International Financial Management

International Financial Management – Evaluate the extent to which the bargaining model can be viewed as a practical implementation of the law of comparative advantage?

International financial management is a coined term in today’s world, and it is also known as International Finance. In simple words, it means financial management in an International business environment. International Financial Management is, however, different countries and regions due to the different currencies, government situations, political situations, deficient markets, varied opportunity sets (Susan, & Anil 2009, pp. 381–399)

It is said that international financial management came into the limelight when countries started opening up their borders due to the liberation and globalization policies that came with capitalism. Because of the open borders and increased freedom to conduct business in any country around the world. Entrepreneurs started to source for raw materials and establish their business in different countries provided that the state met the preferences of the entrepreneur (Wissam & Ellen 2014). The development of liberalization was further enhanced by the swift move towards development of telecommunication and transport technologies. Financial innovations such as currency derivatives, multi-currency bonds, cross-border stock listing and International mutual funds further catalyzed the development of international financial management (Frederic et al. 2010, pp. 395-427).

Globalization and Multi-national Firm

Globalization has manifested itself in today’s world through the relationship of financial markets, increasing roles of the multinational corporations, the dependence of the local economies on foreign trade, transfer of technologies. This type of relationship has led to demands for harmonization of the world statically standards (Susan, & Anil 2009, pp. 381–399). Harmonization and standardization include updating the National Accounts System and the Balances of payment among other systems that would make the exchange of capital easier. Multinational firms have contributed a lot towards international financial management, in fact, MNCs are the focal point for the studies of International Financial Management. Globalization has enabled companies to expand their territories to different countries and regions. For example countries like NIKE, Nescafé, and Shell Oil among others are present in almost the whole world.

According to Frederic et al. (2010, pp. 395-427), the structure of the global industry has experienced great changes especially in the 1990s due to the cross-border mergers and acquisitions; this is evident since most companies committing their affairs freely with stakeholders in different parts of the world is becoming standard. A massive increment by $200 billion to more than $500 billion in cross-border mergers was recorded in a span of only 2years i.e. from 1995 to 1999. This lead to the healthy of business especially to the advanced developing countries like Taiwan and Hong Kong who are currently leading in investing in China and other South East Asia countries. In South America Brazilian and Chilean firms have dominated the region. In the same sense, Brazil and Argentina based companies have reciprocated. Korean companies overseas are roughly one-third of the massive domestic investments during 1999.

Due to this traffic foreign investment and trade have developed to become inter-wined. There are exports of foreign affiliates in developing states to the parent organizations overseas. This accounts for one-third of all the exports that originate from developing countries while two-thirds of the developing states involve a multinational buyer or seller. In the least developed countries, these ratios are probably higher because of the advantage that Multinational Corporations take over the cheap labor available in these countries. The rise of Multinational companies and foreign ownership has given various opinions about their effects on the developing countries.

International Financial Management and International Monetary Systems

Chiara et al. (2010, pp. 42-65), outlines that the international monetary system involves the management of money flows in conjunction with institutions that are government related that keep track of vast bulk of money including supporting currency needs and it also ensures payment obligations within and across countries are met accordingly. Various institutions that are responsible and are part of the international monetary system include the central banks international financial institutions, commercial banks, and some monetary market funds.

International Financial Management Dissertations
International Financial Management Dissertations

Wissam and Ellen (2014), adds that one distinguishing factor that makes IMS different from other financial institutions is that IMS is not interest bearing. Instead, money is considered as a unit of account and also means of exchanging goods and service and capital flows across borders in order to facilitate and ensure a perfect environment for exchange of financial assets and the excellent of financial markets. The commonly known definition of money since time immemorial is that it’s an asset in addition to its storage of value.

The USD has incurred changes that have been unheard of especially the one noted in 1985 where the dollar had hit a peak of USD 100 Billion a year. According to most economists was far much beyond the equilibrium level that has ever been attained. This record was due to the high exchanging rate which was a sign of confidence in the US economy, the high rate of exchange was due to the sticker hypothesis of the Dornbusch to fiscal irresponsibility. It was then decided that the dollar value be lower without considering much what took it high by intervening in the foreign exchange markets, this was done for the protectionist sentiment that conducted the US Congress that was mounting trading deficit

A plaza agreement that was formed by the big five countries i.e. united states France Japan great Britain and West Germany, a coordinated program to reach the target of forcing down the enormously shooting US dollar value against other currencies, the program worked perfect was successful in the end. It lost 11 percent of its SDR in 1986, the decrement of the US dollar was steady when Italy and Canada joined the group 5, forming a new group known as the G-7.The policies worked like a charm, and the US promised to cut the budget deficit and ultimately lower the rate at which the dollar was growing. To achieve this further Japan and Canada promised to stimulate their economies, although they achieved the reduction of the dollar value the budget cuts weren’t forthcoming and so Germany and Japan never succeeded in their mission to stimulate their economies (Arthur 2003, pp. 979-992).

Trade is among the factors in addition to inequities that balances out countries in todays world. These fluctuations in a system of a freely floating exchange of goods and services gives the adjustment system to bring trade back to balances. A country that has both trade and account deficit could get back to balance through devaluing its currency which will increase its exports and lessen the amount of imports (Chiara et al. 2010, pp. 42-65).

In reality the existence of chronic trade deficits in country have consequences to the economy through the systems of flexible exchange rate. One of the main reason for the failure in adjustment of exchange rates is deficit for incentives for various states to keep their currency strong in order to attract foreign investments. But according to the reports by the World Bank over valued currencies only impairs trade more while calling for more inflow of foreign currencies. Finally the game reaches the end and the investors run away and the deficit country have a fall in their currency that erodes even the domestic savings and ushers in inflation and these leads to the international financial management emergency assistance that is directed towards economic austerity.

World Bank statistics recognizes the fact that a mechanism of semi-fixed exchange rates that provides for flexibility in a narrow range and orderly mechanism for adjustments for such ranges. In 1994 the former chairman of the Bretton Woods Commission Volcker Paul openly condemned the liberation of the exchange rates and advocated for the semi-fixed exchange rate regime (Jean et al. 2005, pp. 1-43). In exchange for the Bretton Woods Institution (World Bank and IMF) the countries suffering from deficits are expected to implement a range of deflationary fiscal and deflationary policies, in the late 1990s they were known as Structural Adjustment Program and mostly implemented through letters of intent. The process is usually refer to us loan conditionality’s since IMF financial assistance are conditioned when implementing policy reforms (Xiaoying & Xiaming 2005, pp. 393-407).

Foreign Direct Investments

The rise of foreign Direct Investment started over tree decades ago. From 1980s when the FDI flow was estimated to be 50 billion US Dollars per year OFD has grown up to 2.1 trillion US Dollars in 2007. Due to the economic recession in 2008 FDI fell down to 1.9 trillion US Dollars that is -10% (James & Mark 2000). Foreign direct Investments from developed countries have increased due to the high growth in economies and high performance from the corporate world of these countries.

OFDI particularly flows from the European Union and The United States of America who take up to 84%, the remaining 16% is represented by the transitional economies (BRIC countries).

International financial management, the distribution of emerging market OFDI has evolved considerably changed over the past years. Asia overtook Latin America and Caribbean America has become leading region for Foreign Direct Investment. While MNCs have become fundamental investors in many developing countries, they have also invested in developed countries. The general number of Multinational Corporations has been growing in tandem, with FDI (Caroline 2004, pp. 20-29). This rise does not only show the increasing ownership benefits of these firms but also the pressure for the companies to get a portfolio locality assets as foundation for International competitiveness (Arthur 2003, pp. 979-992).

The Bargaining Model

According to the theory of bargaining, governments yearn for development and a stability payment balance. These goals can be achieved through attracting foreign investments. On the other hand, MNCs are in constant look for sources of raw materials and strategic manufacturing points near their targeted markets. These objectives can be satisfied when MNCs deal successfully with governments of host countries because it is through the sovereignty of the states that the MNCs can achieve these Governments seek economic development and balance-of-payments stability, for example, and both goals can be pursued by attracting and channeling the activities of foreign TNCs. TNCs seek inexpensive sources of raw materials and manufacturing sites (Chiara et al. 2010, pp. 42-65). According to Jean et al. (2005, pp. 1-43).The bargaining process is enhanced by the relative resources that each country has.

