World Economics

The study of world economics (also called international economics) is the study of all of the factors that influence the movement of goods and money around the world, and because it is so intricately tied, the related politics. This includes trade and trade policies, justifications for protection, currency systems and exchange rates, the monetary and fiscal policies of world governments and economic development.

 

Trade and trade policies

Trade policies can be most simply divided into two schools of thought: free trade and protected trade. Free trade proponents advocate a system of trade whereby all goods would cross all country borders freely, without restrictive taxes or import duties.  In this theory, the efficiency gained by each country producing what it produces best and cheapest overrides any losses by individuals who produce those same goods and will lose their advantage when imported goods are introduced. There are two types of efficiencies addressed in this theory: production efficiency and consumption efficiency. Production efficiency recognizes that some countries that can produce more of a good or service (with the same amount of resources) than others.  Consumption efficiency recognizes that consumers in a free trade environment will have a greater collection of goods and services from which to choose.  The proponents of protected trade seek to protect individual industries and even companies within a country from what they perceive as unfair competition.

 

Justifications for protection  

The justifications for protection include the potential for unemployment, development of new industries, national security and the threat of foreign monopolies. Some concerns envelope more than one of these aspects. For instance, protection of the American steel industry is deemed important not only for the jobs that are lost when the steel mills close down, but also the concern that a nation such as the United States should not become totally reliant upon foreign steel. In addition, it is charged that foreign steel industry is only successful because of protectionism and the monopolistic policies of foreign governments.

 

Currency systems and exchange rates

A currency system is the medium of exchange that a country uses to settle its debts with other countries. Most countries have their own exchange rate. (Although, since 2002, most of the member countries of the European Community have agreed to use the same currency, the Euro, and drop the mark, franc, florin, lira, etc.) But many countries that have a currency of their own which they use for domestic settlements may use a benchmark currency to settle international trade or debt. This so-called “settlement currency” is usually the United States dollar.

The exchange rate is a quotation given by stating the number of units of a country’s currency that can be bought in terms of 1 unit of another country’s currency. For example, if we say that the Euro-U.S. Dollar exchange rate is 1.2 USD per Euro, that tells us that it will take 1.2 U.S. Dollars to get 1 Euro.

 

Monetary and fiscal policies of world governments

Most governments view their role in economics as a balance in which they have to protect their citizens from adverse movements in the economy such as unemployment, inflation and economic hardship with the needs of the security of the nation. Governments use two main tools for achieving these objectives: fiscal policy, which is the level of spending by the government and the imposition of taxes and issuance of debt to fund that spending, and monetary policy, through which governments attempt to manage inflation by managing the supply of money.  The fiscal policy of a government  determines what the government should be spending money on, the protection of the nation or social programs or which combination of both and, once decided upon, whether taxes will be raised to pay for the programs or whether government bonds will be issued to raise these funds voluntarily. The monetary policy of a government attempts to achieve certain economic goals such as lowering inflation, raising employment levels or spurring economic growth. This is done through managing the money supply by changing interest rates (through buying or selling their own currency) or by changing reserve requirements of banks,  (open market operations), and setting the reserve requirements, the amounts banks have to leave on deposit with the central bank, thus loosening or tightening the amount of money in circulation.

 

Economic development

Each unit of government, from the national level all the way down to towns and municipalities are interested in fostering the economic development of their constituent area.  Even on an international scale, organizations such as the OECD, the Organization for Economic Cooperation and Development, set goals and design programs to spur controlled economic growth.  On national and local government levels, governments establish many organizations with the purpose of generating new jobs or retain existing jobs, and stimulating industrial and commercial growth.

A nation’s economic development policy, coupled with its trade policies, economic protection systems, manipulations of currency, monetary and fiscal policies will strongly influence its politics and its relations with other nations.

 

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The Basics of Financial Markets

The term “market” refers to a place or group of places where people can exchange certain goods or services for money. There is, of course, the basic “market” drawn from medieval exchanges wherein buyers and sellers would gather to exchange money for goods. Today, there are all sorts of markets, ranging from the supermarket that sells our everyday food and household products, to the art market, the real estate market and even the drug market. Our current financial markets are generally based on the types of goods or “assets” that are traded on them.  The most well known and most commonly traded are the equity market, the bond market, the foreign exchange market and the currency market. Each of these markets have a vast assortment of instruments that are “traded” on them.

