Accounting and Bookkeeping

I INTRODUCTION

Accounting and Bookkeeping, the process of identifying, measuring, recording, and communicating economic information about an organization or other entity, in order to permit informed judgements by users of the information. Bookkeeping encompasses the record-keeping aspect of accounting and therefore provides much of the data to which accounting principles are applied in the preparation of financial statements and other financial information.

Personal record-keeping often uses a simple single-entry system in which amounts are recorded in column form. Such entries include the date of the transaction, its nature, and the amount of money involved. Record-keeping of organizations, however, is based on a double-entry system, whereby each transaction is recorded on the basis of its dual impact on the organization’s financial position or operating results or both. Information relating to the financial position of an enterprise is presented in a balance sheet, while disclosures about operating results are displayed in a profit and loss statement. Data relating to an organization’s liquidity and changes in its financial structure are shown in a statement of changes in financial position. Such financial statements are prepared to provide information about past performance, which in turn becomes a basis for readers to try to project what might happen in the future.

II HISTORY

Bookkeeping and record-keeping methods, created in response to the development of trade and commerce, are preserved from ancient and medieval sources. Double-entry bookkeeping began in the commercial city-states of medieval Italy and was well developed by the time of the earliest preserved double-entry books, from 1340 in Genoa. The development of counting frames and the abacus in China in the first centuries ad laid the basis for similarly advanced techniques in East Asia.

The first published accounting work was written in 1494 by the Venetian monk Luca Pacioli. Although it disseminated rather than created knowledge about double-entry bookkeeping, Pacioli’s work summarized principles that have remained essentially unchanged. Additional accounting works were published during the 16th century in Italian, German, Dutch, French, and English, and these works included early formulations of the concepts of assets, liabilities, and income.

The Industrial Revolution created a need for accounting techniques that were adequate to handle mechanization, factory-manufacturing operations, and the mass production of goods and services. With the emergence in the mid-19th century of large, publicly held business corporations, owned by absentee shareholders and administered by professional managers, the role of accounting was further redefined.

Bookkeeping, which is a vital part of all accounting systems, was in the mid-20th century increasingly carried out by machines. The widespread use of computers broadened the scope of bookkeeping, and the term “data processing” now frequently encompasses bookkeeping.

III ACCOUNTING INFORMATION

Accounting information can be classified into two categories: financial accounting or public information and managerial accounting or internal information. Financial accounting includes information disseminated to parties that are not part of the enterprise proper—shareholders, creditors, customers, suppliers, regulatory bodies, financial analysts, and trade associations—although the information is also of interest to the company’s officers and managers. Such information relates to the financial position, liquidity (that is, ability to convert to cash), and profitability of an enterprise.

Managerial accounting deals with cost-profit-volume relationships, efficiency and productivity, planning and control, pricing decisions, capital budgeting, and similar matters that aid decision-making. This information is not generally disseminated outside the company. Whereas the general-purpose financial statements of financial accounting are assumed to meet basic information needs of most external users, managerial accounting provides a wide variety of specialized reports for division managers, department heads, project directors, section supervisors, and other managers.

A Specialized Accounting

Of the various specialized areas of accounting that exist, the three most important are auditing, income taxation, and accounting for not-for-profit organizations. Auditing is the examination, by an independent accountant, of the financial data, accounting records, business documents, and other pertinent documents of an organization in order to attest to the accuracy of its financial statements. Large private and public enterprises sometimes also maintain an internal audit staff to conduct audit-like examinations, including some that are more concerned with operating efficiency and managerial effectiveness than with the accuracy of the accounting data.

The second specialized area of accounting is income taxation. Preparing an income tax form entails collecting information and presenting data in a coherent manner; therefore, both individuals and businesses frequently hire accountants to determine their tax position. Tax rules, however, are not identical with accounting theory and practices. Tax regulations are based on laws that are enacted by legislative bodies, interpreted by the courts, and enforced by designated administrative bodies. Much of the information required in calculating taxes, however, is also needed in accounting, and many techniques of computing are common to both areas.

A third area of specialization is accounting for not-for-profit organizations, such as charities, universities, hospitals, Churches, trade and professional associations, and government agencies. These organizations differ from business enterprises in that they generally receive resources on some non-reciprocating basis (that is, without paying for such resources), they are not set up to create a distributable profit, and they usually have no share capital. As a result, these organizations call for differences in record-keeping, in accounting measurements, and in the format of their financial statements.

B Financial Reporting

Traditionally, the function of financial reporting was to provide information about companies to their owners. Once the delegation of managerial responsibilities to hired personnel became a common practice, financial reporting began to focus on stewardship, that is, on the managers’ accountability to the owners. Its purpose then was to document how effectively the owners’ assets were managed, in terms of both capital preservation and profit generation.

After businesses were commonly organized as corporations, the appearance of large multinational corporations and the widespread employment of professional managers by absentee owners brought about a change in the focus of financial reporting.

Although the stewardship orientation has not become obsolete, financial reporting is today somewhat more geared towards the needs of investors. Because both individual and institutional investors view owning shares of companies as only one of various investment alternatives, they seek much more information about the future than was supplied under the traditional stewardship concept. As investors relied more on the potential of financial statements to predict the results of investment and disinvestment decisions, accounting became more sensitive to their needs. One important result was an expansion of the information supplied in financial statements.

The proliferation of footnotes to financial statements is a particularly visible example. Such footnotes disclose information that is not already included in the body of the financial statement. One footnote usually identifies the accounting policies or methods adopted when acceptable alternative methods also exist, or when the unique nature of the company’s business justifies an otherwise unconventional approach.

Footnotes also disclose information about lease commitments, contingent liabilities, pension plans, share options, and foreign currency translation, as well as details about long-term debt (such as interest rates and maturity dates). A company having a widely distributed ownership usually includes among its footnotes the income it earned in each quarter, quarterly stock market prices of its shares, and information about the relative sales and profit contribution of its different areas of activity.

IV ACCOUNTING PRINCIPLES

Accounting as it exists today may be viewed as a system of assumptions, doctrines, tenets, and conventions, all encompassed by the phrase “generally accepted accounting principles”. Many of these principles developed gradually, as did much of common law; only the accounting developments of recent decades are prescribed in statutory law. Following are several fundamental accounting concepts.

The entity concept states that the item or activity (entity) that is to be reported on must be clearly defined, and that the relationship assumed to exist between the entity and external parties must be clearly understood.

The going-concern assumption states that it is expected that the entity will continue to operate for the foreseeable future.

The historical cost principle requires that economic resources be recorded in terms of the amounts of money exchanged; when a transaction occurs, the exchange price is by its nature a measure of the value of the economic resources that are exchanged.

The realization concept states that accounting takes place only for those economic events to which the entity is a party. This principle, therefore, rules out recognizing a gain based on the appreciated market value of a still owned asset.

The matching principle states that income is calculated by matching a period’s revenues with the expenses incurred in order to bring about that revenue.

The accrual principle defines revenues and expenses as the inflow and outflow of all assets—as distinct from the flow only of cash assets—in the course of operating the enterprise.

