Monday, May 31, 2021

Concept: ESG


#24


What

  1. ESG - Environmental, Social, and Governance Criteria
  2. Set of standards used by a company's investors to evaluate future investments
    1. Environmental: how does a company perform while being conscious about nature
    2. Social: how does a company manage relationships with employees, stakeholders, customers, and partner communities
    3. Governance: how does a company perform vis-a-vis its leadership, shareholder rights, audits,  and internal operations
Also known as:
  1. Socially Responsible Investing (SRI)
  2. Sustainable investing
  3. Impact investing

How It Works

Environmental criteria:
  1. Investors usually audit a company’s:
    1. Energy use
    2. Amount of waste generated
    3. Pollution levels
    4. Natural resource conservation behaviour
    5. Treatment of animals
  2. Environmental risks evaluated:
    1. Ownership of contaminated land
    2. Disposal of hazardous waste
    3. Toxic emissions management
    4. Compliance with government environmental regulations
Social criteria:
  1. Investors usually evaluate a company's:
    1. Business relationships
    2. Criteria of working with suppliers that hold the same values as the company
    3. Donation policy for profits
    4. Volunteering opportunities for employees in local communities
    5. Policies for health and safety of its employees
    6. Consideration for and category of the interests of its various stakeholders
Governance criteria:
  1. Investors assess if a company: 
    1. Utilizes accurate and transparent accounting methods 
    2. Provides its stockholders an equal opportunity to vote on important issues
    3. Avoids conflicts of interest for choosing board members
    4. Avoids employing political influence for partial treatment
    5. Avoids engaging in illegal practices

Examples

Examples of companies who did not abide by the ESG criteria and were thus deemed risky to invest in:
  1. BP's 2010 oil spill
  2. Volkswagen's emissions scandal

Investors

Companies and financial institutions that evaluate companies using the ESG criteria to determine their potential investments:
  1. Boston-based Trillium Asset Management
  2. JPMorgan Chase
  3. Wells Fargo
  4. Goldman Sachs



Friday, April 16, 2021

Concept: Ring-Fence


#23


I came across this concept when working on a supply chain problem, where one of the requirements was to 'ring-fence the inventory so no other businesses can access it.' Turns out, it has a connotation in finance too.



What?

  • A virtual barrier segregating a portion of an individual's or company's financial assets from all else
  • Usually done to reserve money for some reason, reduce taxes on the individual or company, or to protect the assets from losses incurred by other activities
  • Can also be used as a method for mitigating liquidation risk or to improve a corporate credit rating

Example

Moving a portion of assets offshore to reduce an investor's net worth


History

When Warren Hastings took charge as the Governor-General (1772-1785) at a critical period of British rule when the British were to encounter the powerful combination of the Marathas, Mysore and Hyderabad, he introduced a ring-fence policy, aimed at creating buffer zones to defend the East India Company's frontiers


Related

Ring-fencing in banking - a new regulation requiring the largest UK banks to separate their core retail banking services from their investment banking and international banking activities


Sunday, February 14, 2021

Concept: Golden Parachute

#22


What?

  • Contracts in the form of substantial benefits given to key executives who have been laid off after a takeover
  • Form of poison pill 

Concept

  • Used as a type of anti-takeover measure
  • Named so because their aim is to provide a soft landing for employees at higher levels who have lost their jobs
  • Benefits may include cash bonus, insurance, stock option, severance pay, pension package
  • Compensation is usually thrice the annual basic salary of top executives


Disadvantages

  • Controversial practice 
  • Lucrative for short-lived CEOs and low-performance executives, who get paid large sums for less or poor work
  • The target company becomes less attractive when the Golden Parachute cost is a lot higher for the acquiring company


Examples

  • Dell Inc.'s merger with EMC Corporation compensated EMC's CEO with $27 million
  • CEO Meg Whitman of HP may receive over $9 million if there is a change of control at the company and more than $51 million if she is terminated
  • If in May 2016, the federal court had not blocked the merger, Staples Inc. and Office Depot Inc's merger would have resulted in Office Depot's CEO collecting $39 million


Similar Terms

  • Golden Handshake
    • A contract clause wherein the employer provides a significant severance package to the employees who have lost their jobs
  • Golden Coffin
    • A death benefit package awarded to the heirs of high-ranking executives who pass away during employment
  • Silver Parachute
    • Special compensation for specific employees when their position becomes redundant in the company 



Sunday, January 31, 2021

The fall of Lehman Brothers

#21


What?

Collapse of Lehman Brothers, a financial services firm, in the 2008 financial crisis


Related Concepts

  • Subprime mortgage crisis
  • Mortgage-backed security (MBS) 
  • Collateralized debt obligation (CDO)
  • Too big to fail


Timeline of events

  • In 2004, amidst the housing bubble, Lehman acquired five mortgage lenders and dealt with loans without documenting the numbers
  • Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006
  • In 2007, the firm announced $4.2 billion in net income on $19.3 billion in revenue
  • When Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion, defaults on subprime mortgages began to rise to a seven-year high
  • Things started going downhill from then on
  • On June 7, 2008, Lehman announced a Q2 (2nd quarter) loss of $2.8 billion
  • Lehman's stock plunged by 45% while the firm's debt saw a 66% increase in credit-default swaps
  • Lehman Brothers filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt


Impact

  • A company that had been alive for more than a century and a half was forced to file for bankruptcy, the largest bankruptcy filing in US history
  • The failure of the fourth-largest investment bank in the US had severe ramifications for the global economy
  • The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average (DJIA)


Aftermath

  • President Bush announced a $700 billion bail-out plan to help salvage the remaining pieces of the financial sector
  • The Dodd-Frank Act was implemented to help increase financial regulation


Related Movies

Too big to fail, The big short


Notes

Subprime mortgage crisis:
  • Occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market
  • When the Federal Reserve increased the rate, it resulted in increased mortgage interest rates which in turn caused home prices to plummet, and borrowers to default on their loans

Mortgage-backed security (MBS):
  • An investment similar to a bond 
  • Constitutes a bundle of home loans bought from the banks that issued them
  • Put simply, they are shares of a home loan sold to investors
  • Working:
    • A bank lends a borrower the money to buy a house and collects monthly payments on the loan
    • This loan, one of many, is then sold to a larger bank 
    • This bank ties the loans together into a mortgage-backed security and issues shares aka tranches (French for "slices") to investors
    • Investors collect the dividends in the form of monthly mortgage payments

Collateralized debt obligations (CDOs):
  • In the above working of an MBS, the shares or tranches can be repackaged and resold as other securities aka CDOs 

Too big to fail:
  • A financial organization so massive to the global economy that the central bank must prevent it from going bankrupt



Sunday, January 17, 2021

Concept: Poison Pill

#20

What?

