18 Financial Forecasting 535

Why It Matters 535

18.1 The Importance of Forecasting 536
18.2 Forecasting Sales 541
18.3 Pro Forma Financials 544
18.4 Generating the Complete Forecast 546
18.5 Forecasting Cash Flow and Assessing the Value of Growth 550
18.6 Using Excel to Create the Long-Term Forecast 554
Summary 559
Key Terms 559
Multiple Choice 560
Review Questions 561
Problems 562
Video Activity 563

19 The Importance of Trade Credit and Working Capital in Planning 565

Why It Matters 565
19.1 What Is Working Capital? 566
19.2 What Is Trade Credit? 575
19.3 Cash Management 577
19.4 Receivables Management 579
19.5 Inventory Management 583
19.6 Using Excel to Create the Short-Term Plan 584
Summary 590
Key Terms 590
Multiple Choice 592
Review Questions 594
Video Activity 597

20 Risk Management and the Financial Manager 599

Why It Matters 599
20.1 The Importance of Risk Management 600
20.2 Commodity Price Risk 602
20.3 Exchange Rates and Risk 604
20.4 Interest Rate Risk 614
Summary 618
Key Terms 618
CFA Institute 619
Multiple Choice 619
Review Questions 621
Problems 621
Video Activity 622

Index 623
Access for free at openstax.org
 Preface 1

Preface
About OpenStax
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About Principles of Finance

Summary

Principles of Finance is targeted at the core finance course for undergraduate business majors. The book is
designed for conceptual accessibility to students who are relatively early in their business curriculum (such as
second-year students), yet it is also suitable for more advanced students. Due to the wide range of audiences
and course approaches, the book is designed to be as flexible as possible. Its modular structure allows the
introduction and review of content from prerequisite subjects in financial accounting, statistics, and
2 Preface

economics, depending on student preparation. It provides a solid grounding in the core concepts of financial
theory so that business students interested in a major or minor in finance will also be prepared for more
rigorous upper-level courses. Concepts are further reinforced through applicable connections and practical
calculation techniques for more detailed and realistic company scenarios from various industries.

Pedagogical Foundation

Principles of Finance emphasizes financial concepts relevant to people working in a variety of business
functions. To illuminate the meaningful applications and implications of financial ideas, the book incorporates
a unique use-case approach, providing connections among topics, solutions, and real-world problems. This
multifaceted framework drives the integration of concepts while maintaining a modular chapter structure.
Theoretical and practical aspects are presented in a balanced manner, and select ethical considerations are
introduced, particularly in the context of corporate governance.

In order to create meaning for all students, Principles of Finance exposes them to a range of companies,
industries, and scenarios reflecting different contexts. Examples of large companies such as Apple, Peloton,
and American Airlines are balanced with small businesses—coffee shops, clothing stores, and salons—that
may be more aligned with student experiences. The text includes authentic narratives from corporate finance,
small business, and personal finance to drive relevance and interest of the discipline. Profiles and interviews
include diverse figures in finance, such as Carlos Slim, Irina Simmons, Janet Yellen, and Ben Bernanke.
Problems and exercises have been carefully constructed to place students into a range of settings and
contexts as they develop knowledge and put it into practice. Finally, to reflect very recent experiences, the
authors have incorporated several discussions regarding the COVID-19 pandemic and its impact on people
and businesses.

Throughout, there is an emphasis on data use in business decision-making, with integrative sections on the
importance and analysis of financial, economic, and statistical data. Data types include FRED
(https://openstax.org/r/fred-stlouisfed)® economic data, company financial statements, and stock prices.
Practical techniques and calculation examples for data analysis with financial calculators (the Texas
Instruments BA II Plus™ Professional model is used as the basis for example illustrations) and/or spreadsheets
are included for relevant topics. For key chapters, downloadable Microsoft® Excel® data files are available for
student reference. This technical feature provides students with access to the Excel data files used in the
chapter examples for time value of money (Chapters 7, 8, 9) and statistics (Chapters 14, 15, 16) problems. The
downloadable files for the chapters covering financial forecasting and trade credit (18 and 19) allow students
to see how changing assumptions and variables impact financial decision-making. Chapters 13 and 14
(statistical and regression analysis, respectively) also include brief sections about the R software
(https://openstax.org/r/r-software) package to promote further interest in trends in data science.

Teaching Plan Options

Principles of Finance includes chapters on basic, applied, and integrative finance topics as well as key concepts
from prerequisite financial accounting, quantitative methods (statistics), and economics courses. The chapters
on prerequisite topics highlight examples relevant to finance students. For instructors with a limited one-
semester schedule or whose students have solid knowledge of prerequisite disciplines, we recommend
focusing on the “core” chapters, as indicated in the following table of contents:

1 Introduction to Finance Core

2 Corporate Structure and Governance Core
3 Economic Foundations: Money and Rates Extension
4 Accrual Accounting Process Extension

Table 1

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 Preface 3

5 Financial Statements Core

6 Measures of Financial Health Core
7 Time Value of Money I: Single Payment Value Core
8 Time Value of Money II: Equal Multiple Payments Core
9 Time Value of Money III: Unequal Multiple Payment Values Core
10 Bonds and Bond Valuation Core
11 Stocks and Stock Valuation Core
12 Historical Performance of US Markets Core
13 Statistical Analysis in Finance Extension
14 Regression Analysis in Finance Extension
15 How to Think about Investing Core
16 How Companies Think about Investing Core
17 How Firms Raise Capital Core
18 Financial Forecasting Core
19 The Importance of Trade Credit and Working Capital in Planning Extension
20 Risk Management and the Financial Manager Extension

Table 1

Although chapters are written to be independent, they do generally build on the understanding in the
previous core chapters. Please bear this in mind when considering alternate sequences.

Key Features to Drive Understanding

• Concepts in Practice presents examples of financial challenges, managerial decisions, and the range of
accepted business practice in companies and industries.
• Think It Through guides students through the process of applying the concepts in the chapter to
analyzing and interpreting data.
• Link to Learning introduces students to online resources (further reading, data sources, or videos) that
are pertinent to students’ exploration of the topic at hand.

Organizational and Reinforcement Materials to Support Learning

• Learning Outcomes. Every section begins with a set of clear and concise learning outcomes (LOs). These
outcomes are designed to help the instructor decide what content to include or assign and to guide
students on what they can expect to learn.
• Why It Matters. Chapter opening examples include real-world topics from corporate finance, small
business, and personal finance to explain the relevance and interest of the topic for students.
• CFA® Institute. For certain chapters, a topical connection to the learning outcome statements (LOS) for
the Level I Study Sessions (https://openstax.org/r/level1-study-session) of the CFA Institute’s professional
curriculum is indicated at the end of the chapter.
• Summaries. Designed to support both students and instructors, chapter summaries distill the
information in each section down to key, concise points.
• Key Terms. Key terms are bold and are followed by an explanation in context. Definitions of key terms are
also listed in a glossary that appears at the end of each module online and at the end of each chapter in
print.
• Assessments. A mix of multiple-choice questions, short-answer review questions, and quantitative
problems is provided, depending on topic, providing opportunities for students to recall, discuss, and
4 Preface

examine the concepts learned in each chapter.

◦ Multiple-choice questions are basic review questions that test comprehension.
◦ Short-answer questions are brief open-response questions that allow the application of concepts or
critical thinking.
◦ Quantitative problems range from single-variable to multistep or multivariable calculations,
depending on the difficulty and application level of the chapter.
◦ Sample answers and solutions are provided as part of the instructor resources.

• Video Activity. This optional interactive activity at the end of every chapter provides reflection questions
for students to apply to two online YouTube videos that offer a variety of corporate, economic,
government, and skills-based examples and perspectives.

About the Authors

Senior Contributing Authors

Julie Dahlquist, Texas Christian University

Dr. Dahlquist is a professor of professional practice in the Finance Department of the Neeley School of
Business at Texas Christian University. She holds a PhD from Texas A&M University, an MA from St. Mary’s
University, a BBA from the University of Louisiana at Monroe, and a Chartered Market Technician® (CMT)
designation. Previously, she served on the finance faculties of the University of Texas at San Antonio and St.
Mary’s University. She has extensive international experience teaching finance to undergraduate, graduate,
and executive MBA students in programs in Mexico, Austria, Germany, Switzerland, Italy, Belgium, Greece, and
South Korea. Dr. Dahlquist is president of the Technical Analysis Educational Foundation (TAEF), which works
with universities to include technical analysis as an integral part of their finance curricula. She has coauthored
Technical Analysis: The Complete Resource for Financial Market Technicians (with Charles Kirkpatrick, 3rd
edition, FT Press, 2015) and has contributed to many other scholarly publications. Her research has appeared
in Financial Analysts Journal, Managerial Finance, Applied Economics, Working Money, Financial Practices and
Education, and the Journal of Financial Education. Dr. Dahlquist has served as editor of the Journal of Technical
Analysis, a member of the editorial board of the Southwestern Business Administration Journal, and a reviewer
for several other journals.

Rainford Knight, Florida Atlantic University

Dr. Knight is adjunct faculty in the Finance Department of the College of Business at Florida Atlantic University
and the director of its Financial Analyst Program, which he founded in partnership with Bloomberg in 2011. He
holds a BBA, an MBA, and a PhD in finance from Florida Atlantic University. Dr. Knight is a member of the CFA
Institute and a former director of the CFA Society of South Florida. He has extensive experience teaching
finance at the undergraduate, graduate, and executive levels. Previously, he served on the finance faculty of
Fairleigh Dickinson University. Dr. Knight has coauthored articles on corporate sustainability, cost-benefit
analyses, mutual fund returns, and CEO compensation. He also has significant private industry experience in
corporate finance, investment management, and hedge funds. He has been an adviser to CEOs of small to
midsize companies on a variety of issues, including restructurings, valuation, financing, and acquisitions.
Internationally, he was part of the consulting team advising a sovereign government on the restructuring of its
financial sector and has also made presentations regarding financial sector restructuring to central banks in
Latin America. Since 2021, Dr. Knight has been CEO and cofounder of Transparency Invest, which supports
accountability in organizations.

Contributing Authors

Alan S. Adams, Dean College

Curtis J. Bacon, Southern Oregon University

Samantha T. Cooper, Buena Vista University

Access for free at openstax.org

 Preface 5

Michael P. Griffin, University of Massachusetts Dartmouth

Kevin C. Higgins, Maryville University

Larry Musolino, Pennsylvania State University

Reviewers

Curtis J. Bacon, Southern Oregon University

John Paul Broussard, Rutgers University

Jeffrey M. Brown, Johnson University

Raul S. Consunji, Salem State University

Aaron Cook, Pennsylvania State University

Samantha T. Cooper, Buena Vista University

Ramon P. DeGennaro, University of Tennessee

Francis H. Dong, formerly of The Catholic University of America

Wayne Durr, Western New England University

Fernando Garcia, California State University

Lenaye Harris, Utah State University

Kevin C. Higgins, Maryville University

Samira Hussein, Johnson County Community College

Jiya L. Jain, University of Maryland Global Campus

Robert Jozkowski, Eckerd College

Kristin Burke Martin, Franklin University

Michael McDonald, Fairfield University

Harini Mittal, Bronx Community College, City University of New York

Andrew Jason Novak, Southern New Hampshire University

Daniel E. Rhem, Pitt Community College

Sanjay Sharma, Columbia University

Dennis C. Shea, Upper Iowa University

Jere Smith, Southern New Hampshire University

Tih Koon Tan, University of the District of Columbia

Wilson Zehr, Eastern Oregon University

Additional Resources

We’ve compiled additional resources for instructors, including PowerPoint™ lecture slides, an instructor’s
manual, a test bank, and a solution guide. Instructor resources require a verified instructor account, which you
can apply for when you log in or create your account on OpenStax.org.

Instructor resources are typically available within a few months after the book’s initial publication. Take
advantage of these resources to supplement your OpenStax book.
6 Preface

Community Hubs

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Access for free at openstax.org

 1 • Why It Matters 7

1
Introduction to Finance

Figure 1.1 Finance is the linchpin that connects and directs many parts of a business or organization. (credit: modification of work
“Finance behind the Glass” by Max London/flickr, CC BY 2.0)

Chapter Outline
1.1 What Is Finance?
1.2 The Role of Finance in an Organization
1.3 Importance of Data and Technology
1.4 Careers in Finance
1.5 Markets and Participants
1.6 Microeconomic and Macroeconomic Matters
1.7 Financial Instruments
1.8 Concepts of Time and Value

Why It Matters
Finance is essential to the management of a business or organization. Without good financial protocol,
safeguards, and tools, running a successful business is more difficult. In 1978, Bacon Signs was a family-
owned, regional Midwestern sign company engaged in the manufacture, sale, installation, and maintenance of
commercial signage. The company was about to transition from the second to third generation of family
ownership. Bacon Signs, established in 1901, had weathered the Great Depression, World War II, the Vietnam
War, and the oil embargo and was working its way through historically high rates of inflation and interest
rates. The family business had successfully struggled through the ebb and flow of the regional and national
economy by providing quality products and service to its regional clients.

In the early 1980s, the company’s fortunes changed permanently for the better. The owner recognized that
the custom signs built by his firm were superior in quality to the signs it installed for national franchises. The
owner worked with the company’s banker and vice president of finance and operations to develop a
production, sales, and financing plan that could be offered to the larger national sign companies. The larger
companies agreed to subcontract manufacturing of midsize orders to Bacon Signs. The firm then made a
commitment to build and deliver these signs on time and under budget. As Bacon Signs’ reputation for quality
grew, so did demand for its products. The original financing plan anticipated this potential growth and was
8 1 • Introduction to Finance

designed to meet anticipated capital requirements so that the firm could expand how and when it needed to.

Bacon Signs’ ability to manufacture and deliver a high-quality product at a good price was the true value of the
firm. However, without the planning and ability to raise capital facilitated by the financing plan, the firm would
not have been able to act on its strengths at the critical moment. Financing was the key to expansion and
1
financial stability for the firm.

In this book, we demonstrate that business finance is about developing and understanding the tools that help
people make consistently good and repeatable decisions.

1.1 What Is Finance?

Learning Outcomes
By the end of this section, you will be able to:
• Describe the main areas in finance.
• Explain the importance of studying finance.
• Discuss the concepts of risk and return.

Definition of Finance
Finance is the study of the management, movement, and raising of money. The word finance can be used as a
verb, such as when the First National Bank agrees to finance your home mortgage loan. It can also be used as
a noun referring to an entire industry. At its essence, the study of finance is about understanding the uses and
sources of cash, as well as the concept of risk-reward trade-off. Finance is also a tool that can help us be better
decision makers.

Basic Areas in Finance

Finance is divided into three primary areas in the domestic market: business finance, investments, and
financial markets and institutions (see Figure 1.2). We look at each here in turn.

Figure 1.2 The Three Basic Areas of Study in Finance

Business Finance

Business finance looks at how managers can apply financial principles to maximize the value of a firm in a
risky environment. Businesses have many stakeholders. In the case of corporations, the shareholders own the
company, and they hire managers to run the company with the intent to maximize shareholder wealth.
Consequently, all management decisions should run through the filter of these questions: “How does this
decision impact the wealth of the shareholders?” and “Is this the best decision to be made for shareholders?”

In business finance, managers focus on three broad areas (see Figure 1.3).

1 Dun & Bradstreet. “Bacon Signs, Inc.” D&B Business Directory. https://www.dnb.com/business-directory/company-
profiles.bacon_signs_inc.90df737e33956dd7c76717a20e9d56ad.html#financials-anchor

Access for free at openstax.org

 1.1 • What Is Finance? 9

1. Working capital management (WCM) is the study and management of short-term assets and liabilities.
The chief financial officer (CFO) and the finance team are responsible for establishing company policy for
how to manage WCM. The finance department determines credit policy, establishes minimum criteria for
the extension of credit to clients, terms of lending, when to extend, and when to take advantage of short-
term creditor financing. The accounting department basically implements the finance department’s
policies. In many firms, the accounting and finance functions operate in the same department; in others,
they are separate.
2. Capital budgeting is the process of determining which long-term or fixed assets to acquire in an effort to
maximize shareholder value. Capital budgeting decisions add the greatest value to a firm. As such, capital
budgeting is thought to be one of the most important financial functions within a firm. The capital
budgeting process consists of estimating the value of potential investments by forecasting the size,
timing, and risk of cash flows associated with the investments. The finance department develops and
compiles cash flow estimates with input from the marketing, operations, accounting, human resources,
and economics departments to develop a portfolio of investment projects that collectively maximize the
value of the firm.
3. Capital structure is the process by which managers focus more specifically on long-term debt and
increasing shareholder wealth. Capital structure questions require financial managers to work with
economists, lenders, underwriters, investment bankers, and other sources of external financial
information and financial capital. When Bacon Signs developed its financial plan, the executives included
each of these three aspects of business finance into the plan.

Figure 1.3 How Corporate Finance Decision-Making Activities Relate to the Balance Sheet

Figure 1.3 demonstrates how the three essential decision-making activities of the financial manager are
related to a balance sheet. Working capital management focuses on short-term assets and liabilities, capital
budgeting is focused on long-term assets, and capital structure is concerned with the mix of long-term debt
and equity financing.

Investments

Investments are products and processes used to create and grow wealth. Most commonly, investment topics
include the discussion and application of the different types of financial instruments, delivery vehicles,
regulation, and risk-and-return opportunities. Topics also include a discussion of stocks, bonds, and derivative
securities such as futures and options. A broad coverage of investment instruments would include mutual
funds, exchange-traded funds (ETFs), and investment vehicles such as 401k plans or individual retirement
accounts (IRAs). In addition, real assets such as gold, real estate, and commodities are also common
discussion topics and investment opportunities.

Investments is the most interesting area of finance for many students. Television programs such as Billions
and movies such as Wall Street make investing appear glamorous, dangerous, shady, or intoxicating,
10 1 • Introduction to Finance

depending on the situation and the attitude of the viewer. In these programs, the players and their decisions
can lead to tremendous wealth or tremendous losses. In reality, most of us will manage our portfolios well shy
of the extremes portrayed by the entertainment industry. However, we will need to make personal and
business investment decisions, and many students reading this material will work in the investment industry
as personal investment advisers, investment analysts, or portfolio managers.

Financial Markets and Institutions

Financial markets and institutions are the firms and regulatory agencies that oversee our financial system.
There is overlap in this area with investments and business finance, as the firms involved are profit seeking
and need good financial management. They also are commonly the firms that facilitate investment practices in
our economy. A financial institution regulated by a federal or state agency will likely handle an individual
investment such as the purchase of a stock or mutual fund.

Much of the US regulatory structure for financial markets and institutions developed in the 1930s as a
response to the stock market crash of 1929 and the subsequent Great Depression. In the United States, the
desire for safety and protection of investors and the financial industry led to the development of many of our
primary regulatory agencies and financial regulations. The Securities and Exchange Commission (SEC) was
formed with the passage of the Securities Act of 1933 and Securities Exchange Act of 1934. Major bank
regulation in the form of the Glass-Steagall Act (1933) and the Banking Act of 1935 gave rise to government-
backed bank deposit insurance and a more robust Federal Reserve Bank.

These regulatory acts separated investment banking from commercial banking. Investment banks and
investment companies continued to underwrite and facilitate new bond and equity issues, provide financial
advice, and manage mutual funds. Commercial banks and other depository institutions such as savings and
loans and credit unions left the equity markets and reduced their loan portfolios to commercial and personal
lending but could purchase insurance for their primary sources of funds, checking, and savings deposits.

Today, the finance industry barely resembles the structure your parents and grandparents grew up and/or
worked in. Forty years of deregulation have reshaped the industry. Investment and commercial bank
operations and firms have merged. The separation of activities between investment and commercial banking
has narrowed or been eliminated. Competition from financial firms abroad has increased, and the US financial
system, firms, and regulators have learned to adapt, change, and innovate to continue to compete, grow, and
prosper.

The Financial Industry Regulatory Authority (FINRA) formed in 2007 to consolidate and replace existing
regulatory bodies. FINRA is an independent, nongovernmental organization that writes and enforces the rules
governing registered brokers and broker-dealer firms in the United States. The Securities Investor
Protection Corporation (SIPC) is a nonprofit corporation created by an act of Congress to protect the clients
of brokerage firms that declare bankruptcy. SIPC is an insurance that provides brokerage customers up to
$500,000 coverage for cash and securities held by the firm.

The regulation of the financial industry kicked into high gear in the 1930s and for those times and conditions
was a necessary development of our financial industry and regulatory oversight. Deregulation of the finance
industry beginning in the 1970s was a necessary pendulum swing in the opposite direction toward more
market-based and less restrictive regulation and oversight. The Great Recession of 2007–2009 resulted in the
reregulation of several aspects of the financial industry. Some would argue that the regulatory pendulum has
swung too far toward deregulation and that the time for more or smarter regulation has returned.

Access for free at openstax.org

 1.1 • What Is Finance? 11

CONCEPTS IN PRACTICE

The Great Recession

The Great Recession of 2007–2009 exposed many of the weaknesses of our financial system. The ease with
which banks could lower credit standards to allow ill-prepared consumers to purchase real estate and the
resulting speed with which the world economy plunged into recession is astounding.

Regulation to address the economic crisis was also swift. Fortunately, Ben Bernanke, chairman of the
Federal Reserve at the time, had throughout his career conducted extensive research into the causes of and
2
potential resolution of the Great Depression of the 1930s. He was uniquely qualified to lead the economic
response to the crisis. Some resulting laws moved to address the immediate needs and others to correct
the underlying causes of the recession.

One immediate fix was the Troubled Asset Relief Program (TARP). TARP authorized the Treasury to buy
illiquid assets in order to save the financial institutions so important to lubricating our economy. Politically
this was a tough decision, as it appeared that the government bailed out greedy bankers. In the end,
however, the program was justified because the economy immediately began a slow but steady recovery,
most financial institutions did not fail, and the Treasury recouped all of its investment used in the bailout.
However, individual homeowners suffered greatly.

The Dodd-Frank Act of 2008 attempted to address many of the underlying causes of the Great Recession by
reorganizing and toughening the regulatory framework, including tighter oversight of critically important
financial institutions. Dodd-Frank also created the Consumer Financial Protection Bureau (CFPB) to protect
consumers from harm caused by unscrupulous banking activities. Today, the hope is that financial
institutions will be stopped short of the gross negligence evident prior to 2007 and consumers won’t be left
out in the cold due to actions beyond their control.

Sources: History Channel. “Here’s What Caused the Great Recession.” YouTube. May 15, 2018.
https://www.youtube.com/watch?v=yM0uonkloXY. Accessed April 18, 2021; Randall D. Guynn, Davis Polk,
and Wardwell LLP, “The Financial Panic of 2008 and Financial Regulatory Reform.” Harvard Law School
Forum on Corporate Governance. November 20, 2010. https://corpgov.law.harvard.edu/2010/11/20/the-
financial-panic-of-2008-and-financial-regulatory-reform/. Accessed April 18, 2021; Sean Ross. “What Major
Laws Were Created for the Financial Sector Following the 2008 Crisis?” Investopedia. Updated March 31,
2020. https://www.investopedia.com/ask/answers/063015/what-are-major-laws-acts-regulating-financial-
institutions-were-created-response-2008-financial.asp. Accessed April 18, 2021.

Why We Study Finance

Finance is the lubricant that keeps our economy running smoothly. Issuing a mortgage can be profitable for a
bank, but it also allows people to live in their own homes and to pay for them over time. Do MasterCard,
Venmo, and PayPal make money when you use their product? Sure, but think how much more convenient and
safer it is to carry a card or use an app instead of cash. In addition, these services allow you to easily track
where and how you spend your money. A well-regulated and independent financial system is important to
capital-based economies. Our smoothly functioning financial system has removed us from the days of strictly
bartering to our system today, where transactions are as simple as a tap on your mobile phone.

There are any number of professional and personal reasons to study finance. A search of the internet provides
a long list of finance-related professions. Interviews with senior managers reveal that an understanding of
financial tools and concepts is an important consideration in hiring new employees. Financial skills are among

2 Brookings Institution. “Ben S. Bernanke.” Brookings Institute. https://www.brookings.edu/experts/ben-s-bernanke/; Ben S.

Bernanke. “On Milton Friedman’s 90th Birthday.” The Federal Reserve Board. November 8, 2002. https://www.federalreserve.gov/
boarddocs/speeches/2002/20021108/
12 1 • Introduction to Finance

the most important tools for advancement toward greater responsibility and remuneration. Government and
work-guaranteed pension benefits are growing less common and less generous, meaning individuals must
take greater responsibility for their personal financial well-being now and at retirement. Let’s take a closer
look at some of the reasons why we study finance.

There are many career opportunities in the fields of finance. A single course in finance such as this one may
pique your interest and encourage you to study more finance-related topics. These studies in turn may qualify
you for engaging and high-paying finance careers. We take a closer look at financial career opportunities in
Careers in Finance.

A career in finance is just one reason to study finance. Finance is an excellent decision-making tool; it requires
analytical thinking. Further, it provides a framework for estimating value through an assessment of the timing,
magnitude, and risk of cash flows for long-term projects. Finance is important for more immediate activities as
well, such as the development of budgets to assure timely distribution of cash flows such as dividends or
paychecks.

An understanding of finance and financial markets opens a broader world of available financial investment
opportunities. At one time, commercial bank deposits and the occasional investment in stocks, bonds, real
estate, or gold may have provided sufficient coverage of investment opportunities, portfolio diversification,
and adequate returns. However, in today’s market of financial technology, derivative securities, and
cryptocurrencies, an understanding of available financial products and categories is key for taking advantage
of both new and old financial products.

LINK TO LEARNING

Job Information
The internet provides a wealth of information about types of jobs in finance, as well as reasons to study it.
Investigate the Occupational Outlook Handbook (https://openstax.org/r/bls-gov) issued by the Bureau of
Labor Statistics to see how many of the career opportunities in finance look interesting to you. Think about
the type of people you want to work with, the type of work-related activities you enjoy, and where you
would like to live. Read “5 Reasons Why You Should Study Finance” at Harvard Business School Online
(https://openstax.org/r/why-study-finance) to gain a better understanding of why finance offers a broad
career path and is intellectually stimulating and satisfying.

Risk and Return in Finance

Finance tells us that an increase in risk results in an increase in expected return. The study of historical
financial markets demonstrates that this relationship generally holds true and that riskier investments over
time have provided greater returns. Of course, this is not true all the time and under all conditions; otherwise,
where’s the risk?

At its most basic level, risk is uncertainty. The study of finance attempts to quantify risk in a way that helps
individuals and organizations assess an appropriate trade-off for risk. Risk-return tradeoffs are all around us in
our everyday decision-making. When we consider walking across the street in the middle of a city block or
walking down to the marked intersection, we are assessing the trade-off between convenience and safety.
Should you buy the required text for your class or instead rely on the professor’s notes and the internet?
Should you buy that new-to-you used car sight unseen, or should you spend the money for a mechanic to
assess the vehicle before you buy? Should you accept your first job offer at graduation or hold out for the offer
you really want? A better understanding of finance makes these types of decisions easier and can provide you,
as the decision maker, with statistics instead of just intuition.

Return is compensation for making an investment and waiting for the benefit (see Figure 1.4). Return could be

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 1.1 • What Is Finance? 13

the interest earned on an investment in a bond or the dividend from the purchase of stock. Return could be
the higher income received and the greater job satisfaction realized from investing in a college education.
Individuals tend to be risk averse. This means that for investors to take greater risks, they must have the
expectation of greater returns. Investors would not be satisfied if the average return on stocks and bonds
were the same as that for a risk-free savings account. Stocks and bonds have greater risk than a savings
account, and that means investors expect a greater average return.

The study of finance provides us with the tools to make better and more consistent assessments of the risk-
return trade-offs in all decision-making, but especially in financial decision-making. Finance has many different
definitions and measurements for risk. Portfolios of investment securities tend to demonstrate the
characteristics of a normal return distribution, or the familiar “bell-shaped” curve you studied in your statistics
classes. Understanding a security’s average and variability of returns can help us estimate the range and
likelihood of higher- or lower-than-expected outcomes. This assessment in turn helps determine appropriate
prices that satisfy investors’ required return premiums based on quantifiable expectations about risk or
uncertainty. In other words, finance attempts to measure with numbers what we already “know.”

Figure 1.4 Risk and Expected Return This describes the trade-off that invested money can bring higher profits if the investor is
willing to accept the risk of possible loss.

The overall uncertainty of returns has several components.

• Default risk on a financial security is the chance that the issuer will fail to make the required payment. For
example, a homeowner may fail to make a monthly mortgage payment, or a corporation may default on
required semiannual interest payments on a bond.
• Inflation risk occurs when investors have less purchasing power from the realized cash flows from an
investment due to rising prices or inflation.
• Diversifiable risk, also known as unsystematic risk, occurs when investors hold individual securities or
smallish portfolios and bear the risk that a larger, more well-rounded portfolio could eliminate. In these
situations, investors carry additional risk or uncertainty without additional compensation.
• Non-diversifiable risk, or systematic risk, is what remains after portfolio diversification has eliminated
unnecessary diversifiable risk. We measure non-diversifiable risk with a statistical term called beta.
Subsequent chapters on risk and return provide a more in-depth discussion of beta.
• Political risk is associated with macroeconomic issues beyond the control of a company or its managers.
This is the risk of local, state, or national governments “changing the rules” and disrupting firm cash
flows. Political risk could come about due to zoning changes, product liability decisions, taxation, or even
nationalization of a firm or industry.
14 1 • Introduction to Finance

1.2 The Role of Finance in an Organization

Learning Outcomes
By the end of this section, you will be able to:
• Describe the finance function.
• Explain the role of finance and its importance within an organization.

The Finance Function

Finance has many functions within an organization, and there are many job titles to reflect the varied job
responsibilities. The comptroller, or more commonly a controller, in a for-profit business relies heavily on a
knowledge of accounting. Controllers are in charge of financial reporting and the oversight of the accounting
activities necessary to develop those reports. Controllers are concerned with payroll functions, accounts
receivable, and accounts payable including taxes, inventory control, and any number of short-term asset and
liability tracking and monitoring activities. They aid internal and external auditors and are responsible for
monitoring and implementing the day-to-day financial operations of the firm.

In most organizations, the treasurer might assume many of the duties of the controller. However, the
treasurer is also responsible for monitoring cash flow at a firm and frequently is the contact person for
bankers, underwriters, and other outside sources of financing. A treasurer may be responsible for structuring
loan and debt obligations and determining when and from whom to borrow funds. Treasurers are also
responsible for investing excess funds. Where a controller may face inward toward the organization, the
treasurer often faces outward as a representative to the public.

The vice president of finance (VP-F) is an executive-level position and oversees the activities of the controller
and treasurer. The chief responsibility of the VP-F is to create and mentor a sufficient and qualified staff that
generates reports that are timely, accurate, and thorough.

The chief financial officer, or CFO, is in a “big picture” position. The CFO sets policy for working capital
management, determines optimal capital structure for the firm, and makes the final decision in matters of
capital budgeting. The CFO is also forward looking and responsible for strategic financial planning and setting
financial goals. Compared to a VP-F, a CFO is less of a “hands-on” manager and engages more in visionary and
strategic planning.

