Definitions

Question 1

Change in accounting principle

Answer 1

Occurs when entity:

1) adopts a generally accepted principle different from one previously used
2) changes method of applying a principle, or
3) changes to a new principle when the old one is no longer accepted

Requires retrospective application, so balance sheet is adjusted at beginning of period to reflect cumulative prior period changes

Question 2

Change in accounting estimate

Answer 2

Results from new information and a reassessment of the future benefits and obligations represented by assets and liabilities

Requires prospective application, or only the current and future periods

Question 3

Accounting error

Answer 3

Either:

1) mathematical mistake
2) mistake in application of gaap
3) oversight or misuse of facts when statements were prepared

Requires prior period adjustment by restarting prior period (to ensure consistency and comparability)

Question 4

CAPM formula and use

Answer 4

Req rate of return = Rf + Beta(Rm - Rf)

Quantifies required return by relating the risk of the security to the average return available in the market.

Challenges: hard to estimate risk free rate, and should only be used for single period (1 year or less)

Question 5

Covariance of a two stock portfolio

Answer 5

Correlation coefficient x standard deviation 1 x standard deviation 2

A measure of the two stocks’ mutual volatility

Question 6

Formula - cost of not taking trade discount

Answer 6

Discount % / (100% - discount) x (days in year / (total payment period - discount period))

An annualized cost. Shows the effective rate paid to finance the full amount over the full credit term.

Question 7

Usable funds formula

Answer 7

Invoice amount x (1.0 - discount %)

Question 8

Effective interest rate on loan

Answer 8

Net int expense / usable funds

Is the ratio of the amount the firm must pay to the amount the firm can use

Question 9

Simple interest loan

Answer 9

Occurs when interest is only paid at end of loan term. Stated nominal rate equals effective rate.

Question 10

Discounted loans

Answer 10

Requires interest to be paid at beginning of loan.

Loan amount = usable funds / (1.0 - stated rate)

Interest expense = loan amount x stated rate

Effective interest rate = stated rate / (1.0 - stated rate)

Question 11

Loan with compensating balance

Answer 11

When bank requires borrower to maintain a balance during the loan term

Loan amount = usable funds / (1.0 - compensating balance rate)

Effective rate = stated rate / (1.0 - compensating balance rate)

If loan is offered on discounted basis:
Effective rate = stated rate / (1.0 - stated rate - compensating balance rate)

Question 12

Constant growth dividend discount model

Answer 12

Expected div per share / (discount rate - div growth rate)

Used when dividend growth is expected to be consistent. If calculation is higher than current stock prices stock is undervalued

Expected div = last div paid x (1 - growth rate)^t

t = time periods

Question 13

Calculating stock value with variable dividend growth

Answer 13

Two stage discount model.

1) calc and sum PV of dividends in high growth stage
2) calc the PV of the stock based on street growth, back to year 1
3) sum 1 and 2

Question 14

Preferred stock valuation

Answer 14

Dividend per share / cost of capital

Question 15

Component costs of capital (used for WACC

Answer 15

Debt = effective rate x (1.0 - marginal tax rate)

Pref stock = cash dividend / mkt price of pref stock

Common stock = cash dividend / mkt price of common stock

Retained earnings is same as CS

Question 16

WACC calc (no pref stock)

Answer 16

(Mkt value of equity/(D+E) x cost of equity) + (mkt value of debt/(D+E) x cost of debt) x (1 - tax rate)

Question 17

Marginal cost of capital

Answer 17

Weighted average cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted

Question 18

Cost of new debt, new pref stock, and new common stock

Answer 18

Debt = Annual interest / net issue proceeds

Pref stock = next dividend / net issue proceeds

CS = (next dividend / net issue proceeds) + dividend growth rate

Question 19

Long vs short position

Answer 19

Long = whenever entity benefits from rising price

Question 20

Calculate benefit of speeding up cash collections

Answer 20

(Daily cash receipts x days of reduced float) x opportunity cost of funds

Subtract cost to get total benefit/(loss)

Question 21

4 steps to making disinvestment decision

Answer 21

1. Identify fixed costs eliminated by decision
2. Determine revenue needed to justify continuing ops. In short run, this should at least equal variable cost of production or continued service.
3. Establish opportunity cost of funds received upon disinvestment.
4. Determine whether the carrying amount of the asset(s) is equal to economic value. If not, reevaluate decision using current fair value rather than carrying amount.

Question 22

Price elasticity of demand

Answer 22

measure of change in demand relative to change in price
-always positive value
> 1 means relatively elastic (small change in price results in large change in demand)
= 1 means unitary elasticity. One for one change in both demand and price.
< 1 means relatively inelastic. Large change in price results in small change in demand.
Infinite = demand is perfectly elastic. Results for market in pure competition - single seller demand goes to 0 with any decrease in price.
= 0 means perfectly inelastic. Demand is the same regardless of price.

