Real Option: Definition, Example

Decision-making is crucial to the long-term success of companies and businesses. Usually, these decisions fall under the responsibility and authority of managers. Through the right choices, companies can grow significantly. However, a wrong decision can also hinder progress substantially. The concept of real options also applies to the decision-making process. Therefore, it is crucial to understand what they are.

What is a Real Option?

A real option is the right to make a business decision. However, it does not constitute an obligation to choose that decision. It also represents the decision alternative available for a tangible asset. Through these options, companies can evaluate various choices. Based on that evaluation, they can choose the right one. This way, companies can ensure future growth and expansion.

With the real options concept, companies can examine a range of possibilities. Once they do so, they can make a choice that is the most beneficial. Similarly, these options allow managers to analyze and evaluate business opportunities. Doing so is crucial for long-term profitability. The real options concept applies to investments and projects. Therefore, they are critical in investment appraisal.

Real options get their name from their application to tangible assets. These options do not apply to financial instruments. In essence, real options are an extension of the financial options concept to real assets. These options extrapolate the definition of financial options to non-financial assets. However, real options differ from financial options contracts since they don't involve exchangeable securities.

How do Real Options work?

Real options allow managers to make decisions in several areas. Through these options, managers can choose between various investment opportunities. However, real options do not oblige them to make a choice. Similarly, it provides them with the opportunity to invest at once or wait for better conditions in the future. Real options are also a part of real options value analysis (ROV).

Real options value analysis involves estimating the opportunity costs of various decisions. With this analysis, managers can evaluate whether to continue a project or abandon it. A real options analysis begins with managers reviewing the risks related to a project. Based on that, they develop models for these risks.

A real options analysis allows managers to be more precise with their decisions. They must evaluate several options and choose an outcome that helps with growth and profitability. Usually, the choices within real options may consist of several scenarios. For example, these may include a decision to expand, abandon, contract, wait, etc.

Example

A company, Red Co., considers a project that will provide a positive NPV of $1 million. However, it can expand its operations through those funds. The expansion process would require more time as well. On top of that, it would also require additional funds to finance the project. Red Co. can choose between the project or expanding its operations.

Within real options, Red Co. can evaluate the choices it has. This process involves assessing both projects and how they will impact their operations. Ultimately, the decision will lie with the company's management. In most cases, it will choose the option with the best outcome.

Conclusion

Real options provide companies with the right to make a business decision. These options apply to tangible assets rather than financial instruments. With these options, companies can evaluate various choices. Based on that evaluation, they can select the option with the most beneficial outcomes. Real options also involve real options valuation.

Originally Published Here: Real Option: Definition, Example

General Journal in Accounting

Companies maintain accounts that help prepare financial statements. Usually, these accounts use the books of prime entry to track transactions. These may include various books, each of which has a specific purpose. The information from those books enables companies to record transactions in their general ledgers. One of the books of prime entry includes the general journal.

What is the General Journal in Accounting?

The general journal is a book of prime entry which helps record transactions that don't relate to the other books. These transactions do not qualify for accounting in specialty journals, for example, purchase, sales, or cash journals. Excluding these transactions, the general journal includes only selected types of entries. For example, it may consist of depreciation, amortization, and accrual journal entries.

The general journal involves adjustment entries in most cases. For example, these may relate to year-end updates or modifications. Like the other books, the general journal is essential in the preparation process of financial statements. The information from this book, along with others, helps constitute the entries for the general ledgers. Another name used to describe it is the books of original entry.

Overall, the general journal is a part of a company's accounting records and its financial systems. Most companies maintain specialty journals, including sales, cash, returns, and purchases journals. In some cases, companies may even have more of these journals. The general journal covers any transactions that do not fall into those journals.

How does a General Journal work?

The general journal consists of journal entries that do not fall under any of the specialty journals. In accounting, the term journal entry refers to a record of financial transactions. These entries have two sides, a debit, and a credit. When a transaction occurs, companies record it into their accounting system using journal entries.

The general journal also consists of various journal entries. Usually, it covers financial transactions such as opening balances, year-end adjustments, non-cash items, etc. When these transactions occur, they do not relate to any of the other books of prime entry. However, companies must still record them to include them in the accounting system. This process occurs through the general journal.

