Bec Outline

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Sole Proprietorship and Joint Venture Sole Proprietorship • Filing not required - simplest form of business ownership • Sole proprietor not considered a separate entity from the business, so will have to personally file for bankruptcy • Personally liable for all obligations of the business • Life of entity limited to the life of the sole proprietor • Sole proprietor can transfer interests at will Joint Ventures An association of persons or entities for a single transaction or project. JV's are treated as a partnership (P/S) General Partnership NO STATE FILING General Partnership - an association of two or more persons who agree to carry on as co-owners of an ongoing business for profit • Filing not required • At least two owners of the partnerships • Personally liable for all obligations of the business • A partnership may be dissolved after a partner dies or otherwise dissociates from the partnership unless the partners have agreed otherwise, or vote to continue the partnership • Taxes flow through the P/S to the partners (taxed at their rates) • A partner cannot transfer his P/S interest without unanimous consent of the other partners • A general P/S may file for bankruptcy as a separate entity In a general P/S • All partners are general partners • All partners share equally in mgmt, profits and losses unless agreed otherwise (even when capital contributions are not equal) • Within the ordinary course of business a majority vote is needed • Matters outside the ordinary course of business require unanimous consent - Admitting new partners - Confessing a judgement or submitting a claim for arbitration - Making a fundamental change in the business (sale of goodwill) - Changing the P/S agreement - Assignment of P/S property to others • All partners have unlimited personal liability for obligations of the P/S • All partners (individually) have the actual or apparent authority to bind the P/S with respect to all normal partnership business transaction (except when a third party knows the partner lacks actual authority) - Actual authority - all authority that a principal expressively gives to an agent plus any authority that is reasonable implied from the express grant (Partner is store manager, reasonable to imply the partner has the authority to hire employees, buy merchandise, etc) - Apparent authority extends only to the ordinary course of business (sign a lease, hire/fire employees, purchasing equipment, granting warranties) - The P/S may ratify an unauthorized act (if the P/S likes an unauthorized act by partner) • All partners must approve major business decisions • A partner who acts outside the scope of his actual authority will be liable to the P/S for any damages caused by the unauthorized act (breach of contract) 1

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Intent to form a P/S (either Express, orally or in writing, or Implied, in conduct) is the key to general P/S formation. No express agreement is necessary. An agreement can be implied from conduct showing intent to enter into a business for profit together. However, if the P/S wants to exist for mare than a year, an agreement is required under the statue of frauds Dissociation (P/S may or may not continue) of a partner does not necessarily cause a dissolution (business it wound up and then terminated) Events of a dissociation: • A partner wants to withdraw • An event set forth in the P/S agreement that causes a dissociation • A partner is expelled by unanimous vote • A partner becomes a debtor in bankruptcy • A partner dies When a partner dissociates actual authority ends but apparent authority continues for two years until 3rd party is given notice. For debts prior to dissociation, partners remain liable unless released by creditors (novation) For debts incurred after dissociation, partners are not liable if notice is filled with the state or each 3rd party Liability of an incoming partner is limited to financial contribution to P/S for debts prior to his/her arrival, and is personally liable of all debts incurrent by the partnership after he becomes a partner Events that may cause a dissolution: • A partner withdraws • A P/S lasts for a specified length of time • An event set forth in the P/S agreement that causes a dissolution • Issuance of judicial decree on application of a partner • Issuance of a judicial decree on application of a transferee Distribution of assets • Step 1: Liquidate assets • Step 2: Pay creditors (insiders or outsiders); if the liquidation of assets do not cover the costs to pay the creditors, then the losses are split • Step 3: If there is leftover after paying creditors, return capital to partners or split losses • Step 4: If there is anything left, divide profits

Financial Structure of a general partnership • Partners are not required to make any particular contribution to their P/S • Unless otherwise agreed, partners are required to devote themselves full-time and are not entitled to remuneration (salary) • As a general rule, partners have no right to use P/S property for anything other than P/S business • Partners do not have the right to assign P/S property • An individual partner's creditors can not use P/S property to settle debts (credit card debt can't be settled with P/S property) • Partners right in a P/S do not pass to his estate • P/S interest is completely different that P/S Property - Interest in P/S (profit and losses) is assignable, but no mgmt right come with the assignment 2