  • Counter to Greenmail
  • Defense strategy used by a target firm to prevent a hostile takeover by another company via diluting its shares

Concept


  • Poison pill: something that's difficult to swallow or accept
  • Allows existing shareholders to purchase additional shares at a discount and thus diluting the ownership interest of the hostile party
  • This process raises the acquisition costs thereby deterring takeover attempts

Origin

  • Devised by Wachtell, Lipton, Rosen, and Katz (legal firm in NY)
  • Been around since the 1980s 
  • Spies used to carry poison pills to avoid being questioned by their enemies when captured

Types

  • Flip-in, flip-over (among others)
  • Flip-in is more commonly followed
Flip-in Strategy
  • Allows shareholders (except for the acquirer) to purchase additional shares at a discount before the takeover is finalized
  • Though purchasing additional shares provides shareholders with instantaneous profits, the practice dilutes the shares already purchased by the acquiring company
  • Provisions of flip-in usually in the company's bylaws or charter itself

Flip-over Strategy

  • Allows stockholders of the target company to purchase the shares of the acquiring company at a deeply discounted price if the hostile takeover attempt is successful
  • A target company shareholder may dilute equity by buying the stock of its acquirer at a two-for-one rate
  • The acquirer may thus avoid the acquisition in the case it perceives a dilution of shares after the acquisition

Examples

  • 2012: Netflix (NFLX) announced a shareholder rights plan after investor Carl Icahn acquired a 10% stake
    • Any new acquisition of 10% or more, any Netflix merger, sales, or transfer of more than 50% of assets would enable existing shareholders to purchase two shares for the price of one
    • Icahn criticized this move as "an example of poor corporate governance"
    • Netflix shares soared to $304 by July 2011
    • The poison pill would allow the stock to reach a price of $350 per share
  • July 2018: Papa John’s (PZZA) adopted a poison pill to prevent ousted founder John Schnatter (30% stakeholder) from acquiring the company
    • The company enforced a Limited Duration Stockholders Rights plan aka the wolf-pack provision, which doubled the share price for those who tried to buy a large stake (31% or more for Schnatter and 15% for others) without the board's approval
    • It thus deterred Schnatter from a hostile takeover

Disadvantages

  • Stock values become so diluted that even shareholders need to purchase new shares just to keep even
  • Institutional investors are discouraged from buying into corporations that have aggressive defenses
  • Ineffective managers can stay in place through poison pills, else VCs might buy the firm and improve its value with better managing staff
Example
  • In 2008, Microsoft offered Yahoo! shareholders $31 per share at a 62% premium
  • They pulled out after Yahoo! launched a poison pill
  • Yahoo's share price took a nosedive leading its Head Jerry Pinto to step down


Sunday, January 3, 2021

Concept: Greenmail

#19

What?

  • Blackmail + Greenbacks (US Dollars)
  • Refers to when a raiding company holding a large chunk of stock forces the target company to buy it back at a premium to avoid a hostile takeover
  • The target company is coerced into making a greenmail payment as a defensive measure to stop the takeover bid
  • Aka bon voyage bonus

Concept

  • A rise in corporate mergers during the 1980s led to the inception of greenmail
  • Corporate raiders would initiate takeover bids with no intention of seeing it through
  • Critics see greenmail as a predatory practice much like extortion
  • Some instead see it as a free-market solution to shareholder conflicts

Examples

  • James Goldsmith earned more than $90 million from the Goodyear Tire and Rubber Company in the 1980s (see notes for the full story)
  • Occidental Petroleum paid $194 million greenmail to David Murdock in 1984
    • David Murdock owned a 5% stake in the company and was a member of its board of directors after the company acquired IBP, Inc.
    • Murdock owned 19% of IBP as well
    • Disputes between Murdock and the CEO Armand Hammer led to a greenmail payment to Murdock of $40 per share
    • Share price in the market was only $28.75
  • Wall Street, the 1987 film, portrays greenmail tactics
    • Fellow corporate raider Sir Larry Wildman refers to Gordon Gekko as "a two-bit pirate and a greenmailer"

Measures put in place

  • Federal and state regulations act as deterrents
  • Internal Revenue Service (IRS) introduced an excise tax of 50% on greenmail profits in 1987
  • Companies introduced defence mechanisms such as poison pills to prevent investors from making hostile takeover bids
  • Anti-greenmail provision (a special clause in a firm's corporate charter) prevents the board of directors from approving greenmail payments

Notes

What happened with James Goldsmith:

Sir James Goldsmith was a notorious corporate raider in the 1980s, minting millions via his orchestration of 2 high-profile greenmail campaigns. One was against St. Regis Paper Company from which he earned $51 million. The other venture that earned him $93 million in only 2 months was the Goodyear Tire and Rubber Company.

When Goldsmith acquired 8.6% stake in St. Regis and threatened a takeover, the company was coerced into repurchasing the shares bought at $35.50 by Goldsmith at a hefty premium of $52 per share. After suffering this loss in 1984, St. Regis fell prey to Rupert Murdoch, after which they sought refuge in Champion International,. agreeing to a takeover at $1.84 billion. Murdoch too received remuneration when he sold his 5.6% stake in St. Regis to the Champion.

In October 1986, Goldsmith purchased 11.5% stake in Goodyear at $42 per share while simultaneously planning a takeover of the company. He filed the takeover with the Securities and Exchange Commission (SEC), after which he proposed to sell off all assets of the company except its tire business. Facing obvious resistance from the Goodyear executives, Goldsmith then offered to resell his shares at $49.50 each. Goodyear lost $2.9billion in this transaction by buying back 40 million shares at $50 each. Unfortunately, Goodyear's stock price plunged to $42 after the buyback.


Sunday, December 27, 2020

Famous Folks - Alan Greenspan

#18

Who?