The government has its high points from the control over the two most fundamental requirement of the MNCs which are raw materials and intensive labor. On the other hand, the MNCs have goodies that the government desires that they use to influence the government with some of these goodies include helping in lowering the unemployment rate in the country, improving the host countries balance of payments through providing access to the International Markets (Arthur 2003, pp. 979-992). The relevance of these factors during the bargaining process substantially determines the expected outcome of negotiation between an MNC and the national government. Another factor that greatly influences the negotiation process is the situation between the firm and the government. The relative stakes that each party offers give a situation affecting the bargaining outcome.

Lastly the degree of similarity of interests that both the government and the multinational corporation have. The Similarity of interests makes negotiation more natural and smooth while different and parallel interests among the principles will make decision making very hard (Arthur 2003, pp. 979-992).

The Balance of Payments in International Financial Management

According to Wissam and Ellen (2014) defines this as an account records the payments and receipts of transactions of the citizens of that particular country with residents living in another country. Ones the payments and receipts of each country will include equally only if the operations are also included, neutrality will only favor one state at the expense of the other by allowing it acquire more assets from the not so preferred country. (Xiaoying & Xiaming 2005, pp. 393-407). An evident example is if Americans purchase automobiles from the Japanese, and don’t engage further in other transactions chances are the Japan will end up holding dollars either in the form of bank deposits or engage in other investments in the US. These payments are then balanced depending on the transactions made for the acquisition of the dollar assets (Jean et al. 2005, pp. 1-43).

However much the balancing is done deficits must occur as a result of inequalities and excess payments, therefore leading to a surplus in particular forms of transactions including the service trade merchandise trade (James & Mark 2000). The balance of payments in any country must refer to some class of operations.

Various definitions have been given to the balance of payments surplus and deficits in the past. Every definition had its distinct implications and purposes. It is until 1973 that there was a focus on the definition of balance-of-payments which had the intentions of measuring the ability of a country to meets its responsibilities of exchanging its currency for other currencies or for tagging it to the Gold system at a fixed rate exchange like the Great Britain did (Maurice 2010, pp. 1–23).

So as to meet the newly formed obligations countries strived to maintain a stock of official reserves, in the form of foreign country currencies or gold that they would use to in supporting their local currencies. The decline in this stores stock was seen as crucial balance-of-payment deficit since it threatened a country’s ability to meet its responsibilities (Arthur 2003, pp. 979-992).

This type of debt was not a good indicator at all when looking at the financial position of a state. The reason being that it never looked at the likelihood that the state would be called upon to meet its delegated duties and the willingness of the international monetary institution to provide assistance (James & Mark 2000).

Caroline (2004, pp. 20-29), points that after 1973, official reserves unit of measuring a country’s ability to meet its obligations diminished as various economic giants gave up their responsibility of converting their currency at a fixed exchange. The made reserves look more meaningless, and there was no longer any concern about the changes in a country’s reserves (Ngaire 2000, pp. 82-841).

Xiaoying and Xiaming (2005, pp. 393-407), purports that after the 1973 talks on the balance of payment surplus or deficits now refer to current accounts. This account has a trade in goods, investment incomes earned abroad and the unilateral transfers. It doesn’t include the capital account, which includes the sales of securities or property. Since the current account and the capital account sum up to the total account, which is necessarily balanced, debt in the current account always comes with an equal surplus in the capital account and vice versa (Maurice 2010, pp. 1–23). Deficit or surplus present in the current account cannot be evaluated without different explanations and the evaluation of an equal surplus or deficit in the capital account.

A State is considered to be in deficit when in its current account is higher its price level. When the Gross National Product is greater the interests rates are also higher and the lesser the barriers towards imports and more attractive it’s to international investors, compared to other countries (Barry 1999).

Kenneth (1996, pp. 647-668), argues that the impacts of any change in one of these factors on the country’s current account balance cannot be predicted without looking at the effects of the other international financial management factors. For instance, if the government increases tariffs, citizens are likely to import fewer goods, therefore, decreasing the current account deficit. In this case, where this decline will occur only when one of other factors changes to bring about a reduction in the capital account surplus.

According to Axel and James (2015, pp.120-148), if none of these factors changes then the decrease in imports due to an increase in tariffs will lead to a decline in the demand for the country’s foreign currency, this, in turn, will raise the local value of the respective country. The increase in the value of any countries increase makes that individual country exports more expensive and imports cheaper, therefore offsetting the implications of the growth in Tariffs. The overall result is that the increase in tariff will bring no change to the current account (Caroline 2004, pp. 20-29)

Contrary to the thoughts of most people, the existence of a deficit in the present account in itself is not a signal towards a recessing economy or irrational economic policies. If a country has a deficit in its current account, it can sometimes mean that the country is importing capital. Importing capital is no more a peculiar system it is just like importing coffee or tea.

References

 Arthur, C 2003. “The euro: faith, hope and parity, International Affairs.” pp. 979-992.

 Axel, D 2009. “IMF conditionality: theory and evidence, Public Choice.” pp. 233-267.

 Axel, D, Jan, E, S & James Vreeland 2015. “Politics and IMF Conditionality”. Journal of Conflict Resolution. Vol. 59, Vol. 1, pp.120-148.

 Barry, E 1999. “Kicking the Habit: moving from pegged exchange rates to greater exchange rate flexibility”. The Economic Journal C1 – C14 Equator Principles III.

 Caroline, M 2004. “Managing Exchange Rates: Achievement of Global Rebalancing or evidence of global co-dependency.” Business Economics, pp. 20-29.

 Chiara, F, Francesco, R & Giuseppe, M 2010. “Why do Firms Invest Abroad? An Analysis of the Motives Underlying Foreign Direct Investments.” The IUP Journal of International Business Law. Vol. 9, No. 1 & 2, pp. 42-65

 Frederic, B, Melika, B, S & Marine C 2010. “Detecting Mean Reversion in Real Exchange Rates from a Multiple Regime STAR model.” Annals of Economics and Statistics, pp. 395-427.

 James, R, L & Mark, P, T 2000. “Purchasing power parity over two centuries: strengthening the case for real exchange rate stability A reply to Cuddington and Liang.” Journal of International Money and Finance. Vol. 19, No.1, pp. 759–764.

 Jean, I, Haroon, M, Morten R & Helene Rey 2005. “PPP Strikes Back: Aggregation and the Real Exchange Rate.” The Quarterly Journal of Economics. Vol.34, No 1, pp. 1-43.

 John, H, D 2000. “The eclectic paradigm as an envelope for economic and business theories of MNE activity”. International Business Review 9, pp. 163–190.

 Kenneth, R 1996. “International Financial Management The Purchasing Power Parity Puzzle.” Journal of Economic Literature. Vol. 45, pp. 647-668.

 Maurice, O 2010. “Does the Current Account Still Matter?” American Economic Review. Vol.102, No. 3, pp. 1–23.

Ngaire, W 2000. “The Challenge of Good Governance for the IMF and the World Bank Themselves.” World Development. Vol. 28, No. 5, pp. 82-841.

Shaun, F & Andrew L 2004. “International Financial Management, new financial system? Towards a conceptualization of financial reintermediation.” Review of International Political Economy. Vol. 11, No.2, pp. 263-288.

 Susan, F & Anil G 2009. “Subsidiaries and Country Risk: internalization as a safeguard against weak external institutions.” Academy of International Financial Management, Vol. 52, No. 2, pp. 381–399.

 Wissam, H & Ellen, M 2014. “Hong Kong’s Currency Crisis: A Test of the 1990s.” Washington Consensus’ View, International Finance. Vol. 17, No.3, pp. 273–296.

Xiaoying, L & Xiaming, L .2005. “Foreign Direct Investment, International Financial Management and Economic Growth.” An Increasingly Endogenous Relationship World Development. Vol. 33, No. 3, pp. 393-407.