Financial Planning
Financial planning is critical to any organization, large or small, private or public, for profit or not-for-profit.
Financial planning allows a firm to understand the past, present, and future funding needs and distributions
required to satisfy all interested parties. For-profit businesses work to maximize the wealth of the owners.
These could be shareholders in a publicly traded corporation, the owner-managers of a “mom and pop” store,
partners in a law firm, or the principal owners of any other number of business entities. Financial planning
helps managers understand the firm’s current status, plan and create processes and contingencies to pursue
objectives, and adjust to unexpected events. The more thoughtful and thorough the financial planning
process, the more likely a firm will be able to achieve its goals and/or weather hard times. Financial plans
typically consider the firm’s strategic objectives, ethical practices, and sources and costs of funds, as well as
the development of budgets, scenarios, and contingencies. The financial plan Bacon Signs developed was
thorough enough to anticipate when and how growth might occur. The plan that was presented to commercial
banks allowed the firm to be guaranteed new financing at critical moments in the firm’s expansion.

Good financial planning has a number of common features.

• It uses past, current, and pro forma (forward-looking) income statements. Pro forma income statements
are created using assumptions from past events to make projections for future events. These income
statements should develop likely scenarios and provide a sensitivity analysis of key assumptions.

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 1.2 • The Role of Finance in an Organization 15

• Cash flow statements are a critical part of any financial planning. Cash flow statements estimate the
timing and magnitude of actual cash flows available to meet financial obligations.
• Balance sheets are critical for demonstrating the sources and uses of funds for a firm. One of the most
important aspects of business is accounting (see Figure 1.5).
• Forecasting in the form of expected sales, cost of funds, and microeconomic and macroeconomic
conditions are essential elements of financial planning.
• Financial analysis including ratio analysis, common-size financial statements, and trend statements are
important aspects of financial planning. Such analysis aids in the understanding of where a firm has been,
how it stacks up against the competition, and the assessment of target objectives.

Figure 1.5 The Accounting System The accounting system relies on accurate data used to prepare all the financial reports that help
to evaluate a firm.

LINK TO LEARNING

Elements of a Financial Plan

You can view key elements in a financial plan (https://openstax.org/r/write-your-business-plan) at the US
Small Business Administration’s website.

Forecasting and Budgeting

Forecasting and budgeting are common practices for businesses, governmental agencies, not-for-profit firms,
and individual households. As with many of the financial topics introduced in this chapter, these activities are
valuable for individuals and businesses alike. Budgeting, or planning for the amount, sources, and uses of
cash, occurs early in the planning process. It is common for businesses to have developed an annual budget
well before the start of the year. With budgeting, a firm establishes objectives for the upcoming period by
developing financial statements based on historical data and expectations, as well as aspirations for the
future. The budgeting process helps the firm identify what actions need to be undertaken to achieve its
objectives. However, no matter how strong the budgeting process, actual events can change the timing and
magnitude of expected cash flows.

Financial forecasting addresses the changes necessary to the budgeting process. Budgeting can help identify
the differences or variance from expectations, and forecasting becomes the process for adapting to those
changes. We attribute to President Eisenhower the saying that “plans are worthless, but planning is
everything.” That statement applies to business today as well as it did during his service in the military and
government. The budgeting or planning process is a road map for organizations, and forecasting helps
navigate the inevitable detours toward the firm’s objectives.

The budgeting process develops pro forma financial statements such as income and cash flow statements and
balance sheets. These provide benchmarks to determine if firms are on course to meet or exceed objectives
and serve as a warning if firms are falling short. Budgeting should involve all departments within a firm to
16 1 • Introduction to Finance

determine sources and uses of funds and required funding to meet department and firm objectives. The
process should look to emulate successful processes and change or eliminate ineffective ones. Budgeting is a
periodic renewal and reminder of the firm’s goals.

Financial forecasting often starts with the firm’s budget and recommends changes based on differences
between the budgeted financial statements and actual results. Forecasting adjusts management behavior in
the immediate term and serves as a foundation for subsequent budgets.

1.3 Importance of Data and Technology

Learning Outcomes
By the end of this section, you will be able to:
• Describe the role of data in finance.
• List and describe the various types of corporate data available.
• Explain how the various types of corporate data can be accessed and analyzed.
• Describe the impact of data digitization.
• Explain how stakeholders use data when making decisions.

Importance of Data
Financial data is important for internal and external analysis of business firms. More accurate and timely data
leads to better business and financial decision-making. Financial budgeting and forecasting rely on the
creation of several types of financial statements including income statements, the statements of cash flow,
and balance sheets, as well as the notes and assumptions used to create the financial statements. Insiders
such as executive and middle managers use financial data to evaluate and reevaluate decision-making. Having
current and accurate data is key to making consistent value-adding decisions for a firm. Data helps inform
managers about how and when to finance projects, which projects to undertake, and necessary changes to
make regarding physical, financial, and human resource assets. “Gut feelings” and “seat-of-the-pants”
decision-making tend to be inconsistent with value maximization.

Outsiders also use publicly available data about firms to make purchasing, investment, credit, and regulatory
decisions. Customers, investors, lenders, suppliers, and regulators must be able to access a firm’s financial
information. Investors need to determine how much they are willing to pay for a share of stock, banks need
data to determine if a loan should be made, suppliers need financial information to determine if they should
supply trade credit, and customers need to know that a firm has priced its products appropriately.

Basic Data Types

Financial statements provide some of the data needed for decision-making. Firms summarize data and
develop at least three essential financial statements or reports.

1. The income statement summarizes the flow of revenues and expenses over a specified period. Income
statements for publicly traded companies are available quarterly.
2. Statements of cash flow identify actual receipt and use of cash over a period.
3. Balance sheets show the existing assets, liabilities, and equity as of a particular date.

These statements represent book values and reflect historical costs and accounting adjustments such as
accumulated depreciation. Book values often differ significantly from market values. Market values look
forward and reflect expectations, whereas book values represent what has occurred.

In addition to the internal data summarized on financial statements, firms and outside stakeholders also seek
external sources of information. External data gathering includes surveys of customers and suppliers, market
research, new product development, statistical analysis, agreements with creditors, and discussions with
government officials. Broader macroeconomic data is also valuable as it applies to expected market demand,
unemployment, inflation, interest rates, and economic growth.

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 1.3 • Importance of Data and Technology 17

The Impact of Digitization

Data digitization makes the storage and transmission of data easier and more cost effective. Some data starts
out as digital data, such as that from a Microsoft Suite product. The Excel files and Word documents we create
are ubiquitous and easily stored and transmitted. Cloud storage and video conferencing are now the norm.
Emails and Zoom meetings are quick, easy, and inexpensive ways to share and store information. Businesses
now create an e-trail, or virtual paper trail, to document, verify, and share processes. Because data is now
much easier to access, firms bear the added responsibility of ensuring that it is stored and secured properly so
that individuals cannot inappropriately alter or delete information.

Data storage has changed significantly in the last decade as companies have moved the storage of digital data
to the cloud. The advantages include only paying for the storage actually used, reduced energy consumption,
access to specialized data protection services, and software and hardware maintenance. However, the risk of
data hacks and the safety of data are key concerns in the storage of digitized information.

Uses of Data
Taken together and separately, the internally generated financial statements can provide managers with a
wealth of information to enable superior decision-making. Harvard Business School identifies six ways
3
managers can use financial statements.

1. Measuring the impact of business decisions such as new software, marketing plan, or product line
2. Aiding in the development of budgets by creating a starting point for future expectations
3. Aiding in cost cutting or the reduction of duplicate activities
4. Providing data-supported strategic planning and visioning
5. Ensuring consistent data and content across departments
6. Motivating teams to set, meet, and exceed goals and objectives

CONCEPTS IN PRACTICE

How and Why Managers Use Financial Statements: The Case of Peloton
Should you lease a new car or buy one? Do you opt for the more expensive high-tech production
equipment or reduce your upfront investment and pay higher labor costs over time? Is it better to finance a
new product by borrowing money or selling new shares of stock? Should you manufacture overseas where
the production costs are lower or in your own country where political and transportation costs are lower?
Once you make your choice, how do you know if you’ve made the right decision? Understanding and
applying financial principles can help.

For example, consider Peloton, the leader in social exercising with its bike, treadmill, and yoga platforms. In
2012, the principal founder, John Foley, was inspired to start the company because he lacked the time to
attend bicycle exercise classes due to his demanding career and growing family. He enjoyed cycling classes,
but they could be expensive and often did not fit into his schedule. He recognized that the most popular
instructors had developed a bit of a cult following and that the music playlist was a critical component for
many followers. His choice of the company name, Peloton, comes from the French word for a “pack of bike
riders,” familiar to anyone who has even loosely followed the annual Tour de France bike race. The
company name evokes a measure of mystique and prestige.

Peloton started small and underwent five funding rounds in seven years before the company went public
with an initial public offering in September 2019. Foley and his friends had the idea that they were a
“purposeful music company” and needed to touch on all aspects of the workout experience including the

3 Catherine Cote. “How and Why Managers Use Financial Statements.” Business Insights. June 16, 2020. https://online.hbs.edu/
blog/post/how-managers-use-financial-statements
18 1 • Introduction to Finance

bike; video, audio, and music content; clothing design; competition among the riders; data gathering; and
instructors for livestream and on-demand classes. They were selling an experience, not a bicycle. The
equipment is expensive—a Peloton bike typically costs over $2,000. Peloton equips its studios with state-of-
the-art camera and music systems and pays its instructors top dollar. Along the way, the founders made
several critical financial decisions. They kept control of the firm by using private funding at the start.

How can we tell if Peloton has managed its resources well? The company started with $400,000 of funding
to develop a prototype in 2012. By 2018, firm value increased to $4 billion with yet another round of private
investor funding. As of April 2021, Peloton is a publicly traded company with a stock value of $34 billion. The
executives are sacrificing profits in the short term to generate growth and long-term profitability. The firm
uses its financial statements to identify sources and uses of funds, to test the effectiveness of advertising,
and to forecast future profitability. Analysts like the firm, the stock price is up, and by many financial
measures, Peloton has been a great success. Time will tell if the decisions made over the last several years
will lead to long-term profitability or if the company has overinvested in marketing only to miss current and
long-term profits.

(Sources: Viktor. “The Peloton Business Model—How Does Peloton Work & Make Money?” Productmint.
Updated May 9, 2021. https://productmint.com/the-peloton-business-model-how-does-peloton-make-
money/. Accessed May 18, 2021; John Ballard. “If You Invested $5,000 in Peloton’s IPO, This Is How Much
Money You’d Have Now.” The Motley Fool. June 6, 2020. https://www.fool.com/investing/2020/06/06/if-you-
invested-5000-in-pelotons-ipo-this-is-how-m.aspx. Accessed May 18, 2021; Erin Griffith. “Peloton’s New
Infusion Made It a $4 Billion Company in Six Years.” New York Times. August 3, 2018.
https://www.nytimes.com/2018/08/03/technology/pelotons-new-infusion-made-it-a-4-billion-company-
in-6-years.html)

1.4 Careers in Finance

Learning Outcomes
By the end of this section, you will be able to:
• Describe current job opportunities in finance.
• Describe the financial analyst role.
• Describe the business analyst role.

Job Opportunities in Finance: Market Trends

There are many career opportunities in the field of finance. The Bureau of Labor Statistics (BLS) finds that as of
May 2020, the median income for finance-related positions was $72,250 versus the overall median income of
only $41,950. Further, the BLS predicts that close to an additional 500,000 new finance- and accounting-related
4
jobs will be created by 2029. These new employment opportunities are in addition to the many openings that
will become available as baby boomers continue to retire and leave the workforce.

Several of the BLS-listed finance careers do not even have finance or associated wording in the career titles.
The BLS identifies finance skills as necessary for careers such as management analysts and market research
analysts and work in logistics. Of course, many careers traditionally encourage the study of finance. These
include job titles and descriptions such as these:

• Financial manager: Oversees aspects of and produces reports about an organization’s financial needs,
uses, and related activities
• Investment relations associate: Prepares and presents company financial data to investors and other
company stakeholders

4 U.S. Bureau of Labor Statistics. Occupational Outlook Handbook. https://www.bls.gov/ooh/business-and-financial/home.htm

Access for free at openstax.org

 1.4 • Careers in Finance 19

• Budget analyst: Reviews, plans, and evaluates an organization’s financial activities

• Credit analyst: Reviews financial and related information to determine the creditworthiness of potential
clients and customers; typically works at commercial and investment banks, credit unions, and rating firms
such as Moody’s or Standard and Poor’s
• Financial analyst: Collects and examines data to plan future activities and evaluate past decisions
• Personal financial advisor: Provides advice to clients for short-, intermediate-, and long-term financial
planning
• Loan officer: Helps individuals and organizations apply for loans and typically works for depository
financial institutions such as commercial banks
• Insurance underwriter: Evaluates risk and establishes prices for insurance products such as life, property,
and casualty insurance
• Financial examiner: Evaluates and monitors the activities of depository institutions in an effort to assure
proper practice and behavior
• Finance professor: Teaches college classes, engages in economic and financial research, and provides
community service by serving on boards and providing financial expertise

LINK TO LEARNING

Best Jobs in Finance

You can read more about possible careers in finance (https://openstax.org/r/thebalancecareers) at the
Balance Careers website.

Financial Analyst Roles

Many executive-level finance officers worked their way up via the role of financial analyst. Job descriptions vary
across firms, industries, and government organizations. However, the role of financial analyst usually includes
market research, financial forecasting, modeling, cost analysis, and comparative valuations. Financial analysts
gather data and produce financial reports in conjunction with multiple departments within a business or
organization. They rely on marketing and production personnel to provide accurate sales forecasts, and they
work with accountants to create accurate financial reports.

As a financial analyst, you need strong spreadsheet skills, the ability to develop financial models and pro forma
financial statements, outstanding analytical skills, and an overall understanding of business processes.
Financial analysts possess a well-diversified collection of business and communication skills, both quantitative
and qualitative. Figure 1.6 lists some tasks that financial analysts must perform on a daily basis. Some firms
require an MBA or several years of business experience for their financial analysts.
20 1 • Introduction to Finance

Figure 1.6 Financial Analyst Tasks

Internal financial analysts are important for a successful firm or organization because their work can lead to
more efficient and cost-effective use of financial and nonfinancial resources. Responsibilities include keeping
current with market conditions, developing financial models, reconciling variance between forecasts and
outcomes, and serving as a resource for management. Financial analysts fulfill their responsibilities through
the development and analysis of financial data including ratio analysis, trend analysis, in-depth discussions
with division managers, and the presentation and interpretation of information at meetings and on electronic
platforms.

External financial analysts use similar resources and tools to evaluate financial instruments as an aid to
investment companies, investment and commercial bankers, and individual investors who rely on their
published reports. Various government agencies also use financial analysts to aid in regulatory oversight and
enforcement.

A report from a 2019 BLS survey determines that financial analysts earn an average salary of $81,590, and jobs
5
are predicted to grow at a faster-than-average rate of 5% through 2029.

Business (or Management) Analyst Roles

The job description for a business analyst looks much like that for a financial analyst. However, the strong
quantitative skills required for a financial analyst are less emphasized in favor of overall strategic thinking. A
successful business analyst is able to evaluate business opportunities by using analytical thinking, industry
best practices, process development, team building and organization, and information technology. They then
communicate optimal courses of action to executive decision makers to maximize value in alignment with the
vision and goals of the firm.

Business analysts can help develop strategy and tactics to move a firm forward. They aid in identifying
challenges and solutions. Data-driven solutions help get products to market more quickly, evaluate
performance, and optimize production and product mix. The Bureau of Labor Statistics identifies the following
as typical business analyst duties:

• Gathering information about problems to be solved or procedures to be improved

• Interviewing personnel and conducting onsite observations to determine the methods, equipment, and

5 Ibid.

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 1.5 • Markets and Participants 21

personnel that will be needed

• Analyzing financial data, revenues and expenditures, and employment reports, among other data
• Finding root causes for problems and proposing solutions that may include new systems, procedures, or
personnel changes
• Presenting findings to decision makers
• Conferring with managers to ensure changes work

The average salary for management analysts was $85,260 in May 2019, and the BLS projects 11% growth, or
6
about 94,000 new jobs, over the next decade.

1.5 Markets and Participants

Learning Outcomes
By the end of this section, you will be able to:
• Identify primary and secondary markets.
• Identify key market players.

Primary and Secondary Markets

Simply put, the primary market is the market for “new” securities, and the secondary market is the market
for “used” securities. Think of the primary market as equivalent to the sale of new cars and the secondary
market as equivalent to the sale of used cars. In practice, many market locales trade both new and used
securities. For example, the stock markets trade equity securities daily, and most of the trading takes place
among individual and institutional investors who own shares in publicly traded companies. Trading a share of
Amazon, Facebook, or Nike stock has little impact and no direct cash flow to the underlying firm. However, the
information provided by such transactions is valuable, as it is a costly and public real-time statement by
investors of their perceptions of firm’s value and a reflection of satisfaction and expectations.

Some, though many fewer, transactions in the equity market are for the purchase and sale of new securities.
Firms issue new shares of stock called seasoned equity offerings (SEOs) or initial public offerings (IPOs) into
the market. These are issues of new shares of stock, previously untraded, and their issuance sends cash flows
directly to the underlying firms. SEOs are new shares issued by established firms, and IPOs are new shares
issued by firms going public for the very first time. Once the initial transaction takes place, purchasers of these
new securities may trade them. However, the second and subsequent trades are secondary, not primary,
market transactions.

Extensive primary market transactions take place weekly, when the Treasury Department auctions billions of
dollars of new Treasury securities. These new securities repay maturing Treasury securities and provide for the
ongoing liquidity and long-term borrowing needs of the federal government. Again, subsequent trading of
this government debt occurs as secondary market transactions.

Key Market Players

Key market players in finance include dealers, brokers, financial intermediaries, and you and me. Each of these
players facilitates the exchange of products, information, and capital in different ways. The presence of these
players makes financial transactions, easier, faster, and safer—essentially more efficient. You and your friends
might engage in direct financial transactions, such as buying a coffee or borrowing money for a movie. These
are typically small transactions. However, for transactions that are larger or more complicated, you need
advanced financial entities with capital, expertise, and networks. The two segments of the secondary markets
are broker markets and dealer markets, as Figure 1.7 shows. The primary difference between broker and
dealer markets is the way each executes securities trades.

6 Ibid.
22 1 • Introduction to Finance

Figure 1.7 Broker and Dealer Markets

Dealers

Financial dealers own the securities that they buy or sell. When a dealer engages in a financial transaction,
they are trading from their own portfolio. Dealers do not participate in the market in the same manner as an
individual or institutional investor, who is simply trying to make their investments worth as much as possible.
Instead, dealers attempt to “make markets,” meaning they are willing and able to buy and sell at the current
bid and ask prices for a security. Rather than relying on the performance of the underlying securities to
generate wealth, dealers make money from the volume of trading and the spread between their bid price
(what they are willing to pay for a security) and their ask price (the price at which they are willing to sell a
security). By standing ready to always buy or sell, dealers increase the liquidity and efficiency of the market.
Dealers in the United States fall under the regulatory jurisdiction of the Securities and Exchange Commission
(SEC). Such regulatory oversight ensures that dealers execute orders promptly, charge reasonable prices, and
disclose any potential conflicts of interest with investors.

Brokers

Brokers act as facilitators in a market, and they bring together buyers and sellers for a transaction. Brokers
differ from dealers who buy and sell from their own portfolio of holdings. These firms and individuals
traditionally receive a commission on sales.

In the world of stockbrokers, you may work with a discount broker or a full-service broker, and the fees and
expenses are significantly different. A discount broker executes trades for clients. Brokers are required for
clients because security exchanges require membership in the exchange to accept orders. Discount brokers or
platforms such as Robinhood or E-Trade charge no or very low commissions on many of their trade
executions, but they may receive fees from the exchanges. They also do not offer investment advice.

Full-service brokers offer more services and charge higher fees and commissions than discount brokers. Full-
service brokers may offer investment advice, retirement planning, and portfolio management, as well as
execute transactions. Morgan Stanley and Bank of America Merrill Lynch are examples of full-service brokers
that serve both institutional and individual investors.

Financial Intermediaries

A financial intermediary, such as a commercial bank or a mutual fund investment company, serves as an
intermediary to enable easier and more efficient exchanges among transacting parties. For instance, a
commercial bank accepts deposits from savers and investors and creates loans for borrowers. An investment
company pools funds from investors to inexpensively purchase and manage portfolios of stocks and bonds.
These transactions differ from those of a dealer or broker. Brokers facilitate trades, and dealers stand ready to
buy or sell from their own portfolios. Financial intermediaries, however, accept money from investors and may

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 1.6 • Microeconomic and Macroeconomic Matters 23

create a completely different security all together. For example, if the borrower defaults on a mortgage loan
created by the commercial bank where you have your certificate of deposit, your investment is still safely
earning interest, and you are not directly affected.

Financial institutions usually facilitate financial intermediation. However, occasionally lenders and borrowers
are able to initiate transactions without the help of a financial intermediary. When this occurs on a large scale,
the process, known as disintermediation, can cause much turmoil in the financial markets. In the 1970s,
inflation rose above 10% on an annual basis, and yet commercial banks were limited to offering maximum
7
rates of 5% on their savings deposits. Savers bypassed banks and savings and loan associations to invest
directly into Treasury securities and other short-term marketable securities. This lack of deposit funds and the
subsequent behavior of the industry essentially eliminated the savings and loan industry and led to significant
deregulation of commercial and investment banking in the United States.

The advantages of a robust network of financial intermediaries are many. They add efficiency to the financial
system through lower transaction costs. They gather and disperse information to minimize financial abuse and
fraud. They provide economies of scale and specialized knowledge. Finally, financial intermediaries are critical
for the functioning of a capitalist economy.

1.6 Microeconomic and Macroeconomic Matters

Learning Outcomes
By the end of this section, you will be able to:
• Define microeconomics and macroeconomics.
• Discuss the relationship between microeconomics and macroeconomics.
• Explain the importance of macroeconomic variables in finance markets.

Microeconomics
In the business setting, finance is the intersection of economics and accounting. Financial decision makers rely
on economic theory and empirical evidence combined with accounting data to make informed decisions for
their organization. Economics is the study of the allocation of scarce resources. Economists attempt to
understand the how and why of human and financial capital allocation to governments, businesses, and
consumers.

We typically separate economics into two major areas, microeconomics and macroeconomics. Microeconomics
is devoted to the study of these decisions of allocation by individual businesses, persons, or organizations.
Microeconomics helps us understand incentives and behavior, consumer choices and consumption, and
supply and demand.

Our understanding of microeconomics aids in financial forecasting, planning, and budgeting by understanding
how individuals are likely to respond to changes in product or service functionality, price, supply, quality,
marketing, or other firm-induced stimulus. Empirical research by individuals, businesses, academics, and
government provide evidence of what is going on and suggest what may change or stay the same.

Macroeconomics
Whereas microeconomics studies the decisions of individuals, macroeconomics examines the decisions of
groups. Macroeconomic areas of study and concern include inflation, income, economic growth, and
unemployment. When Bacon Signs developed a financial and operating plan to expand the business, the firm
had to consider unemployment and inflation when estimating its price of labor and materials. Bacon Signs
also had to consider interest rates when estimating the cost of borrowing money to expand the business.

Macroeconomic modeling is limited because models cannot capture every variable in testing and application.

7 United States President and Council of Economic Advisers. “The 1970s: Inflation, High Interest Rates, and New Competition.”
Economic Report of the President. 1991. https://fraser.stlouisfed.org/files/docs/publications/ERP/pages/6688_1990-1994.pdf
24 1 • Introduction to Finance

However, financial forecasting must incorporate macroeconomic assumptions and expectations into individual
firm and industry forecasts. Economic Foundations expands on our discussion of micro- and macroeconomics.

Importance of Macroeconomic Variables in Financial Markets

To make financial forecasts, managers need good information to understand the relationship among several
economic variables. Working from small to large, sales forecasts estimate the likely price and quantity of
goods sold. In doing so, the forecaster will consider local, regional, state, national, and international economic
conditions. Inflation is an important macroeconomic variable that influences prices. Every quarter, financial
information hubs, such as the Wall Street Journal (WSJ), and government agencies and regulatory bodies, such
as the Treasury Department and the Federal Reserve, release estimates about expected and current inflation.
This information informs policy makers how to adjust the money supply to meet target objectives. Financial
forecasters pay close attention to current and expected interest rates, as they have a fundamental impact on
the cost of raising money and determining the required rate of return for investment.

The unemployment rate helps inform financial forecasters about the expected cost of labor and the ability of
employers to hire people if a firm plans to increase the production of goods or services. The stock market is a
forward-looking macroeconomic variable and measures investor expectations about future cash flows and
economic growth. Political economic variables such as changes in regulation or tax policy can also affect
forecasting models.

LINK TO LEARNING

Politics and Stock Markets

Politics and stock market returns make for heated conversations. Who can run the country’s economic
system better, Republicans or Democrats? Presidents often take the credit or blame for overall economic
performance even though their actual influence is less than you might think. See this fun comparison chart
(https://openstax.org/r/macrotrends-net) of political economic performance that measures stock market
returns by each administration going back to President Warren Harding in 1920. Who had the highest
overall increase in the market? What president in the 21st century oversaw an overall decline in the market?
Just to get things going, who had better overall market returns after four years in office, Donald Trump or
Barack Obama?

Each of the variables we have identified—inflation, interest rates, unemployment, economic growth, the stock
market, and government fiscal policy—are macroeconomic factors. They are beyond the scope and influence
of individual firms, but combined, they play a critical role in establishing the market in which firms compete. A
better understanding of the interaction of these macro variables with each other and with individual micro or
firm-specific variables can only strengthen financial forecasting and management decision-making.

CONCEPTS IN PRACTICE

Here, There, and Everywhere: Where Did Your iPhone Come From?
How do international macroeconomic factors affect investment decisions for businesses and individuals?
Foreign investment adds risk and potential return to the decision-making process. Macroeconomic factors
such as different inflation rates, unexpected changes in currency exchange rates, and mismatched
economic growth all add to the uncertainty of making investments abroad. Just as important are
government regulations limiting pollution, exploitation of precious minerals, labor laws, and tariffs. Toss in
a pandemic, and a bottleneck or two, and suddenly international macroeconomic factors can affect almost
every aspect of commerce and international trade.

Access for free at openstax.org

 1.7 • Financial Instruments 25

For example, how far did your new iPhone travel before it got into your hands? Apple is an American
8
company headquartered in Cupertino, California, and worth over $2 trillion. However, your phone may
have visited as many as six continents before it reached you. Each location touched by the Apple corporate
hand requires an understanding of the financial impact on the product cost and a comparison with
alternative designs, resources, suppliers, manufacturers, and shippers. This is where finance can get really
fun!

(Sources: Magdalena Petrova. “We Traced What It Takes to Make an iPhone, from Its Initial Design to the
Components and Raw Materials Needed to Make It a Reality.” CNBC. December 14, 2018.
https://www.cnbc.com/2018/12/13/inside-apple-iphone-where-parts-and-materials-come-from.html;
Natasha Lomas. “Apple’s Increasingly Tricky International Trade-offs.” TechCrunch. January 6, 2019.
https://techcrunch.com/2019/01/06/apples-increasingly-tricky-international-trade-offs/; Kif Leswing.
“Here’s Why Apple Is So Vulnerable to a Trade War with China.” CNBC. May 13, 2019.
https://www.cnbc.com/2019/05/13/why-is-apple-so-vulnerable-to-a-trade-war-with-china.html)

Relationship between Microeconomics and Macroeconomics

In the parable, a group of blind people happen upon an elephant for the first time, and they each touch one
part—but one part only—of the elephant. Subsequently, when they each describe what they have discovered,
the descriptions are vastly different. The group's members become upset, accusing one another of inaccurate
descriptions or worse. The parable demonstrates how individuals can make absolute truths from their own
limited and subjective information. Financial decision makers run a similar risk, if they choose to recognize
only their own findings and ignore other microeconomic or macroeconomic information and the interaction of
these factors.

A common view to understanding economics states that macroeconomics is a top-down approach and
microeconomics is a bottom-up approach. Financial decision makers need to see both the forest and the
individual trees to chart a course and move toward a strategic objective. They need both the macro data, so
important for strategic thinking, and the micro data, required for tactical movement. For example, the national
rate of unemployment may not have been much help when Bacon Signs was searching for skilled laborers
who could form neon signs. However, the unemployment rate helped inform the company about the
probability of demand for new businesses and the signs they would need.

1.7 Financial Instruments

Learning Outcomes
By the end of this section, you will be able to:
• Differentiate between money and capital markets.
• List money market instruments.
• List capital market instruments.

Money Markets and Instruments

The money market is the market for short-term, low-risk, highly liquid securities. “Short-term” refers to
money market securities having maturities of less than one year–sometimes as short as overnight. “Low
risk” specifically means that the probability of default by the issuer in very unlikely. Defaulting on money
market instruments is not unheard of, but it is very rare. “High liquidity” means that money market
instruments can generally be sold in a secondary market very quickly and at or near their current market
value. Finally, money market securities are homogeneous, meaning that within an issue of securities, a single

8 Sergei Klebnikov. “Apple Becomes First U.S. Company Worth More Than $2 Trillion.” Forbes. August 19, 2020.
https://www.forbes.com/sites/sergeiklebnikov/2020/08/19/apple-becomes-first-us-company-worth-more-than-2-trillion/
26 1 • Introduction to Finance

instrument is not unique. For example, if you purchase 13-week T-bills issued in the first week of January, each
bill is identical to any other in the issue. Compare that to the purchase of physical assets such as a car or
house, where each of the assets sold has some unique feature or measure of quality.

Financial institutions, corporations, and governments that have short-term borrowing and/or lending needs
issue securities in the money market. Most of the transactions are quite large, with typical amounts in excess
of $100,000. These large transactions are the norm when trading federal funds, repurchase agreements,
commercial paper, or negotiable certificates of deposit. Our sample company, Bacon Signs, was much too
small to participate directly in the money market. However, Bacon Signs’ borrowing rates were affected by
changes in the money market. Treasury bills are also a very important component of the money market, and
they trade in smaller amounts starting at $10,000 per T-bill.

Treasury bills (T-bills), are short-term debt instruments issued by the federal government. T-bills are
auctioned weekly by the Treasury Department through the trading window of the Federal Reserve Bank of
New York. The federal government uses T-bills to meet short-term liquidity needs. T-bills have very short
maturities and a broad secondary market and are default-risk free. T-bills are also exempt from state and local
income taxes. As a result, they carry some of the lowest effective interest rates on publicly traded debt
securities. In addition to the regular auction of new T-bills, there is also an active secondary market where
investors can trade used or previously issued T-bills. Since 2001, the average daily trading volume for T-bills
9
has exceeded $75 billion.

Commercial paper (CP) is a short-term, unsecured debt security issued by corporations and financial
institutions to meet short-term financing needs such as for inventory and receivables. For example, credit card
companies use commercial paper to finance credit card payments. Commercial paper has a maturity of one to
270 days. The short maturity reduces SEC oversight. The lesser oversight and the unsecured nature of CP
means that only highly rated firms are able to issue the uninsured paper. The default rate on commercial
paper is typically low, but default rates did increase into the double-digit range during the financial crisis of
2008.

