Cost of Capital - Formulas

Cost of Debt = Pre-tax Cost of Debt * (1 - Tax Rate)

Cost of Preferred Stock = (Cash Dividends) / (Net Proceeds of PS [i.e. gross proceeds - costs])

Cost of Retained Earnings:

Capital Asset Pricing Model (CAPM)
= Risk-Free Rate + (beta * [Market Rate - Risk-Free Rate])

Discounted Cash Flow Model (DCF)
= (Dividend at the end of YR 1 / Markte Value of CS ) + Growth Rate

Bond Yield Plus Risk Premium (BYRP)
= Pre-tax cost of LT debt + Market Risk Premium

Variance Analysis

Direct Materials:

Price = Actual Quantity Purchased * (Actual Price - Standard Price)

Quantity Usage = Standard Price * (Actual Quantity Used - Standard Quantity Allowed)

Direct Labor:

Rate = Actual Hours * (Actual Rate/Price - Standard Rate/Price)

Efficiency = Standard Rate * (Actual Hours - Standard Hours Allowed)

Manufacturing Overhead Variance:

Spending = Actual Overhead Costs Incurred - (Actual Hours Worked * Standard O/H Rate)

Efficiency = (Actual Hours Worked * Standard O/H rate) - (Standard Hours Allowed * Standard O/H Rate)

Volume = (Standard Hours Allowed * Standard O/H Rate) - Applied O/H

Sales & CM Variance:

Sales Price = Actual Units Sold * (Actual Price/Unit - Standard Price/Unit)

Sales Volume = Standard CM/Unit * (Actual Units Sold - Budgeted Sales Unit)

Threats in a Computerized Environment

• Virus  
• inserts itself into another program to propagate; 
• cannot run independently
• Worm 
• propagates itself over a network; 
• run independently; 
• cannot attach to other programs
• Trojan Horse 
• appears to be useful but has a hidden, unintended function that presents security risk; 
• cannot replicate itself
• Denial-of-Service Attack 
• bombards another computer with a flood of information to keep users from accessing the computer/network
• Phishing
• phony e-mails 

IT Risk Event Identification

• Strategic Risk - inappropriate technology
• Operating Risk - doing the right things the wrong way 
• Financial Risk - lost/waste/stolen financial resources
• Information Risk - loss of data integrity, incomplete transactions, hackers
• Specific Risk - errors, intentional acts, disasters

ERM Enterprise Objectives

• Strategic - high level goals designed to achieve mission
• Operations - achieve operations through effective & efficient use of resources
• Reporting - reliable reporting
• Compliance - compliance with laws & regulations

Breakeven Computation

Breakeven point in units = (Total fixed costs) / (Contribution margin per unit)

Contribution margin per unit = SP/unit - VC/unit

Breakeven point (in dollars) = Unit price x Breakeven point in units
= (Total fixed costs) / (Contribution margin ratio)

Contribution margin ratio = CM / Sales

Contribution vs. Absorption Approach

Contribution Approach (Not GAAP)

• Revenue - Variable cost = Contribution Margin - Fixed costs = Net income
• Variable costs (DM + DL + Variable O/H + Variable SG&A)
• Fixed costs (Fixed O/H + Fixed SG&A)

Unit contribution margin = Unit sales price - Unit variable cost

Contribution margin ratio = Contribution Margin / Revenue

Absorption Approach (Product vs. Period)

• Revenue - COGS = Gross Margin - Operating expenses = Net income
• COGS (DM + DL + O/H [Variable & Fixed])
• Operating expenses (SG&A period cost)

Difference between Contribution Approach & Absorption Approach 

• Absorption costing: Product costs include Fixed Manufacturing Overhead
• Only expense for portion of units sold 
• Variable costing: Period costs include Fixed Manufacturing Overhead

Effect on Income

• No change in inventory: Absorption net income = Variable net income
• Increase in inventory: Absorption net income > Variable net income
• Fixed O/H to be expensed decreases
• Decrease in inventory: Absorption net income < Variable net income
• Fixed O/H to be expensed increases 

Enterprise Risk Management

• Internal environment
• Setting objectives
• Event identification
• Assessment of risk
• Risk response
• Control activities 
• Information and communication
• Monitoring

Cost Components - Equivalent Units

Background information:

Work-in-process, beginning: 100 units, 30% complete
Units completed and transferred out: 400 units
Work-in-process, end: 300 units, 30% complete