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Behavioral Finance Financial Decision Making

Behavioral Finance and the Psychology of Financial Decision

Behavioral finance and financial decisions have a big role in shaping critical decisions that people make. The study summarizes the facts about financial choices and the behavioral and psychological theories influencing them. We learn that people have predisposed cognitive constraints coupled with low levels of financial literacy, in such regard, their decision-making choices violate sound financial principles. The case studies teach us that most investors and managers over-extrapolate from past returns and trade, or they make decisions based on overconfidence and personal history.

We explain most of these behaviors based on behavioral finance theories like prospect theory, behavioral finance, and behavioral corporate finance. Many companies and institutions today shy away from traditionally defined benefit pension plans in favor of defined contribution plans, in such circumstance, the role of the financial adviser is gaining an integral value.

In this case study, a recent graduate from UMUC is employed to advise different clients on investment. The consultant delves into studying the biases in financial behavior that predict prospective theory. While applying the key concepts of behavioral finance, the consultant can recognize that the client (Violet) displays behavioral biases that impede optimal savings and consumption allocation. He can learn this by deducing from concepts of finance that assess how people organize their financial assets by creating separate slots for money designated for specific roles as well as other approaches such as mental accounting.

Expected Utility and Prospect Theory:

Unlike most of the economic theories, Expected utility theory is the most preferred by scholars ((Shiller, Robert J.). The approach attracts people because it has the best economical representation characterizing true rational behavior in uncertain situations. However, application of expected theory is criticized in many circumstances because of the systematical misrepresentation of human behavior.

Allais (503) proved that Prospect Theory refers to a mathematically developed theory that substitutes “value function” contrasted to “utility function” and “weights” contrasted to “probabilities” in expected utility theory. Here, people work to increase the weighted total value instead of utility such that probabilities do not equal weight. Simply put, people view extremely probable as certain but the improbable events as impossible.

In many circumstances, prospect theory appears inconsistent with expected utility theory. To begin with, in probabilities, utility is all linear but not value. Also, value is defined regarding losses and profits, but utility depends on final wealth.

Contrary to expected utility theory, prospect theory foretells that preferences depend on how a problem is approached. In case the reference point defines the outcome as an advantage, in this case, the resulting value function will be curved in, and those making decision will be risk-averse.  But if the reference point’s outcome is seen as a loss, those making decisions will be risk seeking since is a convex value function.

Violations of Expected Utility

The possible abuses of this theory include the Allais paradox (certainty effect), and inflation of small probabilities. As for Allais paradox, there is an extreme underweighting of high probabilities. In such a case, it falls short of certainties such that the travel time outcomes become extremely attractive. On the other hand, inflation of small probabilities violation projects itself in the form of a set of stated-preference route-choice challenges.

Value Function

The definition of the value function lies on variations from a reference point, and in most circumstances, it is risk aversion–concave for gains, convex for losses. Similarly, value function is acute for losses than for profits. In this case, the stress of decisions is less compared with the equivalent probabilities, with few exceptions in the assortment of low probabilities. A value strategy deals with the purchase of stocks that have low prices compared with the dividends, earnings, book assets, or similar measures of significant value.

The Implications of Prospect Theory for the Efficient Market Hypothesis

An efficient market, based on the definition by (Fama 1965), is characterized by a large pool of rational profit maximizers who compete against each other to interpret the market prices of individual securities in the years to come; out of which a large pool of the present information is easily available to all participants. The prevailing competition in such a market opens the effects of new information on the actual prices in an instantaneous way. In such a way, the prospect theory sets in under the circumstance that makes stock price unpredictable following a random pathway.

Provided that information flow is unrestricted and quickly reflects in the stock price, the probability for the future price to change will depend not on today’s price changes, but on tomorrow’s news. Given that news is unpredictable, consequently, price changes also turnout unpredictable, and this conforms to the principle of prospect theory whereby people view extremely probable as certain but the improbable events as impossible.

Efficient Market Hypothesis is characterized by the security prices that reflect available information. It is based on the traditional view that investors use rationale in executing the present information to increase the expected utility.

Anomalies

The Anomalies of Efficient Market Hypothesis’ set in when people feel there is something wrong with the concept of Efficient Market Hypothesis. Under such conditions, the rational approaches of investors lacks consistence. It is not wholly right and must be analyzed alongside other human behavior approaches like the prospect theory, overconfidence, or expected utility, or over and under reaction, as well as the limits to arbitrage. Examples of anomalies as expressed by prospect theory include the size, valuation, and the momentum effect.

  1. The Valuation Effect. Studies reveal that firms with higher P/B multiples are outperformed by those with low price/book (P/B) multiples.
  2. The Size Effect. Studies predict that firms with smaller market capitalizations outperform those with large market capitalizations, disregard of the controls in their higher risk.
  3. The Momentum Effect. Studies reveal that firms with good performance for the past six months to one year period outperform those that performed poorly over the same period.

Bias identification and how such behavioral finance concepts affect their investment decisions

The First Colleague: The Concept of Illusion of Control

The stated bias happens when people overly justify their ideas. It describes people’s propensity to believe that they can exert influence on the outcomes of action when, in the real sense, they cannot. When this kind of bias occurs, people behave as if they can fully control their situations than they actually can ((Ising, Alexander).

The first colleague responds by claiming to know the technology industry and is determined to invest in them. While he might have worked in the industry for a while, it is not justifiable to assume that the circumstances will prevail in the long run. He is preoccupied with the illusion of control bias.

However, the illusion of control bias can be financially damaging since entrepreneurs might be motivated to trade more than what is right. It may lead them to employ limit orders, maintain under-diversified portfolios, or other related means just to express a false sense of influence over their trade portfolios.

People who practice this bias find it hard acceding with the irrationality and the changing nature of markets and the fact that their expectation is a failed one. The outcome is a spiral of investment catastrophe with the rationalization that while their belief is right, the one who drove the buttons was so incompetent.

In the long run, the investor becomes overconfident. The consequences of long-term investment may not be affected by the immediate-term opinion, emotions, and impulses that frequently engulf financial transactions. Rather, the success or lack of it emanates from uncontrollable factors such as the prevailing economic conditions and corporate performance.

The Second Colleague: Confirmation Bias

According to the second colleague, the value of commercial property in the city has maintained a 14% increase since the year 2000 reported a famous newspaper article. Now, this is almost two decades down the line. It is very unbelievable to assert that the value of the property has remained consistent over such a lengthy period, and very few investors would settle on that. However, depending on the interest of the reader and the prevailing circumstance, we can only assume that the type of newspaper is biased towards such reports and that the investor too is biased and love reading similar reports.

According to confirmation bias, individuals are drawn to information that substantiates their existing perceptions. It is just similar when a person prefers watching news from a TV channel that represents his/her political views while evading those that feature commentators of divergent opinions. Similarly, people behave in the like manner concerning their financial issues. Entrepreneurs believe in the market conditions will make them walk toward information sources that validate such a belief.

While it is acceptable to attach an emphasis to the consequences of our aspirations, for example, investing heavily in the stock of the firm you’re working for, it poses significant risks when it comes to diversification. If you should overcome confirmation bias, stress must be levied on obtaining information from various.

The Third Colleague: Depicting Recency Bias

Recency bias is a cognitive intrusion that encourages to perceive the most recent information as more relevant compared to the old knowledge. However, this may not be necessarily true. People base their investment decisions on how the market has been recently performing. The exact state is seen on the third respondent whose investment decisions in the Omega Corporation are drawn from the current state of the company and industry. She denotes that from the decline of the industry to capitalize on her investments since she presumes that case to remain constant for some time.

Most entrepreneurs have the inclination to follow investment performance by investing more in the industry when it is peaking and just about to reverse. Given that the investment has been picking up recently, investors anticipate that to remain the case. However, based on the behavioral theory, it would be wrong for her to rely on this approach to make financial decisions. In most circumstances, people do extrapolate from recent performance and employ them as a signal of future performance which is very wrong. Consequently, entrepreneurs fall into the ploy of over-purchasing the now outperforming asset and under-own the now drifting asset.