Commercial paper typically carries a minimum face value of $100,000 and sells at a discount with the face
value as the repayment amount. Corporations and financial institutions, not the government, issue
commercial paper; thus, returns are taxable. Further, unlike T-bills, there is not a robust secondary market for
CP. Most purchasers are large, such as mutual fund investment companies, and they tend to hold commercial
paper until maturity.

Negotiable certificates of deposit (NCDs) are very large CDs issued by financial institutions. They are
redeemable only at maturity, but they can and often do trade prior to maturity in a broad secondary market.
NCDs, or jumbo CDs, are so called because they sell in increments of $100,000 or more. However, typical
minimums amounts are $1,000,000 with a maturity of two weeks to six months.

NCDs differ in some important ways from the typical CD you may be familiar with from your local bank or
credit union. The typical CD has a maturity date, interest rate, and face amount and is protected by deposit
insurance. However, if an investor wishes to cash out prior to maturity, they will incur a substantial penalty
from the issuer (bank or credit union). An NCD also has a maturity date and amount but is much larger than a
regular CD and appeals to institutional investors. The principal is not insured. When the investor wishes to
cash out early, there is a robust secondary market for trading the NCD. The issuing institution can offer higher
rates on NCDs compared to CDs because they know they will have use of the purchase amount for the entire
maturity of the NCD. The reserve requirements on NCDs by the Federal Reserve are also lower than for other
types of deposits.

The market for federal funds is notable because the Federal Reserve targets the equilibrium interest rate on

9 Henrik Bessembinder, Chester Spatt, and Kumar Venkataraman. “A Survey of the Microstructure of Fixed-Income Markets.”
Journal of Financial and Quantitative Analysis. February 2020. https://www.sec.gov/spotlight/fixed-income-advisory-committee/
survey-of-microstructure-of-fixed-income-market.pdf

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 1.7 • Financial Instruments 27

federal funds as one of its most important monetary policy tools. The federal funds market traditionally
consists of the overnight borrowing and lending of immediately available funds among depository financial
institutions, notably domestic commercial banks. The participants in the market negotiate the federal funds
interest rate. However, the Federal Reserve effectively sets the target interest rate range in the federal funds
market by controlling the supply of funds available for use in the market. Many of the borrowing and lending
rates in our economy are a direct function of the federal funds rate.

Capital Markets and Instruments

The capital market is the market for longer-term financial instruments. The capital market is similar to the
money market. However, maturities are longer, default risk varies to a greater degree from low to high, and
liquidity is less certain, as is the homogeneity of the financial instruments. Broadly, we separate capital market
instruments into debt instruments traded in the bond markets and equity securities traded on the stock
markets.

The federal government issues Treasury notes and bonds to raise money for current spending and to repay
past borrowing. The size of the Treasury market is quite large, as the US federal government over the years
10
has accumulated a total indebtedness of over $28 trillion.

Treasury notes are US government debt instruments with maturities of 2 to 10 years. The Treasury auctions
notes on a regular basis, and investors may purchase new notes from TreasuryDirect.gov in the same way they
would a T-bill. T-notes differ from T-bills in that they are longer term, pay semiannual coupon interest
payments, and pay the par or face value of the note at maturity. Upon issue of a note, the size, number, and
timing of note payments is fixed. However, prices do change in the secondary market as interest rates change.
Like T-bills, T-notes are generally exempt from state and local taxes. There is an active secondary market for
Treasury notes.

Longer-term Treasury issues, Treasury bonds, have maturities of 20 or 30 years. T-bonds are like T-notes in
that they pay semiannual coupon interest payments for the life of the security and pay the face value at
maturity. They are longer term than notes and typically have higher coupon rates.

State and local governments and taxing districts can issue debt in the form of municipal bonds (“munis”).
Local borrowing carries more risk than Treasury securities, and default or bankruptcy is unlikely but possible.
Thus, munis have ratings that run a spectrum similar to that of corporate bonds in that they receive a bond
rating based on the perceived default risk. The defining feature of municipal bonds is that some interest
payments are tax-free. Interest on munis is always exempt from federal taxes and sometimes exempt from
state and local taxes. This makes them very attractive to investors in high income brackets.

Just as governments borrow money in the long-term from investors, so do corporations. A corporation often
issues bonds for longer-term financing. Bond contracts identify very specific terms of agreement and outline
the rules for the order, timing, and amount of contractual payments, as well as processes for when one or
more of the required activities lapse. A bond contract, known as an indenture, includes both standard
“boilerplate” contract language and specific conditions unique to a particular issue. Because of these non-
standardized features of a bond contract, the secondary market for trading used bonds typically requires a
broker, dealer, or investment company to facilitate a trade.

An important goal of business executives is to maximize the owners’ wealth. For corporations, shares of stock
represent ownership. Stocks are difficult to price compared to bonds. Bonds have contracts that specify the
number and amount of all payments made by the firm to the purchasers of bonds. Stock cash flows are far
more uncertain than bond cash flows. Stocks might or might not have periodic dividend payments, and an
investor can plan to sell the stock at some point in the future. However, no contract guarantees the size of the
dividends or the time or resale price of the stock. Thus, the cash flows from stock ownership are more

10 Trading Economics. “United States Government Debt.” Trading Economics. https://tradingeconomics.com/united-states/

government-debt
28 1 • Introduction to Finance

uncertain and risky than cash flows from bonds.

Ownership of corporations is easily transferable if a company’s stock trades in one of the organized stock
exchanges or in the over-the-counter (OTC) market. Most of the trading consists of used or previously issued
stocks in the over-the-counter market and organized exchanges. The two largest stock exchanges in the world
are the New York Stock Exchange (NYSE) and the NASDAQ. Both exchanges are located in the United States.

1.8 Concepts of Time and Value

Learning Outcomes
By the end of this section, you will be able to:
• Explain the impact of time on saving and spending.
• Describe economic value.

Many students don’t have a choice between saving and spending. College is expensive, and it is easy to spend
every dollar you earn and to borrow to meet the rest of your obligations. Businesses, however, continually
make decisions about when and how much money to borrow or invest. Bacon Signs established banking
relationships to borrow money when needed to expand the business or a product line. Sometimes the best
decision is to invest as soon as possible to grab opportunities, and other times it is better to delay new
investment in order to pay dividends to the owners of the company.

LINK TO LEARNING

The Dow Jones Industrial Average Marches On!

Once you begin to save and invest, here is a “fun fact” about the Dow Jones Industrial Average (DJIA)
(https://openstax.org/r/investopedia-djia), also known as the Dow 30. It first appeared on May 26, 1896, as
a quick way for stock traders to assess if the stock market had gone “up or down” each day and by how
much. Here we are over 100 years later, and the Dow 30 index is alive and well. Of course, the 30 companies
have changed, but the index does represent a continuous yardstick to measure stock performance over
time. As Table 1.1 shows, it took from 1906 to 1972, or a little over 66 years, for the Dow 30 to increase
tenfold, from a value of 100 to a value of 1,000. The next tenfold increase from 1,000 to 10,000 took only a
little under 27 years from 1972 to 1999. Time will tell if or when the Dow 30 will top 100,000 at the closing
bell.

Closing Milestones Date

41 5/26/1896
100 1/12/1906
1,000 11/14/1972
10,000 3/29/1999
20,000 1/25/2017
30,000 11/24/2020

Table 1.1 The Dow 30 Closing

Milestones and Dates

Impact of Time on Saving and Spending

The choice to spend or save and invest is really a choice between consumption today versus consumption in

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 1.8 • Concepts of Time and Value 29

the future. Economists, investment advisers, your friends, and mine love to discuss the trade-off of
consumption now or later—even if not in those words. We have all heard conversations that go something like
this: “Let’s go grab a beer—you can study for tomorrow’s exam in the morning.” Or “My father’s investment
adviser told me that if I invest $500 per month for the next 30 years and earn an annual rate of 10% on my
investments, I will have invested $180,000 over time but accumulated an investment portfolio worth over $1.13
million!”

An important aspect of the trade-off between saving and spending involves your short-, intermediate-, and
long-term goals. Delaying consumption until later comes with risks. Will your consumption choices still be
available? Will the prices be attainable? Will you still be able to consume and enjoy your future purchases?

When saving for short-term objectives, the safety of the principal invested is important, and the value of
compounding returns is minimal compared to longer-term investments. Most short-term investors have a low
tolerance for risk and hope to beat the rate of inflation with a little extra besides. An example could be to start
a holiday savings account at your local bank as a way to save, earn a small rate of return, and assure that you
have funds set aside for consumption at the end of the year.

An intermediate investment may be to save for a new car or for the down payment on a house or vacation
home. Again, maintaining the principal is important, but you have some time to recover from poor investment
returns. Intermediate-term investments tend to earn higher average annual rates of return than short-term
investments, but they also have greater uncertainty and risk.

Long-term investments have the advantage of enough time to recover from temporary poor performance and
the luxury of compounded returns over a long period. Further, long-term investments tend to have greater
risk and higher expected average annual rates of return. Even though this is a business finance text,
sometimes a personal finance example is easier to relate to. To illustrate, Table 1.2 demonstrates four different
investment scenarios. In scenario 1, you invest $5,000 annually from ages 26 through 60 into an account
earning an average annual rate of return of 10% per year. Over your lifetime, you invest a total of $175,000,
and at age 60, you have an estimated portfolio value of $1,490,634. This is a healthy amount that has almost
certainly beaten the average annual rate of inflation. In scenario 1, by investing regularly, you accumulate
roughly 8.5 times the value of what you invested. Congratulations, you can expect to become a millionaire!

Compare your results in scenario 1 with your college roommate in scenario 2, who is able to invest $5,000 per
year from ages 19 through 25 and leave her investments until age 60 in an account that continues to earn an
annual rate of 10%. She makes her investments earlier than yours, but they total only $35,000. However,
despite a much smaller investment, her head start advantage and the high average annual compounded rate
of return leave her with an expected portfolio value of $1,466,369. Her total is almost as great as the amount
you would accumulate, but with a much smaller total investment.

Scenarios 3 and 4 are even more dramatic, as can be seen from a review of Table 1.2. In both scenarios, only
five $5,000 investments are made, but they are made earlier in the investor’s life. Parents or grandparents
could make these investments on behalf of the recipients. In both scenarios, the portfolios grow to amounts
greater than those of you or your roommate with smaller total investments. The common factor is that greater
time leads to additional compounding of the investments and thus greater future values.

Average Annual Rate of Return = 10%

Assumptions Scenario 1 Scenario 2 Scenario 3 Scenario 4
Starting investment age 26 19 14 9
Ending investment age 60 25 18 13
Total investments 35 7 5 5

Table 1.2 Four Investment Scenarios: Assumptions and Expected Outcomes

30 1 • Introduction to Finance

Average Annual Rate of Return = 10%

Assumptions Scenario 1 Scenario 2 Scenario 3 Scenario 4
Annual investment $5,000 $5,000 $5,000 $5,000
Total investment amount $175,000 $35,000 $25,000 $25,000
Value at age 60 $1,490,634 $1,466,369 $1,838,858 $2,961,500

Table 1.2 Four Investment Scenarios: Assumptions and Expected Outcomes

Definition of Economic Value

Value is a term used frequently in business and especially in economics, accounting, and finance. Accountants
track, record, and display value in the form of financial statements and footnotes. The numbers they present
are “book values” and represent what has occurred. Financial people like to speak in terms of “market values.”
Market values are calculated using expected future cash flows discounted to today. Market values are the
prices that consumers pay for a product. Economic value is what we believe consumers are actually willing to
pay for a product, service, or experience. For example, the price of a movie ticket may be $10, but there are
individuals who are willing to pay far more for the experience of watching a movie on the big screen.

Generally, the economic value is at least as great as the market value or current price of an asset. When Bacon
Signs planned for the future, the firm attempted to determine the economic value of its products when
creating an optimal mix of price and quantity sold. Firms that produce unique products for clients may have
multiple prices based on the estimated economic value of their good or service to the client. One way to think
about the difference between market value and economic value is that market value is what you have to pay,
while economic value is what you are willing to pay.

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 1 • Summary 31

Summary
1.1 What Is Finance?
Finance is the study of the trade-off between risk and expected return. There are three broad areas of finance:
business finance, investments, and financial markets and institutions.

1.2 The Role of Finance in an Organization

The accounting department creates financial statements, and the finance department implements the firm’s
policy objectives, monitors results, and responds to necessary strategic and tactical changes. Finance is
responsible for budgeting and forecasting. Finance aids in establishing firm objectives and is responsible for
meeting with creditors, lenders, owners, regulators, and other stakeholders that provide capital to the firm or
have a claim against firm assets.

1.3 Importance of Data and Technology

Much of the data used in business today has been available for many years. However, data today is more
attainable than ever due to technological advancements facilitating a user’s ability to gather, evaluate, and
store information faster and more cost effectively than ever. Information is continually available, so the
quicker and less expensively firms can adjust to the arrival of new information, the more valuable they become
for their stakeholders.

1.4 Careers in Finance

Careers in finance are plentiful, fulfilling, and well compensated. Introductory positions are available in areas
such as data collection and data entry. More skill and experience is required for roles such as data analysis and
forecasting. Eventually, executive-level positions such as CFO present themselves to the most qualified.
Finance careers are not limited to financial firms, as understanding finance is an important skill in government
regulatory positions, nonprofit management, and all types of commercial business—from real estate, to retail,
to manufacturing, to education.

1.5 Markets and Participants

Financial markets are where buyers and sellers of financial securities come together to trade. The trading of
securities allows markets to value assets and signal value as new information arrives. Brokers operate to bring
buyers and sellers together and receive commissions. Dealers trade from their own portfolios and are often
willing to make markets for specific securities by agreeing to buy or sell at the current bid and ask prices.
Financial intermediaries actually change or create new financial products.

1.6 Microeconomic and Macroeconomic Matters

Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and
why of human, physical, and financial capital allocation. Microeconomics is the study of factors affecting an
individual’s consumption, and macroeconomics is the study of all the aggregate factors affecting an economy.
Economics is important in finance due to the number of economic variables critical to good financial
forecasting.

1.7 Financial Instruments

Maturity is one method to differentiate among financial instruments. Using this methodology, we have money
markets and capital markets. Money markets consist of short-term marketable securities, and capital markets
focus on longer-term securities such as bonds and stocks.

1.8 Concepts of Time and Value

The concepts of time and value involve the resolution of conflict between consumption now versus
consumption later. Time and value represent the trade-off between risk and expected return. Many financial
32 1 • Key Terms

exercises examine the relationships among time, interest rates, risk, cash flows now, and cash flows in the
future. You can expect to solve several “time value of money” problems before you complete this book.

Key Terms
brokers individuals or a firm that brings together potential buyers and sellers of a product and receives a
commission at transaction
business finance the study and application of how managers can apply financial principles to maximize the
value of a firm in a risky environment
capital budgeting the process of determining which long-term or fixed assets to acquire in an effort to
maximize shareholder value
capital market market for longer-term financial instruments, such as stocks and bonds, used to finance
long-term projects for organizations
capital structure the mix of financing, usually debt and equity, used by a firm
chief financial officer (CFO) an executive-level officer who sets policy for working capital management,
determines optimal capital structure for the firm, and makes the final decision in matters of capital
budgeting
commercial paper (CP) short-term, unsecured financial obligations issued by firms as a means of short-term
financing for items such as inventory or payables
comptroller also referred to as controller, individual in charge of financial reporting and the oversight of the
accounting activities necessary to develop financial reports
dealers facilitate a market and the trading of securities by holding a portfolio of the underlying asset for easy
purchase and sale; earn money on the spread between ask and bid prices for the asset
default risk the risk that the issuer of a financial security will be unable to make payments as specified in the
terms of a financial contract
diversifiable risk also called unsystematic risk, a risk that can be eliminated without the loss of expected
return by holding a portfolio of securities
economic value the amount a consumer is willing to pay for a particular asset or service, usually greater
than or equal to the current market price or present value of the asset
federal funds rate the rate targeted by the Federal Reserve in the implementation of monetary policy
financial industry regulatory authority (FINRA) an independent, nongovernmental organization that
writes and enforces the rules governing registered brokers and broker-dealer firms in the United States
financial intermediary a commercial bank or a mutual fund investment company that serves as an
intermediary to enable easier and more efficient exchanges among transacting parties, often accepting one
form of financial asset from which they create another, such as taking demand deposits to create mortgage
loans
financial markets and institutions one of the three main areas of the field of finance; firms and regulatory
agencies that oversee our financial system
inflation risk the risk of reduced purchasing power of goods and services due to rising prices
investments one of the three main areas of finance; products and processes used to create individual and
institutional portfolios with the intent of growing wealth
money market the market for short-term, low-risk, highly liquid, homogeneous financial securities; common
money market securities include T-bills, NCDs, and commercial paper
money market mutual funds created by investment companies to pool the money of many investors to
purchase and then manage short-term, low-risk, liquid financial portfolios of securities
municipal bonds (munis) long-term debt obligations issued by state or local governments that often have
important tax advantages relative to corporate bonds
negotiable certificate of deposit very large CDs issued by financial institutions, redeemable only at maturity
but can and often do trade prior to maturity in a broad secondary market; also called jumbo CDs because
they sell in increments of $100,000 or more

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 1 • Multiple Choice 33

non-diversifiable risk risk that cannot be eliminated by simply holding a portfolio of securities; also known
as systematic risk
political risk the risk of local, state, or national governments “changing the rules” and disrupting firm cash
flows
primary market a term used in financial markets to identify the market for the purchase and sale of new
securities
secondary market a term used in financial markets to represent the purchase or sale of used securities that
trade after the initial sale by the offering firm
Securities Investor Protection Corporation (SIPC) a nonprofit corporation that provides brokerage
customers up to $500,000 coverage for cash and securities held by the firm
treasurer position responsible for monitoring cash flow at a firm and frequently is the contact person for
bankers, underwriters, and other outside sources of financing
Treasury bills (T-bills) short-term debt obligations of one year or less issued by the US government
Treasury bonds long-term debt obligations issued by the US government characterized by having maturities
of greater than 10 years and making periodic interest payments as well as principal payment at maturity
Treasury notes long-term debt obligations issued by the US government characterized by having maturities
of 2 to 10 years and making periodic interest payment as well as principal payment at maturity
working capital management the development, oversight, and management of a firm’s short-term assets
and liabilities

Multiple Choice
1. Which of the following was NOT identified by your authors as one of the three main areas of financial
study?
a. business finance
b. capital budgeting
c. investments
d. financial markets and institutions

2. What is the process of determining which long-term or fixed assets to acquire in an effort to maximize
shareholder value?
a. Business finance
b. Capital budgeting
c. Investments
d. Financial markets and institutions

3. In an organization with each of these financial positions, which title is most likely to be associated with a
job description that is less of a “hands-on” manager and that engages more in visionary and strategic
planning?
a. comptroller (or controller)
b. treasurer
c. vice president of finance
d. chief financial officer (CFO)

4. Which of the following statements is false?

a. Financial planning is an important tool of for-profit organizations such as corporations and
partnerships but is not important for not-for-profit enterprises such charitable organizations or
governments.
b. Good financial planning considers past, present, and pro forma income statements.
c. Balance sheets are critical elements of the financial planning process and help demonstrate expected
34 1 • Multiple Choice

sources and uses of funds.

d. Forecasting in the form of expected sales, cost of funds, and micro- and macroeconomic conditions
are essential elements of financial planning.

5. Which of the following statements regarding data is generally NOT true?

a. Financial data is important for internal and external analysis of business firms.
b. Outsiders use publicly available data about firms to make investment and regulatory decisions.
c. “Gut feelings” decision-making tends to be more consistent with value maximization.
d. Suppliers need financial information to determine if they should supply trade credit, and customers
need to know if a firm’s products are reliable and appropriately priced.

6. Which of the following is generally NOT true about cloud data storage versus on-site data storage?
a. Cloud data storage provides storage cost advantages.
b. Cloud data storage causes increased energy consumption.
c. Cloud data storage comes with specialized data protection services.
d. Cloud data storage comes with specialized maintenance services.

7. Which of the following describes United States Bureau of Labor Statistics (BLS) expectations of jobs using
financial skills in the next decade?
a. plentiful but low paying
b. few and low paying
c. plentiful and high paying
d. few and high paying

8. Which of the following organizations would be unlikely to hire a financial analyst?

a. Government agencies may hire financial analysts to aid in regulatory oversight and enforcement.
b. Investment companies may hire financial analysts to produce financial reports.
c. Corporations may hire financial analysts to develop financial forecasts.
d. All of the above organizations are likely to hire and develop financial analysts.

9. The _______________ market is the market for _______________ securities, and the _______________ is the market for
_______________ securities.
a. primary; used; secondary; new
b. primary; new; secondary; used
c. secondary; new; primary; new
d. secondary; used; primary; used

10. _______________ own the securities that they buy or sell; when they engage in a financial transaction, they are
trading from their own portfolio.
a. Dealers
b. Brokers
c. Advisers
d. Comptrollers

11. _______________ act as facilitators in a market, and they bring together buyers and sellers for a transaction.
a. Dealers
b. Brokers
c. Advisers
d. Comptrollers

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 1 • Multiple Choice 35

12. _______________ is the study of the allocation of scarce resources, _______________ is devoted to the study of
these decisions of allocation by small or individual entities, and _______________ examines decisions taken
together or in the aggregate.
a. Macroeconomics; microeconomics; economics
b. Microeconomics; economics; macroeconomics
c. Economics; microeconomics; macroeconomics
d. Economics; macroeconomics; microeconomics

13. Which of the following is NOT an economy-wide macroeconomic variable used in macro-forecasting
models?
a. inflation
b. unemployment
c. economic growth
d. CEO turnover

14. _______________ is the market for short-term, low-risk, highly liquid, homogeneous securities.
a. The capital market
b. The financial market
c. The stock market
d. The money market

15. _______________ are short-term debt instruments issued by the federal government.
a. Treasury bills
b. Treasury notes
c. Treasury bonds
d. Federal Reserve notes

16. _______________ is a short-term, unsecured security issued by corporations and financial institutions to meet
short-term financing needs such as inventory and receivables.
a. A Treasury bill
b. Commercial paper
c. A negotiable certificate of deposit
d. A Treasury note

17. _______________ are US government debt instruments with maturities of 2, 3, 5, 7, or 10 years.

a. Federal funds
b. Federal Reserve notes
c. Treasury notes
d. Treasury bonds

18. _______________ investments tend to have _______________ risk and _______________ expected returns.
a. Long-term; less; smaller
b. Long-term; greater; greater
c. Short-term; greater; smaller
d. Short-term; less; greater

19. _______________ value is what a consumer pays for a product. _______________ value is what a consumer is
willing to pay for a product.
a. Market; Economic
b. Economic; Market
36 1 • Review Questions

c. Book; Market
d. Economic; Book

Review Questions
1. Identify and briefly define the three areas of study in finance.

2. Identify the three focal areas in business finance.

3. Define each of the following types of risk:

• inflation risk
• diversifiable risk
• non-diversifiable risk
• political risk

4. Identify three common components of good financial planning.

5. The Concepts in Practice feature in Section 1.3 discusses the importance of data for decision-making. List
at least three of the ways the article suggests managers can use financial statements.

6. Describe the role of a financial analyst in a financial institution such as a bank or investment company.

7. Is a dealer or a broker more likely to be a market maker? In your answer, define the activities of a market
maker.

8. How can an understanding of micro- and macroeconomic factors aid in small business decision-making?

9. We measure market capitalization by multiplying the number of shares of stock outstanding by the
current price per share. Go to finance.yahoo.com and determine the market capitalization of Nike, Tesla,
and Walmart. Which company has the greatest market capitalization? Which company has the highest
level of sales? If these are not the same companies, why do you think the company with the lower sales
level has greater market capitalization?

Video Activity
Why Climate Change Means New Risk for US Financial Markets

Click to view content (https://openstax.org/r/player-pbs)

1. Cite some examples that the video used to demonstrate the effect of climate change on the value of
property and businesses. Now, identify examples of environmental disasters that you are personally
familiar with. How have businesses in your community adapted in response to climate change?

2. Do you agree or disagree with the following statement: “The young people of today are the investors of
tomorrow, and they will prioritize environmental impact in their investment choices.” How do you think
your investing future will be altered by climate change? Do you agree that environmental changes are a
legitimate and measurable investment risk?

Markets and Participants

Click to view content (https://openstax.org/r/robinhood)

Robinhood is a mobile trading platform for stocks, bonds, and options. The company has transformed the
security trading industry by introducing commission-free trades and simplifying the trading process with its
intuitive mobile app. However, as this Wall Street Journal video about Robinhood explains, the company and its
products are not without controversy.

3. Have you ever traded financial securities? If so, which trading platform(s) have you used? If you have

Access for free at openstax.org

 1 • Video Activity 37

traded using another platform, how does your trading experience compare to that described in the video?
If you have not traded securities, discuss how the Robinhood app affects your willingness to try trading.

4. At the end of the video, one interviewee viewed Robinhood as a gateway trading platform, but not a
platform for serious traders. The other saw Robinhood as a means to level the playing field for all
interested investors. What are your thoughts on the Robinhood trading app? Do you agree that option
trading should be more restricted than the video implies?
38 1 • Video Activity

Access for free at openstax.org

 2 • Why It Matters 39

2
Corporate Structure and Governance

Figure 2.1 The legal structure of any business will have a substantial impact on its operations. (credit: modification of work “New
Board Room at 2 Broadway” by Metropolitan Transportation Authority/Patrick Cashin/flickr, CC BY 2.0)

Chapter Outline
2.1 Business Structures
2.2 Relationship between Shareholders and Company Management
2.3 Role of the Board of Directors
2.4 Agency Issues: Shareholders and Corporate Boards
2.5 Interacting with Investors, Intermediaries, and Other Market Participants
2.6 Companies in Domestic and Global Markets

Why It Matters
When someone opens a business, it is because they want to fulfill important personal financial goals. In
publicly traded companies, managers and employees work on behalf of the shareholders, who own the
business through their ownership of company stock. These managers and employees have an ongoing
obligation to pursue projects, policies, and corporate investments that will increase or promote stockholder
value over the long term. Although many companies focus on financially related goals, such as growth,
earnings per share, and market share, the main financial goal is to create value for investors.

Keep in mind that a company’s stockholders are not just an abstract group. Like the sole business owner, they
are individuals who have chosen to invest their hard-earned cash in a company. They are looking for a return
on their investment in order to meet their own personal long-term financial goals, which might be saving for
retirement, a new home, or college education for their children.

In addition to increasing value, it is also important to realize that a firm has important nonfinancial goals.
Some examples of these might include the following:

• Expanding sales to existing customers

• Increasing customer loyalty to the weaker brands
• Developing new products for current and potential customers
• Becoming international by setting up an online ordering service
40 2 • Corporate Structure and Governance

• Improving customer satisfaction with customer services

If managers are to help stockholders maximize their wealth, they must know how that wealth is determined in
the first place. One of the main concepts in finance is that the value of any asset is determined by the present
value of the stream of cash flows that the asset will provide to its owners over the course of time. In
subsequent chapters, we will also be covering stock valuation in depth, and we will see that stock prices are
based on cash flows expected in future years, not only on those coming in at the present time.

For these reasons, stock price maximization, which leads directly to maximizing shareholder wealth, requires
us to take a long-term view of company operations. It is also important to realize that managerial actions that
affect a company’s value may not immediately be reflected in the price of a company’s stock but rather will
become evident in the long-term prospects of the organization.

In the case of privately held companies, smaller firms, and sole proprietorships, there are no shareholders.
However, attention to long-term growth and maximizing the value of a firm is just as important a goal to the
owners, who are also usually senior management with the company.

2.1 Business Structures

Learning Outcomes
By the end of this section, you will be able to:
• Identify the business form created by most organizations.
• Contrast the advantages and disadvantages that the corporate form has over sole proprietorships.
• Contrast the advantages and disadvantages that the corporate form has over partnerships.
• List and describe characteristics associated with a hybrid business structure.

The Most Common Types of Business Organization

The functions of most executive management teams are very similar for most businesses, and they will not
differ in any significant manner based on how they may be structured or organized. However, the legal
structure of any company will have a substantial impact on its operations, and it therefore deserves a
significant amount of analysis and discussion. The four most common forms of business organizations are the
following:

1. Sole proprietorships
2. Partnerships
3. Corporations
4. Hybrids, such as limited liability companies (LLCs) and limited liability partnerships (LLPs)

The vast majority of businesses take the form of a proprietorship. However, based on the total dollar value of
1
combined sales, more than 80 percent of all business in the United States is conducted by a corporation.
Because corporations engage in the most business, and because most successful businesses eventually
convert into corporations, we will focus on corporations in this chapter. However, it is still important to
understand the legal differences between different types of firms and their advantages and disadvantages.

Sole Proprietorships
A proprietorship is typically defined as an unincorporated business owned by a single person. The process of
forming a business as a sole proprietor is usually a simple matter. A business owner merely decides to begin
conducting business operations, and that person is immediately off and running. Compared to other forms of
business organizations, proprietorships have the following four important advantages:

1. They have a basic structure and are simple and inexpensive to form.

1 Aaron Krupkin and Adam Looney. “9 Facts about Pass-Through Businesses.” Brookings. The Brookings Institution, May 15, 2017.
https://www.brookings.edu/research/9-facts-about-pass-through-businesses

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 2.1 • Business Structures 41

2. They are subject to relatively few government rules and regulations.

3. Taxation on sole proprietorships is far simpler than on other organizational forms. There are no separate
taxes associated with a sole proprietorship, as there are with corporations. Sole proprietors simply report
all their business income and losses on their personal income tax returns.
4. Controlling responsibilities of the firm are not divided in any way. This results in less complicated
managerial decisions and improved timeliness of necessary corrective actions.

However, despite the ease of their formation and these stated advantages, proprietorships have four notable
shortcomings:

1. A sole proprietor has unlimited personal liability for any financial obligations or business debts, so in the
end, they risk incurring greater financial losses than the total amount of money they originally invested in
the company’s formation. As an example, a sole proprietor might begin with an initial investment of
$5,000 to start their business. Now, let’s say a customer slips on some snow-covered stairs while entering
this business establishment and sues the company for $500,000. If the organization loses the lawsuit, the
sole proprietor would be responsible for the entire $500,000 settlement (less any liability insurance
coverage the business might have).
2. Unlike with a corporation, the life of the business is limited to the life of the individual who created it. Also,
if the sole proprietor brings in any new equity or financing, the additional investor(s) might demand a
change in the organizational structure of the business.
3. Because of these first two points, sole proprietors will typically find it difficult to obtain large amounts of
financing. For these reasons, the vast majority of sole proprietorships in the United States are small
businesses.
4. A sole proprietor may lack specific expertise or experience in important business disciplines, such as
finance, accounting, taxation, or organizational management. This could result in additional costs
associated with periodic consulting with experts to assist in these various business areas.

It is often the case that businesses that were originally formed as proprietorships are later converted into
corporations when growth of the business causes the disadvantages of the sole proprietorship structure to
outweigh the advantages.

Partnerships
A partnership is a business structure that involves a legal arrangement between two or more people who
decide to do business as an organization together. In some ways, partnerships are similar to sole
proprietorships in that they can be established fairly easily and without a large initial investment or cost.