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

- Individual's creditors may go after the P/S interest, not the P/S property - P/S interest is passes on to a partners heirs Partners are generally liable for all contracts entered into and all torts committed by other partners within the scope of the P/S business The partners' liability is joint and several for the entire amount. Meaning if the other partners flee the country, you are liable for all P/S obligations Limited Liability P/S MUST FILE WITH STATE A limited liability P/S (LLP) is similar to a G/P in most respects, including sharing of profits/losses, and all the general advantages and disadvantages of a G/P Differences • Not personally liable for debts of the P/S or acts/torts committed by another partner, employee or agent, but you can lose your investment. But you are still liable for your own acts\ • Must file with the sate Limited Partnership • Is comprised of at least 1 general partner who manages the business and is personally liable (for all P/S debts) and at least one limited partner (whose liability is limited to capital contribution) • Unanimous consent required for either the GP or LP to sell their interest, or a new partner be added • Partners must make some type of capital contribution • Absent an agreement, profit and loss allocation is based on capital contribution • A LP is like a shareholder, no control power, may assign interest, does not owe fiduciary duty, is not an agent, has not apparent authority • A LP may be dissolved by - Occurrence of time or stated time in the P/S agreement - Written consent of all general partners - Withdrawal or death of a general partner - Judicial decree • A LP has a right to vote on fundamental changes, inspect the P/S books, transact business with P/S, bring derivative action • A LP can lose limited liability is they do any 1 of the following - Serve as a general partner - Allowing name to be used in P/S name - Participate in control (3rd party has reason to believe that the LP is a general partner) A limited partnership and corporation are both created under a state statute and require filing with the state Limited Liability Company/Corporation • Must file with the state articles of organization which includes - A statement that the entity is an LLC - The name of the LLC - The address of the LLC's registered office and registered agent (usually a corporate lawyer) - Statement about management duties, otherwise all share equally in mgmt [Similar to articles of incorporation except there is no stock information] • The owners or members are not personally liable for the obligations of the company • Income flows through to members 3

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

• • • • • • •

Members may not sell ownership interest in the LLC without consent of other members All members have right to manage, but may adopt agreement to centralize management (manager managed) Like a corporation an LLC is a distinct legal entity, it can own land, sue, file for bankruptcy Each member is an agent and has the actual and apparent authority to bind the LLC. Members owe a fiduciary duty If the LLC is Manager managed, each manager is an agent, but the other members are not agents and does not have the power to bind the LLC Voting strength based on capital, ownership interest [while in GP, LLP, LP voting strength is equal unless agreed otherwise]

Events that may cause a termination or dissolution [similar to a GP]: • Consent of all members • A partner withdraws, death, retirement, bankruptcy (this cause dissociation and may lead to dissolution] • A P/S lasts for a specified length of time • An event set forth in the P/S agreement that causes a dissolution • Issuance of judicial decree Profit and loss allocated based on members contributions Corporation • Must file with state called articles of incorporation - Name of corporation - Name and addresses of the corporations registered agent - Name and addresses of each of the incorporators - Number of shares authorized to be issued - One of more classes of shares must have unlimited voting rights • Directors are elected by shareholders, directors select executive officers to manage day-to-day operations • Stockholders, directors, and officers are not personally liable for obligations of the corporation (just lose investment), but may be liable for torts the individual commits • Perpetual life, can continue after the death of resignation of owners or managers • Stock holders free to transfer ownership interest whenever they want to whomever they want\ C Corp - double taxation (if income is distributed to stockholders), corporate tax rates lower than personal rates S Corp - taxed like a partnership, flowthrough; however there are restrictions on S Corps - Stock can not be held by more than 100 persons - Shareholders must be individuals, estates or certain trusts - The corporation must be domestic - Can only be one class of stock - Foreign shareholders are generally prohibited Certain types of businesses (insurance companies and savings institutions) cannot file for bankruptcy regardless of what type of entity they are formed as Most aspects of corporate law are governed by state law, but some aspects (federal tax, securities regulation) are governed by federal law. The state statue is called Revised Model Business Corporation Act (RMBCA) Promoters, who raise capital for the corporation, enter into contracts with third parties who are interested in becoming shareholders (stock subscription) - Promoters are generally personally liable on the contracts (B1-33 more detail on this) 4