Behavioral Finance Dissertation
Behavioral Finance Dissertation

Behavioral Finance and Investments

Siosan’s utility function. Contrasted with that assumed in traditional finance theory

Traditional finance posits that humans are risk-averse, they love greater certainty than limited certainty and have a perfect utility function. Conversely, behavioral theorists assume that people display multiple characteristics and while they may be risk-averse, they may also be risk-seeking, risk-neutral, or any blend of the three. Depending on how things present themselves influences decision making.

The utility function measures an individual’s preferences over a set of products, measured in units referred to as utils. Utils exemplify the level of satisfaction of a consumer from choosing a specific type or number of products. Traditional finance is built on the utility theory with an assumption of diminishing marginal return. On the other hand, Behavioral theorists assume that human beings don’t always act in their best financial interests.

Appropriate in this case study, the utility function specifies the satisfaction of an investor out of all possible combinations. For example, an investment with low risk and high return has a bigger utility than that with high risk and low gain. This kind of function represents both their welfare along with their preferences. Violet expresses utility function that follows the behavioral approach. She wants to spend more. However, she’s quite unaware of the circumstances of tomorrow reflected in her limited investments. Under a traditional approach, Violet would either invest or not invest at all. It would be that she has knowledge of the future market or she does not, and if she lacks, her utility function would be concave. She would spend less just to avoid the risks in the future.

Similarly, she purchases expensive goods like cars and takes vacations for her satisfaction although, she feels reluctant to incur debts. This is opposed to traditional finance that assumes a diminishing marginal utility; Violet proposes utility function that will always satisfy her interests and won’t diminish. Violet expresses some mix of traditional and behavioral approach in some part, and traditional finance is reflected in the way she detests debts. Albeit, she does little to avert those debts, thus in part demonstrating a behavioral approach.

Siosian’s Behavioral Biases and how a rational economic individual in traditional finance would behave differently concerning each bias

Various cognitive predispositions cause several behavioral biases or under-saving inclinations. This is according to the perception by behavioral scientists who present several biases that emanate from such predispositions by grouping them into three categories. Such include preference biases, perceptions of prospects, perceptions on how to make decisions bearing in mind the rest of variables, and price perceptions. The typical behavioral bias presented in this case is the preference bias, and it manifests itself in the form of the self-control, loss aversion, and anticipatory utility.

Costly self-control bias- Living for today

Behaviorists propose that many people struggle with self-control in various fields. It may present itself through over-eating, under-saving, or over-snoozing, what we can call as “living for today”. Approaches to costly self-control also suggest that such people will value commitment such that they will choose, and even pay, to limit their future decision in some way, in an attempt to discourage their future over-consumption predilections.

However, in this case, study, Violet fits this model of costly self-control bias. We find that she engages in costly endeavors like buying expensive cars and paying for expensive meals in upscale vacation resorts. She does this at the expense of investing. In fact, she would do all the best she can to live a luxurious life while doing little on her mortgage and other investments. Her approach is behavioral and contrary to how traditional theorists would behave since they would fear the risks of tomorrow and would spend less on consumption and be concerned about the future.

Loss Aversion

The bias is comparative to some reference point like current consumption, or friends’ consumption. Loss aversion may also be seen as a potential threat to consumers leveraging their savings rates. People fear more to invest in their view of avoiding losses (Thaler, Richard, and Shlomo 164-187).

Loss aversion occurs when people easily notice the reduction in investment portfolio more than how they view gains, and this may be even when the profits are greater. They frequently get upset when they lose money during the market recession such that they remember those losses forever, but they would hardly remember the time they made 40-percent increase, just the time they lost 30-percent. We can state that Violet has an outspoken loss aversion bias when she says she detests making losses. Given that she has very little investment but high expenditure, this might be the reason why she rarely invests. Her approach reflects a traditional finance theory that assumes people are risk-averse.

Siosian’s Retirement Portfolio and Justification

Violet’s retirement portfolio is such that she maintains a minimal retirement plan where she deposits half the sum of money coming from her annual bonuses and none-salary incomes. On the other, we notice that she runs a very small mortgage and limited investments that can sustain her. Basing on such decisions, her retirement portfolio is so inefficient.

The Social Security Administration posits that on average, a 65-year pensioner can expect to stay for the next 18–20½ years after quitting the job (Benz par 3). Nonetheless, health advancements now make people stay for more years, and it would be advisable that you schedule a retirement portfolio of 30 or more years, and in such a case, the retirement saving plan becomes so essential. Rather than just depositing money in the portfolio, it should be used in investment opportunities to generate more wealth for old age. The objective is remaining invested—and that implies having some part of the money assigned to stocks, but in the right standing with other investments.

The objective of investing retirement portfolio is to generate a mix of investments that merge to preserve capital, create income, and expand. Such a combination of stock, bond and cash investments must be in line with age, income, financial needs, time, and risk. For this reason, we can say Violet’s retirement portfolio is very weak and inappropriate (Williams par 6).

Behavioral Corporate Finance

MEMO

TO: CFO

FROM:

DATE: 28/04/2019

RE: Recent Behavioral Finance Literature dealing with the Board of Directors.

We can study behavioral finance featuring the panel of executives under the concept of corporate governance ((Shivdasani, Anil, and Marc Zenner). Management of financial institutions has taken a different approach given the attrition of the significance of corporate governance in guiding financial decisions. Albeit, this is very recent studied by contemporary economists who assert the role of the board of governors in guiding the company’s value creation and improved financial performance particularly during this onset of consistent corporate flaws. Many companies have since collapsed, examples of Lehman Brothers, Rank Xerox, and Enron just to name a few, all blamed the faulty board of governors (Shivdasani, Anil, and David Yermack).

We have several lessons to learn from this shrinking–specifically–there is one lesson that stands out clear–the role of corporate governance in determining its capacity to contest positively particularly in stormy environmental conditions where others strive hard to exits.

Contemporary literature on behavioral finance vis-à-vis corporate governance emanates from Adolph, Berle and Means (23) study where they assert that, in reality, managers of companies sought their interest at the expense of the shareholders’ interests.  Their investigation stressed the need for an effective plan to help aid in mitigating the conflict of interests between company owners and managers. Therefore, while the concept of corporate governance might appear new, it addresses typical concerns present since time long (Ayuso, Silvia, and Argandoña 2-19).

Many countries, corporations, and agencies across the globe have started to respond to the corporate flaws by initiating a series of legislation and guidelines that guide decisions of the board of governors in financial implications. Such rules are referred to as the codes of best practices. These legislations guide the behavior and structure of the board of directors while doing their monitory and supervisory duties (Shivdasani, Anil, and David Yermack).

Such codes, though, issued in different regions, they have similar peculiarities regarding corporate culture and general corporate environment, and alignment of the interest of parties (Shareholders and Management). Corporate governance codification of governance aims at mitigating the corresponding deficiencies in or lack of appropriate shareholders shields (Shivdasani, Anil, and David Yermack).

Your Future and Behavioral Finance Post 2008

Behavioral Finance Lessons during and after the Great Recession

Several themes emerge drawing from the issues aired by Stephanie pertaining behavioral finance during and after the great recession. While the economic downturn attracted several consequences on the corporate world, I believe the corporate directors and other stakeholders had the mandate to prevent its occurrence, and correspondingly, they can stop the reoccurrence of the same by studying behavioral finance theories. The recession affected the entire globe since businesses collapsed, and many people lost jobs and houses. However, I believe that if financial behaviorist can avoid a repeat of the 2008 great recession, they should derive from behavioral finance theories, Shefrin and Staman reports this in their book, ‘Behavioral Finance in the Financial Crisis’.

Several factors drew the crisis, and such factors persist that perpetuate the current crisis. They include; a weak government regulation, investment banks that exceedingly leverage debts, and strained homeowners’ finances. We can explain the consequences of 2008 crisis from a financial theory basis. While traditional economics base their assumptions of rationality, they assert that people make rational economic choices as they try to maximize their earnings. On the contrary, behavioral economists assume that people make their financial selections based on their emotions psychological conditions, as well as on cognitive errors.

The 2008 crisis is best explained by the principles of behavioral economics. Here, we find a correlation of the crisis with the overly optimistic lending behaviors of people since such is connected to the stock market fluctuations even as witnessed currently. Psychologists have effectively documented the propensity of people to perceive the through rose-tinted lenses, often referred to as the optimism bias.