Partnerships offer some important advantages over sole proprietorships. Among them, two or more partners
may have different or higher levels of business expertise than a single sole proprietor, which can lead to
superior management of a business. Further, additional partners can bring greater levels of investment capital
to a firm, making the process of initial business formation smoother and less risky.

A partnership also has certain tax advantages in that the firm’s income is allocated on a pro rata basis to the
partners. This income is then taxed on an individual basis, allowing the company to avoid corporate income
tax. However, similar to the sole proprietorship, all of the partners are subject to unlimited personal liability,
which means that if a partnership becomes bankrupt and any partner is unable to meet their pro rata share of
the firm’s liabilities, the remaining partners will be responsible for paying the unsatisfied claims.

For this reason, the actions of a single partner that might cause a company to fail could end up bringing
potential ruin to other partners who had nothing at all to do with the actions that led to the downfall of the
company. Also, as with most sole proprietorships, unlimited liability makes it difficult for most partnerships to
raise large amounts of capital.
42 2 • Corporate Structure and Governance

Corporations
The most common type of organizational structure for larger businesses is the corporation. A corporation is a
legal business entity that is created under the laws of a state. This entity operates separately and distinctly
from its owners and managers. It is the separation of the corporate entity from its owners and managers that
limits stockholders’ losses to the amount they originally invest in the firm. In other words, a corporation can
lose all of its money and go bankrupt, but its owners will only lose the funds that they originally invested in the
company.

Unlike other forms of organization, corporations have unlimited lives as business entities. It is far easier to
transfer shares of stock in a corporation than it is to transfer one’s interest in an unincorporated business.
These factors make it much easier for corporations to raise the capital necessary to operate large businesses.
Many companies, such as Microsoft and Hewlett-Packard, originally began as proprietorships or partnerships,
but at some point, they found it more advantageous to adopt a corporate form of organization as they grew in
size and complexity.

An important disadvantage to corporations is income taxes. The earnings of most corporations in the United
States are subject to something referred to as double taxation. First, the corporation’s earnings are taxed;
then, when its after-tax earnings are paid out as dividend income to shareholders (stockholders), those
earnings are taxed again as personal income.

It is important to note that after recognizing this problem of double taxation, Congress created the S
corporation, designed to aid small businesses in this area. S corporations are taxed as if they were
proprietorships or partnerships and are exempt from corporate income tax. In order to qualify for S
corporation status, a company can have no more than 100 stockholders. Thus, this corporate form is useful for
relatively small, privately owned firms but precludes larger, more diverse organizations. A larger corporation is
often referred to as a C corporation. The vast majority of small corporations prefer to elect S status. This
structure will usually suit them very well until the business reaches a point where their financing needs grow
and they make the decision to raise funds by offering their stock to the public. At such time, they will usually
become C corporations. Generally speaking, an S corporation structure is more popular with smaller
businesses because of the likely tax savings, and a C corporation structure is more prevalent among larger
companies due to the greater flexibility in raising capital.

Hybrids: Limited Liability Corporations and Partnerships

Another form of business organization is the limited liability corporation (LLC). This type of business
structure has become a very popular type of organization. The LLC is essentially a hybrid form of business
that has elements of both a corporation and a partnership. Another form of organizational structure is
something called a limited liability partnership (LLP), which is quite similar to the LLC in structure and in
use. It is very common to see LLPs used as the organizational form for professional services firms, often in
such fields as accounting, architecture, and law. Conversely, LLCs are typically used by other forms of
businesses.

Similar to corporation structures, LLCs and LLPs will provide their principals with a certain amount of liability
protection, but they are taxed as partnerships. Also, unlike in limited partnerships, where a senior general
partner will have overall control of the business, investors in an LLC or LLP have votes that are in direct
proportion to their percentage of ownership interest or the relative amount of their original investment.

A particular advantage of a limited liability partnership is that it allows some of the partners in a firm to limit
their liability. Under such a structure, only designated partners have unlimited liability for company debts;
other partners can be designated as limited partners, only liable up to the amount of their initial contribution.
Limited partners are typically not active decision makers within the firm.

Some important differences between LLCs and LLPs are highlighted in Table 2.1.

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 2.1 • Business Structures 43

Limited Liability Corporation Limited Liability Partnership

Advantages Disadvantages Advantages Disadvantages
Fewer restrictions on eligibility (only one Only certain
member allowed; can be professional, professions
although some states disallow professionals) eligible
Personal protection as well
Limited
as protection from
Usually more personal liability protection protection from
negligence of other
partners’ actions
partners
Earnings
Must file taxes
included in
Flexibility in taxation Earnings taxed just once as pass-
members’
through entity
personal taxes

Table 2.1 Advantages and Disadvantages of LLCs and LLPs

LLCs and LLPs have gained great popularity in recent years, but larger companies still find substantial
advantages in being structured as C corporations. This is primarily due to the benefits of raising capital to
support long-term growth. It is interesting to note that LLC and LLP organizational structures were essentially
devised by attorneys. They generally are rather complicated, and the legal protection offered to their
ownership principals may vary from state to state. For these reasons, it is usually necessary to retain a
knowledgeable lawyer when establishing an organization of this type.

Obviously, when a company is choosing an organizational structure, it must carefully evaluate the advantages
and disadvantages that come with any form of doing business. For example, if an organization is considering a
corporation structure, it would have to evaluate the trade-off of having the ability to raise greater amounts of
funding to support growth and future expansion versus the effects of double taxation. Yet despite such
organizational concerns with corporations, time has proven that the value of most businesses, other than
relatively small ones, is very likely to be maximized if they are organized as corporations. This follows from the
idea that limited ownership liability reduces the overall risks borne by investors. All other things being equal,
the lower a firm’s risk, the higher its value.

Growth opportunities will also have a tremendous impact on the overall value of a business. Because
corporations can raise financing more easily than most other types of organizations, they are better able to
engage in profitable projects, make investments, and otherwise take superior advantage of their many
favorable growth opportunities.

The value of any asset will, to a large degree, depend on its liquidity. Liquidity refers to asset characteristics
that enable the asset to be sold or otherwise converted into cash in a relatively short period of time and with
minimal effort to attain fair market value for the owner. Because ownership of corporate stock is far easier to
transfer to a potential buyer than is any interest in a business proprietorship or partnership, and because
most investors are more willing to invest their funds in stocks than they are in partnerships that may carry
unlimited liability, an investment in corporate stock will remain relatively liquid. This, too, is an advantage of a
corporation and is another factor that enhances its value.

LINK TO LEARNING

Amazon
Most people are surprised to learn than Amazon, the largest online retailer, is set up as an LLC.
44 2 • Corporate Structure and Governance

Amazon.com Services LLC is set up as a subsidiary of the larger Amazon.com Inc. Take a look at the Amazon
LLC company profile provided by Dun & Bradstreet (https://openstax.org/r/company-profiles-amazon).
Why do you think such a large corporation is set up as an LLC?

Incorporating a Business
Many business owners decide to structure their business as a corporation. In order to begin the process of
incorporation, an organization must file a business registration form with the US state in which it will be based
and carry on its primary business activities. The document that must be used for this application is generally
referred to as the articles of incorporation or a corporate charter. Articles of incorporation are the single
most important governing documents of a corporation. The registration allows the state to collect taxes and
ensure that the business is complying with all applicable state laws.

The exact form of the articles of incorporation differs depending on the type of corporation. Some types of
articles of incorporation include the following:

• Domestic corporation (in state)

• Foreign corporation (out of state or out of country)
• Close (closely held) corporation
• Professional corporation
• Nonprofit corporation (several different types of nonprofits)
• Stock corporation
• Non-stock corporation
• Public benefit corporation

It is important to note that articles of incorporation are only required to establish a regular corporation.
Limited liability corporations require what are referred to as articles of organization (or similar documents) to
register their business with a state. Some types of limited partnerships must also register with their state.
However, sole proprietorships do not have to register; for this reason, they are often the preferred
organizational structure for a person who is just starting out in business, at least initially.

Articles of incorporation provide the basic information needed to legally form the company and register the
business in its state. The state will need to know the name of the business, its purpose, and the people who
will be in charge of running it (the board of directors). The state also needs to know about any stock that the
business will be selling to the public. The websites of various secretaries of state will have information on the
different types of articles of incorporation, the requirements, and the filing process.

2.2 Relationship between Shareholders and Company Management

Learning Outcomes
By the end of this section, you will be able to:
• Explain the difference between principals and agents.
• List and discuss various stakeholders associated with a company and its operations.
• Explain how management impacts the operations and future of a company.

Stakeholders
A stakeholder is any person or group that has an interest in the outcomes of an organization’s actions.
Stakeholders include employees, customers, shareholders, suppliers, communities, and governments.
Different stakeholders have different priorities, and companies often have to make compromises to please as
many stakeholders as possible.

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 2.2 • Relationship between Shareholders and Company Management 45

Shareholders’ Roles and Composition

A shareholder or stockholder can be a person, company, or organization that holds stock in a given company.
Shareholders typically receive dividends if the company does well and succeeds. They are entitled to vote on
certain company matters and to be elected to a seat on the board of directors. One advantage of being a
shareholder is that creditors cannot compel shareholders to pay for any of the company’s financial obligations
or debts. However, being a shareholder includes responsibilities such as appointing the company’s directors,
deciding on director compensation, setting limits on directors’ power, and monitoring and approving the
company’s financial statements.

Types of Shareholders

There are two types of shareholders: common shareholders and preferred shareholders. Common
shareholders are any persons who own a company’s common stock. They have the right to control how the
company is managed, and they have the right to bring charges if management is involved in activities that
could potentially harm the organization. Preferred shareholders own a share of the company’s preferred stock
and have no voting rights or involvement in managing the company. Instead, they receive a fixed amount of
annual dividends, apportioned before the common shareholders are paid. Though both common shareholders
and preferred shareholders see their stock value increase with the positive performance of the company,
common shareholders experience higher capital gains and losses.

Shareholders and directors are two different entities, although a director can also be shareholder. The
shareholder, as already mentioned, is a part owner of the company. A director, on the other hand, is the
person hired by the shareholders to perform oversight and provide strategic policy direction to company
management.

The Differences between a Shareholder and a Stakeholder

The terms shareholder and stakeholder mean different things. A shareholder is an owner of a company
because of the shares of stock they own. Stakeholders may not own part of the company, but they are in many
ways equally dependent on the performance of the company. However, their concerns may not be financial.
For example, a chain of hotels in the United States that employs thousands of people has several classes of
stakeholders, including employees who rely on the company for their jobs and local and national governments
that depend on the taxes the company pays.

Before a company becomes public, it is a private company that is run, formed, and organized by a group of
people called subscribers. A subscriber is a member of the company whose name is listed in the
memorandum of association. Even when the company goes public or they depart from the company,
subscribers’ names continue to be written in the public register.

Role of Management
Corporations are run at the highest level by a group of senior managers referred to as the board of directors
(BOD). The BOD is ultimately responsible for providing oversight and strategic direction as well as overall
supervision of the organization at its highest managerial level. From an operational standpoint, the practical
day-to-day management of a company comprises of a team of several mid-level managers, who are
responsible for providing leadership to various departments in the company. Such managers may often have
different functional roles in a business organization. The primary roles of any management group involve
setting the objectives of the company; organizing operations; hiring, leading, and motivating employees; and
overseeing operations to ensure that company goals are continually being met.

It is also important that managers have a long-term focus on meeting growth targets and corporate
objectives. Unfortunately, there have been many examples of companies where the managerial focus was
shifted to short-term goals—quarterly or fiscal year earnings estimates or the current price of the company
stock—for personal reasons, such as increased bonuses and financial benefits. Such short-term thinking is
46 2 • Corporate Structure and Governance

often not in the best interest of the long-term health and objectives of companies or their shareholders.

2.3 Role of the Board of Directors

Learning Outcomes
By the end of this section, you will be able to:
• Describe the oversight functions performed by boards.
• Define an independent board member.
• Compare arguments for and against having independent board members.
• Describe ways boards can become diverse.

Functions of a Board of Directors

A board of directors is a group of people who are elected to represent shareholders, and these directors are
then ultimately responsible for running the company. Every public company is legally required to install a
board of directors. Nonprofit organizations and many private companies often establish a board of directors
as well, even if they are not legally required to do so.

The board is responsible for protecting shareholders’ interests, establishing management policies, overseeing
the corporation or organization, and making decisions about important issues. The board of directors acts as a
fiduciary for shareholders. The board is also tasked with a number of other responsibilities, including setting
company goals, creating dividend and stock option policies, hiring and firing chief executive officers (CEOs),
and ensuring that the company has the resources it needs to perform well.

Basic Structure of a Board of Directors

The bylaws of a company or organization determine the structure, responsibilities, and powers given to a
board of directors. The bylaws also determine how many board members there are, how the members are
elected, and how frequently the board members meet.

The board must represent shareholder and management interests, so it is best for the board to include both
internal and external members. Usually, there is an internal director and an external director. The internal
director is a member of the board who is involved with the daily workings of the company and manages the
interests of shareholders, officers, and employees. The external director represents the interests of those who
function outside of the company. The CEO often serves as the chairman of the company’s board of directors.

Figure 2.2 Corporate Boardroom (credit: “495 Express Lanes Board Room” by Fairfax County Chamber of Commerce/flickr, CC BY
2.0)

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 2.3 • Role of the Board of Directors 47

International Structure of a Board of Directors

The structure of a board of directors varies more outside of the United States. In Asia and the European Union,
there are commonly executive and supervisory boards. The executive board is made up of company insiders
who are elected by employees and shareholders. In most cases, the executive board is headed by the company
CEO or a managing officer. The supervisory board oversees daily business operations and acts much like a
typical US board of directors. The chair of the board varies, but the board is always led by someone other than
the prominent executive officer.

Oversight: Corporate Governance

Corporate governance is a discipline that focuses on how a company conducts its business and the various
controls that are implemented to ensure proper procedures and ethical behavior.

Although many companies and managers do operate with a fair and honest philosophy, others will try to
exploit the temporary benefits of actions that fall outside ethical behavior. Companies do not always adhere to
laws. You may have seen or read news stories about false reporting of earnings, failure to reveal financial
information, or payments of large bonuses to top executives shortly after a company files for bankruptcy.

In one infamous example, the insurance giant AIG paid for a lavish trip to California for top employees of the
company immediately after declaring that the company was insolvent. It asked for and received financial
2
support from the US government in the bailout of 2008.

At other times, a company may cross the line between legal and illegal and violate the law in order to increase
profits. Because of the potential for human self-interest and greed, governments have enacted laws and
regulations that require specific actions of a company or restrict its activities in an effort to ensure fair
competition and ethical behavior.

Often, Congress enacts laws and regulations in response to major economic or other highly visible events.
Following the great market crash of 1929, the US government created a new set of rules and regulations
governing the issuing and trading of securities, the Securities Act of 1933 and the Securities Exchange Act of
1934. The government also created the Securities and Exchange Commission (SEC) to oversee these laws
and regulations.

The new laws required that firms make available specific financial information to current owners and
prospective owners and that the SEC approve the initial sale of securities to the public. More recently,
following a series of major ethical lapses at some firms, the US government enacted new legislation in 2002.
One of the most sweeping acts is the Sarbanes-Oxley Act (SOX), which requires, among other things, the
following:

• That the CEO and chief financial officer (CFO) must attest to the fairness and accuracy of the company’s
financial reporting
• That the company implements and maintains an effective structure of internal controls responsible for the
reporting of financial results
• That the company and an external public accounting firm confirm the effectiveness of the controls over
the most recent fiscal year

In addition, SOX created the Public Company Accounting Oversight Board, outlining the prohibited activities of
auditors. It also set a requirement that the SEC issue new rulings that establish compliance with the act.

Board of Directors Oversight and Corporate Governance

Because of the widely publicized control breakdowns at Wells Fargo Bank and recent regulatory actions,
boards of directors of public companies and financial institutions have been directed to improve oversight and

2 Scott Vogel. “You Paid for It: AIG’s Retreat Destination, Up Close.” Washington Post. October 9, 2008.
http://voices.washingtonpost.com/travellog/2008/10/disaster_tourism_comes_to_cali.html
48 2 • Corporate Structure and Governance

corporate governance. Boards are evolving from focusing primarily on the needs of top key individuals to
considering broader aspects of ethics, values, and corporate culture. Boards now oversee the monitoring
systems being put in place and may take on direct responsibilities related to senior management.

The Role of the Audit Committee

A strong independent audit committee (AC) is an important part of the corporate governance efforts of any
firm. The AC is formed by the board of directors as a separately chartered subcommittee of the board of
directors. It reports regularly to the BOD and assists the board by assuming responsibilities for critical
corporate financial matters, such as reviewing audit plans and findings, approving external public accountants,
and coordinating the efforts of both internal and external financial reviews and audits. The audit committee
provides expertise in all financial and accounting matters for a company, and it is therefore a critical part of a
company’s corporate governance efforts.

Some important functions of the audit committee include

• confirming the accuracy of the firm’s financial reporting;

• verifying that systems of internal control and risk management are operating effectively;
• ensuring compliance with legal and regulatory requirements;
• verifying the qualifications, independence, and performance of the external public auditing firm; and
• coordinating the activities and performance of the internal audit function.

The role of the audit committee has significantly expanded over the years, and it has become exceedingly
important with the enactment of the Sarbanes-Oxley Act. Due to this increase in importance and recognition,
several boards have shifted some of the audit committee’s responsibilities to separately chartered committees
in order to create a balance of duties and ensure that those duties are effectively focused on and efficiently
executed. Some of these additional committees have been known to include a compensation committee, a
disclosure committee, and a governance committee, and they all have related objectives that need to be
documented within the charter of each of the individual committees. It is important for the different
committees to have close working relationships so that the audit committee can help each one fulfill its
responsibilities to senior management, the greater board of directors, shareholders, and other stakeholders.

The audit committee performs an internal audit to review the organization’s corporate governance process
and to communicate any recommendations for changes. The audit committee will usually follow up and
monitor the process put in place to implement any changes or necessary improvements. As with any other
corporate function, the audit committee’s role is greatly affected by the legal, institutional, financial, cultural,
and political circumstances that impact the company.

Importance of Improving Oversight and Governance

It is crucial to today’s corporate environment that firms do not lose sight of achieving and maintaining strong
and efficient oversight and governance. This is true despite the litany of other important items on the busy
agendas of most boards.

Keeping a focus on the critical ethics of management, as well as the traditional focus on the importance of
ethics to the overall organization, is not only timely in this day and age but also sound business practice. The
importance of establishing a comprehensive system of checks and balances cannot be overemphasized.
Beginning with the chief executive officer, these checks and balances need to progress through senior
management, and they ultimately include the board of directors itself. Similar checks and balances need to
then filter down though the rest of the entire firm. By taking the appropriate steps to improve corporate
oversight and governance, overall business risk can be mitigated and future operational problems reduced.
Additionally, such steps can lead to the positive effects of achieving sustainable operational and financial
benefits for a company and its shareholders.

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 2.3 • Role of the Board of Directors 49

LINK TO LEARNING

PepsiCo
PepsiCo is a global leader in the food and beverage industry. It has also been noted for its excellence in
corporate governance. Take a look at the PepsiCo website (https://openstax.org/r/pepsico). Why do you
think the company has won numerous awards and was featured in Fortune’s annual Blue Ribbon
Companies list for 2021?

The Importance of Independence in Boards of Directors

An independent board of directors is composed of individuals who have no material interest in the company
other than their directorship. They maintain their independence by only accepting compensation from the
company for their BOD services. They also have their own information sources, instead of relying on
information provided by senior management of the company. It is considered a corporate governance best
practice to have independent members serve on boards of directors for both publicly and privately held
companies.

In most cases, board members have no affiliation with activities or organizations that could result in conflicts
of interest. An example of this might be a scenario in which a board is considering the formation of a
partnership or alliance with an organization that is directly associated with one of its board members. In such
an instance, a director might be excused from participating in that decision process, particularly if it is clear
that it would lead to potential conflict.

A board with a majority of independent directors can bring expertise and objectivity, which

• helps assure ownership that the company is being run legally, ethically, and in the best interest of
shareholders;
• allows for both independence and objectivity regarding senior managerial representatives and limits
situations in which a key decision maker might have a vested interest or an “ax to grind”; and
• enables board members to advance discussions with no hidden agendas for self-advancement or other
self-profiting motives.

The Importance of Diversity in Boards of Directors

As mentioned earlier, diversity can be an important quality for any board of directors. Increasingly over recent
years, corporate management has begun to appreciate the value of diversity in boards of directors. This has
resulted in a significant increase in the total number of women and people of color in boardrooms in the
United States. However, many business observers believe that corporate governance practices have a long
way to go in this respect. Increasing representation has now grown to become a high priority for most
businesses and organizations around the world.

Board members face many challenges in making decisions effectively and efficiently as possible. Because of
such challenges, the potential objective of diversifying the boardroom competes with other worthy topics and
objectives such as improving cybersecurity, advancing customer service, identifying and reducing risk,
improving community relations, and positioning strategically within an industry. This has left corporate
governance experts and researchers in a situation where they find themselves “playing catch-up” to
adequately diversify.
50 2 • Corporate Structure and Governance

2.4 Agency Issues: Shareholders and Corporate Boards

Learning Outcomes
By the end of this section, you will be able to:
• Define the concept of agency costs.
• Discuss conflicts of interest between board members, company management, and employees.
• Define each component of ESG.
• Discuss the findings indicating how ESG policies impact stock returns.

Agency Problems and Issues

Agency problems refers to conflicts that occur when an agent (manager) who is entrusted with following the
interests of the principal (shareholder or owner) of an organization abuses their position to further their own
personal goals. In the field of corporate finance, agency problems are often related to a conflict of interest
between the management of a company and its shareholders.

For many years, this has been a very common problem that has been seen in nearly every kind of organization,
irrespective of it being a church, a club, a not-for-profit organization, a multinational corporation, or any other
government agency or institution. As with most problematic issues in business, agency problems can be
resolved, but only if organizations are willing to take the appropriate steps to resolve them.

Every company has its own set of goals and objectives, but it is important to note that the employee and
personal goals of managers may differ and may not align with the goals and objectives of stockholders
(ownership). Because these differences exist, and because all parties have a desire to maximize their own
wealth, agency problems can often arise, having a negative impact on company profits, stock price, and the
goodwill of the shareholder base.

There are three primary types of agency problems, discussed below.

CONCEPTS IN PRACTICE

Example of an Agency Problem

ABC Co. used to sell organic shampoo for $15, but the stockholders of ABC lobbied for an increase in the
selling price of the shampoo from $15 to $18. This was to increase earnings and, ultimately, their own
personal wealth through an uptick in stock price. However, as a result of this unnecessary rise in the price
of the shampoo, customers were disappointed, and a majority of them wound up boycotting the product.
Additionally, some of the consumers who continued to purchase the product noticed a decline in the overall
quality of the shampoo and were also very disappointed. In this scenario, agency problems surfaced
between stockholders and loyal customers of the company.

Stockholders versus Management

Large corporations typically have a substantial number of stockholders forming their ownership. It is essential
for an organization to separate the management of a company from this ownership in order to avoid this type
of agency problem.

Segregating ownership from management can be advantageous for an organization. Doing so will usually not
have any effects on normal business operations. At the same time, the company can employ different experts
and professionals to manage key operations of the business.

However, a drawback to this is that hiring outsiders may eventually become troublesome for shareholders.
External managers who are brought into a company may end up making self-serving decisions or even

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 2.4 • Agency Issues: Shareholders and Corporate Boards 51

misusing company funds. This could eventually result in declining bottom line results and company share
prices, which would then lead to conflicts of interests between stockholders and company management.

An example of an agency problem between management and shareholders occurred at WorldCom in 2001,
3
when their CEO used company assets to underwrite several personal loans. As a result of these inappropriate
actions, the company took on additional debt that negatively impacted WorldCom’s capital structure, liquidity,
and ultimately its stock price. From this example, we can see how individual greed on the part of agents,
executives, or corporate management can lead to significant agency problems.

Investors versus Creditors

If a company decides to engage in risky investments and projects in order to drive organizational profitability,
these increased risk levels could threaten the company’s ability to service (repay) their debts, leading to
possible default.

This additional risk could also result in creditors taking steps to devalue such debts, which in most cases refers
to company bond issues. In the end, if these riskier projects end up failing and the company loses money,
investors (bondholders) may also experience financial risk as bonds go into default or otherwise lose market
value. This then becomes a potential agency problem between bondholders (investors) and creditors.

Stockholders versus Other Stakeholders

Situations may arise in which stockholders of a firm find themselves in conflicts of interest with other
stakeholders of the company. For example, employees of a firm might be asking for a general wage increase.
If such a wage increase were voted down by stockholders, this could result in key employees departing the
organization, eventually leading to poorer business results and the dissatisfaction of other stakeholders in the
company as company profits decline. In such an example, we see the agency problem of stockholders versus
other stakeholders.

A more specific example of such an agency problem occurred in 2011, when Oregon-based food and gift
4
basket company Harry & David was forced to file for bankruptcy. This was a direct result of the company
being purchased through a leveraged buyout that left the company saddled with a tremendous amount of
debt. However, the most important factor leading to the company’s failure was the actions of Steven Heyer,
who was a friend of the new owners and had been hired as CEO. Heyer, who was awarded an exorbitant
executive salary, was also allowed to sink the company into further debt. Harry & David has since emerged
from bankruptcy under new leadership. But this example should serve as a cautionary tale of what can happen
when stockholders are able to put their interests ahead of those of other stakeholders in a corporate
environment.

CONCEPTS IN PRACTICE

Infamous Agency Problems

Enron

Enron is one particularly infamous example of an agency problem. Enron’s directors were responsible for
protecting and promoting investor interests, but they failed to carry out their regulatory and oversight
responsibilities, enabling the company to venture into illegal activity. The company’s resulting accounting
scandal resulted in billions of dollars in losses to its investors.

At one time, Enron had been one of the largest companies in the United States. Despite being a multibillion-

3 Anshita Kohli. “Worldcom Scam: The Fall of the Biggest US Telecommunication Company.” The Company Ninja. JD Learning
Ventures, May 26, 2020. https://thecompany.ninja/worldcom-scam/
4 Beth Kowitt. “Harry & David’s Failed Mr. Fix-It.” Fortune. April 1, 2011. https://fortune.com/2011/04/01/harry-davids-failed-mr-fix-
it/
52 2 • Corporate Structure and Governance

dollar company, Enron began losing money in 1997. It had also started incurring a tremendous amount of
debt. Fearing a drop in stock prices, Enron’s management team tried to disguise the problems by
misrepresenting them through inappropriate accounting methods, which resulted in confusing and
misleading financial statements.

Disaster started to unfold in 2001, when common stock prices fell from $90 to under $1 per share. The
company filed for bankruptcy in December 2001, and criminal charges were brought against several key
Enron employees, including former CEO Kenneth Lay and former CFO Andrew Fastow. Jeffrey Skilling was
subsequently named CEO in February 2001, but he ended up resigning six months later.

Bernard L. Madoff Investment Securities LLC

Ponzi schemes are common examples of the agency problem. Agency theory claims that a lack of
oversight and incentive alignment greatly contributes to these problems. Many investors fall into Ponzi
schemes thinking that taking fund management outside a traditional banking institution reduces fees and
saves money.

Even though established financial institutions reduce risk by providing oversight and enforcing legal
practices, some Ponzi schemes simply involve taking advantage of consumer suspicions about the banking
industry and financial markets. In this type of environment, the consumer cannot ensure that an agent is
acting in their best interest. Investments are made under limited or, in many cases, completely nonexistent
oversight.

Bernie Madoff’s scam is probably one of the most infamous examples of a Ponzi scheme. Madoff’s fraud
started with friends, relatives, and acquaintances in New York, but it ultimately grew to encompass major
charities such as Hadassah, universities such as Tufts and Yeshiva, institutional investors, and wealthy
families in Europe, Latin America, and Asia. The cash losses of Madoff’s scheme were recently estimated to
be between $17 billion and $20 billion. The returns he promised were higher than what most investment
firms and banks were offering—so promising that almost all of his investors ignored any concerns they may
have had and basically looked the other way. Madoff paid for any redemption requests with money that
had been newly invested.

Madoff’s Ponzi scheme fell apart when he could no longer pay his investors. He was criminally charged,
convicted, and given a 150-year prison sentence. Madoff died in April 2021 while serving his prison term.

(Sources: Diana B. Henriques. “Bernard Madoff, Architect of Largest Ponzi Scheme in History, Is Dead at
82.” New York Times. April 14, 2021. https://www.nytimes.com/2021/04/14/business/bernie-madoff-
dead.html; Chase Peterson-Withorn. “The Investors Who Had to Pay Back Billions in Ill-Gotten Gains from
Bernie Madoff’s Ponzi Scheme.” Forbes. April 14, 2021. https://www.forbes.com/sites/chasewithorn/2021/
04/14/the-investors-who-had-to-pay-back-billions-in-ill-gotten-gains-from-bernie-madoffs-ponzi-scheme/;
Adam Hayes. “The Agency Problem: Two Infamous Examples.” Investopedia. Dotdash, updated April 15,
2021. https://www.investopedia.com/ask/answers/041315/what-are-some-famous-scandals-demonstrate-
agency-problem.asp)

How to Resolve Agency Problems

Ultimately, agency problems result from the differences among the interests of a company’s management,
other stakeholders of the firm, and its ownership or stockholders. When perpetuated, these differences may
eventually result in lasting conflicts of interest. In order for companies to avoid such problems, it is imperative
that they address the underlying problems of these differences. This will help ensure that normal business
operations are not being adversely impacted by the agency problem.

While there is no surefire way to resolve all conflicts of interest and agency problems, some measures that can

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 2.4 • Agency Issues: Shareholders and Corporate Boards 53

help mitigate such issues include the following:

• Offering incentives to management for strong performance and ethical behavior

• Awarding decision makers with stock packages, commissions, and other long-term compensation
packages to encourage long-term thinking and matching of company objectives with shareholders’
priorities
• Penalizing poor performance, shortsightedness, and unethical behavior

The prevailing belief in agency theory is that when a business creates organizational incentives that encourage
hard work on projects that will benefit the company in both the short and long term, more employees will be
encouraged to act in the business’s best interest.

Another means of resolving agency problems is through a hostile takeover of the organization. Even the threat
of such a takeover may be effective in reducing or eliminating these conflicts of interest. A hostile corporate
takeover tends to unify and discipline a management or agent group, thus fostering a union of agent and
shareholder interests. When such a potential threat or outright ownership change is introduced to a company,
its managers are more likely to act in the best long-term interests of the shareholders in order to maintain
their leadership positions within the company.

By better aligning agent (management) and principal (ownership) goals, agency theory attempts to bridge any
gulfs among employees, employers, and stakeholders that are created by the principal-agent problem. While it
is recognized as being nearly impossible for companies to eliminate the ongoing agency problem, it is also
recognized that it is possible to minimize its negative effects.

Impact of ESG Ratings

In recent years, many publicly traded companies, as well as many that are privately owned, are being
evaluated and rated according to environmental, social, and governance (ESG) factors. These ratings and
evaluations are primarily conducted by third-party organizations. As a result, the investment community is
using these reports and ratings to an ever-increasing degree in order to measure and assess corporate ESG
factors and performance.

