# Economic Foundations: Money and Rates

## Macroeconomics

### Learning Outcomes

By the end of this section, you will be able to:
1. Define inflation and describe historical trends in inflation.
2. Define unemployment and describe how unemployment is measured.
3. Define gross domestic product and describe historical trends in gross domestic product.

### Inflation

Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation, unemployment, and growth of production. When the managers of an automotive company look at the market for steel and how the price of steel impacts the company’s production costs, they are looking at a microeconomic issue. Rather than being concerned about individual markets or products, macroeconomics is the branch of economic theory that considers the overall environment in which businesses operate.
Perhaps you have heard your parents talk about how much they paid for their first automobile. Or maybe you have heard your grandparents reminisce about spending a quarter to purchase a Coke. These conversations often turn to a discussion of how a dollar just doesn’t go as far as it used to. The reason for this is inflation, or a general increase in price levels.
It is not that just the price of an automobile has increased or that the price of a Coke has increased. Over time, the prices of many other things, from the salt on your table to college tuition, have increased. Also, you were paid a higher hourly wage at your first job than your parents and grandparents were paid; the price of labor has risen.
When economists talk about inflation, they are discussing this phenomenon of the price of many things rising. Instead of tracking the price of one particular item, they consider the price of purchasing a basket of goods. Inflation means that the purchasing power of currency falls. Whenever there is inflation, a $100 bill will not purchase as much as it did before.

### How Is Inflation Measured

Each month, the US Bureau of Labor Statistics (BLS) collects price data and publishes measures of inflation. The measure most commonly cited is the consumer price index (CPI). The CPI is based on the cost of buying a fixed basket of goods and services comprising items a typical urban family of four might purchase. The BLS divides these purchases into eight major categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.
Sometimes you will hear a core inflation index being quoted. This index is calculated by excluding volatile economic variables, such as energy and food prices, from the CPI measure. Energy and food prices can jump around from month to month because of weather or other short-lived events. A drought can cause food prices to spike; a temporary rise in gasoline prices can occur as a hurricane approaches the coastline. These types of shocks are transitory in nature and do not represent underlying economic conditions.
While the CPI and the core inflation index are based on the prices that households pay, the producer price index (PPI) is based on prices that producers of goods and services pay for their supplies and raw materials. The PPI captures price changes that occur prior to the retail level. Because it indicates rising costs to producers, increases in the PPI can foreshadow increases in the CPI.
Both the CPI and the PPI are calculated by the BLS. The Bureau of Economic Analysis (BEA) also calculates a measure of inflation known as the GDP deflator. The calculation of the GDP, or gross domestic product, deflator follows a different approach than that used to calculate the CPI and the PPI. Instead of using a fixed basket of items and measuring the price change of that fixed basket, the GDP deflator includes all of the components of the gross domestic product. Prices are taken from a base year and used to calculate what the GDP would have been in a given year if prices were identical to those in the base year.

### Historical Trends in the Inflation Rate

Inflation, as measured by the CPI for 1947–2020, is displayed in . The graph shows that for the past 70 years, inflation has been the norm. Although inflation dipped into negative territory several times, each period of negative inflation was short-lived. Also, you will notice that during the 1970s and early 1980s, inflation was abnormally high; the inflation rate remained above 5% for approximately a decade. This was also the only time period in which the US economy experienced double-digit inflation. By the mid-1980s, inflation had fallen below 5%, and it has remained below 5% for much of the past 35 years.
The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88% of the total population, accounting for wage earners, clerical workers, technical workers, self-employed workers, short-term workers, unemployed workers, retirees, and those not in the labor force.
The CPIs are based on prices for food, clothing, shelter, fuels, transportation fares, service fees (e.g., water and sewer service), and sales taxes. Prices are collected monthly from about 4,000 housing units and approximately 26,000 retail establishments across 87 urban areas. To calculate the index, price changes are averaged with weights representing their importance in the spending of a particular group. The index measures price changes (as a percent change) from a predetermined reference date. In addition to the original unadjusted index distributed, the BLS also releases a seasonally adjusted index. The unadjusted series reflects all factors that may influence a change in prices. However, it can be very useful to look at the seasonally adjusted CPI, which removes the effects of seasonal changes such as weather, the school year, production cycles, and holidays.
The CPI can be used to recognize periods of inflation and deflation. Significant increases in the CPI within a short time frame might indicate a period of inflation, and significant decreases in CPI within a short time frame might indicate a period of deflation. However, because the CPI includes volatile food and oil prices, it might not be a reliable measure of inflationary and deflationary periods. For more accurate detection, the core CPI, or CPILFESL—the CPIAUCSL minus food and energy—is often used. When using the CPI, please note that it is not applicable to all consumers and should not be used to determine relative living costs. Additionally, the CPI is a statistical measure vulnerable to sampling error because it is based on a sample of prices and not the complete average.

### Unemployment

Unemployment is a measure of people who are not working. For the individuals who find themselves without a job, unemployment causes financial hardship. From a macroeconomics standpoint, unemployment means that society has labor resources that are not being fully utilized.
Not everyone who is without a job is unemployed. To be considered unemployed, a person must be (1) jobless, (2) actively seeking work, and (3) able to take a job. The official unemployment rate is the percentage of the labor force that is unemployed. It is calculated as
Note that the unemployment rate is calculated as the percentage of the labor force that is unemployed, rather than the percent of the total population. Only those who are currently employed or who meet the definition of being unemployed are counted in the labor force. In other words, someone who is retired or a stay-at-home parent and is not seeking employment is not counted as unemployed and is not part of the labor force.
The Bureau of Labor Statistics (BLS) of the US Department of Labor reports the unemployment rate each month. These figures are attained through an interview process of 60,000 households conducted by the Census Bureau. (See  for a graphic representation of historical trends in unemployment from 1950 to early 2021.)

### Gross Domestic Product

Gross domestic product (GDP) is a measure of the size of an economy. A country’s GDP is the dollar value of all of the final goods and service produced within that country during a year. GDP measures the value of all of the automobiles produced, apples grown, heart surgeries performed, students educated, and all other new goods and services produced in a current year.

### How Is GDP Measured?

GDP can be measured by adding up all of the items that are purchased in the economy. Purchases are divided into four broad expenditure categories: consumption spending, investment, government spending, and net exports. Consumption spending measures the items that households purchase, such as movie theater tickets, cups of coffee, and clothing. Consumption expenditure accounts for about two-thirds of the US GDP.US Bureau of Economic Analysis. “GDP and the Economy: Advance Estimates for the First Quarter of 2020.” Survey of Current Business 100, no. 5 (May 2020): 1–11. https://apps.bea.gov/scb/2020/05-may/0520-gdp-economy.htm
Investment spending refers primarily to purchases by businesses. It is important to note that in this context, the term investment does not refer to purchasing stocks and bonds or trading financial securities. Instead, the term refers to purchasing new capital goods, such as buildings, machinery, and equipment, that will be used to produce other goods. Residential housing is also included in the investment-spending category, as are inventories. Products that producers make but do not sell this year (and so are not included in consumption spending) are included in this year’s GDP calculation through the investment component. The investment spending category is roughly 15% to 18% of the US GDP.
Government spending includes spending by federal, state, and local governments. Federal spending would include purchases of items such as a new military fighter jet and services such as the work of economists at the BLS. State governments purchase products such as concrete for a new highway and services such as the work of state troopers. Local governments purchase a variety of goods and services, such as books for the city library, playground equipment for the community park, and the services of public school teachers. In the United States, government spending accounts for nearly 20% of the GDP.
Some items that are produced in the United States are sold to individuals, businesses, or government entities outside of the United States. For example, a bottle of Tabasco sauce produced in Louisiana may be sold to a restaurant in Vietnam, or tires produced in Ohio may be sold to an auto producer in Mexico. Because these items represent production in the United States, these exports should be included in the US GDP. Conversely, some of the items that US consumers, businesses, and government entities purchase are not produced in the United States. A family may purchase maple syrup from Canada or a Samsung television that was produced in South Korea. A business may purchase a Toyota vehicle that was produced in Japan. These items are imported from other countries and represent production in the country of origin rather than the United States. Because we already counted these items when adding consumption, investment, and government spending, we must subtract the value of imports in our GDP calculation. Net exports equals exports from the United States minus imports from other countries. Including net exports in the GDP calculation adjusts for this international trade.