The consistency criterion states that the accounting procedures used at a given time should conform with the procedures previously used for that activity. Such consistency allows data of different periods to be compared.

The disclosure principle requires that financial statements present the most useful amount of relevant information—namely, all information that is necessary in order not to be misleading.

The substance-over-form standard emphasizes the economic substance of events even though their legal form may suggest a different result. An example is a practice of consolidating the financial statements of one company with those of another in which it has more than a 50 percent ownership interest.

The prudence doctrine states that when exposure to uncertainty and risk is significant, accounting measurement and disclosure should take a cautious and prudent stance until evidence shows sufficient lessening of the uncertainty and risk.

A The Balance Sheet

Of the two traditional types of financial statements, the balance sheet relates to an entity’s value, and the profit and loss account—or income statement—relates to its activity. The balance sheet provides information about an organization’s assets, liabilities, and owners’ equity as of a particular date (such as the last day of the accounting or fiscal period). The format of the balance sheet reflects the basic accounting equation: assets equal equities. Assets are economic resources that provide potential future service to the organization. Equities consist of the organization’s liabilities together with the equity interest of its owners. (For example, a certain house is an asset worth £70,000; its unpaid mortgage is a liability of £45,000, and the equity of its owners is £25,000.)

Assets are categorized as current or fixed. Current assets are usually those that management could reasonably be expected to convert into cash within one year; they include cash, receivables, goods in stock (or merchandise inventory), and short-term investments in stocks and bonds. Fixed assets encompass the physical plant—notably land, buildings, machinery, motor vehicles, computers, furniture, and fixtures. They also include property being held for speculation and intangibles such as patents and trademarks.

Liabilities are obligations that the organization must remit to other parties, such as creditors and employees. Current liabilities usually are amounts that are expected to be paid within one year, including salaries and wages, taxes, short-term loans, and money owed to suppliers of goods and services. Long-term liabilities are usually debts that will come due beyond one year—such as bonds, mortgages, and long-term loans. Whereas liabilities are the claims of outside parties on the assets of the organization, the owners’ equity is the investment interest of the owners of the organization’s assets. When an enterprise is operated as a sole proprietorship or as a partnership, the balance sheet may disclose the amount of each owner’s equity. When the organization is a corporation, the balance sheet shows the equity of the owners—that is, the shareholders—as consisting of two elements: (1) the amount originally invested by the shareholders; and (2) the corporation’s cumulative reinvested income, or retained earnings (that is, income not distributed to shareholders as dividends), in which the shareholders have equity.

B The Profit and Loss Statement

The traditional activity-oriented financial statement issued by business enterprises is the profit and loss statement, often known as the income statement. Prepared for a well-defined time interval, such as three months or one year, this statement summarizes the enterprise’s revenues, expenses, gains, and losses. Revenues are transactions that represent the inflow of assets as a result of operations—that is, assets received from selling goods and providing services. Expenses are transactions involving the outflow of assets in order to generate revenue, such as wages, rent, interest, and taxation.

A revenue transaction is recorded during the fiscal period in which it occurs. An expense appears in the profit and loss statement of the period in which revenues presumably resulted from the particular expense. To illustrate, wages paid by a merchandising or service company are usually recognized as an immediate expense because they are presumed to generate revenue during the same period in which they occurred. On the other hand, money spent on raw materials to be used in making products that will not be sold until a later financial period would not be considered an immediate expense. Instead, the cost will be treated as part of the cost of the resulting stock asset; the effect of this cost on income is thus deferred until the asset is sold and revenue is realized.

In addition to disclosing revenues and expenses (the principal components of income), the profit and loss statement also lists gains and losses from other kinds of transactions, such as the sale of fixed assets (for example, a factory building) or the early repayment of long-term debt. Extraordinary—that is, unusual and infrequent—developments are also specifically disclosed.

C Other Financial Statements

The profit and loss statement excludes a number of assets withdrawn by the owners; in a corporation, such withdrawn assets are called dividends. A separate activity-oriented statement, the statement of retained earnings, discloses income and redistribution to owners.

A third important activity-oriented financial statement is the cash-flow statement. This statement provides information not otherwise available in either a profit and loss statement or a balance sheet; it presents the sources and the uses of the enterprise’s funds by operating activities, investing activities, and financing activities. The statement identifies the cash generated or used by operations; the cash exchanged to buy and sell plant and equipment; the cash proceeds from issuing shares and long-term borrowings; and the cash used to pay dividends, to purchase the company’s outstanding shares of its own stock, and to pay off debts.

D Bookkeeping and Accounting Cycle

Modern accounting entails a seven-step accounting cycle. The first three steps fall under the bookkeeping function—that is, the systematic compiling and recording of financial transactions. Business documents provide the bookkeeping input; such documents include invoices, payroll records, bank cheques, and records of bank deposits. Special ledgers are used to record recurring transactions. (A ledger is a book having one page for each account in the organization’s financial structure. The page for each account shows its debits on the left side and its credits on the right side so that the balance—that is, the net credit or debit—of each account can be determined.) These include a sales ledger, a purchases ledger, a cash receipts ledger, and a cash disbursements ledger. Transactions that cannot be accommodated by a special journal are recorded in a general ledger. In many modern offices, these records are held in computer records that normally follow the traditional ledger structure.

D1 Step One

Recording a transaction in a ledger marks the starting point for the double-entry bookkeeping system. In this system, the financial structure of an organization is analysed as consisting of many interrelated aspects, each of which is called an account (for example, the wages payable account). Every transaction is identified in two aspects or dimensions, referred to as its debit (or left side) and credit (or right side) aspects, and each of these two aspects has its own effect on the financial structure. Depending on their nature, certain accounts are increased with debits and decreased with credits; other accounts are increased with credits and decreased with debits. For example, the purchase of stock for cash increases the stock account (a debit) and decreases the cash account (a credit). If the stock is purchased on the promise of future payment, a liability would be created, and the journal entry would record an increase in the stock account (a debit) and an increase in the liability account (a credit). Recognition of wages earned by employees entails recording an increase in the wage expense account (a debit) and an increase in the liability account (a credit). The subsequent payment of the wages would be a decrease in the cash account (a credit) and a decrease in the liability account (a debit).

D2 Step Two

In the next step in the accounting cycle, the amounts that appear in the various ledger are transferred to the organization’s general ledger—a procedure called posting.

In addition to the general ledger, subsidiary ledgers—usually a sales ledger and a purchase ledger—are used to provide information in greater detail about the accounts in the general ledger. For example, the general ledger contains one account showing the entire amount owed to the enterprise by all its customers; the sales ledger breaks this amount down on a customer-by-customer basis, with separate sales account for each customer. Subsidiary accounts may also be kept for the wages paid to each employee, for each building or machine owned by the company, and for amounts owed to each of the enterprise’s creditors.