In the past, companies maintained a separate book to record these transactions. However, modern accounting systems organize all these books together. Any transactions that occur in these books also enter the general ledger. From there, this information ends up on the trial balance and, ultimately, the financial statements.

What is the format of General Journal?

There is no specific format or standard that companies must use to maintain the general journal. These records are a part of a company's internal accounting systems. Despite that, the general journal must include essential information about financial transactions. This information must cover the following areas.

• Date of the transaction.
• Debit/credit accounts.
• Debit/credit amounts.
• A reference number.
• A short description or memo describing the transaction.

The above information should cover the fundamental requirements for further processing. However, companies may cover more areas if they choose to do so. In practice, nonetheless, most general journals use a minimal format.

Conclusion

Companies maintain books of prime entry that record financial transactions. Usually, these books include specialty journals and a general journal. All financial transactions enter those journals. In most cases, the specialty journals may cover financial transactions. Any remaining items end up in the general journal. Usually, it includes transactions, such as depreciation, balance adjustments, year-end adjustments, non-cash entries, etc.

Originally Published Here: General Journal in Accounting

How Rising Inflation Affects Your Investments

Inflation is an important indicator of an economy's health, as it indicates how the costs of goods and services are rising. While consumers often look at the prices of individual products as a gauge of their affordability, they have a broader need for a wide range of commodities. These include food grains, metal, fuel, utilities, transportation, entertainment, and labor. Rising prices of commodities are often the main cause of inflation, and they must continue to rise in order to maintain economic growth.

While inflation may be good for the economy, it can pose a threat to investors. Inflation can impact not only your spending but also your savings and investments.  Rising inflation can hurt your savings and investments in many different ways:

1. Forcing tough choices: … People cutting back spending in one area of their life due to unavoidable inflation elsewhere reduces revenue for those companies associated with those less-immediately essential products. That can hurt the stocks associated with those types of companies.
2. More aggressive cost-cutting actions: When companies are faced with higher costs, they start getting aggressive with their cost-cutting actions. That could include things like changing formulas to reduce input and processing costs, reducing staff to cut salary and benefit costs, or stretching out maintenance cycles to reduce downtimes.
3. Higher borrowing costs: If you're in the market for something that you can't pay cash for (such as a house or potentially a car), you will borrow money to complete the transaction. If inflation means the price of that item is higher today than it was in the past, you will likely both pay more and borrow more for that item.
4. A greater need to hold assets in other forms: As a general rule, money you expect to spend from your portfolio within in the next five years does not belong in stocks. If you're a retiree who expects to spend $40,000 per year from your portfolio, that means you'll need $200,000 in lower-risk investments, assuming no inflation.
5. Better risk-adjusted returns elsewhere: Low interest rates have helped bolster the stock market. It stands to reason that if rates rise in response to inflation, the stock market can get hurt as the money forced into stocks by lower rates can find better risk-adjusted returns elsewhere. Read more

Article Source Here: How Rising Inflation Affects Your Investments

Chief Investment Officer: Job Description, Career Path, vs Chief Financial Officer

In a company, firm, or organization, there's a high need for professionals to manage different departments. The management of an organization's investment portfolio should be handled by efficient professionals to ensure proficiency. One of such important positions is the Chief Investment Officer (CIO).

This position is critical because the performance of an organization's investment portfolio largely depends on the efficiency of the CIO. So, In this article, you will get a comprehensive understanding of who a CIO is, their responsibilities, and how they differ from a Chief Financial Officer.

Who is a Chief Investment Officer

A Chief Investment Officer is a director in a company who is in charge of managing its investment portfolio. They take up the responsibility of setting up the company's investment style and strategy.

They work together with a body of team members in the company to develop its long-term and short-term investment plans. Hence, whether or not a company's investment turns out profitable is a direct responsibility of the CIO and his team.

Different kinds of organizations including investment companies, insurance firms, banks, or non-profit organizations with endowments can have a CIO.

Who Qualifies To Be a CIO?

When you’re looking out for personnel to be in charge of this position, ensure to consider these qualities:

• An enhanced knowledge of asset classes and return generation strategies.
• Profound knowledge of different investment products.
• The ability to operate digital and telecommunication systems.
• The ability to be proficient in leadership, written and verbal communication, as well as balance multiple projects.