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- Even if the corporation adopts a promoters contract, the promoter remains liable unless the promoter is released by the third party (novation) Ultra Vires Act - If the corporation has a narrow purpose cause (some states do not require it) and the corporation undertakes business outside the clause, it is said to be acting "ultra vires" and may effect the firm. • A shareholder may seek an injunction (order from the court) prohibiting the corp from the action • The corp or shareholders may sue to recover damager from the directors or officers who authorized the ultra vires act • The state (usually the attorney general) may bring an action to have the corp dissolved for committing the act Bylaws - rules for running the entity. They are not part of the articles of incorporation and are not required to be filed with the state • Bylaws may not contain rules that conflict with the articles of incorporation • Can be amended by board of directors or the shareholders De jure - all of the requirements for incorporation are met and it will be recognized for all purposes De facto corporation doctrine - requirements for incorporation are not met, but the business might still be treated as a corporation, if the incorporators made a good faith attempt to incorporate and operated as if they had incorporated, the business will be treated as a corporation in all aspects Doctrine of incorporate Estoppel - requirements for incorporation are not met, but the business might still be treated as a corporation, if a party who treats a business as if it were a validly formed corporation will be estopped (legally barred) from claiming in a legal proceeding that the corporation was not validly formed [if the 3rd party reasonably believes that they were dealing with a corp {not fraud}, then the party can not claim the corp was not valid] Defective corporation - entity did not make a good faith attempt to incorporate so shareholders are personally liable Piercing the corporate veil - courts hold shareholders, officers or directors, active in operation of the business, of a de jure (properly formed) corporation will be held liable (because the legislative privilege of conducting business is being abused). There are three reasons the corporate veil will be pierced: 1. Commingling personal funds with corporate funds 2. Inadequate capitalization - corporation is under capitalized at the time of formation 3. Committing fraud on existing creditors - if the corporation was formed to defraud existing personal creditors Foreign corporation - a corporation not incorporated within the state (Cali corp going to NY to do business) Domestic corporation - incorporated within the state A foreign corporation may not transact business (maintain an office within the state or conduct regular intrastate business) within a state it has registered with the state and has obtained a certificate of authority. [So you don't need to file twice for incorporation] Quorum - a majority in attendance, so if there are 10 board members, 6 must be present at a meeting to have a quorum Operation of a corporation • A corporation only needs only one director 5

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

• The articles of incorporation usually name the initial director, who hold office until the first annual meeting. • Directors may be removed by shareholder vote with or without cause • Director's meetings are only valid if a quorum is present, and action may be taken with a majority of vote of those present, so if 4 of the 6 approve the action, it would be valid • Individually, directors have no right or power to act, they are not agents, they owe a fiduciary duty • Directors may not vote by proxy, must be there physically • Individually, officers have powers, they are agents and have fiduciary duties Fundamental changes require both board and shareholder approval, examples are: • Amendments to the articles of incorporation • Mergers A+B=A; both A&B's boards and shareholders must approve the fundamental change • Consolidations A+B=C; both A&B's boards and shareholders must approve the fundamental change • Share exchanges A acquires all the outstanding shares of B; A needs only the board approval, B's boards and shareholders must approve the fundamental change • Sale of all or substantially all of the corporations assets (purchasing company, buy side, only needs board approval) • Dissolutions - termination of corporate existence (could be involuntary through judicial proceedings) Procedures for fundamental changes 1. Board adopts resolution by majority vote, setting forth the proposed action for shareholder approval 2. Notice to shareholders given whether they are entitled to vote 3. Eligible shareholders vote, need majority 4. Filing of articles, setting forth the action taken, with the state Merger of a subsidiary (parent owning 90% or more of a subsidiary) - Parent needs only boards approval. Parent's board makes decision unilaterally Authorized shares - shares described in the articles of incorporation Outstanding shares - authorized shares issues to shareholders Treasury shares - outstanding shares repurchases by the corporation Par value - minimum price the stock can be issued for legally (to ensure the corporation would be capitalized to a certain level Under RMBCA, board of directors can issue the stock price at any level and be issued in exchange for any benefit to the corporation (services rendered, services to be performed, real estate, etc) If property is accepted for stock, the board must value the land in good faith Unpaid stock - a subscriber has promised, but failed, to pay for stock, the subscriber may be liabel to either the corporation or its creditors Watered stock - stock that has been issued in exchange for property worth less than the part value A corporation has no obligation to allocate profits and losses to among shareholders. However, if dividends are declared by the board of directors, shareholders are treated as unsecured creditors Cumulative Preferred shares - gets paid dividends in arrears. Gets paid before noncumulative preferred 6