D3 Step Three

Posting data to the ledgers is followed by listing the balances of all the accounts and calculating whether the sum of all the debit balances agrees with the sum of all the credit balances (because every transaction has been listed once as a debit and once as a credit). This process is called producing a trial balance. This procedure and those that follow it take place at the end of the financial period, normally each calendar month. Once the trial balance has been successfully prepared, the bookkeeping portion of the accounting cycle is concluded.

D4 Step Four

Once bookkeeping procedures have been completed, the accountant prepares certain adjustments to recognize events that, although they did not occur in conventional form, are in substance already completed transactions. The following are the most common circumstances that require adjustments: accrued revenue (for example, interest earned but not yet received); accrued expenses (wage costs incurred but not yet paid); unearned revenue (earning subscription revenue that had been collected in advance); prepaid expenses (for example, expiration of a prepaid insurance premium); depreciation (recognizing the cost of a machine as expense spread over its useful economic life); stock movements (recording the cost of goods sold on the basis of a period’s purchases and the change in the value of stocks between beginning and end of the financial period); and receivables (recognizing bad-debt expenses on the basis of expected uncollected amounts).

D5 Steps Five and Six

Once the adjustments are calculated, the accountant prepares an adjusted trial balance—one that combines the original trial balance with the effects of the adjustments (step five). With the balances in all the accounts thus updated, financial statements are then prepared (step six). The balances in the accounts are the data that make up the organization’s financial statements.

D6 Step Seven

The final step is to close non-cumulative accounts. This procedure involves a series of bookkeeping debits and credits to transfer sums from income statement accounts into owners’ equity accounts. Such transfers reduce to zero the balances of non-cumulative accounts so that these accounts can receive new debit and credit amounts that relate to the activity of the next business period.

V REGULATIONS AND STANDARDS

Accounting has a well-defined body of knowledge and rather definitive procedures. Nevertheless, many countries (such as the United States and the United Kingdom) have Accounting Standard boards that continue to refine existing techniques and develop new approaches. Such activity is needed in part because of innovative business practices, newly enacted laws, and socio-economic changes. Better insights, new concepts, and enhanced perceptions have also influenced the development of accounting theory and practices. However, despite considerable efforts to create internationally agreed accounting standards, there still exist important differences in the way accounting information is produced in different countries. These differences often make international comparisons of accounting information extremely hazardous.

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Capital

I INTRODUCTION

Capital, the collective term for a body of goods and monies from which future income can be derived. Generally, consumer goods and monies spent for present needs and personal enjoyment are not included in the definition or economic theory of capital. Thus, a business regards its land, buildings, equipment, inventory, and raw materials, as well as stocks, bonds, and bank balances available, as capital. Homes, furnishings, cars and other goods that are consumed for personal enjoyment (or the money set aside for purchasing such goods) are not considered capital in the traditional sense.

In the more precise usage of accounting, capital is defined as the stock of property owned by an individual or corporation at a given time, as distinguished from the income derived from that property during a given period. A business firm accordingly has a capital account (frequently called a balance sheet), which reports the assets of the firm at a specified time, and an income account, which reckons the flow of goods and of claims against goods during a specified period.

Among the 19th-century economists, the term capital designated only that segment of business wealth that was the product of past industry. The wealth that is not produced, such as land or ore deposits, was excluded from the definition. Income from capital (so defined) was called profit, or interest, whereas the income from natural resources was called rent. Contemporary economists, for whom capital means simply the aggregate of goods and monies used to produce more goods and monies, no longer make this distinction.

The forms of capital can be distinguished in various ways. One common distinction is between fixed and circulating capital. Fixed capital includes all the more or less durable means of production, such as land, buildings, and machinery. Circulating capital refers to nonrenewable goods, such as raw materials and fuel, and the funds required to pay wages and other claims against the enterprise.

Frequently, a business will categorize all of its assets that can be converted readily into cash, such as finished goods or stocks and bonds, as liquid capital. By contrast, all assets that cannot be easily converted to cash, such as buildings and equipment, are considered frozen capital.

Another important distinction is between productive capital and financial capital. Machines, raw materials, and other physical goods constitute productive capital. Claims against these goods, such as corporate securities and accounts receivable, are financial capital. Liquidation of productive capital reduces productive capacity, but the liquidation of financial capital merely changes the distribution of income.

II THEORIES OF CAPITAL

The 18th-century French economists known as physiocrats were the first to develop a system of economics. Their work was developed by Adam Smith and emerged as the classical theory of capital after further refinements by David Ricardo in the early 19th century. According to the classical theory, capital is a store of values created by labour. Part of capital consists of consumers’ goods used to sustain the workers engaged in producing items for future consumption. The part consists of producers’ goods channelled into further production for the sake of expected future returns. The use of capital goods raises labour productivity, making it possible to create a surplus above the requirements for sustaining the labour force. This surplus constitutes the interest or profit paid to capital. Interest and profits become additions to capital when they are ploughed back into production.

Karl Marx and other socialist writers accepted the classic view of capital with one major qualification. They regarded as capital only the productive goods that yield income independently of the exertions of the owner. An artisan’s tools and a small farmer’s land holding are not capital in this sense. The socialists held that capital comes into being as a determining force in society when a small body of people, the capitalists, owns most of the means of production and a much larger body, the workers, receives no more than bare subsistence as reward for operating the means of production for the benefit of the owners.

In the mid-19th century the British economists Nassau William Senior and John Stuart Mill, among others, became dissatisfied with the classical theory, especially because it lent itself so readily to socialist purposes. To replace it, they advanced a psychological theory of capital based on a systematic inquiry into the motives for frugality or abstinence. Starting with the assumption that satisfactions from present consumption are psychologically preferable to delayed satisfactions, they argued that capital originates in abstinence from consumption by people hopeful of a future return to reward their abstinence. Because such people are willing to forgo present consumption, productive power can be diverted from making consumers’ goods to making the means of further production; consequently, the productive capacity of the nation is enlarged. Therefore, just as physical labour justifies wages, abstinence justifies interest and profit.

Inasmuch as the abstinence theory rested on subjective considerations, it did not provide an adequate basis for objective economic analysis. It could not explain, in particular, why a rate of interest or profit should be what it actually was at any given time.

To remedy the deficiencies of the abstinence theory, the Austrian economist Eugen Böhm-Bawerk, the British economist Alfred Marshall, and others attempted to fuse that theory with the classical theory of capital. They agreed with the abstinence theorists that the prospect of future returns motivates individuals to abstain from consumption and to use part of their income to promote production, but they added, in line with classical theory, that a number of returns depends on the gains in productivity resulting from accretions of capital to the productive process. Accretions of capital make production more roundabout, thus causing greater delays before returns are realized. The amount of income saved, and therefore the amount of capital formed, would accordingly depend, it was held, on the balance struck between the desire for present satisfaction from consumption and the desire for the future gains expected from a more roundabout production process. The American economist Irving Fisher was among those who contributed to refining this eclectic theory of capital.