### Historical Trends in GDP

US GDP over the past 70 years is represented by the blue line in . At the turn of the millennium, the yearly GDP of the United States was approximately $10 trillion. By 2020, the GDP exceeded $21 trillion, indicating that the US economy had more than doubled in size in the first 20 years of the 21st century.“GDP (Current US$): United States.” The World Bank. 2020. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US
Because GDP is the market value of all goods and services produced, it can increase either because more goods and services are being produced or because the market value of these goods and services is rising. If 100 cars were produced and sold for $30,000 each, that would contribute $3,000,000 to the GDP. If, instead, the cars were sold for $33,000 each, the same 100-car production would contribute $3,300,000 to the GDP. The $300,000 increase in GDP would be due simply to higher prices, or inflation.
Multiplying the current price of goods by the number of goods produced results in what is known as nominal GDP. In order to determine what the actual increase in production is, nominal GDP must be adjusted for inflation. This adjustment results in a calculation known as real GDP. To calculate real GDP, the amounts of goods and services produced are multiplied by the price levels in a base year. Thus, real GDP will rise only if more goods and services are being produced. The red line in  represents the real GDP. Although its growth has not been as large as that of nominal GDP, real GDP has also grown significantly over the past 70 years.

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Macroeconomics looks at the economy as a whole. It focuses on broad issues such as inflation, unemployment, and growth of production. The consumer price index is a common measure of inflation. Unemployment equals the percent of the labor force that is without a job but looking for work. Gross domestic product is a measure of the growth of production and growth of the economy.

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### Should Investors Prepare for Inflation or Hyperinflation?

Inflation is a general increase in the price level. If inflation is extremely high, hyperinflation is said to exist. The video Should Investors Prepare for Inflation or Hyperinflation? by TD Ameritrade explores economic conditions that existed in the spring of 2021 that led some economists to be concerned that investors should be preparing for high inflation.

### Unemployment Explained

The video Unemployment Explained, produced by the International Monetary Fund (IMF), explores how economists think about unemployment. The basic economic tools of supply and demand are used to explain what causes unemployment. In this video, you will also learn about how economists categorize different types of unemployment and why a zero rate of unemployment is not likely or even desirable.


# Economic Foundations: Money and Rates

## Business Cycles and Economic Activity

### Learning Outcomes

By the end of this section, you will be able to:
1. Outline the stages of the business cycle.
2. Identify recessionary and expansionary periods.

### What Is the Business Cycle?

Although the US economy has grown significantly over time, as seen in , the growth has not occurred at a constant, consistent pace. At times, the economy has experienced faster-than-average growth, and occasionally the economy has experienced negative growth.
The percentage change in real GDP for each quarter is shown in . For any quarter in which real GDP is growing, the percentage change will be positive. When the growth rate of real GDP is negative, the economy is shrinking.
 is an illustration of the growth of GDP over time. There has been a definitive long-term upward trend in GDP, but it has not been in a straight line. Instead, the economy has expanded much like the curve; periods of quick growth are followed by slower or even negative growth. These alternating growth periods are known as the business cycle.

### Stages of the Business Cycle

The business cycle consists of a period of economic expansion followed by a period of economic contraction. During the period of economic expansion, GDP rises. Employment expands as businesses produce more; conversely, unemployment falls. Other measures of economic growth may include increased new business starts and new home construction. The economy is said to be “heating up.” As the expansion continues, inflation often becomes a concern.
Fast-paced economic expansion is not sustainable. Eventually, growth slows and unemployment rises. The economy has moved from expansion to contraction when this occurs. The point at which the business cycle turns from expansion to contraction is known as the peak. The point at which the contraction ends and the economy begins to expand again is known as the trough. The length of one business cycle is measured by the time from one trough to the trough of the next cycle, as shown in .
Often, the contraction is referred to as a recession. A private think tank, the National Bureau of Economic Research (NBER), tracks the business cycle in the United States. The NBER is the entity that officially declares recessions in the United States. Historically, a recession was defined as two consecutive quarters of declining GDP. Today, the NBER defines a recession in a broader, less precise manner; it will declare a recession when there is a significant decline in economic activity that is spread across the economy and lasts for at least a few months.National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/research/business-cycle-dating/business-cycle-dating-committee-announcements Measures of real income, employment, industrial production, and wholesale and retail sales are considered in addition to real GDP.

### Historical Trends

The NBER has identified business cycle peaks and troughs in data going back to the mid-19th century.  lists each of these cycles, denoting the months of peaks and troughs. We see a repetition of the economic behavior—an expansion, a peak, a recession, and a trough, followed by yet another expansion, peak, recession, and trough. The cycles are events that repeatedly occur in the same order.
However, the cycles are not identical; the lengths of the cycles vary greatly. On average, the contractions have lasted about 17 months and expansions have lasted about 41 months. The typical business cycle has been about 4.5 years long.
At the time of this writing, the United States is in an economic recession.National Bureau of Economic Research. “Business Cycle Dating Committee Announcements.” July 19, 2021. https://www.nber.org/research/business-cycle-dating/business-cycle-dating-committee-announcements The previous trough was in June 2009. From the summer of 2009 through February 2020, the US economy was in the expansionary phase of the business cycle. This expansion peaked in February 2020, when the economy fell into a contractionary period associated with the COVID-19 pandemic. This 128-month expansion is the longest expansion in US history. Only two other expansions have lasted for over 100 months: the 120-month expansion that ran through the 1990s and the 106-month expansion that ran during the 1960s. The longest recessionary period on record is the 65-month recession that occurred during the 1870s. The recession that began in 1929 was the second-longest recession in US history. At 43 months long, this recession that ended in 1933 was so severe that it has been called the Great Depression.National Bureau of Economic Research. “US Business Cycle Expansions and Contractions.” Last updated July 19, 2021. https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions

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The business cycle is the repeated pattern of the economy experiencing expansion, a peak, contraction, and a trough. During the expansion, the economy is growing and real GDP is rising. During a contraction, also known as a recession, the economy is slowing down.

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# Economic Foundations: Money and Rates

## Interest Rates

### Learning Outcomes

By the end of this section, you will be able to:
1. Explain the relationship between the nominal interest rate and inflation.
2. Calculate the real rate of interest.
3. Explain the relationship between interest rates and risk.