  • American economist
  • Chairman of the Federal Reserve from 1987 to 2006



Career and Personality

  • Came to the Federal Reserve Board from a consulting career
  • Subdued in public appearances, but media and followers considered him a rockstar
  • Criticized by Democratic leaders of Congress for increasing the deficit via his support for Social Security privatization and tax cuts
  • Called 'inflation hawk' because of his inflation policy, wherein critics claimed he was focusing on controlling prices rather than achieving full employment
  • Blamed in part for both the 2000 dot-com bubble and 2008 financial crisis
  • Known for being adept at gaining consensus among Fed board members on policy issues and for serving during one of the most severe economic crises of the late 20th century, the stock market crash of 1987


Views and Contributions

    • Greenspan was found by the Financial Crisis Inquiry Commission to have contributed to the 2008 financial crisis for his failure to curtail subprime mortgage loans during the housing bubble
      • In a 2004 speech, he suggested that more homeowners should consider taking out adjustable-rate mortgages (ARMs) where the interest rate adjusts itself to prevailing market interest rates
      • He argued that the housing bubble was not a product of short term low-interest rates but rather a worldwide phenomenon caused by the progressive decline in long-term interest rates
      • When interest rates rose, it reset people's mortgages to higher payments causing even more distress for homeowners, exacerbating the impact of the crisis
    • He advocated for slashing interest rates after the 1987 stock market crash to prevent the economy from sinking into a depression
    • After the 9-11 World Trade Center attack, Greenspan led the FOMC to reduce the Fed funds rate from 3.5% to 3% and subsequently to 1%; despite this, the economy remained sluggish
    • The easy-money policies of the Fed during his tenure such as the Greenspan put have been suggested to be a leading cause of the dot-com bubble
      • He used the phrase "irrational exuberance" to imply a warning that the stock market might be overvalued


    Objectivism

    • Greenspan met novelist and philosopher Ayn Rand in the early 1950s, who nicknamed him "the undertaker" because of his penchant for dark clothing and reserved demeanor 
    • He was initially a logical positivist before he converted to Rand's philosophy of Objectivism by her associate Nathaniel Branden
    • During the 1950s and 1960ss Greenspan was a proponent of Objectivism and wrote essays and articles for Rand's 1966 book Capitalism: The Unknown Ideal


    The 'Greenspan Put'

    • Trading strategy popular during the 1990s and 2000s
    • Greenspan attempted to help the U.S. economy by actively using the federal funds rate as a lever for change
      • This encouraged excessive risk-taking leading to put options being lucrative
    • The 'Put' referred to a reliance on a stock market put option strategy that would aid investors in mitigating their losses, thus profiting from deflating market bubbles
    • It suggested that informed investors could expect the Fed to act predictably and make put option derivative strategies profitable during crises


    Fun Facts

    • Greenspan’s interest in facts and figures began at age 5 when he took a liking to recite baseball batting averages of players, which helped him figure out calculations in his head
    • Studied music at Juilliard and toured the country playing tenor sax and clarinet with The Henry Jerome Orchestra
    • Served under four presidents, starting with Ronald Reagan and ending with George W. Bush
    • Describes himself as a "lifelong libertarian Republican"


    Timeline of events

    • Stepped down as Federal Reserve chairman in 2006
    • Global financial markets began to unravel
    • Few financial institutions collapsed while governments experienced massive bailouts 
    • The worst economic downturn in three-quarters of a century ensued
    • Lots of people blamed Greenspan for some or all of this
    • He claimed to have found a flaw, so to speak, in how the world works, in a Congressional hearing in October 2008


    Awards and Honours

    • U.S. Senator John Heinz Award, 1976 (Greatest Public Service by an Appointed Official)
    • Fellow of the American Statistical Association, 1989
    • Commander of the Legion of Honour in France, 2000
    • Order of the British Empire (Civil), 2002
    • Dwight D. Eisenhower Medal for Leadership and Service, 2004
    • First recipient of the Harry S. Truman Medal for Economic Policy, 2005
    • Presidential Medal of Freedom, 2005 (Highest US civilian award)
    • Thomas Jefferson Foundation Medal in Citizen Leadership, 2007


    Quotes

    "It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously."

    "I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant."

    "Government regulation cannot substitute for individual integrity."

    "Unless you are willing to compromise, society cannot live together."

    "I have found no greater satisfaction than achieving success through honest dealing and strict adherence to the view that, for you to gain, those you deal with should gain as well."

    "Anything that we can do to raise personal savings is very much in the interest of this country."

    "The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake."

    "I'm not denying that monopolies are terrible things, but I am denying that it is readily easy to resolve them through legislation of that nature."

    "The very nature of finance is that it cannot be profitable unless it is significantly leveraged... and as long as there is debt, there can be failure and contagion."

    "History has not dealt kindly with the aftermath of protracted periods of low-risk premiums."

    "Revolutions are something you see only in retrospect."


    Notes

    Harsh criticism of his tenure at Fed Reserve:

    Some of Greenspan’s harshest critics point to his earlier association with famed philosopher and novelist Ayn Rand. The essay he wrote for Rand, which also appeared in her book attacked the Federal Reserve and supported the gold standard to back the money.

    Former Congressman Ron Paul of Texas once confronted Greenspan about his turn away from Rand’s ideas of free-market economics and the gold standard, but Greenspan stood firm with his change of views on economics.

    Although Greenspan saw the nation go through tremendous economic growth through the 1980s and 1990s, his last five years as Fed chairman witnessed a 13% plunge in the S&P 500.

    Greenspan featured as one of the "25 People to Blame for the Financial Crisis" Time magazine article, which also suggested that Greenspan's advocation of low-interest rates combined with the unregulated financial system may have sparked the mortgage and banking crisis.


    Sunday, December 20, 2020

    Analysis of Franklin Templeton's Closure

     #17

    Overview

    • Franklin Templeton Mutual Fund closed 6 of its debt schemes in India:
    • Franklin India Low Duration Fund (62.8% of assets invested in bonds rated below A+, 45.76% rated AA)
    • Ultra Short Bond Fund (82.8% in AA rated, 23.9% in A rated)
    • Short Term Income Plan (58.6% in AA rated, 57.5% in A rated)
    • Credit Risk Fund (60% AA rated, 49.6% in A rated)
    • Dynamic Accrual Fund (52.7% in AA rated, 44% in A rated)
    • Income Opportunities Fund (63.97% in AA rated, 41% in A rated)

    Reasons

    • Illiquidity in bond markets
    • Severe redemption pressure
    • SEBI's opening of a window for AMCs to borrow to meet redemptions

    Cause

    COVID-19

    What happened?

