden except Brown's offer. And why, while Brown is offering what Brown will sell us 5,000 units for $19.

Each let's work it out. If we buy 5,000 units from Brown at $19, each that's $95,000. But if I buy the part from Brown, that frees up the facilities and notice I can make product RAC. And generate 4,000 of profit. So what does it really cost me to buy the parts from Brown? It costs me 95,005,000 parts at 19 minus the 4,000 profit I can make on product RAC by freeing up the facilities.

What it really costs me to buy the part is 91,000. What it really costs me to make the part is 80,000. The answer is, Hey, now I reject this. I'm going to reject it. Why? Because it's $11,000 cheaper to make the part. The answer is a, that's sort of a classic illustration of profit analysis. Let's do another one.

Question number three, noticing question number three, we have East division, East division notice as incurred a $25,000 operating loss. If you look at the income statement and what they want to know is if East is eliminated, what's the effect on operating income. If East, if that East division is eliminated, what is the effect on operating income?

Well, B let's start with what everything looks like before we eliminate East. Before I eliminate the East division. Isn't the total contribution margin? 390,000 for West 70,000 for East it's 460,000 total contribution margin. What's total fixed costs 110,000 for West 50,000 for East 160,000. So my profit contribution after fixed costs would be 300,000 back out.

The corporate cost of 180,000. That's one 35 for West and 45 for East back out the corporate cost of 180,000. Right now, before I eliminate East, I'm making $120,000 profit. Now what happens if I eliminate East, if I eliminate East, now I lose East contribution margin of 70. So now my total contribution margin is just that 390,000 for West.

How about fixed costs? Yeah, the fixed cost now would just be the 110,000 for West. They say that East fixed costs would be eliminated. They did say in the problem that if East is, if East is eliminated, The fixed costs for East could be avoided. So now my fixed costs are just 110,000. That gives me a total contribution margin of 280,000.

What am I corporate costs? My corporate costs would still be one 80. They didn't say I'd eliminate the corporate cost allocated the East that still exists. So my total corporate costs is still one 80. So notice my profit is now a hundred thousand. My profit. For the company was 120,000 before I eliminated East.

It's a hundred thousand when I eliminate East, the answer is a, if I eliminate East, my total profit is $20,000 lower. Again, the key is just look at what changes. If you make a certain decision only look at variable items, what's going to change. That's always the question. Question. Number four. Rice is.

Going to discontinue a department that has a $24,000 contribution margin. So that's all we do. No. They're going to eliminate a department that has a $24,000 contribution margin or $24,000 contribution to the recovery fixed costs. Now 48,000 of costs are allocated to this department, but they said 21,000 of that 48 can not be eliminated no matter what you do well, if 21,000.

Of the 48,000 cannot be eliminated no matter what you do, then don't worry about it. You're stuck. That's 21,000 is irrelevant to the decision. If the cost is going to go on, whatever you do, you're stuck with it. It's fixed. Don't worry about it. But isn't that another way of saying 27,000 of the 48,000 can be eliminated.

So I'm losing 24,000 of contribution margin. That's true by eliminating the department. But I'm also eliminating 28,000. Excuse me, I'm eliminating 27,000 of costs. So I was 24,000 of contribution margin. I've eliminated 27,000 of costs. Overall I'm $3,000 better off the answer is C the total effect of my profit is a $3,000 increase.

Lose 24,000, the contribution margin, but say 27,000 of costs. Overall, my profit is $3,000 higher. If I eliminate the division answers, see question five, cuff caterers, cuff caters is on the phone and they quote a price. They're going to charge $60 per person for some dinner party. So you stuck with that.

Someone's on the phone and they've quoted that price. So you stuck with that. And they want to know. All right. If you're stuck with that, if you're only going to get $60 from each person, what can you charge for the food? Well, they say that there's a sales tax of 6% on the food plus the service charge and there's a 15% service charge just on the food.

So if you're stuck on a $60 charge per person, Given these other charges, what can you charge for the food? Well, I'm sure you see that fundamentally. This is a little algebra question, and obviously that's one way you can solve this, but if you're not good at algebra, I'll show you another way. You've got answers here.

Why can't you just test the answers? Let's let's go to answer B you know, pick an answer. That's easy to work with $51. Even. What if they charge $51 for the food? Well, if they charge $51 for the food. Remember, there's a 15% service charge just on the food. So take 15% times $51. They'd be at $7 and 65 cents service charge, 15% of 51.

And then there's a 6% sales tax on the food and the service charge. So I'm going to add up the 51 and the $7 and 65 cents. That adds up to $58 and 65 cents. Times 6%. The sales tax would be $3 and 52 cents. If you add up 51 plus seven 65 service charge, plus three 52 sales tax, it adds up to $62 and 17 cents.

That can't be the answer. If I charge $51 for the food, I have to get $62 and 17 cents out of every person, but I've already quoted a price of 60. I'm stuck with 60, so that's not going to work. All right. Now my next question is this. You gotta be logical. If you're testing answers. If, if 51 is too much, what are you going to test next?

56. 40, of course not. Right. You know, you have to go down, right? You have to be logical here. If 51 is too high. Do you want to try a little bit lower don't don't go to, you know, $56 and 40 cents. Obviously not. Let's go down to $49 and 22 cents. What if I charge $49 and 22 cents for the food? Well, if I do, there's a 15% service charge just on the food.

So I'll take 15% of 49, 22. The service charges, $7 and 38 cents. Now the sales tax. Is on the food and the service charge. So I'm going to add up 49, 22 plus the service charge $7 and 38 cents. That's 56, 60 times 6%. The sales tax is three 40. And notice if you add up $49 and 22 cents for the food and $7 and 38 cents for the service charge and $3 and 40 cents.

For the sales tax does add up to exactly $60. And the answer is C. If you've, if you've quoted a price of $60 a person, what you can charge for the food is $49 and 22 cents. No, that's not the only way you can solve that. But like, as I say, if you know, you're really good at algebra, just set up a little algebra problem.

You've got that. But if you're bad at algebra, don't forget, you have answers. Just test out the answers. Same thing with question number six, question number six says, Hey, we're going to sell 500 units. We expect the traceable cost to be 990,000. If we're going to sell units for $500 each and the traceable costs for this department, 990,000, and we want to make a $15, 15% profit on sales.

A 15, 15% profit margin on sales. What's our target price. Well, again, you could set up an equation or you can test answers. Let's go down to answer six. In other words, you sit in the CPA Exam and go. What if I did sell for $1,980 a unit? Well, if I sell for $1,980 a unit, I know I'm going to sell 500 units that's given.

So you multiply it out. My total sales are 990,000. That's just enough to cover my traceable cost of nine 90. There is no profit in answer. See that can't be the answer because I want a profit. That's going to be 15%. Sales and there's no profit. Any answer C so, all right. So C doesn't work. Let's try B.

What if I sell for $2,277 per unit? Well, if I sell for $2,277 a unit, I know I'm going to sell 500 units. That's given my total sales would be 1 million, 138,500. Back out my traceable costs, which are given a 990,000. I make $148,500 profit. If you make $148,500 profit on 1 million, $138,500 of sales, the profit margins, about 13% of sales.

That's not enough. I want the sales price to be high enough. So that my profit margin is 15% of sales here. It's about 13%. All right, let's go a little higher. Let's try answer a, if I sell units for $2,329 each, I know I'm going to sell 500. So my total sales at that level would be 1 million, 1 million, 164,500 back out.

My traceable costs 990,000. I make a profit of 174,500 over the sales, 1 million, one 64 or five. It's exactly 15%. And that the answer is a, that was my objective. I want a profit margin equal to 15% of sales and answer a fits the bill. And again, that's not the only way to solve a problem like that, but if you're not good at algebra, don't forget, you've got answers and you can just test those out.

Keep studying, get your homework done. I'll look to see you in the next class. Yeah,

welcome back to our discussion on planning and measurement. And in this class, we're going to begin to discuss the different cost accounting systems that you have to be comfortable with on the exam. And let me say right off the bat, that the goal of any cost accounting system is to simply tell management what it's costing to produce one single unit.

That's the goal of any cost accounting system. And of course, you know why management has to have that information. If management does not know what it's costing to produce one single unit, they don't know what to build for their work. They don't know how to value their ending inventory for the balance sheet.

So the real issues here are billing and control. Now here's the basic point. If I'm a manufacturing company, And I'm trying to determine what it costs to produce one single unit. I basically have two ways to go. There are basically two pure systems. It's either going to be number one, some sort of job order approach or a number two, it'll be some sort of process approach.

Those are the two pure systems and the bottom line is this what determines whether I should use a job order approach or process approach. Is the type of units that I produce, the type of units that you produce, the type of production you're involved in will dictate whether you should use a job order approach or process approach.

Let me explain if a factory is involved with custom made items. If every unit they're working on is custom made its unique has its own list of customer specifications. It's different from any other unit they're working on in the factory. Well that factory's basically forced to use some sort of job loader approach.

But if a factory is involved in any sort of mass production, any type of mass production, they're basically forced to use some sort of process approach. So that's what determines what sort of system you should use. It's really the kind of units that you produce. Now, we're going to begin with job order costing.

And as I said, a moment ago in a job order system, Every unit we're working on in the factory is unique. It's custom made it's different from any other unit I'm working on in the factory. And if every unit is custom made, if every unit is unique, the only way to reasonably figure out what that unit costs is to keep track of all the material, labor and overhead I've put into that unit or that job.

In other words, in a job order system, when I start a custom made job, I also started a job order cost sheet or a job order cost card. And on that sheet or on that card, I simply keep track of all the material, all the labor, all the overhead I put into that unit or that job. Let me just show you a job order cost sheet for say job 1501 in job, 1501.

We put in six pounds of direct material at. $8 a pound. So what did we do? We charged $48 of material to that job labor. We spent nine hours of direct labor on that job at $11 per hour. That's our hourly rate. So what we did is charged $99 of labor to that job. Now notice overhead's a little different overhead.

We're applying at $8 per direct labor hour. That's my predetermined rate for overhead. And I took that $8 times the nine hours we spent on the unit and we applied $72 of overhead to this job. If you add it up, this job, 1501, it cost in total $219. Now that job cost sheet, as simple as it looks really illustrates the main thing that you have to remember about job order costing.

Here's the main point in job order costing. Direct material and direct labor are charged with job based on actual, based on the actual amounts incurred on the job. But overhead gets applied to a job based on a predetermined rate. That's the essence of it right there. Direct material direct labor, get charged with job based on actual, just based on the actual amounts incurred on the job.

But overhead gets applied to a job based on a predetermined rate. Now, as we go through cost accounting, I'm not going to spend a lot of time on journal entries, but I do want to look at a couple of journal entries in this case, because this is something you have to see here in terms of entries. How do we handle it with entries that I apply overhead to jobs based on a predetermined rate, based on an estimate, but direct material direct labor are charged to jobs based on actual, how is this all handled with entries?

Well, let me show you the entries that we would make for that job. 1501, you know that in job 1501, we charged $48 of material to that job. My entry for the material would be debit work in process $48 credit material inventory, $48. Now, you know, I charged $99 of labor to that job. What's the entry for the labor.

I debit work in process 99 credit wages payable 99. So again, notice direct material direct labor, simply get charged to work in process based on actual, based on the actual amounts incurred on the job. Now, the overhead I apply based on that predetermined rate, I took that predetermined rate, $8 an hour times the nine hours we spent on the unit.

I'm going to debit work in process $72. Notice the overhead that's based on the predetermined rate. And I credit an account called overhead applied $73. What you have to remember is that a factory like this is going to have an overhead applied account. Overhead applied, always has a credit balance, has a credit balance.

And it's where we keep track of what it's, where we keep track of all the overhead we've estimated for jobs. Remember the predetermined rate. That's just an estimate. That has nothing to do with actual overhead costs. That's just an estimate. So overhead applied has a credit balance, and it's where we keep track of all the overhead we've estimated for jobs.

Now, you know, in a factory like this, there has to be some way to keep track of actual overhead costs. So now let's say the same factory goes out and purchases, they actually go out and purchase a hundred dollars worth of supplies for the factory. Now, you know, that supplies for the factory is an actual overhead costs.

So what is the entry? Well, when there's an actual overhead costs like supplies, we're going to debit say stores control a hundred we'll credit cash. A hundred. The reason I'm using stores control is because it's supplies and presumably with supplies that have some sort of inventory of supplies. So I'm going to debit stores.

Inventory of stores control a hundred credit cash, a hundred. Now, one more thing. Now let's assume we actually send $25 worth of supplies. From stores inventory to work in process. If I actually send $25 worth of supplies from stores, inventory, work process, I'm going to debit. Do I debit work in process?

Now, remember working process is always debit. The estimate for overhead work in process is debited for the you determined right now. If I actually send $25 worth of supplies from. Stores inventory to work in process. I'm going to debit overhead control 25 and credit stores inventory 25. What you have to remember is that a factory like this is going to have an overhead control account.

Overhead control always has a debit balance, and it's where we keep track of what all the actual overhead costs. You know what I'm trying to say. You don't go in that exam. Without understanding the difference between overhead control and overhead applied again, overhead control always has a debit balance, and it's where we keep track of all the actual overhead costs.

Overhead applied, always has a credit balance, and it's what we keep track of what all the overhead we've estimated for jobs. And of course, when you get to the end of the period, there's going to be a difference between overhead control, your actual overhead costs, overhead apply all the overhead you've estimated for jobs.

That's your overhead variance. We'll talk about that later on. Now, with that in mind, let's do a couple of questions. Hopefully you've downloaded and printed out the questions for this cpa review course class. And if you look at question number one, they say in a traditional job order system, when you issue indirect material like supplies to production, what are you going to do?

We'll think of the entry when I actually issue. Something like supplies, indirect material to production. I debit overhead control and I credit stores control. I credit stores inventory. They asked me what increases, what increases is overhead control. You have to know those entries and the answer is see that's, what's going to increase overhead control question number two, in a job order system, the use of those direct material.

The use of direct material would increase what I, when I use direct material, I debit work in process and I credit material inventory, direct material, direct labor, simply get charged to jobs based on the actual amounts of spend on the job. So what would increase is work in process, answer a work in process would just be debited for the actual direct material that we used in the job.

Question number three. In a process system that's applying overhead based on a predetermined rate. Remember, even though we haven't discussed process costing in any detail yet in process costing, you can also apply overhead based on a predetermined rate. And it's the same basic idea. You're gonna have an overhead control account.

You're gonna have an overhead applied account in a process system when you apply overhead. What's going to increase well, when you apply overhead, what's your entry. I don't care whether it's job order or process you debit work in process for the estimate and you credit, overhead applied. So what's going to increase is work in process, answer date, question number four in a job order system that uses a predetermined rate for overhead.

What's going to explain under applied overhead, what explains on applied overhead. Well, what's going to, what's going to cause you to under apply overhead in terms of volume is if the actual volume is less than expected. See if you actually, if you thought you were going to produce a thousand units and you only produce two, you don't apply enough.

You don't apply enough overhead. Based on that predetermined rate. So you're under apply. So actual volume must be less than you expected. How about the amount of fixed? The amount of actual fixed costs? The amount of actual fixed lost must be greater than you thought, because you know, you set up your predetermined rate.

You thought your fixed costs were going to be a million dollars. That's how you set up your, your predetermined rate. If you fixed cost, turn out to be a hundred million. You don't would that predetermined rate of $10 an hour or whatever it is, you don't apply nearly enough you under apply so that the answer is C that's.

What causes and replied overhead. If you produce less than you expected, or if the actual fixed costs are much greater than you expected you under apply. Now question number five, we have a job order question. And the basic question at the bottom is what was the amount of. Direct material charge to job five.

And if you read it carefully, job five is the only job that's still in production to solve this. Let's set up a little T account. If we set up a T account for work in process, we know they started the month with a beginning balance and work in process of $4,000. And then they charged work in process with $24,000.

Direct material that would have been a debit to work in process for 24,000 of direct material, that would, would've been a debit to work in process for $16,000 of direct labor. And remember, overhead in this problem is applied at 80% of labor costs. So with labor was charged at 16,000 overhead. Must've been charged at 80% of 16,000 or 12,800.

If you add up all the debits to work in process, they add up to 56,800. Those are the total debits to work in process. Now with th there was a credit to work in process of 48,000 that went to finished goods. In other words, they must have in terms of entries, they must have debited finished goods, 48,000 credit work and process 48,000.

The point is what's still left as a balance and work and process is 8,800. Now they want to know how much. Direct material is still in there. There's only job. Number five, still in process. And we know job number five is worth 8,800. That's the balance and work in process. But how much of that is material?

Well, we know of that. 8,800 2000 is labor that's given. Well, if 2000 is labor, 1600 must be overhead because overhead is applied at 80% of labor costs. So if there's 2000 of labor, it must be 1600 of overhead. So now you can plug the material. If there's 2000 of labor, 1600 of overhead, there must be 5,000, 200 of material.

The answer is B because we know the whole job is worth 8,800. That's still the balance left in work in process. I want to say a couple of comments about activity-based costing ABC costly in activity-based costing. Direct material direct labor are handled exactly the same way we've been handling them in all these problems.

What's different is overhead in an activity-based costing system. They try to identify the activities that add value to the product. What activities really add value to the product, what they call value, adding activities. And in an activity based costing system in an ABC system, they try as much as possible to identify and eliminate non-value adding activities like storage, you know, storage does not add value to the product.

Customers not willing to pay for storage storage is what they call a non-value adding activity. So you try as much as you can to eliminate something like storage and you try to identify what activities. Really add value to the product. What are these value adding activities? And then when you identify the activities that add value to the product, what, what really drives those costs?

Is it labor hours? Is it machine hours? Is it labor costs? You try to find the cost drivers. That's what activity-based costing is about. So direct material, direct labor handled exactly the same way we've been handling them in all these problems. But overhead is handled differently where we identify all the value adding activities, and we identify what really drives those costs.

What are the cost drivers? So with that in mind, look at question number six, they say, what effect does ABC costing have on the number of cost pools and allocation basis? Well with activity-based costing, you're going to have a lot more cost pools. You know, remember in a traditional job order system, you basically just add up all the costs in a department.

All the indirect manufacturing costs, the department, you have one cost pool, but in an activity-based system, you're identifying cost by activity that all you have, all these activities that add value to the product. So cost pools are much greater and allocation bases much greater. The answer is D you want to increase a hundred boats.

Because once you identify all the different cost pools, then you want to identify what really drives those costs. So you're going to have labor hours, machine hours, labor costs. There's going to be all sorts of allocation bases also. So it's increased under both answer deep in question number seven,

what is characteristic of an activity-based costing system? How about number one? Our cost drivers used. As a basis for cost allocation. Yes. In an activity-based costing system, you look for cost drivers, you identify all the activities that add value to the product, and then you have to identify what really drives those costs.

Is it labor hours? Is it machine hours? What really drives those costs? So you want, you, you do use cost drivers. How about number two? So you want yes. For the, for statement number one. How about number two? Our costs accumulated by department. No, that's not activity. No cost were accumulated by activity, not by department.

If you're accumulating costs by department, that's just a traditional job order approach. And of all the indirect costs in the department and, and use labor hours allocated based on labor hours, that's a traditional system, but in an activity-based costing system, you're going to accumulate cost by activity, not by department.

So no to the second state. How about number three, activities that do not add value to the product are identified. And eliminated to the extent possible. Yeah, that's true. Both first and third statements are true. The answer is C that's the whole point of activity-based costing. Try to try to identify those non-value adding activities and as much as possible eliminate any non-value adding activities like storage.

As I say, customers not willing to pay for storage storage is not add value to the product. So as much as possible, you'd want to eliminate storage, try to eliminate non-value adding activities. And in an activity based system, you would order things like supplies just in time to use them. You wouldn't have an inventory of supplies.

You wouldn't have storage you'd order things like supplies, materials, Chastain's that you'd use a just-in-time system. You'd order them just in time to use them, keep studying don't fall behind and I'll look to see you in the next class. Welcome back to our discussion on planning and measurement. And in this cpa review course, we are going to continue our discussion of cost accounting.

And what we're going to get into next is mass production. And as we said in an earlier class, if a factory is involved in mass production, any sort of mass production, they're basically forced to use a process costing system. Now, I want you to know that. Immediately. There's something about process costing that makes it a little bit more complicated.

And that is in process costing. You are required to make a cost flow assumptions you have to, and there are only two, it's either going to be first in first out or weighted average, but you can avoid that in process costing. You have to make a cost low assumption either going to be weighted average or first in, first out.

Now we're going to begin with weighted average, a weighted average cost flow assumptions with process costing. And if you downloaded the viewer's guide for this class, you'll notice that in your packet for this class, there is a problem called joy manufacturing company together. Let's do the problem on joy manufacturing company.

It's a process costing problem, and let's assume. It is a weighted average costs, low assumption. The way I'd want you to remember process costing is that it comes down to three critical steps. That's really what process costing comes down to. It always comes down to three critical steps. Step number one is to account for all units let's account for all units.

I like my students to think of accounting for all units as fundamentally a two column reconciliation. We'll start with the column on the left. Notice that in the beginning working process, January 1st, there were 25,000 units. And let me ask you something. Does it matter whether those units are 50% complete?

40% complete, 80% complete, a hundred percent complete, not in this step. Remember when you account for all units, you just deal in whole units. Don't worry about how complete they are at this point. You're just dealing in whole units. In other words, in the beginning work and process, there were 25,000 raw units just think of them as raw units.

And then during the year they started another 80,000 units into production. So you add that up that tells you there are 105,000 units to account for. Now, once you work that out, once you know that there's 105,000 units to account for now, you basically sit back and ask yourself a question logically, what can happen to any unit that you're working on?

Well, if I gave you time to think of it, I think you'd agree with me. There's three possibilities. There are three physical things that can happen to any unit work we're working on. We can finish it and transfer it out. We can still be working on it cause we're not done with it yet. Or we can ruin it.

Those are the three possibilities. You can finish it. You can still be working on it or you can spoil it. And if that makes sense to you, what that does is set up your right-hand column. Let's set up the right hand column. I'm going to set up finished ending work in process spoiled. Now of that 105,000 units.

How many were finished? 65,000 notice 65,000 units were finished and transfer. How many are still being worked on in the ending work in process 35,000. We haven't had time to finish those. Notice that only adds up to a hundred thousand units. We must've spoiled. We must've lost 5,000 units that gets you back to the 105,000 units that you had to account for.

And I'll say that very often in the CPA Exam what's missing is spoilage. And if you know that little two column reconciliation, you can find the spoilage, but let's agree on this in an exam like this. Any piece of information can be missing. That's that's the problem. the CPA Exam plays games with you, maybe the number of units that you finished is missing, or maybe the number of units that you started in the period is missing.

But if you know this two column reconciliation, you should be able to find, that's why you have to know step one, anytime you're in the CPA Exam and you're doing a problem and say, Hey, I, this, I don't have something. There's something missing, go back and do step one. You'll find it. And as I say, normally, it's the spoilage.

Here, there are 5,000 spoiled units. Now let's go to step two in step two, you must calculate your EFU. Your equivalent finished units, your E F U. Now, before we do the calculation, I just want to take a moment and make sure that you understand the concept of whole unit equivalents. I'm sure you do, but just to make sure the basic idea of this step comes down to this.

Let's say, I tell you that there's a a hundred thousand units on hand, and I tell you, each one is 70% complete. Well, if there's a hundred thousand units on hand and each one is 70% complete that's equivalent to having 70,000 units on hand that are finished. See, when you calculate your EFU, you're taking their production.

You're taking whatever they accomplished and you're converting it into finished whole units. So if I tell you that there's a million units on hand and each one is 55% complete, well that's equivalent to having 550,000 units on hand that are done. That's the thinking in this step now, before we do the calculation, there's another little wrinkle that you have to think about.

Normally in a process problem, normally you have to do a separate EFU calculation for raw material and a separate EFU calculation for labor and overhead or conversion costs. Now, why is that? Yeah, because don't forget different elements of production can be at different stages of completion. In other words, can't I have units that are say 90% complete in terms of raw material.

But only 20% complete in terms of labor and already that's the basic problem that different elements of production can be at different stages of completion. You can have units that are 94% complete in terms of material, but only 85% complete in terms of labor and overhead. So you'd have no choice, but to do a separate EFU calculation for raw material and a separate EFU calculation for conversion costs.

And that's normally what you see in the exam. So be ready to do that as well. Now I'm assuming in this problem that we are using a weighted average cost flow. If we're using a weighted average cost flow, let's do R EFU R equivalent finished units for material. Here's the format under weighted average to calculate your equivalent finished units.

You have to take the number of units. They finished just pick up what they finished. Notice they finished and transferred here. 65,000 units. Now you add to that what they accomplished, what they. Did to the ending work in process notice in this problem, there were 35,000 units in the ending work and process December 31.