Question 23

5 types of risks

Answer 23

1. Hazard risks - insurable risks (natural disasters, death, sabotage, impairment of assets, terrorism)
2. Financial risks - risk related to interest rates, FX, commodities, credit, liquidity, and markets.
3. Operational risks - related to everyday, ongoing operations. Risk of loss from inadequate or failed internal processes, people, and systems. Includes legal and compliance risks.
4. Strategic risks - includes global economic risk, political risk, regulatory risk, and risks related to global market conditions. Also reputation risk, leadership risk, brand risk, and changing customer needs.
5. Business risk - risk that company will have lower than expected profits.

Question 24

5 step in risk management process

Answer 24

1. Identify risks that could have impact on organization.
2. Assess risk probability and potential impact.
3. Prioritize risks - large orgs may appoint a committee to review risks and allocate resources
4. Formulate response - committee proposes response strategies, and communications sent out to relevant team members
5. Monitor risk responses - someone close to the operations (ex. manager) must monitor, and internal audit should also review effectiveness.

Question 25

5 strategies for risk response

Answer 25

1. Avoidance - ends activity from which risk arises
2. Retention - acceptance of risk (i.e. self insurance)
3. Reduction - act of lowering the risk of an activity (mitigation)
4. Sharing - transfers loss to another party (ex. insurance)
5. Exploitation - deliberate courting of risk to pursue high return on investment

Question 26

5 components of COSO ERM framework

Answer 26

1. Governance and culture - sets the tone and establishes culture. 5 principles:
   A. Board exercises risk oversight
   B. Org establishes operating structures
   C. Org defines desired culture
   D. Org demonstrates commitment to core values
   E. Attracts, develops, retains capable individuals
2. Strategy and objective setting - supports mission, vision, and core values. 4 principles:
   A. Org analyzes business context and risk profile
   B. Org defines risk appetite
   C. Org evaluates alternative strategies
   D. Org established business objectives
3. Performance - practices that support the org’s decisions in support of value. 5 principles:
   A. Org identifies risks
   B. Org assesses severity of risks
   C. Org prioritizes risks
   D. Org selects risk responses
   E. Org develops portfolio view of risk
4. Review and Revision - reviews and revises ERM capabilities based on changes. 3 principles:
   A. Identify and assess changes
   B. Review entity performance results
   C. Pursue ERM improvement
5. Information, communication, and reporting - org must capture, process, manage, and communicate information to identify risks. 3 principles:
   A. Leverage information systems
   B. Use communication channels effectively
   C. Report on risk, culture, and performance

Question 27

Internal capital market

Answer 27

Provision of funds from one internal department to another. Avoids issuance and interest costs, but is not really a “market”. More internal budgeting.

Question 28

Linear programming

Answer 28

Computerized technique for optimizing resource allocations to select the most profitable (or least costly) way to use resources

Question 29

IMA statement of Ethical Professional Practice

Answer 29

4 principles (P-HFOR). All members shall act in accordance:

1. Honesty
2. Fairness
3. Objectivity
4. Responsibility

4 standards (S-CCIC). Responsibility to comply and uphold:

1. Competence - maintain leadership and expertise by enhancing knowledge and skills. Perform duties in accordance with laws and regulations. Provide decision support that is accurate, clear, concise, and timely. Recognize and help manage risk.
2. Confidentiality - keep information confidential except when authorized or required. Inform relevant parties regarding use of confidential info. Refrain from using confidential info for unethical or illegal advantage.
3. Integrity - Mitigate actual conflicts of interest and avoid apparent conflicts of interest. Refrain from conduct that would endanger ethics. Abstain from activities that might discredit the profession. Contribute to positive ethical culture.
4. Credibility - communicate objectively and fairly. Provide all relevant information that could be reasonable expected. Report delays and deficiencies. Communicate professional limitations or constraints.

Resolving ethical issues - member should actively seek resolution. Consider all risks involved and protections against retaliation. Follow established policies of organization.

If no policies, consider these options:

1. Discussion with supervisor. IF they are involved, go to next level.
2. IMA anonymous help line can provide guidance.
3. Member should consider consulting personal attorney .

If all are unsuccessful, member should consider disassociating from org.

Question 30

Fraud Triangle Model

Answer 30

3 characteristics of fraud (ORP):

1. Opportunity - to perpetrate and conceal. ONLY characteristic that management can control
2. Rationalization - ability to justify fraud based on varying ethical principles and integrity.
3. Pressure - reason/need for committing fraud

Question 31

SOX 406(a)

Answer 31

Requires code of ethics for senior officers, or disclose reasons for not having one

Question 32

4 levels of corporate social responsibility (CSR)

Answer 32

(ELEP) From most important to least:

1. Economic responsibility - company should profit and stay in business
2. Legal responsibility - company should obey laws and operate within them.
3. Ethical responsibility - company should do the right thing, even if not required by law.
4. Philanthropic responsibility - require company to give back to society (money, goods, or social deeds)

Question 33

Risk profile

Answer 33

Composite view of:

1) the types, severity, and interdependencies of risks related to a specific strategy, and
2) their effect on performance