Duties And Responsibilities of a Chief Investment Officer

The responsibilities of a CIO in an organization include but are not limited to:

#1. Organization of Team Members

A CIO should possess good leadership skills to be able to select, organize and build a strong team. To achieve this, the CIO will conduct interviews to identify potential candidates with the required skills and expertise or at least the potential to acquire them.

#2. Assets Allocation

The CIO analyzes and decides the kind of assets the organization invests in based on the company's investment goals and strategy. They decide on the amount of money to invest in each asset in line with the investment plan.

#3. Recommend And Create Investment Processes

The CIO is responsible for assessing potential investment opportunities. They usually set up an investment assessment system that helps ascertain whether an opportunity is aligned to their strategy and will be profitable or not.

Who is a Chief Financial Officer?

A Chief Financial Officer (CFO) is an executive in an organization, firm, or company that's in charge of managing its financial operations. The CFO is also responsible for planning, analyzing the company's finances, and recommending corrective actions.

CIO vs CFO: Similarities and Differences

The CFO and the CIO are both associated with the finances and investment decisions of an organization. So, they are closely related offices and can easily overlap in their responsibilities.

In fact, in some organizations, the CFO takes the responsibilities of the CIO. But there are some other organizations where investment is a key part of their operations. In such places, the CIO is usually a distinct office, and sometimes, they report to the CFO who is in charge of all finance-related matters.

The notable difference between the CFO and the CIO is that while the CFO oversees the general finance of an organization, the CIO is streamlined to the investment portfolio.

Conclusion

Investment management is a crucial part of the success of any organization. Therefore, understanding the role of the Chief Investment Officer and how it relates to the CFO and other vital operations of an organization is very important.

Originally Published Here: Chief Investment Officer: Job Description, Career Path, vs Chief Financial Officer

Absorption Costing

Companies use various costing methods to establish the unit cost of manufacturing a product. Determining these costs is highly crucial in understanding how a company’s production process works. On top of that, it provides a base for measuring the price to charge for the underlying product. One of the methods that can help in this regard is absorption costing.

What is Absorption Costing?

Absorption costing is a costing method that companies use to determine the cost of a product. This method falls under managerial accounting, which includes establishing those costs. However, absorption costing doesn't only apply to managerial accounting. It is also crucial in establishing costs under financial accounting under different accounting standards.

Absorption costing involves absorbing a company's variable and fixed manufacturing overheads into a product's cost. This approach differs from other methods that only consider variable material and labour costs. Another name for absorption costing is full costing since it includes all the costs associated with manufacturing a product.

Overall, the absorption costing method involves accumulating all costs associated with a production process. Later, it apportions those costs to individual products. These costs then help establish the value of inventory that companies keep. Furthermore, it also allows companies to estimate the cost of goods sold during an accounting period.

What are the components of Absorption Costing?

Absorption costing considers various components when establishing a product’s cost. Some of these include the following.

Direct material

Direct material includes any raw materials that contribute directly to a product. However, it does not involve any items that do not form a part of the finished product. For example, for companies that manufacture furniture, direct material will consist of wood.

Direct labour

Direct labour includes any costs paid to workers in exchange for working on a product. These costs must contribute directly to the finished goods. For example, salaries and wages paid to production line workers form direct labour costs.

Variable manufacturing overheads

Apart from direct labour and direct material, companies may also incur other variable manufacturing overheads. These overheads include expenses necessary to operate a production facility and relate to production volume. Like direct material and labour, these costs also vary with volume.

Fixed manufacturing overheads

Apart from variable manufacturing overheads, absorption costing also considers fixed overheads. These are similar to the above as it includes expenses to run a manufacturing facility. However, these costs do not change with production levels.

What are the advantages and disadvantages of Absorption Costing?

Absorption costing can provide several advantages. One of the most prominent of these includes being compliant with most accounting standards. Similarly, absorption costing considers all production-related costs when evaluating inventory. This way, it allows companies to value their stock more accurately. Absorption costing can also provide better results for smaller companies and dynamic environments.

However, absorption costing can have some disadvantages. Some companies may prefer other methods such as marginal costing since it helps in better decision-making. Similarly, absorption costing can also impact the accurate presentation of profits. Some companies may use this method to manipulate profits and overstate inventory.