    • The above 6 schemes of Franklin Templeton Mutual Fund (FTMF) took aggressive credit calls in their portfolios in the recent past
    • Despite getting higher returns by taking on these high risks, the debt funds and a few liquid funds (safest of the lot) experienced tremendous volatility
    • In the last 18 months due to COVID, worried investors withdrew money and exacerbated the problem

    Which led to

    • Shrinking of the portfolios
    • Funds left with a higher proportion of less liquid (riskier) investments
    • FTMF having to keep borrowing money to pay off the redemptions but reached the borrowing limit as per regulations

    Outcome

    Investors unable to:
    • Withdraw or transfer their existing investments
    • Start any SIP in those schemes
    • Make fresh investments

    Let's talk numbers

    Debt funds:
    • Outflow: Rs 1.94 lakh crore (March 2020)
    • Inflow: Rs 43,431.55 crore into liquid schemes, corporate bond funds, banking and PSU funds, overnight funds, and gilt funds (April 2020)
    Category-wise outflows:
    • Medium duration funds: Rs 6,363.53 crore
    • Short duration funds: Rs 2,309.05 crore
    • Money market funds: Rs 1,210.35 crore
    • Low duration funds: Rs 6,841.07 crore
    • Ultra-short duration funds: Rs 3,419.32 crore
    Credit risk funds:
    • Outflow: Rs 19,238.98 crore (April 2020)
    • Inflow: Rs 6,279.23 crore (March 2020)

    What all did FT try before winding up?

    Borrow
    • FTMF AMC borrowed continuously to fund redemption requirements
    • But were unable to repay the borrowings by selling bonds
    • Will lead to gross asset-liability mismatch in the long run

    Restrict redemptions
    • Current terms for restrictions under the regulatory framework:
      • Maximum suspension period of 10 working days limited to once in a 90-day cycle
      • AMC needs to honour redemptions up to Rs 2 lakh per day per investor
    • The above terms made this approach infeasible

    Elongate redemption payments
    • Redemptions pay-outs were being made on a T+1 basis with a maximum of 10 working days
    • This approach too was unviable because it would only handle the short-term liquidity issues and not the sustained impact of the crisis

    Distress Sale
    • In a distress sale, the AMC would have to sell the securities at a discount to meet redemption requests
    • If so, investors staying invested would have borne significant losses

    Winding up was the only forced choice for FTMF.

    So, when will the investors get their money?

    Once:
    • The macroeconomic situation improves
    • Cash-flow pains will be relieved
    • FTMF makes good on their debts
    • Investors are allowed to withdraw their investments
    • FT does an orderly sale of their investments in order to return the money to investors
    • FTMF communicates an exit strategy for their schemes

    Bright side

    Debt fund redemptions slowed after RBI announced a Rs 50,000 crore credit support for MFs

    FT can attempt to retrieve the value invested in those schemes either by selling the underlying assets (e.g. corporate bonds), or wait for them to reach maturity, when those companies will have to pay back what is owed to them.

    Sunday, December 13, 2020

    Article: Risk in MFs

    #16

    This post compares the risk between equity funds and debt funds.

    Risk: volatility aka fluctuation in price

    Equity

    • Equity funds are riskier in the short to medium term
    • They have a propensity to swing more intensely in either direction

    Debt

    • Two aspects of risk: interest risk, credit risk
    • Interest risk
      • Interest rates may move up or down
      • Rise in interest rates --> fall in bond prices (and vice-versa)
      • A fund comprising long-duration bonds is subject to high risk
    • Credit risk:
      • Risk of default by the bond issuer
      • Debt funds investing in low-rated paper are subject to credit risk

    Fund types and their risk grade

    Equity funds in increasing order of risk:

    • Aggressive hybrid funds (least risky) (35% of assets invested in debt)
    • Large companies (don’t fluctuate erratically)
    • Mid and small caps 
    • Thematic and sectoral funds (undertake theme-specific bets, hence riskiest)


    Debt funds in increasing order of risk:

    • Liquid funds (least risky)
    • Ultra short-duration funds
    • Short-duration funds
    • Medium-duration funds
    • Credit-risk funds
    • Dynamic-bond funds
    • Long-term gilt funds

    How to take risk into account while investing

    Solution: Diversify.

    • Invest across fund houses and schemes
      • This decreases fund-house-specific, fund-manager specific and scheme-specific risks
    • Lessen portfolio risk by investing in multi-cap equity funds


    Sunday, December 6, 2020

    Lessons from Freakonomics

    #15

    While you’ll find my latest book summary on the key takeaways from the book Freakonomics here, which I’ve also recommended as a good book here, let’s understand some of the other lessons mentioned in the book via simple anecdotes.

    Lesson 1:

    Economics is mostly about incentives, which can backfire if you don’t understand how they work

    Anecdote 1:

    There was a daycare that was subject to late pickups. Despite sending home notes and arguing in favour of having respect of children and their caretakers at home, there was no change. So, the daycare decided to send another note one day, saying that a financial penalty would be levied for late pickups. Instead of remedying the situation, the number of late pickups increased exponentially! This was because the guilt had been removed and the financial penalty was so low that the late pickup was now a perk accessible to most parents.


    Lesson 2:

    Men will lie about their height on dating websites due to information asymmetry

    Anecdote 2:

    Asymmetry of power refers to someone having or knowing considerably more than the another party. The ability to awe, intimidate, lie, or otherwise affect the outcome of a decision is vast. Susie’s love life moved from real life to the Internet. What was once known upfront became reported information. Though Susie checked several boxes declaring that she didn’t care about height, income, weight, or race, deep down she knew she did to some extent, just like the old times. Looks like her man too, adjusted his online response accordingly! What he lacked in reported stature, he made up for with charm and wit in person, as we would assume. Did Susie go on a second date? I guess we’ll never know.

    Lesson 3:

    Parenting experts are fear mongers who moonlight in product placement

    Anecdote 3:

    When experts rely on not knowing and use intimidation to defend their theory, some poor clueless parents fall prey to such tactics, as outlined below:

    Bob and Lucy bought car seats for $200! Statistics clearly show that despite buying expensive car seats, this does not actually save more lives. 