Much of the 2008 crisis revolved around financial psychology. We can study psychology as part of the behavioral finance theory. In essence, it incorporates aspects like overconfidence, perception and cognition, aspirations, emotions, and culture (Morgenson, Gretchen and Joshua Rosner).

Overconfidence– Behavioral economists had warned of the inhibiting economic crisis. While banks, businesses, and many corporations received such warnings, many were overconfident in their investments. Overconfidence Before the great 2008 recession, economists warned that the economy was going under. Entrepreneurs were such overconfident such that they hardly analyzed the risk of holding such huge portfolios in mortgage-backed securities, provided the threat of being in a bubble. Most of the homeowners took out loans just to satisfy the American dream — they purchased during a bubble overconfident that housing prices would skyrocket and remain persistent.

However, an increase in the housing market, and the stock market, only works to raise people’s overconfidence since they would ascribe the gains or losses they achieve as a result of their proficiency in finance, although, it results from market moods.

Recency bias was one implication that cultivated the crisis. That’s because entrepreneurs make choices based on the most recent information. Decisions may be constructed on the very latest feedback. Although, such information may not be primarily relevant. During the time, investors overreacted because of the congress’s finance rescue project.

Similarly, people’s emotions such as anger, fear, and sadness influence the type of decisions made, including economic choices. More fearful people become risk-averse, but more angry people become more enthusiastic to incur risks, even financial risks. As for the economic downturn, people had others in mind to accuse of the financial crisis. Take the example of Wall Street banks that became so angry such that they easily took the financial risk to punish the offenders.

Behavioral economists assume that the kind of financial errors made aren’t haphazard, and the choice made too aren’t fundamentally rational. Rather, they are built on psychological conditions such as cognitive errors and biases.

In our attempts to evade the similar crisis in our market, we can learn a lot from the economic downturn of 20008 and the related occurrences of the past. For instance, the 1974-75 economic recession almost resembled the 2007-2009 crisis. On the same note, the twin Reagan-era recessions of the 1980s had profound consequences such as joblessness and a subsequent S&L and sovereign debt crunch. The 1990s foreign currency crisis mandated an immediate discarding of the Long-Term Capital Management without interfering with the worldwide economic system. Just like Lipsky reports, the 2008 housing bubble was a consequence of a simmering stock market.

Hindsight bias wrongly predisposes us to imagine we can see and analyze the future crises pretty well the way we do the previous and establish strategies that would impede future crises. However, we are limited to devise policies that can avert future crises should we even be able to identify them since those who would lose are in our paths standing against us. No doubt restraining bank leverage would do some good; nonetheless, bankers have the smack to strangle it. Consequently, we have a few decision left–our psychological fallibilities. Assessing our psychological biases will work a great deal in averting and mitigating some crises.

Conclusion

From the discussion above, behavioral finance case studies focus on determining the clear-cut direction to which various market forces—such as rational analysis of organization-specific and macroeconomic basics; cultural, human and social psychology trends—affect investors and managers expectations and define their level of confidence.

Works Cited

Adolph, Berle, and Gardiner Means. The Modern Corporation and Private Property. New York, NY, Macmillan, 1932.

Allais, M. “Le Comportement De L’homme Rationnel Devant Le Risque: Critique Des Postulats Et Axiomes De L’ecole Americaine.” Econometrica, vol 21, no. 4, 1953, p. 503. JSTOR.

Ayuso, Silvia, and Antonio Argandoña. “Responsible Corporate Governance: Towards A Stakeholder Board of Directors?” SSRN Electronic Journal, 2009, p.2-19. Elsevier BV.

Benz, C. “The Bucket Investor’s Guide to Setting Asset Allocation for Retirement.” News.Morningstar.Com, 2016, par 3.

Ising, Alexander. “Pompian, M. (2006): Behavioral Finance And Wealth Management – How To Build Optimal Portfolios That Account For Investor Biases.” Financial Markets and Portfolio Management, vol 21, no. 4, 2007, pp. 491-492. Springer Nature.

Lipsky, J. Overcoming the Great Recession An Address to the Japan National Press Club, Remarks by John Lipsky, First Deputy Managing Director of the International Monetary Fund, at the Japan National Press Club, Tokyo, May 18, 2009. Tokyo: Japan National Press Club, 2009.

Morgenson, Gretchen, and Joshua Rosner. Reckless Endangerment: How Outsized Ambition, Greed, And Corruption Led To Economic Armageddon. New York, New York, St. Martin’s Griffin, 2012.

Shefrin Hersh, &Meir Statman. Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes. Santa Clara: Santa Clara University, 2011.

Shiller, Robert J. “Bubbles, Human Judgment, and Expert Opinion.” Financial Analysts Journal, vol 58, no. 3, 2002, pp. 18-26. CFA Institute.

Shivdasani, Anil, and David Yermack. “CEO Involvement in the Selection Of New Board Members: An Empirical Analysis.” The Journal of Finance, vol 54, no. 5, 1999, pp. 1829-1853. Wiley-Blackwell.

Shivdasani, Anil, and Marc Zenner. “Best Practices In Corporate Governance: What Two Decades Of Research Reveals.” Journal of Applied Corporate Finance, vol 16, no. 2-3, 2004, pp. 29-41. Wiley-Blackwell.

Thaler, Richard H., and Shlomo Benartzi. “Save More Tomorrow™: Using Behavioral Economics To Increase Employee Saving.” Journal of Political Economy, vol 112, no. S1, 2004, pp. S164-S187. University Of Chicago Press.

Williams, Rob. “Plan, Allocate and Distribute: Structuring Your Retirement Portfolio for Your Income Needs.” Par 6. Schwab Brokerage, 2017.

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Financial Ratios Financing Constraints

Impact of Financial Ratios and Financing Constraints on Firms

Importance of financial ratios and financing constraints on modern business. The target audiences of this paper are investors looking for financial investment options and small business firms seeking growth.  Therefore, the article and information might be contained in a financial magazine such as wall street journal. The goal of this paper is to inform audiences on the important financial ratios, and how they are important in determining whether a company is worth investing in or not. Any business owner will want to find out the performance of his or her company in order to make informed management decisions.

In addition, an investor will want to have accurate financial position of any business firm for investment decision processes. In this regard, business organizations and financial analysts use a variety of analytical tools that are aimed at comparing the existing relative strengths and weaknesses of their businesses. These basic tools and techniques have enabled the investors as well as the analysts to develop fundamental analysis systems (Butzen & Fuss, 2003). Therefore, ratio analysis was developed as a tool that established the functions of quantitative analysis in the financial statement numbers. These ratios link the financial statements and determine figures that are comparable between sectors, companies, and across industries. Therefore, financial ratios have a significant financial analysis technique that is used for comparative analysis.

Financial Ratios and Business Growth

Small and growing business firms use financial ratios to determine how their businesses perform.  A significant financial ratio is the activity ration that is used in measuring how companies are efficient in utilizing their assets (World Bank, 2005). Therefore a negative ratio will force a company or an organization to either increase or decrease their assets or liabilities. These ratios are widely used by investors who can easily check out the overall operation of a prospective company for investment decisions (Harrison et al, 2002). If the overall performance of a company is determined to be poor, a company may lose investor confidence and as a result, lose business.

In addition, activity ratios are deemed to be turnover ratios that are associated with a balance sheet line item and an income statement line item. Generally, income statements are used for measuring the performance of any company, but for a specified period of time. However, the balance sheet provides data for a specific point in time. The advantage of using activity ratios is that they are able to give an average figure between the two financial statements. This means that companies or organizations are able to determine the rate of turning over their liabilities or assets. This helps the companies to control their receivables or inventories per year (Harrison et al, 2002).

Moreover, there are inventory turnovers that are used in the management effectiveness of any business organization (Butzen & Fuss, 2003). This ratio is determined when the cost of goods sold is divided by the average inventory. In this regard, a company is able to know whether its inventory is sold at a higher rate, when the turnover is recorded to be high.