John Maynard Keynes rejected this theory because it failed to explain the discrepancy between money saved and capital formed. Although according to the eclectic theory and, indeed, all previous theories of capital, savings should always equal investments, Keynes showed that the decision to invest in capital goods is quite separate from the decision to save. If investment appears unpromising of profit, saving still may continue at about the same rate, but a strong “liquidity preference” will appear that will cause individuals, business firms, and banks to hoard their savings instead of investing them. The prevalence of a liquidity preference causes unemployment of capital, which, in turn, results in unemployment of labour.

III HISTORY OF CAPITAL

Although theories of capital are of relatively recent origin, capital itself has existed in civilized communities since antiquity. In the ancient empires of the Middle and the Far East and to a larger degree in the Graeco-Roman world, a considerable amount of capital, in the form of simple tools and equipment, was employed to produce textiles, pottery, glassware, metal objects, and many other products that were sold in international markets. The decline of trade in the West after the fall of the Roman Empire led to less specialization in the division of labour and a reduced use of capital in production. Medieval economies engaged almost wholly in subsistence agriculture and were therefore essentially non-capitalist. Trade began to revive in the West during the time of the Crusades. The revival was accelerated worldwide throughout the period of exploration and colonization that began late in the 15th century. Expanding trade fostered the greater division of labour and mechanization of production and therefore a growth of capital. The flow of gold and silver from the New World facilitated the transfer and accumulation of capital, laying the groundwork for the Industrial Revolution. With the Industrial Revolution, production became increasingly roundabout and dependent on the use of large amounts of capital. The role of capital in the economies of Western Europe and North America was so crucial that the socio-economic organization prevailing in these areas from the 18th century through the first half of the 20th century became known as the capitalist system or capitalism.

In the early stages of the evolution of capitalism, investments in plant and equipment were relatively small, and merchant, or circulating, capital—that is, goods in transit—was the preponderant form of capital. As industry developed, however, industrial, or fixed, capital—for example, capital frozen in mills, factories, railways, and other industrial and transport facilities—became dominant. Late in the 19th and early in the 20th centuries, financial capital in the form of claims to the ownership of capital goods of all sorts became increasingly important. By creating, acquiring, and controlling such claims, financiers and bankers exercised great influence on production and distribution. After the Great Depression of the 1930s, financial control of most capitalist economies was superseded in part by state control. A large segment of the national income of the United States, Great Britain, and various other countries flows through government, which as the public sector exerts a great influence in regulating that flow, thereby determining the amounts and kinds of capital formed.

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Interest

Interest, payment made for the use of another person’s money; in economics, it is regarded more specifically as a payment made for capital. Economists also consider interest as the reward for thrift; that is, payment offered to people to encourage them to save and to make their savings available to others.

Interest paid only on the principal, that is, on the sum of money loaned, is called simple interest. Interest paid not only on the principal but also on the cumulative total of past interest payments is called compound interest. The rate of interest is expressed as a percentage of the principal paid for its use for a given time, usually a year. The current, or market, the rate of interest is determined primarily by the relation between the supply of money and the demands of borrowers. When the supply of money available for investment increases faster than the requirements of borrowers, interest rates tend to fall. Conversely, interest rates generally rise when the demand for investment funds grows faster than the available supply of funds to meet those demands. Business executives will not borrow money at an interest rate that exceeds the return they expect the use of the money to yield.

In medieval Christendom and before, the payment and receiving of interest were questioned on moral grounds, as usury was considered a sin. The position of the Christian Church, as defined by St Thomas Aquinas, condoned interest on loans for business purposes, because the money was used to produce new wealth, but adjudged it sinful to pay or receive interest on loans made for the purchase of consumer goods. Under modern capitalism, the payment of interest for all types of loans is considered proper and even desirable because interest charges serve as a means to allocate the limited funds available for loan to projects in which they will be most profitable and most productive. Islamic Shari’ah law, however, still regards interest as, strictly speaking, sinful, and in some Islamic countries, legal provisions are made to replace interest with other rewards for thrift or investment such as shares in profits.

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Loan

Loan, in finance, the lending of a sum of money. In common usage, the lending of any piece of property. A loan may be secured by a charge on the borrower’s property (as a house purchase mortgage is) or be unsecured. There will also be a number of conditions attached to the loan: for example when it is to be repaid and the rate of interest to be charged on the sum of money loaned. Almost any person or any organization can make or receive a loan, but there are restrictions on some types of the loan; for example, those made by a company to one of its directors.

Loans can take many forms. Many businesses are financed by long-term loan capital, such as loan stock or debentures. Governments also finance their borrowing requirements by issuing long-term fixed-interest bonds that in the United Kingdom are known as gilt-edged stock (or gilts). These loans will usually have a fixed repayment (or redemption or maturity) date and will earn the lender (owner of the stock/debenture/bond) a fixed rate of interest until that date. In the meantime, the price at which the stock can be traded on a stock exchange will depend on a number of things, including how the interest rate on the stock compares with the current rate available on other loan stock. For example, if interest rates have gone down, the price of the loan stock should go up, because the stock is now earning a higher rate of interest than would be earned on its original value at the current market rate. But the market price of a bond will also depend on its maturity date and its quality. In the United States, bonds issued by companies whose credit ratings are below investment grade are known as junk bonds; these pay a higher rate of interest than “non-junk” bonds but their market value will take into account the deemed higher risk of the bond issuer defaulting on interest payments or on redeeming the bonds at their full redemption value. A company’s loan capital is normally recorded on its balance sheet, at the repayment amount, as long-term liabilities. One of the factors by which investors judge a company and by which lenders decide whether to lend it money is the ratio of its debt to its equity. This is known as gearing or leverage; the higher the proportion of loan finance to equity, the higher the gearing or leverage. One of the other ratios people look at when evaluating a company is the proportion of its profits being used to pay the interest on its loan finance.

The interest rate payable on loans is usually determined by market forces at the time the loan is taken out. However, governments may give soft loans (loans on more favourable terms than can be obtained in the market) to businesses they wish to support or encourage. The International Development Association, part of the World Bank, is specifically concerned with organizing loans to developing countries on soft terms.

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International Bank for Reconstruction and Development

I INTRODUCTION

International Bank for Reconstruction and Development, also known as the World Bank, specialized United Nations agency established at the Bretton Woods Conference in 1944. A related institution, the International Monetary Fund (IMF), was created at the same time. The chief objectives of the bank, as stated in the articles of agreement, are “to assist in the reconstruction and development of territories of members by facilitating the investment of capital for productive purposes [and] to promote private foreign investment by means of guarantees or participation in loans [and] to supplement private investment by providing, under suitable conditions, finance for productive purposes out of its own capital …”.

The bank grants loans only to member nations, for the purpose of financing specific projects (at the start of the 21st century it had 183 members and operated in 100 countries). Before a nation can secure a loan, advisers and experts representing the bank must determine that the prospective borrower can meet conditions stipulated by the bank. Most of these conditions are designed to ensure that loans will be used productively and that they will be repaid. The bank requires that the borrower is unable to secure a loan for the particular project from any other source on reasonable terms and that the prospective project is technically feasible and economically sound. To ensure repayment, member governments must guarantee loans made to private concerns within their territories. After the loan has been made, the bank requires periodic reports both from the borrower and from its own observers on the use of the loan and on the progress of the project.