    They then purchased a 'family bed', since the salesman convinced them that they were the only parents who really cared. Unfortunately for them, they were unaware that all they had to do was advocate a parenting style that nurtured self-reliance and self-soothing. They were also oblivious to the below factors which do and do not correlate to higher test scores:

    Factors correlating to higher test scores

    1. Highly educated English-speaking parents with high socioeconomic status
    2. Low birth weight of their child
    3. Adopted child
    4. Parents involved in PTA
    5. Mother being 30+ at the time of their first child’s birth
    6. Child surrounded by books at home

    Factors not correlating with higher test scores

    1. Intact family who moved to a better neighbourhood recently
    2. Child watching television daily
    3. Regularly spanked child
    4. Mother not having gone to work between birth and kindergarten
    5. Parents reading to their child often



    Sunday, November 29, 2020

    Barbell strategy

    #14


    What?

    • Formed when a trader invests in long- and short-duration bonds, but not in intermediate-duration bonds
    • Focuses on the maturities of the securities in the portfolio by ensuring the maturity dates are either very close or at a distant date

    Philosophy

    • The best way to strike balance between risk and reward by investing in both extremes of high risk vs no risk assets while avoiding middle-of-the-road choices
    • Be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative

    When?

    • Useful when interest rates are rising
    • More frequently applied to bond portfolios

    How?

    • When short term maturities are rolled over they receive a higher interest rate, raising the value
    • If an investor's money is tied up in a long-term high-quality bond, he or she won't be able to put that money in a higher-yielding bond if one becomes available in the meantime

    Benefits

    • Allows for a quick turnover of a significant amount of the assets in the portfolio at one time
    • Reduces interest rate risk since short-term bonds can be reinvested
    • Includes long-term bonds, which usually deliver higher yields than short-term bonds
    • Offers diversification between short-term and long-term maturities
    • Can be customized to hold a mix of equities and bonds

    Limitations

    • Long-term bonds held till maturity tie up funds and limit cash flow
    • Inflation risk exists if prices are rising at a faster pace than the yield of the portfolio
    • Mixing equities and bonds can increase market risk and volatility

    Etymology

    Investment strategy looks like a barbell with bonds heavily weighted at both ends of the maturity timeline




    Example

    Portfolio created with: 

    • Speculative stocks (high risk): initial public offerings (IPOs)
    • Blue-chip stocks (less risky): unprotected against ups and downs of the economy
    • Bonds (safer)
    • Bank certificates of deposit aka CDs (safest)

    Asset allocation based on types of investors:

    • Risk-loving:
      • 40% in speculative stocks
      • 40% in blue-chip stocks
      • 20% in bonds
    • Risk-averse:
      • 80% in bonds
      • 20% in blue-chip stocks


    Related

    • Contrast: bullet strategy
      • Involves investing only in intermediate-term bonds
    • This approach allowed Nassim Taleb, an essayist and mathematician to thrive during the 2008 economic recession while his fellow Wall Streeters floundered

    Sunday, November 22, 2020

    Article: Intro to Debt Funds

    #13


    What is a bond?

    • Not James or covalent, but fixed-income instruments!
    • It’s like a certificate of deposit or IOU
    • Issued by the borrower to the lender
    • Similar to setting up a fixed deposit in a bank
    • When you make an FD with a bank, you are essentially lending money to the bank


    Types

    Corporate bonds, Government bonds, corporate debt securities


    What is a debt fund?

    • A fund that invests in bonds or other debt securities
    • Can be contrasted with stock funds or money funds
    • Usually pay periodic dividends that include interest payments on the fund’s underlying securities + periodic realized capital appreciation

    Advantages:
    • Relatively stable returns
    • Relatively high liquidity
    • Reasonable safety
    • Low cost structure


    Who should invest?

    • Investors aiming for regular income
    • Risk-averse folks - because they are less volatile and hence less risky than equity funds or stocks


    How do debt funds work?

    • They are similar to other mutual funds, but they lend money and earn interest on it
    • Interest earned determines the basis for the returns generated for investors


    Why debt funds?

    • They are able to invest in many types of bonds that are not available to individuals
      • For example, the Government of India, (largest borrower and bond issuer in the country) issues bonds which individuals cannot purchase
    • Mutual funds also invest in bonds issued by large and medium-sized businesses
      • The funds pass on the interest income they receive from the bonds they invest in


    Notes:

    Additional info on bond prices

    Reasons for bond prices to rise or fall:

    • Change in interest rates
    • Expectation of change in interest rates!


    Example:

    If:

    • A bond pays out interest at a rate of 9% p.a.
    • Interest rate in the economy falls 


    Then:

    • Newer bonds start getting issued with a lower rate (e.g. 8% p.a.)
    • Old bond would now be worth more than before
    • Its price will accordingly rise 
    • Investors will see the value of their investments go up


    Implications:

    Mutual funds that hold this bond will find their holdings worth more, allowing them to make additional profits by selling it.


    The reverse is true as well. 

    If interest rates rise, mutual funds holding older bonds would see the value of their investments fall and they could lose money.



    Sunday, November 8, 2020

    Famous Folks - Raghuram Rajan (RR)

    #12


    Who?

    • Chief Economist at the International Monetary Fund (IMF) from 2003-2006
    • RBI Governor from 2013-2016
    • ‘James Bond’ of the Indian economy
    • Finance Professor at the University of Chicago Booth School of Business




    Tidbits from his personal life:

    • RR was born in Bhopal into a Tamil family
    • He was appointed as Chief Economic Adviser to India's Ministry of Finance for a year before he served as the RBI Governor
    • RR is an active crusader of the free market system
    • Due to his interest in math, he read Asimov's Foundation series after his friend told him about econometrics
    • His other inspiration is John Maynard Keynes, whose work he finds extraordinary
    • RR is an avid quizzer and enjoys reading the works of Tolkien, Tolstoy, and Upamanyu Chatterjee
    • RR was extensively interviewed for the award-winning documentary Inside Job
    • He suggests that capitalism serves as a handy tool to abate poverty and provides equal opportunity for all
    • He believes that there is nothing more motivating than the drive to deliver better

    What he did as the Governor of RBI:

    1. UPI (Unified Payments Interface) was launched to reduce the cost and time taken to make simple payments for transactions up to Rs. 1,00,000. It avoids the long-winded payment transfer procedure. All one requires is a UID (unique ID) and a mobile pin to authenticate the payment.
    2. Payment Banks would accept only deposits and not be involved in lending. This initiative was aimed at providing banking facilities to those deprived of them. The RBI licensed 2 universal banks and approved 11 payments banks for providing banking services.
    3. RR successfully managed to curb the retail inflation from 9.8% (September 2013) to 3.78% (July 2015), and Wholesale inflation from 6.1% (September 2013) to a historic low of -4.05% (July 2015).
    4. When RR joined office, the currency was at Rs. 70 against the US Dollar. During his tenure, he successfully managed to pull up the rupee.
    5. On his very first day as the Governor of RBI, he spoke about a new approach to formulating monetary policy, and in the same month also picked Deputy Governor Urjit Patel to examine the monetary policy framework, which stated the objective of maintaining inflation under 6 per cent.
    6. RR initiated a total restructuring of the RBI from the inside. He organized the RBI central office departments into five groups namely, Regulation and Banking Services, Operations and HR, Supervision and Risk Management, Financial Markets and Infrastructure, and Monetary Stability.
    7. Indian banks hold more than $110 billion of corporate stressed debt, which result in preventing fresh loans to be given, dampening a quicker economic recovery. RR focused his efforts on cleaning up the banks' balance sheets and put pending projects back on track.

    Fun fact:

    RR was in the running for an Economics Nobel Prize for the following reasons:
    • RR, at 40, became the youngest ever Chief Economist of the IMF.
    • He predicted the financial crisis of 2008 three years before the economic meltdown actually happened. He was greeted with laughter and disbelief when he highlighted unsustainable banking practices and risky financial instruments such as mortgage-backed securities and credit default swaps that could lead to economic collapse.
    • RR's book Fault Lines garnered global attention to income inequality, where he warns against the reforms not addressing the stagnating middle-class earnings, which in turn played a role in the 2008 meltdown.
    • His subtle handling of the rupee crisis in 2013 that helped bring back foreign investors to India. He made handing out new bank licences transparent and controversy-free, and also fought against inflation by targeting CPI (consumer price inflation) rather than WPI (wholesale price inflation), the index traditionally targeted by the RBI.

    View on demonetization:

    • In 2014, RR stated in a speech that demonetization was not an effective enough measure to curb black money, because to him, “clever people find ways around it.”
    • In 2017, RR mentioned that the RBI was against demonetization and warned the Indian Government about its negative impact.
    • RR wondered if currency notes ban would result in economic success or not.
    • Some people speculate that this conflict regarding a difference of opinions in terms of the demonetization policy was the reason for his exit from the RBI Governor’s office.

    A few of the awards he's won:

    • Fischer Black Prize in 2003
      • Awarded by the American Finance Association
      • For contributions to the theory and practice of finance by an economist under the age of 40
    • Financial Times and McKinsey Business Book of the Year Award in 2010
      • Fault Lines: How Hidden Fractures Still Threaten the World Economy
    • Deutsche Bank Prize in Financial Economics in 2013
      • For his ground-breaking research, which influenced financial and macroeconomic policies globally
    • Governor of the Year Award from London-based financial journal Central Banking in 2014
    • Yashwantrao Chavan National Award in 2019
      • For his contribution to economic development

    One of his books which I'd like to read, which explores the causes of the 2008 financial crisis:


    Some of my favourite RR Quotes:

    "Strong government doesn't mean simply military power or an efficient intelligence apparatus. Instead, it should mean effective, fair administration - in other words, 'good governance.'"

    "Central bankers have had enormous responsibilities thrust on them to compensate, essentially, for the failings of the political system. And my worry is we don't have sufficient tools to do that, but we're not willing to say it."

    "How do we get more politicians to move from 'fixing' the system to reforming the system? The obvious answer is to either improve the quality of public services or reduce the public's dependence on them. Both approaches are necessary."

    "Everyone may have some advice for the RBI. Some may advise, 'Cut your lending rates and raise the deposit rate.' How will a bank function? We take a medium-term view. The bank has an 80-year-old history. I don't want to destroy it for a few decisions."

    "We should make sure that unscrupulous schools do not prey on uninformed students, leaving them with high debt and useless degrees."

    "Perhaps the hardest challenge has been to persuade the public, impatient for rapid growth, of the need to ensure stability first. Growth, it is argued, is always more important, regardless of the looming economic risks."

    "Democratic accountability means that governments must be popularly accepted, with citizens empowered to replace corrupt or incompetent rulers."

    "If economists were to wait for careful studies before offering opinions about policy, we would never have anything timely to say."

    "It is not because of the benevolence of the baker that we eat fresh bread in the morning but because of his desire to make money."

    Sunday, October 25, 2020

    Article: SIPs and rupee cost averaging

    #11


    Concepts

    Rupee cost averaging
    • Approach wherein you invest a fixed amount of money at regular intervals
    • Ensures that you buy more shares of an investment when prices are low and less when they are high
    • You avoid the manual, complex task of researching the best time to invest
    • Averages out the costs of your units 
    • Lessens the results of short-term market fluctuation on your investments
    SIP
    • Systematic Investment Plan
    • Facility offered by mutual funds to investors
    • Helps you invest in a disciplined manner
    • You invest a fixed amount of money at pre-defined intervals in the selected mutual fund scheme
    • Amount can be as low as Rs. 500
    • Intervals can be weekly, monthly, quarterly, semi-annually, or annually 
    • Investor need not worry about market dynamics or timing
    • Stands to benefit in the long-term due to average costing and power of compounding

    Gist

    • SIPs help you lower your investment cost and hence maximize returns
    • When you invest through SIPs, you automatically experience the benefit of rupee cost averaging
    • When you invest, you accumulate units at various prices called net asset value aka NAV
    • You get more units when the market is down and the fund's NAV is lower and vice-versa


    Why it works

    Markets are volatile, hence it makes sense to spread your investments over a period of time to benefit from the lows that frequently occur


    How it works

    • Say you invest Rs 10,000 in a fund at each of these NAVs: Rs 100, 150, 200, 250, and 300
    • Number of units accumulated (amount/NAV): 100, 66.66, 50, 40, and 33.33
    • Total amount invested = Rs 50,000
    • Total units = 289.99
    • Average NAV = Rs 172.41 (This amount is less than three of the five NAVs at which you bought the fund!)


