Cost Concepts Flashcards
Identify some of the responsibilities of the financial management function of an entity.
- Managing the capital and financial structure of the entity;
- Planning, allocating and controlling an entity’s financial resources;
- Identifying and managing financial risks faced by the entity.
What is the ultimate objective of the financial management function in a profit-oriented entity?
The ultimate objective of financial management is to maximize the value of the entity, usually as reflected by the market price for the firm’s stock.
Define “cost” as used in accounting.
Amount paid or obligation incurred for a good or service; may be unexpired or expired. An unexpired cost is an asset. An expired cost is an expense.
Define “sunk cost.”
Costs incurred in the past that cannot be changed by current or future decisions and, therefore, are irrelevant to current decisions. (EX: original cost of equipment - has already been paid)
Define “opportunity cost.”
Benefit lost from an opportunity as a result of choosing another opportunity. It is measured as the discounted value of the cash flow or other benefit foregone and is relevant in making current decisions.
Define “differential cost.” (also called incremental costs)
Costs which are different between two or more alternatives. Differential costs are relevant in making decisions between the alternatives. For example: In deciding whether or not to accept a special order for a product, only the new costs that would be incurred in accepting the order would be relevant. Fixed costs that would not change whether or not the order is accepted would not be relevant.
What are the major elements of a firm’s capital (or capital structure)?
Long-term debt, Preferred stock and Common stock.
Define “weighted-average cost of capital.”
Cost of each element of capital weighted by the proportion (percentage) of total capital provided by each element, with the resulting products summed to get the weighted average cost for all elements of capital.
Define “expired cost.”
The benefit to an entity from the good or service that has been used up and is of no future value to the entity. An expired cost is an expense (.e.g., cost of wages and salaries) or a loss (e.g., cost of goods destroyed by fire).
Define “unexpired cost.”
An asset; it has future value to the entity (e.g., the cost of a 3-year insurance policy would be an asset during the period covered).
Define the “present value” of $1.
Value now (at present) of a single amount to be received in the future.
Amount to be received in the future is discounted using an interest rate to get the present value of that amount.
Define the “future value” of $1.
Value at some future date of a single amount invested now.
Amount that will accumulate as a result of compounding of interest on the single amount invested at the present.
Define the “present value” of an ordinary annuity.
Value now of a series of equal amounts to be received at the end of equal intervals over some future period
Equal amounts to be received at the end of a number of equal periods are discounted using an interest rate to get the present value of those amounts.
Define “future value” of an ordinary annuity.
Value at some future date of a series of equal amounts to be invested at the end of equal intervals over some period of time.
Amount that will accumulate as a result of the amounts invested at the end of each period and the compounding of interest on those amounts.
Define the “future value” of an annuity.
Value at some future date of a series of equal amounts to be invested at the beginning of equal intervals over some period of time.
Amount that will accumulate as a result of the amounts invested at the beginning of each period and the compounding of interest on those amounts.
Distinguish between an “ordinary annuity (also called an annuity in arrears)” and an “annuity due (also called an annuity in advance).”
Ordinary annuity: Series of equal amounts received or paid at the end of each equal period. (Vowels - OA E)
Annuity due: Series of equal amounts received or paid at the beginning of each equal period. (Rent due at beg of each month)
Define “interest”.
Cost of the use of money. Expressed as a percentage rate, almost always as an annual percentage rate, applied to the principal to determine dollar amount.
Define a “fixed interest rate”.
The percentage rate of interest does not change over the life of the loan or parts of that life.
Define a “variable interest rate”.
The percentage rate of interest can change over the life of the related debt instrument.
Define “stated rate (of interest)” (also used interchangeably as “nominal rate” or “quoted rate”).
The annual rate of interest specified in a debt instrument or other contract/agreement; it does not take into account the compound effects of payment frequency.
Define “simple interest”.
Interest computed on the principal only; there is no compounding in the interest computation (i.e., no interest paid on interest).
Define “compound interest”.
Interest computed not only on the principal but also on any accumulated unpaid interest (i.e., interest is paid on interest).
Define “effective interest rate”.
- The annual interest rate implicit in the relationship between the net proceeds of a borrowing (or other arrangement) and the dollar cost of the borrowing (or other arrangement).
- Computed as: Dollar cost of borrowing/Net proceeds of borrowing.
Define “annual percentage rate (APR)”.
- The annualized effective interest rate (without compounding) on loans that are for a fraction of a year. In effect, the effective interest rate for a portion of a year is “grossed up” 2. Computed as the effective interest rate for the fraction of a year multiplied by the number of such fractions in a whole year.
- Basis of interest rate disclosure in U.S.
How many days in a year should be used on the exam?
360 commonly used on CPA exam to make calculations easier.
Define “effective annual percentage rate” (also called the “annual percentage yield”).
Annual percentage rate with compounding on loans that are for a fraction of a year.