In the early period of the World Bank’s existence, loans were granted chiefly to European countries and were used for the reconstruction of industries damaged or destroyed during World War II. Since the late 1960s, however, most loans have been granted to economically developing countries in Africa, Asia, and Latin America. The bank gave particular attention to projects that could directly benefit the poorest people in developing nations by helping them to raise their productivity and to gain access to such necessities as safe water and waste-disposal facilities, health care, family planning assistance, nutrition, education, and housing. Direct involvement of the poorest people in economic activity was being promoted by providing loans for agriculture and rural development, small-scale enterprises, and urban development. The bank also was expanding its assistance to energy development and ecological concerns.

II SOURCES OF FUNDS

World Bank funds are provided primarily by subscriptions to, or purchase of, capital shares. The minimum number of shares that a member nation must purchase varies according to the relative strength of its national economy. Not all the funds subscribed are immediately available to the bank; only about 8.5 percent of the capital subscription of each member nation actually is paid into the bank. The remainder is to be deposited only if, and to the extent that, the bank calls for the money in order to pay its own obligations to creditors. There has never been a need to call in capital. The bank’s working funds are derived from sales of its interest-bearing bonds and notes in capital markets of the world, from the repayment of earlier loans, and from profits on its own operations. It has earned profits every year since 1947.

All powers of the bank are vested in a board of governors, comprising one governor appointed by each member nation. The board meets at least once annually. The governors delegate most of their powers to 24 executive directors, who meet regularly at the central headquarters of the bank in Washington, D.C. Five of the executive directors are appointed by the five member states that hold the largest number of capital shares in the bank. The remaining 19 directors are elected by the governors from the other member nations and serve 2-year terms. The executive directors are headed by the president of the World Bank, whom they elect for a 5-year term, and who must be neither a governor nor a director.

III AFFILIATES

The bank has two affiliates: the International Finance Corporation (IFC), established in 1956; and the International Development Association (IDA), established in 1960. Membership in the bank is a prerequisite for membership in either the IFC or the IDA. All three institutions share the same president and boards of governors and executive directors.

IDA is the bank’s concessionary lending affiliate, designed to provide development finance for those countries that do not qualify for loans at market-based interest rates. IDA soft loans, or “credits”, are longer term than those of the bank and bear no interest; only an annual service charge of 0.75 per cent is made. The IDA depends for its funds on subscriptions from its most prosperous members and on transfers of income from the bank.

All three institutions are legally and financially separate, but the bank and IDA share the same staff; IFC has its own operating and legal staff but uses administrative and other services of the bank. Membership in the International Monetary Fund is a prerequisite for membership in the World Bank and its affiliates.

IV RECORD

The World Bank has been heavily criticized in recent years for its poor performance in development economics, especially with regard to the social and environmental consequences of the projects it supported in developing countries. The bank itself has admitted considerable wrongdoing. Resulting reforms were embodied in the Strategic Compact of 1997, which decentralized the bank’s operations. However, it is arguable that it is less at fault than many of the corrupt or incompetent regimes whose schemes it is called on to fund. The bank’s role in development has in any case diminished with the vast influx of private capital into profitable projects in developing countries. Health, education, and other fields unlikely to yield profits remain in need of an institution such as the World Bank.

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Reconstruction Finance Corporation

Reconstruction Finance Corporation (RFC), the independent agency of the United States government, created during the economic depression by the congressional enactment in 1932, and abolished by Congress in June 1957. The stated purpose of the RFC was “to provide emergency financing facilities for financial institutions; to aid in financing agriculture, commerce, and industry; to purchase preferred stock, capital notes, or debentures of banks and trust companies; and to make loans and allocations of its funds as prescribed by law”. These purposes were subsequently enlarged by legislative amendment to include participation in the maintenance of the economic stability of the country through the promotion of maximum production and employment and the encouragement of small business enterprises. The basic activities of the RFC were to make and collect loans and to buy and sell securities. Originally, the capital stock of the corporation was fixed at $500 million.

For seven years following its creation, the RFC was classified as an emergency agency. In 1939 it was grouped with other agencies to constitute the Federal Loan Agency. It was transferred to the Department of Commerce in 1942 and reverted to the Federal Loan Agency three years later. When that agency was abolished in 1947, its functions were assumed by the RFC.

Approximately two-thirds of the disbursements of the RFC were made in connection with the national defence of the United States, especially during World War II. Loans were also made by the RFC to federal agencies and to state and local governments in connection with the relief of the unemployed and the relief of victims of disasters such as floods and earthquakes. Disbursements to private enterprises included loans to banks and trust companies to aid in their establishment, reorganization, or liquidation, and to mortgage loan companies, building and loan associations, and insurance companies. Loans were also made to agricultural financing institutions, to enterprises engaged in financing the export of agricultural surpluses, and to railways, mines, mills, and other industrial enterprises. Hundreds of millions of dollars were disbursed by the RFC for the purchase of securities offered by the Public Works Administration, other government agencies, and private corporations.

In 1948, after the financial crisis of the depression and World War II had passed, Congress reduced the capital stock of the RFC to $100 million and provided for the retirement of the outstanding capital stock in excess of that amount. It also authorized the RFC to issue to the Treasury its own notes, debentures, bonds, or other similar obligations, in a number of its outstanding loans, in order to borrow money with which to carry on its functions.

During 1951 and 1952 congressional investigators found considerable evidence of fraud and corruption among RFC officials. In July 1953, Congress enacted the RFC Liquidation Act, providing for the gradual transfer of the functions of the RFC to other government agencies. The RFC loan powers were transferred in 1954 to the Small Business Administration. The RFC was abolished in June 1957, and its remaining functions were transferred to the Housing and Home Finance Agency, the General Services Administration, and the Department of the Treasury. During its existence from 1932 to 1957, the RFC disbursed more than $50 billion in loans.

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Stock Exchange

Stock Exchange, also known as bourse, organization that facilitates the trade in company shares or other types of securities, such as bonds, unit trusts, and derivative products. Today, they fulfil several objectives: allowing a company to raise capital by floating its stock (often known as an “initial public offering”, or IPO); giving investors a way to participate in a company’s success by sharing in their profits (through share price appreciation and dividends); and allowing access to securities covering more esoteric investments such as commodities or pooled investments. Increasingly, stock exchanges such as Deutsche Börse, based in Frankfurt, provide more than just a trading venue, and can offer transaction settlement services, provision of market information, as well as the development and operation of electronic trading systems.

For a company to raise cash for investment or day-to-day operations, it can either borrow through the banking system or issue stocks or bonds. This issuance takes place in the primary market, which involves large investment banks and investors purchasing these shares through an IPO. Subsequent trading of these shares or bonds takes place on the secondary market, through the stock exchange. Exchanges have regulations to which companies must conform in order to be allowed to use their facilities. These rules differ but generally include the publication of audited accounts, announcement of corporate actions, and payment of dividends. While there have been stock market crashes and scandals in the past, the greater level of regulation and oversight by institutions mean such occurrences are rarer. However, because some exchanges have higher levels of regulation and listing requirements than others, they may be more attractive for a company to list on. These requirements may be based on company size in terms of income or capital worth and how long it has been trading.