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Noncumulative Preferred shares - gets paid before common stockholders, if a dividend is declared but not paid within the year, the noncumulative shares lose out Stock dividends - authorized shares owned by the corporation but unissued, because no assets are issued, shareholder do not owe federal taxes Cumulative voting - each share is entitled to one vote for each director position being filled in any way, so can cast all votes for one single candidate (protects minority shareholder) B1-46 example of cumulative voting Shareholders may vote only is a quorum is present, and they may vote by proxy (appointment valid for 11 months) Shareholders may enter into several agreements to protect voting power • Voting trust - all shared owned by the party are transferred to a trustee, who votes and distributed dividends in accordance with provisions of the voting trust • Voting agreements - less formalistic, shareholders simple agree among themselves to vote a certain way Shareholders in small corporations (closely held corporations) can put restriction on the transfer of stock, but they can not put an absolute bar against selling shares. Examples of restrictions include: • Right of first refusal - giving specified persons the option to buy shares before selling to an outsider • Requiring that specified persons approve the transfer of stock • Prohibiting the transferring of shares to a certain type of persons, such as competitors Shareholders have the right to inspect the books and records upon request if its for a proper purpose. Improper purposes to personally benefit the inspecting shareholder include obtaining the contact information of shareholders to create a commercial mailing list Pre-emptive rights - the right to purchase additional shares to maintain their proportionate voting strength. No pre-emptive right unless articles of incorporation provide for them Dissenting shareholder - vote on a fundamental change and lose. The shareholder may dissent and demand that the corporation pay them fair value of their shares (buy them out) Derivative action - the corporation has legal cause of action but refuses to bring action, the shareholder may that the right to bring derivative action to enforce the corporations rights if three prerequisites are met: 1. Shareholder must have been a shareholder during time of the alleged wrong 2. The shareholder must be suing in the best interests of the corporation 3. The shareholder must have made a demand on the board Board of directors • Job to initiate fundamental changes • Declare dividends • Uses good faith (talks and relies on the officers, auditors, consultants to make decisions) • Should not profit from material inside information • Can not serve on the board of a competitor • Should disclose conflicts of interest and abstain from voting - Only liable of the deal is unfair and causes damage to the corporation • Directors may remove officers with or without cause. The removal can occur even if it breaches the officers' contract, but the corporation may be liable for damages (not the stockholders or directors) 7

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Corporations are allowed to indemnify (repay) directors for expenses for any lawsuit (for accidents or negligence, not intentional torts) brought against them in their corporate capacity Limitation on director's liability - breach of fiduciary duty intentional act • Financial benefits received by the director for which he was not entitled • Intentional harm inflicted upon the corporation or shareholders • Unlawful distributions authorized by the director (pay dividends which renders the corp. insolvent) • Intentional violations of criminal law • Breaches of duty of loyalty For tax purposes, if a company desires a fiscal year (instead of calendar year), that year end must be approves by the IRS Corporations may defer taxes, up to three months, by switching from calendar year end to fiscal year end, must be approves by IRS

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BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Chapter 3 Factors affecting financial modelling and decision making Relevant data - data, such as future revenues or costs, that change as a result of selecting different alternatives • Can either be fixed or variable, but usually variable • Direct costs - costs that can be identified with or traced to a given cost object • Prime costs - DM & DL • Discrentionary costs - costs arising from a periodic or annual budgeting decision (i.e. landscaping) • Incremental/differential costs - additional costs incurred to produce an additional unit over current output • Avoidable - costs or revenues resulting from choosing one course of action instead of another Not Relevant data • Unavoidable - costs or revenues that will be the same regardless of the chosen course of action • Absorption costs - represent the allocated portion of fixed mfg OH, and therefore are not relevant Objective probability - based on past outcomes (like returns on the stock market Subjective probability - based on an individuals belief about the likelihood of an event occurring (a lawsuit) Expected value - is the weighted avg of the probable outcomes Expected value = (probability of each outcome * its payoff) then sum the results

Financial modelling for capital decisions Cash flow direct effect - a company pays out or receives cash Cash flow indirect effect - transactions either indirectly associated (sale of old assets) with a capital project or that represent non-cash activity (depreciation) that produce cash benefit (reduces taxable income) Invoice price + cost of shipping + cost of installation +/- Working capital [such as increase in payroll, supplies expenses or inventory requirements] - Cash proceeds on sale of old asset net of tax = net cash outflow for new PPE Tax depreciation on new PPE * Marginal tax rate = Depreciation tax shield After-tax cash flow on operations + Depreciation tax shield = Total after tax cash flow on operations * present value of annuity - initial cash outflow = Net Present Value (NPV) 9