Beginning cost: $10,000
Current cost: $15,000

FIFO equivalent units of production

1. (Work-in-process, beginning)*(% remaining to be completed) = 100 * 70% = 70
2. (Units completed) - (Work-in-process, beginning) = 400 - 100 = 300
3. (Work-in-process, end)*(% completed) = 300 * 30% = 90

Equivalent units (EU) = 70 + 300 + 90 = 460

Cost per equivalent unit = (Current cost) / (EU) = $15,000 / 460 = $32.61

Weighted-average equivalent units of production

1. Units completed = 400
2. (Work-in-process, end)*(% completed) = 300 * 30% = 90

Equivalent units (EU) = 400 + 90 = 490

Cost per equivalent unit = (Beginning cost + Current cost) / (EU) = ($10,000 +15,000) / 490 = $51.02

COGM and COGS

Gross profit:

• Sales - COGS = Gross Profit

Cost of good sold (COGS):

• Finished Goods Beginning + COGM - Finished Goods Ending = COGS
• Goes to Income Statement

Cost of goods manufactured (COGM):

• WIP Beginning + Manufacturing Costs (DM + DL + O/H Applied) - WIP Ending = COGM
• Goes to COGS

Direct material (DM) used:

• Raw Materials Beginning + Purchase (includes freight in) - Raw Materials Ending = DM
• Goes to COGM 

Common Cost Objects and Calculation

• Prime cost = Direct material + Direct labor
• Conversion costs = Direct labor + Factory overhead (applied)
• Product costs = Prime cost + Conversion cost = Direct material + Direct labor + Factory overhead applied 

Applied Overhead Calculation

Applied overhead = Actual cost driver x Overhead rate

Overhead rate = Budgeted overhead cost / Estimated cost driver

COSO: Internal Control Integrated Framework

• Control environment
• Risk assessment
• Information & communication
• Monitoring
• Existing control activities

Control environment principles:

• Competency commitment
• HR
• Organization structure
• Philosophy
• Participation of BOD
• Ethics and integrity
• Responsibility and authority 

Impaired Independence

1. CPA has direct financial interest regardless of immateriality OR material indirect interest
2. Audit fees remain unpaid for 1 year+ prior to the issuance of the current audit report**
3. CPA has a management position with a client
4. CPA makes hiring decisions for a client
5. Litigation (exception: immaterial amounts unrelated to audit)
6. Contingent fees

**Notice also the period to look at is one year from the issuance date of the current year report. The CPA can perform the work without the prior year fee being paid, but he cannot issue the report without the prior year fee being paid. (Source Example)

Auditing through the Computer (CAAT)

Emphasizes input & processing

• Transaction tagging - electronically marks a transaction
• Embedded audit modules - collects transaction data for the auditor
• Test data - runs fictitious data for the auditor
• Integrated test facility (data checks) - runs fictitious data for auditor
• Parallel simulation (re-performance) - process actual client data through auditor controlled program
• Generalized audit software packages - perform tests of controls &substantive tests directly on Client system
• allow the auditor to independently process & verify client electronic data processing records  

Government Auditing

3 Sources of Guidance:

• GAAS
• GAGAS - the Yellow Book (Generally Accepted Government Auditing Standards)
• Single Audit Act

Government Audit Scope (based on the Yellow Book)

In additional to financial statements, audit should include the following considerations:

• Program results
• Compliance with laws & regulations
• Economy & efficiency 

Types of Independence Impairments:

• External - undue influence threat to impact auditor's objective judgment
• Organizational - auditor is in the same reporting unit as the audited entity
• Personal - auditor having personal connection/interest in the audited entity

Syndication vs. Organization Costs - VC

Syndication Cost

• Packaging & selling of the investment/partnership unit & promotion of it
• marketing & fundraising costs
• production of any offering memo/promotional materials
• legal costs associated with offering, due diligence, costs of transferring assets to the partnership

Organization Cost

• legal & accounting fees necessary to form the Fund
• Facilitate the filings of necessary legal documents & regulatory paperwork required at the state & national levels

Overall Note - Management must evaluate costs incurred by the Fund. Generally, syndication costs are associated with the sale of actual investment units & organization costs are associated with costs necessary to legally create the partnership.