### Market for Loanable Funds

An interest rate is the rental price of money. The concepts of supply, demand, and equilibrium apply in this market just as they do in other markets. This market is referred to as the market for loanable funds.
In the market for loanable funds, the suppliers of funds are economic entities that currently have a surplus in their budget. In other words, they have more income than they currently want to spend; they would like to save some of their money and spend it in future time periods. Instead of just putting these savings in a box on a shelf for safekeeping until they want to spend it, they can let someone else borrow that money. In essence, they are renting that money to someone else, who pays a rental price called the interest rate.
The suppliers of loanable funds, also known as lenders, are represented by the upward-sloping curve in . A higher interest rate will encourage these lenders to supply a larger quantity of loanable funds.
The demanders of funds in the loanable funds market are economic entities that currently have a deficit in their budget. They want to spend more than they currently have in income. For example, a grocery store chain that wants to expand into new cities and build new grocery stores will need to spend money on land and buildings. The cost of buying the land and buildings exceeds the chain’s current income. In the long run, its business expansion will be profitable, and it can pay back the money that it has borrowed.
The downward-sloping curve in  represents the demanders of loanable funds, also known as borrowers. Higher interest rates will be associated with lower quantities demanded of loanable funds. At lower interest rates, more borrowers will be interested in borrowing larger quantities of funds because the price of renting those funds will be cheaper.
The equilibrium interest rate is determined by the intersection of the demand and supply curves. At that interest rate, the quantity supplied of loanable funds exactly equals the quantity demanded of loanable funds. There is no shortage of loanable funds, nor is there any surplus.

### Nominal Interest Rates

The nominal interest rate is the stated, or quoted, interest rate. If you want to borrow money to purchase a car and the bank quotes an interest rate of 5.5% on a four-year auto loan, the 5.5% is the nominal interest rate.
Or suppose you have $1,000 you would like to place in a savings account. If the bank quotes an interest rate of 6% on its savings accounts, the 6% is a nominal interest rate. This means that if you place your $1,000 in a savings account for one year, you will receive $60 in interest for the year. At the end of the year, you will have a balance of $1,060 in your savings account—your original $1,000 plus the $60 in interest that you earned.

### Real Interest Rates

Suppose you are deciding between saving your $1,000 for the year and using it to purchase a flat-screen TV. The advantage of spending the money on the TV today is that you can enjoy watching programs on it over the next year. The advantage of saving the money is that you will earn 6% nominal interest; in one year, you will have $1,060 to spend.
If there is a 2% inflation rate, you would expect the TV that costs $1,000 today to cost $1,020 in one year. If you save the $1,000, you will have $1,060 in one year. You could purchase the TV for $1,020 and have $40 left over; then you could use the $40 to order pizza to celebrate the first big game you are watching on the new TV.
Your choice comes down to enjoying a TV today or enjoying a TV and $40 in one year. The $40 is your reward for delaying consumption. It is your real return for saving money. The remaining $20 of the interest you earned just covered the rate of inflation. This reward for delaying consumption is known as the real interest rate. The real interest rate is calculated as
The real interest rate, rather than the nominal interest rate, is the true determinant of the cost of borrowing and the reward for lending. For example, if a business had to pay 15% nominal interest rate in 1980, when the inflation rate was 12%, the real cost of borrowing for the firm was 3%. The company would have had to pay $15 in interest each year for each $100 it borrowed, but $12 of that was simply compensating the lender for inflation. In real terms, the business was only paying $3 to borrow $100.
In recent years, a business may have paid 6% interest to borrow money. This nominal rate is half of what it was in 1980. However, inflation has been much lower. If inflation is 1% and the company pays 6% nominal interest, that results in a 5% real interest rate. For every $100 the company borrows, it pays $6 in interest; $1 is compensating for inflation, and the remaining $5 is the real cost of borrowing.

### Risk Premiums

As we have discussed interest rates, we have talked about how the interest rate is determined by the demand and supply of loanable funds. This tells us the underlying interest rate in the economy. You will notice, however, if you look at the financial news, that there is more than one interest rate in the economy at any given time.
 shows the interest rates that three different types of borrowers have paid over the past 20 years. The bottom line shows the interest rate that the US government paid to borrow money for a three-month period. This rate is often referred to as the risk-free rate of interest. While theoretically it would be possible for the US government to default and not pay back those people who have loaned money to it, the chances of that are occurring are extremely low.
When someone borrows money, they enter into a contract to repay the money and the interest owed. However, sometimes, certain circumstances arise such that the lender has a difficult time collecting the money, even though the lender has the legal right to the money. For example, if a company goes bankrupt after borrowing the money and before paying back the loan, the lender may not be able to collect what is due. The chance that the lender may not be able to collect all of the money due at the time it is due is considered . Lenders want to be rewarded for taking on this risk, so they charge a premium to borrowers who are higher risk.
Companies are more likely to go bankrupt and not be able to pay their bills on time than is the US government. So, corporations have to pay a higher interest rate than the US government. If a lender can earn 1% lending to the US government, the lender will only be willing to lend to the riskier corporation if they can earn more than 1%. In , the interest rates paid by very creditworthy companies is shown. The prime rate is the interest rate that banks charge their very best customers—large companies that are financially very strong and have a very low risk of default.
It is generally riskier for a lender to make a loan to an individual than to a corporation. Individuals are more likely to become ill, lose their job, or experience some other financial setback that makes it difficult for them to repay their loans. In , the interest rate on credit card loans is much higher than the interest rate charged to corporate borrowers. That is because credit card loans are a high risk to the lender. Unlike other loans made to an individual, such as a car loan, the credit card company has no collateral if a consumer cannot pay back the loan. With car loans, if the borrower fails to repay the borrowed money, the lender can repossess the automobile and sell it to recoup some of the money it is owed. If you use a credit card to buy groceries and do not repay the loan, the credit card company cannot repossess the groceries that you purchased. Therefore, credit card loans have notoriously high interest rates to compensate the lender for the high risk.

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The interest rate is the rental price of money. The nominal interest rate is the quoted, or stated, rate of interest. The real rate of interest equals the nominal interest rate minus the inflation rate. Lenders charge a risk premium to compensate them for lending to higher-risk borrowers.

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# Economic Foundations: Money and Rates

## Foreign Exchange Rates

### Learning Outcomes

By the end of this section, you will be able to:
1. Explain what it means for a currency to appreciate or depreciate.
2. Define spot exchange rate.
3. Explain the risks involved in translation exposure.

### Spot Exchange Rate

An exchange rate is simply the price of a currency. If you live in the United States and are going on a trip to Mexico, you will need pesos to pay for your food, hotel, and other items. You will need to purchase pesos. Suppose that you go to your bank to purchase pesos. Suppose the bank tells you that it will cost $0.0625 to purchase one Mexican peso. If you want to take 10,000 Mexican pesos with you on your trip, it will cost you $625 to purchase the desired pesos.
In this example, the price of one peso is six and one-quarter cents. This price will often be written in the form of
MXN is an abbreviation for the Mexican peso, and USD is an abbreviation for the US dollar. This price is known as a currency exchange rate, or the rate at which you can exchange one currency for another currency. Because this is the price you would pay to purchase Mexican pesos right now, it is known as the spot exchange rate.
If you know the price of Mexican pesos in dollars, you can easily find the price of US dollars in Mexican pesos. Simply divide both sides of the equation by 0.0625, or the price of a peso:
If you have Mexican pesos and you want to exchange them for dollars, you will be using the pesos to buy dollars. Each US dollar will cost you MXN 16.

### Currency Appreciation

Just as the price of gasoline changes, resulting in it costing more to purchase gasoline on some visits to the gas station than on other visits, the price of a currency also changes. Currency appreciation occurs when it costs more to purchase a currency than it did before.
If the next time you go to the bank to purchase pesos, the bank quotes an exchange rate of , it means that it now costs $0.0800 (up from $0.0625) to purchase a Mexican peso. Hence, the price of a peso has risen, or the peso has appreciated.
Currency prices are determined in the marketplace through the same types of supply-and-demand forces we discussed earlier in this chapter. What would cause the peso to appreciate? Either an increase in the demand for pesos or a decrease in the supply of pesos.