Financial Ratios Essays
Financial Ratios Essays

This ratio is then significant in giving companies signals for inventory management effectiveness. In addition, this kind of inventory ratio communicates that there are less resources which are tied up in the company’s inventory (Butzen & Fuss, 2003). However, it is also important to understand that an unusually high turnover means that the company’s inventories are too lean. Consequently, the management discovers that the company may be ineffective in keeping up with the demand that is increasing (Harrison et al, 2003). Therefore the management is forced to act swiftly in adjusting the company’s operations to fit a favorable inventory ratio. Investors are keen in checking out companies with high inventory turnovers since it means that that specific industry gets stale quickly, thus an attractive investment option.

Another significant financial ratio is the receivables turnover ratio, that enables a business organization determines how fast it collects the bills that are outstanding (Harrison et al, 2002). This specific ratio determines the effectiveness of any company credit policy towards its customers. In this regard, negative receivables will force a company to have stringent credit policies that are aimed at ensuring that bills are collected as easily and fast as possible (Butzen & Fuss, 2003). This particular ratio is achieved by dividing the all the net revenues with the average receivables. In this case a company is able to know how many times per financial period, it is able to collect all its outstanding bills and have the cash used in the operations of the business.

However, it is important for a prospective investor to understand that a high turnover does not only indicate that the company is operating in the best interests of its customers. A high turn over may also indicate that the business company policies are too stringent and thus the company is missing out on sales opportunities to its competitors (Harrison, et al, 2002). Alternatively, a low turnover or which is seen declining means that the company’s customers are struggling with the credit policy that is set out by the company and thus are having trouble paying their bills. In this regard, this turnover ratio is very significant when any company is developing its credit policy.

Creditors are able to measure how effective companies are in paying off their financial obligations, when determining whether to extend their credit facilities to them. The financial ratio that is used in this case is the liquidity ratio, that helps establish any company’s ability in meeting its financial obligations usually short term financial obligations (Harrison et al, 2003). However, it is important to understand that the level of liquidity is not standard and thus varies from different existing industries. One example is a business that runs a grocery store; this business entity, usually demands cash on a regular basis in order to run its business operations. In contrast, a technological run store will need less operational cash in the daily running business operations. In addition, every business has its own unique trend over the liquidity ratio that is recorded over a financial period.

When a company wants to expand its business operations, it is the ideal option of seeking long term financial services. In this regard, a company is able to measure or determine its payback ability by calculating its solvency ratio. This is an important financial ratio that either allows a company to get long-term financing or to stay steer on it. This ratio is able to do this because it provides an insight to the capital structure of any company as well as its existing financial leverage that is being used by a firm (Butzen & Fuss, 2002). In the recent years, investors use the insolvency ratio in determining whether firms have adequate cash flows that are important in paying fixed charges or even the interest payment. Therefore, a company that presents low cash flows is deemed to be overburdened with its debts. In this scenario, investors may opt out and the company’s bondholders are likely to push the company into default.

Ratios are an important tool of making profitable financial decisions from any angle, whether as an investor or as a business firm. All these financial ratios have their own distinct impact of firms and business organizations. They present financial constraints that may hinder firms from accessing venture capital or financial aid from companies. In addition, other constraints may include rising interest rates as well as inflation (World Bank, 2005). Therefore, it is very stringent for companies strive in building contingencies in their cash flow budgets that are important in dealing with such adverse changes that may occur in the financial environment. In addition, it will be a bad idea for any start up firm to rely fully on loans from financial institutions such as banks or funding from venture capitals for their business plans (World Bank, 2005). This is because there could be a rise of financial constraints that would be unfavorable for the company. A financial constraint such as inflation could mean that raw materials or labor costs may consequently increase to higher levels causing such start ups to close business.

References

Butzen P., Fuss, C. (2003) Firm’s Investment and Finance Decisions: Financial Ratios Theory and Practice. New York: Routledge

Harrison, A., McMillan M., & Love, I. (2002). Global Capital Flows and Financing Constraints. New York: Rowman & Littlefield Publishers.

World Bank. (2005). Financial Ratios in the Finance Sector: A Handbook. New York: International Monetary Fund.

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Revenue Recognition Construction IAS 11

Revenue Recognition

A Summary of How Revenue is recognized within the Construction Industry under IAS 11

Title: Revenue Recognition: Construction contracts are designed to meet specifications for the negotiations on how assets are constructed or combined to meet their ultimate objectives (Buschhüter, Michael & Andreas 2011). Contract constructions may involve fixed prices where some are subjected to the cost escalation costs. On the hand, a cost plus contract involves reimbursements or allowable and percentages of costs or the fixed rates present. The changes were made to meet the standards of Financial Accounting (IFRS 15 2014). Revenue is considered to be income earned from everyday activities as it goes by different names such as royalties, dividends, interest, fee or sales.

Revenues that are to be recognized would be from the selling goods, providing services royalties and interest. However, in this case, revenue is to be recognized from the construction of contracts. Construction contracts may be either fixed or cost plus contracts or a combination of the two (IAS 11 2011).

In this regard, a contractor needs to identify and determine what contract to use to know when to recognize revenue and costs as well. When the outcome can be properly estimated, the contract revenues and costs would be recognized as revenues and expenses respectively at the end of the contract period. A loss is also recognized as an expense by the accounting standards.

In fixed price contracts, construction contracts are estimated reliably once total contract revenues are reliable. The revenues are considered as benefits since the effects will be felt positively by any business. Stages of contract completion, as well as, the contract costs have been reliable to meet the standards. All contract costs are to be measured reliably to account for the actual contract costs that would be incurred when compared.

Similarly, for cost plus contract to be enforceable, the economic benefits of the contract have to be passed to the entity. The costs have to be also clearly and easily identified for measurements to be done reliably (IFRS 15 2014). The recognized revenue at the end of a contract is considered to be the percentage of completion. This whereby the contract revenues are matched with the contract costs and then reported in the books of account.

Revenue Recognition
Revenue Recognition

Afterward, the contract revenues and costs are recognized as revenues costs in the profit and loss account. The expected excess of costs over revenues is treated as expenses. If the outcomes are not measured reliably, the revenues will not be recognized and perhaps not even recoverable in the business. An entity will then disclose the revenues recognized during the accounting period as techniques of arriving at the revenues will be recognized as well.

A Description of the Process of Developing New Standards IFRS 15

The International Financial Reporting Standard had to be formed by the Internal Accounting Standards Board; IASB to provide rules and procedures on how to account for revenues that are from customers. There were significant differences between IASB and the IFRS when it came to the definitions of revenue.

Even though they were almost similar, the different understanding of revenue resulted in different ways of treating revenue in financial accounting. The IASB thought they had not given enough revenue standards, policies and procedures on how revenue was treated (IAS 18 1993).

The IASB began working on the issues to try and formulate ways it could solve the issue from 2002.Their first review paper was released in 2008 as they further discussed it and gathered information from relevant sources. Afterward, a release on the exposure draft was done proposing the new accounting standards in 2010 and 2011. After a long process of deliberations and reviews that took several years, the IASB issued the final standard on 28th May 2014.

Changes made about the IAS 18 included recognizing and measuring financial tools revised in 2003 and the 2004 revision of insurance contracts. In 2007, the presentation of financial statements was reviewed through amendments in the different terms used. Their first issued review in 2008, involved investment costs in jointly controlled entities and subsidiaries as well as improvements on the IFRS. The same year also saw IFRIC agreements on issues relating to the constructions of the real estate.

The IFRIC 15 also dealt with issues of the non-monetary contributions by investors in entities that are jointly controlled as they evaluated all legalities in leasing or substance transactions. Barter trade and service concession agreements were also made as they issued customer loyalty programs in 2007 (IAS 18 1993). The IFRS 15 model follows procedures that begin with the; identification of the contracts as well as all individual parties involved.

Transaction prices are also determined as the prices are allocated to the different obligations in accounting. Revenues are finally recognized as the performance obligations are fulfilled. The amount of revenue to recognize and when acquiring costs are capitalized as assets are under the guidelines of the IFRS 15. Any of the expenses not capitalized as assets are considered to be expenses incurred. After all proper recognitions are reporting is done, financials are to be properly disclosed by the company.