Since the 1980s, many developments in the structures and operations of stock exchanges have seen them hugely changed from the time of their inception. The earliest form of a stock exchange is believed to have emerged in France in the 12th century, and was primarily based on the central trading of government-issued securities. Unofficial markets existed across Europe through to the 17th century, and the Amsterdam Stock Exchange, opened in 1602, is credited as having been the first to have issued and traded shares in a company—the Dutch East India Company. The London Stock Exchange (LSE) is one of the world’s oldest and largest. It started in the coffee-houses of London in the 17th century. By 1761 groups of stockbrokers had formed a club to trade shares and 12 years later they built their own exchange with coffee-shop above. By 1801, it had reopened under a membership basis and London’s first regulated stock exchange began.

The mutual structure of an exchange such as London’s has been one characteristic that has changed most recently. Many stock exchanges have themselves floated shares to become listed companies. For many years the dominant players in the world of stock exchanges in terms of the value of companies listed with them have been the New York Stock Exchange (NYSE), the LSE, and the Tokyo Stock Exchange. However, just as institutions have demutualized, developed electronic trading systems, and handle ever-more complex forms of securities, so too has the competition. The NYSE is today known as the NYSE Euronext since its acquisition of the Euronext group, completed in 2007. In 2008 NYSE Euronext announced that it plans to take over the American Stock Exchange (Amex). The Euronext group is a rare example of a multinational exchange organization, providing services for regulated markets in Belgium, France, the Netherlands, and Portugal, and derivatives for the United Kingdom. In the face of this form of competitive market with exchanges such as Deutsche Börse growing, and the merger of Euronext and the NYSE, players such as the LSE have merged with other exchanges such as Borsa Italiana, based in Milan. Additionally, as emerging economies develop, in particular in South East Asia, exchanges in places such as Hong Kong and Singapore become more important.

However, the leap in technology (and in Europe, a changing regulatory environment) has created even more competition with an increasing number of alternative trading systems known as Electronic Trading Networks (ECNs), such as Instinet. These systems boast lower costs. A further important “exchange”, although of a much less regulated sort, is the National Association of Securities Dealers Automated Quotation (NASDAQ) system. This is a computerized market linking dealers throughout the United States and, to some extent, Europe. The computerized nature of the NASDAQ pre-empted what is now a more common method of trading on exchanges throughout the world. Computerized systems have increasingly replaced the traditional stock exchange “floor” where dealers and stockbrokers met and traded by face-to-face “open outcry”. The LSE has been entirely computer-based since the reorganization dubbed the “Big Bang” in October 1986, with dealers able to see all prices on-screen instantaneously.

Other technological developments have also changed the face of the markets and the world of exchanges. The Stock Exchange Automated Quotation International (SEAQ International) system allows French shares to be traded in London, for example. SEAQ International has been dramatically successful in capturing market share from the domestic stock exchanges of many countries, to the extent that, for some countries, a larger proportion of trades takes place in London than on their own exchanges.

As competition between exchanges has developed, the trading systems of stock exchanges have divided into two broad categories. First, in order to reduce volatility and increase share liquidity, many exchanges use the “market-maker” or “liquidity provider” system. There are variations on how this system works but essentially a market-maker is a financial company that provides a price at which it is prepared to buy and sell each share. It can make money on the “turn”, which is the difference between the sell and the buy price, and is known as the spread. Usually the largest of the companies traded on an exchange in terms of capitalization do not have market-markers. Exchange regulations dictate that the best of these quoted prices are used when an investor’s order to buy or sell shares goes to a stockbroker, who in turn passes the deal on to a market-maker who will execute it. All the prices are visible on computer screens, and market-makers are committed to honouring their prices for trades up to a certain size (the “normal market size”, or NMS).

The second type of trading is the “auction” system, which has a matched-bargain or order-driven basis whereby all buy-and-sell orders from investors are collected together and matched, with the price being set to attempt to clear the market.

Individual countries seem loath to give up their domestic stock exchanges, although as financial markets are now so liberalized, and as information technology develops further, there is nothing to stop individual investors using whichever stock exchange system is the cheapest or most efficient.

Reviewed By:
Gerard O’Kane

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Charities and Fund-Raising

I INTRODUCTION

Charities and Fund-Raising, organizations established for exclusively charitable purposes and governed by charity law; fund-raising is a major means by which charities finance themselves. Charities are subject to the jurisdiction of the High Court in England and Wales.

A recognized charity usually benefits from both tax advantages and the goodwill of the public. In England and Wales, official recognition is secured when a body is registered as a charity with the Charity Commission, thus gaining charitable status. Society supports charity in a number of ways, and the process of registration must reflect the responsibility that a charity has as a result of this. When the Charity Commission registers an organization as a charity, this confirms that it exists for the public benefit and that it is expected to be publicly accountable in a number of ways. Registration or official recognition of charities in other countries usually operates under similar criteria.

II CHARITY FUND-RAISING

Charities perform many valuable services in the community and often raise funds from the public and other sources in order to fulfil their objectives. In many cases, the only dealings the public have with a charity is through their fund-raisers.

Over the years there have been many innovative methods used by charities to raise funds. The precise methods used are usually a matter for the trustees or other directors of the charities to determine. However, when deciding upon potential fund-raising opportunities, trustees should be alert and sensitive to public opinion and criticism. Methods that are distasteful or extremely costly may meet with disapproval that can damage the charity and the sector as a whole.

The most common methods of raising funds are street collections, house-to-house collections, direct mail, and fund-raising events. Charities may use volunteers and paid employees, but increasingly the larger charities are turning to professional organizations to support their fund-raising efforts in areas such as general fund-raising, advertising, direct mail, and telephone fund-raising. More often, charities also enter into agreements with commercial manufacturers and retailers to associate their charitable cause with products offered for sale.

Charities that decide to raise funds can do so by using professional fund-raisers: individuals contracted externally to raise donations. In order to raise funds, charities can also enter into a promotion with someone who is known legally as a “commercial participator”. This is someone who runs a business and sells a product, stipulating that some of the purchase prices will benefit the charity. However, there are usually legal constraints on this kind of fund-raising, and charities must exercise discretion. The controls usually include requirements for a written agreement between the charity and the professional fundraiser or commercial participator, a statement informing potential donors or purchasers what proportion of their donation will be used to pay the costs of the fund-raiser, a statement detailing how the charity will benefit from its involvement with a commercial participator, and formal arrangements for the transfer of funds raised by professional fund-raisers or commercial participators to the charity.

Finally, it must be remembered that a charity’s name is both precious and valuable and should not be given to a third party without serious consideration of how the charity will benefit. As the name is the means by which a charity is recognized and by which its reputation will be judged, great care is required when allowing its name to be used in conjunction with a promotional venture. Before any agreement is reached it is essential to decide whether a particular relationship is appropriate for a charity and whether it may damage the charity or the good name of the charity sector.