The equity market is the financial market that is most commonly known among the public.  The term comes from the fact that a company’s value is known as its equity, or its equity stock, and it can sell parts of that equity to investors. These parts of its equity are known as “equity shares” or “stock shares” and hence we have the expressions “buying shares on the stock market”, or “owning shares of a stock”. These shares do not pay any interest; the value of shares in the equity market go up an down constantly, so those who buy them are counting on the value going up, so they can sell them at a higher rate. Remember Will Rogers advice on the stock market: “Buy when the price is low and sell when the price goes up. If the price doesn’t go up, don’t buy.”  Since the rest of us don’t have that kind of hindsight, we just hope the price goes up. Shares on the stock market do not pay any interest, so anyone investing in them is only hoping to make money by the increase in the value (price) of the shares. The stock market is divided by company size (measured by capitalization), industry or type of growth pattern. Investors and their advisors therefore talk about large-cap vs. small-cap stocks, energy vs. technology stocks, or growth vs. value stocks, for example.

The fixed income market is comprised of bonds, notes, bills, and certificates of deposit. The fixed income market is called just that because, unlike stocks, the securities on it pay interest (income) to the holder. Each bond, note, bill or certificate of deposit is issued at an interest rate that will be paid the holder, either over time or at maturity.  Companies or governments issue bonds to fund their day-to-day operations or to finance specific projects. The owner of a bond, note, bill or CD does not own a piece of the company, as the owner of a share does. A bond holder, in essence, is lending money for a certain period of time (until the maturity date) to the issuer of the bond. That issuer may be Ford Motor, the U.S. Government, the City of Los Angeles, or the Government of Brazil. The bond holder will get back the “loan” amount plus interest payments at the maturity date of the bond.  The underlying value of the bond may change during the course of holding the bond. If the bond was issued with an interest rate (coupon) of 8%, and interest rates on other, similar bonds are being issued at 10%, this bond will become less attractive to other buyers and will become less valuable. This is not an issue if an investor intends to hold onto the bond until maturity, but if he wants to sell it at some point before it matures, the face value may be less. It may also be more, if interest rates on similar bonds went down to 6%, a bond paying 8% would be more valuable.

The commodities market is comprised of promises to buy or sell goods such as wheat, oil or gold at a certain price on a certain day. This market evolved from the nineteenth century Midwest market where farmers (sellers) and dealers (buyers) committed to future exchanges of grain for cash. Farmers gave up any increase in the price of their crop for the security of knowing their crop was sold for a set price, even if the bottom fell out of the market.  In time, these contracts became a market of their own, as they changed hands before the delivery date. Before long, traders who had no intention of ever buying or selling a crop, but who thought they could outguess how the price of the commodity would perform, were trading commodities for the potential profit.

The currency market, also known as the foreign exchange market, or the Forex market, is where companies or governments that need to settle their debts in another currency, can obtain that currency.   If the owner of a shoe store in the United States wants to buy leather shoes from Brazil, he will have to obtain Brazilian Reals in order to pay for them. (Or, the manufacturer in Brazil may accept the dollars, but have to sell them for Reals when he receives the dollars.) Banks and brokerages perform this exchange service and, in addition to charging a fee for it, will try to make money off the fluctuations of the various currencies that they exchange.  Just as with the commodities markets, the allure of buying a currency at a low rate and selling it higher appealed to speculative types, and today the currency market is dominated by  speculative traders who never actually use the currencies they buy and sell.

The derivatives market  is comprised forwards, futures, options and swaps on all of the underlying products in the above markets. Both companies and governments, when faced with the increasing risks of issuing stocks and bonds, or covering commodity or foreign exchange positions, have decided to manage or reduce these risks and to hopefully increase returns. The derivative market is an intensely complex market wherein almost any aspect of debt or risk can be broken away into a separate trading instrument and bought or sold.  These sales are made on the basis of a guaranteed future sale at a current price, which is known as the underlying price. For example, the company that issued the 8% bond in our above example, may want to manage the risk of that 8% bond if the interest rates go down by selling off the coupon on the bond and financing it at a lower rate through the use of a derivative.

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Fundamentals of Economics

Economics has been known as the dismal science ever since Thomas Carlyle coined the phrase to summarize T. R. Malthus’ sad predictions in the 19th century: that the fate of humanity’s economic life would be poverty, hardship and even starvation.  In most of the developed world today, this prediction has not been borne out, but in many third world nations, there are large pockets of poverty, hardship and starvation, and the contrast between these worlds illustrates some of the fundamentals of economics at work and how they are all interrelated.