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Discounted cash flow (DCF) methods are considered the best methods to use for long-run decision because it accounts for time value of money. However, it only uses a single growth rate, which is unrealistic as interest rates change over time. Payback period - is simple to understand and focuses on the time period for return of investment (liquidity). However, it ignores the time value of money. It shows the return of investment not the return on investment (ignores cash flows occurring after initial investment is recovered) Net initial investment [cash outflow + change in WC - sale proceeds on old PPE] ÷ increase in annual net after-tax cash flow [After-tax cash flow on operations + Depreciation tax shield] = payback period The larger the denominator the shorter the payback period Discounted payback method - computes payback period using expected cash flows that are discounted by the projects cost of capital NPV uses a hurdle rate to discount cash flows NPV = or > than 0, make the investment because the rate of return is = or > than the hurdle rate/discount rate/required rate of return NPV is superior to IRR because it can still calculate when there are uneven cash flows or inconsistent rates of return. Use Present value of $1 when the cash inflows are different Use Present value of an Ordinary Annuity of $1 when the cash inflows are same across all years NPV is considered the best single technique for capital budgeting, however, NPV does not indicate the true rate of return on investment, just merely if it is less than or greater than our hurdle rate. Internal rate of return (IRR) is the expected rate of return of a project NPV calculates amounts, while the IRR calculates percentages Reject IRR if it is less than or equal to the hurdle rate How to calculate the IRR Determine the life of the project Use the payback period (net increment investment ÷ net annual cash flows) as the present value factor Use the table to calculate IRR B3-27 example of how to calculate the IRR Limitations IRR assumes cash flows from reinvestment are reinvested at the IRR % Less reliable when there are differing cash flows Does not consider the amount of profit Want profitability index over 1.0 which means that the PV of inflows is greater than the PV of outflows PV of net future cash inflows ÷ PV of net initial investment = Profitability index 10

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The profitability index measures the cash-flow return per dollar invested; the higher the better Strategies for short-term and long-term financing • Risk indifferent behaviour - increase in risk does not increase management's required rate of return Certainty equivalent = expected value • Risk averse behaviour - increase in risk, increases management's required rate of return Certainty equivalent < expected value • Risk-seeking behaviour - increase in risk, decreases managements required rate of return Certainty equivalent > expected value • Diversifiable risk, unsystematic risk, non-market risk - risk that is firm specific and can be diversified away • Nondiversifiable risk, systematic risk, market risk - risks that can not be diversified away As any risk factor increases (interest rate risk, market risk, credit risk, default risk) the required rate of return increases, which causes the PV or an asset to decrease Projected cash flow ÷ required rate of return = PV of asset Stated interest rate (nominal interest rate) - is the interest rate charged before any adjustments for market factors [rate shown in the debt agreement] Effective interest rate = the actual interest rate charged with a borrowing after reducing loan proceeds for charges and fees related to a loan origination. Effective interest rate = coupon ÷ proceeds Annual percentage rate = effective periodic interest rate * number of periods in a year The annual % rate is the rate required for disclosure by federal regulators Simple interest = original principal * interest * number of periods Compound interest = original principal * (1 + interest rate) number of periods Operating Leverage - the degree to which a firm uses fixed costs (as opposed to variable costs) for leverage Fixed (i.e. Executive salaries) - risk and potential return increases Variable (i.e. commissions) - risk and potential return decreases % change in EBIT ÷ % change in sales = Degree of Operating Leverage If the numerator changes by a bigger amount than the denominator, that firm is employing leverage So if a firms EBIT increases by 21% as sales increase by 7% then the DOL is 3. Meaning for every 1% increase in sales, profit increases by 3% Higher DOL implies that a small increase in sales will have a greater affect on profits and shareholder value. But more risk. Financial leverage - the degree to which a firm uses fixed financial costs for leverage % change in EPS [or net income ÷ % change in EBIT = Degree of financial leverage