Review of Financial Statements

Obtain limited assurance that there are no material modifications to the FS

Requirements:

• Understanding the Client
• Inquiries of internal personnel (no external people/entities)
• Analytical procedures
• MRL (required!)

DO NOT:

• Obtain understanding of internal control 
• Test internal control 
• Assess control risk
• Perform audit tests
• Assess fraud risk
• Communicate with predecessor accountant (not required, but may)

Other notes:

• If FS has GAAP departure, disclose in separate paragraph in the Independent Accountant's Review Report
• All FS must refer to "see Independent Accountant's Review Report"

Compilation of Financial Statements

To assist management in presenting financial information in the form of financial statements

No assurance provided

Requirements:

• Knowledge of industry accounting principles and practices
• Understanding of Client's business
• Reading of financial statements for obvious material errors 
• fraud, illegal acts, going concern, subsequent events

Compiled statements that omit GAAP disclosures - include in report that:

• FS are prepared in conformity with comprehensive basis of accounting other than GAAP
• FS are otherwise in conformity with GAAP
• Reason for omission was not to deceive user
• Warns user of missing disclosures

Other notes:

• Accountant DOES NOT need to obtain an understanding of internal control (review and comp)
• MRL is NOT required
• If Client fails to provide a rep letter for a review of a balance sheet, accountant may issue a compilation report with Client's consent

Fraud Risk

3 Fraud Risk Factors (conditions generally present for fraud to occur):

1. Incentive/pressure - reason to commit fraud
2. Opportunity - lack of effective controls
3. Attitude that allows the person to rationalize fraud - attempt to justify fraudulent behavior 

Types of Fraud:

1. Fraudulent Financial Reporting - LYING
• intentional misstatements/omissions of amounts/disclosures
• manipulation of accounting records
• misrepresentation in financial statements
• intentional misapplication of accounting principles 
2. Misappropriation of Assets - STEALING
• theft of assets 
• unreliable accounting system
• inadequate: internal control, management understanding, access controls, physical safeguard 
3. Corruption - CHEATING 

Going Concern & Uncertainty

Going Concern - Auditor's report presentation:

• Adequate disclosure: Unmodified with Emphasis-of-Matter paragraph
• must include terms: substantial doubt, going concern
• Inadequate disclosure: Qualified or Adverse
• Significant going concern uncertainty: Disclaimer 

Going Concern Mitigating Factors (intent & ability to execute):

• Borrow money or restructure debt
• Sell assets
• Delay or reduce expenses
• Increase ownership equity

Uncertainty

• No material misstatement & sufficient evidence: Unmodified
• Material misstatement related to uncertainty: Qualified or Adverse
• Insufficient evidence (scope limitation): Qualified or Disclaimer 

Evaluating for Attribute Sampling

• Sample deviation rate + Allowance for sampling risk > Tolerable rate
• bad result; cannot rely on control
• Sample deviation rate + Allowance for sampling risk < Tolerable rate 
• good result; can rely on control 

Definition:

1. Upper deviation rate = sample deviation rate + allowance for sampling risk
2. Tolerable rate of deviation =  highest deviation rate the auditor could accept & still conclude that the design and operation of an internal control is effective
• used in drawing conclusion on effectiveness of control
• based on auditor judgment
• compared to upper deviation rate
3. Sample deviation rate = (# of errors) / (sample size)

Ratios & Interpretations

1. Quick (acid-test) ratio
• formula: (cash + marketable securities + net receivables) / CL
• interpretation: immediate short term liquidity
2. Current ratio
• CA / CL
• short term liquidity
3. Debt to equity ratio
• Total liabilities / Common stockholders' equity
• degree of protection afforded to creditors in case of insolvency
• what proportion of equity & debt the company is using to finance assets 
4. Debt ratio = Total liabilities / Total assets 
5. Times interest earned
• recurring income before interest and taxes / interest
• ability to cover interest charges
6. Accounts receivable turnover
• Net sales / Net AR
• success (or lack of) in collecting outstanding receivables
7. Inventory turnover
• Cost of goods sold / Ave. inventory
• how quickly inventory is sold 
8. Total asset turnover
• Net sales / Total assets
• how effective Company makes use on its assets
• higher ratio = more revenue per asset dollar 
9. Operating cycle = AR turnover in days + Inventory turnover in days
• indicates the number of days between the acquisition of inventory & the realization of cash from selling the inventory
• "cash to cash" cycle
10. Gross margin = revenue - cost
11. Gross margin % = Gross margin / Net sales 
12. Net profit margin %
• Net income / Net sales
• profit rate
13. Net operating margin percentage = Net operating income / Net sales
14. Return on total assets
• Net income / Average total assets
• effectiveness in using resources
• higher ratio = more earning profits per asset dollar
15. Return on equity
• Net income / Stockholders' equity
• return earned by stockholders