III HISTORY

Forms of charity and philanthropy have been present throughout history, frequently to provide some form of social welfare or to alleviate poverty. Most major world religions have given rise to charitable organizations of one form or another: Christianity and Buddhism are notable for their charitable traditions. Monasticism has been historically associated with charity work, but most monastic orders were and are self-financing organizations with little in common with modern charities, their chief purpose being religious rather than philanthropic.

The charitable trusts that established almshouses are one of the earliest Western examples of charities. Charitable fraternities and trusts often related to guilds of urban origin were another important precursors of modern charities. The Reformation encouraged the spread of secular charities in Protestant countries, as the end of monasticism created a need for other philanthropic bodies to provide the services previously offered by the monasteries. As legal codes became more complex and formal, and methods of tax collection more prevalent and effective, statutes were drafted to define charitable status, and more organizations began to apply for the benefits of this status.

Modern-day charities cover many fields and often have little more than their legal status and a broad philanthropic purpose to link them. For example, the Royal College of Surgeons of England, which oversees surgical standards, is a registered charity, as is the British Film Institute; many educational bodies, including fee-paying schools, adopt charitable status. Modern charities may be religious in origin, as with Christian Aid and the Young Men’s Christian Association (YMCA), or entirely secular in inspiration, as with the Zoological Society of London or the British Association for the Advancement of Science. They may be international in scope (Oxfam, Médecins Sans Frontières), or confined to one country (the Ramblers’ Association, the National Trust). They may exist to do medical, emergency, or aid work (the Royal National Lifeboat Institution, Action Aid), or they may have cultural or more general social aims (the Prince’s Trust). Very large and important charities sometimes achieve the status of Non-Governmental Organizations (NGOs), and can actually influence governments worldwide.

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Finance

I INTRODUCTION

Finance, a term applied to the purchase and sale of legal instruments that give owners specified rights to a series of future cash flows. These legal instruments, known as financial assets or securities, are issued by private concerns, such as companies and corporations, and government bodies, and include bonds, stocks, and shares.

The original issuer of a security is in effect borrowing money that the purchaser is lending. Borrowers have an immediate need for cash, whereas lenders have an excess of cash. When the borrower issues a security such as a bond to the lender, both parties benefit; the borrower obtains the current use of cash and the lender obtains a claim to future cash flows that involve repayment of the initial loan as well as the payment of interest. In the case of equities (the ordinary shares of a company), the provider of finance (the lender) hopes to realize an increase in the value of the capital acquired as well as to receive share dividends, though neither is guaranteed.

II FINANCIAL MARKETS

Transactions between an initial borrower and lender are called primary market transactions. Many financial assets created in the primary market may be sold by the original lender to other people in what are known as secondary markets. The trading of marketable securities in secondary markets has no impact on the original borrower; only the legal owner of the security changes. Examples of formally incorporated secondary markets are stock exchanges such as the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange. Secondary market transactions that do not take place on incorporated exchanges are referred to as over-the-counter transactions.

III TYPES OF SECURITIES

Most securities traded in the secondary markets belong to one of two broad classifications: bonds or stocks (shares). Bonds are credit instruments redeemable for a given sum and yielding a fixed return. Important characteristics of bonds include face (or par) value, maturity date, and coupon rate. Face value represents the total amount of cash payable to the owner at the bond’s maturity date, which can range from 3 months to 30 years. Prior to maturity, yearly coupon payments equal to the coupon rate times the face value are paid. These payments are the bond owner’s profit. Once set in the initial primary market sale, the coupon rate on a given issue will not change in response to changing interest rates in the economy. Instead, the market price of the bond changes. When a bond’s coupon rate is equal to the general level of interest rates prevailing in the economy, the bond’s market price will be equal to its face value. When the coupon rate is higher than prevailing interest rates, the bond will sell for more than its face value. When the coupon rate is lower than prevailing interest rates, the bond will sell at less than its face value. Interest on bonds constitutes a legal obligation, and failure to pay it may result in bankruptcy.

Preference shares are similar to bonds in that they have stated face values and a specified dividend payment (similar to a bond’s coupon). They differ from bonds because they do not have a scheduled maturity date and because yearly dividends may remain unpaid for a few years without forcing the issuer into bankruptcy. Common stocks (ordinary shares) have no specified yearly cash payments or maturity date. These securities have an infinite life on which a cash return will be earned only if the issuer has satisfactory profits. They, therefore, carry a higher level of risk than other securities, their attraction to the holder being larger expected a (if not guaranteed) return. Because the cash returns on bonds are in general the most certain, they are viewed as the least risky investment and provide a lower expected return. However, junk bonds issued by companies with low credit ratings offer higher rates of return because of the higher risk that the bond issuer will default. Preference shares are viewed as riskier than bonds and less risky than ordinary shares.

Security issuers are classified as either private or public. Private issuers consist of individuals, partnerships, and corporations. Public issuers are various governmental bodies.

IV FINANCE IN THE PRIVATE SECTOR

Many businesses issue financial securities to pay for various assets they wish to purchase. Because companies represent the dominant financial force in the private sector, this section focuses on corporate finance. Companies acquire new capital by the sale of stocks and bonds, or they may finance their temporary needs by borrowing money from banks.

Asset-investment decisions are based on two criteria: the expected rate of return and the risk. In order to estimate the expected return on a project, detailed forecasts are made of the costs and revenues that might result from a given investment. The level of risk involved depends on how much control the firm has over factors that affect such matters. Having arrived at a judgement that assesses the return and weighs up the risk, it is the board of directors that has the final decision in a company on how the acquisition of costly assets should be financed.

Their decision will largely be determined by the cost of finance. This is basically the effective rate of interest that the company will have to pay to borrow the money.

A Short-Term Financing

Debt financing is classified as short term or long term. Short-term debt issues must be repaid within five years. Loans obtained from commercial banks are a common form of short-term debt. Bank lines of credit allow a firm to borrow up to a specified maximum but generally require that the loan balance be zero for one or more months during a year. Lines of credit are typically not backed by collateral. Banks will also provide two- to three-year loans, but these are often secured by a claim to inventories or accounts receivable if they are not repaid on time.

Three other major types of short-term financing include commercial paper, pledging, and factoring. Commercial paper is a debt of the firm that has a maturity of one year or less. It is sold only by large, financially sound firms and its financing cost is slightly less than the prime rate given to lowest-risk bank loans. Factoring and pledging are used by smaller, less stable companies. Factoring is when a business sells to a factor (often a bank or a bank subsidiary) the right to collect the money it is owed (its receivables); in return for providing the business with cash in advance of the time payment is due the factor takes a percentage of the invoice value and may provide cover for bad debts. Pledging is a loan secured by the firm’s receivables due from customers. Because of their increased risk, the financing cost to a business of pledging and factoring is higher than if it issued commercial paper.