### Currency Depreciation

Just as a currency can appreciate, it can depreciate. If the quote at the bank was , it would only cost $0.0500 to purchase a Mexican peso. When it costs fewer dollars to purchase a peso, the peso has depreciated. Either a decrease in demand for pesos or an increase in supply of pesos will cause the peso to depreciate.
Because an exchange rate is the price of one currency expressed in terms of another currency, if one of the currencies depreciates, the other currency must, by definition, appreciate. If it costs $0.0500 to purchase a Mexican peso, the price of a US dollar, in terms of a Mexican peso would be calculated as
So, the price of one US dollar would be 20 Mexican pesos.

### Exchange Rate Risk

Businesses that engage in international business face currency exchange rate risk. As exchange rates change, a business can be impacted in a number of ways. One of these risks, transaction exposure, is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. A pottery-making business that has sold merchandise to a company in the United States for $20,000, for example, will need to exchange the $20,000 for pesos to be able to pay its workers and other expenses in pesos. How many pesos it will receive for $20,000 will change depending on the exchange rate. If the exchange rate is , the company will receive 320,000 pesos for the $20,000. If the exchange rate is , the company will receive 400,000 pesos for the $20,000. Thus, as the peso depreciates (and the US dollar appreciates), the same number of dollars will provide more pesos. Conversely, as the peso appreciates (and the US dollar depreciates), the same number of dollars will provide fewer pesos.
Firms that hold assets in a foreign country also face translation exposure. When a company creates its financial statements, items are reported using one currency. As foreign exchange rates change, the value of how items are reported on these financial statements can change. This type of risk is an accounting risk.
Economic exposure is the risk that a change in exchange rates will impact a business’s number of customers and sales. For example, tourists have the option of spending a week-long vacation at a resort in the United States or in Mexico. As the dollar appreciates, US citizens can exchange their dollars for more pesos, resulting in their purchasing power going further at a Mexican resort. Because an appreciating dollar also means a depreciating peso, it would mean that Mexicans who earn pesos will receive fewer dollars when they exchange their pesos. A Mexican who wants to stay at a $200-per-night hotel in Colorado will need more pesos to pay for the room when the peso depreciates. The depreciating peso will likely mean that more Mexicans will spend their vacation week in Mexico, and fewer will vacation in the United States.
Even businesses that do not view themselves as involved in international business can face economic exposure. The ski lodge in Colorado will find that its customers from Mexico decrease when the dollar appreciates. Likewise, when the dollar appreciates, some of the ski lodge’s US-based customers may choose instead to visit a resort in Mexico, where their purchasing power is strong.

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A foreign exchange rate is the price of a currency in terms of another currency. If a currency will purchase more of a foreign currency than it would previously, the purchasing currency is said to have appreciated. If a currency will purchase less of a foreign currency than it would previously, the purchasing currency is said to have depreciated.

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# Economic Foundations: Money and Rates

## Sources and Characteristics of Economic Data

### Learning Outcomes

By the end of this section, you will be able to:
1. Interpret economic data.
2. Compute the percent change for economic variables.

### FRED: Federal Reserve Economic Data

One of the largest sources of economic data is the Federal Reserve Economic Data (FRED) database.Federal Reserve Bank of St. Louis. Economic Resources & Data. Accessed October 25, 2021. https://www.stlouisfed.org/ This database is maintained by the Federal Reserve Bank of St. Louis and contains more than 765,000 economic time series. These time series are compiled by the Federal Reserve and come from a number of sources, including the Bureau of Labor Statistics and the US Census.
You can find statistics on employment, inflation, exchange rates, gross domestic product, interest rates, and many other economic variables in the FRED database. Although much of the data is about the US markets, macroeconomic data from other countries is also available. In addition to being viewable in graphical and text form on the FRED site, the data is easily downloaded into an Excel spreadsheet for analysis.

### Levels versus Percentage Changes

The same information can be presented in graphs several different ways. The particular format you choose will depend on how you are using the data.
 shows the real GDP of Japan for 2010–2020. This chart is created showing the level of real GDP. The steep drop in 2020 highlights the economic decline associated with the COVID-19 pandemic. Looking at the chart, it is easy to see that after 10 years of a general upward trend, Japan’s GDP quickly fell to a level not seen in the previous decade as COVID-19 began spreading in early 2020.
The vertical axis in  is measured in yen. Over the time period shown, the real GDP ranged from 500 trillion yen to 560 trillion yen. The general trend (until COVID-19) was upward, indicating growth in the Japanese economy. However, the growth was not consistent from year to year.
 also contains information about Japanese real GDP from 2010 to 2020. This chart measures the percent change for each quarter on the vertical axis. It is created using the same underlying data as .  demonstrates a way of highlighting the growth (or contraction) of an economy at a particular point in time.
The formula to calculate the percentage change from one quarter to the next is
In the first quarter of 2013, the real GDP for Japan was 522,594.2 billion yen. In the second quarter of 2013, the real GDP had risen to 527,277.0 billion yen. Thus, the percentage change in real GDP from quarter one to quarter two was
As long as the percentage change for a quarter is positive, the real GDP in  will rise; this indicates that the economy is growing. If the percentage change shown in  is negative, then real GDP will fall; this indicates that the economy is contracting. Looking at the percentage change in  is helpful for detecting when the economy is growing but the growth is slowing. If the percentage change is positive but lower than it was for the previous quarter, then GDP is growing, but the growth rate is slowing.

### Indexes

An index is created to track the performance of a particular aspect of the economy or the financial markets. An index helps compare the level of a variable at one point in time relative to another point in time. Indexes are often used when movement over time is more important than the absolute level of the variable at any one point in time.
Earlier in this chapter, we looked at the rate of change in the CPI to measure the rate of inflation. In its raw form, the CPI is an index. Remember that the CPI is a measure of the cost of a market basket of goods. When the index is created, the total cost of the market basket, whether it is $300 or $950, is irrelevant. What economists are interested in is the magnitude of the difference in cost of the same market basket at a later date.
In order to focus on the change over time, a base year is identified. The cost of the market basket in the base year is given an index level of 100. Let’s assume that the market basket costs $300 in the base year. If the same basket of goods costs $330 the following year, then the index level the following year would be 110. The index level increases by 10% when the cost of the market basket increases by 10%. This makes it easy to compare different measures of inflation.
For example, suppose a market basket costs 40,000 yen in the first year and 42,000 yen in the second year. In the base year, the CPI in Japan would be set at 100; the following year, the index would rise to 105 (because of the 5% rise in the market basket cost). Comparing the levels of the index in Japan with the index in the United States allows you to compare inflation trends in the two countries.
 contains the CPI for the United States, Japan, and Switzerland for each decade since 1970. A base year of 1970 is used for all three countries, so the index level is 100 for all three countries in 1970. You can see that Japan has experienced virtually no inflation for the last several decades. If the index level remains the same from one year to the next, there is a zero rate of inflation. Negative rates of inflation, or deflation, would be associated with a falling index level.
Using an index level helps us compare the impact that inflation has had on the cost of living in the three countries. Prices were rising rapidly in Japan in the 1970s, outpacing price increases in both the United States and Switzerland. By the mid-1980s, however, price increases in Japan tapered off. Although prices in Switzerland rose much more slowly in the 1970s, the price level continued to rise over the next couple of decades. Even though the price increases have followed different patterns in Switzerland and Japan, the overall price level today is about three times what it was in 1970 in both of those countries. However, the price level in the United States has continued to rise; today, the price level in the United States is about seven times higher than it was in in the 1970s.

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One of the most comprehensive sources of economic data is the FRED database, maintained by the Federal Reserve Bank of St. Louis. Over 765,000 time series of data are available. In addition to being viewable in graphical and text form on the FRED site, the data is easily downloaded into an Excel spreadsheet for analysis.

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This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session. Reference with permission of CFA Institute.