If you look at the degree of completion table, those 35,000 units are 50% complete in terms of raw material. That's 17,500 whole unit equivalent. So if you add it up, the EFU for raw material comes out to 82,500, a whole unit. That's how you do equivalent finished units under weighted average. It's what you finished, plus what you accomplished, what you did to the ending work and process.

We finished and transferred 65,000 units. Then we add what we did to the ending work and process. 35,000 units got them 50% complete in terms of material that's 17,500 whole unit equivalents. EFU for material 82,500 units. Let's do the EFU four. Conversion costs for labor and overhead. While I follow the same format, I'm going to take the number of units.

They finished 65,000 and I'm going to add to that what they accomplished in the ending work in process. There are 35,000 units in the ending work in process. Cable says we got them 30% complete in terms of conversion costs. Before we ran out of time, what is that? That's 10,500 whole unit equivalents. So he added up the EFU for labor and overhead for conversion costs for the period, 75,500 whole units.

That's the format you follow that's how you do EFU equivalent finished units under weighted average. It's the number of units you finished, plus what you accomplished in the ending work in process. Now, before we go to step three, I want to step back for a moment. And have you noticed that we did have some spoilage here in this problem?

There were 5,000 lost units. We found those 5,000 lost units back in step one. When we accounted for all units now. When you see spoilage in a problem, I want you to remember that there are basically two types of spoilage. There is normal spoilage and there is abnormal spoilage. Let's talk about the difference.

Normal spoilage is spoilage that cannot be prevented, cannot be prevented by management. In other words, a certain amount of spoilage is inevitable. A certain amount of spoilage is the natural result. Of producing anything in this world and there's nothing management can do to prevent a certain level of spoilage.

That's the definition of normal spoilage it's spoilage that cannot be prevented by management. Now, on the other hand, abnormal spoilage is spoilage that could have been prevented by management spoilage that should and could have been prevented by management. Now, of course, the important thing is how do you account for each type.

Normal spoilage. Generally speaking is ignored normal spoilage. Generally speaking is ignored. In other words, generally, you do not put normal spoilage in an EFU calculation. You just ignore it. And that has the effect of spreading the cost of the normal spoilage among the remaining good units. That's the effect that has again, normal spoilage.

Generally you just ignore it. You don't put normal spoilage in any EFU calculation. And that'll have the effect of spreading the cost of the normal spoilage among the remaining good units. And that makes a lot of sense when you keep in mind one basic point, and that is normal. Spoilage is a product cost.

That's the bottom line. Normal spoilage is a product cost. Why? Because it ends up being part of the unit cost of all the surviving good units. Now abnormal spoilage is different abnormal spoilage. Is handled completely differently. And there's two big things to remember about abnormal spoilage. First of all, abnormal spoilage is added to your equivalent finished units calculation.

In other words, if I had abnormal spoilage in this problem, now my format for EFU would have three lines. I would take what they finished. Add what they did to the ending work and process. And I'd add the abnormal spoilage. You have to add another line to that format, what you finished, plus what you did to the ending work in process.

Plus the abnormal spoilage. So abnormal spoilage belongs in your EFU calculation. And what you ultimately do with abnormal spoilage is add up the material, the labor, and the overhead costs related to the abnormal spoilage and show it as a loss on the income statement. It's a loss for the period. That's why in the exam, they refer to abnormal spoilage as a period cost.

So that's the fundamental difference. Normal spoilage is a product cost. Why? Because it ends up being part of the unit cost of all the surviving good units. Abnormal spoilage is a period cost. Why? Cause it gets reported as a loss for the period. That's the fundamental difference with spoilage. Now, one of the point, if the BEC CPA Exam is silent, As they are here.

If they say nothing, you assume the knowledge, you assume spoilage is normal. If they're silent, they don't specify. You just assume spoilage is normal. So if you go back to joy manufacturing, we had 5,000 lost units. They said nothing about it. I'm assuming that's normal spoilage. And I basically ignore it.

Notice I didn't put that normal spoilage in my EFU calculation. All right. Now let's go to step three. The third step. Is unit costs. You have to be able to do a unit cost schedule. So let's set it up under weighted average. You're going to take costs from the beginning, work and process. Take the costs from the beginning working process.

Plus current costs. That'll give you a total. Then you divide by equivalent finished units and that'll give you unit costs. So let's start with direct material. There was $95,000 of. Direct material in the beginning, working can process the current material costs 400,000. If you add that up, that adds up to $495,000 of material.

I'm going to divide that by 82,500 equivalent, whole units of material produced this period. And the unit cost material comes out to exactly $6. Let's do conversion costs or labor and overhead. There was $78,750 of labor and overhead in the beginning working process. The current conversion costs. 110,000.

If you add that up, that's $188,750 of conversion costs. I'm going to divide that by 75,500 equivalent finished units have labored over it, that I completed this period. And the unit cost for conversion cost comes out to $2 and 50 cents. My total unit cost is $8 and 50 cents per unit, $6 of material, $2 and 50 cents of conversion costs.

I want to back up a step for a minute. Remember we said that we're going to use process Costman when we're involved in mass production. And I think that in step three, you can graphically see what mass production is all about. What you basically do in mass production is you keep track of all the costs in a department, in a process.

Then you divide by the number of equivalent, whole units produced. And that tells you what each one costs. Cause they're all the same. Each widget costs $8 and 50 cents. Each gallon of solvent costs, $8 and 50 cents. One gallon of solvent is just like another gallon of solvent. One widget, just like another widget.

So that's what step three is really the whole focus right there. Take all the costs in the department, divided by the whole units produced. And that tells you what each one costs, because they're all basically the same. This is mass production. All right, now that we've done the three steps. Let's talk about a couple of things the CPA Exam could ask you for the CPA Exam might ask you, what were the cost transferred onto the next department?

What would the cost transferred to finished goods? Well, now I can answer that. I take the 65,000 units that I transferred times $8 and 50 cents. Every unit I transferred is that an average unit cost of $8 and 50 cents. If you multiply that out, it comes out to $552,500. This is my transferred out costs.

the CPA Exam could ask you that. What's the value then doing work in process. What are the costs I still have on hand? Well, in the ending work in process, December 31, I have 35,000 units. Aren't they? 50% complete in terms of material. So we know though that 17,500 whole unit equivalents, times $6, the unit cost of material, I've got $105,000 of raw material in the ending work in process.

How about labor and overhead or conversion costs? Well, I've got 35,000 units in the ending work in process. They are 30% complete in terms of conversion cost. So that's 10,500 whole unit equivalents, times $2 and 50 cents. The unit cost for conversion costs. I've got $26,250 a conversion cost in the, any work and process.

The value of any work in process would be 130 1002 50. That's 105,000 of material, 26,000 to 50 of labor and overhead or conversion costs. Value of any work in process is 130 1002 50. Now. I could have plugged that. Couldn't I, you see a little shortcut here. If you go back to the problem, notice that the total manufacturing cost I have to account for 680 3007 50.

That's the total production costs. So if I, if I sent 552,500 out the door, I have to have the rest 130 1002 50 on hand. Cause that gets me back to the total manufacturing costs of six 83, seven 50, or you go the other way. I know the total cost to be accounted for 680 3007 50. So if one 31 and two 50 is on hand, I must've transferred five 50, two, five out the door.

So sometimes that'll speed up in the exam, knowing that you can reconcile back to the total manufacturing costs. Now there's another thing that the CPA Exam likes to do with process. You know, that in process costing, we normally do a separate calculation for raw material. Equivalent finished units and a separate calculation for conversion costs, equivalent finished units.

And we know why, because as we said before, different elements of production can be at different stages of completion. Well, what I want to focus in on for a couple of minutes is the EFU calculation that you make for raw material, because what the CPA Exam can do is make different assumptions about when you add the material.

For example, they could say in a problem like this, all the materials added at the beginning, And you have to know what that does to your equivalent finished units calculation, or they could say all of the materials added at the end, and you have to know what that does to your equivalent finished units calculation.

So let's, let's do this problem again. Remember in this problem, when I did the EFU for raw material, how did I do it? I said, well, under weighted average, I take the number of units that I finished 65,000. And I add what I accomplished in the ending work and process. There were 35,000 units in the ending work in process.

They gave me a table. They said they were 50% complete in terms of raw material. I got them 50% complete in terms of raw material before I ran out of time. So that's 17,500 whole unit equivalents. My EFU for material came out to 82,500 whole units. That's what we did in this problem. Now, let me change it.

What if we did the same problem, but now they said all the materials added at the beginning. In other words, now they wouldn't give you these percentages. They wouldn't give you the degree of completion table. They would just have a line in the problem. All the materials added at the beginning. What would you do?

Well, if all the materials added at the beginning, I'm going to start the same way under weighted average. I take the number of units that I finished. 65,000. And I add what I accomplished in the ending work and process. Now I've got 35,000 units in the ending work in process. And if I add all the material at the beginning, I assume those 35,000 units are a hundred percent complete in terms of material.

Because the first thing I did was that all the material now, the EFU. Would be a hundred thousand units is what I finished 65,000 units. Plus what I get to the ending work and process. And I'm assuming those 35,000 units would be a hundred percent complete neuros material. That's 35,000 whole units.

Notice. Now my EFU is a hundred thousand whole units, a little different. If you want to picture this, when they say all the materials added at the beginning, it's the way a sculptor works. You know, sculptor says I'm gonna make a statue. First thing I did was put a hunk of marble down. Well, that's not right.

There's a hundred percent of the material now comes the labor and overhead. Now I sculpt the marble. That's exactly what they're saying now. Same problem. What if they said all the materials added at the end of the process? Well, they say all the materials added at the end. It means the last thing you do, the very last step in the process.

The very last thing you do to a unit is add the material. So now if they say all the materials added at the end, I say, well, under weighted average, the way I figure out equivalent finished units, I take the number of units that I finished again, 65,000 start the same way. I'm going to add what I did to the ending work in process.

There are 35,000 units in the ending work in process. Now I assume they are 0% complete in terms of material. There's no material to their finished. There's no material till the very end. So those 35,000 units in the ending work in process, I'm assuming there's 0% complete in terms of material. So I'd add zero and the answer would be 65,000.

So what are they saying here? They're saying, gee, the last thing I do is add the material, right? All the labor and overhead comes first. Then I add the material. Is that, is that realistic? Well, you want to picture it, imagine a factory where all the labor and overhead goes into setting up a mold saying that's sort of what's going on here.

Just imagine a factory where all the labor and overhead goes into setting up a mold and calibrating it. Then the last step is, you know, add melted plastic. That's sort of what they're saying, but that's the very last thing you do. And now those 35,000 units in the ending work in process. They would have zero material on them.

There's 0% complete in terms of material. So I had zero and the answer, like I say, would be 65,000. I just wanted to show you that because the CPA Exam is not always give you degree of completion tables. A lot of times in these problems, a lot of times in multiple choice, they just kind of throw in all the materials added at the beginning or all the materials added at the end.

And you have to know how to deal with that in terms of your equivalent finished units. We will continue our discussion of process costing in our next class. I look, you

welcome back to our discussion on process costing and you know that I wanted you to do a couple of questions before watching this particular class. Let's go to question number one. I'm sure you noticed in question number one, the cost flow assumption is weighted average. Remember in process costing, you have to make a cost low assumption.

There's only two either first in first out or weighted average. And the CPA Exam is going to have to mention what it is here. It's weighted average. And what they're asking is underweighted average. What is the unit cost for direct material? Well, let's go through our steps. Step one, we account for all units.

And remember we think of that as a two column reconciliation, starting with a column on the left. We know there were 15,000 units in the beginning work process, and remember, it doesn't matter how complete they are when you're accounting for all units, you just deal in whole units, raw units. There were 15,000 raw units in the beginning working process.

Then during the year they started 40,000 units into production. So you just add that up. That gives you 55,000 units to account for, and as I said earlier, once you know that, you know, logically, there are only three things that can happen to any unit you're working on. You can finish it, you can still be working on it, or you can ruin it.

And that just sets up the right-hand column. How many did we finish? 42,500 units. How many are we still working on in the ending work and process that we haven't had time to finish 12,500 and notice that does add up. To the 55,000 units we have to account for, in other words, there are no spoiled units and that's, that's always why I do the first step.

See if there's any spoilage, make sure I have all the information that I need. As I said, in a prior class, if anything is missing, you do step one. You'll find it. Here. There is no spoilage. Let's go to step two in step two, we have to calculate our EFU are equivalent finished units, and we're only doing the EFU for material.

Remember, normally in process costing, you do a separate EFU calculation for raw material and a separate EFU calculation for conversion costs here. We're just going to do material under weighted average to Cal. He laid our equivalent finished units. I'm going to take the number of units they finished.

Just pick up. What they finished and transferred 42,500 whole units. Then I add to that what they did, what they accomplished in the ending work in process, we know there were 12,500 units in the, any work and process question is. How completed those units in terms of material that's right. A hundred percent.

How do you know that? Because they said all the materials added at the beginning, they threw that in there. Didn't they, if all the materials added at the beginning, the first thing I did was that all the material like a sculptor put a lump of, of marble down, then the labor and overhead comes to sculpt the marble it's already done.

So there's 12,500 whole units of material in the ending work and process. If you added up the equivalent finished units of material for the period, 55,000. This period, we produced 55,000 whole units of material. Now let's go to step three unit cost number under weighted average. I'm going to take the material costs in the beginning work process, 5,500 plus the current material costs, which is 18,000.

That adds up to $23,500 of total material. I divide by the number of equivalent whole units of material produced 55,000. And that gives me the unit cost for material 43 cents. And the answer is D let's go to question number two and question number two. Again, the cost flow assumption is weighted. Average exams got to say, and they say how much conversion costs, labor and overhead was transferred to the second department?

Well, let's go through our steps. First thing we're going to do is account for all units. Step one, we know that they worked, they were. 2000 units in the beginning, work in process. Then during the year they started an additional 8,000 units into production. So that gives me 10,000 units to account for just 10,000 raw units have to be accounted for.

I can finish units. I can still be working on the, or I can spoil them. That sets up the right-hand column. How many did you finish? 7,000. How many units are you still working on? 2,500. And you spoiled 500. And that gets us back to the 10,000 units we had to account for. We have accounted for all units. Now, since they're asking for the conversion cost that were transferred to the next department, let's just do our EFU our equivalent finished units for conversion costs.

We know in weighted average, I'm going to take the number of units they finished and transferred 7,000. I'm going to add to that what they did, what they accomplished in the ending work and process. There are 2,500 units in the ending work and process table says they got them 80% complete in terms of conversion costs before they ran out of time.

That's 2000 whole unit equivalents. So we put that in. Now, how about the spoilage now I want to go back to something we said in a prior class, notice this is normal spoilage. They said it was normal. And I said in a prior class that normal spoilage, generally speaking is ignored. But I did make the point.

Generally speaking, it's ignored. Generally speaking, you don't put normal spoilage in an EFU calculation and that will have the effect of spreading the cost of the normal spoilage among the surviving good units. That's generally what you do this problem. There's a twist. If you read it carefully, they said about halfway down the costs of spoiled units.

Will be assigned to the units completed and transferred to the second department in the period that spoilage is identified. That sentence changes everything. When they said the cost of spoiled units, the cost of spoilage will be assigned to the units completed and transferred to the second department in the period, the spoilage is identified.

That's that's going to change how we handle this. Normal spoilage, even though it's normal spoilage, I'm going to include in the equivalent finished units. I'm going to add another 500 units. And now the equivalent finished units for conversion costs would be 9,500, 9,500, not 9,000 9,500. By the way, if I were doing the EFU for material, I'd also put the spoilage in because of that one.

In other words, when you, when spoilage is added to a couple of finished units, it's not just for labor and overhead. It's also for material as well, but we're not doing material, but my point is the equivalent finished units for labor and overhead for conversion costs now would be 9,500 units. Now let's go to step three.

The unit cost remember under weighted average, I'm going to take the labor and overhead the conversion costs in the beginning, working process. 10,000. Plus the current conversion costs 75,500. That gives me a total of 85,500 of total conversion costs. I'm going to divide by the number of equivalent whole units produced at 9,500 and the unit cost labor and overhead for conversion costs.

It comes out to $9. Now at the bottom, when they say, what was the conversion cost transfer to the second department? Well, didn't I finish the transfer 7,000 units. There's $9 of conversion costs on each one of those units. That's 63,000 of conversion costs. I transfer it to the next department, but I also transferred the spoilage.

They said the cost of spoilage is assigned to the units and transferred to the second department in the period in which the spoilage is identified. I'm also sending the second department 500 spoiled units is $9 of labor and overhead on each one of those units. That's another. 4,500. See, what's probably happening here is the second department is taking that spoiled units, taking that 500 units and probably correcting them, saving them.

I mean, if it was true spoilage, you know, scrap. It would be thrown away. But the fact that the 500 units are being transferred to the second department must mean that they can work on the units and save them and still turn them into sellable units. That's why this is that's why, even though it's normal spoilage it's handled differently because they are being transferred to the second department to be worked on.

So that's another $4,500 of. Labored overhead transferred to the second department with the spoiled units. So what's the total labor and overhead. What's the total conversion costs. I transferred to the second department, 63,000 with a units transferred and 4,500 with a spoilage 67,500, which is answered.

See, that's a hard one problem because of that little wrinkle on the normal spoilage. Continue your studying. Don't fall behind. And we will continue our discussion of process costing in the next class. See you then

welcome back to our discussion on cost accounting. And if you've downloaded the problem for this cpa review course class, I'm sure you've noticed it's joy manufacturing company. Once again, it's a problem. We did it in an earlier class only. Now. We're going to solve joy manufacturing company. Under first, in, first out up to this point, all we've covered is processed, costing under weighted average.

But what if we did join manufacturing company under a first, in first out cost flow? Or remember it comes back to the same three steps, step number one let's account for all units, we know that there were 25,000 units in the beginning working process. It doesn't matter how complete they are not in this step.

You just deal with raw units. Then they started another 80,000 raw units into production. So if you add that up, that gives you a 105,000 units to account for, and again, we know there's only three things that can happen to any unit you're working on. You can finish it, you can still be working on it or you can roll it.

So that sets up your right hand column. How many did we finish? 65,000. How many are we still working on 35,000 and we spoiled 5,000 and that gets us back to the five that gets us back to the 105,000 units. That we knew we had to account for it in the first place. I'm sure you've already noticed step one, accounting for all units is always done the same way.

It doesn't matter what the cost flow assumption is. You're just accounting for raw units. So it's 5,000 lost units either way. And by the way, the notes I gave you in an earlier class on spoilage would all still apply this normal spoilage. This abnormal spoilage normal spoilage is a product cost.

Abnormal spoilage is a period cost. All those notes are exactly the same. If the CPA Exam is silent, I assume it's normal spoilage, generally normal spoilage is just basically ignored. So we'll ignore it from this point on, but I just wanted to mention that the notes that we went over earlier on spoilage would still apply whether it's Five-O or weighted average, let's go to step two in step two, we have to calculate our equivalent finished units, and you know that we're going to have to calculate a separate EFU.

Well, raw material and a separate EFU for conversion costs because different elements of production can be at different stages of completion. So let's do our equivalent finished units for our material.

EFU for raw material. I'm going to take the number of units that I finished, 65,000. I'm going to add to that. What I accomplished in the ending work and process, there are 35,000 units in the ending working process. They say we got them 50% complete in terms of material before we ran out of time. That's another 17,500 whole unit equivalents.

And I'm sure you've noticed down to this point. It's exactly like weighted average. It's identical. But with FIFO, you add one more thing. You have to put another line in here with FIFO. Now you must subtract. What you already, what you already accomplished in the beginning work process before the period started, you've got to back out what was already done to the beginning.

Work in process before the period started in this problem, there were 25,000 units in the beginning working process, January one, the table says they were already 10% complete in terms of material. When I started the month, when I started the year. That's 2,500 whole unit equivalents. You back out that 2,500 hundred, the EFU for raw material is 80,000 whole units.

Let's do conversion costs. I'm going to take the number of units that I finished, 65,000. I'm going to add to that. What I accomplished in the ending work and process, there are 35,000 units in the ending work and process table says I got them 30% complete in terms of conversion costs. Before I ran out of time, that's another 10,500, a whole unit equivalents.

But remember in five, four, you have to do one more thing. You have to subtract what was already done to the opening work and process. Before you started, there were 25,000 units in the opening work and process. January one table says they were already 20% complete in terms of conversion costs before you started.

So back out 5,000, the whole unit equivalent, and it comes out to 70,500 whole unit equivalents of conversion costs under FIFO. Now let's go to step three in step three, we have to calculate the unit cost and it's a little different in Fibo. When you do your unit cost, you take current costs only. It's not like weighted average and weighted average.

You would take cost from the beginning working process plus current costs, but not in FIFA Fiverr, you're going to take current costs only. So for raw material, I'm going to pick up the current raw material costs only 100,000. I divide by the number of equivalent, whole units of material produced this period 80,000.

And the unit cost for material comes out to $5. Same thing with conversion costs. I'm going to pick up the conversion cost of the current period. Current period, only 110,000 divided by the EFU for conversion costs, 70,500 whole units. And the EFU for labor and overhead conversion costs comes out to a dollar 56.

My total unit cost is $6 and 56 cents. Those are the three steps under first, in, first out. All right. Now what if they were to ask. What's the cost and the ending work and process. How would I do it? Well, in the ending work in process, I've got 35,000 units. Don't I, December 31 table says they're 50% complete Andrews material.

So that's 17,500 to whole unit equivalents, times $5. The unit cost material, there must be $87,500 of material in the ending work in process. How about conversion costs? Well, there's 35,000 units in the, any work in process December 31. Table says that 30% complete in terms of labor and overhead. So that's 10,500, a whole unit equivalents times dollar 56.

The unit cost for conversion cost is $16,380 a conversion costs in the end. The work in process of the added up any work in process comes out to $103,880. That's 87,500 of materials, $16,380. Of labor and overhead. Total ending work in process is $103,880. What if they wanted the cost transferred out? You know, you know what to do?

Don't I know the total manufacturing costs are 680 3007 50. I knew when I started, I had total manufacturing costs to account for of $683,750. If 103,880 is in the ending work in process, I must have transferred the rest out 579,000. $870. Must've been transferred out. Maybe you can plug that because you're always proving back to the total manufacturing costs for the period though.

Those are the steps under first, in, first out, why don't we try a multiple choice if you go to multiple choice, number one for this cpa review course class at the bottom, it says, what is the total value of material costs in the ending work in process? Under first in, first out. Well, let's go through our steps. First. We want to account for all units.

We think of that as a two column reconciliation column on the left, we know there were a hundred, a hundred units in the beginning working process January one. Then they started another 500 units into production during the quarter. So, so you add it up. That gives us $600, $600, 600 user units to account for.

Right. That's all the left-hand column is about just dealing with raw units. What were the raw units to account for 600? And now we know there's just three things that can happen. Two units, you can finish them, you can still be working on them, or you can spoil them. How many did we finish? 400. How many are we still working on 200.

That does reconcile the 600 whole units. The spoilage must have been zero. We assume that they spoiled zero units. Let's do step two. We calculate equivalent finished units. Remember under FIFO. That is the cost low assumption here under Five-O. We're going to take the number of units. They finished just pick up what they finished and transfer 400 units.

We're going to add to that what they accomplished, what they did to the ending work and process. There were 200, there were 200 units in the ending work in process. They say they got them 75% complete in terms of material. Before we ran out of time, that's another 150 equivalence of material. And as I pointed out earlier down to there, it's exactly like weighted average, isn't it.

But in firewall, you have to do one more thing. Now you have to subtract what was already done to the beginning, work in process before you started weren't there a hundred units in the beginning working process, January one, they said they were already 50% complete, already 50% complete in terms of material for you started, you're going to back out 50 whole unit equivalents and the EFU for material under FIFO.

Comes out to exactly 500 units. Now let's go to step three unit cost under Five-O. You want to pick up the current cost only what's the current material costs 720,000 notice. I don't pick up the costs in the beginning working process, just the current costs, 720,000 of material. I divide by the number of equivalent, whole units of material produced 500 and the unit cost of material $1,440.

That's my unit cost material $1,440 for each unit of material produced. Now I can answer the question when they ask at the bottom what's the total material costs in the ending work in process. Well, don't, I have 200 units in the ending work in process table says there's 75% complete in terms of material.

That's 150 whole unit equivalents of material times 1004 40. The unit cost material is exactly 216,000 of material, $216,000 worth of material in that any work in process. And the answer is D make sure with process costing, you know, both first in, first out and weighted average. Keep up with your studying.

Don't fall behind with your homework. I'll look to see you in the next class.