Before the mid-1960s virtually all debt issues were sold within the country in which the issuing corporation resided. Since then international financing has increased dramatically. Much of this international financing is short term and takes place in what is referred to as the Eurobond market, the major centre for which is London. The Eurobond market allows companies to raise finance in foreign currency (often United States dollars) and avoid the regulations and restrictions of their domestic financial markets. The proceeds of such bond issues are frequently converted into the companies’ domestic currency at the time of the issue. The Eurobond market is used for raising both short-term and long-term finance. In recent years bonds with up to 50-year maturities have been issued.

B Long-Term Financing

Long-term debt frequently takes the form of a bond issue or lease financing. Bonds that have no claim to specific assets if the firm defaults are referred to as debentures. Because of their risk, debentures carry a higher interest rate than secured bond issues. Leases are similar to debt issues except that the legal title to the asset being financed does not pass to the firm doing the leasing. Lease financing has been used increasingly in recent years owing to various taxation advantages not found in debt or equity financing.

Occasionally, long-term bond issues are sold that provide the buyer with a claim to purchase ordinary shares of the issuing firm. Convertible bonds allow the owner to convert the bond into a specified number of shares. Bonds with warrants attached allow the holder to purchase shares at a favourable price. From the corporation’s viewpoint, convertible bonds will eventually become new shares, whereas bonds with warrants will remain debt but will (or should) also provide new equity money in the future.

Preference shares are in many ways similar to bonds. They are sold at a specified face value or par; pay a stated amount each year; and, in the event of a company bankruptcy, carry a claim to a share in the liquidation of assets before that of ordinary shares. They also have certain features of ordinary shares: dividends need not be paid unless the firm has cash available for this purpose, and they will often be allowed to increase as profits of the firm increase. Straight bonds, on the other hand, pay a guaranteed and specified coupon rate each year.

The true owners of a corporation are the holders of its ordinary shares; they receive any profits from asset investments after all debt interest and preference share dividends are paid. These profits are distributed in two ways: as cash from the corporation to the shareholder in the form of dividends and as capital gains realized when the shares are sold at a price higher than was paid for them. Increases (or decreases) in common stock prices are caused by two things. (1) The retention of profits to provide for growth and other corporate goals increases the total asset value of the firm and thus increases the value of the stock. If for example, a given figure in earnings per common share is retained within the firm, the value per share should increase by that figure. (2) Changes in the opinions of shareholders about the future profit potential of the firm will cause share prices to rise or fall. The actual rate of return earned by ordinary shareholders is determined by the actual cash dividend received plus or minus any price gain or loss on the shares.

C Financial Intermediaries

Institutions that obtain financial resources from a lender and supply them to a borrower are known as financial intermediaries. A commercial bank, for example, obtains money from demand deposits, savings accounts, and bond sales. This money is then lent to private individuals, corporations, or governments. Other types of financial intermediaries are building societies, mutual funds, insurance companies, and pension funds. These institutions allow savers with small amounts of capital to pool their funds in order to diversify across a large number of investments. In addition, the financial expertise of the institutions’ managers can provide a high return for the savers on their investment.

V FINANCE IN THE PUBLIC SECTOR

Through public expenditure, a nation carries out the functions required of it by its citizens. During the past century, the public sector has expanded greatly in virtually every country, regardless of its political system.

Public expenditure falls into three main categories: defence, public works, and social welfare programmes. Public works include such services as roads and housing, public utilities, and, in many countries, the postal, railway, telephone, and telecommunications systems, as well as other services such as public service broadcasting. Social welfare programmes involve expenditure on public health services, education, and unemployment benefit. In some states, such as France or China, state financial support of industry or agriculture also accounts for a sizeable share of public expenditure.

A Taxation

Public expenditure is financed chiefly by taxation. This takes various forms, such as excise duties, income tax, value added tax, and other revenue-raising mechanisms.

B Financing Deficits

When government expenditure exceeds revenues from taxation and other sources (such as privatization of public assets), the resulting deficit must be financed by borrowing money. At the national level, a treasury department is usually empowered to sell both short- and long-term securities. In Great Britain, treasury bills have a maturity of three months or more; government bonds have maturities ranging from 1 year to around 20 years. Government bonds are normally regarded as especially safe forms of security.

State and local debt issues have increased rapidly in many countries. Such issues are similar in many respects to government securities but have a larger risk of default. They, therefore, tend to carry higher yields than government issues with a similar maturity. In some countries, they may also offer tax advantages.

C Money Creation

The final way in which government expenditures are financed is by the creation of new money. This source of financing is available only to national governments, and although it is widely discredited as a tool in macroeconomic management because it inevitably creates inflation, governments have historically resorted to it, often for political rather than economic reasons. If a national government wishes to spend a set amount on various projects, for instance, it can pay for them by printing that figure in new money. In practice, however, the process is more complex; usually, it is conducted by a central bank. In Great Britain, this central bank is the Bank of England, which is responsible for controlling the money supply available to the country. Where the central bank has less power to resist the demands of central government, the manipulation of the money supply for budgetary ends may be greater, and it is often international financial markets that exercise greater restraint on the state’s tendency to print money. The supply of money is often manipulated to aid the central government in financing deficits, controlling interest rates, controlling inflation, and increasing employment. Unfortunately, the procedures used to meet many of these goals conflicts. For example, attempts to keep interest rates low at one point in time often lead to higher interest rates and inflation in the long run.

VI INTERNATIONAL FINANCE

Capital movements between countries are classified either as current account or capital account movements. Current account movements refer to payments for imports and exports, as well as the payment of interest and dividends. During any year, a given country will have either a surplus or a deficit of current account transactions. Capital account movements refer to the purchase or sale of securities in one country by citizens of another country. Such transactions will also result in a net surplus or deficit for a given country. When the capital and current account are added together, the result is the overall balance of payments position of a country. A net balance of payments deficit means that more financial resources have flowed out of a country than into it; a net surplus means the opposite.

Each country will demand payment for net surpluses in the currency it uses. The United Kingdom, for example, uses the pound sterling, while the United States uses the dollar. The value of one currency relative to another depends on which country has a net deficit to the other. If the United States, for instance, has a net deficit to the United Kingdom, the value of the British pound will rise relative to the dollar. This relative value is indicated by the exchange rate, which represents the cost of one unit of a given currency in terms of another. The rise in the value of the British pound will make British exports to the United States more expensive, and US exports to the United Kingdom cheaper. As a result, the deficit should tend to correct itself. The exchange rate is, therefore, important because of its role in restoring a balance between deficits and surpluses in different countries.

Capital movements have become more important as a result of financial liberalization reforms during the 1980s and 1990s and the lifting of exchange controls. As a result, currency speculators and investors, aided by advanced communication technology, can shift enormous sums of money around the world with tremendous speed. The power of this international financial system was demonstrated in 1992, when concerted speculative pressure forced Britain and Italy to withdraw from the Exchange Rate Mechanism of the European Union, and again in early 1995, when the financial markets lost confidence in Mexico, instigating domestic panic and a vast US government financial aid package.

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