Environmental, social, and governance issues have become an important part of the investment community’s
evaluation of publicly traded companies. Each component of what is now referred to as ESG has equal
importance in ongoing corporate evaluations, as per Figure 2.3 below. It is critical for the senior management
of any corporation to stay abreast of any and all ESG issues as they arise and take immediate corrective action
when necessary.

Figure 2.3 Importance of ESG Factors to a Business Concern

ESG measurements and assessments have become very important to firms, as they often become the basis of
formal and informal buy recommendations by investment professionals. ESG ratings were originally developed
to assist in determining the general risk of ESG factors for any public company, but they have since grown to
become unique scores used by investors to gauge the potential attractiveness of investment in the subject
company. Because of the nature of these factors, firms that are rated with high ESG metrics are believed to
54 2 • Corporate Structure and Governance

represent superior investments and to have proactive management teams focused on creating long-term
value of company stock.

Thus, with investors increasingly using ESG scores to form their investment strategies, the consequences of a
poor rating can have a negative impact on a firm’s share price and result in substantial problems. In any case,
it is important to note that ESG is only a starting point from which it is possible to gather indicators on a
business and its direction. In the end, it does not present the entire story of a firm. Any investment decisions
about the company in question should include a significant amount of additional data.

2.5 Interacting with Investors, Intermediaries, and Other Market Participants

Learning Outcomes
By the end of this section, you will be able to:
• Define the investor relations function.
• Discuss how the investor relations office interacts with investors, regulators, and other corporate
stakeholders.
• Describe the topics most often discussed during a quarterly conference call.
• Explain how press release information impacts company stock prices.

Investor Relations
Within the general field of corporate public relations is a specific subdivision referred to as investor relations
(IR). IR involves elements of communication, marketing, and finance and is designed to control the flow of
information from the management of a public corporation to its investors and stakeholders.

Because the investment community plays such a critical role in the overall growth and success of any
corporation, it is imperative that firms maintain strong and open relationships with their shareholder or
potential investor audience. IR was developed to take responsibility for achieving and maintaining these
crucial relationships.

Investor relations are quite different from typical public relations practices. A firm’s IR group must work very
closely with the accounting and legal departments, as well as with members of the senior management team,
such as the CEO and CFO.

As might be expected, IR has far more regulatory obligations than standard public relations functions, largely
due to corporate reporting requirements enforced by the SEC and the International Financial Reporting
Standards (IFRS). IR became significantly more important in 2002, when the United States Congress passed
the Sarbanes-Oxley Act (SOX), also known as the Public Company Accounting Reform and Investor Protection
Act. This legislation resulted in requirements that dramatically increased the extent of financial reporting for
any publicly traded company. SOX was enacted in an attempt to prevent the occurrence of corporate financial
scandals such as the one notoriously committed by the Enron Corporation that we discussed earlier.

In summary, investor relations functions have responsibilities including, but not limited to,

• coordinating live shareholder meetings and press conferences;

• disseminating financial information to the investment community;
• conducting briefings to the financial analyst community;
• publishing the quarterly report and annual report; and
• addressing any issues that arise as a result of financial disclosure.

The best time to form an internal IR function or to engage an IR firm is when a company begins the process of
becoming publicly traded through an initial public offering, or IPO.

Quarterly Earnings Conference Calls

As a result of the Securities Exchange Act of 1934, all publicly traded companies are required to file certain

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 2.5 • Interacting with Investors, Intermediaries, and Other Market Participants 55

financial reports with the SEC. The underlying purpose of these requirements is to provide shareholders and
the investment community with important operational and financial information on a regular basis and in a
transparent manner. Reports filed with the SEC include the annual Form 10-K, quarterly Form 10-Qs, and
current periodic Form 8-Ks, in addition to proxy reports and certain shareholder and affiliate reporting
documents. Quarterly 10-Qs are an ongoing and regular reporting requirement of publicly traded companies
and are to be filed within 45 days following the end of each fiscal quarter.

Depending on a company’s size and the complexity of its operation, a firm is likely to issue an earnings press
release and conduct a conference call with the investment community within this same 45-day period. There
is no legal requirement for companies to do either of these things, but experts in IR view these
communications tools as best practice. They can add context and commentary to the reported financial
results.

It is important for companies to do their planning and not enter a quarterly earnings conference call
unprepared. There is a multitude of available resources for companies to analyze and review in preparation.
Among such resources are industry reports prepared by government agencies; the financial reports and
earnings calls of competing organizations, both within and outside of a company’s primary industry; and
financial research reports prepared by various covering analysts, who follow the specific company and are
employed by financial brokerage firms.

Investment Meetings and Conferences

Organizing the annual meeting of shareholders, investor roadshows, and investment conferences is no easy
task for any corporation, though all of these audience-facing events are critical to maintaining strong relations
with shareholders and the investment community. It is important to reach shareholders and investors on an
almost personal basis by crafting a successful and interesting investment story. For effective investor relations,
key messages supporting any ownership or potential investment case should be clear and consistent. These
key messages should be embedded within the company’s materials and should form the basis of
presentations, the corporate website, and annual reports. They should also be reinforced via concrete
examples during annual meetings, roadshows, and investor presentations.

Figure 2.4 Quarterly Investor Relations Presentation (credit: “MAPFRE” by Castilla y León Económica/flickr, CC BY 2.0)

Corporations have found that using senior management’s time efficiently is also important to investor
relations. By targeting the ownership and potential investing audience, senior executives can make the best
use of their time and improve their interactions with the investing public during these events. If smaller
companies outsource the investor meeting planning process, the third-party firm should be thoroughly
grounded in the client’s corporate culture.
56 2 • Corporate Structure and Governance

The most productive investor and shareholder meetings begin with a strong, understandable corporate
introduction and continue by delivering an engaging story that demonstrates the company’s successes, a
track record of growth, and the high probability of favorable future prospects. Additionally, it is important for a
company’s senior management to end any meeting with feedback from the investor audience and set
timelines for follow-up. There will always be times when something unexpected may happen and the addition
of information or impromptu changes to scheduled agendas may occur. It is at times like these when
understanding the body language and facial expressions of an audience can be critical in producing a
favorable outcome of the meeting.

It is unlikely that the decision to invest or to remain an investor will be made based on a single corporate
event, but impressions, good or bad, will certainly factor into such decisions over a period of time. Thus, it is
important for IR officers to understand the importance of follow-up communication with their audience.

Purposes of Corporate Press Releases

Press releases have always been a vital tool in the communications toolkit of an IR professional. Various social
media channels are also becoming increasingly popular for delivering company information and news.
However, the press release remains a standard medium for most companies to communicate corporate news,
results, and ideas.

Press releases can be written with various intentions. Whether to release financial information, unveil new
products or services, announce changes in management, or a host of other reasons, all communications have
a different objective. Not all press releases are created equally, and they have varying degrees of effectiveness.
Any press release should contain information in easy-to-understand language that is free of corporate jargon
and as concise as possible. Press releases may be viewed by multiple audiences, such as customers,
stakeholders, investors, potential investors, and the general public, which is vital to consider when drafting a
press release.

According to PR Newswire statistics, press releases that contain multimedia content have been known to
5
substantially increase press release views. Using infographics and charts where possible and relaying the key
messages in short, easy-to-digest points make a press release easier for the reader to take in. Quotes from
senior management can provide valuable insight, but they should not provide any new information; they
should simply extend or expand on a subject already mentioned and further back up a claim.

LINK TO LEARNING

Press Releases Approved by PR Newswire

Take a look at this press release on mobile drive-in movies during the COVID-19 pandemic
(https://openstax.org/r/mobile-drive-in-movies).

How would you judge this press release? Is it effective? Why or why not?

2.6 Companies in Domestic and Global Markets

Learning Outcomes
By the end of this section, you will be able to:
• Explain why corporations expand beyond domestic borders.
• Determine how different strategic decisions may influence corporate performance.

5 “Multimedia Content Distribution.” PR Newswire. Cision, accessed August 27, 2021. https://www.prnewswire.com/products/
multimedia-distribution-options.html

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 2.6 • Companies in Domestic and Global Markets 57

Important Differences among Domestic, International, and Global Organizations

If a company becomes global or multinational in scope, fundamental analysis of the organization by the
investment community can become more complex. In order to better understand a company, it is important to
determine what laws affect the company’s governance process and which set of accounting rules is used to
fashion its financial reports.

Domestic companies operate completely or for the most part within the borders of the United States. While
such organizations may import raw materials and supplies from other nations or end up exporting their
finished products to other countries around the world, in the end, these international activities represent only
a very small portion of their overall business activities.

Domestic companies are typically governed by US accounting and securities laws that have been established
by the SEC. Further, financial reporting for these domestic organizations is to be completed using Generally
Accepted Accounting Principles (GAAP).

International firms, while based in the United States, will typically maintain significant levels of international
investment and conduct operations that may be quite diverse, both geographically and culturally. For such
international firms, parent company accounting will usually adhere to GAAP standards. Conversely, non-US
subsidiaries of such international firms may be regulated by laws dictated by their host countries. These will
often differ significantly from those in the United States.

In recent years, accounting regulations in countries outside the United States have come under the jurisdiction
of International Financial Reporting Standards (IFRS). It should be noted that guidelines and regulations under
IFRS and those under GAAP can differ significantly. As a result of these regulatory differences, any specific
divergences in accounting or governance practices between foreign subsidiaries and a US parent company
should be clearly stated and disclosed in the parent company’s financial reports.

Global firms have substantial operations and investments in different countries (global markets), and they
may have no single center or basis of operational activity. In such cases, regulations for corporate governance
are usually determined by the laws of the country in which the parent company has been established. While
there are some global firms that report their financial statements according to GAAP standards, usually to
satisfy the informational needs of US investors, most global parent companies’ financials will adhere to IFRS
reporting standards.

Difference in Financial Reporting: GAAP versus IFRS

Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) were
designed with similar objectives in mind: to provide a common and structured set of guidelines to assist in the
preparation of accurate and unbiased financial reporting for public corporations.

Yet despite these commonalities in purpose, there are important differences between them. Among these are
differences in inventory accounting and reporting, guidelines for consolidation of subsidiaries, and the
accounting and reporting of minority interests.

LINK TO LEARNING

GAAP and IFRS

Learn more about US GAAP reporting from the SEC website (https://openstax.org/r/corpfin-manual), and
learn about international standards from the IFRS website (https://openstax.org/r/ifrs-org).

SEC Reporting and EDGAR

EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) is the primary system for collecting and
58 2 • Corporate Structure and Governance

indexing documents submitted by companies to the SEC under the Securities Act of 1933, the Securities
Exchange Act of 1934, the Trust Indenture Act of 1939, and the Investment Company Act of 1940.

LINK TO LEARNING

EDGAR System
The SEC’s EDGAR system (https://openstax.org/r/edgar-html) contains millions of corporate and individual
filings. It benefits investors, corporations, and the US economy overall by increasing the efficiency,
transparency, and fairness of the securities markets. The system processes about 3,000 filings per day,
serves up 3,000 terabytes of data to the public annually, and accommodates 40,000 new filers per year on
6
average.

6 “About EDGAR.” US Securities and Exchange Commission. Modified March 23, 2021. https://www.sec.gov/edgar/about

Access for free at openstax.org

 2 • Summary 59

Summary
2.1 Business Structures
The most common forms of business organizations are sole proprietorships, partnerships, corporations, and
hybrids. There are advantages and disadvantages to each type of organization involving ease of formation, tax
requirements, and personal liabilities. The most common type of organization for larger businesses is the
corporation, the establishment of which involves filing articles of incorporation.

2.2 Relationship between Shareholders and Company Management

A stakeholder is any individual or group that has an interest in the outcomes of an organization’s actions.
Shareholders are relevant to a corporation form of business because they own stock in the corporation. The
board of directors of a company is ultimately responsible to shareholders for effectively running the business.

2.3 Role of the Board of Directors

The board of directors acts as a fiduciary for shareholders. The board is also tasked with a number of other
responsibilities, including setting company goals, creating dividend and stock option policies, hiring and firing
CEOs, and ensuring that the company has the resources it needs to perform well. Diversity and experience
play important roles in corporate governance and in the strength and effectiveness of a board of directors.

2.4 Agency Issues: Shareholders and Corporate Boards

Issues and conflicts of interest might arise between shareholders (public ownership) and senior management,
including C-level executives and the board of directors. Although there is no definite way to resolve all conflicts
of interest, some measures that can help mitigate problems include offering incentives for strong
performance and ethical behavior and awarding decision makers with stock packages to encourage long-term
thinking.

2.5 Interacting with Investors, Intermediaries, and Other Market Participants

Investor relations are important to a company’s overall corporate governance strategy. Effective
communication that is straightforward, open, and free of potentially confusing corporate jargon has become a
critical component of a company’s image, overall message, and long-term success.

2.6 Companies in Domestic and Global Markets

Companies sometimes expand internationally, and there are advantages and disadvantages of such growth.
International or global expansion efforts require careful and efficient communication, planning, and financing.

Key Terms
agency theory a principle that is used to explain and resolve issues in the relationship between business
principals and their agents, most commonly between shareholders (principals) and company executives
(agents)
agent a person who acts on behalf of another person or group
annual meeting a meeting of the general membership and shareholders of a corporation; also known as an
annual general meeting (AGM)
annual report a document describing a public corporation’s operations and financial condition that must be
provided to shareholders once per year; also known as Securities and Exchange Commission (SEC) Form
10-K
articles of incorporation a set of formal documents filed with a government body to legally document the
creation of a corporation
board of directors (BOD) a group of people who jointly supervise the activities of an organization
C corporation a legal structure for a corporation in which the owners, or shareholders, are taxed separately
60 2 • Key Terms

from the entity

close (closely held) corporation a company that has only a limited number of shareholders
conference call a meeting or presentation conducted via telephone or internet to relay company
information to all interested parties, including institutional and individual investors, as well as buy-and-sell
side analysts; also known as an earnings conference call
corporate governance the system of rules, practices, and processes by which a firm is directed and
controlled
corporation a legal entity that is separate and distinct from its owners
domestic corporation (in state) a corporation incorporated under the laws of the country or state in which
it does business
Electronic Data Gathering, Analysis, and Retrieval system (EDGAR) the primary system for collecting and
indexing documents submitted by companies and others under the Securities Act of 1933, the Securities
Exchange Act of 1934, the Trust Indenture Act of 1939, and the Investment Company Act of 1940
ESG environmental, social, and governance (ESG) standards for a company’s operations that socially
conscious investors use to screen potential investments
foreign corporation (out of state or out of country) an existing corporation that conducts business in a
state or jurisdiction other than where it was originally incorporated
Generally Accepted Accounting Principles (GAAP) a common set of accounting principles, standards, and
procedures issued by the Financial Accounting Standards Board (FASB)
global markets economies or markets that are multinational in nature, spanning several different countries
or jurisdictions
hybrid form of business a limited liability company (LLC) or limited liability partnership (LLP) that combines
the characteristics of a corporation with those of a sole proprietorship or partnership
International Financial Reporting Standards (IFRS) accounting standards used by international
corporations, issued by the IFRS Foundation and the International Accounting Standards Board
investor a person or an entity, such as a firm or mutual fund, that invests capital with the expectation of
receiving financial returns
investor relations (IR) a strategic management responsibility that is capable of integrating finance,
communication, marketing, and securities law compliance to enable the most effective two-way
communication between a company and the financial community or other constituencies, which ultimately
contributes to a company’s securities achieving fair valuation
limited liability corporation (LLC) a US-specific form of a private limited company; a business structure that
can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a
corporation
limited liability partnership (LLP) a partnership in which some or all partners have limited liabilities; can
exhibit elements of both partnerships and corporations
non-stock corporation a corporation that does not have owners represented by shares of stock but typically
has members who are the functional equivalent of stockholders in a stock corporation (having the right to
vote, etc.); describes the vast majority of not-for-profit corporations
nonprofit (not-for-profit) corporation a legal entity that has been incorporated under the law of its
jurisdiction for purposes other than making profits for its owners or shareholders
partnership a formal arrangement by two or more parties to manage and operate a business and share its
profits and liabilities equally
press release an official statement delivered to members of the news media for the purpose of making an
announcement or otherwise providing information
principal the person with the highest authority or most important position in a company, organization,
institution, or group
professional corporation a form of corporate entity used by licensed professionals such as attorneys,
architects, engineers, public accountants, and physicians, which is regulated by special provisions in many
corporation statutes

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 2 • CFA Institute 61

public benefit corporation a specific type of Delaware general corporation that is owned by shareholders
who expect the company to make a profit and return some of that money to them in the form of dividends
quarterly report a document describing a public corporation’s operations and financial condition that must
be provided to shareholders four times per year; also known as Securities and Exchange Commission (SEC)
Form 10-Q
S corporation a closely held corporation that makes a valid election to be taxed under Subchapter S of
Chapter 1 of the Internal Revenue Code, which does not require such corporations to pay income taxes and
instead taxes owners as individuals
secretaries of state the state officials who head the agencies responsible for, among other functions, the
chartering of businesses (usually including partnerships and corporations) that wish to operate within their
state and, in most states, for maintaining all records on business activities within the state; also known as
secretaries of the commonwealth in Massachusetts, Pennsylvania, and Virginia
Securities and Exchange Commission (SEC) a large, independent agency of the United States federal
government whose primary purpose is to enforce laws against market manipulation; created following the
stock market crash of 1929 to protect investors and the national banking system
shareholder (stockholder) an individual or institution that legally owns one or more shares of the share
capital of a public or private corporation; may be referred to as members of a corporation
sole proprietor (and sole proprietorship) a form of business that is operated and run by a single individual,
known as the sole trader, with no legal distinction between the owner and the business entity
stakeholder a person with an interest or concern in a business
stock corporation a for-profit organization that issues shares of stock to shareholders (also known as
stockholders) to raise capital, with each share representing partial ownership of the corporation and
granting shareholders certain ownership rights to shape company policies
subscriber an initial shareholder of a company at the time of its incorporation whose name appears on the
memorandum of association, a legal document prepared in the formation and registration process of a
company to define its relationship with shareholders

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-institute-org). Reference with permission of CFA Institute.

Multiple Choice
1. An S corporation _______________.
a. is taxed in the same manner as a C corporation
b. is eligible for more efficient financing in the face of company growth than a C corporation
c. is usually more difficult to form than a C corporation
d. is not taxed at the corporate level, unlike a C corporation

2. An important advantage of a sole proprietorship is that _______________.

a. it is easier to raise capital under such a structure than under other organizational forms
b. it allows for an unlimited life of the business
c. it is relatively easy to create
d. Both a and b are correct.

3. A shareholder is someone who _______________.

a. sits on the audit committee of a firm
b. is an ex-employee of a company
c. profits from the favorable results of a company
62 2 • Multiple Choice

d. follows the company for an investment firm

4. Effective corporate governance includes all of the following EXCEPT _______________.

a. fairness
b. accountability
c. objectivity
d. higher share price

5. A stakeholder is someone who _______________.

a. is required to read a company’s annual report
b. answers to a board of directors
c. has a vested interest in a company’s success
d. is hired to do a specific job

6. “An effective business leader will recognize the social and environmental responsibilities of their business
as well as the eventual goal of achieving long-term, sustainable global development.” This statement
refers to _______________.
a. employing an experienced environmental consulting firm
b. the advantages of having an audit committee
c. having a diversified and well-experienced board of directors
d. practicing strong corporate governance

7. An important component of a strong board of directors (BOD) is having members who are _______________.
a. former employees of the company
b. able to write a strong corporate press release
c. culturally diverse and experienced in the industry
d. new to the industry and without preconceptions

8. Which of the following is NOT a reason why a company needs good corporate governance?
a. to avoid mismanagement of the company
b. to enable the company to raise capital more efficiently and mitigate financial and operational risk to
stakeholders
c. to analyze the company’s operations and systems of internal control in order to detect and prevent
various forms of fraud and other accounting irregularities
d. to increase the company’s overall accountability and prevent significant organizational problems

9. Who ultimately runs the company operations for a large corporation?

a. shareholders
b. board of directors
c. external auditors
d. stakeholders

10. One of the ways in which companies attempt to mitigate short-term managerial focus is by offering
managers _______________.
a. increased vacation time
b. increased paid sick leave
c. stock options
d. comprehensive health insurance

11. Which of the following are used to ensure fiduciary responsibility?

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 2 • Multiple Choice 63

a. audits
b. press releases
c. end-of-year financial ledgers
d. a letter from the board of directors

12. Which of the following is NOT one of the roles of an audit committee?
a. reviewing the work of the internal audit
b. reviewing systems of internal control.
c. ensuring that appropriate resources are used in company operations
d. launching special investigations of employees, company practices, or procedures

13. Which of the following is a major issue addressed in corporate governance?

a. improving banking relations
b. ethics and its implementation
c. improving profits for shareholders
d. expanding operations internationally

14. Agency problems are essentially _______________.

a. conflicts of interest
b. problems with the IRS
c. fraudulent business activities
d. nepotism

15. The term ESG, when used in the context of corporate governance, refers to which of the following?
a. earnings, shareholders, and governance
b. earnings, social, and general profit
c. environmental, social, and goals
d. environmental, social, and governance

16. Which of the following is the best method to ensure that shareholders are well informed of corporate
policies and financial results?
a. self-evaluation and training for members of the board of directors
b. hiring a prestigious independent public accounting firm
c. ensuring cultural diversity and public speaking eloquence of the senior management team
d. conducting well-organized shareholder meetings and conference calls with the investment
community

17. The Securities and Exchange Commission (SEC) requires that public corporations file which of the
following financial reports on a quarterly basis?
a. Form 10-K
b. Form 8-Q
c. Form 10-Q
d. Form Q

18. Investor relations has substantially more _______________.

a. regulatory obligations than standard public relations because of government-mandated financial and
legal requirements
b. personnel within a company dedicated to its function compared to other corporate departments
c. interpretations regarding its effective implementation and use than other managerial and financial
disciplines
64 2 • Review Questions

d. documented historical cases of corporate failure than other managerial and financial disciplines

19. The corporate press release is _______________.

a. no longer an important component of modern investor relations strategy
b. not yet a thing of the past, though it is highly likely to be replaced by social media in the near future
c. written by the chief financial officer in conjunction with the audit committee
d. best written to be easy to understand, free of corporate jargon, and as concise as possible

20. International firms are _______________.

a. headquartered in a non-US country but have homogeneous profit centers with little differentiation in
product or service
b. based in the United States but operate through the use of heavy investments outside the country via
multinational profit centers
c. larger and more complex than their domestic counterparts
d. more likely to be formed as partnerships or sole proprietorships than as corporations

Review Questions
1. What are the key differences between the potential life of a business that is formed as a sole
proprietorship and that of a business set up as a corporation?

2. What are the most common types of firms that are organized as limited liability partnerships?

3. What advantages does a sole proprietorship offer?

4. What are major disadvantages of a sole proprietorship?

5. If a company wishes to limit the liability of some of its investing partners, what form of business might it
consider? Explain briefly.

6. In order to form a corporation, what is the most important document required?

7. What is the difference between a shareholder and a stakeholder?

8. What group within a corporation has the primary responsibility for protecting the interests of
shareholders?

9. What is corporate governance?

10. What role does a corporation’s board of directors play in corporate governance?

11. Briefly explain the concept of corporate governance.

12. What is the key component of agency theory, and why might this be more important to a public company
than to one that is privately held?

Video Activity
Corporate Governance (Introduction)

Click to view content (https://openstax.org/r/corporate_governance)

1. a. Describe the five key responsibilities of the board of directors of a company. Why are each of these
responsibilities important to the operation of the organization as a whole?
b. Discuss important related concepts, such as establishing corporate objectives, determining
strategies to reach those objectives, providing leadership, supervising management of the business,
and reporting to shareholders on the status and operations of the business.

Access for free at openstax.org

 2 • Video Activity 65

c. Discuss why these responsibilities of the board of directors may be more important for a public
corporation than for a privately held company.

2. a. What are three essential best practices in corporate governance? Discuss important relevant
concepts, such as separation of duties, the need for non-executive directors, the importance of
board member independence from other executives, company operations, and financial ties, as well
as the importance of a non-executive audit committee.
b. Discuss why corporate governance is an ongoing process that must continuously be evaluated by a
company even after separation of duties, independence, and audit committees have been
established.

The Basics of Corporate Governance

Click to view content (https://openstax.org/r/the-basics-of-corporate-governance)

3. What is meant by LEARR in the context of governance codes? Discuss the various components that are
referred to in the LEARR acronym and why they are important to a company’s continuing operations.

4. Discuss the role of corporate governance in attempting to minimize agency problems and ensuring that a
company’s directors and management act in the best interest of the shareholders.
66 2 • Video Activity

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 3 • Why It Matters 67

3
Economic Foundations: Money and Rates

Figure 3.1 Every company is impacted by the global economy. (credit: "World Currency" by Kari/flickr, CC BY 2.0)

Chapter Outline
3.1 Microeconomics
3.2 Macroeconomics
3.3 Business Cycles and Economic Activity
3.4 Interest Rates
3.5 Foreign Exchange Rates
3.6 Sources and Characteristics of Economic Data

Why It Matters
1
American Airlines is one of the largest airlines in the world, flying to 350 destinations in 50 countries. The
managers of American Airlines are running a complex company. They have to be familiar with aeronautical
science, they have to know the laws and regulations impacting commercial air travel, and they must keep
abreast of global weather conditions. There is a lot to know about the airline industry itself.

However, operating a company such as American Airlines requires more than knowledge of the science and
technology of the industry. American Airlines does not operate in a vacuum. Like every company, it is impacted
by the economic environment in which it operates. American Airlines has to be familiar with how supply and
demand will impact fuel costs and other expenses. It must also be familiar with macroeconomic trends. During
periods of high unemployment, it may be difficult for the company to sell tickets to people wanting to travel to
vacation getaways. During periods of low unemployment, American Airlines may find it difficult to hire quality
workers at a wage rate it considers reasonable. Global economic conditions will also impact American Airlines;
as the economies of Europe expand rapidly, the euro will increase in value and impact the cost of items that
American Airlines purchases along its European routes.

In “Item 1A. Risk Factors,” beginning on page 16 of the 2019 annual report for American Airlines
(https://openstax.org/r/2019-annual-report-for-american-airlines), the company lists some of the ways that it

1 American Airlines. “American Airlines Group.” AA.com. Accessed October 25, 2021. https://www.aa.com/i18n/customer-service/
about-us/american-airlines-group.jsp
68 3 • Economic Foundations: Money and Rates

is impacted by macroeconomic and microeconomic conditions and the risks that these conditions place on the
company. In this chapter, we explore some of the economic concepts that managers should use as part of
their strategic plan.

3.1 Microeconomics
Learning Outcomes
By the end of this section, you will be able to:
• Identify equilibrium price and quantity.
• Discuss how changes in demand will impact equilibrium price and quantity.
• Discuss how changes in supply will impact equilibrium price and quantity.

Demand
Microeconomics focuses on the decisions and actions of individual agents, such as businesses or customers,
within the economy. The interactions of the decisions that businesses and customers make will determine the
price and quantity of a good or service that is sold in the marketplace. Financial managers need a strong
foundation in microeconomics. This foundation helps them understand the market for the company’s
products and services, including pricing considerations. Microeconomics also helps managers understand the
availability and prices of resources that are necessary for the company to create its products and services.

A successful business cannot just create and manufacture a product or provide a service; it must produce a
product or service that customers will purchase. Demand refers to the quantity of a good or service that
consumers are willing and able to purchase at various prices during a given time period, ceteris paribus (a
Latin phrase meaning “all other things being equal”).

Let’s consider what the demand for pizza might look like. Suppose that at a price of $30 per pizza, no one will
purchase a pizza, but if the price of a pizza is $25, 10 people might buy a pizza. If the price falls even lower,
more pizzas will be purchased, as shown in Table 3.1.

Price ($) Quantity

30 0
25 10
20 20
15 30
10 40
5 50

Table 3.1 Demand

Schedule for Pizza

The information in Table 3.1 can be viewed in the form of a graph, as in Figure 3.2. Economists refer to the line
in Figure 3.2 as a demand curve. When plotting a demand curve, price is placed on the vertical axis, and
quantity is placed on the horizontal axis. Because more pizzas are bought at lower prices than at higher prices,
this demand curve is downward sloping. This inverse relationship is referred to as the law of demand.

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 3.1 • Microeconomics 69

Figure 3.2 Demand Curve for Pizzas

The inverse relationship between the price of a good and the quantity of a good sold occurs for two reasons.
First, as you consume more and more pizza, the amount of happiness that one more pizza will bring you
diminishes. If you have had nothing to eat all day and you are hungry, you might be more willing to pay a high
price for a pizza, and that pizza will bring you a great deal of satisfaction. However, after your hunger has been
somewhat satisfied, you may not be willing to pay as much for a second pizza. You may only be willing to
purchase a third pizza (to freeze at home) if you can get it at a fairly low price. Second, demand depends not
only on your willingness to pay but also on your ability to pay. If you have limited income, then as the price of
pizza rises, you simply cannot buy as much pizza.

The demand curve is drawn as a relationship between the price of the good and the quantity of the good
purchased. It isolates the relationship between price and quantity demand. A demand curve is drawn
assuming that no relevant factor besides the price of the product is changing. This assumption is, as
mentioned above, ceteris paribus.

If another relevant economic factor changes, the demand curve can change. Relevant economic factors would
include consumer income, the size of the population, the tastes and preferences of consumers, and the price
of other goods. For example, if the price of hamburgers doubled, then families might substitute having a pizza
night for having a hamburger cookout. This would cause the demand for pizzas to increase.

If the demand for pizzas increased, the quantities of pizza purchased at every price level would be higher. The
demand schedule for pizzas might look like Table 3.2 after an increase in the price of hamburgers.

Price ($) Quantity

30 9
25 19
20 29
15 39
10 49
5 59

Table 3.2 Demand

Schedule for Pizzas
after the Price of
Hamburgers Doubles
70 3 • Economic Foundations: Money and Rates

This change leads to a movement in the demand curve—outward to the right, as shown in Figure 3.3. This is
known as an increase in demand. Now, at a price of $25, people will purchase 19 pizzas instead of 10; and at a
price of $15, people will purchase 39 pizzas instead of 30.

Figure 3.3 An Increase in Demand Represented as a Movement of the Demand Curve to the Right

A decrease in demand would cause the demand curve to move to the left. This could happen if people’s tastes
and preferences changed. If there were, for example, increased publicity about pizza being an unhealthy food
choice, some individuals would choose healthier alternatives and consume less pizza.

LINK TO LEARNING

Demand Curve Shifts

If any of the items that are assumed not to change when a demand curve is drawn do change, then the
demand curve can shift. To learn more about these changes in demand, watch the MRU video on demand
curve shifts (https://openstax.org/r/mru-video).

Supply
Supply is the quantity of a good or service that firms are willing to sell at various prices, during a given time
period, ceteris paribus. Table 3.3 is a fictional example of a supply schedule for pizzas. In some cases, higher
prices encourage producers to provide more of their product for sale. Thus, there is a positive relationship
between the price and quantity supplied.

Price ($) Quantity

30 60
25 50
20 40
15 30
10 20
5 10

Table 3.3 Supply

Schedule for Pizzas

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 3.1 • Microeconomics 71

The data from the supply schedule can be pictured in a graph, as is shown in Figure 3.4. Because a higher price
encourages suppliers to sell more pizzas, the supply curve will be upward sloping.