# Accrual Accounting Process

## Why It Matters

Emma, an accounting major, was on her way to her Wednesday morning accounting class with her friend Sam. Sam, a finance major, kept complaining to Emma that he didn’t enjoy their accounting class at all. “Why do we have to spend so much time worried about debits, credits, accounts, and all this other accounting jargon anyway? I’m a finance major. I won’t be spending my days recording entries and counting pennies. I’m dreading class today. I looked at the syllabus, we’re studying the accrual method. So what? Just give me the financial statements so I have the data I need.”
Emma smiled at her friend and thought for a moment before responding. Emma loves the details of debits, credits, and “all that other accounting jargon,” as Sam put it. She knows that while not everyone enjoys the details or understands them, they do play a big role in the timing and accuracy of financial statements. “Yeah, yeah, Sam, accounting isn’t always easy or fun, but it’s important. The financial statements you will use in finance are a part of the foundation for many decisions. They are an important tool. Even though you don’t have to create financial statements in a finance role, it’s still necessary to understand the accounting principles they are based on. We haven’t covered the details yet, but I do know that income or loss in a period can be significantly different if the income statement is prepared under cash versus accrual methods. I would think that would be important to know if you are the one using the income statement.”


# Accrual Accounting Process

## Cash versus Accrual Accounting

### Learning Outcomes

By the end of this section, you will be able to:
1. Outline the key concepts of the cash-basis accounting method.
2. Explain the key characteristics of the accrual-basis accounting method.
3. Identify businesses for which cash accounting or accrual accounting is more appropriate.
In this section, we will explore the basic elements of cash and accrual accounting and the businesses that are most likely to use each one. Some private companies may choose to use cash-basis accounting rather than accrual-basis accounting to report financial information.

### Cash-Basis Accounting

In business, cash is certainly important. In fact, it’s so important that it dictates one of two ways we can account for our business transactions. The cash method is just as the name implies—it records transactions only when cash flows. We track cash inflows and outflows as they occur. This method is most commonly used by small businesses that deal primarily in cash transactions. The other method, called the accrual method, records transactions when they occur, rather than waiting for cash to be accumulated. Using the accrual method, we match cash inflows and the outflows required to generate them. We call this the matching principle. This method is used by most publicly traded companies. In this chapter, you’ll explore both methods, see how each impacts financial statements differently, note the role of timing in each method, and learn how and when to record capital and expense transactions.
Let’s look at an example. Chris just finished the first month of her landscaping business operations at the end of August, and she used the cash method of accounting to figure out her net income. Most small start-up companies use the cash method of accounting because it is easy to understand, requires no special training, and helps them focus on one big key to their survival—cash. This means that she simply recorded the cash that came in and the cash that went out of her business. She brought in $1,400 in revenue in her first month, which she felt was substantial given that it was her first month. But after deducting her expenses, she had only $250 left, so she worried about the future of her business. Would she have to increase her sales exponentially in order to start bringing in a decent profit each month?
As you move through the chapter, you’ll get to see the impact of the two methods of accounting and how these methods impact the insights and decisions Chris made for her new business.
Cash-basis accounting is a method of accounting in which transactions are not recorded in the financial statements until there is an exchange of cash. Cash-basis accounting sometimes impacts the timing of revenue and expense reporting until cash receipts or outlays occur. For example, as you saw above, Chris measured the performance of her landscaping business for the month of August using cash flows. Cash accounting is far simpler to track than accrual-basis accounting.

### Accrual-Basis Accounting

Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations. GAAP is a set of accounting standards created by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). It’s key to note that though they are similar in many areas, there are still key areas that differ between GAAP and IFRS. Therefore, when using financial statements, it’s important to be aware of the standards under which they were prepared. However, public or private companies using GAAP or IFRS must prepare their financial statements using the rules of accrual accounting. Accrual-basis accounting prescribes that revenues and expenses must be recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the revenue recognition principle and the expense recognition principle (also known as the matching principle).
The accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability purposes. Having comparable information is important to external users of information trying to make investment or lending decisions and to internal users trying to make decisions about company performance, budgeting, and growth strategies.

### Who Uses Each Method?

Cash-basis accounting can be more efficient and well-suited for certain types of businesses, such as farming or professional services provided by lawyers and doctors. However, the accrual basis of accounting is theoretically preferable to the cash basis of accounting because it takes into account the timing of the transactions (when goods and services are provided and when the cash involved in the transactions is received). Cash can often be received a significant amount of time after the initial transaction. Considering this amount allows accountants to provide, in a timely manner, relevant and complete information to stakeholders.
There are several reasons accrual-basis accounting is preferred to cash-basis accounting. Accrual-basis accounting is required by GAAP because it typically provides a better sense of the financial well-being of a company. Accrual-based accounting information allows management to analyze a company’s progress, and management can use that information to improve their business. Accrual accounting is also used to assist companies in securing financing because banks will typically require a company to provide accrual-basis financial income statements. The Internal Revenue Service requires businesses to report using accrual-basis information when preparing tax returns. In addition, companies with inventory must use accrual-based accounting for income tax purposes, though there are exceptions to the general rule.
So why might a company use cash-basis accounting? Companies that do not sell stock publicly can use cash-basis instead of accrual-basis accounting for internal management purposes or because they are exempt from such requirements in agreements such as a bank loan. Cash-basis accounting is a simpler accounting system to use than an accrual-basis accounting system when tracking real-time revenues and expenses.

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Cash-basis accounting records revenues and expenses only when cash is received or distributed. Accrual-basis accounting, on the other hand, records revenues and expenses when they are earned or incurred rather than waiting until cash changes hands. Most publicly traded companies are required by the SEC to use accrual-basis accounting. Generally, smaller businesses that deal primarily in cash are the best candidates for using the cash basis since the accrual method more accurately depicts net income or net loss each period.

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# Accrual Accounting Process

## Economic Basis for Accrual Accounting

### Learning Outcomes

By the end of this section, you will be able to:
1. Assess the impact of business transactions on cash flow.
2. Define double-entry accounting and explain how it supports the accounting equation.
How and when we record our transactions can have a significant impact on financial statements, especially the income statement (net income). In this section you will explore the impact business transactions have on financial statements under each method. In doing so, you’ll be introduced to double-entry accounting and see how it functions to support the accounting equation.

### Timing of Business Activity versus Cash Flow

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance for a given period of time. We already saw that Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. She categorized her business as a service entity and used the cash-basis method of accounting to record the initial operations for her business. Although Chris was using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance costs. So, on August 31, Chris realized she had only $250 in her checking account.
This balance was lower than expected because she had spent only slightly less ($1,150 for brakes, fuel, and insurance) than she earned ($1,400)—leaving a net income of $250. While she would like the checking balance to grow each month, she realized that most of the August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large expense. She knew that the checking account balance would likely grow more in September because she would earn money from some new customers; she also anticipated having fewer expenses.
This simple landscaping example can be used to discuss the elements of the income statement, which are revenues, expenses, gains, and losses for a particular period of time (see ). Together, these determine whether the organization has net income (where revenues and gains are greater than expenses and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues, expenses, gains, and losses are further defined in the Income Statement provided.
The income statement can also be visualized by the formula:
Let’s change this example slightly and assume the $1,000 payment to the insurance company will be paid in September rather than in August. In this case, the ending balance in Chris’s checking account would be $1,250, a result of earning $1,400 and only spending $100 for the brakes on the tractor and $50 for fuel. This stream of cash flows is an example of cash-basis accounting because it reflects when payments are received and made, not necessarily the time period that they affect. At the end of this section, you will address accrual accounting, which does reflect the time period that payments affect.