The most basic principle of economics is the “law of supply and demand”, which is based on the concept of scarcity of goods.  Since there are no “goods”, including the means to pay for those goods, that are unlimited in supply, human beings have to make choices between the options open to them.  Even air and water, the basics of life, can be limited so that water in the desert and air on a mountain command a premium.  Each person makes a decision as to how he wants to allocate his limited resources. In a subsistence society, man allocates his only resources, time and labor, to raising food, building shelter and weaving cloth. If the soil and weather conditions are optimum in a certain locale, it would be easy for each member of the society to raise enough crops for himself and have some left to give to his neighbor in exchange for something the neighbor may have. However, if crops were that easy to grow, everyone would have more than they needed, which would force the value (prices) of these crops down.  Imagine, however, that trees were very rare and so it was difficult to build a strong shelter. The enterprising members of this society could travel to a region where there was wood and spend their time and labor resources obtaining this good.  This is called the “production possibility frontier”, which, in turn will affect the law of supply and demand. The wood to build shelters would become very valuable since there would not be much of it, since it requires so much in resources to produce.  Now each member of this society has to decide on how much of his relatively cheap food he is going to give up in order to obtain the expensive wood.

We have the same choices in modern, industrialized societies. Each member has to choose how he is going to spend his limited resources. Some of the members may have very few resources and have to spend most of them on basic necessities.  Others who have few resources many nevertheless make different choices, to cut back on a basic such as shelter in order to afford a luxury such as cigarettes. Many members of developed societies have more than enough resources to obtain food, clothing and shelter and need to make their economic decisions about whether they want to live in big house or live in a smaller house and afford a nice vacation every year. These choices (cigarettes for a nicer apartment, a vacation instead of a bigger house) are called “opportunity costs”, since each member is giving up one thing (the cost) to obtain something else (opportunity).

In some societies some items may be cheaper than others. Homes in Switzerland are very expensive because building materials and land are scarce and therefore expensive. Relatively speaking, homes in the United States are cheap because the United States has a lot of natural resources and land. This is the principal of “comparative advantage”.  Members of society in Switzerland have to make different choices regarding shelter than members of society in the United States.

As societies develop, these shifts constantly and naturally occur, so that if the price of housing comes down, our smoker may still be able to afford a better apartment, and our homeowner might be able to keep his big house and still go on vacation. Housing prices (cost of shelter) may come down because the supply of housing in the area goes up or interest rates go up and make it less desirable for people to have a mortgage.

At a certain point, however, in each society and for each good, choice becomes more limited. Once the price of cigarettes becomes so expensive that a smoker could no longer afford them and an apartment, he would have to give up cigarettes in order to have a place to live.  No matter how expensive food became, members of both subsistence and advanced societies would have to have food. This is the principal of “elasticity of demand”.  The demand for food is very inelastic because it is essential to life. The demand for other goods, such as cigarettes and vacations is elastic. We will give them up in order to have food and shelter.

Woven into all of these economic principles, however is another principle. There are some consumers who, no matter how high the price of cigarettes becomes, or not matter what they had to give up to take vacations, would still pursue that good. This is the principle of “utility”, which measures the perceived benefit each consumer receives from the goods he chooses. On an individual basis, this sometimes contradicts the laws of supply and demand. Since, under the law of supply and demand, as prices rise for an elastic good such as cigarettes go up, demand should go down and all smokers should no longer buy cigarettes.  An addicted smoker, however, will sacrifice many things in order to afford cigarettes now matter how high the price.  Someone who can’t live without vacations may end up with no home and just “follow the sun”.

These fundamentals of economics, therefore, can be summed up by these interrelations: the law of supply and demand, as determined by the comparative advantage of different societies and the production possibility frontier, dictates prices, which dictate demand, except as affected by the elasticity of a good and its utility to the consumer.

 

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Understanding Basic Business Accounting

If you ever wondered what the whole idea of business accounting was all about (but were afraid to ask) now is the time to learn.  Most accounting terminology is complicated and scares off those who are not trained in the field.  Acronyms and jargon abound, just like in any field, but the basics are really just logic and common sense. So even if you don’t know your EBIT from your working capital, you can understand the basic concepts of how a company keeps (or is supposed to keep) its books.

Accounting Books

The “books” of a company were, at one time, literally that.  Each company had a book in which it would tally money coming in and money going out.  That is the essential premise of a basic accounting system.  What was left over after the money came in and the expenses went out was the owner’s capital or equity.  He always had a choice of putting that money in his pocket (withdrawing his equity) or leaving it in a bank account or buying more equipment or products for his company (building assets).  If, in any given period, his business expenses exceeded his income, he would have to put more money in to cover the difference (inject capital or equity).