Welcome back to our discussion on cost accounting. And before we leave the topic of process costing, I want to cover one more facet of process costing, and that is the topic of joint products and byproducts. Let me just start with a couple of quick definitions. Joint products are two or more. Could be three, it could be for two or more products that produce significant total revenue, two or more products that produced significant total revenue and our process together in the same department.

In other words, two or more main products that are processed, jointly that process together in the same department, a by-product is a product of insignificant total value. Insignificant total revenue that is produced incidental to the production of a main product. So a by-product just sort of tumbles out.

It's a product that produces insignificant total revenue, and it's produced incidental to the production of a main product, which is our real objective. And if you, with me on the definitions, let me just get right to what the CPA Exam likes to ask. What the CPA Exam likes to ask. Is the relative sales value method of allocating the joint costs.

If joint products are two or more main products processed together in the same department, how do we allocate those joint processing costs? And as I say, what the CPA Exam likes to ask is the relative sales value method of allocating joint costs. Now you have to be careful. There's different names for this approach.

It's called the relative sales value method. It's called the relative sales value at split off method. It's called the net realizable value method. It's really different ways of saying the same thing, but it's what the BEC CPA Exam always hits on the relative sales value method. The relative sales value at split off method, the net realizable value method.

Let's go right to a problem. If you look at question number one that you've downloaded for this cpa review course class. You'll notice that a and B are joint products. There are two main products they're processed together in the same department. And they say at the bottom, what joint costs would be allocated to a, if we use the net realizable value method.

Well, first of all, let's work out the sales value for each product. The sales value of a is $80,000. That's what we can sell a four. 80,000. Now what about the additional processing costs? You've got to remember the additional processing costs are a dollar for dollar reduction of the sales value. So the sales value of product, a, the net realizable value of product a is 72,000 same thing with B, we can sell beef for $40,000.

But there's some additional processing costs. And again, those additional processing costs are a dollar for dollar reduction in the sales value. So we're going to back out those additional processing costs of 2200, the net realizable value of product B is 18,000. The total sales value of both products combined 90,000.

Now, before we do the final solution here, I want to point out a couple of things. What would you do in this problem? If they said they actually intend to sell so many pounds of a, they actually intent, they actually intend to sell so many pounds of B. You couldn't care less. I want you to remember that in the relative sales value method, what we need is the theoretical sales value of all the good pounds produced.

They start telling me. How many pounds they actually sold, they couldn't care less. It's one of the big tricks in the exam. They start telling you how many pounds were actually sold. That doesn't mean anything. What you're after in this method is the theoretical sales value of all the good pounds produced.

And the other important point is don't forget those additional processing costs. As I said, those additional processing costs are a dollar for dollar reduction of the sales value. So as I say, the relative sales value of product, a. 72,000, the relative sales value of product B 18,000 total sales value for both products.

90,000. Now I strike a ratio since a makes up 72,000 of the total $90,000 sales value since EI makes up 80% of the total theoretical sales value, 80% of the net realizable value in this method, a would be allocated 80% of the 60,000 joint costs are 48,000. And the answer is C. Notice you are literally using relative sales values to allocate those joint costs.

And again, sometimes the CPA Exam calls it the relative sales value method, the net realizable value method as they did here, the relative sales value at split-off method. Really different ways of saying exactly the same thing.

Let's go to question number two.

they say in question number two, that actual sales values at split off are not known for products, Y and Z. So we don't know the sales value is split off for Y and Z. The relative sales value at split-off point is being used to allocate joint costs. There's been an increase in costs beyond split off for product Z while wise costs remain constant.

That's all, you know, All you know, is that there's been an increase in costs beyond split off for product Z wise has remained constant. If the final sales values remain constant, the final sales price has remained constant. What's going to happen to joint costs. Well, remember that the costs beyond split off are a dollar for dollar reduction of the sales value.

They reduce the net realizable value of the product. So if there's been an increase in costs beyond split off for product Z. Then what I'm going to net out of these, going down, down, down with, there's been an increase in cost beyond split off for product Z I'm netting, less and less out of Z net realizable value.

Fuzzy's going down Weizmann and constant. So if I use relative sales value with split off to allocate joint costs, the percent of joint costs will increase for Y and go down for Z because the net realizable value of Z is good. Went down. So joint costs for Y would increase joint cost per Z. Would go down now, we haven't, you said much about byproducts to this point.

Remember a by-product is a product that produces insignificant total revenue in material, total revenue, and is produced incidental, the production incidental to the production of a main product. Now under generally accepted accounting principles, because a by-product is insignificant. It's immaterial by definition.

You have a lot of latitude on how to handle byproducts. Some companies treat what they net out of a by-product as miscellaneous income. That's perfectly. Okay. So you can treat what you net out of a by-product, you know, make a few dollars on it. You can treat that as miscellaneous income, other income on the income statement.

Some companies. Treat what they get out of the bi-product. They can make a little profit on the by-product and they treat that as a reduction of cost of goods sold. That's fine. Now the most common approach you see in the CPA Exam is this gimme exam. What they liked the best is taken and what you're going to net out of that byproduct.

Let's go to question number three and question number three, we have a process that produces two joint products. J and K and a by-product B and notice B can be sold for $9,000, but there's also additional costs beyond split off of 4,000. So let's work that out quickly. What's the net realizable value for the by-product I expect to sell the by-product for $9,000.

There are additional processing costs of 5,000. So

what I expect to. Net out of the by-product is $4,000. The net realizable value of that byproduct is $4,000. Now, what do they say about the by-product? They said that the net realizable value, the by-product is subtracted from joint costs. This is the method that you see most often in the BEC CPA Exam where they take what they're going to net out of the by-product, what they call the net realizable value.

The by-product that. $4,000 and they use it to lower joint costs. And you gotta be careful. There's a name for that. Sometimes the CPA Exam calls this, the net realizable value method of accounting for byproducts. I think you should be aware of that. If the CPA Exam mentioned the net realizable value method of accounting for byproducts, this is what they're doing.

They're taking the net realizable value of the byproduct. Again, that's the 9,000. You can sell it for minus the additional costs of 5,000. That's 4,000. They are taking what they're going to net out of the by-product and treating it as a reduction of joint costs. And one more time, they have a name for that.

That's called the net realizable value method of accounting, but byproducts. That's what they're doing here. So because I'm using the net realizable value method of accounting for the by-product, I'm going to take their joint costs, which are 54,000, but I'm going to lower that 54,000 by the 4,000 net realizable value.

The by-product. So now the joint costs are 50,000 and once you've made that adjustment, now it's just a straight. Relative sales value at split off problem. I'm going to take the sales value of my main products. The sales value of K is 40,000. There are no additional costs beyond split off. So the net realizable value of K is that 40,000.

I'm going to take the sales value of J 60,000. There are no additional costs beyond split off. So the net realizable value of J is 60,000. My total theoretical sales value is a hundred thousand. And let me say to you again, they start telling you how many.

You couldn't care less you're after the theoretical sales value of the good pounds produced, that's what you care about here method. So I'm going to take the total theoretical sales value for my main products, a hundred thousand. And I say, well, since K makes up 40,000 over a hundred thousand since K makes up 40% of the total theoretical sales value in this method, K would get 40% of joint costs.

And what a joint costs now? Well, they were 54,000, but because I use the net realizable value method because I'm. Taking the net realizable value. The by-product 4,000 subtract them from joint costs. Now there's only 50,000 of joint costs. He gets 40% of that or 20,000 answers. See, that's what they wanted.

They wanted to know the joint costs that would be allocated to product K. And the answer is 20,000. The answer is C. So, like I say, with byproducts, you can treat them that net realizable value is other income. You can treat it as a reduction of cost of goods sold, but that's the approach. the CPA Exam likes usually what they call the net realizable value method of accounting, but byproducts where you take the net realizable value, the by-product and use that net realizable value the by-product to lower joint costs.

Watch out. You got to know what that net realizable value method of accounting for byproducts. It's all about. Don't fall behind. Keep up with your work. I'll see you in the next class. Welcome back to our discussion on cost accounting. And before we leave the topic of cost accounting, there's one more subject we have to discuss, and that is the subject of standard cost accounting.

Now, when I say standard costing, I am saying that a corporation. Has a job order or a process system, either one, but they've set up standards, they've set up goals that management should reasonably be able to meet. I want to go back for a minute to an earlier class. Remember in an earlier class, we talked about job order costing, and we said that the essence of job order costing is to remember that.

In job order costing direct material and direct labor are charged to a job based on actual, always based on the actual amounts incurred on the job, but overhead gets applied to a job based on a predetermined rate. I know you remember that. Well, just remember with standard costing, all elements of production will be applied to a job based on a predetermined rate.

In other words, in standard costing. Now I'm going to have a predetermined rate for raw material or what a standard amount of material that I apply to every unit I produce, I'm going to have a predetermined rightful labor, or what a standard amount of labor that I apply to every unit I produce. And as always, there will be a predetermined rate for overhead or a standard amount of overhead.

I applied to every unit I produced that standard costing. Another thing that might help you is to remember in this topic, when you see standard think budget, Standard means budget. So when I say I have a standard for material, it means I have a budget for material. For every unit. I have a standard or a budget for labor.

I have a standard or a budget for overhead for every unit I produce. And I'm sure you know, that the whole reason we come up with these budgets, these standards is ultimately to compare standard or budget with what actually happens. So I can judge management. I set up these standards or these budgets to give them management a yardstick to measure performance by that's why we go through this whole process.

And of course, the way I judge management  is with the use of variances. It's what I want to get into next. What we're going to get into next are all the different variances that you have to know for the exam. There's quite a few. And if you downloaded the problem for this class, I'm sure you noticed that we have a big problem to work on Armando corporation.

If you take a look at it, they start off by giving you the standards. Very typical set up for a problem like this. Here are the standards on every unit that's supposed to put 20 standard yards of material at a dollar 35, a yard. That's the standard price per yard. So what are they doing? They're applying $27 of material to every unit they produce.

Labor that's supposed to put for standard hours of labor into every unit. They produce $9 per hours, the standard rates. So what are they doing? They're applying $36 of labor to every unit they produce. They say overhead is applied at five, six of direct labor. If you take five, six of 36, you get 30. That's where the 30 comes from.

So every unit they produce, they're applying $30 of overhead. That's their budget, that's the standard for overhead. And they say, That in that 30, the ratio of variable cost to fix this two to one. Well, if the ratio of variable costs to fixed is two to one, then that $30 must break down to $20, variable, $10 fixed.

I might want to speak a little note of that. We'll talk about that later, but that's how the $30 must break down $20 variable, $10 fixed. We'll talk about that later, but the standard, the budget for every unit. Is $93. Then they say the standards are based on normal monthly activity involving 2,400 direct labor hours or 600 units of product.

Well, that makes sense too, because if normal activity is 2,400 hours and they're supposed to put four standard hours in every unit they produce, doesn't it make perfect sense that normal activity in units, 600, the fixed overhead budget for the month is $6,000. The variable factory overhead rate per direct labor hour is $5.

So there's all your standards. There's all your budget information. Now. Here's what actually happened. And that's the basic setup of all of these problems. We give you the standards. We give you the budget. Here's what actually happened. They went out and they actually purchased 18,000 yards of material with a dollar 38 yard.

They actually spent $24,840 on material and notice they actually used 9,500 of those yards. They actually worked 2,100 hours of labor nine, 15 an hour. That was the actual rate. So they actually spent $19,215 on labor. And they actually spent $16,650 on overhead. And they say one more thing. 500 units of product were actually produced.

I want to circle that 500. That's important in a bearings problem. You have to know. How many units were actually produced. Remember, we're going to judge management on what they actually produced. We don't judge management on what they should have produced. No, that's a different question. We judge management.

How well did they do on the units they actually produced? So that's a critical number. We want to know how many units they actually produce. That's 500. They say we have to come up here with six variances. And let me just say, these are the big six. These are the six. the CPA Exam has asked for the most. Now, as we go through these six, I'm going to mention some other variances they might ask for, but these are the big six.

Let's start with material price variance. Now, before we get into how to solve this, let me just quickly say that there are basically two ways you can approach variances. You can memorize a format or you can take a shortcut. And what I want for you. Is that you can do both. I know that seems unreasonable, but that's really what you should be able to do.

You should know the formats. And I think sometimes the shortcuts help you also, I know you want to say Bob, just show me the shortcut, but depending on how they write the problem, sometimes the shortcuts can be difficult. In other words, sometimes the shortcuts are great. They save you time, but sometimes you need the format.

The formats will never let you down. I don't care how they set up a problem. It's good to come back to the format sometimes. So it's really good to know both, if you can. So let's start with the format for material price variance. The first one they asked if I want to do a material price variance, I'm going to take the actual yards purchased times the actual price.

It's the actual yards purchase times the actual price, and compare that with the actual yards purchase times the standard price. Just remember it's actual times actual compared with actual time standards. Let's fill it in. I'm going to take the actual yards purchased 18,000 times the actual price per yard, which is a dollar 38.

They actually did spend $24,840 on material. Now I'm going to compare that with the actual yards purchased 18,000 times the standard price, they should have paid per yard, which is a dollar 35. What they should have spent was 24,300. There's a $540 material price variance. Now I know you're aware of this, but we have to say it right away.

You never come up with a bearing it's. Where you don't immediately stop and think, is it favorable or unfavorable? I mean, all that matters really is whether it's favorable or unfavorable, we're trying to judge management. So just to come up with a number, it doesn't really mean it in a vacuum doesn't mean anything.

The question is, is it favorable or unfavorable? This is unfavorable. It's definitely unfavorable. Now the reason is because they're over budget, they're looking at it that way. They spent too much, but I'll just give you another, another quick way to get favorable or unfavorable. Just remember in every variance that we do, if the top number is higher than the bottom number, it's automatically unfavorable.

I'm trying to take the thinking out of it. Because a lot of students can get the number. They just aren't sure whether it's favorable or unfavorable. So just remember in everyone, we do not just this one in every variance we do together. If the top number is higher than the bottom number, it's automatically on favorable.

If you ever see a bottom number higher than a top number, it's favorable every time. Nevermind. Why it'll just slow you down that way. That's why it's automatic. You can label them immediately. Now another point that variance is unfavorable. That's true. So it's a debit. I want you to remember. That unfavorable bearings are always debits.

Favorable. Bearings are always credits sometimes that misses the student up. So that's a $540 debit. Cause unfavorable bearings are always debits. Favorable. Variances are always credits. So that would be a $540 debit, unfavorable material, price meringues. Now that's the format. I'm sure you already see it.

What's the shortcut. Well, the other way to get it is didn't they pay 3 cents more than standard. Weren't they 3 cents over budget for every yard they purchased. If you take 3 cents, times, 18,000 yards, that'll also give you five 40 and sometimes it'll help if you know that shortcut, but that's the other way to get it.

The 3 cents over budget for every yard they purchased multiply 3 cents, times, 18,000 yards, and that will give it to you. Also, let's do number two, the material usage variance to get the material usage. Marriott's we're going to take the actual yards used, not purchased. Used time standard price. And we're going to compare that with the standard yards, they should have used times standard price.

It's actual time standard compared with standard time standard, let's work it out. We're going to take the actual yards. They used 9,500 notice. Actual yards use not purchased used. 9,500 times the standard price per yard, a dollar 35 that comes out to $12,825. Now we're going to compare that with the standard yards they should have used.

How do we get that? Well, they made 500 units, so let's get back to that again. That's a critical number. They made 500 units according to budget. Aren't they supposed to put 20 standard yards into every unit they produce. If you take 500 times 20, they should have used 10,000 yards. Time's a dollar 35 standard price that comes up to 13 five.

There's a $675 material usage variance. And of course that's favorable because the bottom number is higher than the top number. It's a credit it's favorable that's material usage variance. And of course the shortcut what's the shortcut. Didn't we say 500 yards look, our standards. Our budgets are reasonable.

Our budget says you make 500 units. It ought to take 10,000 yards of material. Well, we made 500 units. And for some reason, we only use 9,500 yards somewhere along the line. We saved 500 yards. And if you multiply 500 yards saved times a dollar 35 standard price, that'll also give you $675 favorable material usage, variance, or now they could ask you for this variance.

Okay. As I mentioned, I'm going to, I'm going to bring up a couple, they could ask for what if they wanted the. Total material bearings. Well, I hate you to miss that. Just combine the two you have. I have an unfavorable material price. That's a $540 debit. I have a favorable material usage, a $675 credit. Just combine the two total material variance is $135 credit or favorable hate you to miss that.

Cause you just combine the two. You already have the hard work's already done. Now I'll tell you one thing you're going to like. If you don't mind material price and material usage, I don't think you're going to mind all labor rate and labor efficiency, because it's the same formats. So notice if you just know these two formats, you get four of the, of the big six marriages right away.

Here's what I'm saying. We can take the same format we use for material price, actual times actual compared with actual time standards. But now I can use it for labor price or labor rate variance. If I'm going to use the same format for labor, what are the letters stand for now? I'm going to take the actual hours, worked 2100 times the actual rate nine, 15 per hour.

They actually spent $19,215 on labor. I'm going to compare that with the actual hours worked 2100 times the standard rate, which is $9 an hour that comes out to 18,900. There's a $315. Debit unfavorable labor rate variance. Why is it a debit? Because the top number is high and the bottom number. Just remember top numbers high and the bottom number.

It's a debit it's unfavorable every time, Bob number higher than the top number. It's a credit it's favorable every time. Nevermind. Why? That way it's it's quick. It's automatic. And of course the shortcut on this one is to do what didn't. They spend 15 cents over budget didn't they spend 15 cents over standard, over budget for every hour.

They work. And if you multiply 15 cents times 2100 hours, that'll also give you three 15. That's the other way to do that. Now let's get the labor usage or labor efficiency, variance. It's the same format as material usage. We're going to take the actual hours worked 2100 times the standard rate nine that comes out to $18,900.

As you already know, we're going to compare that with the standard hours they should have worked. Times standard rate. Now what's the standard hours. They should have worked. That's the number you got to come up with? Well, how many units they produce? No, it's like you're coming back to that. We judge management on what they actually produced, not what they should have produced.

They actually produced 500 units. Budget says they're supposed to put four standard hours in every unit. So they should've worked 2000 standard hours. Times nine that comes out to 18,000. There's a $900 debit, unfavorable, labor efficiency variance. Now, you know the shortcut here, what's the shortcut didn't they waste a hundred hours.

Your standards say, look, if you make 500 units, it ought to take 2000 hours. Well, our workers made 500 units and it took 2100 hours somewhere along the line. We wasted a hundred hours. And if you take a hundred hours wasted times the standard rate nine, that'll also give you 900. Unfavorable labor efficiency, variance.

It's a debit. Now here's one they could ask for what if they wanted the total labor variance. I hate you to miss that. You've already done the hard work. If they want the total labor variance, just combine the two. You have, you have an a $315 unfavorable labor rate variance. That's a debit. You've got a $900 unfavorable labor efficiency variance.

That's a debit. Your total labor variance would be 1000 to 15 debit on favorable. So, as I say, what you've really just learned is if you get those two formats down, you can handle four of the big variances they asked for all the time, material, price, material usage, labor rate, labor efficiency. It's really not too bad in our next class.

We will continue with our Mondo and we will go through the overhead variances. I look to see you in the next class. Welcome back to our discussion on cost accounting. And in this cpa review course class, we're going to finish our discussion on Armando corporation. The big problem that we started in our last class on variances.

And I know you remember that in our last class, we had discussed the raw material variances and the direct labor variances. And I want you to keep in mind that direct material. And direct labor represent purely variable costs, simply meaning the amount of cost incurred is directly related, directly related to the number of units produced or the number of hours worked.

After all the more units I produced, the more direct material costs I incur, the less units I produce, the less direct material costs I incur. The more units I produce, the more direct labor costs I incur, the less units I produced, the less direct labor costs. I incur direct material and direct labor are purely variable manufacturing costs.

And I mentioned that because when you begin to discuss factory overhead variances, it's important to keep in mind. That factory overhead is both variable and fixed. And I want to make sure you see why he keep in mind that factory overhead represents all the indirect manufacturing costs. And the fact is some of those indirect manufacturing costs are considered variable.

Some of the indirect manufacturing costs are considered fixed. That's why factory overhead is really both. I mean, think of the things we put under factory overhead. I put depreciation on the factory under factory overhead. That's a fixed cost, but I also put supplies for the factory under factory overhead.

That's a variable cost and that's the basic point factory overhead as both fixed elements like depreciation, property taxes, insurance, but factory overhead also has variable elements, supplies, utilities. Factory overhead is both variable and fixed. And in order to do overhead variances, the first thing you have to be able to do is a flexible budget for factory overhead at different levels of activity.

If you go back to Armando corporation, you'll notice that the fixed overhead budget is $6,000 a month. They also say that the variable factory overhead rate per direct labor hour is $5. So with that information in mind, let's do a couple of flexible budgets for factory overhead. In order to do the overhead variances, you have to be able to do two flexible budgets.

First, we're going to do a flexible budget for factory overhead based on the standard hours they should've worked. So let's go over the standard hours. In this problem, how many units were actually produced 500. And if you go back to the standards, how many standard hours should they put into each unit for?

So the standard hours they should have worked for what they accomplished is 2000. They made 500 units. They're supposed to put four standard hours in every unit. So they should have worked to that 2000 standard hours for what they accomplished together. Let's do a flexible budget. For factory overhead based on those 2000 standard hours at 2000 standard hours, what's the fixed factory overhead budget, 6,000.

Remember fixed is fixed. It's set in amount. This budget is not going to rise and fall with activity. So the fixed that stays setting them out 6,000, which always have to be careful about is the variable budget. They gave us that other information that. The variable factory overhead rate for direct labor hours, $5.

In other words, they're saying every time this factory works another hour, they incur another $5 of supplies. Supervisor salaries, utilities. Remember some overhead costs are variable. So that's what they're getting at every time this factory works an hour, they incur another $5 of purely variable factory overhead.

So I'm going to take those 2000 standard hours, times $5, theoretically at that level. The variable overhead budget would be 10,000. The fixed overhead budget is 6,000 a fixed factory overhead budget. Based on those 2000 standard hours would be $16,000. Now let's do another budget. Let's do a flexible budget per factory overhead based on the actual hours, they work.

Go back to the actual information. How many actual hours did they work? 2100. So let's do a flexible budget for factory overhead based on the 2100 hours, they actually did work. Well, first of all, what's the fixed budget. 6,000 fixed is fixed. It's set in amount. Again, that budget is not going to rise and fall with activity.

No matter how many hours they work within a relevant range within a certain range of activity within a certain range of activity, maybe from, you know, zero hours of, of labor, zero hours of production up to 10,000 hours, some costs they fixed within that relevant range. So fixed is fixed. It's setting them out 6,000.

What you always have to be careful about is that variable budget. They said every time they work an hour, they incur another $5 of variable factory overhead. So I'm going to take the 2,100 hours. They actually did work times $5. Theoretically, at that level, the variable budget would be $10,500. The fixed budget stays 6,000.

So a budget based on the actual hours, they worked. Would be 16,500. You can not do overhead variances. If you cannot do those budgets, those are the two budgets. You have to be able to do a budget based on the standard hours. They should have worked and a budget based on the actual hours. They did work.

Once you have those budgets. Now you can do the overhead variances. We're going to start with the two way analysis of analyzing overhead. That's what they asked for here. If you go back to the problem. Notice they asked for the controllable factory, overhead variance and the volume or capacity, overhead variants.

They want to overhead variances. This is what the CPA Exam refers to as the two way analysis, the two variants method of analyzing factory overhead. Here's how you do the two way analysis at the top. Put in their actual overhead costs. If you go down to the actual information in the problem, notice they actually did spend $16,650 on actual overhead costs.

That's what they actually spent on fixed items. Plus what they actually spend on variable items, 16,006 50 with the exam, have to give you that. Yes, there's no way you could come up with that actual overhead costs that'll be given. All right, then you leave a good amount of space. And at the bottom, you're going to put in the overhead applied to work in process.

Now, if you go back to the standards, What's their predetermined rate for overhead. Isn't it? $30 per unit. If you look at the standards, so I'm going to take that $30 times the 500 units they produced, they must have applied $15,000 of overhead to work in process. Now, the difference between the actual overhead costs, 16,006 50 at the top.

And the overhead applied to work in process 15,000, that 1006 50 difference. That's called total overhead variance or the net overhead variance. And I want to show you that because the CPA Exam has asked for that a lot. They didn't ask for it here, but you have to be able to get that number again. That's called.

The total overhead variance or the net overhead variance 1006 50. And we know it's unfavorable. Why? Because the top number is higher than the bottom number. Remember that never lets you down. If the top number is higher than the bottom number, it's a debit it's unfavorable every single time. Now, before I leave that applied number, think about how I got that applied.