### The Accounting Equation

It may be helpful to think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners.
You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides of the accounting equation are always equal. We will explore the components of the accounting equation in more detail shortly. First, we need to examine several underlying concepts that form the foundation for the accounting equation: the double-entry accounting system, debits and credits, and the “normal” balance for each account that is part of a formal accounting system.
Let’s continue our exploration of the accounting equation, focusing on the equity component in particular. Recall that we defined equity as the net worth of an organization. It is helpful to also think of net worth as the accounting value of the organization. Recall, too, that revenues (inflows as a result of providing goods and services) increase the accounting value of the organization. So every dollar of revenue an organization generates increases the overall value of the organization.
Likewise, expenses (outflows as a result of generating revenue) decrease the value of the organization. So each dollar of expenses an organization incurs decreases the overall value of the organization. The same approach can be taken with the other elements of the financial statements:
1. Gains increase the value (equity) of the organization.
2. Losses decrease the value (equity) of the organization.
3. Investments by owners increase the value (equity) of the organization.
4. Distributions to owners decrease the value (equity) of the organization.
5. Changes in assets and liabilities can either increase or decrease the value (equity) of the organization depending on the net result of the transaction.
Let’s look at Chris’s Landscaping business again and do the same quick exercise you did with your personal finances. If we were to total all of Chris’s assets, we would find just one: $250 in cash. She’s using the family’s tractor, but she doesn’t own the tractor, so it is not her asset. Her liabilities are currently $0, as she paid cash for all the expenses she incurred already. If we total her assets, we get $250. Liabilities total $0. Using the accounting equation, we find her equity to currently be $250, or

### Double-Entry Accounting

Accounting is based on a double-entry accounting system, which requires the following:
1. Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
2. Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
3. The sum of the debits must equal the sum of the credits for each transaction.
In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system. Journals are useful tools to meet this need.

### Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. The graphic representation of a general ledger account is known as a T-account. It is called this because it looks like a “T,” as you can see with the T-account shown in .
A debit records financial information on the left side of each account. A credit records financial information on the right side of an account. One side of each account will increase, and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded equation (see ).
As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal balance of an account.
The balance sheet is a reflection of the accounting equation (see ). It has two sections, assets in one section and liabilities and equity in the other section. It’s key to note that both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency. Current assets are those that are consumed within a year. Assets that will be in use longer than a year are considered noncurrent. Current liabilities are those that will be due within a year. Noncurrent liabilities are those that are due more than a year into the future.
Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an “increase” side and a “decrease” side. As you may recall, these are called T-accounts, and they are used to analyze transactions.
The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company   maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

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Double-entry accounting means that each time a transaction is recorded, there are at minimum two accounts impacted by the entry. Each entry’s debits must total its credits in order to support and maintain the balance in the accounting equation. The accounting equation is expressed as

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# Accrual Accounting Process

## How Does a Company Recognize a Sale and an Expense?

### Learning Outcomes

By the end of this section, you will be able to:
1. Explain the revenue recognition principle and how it relates to current and future sales transactions.
2. Explain the expense recognition principle and how it relates to current and future purchase transactions.
3. Assess the role of ethics in revenue and expense recognition.
You’ve learned the basics of each method as well as the accounting equation and double-entry accounting. Next, let’s turn our attention to when we record transactions, as timing is key.

### Revenue Recognition

Revenue is the value of goods and services the organization sold or provided to customers for a given period of time. In our current example, Chris’s landscaping business, the “revenue,” or the value of services performed, for the month of August would be $1,400. It is the value Chris received in exchange for the services provided to her clients. Likewise, when a business provides goods or services to customers for cash at the time of the service or in the future, the business classifies the amount(s) as revenue. Just as the $1,400 revenues from a business made Chris’s checking account balance increase, revenues increase the value of a business. In accounting, revenue recognition involves recording sales or fees earned within the period earned. Just as earning wages from a business or summer job reflects the number of hours worked for a given rate of pay or payments from clients for services rendered, revenues (and the other terms) are used to indicate the dollar value of goods and services provided to customers for a given period of time.

### Short-Term Revenue Recognition Examples

Two brief examples may help illustrate the difference between cash accounting and accrual accounting. Assume that a business sells $200 worth of merchandise. In some businesses, there are two ways the customers pay: cash and credit (also referred to as “on account”). Cash sales include checks and credit cards and are paid at the time of the sale. Credit sales (not to be confused with credit card sales) allow the customer to take the merchandise but pay within a specified period of time, usually up to 45 days.
A cash sale would be recorded in the financial statements under both the cash basis and accrual basis of accounting. It makes sense because the customer received the merchandise and paid the business at the same time. It is considered two events that occur simultaneously (exchange of merchandise for cash).
A credit sale, however, would be treated differently under each of these types of accounting. Under the cash basis of accounting, a credit sale would not be recorded in the financial statements until the cash is received, under terms stipulated by the seller. For example, assume that in the next year of Chris’s landscaping business, on April 1, she provides $500 worth of services to one of her customers. The sale is made on account, with the payment due 45 days later. Under the cash basis of accounting, the revenue would not be recorded until May 16, when the cash was received. Under the accrual basis of accounting, this sale would be recorded in the financial statements at the time the services were provided, April 1. The reason the sale would be recorded is that, under accrual accounting, the business reports that it provided $500 worth of services to its customer. The fact that the customers will pay later is viewed as a separate transaction under accrual accounting (see ).
Let’s now explore the difference between the cash basis and accrual basis of accounting using an expense. Assume a business purchases $160 worth of printing supplies from a supplier (vendor). Similar to a sale, a purchase of merchandise can be paid for at the time of sale using cash (also a check or credit card) or at a later date (on account). A purchase paid with cash at the time of the sale would be recorded in the financial statements under both cash basis and accrual basis of accounting. It makes sense because the business received the printing supplies from the supplier and paid the supplier at the same time. It is considered two events that occur simultaneously (exchange of merchandise for cash).
If the purchase was made on account (also called a credit purchase), however, the transaction would be recorded differently under each of these types of accounting. Under the cash basis of accounting, the $160 purchase on account would not be recorded in the financial statements until the cash is paid, as stipulated by the seller’s terms. For example, if the printing supplies were received on July 17 and the payment terms were 15 days, no transaction would be recorded until August 1, when the goods were paid for. Under the accrual basis of accounting, this purchase would be recorded in the financial statements at the time the business received the printing supplies from the supplier (July 17). The reason the purchase would be recorded is that the business reports that it bought $160 worth of printing supplies from its vendors. The fact that the business will pay later is viewed as a separate issue under accrual accounting.  summarizes these examples under the different bases of accounting.
Businesses often sell items for cash as well as on account, where payment terms are extended for a period of time (for example, 30 to 45 days). Likewise, businesses often purchase items from suppliers (also called vendors) for cash or, more likely, on account. Under the cash basis of accounting, these transactions would not be recorded until the cash is exchanged. In contrast, under accrual accounting, the transactions are recorded when the transaction occurs, regardless of when the cash is received or paid.

### Expense Recognition

An expense is a cost associated with providing goods or services to customers. In our opening example, the expenses that Chris incurred totaled $1,150 (consisting of $100 for brakes, $50 for fuel, and $1,000 for insurance). You might think of expenses as the opposite of revenue, in that expenses reduce Chris’s checking account balance. Likewise, expenses decrease the value of the business and represent the dollar value of costs incurred to provide goods and services to customers for a given period of time.

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In accrual accounting, the timing of revenues (when to record them) is governed by the revenue recognition principle. The principle indicates that revenue is only recognized on the income statement once it is earned. This means goods or services must have been delivered or rendered. Expenses, on the other hand, are guided by the expense recognition principle, which dictates that expenses must be recorded in the period in which they are incurred.