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Total combined leverage - the use of fixed costs resources and fixed cost financing to magnify returns to firm owners % change in EPS ÷ % change in sales = Degree of total combined leverage Or Degree of total combined leverage = DOL * DFL The optimal capital structure is the mix or debt and equity that produces the lowest WACC which maximizes firm value WACC = (Cost of equity * % of capital structure) + (Cost of debt * % of capital structure) Cost of debt must be after tax so, cost of debt = effective interest rate * (1 - tax rate) As a general rule, as a firm raises more capital either equity or debt, the WACC increases As the WACC or discount rate decreases, the PV increases Debt carries the lowest cost of capital and is tax deductible The higher the tax rate, the more incentive to use debt financing After tax cost of debt = pre-tax cost of debt * (1 - tax rate) Cost of preferred stock = dividends ÷ net proceeds B3 44-45-47 examples of how to calculate cost of debt, preferred stock, and equity (retained earnings) Cost of Equity (or Retained earnings) A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk, otherwise they should pay dividends 3 common methods of computing cost of equity - Capital Asset Pricing Model (CAPM) - DCF - Bond Yield plus Risk Premium CAPM = risk free rate + beta *(expected return on market - risk free rate) [market risk premium] B =1 as risky as market B> 1 more risky than market B< 1 less risky than market Short-term financing is classified as current and will mature within 1 year Short-term financing rates are lower than long term rates, which increases profitability However, increased interest rate risk (didn’t lock in a rate), and increased credit risk Debentures are unsecured, while bonds are often secured ROI - ignores cash flows and uses GAAP income ROI = income ÷ investment capital [avg assets] [which is avg PPE + avg WC] or ROI = profit margin * investment turnover [NI ÷ sales] [sales ÷ investment] 12

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ROA = NI ÷ assets Net Book value = historical cost - accumulated depreciation Net book value is affected by age and method of depreciation so it can be a misleading indicator Gross book value - historical cost Ignores depreciation Replacement cost = cost to replace asset Ignores both age and method of depreciation The method used to value the investment affect the ROI. As the denominator increases the ROI decreases ROI focuses on short term results and my cause a disincentive to invest because the short-term result of the new investment may reduce ROI Residual income measures the excess actual income earned by an investment over the required rate of return, while ROI provides a % return Required return = net book value * hurdle rate [Equity] [CAPM] Residual income = NI - Required return Debt to total capital ratio or assets = debt ÷ assets Debt to equity = debt ÷ equity Financial Statement and business implications of liquid asset management Working Capital (WC) = Current assets - current liabilities High WC, less risk, lower expected return Current ratio = current assets ÷ current liabilities High current ratio shows more solvency Quick ratio = (cash + marketable securities + A/R) ÷ current liabilities [inventory and prepaids not included] Transaction motive - cash to meet ordinary course of business Speculative motive - enough cash to take advantage of temporary opportunities Precautionary motive - enough cash to maintain safety cushion/ liquidity Primary method to increase cash levels is to either speed up cash inflows or slow down cash outflows Annual cost of payment discount = 360 ÷ (pay period - discount period) * discount % ÷ (100 - discount %) [works from either perspective, buyer or seller] B3-62 has an example of payment discount calculation Lockbox at bank may speed up cash inflow, however only worth it if the additional interest income earned on the prompt deposit exceeds the cost of the lockbox

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Disbursement float (positive) - occurs when checks have been written but not received by vendor and recorded by the bank Collection float (negative) - occurs when deposits have been recorded on the company's books but not recorded by the bank The shorter a cash conversion cycle the better Cash conversion cycle = inventory conversion period + A/R collection period - Payables deferral period [avg inventory ÷ avg cost of sales per day] [avg payables ÷ avg purchases per day] [avg receivables ÷ avg sales per day] Credit period is the length of time buyers are given to pay for their purchases Accounts payable or trade credit, provides the largest source of short term financing for small firms. Defer, try to pay your bills at the end of the pay period Re-order point = safety stock + (lead time in days or weeks * units sold per days or weeks) Inventory turnover = COGS ÷ avg inventory Cost savings = inventory turn over * APR Economic Order Quantity (EOQ) attempts to minimize ordering and carrying costs EOQ = .5(( 2 * annual unit sales * cost per order) ÷ carrying cost per unit)

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Cost measurement and cost measurement concepts Cost measurement concepts is associated with managerial accounting and internal reporting. - Future orientation and usefulness characterize managerial accounting - Meant for internal users Cost drivers (a factor that has the ability to change total costs) may be based on - Volume (output) - Activity (value added) - other Types of theoretical cost drivers • Executional (short-term) - cost drivers that are helpful to the firm in managing short term costs (relationship with suppliers, improvements to the production process) • Structural (long-term) - cost drivers that have long term effect on cost (experience, available technology, complexity) Types of operational cost drivers • Volume based - associated with traditional cost acctg systems. Based on aggregate volume output (# of direct labor hours used, # of production units) • Activity based - associated with contemporary cost acctg systems. Based on an activity that adds value to output (packaging, inspection) Cost objects - resources or activities that serve as the basis for management decisions. Cost objects require separate cost measurement and may be products, product lines, departments, geographic locations, or any other classification that aids in decision making. A single cost object can have more than one measurement. Inventory (product) costs for financial statements are usually different than costs reported for tax purposes. These costs differ than the inventory (product) costs that management uses to make decisions Prime costs (direct costs) = DM + DL Conversion costs = DL + Factory overhead Product costs = DM + DL + Mfg OH applied. These costs are not expensed until the product is sold (inventoriable) Period costs = non mfg costs (SG&A). Are expensed in the period they are incurred and are not inventoriable. 15