Conclusion

Absorption costing is a product costing technique that considers all production-related costs. This method can help in evaluating inventory and establishing the cost of goods sold. Similarly, it is also compatible with accounting standards. Absorption costing requires four components to calculate product costs. This method can have several advantages and disadvantages, as mentioned above.

Originally Published Here: Absorption Costing

Cross-Sectional Momentum in the Commodity Market

Momentum trading is often divided into 2 categories: time-series momentum and cross-sectional momentum. Time-series based trading strategies generate trading signals based on the asset’s past returns. A typical time-series trading strategy usually involves buying assets with positive trend signals and selling those with negative trend signals. In contrast, cross-sectional trading strategies generate trading signals based on the relative performance of assets. A typical cross-sectional trading strategy involves buying assets with the highest-ranked trend signals and selling those with the lowest-ranked trend signals. So basically this is a relative value strategy.

Reference [1] examined trend trading in the commodity market from the cross-sectional momentum perspective. The authors conducted a study on a portfolio of 35 commodity futures. They pointed out,

In this paper, we provide a trend factor that exploits the short-, intermediate-, and long-run moving averages of settlement prices in commodity futures markets. It outperforms the momentum benchmark significantly. During our sample period January 2004–December 2020, the trend factor generates statistically and economically large returns while the average return of the momentum factor is insignificant. The trend factor also has less downside risk than the momentum factor. The returns of the trend factor cannot be explained by existing multifactor models. The trend factor also generates a significant and positive risk premium.

In short, cross-sectional momentum exists in the commodity market and it is possible to construct a profitable trend trading strategy. The authors went on to identify the underlying risk/PnL driver of the thus developed trading strategy,

…the trend factor is correlated with funding liquidity measured by the TED spread. Overall, our results indicate that past prices contain important information on the expected returns in commodity futures markets.

In other words, the underlying PnL driver is the TED spread which represents the funding liquidity.

References

[1] Han, Yufeng and Kong, Lingfei, A Trend Factor in Commodity Futures Markets: Any Economic Gains From Using Information Over Investment Horizons? (October 31, 2021). Available at SSRN: https://ssrn.com/abstract=3953845

Article Source Here: Cross-Sectional Momentum in the Commodity Market

Basis Points and Basis Point Values

When it comes to bonds, mortgages, and other interest-rate-sensitive instruments, most people refer to the change in interest rates as basis points or bps for short. For example, you might hear someone say that a bond yield increased by 12 bps. The actual meaning is that the new yield is 0.12% higher than the old one. BPS is used to describe changes in interest rates on fixed income instruments because it is the decimal form of the change.

In this article, we are going to look at what is Basis Point and how to calculate it.

What is a Basis Point

A basis point is a unit in measurement used to quantify change. To calculate the basis points from any given percent change, you simply need to multiply the change by 100 to obtain the value in basis points.

Now when it comes to bonds and mortgages, most people refer to the change in the interest rate as basis points or bps for short. So, bps is used to describe changes in interest rates on fixed income instruments because it is the decimal form of the change.

Example of Basis Points

Question: What is the change in yield in basis point of a bond trading at par that has a yield increase from 6% to 6.10%?

Answer: Using the calculation method mentioned above, we multiply the change (0.10%) by 100 and obtain 10 BPS.

Another Example

Question: What is the change in yield of a bond trading at 103 that has a yield decrease from 5.02% to 4.98%?

Answer: -0.04 multiplied by 100 = -4 BPS

So, as you can see it simply requires multiplying the change by 100 to get your answer.

Why use basis points

BPS is widely used for quoting changes in financial assets, especially bonds and interest rates. This is because the basic point is a decimal form of change that makes it easy to understand the relative change in numbers, compared to percentages, which can be confusing and misleading in certain cases.

It gives you a better idea of a security's or an instrument's volatility. BPS is a unit that is used to measure the change in various fixed-income instruments which have different values for each one, just like interest rates. It does not matter if you are dealing with bonds, mortgages, or other interest-rate-sensitive instruments, BPS measures the increase or decrease from the previous value.

How to Calculate Basis Point Value of a Bond or Mortgage

In order to calculate the basis point value of a bond or mortgage, you need to know how much they are worth currently. Then you have to find out how much their value changes after the shift in interest rates. Once you have done this you divide the change in the instrument’s value by the basis points and you’ll get the basis point value

Benefits of using basis points and basis point values

• It is beneficial because it makes transaction costs easier to understand.
• It makes it easy to compare bonds with different prices and yields
• It is easier to compare bond yields with those on other securities such as mortgages.