    Conclusion

    • SIPs: psychological tool of discipline
    • By nature, investors are tempted to invest more when the market is racing and stop investing altogether when it is falling, which hurts returns
    • SIPs automate the entire investment process and delink sentiment from investing
    • Via SIPs, you benefit from rupee cost averaging to get a good return

    Sunday, October 18, 2020

    Article: How to buy the right health cover?

    #10


    Let's look at the types of plans commonly offered. What they do and don't cover should help you determine which one is suitable.

    Individual Health Plans aka  'mediclaim' policies

    Covers:
    • Hospital treatment expenses provided the treatment is on an in-patient basis and lasts for at least 24 hour
    • Expenses include hospital bed and room, nursing, surgeon's fees, consultant doctor's fees, blood transfusions, oxygen and operation theatre charges
    Does not cover:
    • Pre-existing diseases or complications arising from them for the first four years of the policy
    • Specific conditions that may not be covered for a certain initial period
    There is generally an enhancement for every year during which no claim is made.


    Family Floating Policies

    The sum insured can be used for the treatment of any or all members of the family and not a single person. Rather than buying an R2 lakh health cover for each member of the family of four by spending for a total cover of R8 lakh, if you buy a Family Policy for R8 lakh, each person covered under it can avail benefits up to R8 lakh as opposed to R2 lakh in the earlier instance.
    • Comes at a lower premium than individual policies would have done
    • Can be bought by an individual who becomes the proposer along with spouse, including dependent children up to 25 years or even unmarried, divorced, widowed daughter and dependent parent


    Critical Illness Plan

    • Not a substitute for the basic individual or family policy
    • Designed to be added as an addition to the former (The fact that these have to be bought separately is a major flaw in the way health insurance is sold in India)
    • Provides financial assistance if the insured develops a serious ailment, such as cancer, or has a stroke
    • Each cover has a list of ailments, usually 9-12 of them
    • Can get it in the form of a rider attached to a life insurance cover, or as a standalone policy from either a life insurer or a non-life insurer
    • If critical illness occurs, it pays the entire sum insured and terminates and can happen only once for any particular illness
    • To get the payout, the insured has to survive for 30 successive days after the diagnosis
    • No claim can be made during the first 90 days of the inception of the policy


    Medical Cover From Life Insurance Companies

    Life insurance companies, too, have started offering health plans. Most of these are, however, defined benefit plans - the pre-specified amount which is the sum insured is paid as compensation, irrespective of the actual amount of expenses incurred. Also, these are long-term, having a fixed premium for, say, three, five, or even 10 years. 

    If you opt for a good combination of basic mediclaim, family policy and a critical illness plan, then these are not needed.

    Sunday, October 11, 2020

    Types of Accounting Statements

    #9


    Topic:

    Financial statements - consolidated reports of thousands of individual transactions

    Function:

    They summarize a company's
    • Operations
    • Financial position
    • Cash flows over a period


    Types:

    Income statement


    • Aka Profit and Loss (P&L) Statement
    • Reveals the financial performance of an organization for the entire reporting period
      • Income: what the business has earned over a period (e.g. sales revenue, dividend income)
      • Expenses: cost incurred by the business over a period (e.g. salaries and wages, rental charges, depreciation)
      • Net profit or loss = Expenses - Income
    • Begins with sales, then subtracts out all expenses incurred during the period to arrive at a net profit or loss
    • Earnings per share (EPS) may also be added if the financial statements are being issued by a publicly-held company
    • Usually considered the most important financial statement, since it describes performance

    Balance sheet

     


    • Aka Statement of Financial Position
    • Shows the financial position of a business as of the report date
    • Covers a specific point in time
    • Aggregated into assets, liabilities, and equity
      • Assets: something a business owns (e.g. cash, inventory, plant and machinery)
      • Liabilities: something a business owes (e.g. creditors, bank loans)
      • Equity: what the business owes to its owners or stakeholders
      • Balance sheet must balance: Assets - Liabilities = Shareholder's Equity
    • Line items within the asset and liability classification are presented in their order of liquidity: most liquid items stated first

    Cash flow statement



    • Reveals cash inflows and outflows experienced by an organization during the reporting period
    • Broken down into operating activities, investing activities, and financing activities
      • Operating Activities: represents cash flow from primary activities of a business
      • Investing Activities: represents cash flow from purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
      • Financing Activities: represents cash flow generated or spent on raising and repaying share capital and debt along with the payments of interest and dividends
    • Can be difficult to assemble
    • Issued usually only to outside parties




    Sunday, October 4, 2020

    Scandalous - Charles Ponzi

    #8

    What?

    Origin of the Ponzi Scheme

    Who?

    Charles Ponzi (1882–1949) - an Italian immigrant living in Boston.

    When?

    It happened in 1919.

    Crime in one line

    Ponzi conned investors into giving him millions of dollars and paid them returns with other investors’ money.

    What did he do?

    He came up with a scheme to get rich by purchasing international reply coupons (IRC) for a low price abroad and then selling them for profit in the US.

    What’s a reply coupon?
    It’s a coupon that can be exchanged for several priority airmail postage stamps from another country.

    What was the problem?

    Though Ponzi was able to repay his investors their money, via subsequent investors, he had not yet figured out a way to actually convert the IRCs to cash. He then realized that changing the coupons to money was logistically impossible.

    What this led to

    The ‘Ponzi scheme’
    In short:  “robbing Peter to pay Paul”

    Damages and Impact

    In order to cover the investments made with the Securities Exchange Company, 160 million postal reply coupons would have to be in circulation. However, only about 27,000 were in circulation.

    In August 1920, Ponzi was declared hopelessly insolvent, reporting at least $2 million in debt. It was later found that he was actually $7 million in debt.

    Magnitude of losses

    Ponzi’s investors were essentially wiped out, receiving less than 30 cents to the dollar. They lost about $20 million in 1920 dollars (approximately $196 million in 2019 dollars). By comparison, Bernard Madoff’s similar scheme that collapsed in 2008 cost his investors about $18 billion, 53 times the losses of Ponzi’s scheme.