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Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include: - Product costing (inventory and COGS) - Efficiency measurements (comparisons to standards) - Income determination (profitability) Examples of indirect costs - not easily traceable to a cost pool or cost object (B5-7) Indirect costs are allocated to a single cost pool called overhead, i.e. manufacturing overhead Indirect costs in mfg OH consist of both fixed and variable components (such as rent and indirect materials). Total overhead cost is a mixed cost because it includes both fixed and variable costs Depreciation is a fixed cost

In a standard costing system, standard costs are used for all mfg costs (DM, DL, mfg OH) Joint product costs - costs incurred in production up to the split-off point. Only allocated to the main products. By-products do not receive an allocation of joint costs. Separable costs - costs incurred on a product after the split-off point. 3 methods to allocate joint product costs Method 1: Volume allocation (Volume product A ÷ Total volume) * joint costs = portion of product A joint costs Method 2: Net realizable value (value at split-off point), used for inventory costing only (Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A joint costs Method 3: Sales value not available at split-off, subtract separable costs from final selling price to find net realizable value at split-off Final sales value of product A - Separable costs = sales value of product A at split-off (Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A joint costs *subtract value of byproduct from joint costs when allocating. Because proceeds from by-product reduce costs. The lowest unit price acceptable is the variable cost of the product (DL + DM + Var mfg OH) plus the contribution margin of the alternative use for the production capacity. Accumulating and assigning costs • Full absorption costing - treats fixed manufacturing costs as product costs, while variable costing expenses these as period costs. • Job costing - custom orders • Process costing - mass produced homogeneous product • Operations costing - uses components of both job order costing and process costing • Back flush costing - accounts for certain costs as the end of the process • Life cycle costing - monitors costs throughout the products life cycle and expand on the traditional costing systems. Beg materials + net purchases = available for use 16

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Available for use - ending materials = materials used Beg WIP + total mfg costs [DL + DM used + mfg OH applied] - ending WIP = COGM

Application of overhead Overhead rate = Budgeted overhead costs ÷ Estimated cost driver [such as labor hrs or costs, machine hrs] Overhead applied = Actual cost driver * overhead rate [based on actual production] Overhead applied consists of both variable overhead and fixed overhead. The calculation is as follows (with direct labour hours as the cost driver): Variable overhead rate = budgeted variable mfg OH / budgeted direct labor hours Fixed overhead rate = Budgeted fixed mfg OH / budgeted direct labor hours Total overhead rate = Variable overhead rate + Fixed overhead rate Overhead applied to the job = Total overhead rate x actual direct labor hours = $5,625 Normal spoilage is an inventory cost and is included in the standard cost of the manufactured product Abnormal normal spoilage is a period expense and is charged against income of the period as separate component of cost of goods sold. Weighted Avg method to find equivalent units Equivalent units = Units completed + (Ending WIP * % completed ) Weighted average = (beginning cost + current cost) ÷ equivalent units FIFO method to find equivalent units Equivalent units = (Beginning WIP * % to be completed) + (units completed - beginning WIP) + (ending WIP * % completed) FIFO = current costs only ÷ equivalent units Activity based costing (ABC) uses multiple OH rates to assign indirect costs to products (cost objects) based on the resources a product consumes. An ABC system will apply high amounts of overhead to a product that places high demands on expensive resources Factors affecting productions costs Factors contributing to economies of scale include: - Labor specialization - Managerial specialization - Utilization of by products (or joint products) - Efficient use of capital equipment - Volume discount purchasing Financial models used for operating decisions Revenue Less: Variable Costs (DM + DL + Variable OH + Variable SG&A) Contribution Margin Less: Fixed Costs (Fixed OH + fixed SG&A) Net Income Absorption approach (GAAP) 17