I took the predetermined rate $30 a unit times. 500 units produced. That's how well they applied 15,000. Well, I have to warn you sometimes in the CPA Exam rather than give you a predetermined rate per unit. They give you a predetermined rate per hour. So let me show you another way to get that number just in case it comes up.

If you go back to the standards, we know that they are applying $30 of overhead to every unit. Now, if you look at the standards, how many standard hours do they spend on every unit for, if you take that $30 divide by four. The predetermined rate per hour is $7 and 50 cents. So my point is you could be in the CPA Exam and rather than give you the amount they're applying per unit, they could just simply say the predetermined rate for overhead is $7 and 50 cents an hour.

Notice in order to get applied, I would take that $7 and 50 cents times the 2000 standard hours. They should have worked. That'll give me the 15,000 also, remember don't use actual hours there. If I want to work out applied, remember everything goes to work in process at standard. So again, if I hadn't, if I did not have the $30 a unit here, if all they said was overhead is applied at $7 and 50 cents per hour, I would take that $7 and 50 cents an hour times the 2000 standard hours they should have worked.

And that would also give me 15,000, but you have to be able to get that applied number. All right. Now, back to the basic format, we put their actual overhead costs at the top. At the bottom, we put the overhead applied to work in process. The difference between what they spent and what they applied. That's your total overhead variance, net, your net, overhead variance.

They could ask for that. And if all they want is the two way analysis, you just put something in the middle, in the middle, you put. The flexible budget for factory overhead based on standard hours, we already did that. A flexible budget for factory overhead based on standard hours. Remember came out to 16,000, just put that in the middle.

And now you have the two way analysis. The difference between what they actually spent 16,006 50 and the budget based on standard hours, 16,000 that's $650. That's called overhead controllable variance, and it's unfavorable. Because the top number is higher than the next number down. Never lets you down.

That's a debit unfavorable. And then finally the difference between the budget based on standard hours, 16,000 and what they applied 15,000, that thousand dollars that's called overhead volume variance or overhead capacity bearings. The exams use both terms. It's called overhead volume variance or overhead capacity variants.

And that's unfavorable because 16,000 is higher than 15. The top number is higher than the next number down, you know, it's a debit, you know, it's unfavorable. So that's what they mean by the two way analysis. It's overhead controllable, overhead volume. That's the two way analysis. The two variants method.

Now a couple of things about these two variances, the controllable variance, the controllable variance. That's six 50 that is made up of both fixed and variable costs, fixed and variable. And it's really a function of two things. The controllable is really a function of spending and efficiency and theoretically spending and efficiency are within the control of management.

So in the two way analysis, we just say they should have been able to control it, but that's what it's about. It's made up of spending and efficiency and theoretically spending and efficiency. It's controllable by management. So we just, wait, what were you saying in the, in the two-way analysis is six 50.

Should've been controlled now the thousand dollar volume. Barron's the reason why you get a volume variance is you've either worked over normal. You've worked over normal. So you've over applied your fixed overhead. Or you've worked under normal and you've under applied your fixed orbit. That's why you have a volume variance volume variance represents purely fixed costs.

There's no variable in there purely fixed costs. You get a volume bearings because you work over normal and therefore you over apply your fixed overhead. Or as you did here, you work under normal. So you under applied your fixed overhead. If you go back to this problem, what's normal activity. 600 units.

How many did they produce? 500. They produced under normal. And if you produced under normal, you must have under applied your fixed backyard. Remember the unders go together. If you produce under normal, well, then you under apply your fixed factory overhead. If you go back to the standards, we know their predetermined rate for overhead is $30 a unit.

And didn't they say that? The ratio of variable cost to fix this two to one. Well, if the ratio of variable cost to fix this two to one, we know that $30 breaks down to $20 variable, $10. So if that's true, doesn't it mean they're applying $10 a fixed over at w and if they produce, how many units did they produce?

500. If you take $10 times 500 didn't they apply 5,000 of fixed overhead to production to work in process. But the problem is the fixed budget is 6,000 at any level, fixed is fixed. So, what they did is under apply this, they fixed factory overhead. That's why you have a volume merits volume bearings represents purely fixed costs.

You either produce over normal. So you overplay your fixed overhead, or like in this problem you produced under normal. So you under apply your fixed factory overhead. Now notice if you understand the two way analysis, you can handle some questions in the exam. If you look at question number one for this cpa review course, They say under the two way analysis of analyzing overhead, what is used to calculate the controllable variance to calculate controllable?

Do we need a budget based on actual hours? No. No, we don't need that. You want to know in that column control, that was defined as actual overhead cost compared with budget based on standard hours. I don't need the budget based on actual hours. And of course the second column budget based on standard hours, I do need that and it's no, yes.

Answer D. Let's look at question number two, under the two variants method of analyzing overhead, the difference between a budget based on standard hours and what you applied is called what that's the volume variance or the capacity of Aaron's answer C. So make sure you know that basic format for the two way analysis.

Now let's take our Mondo. Let's do the same problem, but now let's do the three-way analysis. Of analyzing overhead because the CPA Exam has asked for that. So let's go with a three-way analysis. If they want the three-way analysis of analyzing overhead, you start the same way at the top of the page, what their actual overhead costs, 16,006 50.

They have to give you that. Leave a good amount of space at the bottom. Put in the overhead applied to work in process, we know they're applying $30 of overhead to every unit. They made 500 units, so they applied $15,000 of overhead to work in process. And once again, the difference between what they actually spent 16,006 50 and what they applied 15,000, that 1006 50, that's called the total overhead variance or the net overhead variance.

We know it's unfavorable. I always start by getting that one. Now I'm going to put in a budget based on standard hours, that's 16,000 and as always the difference between a budget based on standard hours, 16,000, and what was applied 15,000, that thousand dollars, that's called overhead volume variance or overhead capacity variance.

It's a thousand. And we know it's unfavorable notice to this point, it's exactly the same format as the two way analysis, but in the three-way analysis, I add one more thing. Now I add a budget based on actual hours. And remember we already calculated that that came up to 16,500. When I put in the budget based on actual hours, based on the actual 2100 hours, they did work 16,500.

Now I have two more variances. See what the three-way does is take the controllable and divide it up into it's. Spending and efficiency problem. So I put in the budget based on actual hours. Now I do a further analysis. The difference between what they actually spent on overhead 16,006, 50, and a budget based on actual hours, 16 five, that $150 that's called overhead spending bearings.

And of course it has to be unfavorable because 16, six 50 is higher than 65. Top is higher than the next number down. You know, what's a debit, you know, it's unfavorable. And then finally the difference between the budget based on actual hours, 16,500 and a budget based on standard hours, 16,000, that $500, it's called overhead efficiency variance.

And of course that's unfavorable because 16 five is higher than 16,000. And did you notice this? If I take overhead spending one 50 overhead efficiency, 500 overhead volume, a thousand. It gets me back to the total overhead variance of 1006, 50 unfavorable. You know, all the individual variances have to get back to the net, have to get back to the total overhead barons.

Sometimes that'll help you.

Anytime the CPA Exam mentions the three-way analysis. That's what they're looking for. They're looking for overhead spending, overhead efficiency, overhead volume. That's the three-way analysis, overhead spending overhead efficiency, overhead volume variance. Now there is a four way analysis. Now, if they want the full way analysis, which the CPA Exam is asked for.

Use the same basic format at the top of the page, put their actions, overhead costs 16,006 50. They have to give that to you. We have a good amount of space at the bottom, put in the overhead, applied to work in process. We know that's 15,000 and as always the difference between what they spent 16,006 50 and what they applied 15,000, that 1006 50 that's called the total overhead variance or the net of adherence.

Unfavorable. We got that. Then you put in a budget based on standard hours. That's 16,000. So the volume Baron stays the same difference between the budget based on standard hours, 16,000. And what was applied 15,000 overhead volume. Barron's 1000 unfavorable that hasn't changed. Then I put in a budget based on actual hours, 16, five.

We've got that. Notice the efficiency variance stays the same. That's the difference between the budget based on actual hours, 16, five, and a budget based on standard hours, 16,000. So notice when you go from the three-way analysis to the four-way analysis, volume variance stays the same efficiency, variance stays the same.

What's different in the four-way analysis is that in the four-way analysis, they take the spending bearings and divide it into two. They have to come. You have to come up with a fixed spending variance and a variable spending variance. And the only way to come up, the only way to do the four way analysis is they have to break down that 16,006 50, what they actually spent on overhead costs.

That's 16,006 50. They have to tell you how much they spent on fixed items, how much they spent on variable that was not given in the Armando problem, but let me just make it up. Let's say the 16,006 50 broke out this way. Let's say they spent 6,200 on fixed items, 10,004 50 on variable items. And again, the examiner have to give you that.

So let's say that's how the 16,006 50 broke down. They spent 6,200 on fixed items, 10,004 50 on variable items. Well, now you can do it. They spent 6,200 on fixed items, depreciation and so forth on the factory. What was their fixed budget at any level? 6,000? Don't forget that fixed budget was 6,000 at any level.

So they have, they have a $200 unfavorable. Top number is higher than the bottom number. They spent too much. They have a $200 unfavorable fixed spending variance. Now how about the variable spending variance? Will they actually spent 10,004 50 on variable items? What should they have spent? Well, they worked 2,100 hours.

Every time they work an hour, they're supposed to incur $5 of variable factor overhead. Take $5 times 2100 hours. They should have spent 10,500. They spent 10,004 50. They have a $50 favorable variable spending barons. So there's your four way analysis. You have a $200 unfavorable fixed spending variance, a $50 favorable variable spending variance 500 unfavorable.

Efficiency variance, a thousand unfavorable volume bearings, and notice all the variances combined. Get back to the net. The 1006 50 on favorable. You can actually give five overhead variances, fixed spending variable spending efficiency, volume, and net. You've got five overhead variances. Now, before you do the next class, there are five multiple choice that I want you to do for the next class.

I want you to get the answers for those questions before you do the next class, that is your assignment. And I'm sure you've noticed that I did not include solutions in the viewer's guide to any of the questions that I've had you do with me. And that's because I want to solve questions with you. And I want, when I assigned questions, I want you to get the answer so deliberately you don't have answers in the viewers guide for the questions that I give you.

So you have five questions that are. That I want you to get done before you watch the next class and I'll look to see you then welcome back to our discussion on cost accounting. And for this cpa review course class, I gave you a group of variance questions that I wanted you to get done before watching this class. Now let's go through them in question number one, they're asking you for the material price, variance, and.

What I'm hoping is eventually you get these formats down. We know that the format for material price is the same format you use for labor rate variance. It's actual times actual compared with actual time standards. So you start to fill it in. We're going to take the actual units. They purchased 4,200 times the actual price per unit.

I'm not sure what that is, but we know they did spend 10,000 Oh 80 on material. If you take the 10,880, they spent divided by the 4,200 units. They purchased the actual price per unit. Must've been the divided out $2 and 40 cents. Now we're going to compare that with the actual units, they purchased 4,200 times the standard price per unit, which is $2 and 50 cents.

What they should have spent was 10,000. 500 on material. What you have here is a $420 material price variance. And, you know, it's favorable because the bottom number is higher than the top number. It's a credit it's favorable and the answer is B. And of course, the other way to get this variance, the shortcut, if you will, is looking at the difference in price, the standard price per unit is $2 and 50 cents.

The actual price was $2 and 40 cents. Turns out, they actually saved 10 cents on every unit they purchased. You multiply 10 cents times the 4,200 units they purchased. That would also give you the $420. As I said, in a prior class, what I want for you is, you know, the format and the shortcut, that way you can adjust to how the CPA Exam tests in number two, they ask for the unfavorable.

So they're telling you it's unfavorable, the unfavorable. Labor efficiency, variance. And in terms of formats, remember the same format you use for material usage. You're going to use for labor usage or labor efficiency, variance it's actual time standard compared with standard time standards. So let's fill it in.

We're going to take the actual hours. They worked 4,100 times the standard rate per hour, which is $12 per hour. Multiply that out. That comes out to $49,200. Now you're going to compare that with the standard hours, they should have worked time standard hours. The number you had to come up with, the number you had to think about is the standard hours they should have worked.

How do you get that? Well, how many units did they produce a thousand? How many standard hours should go into each unit for, so the standard hours they should have worked for what they accomplished 4,000 times 12, that comes up to 48,000. You have a. $1,200 unfavorable, labor efficiency, variance, and you know, it's unfavorable top numbers hide in the bottom number.

It's a debit it's on favorable. And the answer is B by the way, notice that the actual rate per hour, $12 and 20 cents, that's not used here, not in labor efficiency, variance. I just need the standard rate per hour actual rate per hour. I would use that. If I was figuring out the rate merits, but not the efficiency barons, I didn't need that $12 and 20 cents at all.

Now in the next two questions, we have a set and in both questions, we are using the three way analysis of analyzing factory overhead. Now, remember in order to do a variance analysis on factory overhead. You have to be able to do two flexible budgets for factory overhead. Why don't we start by doing our flexible budgets.

First, you have to be able to do a flexible budget for factory overhead based on the standard hours they should have worked. And they gave you that that's 7,600 at 7,600 standard hours. What's the fixed budget for overhead 14,000. Fixed is fixed. It's set in out. That's a budget that does not rise and fall does not rise and fall with activity.

It's going to stay fixed, setting them out 14,000, but the variable budget I have to work with, if the standard hours they should have worked total 7,600 and every time they work an hour, they incur another $2 and 50 cents of variable factory overhead. They gave you that the variable factory overhead rate per hour.

Two 50 times, 7,600 standard hours. The variable budget should have been 19,000. The fixed budget, 14,000, a budget based on standard hours for overhead comes out to 30 3030 3000. Now let's come out with our flexible budget for factory overhead based on the actual hours they worked. And that was 7,000. So let's work it out.

We know the fixed budget at that level would still be 14,000. Fixed is fixed set in them out that budget does not rise and fall with activity, but if the standard hours, excuse me, if the actual hours they work total 7,000 and every time they work an hour, they incurred $2 and 50 cents of purely variable factory overhead they're variable budget.

At that rate at that level should have been 17,500. The fixed budget stays 14,000 a budget based on the actual hours, they work 7,000 comes out to 31,500. Now with those two budgets, now we can do our analysis. The difference between what they actually spent on factory overhead, they gave you that 30,000 and a budget based on actual hours that 31,500, that $1,500 difference.

That's called. Overhead spending variance and it's gotta be favorable because the bottom number, the budget based on actual hours is higher than the next number up what they actually spent. So we know that that's 1500 favorable. So the answer to number three is a now number four, they want the overhead efficiency variance.

Well, you have to put in the other budget, the difference between. A flexible budget based on actual hours that 31 five and a flexible budget based on the standard hours, they should have worked 33,000 that's that's your overhead efficiency variance. And that's also 1500 and it's also favorable because the bottom number 33,000 is higher than the next number up 31 five.

So the answer is also a. If you can do those two budgets, if you can do a budget for overhead based on standard hours, they should have worked and a budget for overhead based on the actual hours, they did work. You can do any variance problem up. As in a prior class, we learned up to the four way analysis.

You'd have no problem at all with overhead variances. And then even a question like number five, a theoretical question saying under the three-way analysis. What is used to calculate the spending variance. Do I need actual overhead costs to get spending variance? I do. Spending variance is defined as the difference between actual overhead costs and a budget based on actual hours.

So yes, I need actual overhead costs to work out. Yeah. Spending varies. I also need a budget based on actual hours. I need yes. Under both columns and the answer is D I hope he did well on that set. Keep up with your work. Don't fall behind. That's always what I worry about. I'm sure it's what you worry about.

And I will look to see you in the next class.

What I want to talk about next is strategic management, strategic management concentrates on decisions that will map out the long run operations of a company. Long run operations. And the basic benefits of strategic management would be unimproved vision of the future for the company. Also an improved perception of what is important for the company and also an improved perception of changes in the environment in a dynamic marketplace.

So there are a lot of benefits from this sort of strategic management. Now the strategic management model basically has four components. Let's go over the four components. Number one, there's environmental analysis, environmental analysis. Number two, strategy development. Number three, strategy implementation and number four, evaluation and control.

Those are the four components to strategic management. Let's talk a little bit about each one. When we talk about environmental analysis, we are talking about analyzing both the external environment and the internal environment. Both. You're trying to identify factors. You're trying to identify factors that.

Will have an impact on future performance. And these factors are not necessarily within the short term control of management. So when I say that we're going to evaluate the environment, what's the environment. Well, first of all, you look at general trends, like, you know, the aging of the population the percent of baby boomers.

In the marketplace. So you look at general trends, you look at industry trends, it could be that people are really concerned about food additives in your industry. So there are industry trends you look at also, you look at societal trends. Are they more single person households now do more people use email, the more people use cell phones, you know, what kind of societal changes are you dealing with?

And also you consider the internal environment as well. You know, what is the corporate culture? What is the chain of command? What are the corporate resources? That's all part of the environment that is environmental analysis. The first part of strategic management. The second part is strategy development.

Strategy development is the formulation of a long-term plan to seize advantage of opportunities. That's that's what it's all about. You're trying to take advantage of opportunities. You're also trying to manage threats. You trying to do that as well. And basically in terms of strategy development, you start by defining your mission.

What is the purpose of the company's existence? You define your mission. And sometimes as a separate statement, a company will do a vision statement. You know, what the company is seeking to become in the future and what it all leads to is a master plan. That's really what, what you're willing to want to develop with strategy development, a master plan.

You know what is to be done. And by what deadline, and also in a master plan, what plans do you have for expansion corporate growth? How are you going to manage corporate growth? Is it going to be vertical growth? Vertical growth is assuming functions that were previously done by some of your suppliers by some of your distributors.

That's vertical growth. It could be that you're planning on horizontal growth, horizontal growth is increasing your market share within your current industry. Maybe you're going to diversify. There are two types of diversification could be concentric. Concentric diversification is expanding into a related industry and industry related to the current industry that you're in.

Con conglomerate strategy would be expanding into an unrelated industry, but that's all part of the master plan. How are you going to manage corporate growth as well? That's all part of strategy development in terms of strategy implementation. That's really all about developing programs, budgets, and procedures to implement the strategy.

That's what I mean by strategy implementation. You're coming up with budgets. You're coming up with programs. You're cutting, coming up with procedures to implement our overall strategy. And then by the fourth and final step evaluation and control, we simply mean over a period of time. You have to monitor the performance of the strategy and take corrective action where it's needed.

So prior to remember though, the four basic components of the strategic management model, the environmental analysis, strategy development strategy, implementation, and evaluation and control. Okay. Let's do a couple of questions on strategic management in number one, question number one says, which of the following is the least beneficial result.

Of strategic management, least beneficial result a says a focus on the future. Now that's what it's all about. Strategic management is all about long-term planning. B says our perception of the environment. Now that's, that's part of it. Environmental analysis is a big part of the strategic management vision.

Of course, that's a big part of it trying to improve your vision, but D having a written plan that's that is that's the least benefit. That's the least beneficial result of doing strategic management fact that you've written down a plan of all the ones listed that as the least beneficial answer gate question number two.

what is the typical link that to businesses being combined in a conglomerate diversification strategy have what is their typical link? Well, if it's a conglomerate strategy, Remember the company is expanding into an unrelated industry, unrelated. So they don't have a common customer base answer. Eh, they don't have be a common distribution network.

They don't have, they don't have D common management skills. They don't have E common technology. No, their link is probably financial answer C because of conglomerate strategy needs. You're expanding into an unrelated industry. Your link is really financial. Question number three.

What strategy involves increasing your market share in the same industry? Same industry. How about concentric answer a now concentric, you are expanding into a related industry, not the same industry. Be a conglomerate conglomerate growth, no conglomerate growth. Remember you're expanding into an unrelated industry.

Can't be they. How about D vertical? No vertical. Remember is you're S you're assuming responsibilities functions that were previously done by somebody else within your industry. Like you are doing functions that were previously done by suppliers or distributors, but. In terms of increasing your market share in the same industry, that's the definition of horizontal growth.

That's what horizontal growth is. It's insist increasing your market share in the same industry. And the answer is seeing horizontal growth. Let's go to question number four, in question number four, we have a question about regression analysis and regression analysis. Studies the relationship between a dependent variable and one, a more independent variables.

If you're talking about simple regression analysis to simple regression analysis, you're comparing the change in one dependent variable, and you're associating that change with one other independent variable with multiple regression analysis. You are studying the relationship between the change in one dependent variable, associating it with the change in more than one independent variable.

So if you look at this graph that they gave us sales would be the dependent, variable and income levels. Increasing would be the independent variable. This is a simple regression analysis. Now what you're looking for is correlation the measure of correlation, what they call the coefficient of correlation is always measured between a plus one and a minus one.

In other words, a perfect positive correlation where. Both variables are moving in the same direction, a perfect correlation where both variables are moving in the same direction would be a plus one, a perfect correlation where the variables are moving in an opposite direction would be a perfect minus one.

The plus one and minus one is trying to measure the degree of linearity, how linear the relationship is. So if you look at this graph, What you'll notice is there's a negative correlation as income is rising. Sales are going down, right? So it's not a positive correlation. It's negative. And if you just notice that that is income levels, arising sales are going down.

If you notice it's a negative correlation, it can't be C or D because C and D has a, a positive correlation. So when they ask you, what is. The coefficient of correlation, can't be CRD. It's gotta be a minus answer. Rate makes no sense at all, because it's saying minus 9.0, remember the, the coefficient of correlation is always measured as either a plus one or a minus one.

It's always in regard to one, one being perfect correlation, a plus one being perfect positive correlation, a minus one being a perfect negative correlation. Your best answer here is the answer B. No a little less, you know, minus point 93, it's a negative correlation, not quite perfect, but it's a very strong correlation where if income rises in this case, sales are going down.

Question number five is a probability question we're involved in a lawsuit and a vendor has offered Wyatt a $25,000 settlement. A lawyer comes along and says, no, let's bring them to court. If we bring them to court, I think I can win 75,000. You know, what should you do? We've already got a $25,000 settlement in hand.

Lawyer thinks if we go to court, we could win 75,000 notice. There's a 60% probability. We'll win that case. So let's work it out. What is the expected value of going to court? What is the expected value of litigation here? Well, If we go to court, there's a 60% chance we'll win seventy-five thousand, but we've got to pay the lawyers retainer, no matter what happens.

That's 12,000 plus the lawyer gets a contingency fee. Lawyer gets 50% of everything over 35,000. So if we win 75,000 with 40,000, over 35,000, Laurie gets 50% of that or another 20,000. So if we go to court and we win. We don't get 75,000. We get 75,000 minus 12. The retainer minus 20,000 lawyer gets 50% of everything over 35.

What we net out of the, the, the win in court is 43,000 because there's a 60% chance that that'll happen. I multiply by 60%. The expected value of that outcome is $25,800. Now there's also a 40% chance we'll go to court and we'll lose. So do I multiply 40% times nothing. Now, if I lose, I still pay the lawyer, the $12,000 retainer.

So there's a 40% chance that I have to pay a $12,000 retainer and end up with nothing else. That's a $4,800 loss. The expected value of going to court is a 60% chance that they'll get 25840% chance. I'll have a $4,000 loss. The expected value of going to court is 21,000. So the answer is C right now.

It's not see, I already have a twenty-five thousand offer in hand, they've offered a $25,000 settlement. My expected value of going to court is just 21,000, but if I litigate, I'm expecting the $4,000 loss answer a

that concludes our discussion of decision-making and. Planning and measurement. I want to wish you the best of luck on the CPA Exam study heart.

Hi, my name is Russ jacks. I've been practicing public accounting for nearly 21 years as a Florida CPA. I've been a professor for almost 20 of those years as well. I'm here to talk to you about information technology, which is also known as it and give you some pointers on what I think you'll need to know to pass the BEC CPA Exam questions on this subject.

First, a little background on how I passed the exam. I worked pretty hard and I was able to pass the CPA Exam on the first sitting in 1982. And the way I did it was I just plain ripped into it. I budgeted about 200 hours from the middle of September until exam time, which means every night weekends. I constantly went through it developed flashcards.

What I did was I went through every one of the practice questions that were in the study guide that I had. And for every question that I missed, I created a flashcard to discuss that. Went through the flashcard deck over and over again, again, wintering them out as I was able to master the concepts.

And finally, by the end, I'll just about out of flashcards. I'm thinking out loud, there's nothing like being able to say that you pass the CPA Exam on the first sitting when you do it. No one can take it away from you. And from time to time, people were even impressed by it. the CPA Exam format is different from when I took the exam, but your study habits should be the same, a lot of time.

Systematic approach diligent. Don't put it off till the last minute. Now we're feeling in the dark a little bit here. It questions have been asked on various parts of the CPA Exam for many years, but the importance and frequency of the questions has been steadily increasing as has the importance of the topic.