Why the Process of Developing New Standards has proven to be difficult and Time-consuming

The new revenue recognition standards had left out key areas that bring in revenue and had not been recognized. New standards on how to recognize revenue had to be set for businesses to follow by the relevant bodies. The objective of the new set of rules and procedures is to explain how the different revenues would be treated.

Revenue recognition is recognized when it estimated to bring economic benefits that are measurable to the business in the future. Therefore, practical guidance is given on how the criteria will be met. The International Accounting Standards Board adopted previously issued the construction contracts and the new standards of recognizing revenue.

IAS 18 was put in place to replace the former methods of recognizing revenue while the IAS 11 replaced some accounting rules on the construction of contacts (Buschhüter, Michael & Andreas 2011). This is to help in knowing how to treat costs and revenues that are associated with the nature of activities undertaken.

Also, due to the then existing rules, changing to new standards had to take long processes of deliberations that were time-consuming. Steps had to be followed as described above as company’s found it hard to easily and quickly adapt to the new set of rules. The new set rules had to be then applied first to see if they would meet the specifications with no interference of other accounts that would result in imbalances in the financial statement and misappropriation and misallocation of resources.

Changing one side would have to result in changing of the other side to cancel out the effects. For instance, in ledger accounts, a debit entry has to be followed a credit entry and vice versa is also true.

What people do not know is that different firms have different accounting rules they follow. A majority however, follow the international standards while others follow the U.S. GAAP principles (Kieso, Jerry & Terry 2010). Unlike the U.S. GAAP, the International Financial Reporting Standards does not always give extensive regulation prompting the need of having some exercises in judgments in some instances. The U.S. GAAP accounting is based on standards while the IFRS focuses more on principles.

The accounting differences have made the financial comparison between different organizations difficult. For instance, actuarial gains and losses are treated differently. They are treated as off-balance sheet items by the IFRS standards unlike under the U.S GAAP. The off-balances in the balance sheets would cause volatilities and fluctuations. Therefore, the IASB is trying as much as it can to harmonize the differences in the standards. This would also take time as the harmonization would require changes in almost every aspect of accounting (IASB 2006). Adaptation by firms would take time as well making it a difficult and a long, tedious process.

A Summary of how the New Standard IFRS 15 would Deal with a Construction Contract where Construction Happened Over One Accounting Period

The important principle of IFRS is that a company would have to recognize revenue for it to be related to the transfer of the commodities and services that were promised and what the company is expected to get. Services rendered depend on the agreement of the specific time it should cover. The period might exceed one accounting period as would be expected.

An accounting period is often considered to take one year. This, therefore, means that more than one accounting period takes more than one year. The work done at construction contracts usually take more than one accounting period. Therefore, rules have to be set that best suit the situation. One of the methods is to recognized revenues or profit at the end of the contract. This would be through following the IAS 18 – Revenue (IAS 18 1993).

Recognizing profit at the end of the period does not show that profit was accrued. Under the IAS 11 all revenues and costs will be matched to the accounting period and documented at the end of each financial period (IAS 11 2011). Recognition of profit at the end of the contract would see the company reporting spikes or rises in profits that may not often be matched with the accruals. This is because the revenues would have accumulated to amounts exceeding what would have been recognized in one accounting period (Ursachi, Antonela, & Geanina 2014).

In this regard, revenues and costs are only recognized once estimations of the outcome are reliable. As stated earlier, properly estimated outcomes from contracts should be reliable for use and interpretation. An expected contract loss should be recognized immediately. The completion stage would be calculated on the basis of sales, costs, and physical proportions.

Revenue recognition done at the end of the construction contracts is known as the percentage of completion method. The reported revenue and costs would later be credited to the proportion of work that was completed (IAS 11 2011). The contract revenue is recognized as revenues while the contract costs as expenses in the profit and loss accounts. Similar to when accounting was done in one accounting period, expected amount that exceeds when contract costs are more than contract revenues are treated as expenses.

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Reference List

Buschhüter, M & Andreas S 2011, ‘IAS 11–Revenue Recognition & Construction Contracts’, Kommentar Internationale Rechnungslegung IFRS. Gabler, 374-391.

International Accounting Standards Board Revenue Recognition: (IASB) 2006, ‘International Financial Reporting Standards (IFRS’s): Including International Accounting Standards (IAS’s) and Interpretations’, International Accounting Standards Board.

International Accounting Standards Committee 2010, Revenue Recognition – ‘IAS 18’ Revenue, London: IASC 1993.

Kieso, E, Jerry W, & Terry W 2010, Intermediate accounting – Revenue Recognition: IFRS edition. Vol. 1. John Wiley & Sons.

Ursachi, Antonela, & Geanina M 2014, ‘IFRS 15–revenue from contracts with customers – Revenue Recognition,’ 2nd International Conference-2014.

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Accounting Information System Risk

Accounting Information System Risk

The main aim of this article is to highlight the risks and security threats faced by a Hong Kong based online supermarket. It typically examines the status of current e-commerce businesses across Hong Kong, particularly the ones specializing in fresh produce. The careful analysis of facts and figures based on this information shows that there are several risks and security threats associated with online supermarkets. The risks can be broadly categorized into primary and secondary, and can be further sub-categorized. For the safe running of an extremely vulnerable (yet profitable) online business, it is quite important to chalk out the strategies and measures beforehand. The report concludes by enlisting the various risk management measures that can be applied efficiently to protect the business in times of a crisis.

Background

Online shopping has become a part and parcel of everyone’s life. It is a fact beyond denial that e-commerce has slowly but gradually posed itself as a market takeover business, ready to outpace U.S. brick-and-mortar in the upcoming decade. Numbers suggest that it will reach a total of around $370 billion by the year 2017. The extensive growth of e-commerce is irrespective of the geographical location in contrary to the popular belief that western countries are much more advanced in this business. E-commerce industries are budding in countries like China, Japan and India, and these companies are equally competing in the global market. For instance, Chinese e-commerce Company – Alibaba group has been giving a tough time to giants like Amazon and Walmart. Recent statistics has shown that the numbers are rising in countries like China and India, and they are even successful. On the other hand, over the past few years the numbers have steadily declined in the West due to the stringent government policies. The tax laws have become stricter, the revenues have gone down and there are numerous other reasons for this decline.

Hong Kong has seen a tremendous growth in the online business sector over the last decade. Here are a few facts about Hong Kong:

  • The overall penetration rate of mobile subscribers: 240.2%
  • The penetration rate of broadband connection: 83.3%
  • Penetration rate of PCs for various business sizes (ranging from small to big): 75.2%
  • Percentage of internet usage by business organizations (all inclusive): 74.8%
  • Total number of hotspots established by private sector and the Government: 31,879
  • Total ICT spending: 6,273 million

These stats clearly reveal that why Hong Kong has become an ideal place for a new online based business. There are other benefits as well. The initial capital and fund requirement is low. The friendly government policies like 0% corporate tax for outward-bound transactions, no sales tax make it even easier for the new companies. So Hong Kong is an ideal place for setting up an online business.

Despite several policies and benefits, there are potential risks even in Hong Kong. Every business has its unique set of risks. A physical warehouse situated in an earthquake-prone area, for instance, can go down at any point of time. An online store’s payment getaway can be brought down by an anonymous hacker. Likewise, online companies in Hong Kong also face a wide variety of risks.

On the other hand, security threats have become a major issue for online companies over the past few years. Cyber-attacks have led to the loss of revenues. Many people have had a psychological effect on their mind questioning the safety during a purchase. So starting a business may seem very exciting and well-decided initially but as the problems slowly develop, they begin to diminish all the excitement that once used to exist.

An online supermarket based in Hong Kong is prone to all kinds of risks. The involvement of perishable items, dependency on online consumers and several other essential factors play a huge role in determining the success of the business. There will be risks, but there is no denying the fact that effective strategies can be devised to minimize them to a certain extent (if not completely).

The next section presents an elaborate discussion on the various risks posed on an online supermarket specializing in fresh produce. The countermeasures have also been highlighted elaborately.