Audit Reports

1. Unqualified Opinion - financial statements are presented fairly without material error
• terms: "present fairly"
2. Qualified Opinion - financial statements are presented fairly except for certain matters that have deviated from GAAP/GAAS
• no misrepresentation have been identified 
• additional paragraph to highlight why report is not an unqualified opinion
• terms: "except for"
3. Adverse Opinion - material departure from GAAP
• financial statements are materially misstated as a whole
• worst opinion!
• terms: "do not present fairly"
4. Disclaimer of Opinion - material departure from GAAS 
• auditor is unable to obtain sufficient, appropriate audit evidence 
• auditor does not express an opinion 
• terms: "engaged to audit", "not able to obtain" 
• auditor is associated with FS of a public company but has not audited/reviewed the statements

Withdraw - false, fraud, deceptive, misleading!

Emphasis-of-Matter Paragraph: refers to some aspect of the financial information included in the financial statements

Other-Matter Paragraph: refers to some aspect of the financial information that is not explicitly included in the financial statements

Key 401K People

• Participant - person in the plan; considered to be active if received contributions during the year
• Plan sponsor - employer who sets up the plan
• Plan Administrator - responsible for running the plan
• duties include: appointing legal, filing returns, reviewing, directing, etc. 
• typically the employer unless otherwise appointed/hired by the employer
• Third Party Administrator - an entity/organization/firm hired by the employer to assist in actual Plan Administrator
• duties include: designing, producing, amending, and restating plan documents; assist in processing transactions, testing the plan, etc.
• Trustee - someone who has exclusive authority and discretion to manage & control Plan assets
• duties include: making decisions regarding investments and managing the assets 
• Custodian - the entity that has physical control of contents of the plan
• duties include: protecting assets from theft and keeping it secure

Reference: IRS Definitions for Employee Benefit Plans

Audit Risk

Risk of Material Misstatement (RMM) = Inherent Risk * Control Risk 
- Functions of the Client and its environment

Audit Risk = RMM * Detection Risk

RMM & DR has an inverse relationship: 

• RMM high (bad), DR low, substantive tests high, (control risk increase) 
• RMM low (good), DR high, substantive tests low

Terms defined:

• Audit Risk - risk of failing to discover material misstatement 
• Inherent Risk - risk that material misstatement will actually occur in the accounting system before consideration of internal controls
• Control Risk - risk that material misstatement (once occurred) will fail to be caught by internal control policies and procedures of the company
• assessed in terms of financial statement assertions
• important to assess as it affects the level of detection risk that auditor may accept 
• Detection Risk - risk that auditor will fail to detect misstatement with audit procedures
• controlled by auditor

Audit - General Issues: Part 2

General Accepted Auditing Standards & Elements - AICPA provided PDF

3 General Standards:

1. Adequate training & proficiency
2. Independence of mental attitude
3. Due professional care 

3 Fieldwork Standards:

1. Proper planning & supervision
2. Understanding the entity & its environments, including internal control
3. Sufficient appropriate audit evidence

4 Reporting Standards:

1. Financials are presented in accordance with GAAP
2. Circumstances where principals are not consistent with PY are identified
3. State any informative disclosures that are not reasonably adequate
4. Express an opinion

5 Quality Control Elements:

1. Independence, integrity, objectivity
2. Personnel management
3. Acceptance & continuation of clients
4. Engagement performance
5. Monitoring

To succeed in an action against the auditor, the Client must be able to show the following:

1. CPA had a duty to perform
2. CPA breached the contract
3. Client suffered losses
4. There is a close causal connection between the auditor's behavior and damages suffered by the Client 

Audit - General Issues: Part 1

Terms and Definitions:

Risk - fundamental concept that underlies audit process

Materiality & audit risk - underlies application of GAAS

Quality control - process to provide firm with reasonable assurance that its personnel comply with applicable professional standards

Public Company Accounting Oversight Board (PCAOB):

• Established by Sarbanes-Oxley Act
• Appointed & overseen by the SEC