Well, what are we looking at? You're probably going to see all 20%, maybe as much as 30% of the business environment and concepts section made up of it questions. And this is no small potatoes. So clearly we want to deal with these questions. We feel we have a pretty good handle on what to expect on the CPA Exam and we're going to cover it in this section.

Now let's start with a little orientation and warm up before we really start grinding. You're ready. All right. I am to first, most important. I want to make sort of a forest in the trees kind of observation. Sometimes the discussion of information technology can take on a life of its own. We can get mired down in techno-babble.

Now let's remember the objective of it is information technobabble has its place and I'll even engage in it just a little bit, but we're studying for the CPA exam. We're not studying for the it exam. In our context, it is the trees part of the forest and trees analogy. What should matter to us as accountants, the forest.

Is how it fits into and can be used to improve and entities, information gathering, and reporting process. Notice I said information, not just accounting info, but all information. Now there's a big movement of foot today to reinvent the job description of the accountant being counters are rapidly disappearing and being replaced with information professionals.

The new accountants are no longer producing only the standard products. That is the basic four financial statements, which are made, you know, in the limited number of flavors of balance sheet, income statement, statement of cash flows and so on. We're not producing products that are adapted to the needs of the users.

Now this change is proving difficult for some of the more traditional practitioners, but it's very exciting for those of us are ready to embrace the future of accounting. Needless to say, one of the big keys to this change is information technology. Historically, the accountant's job was limited by the speed with which information could be manually processed.

Think back just 50 years ago, everything was being done manually. And the cost of obtaining the answer to a question could be so high that it made more sense to guess, or for the purists to estimate. Now with modern it, capacity speed is no longer a constraint. Our new constraint is information overload.

Why? Well, people can only process so much information. So that's where the modern accounting practitioner can shine by taking enormous quantities of data and compiling them into succinct reports that are useful to the accountants information customers. That's a kind of a little expression, the accountants information customers, which of course is usually going to be your boss, IE management.

Here's an illustration of the progress that we've made over the last 50 years, let's say, well, the management of a company with many sales outlets across the country wants to know which products are selling at what time of day and what part of the country. And the days of manual it, the cost of manually obtaining the data would be so high that guessing, or I should say estimating would probably be the cheaper and more cost-effective alternative now with modern it, this information is relatively easy to obtain.

If the data is not already in the company's database, a simple change to most, most database based programs. Forgive me, is all that would be needed to capture the info. As a matter of fact, our risk lies in the information overload. We can spend way too much time answering questions with little or no value, or we can become so mired in the detail that we can't see the big picture.

Okay. A final opening remark a little while back, I said that the modern accounting practitioner can shine by taking enormous quantities of data and compiling it into reports that are useful to the accountants information customers. Are few key words in that sentence. The one that I would like to point out though, is reports as we're using it in this context, as announced, you can be the very best accountant in the world.

You know, the sharpest pencils, the straightest, rulers, everything you possibly want the most up to date technology. But if your report is not relevant, you have added little or really no value to your organization. Now we're going to talk a lot about process and that is what you need to know for the exam.

But remember, do me a favor. The report is what it's all about. Okay. That's enough in the way of opening remarks let's get started. Here's the overview also known as it fundamentals and BEC CPA Exam parlance. First, how does source info become a report? This one you're supposed to start taking notes by the way.

Well, this is a very straightforward forward proposition source info information enters the processing system and becomes output. Okay. It could be manual or electronic, and we can even think of it just like a factory. For example, in a factory, you have raw materials which go through a production process and they become product.

All right. Let's take a look at each of the three elements of an it system. First let's think of the source information. It can be documents, it can be electronic. And when thinking of documents, it helps to put everything in play and not just invoices, but think timecards shipping, receiving documents, you know, any kind of document that's generated as a business undergoes or produces product.

Electronic source info, thinking out loud would include e-commerce and other things like EDI, which we'll talk about a lot in a little while online retail transactions, which we will also talk about and B2B, which we will also talk about. Okay. Okay. EDI, electronic data interchange, B2B business to business, kind of like the Y2K B2B anyways, more on that later in the e-commerce section.

Source info now has to get into the system. Most, this won't work and we do get it in there. We are going to need to use input devices like keyboards, scanners, and modems. And once in the system, we're going to need some hardware and software to process it. The hardware and software is kind of similar or analogous to the machinery and labor in the factory analogy.

Anyways. Finally, the product has to S exit the system via some sort of output device. And, you know, everything's in play again. Output is not just going to be our traditional paper reports. It can also be electronic output to tapes, disks transmitted, electronically the EDI or B2B. Okay. Whether you hold that transmitted electronically EDI B2B.

Yeah, absolutely. A lot of businesses are engaged in direct commerce without human enters. Okay. That gets us, started looking at the basics of it. Let's finish this warmup by working through a few exam, like questions. Let's take a look at a, at a question here first. What does data well, would it be numerical facts?

Would it be all facts? Would it be the name of a rock group? Would it be identity identical to information? Well, data is all facts. It could be temperature. It could be time of day could be customer demographics, like zip code address. And so on next question, too much data. Is that a good thing? Is that a bad thing?

Is it information overload or it depends. Well, the answer I'm looking for is information overload. Although some people will say it depends, but you know, I'm looking for information overload. Anyways, data is used to produce information and deciding how much data to obtain will often be a cost versus benefits sort of debate.

And the biggest problem though, is not getting too much data. Information overload is the biggest problem. What am I getting at? I mean, data, isn't that the same as information? No, no, not even, well, it's close to it, but it's not the same thing for sure. That are the raw facts. Information is the reports is what gets disseminated to people that they're able to use for making decisions or gaining their own knowledge of a situation.

Okay. So that is a bunch of facts. Information is what you produce with those facts. Okay. And the modern accountant is called to take care to report information that is relevant to decision-making. You know, you may have heard the expression before when someone asks you what time it is. You tell them what time it is.

You don't tell them how to build the watch. They really don't care. Okay. Another question, which one of the items I'm going to mention in a moment? Is not one of the main components of a central processing unit, a CPU central processing unit. Would that be an arithmetic logic unit, a control unit, a disc drive, or would it be primary memory?

Well, first let's think of a disc drive, you know, say a floppier or hard disc drive. This is a memory storage drive that is external to the CPU. So that's the correct answer. The CPU is the heart of a computer and consists of the arithmetic logic unit, the control unit with basic operating instructions, you know, like how the computer communicates with the monitor that you're looking at permanently burned into it, into it's wrong read only memory.

And by the way, rom is the primary memory. The memory that's active during romp question. The personal computer part that permanently stores, the operating system program would be what floppy disk drive, floppy disc memory, the operating system. How about Ram the random access memory, or would it be the wrong, the read only memory, or how about sequential access memory?

I mean, we are talking to the operating system. Okay. If you were paying attention with what I said about rom in the first place, you'll remember that rom is the correct answer. The operating system is so vital. It is stored on that non erasable memory. The read only memory, the rom the operating system answered by the way, is a distractor.

An awful lot of multiple choice questions have things that are called distractors. There are things that sound close or sound plausible that you're, you're drawn to them. A well-written test question. Typically we'll have four or five possible answers. One or two will be obviously wrong. Two or three will be distractors.

And of course it would be the right answer. Okay. Now, floppy drive answer. That's a piece of hardware and the floppy and Ram answers are for erasable memory memory anyways. Okay. Sequential access. Well, that's a method or a way to organize stored info. And the word memory in that answer is also a distractor.

Now no a backup copy of operating systems is often kept on a floppy disc in the event, the operating system is corrupted and that's yet another distractor for that reason though. I mean, it's a backup copy. It's not what gets used. It's only if you have a disaster and you need to recover. Right. Another question, the part of the central processing unit CPU that stores data and programs temporarily during process is the.

Well, same set of answers. Would it be a floppy disk drive, the floppy disc memory, the operating system, the Ram the random access memory, the rom the read only memory or the sequential access memory. Okay. As I said, these are the same answer choices that we had for the question before. And you want to note the word Storz and the question when a computer is turned on, that is when it's running.

Ram is the memory that stores, the programs and data that are running. Okay. Their Ram is sort of in the moment kind of storage. It only contains what is being worked on. And unlike rom, when the computer's turned off Ram goes blank. Okay. Another question, which of the following is not an input device.

Would that be a scanner? Touch screen, would it be a keyboard? How about a printer or an environmental sensor, a floppy disk drive, or maybe a CD reader? Well, except for printer, every one of these devices has input as a primary function. Be aware of this kind of question. Reading too deeply. That is overanalyzing.

The question can result in the wrong answer. You want to take care as you analyze exam questions to choose the best answer, or am I getting at well? You know, why did I even bring that point up at this juncture? The computer savvy person will note that printers do have a very minor input function. For example, you get an auto paper message when you're using your printer and it runs out of paper.

But that's not one of their primary functions. Okay. Another question, which of the following is, or our output device or devices is an output device or our output devices, same choices, scanner, touchscreen keyboard, printer, environmental sensor, floppy disk drive CD reader. Well, how many. How about three of these are public devices?

Which three do you think they are? Scanner? No touchscreen. Yes. Keyboard. No, don't don't overanalyze, please. I know that your typical keyboard will have capital and number lock lights, but it's not an I'll put devices. Our printer absolutely floppy disk drive. Absolutely. CD reader. Nope. Okay. That's it for module one.

Thank you for joining me. I'll talk to you again soon.

Hi, welcome back. Let's talk about software now. What is software? Well, software is computer instructions, which are also known as programs. There's kind of an interesting thing about software. It really lags hardware. And it's kind of interesting because software is the key to the information system.

It's fun to talk gadgets and, and, you know, people love to talk about processor speed and all kinds of stuff, but the kind of info that we get out of a system depends on the software. Why does it lag? You might ask, well, the software is developed to match hardware and because of the lead time necessary to develop software.

And uncertainty about what hardware will be available when it hits the market. It pretty much has to be based on soft on hardware. As of today, let's say I'm starting to develop software today for use in a year or so. And, or it'll take me a year to get a fully developed and ready to market. I really don't know what hardware is going to look like a year from now.

So I'm stuck with looking at using the hardware platforms that we have available today for software development purposes. It always lags. Anyways, what are some of the uses of software? Well, first big use is to improve workflow. You know, we have to never be afraid to, to redefine the work view workflow model.

We don't want to let outdated systems become the the driving force here.  I'm tempted to say something now, but I'll I'll hold off, mentioned something later. We also use software to enhance productivity. I mean, hopefully everybody reading. This is fluent in word and XL. Could you imagine doing a work today without having word and Excel at our disposal?

I just couldn't. I mean, gosh, if you ever seen my handwriting you'd understand, but more importantly, the extent to which it speeds up the work without putting any additional stress on the worker is just marvelous. Also another use of software is to provide some real time useful information. Software is also used to help control.

Business, you know, production software and so on and information risks to help control business and information risks efficiently and effectively. Remember that from auditing, you want your audits to all be done efficiently and effective effectively. Same thing for business. I mean, same thing for, for most work-related activities.

We want to be efficient as well as effective. Now the use of software is to facilitate goal achievement. Our system should be adapted to the organization's needs, not vice versa. Okay. And this is, I, I almost can't resist saying it. You know how many times you find yourself working too? Because the software is set up a certain way and the software is not designed to make your life easier.

We want to try to avoid that whenever possible. No. How does the computer know what to do now? It receives instructions, which tell it. How to process the input that it has. And there are two basic classes of instruction. First you have operating systems and second, you have application systems. Now the emphasis here operating systems and application programs are software.

They're not hardware. Software is instruction. The programs hardware is devices. Now after it's basic rom, which is the most basic of all building blocks, our computers operating system is its most fundamental program. The operating system is the software that manages the computers, hardware. It turns devices on and off.

It manages data flow and program execution. And in connection with that, the operating system coordinates the application software. Some examples of operating systems would be windows, the Apple operating system in Lynox application programs. On the other hand are software that are, is, are, are used to perform specific tasks.

General ledger programs are very popular and they range from the stripped down QuickBooks to very powerful programs with many plugin modules, personal productivity software. Another example of application software would include Microsoft word and Microsoft Excel. What other well application software let's think the engineers use it for their CAD or computer assisted design software and manufacturers use a cam C a M computer assisted manufacturing software as well.

Of course thinking out loud, the, some of those popular software would be games, programs. I spend too much time playing games sometimes, but anyways, very popular. Another category of software, database management programs. These are widely used. And we're gonna talk about them a lot in the section to come, but thinking database management programs is just amazes me.

When I call my cable company up to report an outage or ask a question, all they want to know is my phone number. They have everything about me, indexed or organized. By telephone about, about their customers. I should say indexed or organized by telephone numbers. And I just have to, you know, give him the Sev seven digits and bingo, everything you could possibly want to know about me, at least with respect to my relationship with them pops up on somebody's screen database management programs.

Let's do a question here, which of the following is not an example of software. Would it be database management system? Would it be a firewall? How about the operating system? How about a router spreadsheet application? Would that not be software? Well, three, the choices, the database management system, the operating system and spreadsheet application have the word system or application in their name.

And it's a safe bet that these guys are your software. Now firewall might be a tough one. To figure out, because it sounds like a structure or a device, but it's not it's software intended to protect the data of a network computer from being accessed by an unauthorized user. So that leaves router as the correct answer, a router is a hardware switch that manages messages.

Okay. We spent a little bit of time discussing some nitty-gritty and let's switch gears here. Let's do a little top level, top level software thinking after all. As accountants, hopefully we will be more concerned with the high level considerations. Okay. Top level stuff, business information systems. They can range from manual to computerized.

And the computerized systems can range from really basic to very sophisticated. As a matter of fact, ERP you don't, you just love all these combinations of letters. Anyways, ERP, which stands for enterprise resource planning software. Is perhaps the most sophisticated business information system, ERP software does not have financial accounting and preparation of financial statements as its primary goal.

Instead ERP systems are integrated software systems designed to serve not only accounting, but all of an entities information needs. Now ERP systems are comprised of different modules and the modules are created to support various entity functions other than accounting, including stuff like inventory management, not just the dollar amounts, but the movement rates and what you have on hand.

And what's been sold a logistics management, you know, how is your product being transported from one place to another? Human resources management, imagine software sophisticated enough to keep track of everyone's birthday. That's certainly not an accounting task. Is it? No ERP software? Absolutely. I mean, how many insurance agents said your birthday cards?

They'd all do because that's in their system anyways manufacturing, which would include automated production line mess management would be a possible ERP module. And one of the neat features of ERP is that tools exist to enable an entity, to communicate directly with its trading partners, ERP systems.

All right. Still top level. How about some future developments in software? Well, thing that's coming and we're working on it is to decrease the time lag in software development. There will also be a continued trend towards the ERP prices are coming down and Affect not effectiveness, ease of use going up, which is related to also thinking out loud, user-friendliness, we'll have a smarter interfaces with computers or our screens will be easier to figure out and use.

In addition, where you can expect some increased exploitation of the web may have noticed that bill Gates is kind of nuts about this, and we should see some communication gains as well. That is computers being able to deal directly with each other across entity boundaries.

Networking. Well, the short story is that networking is where two or more computers are connected in some way to share data or software and or software. I should say there are a bunch of different types of networks, so you can have PC to PC network, PC to host networks, clients, server networks. Local area networks land you can have an intranet.

You can have a wide area network on when, or you can have the web, the internet. That's all sorry, huge network. Let's take a look at them individually here in a PC to PC network. What you have are directly connected PCs. The point of this is that the PCs can share data. Pass messages or share resources.

I have two computers at home sitting side by side. I have them network PC to PC network more than I at home kind of thing. But those are one usage that I have, I have to put together to share data and resources. Anyways, another kind of network PC to host. These are terminals that are terminals, that are connected to a host and the data and the software.

We'll be resident on the host. You may have heard it called a dumb terminal, being connected to a host. What that does is it enables the PC, the terminal to access the resources of a more powerful computer. It also centralizes transaction recording, and it can do some messaging as well. Our client server network.

Is where you have distributed processing. You have your data on the server, but the processing can be done by the client computers. This is similar to PC to host but the user oriented application programs are run at the client level and the shared data is available at the server level. You, of course you can have multiple clients and single or multiple servers and still have it be a client server network, a local area network.

Is computers linked together in a small area. It coordinates interaction and it facilitates data sharing among the computers messaging among the computers and also sharing peripheral devices, not unusual to have centralized printing and a bunch of computers connected through a LAN, a local area network.

All using the same set of printers. An intranet I N T R a intranet. Is a situation where you have computers linked together, but it is not accessible from the outside. It's kind of like a smaller and dedicated version of the internet. There's links, you know, an intranet will link and entities, internal documents and databases could be accessible through web browsers or internally developed software, a wide area network.

Is similar to a local area network is the computer bunch of computers linked together over a large area. And a wide area network will often connect many, a local area networks. As I sort of mentioned at the beginning, the web or the internet is a very big wide area network. As you know, probably the internet, the web is basically a worldwide computer network.

And it connects, you know, many, many individual computers and computer networks, and it enables communication between the similar platforms. That's really sort of the gist of the web, a bunch of different communicate, different computers. Some of them speaking quite differently from others are able to communicate through the worldwide web, the internet.

All right. Here's a question software. That allows two personal computers to be directly linked and share files is called a window software, internet software PC to host the software PC to PC software or spreadsheet software, by the way, networking is software, right? Yes. And you want to note that all answers say software.

Why? Well, softwares needed to network computers the way they talk to each other needs to be regulated. And you need networking software to do that now, for what it's worth, you also need a piece of hardware to network computers, and that's called an interface card. Now, in this case, the PC, the PC software is the correct answer because when software.

Internet software and PC to host software involve the use of some sort of hardware and intermediary. In addition to software spreadsheets software would be application software like XL or, or word or something. And that's nothing like networking software. Here's another question. The bus network, and we're not talking city bus, a bus network is characterized by communication channels that are.

Directly linked to a single host computer that are linked to a loop with each message past neighbor to neighbor until the message reaches its destination are linked to one common line with direct access to the message. Destination are organized under hierarchical channels that eventually are linked to a single host computers.

Well, there are a bunch of different ways to, to network computers and the choice depends upon the circumstances. The first answer here directly linked to a single host computer is what is called a star network. The second choice will link to a loop and pass from neighbor to neighbor is called a ring network.

The third choice, a link to one common line with direct access to the message. Destination is a bus network and the bus is the common line. And that's where we do want to think of city bus. The last answer, hierarchical channels is a tree as in, you know, branches and tree network. Okay. Another question. A local area network, a LAN is on our answer choices, a system that connects computers and other devices in a limited physical area.

How about a system that rents time on a central computer to several entities with each entity having remote input and output devices. How about it facilitates meetings among several people at different physical locations? Alana, how about facilitates working outside of a traditional office remaining connected to the office by the internet or phone lines and so on.

The key that makes the first answer. That is a system that connects computers and other devices in a limited physical area is the correct answer. The key is the word or the phrase limited physical ant area. Gosh, I'm getting a little twisted around here. Why the L in land stands for local, not limited, but local.

Okay. Anyways, the second answer, a system that rents time on a central computer to several entities with each entity, having remote input and output devices is not correct because such an arrangement will be geographically dispersed and it won't local third answer. Yeah. Facilitates meetings amongst several people at different physical locations is that's teleconferencing.

It's networking to be sure, but it's human to human networking. The through technological intermediary, but anyways, the fourth answer facilitates working outside of a traditional office remaining connected by the internet or the phone and so on. Well, that's telecommuting, that's also networking, but it's certainly not local.

Okay. Back to work, go do some questions. Talk to you later.

Right. Welcome back. Let's talk about file organization. First off, I want you to forget about bits and bytes. I mean, they may have been drummed into you and they're still the building blocks of it to be sure. But as information professionals, they're not that important to us. They're more important to the computer engineers.

So let's start off with a question first. What are files? Well, files are a set of related data files are used to organize and store data. Data files and to organize and store processing instructions, destructions that's 14. Okay. Where or how are files stored? Well, you store files on floppy disks, hard drives, CD ROMs, magnetic tapes, USB keys, all kinds of places, anywhere that you can store something magnetic.

And. Working backwards might be the best way to master the basics of this. So let's go. First files are made up of records and records are made up of fields and fields are made up of characters. Okay. A file can be the term used to describe a set of related data or processing instructions. Whatever the storage, meaning whether it's a floppy or a hard drive, it's got to be made up of files and files are used to organize the data and information stored on a computer, a lot of repetition, but I'm trying to get a point across that matters.

Now, an example of a data file is a sales transaction file. Let's say it's all of the sales transactions for a particular day. An example of a processing file would be a program file, like say Microsoft word. So data files will be made up of individual records in the transaction file example. The individual record could be each sale.

Now these records have to be organized on some basis in a sales transaction file. We could be organizing that data on a. Transaction basis, customer basis, time as in time of day basis or any other relevant basis, depends upon what your information needs are. Okay. That's it records records are made up of fields.

Fields are categories of information in a record in the sales transaction file. Each record may have fields for things like the customer's name. The date of the sale transaction number description of the merchandise sold quantities, prices, lots and lots of fields. It's only limited by your information expected information requirements.

Okay. Let's take field fields, contain categories of information and a category is a type of fact the number of fields is very flexible. Gosh, you know, I could keep rambling on, I suppose, about the kind of fields that we would be capturing are kind of information, facts that we would be capturing and storing and fields in the sales transaction example.

Because if you think about it what time of day, when, what is sold would be useful, zip code, where the customers are from would be useful. Customer's past purchasing history. You know, those cards that they give you the supermarkets lots of stuff. Anyways, fields. Fields are made up of characters, the letters, the numbers, and whatever other symbols are used to record the transaction in organizing accounting data files.

Remember the CPA exam focuses on accounting, and you really won't need to know how other types of data files are organized. They engineering files it helps to sort them into different categories. The basic file types are master files. Transaction or activity files, history also known as archive files, reference files and suspense files.

The accounting master files contain things like balance information. The master files kind of like a general ledger or a sub ledger account and account balance file. Master files contain, I guess basically the entity status data. And like I was saying, oftentimes organize on an account by account basis.

Now no, they're going to have the balance information, the master files, because they're kind of like ledger files. They won't have the information about the activity, but you do update your master files with your activity data. Okay. That said transaction or activity files are the ones with the transaction info.

The transaction files are used to update the master files. As a matter of fact, to sort of think of it this way, a transaction files are analogous to journals. Okay. Transaction files or journals. The master files are like ledgers. Another category of file. The history of the archive files. You don't need to keep really old, dead on your computer.

From time to time, you want to download it to some sort of permanent storage, meta media and archive it. Just like you would do with paper. Then matter of fact, the older it gets, the more summarized it gets as well. And oddly enough, some places they're still archiving the paper beats me, but they do reference files.

Another category of files. These are for items or information, or I probably should say data that are needed by many, many files. Things like the chart of accounts price lists, customer lists. These sorts of things would be you know, customer address lists. These would be organized into reference files.

Suspense files are the files that are waiting are awaiting further processing. Often a suspense file is needed because the file lacks info or contains a Roni's info and it can't be processed until it's fixed. Another reason for using suspense files is because in some cases a file can't be processed until some time has passed.

Why do we want to use all these different files? Well, it depends on whether your, your system is batch or online. Real-time in batch. You probably will need them. And we'll discuss batch versus online and online real time later. But an example for now, just to sort of try to set the the thought in your mind, let's say you open an Excel worksheet.

At some point, you save your work with a file name at that point. At the point of the save, it becomes a master file. You keep working on it, the key strokes, the entries before the next save are kind of like your transaction files. When he hit save again, you just updated your master file. I know I'm not doing journals and ledgers, but I'm trying to come up with an example.

There are different ways by the way, for computers to physically access the file. A file and the method employed depends upon storage, medium sequential access is the method originally used in computer applications. You know, those big reels of tape or punched paper cards, punched paper tape sequential access can be pretty slow.

Matter of fact, to conceptualize sequential access, think of a cassette tape. The access to a file is gained by reading each successive file until the desired file is reached. Okay. The other basic access method is the director random access method with direct or random access. The computer creates an index of where it is storing files and when the files are needed, the computer first goes to the index and then using the index goes directly to the file and retrieves it.

Modern disc technology is what made direct access possible for direct our random access to conceptualize it, to understand it, think of a library. You can put the books anywhere in the library, but if you index them by shelf for Ben or some other location index retrieving them is just a matter of consulting the index piece of cake, the Dewey decimal system question which of the following policies.

Is most appropriate. Should you always sort transactions before updating the master files? Should you always sort transactions after updating the master files? Should you sort transactions before updating the master file? Only if random access storage is used. How about sorting transactions before updating the master file?

Only sequential access storage is used, or finally, how about it's not necessary to serve transactions before updating the master file? Okay. And an accounting package, master files are like ledger accounts. I've said this already, there would be a separate master file for each ledger account. And these answer choices are interesting.