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Revenue Less: COGS (DM + DL + Variable OH + Fixed OH) Gross Margin Less: Operating Expenses (Fixed SG&A, Variable SG&A) Net Income Variable costing and absorption costing are the same except that all fixed mfg costs are treated as period costs Under the contribution approach (variable costing), all fixed mfg OH is treated as a period cost and expensed immediately. i.e. COGS includes only variable mfg costs. Not GAAP Under the absorption approach (absorption costing), all fixed mfg OH is treated as a product cost and included in inventory values. i.e. COGS includes both fixed and variable costs. GAAP Net income effect between variable and absorption costing Fixed cost per unit = fixed mfg OH ÷ units produced Change in net income = change in inventory units * fixed cost per unit No change in inventory: absorption NI = Variable NI Increase in inventory: Absorption NI > Variable NI [because less fixed OH expensed under absorption] Decrease in inventory: Absorption NI < Variable NI [because more fixed OH expensed under absorption] Contribution margin ratio = contribution margin ÷ revenue Breakeven in units = total fixed costs ÷ contribution margin per unit Break even in dollars = total fixed costs ÷ contribution margin ratio Break even in dollars = unit price * break even point in units Required sales volume for target profit Sales = (Fixed cost + target profit) ÷ contribution margin ratio Target profit before tax = target profit after tax ÷ (1 - tax rate) Margin of safety = total sales in dollars - breakeven in dollars Margin of safety % = margin of safety in dollars ÷ total sales Target costing - the selling price of the product determines the production costs allowed Economic value added (EVA) - measures the excess of income after taxes earned by an investment over the return rate defined by the company's cost of capital. Investment * cost of capital = required rate of return Income after taxes - required return = economic value added When considering alternatives, such as discontinuation of a product line, management should consider relevant costs. Relevant costs are those costs that will change under different alternatives.

Forecasting and projection techniques Regression analysis - statistical model that can estimate the dependent cost variable based on changes in the independent variable. Learning curve analysis - used to determine increases in efficiency or production as experience is gained. Both products have long production runs, making learning curve analysis the best method for estimating the cost of the competitive bid. 18

BEC - Notes Chapter 1 http://cpacfa.blogspot.com

Attainable standards are used with flexible budgets Authoritative standards are set exclusively by management, while participative standards are set by both managers and employees Planning/budgeting overview and planning/budget techniques A master budget - an overall budget, consisting of many smaller budgets, that is based on one specific level of production (usually begins with sales budget) A flexible budget - a series of budgets based on different activity levels within the relevant range. The production budget - begins with sales budget and then adds in the effect of any changes in inventory levels Standard costs usually means that a flexible budget is being used. Standard costs per unit can be used to adjust the flexible budget to the actual volume.

Budget Variance Analysis DM price variance = actual quantity purchased * (actual price - standard price) DM quantity variance = standard price * (actual quantity used - standard quantity allowed) DL rate variance = actual hours works * (actual rate - standard rate) DL efficiency variance = standard rate * (actual hours worked - standard hours allowed) Standard quantity allowed (SQA) = actual output * standard allowed output B5-63 variance chart Sales volume variance = (actual units sold - budgeted unit sales) * standard contribution margin per unit Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold Variable overhead efficiency variance - computed as budgeted variable overhead based on standard hours minus budgeted variable overhead based on actual hours. Budgeted variable OH = standard direct labor hours allowed x standard variable overhead rate Budgeted variable OH = actual direct labor hours x standard variable overhead rate Production volume variance component for overhead variances is computed as applied overhead minus budgeted overhead based on standard hours 19

BEC - Notes Chapter 1 http://cpacfa.blogspot.com Applied Overhead (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Actual Production) Budgeted overhead based on standard hours (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Standard Production) The fixed overhead rate is $5 per machine hour [$1,200,000 / 240,000 = $5]. • The amount of FIXED manufacturing overhead planned for November is $100,000. • Therefore, the standard production for FIXED overhead is 20,000 machine hours [$100,000/$5 = 20,000.]

Organizational performance measures Strategic business units (SBU), are generally classified around 4 financial measures - Cost SBU - Revenue SBU - Profit SBU - Investment SBU (most like and independent business) (highest level) Critical success factors to accomplish a firm strategy are FICA: - Financial - Internal business processes - Customer Satisfaction - Advancement of innovation and human resource development Benchmarking Techniques and best practices Control chart - determine zero defects, shows quality performance trends Pareto diagrams (histogram) - used to determine frequency of quality control issues Cause and effect (fishbone) - analyze the source and location of a problem Conformance costs - costs to ensure products conform to quality standards - Prevention costs - incurred to prevent production of defects (employee training, engineering) - Appraisal costs - remove defects before they reach customer (testing, inspections) Non-conformance costs - costs that result from lost sales or reputation damage - Internal failure - cost of defective parts or lost production time (scrap, rework) - External failure - cost of returns and lost customer loyalty (warranty, liability)

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