Discussion

This section talks about the potential threats faced by a typical online supermarket in Hong Kong and the measures to mitigate those threats.

As the risks are exclusive to a typical online supermarket, it is very important to focus on the particular dimensions that define the risks, value and financial forecast for it. The following are a few issues that require investigations, analysis and interpretation prior to their acceptance.

Social Risks

Social risks are an important constraint for every online-based business. One of the issues that will eventually crop up is Unsustainable Site Traffic. In the parallel online universe, site traffic and success are two sides of the same coin. Online Companies depend heavily on organic search capabilities in order to achieve sustained site traffic. It is a fact that online companies generally advertise through Google AdWords and other such mediums. Still, sustaining site traffic remains a sturdy and hard to deal with the challenge for any online company.

Nowadays, Corporate Social Responsibility (CSR) is an important aspect for every company. There are regulatory organizations constantly monitoring a company on social and environmental grounds. Any violation can lead to huge amounts of fine. And, there is always a risk for companies (specializing in fresh produce) because the main source of raw materials is very closely linked to environment and other related factors.

Financial Risks

One of the most important and dreadful financial threats a business may pose is the risk of losing the main income source. Such horrifying moments may appear in any business where the business model may crumble in an instant without any warning, leading to bankruptcy. Once the online business starts to roll smoothly, nobody cares about the worst. There is a certain possibility of becoming complacent thinking that good times will continue till eternity. But the scenario may change entirely within moments and without any prior notice.

For an online supermarket, the business is fragile during the initial stages. There is a lot of competition all around and there is not a consumer base yet. The stakes are high and a lot of money is involved. There is no fixed “return on investment”. In the case of other online companies, the market gradually becomes stable. But the scenario is not the same here. Even if the market becomes stable, the customers will always root for the cheapest and best products. There is always some company ready to shell out quality products at a lower rate to get a hold of the market. Again at times, the quality can degrade due to some unknown reasons. All this affects the revenue of the company.

Accounting Information System Risk
Accounting Information System Risk

It is a matter of fact that most online businesses do not audit their financial records. As a result, in order to verify financial disclosures, the sellers have no other choice but to rely on secondary checks by using combined site metrics and industry benchmarks. If one such aspect of the website’s financial information does not fit with the site metrics, it could indicate that the particular financial information is fraudulent or flawed. In that case, the business may run the risk of being labeled as fraud and non-genuine.

Marketing or Business Risks

Staying unaware of the present market demands and trends can prove hazardous for any online business. Innovation is the key to success in these kinds of companies. The current trends of the market keep changing every now and then without any prior notice. On closer examination, it has been seen that sometimes a business can lead astray and not serve the demands of the market properly. It, therefore, runs the risk of becoming vague and unpopular among the audiences or customers. Every time it’s not about innovating a new product, sometimes a different approach is needed. And not everybody can do that. And that’s why a majority of the online ventures fail today.

For instance, a majority of the online supermarket store sells discounted products to get a stronghold in the online market. This is a common approach used by almost all the sellers. After a certain point of time customers are not interested anymore. Why? Because they are bored to see the same adverts and the same type of deals every day. Some of the online companies take a major hit from this decline and are forced to shut down. And, this can happen to anyone.

Physical Risks

Starting a business is one thing, and managing it is totally different. The owner not only has to manage the funds and invest a lot, but a lot of physical exertion is required in order to ensure smooth flow of the business. Reliable survey reveals that 60% of the average businessman’s time is spent in working hard in order to make the company successful, and the rest of the time is spent on worrying about what is still left to be done. Although more often than not, the rewards of entrepreneurship outweigh the personal risks undertaken by businessmen, but it has also been observed that these risks prove to be lethal in more than a few cases.

Security Threats

Security threats are a major concern among the online retailers these days. The number of hackers has grown over the past few years, and the consequences are worse than ever. From sites getting affected by malware to the breaching of firewalls and what not – the safety of online companies are in jeopardy. Nobody knows when a DOS (Denial of Service) attack will cripple the entire system or when the entire database is wiped out. Things can go haywire in spite of stringent measures. And, this kind of online attacks is even carried out just for fun. A simple example will highlight the present condition of cyber security throughout the world.

A customer has a particular set of products in his cart waiting to checkout, scrutinizing the last minute changes. Once the payment is successful, the seller confirms that the products will be delivered within the next 24 hours. The hacker has already played his part in between. When the products are delivered the next day, the customer is shocked to find the irrelevant products. The hacker had changed the products in the cart. So the customer ordered something, and the online seller received something totally different. So, this customer will never visit the particular website again. And, the company gradually loses its customer base.

Control Measures

Continuous and critical analysis and examination of business have led to the discovery of one fact: Risks in business cannot be nullified, they can only be minimized. While describing the various ways by which one could minimize risks and protect one’s business from threats, proper identification of the threats and its consequences must be clearly illustrated. After that, a company might resolve to a simple good risk management practice that includes contingency and vigilance arrangements or it might adhere to protective security measures in order to reduce the risk to a greater extent.

The following are some of the tried and tested risk management strategies to ensure the smooth running of a business:

Risk Assessment

Assessing the risk is the foremost job that must be undertaken because that would determine the necessary control procedures or security measures required to be implemented. A thorough examination of the available options must be performed in order to avoid investment in ineffective, expensive and unnecessary equipment. Careful planning can prove to be really instrumental in keeping the costs down. For example, introducing new changes at the time of building or refurbishment work may turn out to be profitable.

Planning

Planning is a two-step process. The first one is forecasting because planning foresees the future. Forecasting is all about estimation techniques based on some predefined methods and proper analysis. Estimating the demand, revenues and the risks priorly can cut down the potential threats. Predicting the amount of particular item that a customer will buy the next month requires some amount of skill and a lot of analyses. A lot of wastage can be saved, which in turn reflects in the base revenue. Planning is the best way to devise some strategies (and the backup plans) so that a structured way can be followed while managing a risk.

Adept Cyber Security

In the case of an online shopping website, the importance of cyber security increases manifold. Information security controls are the process, technical, policy and physical safeguards that are designed for the protection of sensitive data by mitigating the identified risks to its integrity, confidentiality and availability. Obtaining an excellent data security program that ensures control and management of identified data security risks is a must regardless of the type of online business. It will limit the organization’s vulnerability to data compromise and hence significantly influences operational, reputational, legal and strategic risks.

Prevention of Employee Theft

Preventing embezzlement or employee theft can be difficult at times. The first and foremost thing is to recognize the signs of warning and, therefore, implement an efficient internal system of controls. The term ‘embezzlement’ is a fancy way of describing that the employees are stealing from the company, and it is a common scenario, especially in online-based grocery stores. A few signs have been interpreted below as warning signs of embezzlement.

  1. A fraudulent scheme is often covered up by atypical bad-debt write-offs. A decrement or little increase in credit or cash sale could indicate that a number of transactions have not been traced.
  2. Concealments of accounts receivable payments can be done by increasing the overall sales returns.
  3. Too many bounced company checks can be a result of funds that are siphoned out of the bank account.
  4. Often embezzlement is masked aptly by slow collections.

Risk Insurance

In managing risk, insurance could act as a principle safeguard. And it must be noted that most risks are insurable. For any business occupying physical space, the first necessity is fire insurance. Product liability insurance comes next in the list. Some specialized insurance companies underwrite cash bond in order to provide monetary coverage in case of embezzlement, fraud and theft. The golden rule is to consider the worst case scenario while insuring against the potential risks.

As the business develops and evolves, the risks and threats associated with it emerges side by side. But sure enough there are ways to prevent them, insure them, and minimize the damage if not nullify them.

Conclusion

A business cannot exist without a particular set of risks. There’s nothing called a risk free business. It is never easy to run an online supermarket because there are lots of factors that are constantly changing, and so are the risks. Scheduled evaluation and efficient planning are the only way to keep a check on the dangling factors. No matter whatever the strategies are, they should be revised and updated from time to time ensuring an almost perfect way to mitigate the risks, and assure the consistent functioning of the business.

References

Dozier, W. John (2008, July 30). Legal: The Top Ten Risks For Online Businesses.

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