Well, how do we, how are we going to choose the right answer? Well, let's start off with trying to find some key words. The first choice, always sort of transactions before updating the master files. One of the keyword here is before. And we heard that it, matter of fact, if you look at all the choices before shows up a lot now for the second choice, always sort of transactions after updating the master files or the keyword is after the two choices are the same, except one says before.

The other says after now the third choice, which is sort transacts would be for updating the master file. Only if random access storage is used, we have before again, but we also have random access. The fourth choice is worded essentially the same, but it substitutes the word sequential access for random access another before choice.

And finally, the last choice is not necessary. I mean, the men, the choices necessary. I mean, it's there, but the key phrase is not necessary to choose the right answer. You need to know that sequential access requires sorting. And that the sorting must be done before updating the master file. If this sorting wasn't done before, it would have to be done during, and that would multiply the processing time exponentially.

It might even be, make it impossible. Another question, true or false master files, corresponded journals, and transaction files correspond to ledgers. Right. Probably said this two or three times. I hope you got it instantly. The answer is false because just the opposite. That is true. Journals are the books of original entry for most business events.

Transaction is when a business event enters the accounting system. So transaction files are analogous to journals. Transaction files are organized on the basis of transactions. Master files are not, they are organized on the basis of ledger accounts. Aside in a manual accounting system, posting is where the journal totals are transferred to the ledgers in computerized accounting.

That activity occurs when the master files are updated. That's when they're getting posted. All right, that's it for this one. Why don't you go back and work on some questions? I wish you the best of luck with your study.

Let's talk about working with files. No files are, are, are built up sort of, you know, you have characters that you enter into fields and the fields are built into records and the records of course become a file. And you know, it's nice to have a file, but it's even nicer to do something with it. Let's talk.

And I want to talk about it in in the database management system con context, you know, we have files, we've organized the, our data into files. Now, what do we do with it? Where do you store it? You know, you have this great file. What do you, what do you do with it? Where do you store it? Well, in the not so distant early days of it, data was or were data was I think, I'll say stored with its related application.

For example, all the payroll related files would be stored with the payroll application program. There's a model. Imagine that led to an awful lot of duplicative work because you'd be entering data to go with this application program, then you'd be taking the same set of data and entering with another application program.

And so on. I can't tell you, you know, going back some time, how many clients had people taking the same data and entering it into yet another application program? I just watched a waste of time and puzzled over it. And not only did this duplicative work waste time. Well, I don't want to say waste. You had to do it, but it took time.

And it also resulted in error because every time someone has the opportunity to keep punch something, while you have the opportunity to make a mistake, you know, thinking of an example, let's say you have a sale. Well to get the data into the sales file, you'd enter it there to get it into the accounts receivable file.

You'd have to enter it there and to get her into the customer file. You'd enter it there. And, and maybe having even a commission file where you're keeping track of it to pay commissions. You'd have to enter again a lot of time. And of course the error possibility goes up with each opportunity to keep punch now with the evolution of technology.

It's now pretty easy to store data files on their own. I mean, just to have data files off separate, and then you let the applications access them only when needed during almost like a dictionary or something like that. Matter of fact, you might even want to think of it as a traditional paper file. You could imagine a customer price list that you used to have to consult by looking at a sheet of paper.

You wouldn't have to store the price list with every customer's record or anything like that. You just have the price list somewhere and consultant. Always the key to build and these situations where you have the data stored off by itself, you know, to be accessed by different application programs is the basic concept behind a database management system.

All right, DBMS, by the way, there is a common abbreviation database management system. Now the key to building an effective database management system, isn't deciding what kind of data you want to capture. It's always a dilemma, not capturing enough data leaves. You're wishing you had captured more and too many pieces of unnecessary data being captured in places that unnecessary burden on clerical staff.

I mean, you know, you, you can get ridiculous by asking people for too much personal information when you're just selling them a battery or something like that. Okay. After you decide on the data that you want to include, then you have to decide how you want to organize it. Okay. So step one, decide what kind of daddy want to get?

Step two, decide how you want to organize it. There are four basic ways to organize databases. They are hierarchical network relational and object oriented. A hierarchical database structure is kind of tree and branches in nature. Each parent record member files are made up of records. Each parent record may have several subordinate called child records, determining which records will be parents and which records will be children as a matter of judgment and is often influenced by what you expect.

The most likely query to be query is where, you know, user comes in and asks for some information from the database. Let's say you have a sales database. Well, most of your queries be by customer name, customer number, sale number. Product sold a date sold whatever. I mean, you know, what, what do you anticipate your most common query to be?

Or another way to understand hierarchical database structures is to think drill down. Okay. How many times do you access the internet and you have, you know, some sort of choice bar across the top and you drill down and down and down until you get what you need. Okay. Hierarchical or how many times did you call, you know, someplace up and press three for that?

Then you listen to another menu, press five. So on it just goes on and on. That's hierarchical as well. They're working you down the branches to get to where you want to be. Sticking with the telephone example one of the major drawbacks to hierarchical. Hierarchical structures is that they can limit user access, whether it's intentional or unintentional, they can limit user access.

How many people give up on trying to use the telephone menuing system and just say the heck with it, I'll buy from somebody else that puts a live person on the line. Now, another type of way of organizing is a network type of database structure. Now, this is an improvement on the hierarchical structure because rather than just one access point, a network structure has multiple access points.

A superior record can have a number of subordinate records. Okay. You know, in the sale example where we had customer number sales, person merchandise and so on in a network structure, the ordering and the linkage is not set in stone. Any one of those things could be our access point for dealing with a query.

You can start to, you know, you can start the query with any field. The drawback to network database structures is you must know the physical structure of the data in order to be able to use the database well and improvement on network, database structure. And one of the most popular technologies now is the relational database structure.

The way relational databases work is that they use tables and they're organized by columns and rows. To pardon me. The data in the table is organized by columns and rows, just like an Excel spreadsheet. With relational databases, the data from different tables can be combined to provide responses to user queries.

Now this will require some duplication of data and in one of the big deals about databases was to, you know, get rid of duplication. But. And it requires considerable computation power as well come to think of it. But given the advances that we've had in hardware, it's only an obstacle when there are just enormous number of records.

There's so many records that the system can't handle it. That's atypical because you're going to Metro systems up as you design and engineer them, right? The fourth choice would be an object oriented database. Okay. These are the coming things. Their application now is limited because their computational demands are very high and not many places can afford to implement them.

The objects in an object oriented database contain instructions in addition to data. And as you can imagine, that greatly increases their flexibility and ability to do things like voice, video, audio manipulation, all kinds of cool stuff. Okay. When working with a database, there are three basic or major categories of database management system, conveyance commands.

Okay. The commands that are used to manage the DBMS, you have data query commands, you have data definition commands, and you also have data manipulation commands, data query commands are the commands that help users ask questions is very important. That if a question is not properly asked even if the data is in the database, it may not be returned in response to the query.

Okay. So data query commands. These are the questions that help the users ask the right question. Okay. Popular query tools, by the way, include to be E which is query by example, the fill in the blank. A query command. A matter of fact, thinking of an airline, you want to reserve an airline ticket. You go through various fields to tell it when you want to fly, where you want to fly.

What's your preferred time of flight is. And so on. That's query by example, they're asking you to fill in the blanks so that they can see if they have space available on a flight and then return information about how much the flight will cost. Now, that kind of query languages, S Q L structured query language.

This is a programmer's query language and it's useful for modifying database management systems. And it's also useful for other purposes, right? Second category of commands, data definition commands. These commands are used to set up the structures within the databases and their appearance and the content of the user views.

That is what users see when they're trying to access the database. Third category of commands for databases are the database manipulation commands. These are used, add the lead and manipulate database data. Okay. A DBMS, a database management system usually usually requires a DVMs administrator to monitor, maintain and upgrade the system.

Okay. Now, Let's talk about some of the advantages of a DBMS system, at least advantages relative to storing our data with the application program. Okay. First DBMS should eliminate some redundancy. It should be relatively easy to maintain compared with an application-based storage system should result in reduced storage costs as well.

As a matter of fact, some data integrity results from redundancy, elimination. Why. Because there's less chance of miskeying data, keeping data independent of the application program also makes it easier to change the views. If you're storing your data with the application, oftentimes the program has to be rewritten to change the view with the DVMs situation.

Nah, no such that's not the case with a DVMs system. Typically it's fairly easy. They're designed as a matter of fact, to be manipulated, to change user views. Now, the DVS administrator is someone that is charged with the responsibility of monitoring the system, maintaining the system and updating the system or upgrading the system.

Now not everything's perfect. The major drawback to DBMS is that when the database is down, all programs relying on the database are also down. Almost kind of like when a network goes down or something, if you're relying on the network to get where you're going, you can't get there. If you're relying on the database to provide you with the data necessary to do your work and the database goes down, you're frozen until it comes back.

Okay. That's it. Back to studying some questions I'll talk to,

well, let's take a look at systems development as with any project. There are certain basic steps that should be followed to assure success. And the typical steps in a systems development project are your systems analysis, your feasibility study, which often has done during the systems analysis phase systems, design systems, implementation and systems maintenance systems analysis is the first step.

This is where, how a system works and what the user needs would be are, are identified. And that in turn helps us determine what our system objectives are, what our system goals are and what kind of requirements we're going to have from the system. Okay. Or not from the system as well as in the system, what kind of requirements we're going to have this step?

Problem probably will include a feasibility study and it's conceptual in nature. I mentioned conceptual because after this, we will be doing our practical steps. The system design step comes down to determining the business rules to incorporate into a system. Business rules can be sorted into three categories.

First, your data design. That is what kind of data are you going to capture? Second, your process design. How are you going to process the data? And finally your user interface design. How are you going to capture the data and present the information? The systems design phase is the very best opportunity to assure system effectiveness, especially effectiveness from a cost benefit point of view.

It's relatively inexpensive to do this. This is where you write your program specifications and you identify. Your hardware and your software that you're going to need are there, or what your needs are, perhaps I should say oftentimes by requesting proposals from different vendors through an iterative process different approaches are to identify different possibilities and then software and hardware recommendations are made.

Now, once this is done, the recommended approach is designed in detail. And that's when the program was started writing their code. If you're self developing or hardware and software is purchased, if you're acquiring your system from outside vendors, okay. Once that step is done, we can move on to the implementation phase.

In the implementation phase, we're going to hire and train new employees if needed, or at a minimum, of course, we're going to want to retrain our present employees to use the new system. Now. Oh, and by the way, we're going to test our new procedures as well as training employees in how to use them. I'm thinking out loud.

Once we get to this point, we have quite a bit of work under our belt. And that means that system errors are relatively expensive to correct at this point, of course you want to correct them before you go live with the system, but you've missed your best opportunity to correct. Which was earlier in the process.

Also during the implementation phase, the system has to be tested and debugged. I mean, nearly everything has nearly every kind of software or computer system has bugs in it when it first comes out and it has to be debunked. We want to remove it, any bugs that we have before we go live. And once we were done debugging the system the old system or manual records of the business processes being computerized for the first time.

Will be converted to the new system. And then we want to do some volume testing with volume testing. This is where you're subjecting it to a full load. Now with the expectation that you're going live, that is you're going to, you know, leave your past behind and go fully with the new system. But you want to put some load on it to make sure it's going to be able to produce information the way you want it.

That is that it's going to be able to successfully capture the data, process it, and in turn. Turn it out or turn it into some sort of useful information. Why do you do it? Well, occasionally volume testing will reveal some processing weakness that has to be ready remedied before full implementation. Okay.

After that, well, it's time to implement the system and go live with it, get it to work and start getting product out of it. And now you're into the monitoring phase. Very essential to a successful computer operation monitoring the, the users of the system to see that they're able to get their work done effectively.

That processing is likewise being done effectively. And the information or the output from the system is useful. This is done on a, on an ongoing basis. This such maintenance includes repairing flaws that were not Evelyn evident during the earlier development phases. Some specific maintenance steps would include a post-implementation review.

That is, is it working the way that we thought it would? And if not, do we need to fix it? Next monitoring, that's just constantly keeping an eye on it, evaluating that's the formal process related to the monitoring and modifying as necessary. Okay. From time to time, you know, things change, you have new information requirements, something that you were doing for the longest time, you were no longer doing products.

Get added products, get dropped. A new processing plants are brought online, the things change, and you have to modify your system to accommodate. Okay. Small change of gears here. Let's talk a look at different ways to process transactions. The timing of transaction process. Well impact when master files are updated, which in turn dictates how to update a, pardon me, how up-to-date the master files are, you know, as a quick refresher or a quick thought master files and accounting software are akin to ledger files.

Anyway, there are two basic approaches to processing transactions. One is a batch processing approach and the other one is online processing. With batch processing transaction data is accumulated in a batch and use the update master files periodically. The period is usually at a set time, for example, once a day or every three days batch processing is popular because it's the least expensive choice.

The drawback to batch processing though, is that the only time the master file that is your ledger account in an accounting scenario is the only time the master file is current is right after processing. Okay. As you've updated, it everything's current as of that processing incident. But as soon as new transactions begin occurring after then your master file is not updated, which means it's not up to date.

An example of batch processing is how banks update account balances overnight for all transactions received before some cutoff around here. It's 2:00 PM of the related business day. With online processing the input device or wrong emphasis with online processing, different than batch with online processing, the input device is connected to the CPU and the master files are updated as transaction data is input.

Now a variation on online is something called online real-time or O L R T. Okay. This is a version of online processing, but it's kind of like online plus okay. In online, real time, not only are the master files updated contemporaneously with the input, but the updated master file input input. For you, the updated master file info is available to the user.

Okay. And that can influence the outcome of the transaction because the data is available. I love using airplane reservation. Examples. You want to reserve a flight well, online, real time will tell you whether there are seats available on that flight. As you're making your queries. An example of online realtime is to provide customers with accurate inventory information.

I should say another example as they make online purchases, a minor distinction online time occurs at the same time, the business activity is, is occurring. Online need not be that way. Okay. Online, real time occurs at the same time, the business activity is occurring. Just playing online, need not be that way.

For example, a salesperson, you can come back from a day on the road with a stack of orders, which are input in the evening. After the business activity occurs that can easily be online. That is the records being updated with every transaction that's being input by the salesperson, but it's not online.

Real-time online. Real-time requires an appropriate input device. Okay. Now, Switching gears just a little bit, or perhaps adding to our discussion distributed processing is used when processing tasks are too much for a single computer, either because of the quantity of data to be processed, or perhaps the complexity of data would be processed with distributed processing.

Such processing tasks are divided among multiple computers. Okay. Let's take a question here, which of the following statements about online processing is true. First choice. First answer choice. Online processing is the same as real-time processing. Second choice, a real-time processing must be online.

Third choice online processing updates, master files of preset times. How about online processing updates? Master files is transaction. Data is entered, or how about transaction? Data must be entered as the business activity occurs. Well, real-time processing must be online. You can't have real time without online and online processing updates.

Master files as transaction data is entered. Okay. These are the two correct answers. Real-time processing must be online and online processing updates, master files as transaction data is entered. Let's go through the incorrect answers. How about online processing is the same as real-time processing?

Well, that answer is incorrect because with online real-time the processing occurs at the same time. As the related business activity, online processing can occur sometime later. It just has to involve updating master files as the transaction data is input online processing updates, master files that preset times.

Well that answer's incorrect because by definition, online processing updates, master files, as the data is input. How about transaction? Data must be entered as the business activity occurs. Well, this answer is incorrect because we're processing to be online. The only requirement is that master files be updated as transaction data is input that can occur sometime after the, or I should say sometime after the related business activity.

How about another question? True or false? All modern computer systems use online processing. Well, this is patently false batch is still a very viable form of transaction processing. Be aware of such questions just because technology is not the latest doesn't mean it is no longer used. Okay. We've discussed the three basic types of data processing that is batch online and distributed.

Let's take a look at application processing. What are the three basic phases in application processing? Well, first we have data capture and editing. Then we have master file updating. And finally we have reporting or querying data capture and editing are done in the data processing phase. Master file.

Updating depends on whether the system is batch or online in a batch system. The application takes the most recent master file and updates it with the current transaction file producing an updated master file. In an online system, the master file is updated as the data is captured or entered. Now reporting and querying can take many forms, ranging from simple responses to queries.

Like what is the customer's balance to full blown reports a month cash disbursements or production reports, or a complete set of financial statements, for example. Okay. Earlier I emphasize the importance of documentation and the systems development process. Now let's take a look at two basic forms of documentation, flow charts and data flow diagrams.

Both forms are needed. Neither alone is sufficient flow charts. Present the physical as well as the logical characteristics of a system, but they're kind of biased towards presenting the physical characteristics of a system. Data flow diagrams. On the other hand can omit the physical attributes or dual myth, the more physical pardon me, data flow diagrams omit the physical attributes of a system and they focus on the system's logical attributes at first blush.

Then at least to me, it would seem that flow charts are superior to data flow diagrams, but that's not true for a number of reasons first because of their bias toward physical characteristics. Flow charts have to be updated when hardware is replaced. That's not the case with data flow diagrams. Next data flow diagrams focus more on information than on technology.

Okay. Float charts can appear to be pretty busy and comparisons in comparison with the elegance of a data flow diagram. Sometimes concepts are easier to explain to non it persons when data flow diagrams are used, these are the kinds of things you'd, you'd walk up to a whiteboard or something like that in a group presentation and start drawing your circles and lines to explain how the system's working and people would get it a lot quicker than if you started putting all the data flow.

Pardon me? All the flow charts, symbols on the board with all the arrows and lines and everything going all over the place. Not to rule out flowcharts though. I'm not knocking them to be sure. Flowcharts are extremely useful and a very important part of systems design with they're perhaps more for the the people that are interested in the technological aspects of the, of the system.

They want the, the heavy detail. Alright, let's try a question. Which of the following statements are true. First data flow diagrams present the physical app aspects of the system. How about flow charts present the physical aspects of a system? How about data flow diagrams present the logical aspects of a system.

How about flow charts present the logical aspects of a system? And how about flow charts usually require updating more frequently than data flow diagrams? Well, as discussed a moment ago, flowcharts present physical and logical aspects of a system where data flow diagrams usually present only the logical attributes.

Because they include physical attributes, flow charts must be updated more often than data flow diagrams, other questions, which of the following illustrates the path of data as it is processed by a system. Would that be a decision table, a program flow chart, pseudo code, or a system flow chart. Let's solve this one by elimination.

A decision table presents all the identified decision choices in a given situation, not the right answer. Our program flow chart illustrates a program, not a system. This one of those distractor answers. It may be important for the CPA Exam to know that systems flow charts are not the same thing as program flow charts.

Now pseudocode, that's a structured language that's used by programmers to assist in programming. Perhaps it distract your answer. Cause it sounds so weird that it's gotta be right. It's wrong now that leaves the system flow chart is a correct answer. Now that this question like many questions on the CPA Exam is a definition question.

Flashcards are great tools for mastering these kinds of questions. Matter of fact, I might've just said a mouthful, how much of the exam, or at least this portion of the CPA Exam and even auditing and law are definition questions, key to perhaps mastering. This is understanding the definitions and perhaps flashcards are the way to go to get you to where you need to be.

Drill question after drill question flashcard after flashcard brick by brick block by block, you build your body of knowledge to master the exam. Okay, that's it. Thanks for joining me.

Welcome back. Now, we're going to take a look at business information systems. A business information system can be either manual or computerized and computerized systems can range from very basic. Too sophisticated to even really sophisticated like enterprise resource planning systems, ERP systems, quick question.

True, true or false counting information systems can be thought of as a subsystem of business information systems, true or false. That's a hundred percent true. And it's not just true for ERP systems. Only ERP is very neat, but not every entity has it. Every entity does, however, have a business information systems system.

Gosh, it could be quite frankly a hodgepodge and it could even be partially manual, but it's still a business information system. And the accounting information system will be a part of a business information systems. All right. Let's take a quick pass at some top level materials before looking at the benefits and the risks of it first.

Why have it? What are the benefits? Well, you know, it's one of those funny sort of questions, you know, you sit around and everybody starts nodding their head or yeah, we need to have it, but are there benefits? Yeah, of course. First we get consistent processing, consistent processing the machines go very fast, but they do the same thing over and over again of large vines of data.

We also get improved timeliness. Okay. All right. Information is delivered on time or more timely. It facilitates analysis. We can get quicker answers to our questions and it can also in a properly designed system, reduce our control risks. Are there any risks , you know, or is it just all grand and glorious?

Well, yeah, there are risks first. Then we can have the perpetuation of processing errors that is. If there's something that's been written wrong in the program and the system's doing something wrong, it doesn't know any better and will continue to do it wrong. It'll just do it at lightning. Fast speed.

Also in an it system, it's more difficult to detect circumvented controls. That is if you have some weakness in your system and approach has gone in there and messed with it, it's got to be harder to spot. It's not like an altered check or, or records that have been erased and rewritten or something like that.

It's, it's more difficult to detect circumvented controls. Another weakness of it is that the programs can be come out dated or they can be costly to update in thinking out loud, related to programs, being update outdated or costly to update their costs to date. I mean, to, to manufacturer, to design in the first place and another risk of it, it's not exclusive to it, but it seems to be able to happen easier is data loss or destruction.

I mean, how many times have you heard about somebody deleting a complete data file or losing a bunch of work? Because the system goes down to the power, goes down throwing a a tape of some data files being stored into a glove box and forgetting about, and having the heat ruin it. A lot of it seems to be easier to suffer data loss or destruction in an it system.

All right. Let's think of a question here. Which of the following characteristics, I'm going to list them distinguish or distinguishes computer processing from manual processing or put it another way, which of the following statements are true and which ones are false. First statement, computer processing virtually eliminates the occurrence of computational error normally associated with manual processing.

Is that true or false? How about the potential for systematic error? Is ordinarily greater in a manual processing than it is in computerized processing. How about errors or fraud and computer processing will be detected soon after they were occurrences. Is that statement true or false? How about most computer systems are designed?

So the transaction trails useful for audit purposes do not exist. Is that question true or false? Finally, how about once it implemented, it is more difficult to change an it system. Is that true or false? Okay. Let's look at the answer choices first. The choice that computer processing virtually eliminates the occurrence of computational error normally associated with manual processing.

Well, that's true. And hopefully it's obvious that it's true. Computers are just devices. They do what they're designed to do, and they do it reliably and quickly. So long as they're properly designed, they'll do it correctly, reliably and quickly. Right? The answer choice, the potential for systematic error is ordinarily greater in manual processing.

Then in computerized processing. Well, the keywords there are systematic and ordinarily, if you substitute human for systematic. The state, the statement becomes true, but not. So for systematic error, how about the answer choice errors or fraud and computer processing will be detected soon after they are occurrences.

No, that answers faults. Some errors in fraud are never detected in any system, but the timeliness of the detection of those that do get detected doesn't have anything to do with the type of computer system. Okay. Nothing unique to a computer system. Now moving on because of the disappearance of a paper trail in a computer system, you might be inclined to include.

Most computer systems are designed, you know, the answer choice most computer systems are designed. So the transaction trails useful for audit purposes do not exist. You might choose that one as true, but that's not the case. As a matter of fact, computer system designers take great pains to provide an audit trail.

They require an audit specialist, like a computer audit specialist to, to work through the audit trail and verify that it's functioning properly, but in a well-designed system, the audit trails there. How about the answer choice once implemented? It is more difficult to change an it system. Well changing any system is not easy, but popular evidence or empirical evidence shows that.

Popular and empirical or not the synonyms for, by the way. Anyways, evidence shows that it systems are more difficult to change. The basic reason is because of the, of the substantial cost and lead time and the need to thoroughly test the system once after the changes are made. Okay. Let's take a look at business information systems as well as it benefits and risks.

I want to stay at. On a top level here and let's look at business processes. A business can be conceptualized as being made up of processes. And the short definition of process is that a business process is a series of activities intended to achieve a business objective. This definition is important because it encourages us to stay focused on goals rather than getting caught up in the mechanics when developing business information systems.

Okay. Now that business processes and the business information system are completely different. The process is intrinsic to the business. It may get modified. You can actually developing a business information system, but it's not the business information system itself. Also note all business processes are, I don't want to say all too global, but to some extent, the business processes are independent.

We use some broad categories to help us conceptualize the business processes, but none of them are standalone not by any stretch of the imagination. Okay. The three basic business processes are sales and collection, acquisition, payment, and conversion as a, you know, as a side note, as I talk about the application programs on this.

And, and then for the next couple of minutes here, please note. That they're not usually separate programs more often than not. They're going to be components of a single integrated software system. All right. What goes on in the sales collection process? Well, it's concerned with the bring product to customers, you sell something and then you collect them.