Conclusion

BASIS POINT is a unit of measurement used to quantify change. It is widely used for quoting changes in financial assets, especially bonds and interest rates. It gives you a better idea of a security's or an instrument's volatility. It is very easy to calculate the basis point. All you have to do is to multiple the change in percent by 100.

Article Source Here: Basis Points and Basis Point Values

Net Sales Vs. Gross Sales

Net sales and gross sales are important financial metrics for businesses to track. Both metrics provide valuable insight into a business’s performance, thereby painting a picture of where a business is going.

If you’re not sure what these metrics are and how they differ from each other, you’re in the right place.

In this article, we will explain the basics of net sales and gross sales to help you understand the distinction between the two.

What Are Net Sales?

Net sales refers to a business’s total sales revenue generated over a specified period of time after subtracting allowances, discounts, and sales returns. In other words, net sales is a business’s gross sales minus the cost of allowances, discounts, and sales returns.

How To Calculate Net Sales

The formula for net sales is:

Net Sales= Gross Sales –Sales Returns-Allowances-Discounts

Let’s define the terms that constitute the net sales formula.

• Gross Sales-This is the amount of sales a business generates over a specified period of time, unadjusted for sales returns, allowances, and discounts.
• Allowances-These are grants given to customers on account of damaged goods, defective goods, wrong goods sent, and other reasons other than discounting.
• Sales Returns- These are product items that are returned in exchange for a partial or full refund. Sold items can be returned due to late shipping, defective products, incorrect product specifications, wrong items shipped, excess quantity shipped, etc.
• Discounts-These are rewards a business extends to customer’s invoices when certain conditions are met. For example, if you offer your customers a 30-day invoice period, you can extend a 5% discount if they make payment within 15 or 20 days.

An Example of the Net Sales Formula

Suppose a book store sold 10,000 books over the financial year, with book retailing for $15. However, they gave out allowances worth $10,000 and discounts of $7,000 and had sales returns worth $10,000.

Using the net sales formula, the net sales for this bookstore is:

Net Sales= (10,000 x $15) - $10,000 - $7,000 - $10,0000 = $123,000

Benefits of Knowing Your Net Sales

Net sales helps businesses to get a better idea of their performance and financial health. Businesses can also use this metric to measure deductions, discounts, and returns for purposes of making the necessary adjustments towards profitability.

What Are Gross Sales?

Gross sales refers to the total sales a business makes within a specified period of time without accounting for any deductions. That is, the total number of units sold multiplied by sales price per unit. Knowing your gross sales helps you to track your sales volume. However, this metric is not a good measure for decision making.

Benefits of Knowing Your Gross Sales

Gross sales gives insight into the total amount of revenue a business generates during a certain period of time. Using gross sales, you can measure how well your sales team is doing and how they can take their sales game to the next level.

Conclusion

Gross sales and net sales are important metrics to track in order to make informed decisions.

Article Source Here: Net Sales Vs. Gross Sales

Brokers and Dealers in Securities

Brokers and dealers are two key figures in the security market. However, both have their distinct functions and relevance to the security market.

Practically, there is no security market without a broker. A broker provides a technical base for transactions. On the flip side, a dealer trades securities for his(her) own profit. Let's take a detailed look at the two figures and see how they differ.

Who is a Broker?

In the security market, a broker acts as an intermediary between a seller and a buyer, facilitating transactions. A broker (either be an individual or a corporate entity) trades on behalf of another for a commission. Put another way, he(she) executes a trade on behalf of stock traders, based on their instructions, and receives a fee as compensation.

This fee can be fixed or a particular percentage of the amount used for a transaction, it all depends on the agreement between the broker and their client.

However, aside from mediation - connecting buyers and sellers of securities, brokers offer their clients some other key benefits which include:

• Provide support for clients via helpful information regarding trading; trading strategies and mechanisms, activities of other market participants, notifications about quotes, etc. In other words, brokers can help to facilitate learning and success in security trading.
• Provide a platform for transactions.
• Stores and protects clients' data.
• Lend securities to clients for margin transactions.

Who is a Dealer?

In the security market, a dealer buys and sells securities for their profit. Dealers diligently follow market moves, ready and willing to take advantage of every opportunity to buy securities.