Figure 3.4 Supply Curve for Pizzas

The supply curve isolates the relationship between the price of pizzas and the quantity of pizzas supplied. All
other relevant economic factors are assumed to remain unchanged when the curve is drawn. If a factor such
as the cost of cheese or the salaries paid to workers changes, then the supply curve will move. A shift to the
right indicates that a greater quantity of pizzas will be provided by firms at a particular price; this would
indicate an increase in supply. A decrease in supply would be represented by a shift in the supply curve to the
left.

LINK TO LEARNING

Supply Curve Shifts

The ceteris paribus assumption is made when drawing a supply curve, just as it is when drawing a demand
curve. If a relevant economic variable other than the price of the good for which the supply curve is drawn
changes, the supply curve will shift. For more information about how changes in these variables will move
the supply curve, watch the MRU video on supply curve shifts (https://openstax.org/r/mru-video-on-
supply).

Equilibrium Price
Demand represents buyers, and supply represents sellers. In the market, these two groups interact to
determine the price of a good and the quantity of the good that is sold. Because both the demand curve and
the supply curve are graphed with price on the vertical axis and quantity on the horizontal axis, these two
curves can be placed in the same graph, as is shown in Figure 3.5.
72 3 • Economic Foundations: Money and Rates

Figure 3.5 Graph of Demand and Supply Showing Equilibrium Price and Quantity

The point at which the supply and demand curves intersect is known as the equilibrium. At the equilibrium
price, the quantity demanded will equal exactly the quantity supplied. There is no shortage or surplus of the
product. In the example shown in Figure 3.5, when the price is $15, consumers want to purchase 30 pizzas and
sellers want to make 30 pizzas available for purchase. The market is in balance.

A price higher than the equilibrium price will not be sustainable in a competitive marketplace. If the price of a
pizza were $20, suppliers would make 40 pizzas available, but the quantity of pizzas demanded would be only
20 pizzas. This would be a surplus, or excess quantity supplied, of pizzas. Restaurant owners who see that they
have 40 pizzas to sell but can only sell 20 of those pizzas will lower their prices to encourage more customers
to purchase pizzas. At the same time, the restaurant owners will cut back on their pizza production. This
process will drive the pizza price down from $20 toward the equilibrium price.

The opposite would occur if the price of a pizza were only $5. Customers may want to purchase 50 pizzas, but
restaurants would only want to sell 10 pizzas at the low price. Quantity demanded would exceed quantity
supplied. At a price below the equilibrium price, a shortage would occur. Shortages drive prices up toward the
equilibrium price.

LINK TO LEARNING

The Equilibrium Price

A competitive market will drive prices to equilibrium. For a more in-depth understanding of this process,
watch the MRU video on equilibrium price and quantity (https://openstax.org/r/mru-video-on-equilibrium).

THINK IT THROUGH

Graphing Demand and Supply

Consider the demand and supply schedules for sweatshirts shown below. Sketch a graph of demand and
supply, placing quantity on the horizontal axis and price on the vertical axis. What will the equilibrium price
for sweatshirts be? Table 3.4 provides the demand and supply schedules for the sweatshirts.

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 3.1 • Microeconomics 73

Demand Schedule for Sweatshirts Supply Schedule for Sweatshirts

Price ($) Quantity Price ($) Quantity
55 0 55 45
50 4 50 40
45 8 45 35
40 12 40 30
35 16 35 25
30 20 30 20
25 24 25 15
20 28 20 10
15 32 15 5
10 36 10 0
5 40

Table 3.4 Demand and Supply Schedules for Sweatshirts

Solution:

The demand curve for sweatshirts is the downward-sloping curve in Figure 3.6, showing the inverse
relationship between price and quantity demanded. The upward-sloping curve is the supply curve for
sweatshirts. The equilibrium price will be $30. At a price of $30, the quantity demanded of 20 sweatshirts
equals the quantity supplied of 20 sweatshirts.

Figure 3.6 Graph of Demand and Supply for Sweatshirts

Changes in Equilibrium Price

A price that is either too high (above the equilibrium price) or too low (below the equilibrium price) is not
sustainable in a competitive market. Market forces pull prices to the equilibrium, where they stay until either
supply or demand changes.

If supply increases and the curve moves outward to the right, as in Figure 3.7, then the equilibrium price will
fall. With the original supply curve, Supply1, the equilibrium price was $15; quantity demanded and quantity
supplied were both 30 pizzas at that price. If a new pizza restaurant opens, increasing the supply of pizzas to
74 3 • Economic Foundations: Money and Rates

Supply2, the equilibrium will move from Equilibrium1 to Equilibrium2 . The new equilibrium price will
be $10. This new equilibrium is associated with a quantity demanded of 40 pizzas and a quantity supplied of 40
pizzas.

Figure 3.7 Supply Curve Changes When Supply Increases An increase in supply leads to a lower equilibrium price and an increase
in quantity demanded.

It is important to note that the demand curve in Figure 3.7 does not move. In other words, demand does not
change. As the equilibrium price falls, consumers move along the demand curve to a point with a combination
of a lower price and a higher quantity. Economists call this movement an increase in quantity demanded.
Distinguishing between an increase in quantity demanded (a movement along the demand curve) and an
increase in demand (a shift in the demand curve) is critical when analyzing market equilibriums.

Equilibrium price will also fall if demand falls. Remember that a decrease in demand is represented as a shift
of the demand curve inward to the left. In Figure 3.8, you can see how a decrease in demand causes a change
from to .

Figure 3.8 A Decrease in Demand

At the new equilibrium, , the price of a pizza is $10. The new equilibrium quantity is 20 pizzas. Note that the
supply curve has not moved. Producers moved along their supply curve, producing fewer pizzas as the price
dropped; this is known as a decrease in quantity supplied.

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 3.1 • Microeconomics 75

THINK IT THROUGH

Graphing Demand
Suppose that the demand for sweatshirts in our previous example changes, and the demand schedule
becomes the data shown in Table 3.5.

Price ($) Quantity

55 18
50 22
45 26
40 30
35 34
30 38
25 42
20 46
15 50
10 54
5 58

Table 3.5 Demand

Schedule for
Sweatshirts

Has the demand for sweatshirts increased or decreased? Show this movement in a graph. What happens to
the equilibrium? What are some reasons you can think of that may have caused this change in demand?

Solution:

This is an increase in demand. At every price, consumers now want to purchase more sweatshirts than they
did before. This is shown in the graph as a movement of the demand curve outward to the right. Both the
equilibrium price and the equilibrium quantity will rise because of this increase in demand. The equilibrium
price will now be $40, and the equilibrium quantity of sweatshirts will be 30. Note that there is not an
increase in supply; the supply curve does not move. There is simply an increase in quantity supplied (see
Figure 3.9).
76 3 • Economic Foundations: Money and Rates

Figure 3.9 Graph Showing Increase in Sweatshirt Supply

A change in any of the factors that are assumed to be held constant under the ceteris paribus assumption
could have caused the demand curve to shift to the right. Perhaps a rise in consumers’ incomes led them to
purchase more clothing, including sweatshirts. Or an unseasonably cool fall could result in more people
purchasing sweatshirts. If a popular TV personality indicates that their favorite weekend wardrobe consists
of jeans and a sweatshirt and the tabloids run pictures of the celebrity wearing sweatshirts, the tastes and
preferences of consumers may change. Another possibility is that the price of sweaters may have risen,
causing people to substitute sweatshirts for sweaters.

3.2 Macroeconomics
Learning Outcomes
By the end of this section, you will be able to:
• Define inflation and describe historical trends in inflation.
• Define unemployment and describe how unemployment is measured.
• Define gross domestic product and describe historical trends in gross domestic product.

Inflation
Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation,
unemployment, and growth of production. When the managers of an automotive company look at the market
for steel and how the price of steel impacts the company’s production costs, they are looking at a
microeconomic issue. Rather than being concerned about individual markets or products, macroeconomics is
the branch of economic theory that considers the overall environment in which businesses operate.

Perhaps you have heard your parents talk about how much they paid for their first automobile. Or maybe you
have heard your grandparents reminisce about spending a quarter to purchase a Coke. These conversations
often turn to a discussion of how a dollar just doesn’t go as far as it used to. The reason for this is inflation, or
a general increase in price levels.

It is not that just the price of an automobile has increased or that the price of a Coke has increased. Over time,
the prices of many other things, from the salt on your table to college tuition, have increased. Also, you were
paid a higher hourly wage at your first job than your parents and grandparents were paid; the price of labor
has risen.

When economists talk about inflation, they are discussing this phenomenon of the price of many things rising.
Instead of tracking the price of one particular item, they consider the price of purchasing a basket of goods.

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 3.2 • Macroeconomics 77

Inflation means that the purchasing power of currency falls. Whenever there is inflation, a $100 bill will not
purchase as much as it did before.

LINK TO LEARNING

CPI Inflation Calculator

According to the US Bureau of Labor Statistics, $100 in January 1913 had the same purchasing power as
$1,722.45 in January 2000 and $2,699.20 in January 2021. If you would like to compare the purchasing power
of a dollar amount in two different time periods, you can use the CPI Inflation Calculator
(https://openstax.org/r/cpi-inflation-calculator). You can enter a current dollar amount and calculate its
value in an earlier period. Alternatively, you can calculate the current value of dollar amounts from years
ago.

How Is Inflation Measured

Each month, the US Bureau of Labor Statistics (BLS) collects price data and publishes measures of inflation.
The measure most commonly cited is the consumer price index (CPI). The CPI is based on the cost of buying
a fixed basket of goods and services comprising items a typical urban family of four might purchase. The BLS
divides these purchases into eight major categories: food and beverages, housing, apparel, transportation,
medical care, recreation, education and communication, and other goods and services.

Sometimes you will hear a core inflation index being quoted. This index is calculated by excluding volatile
economic variables, such as energy and food prices, from the CPI measure. Energy and food prices can jump
around from month to month because of weather or other short-lived events. A drought can cause food prices
to spike; a temporary rise in gasoline prices can occur as a hurricane approaches the coastline. These types of
shocks are transitory in nature and do not represent underlying economic conditions.

While the CPI and the core inflation index are based on the prices that households pay, the producer price
index (PPI) is based on prices that producers of goods and services pay for their supplies and raw materials.
The PPI captures price changes that occur prior to the retail level. Because it indicates rising costs to
producers, increases in the PPI can foreshadow increases in the CPI.

Both the CPI and the PPI are calculated by the BLS. The Bureau of Economic Analysis (BEA) also calculates a
measure of inflation known as the GDP deflator. The calculation of the GDP, or gross domestic product,
deflator follows a different approach than that used to calculate the CPI and the PPI. Instead of using a fixed
basket of items and measuring the price change of that fixed basket, the GDP deflator includes all of the
components of the gross domestic product. Prices are taken from a base year and used to calculate what the
GDP would have been in a given year if prices were identical to those in the base year.

LINK TO LEARNING

The Billion Prices Project

Although the concept of inflation as a rise in the general price level is simple, measuring and documenting
this increase is complicated. The CPI is designed to measure the cost of a market basket of goods that a
typical urban family purchases. But what the typical family purchases over time changes. As an item in the
basket becomes more expensive, families tend to substitute and replace the item with similar goods. Also,
the quality of goods changes over time. Think of how purchases in a typical household have changed over
the last two decades. Today, few families purchase answering machines, CDs, DVDs, or alarm clocks;
smartphones have replaced many such products. Smartphones are even used to make purchases for
78 3 • Economic Foundations: Money and Rates

delivery from an online retailer. Although keeping the items in the market basket constant allows
economists to focus on price changes, the market basket quickly becomes outdated and does not reflect a
typical family’s purchases.

In an attempt to provide new measures of inflation that better represent the changing basket of goods
purchased and the purchasing habits of families, Alberto Cavallo and Roberto Rigobon founded the Billion
Prices Project. Through this academic initiative at the Massachusetts Institute of Technology, prices are
collected daily from online retailers around the world. The Billion Prices Project website
(https://openstax.org/r/billion-prices-project) provides measures for inflation using this data as well as
research papers regarding macroeconomic research.

Historical Trends in the Inflation Rate

Inflation, as measured by the CPI for 1947–2020, is displayed in Figure 3.10. The graph shows that for the past
70 years, inflation has been the norm. Although inflation dipped into negative territory several times, each
period of negative inflation was short-lived. Also, you will notice that during the 1970s and early 1980s,
inflation was abnormally high; the inflation rate remained above 5% for approximately a decade. This was also
the only time period in which the US economy experienced double-digit inflation. By the mid-1980s, inflation
had fallen below 5%, and it has remained below 5% for much of the past 35 years.

2
Figure 3.10 Rate of Inflation Measured by the Consumer Price Index, 1947–2020

The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly
change in the price for goods and services paid by urban consumers between any two time periods. It can also
represent the buying habits of urban consumers. This particular index includes roughly 88% of the total
population, accounting for wage earners, clerical workers, technical workers, self-employed workers, short-
term workers, unemployed workers, retirees, and those not in the labor force.

The CPIs are based on prices for food, clothing, shelter, fuels, transportation fares, service fees (e.g., water and
sewer service), and sales taxes. Prices are collected monthly from about 4,000 housing units and
approximately 26,000 retail establishments across 87 urban areas. To calculate the index, price changes are
averaged with weights representing their importance in the spending of a particular group. The index
measures price changes (as a percent change) from a predetermined reference date. In addition to the
original unadjusted index distributed, the BLS also releases a seasonally adjusted index. The unadjusted series
reflects all factors that may influence a change in prices. However, it can be very useful to look at the

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 3.2 • Macroeconomics 79

seasonally adjusted CPI, which removes the effects of seasonal changes such as weather, the school year,
production cycles, and holidays.

The CPI can be used to recognize periods of inflation and deflation. Significant increases in the CPI within a
short time frame might indicate a period of inflation, and significant decreases in CPI within a short time frame
might indicate a period of deflation. However, because the CPI includes volatile food and oil prices, it might
not be a reliable measure of inflationary and deflationary periods. For more accurate detection, the core CPI,
or CPILFESL (https://openstax.org/r/fred-stlouisfed-org)—the CPIAUCSL minus food and energy—is often
used. When using the CPI, please note that it is not applicable to all consumers and should not be used to
determine relative living costs. Additionally, the CPI is a statistical measure vulnerable to sampling error
because it is based on a sample of prices and not the complete average.

Unemployment
Unemployment is a measure of people who are not working. For the individuals who find themselves without
a job, unemployment causes financial hardship. From a macroeconomics standpoint, unemployment means
that society has labor resources that are not being fully utilized.

Not everyone who is without a job is unemployed. To be considered unemployed, a person must be (1)
jobless, (2) actively seeking work, and (3) able to take a job. The official unemployment rate is the percentage
of the labor force that is unemployed. It is calculated as

Note that the unemployment rate is calculated as the percentage of the labor force that is unemployed, rather
than the percent of the total population. Only those who are currently employed or who meet the definition of
being unemployed are counted in the labor force. In other words, someone who is retired or a stay-at-home
parent and is not seeking employment is not counted as unemployed and is not part of the labor force.

The Bureau of Labor Statistics (BLS) of the US Department of Labor reports the unemployment rate each
month. These figures are attained through an interview process of 60,000 households conducted by the
Census Bureau. (See Figure 3.11 for a graphic representation of historical trends in unemployment from 1950
to early 2021.)

2 Data from US Bureau of Labor Statistics. “Consumer Price Index for All Urban Consumers: All Items in US City Average
(CPIAUCSL).” FRED. Federal Reserve Bank of St. Louis, accessed July 7, 2021. https://fred.stlouisfed.org/series/CPIAUCSL
80 3 • Economic Foundations: Money and Rates

3
Figure 3.11 Historical Trends in the Unemployment Rate by Year, 1950–2021 The unemployment rate represents the number of
unemployed as a percentage of the labor force. Labor force data are restricted to people 16 years of age and older who currently
reside in one of the 50 US states or the District of Columbia, who do not reside in institutions (e.g., penal or mental facilities, homes
for the aged), and who are not on active duty in the US Armed Forces.

LINK TO LEARNING

Unemployment around the World

The World Bank publishes unemployment figures for countries around the world. In 2020, the World Bank
figures showed that Cambodia had the lowest unemployment rate at 0.3% and that South Africa has the
highest unemployment rate at 28.7%. To compare the rates in various countries, visit the unemployment
statistics section (https://openstax.org/r/data-world-bank) of the World Bank website.

Gross Domestic Product

Gross domestic product (GDP) is a measure of the size of an economy. A country’s GDP is the dollar value of
all of the final goods and service produced within that country during a year. GDP measures the value of all of
the automobiles produced, apples grown, heart surgeries performed, students educated, and all other new
goods and services produced in a current year.

How Is GDP Measured?

GDP can be measured by adding up all of the items that are purchased in the economy. Purchases are divided
into four broad expenditure categories: consumption spending, investment, government spending, and net
exports. Consumption spending measures the items that households purchase, such as movie theater tickets,
4
cups of coffee, and clothing. Consumption expenditure accounts for about two-thirds of the US GDP.

Investment spending refers primarily to purchases by businesses. It is important to note that in this context,
the term investment does not refer to purchasing stocks and bonds or trading financial securities. Instead, the
term refers to purchasing new capital goods, such as buildings, machinery, and equipment, that will be used
to produce other goods. Residential housing is also included in the investment-spending category, as are
inventories. Products that producers make but do not sell this year (and so are not included in consumption

3 Data from US Bureau of Labor Statistics. “Unemployment Rate (UNRATE).” FRED. Federal Reserve Bank of St. Louis, accessed July
6, 2021. https://fred.stlouisfed.org/series/UNRATE
4 US Bureau of Economic Analysis. “GDP and the Economy: Advance Estimates for the First Quarter of 2020.” Survey of Current
Business 100, no. 5 (May 2020): 1–11. https://apps.bea.gov/scb/2020/05-may/0520-gdp-economy.htm

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 3.2 • Macroeconomics 81

spending) are included in this year’s GDP calculation through the investment component. The investment
spending category is roughly 15% to 18% of the US GDP.

Government spending includes spending by federal, state, and local governments. Federal spending would
include purchases of items such as a new military fighter jet and services such as the work of economists at
the BLS. State governments purchase products such as concrete for a new highway and services such as the
work of state troopers. Local governments purchase a variety of goods and services, such as books for the city
library, playground equipment for the community park, and the services of public school teachers. In the
United States, government spending accounts for nearly 20% of the GDP.

Some items that are produced in the United States are sold to individuals, businesses, or government entities
outside of the United States. For example, a bottle of Tabasco sauce produced in Louisiana may be sold to a
restaurant in Vietnam, or tires produced in Ohio may be sold to an auto producer in Mexico. Because these
items represent production in the United States, these exports should be included in the US GDP. Conversely,
some of the items that US consumers, businesses, and government entities purchase are not produced in the
United States. A family may purchase maple syrup from Canada or a Samsung television that was produced in
South Korea. A business may purchase a Toyota vehicle that was produced in Japan. These items are imported
from other countries and represent production in the country of origin rather than the United States. Because
we already counted these items when adding consumption, investment, and government spending, we must
subtract the value of imports in our GDP calculation. Net exports equals exports from the United States minus
imports from other countries. Including net exports in the GDP calculation adjusts for this international trade.

Historical Trends in GDP

US GDP over the past 70 years is represented by the blue line in Figure 3.12. At the turn of the millennium, the
yearly GDP of the United States was approximately $10 trillion. By 2020, the GDP exceeded $21 trillion,
5
indicating that the US economy had more than doubled in size in the first 20 years of the 21st century.

Because GDP is the market value of all goods and services produced, it can increase either because more
goods and services are being produced or because the market value of these goods and services is rising. If
100 cars were produced and sold for $30,000 each, that would contribute $3,000,000 to the GDP. If, instead, the
cars were sold for $33,000 each, the same 100-car production would contribute $3,300,000 to the GDP. The
$300,000 increase in GDP would be due simply to higher prices, or inflation.

Multiplying the current price of goods by the number of goods produced results in what is known as nominal
GDP. In order to determine what the actual increase in production is, nominal GDP must be adjusted for
inflation. This adjustment results in a calculation known as real GDP. To calculate real GDP, the amounts of
goods and services produced are multiplied by the price levels in a base year. Thus, real GDP will rise only if
more goods and services are being produced. The red line in Figure 3.12 represents the real GDP. Although its
growth has not been as large as that of nominal GDP, real GDP has also grown significantly over the past 70
years.

5 “GDP (Current US$): United States.” The World Bank. 2020. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US
82 3 • Economic Foundations: Money and Rates

6
Figure 3.12 Growth of the US GDP Gross domestic product (GDP), the featured measure of US output, is the market value of the
goods and services produced by labor and property located in the United States. Real gross domestic product is the inflation-
adjusted value of the goods and services produced by labor and property located in the United States. For more information, see the
NIPA Handbook: Concepts and Methods of the US National Income and Product Accounts and the US Bureau of Economic Analysis.

LINK TO LEARNING

US Bureau of Economic Analysis

The US Bureau of Economic Analysis, an agency of the Department of Commerce, produces economic
accounting statistics, including GDP. The agency’s economists and statisticians also produce measures of
state and local economies, foreign trade statistics, and industry data. To learn more about the US Bureau of
Economic Analysis and how it measures economic activity, visit the BEA website (https://openstax.org/r/
bea-website). You can find data regarding the GDP and economic growth in your state, as well as
international trade and industry statistics.

3.3 Business Cycles and Economic Activity

Learning Outcomes
By the end of this section, you will be able to:
• Outline the stages of the business cycle.
• Identify recessionary and expansionary periods.

What Is the Business Cycle?

Although the US economy has grown significantly over time, as seen in Figure 3.12, the growth has not
occurred at a constant, consistent pace. At times, the economy has experienced faster-than-average growth,
and occasionally the economy has experienced negative growth.

The percentage change in real GDP for each quarter is shown in Figure 3.13. For any quarter in which real GDP
is growing, the percentage change will be positive. When the growth rate of real GDP is negative, the economy

6 Data from US Bureau of Economic Analysis. “Gross Domestic Product (GDP).” FRED. Federal Reserve Bank of St. Louis, accessed
July 27, 2021. https://fred.stlouisfed.org/series/GDP

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 3.3 • Business Cycles and Economic Activity 83

is shrinking.

7
Figure 3.13 Quarterly Percentage Change in US Real GDP with Shading Representing Recessions

Figure 3.14 is an illustration of the growth of GDP over time. There has been a definitive long-term upward
trend in GDP, but it has not been in a straight line. Instead, the economy has expanded much like the curve;
periods of quick growth are followed by slower or even negative growth. These alternating growth periods are
known as the business cycle.

Figure 3.14 Growth of GDP and the Business Cycle

Stages of the Business Cycle

The business cycle consists of a period of economic expansion followed by a period of economic contraction.
During the period of economic expansion, GDP rises. Employment expands as businesses produce more;
conversely, unemployment falls. Other measures of economic growth may include increased new business
starts and new home construction. The economy is said to be “heating up.” As the expansion continues,
inflation often becomes a concern.

7 Data from US Bureau of Economic Analysis. “Gross Domestic Product (GDP).” FRED. Federal Reserve Bank of St. Louis, accessed
July 7, 2021. https://fred.stlouisfed.org/series/GDP
84 3 • Economic Foundations: Money and Rates

Fast-paced economic expansion is not sustainable. Eventually, growth slows and unemployment rises. The
economy has moved from expansion to contraction when this occurs. The point at which the business cycle
turns from expansion to contraction is known as the peak. The point at which the contraction ends and the
economy begins to expand again is known as the trough. The length of one business cycle is measured by the
time from one trough to the trough of the next cycle, as shown in Figure 3.15.

Figure 3.15 Stages of the Business Cycle

Often, the contraction is referred to as a recession. A private think tank, the National Bureau of Economic
Research (NBER), tracks the business cycle in the United States. The NBER is the entity that officially declares
recessions in the United States. Historically, a recession was defined as two consecutive quarters of declining
GDP. Today, the NBER defines a recession in a broader, less precise manner; it will declare a recession when
there is a significant decline in economic activity that is spread across the economy and lasts for at least a few
8
months. Measures of real income, employment, industrial production, and wholesale and retail sales are
considered in addition to real GDP.

LINK TO LEARNING

National Bureau of Economic Research

The National Bureau of Economic Research was founded in 1920 to create measures of economic activity
that could be used in public policy discussions. It is a private, nonpartisan organization that conducts
research that is followed by businesses and the public sector. You can find out more about the NBER and
view many of its research papers by visiting its website (https://openstax.org/r/nber-website).

Historical Trends
The NBER has identified business cycle peaks and troughs in data going back to the mid-19th century. Figure
3.16 lists each of these cycles, denoting the months of peaks and troughs. We see a repetition of the economic
behavior—an expansion, a peak, a recession, and a trough, followed by yet another expansion, peak,
recession, and trough. The cycles are events that repeatedly occur in the same order.

8 National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/
research/business-cycle-dating/business-cycle-dating-committee-announcements

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 3.3 • Business Cycles and Economic Activity 85

Figure 3.16 Peak and Trough Months of Historical Business Cycles (source: National Bureau of Economic Research)

However, the cycles are not identical; the lengths of the cycles vary greatly. On average, the contractions have
lasted about 17 months and expansions have lasted about 41 months. The typical business cycle has been
about 4.5 years long.
9
At the time of this writing, the United States is in an economic recession. The previous trough was in June
2009. From the summer of 2009 through February 2020, the US economy was in the expansionary phase of the
business cycle. This expansion peaked in February 2020, when the economy fell into a contractionary period
associated with the COVID-19 pandemic. This 128-month expansion is the longest expansion in US history.
Only two other expansions have lasted for over 100 months: the 120-month expansion that ran through the
1990s and the 106-month expansion that ran during the 1960s. The longest recessionary period on record is
the 65-month recession that occurred during the 1870s. The recession that began in 1929 was the second-
longest recession in US history. At 43 months long, this recession that ended in 1933 was so severe that it has
10
been called the Great Depression.

9 National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/
research/business-cycle-dating/business-cycle-dating-committee-announcements
86 3 • Economic Foundations: Money and Rates

3.4 Interest Rates

Learning Outcomes
By the end of this section, you will be able to:
• Explain the relationship between the nominal interest rate and inflation.
• Calculate the real rate of interest.
• Explain the relationship between interest rates and risk.

Market for Loanable Funds

An interest rate is the rental price of money. The concepts of supply, demand, and equilibrium apply in this
market just as they do in other markets. This market is referred to as the market for loanable funds.

In the market for loanable funds, the suppliers of funds are economic entities that currently have a surplus in
their budget. In other words, they have more income than they currently want to spend; they would like to
save some of their money and spend it in future time periods. Instead of just putting these savings in a box on
a shelf for safekeeping until they want to spend it, they can let someone else borrow that money. In essence,
they are renting that money to someone else, who pays a rental price called the interest rate.

The suppliers of loanable funds, also known as lenders, are represented by the upward-sloping curve in Figure
3.17. A higher interest rate will encourage these lenders to supply a larger quantity of loanable funds.

The demanders of funds in the loanable funds market are economic entities that currently have a deficit in
their budget. They want to spend more than they currently have in income. For example, a grocery store chain
that wants to expand into new cities and build new grocery stores will need to spend money on land and
buildings. The cost of buying the land and buildings exceeds the chain’s current income. In the long run, its
business expansion will be profitable, and it can pay back the money that it has borrowed.

The downward-sloping curve in Figure 3.17 represents the demanders of loanable funds, also known as
borrowers. Higher interest rates will be associated with lower quantities demanded of loanable funds. At lower
interest rates, more borrowers will be interested in borrowing larger quantities of funds because the price of
renting those funds will be cheaper.

Figure 3.17 Equilibrium in the Loanable Funds Market

The equilibrium interest rate is determined by the intersection of the demand and supply curves. At that
interest rate, the quantity supplied of loanable funds exactly equals the quantity demanded of loanable funds.
There is no shortage of loanable funds, nor is there any surplus.

10 National Bureau of Economic Research. “US Business Cycle Expansions and Contractions.” Last updated July 19, 2021.
https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions

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 3.4 • Interest Rates 87

Nominal Interest Rates

The nominal interest rate is the stated, or quoted, interest rate. If you want to borrow money to purchase a
car and the bank quotes an interest rate of 5.5% on a four-year auto loan, the 5.5% is the nominal interest rate.

Or suppose you have $1,000 you would like to place in a savings account. If the bank quotes an interest rate of
6% on its savings accounts, the 6% is a nominal interest rate. This means that if you place your $1,000 in a
savings account for one year, you will receive $60 in interest for the year. At the end of the year, you will have a
balance of $1,060 in your savings account—your original $1,000 plus the $60 in interest that you earned.

Real Interest Rates

Suppose you are deciding between saving your $1,000 for the year and using it to purchase a flat-screen TV.
The advantage of spending the money on the TV today is that you can enjoy watching programs on it over the
next year. The advantage of saving the money is that you will earn 6% nominal interest; in one year, you will
have $1,060 to spend.

If there is a 2% inflation rate, you would expect the TV that costs $1,000 today to cost $1,020 in one year. If you
save the $1,000, you will have $1,060 in one year. You could purchase the TV for $1,020 and have $40 left over;
then you could use the $40 to order pizza to celebrate the first big game you are watching on the new TV.

Your choice comes down to enjoying a TV today or enjoying a TV and $40 in one year. The $40 is your reward
for delaying consumption. It is your real return for saving money. The remaining $20 of the interest you
earned just covered the rate of inflation. This reward for delaying consumption is known as the real interest
rate. The real interest rate is calculated as

The real interest rate, rather than the nominal interest rate, is the true determinant of the cost of borrowing
and the reward for lending. For example, if a business had to pay 15% nominal interest rate in 1980, when the
inflation rate was 12%, the real cost of borrowing for the firm was 3%. The company would have had to pay $15
in interest each year for each $100 it borrowed, but $12 of that was simply compensating the lender for
inflation. In real terms, the business was only paying $3 to borrow $100.

In recent years, a business may have paid 6% interest to borrow money. This nominal rate is half of what it was
in 1980. However, inflation has been much lower. If inflation is 1% and the company pays 6% nominal interest,
that results in a 5% real interest rate. For every $100 the company borrows, it pays $6 in interest; $1 is
compensating for inflation, and the remaining $5 is the real cost of borrowing.

Risk Premiums
As we have discussed interest rates, we have talked about how the interest rate is determined by the demand
and supply of loanable funds. This tells us the underlying interest rate in the economy. You will notice,
however, if you look at the financial news, that there is more than one interest rate in the economy at any
given time.

Figure 3.18 shows the interest rates that three different types of borrowers have paid over the past 20 years.
The bottom line shows the interest rate that the US government paid to borrow money for a three-month
period. This rate is often referred to as the risk-free rate of interest. While theoretically it would be possible for
the US government to default and not pay back those people who have loaned money to it, the chances of that
are occurring are extremely low.

When someone borrows money, they enter into a contract to repay the money and the interest owed.
However, sometimes, certain circumstances arise such that the lender has a difficult time collecting the
money, even though the lender has the legal right to the money. For example, if a company goes bankrupt
after borrowing the money and before paying back the loan, the lender may not be able to collect what is due.
The chance that the lender may not be able to collect all of the money due at the time it is due is considered
88 3 • Economic Foundations: Money and Rates

credit risk. Lenders want to be rewarded for taking on this risk, so they charge a premium to borrowers who
are higher risk.