So what are the main objectives of the sales and collection process? Well, you want to keep track of your sales. You want to keep track of the customer payments on their accounts. Incidentally, you might want to keep track of how this process impacts inventory as well. I mean, when you sell that is if you're selling product from inventory, but when you sell inventory is going to get impacted now to manage the sales collection process, you're going to need application software tailored to assist you in meeting these objectives.

The application programs associated with the sales collection process would include the sales application program. The accounts receivable application program and the inventory application program. Okay. Next process. What goes on in the application payment process? Well, it's sort of the mirror image of the sales collection process and it is concerned with acquiring the resources needed to produce a product to sell.

So what are the main objectives of this process? Well, You want to keep track of your purchases of raw materials and other inputs like supplies, property, and equipment. And so on that you're acquiring by purchase. You also want to keep track of the amount that you owe to vendors, your accounts payable so that you can assure timely payment to them.

Avoid overpayment to your vendors as well. This process impacts raw materials, inventory, or merchandise for sale inventory in the case of a wholesaler retailer. Okay. That the objective or the objective of this be well, I efficient and effective management of inventory would be an additional objective of the acquisition payment process to manage the acquisition payment process.

You're going to need some application software designed to meet these objectives. They keeping track of purchases amount owed to vendors and inventory. Some examples would include the purchases application program. And accounts payable, application program, and some sort of inventory application program.

All right. Third basic process. That conversion process. What goes on in this process? What are the main objectives of this process? Well, the main objective of the conversion processes is to take a set of inputs and convert them to outputs effectively and efficiently. Another objective would be to assure that an acceptable level of quality of the output is maintained.

You want to also assure that steps be undertaken to encourage product development. How about also assuring that government regulations are being complied with how about another objective to assure that the product is made in accordance with customer specifications? Okay. This process also impacts inventory, raw materials, inventory, or merchandise for sale inventory, depending upon what kind of entity you are and effective and efficient.

Pardon me? I like to say efficient and effective management of inventory is also a business objective. To manage the conversion process. You're going to need some application software designed to meet these objectives, like an inventory application program of some sort and a production application program of some sort.

Okay. These are the pro the programs you're going to want to be using in the conversion process. Yes. There are some other common business processes as well. First you might have might be able to identify a financing process. That would be a subset of the acquisition payment process and has to do with the acquisition of financing.

There's also a human resources process that usually would be classified by some people under the acquisition payment process as well. You know, more simplified ways of conceptualizing business processes. But anyways, the human resource process has to do with all the aspects of managing an organization's human resources.

Okay. There are other business processes as well, and additional processes need to be identified if it helps to understand how an entity goes about achieving its goals. Matter of fact, let's take a closer look at the human resources process. It's kind of an interesting process. First what goes on in this process?

Well, it's quite a bit different from most other processes and let's take a look at some of the main objectives of the human resources process. First, we want to make sure that an employer complies a payroll tax and other human resource related laws. Second, we want to assure that the employee's legal rights don't get violated next to maintain employee performance, evaluation information next to keep track of employee retirement and other benefit programs.

Another objective would be to hire and train qualified employees. Another objective to assure that sufficient staff are available timely for operations. And finally, while finally then the list of examples that I want to go through to promote and monitor safety in the workplace. And if you're looking at all of these objectives that we go through, it's kind of funny how many of them has a legal or regulatory angle to them?

Okay. Well, It's obvious. I hope it. At least I hope it's obvious. Human resources has all kinds of legal considerations ranging from ocean other, you know, laws designed to maintain workplace safety through equal opportunity laws, discrimination, laws goodness, retirement or Rissa laws, just a bucket of laws.

And there's an awful lot of work involved in and keeping track of all of this. And you really need. To understand how that process works and design your system to help you manage the process well, okay. And to do it, there's an awful lot of specialized application software to help you meet those objectives.

All right. A question for you. True or false, the general ledger application program controls all other accounting application programs. Well, the answer to this question is faults many accounting programs interface with the general ledger application program. But that program by no means controls all other accounting application programs.

Okay. I've said this before. I'm going to repeat myself in many ways. The objective of it is reporting. You can do a great job of gathering data processing and storing it. But if you can't report relevant information to decision makers on a timely basis, you haven't done your job. So let's take a look at some of the basic types of reports.

Obvious ones would be financial statements. Okay. But in the financial statement area, you would have your gap reports as well as your managerial or your contribution margin format, financial statements. Another one would be data mining. This one might be a new term to you, but data mining is searching previously captured information to satisfy newly identified information needs.

Data mining is also done to better understand an organization's business processes, trends in those business processes and potential opportunities to improve an organization's efficiency and effectiveness. Data mining involves processing large amounts of data to make data mining effective. There are tools that are able to identify data relationships that would be difficult to otherwise spot data.

Mining tools include things like sieves, customer profiling and auditing. Okay. How about some key performance indicators? These are statistics that provide early warning of matters that may need correction. Key performance indicators. KPIs can include defect reports. Okay. That would certainly be a performance indicator, unexpected stock outs that as you don't have the merchandise in stock or the supply or raw material in stock, I usual output levels or perhaps unusual, unusual refund or bank transfer activity.

You may have heard the term exception reports and they're not key performance indicators necessarily, but the same idea. Okay, another kind of report ad hoc reports. These are reports that are generated to satisfy an information, an immediate information need. They typically are generated only once. For example, an ad hoc report would be generated to satisfy or to answer the question, how much sales or how many sales were generated from particular, from a particular zip code in the month of September and, you know, just sort of a refresher or a rehash here.

Some popular DBMS database management systems. Remember query tools would include QBE, which is query by example, fill in the blank, you know, kind of like searching the schedules that an airline website or SQL structured query language. This is the program is query language, which is useful for modifying DBMS is, and it's useful for other purposes.

A question. Which of the following is not a characteristic of an executive information system. First answer choice, supplying advice to top management from an expert knowledge based system. How about supplying financial and non-financial information? How about supplying in immediate information about an entities, critical success factors?

How about it's used on both mainframes and personal computer networks? Okay, this is the kind of question where it's a little difficult to discern the key parts of the question and the possible responses, but by reading and rereading the response choices, one thing will emerge. The second, third and fourth choices are pretty vanilla.

They could apply to many situations and certainly would apply to an executive information system. The first choice though, is a different matter. There are times when an expert needs to be consulted, but this is not always the case. Further an expert system is typically based on rules developed by an expert to address specific situations.

Not the difference. An expert system is static and unable to adapt. If you have an unusual situation and you require the services of an expert, you need a live expert, not a system. So in an executive information system, the focus is on long range objectives and situations where an expert system would not be appropriate.

Plenty of times they are appropriate by the way, expert systems, just not in the executive information system. Okay. Quick topic here I T team members, as we wrap up this presentation, this portion of our presentation, I T team members include administrators. Computer operators, librarians, systems, programmers, application programmers, and there are two in more detail.

There are two common types of administrators, database, administrators, and network administrators. Their duties include maintaining their portion of the system and making sure that access is given only to the appropriate persons. Computer operators and librarians perform the roles that their title suggests systems programmers are responsible for programming and maintaining the software that enables the system to run application programmers are responsible for programming and maintaining specific application software.

Okay. That's it. Thanks for joining me. How about going and making some flashcards definitions? Good luck.

Hi, welcome back. Now, we're going to head into a pretty big topic. We're going to talk about controls. This is usually tested pretty heavily on the exam, and we're going to cover the gamut. We're going to start with a general discussion of. Control objectives. The component are an internal control system and three types of control activities and information risks.

Then after that, we're going to get a little more specific and take a closer look at separation of duties, some of the physical controls and some information processing controls. Couple of observations before we start, number one, controls are tested heavily on the exam. I mean, that's part of what we are as CPAs.

We not only do debits and credits, but we advise our clients about accounting systems and, and the importance of controls and what kind of controls they need to implement. I'm thinking further, you know, let's get ourselves grounded in a subject before I start talking about it in detail. Why are controls implemented in the first place?

Well, controls are implemented to minimize our Olympic risk and perhaps the most important thing when it comes to controls beyond trying to eliminate or minimize risks, is that we have to be sure that the controls we're implementing have a good cost benefit ratio. Okay. We always want to consider that that is the cost of the control should not exceed the anticipated benefit from having such a control in place.

For example, having very strict controls over a pencil inventory. In an office would likely not be cost beneficial. Can you imagine having a sign out sheet for pencil? No, no point to that. You take your chances. People are people. I mean, they're going to take them from time to time and hopefully no one will be excessive in going to business.

Anyways, anyways, getting serious back to the subject. Internal control objectives fall into three basic categories. And I'm thinking controls over financial reporting to assure the information reported is reliable and consistent with the underlying accounting records and presents a fair depiction of the subject of the report will be the first category.

Second category would be controls over operations to assure physical security of the assets and that our operations process efficiently. And effectively, and the final category of controls would be controls over compliance. These controls relate to monitoring the effectiveness of the controls established to promote employee and entity compliance with laws, agreements, and company policies.

Internal control system. Well, you can break it down a lot of different ways, but perhaps the more common most common way would be to consider these five components of an internal control system. First, you have control the control environment itself, some risk assessment, the actual control activities.

You'll have some information and communication involved in an internal control. You'll be monitoring as well. Well, what is the control environment? Well, it's the general control tone of an organization. Some organizations have strong control environments. I'm not so strong, so I'm even weak. And some factors that contribute to a strong control environment include an endurance attitude toward control.

Now management attitude, it'd be indicated by their philosophy as well as their operating style. Other factors to consider in the control environment would be the attitude of the board of directors and the audit committee of the board of directors. How much participation you get from management? What kind of organization structure?

Some organization structures are structures are more conducive to internal control. Some are not another factor also in the Control environment would be a human resources, policies and practices. Is it emphasized, also do all employees or they're required to sign a statement, acknowledging the importance of internal control and are they given sufficient information to be able to help the company adhere to its internal control policies?

Okay. Another component of internal control is risk assessment. You need to undertaken a risk assessment to determine the risks associated with an organization, reaching its objectives, which of those risks need to be managed and what controls that are needed to manage those risks. The next component.

Control activities, which are the policies and procedures undertaken to assure the risks associated with an Oregon organization achieving its objectives are minimized, but we'll be discussing this one a little further in just a moment, but first let's note information and communication, the next component of internal control, this relates to the methods and records used to record, maintain and report.

The events of an entity as well as maintain accountability for the related assets, liabilities and equity of the entity. The last internal control system component would be monitored. This is just what it suggests. What we want to do is continually assess the effectiveness of our internal control and make adjustments and changes as needed.

Right? As promised a closer look at control activities You know, by the way, if it was me, I'd be diagramming this stuff out because it just, just follows into a, a natural ordering or hierarchical structure. That's best understood once diagrammed. And th this sort of information can easily be found in an auditing textbook and other sources as well.

But anyways, matter of fact, backtracking, because when you go to an exam, this isn't the only place where you're going to be asked questions about controls. Okay. It's going to pop up over and over again because of the pervasiveness of controls in the accounting, education testing, and practice aspects of our career.

Okay. Anyways, control activities fall into three categories. They can be preventive detective or corrective. The determination of type is dependent on where in the control sequence that occurs preventive controls are usually the least expensive to implement separation of duties and physical controls.

Over assets are two examples of fraud related. Preventive controls using hash totals or having an employee check the work of another before it is input are examples of error related preventive controls. Okay. Preventive controls. What are you trying to do? You're trying to prevent an error or fraud from occurring.

You're trying to intercede before a mistake has a chance to occur the next step up. Further downstream. Our detective controls. These controls are intended to identify system failures. After they've occurred. An example would be a performance report where actual results are compared to budgeted results and variances are investigated.

You may have error reports and steps. Detective controls. These are occurring after an error has occurred, but it's giving management a heads up so that they can do something to control damage. Corrective controls are sort of last chance controls. They're the controls that are established to recover from a failure in the system.

These controls are usually the most expensive, but are needed because failure do occur. Failures do occur. For example, calling defective products. During the QC, the quality control portion of production would be a corrective control. Okay. Let's consider a question. Which of the following statements generally is, or are, if you think more than one statement.

True. First preventive controls are superior to detective controls. Detective controls are superior to corrective controls. Corrective controls are superior to preventative controls, fucker and tracking corrective controls are superior to detective controls or how about some controls are better than no controls.

Finally, how about all controls are equal in cost effectiveness. Well to answer this question, you have to know that the order of preference is that preventive controls generally are superior to detective controls, which generally are superior to corrective controls. The reason for this ordering has to do with the cost of failure increasing the later in the accounting cycle that errors or fraud are detected.

So the first, second and fifth responses are correct. No. This ordering does not always hold. It's just the usual case. For example, listen to this, it may be less expensive to check the quality of all of the output. After it's produced rather than earlier in the process. Okay. It, it just might be less expensive to do it that way.

Or in some situations, this is a little cynicism coming through. I guess I've been a CPA too long. And some situations, some manufacturers seem to rely on the consumer to do the quality control work that is they'll ship product. And they know it has a 10% failure rate in there and they have no problems with just exchanging it for new merchandise where it goes back.

Okay, we've covered the basics. Plus control objectives. Let's  party, the basics plus control objectives and the internal control system. Now I want to take a look at control types. Okay. There are four basic control types. You have separation of duties. You have physical controls, you have information processing controls.

And you have performance controls, and we're going to take a look at these in the next few minutes here, before we start though on this discussion of control types I'd like to pause for just a moment and state the obvious. Okay. There are three basic steps in processing information. We've had this before recording data, maintaining data and reporting information.

Each of these steps presents its own unique operation opportunities for errors and fraud. That's the recording step. For example, incomplete or incorrect data may be recorded at the maintenance step. Data may not be properly maintained. For example, an unauthorized user may intentionally or unintentionally corrupt the data.

At the reporting step of variety of errors, emissions in fraudulent activities may occur, you know, just think Enron or WorldCom and you'll understand what I'm getting at. Separation of duties, which is called segregation duties by some authors is primarily degree geared toward preventing fraud.

Traditional traditionally duties have been sorted, you know, duties have been sorted into three general categories. The first category would be the authorization of transactions. The second category would be recording the transactions or records maintenance, and the last category would be asset custody.

The conventional wisdom is that the risk of fraud and we're looking primarily fraud. You're not errors. The risk of fraud is the mission diminished. As long as no one person is able to perform all three duties. And it's even better if they're limited to only performing one of these three duties with respect to a class of transactions, the point of the separation of duties is to reduce the opportunity for a single person to perpetrate and conceal the fraud, perpetrate and conceal that's one thing to, to be able to seal quite another, to keep everybody from knowing about it.

All right. Question in the accounting function. Which of these following sets that I'm going to mention? The following sets of duties should be separated. That is not done by the same person. Would it be authorization, recording, and audit. How about authorization, audit, and custody? How about authorization, custody and recording.

How about recording custody and audit? Or finally, how about authorization approval and signature? Right? Some of these combinations are pretty interesting, but the correct answer is the third response, authorize custody and recording. These should not be done by the same person, not demonic to help with this is arc arc authorize, record and custody.

In addition to the traditional separation of duties, it requires additional separation of duties. The it function requires additional separation of duties to promote effective internal control, three additional controls in this area probably should be mentioned first. Because of their unique ability to alter accounting records, with little risk of detection, the it department should be separate from the accounting department.

Second, because their critical role in developing applications, the application programming function should be separate from the other it functions in addition, and this isn't exclusive to just it job rotation should be required. If someone is perpetrating a fraud, what has been concealed will ultimately be revealed when they are rotated out of their job or vacation on this.

Part of our variation on this is mandatory vacations with someone substituting in someone's job function. It works wonders. I can't tell you in practice. Well, it's not like there's been hundreds of times, but literally dozens of times, as soon as someone got rotated out of a job or quit or get sick and couldn't show up for work, the fraud that they had been perpetrating got revealed.

Okay. Note, by the way, you know, I go and list these additional it related controls. They're almost exclusively fraud related. Not that it people do a lot of frauds, but the additional controls are to help prevent. The, or reduce the threat of fraud occurrence. All right. That wraps up our discussion of separation of duties.

Let's take a look at some of the physical controls. The most basic physical controls are access controls, and these would include things like locks or security personnel that restrict access to the computer per to the computer room to authorize personnel. Okay. Sort of related to physical access controls.

Access to data files and applications should also be limited to authorized personnel. This is usually done by passwords because of the efforts of hackers though, and other malicious persons passwords can no longer be the, you know, simple, you know, one of your kids' names or street where you live or whatever they should consist of random combinations of letters and numbers, and they should be changed often.

Okay. That, you know, you notice that you go to some sites, they tell you it has to be at least six characters in length. One of which has to be a number of, sort of stuff, because hackers have automatic gear that just goes in and tries the dictionary to see if they can gain access by just going through a list of potential passwords.

And if it's a word you have a problem. If it's letters random with a number inserted gets much better. Okay. Another physical control would be the periodic reconciliation of the physical that is determined by an inventory or some other manner of observation. The reconciliation of the physical to book quantities.

You want to make sure that your book quantities tie to what is actually out there physically live real in person. All right, let's try question. True or false. Physical controls include limiting access to assets assure accurate information or include reports on an entities performance, or are difficult to implement or include reconciliations of assets to accounting records or the bad choice of emphasis.

They include reconciliations of assets to accounting records. Well, Limited access to assets and periodic reconciliation of physical assets to the accounting records are the correct answers, assure accurate information. That answer is incorrect because no one type of control can assure accurate information.

How about the include reports on an entities performance choice? No, that one's incorrect as well because physical controls have no reporting aspect. Of course they're related to it in that everything in the business information system is related and even in the accounting information systems related, but it's not an answer that's directly related and therefore the answer is false.

The are difficult to implement answer choice. That's also incorrect because many physical controls are very easy to implement. I mean, how long does it take to put a lock on the door? I mean, not very long at all. Passwords. How long does it take to come up with effective password system? Not very long at all.

All right. That's it for this bunch, a good time to go back to your materials and start working some questions. Study, study, study. You remember my story? I mean, you know, I budgeted two hours, 200 hours to do this. I got it nailed in the space of about two, two and a half months. I mean, that's a lot of hours per week.

There's no substitute for it. It's the only way to go. So we'll get going. Thanks.

I'll take a look at information processing controls the controls over the processing of information. There are two basic categories of these controls. First you have general controls and then you have application controls. Now general controls apply to the it function in general and application controls.

Apply to the controls or that term applies to controls that are needed to assure that applications are run as designed. Let's take a closer look at the general controls. First we've already talked about separation of duties and access controls, but some other general controls would include a data center.

Operation controls, like providing a proper physical environment, which would be free from temperature extremes. Again, cabinets. And also protecting computers from power fluctuations and so on. Further, we want to protect the environment as possible from disasters, you know, flood fire, the usual another general control would be a written manual of systems and procedures, which should be maintained and kept up to date.

You know, it's one thing to write it originally, but it's worthless unless it's maintained and kept up to date. Another general control would be internal auditors. Should review and test computer processing activities. And another control would be the controls over data to assure that all data are recorded and that any input errors are followed up on.

Well, we need to have physical controls. Also to assure that only authorized persons have access to the system. It's not unusual to limit access to the system, to people that have a need to access the system and bar them from the remaining parts of the system. I think interesting. Yeah, troll category will be software acquisition and maintenance controls.

Some controls here would be system specifications, which of course should be written. And. Master and transaction file conversions need to be controlled to avoid unauthorized changes. Okay. In the system, software acquisition and modification control area. We need to have required approval of new programs and modifications of existing programs as well.

You don't want the programmers out there. Minding their own chicken coop. You want to have someone up above giving the approval to any changes in the software before it occurs useful control as well as to have some active participation in the decision process, by the anticipated users of the software.

Matter of fact, this would be so important. This kind of control should be required. Let's consider a question. An auditor would most likely be concerned with which of the following controls in a distributed data processing system. Remember distributed data processing system. The task is, is chopped up over a number of processing units.

Number of computers. Do you want to have primarily hardware controls systems, documentation controls, access controls, or disaster recovery controls. Okay. Remember to repeat, to sort of get us grounded. So we may answer the question. There are two basic types of distributed systems. One type is where multiple users have access to a main computer from dispersed locations.

And the other type is where separate. Usually geographically dispersed computers are used to process data and those kinds of systems that computers are linked by communication devices. Now, when the systems are dispersed so access to the computers access to the computers that are part of the network could be an issue.

Then on an authorized users could gain access to that system and create problems. That's why access control is the best answer. If you have to repeat, if you have a distributed processing system and you're using communications networks, then you're opening yourself up for others to compromise the communications.

Links and gain access to the system. So you want to have access controls to keep them out. Hardware controls, systems, documentation controls, and disaster recovery controls. The other three answer choices are always good controls, but their existence would not be that great. A concern for a distributed data processing system as access controls would be.

So those three answers are not most likely. Okay. Application controls. They fall into three categories. You have data input controls. Yeah. Processing controls. And you have file controls. There's some overlap with many of the data input controls and processing controls. So I'm going to deal with them jointly.

It's easier to try to separate them cause I'd have to come up with distinctions that may be hard to follow. Okay. Data input controls. These include event processing rules, you know, in a vector B transaction or something like that event processing rules. And these are controls that are intended to ensure that data is processed reliably.

Okay. Data entry, for example verification controls, which are intended to assure that only valid data are entered into the system. Okay. And we include things like edit checks and The data validity checks as well. Let's consider some examples of event processing control controls. One control totals should be produced from process data and reconcile with the control totals on the input.

Such control totals could be things like financial controls. That is, you know, does the number make sense in general or does it tie to total sales? For example another sort of control total that can be used would be a hash total. This is a number that has meaning only as a control total. It has no meaning from a financial point of view or similar.

For example, the, some of the invoices invoice numbers, and it would be a control total, you know, you just entered invoices numbered one to four, then the control total here should be the number 10. The hash total would be number 10. Our record called total apartment or record count total control.

This would be a completeness or duplicate entry control total. For example, you're doing a pay run. You know, that you have 120 employees. You want to have a record count on your system to make sure that you didn't did not enter only 119 records or that you didn't enter 121 records. Anything other than 120 employees entered.

As part of a payroll processing would be an error. And you'd want to know about that before you went through and process the payroll did all the checks and everything else and found out that you made a mistake. Okay. Another control that you want to have would be a control against processing the wrong file.

Okay. I mean, could you imagine you, you went to update a master file, but as the master file from two updates ago, because you're keeping, you know, successive generations. You would've just wasted your time. Plus you'd ruin a backup. Okay. Some data entry controls, these include limit and reasonableness tests, and these should be built into the system to detect input errors that is values greater than, or less than certain preset limits will generate exception reports.

I mean, you're entering data for your local electric utility from residential customers. If you get an entry in there for $10,000 being paid, that likely would not be an inappropriate amount for residential electric bill. And you'd want to see that on an exception report. So, you know, go no to go back and correct it.

Okay. Now there are also processing and edit check controls in this category as well. And control totals that like I discussed earlier can do double duty as a controlled totals, can do double duty as input controls. I mentioned edit checks real quick. What are edit checks? Well, they are things like the valid field and character tests and they're done by comparison or, or, or standards.

For example, social security numbers all contain nine digits. If you were to. Having an eight digit social security number entered into a field that should be rejected immediately because it can't be a proper piece of debt. Also, you might want to use sequence checks, okay. Sequence. This would be done to make sure that all information has been entered.

The integrity of sales invoice number sequences could be verified. Okay. Another way to get this done and other good control to have in place would be a missing data test. That is input can't proceed until all required. Data has been entered. You know, you have a blank field, you get an error message generated immediately.

You know, you've seen it probably as you've tried to enter data and maybe the missing field will be highlighted or something. So you know what you've missed and you go back and you complete it. Another input control would be a check digit. This is determined according to a specified routine. And it's added to the numeric data to assure that the data has been input correctly.

Okay, let's do with the question, the completeness, here's the question. The completeness of it generated sales figures can be tested by comparing the number of items listed on the daily sales report with the number of items billed on the actual invoices. Okay. The number of items listed on the daily sales report with the number of items billed on the actual invoices.

This project process is using what check digits. Control don't totals process tracing data or validity tests. Okay. Check digits, control, totals, and validity tests all seem to be controls, but process tracing data appears different that might choose you to choose process tracing data as your answer, be careful.

You always want to work all of the choices. In this case, the control is comparing the number of items listed in output. Okay. The sales report with the number of items listed in the input, the sales invoices. Okay. So check digits. That answer doesn't apply because check digits are oriented towards checking the numerical integrity of a single entry.

Okay. Process tracing data. Now, here it comes. And all that's a tag added to data to follow it through a system. This is more of a tool for auditors or system developers. So that choice is not correct either. How about validity tests? These are tests to ensure that only data meeting specific criteria are entered and it makes that choice incorrect as well.