Generally, the sole target of a dealer is to make a profit for themselves from the spread between the bid and ask prices. By doing so, dealers contribute to the liquidity of the security market.

Hence, conclusively, a dealer does not facilitate trade nor connect the two parties (sellers and buyers) rather they trade on their own behalf.

Key Differences Between Brokers and Dealers in Securities

• A broker facilitates transactions in the security market by creating a technical base for exchange between sellers and buyers. In contrast, a dealer does not facilitate trading, they carry out trading activities for their own benefit.

However, most dealers also double as brokers and are called broker-dealers.

• A dealer does not receive a commission for trade unlike a broker, he/she trades in their account and therefore is the principal. A broker charges the client a commission for trading on their behalf.
• Brokers trade based on what their clients want, whereas dealers do not take instructions from anyone regarding trades.
• A dealer tends to have more knowledge about securities trading than a broker. Since they trade on their behalf, they will dig into every information necessary for profitable trading. This might give them an edge over brokers who only act according to the instructions of their clients.

Bottom Line

Both brokers and dealers matter in the security market. While a broker enables the transaction of securities, a dealer ensures that the market stays liquid, which is also very vital to the existence of the market.

Originally Published Here: Brokers and Dealers in Securities

Sales Returns: Definition, Journal Entry, Example, Allowances

Companies that manufacture products and services may offer sales returns or allowance policies. These are a normal part of the business that these companies conduct. Usually, customers return goods sold to them for various reasons. For companies, these sales returns are a reduction in sales. First, however, it is crucial to understand what sales returns are.

What are Sales Returns?

Sales returns are goods that customers return to a company for various reasons. Usually, companies provide this facility to customers to increase sales. In essence, a sales return policy allows customers to return goods when they find issues with those goods. In some cases, companies may offer goods in exchange for any returns. However, some others may return the customer's money.

A sales return policy is essential in ensuring customers of the quality of the goods delivered. However, it can lead to a decrease in revenues for companies. Some companies may also offer a sales allowance policy, which is similar to accounting treatment. However, both processes are fundamentally different.

What are the reasons for Sales Returns?

As mentioned, customers may have several reasons to return goods to a company. Some of the primary ones include the following.

• The company sent defective goods.
• The customer received the goods late, or the company failed to deliver them on time.
• The company did not send the right order to the customer.
• The goods do not satisfy the customer’s needs.
• The company delivered a higher quantity than what the customer requested.
• The customer made an unintended order.

What are the journal entries for Sales Returns?

The accounting treatment of sales returns involves recording two journal entries. The first entry requires companies to reduce the customer's account while decreasing revenues. Usually, this decrease in revenues occurs through a contra revenue account. This account does not impact a company's revenues directly. However, it can lead to a reduction in the income statement later.

When companies receive goods returns from customers, they can use the following journal entries to record them.

Dr Sales Returns and Allowances

Cr Customer account

The above double-entry assumes the customer has not paid for the goods yet. If customers have already done so, the company may create a liability for the customer. In that case, the journal entries will be as follows.

Dr Sales Returns and Allowances

Cr Payable to customer

When customers return sales, the company also receives goods back from the customer. Therefore, it must record those goods in the inventory account. It is the second accounting treatment that involves sales returns. For this process, the journal entries will be as below.

Dr Inventory

Cr Cost of goods sold

Example

A company, Red Co., manufactures and sells electronic items. During an accounting period, the company sold $100,000 worth of electronics. Red Co. records these sales using the following journal entries.

Dr Accounts receivables $100,000

Cr Sales $100,000

However, some of the goods that Red Co. sent were faulty. These goods got damaged during the delivery process. As a result, Red Co. received $10,000 worth of electronics back from customers. However, none of the customers had paid for those goods at the time. The company used the following journal entries to record them.

Dr Sales returns and allowances $10,000

Cr Accounts receivables $10,000

Conclusion

Sales returns are goods returned by a customer. There are several reasons why a customer may do so. For example, these may include faulty goods, incorrect orders, shipping delays, etc. The accounting entries for sales returns involve two steps. First, a company must record a decrease in sales through a contra revenue account. The second step is to record the increase in inventory from those goods.

Article Source Here: Sales Returns: Definition, Journal Entry, Example, Allowances