Companies are more likely to go bankrupt and not be able to pay their bills on time than is the US
government. So, corporations have to pay a higher interest rate than the US government. If a lender can earn
1% lending to the US government, the lender will only be willing to lend to the riskier corporation if they can
earn more than 1%. In Figure 3.18, the interest rates paid by very creditworthy companies is shown. The prime
rate is the interest rate that banks charge their very best customers—large companies that are financially very
strong and have a very low risk of default.

It is generally riskier for a lender to make a loan to an individual than to a corporation. Individuals are more
likely to become ill, lose their job, or experience some other financial setback that makes it difficult for them to
repay their loans. In Figure 3.18, the interest rate on credit card loans is much higher than the interest rate
charged to corporate borrowers. That is because credit card loans are a high risk to the lender. Unlike other
loans made to an individual, such as a car loan, the credit card company has no collateral if a consumer cannot
pay back the loan. With car loans, if the borrower fails to repay the borrowed money, the lender can repossess
the automobile and sell it to recoup some of the money it is owed. If you use a credit card to buy groceries and
do not repay the loan, the credit card company cannot repossess the groceries that you purchased. Therefore,
credit card loans have notoriously high interest rates to compensate the lender for the high risk.

11
Figure 3.18 Interest Rate on US Treasury Bills and Credit Cards This graph shows the rates posted by a majority of top 25 (by
assets in domestic offices) insured US-chartered commercial banks. The prime rate is one of several base rates used by banks to
price short-term business loans. For further information regarding Treasury constant maturity data, please refer to the Board of
Governors and the Treasury.

11 Data from Board of Governors of the Federal Reserve System (US). “Bank Prime Loan Rate (DPRIME).” FRED. Federal Reserve
Bank of St. Louis, accessed July 8, 2021. https://fred.stlouisfed.org/series/DPRIME; Board of Governors of the Federal Reserve System
(US). “3-Month Treasury Constant Maturity Rate (DGS3MO).” FRED. Federal Reserve Bank of St. Louis, accessed July 8, 2021.
https://fred.stlouisfed.org/series/DGS3MO; Board of Governors of the Federal Reserve System (US). “Commercial Bank Interest Rate
on Credit Card Plans, All Accounts (TERMCBCCALLNS).” FRED. Federal Reserve Bank of St. Louis, accessed July 8, 2021.
https://fred.stlouisfed.org/series/TERMCBCCALLNS

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 3.5 • Foreign Exchange Rates 89

3.5 Foreign Exchange Rates

Learning Outcomes
By the end of this section, you will be able to:
• Explain what it means for a currency to appreciate or depreciate.
• Define spot exchange rate.
• Explain the risks involved in translation exposure.

Spot Exchange Rate

An exchange rate is simply the price of a currency. If you live in the United States and are going on a trip to
Mexico, you will need pesos to pay for your food, hotel, and other items. You will need to purchase pesos.
Suppose that you go to your bank to purchase pesos. Suppose the bank tells you that it will cost $0.0625 to
purchase one Mexican peso. If you want to take 10,000 Mexican pesos with you on your trip, it will cost you
$625 to purchase the desired pesos.

In this example, the price of one peso is six and one-quarter cents. This price will often be written in the form
of

MXN is an abbreviation for the Mexican peso, and USD is an abbreviation for the US dollar. This price is known
as a currency exchange rate, or the rate at which you can exchange one currency for another currency.
Because this is the price you would pay to purchase Mexican pesos right now, it is known as the spot
exchange rate.

If you know the price of Mexican pesos in dollars, you can easily find the price of US dollars in Mexican pesos.
Simply divide both sides of the equation by 0.0625, or the price of a peso:

If you have Mexican pesos and you want to exchange them for dollars, you will be using the pesos to buy
dollars. Each US dollar will cost you MXN 16.

LINK TO LEARNING

Currency Conversion
Do you want to know how many British pounds your $100 would buy? Or would you like to see how much
that 10,000-yen-per-night hotel room will cost you in your home currency? You can enter the amount of one
currency in the MSN Money currency converter (https://openstax.org/r/currencyconverter) to see what the
equivalent amount is in another currency.

Currency Appreciation
Just as the price of gasoline changes, resulting in it costing more to purchase gasoline on some visits to the
gas station than on other visits, the price of a currency also changes. Currency appreciation occurs when it
costs more to purchase a currency than it did before.

If the next time you go to the bank to purchase pesos, the bank quotes an exchange rate of
, it means that it now costs $0.0800 (up from $0.0625) to purchase a Mexican peso.
Hence, the price of a peso has risen, or the peso has appreciated.
90 3 • Economic Foundations: Money and Rates

Currency prices are determined in the marketplace through the same types of supply-and-demand forces we
discussed earlier in this chapter. What would cause the peso to appreciate? Either an increase in the demand
for pesos or a decrease in the supply of pesos.

Currency Depreciation
Just as a currency can appreciate, it can depreciate. If the quote at the bank was , it
would only cost $0.0500 to purchase a Mexican peso. When it costs fewer dollars to purchase a peso, the peso
has depreciated. Either a decrease in demand for pesos or an increase in supply of pesos will cause the peso to
depreciate.

Because an exchange rate is the price of one currency expressed in terms of another currency, if one of the
currencies depreciates, the other currency must, by definition, appreciate. If it costs $0.0500 to purchase a
Mexican peso, the price of a US dollar, in terms of a Mexican peso would be calculated as

So, the price of one US dollar would be 20 Mexican pesos.

Exchange Rate Risk

Businesses that engage in international business face currency exchange rate risk. As exchange rates change,
a business can be impacted in a number of ways. One of these risks, transaction exposure, is the risk that the
value of a business’s expected receipts or expenses will change as a result of a change in currency exchange
rates. A pottery-making business that has sold merchandise to a company in the United States for $20,000, for
example, will need to exchange the $20,000 for pesos to be able to pay its workers and other expenses in
pesos. How many pesos it will receive for $20,000 will change depending on the exchange rate. If the exchange
rate is , the company will receive 320,000 pesos for the $20,000. If the exchange rate is
, the company will receive 400,000 pesos for the $20,000. Thus, as the peso depreciates (and
the US dollar appreciates), the same number of dollars will provide more pesos. Conversely, as the peso
appreciates (and the US dollar depreciates), the same number of dollars will provide fewer pesos.

Firms that hold assets in a foreign country also face translation exposure. When a company creates its
financial statements, items are reported using one currency. As foreign exchange rates change, the value of
how items are reported on these financial statements can change. This type of risk is an accounting risk.

Economic exposure is the risk that a change in exchange rates will impact a business’s number of customers
and sales. For example, tourists have the option of spending a week-long vacation at a resort in the United
States or in Mexico. As the dollar appreciates, US citizens can exchange their dollars for more pesos, resulting
in their purchasing power going further at a Mexican resort. Because an appreciating dollar also means a
depreciating peso, it would mean that Mexicans who earn pesos will receive fewer dollars when they exchange
their pesos. A Mexican who wants to stay at a $200-per-night hotel in Colorado will need more pesos to pay for
the room when the peso depreciates. The depreciating peso will likely mean that more Mexicans will spend
their vacation week in Mexico, and fewer will vacation in the United States.

Even businesses that do not view themselves as involved in international business can face economic
exposure. The ski lodge in Colorado will find that its customers from Mexico decrease when the dollar
appreciates. Likewise, when the dollar appreciates, some of the ski lodge’s US-based customers may choose
instead to visit a resort in Mexico, where their purchasing power is strong.

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 3.6 • Sources and Characteristics of Economic Data 91

3.6 Sources and Characteristics of Economic Data

Learning Outcomes
By the end of this section, you will be able to:
• Interpret economic data.
• Compute the percent change for economic variables.

FRED: Federal Reserve Economic Data

12
One of the largest sources of economic data is the Federal Reserve Economic Data (FRED) database. This
database is maintained by the Federal Reserve Bank of St. Louis and contains more than 765,000 economic
time series. These time series are compiled by the Federal Reserve and come from a number of sources,
including the Bureau of Labor Statistics and the US Census.

LINK TO LEARNING

FRED
Data included in the FRED database is divided into these broad categories:

• Money, Banking, and Finance

• Population, Employment, and Labor Markets
• National Accounts
• Production and Business Activity
• Prices
• International Data
• US Regional Data
• Academic Data

Watch this FRED introduction video (https://openstax.org/r/what-is-fred) to learn more information about
how to use FRED.

You can find statistics on employment, inflation, exchange rates, gross domestic product, interest rates, and
many other economic variables in the FRED database. Although much of the data is about the US markets,
macroeconomic data from other countries is also available. In addition to being viewable in graphical and text
form on the FRED site, the data is easily downloaded into an Excel spreadsheet for analysis.

LINK TO LEARNING

Creating a Stacked Area Graph

Not only does FRED provide an excellent source for economic data, but it allows users to create custom
graphs that can be used in presentations and reports. To learn more about how to create these graphs,
read this article on using stacking (https://openstax.org/r/fred-gdp-stacking). This tutorial provides step-
by-step instructions for creating a stacked area graph of real GDP and its separate components and a real
GDP area graph showing the percent that each of these components contributes to the total value of real
GDP.

12 Federal Reserve Bank of St. Louis. Economic Resources & Data. Accessed October 25, 2021. https://www.stlouisfed.org/
92 3 • Economic Foundations: Money and Rates

Levels versus Percentage Changes

The same information can be presented in graphs several different ways. The particular format you choose will
depend on how you are using the data.

Figure 3.19 shows the real GDP of Japan for 2010–2020. This chart is created showing the level of real GDP. The
steep drop in 2020 highlights the economic decline associated with the COVID-19 pandemic. Looking at the
chart, it is easy to see that after 10 years of a general upward trend, Japan’s GDP quickly fell to a level not seen
in the previous decade as COVID-19 began spreading in early 2020.

13
Figure 3.19 Real Gross Domestic Product for Japan, 2010–2020

The vertical axis in Figure 3.19 is measured in yen. Over the time period shown, the real GDP ranged from 500
trillion yen to 560 trillion yen. The general trend (until COVID-19) was upward, indicating growth in the
Japanese economy. However, the growth was not consistent from year to year.

Figure 3.20 also contains information about Japanese real GDP from 2010 to 2020. This chart measures the
percent change for each quarter on the vertical axis. It is created using the same underlying data as Figure
3.19. Figure 3.20 demonstrates a way of highlighting the growth (or contraction) of an economy at a particular
point in time.

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 3.6 • Sources and Characteristics of Economic Data 93

14
Figure 3.20 Percent Change for Gross Domestic Product for Japan, 2010–2020

The formula to calculate the percentage change from one quarter to the next is

In the first quarter of 2013, the real GDP for Japan was 522,594.2 billion yen. In the second quarter of 2013, the
real GDP had risen to 527,277.0 billion yen. Thus, the percentage change in real GDP from quarter one to
quarter two was

As long as the percentage change for a quarter is positive, the real GDP in Figure 3.20 will rise; this indicates
that the economy is growing. If the percentage change shown in Figure 3.20 is negative, then real GDP will fall;
this indicates that the economy is contracting. Looking at the percentage change in Figure 3.20 is helpful for
detecting when the economy is growing but the growth is slowing. If the percentage change is positive but
lower than it was for the previous quarter, then GDP is growing, but the growth rate is slowing.

Indexes
An index is created to track the performance of a particular aspect of the economy or the financial markets. An
index helps compare the level of a variable at one point in time relative to another point in time. Indexes are
often used when movement over time is more important than the absolute level of the variable at any one
point in time.

Earlier in this chapter, we looked at the rate of change in the CPI to measure the rate of inflation. In its raw
form, the CPI is an index. Remember that the CPI is a measure of the cost of a market basket of goods. When
the index is created, the total cost of the market basket, whether it is $300 or $950, is irrelevant. What
economists are interested in is the magnitude of the difference in cost of the same market basket at a later
date.

In order to focus on the change over time, a base year is identified. The cost of the market basket in the base

13 Data from JP, Cabinet Office. “Real Gross Domestic Product for Japan (JPNRGDPEXP).” FRED. Federal Reserve Bank of St. Louis,
accessed July 7, 2021. https://fred.stlouisfed.org/series/JPNRGDPEXP
14 Data from JP, Cabinet Office. “Real Gross Domestic Product for Japan (JPNRGDPEXP).” FRED. Federal Reserve Bank of St. Louis,
accessed July 7, 2021. https://fred.stlouisfed.org/series/JPNRGDPEXP
94 3 • Economic Foundations: Money and Rates

year is given an index level of 100. Let’s assume that the market basket costs $300 in the base year. If the same
basket of goods costs $330 the following year, then the index level the following year would be 110. The index
level increases by 10% when the cost of the market basket increases by 10%. This makes it easy to compare
different measures of inflation.

For example, suppose a market basket costs 40,000 yen in the first year and 42,000 yen in the second year. In
the base year, the CPI in Japan would be set at 100; the following year, the index would rise to 105 (because of
the 5% rise in the market basket cost). Comparing the levels of the index in Japan with the index in the United
States allows you to compare inflation trends in the two countries.

Table 3.6 contains the CPI for the United States, Japan, and Switzerland for each decade since 1970. A base year
of 1970 is used for all three countries, so the index level is 100 for all three countries in 1970. You can see that
Japan has experienced virtually no inflation for the last several decades. If the index level remains the same
from one year to the next, there is a zero rate of inflation. Negative rates of inflation, or deflation, would be
associated with a falling index level.

Year United States Switzerland Japan

1970 100.0 100.0 100.0
1980 212.3 162.3 232.5
1990 336.5 226.4 291.2
2000 443.5 278.2 322.1
2010 561.6 304.3 313.6
2020 666.6 302.3 331.8

Table 3.6 CPI Levels for the United States,

15
Switzerland, and Japan

Using an index level helps us compare the impact that inflation has had on the cost of living in the three
countries. Prices were rising rapidly in Japan in the 1970s, outpacing price increases in both the United States
and Switzerland. By the mid-1980s, however, price increases in Japan tapered off. Although prices in
Switzerland rose much more slowly in the 1970s, the price level continued to rise over the next couple of
decades. Even though the price increases have followed different patterns in Switzerland and Japan, the
overall price level today is about three times what it was in 1970 in both of those countries. However, the price
level in the United States has continued to rise; today, the price level in the United States is about seven times
higher than it was in in the 1970s.

15 Data from US Bureau of Labor Statistics. “Consumer Price Index for All Urban Consumers: All Items in US City Average
(CPIAUCNS).” FRED. Federal Reserve Bank of St. Louis, accessed July 31, 2021. https://fred.stlouisfed.org/series/CPIAUCNS;
Organization for Economic Co-operation and Development. “Consumer Price Index: All Items for Switzerland (CHECPIALLMINMEI).”
FRED. Federal Reserve Bank of St. Louis, accessed July 31, 2021. https://fred.stlouisfed.org/series/CHECPIALLMINMEI; Organization
for Economic Co-operation and Development. “Consumer Price Index of All Items in Japan (JPNCPIALLMINMEI).” FRED. Federal
Reserve Bank of St. Louis, accessed July 31, 2021. https://fred.stlouisfed.org/series/JPNCPIALLMINMEI

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 3 • Summary 95

Summary
3.1 Microeconomics
Microeconomics is the study of individual economic decision makers. In the marketplace, buyers and sellers
come together. The buyers are represented by a downward-sloping demand curve; lower prices are associated
with a larger quantity demanded. The sellers are represented by an upward-sloping supply curve; higher
prices are associated with a large quantity supplied. The point of intersection of the supply and demand curves
determines the equilibrium price and quantity.

3.2 Macroeconomics
Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation,
unemployment, and growth of production. The consumer price index is a common measure of inflation.
Unemployment equals the percent of the labor force that is without a job but looking for work. Gross domestic
product is a measure of the growth of production and growth of the economy.

3.3 Business Cycles and Economic Activity

The business cycle is the repeated pattern of the economy experiencing expansion, a peak, contraction, and a
trough. During the expansion, the economy is growing and real GDP is rising. During a contraction, also
known as a recession, the economy is slowing down.

3.4 Interest Rates

The interest rate is the rental price of money. The nominal interest rate is the quoted, or stated, rate of
interest. The real rate of interest equals the nominal interest rate minus the inflation rate. Lenders charge a
risk premium to compensate them for lending to higher-risk borrowers.

3.5 Foreign Exchange Rates

A foreign exchange rate is the price of a currency in terms of another currency. If a currency will purchase
more of a foreign currency than it would previously, the purchasing currency is said to have appreciated. If a
currency will purchase less of a foreign currency than it would previously, the purchasing currency is said to
have depreciated.

3.6 Sources and Characteristics of Economic Data

One of the most comprehensive sources of economic data is the FRED database, maintained by the Federal
Reserve Bank of St. Louis. Over 765,000 time series of data are available. In addition to being viewable in
graphical and text form on the FRED site, the data is easily downloaded into an Excel spreadsheet for analysis.

Key Terms
business cycle a period of economic expansion followed by economic contraction
ceteris paribus holding all other things constant
consumer price index (CPI) a measure of inflation based on the cost of a market basket of goods that a
typical urban family of four might purchase
core inflation index a measure of inflation that removes food and energy prices from the CPI
demand the quantity of a good or service that consumers are willing and able to purchase during a given
time period, ceteris paribus
economic exposure the risk that a change in exchange rates will impact a business’s sales and number of
customers
equilibrium the point at which the demand and supply curves for a good or service intersect
equilibrium price the price at which quantity demanded equals quantity supplied
expansion the part of the business cycle in which GDP is growing
96 3 • CFA Institute

GDP deflator a measure of inflation tracked by the Bureau of Economic Analysis, intended to measure what
GDP would be if prices did not change from one year to the next
gross domestic product (GDP) the market value of all goods and services produced within an economy
during a year
inflation a general increase in prices
law of demand the principle that the quantity of purchases varies inversely with price; the higher the price,
the lower the quantity
macroeconomics the study of the economy as a whole, focusing on unemployment, inflation, and total
output
microeconomics the study of the economy at the individual level, focusing on how individuals and
businesses choose to allocate scarce resources
nominal interest rate the quoted or stated interest rate
producer price index (PPI) a measure of the prices that producers of goods and services pay for their
supplies and raw materials
real interest rate the nominal interest rate minus the rate of inflation
recession the part of the business cycle characterized by contraction
spot exchange rate the price to immediately buy one currency in terms of another currency
supply the quantity of a good or service that firms are willing to sell in the market during a given time
period, ceteris paribus
transaction exposure the risk that the value of a business’s expected receipts or expenses will change as a
result of a change in currency exchange rates
translation exposure the risk that a change in exchange rates will impact the financial statements of a
company
unemployed members of the labor force who are not currently working but are actively seeking a job

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-study-session-4-economics). Reference with permission of CFA Institute.

Multiple Choice
1. Demand is the _______________.
a. amount of a good or service that consumers need
b. amount of a good or service that consumers want to purchase at the equilibrium price
c. quantity of a good or service that consumers want to purchase minus the amount that producers are
currently supplying
d. quantity of a good or service that consumers are willing to purchase at various prices over a given
time period, ceteris paribus

2. An increase in supply will lead to _______________.

a. a lower equilibrium price and a lower equilibrium quantity
b. a higher equilibrium price and a lower equilibrium quantity
c. a higher equilibrium price and a higher equilibrium quantity
d. a lower equilibrium price and a higher equilibrium quantity

3. An increase in the price of a basket of goods is known as _______________.

a. inflation
b. falling GDP
c. rising GDP

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 3 • Multiple Choice 97

d. a change in quantity demanded

4. The unemployment rate equals _______________.

a. the number of people unemployed divided by the labor force
b. the number of people seeking work divided by the adult population
c. the number of people unemployed divided by the number of people employed
d. the number of people unemployed plus the number of people working part-time divided by the adult
population

5. To be considered unemployed, an individual must be _______________.

a. out of work
b. actively seeking a job
c. able to work
d. All of the above

6. When measuring GDP, purchases are divided into the four broad categories of _______________.
a. interest rates, inflation, unemployment, and investment
b. demand, inflation, interest rates, and government spending
c. imports, exports, loanable funds, and government spending
d. consumer spending, investment, government spending, and net exports

7. A business cycle is measured from _______________.

a. one peak to the next trough
b. one trough to the next trough
c. one trough to the next peak
d. the time of the highest unemployment rate to the time of the lowest unemployment rate

8. Which of the following economic environments would most likely be associated with a recession?
a. Unemployment falling to 30-year low
b. GDP growing at an annual rate of 4.2%
c. Unemployment increasing from 5% to 9% during the year
d. New businesses opening in record numbers while new housing starts reach a 10-year high

9. The interest rate is the _______________.

a. rental cost of money
b. increase in the price of a market basket of goods
c. measure of economic activity
d. speed at which the money supply is increasing

10. If the nominal interest rate is 9% and the rate of inflation is 2%, the real rate of interest is approximately
_______________.
a.
b. 7%
c. 11%
d. 18%

11. A foreign exchange rate is _______________.

a. the rate of inflation in a foreign country
b. the amount of imports a country has relative to its exports
c. the price of one currency in terms of another currency
98 3 • Review Questions

d. the rate of unemployment in one country compared to the rate in another country

12. In 2020, the CPI in a country is 120. In 2021, the CPI in the same country is 126. This would mean that
inflation is _______________.
a. 5%
b. 6%
c. 26%
d. 46%

Review Questions
1. Explain the difference between an increase in demand and an increase in quantity demanded.

2. You see that price of laptop computers is falling at the same time that the quantity of laptop computers is
rising. Would you attribute this to a change in supply or a change in demand for computers? Explain.

3. Outline the stages of the business cycle.

4. Use a graph of the supply of loanable funds and demand for loanable funds to explain what will happen if
the Federal Reserve increases the money supply. What would you expect to happen to the interest rate
when this occurs?

5. Your bank offers you a car loan with an interest rate of 6%. You expect inflation to be 2%. What is the real
interest rate on this loan?

6. You see that First National Bank is willing to make you a four-year $40,000 car loan with an interest rate of
4.2%. However, the same bank will charge you 16.5% interest on a credit card that it issues. Why is the
interest rate on the credit card so much higher than the interest rate on the car loan?

7. Last year, the exchange rate between the Korean won and the US dollar was . This
year, the exchange rate is . Has the Korean won appreciated or depreciated over the
past year? Explain.

Problems
1. You are planning a budget for an upcoming trip to Japan. Your hotel will cost 12,000 yen per night, and you
will stay in the hotel for six nights. If the current exchange rate is , how much will the
hotel stay cost you in US dollars?

2. Visit the Federal Reserve Bank of St. Louis’s FRED site. Create a graph that plots the unemployment rate
for men and the unemployment rate for women since 1948. Turn recession shading on so that you can tell
when recession occurred. Are there any patterns that you detect when looking at your chart?

Video Activity
Should Investors Prepare for Inflation or Hyperinflation?

Click to view content (https://openstax.org/r/inflation-or-hyper-inflation)

Inflation is a general increase in the price level. If inflation is extremely high, hyperinflation is said to exist. The
video Should Investors Prepare for Inflation or Hyperinflation? by TD Ameritrade explores economic
conditions that existed in the spring of 2021 that led some economists to be concerned that investors should
be preparing for high inflation.

1. How might the Federal Reserve’s response to the economic conditions that existed in the wake of the
COVID-19 pandemic lead to a higher rate of inflation than the United States has experienced over the

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 3 • Video Activity 99

previous few decades?

2. What suggestions does the video provide to investors who want to protect the value of their savings from
being negatively impacted by inflation? Do some research to find out how much inflation has occurred
since the spring of 2021 and how an investor who followed the advice would have fared.

Unemployment Explained

Click to view content (https://openstax.org/r/unemployment-explained)

The video Unemployment Explained, produced by the International Monetary Fund (IMF), explores how
economists think about unemployment. The basic economic tools of supply and demand are used to explain
what causes unemployment. In this video, you will also learn about how economists categorize different types
of unemployment and why a zero rate of unemployment is not likely or even desirable.

3. List the types of unemployment presented in the video, giving an example of each type.

4. Choose three countries and find out what unemployment has been in each of those countries over the
past decade. Do you detect any patterns in the unemployment rates in those countries over time or across
the three different countries? Tell which type of unemployment you think has been most prevalent in each
country, and explain your reasoning.
100 3 • Video Activity

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 4 • Why It Matters 101

4
Accrual Accounting Process

Figure 4.1 Accrual accounting reports revenue when goods are delivered or services are performed but are not necessarily paid for.
(credit: modification of work "Reviewing Financial Statements" by Instructional Institutions)

Chapter Outline
4.1 Cash versus Accrual Accounting
4.2 Economic Basis for Accrual Accounting
4.3 How Does a Company Recognize a Sale and an Expense?
4.4 When Should a Company Capitalize or Expense an Item?
4.5 What Is “Profit” versus “Loss” for the Company?

Why It Matters
Emma, an accounting major, was on her way to her Wednesday morning accounting class with her friend Sam.
Sam, a finance major, kept complaining to Emma that he didn’t enjoy their accounting class at all. “Why do we
have to spend so much time worried about debits, credits, accounts, and all this other accounting jargon
anyway? I’m a finance major. I won’t be spending my days recording entries and counting pennies. I’m
dreading class today. I looked at the syllabus, we’re studying the accrual method. So what? Just give me the
financial statements so I have the data I need.”

Emma smiled at her friend and thought for a moment before responding. Emma loves the details of debits,
credits, and “all that other accounting jargon,” as Sam put it. She knows that while not everyone enjoys the
details or understands them, they do play a big role in the timing and accuracy of financial statements. “Yeah,
yeah, Sam, accounting isn’t always easy or fun, but it’s important. The financial statements you will use in
finance are a part of the foundation for many decisions. They are an important tool. Even though you don’t
have to create financial statements in a finance role, it’s still necessary to understand the accounting principles
they are based on. We haven’t covered the details yet, but I do know that income or loss in a period can be
significantly different if the income statement is prepared under cash versus accrual methods. I would think
that would be important to know if you are the one using the income statement.”
102 4 • Accrual Accounting Process

4.1 Cash versus Accrual Accounting

Learning Outcomes
By the end of this section, you will be able to:
• Outline the key concepts of the cash-basis accounting method.
• Explain the key characteristics of the accrual-basis accounting method.
• Identify businesses for which cash accounting or accrual accounting is more appropriate.

In this section, we will explore the basic elements of cash and accrual accounting and the businesses that are
most likely to use each one. Some private companies may choose to use cash-basis accounting rather than
accrual-basis accounting to report financial information.

Cash-Basis Accounting
In business, cash is certainly important. In fact, it’s so important that it dictates one of two ways we can
account for our business transactions. The cash method is just as the name implies—it records transactions
only when cash flows. We track cash inflows and outflows as they occur. This method is most commonly used
by small businesses that deal primarily in cash transactions. The other method, called the accrual method,
records transactions when they occur, rather than waiting for cash to be accumulated. Using the accrual
method, we match cash inflows and the outflows required to generate them. We call this the matching
principle. This method is used by most publicly traded companies. In this chapter, you’ll explore both methods,
see how each impacts financial statements differently, note the role of timing in each method, and learn how
and when to record capital and expense transactions.

Let’s look at an example. Chris just finished the first month of her landscaping business operations at the end
of August, and she used the cash method of accounting to figure out her net income. Most small start-up
companies use the cash method of accounting because it is easy to understand, requires no special training,
and helps them focus on one big key to their survival—cash. This means that she simply recorded the cash
that came in and the cash that went out of her business. She brought in $1,400 in revenue in her first month,
which she felt was substantial given that it was her first month. But after deducting her expenses, she had only
$250 left, so she worried about the future of her business. Would she have to increase her sales exponentially
in order to start bringing in a decent profit each month?

As you move through the chapter, you’ll get to see the impact of the two methods of accounting and how
these methods impact the insights and decisions Chris made for her new business.

Cash-basis accounting is a method of accounting in which transactions are not recorded in the financial
statements until there is an exchange of cash. Cash-basis accounting sometimes impacts the timing of
revenue and expense reporting until cash receipts or outlays occur. For example, as you saw above, Chris
measured the performance of her landscaping business for the month of August using cash flows. Cash
accounting is far simpler to track than accrual-basis accounting.

Accrual-Basis Accounting
Public companies reporting their financial positions use either US generally accepted accounting principles
(GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange
Commission (SEC) regulations. GAAP is a set of accounting standards created by the Financial Accounting
Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). It’s key to note that
though they are similar in many areas, there are still key areas that differ between GAAP and IFRS. Therefore,
when using financial statements, it’s important to be aware of the standards under which they were prepared.
However, public or private companies using GAAP or IFRS must prepare their financial statements using the
rules of accrual accounting. Accrual-basis accounting prescribes that revenues and expenses must be
recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or
payments occur. It is because of accrual accounting that we have the revenue recognition principle and the

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 4.1 • Cash versus Accrual Accounting 103

expense recognition principle (also known as the matching principle).

The accrual method is considered to better match revenues and expenses and standardizes reporting
information for comparability purposes. Having comparable information is important to external users of
information trying to make investment or lending decisions and to internal users trying to make decisions
about company performance, budgeting, and growth strategies.

Who Uses Each Method?

Cash-basis accounting can be more efficient and well-suited for certain types of businesses, such as farming or
professional services provided by lawyers and doctors. However, the accrual basis of accounting is
theoretically preferable to the cash basis of accounting because it takes into account the timing of the
transactions (when goods and services are provided and when the cash involved in the transactions is
received). Cash can often be received a significant amount of time after the initial transaction. Considering this
amount allows accountants to provide, in a timely manner, relevant and complete information to stakeholders.

There are several reasons accrual-basis accounting is preferred to cash-basis accounting. Accrual-basis
accounting is required by GAAP because it typically provides a better sense of the financial well-being of a
company. Accrual-based accounting information allows management to analyze a company’s progress, and
management can use that information to improve their business. Accrual accounting is also used to assist
companies in securing financing because banks will typically require a company to provide accrual-basis
financial income statements. The Internal Revenue Service requires businesses to report using accrual-basis
information when preparing tax returns. In addition, companies with inventory must use accrual-based
accounting for income tax purposes, though there are exceptions to the general rule.

So why might a company use cash-basis accounting? Companies that do not sell stock publicly can use cash-
basis instead of accrual-basis accounting for internal management purposes or because they are exempt from
such requirements in agreements such as a bank loan. Cash-basis accounting is a simpler accounting system
to use than an accrual-basis accounting system when tracking real-time revenues and expenses.

THINK IT THROUGH

Cash- or Accrual-Basis Accounting?

You are a new accountant at a beauty salon. The salon had previously used cash-basis accounting to
prepare its financial records but is now considering switching to an accrual-basis method. You have been
tasked with determining if this transition is appropriate.

When you go through the records, you notice that this transition will greatly impact how the salon reports
revenues and expenses. The salon will now report some revenues and expenses before it receives or pays
cash.

How will this change positively impact its business reporting? How will it negatively impact its business
reporting? If you were the accountant, would you recommend the salon transition from cash basis to
accrual basis?