That leaves control totals as the correct choice. In fact, it is a record count. Alright, file controls are intended to help assure that files are not modified without proper authorization. Okay. File controls. They're really simple things and no doubt you've used them, you know, in your studies and perhaps in work as well.

Yeah, we want to have rules for proper file labeling, you know, you're putting the labor well on it. It should have enough information to keep people from mistakenly grabbing that data storage, medium and modifying it without, you know, inappropriately modifying it inappropriate. You also want to restrict physical access to files to those that are needed to work with them.

In some entities, you have a library that keeps track of the files and they check them out to people as needed. And this can be done electronically as well, by the way, thinking out loud, also designating certain files as read only is a good choice. If they're read only people can't modify. You also want to consider using protective devices like rings or on floppy drives.

Just flipping the little. Window out of the way so that you can't write over it. Okay. That keeps the user from accidentally modifying or writing over data. Okay. Another good policy is to have a policy of regularly backing up data and storing the backed up data offsite. Okay. You have to do both, you know, it's fine if you back up your data, but if you just sit there and take the backup and put it next to the computer, you have zero protection from a fire or even a theft.

Okay. The factor computer systems is not unheard of. And sometimes that these take everything, whether they need it or not, you know, just throwing out what's unneeded. Okay. Another good control. Another good safeguard is redundant systems running parallel. Now this can be a little overkill, right? Your nine one one call center while maybe they need it because they have.

Very important systems and operation that you want with zero downtime. I don't know about you, but I'm not going to run my home computer parallel. Although I did come to think of, I know some people that do a lot of costs, but I don't know about it. Anyways. Hang in there. We're almost done with controls.

This last section here is sort of a grab bag of controls, and we're going to talk about some hardware controls, some documentation, documentation controls, and some virus controls. First, let's take a look at some hardware controls. Parody bits are used to detect the physical corruption of disks. Okay.

Parody bits. These are just physical, physical controls built into the hardware it's happening all the time. You don't even know what's going on. It's going on in the background. You also have echo or verification checks, which are done to compare the data recorded to the data transmitted before the new data is accepted.

You know, you burn a CD, it says, wait a minute, I'm going to verify it. And they go and check it, you know? And I don't know whether it's a CDs I buy, but from time to time, I get that message. I wonder about it. Anyways, hardware checks what they are a self-diagnostic checks performed by computers to try to identify circuits or components that are failing or have failed.

Okay. Great checks, you know, but they're running in the background as users. We don't really mess with them much. They just pop up when an error report is generated and then they require user intervention. Documentation controls very important in the event of a problem with the system or the application software.

Good documentation is vital to remedying the problem, the, a mnemonic to remember the different types of it. Documentation is ops soup. Oh, P S O U P let's deal with the first Oh, is operations documentation. Okay. That's a description of the program, its inputs, how it works, emergency procedures. And so on the first P is problem definition, documentation.

That is the reasons for implementing the system in the first place and how the system was chosen. The S is systems documentation, and that includes systems flow chart. Inputs outputs file descriptions controls and change records. Change records really important. Somebody changes something. It's nice to have a change.

Rudder. A second DOE is operator documentation. These would be things like daily logs and console logs. They don't have to be manual. They can be electronic and generated automatically by the system. You is user documentation. That'd be a record of the system users and their activity. And you do want to keep track of this because if something goes wrong, it might be nice to know who's behind the wheel when it happened.

A second P last letter of the mnemonic would be program documentation. Now, this is also known as application documentation. The flowchart decision table. Logic narrative and all the information that would be needed by our programmer, new to the program to figure out how to modify a repair. It would be a, would falls under the program documentation heading.

Okay. Finally, let's do a little chit chat here about computer virus protection. No, I'm hoping everyone's fully aware of this control and that further discussion is not unnecessary, but I'm going to state the obvious you want to have good antivirus software. In place, not just on your home PC, but also on business applications as well.

And you want to update it constantly. Many of the programs have provisions in them where they're always checking the publisher's website for updates, but even if you don't have that, you want to be doing it yourself. Okay. Next let's let's think a real question is this is true statement. As a matter of fact, it's true.

As a statement can be. From time to time, computer functions, computer programs malfunction. Let's say we have an accounts receivable aging program. The person who wrote the program no longer works for the company. This happens to the best control to have had in place. When the program was written would be well, here are our choices, application, documentation, data, documentation, procedure, documentation.

Systems documentation or a user manual. All right. Data documentation should be an immediate rejection. Nope. Process of elimination says can't be word. Data is in the phrase and you're right. It's out procedure documentation, or that should be rejected because it's not specific enough users manual. No, that's not appropriate either.

It applies to users, not programmers. That leaves too. Application documentation systems, documentation, the correct choice of application documentation should be reached because you remember the difference between application software and system software and AR program is an example of an application program, a program designed for a specific task, unlike systems programs, which are, which relate to the operation of this system itself.

Okay. We're just about done with controls and I'd like to make a final point developing systems with good controls is one of the core responsibilities of accountants. You've heard this from me already. Consequently, you're going to expect some questions on controls. If I was studying for the exam, this is one of the areas where I would make flashcards.

Now I understand that there is some overlap between areas and it can seem a little difficult to neatly categorize the control, but I would put the effort into gaining the best understanding of the area that I could. And like I've said already, and you'll probably hear me say it another couple, three times.

There's a lot of this part of the CPA Exam is related to being able to define the terms. Flashcards are great for that. It's not the only way to do it and whatever works for you because we all don't learn the same. Is fine, but you really want to approach this with, with considerable academic rigor. It's not easy, but if it's done over and over again, enough should stick so that you pass the CPA Exam and that's it.

Go make some flashcards. Bye.

This is our disaster discussion. Now not about the quality of my presentation disasters. They strike. Common disasters include the usual assortment of fires, floods, power failures, viruses, even sabotage. Okay. Hackers consequently as vital that an entity establish a good disaster recovery plan. Okay.

The plan needs to include procedures like frequent backups systems documentation so that you can recover loss destroyed her. Corrupted data and programs. Okay. You need to have a business continuity plan. These are procedures to get computer operations restored within a reasonable time. Okay. You know, reasonable depends on the entity for nine 11 call center.

You want to be back up and running instantly and for a small business, a very small business that only processes data. Occasionally you have a little more time. Matter of fact, I said sabotage, let's start to think about hackers here. It's a good time to talk about them. Hackers fall into three categories.

You have your computer enthusiasts that just, you know, like computers, computers are fun. They're neat. You know, there's hobbyists for everything and they hack just for fun. They might not even do bad things. They're just doing it because they can, you have another category called crackers. That's like criminal and hackers put together crackers.

These are the not nice guys that go in and steal information and use it for illegal purpose. Finally, you got a group called and then jeez, you know, these definitions change all the time. And there's probably been more definitions added since I started this presentation a minute or two ago. Anyways, there are script kiddies.

These are kids or youths that are somewhat fluent in computer terminology and how to make them work. And they you know, another category hackers usually doing it for fun. Although I, you know, when I was a kid, I did other things for fun, like sports. Anyways, hackers have a variety of tools. They have things called demon dialers, you know, demon dollars are nice.

If you're trying to enter a radio call program, you know, calling for a prize or something like that, they have a drawback, of course, in that they can horse they're hopelessly tie up a telephone system because they can flood it with so many calls. I mean, these dial, dial, dial, dial, dial. And it can cause a system or a site to break down.

You also have port scanners these acute little electronic software routines that, you know, try to tap on the door of a network to see which parts of the network are live and maybe probe further to gain the access to information that they're trying to steal. You have automated scripts and other tool of the hackers.

These automated scripts are. Programs or software designed to try to figure out ways to enter a system without having proper authorization, a sniffer similar idea. It goes into the system and it looks for opportunities to, or tries to figure out passwords and access codes and so on to get deeper into a system, to get the sensitive data either to trash it or to steal it a Trojan horse.

Is a variety of virus that looks like a legitimate program. It's masquerading as a legitimate program, but then it enters, the system opens up, starts to cause damage. Of course, you have your regular run of the mill virus that goes in and does all kinds of nasty things ranging from annoyances to completely wiping out.

Assistant's hard drive. You also have virus hoaxes, which are not such a good thing either. These are funny sort of things. I don't know whether you've seen them. I certainly have you had an email from someone that says caution this viruses, flooding the internet to fix your computer. Just do these few simple steps.

Of course, those few steps, simple steps to Sable your computer. You know, you kind of like holding the knife to your own throat passwords passwords. Very strong protection against hackers. You want to follow certain rules to get an effective password. Matter of fact, there have been studies done, and I think things are changing because people are, are getting wise to it, but I'll bet you, it's not changing as much as they should.

You know, people would use things like their birthday for her password and stuff like that. But anyways, in setting up a password, you want to have it to be a certain minimum length. Okay. That way these automated hacker programs are less likely to break it. You know, six characters is what I've sort of seen as a minimum.

A little longer is probably better. The types of characters, of course, you want to mix up letters and numbers. Some systems were able to distinguish between opera case and lowercase. That helps even more. You also want to have a limit on the password attempts because some of this hacker stuff would just keep trying until it finally gets in.

And if there's no limit, the computer doesn't know any better. It'll just patiently sit there and tolerate every attempt until one works. I shouldn't have said patiently. There's no such thing as patients to machines, but anyways limit password attempts. I don't know about you, but sometimes I've forgotten the password trying to gain access.

So I'll try the first three that come to mind then. Bingo, a number four. Sorry you can't try again until tomorrow. Great block. It just keeps people hackers out. Observation wireless networks. These are at special risks from hackers because now we're broadcasting over the air. As opposed to through a wired sort of situation you may recollect when we were still had analog cell phones it was possible to steal cell phone numbers and reprogram phones, you know, get the digital IDs very easily with equipment that people would drive around in their car and use not such a big deal with digital phones, but you could do it more easily than analog phones.

Same idea wireless networks are exposed to a similar risk. All right, a question. And this is just a quick check on whether you've been paying attention, which of the following computer programs part is a computer program that appears to be legitimate, but perform some illicit activity when it's run.

Would that be a hoax virus, a web crawler, a Trojan horse, or a killer application? The first Cho choice, a hoax virus, our virus hoax is a false email. Warning that, so that makes that choice incorrect. The second one, a web crawler, that's usually a search engine and not a virus. So that is not a correct choice either.

Quite frankly, some viruses may be spread by web crawlers, but the web crawler itself is not a virus and that's a highly technical point by the way. So don't concern yourself with it. And once you get on the exam, not the web crawler part. Yes. But spreading viruses by what? Crawlers? No. Trojan horse.

That's correct answers. That's correct by definition. As a matter of fact, charging horse appears legitimate and that gets the user to download it. But when it is run after downloading it then causes the computer to perform an illicit activity. Killer application is like a distractor or a trick term. It looks like it might be the answer to the question, but it's just a slang expression for a great application program.

Okay. When disaster strikes. Many businesses must get up and running again, ASAP as soon as possible using an alternate site is often the best choice. There are different alternatives and the cost increases in conjunction with the state of readiness of the alternate site. Some of the common choices are all first would be a mirrored site.

That's the most expensive alternative. The way it works is at least two geographically dispersed sites are run parallel with exact copies of programs and data. Okay. This is usually only chosen for critical computer functions like nine one, one or military applications. Clustered sites would be in the next step down.

And this is where multiple sites are used to process data. If one of the sites goes down, the other sites can pick up the load. There's some limited redundancy among the members of the cluster to help this, you know, make the thing go. But it's basically, you got a bunch of sites all working together to get the job done.

One falls off, you can still get up and running again. Another choice is vaulting sometimes known as shadowing or replicating. And this is where the event related data. You know, it's not bolting like pole vaulting. It's like vaulting, like saving. This is where event related data and master data changes are continuously transmitted to an offsite electronic vault.

Okay. And that data is all saved there. Kept you can use it to get yourself up and running again quickly. Now let's start a hot site. A hot site is a fully functioning site that can be brought online with a minimal effort. Hot sites are often shared by many businesses. You know, the businesses would be geographically dispersed on the theory that they all won't re require it simultaneously.

This, you know, why geographically disperse businesses? Well, I live in Tampa. We're at risk of hurricane. You wouldn't want to have a hot site. Well, a hot site in Nebraska would be a good idea, but you wouldn't want it to serve exclusively Tampa businesses because you know, if one of us gets hit, probably more than one of us will get hit and we'd overwhelm the center in an instant.

So, you know, the one in Nebraska would have customers from Minnesota, Florida California, and hopefully the odds of all three getting hit at the same time. They're small cold site is similar to a hot site, but it takes much more time and effort to bring it online. Cold site might just be an empty room with the appropriate power hookups, but not even any gear in it.

And. As we'll see in the question, there are a variety of possibilities in between. It's just a matter of terminology. Here's the question. You have a client, your client's concern that a power outage or disaster can impair the computer hardware's ability to function as designed the client wants to have some sort of backup hardware facilities that are fully configured and ready to operate within several hours.

The client most likely would consider what a cold site. A cool site, a warm site or a hot site. Well, choosing the response for this one is a matter of degree, but key phrases like fully configured and within several hours should point you in the direction of hot site as the correct answer. Okay. That's it for discussion of disasters?

They do happen. Proper planning is very important, right? Back to go back and study, go look at some questions. I'll see you. Wow.

All right. Let's talk like Tronic commerce after a little stumbling, electronic commerce is back on track. And as a matter of fact, it's picking up speed. Matter of fact, if I was to conduct a survey right here right now, I bet nearly everyone hearing my voice. Has bought something or made a reservation or engaged in some sort of electronic commerce in the last year.

Matter of fact, I bet most people and probably in the last month and many in the last week, I certainly use it regularly. The ways in which electronic commerce is conducted are varied, but certain methods are common and we're studying for the exam. The basic categories are online retailers. E F T, which is electronic funds transfer POS point of sale and EDI electronic data interchange first online realtor realtors right now, there are some, but anyways, online retailers, some entities are exclusively online and others have online as a choice to their brick and mortar operation.

And they developed a language of their own for sure. Number one back end transaction processing. That's nothing different than the traditional backroom operation. You know, the, where the paperwork gets done, that paperwork where the accounting and other matters related to processing order get done connection list environment.

That's being connected with the internet product space. Well, this is where the catalogs developed what items you're going to have available for your customers. Shopping cart is kind of cool. You know, we sort of get used to it when you do your online shopping, putting things in your cart. The neat thing about it is, you know, you can have many, many users hooked up to a site at any given time.

And what a shopping cart is, is an electronic way to keep track of each of those users as they make selections from the catalog. Transacting network security, assert assurance, couple of coral terms. The AICPA has a security assurance service available called web trust where, you know, a CPA goes in and evaluates sites controls over matters necessary to assure that their customer's information won't be compromised and made available to those that would do illegal things with it.

And that's a very useful imprimatur to have added to a website that is the security assurance, so that you can be somewhat assured that your data will be safe. In developing an online retailing presence, we need to assemble a team and his team would have, you know, a number of different members. And depending upon the project, we may have all of these positions filled that I'm about to list, or some people might be doubling up or tripling up even.

But first of all, we need an accountant. That's familiar with controls. I mean, this is an accounting review course. You would expect us to get some billing here, but that's the help the site designer make sure that appropriate controls are in place to protect customer data. You actually going to want a graphics designer to set up this site to give it the wow factor, a marketing specialist.

Somewhat familiar with marketing and identifying products for which there would be a good market pricing them, promoting them, getting the word out to the public. You'd want to have a usability specialist. This is someone that's familiar with how to set up websites to make it a user-friendly to have the right kind of interface that makes it easy for customers to buy.

You also need a webmaster who is responsible for the nuts and bolts of operating the site. Making sure it stays up and running. Did any glitches are fixed on in reasonable time. And you'd also want a wider someone that's writing the copy or composing the printed matter that will be available printed the written matter written, whatever the material that people will read as they access the website.

All right. That's it for online retailing. How about wire transfers? Wire transfers have been around for a long time, but there's a huge push on lately to convince people, to use internet banking and other forms of EFT electronic funds transmit electronic transmission. Gosh, time, the memory fails slip from time to time.

Thing that I keep asking myself though, I use online banking is one of the things I started charging for it. And I'm liking it when it's free. I'm wondering when the charges are going to start to hit. Also point of sale terminals, they've been around for quite some time as well. But if you think about it, they also qualify as electronic commerce go to your supermarket, your order scan, and then you pay.

The data from your order, especially if you're using one of those supermarket cards is transmitted to the company's main computer, furnishing it with all kinds of information. First, the information peculiar to the store itself. That is what stock is getting sold. When, and should we be reordering because stock is getting low and so on, but they are Also going on with the supermarket cars and keeping track of your buying habits to tailor marketing campaigns, where they may be sending you an email or, or snail mail offers a product that they think would be of interest to you right now to the biggie is not a biggie from online retailers.

It's probably bigger from a number of transactions and the average consumer's point of view, but EDI is pretty big and it's coming on even stronger. What is EDI while it's the trend? It's the transmission of business data within an entity. Oh, it's electronic data interchange within an entity or between entities.

It is in a structured machine, retrievable format, not like email or fax communication. EDI is usually done in batches and the major benefit of VDI is that it improves accuracy and the timeliness. Of information sharing with electronic commerce. There are some new risks, however, such things as unsafe websites, vulnerability of personal data while it's being transmitted and unethical merchants are some of the risks as well.

In response to these risks, some protections are available. First off, the sensitive data can be encrypted. Encryption means, you know, gobbled up except for the transmitting, the scent and the receiving unit, which have the appropriate decoders encryption. Our sensitive data helps ensure that malicious users don't gain access to personal information.

This is very common when transmitting such information over the internet. And there's also, as we were talking about earlier with the assurance services for online E-commerce there are services available where an outside entity comes in and essentially audits a website. And if their website needs certain minimum standards the merchant is allowed to display the assurance companies seal now walking away from BDI for a second, although we're going to come back to it.

Some questions, EDI are probably e-commerce has risks, right? Okay. Let's think about this unsafe websites. What could be an unsafe website? Well, is it a website that's set up to gain people's credit card and other personal information? Absolutely. Are there many of them they, goodness. No, but they're there also when transmitting over the internet, your personal data without appropriate encryption software can be vulnerable to theft from unscrupulous people, it does happen and there are, there are things you can do.

Do you help protect that data? In addition to encryption I've ordered some stuff for example, where I've sent half of a credit card number in one email, then waited a while and sent the second half of it. It's not a great system, but it works. There are also unethical merchants shoot there's eBay, which has all kinds of problems.

Mostly. Very good. I don't want to knock you be at all. I, I participate in that, but there are people that go on with their sole intention to be, to part people from their money. But anyways, encryption assurance services, there are people out there trying to do that things. And there are ways to protect ourselves to your question, which of the following characteristics distinguishes EDI, electronic data interchange from other forms of electronic commerce.

First answer choice. EDI transactions are formatted using standards that are uniform worldwide. Second choice. EDI transactions did not comply with generally accepted accounting principles. Is that true or not? Next choice. EDI transactions ordinarily are processed without the internet to a fault. Finally, EDI transactions are usually recorded without security and privacy concerns.

All right. The first answer is the correct answer and this comes as a surprise to a lot of people. But EDI standards in fact are uniform worldwide. The second answer is incorrect because with respect to gap, NDI is no different than other transactions. The third answer is wrong because the internet is an integral component of EDI, just like other electronic commerce.

Finally, the fourth answer choice is incorrect because security and privacy concerns are a big issue with all forms of electronic commerce. All right. Next question. What are the benefits of VDI? First answer choice. I compress it business cycle with lower year-end receivable balance balances, or how about a reduced need to test computer controls related to sales and collections transactions.

Third choice increased opportunity to apply statistical sampling techniques to account balances. Or three, no need to rely on third party service providers to ensure security well because of the linkage of the computer systems with EDI, the risks of software and compatibility and viruses go up. So security risks increase in controls must be tested more often.

That's why the second and the fourth answers are incorrect. The third answer is incorrect because EDI has a negligible effect on substantative. Both audit on substantive audit procedures, both internal and external. Okay. Now internal and external audit. Remember substantive audit procedures. This is where your testing account balances not controls, but account balances, right.

Which want to do is pause and think for a minute. What is the point of the question? Well, EDI is all about speeding things up and improving accuracy. This question involves the increase in speed. So the first answer, compressed business cycle and Laurel receivables is the correct answer. Okay. Comments e-commerce paperless.

Personless the convenience comes with at least some loss of personal service. Okay. A member of the EDI family is B to B business to business. What that boils down to is networking. The computers have completely separate business entities, usually between a supplier and their customer, such that they work together to further each other's business needs B to B is usually online and real time.

E-commerce in general. As a matter of fact, generally, it needs to be online real time. It'd be difficult for a company. Like Amazon to stay in business. If their inventory was not being updated, as the merchandise was being sold, they'd have some unhappy customers, especially during the holiday. All right.

Econ, there's another term perhaps that we want to master to make sure we understand it. XBRL, extensible business reporting language. This is a business reporting language, which is basically a way of tagging business info or info. So that it can be easily read by almost any software package. Another question, a system that provides vendors and customers access to each other's internal computer data to facilitate service deliveries and payments is called what a distributed processing XBRL EDI, electronic mail timesharing.

Are online, realtime. The correct answer is electronic data interchange. Distributed processing is internal. That is an entities. Data processing needs are distributed to the various business segments based on need and capacity. Electronic mail is playing on Liberty, email and time sharing is running processing time on a large computer.

Online real-time is an approach to processing. This is an e-commerce type of question that might appear on the exam. Okay. Let's take a look at another question, which of the following represents an additional cost of transmitting business debt transactions by means of electronic data interchange, rather than in a traditional paper environment.

Our first answer choice choices, redundant data checks are needed to verify that individual EDI transactions are not recorded twice. Our second answer choice would be internal audit work is needed because the potential for random data entry errors is increased. Third choice transaction software is needed to convert transactions from the entities internal format to a standard EDI format.

And last answer choice. More supervisory personnel are needed because the amount of data entry is greater in an EDI system. Or the third choice is the correct one that is translation. Software is needed to convert transactions from the entities internal format to a standard EDI format. EDI involves electronic communication among two or more entities.

These entities need a common standard transmission format. Individually EDI transactions are no more likely to be recorded twice than transactions performed in a paper environment. And one primary advantage of EDI is a reduction of data entry and a corresponding reduction of associated errors. Random did data entry errors are generally reduced in an EDI system because information is entered once allowing one opportunity for errors, kind of like the story of database management systems rather than storing the data with application programs.

Okay. So rather than doing it multiple times, we do it once a fewer chance for errors. Now, another question. In building an electronic data interchange system, EDI system. What process is used to determine which elements in the entities, computer system correspond to the standard data elements. Okay. Would it be mapping translation, encryption or decoding?

The correct answer is mapping. Mapping converts data between EDI applications and a standard EDI form translation changes representations between a standard EDI form and an encoded standard EDI form encryption, scrambles files, and communications to prevent unauthorized use decoding means converting data back to its original form.

Another question, a system that provides vendor and customer access to each other's internal computer data to facilitate service deliveries and payment is called what distributed processing electronic data interchange, electronic mail or time-sharing or the correct choice is electronic data interchange.

Okay. EDI is a method of conducting routine business transactions, such as inventory purchases. It relies on standardized guidelines that everyone can use. Distributed processing is an allocation of various processing tasks to various business divisions, with some tasks centralized and some decentralized electronic mail refers to the electronic transmission of messages, including attached files.

From programs unrelated to the email software. I time sharing center, rents time on a central computer to several entities with each entity, having remote input and output devices to each entity. It seems as if it is the only one using the system. Okay. That's pretty much it for me. Thank you for joining me.

And it's been my pleasure to work with you as you study for the exam. I know it's quite difficult as you're preparing, and if you're, you know, maybe having a couple of doubts as to whether it's all worthwhile, I'd like to strongly encourage you to stick with it and put everything into it that you have to make sure that you pass the exam.

I've been practicing public accounting for 21 years. I met some great people in the, in the public accounting profession, a lot of wonderful clients, a lot of great jobs. I have some more stories that are absolutely hilarious. I have some more stories that are touching. The relationships I've forged have really contributed to my personal as well as my professional life.

And if I had to do it all over again, I would. So you've chosen the right career stick with it. Pursue it professionally, make it everything that it can possibly be. Okay. Make yourself everything that you can be, whether you choose to continue and go on and public accounting as I have, or whether you go straight to private accounting or do a mix of public and private accounting it's worthwhile, but it's worthwhile.

If you pursue it with professional diligence and PR and the complete state of professionalism in your mind. Anyways. Good luck as you take the exam, keep working hard. You'll make it. I'm positive. You will. And at the conclusion of it, it'd be my pleasure to welcome you as a fellow professional in the practice as a certified public accountant.

Thanks again for joining me.