    Typical Characteristics of a Ponzi Scheme

    Scheme:

    • Guarantee of high returns with low risk
    • Consistent flow of returns regardless of market conditions

    Investment:

    • Unregistered investments with the Securities and Exchange Commission (SEC)
    • Investment strategies described as too complex to describe

    Customers:

    • Clients unallowed to view official paperwork for their investments
    • Clients facing difficulties removing their money

    Stay tuned

    We’ll later look at some of the Ponzi scheme scandals that took place more recently, like Bernie Madoff, whose name this scheme is synonymous with, and also the Ponzi scheme employed by Sahara’s Subrata Roy to dupe thousands of poor investors.

    Related




    Sunday, September 27, 2020

    Article: How ELSS scores over other tax saving avenues

    #7

    Fact

    Under Indian tax laws, savers have a complete range of tax-saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits (FDs), National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others

    Question

    Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

    Answer

    There is a confusion of goals between saving tax and making investments.

    Equity Options

    There are two options other than ELSS that give equity-linked returns - Unit-Linked Insurance Plans (ULIPs) and the National Pension System (NPS)

    ULIPs

    Longer lock-in period of 5 years, coupled with high costs and poor transparency.

    Traps:
    1. Mix of investment + insurance 
    2. Savers don't have clear cost-vs-benefit understanding of either 
    3. Both transparency and liquidity relinquished
    4. Terminating the policy early affects returns adversely (instead of 5-year lock-in, it becomes a 10-15-year commitment)
    ULIPs aren't suitable for investment due to:
    1. High costs
    2. Difficulty in evaluation
    3. Lack of transparency
    4. Low liquidity

    NPS

    Retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age.

    ELSS

    3-year lock-in period

    Short-term vs long-term: 
    1. Equity investment carry higher risk over the short-term. 
    2. However, for investment periods of five years or more, the risk on equity investments is considerably lower. 
    3. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation.
    The best way of investing in an ELSS is through monthly SIPs (Systematic Investment Plan) throughout the year. SIPs also give the dual advantage of avoiding any last-minute rush.
     
    At the beginning of every year, estimate the amount you have leftover from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP. 
    Simple.


     

    Sunday, September 20, 2020

    Accounting Principles

    #6


    This post attempts to help you remember the 10 principles of accounting.

    1. Separate Legal Entity Assumption

    Accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions.

    Note: 
    For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes, they are considered to be two separate entities.




    2. Monetary Unit Assumption

    Generic version:
    Money itself is treated as a unit of measurement and all transactions or economic events recorded in the accounts of a business can be expressed and measured in monetary terms by a currency.

    Specific version:
    Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

    Note: 
    It is assumed that the dollar's purchasing power has not changed over time. As a result, accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2019 transaction.


      

    3. Time Period Assumption

    This principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2019, or the 5 weeks ended May 1, 2019. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2018, the amount is known; but for the income statement for the three months ended March 31, 2019, the amount was not known and an estimate had to be used.

    Note:
    It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labelling one of these financial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2019, the month ended December 31, 2019, the three months ended December 31, 2019, or the year ended December 31, 2019.


    4. Cost Principle

    "Cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.

    Note: 
    Asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.


    5. Full Disclosure Principle

    If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement.

    Example:
    A company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared, it is not clear whether the company will be able to defend itself or lose the lawsuit. As a result of these conditions and the full disclosure principle, the lawsuit will be described in the notes to the financial statements.

    Note: 
    A company usually lists its significant accounting policies as the first note to its financial statements.


    6. Going Concern Principle

    This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue, the accountant is required to disclose this assessment.

    Note: 
    The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.


    7. Matching Principle

    This accounting principle requires companies to use the accrual basis of accounting to match expenses with revenues.

    Example:
    Sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid).
    Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2019 revenues as a bonus on January 15, 2020, the company should report the bonus as an expense in 2019 and the amount unpaid at December 31, 2019, as a liability.

    Note:
    Since we cannot measure the future economic benefit of things such as advertisements and thereby not be able to match the ad expense with related future revenues, the accountant charges the ad amount to the expense in the period the ad is run.


    8. Revenue Recognition Principle

    Under the accrual basis of accounting, revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

    Example:
    ABC Consulting completes its service at an agreed price of $1,000.
    ABC should recognize $1,000 of revenue as soon as its work is done. It does not matter whether the client pays the $1,000 immediately or in 30 days.
    Note: 
    Do not confuse revenue with a cash receipt.


    9. Materiality

    An accountant can violate another accounting principle if the amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.

    Example:
    Purchase of a $150 printer by a highly profitable multi-million dollar company. Since the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.

    Note: 
    This principle allows financial statements to show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.


    10. Conservatism

    If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

    Example:
    Potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported.
    Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

    Note: 
    The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains.



    Here's an interesting tutorial explaining the fundamental principles.

    Sunday, September 13, 2020

    Intro to GAAP

    #5


    Let's close our knowledge gap by knowing about GAAP!

    WHAT

    GAAP - "generally accepted accounting principles"

    Three types of rules:
    • Basic accounting principles and guidelines
    • Detailed standards issued by FASB (Financial Accounting Standards Board) and APB (Accounting Principles Board)
    • Generally accepted industry practices

    WHEN

    • When a company distributes its financial statements to the public - it has to follow GAAP during the preparation of those statements
    • When a company's stock is publicly traded - financial statements have to be audited by independent public accountants as per Federal Law

    WHERE

    • Primarily used by businesses reporting their financial results in the United States.
    • International alternative to GAAP:
      • International Financial Reporting Standards (IFRS) - set by the International Accounting Standards Board (IASB)

    WHY

    • Useful - attempts to standardize and regulate accounting definitions, assumptions, and methods
    • Consistent - in the methods used every year to prepare a company's financial statements
    • Compare - one company to another, w.r.t financial statistics
    • Improve - clarity, consistency, comparability of the communication of financial information

    HOW

    • Accountants commit to applying the same GAAP guidelines throughout the reporting process, from one accounting period to the next, to ensure financial comparability between periods (principle of regularity)
    • Accountants must strive to fully disclose all financial data and accounting information in financial reports (principle of good faith)
    • Accountants have to fully disclose and explain the reasons behind any modified standards in the footnotes of financial statements (principle of consistency)
    • Accountants strive to provide an accurate and impartial depiction of a company’s financial situation (principle of sincerity)
    • Accountants must report positives and negatives with full transparency and without the expectation of debt compensation (principle of non-compensation)
    • Accountants must assume the business will continue to operate while valuing assets (principle of continuity)
    • Accountants must distribute entries (such as revenue) across the correct accounting periods (principle of periodicity)