Solution:

Accrual accounting creates a more accurate picture of profit or loss, so the salon’s owner can have a better
understanding of its profitability from period to period. However, it can be more work to record under
accrual accounting. If the salon is small and the profits and costs are easily understood, it might not be
worth the extra effort to the owner to use accrual-basis accounting. If the salon is seeking ways to better
understand profits and costs, accrual-basis accounting would be a great choice.
104 4 • Accrual Accounting Process

4.2 Economic Basis for Accrual Accounting

Learning Outcomes
By the end of this section, you will be able to:
• Assess the impact of business transactions on cash flow.
• Define double-entry accounting and explain how it supports the accounting equation.

How and when we record our transactions can have a significant impact on financial statements, especially the
income statement (net income). In this section you will explore the impact business transactions have on
financial statements under each method. In doing so, you’ll be introduced to double-entry accounting and
see how it functions to support the accounting equation.

Timing of Business Activity versus Cash Flow

The first financial statement prepared is the income statement, a statement that shows the organization’s
financial performance for a given period of time. We already saw that Chris, who is a sole proprietor, started a
summer landscaping business on August 1, 2020. She categorized her business as a service entity and used
the cash-basis method of accounting to record the initial operations for her business. Although Chris was
using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance
costs. So, on August 31, Chris realized she had only $250 in her checking account.

This balance was lower than expected because she had spent only slightly less ($1,150 for brakes, fuel, and
insurance) than she earned ($1,400)—leaving a net income of $250. While she would like the checking balance
to grow each month, she realized that most of the August expenses were infrequent (brakes and insurance)
and the insurance, in particular, was an unusually large expense. She knew that the checking account balance
would likely grow more in September because she would earn money from some new customers; she also
anticipated having fewer expenses.

This simple landscaping example can be used to discuss the elements of the income statement, which are
revenues, expenses, gains, and losses for a particular period of time (see Figure 4.2). Together, these
determine whether the organization has net income (where revenues and gains are greater than expenses
and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues, expenses,
gains, and losses are further defined in the Income Statement provided.

Figure 4.2 Income Statement for Chris’s Landscaping

The income statement can also be visualized by the formula:

Let’s change this example slightly and assume the $1,000 payment to the insurance company will be paid in

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 4.2 • Economic Basis for Accrual Accounting 105

September rather than in August. In this case, the ending balance in Chris’s checking account would be $1,250,
a result of earning $1,400 and only spending $100 for the brakes on the tractor and $50 for fuel. This stream of
cash flows is an example of cash-basis accounting because it reflects when payments are received and made,
not necessarily the time period that they affect. At the end of this section, you will address accrual accounting,
which does reflect the time period that payments affect.

The Accounting Equation

It may be helpful to think of the accounting equation from a “sources and claims” perspective. Under this
approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided
by owners. Stated differently, every asset has a claim against it—by creditors and/or owners.

You may recall from mathematics courses that an equation must always be in balance. Therefore, we must
ensure that the two sides of the accounting equation are always equal. We will explore the components of the
accounting equation in more detail shortly. First, we need to examine several underlying concepts that form
the foundation for the accounting equation: the double-entry accounting system, debits and credits, and the
“normal” balance for each account that is part of a formal accounting system.

THINK IT THROUGH

The Accounting Equation

On a sheet of paper, use three columns to create your own accounting equation. In the first column, list all
the things you own (assets). List only the asset itself; don’t worry about any associated liabilities (expenses)
in that column. In the second column, list any amounts owed (the liabilities). When you are done, total up
all the assets. Then total up all the liabilities.

Now, use the accounting equation to calculate the net amount of the asset (equity). To do so, subtract the
total assets from the total liabilities. This figure makes the accounting equation balance and represents
equity, or an estimate of your net worth.

Here is something else to consider: Is it possible to have negative equity? It sure is . . . ask any college
student who has taken out loans. At first glance there is no asset directly associated with the amount of the
loan. But is that, in fact, the case? You might ask yourself why you should make an investment in a college
education—what is the benefit (asset) to going to college? The answer lies in the difference in lifetime
earnings with a college degree versus without a college degree. This is influenced by many things, including
the supply and demand of jobs and employees. It is also influenced by the earnings for the type of college
degree pursued.

Solution:

Answers will vary but may include vehicles, clothing, electronics (include cell phones and computer/gaming
systems), and sports equipment. They may also include money owed on these assets, most likely vehicles
and perhaps cell phones. In the case of a student loan, there may be a liability with no corresponding asset
(yet). Responses should be able to evaluate the benefit of investing in college and the wage differential
between earnings with and without a college degree.

Let’s continue our exploration of the accounting equation, focusing on the equity component in particular.
Recall that we defined equity as the net worth of an organization. It is helpful to also think of net worth as the
accounting value of the organization. Recall, too, that revenues (inflows as a result of providing goods and
services) increase the accounting value of the organization. So every dollar of revenue an organization
generates increases the overall value of the organization.
106 4 • Accrual Accounting Process

Likewise, expenses (outflows as a result of generating revenue) decrease the value of the organization. So
each dollar of expenses an organization incurs decreases the overall value of the organization. The same
approach can be taken with the other elements of the financial statements:

• Gains increase the value (equity) of the organization.

• Losses decrease the value (equity) of the organization.
• Investments by owners increase the value (equity) of the organization.
• Distributions to owners decrease the value (equity) of the organization.
• Changes in assets and liabilities can either increase or decrease the value (equity) of the organization
depending on the net result of the transaction.

Let’s look at Chris’s Landscaping business again and do the same quick exercise you did with your personal
finances. If we were to total all of Chris’s assets, we would find just one: $250 in cash. She’s using the family’s
tractor, but she doesn’t own the tractor, so it is not her asset. Her liabilities are currently $0, as she paid cash
for all the expenses she incurred already. If we total her assets, we get $250. Liabilities total $0. Using the
accounting equation, we find her equity to currently be $250, or

Double-Entry Accounting
Accounting is based on a double-entry accounting system, which requires the following:

• Each time we record a transaction, we must record a change in at least two different accounts. Having two
or more accounts change will allow us to keep the accounting equation in balance.
• Not only will at least two accounts change, but there must also be at least one debit and one credit side
impacted.
• The sum of the debits must equal the sum of the credits for each transaction.

In order for companies to record the myriad of transactions they have each year, there is a need for a simple
but detailed system. Journals are useful tools to meet this need.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. The
graphic representation of a general ledger account is known as a T-account. It is called this because it looks
like a “T,” as you can see with the T-account shown in Figure 4.3.

Figure 4.3 T-Account

A debit records financial information on the left side of each account. A credit records financial information on
the right side of an account. One side of each account will increase, and the other side will decrease. The
ending account balance is found by calculating the difference between debits and credits for each account.
You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr,
respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate
each account type and its corresponding debit and credit effects in the form of an expanded equation (see
Figure 4.4).

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 4.3 • How Does a Company Recognize a Sale and an Expense? 107

Figure 4.4 Expanded Accounting Equation

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and
decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the
credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This
becomes easier to understand as you become familiar with the normal balance of an account.

The balance sheet is a reflection of the accounting equation (see Figure 4.5). It has two sections, assets in one
section and liabilities and equity in the other section. It’s key to note that both assets and liabilities are broken
down on the balance sheet into current and noncurrent classifications in order to provide more detail and
transparency. Current assets are those that are consumed within a year. Assets that will be in use longer than
a year are considered noncurrent. Current liabilities are those that will be due within a year. Noncurrent
liabilities are those that are due more than a year into the future.

Figure 4.5 Graphical Representation of the Accounting Equation Both assets and liabilities are categorized as current and
noncurrent. Also highlighted are the various activities that affect the equity (or net worth) of the business.

Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an “increase” side
and a “decrease” side. As you may recall, these are called T-accounts, and they are used to analyze
transactions.

The basic components of even the simplest accounting system are accounts and a general ledger. An account
is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in
the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a
company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s
accounts with their individual balances.

4.3 How Does a Company Recognize a Sale and an Expense?

Learning Outcomes
By the end of this section, you will be able to:
• Explain the revenue recognition principle and how it relates to current and future sales transactions.
• Explain the expense recognition principle and how it relates to current and future purchase transactions.
• Assess the role of ethics in revenue and expense recognition.

You’ve learned the basics of each method as well as the accounting equation and double-entry accounting.
Next, let’s turn our attention to when we record transactions, as timing is key.

Revenue Recognition
Revenue is the value of goods and services the organization sold or provided to customers for a given period
of time. In our current example, Chris’s landscaping business, the “revenue,” or the value of services
108 4 • Accrual Accounting Process

performed, for the month of August would be $1,400. It is the value Chris received in exchange for the services
provided to her clients. Likewise, when a business provides goods or services to customers for cash at the time
of the service or in the future, the business classifies the amount(s) as revenue. Just as the $1,400 revenues
from a business made Chris’s checking account balance increase, revenues increase the value of a business. In
accounting, revenue recognition involves recording sales or fees earned within the period earned. Just as
earning wages from a business or summer job reflects the number of hours worked for a given rate of pay or
payments from clients for services rendered, revenues (and the other terms) are used to indicate the dollar
value of goods and services provided to customers for a given period of time.

THINK IT THROUGH

Coffee Shop Products

Think about a coffee shop in your area. Identify items the coffee shop sells that would be classified as
revenues. Remember, revenues for the coffee shop are related to its primary purpose: selling coffee and
related items. Or, better yet, make a trip to the local coffee shop and get a first-hand experience.

Solution:

Many coffee shops earn revenue through multiple revenue streams, including coffee and other specialty
drinks, food items, gift cards, and merchandise.

Short-Term Revenue Recognition Examples

Two brief examples may help illustrate the difference between cash accounting and accrual accounting.
Assume that a business sells $200 worth of merchandise. In some businesses, there are two ways the
customers pay: cash and credit (also referred to as “on account”). Cash sales include checks and credit cards
and are paid at the time of the sale. Credit sales (not to be confused with credit card sales) allow the customer
to take the merchandise but pay within a specified period of time, usually up to 45 days.

A cash sale would be recorded in the financial statements under both the cash basis and accrual basis of
accounting. It makes sense because the customer received the merchandise and paid the business at the
same time. It is considered two events that occur simultaneously (exchange of merchandise for cash).

A credit sale, however, would be treated differently under each of these types of accounting. Under the cash
basis of accounting, a credit sale would not be recorded in the financial statements until the cash is received,
under terms stipulated by the seller. For example, assume that in the next year of Chris’s landscaping
business, on April 1, she provides $500 worth of services to one of her customers. The sale is made on account,
with the payment due 45 days later. Under the cash basis of accounting, the revenue would not be recorded
until May 16, when the cash was received. Under the accrual basis of accounting, this sale would be recorded
in the financial statements at the time the services were provided, April 1. The reason the sale would be
recorded is that, under accrual accounting, the business reports that it provided $500 worth of services to its
customer. The fact that the customers will pay later is viewed as a separate transaction under accrual
accounting (see Figure 4.6).

Figure 4.6 Credit versus Cash On the left is a credit sale recorded under the cash basis of accounting. On the right, the same credit
sale is recorded under the accrual basis of accounting.

Let’s now explore the difference between the cash basis and accrual basis of accounting using an expense.

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 4.3 • How Does a Company Recognize a Sale and an Expense? 109

Assume a business purchases $160 worth of printing supplies from a supplier (vendor). Similar to a sale, a
purchase of merchandise can be paid for at the time of sale using cash (also a check or credit card) or at a later
date (on account). A purchase paid with cash at the time of the sale would be recorded in the financial
statements under both cash basis and accrual basis of accounting. It makes sense because the business
received the printing supplies from the supplier and paid the supplier at the same time. It is considered two
events that occur simultaneously (exchange of merchandise for cash).

If the purchase was made on account (also called a credit purchase), however, the transaction would be
recorded differently under each of these types of accounting. Under the cash basis of accounting, the $160
purchase on account would not be recorded in the financial statements until the cash is paid, as stipulated by
the seller’s terms. For example, if the printing supplies were received on July 17 and the payment terms were
15 days, no transaction would be recorded until August 1, when the goods were paid for. Under the accrual
basis of accounting, this purchase would be recorded in the financial statements at the time the business
received the printing supplies from the supplier (July 17). The reason the purchase would be recorded is that
the business reports that it bought $160 worth of printing supplies from its vendors. The fact that the business
will pay later is viewed as a separate issue under accrual accounting. Table 4.1 summarizes these examples
under the different bases of accounting.

Transaction Under Cash-Basis Accounting Under Accrual-Basis Accounting

Recorded in financial statements at time of Recorded in financial statements at time
$200 sale for cash
sale of sale
$200 sale on Not recorded in financial statements until Recorded in financial statements at time
account cash is received of sale
$160 purchase for Recorded in financial statements at time of Recorded in financial statements at time
cash purchase of purchase
$160 purchase on Not recorded in financial statements until Recorded in financial statements at time
account cash is paid of purchase

Table 4.1 How Transactions Are Viewed under Cash and Accrual Accounting

Businesses often sell items for cash as well as on account, where payment terms are extended for a period of
time (for example, 30 to 45 days). Likewise, businesses often purchase items from suppliers (also called
vendors) for cash or, more likely, on account. Under the cash basis of accounting, these transactions would not
be recorded until the cash is exchanged. In contrast, under accrual accounting, the transactions are recorded
when the transaction occurs, regardless of when the cash is received or paid.
110 4 • Accrual Accounting Process

CONCEPTS IN PRACTICE

Ethics in Revenue Recognition

Because each industry typically has a different method for recognizing income, revenue recognition is one
of the most difficult tasks for accountants, as it involves a number of ethical dilemmas related to income
reporting. To provide an industry-wide approach, Accounting Standards Update No. 2014-09 and other
related updates were implemented to clarify revenue recognition rules. The American Institute of Certified
Public Accountants (AICPA) announced that these updates would replace US GAAP’s current industry-
specific revenue recognition practices with a principle-based approach, potentially affecting both day-to-
1
day business accounting and the execution of business contracts with customers. The AICPA and the
International Federation of Accountants (IFAC) require professional accountants to act with due care and to
remain abreast of new accounting rules and methods of accounting for different transactions, including
revenue recognition.

The IFAC emphasizes the role of professional accountants working within a business in ensuring the quality
of financial reporting: “Management is responsible for the financial information produced by the company.
As such, professional accountants in businesses therefore have the task of defending the quality of financial
2
reporting right at the source where the numbers and figures are produced!” In accordance with proper
revenue recognition, accountants do not recognize revenue before it is earned.

CONCEPTS IN PRACTICE

Gift Card Revenue Recognition

Gift cards have become an essential part of revenue generation and growth for many businesses. Although
they are practical for consumers and are a low cost for businesses, navigating revenue recognition
guidelines can be difficult. Gift cards with expiration dates require that revenue recognition be delayed until
customer use or expiration. However, most gift cards now have no expiration date. So when do you
recognize revenue?

Companies may need to provide an estimation of projected (or deferred) gift card revenue and usage
during a period based on past experience or industry standards. There are a few rules governing reporting.
If a company determines that a portion of all the issued gift cards will never be used, it may write this off to
income. In some states, if a gift card remains unused, in part or in full, the unused portion of the card is
transferred to the state government. It is considered unclaimed property for the customer, meaning that
the company cannot keep these funds as revenue because, in this case, they have reverted to the state
government.

Expense Recognition
An expense is a cost associated with providing goods or services to customers. In our opening example, the
expenses that Chris incurred totaled $1,150 (consisting of $100 for brakes, $50 for fuel, and $1,000 for
insurance). You might think of expenses as the opposite of revenue, in that expenses reduce Chris’s checking
account balance. Likewise, expenses decrease the value of the business and represent the dollar value of costs
incurred to provide goods and services to customers for a given period of time.

1 American Institute of Certified Public Accountants (AICPA). “Revenue Recognition.” n.d. https://www.aicpa.org/interestareas/frc/
accountingfinancialreporting/revenuerecognition.html
2 Len Jui and Jessie Wong. “Roles and Importance of Professional Accountants in Business.” China Accounting Journal. October 21,
2013. https://www.ifac.org/news-events/2013-10/roles-and-importance-professional-accountants-business

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 4.4 • When Should a Company Capitalize or Expense an Item? 111

THINK IT THROUGH

Coffee Shop Expenses

While thinking about or visiting a coffee shop in your area, look around (or visualize) and identify items or
activities that are the expenses of the coffee shop. Remember, expenses for the coffee shop are related to
resources consumed while generating revenue from selling coffee and related items. Do not forget about
any expenses that might not be so obvious—as a general rule, every activity in a business has an associated
cost.

Solution:

Costs of the coffee shop that might be readily observed would include rent, wages for the employees, and
the cost of the coffee, pastries, and other items/merchandise that may be sold. In addition, costs such as
utilities, equipment, and cleaning or other supplies might also be readily observable. More obscure costs of
the coffee shop would include insurance, regulatory costs such as health department licensing, point-of-
sale/credit card costs, advertising, donations, and payroll costs such as workers’ compensation,
unemployment, and so on. There are also unseen costs, such as aging of the building (if owned by the
coffee shop) and wear and tear or aging of the equipment.

4.4 When Should a Company Capitalize or Expense an Item?

Learning Outcomes
By the end of this section, you will be able to:
• Define the key characteristics of a fixed asset.
• Explain how the cost of a fixed asset is spread throughout its useful life via depreciation.
• Assess the impact to net income of expensing versus capitalizing an item.

Assets are items a business owns. For accounting purposes, assets are categorized as current versus long term
and tangible versus intangible. Any asset that is expected to be used by the business for more than one year is
considered a long-term asset. These assets are not intended for resale and are anticipated to help generate
revenue for the business in the future. Some common long-term assets are computers and other office
machines, buildings, vehicles, software, computer code, and copyrights. Although these are all considered
long-term assets, some are tangible and some are intangible.

To better understand the nature of fixed assets, let’s get to know Liam and their new business. Liam is excited
to be graduating from their MBA program and looks forward to having more time to pursue their business
venture. During one of their courses, Liam came up with the business idea of creating trendy workout attire.
For their class project, they started silk-screening vintage album cover designs onto tanks, tees, and yoga
pants. They tested the market by selling their wares on campus and were surprised how quickly and how often
they sold out. In fact, sales were high enough that they decided to go into business for themselves. One of
their first decisions involved whether they should continue to pay someone else to silk-screen their designs or
do their own silk-screening. To do their own silk-screening, they would need to invest in a silk screen machine.

Liam will need to analyze the purchase of a silk screen machine to determine the impact on their business in
the short term as well as the long term, including the accounting implications related to the expense of this
machine. Liam knows that over time, the value of the machine will decrease, but they also know that an asset
is supposed to be recorded on the books at its historical cost. They also wonder what costs are considered part
of this asset. Additionally, Liam has learned about the matching principle (expense recognition) but needs to
learn how that relates to a machine that is purchased in one year and used for many years to help generate
revenue. Liam has a lot of information to consider before making this decision.
112 4 • Accrual Accounting Process

What Is a Fixed Asset?

An asset is considered a tangible asset when it is an economic resource that has physical substance—it can
be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term,
such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be
used in the normal operation of the business for more than one year, be of material value, and not be near the
end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is
the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets. It’s
also key to note that companies will capitalize a fixed asset if they have material value. A $10 stapler to be
used in the office, for example, may last for years, but the value of the item is not significant enough to
warrant capitalizing it.

Businesses typically need many different types of these assets to meet their objectives. These assets differ
from the company’s products. For example, the computers that Apple, Inc. intends to sell are considered
inventory (a short-term asset), whereas the computers Apple’s employees use for day-to-day operations are
long-term assets. In Liam’s case, the new silk screen machine would be considered a long-term tangible asset
as they plan to use it over many years to help generate revenue for their business. Long-term tangible assets
are listed as noncurrent assets on a company’s balance sheet. Typically, these assets are listed under the
category of Property, Plant, and Equipment (PP&E), but they may be referred to as fixed assets or plant assets.

Apple, Inc. lists a total of $36.766 million in total Property, Plant, and Equipment (net) on its September 2020
consolidated balance sheet (see Figure 4.7). As shown in the figure, this net total includes land and buildings,
machinery, equipment and internal-use software, and leasehold improvements, resulting in a gross PP&E of
$103.526 million—less accumulated depreciation and amortization of $66.760 million—to arrive at the net
amount of $36.766 million.

3
Figure 4.7 Apple’s Property, Plant, and Equipment, Net (September 2020, in $ million) This report shows the company’s
consolidated financial statement details as of September 30, 2020, and September 30, 2019.

THINK IT THROUGH

Classifying Assets and Related Expenditures

You work at a business consulting firm. Your new colleague, Milan, is helping a client company organize its
accounting records by types of assets and expenditures. Milan is a bit stumped on how to classify certain
assets and related expenditures, such as capitalized costs versus expenses. They have given you the
following list and asked for your help to sort through it. Help your colleague classify the expenditures as
either capitalized or expensed, and note which assets are property, plant, and equipment.

Expenditures:

• Normal repair and maintenance on the manufacturing facility

• Cost of taxes on new equipment used in business operations
• Shipping costs on new equipment used in business operations
• Cost of a minor repair on existing equipment used in business operations

Assets:

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 4.4 • When Should a Company Capitalize or Expense an Item? 113

• Land next to the production facility held for use next year as a place to build a warehouse
• Land held for future resale when the value increases
• Equipment used in the production process

Solution:

Expenditures:

• Normal repair and maintenance on the manufacturing facility: expensed

• Cost of taxes on new equipment used in business operations: capitalized
• Shipping costs on new equipment used in business operations: capitalized
• Cost of a minor repair on existing equipment used in business operations: expensed

Assets:

• Land next to the production facility held for use next year as a place to build a warehouse: property,
plant, and equipment
• Land held for future resale when the value increases: investment
• Equipment used in the production process: property, plant, and equipment

Why are the costs of putting a long-term asset into service capitalized and written off as expenses
(depreciated) over the economic life of the asset? Let’s return to Liam’s start-up business as an example. Liam
plans to buy a silk screen machine to help create clothing that they will sell. The machine is a long-term asset
because it will be used in the business’s daily operation for many years. If the machine costs Liam $5,000 and it
is expected to be used in their business for several years, GAAP require the allocation of the machine’s costs
over its useful life, which is the period over which it will produce revenues. Overall, in determining a company’s
financial performance, we would not expect that Liam should have an expense of $5,000 this year and $0 in
expenses for this machine for future years in which it is being used. GAAP addressed this through the expense
recognition (matching) principle, which states that expenses should be recorded in the same period with the
revenues that the expense helped create. In Liam’s case, the $5,000 for this machine should be allocated over
the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur.
As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated
costs on the income statement over the asset’s economic life. Therefore, when Liam purchases the machine,
they will record it as an asset on the financial statements (see journal entry in Figure 4.8).

Figure 4.8 Journal Entry for Machine/Cash

When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This
includes additional costs beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees.
For example, if a real estate broker is paid $8,000 as part of a transaction to purchase land for $100,000, the
land would be recorded at a cost of $108,000.

Over time, as the asset is used to generate revenue, Liam will need to depreciate recognize the cost of the
asset.

3 In the Chapter 4 financial statements, a number contained within parentheses is a negative number, such as the “Accumulated
depreciation and amortization” line item.
114 4 • Accrual Accounting Process

What Is Depreciation?
When a business purchases a long-term asset (used for more than one year), it classifies the asset based on
whether the asset is used in the business’s operations. If a long-term asset is used in the business’s
operations, it will belong in property, plant, and equipment or intangible assets. In this situation, the asset is
typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet
and its allocated costs are expensed on the income statement over the asset’s economic life.

Long-term assets that are not used in daily operations are typically classified as an investment. For example, if
a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would
be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which
the business conducts no operations (and assuming no current or intermediate-term plans for development),
the land would be considered an investment.

Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time
that the business believes it will use the asset to help generate revenue.

Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the
cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when
you purchase or acquire a long-term asset, it must be recorded at the historical (initial) cost, which includes all
costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as
property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an
outflow of cash.
2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Depreciation
expense is the amount of the asset’s cost to be recognized, or expensed, in the current period. Companies
may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s
estimated useful life.

Recording the Initial Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare
the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes,
installation, and modifications to the asset.

The journal entry to record the purchase of a fixed asset (assuming that a note payable, not a short-term
account payable, is used for financing) is shown in Figure 4.9.

Figure 4.9 Journal Entry for Fixed Asset

Applying this to Liam’s silk-screening business, we learn that they purchased their silk screen machine for
$54,000 by paying $10,000 cash and the remainder in a note payable over five years. The journal entry to
record the purchase is shown in Figure 4.10.

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 4.4 • When Should a Company Capitalize or Expense an Item? 115

Figure 4.10 Journal Entry for Equipment/Cash

CONCEPTS IN PRACTICE

Estimating Useful Life and Salvage Value

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and
expected that the estimates are inaccurate due to the uncertainty involved in estimating the future.
Sometimes, however, a company may attempt to take advantage of estimating salvage value and useful life
to improve earnings. A larger salvage value and longer useful life decrease annual depreciation expense
and increase annual net income. An example of this behavior is Waste Management, which was disciplined
by the SEC in March 2002 for fraudulently altering its estimates to reduce depreciation expense and
4
overstate net income by $1.7 billion.

Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful
life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we
would allocate the cost and record depreciation expense across the entire five-year period. The calculation of
the depreciation expense for a period is not based on anticipated changes in the fair-market value of the
asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its
useful life.

The following items are important in determining and recording depreciation:

• Book value: the asset’s original cost less accumulated depreciation.

• Useful life: the length of time the asset will be productively used within operations.
• Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life
expires. The determination of salvage value can be an inexact science since it requires anticipating what
will occur in the future. Often, the salvage value is estimated based on past experiences with similar
assets.
• Depreciable base (cost): the depreciation expense over the asset’s useful life. For example, if we paid
$50,000 for an asset and anticipate a salvage value of $10,000, the depreciable base is $40,000. We expect
$40,000 in depreciation over the time period in which the asset was used, and then it would be sold for
$10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset
from the balance sheet. The journal entry to record depreciation is shown in Figure 4.11.

4 United States Securities and Exchange Commission. “Waste Management, Inc. Founder and Five Other Former Top Officers Sued
for Massive Earnings Management Fraud.” March 26, 2002. https://www.sec.gov/litigation/litreleases/lr17435.htm
116 4 • Accrual Accounting Process

Figure 4.11 Journal Entry for Depreciation Expense

Depreciation expense is a common operating expense that appears on an income statement. It represents the
amount of expense being recognized in the current period. Accumulated depreciation, on the other hand,
represents the sum of all depreciation expense recognized to date, or the total of all prior depreciation
expense for the asset. It is a contra account, meaning it is attached to another account and is used to offset
the main account balance that records the total depreciation expense for a fixed asset over its life. In this case,
the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated
depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet
to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense
through depreciation.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not
depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one
determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not
depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most
commonly used to calculate the allocation of depreciation expense: the straight-line method, the units-of-
production method, and the double-declining-balance method. A fourth method, the sum-of-the-years-digits
method, is another accelerated option that has been losing popularity and can be learned in intermediate
accounting courses. Note that these methods are for accounting and reporting purposes. The IRS allows firms
to use the same or different methods to depreciate assets in calculating taxable income.

THINK IT THROUGH

Fixed Assets
You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a
production and warehouse facility in Pennsylvania. The facility is in the process of updating and replacing
several asset categories, including warehouse storage units, fork trucks, and equipment on the production
line. It is your job to keep the information in the fixed assets subsidiary ledger up to date and accurate. You
need information on original historical cost, estimated useful life, salvage value, depreciation methods, and
additional capital expenditures. You are excited about the new purchases and upgrades to the facility and
how they will help the company serve its customers better. However, you have been in your current
position for only a few years and have never overseen extensive updates, and you realize that you will have
to gather a lot of information at once to keep the accounting records accurate. You feel overwhelmed and
take a minute to catch your breath and think through what you need. After a few minutes, you realize that
you have many people and many resources to work with to tackle this project. Whom will you work with,
and how will you go about gathering what you need?

Solution:

Though answers may vary, common resources would likely include purchasing managers (those actually
buying the new equipment), maintenance managers (those who will repair and take care of the new
equipment), and line managers (those in charge of the departments that will use the new equipment). To

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 4.4 • When Should a Company Capitalize or Expense an Item? 117

gather the information needed, set up short meetings to visit with the individuals involved, walk around to
see the equipment, and ask questions about functionality, life span, common problems or repairs, and
more.

Assume that on January 1, Liam bought a silk screen machine for $54,000. Liam pays shipping costs of $1,500
and setup costs of $2,500 and assumes a useful life of five years or 960,000 prints. Based on experience, Liam
anticipates a salvage value of $10,000. Recall that determination of the costs to be depreciated requires
including all costs that prepare the asset for use by the company. Liam’s example would include shipping and
setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so
the total cost would be $58,000, and after allowing for an anticipated salvage value of $10,000 in five years, the
business could take $48,000 in depreciation over the machine’s economic life (see Figure 4.12).

Figure 4.12 Purchase Price and Depreciable Base

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the
useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the
depreciable base of $48,000 by the economic life of five years, giving an annual depreciation expense of
$9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet
information. Here are the journal entry and information for year one (Figure 4.13):

Figure 4.13 Journal Entry for Silk Screen Machine Depreciation Expense, Year 1

After the journal entry in year one, the machine would have a book value of $48,400. This is the original cost of
$58,000 less the accumulated depreciation of $9,600. The journal entry and information for year two are shown
in Figure 4.14.
118 4 • Accrual Accounting Process

Figure 4.14 Journal Entry for Silk Screen Machine Depreciation Expense, Year 2

Liam records an annual depreciation expense of $9,600. Each year, the accumulated depreciation balance
increases by $9,600, and the machine’s book value decreases by the same $9,600. At the end of five years, the
asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of
from the cost of $58,000.

Units-of-Production Depreciation

Straight-line depreciation is efficient accounting for assets used consistently over their lifetime, but what about
assets that are used with less regularity? The units-of-production depreciation method bases depreciation on
the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of
time. For example, this method could account for depreciation of a silk screen machine for which the
depreciable base is $48,000 (as in the straight-line method), but now the number of prints is important.

In our example, the machine will have total depreciation of $48,000 over its useful life of 960,000 prints.
Therefore, we would divide $48,000 by 960,000 prints to get a cost per print of $0.05. If Liam printed 180,000
items in the first year, the depreciation expense would be . The
journal entry to record this expense would be the same as with straight-line depreciation: only the dollar
amount would have changed. The presentation of accumulated depreciation and the calculation of the book
value would also be the same. Liam would continue to depreciate the asset until a total of $48,000 in
depreciation was taken after running 960,000 total prints.

THINK IT THROUGH

Deciding on a Depreciation Method

Liam is struggling to determine which deprecation method they should use for their new silk screen
machine. They expect sales to increase over the next five years. They also expect (hope) that in two years
they will need to buy a second silk screen machine to keep up with the demand for products of their
growing company. Which depreciation method makes more sense for Liam: higher expenses in the first few
years or keeping expenses consistent over time? Or would it be better for them to think not in terms of
time, but rather in the usage of the machine?

Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it
accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double
declining considers time by determining the percentage of depreciation expense that would exist under
straight-line depreciation. To calculate this, divide 100 percent by the estimated life in years. For example, a
five-year asset would be 100/5, or 20 percent a year. A four-year asset would be 100/4, or 25 percent a year.
Next, because assets are typically more efficient and are used more heavily early in their life span, the double-

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