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# Accrual Accounting Process

## When Should a Company Capitalize or Expense an Item?

### Learning Outcomes

By the end of this section, you will be able to:
1. Define the key characteristics of a fixed asset.
2. Explain how the cost of a fixed asset is spread throughout its useful life via depreciation.
3. Assess the impact to net income of expensing versus capitalizing an item.
Assets are items a business owns. For accounting purposes, assets are categorized as current versus long term and tangible versus intangible. Any asset that is expected to be used by the business for more than one year is considered a long-term asset. These assets are not intended for resale and are anticipated to help generate revenue for the business in the future. Some common long-term assets are computers and other office machines, buildings, vehicles, software, computer code, and copyrights. Although these are all considered long-term assets, some are tangible and some are intangible.
To better understand the nature of fixed assets, let’s get to know Liam and their new business. Liam is excited to be graduating from their MBA program and looks forward to having more time to pursue their business venture. During one of their courses, Liam came up with the business idea of creating trendy workout attire. For their class project, they started silk-screening vintage album cover designs onto tanks, tees, and yoga pants. They tested the market by selling their wares on campus and were surprised how quickly and how often they sold out. In fact, sales were high enough that they decided to go into business for themselves. One of their first decisions involved whether they should continue to pay someone else to silk-screen their designs or do their own silk-screening. To do their own silk-screening, they would need to invest in a silk screen machine.
Liam will need to analyze the purchase of a silk screen machine to determine the impact on their business in the short term as well as the long term, including the accounting implications related to the expense of this machine. Liam knows that over time, the value of the machine will decrease, but they also know that an asset is supposed to be recorded on the books at its historical cost. They also wonder what costs are considered part of this asset. Additionally, Liam has learned about the matching principle (expense recognition) but needs to learn how that relates to a machine that is purchased in one year and used for many years to help generate revenue. Liam has a lot of information to consider before making this decision.

### What Is a Fixed Asset?

An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, be of material value, and not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets. It’s also key to note that companies will capitalize a fixed asset if they have material value. A $10 stapler to be used in the office, for example, may last for years, but the value of the item is not significant enough to warrant capitalizing it.
Businesses typically need many different types of these assets to meet their objectives. These assets differ from the company’s products. For example, the computers that Apple, Inc. intends to sell are considered inventory (a short-term asset), whereas the computers Apple’s employees use for day-to-day operations are long-term assets. In Liam’s case, the new silk screen machine would be considered a long-term tangible asset as they plan to use it over many years to help generate revenue for their business. Long-term tangible assets are listed as noncurrent assets on a company’s balance sheet. Typically, these assets are listed under the category of Property, Plant, and Equipment (PP&E), but they may be referred to as fixed assets or plant assets.
Apple, Inc. lists a total of $36.766 million in total Property, Plant, and Equipment (net) on its September 2020 consolidated balance sheet (see ). As shown in the figure, this net total includes land and buildings, machinery, equipment and internal-use software, and leasehold improvements, resulting in a gross PP&E of $103.526 million—less accumulated depreciation and amortization of $66.760 million—to arrive at the net amount of $36.766 million.
Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic life of the asset? Let’s return to Liam’s start-up business as an example. Liam plans to buy a silk screen machine to help create clothing that they will sell. The machine is a long-term asset because it will be used in the business’s daily operation for many years. If the machine costs Liam $5,000 and it is expected to be used in their business for several years, GAAP require the allocation of the machine’s costs over its useful life, which is the period over which it will produce revenues. Overall, in determining a company’s financial performance, we would not expect that Liam should have an expense of $5,000 this year and $0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the expense recognition (matching) principle, which states that expenses should be recorded in the same period with the revenues that the expense helped create. In Liam’s case, the $5,000 for this machine should be allocated over the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset’s economic life. Therefore, when Liam purchases the machine, they will record it as an asset on the financial statements (see journal entry in ).
When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This includes additional costs beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees. For example, if a real estate broker is paid $8,000 as part of a transaction to purchase land for $100,000, the land would be recorded at a cost of $108,000.
Over time, as the asset is used to generate revenue, Liam will need to depreciate recognize the cost of the asset.

### What Is Depreciation?

When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used in the business’s operations. If a long-term asset is used in the business’s operations, it will belong in property, plant, and equipment or intangible assets. In this situation, the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life.
Long-term assets that are not used in daily operations are typically classified as an investment. For example, if a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which the business conducts no operations (and assuming no current or intermediate-term plans for development), the land would be considered an investment.
Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue.

### Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when you purchase or acquire a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:
1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Depreciation expense is the amount of the asset’s cost to be recognized, or expensed, in the current period. Companies may record depreciation expense incurred annually, quarterly, or monthly.
Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s estimated useful life.

### Recording the Initial Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.
The journal entry to record the purchase of a fixed asset (assuming that a note payable, not a short-term account payable, is used for financing) is shown in .
Applying this to Liam’s silk-screening business, we learn that they purchased their silk screen machine for $54,000 by paying $10,000 cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown in .

### Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair-market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.
The following items are important in determining and recording depreciation:
1. Book value: the asset’s original cost less accumulated depreciation.
2. Useful life: the length of time the asset will be productively used within operations.
3. Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
4. Depreciable base (cost): the depreciation expense over the asset’s useful life. For example, if we paid $50,000 for an asset and anticipate a salvage value of $10,000, the depreciable base is $40,000. We expect $40,000 in depreciation over the time period in which the asset was used, and then it would be sold for $10,000.
Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown in .
Depreciation expense is a common operating expense that appears on an income statement. It represents the amount of expense being recognized in the current period. Accumulated depreciation, on the other hand, represents the sum of all depreciation expense recognized to date, or the total of all prior depreciation expense for the asset. It is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.
It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.
Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance method. A fourth method, the sum-of-the-years-digits method, is another accelerated option that has been losing popularity and can be learned in intermediate accounting courses. Note that these methods are for accounting and reporting purposes. The IRS allows firms to use the same or different methods to depreciate assets in calculating taxable income.
Assume that on January 1, Liam bought a silk screen machine for $54,000. Liam pays shipping costs of $1,500 and setup costs of $2,500 and assumes a useful life of five years or 960,000 prints. Based on experience, Liam anticipates a salvage value of $10,000. Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. Liam’s example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be $58,000, and after allowing for an anticipated salvage value of $10,000 in five years, the business could take $48,000 in depreciation over the machine’s economic life (see ).
Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of $48,000 by the economic life of five years, giving an annual depreciation expense of $9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one ():
After the journal entry in year one, the machine would have a book value of $48,400. This is the original cost of $58,000 less the accumulated depreciation of $9,600. The journal entry and information for year two are shown in .
Liam records an annual depreciation expense of $9,600. Each year, the accumulated depreciation balance increases by $9,600, and the machine’s book value decreases by the same $9,600. At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of  from the cost of $58,000.

### Units-of-Production Depreciation

Straight-line depreciation is efficient accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of time. For example, this method could account for depreciation of a silk screen machine for which the depreciable base is $48,000 (as in the straight-line method), but now the number of prints is important.
In our example, the machine will have total depreciation of $48,000 over its useful life of 960,000 prints. Therefore, we would divide $48,000 by 960,000 prints to get a cost per print of $0.05. If Liam printed 180,000 items in the first year, the depreciation expense would be . The journal entry to record this expense would be the same as with straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the calculation of the book value would also be the same. Liam would continue to depreciate the asset until a total of $48,000 in depreciation was taken after running 960,000 total prints.

### Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100 percent by the estimated life in years. For example, a five-year asset would be 100/5, or 20 percent a year. A four-year asset would be 100/4, or 25 percent a year. Next, because assets are typically more efficient and are used more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25 percent , or 50 percent. For a five-year asset, multiply 20 percent , or 40 percent.
One unique feature of the double-declining-balance method is that in the first year, the estimated salvage value is not subtracted from the total asset cost before calculating the first year’s depreciation expense. Instead, the total cost is multiplied by the calculated percentage. However, depreciation expense is not permitted to take the book value below the estimated salvage value, as demonstrated in .
Notice that in year four, the remaining book value of $12,528 was not multiplied by 40 percent. This is because the expense would have been $5,011.20, and since we cannot depreciate the asset below the estimated salvage value of $10,000, the expense cannot exceed $2,528, which is the amount left to depreciate (difference between the book value of $12,528 and the salvage value of $10,000). Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five.
In our example, the first year’s double-declining-balance depreciation expense would be . For the remaining years, the double-declining percentage is multiplied by the remaining book value of the asset. Liam would continue to depreciate the asset until the book value and the estimated salvage value are the same (in this case, $10,000). The net effect of the differences in straight-line depreciation versus double-declining-balance depreciation is that under the double-declining-balance method, the allowable depreciation expenses are greater in the earlier years than those allowed for straight-line depreciation. However, over the depreciable life of the asset, the total depreciation expense taken will be the same no matter which method the entity chooses. In the current example, both straight-line and double-declining-balance depreciation will provide a total depreciation expense of $48,000 over its five-year depreciable life.

### Summary of Depreciation

 and  compare the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset’s useful life, it was expected to be worth $10,000: thus, both methods depreciated the asset’s value by $48,000 over that time period.
When analyzing depreciation, accountants are required to make a supportable estimate of an asset’s useful life and its salvage value. However, “management teams typically fail to invest either time or attention into making or periodically revisiting and revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as prescribed by GAAP.”Howard B. Levy. “Depreciable Asset Lives: The Forgotten Estimate in GAAP.”  This failure is not an ethical approach to properly accounting for the use of assets.
Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation. An asset’s depreciation may change over its life according to its use. If asset depreciation is arbitrarily determined, the recorded “gains or losses on the disposition of depreciable property assets seen in financial statements”Ibid. are not true best estimates. Due to operational changes, the depreciation expense needs to be periodically reevaluated and adjusted.
Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Therefore, “financial statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains.”Ibid. An accountant should always follow GAAP guidelines and allocate the expense of an asset according to its usage.

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Determining when an item is actually an expense depends on whether it is capitalized (a fixed asset) or not. Fixed assets are those that are of significant value and last longer than one year. The cost of fixed assets is capitalized (placed on the balance sheet as an asset) and expensed over the useful life of the asset by recording depreciation. Depreciation can be calculated using straight-line, double-declining-balance, or units-of-production methods.

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### Depreciation Basics! With Journal Entries


# Accrual Accounting Process

## What Is “Profit” versus “Loss” for the Company?

### Learning Outcomes

By the end of this section, you will be able to:
1. Outline the components necessary to calculate profit or loss.
2. Contrast revenue and gains versus expenses and losses.
3. Differentiate revenue and expense versus receipt or payment of cash.
It’s a common misconception that if a business has cash they are making a profit, and if they are suffering a loss they must not have any cash. While this could be true, it’s not necessarily true. In this section you’ll explore key differences between cash flow, revenue, expense, profits, and losses.

### Calculating Profit and Loss

Net income (net loss) is determined by comparing revenues and expenses. Net income is a result of revenues (inflows) being greater than expenses (outflows). A net loss occurs when expenses (outflows) are greater than revenues (inflows). In accounting it is common to present net income in the following format:
Recall that revenue is the value of goods and services a business provides to its customers and increases the value of the business. Expenses, on the other hand, are the costs of providing the goods and services and decrease the value of the business. When revenues exceed expenses, companies have net income. This means the business has been successful at earning revenues, containing expenses, or a combination of both. If, on the other hand, expenses exceed revenues, companies experience a net loss. This means the business was unsuccessful in earning adequate revenues, sufficiently containing expenses, or a combination of both. While businesses work hard to avoid net loss situations, it is not uncommon for a company to sustain a net loss from time to time. It is difficult, however, for businesses to remain viable while experiencing net losses over the long term.
Shown as a formula, the net income (loss) function is:
To be complete, we must also consider the impact of gains and losses. While gains and losses are infrequent in a business, it is not uncommon that a business would present a gain and/or loss in its financial statements. Recall that gains are similar to revenue and losses are similar to expenses. Therefore, the traditional accounting format would be as shown in .
Shown as a formula, the net income (loss) function, including gains and losses, is:
When assessing a company’s net income, it is important to understand the source of the net income. Businesses strive to attain “high quality” net income (earnings). High-quality earnings are based on sustainable earnings, also called permanent earnings, while relying less on infrequent earnings, also called temporary earnings. Recall that revenues represent the ongoing value of goods and services the business provides (sells) to its customers, while gains are infrequent and involve items ancillary to the primary purpose of the business. For example, assume a bakery sells the truck it uses to deliver wedding cakes and experiences a gain on the sale. The bakery is not in the business of buying and selling trucks. It is in the baked goods business. Thus, the gain on the sale of the truck would be ancillary to the primary purpose of the business and represent a gain rather than revenue. We should use caution if a business attains a significant portion of its net income as a result of gains rather than revenues. Likewise, net losses derived as a result of losses should be put into the proper perspective due to the infrequent nature of losses. While net losses are undesirable for any reason, net losses that result from expenses related to ongoing operations, rather than losses that are infrequent, are more concerning for the business.

### Profit versus Cash Flow

Knowing the difference between the cash basis and accrual basis of accounting is necessary to understand the need for the statement of cash flows. Stakeholders need to know the financial performance (as measured by the income statement—that is, net income or net loss) and financial position (as measured by the balance sheet—that is, assets, liabilities, and owners’ equity) of the business. This information is provided in the income statement, statement of owner’s equity, and balance sheet. However, since these financial statements are prepared using accrual accounting, stakeholders do not have a clear picture of the business’s cash activities. The statement of cash flows solves this inadequacy by specifically focusing on the cash inflows and cash outflows. It also helps better delineate the difference between revenues and cash flow in versus expenses and cash flow out. As mentioned in prior sections, revenue can occur without cash actually flowing. For example, a customer may buy a good on account. Revenues would be recorded, but cash would not yet be received. The same is true on the expenses side. An expense can be incurred, such as an electric bill, but cash may not have been paid out yet. Thus, an expense is recorded and recognized on the income statement, but cash has not yet been given up. The statement of cash flows helps reconcile the difference between net income (a result of recorded revenues and expenses) and actual cash flow.

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Profit or loss for a company is calculated by subtracting expenses from revenue. The result is a profit if revenues are larger than expenses. Profit (or loss) is the money earned from the day-to-day general business operations. Gains and losses, on the other hand, occur when the business does something they don’t normally do (like sell a piece of their equipment) and earns or loses money on the transaction. It’s key to note that the timing of cash flows can vary from the timing of recording revenues or expenses. Thus a revenue does not necessarily equal cash in, and an expense does not necessarily equal a cash flow out.

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### Difference between Cash Flow and Profit


# Financial Statements

## Why It Matters

People say that accounting is the “language of business.” Using the language of business, accountants are able to communicate the financial performance and health of a firm via four key financial statements. These statements are the income statement, balance sheet, statement of owner’s equity, and statement of cash flows. Each statement provides different insights into a firm’s performance and financial health. Though some users may favor one or two statements over another, they are best used together to get a full picture.
In this chapter, you’ll be introduced to a firm called Clear Lake Sporting Goods. Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells them to consumers) that sells hunting and fishing gear. It needs financial statements to understand its profitability and current financial position, manage cash flow, and communicate its finances to outside parties like investors, governing bodies, and lenders. We will walk through each financial statement, its components, how they are connected, and how financial statement users understand each one.