Double Entry Bookkeeping

In order to keep track of things, a company will establish a chart of accounts to put each of the entries into. The chart of accounts will list income items, expense items and asset and liability items.  The way of keeping track of income and expenses is the “double entry” bookkeeping system, which record debits and credits. In this system, each transaction has a balancing transaction. A debit is what you got, and the credit is the source of the item you received.  When you set up your business, you put your personal money in a business bank account. You debit that bank account and credit your owner’s equity account because that bank account now owes you money, the amount you put in it.  If you buy a ream of paper to send out sales letters, you debit your “stationary” expense account and you credit your bank account with the amount of the purchase.   The bank account balance has gone down, so the bank account owes you (in the form of your owner’s equity) less. You own a ream of paper worth that amount of money instead.

When you have a few sales resulting from your fabulous sales letter, you will deposit money and debit the business bank account.  That bank account now owes you more money again. Most items in running a business are “expensed” in this way, but many times an item might be used over and over again, such as a computer or a machine.   The money you spent on the paper is gone once the sales letters have gone out. Those funds are “expensed”.  But the computer that you typed them on stays to do more work.  You need to account for such an item in a different way. That item is “capitalized” and listed in your books as an asset. The bank account that you used to pay for it was credited, and an asset account is debited. This asset will not last forever, so this asset account is reduced a little bit each year to reflect the fact that the computer is getting older and is not worth as much.  Theoretically, after about five years, you will want to buy a new computer, so the cost of this computer should be spread out over five years until it is fully “amortized”.  The other “double entry” side of this is that one fifth of the cost of the computer is expensed each year.  You can then throw out that computer, get a new one and start all over.

Owners Equity

To better understand the workings of an accounting system such as this, it is helpful to pretend that the company goes out of business at the end of each year. Whatever is left at the end goes back to the owner as his equity. Suppose after one year, our fictional sales business owner closed up shop.  His business would be worth $4,100.  His bank account has $12,500 in it. (He put in $10,000, spent $500 on paper for sales letters and $2000 for a computer, and earned $5,000 in sales.)  He still has a computer that is worth $1,600 because it was worth $2,000 and decreased in value by $400 a year. His total assets-short term assets in the bank and long term assets in the computer-are worth $14,100. His only liability against these assets is his own initial investment (if he never borrowed any money).  So, even though the business is worth $14,100, if he kept his double entry books right, the business owes him the owners equity of $10,000 and is therefore worth $4,100.

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Reading an Annual Report

Publicly traded companies are required by law to publish an annual report to their shareholders. Many companies publish quarterly reports as well. Though there is no government mandated format that an annual report should take or the exact information it should contain, custom has developed some standards, and some professional accounting organizations have required compliance with certain formats to be considered “generally accepted”.

Typically, the report will begin with the Chairman’s letter. This should note significant developments over the period being reported and plans and predictions for the next period.  In a large company, the operations of various segments or operating centers will be described and commented upon.

The next, and to some the most important section of an annual report is the financial section. This will contain the profit and loss statement (the P&L, or income statement), the balance sheet and the cash flow statement. The P&L lists all of the summarized income and expenses for the firm, and the net profit or loss resulting from the difference.  The level of detail for the income and expenses differs for each company, making it difficult to determine the factors responsible for the profit or loss. In addition, varying and sometime unorthodox treatment of some types of costs may mask underlying problems the company is experiencing. These are the types of issues that covered up the problems with Worldcom, Adelphia and Parmalat in recent years.

The next section of an annual report is the Balance Sheet, which lists all of the assets and liabilities of a company. The difference between the assets and liabilities of a company is the company’s net worth. This has also become an area of reporting controversy when creative accounting has allowed some companies to capitalize some expenses (in other word, make them long term assets) instead of treating them as current (in other words, putting them on the P&L).  The Balance Sheet has always been described as a “snapshot” of the company; if an acquisition is made on January 1 and the annual report is as of December 31, that asset will not be reflected. Accountants should use footnotes to inform the shareholders of any pending items such as this as well as lawsuits or other items that may have a material effect on operations. Valuable information about the organization’s financial status is often found here even if it is not obvious in other parts of the report. Information on a management reorganization may signal problems in the executive suite, or a bad debt that was written off by the company may only be seen in the notes since it was included in a summary expense line.

The final segment of the report is the auditor’s letter confirming that a Certified Public Accounting firm (CPA) has deemed the information to be accurate and presented under the relevant accounting principals. Any qualifications presented by the auditor should be carefully evaluated.

Remember that the annual report is published by the company itself, and by its Public Relations Department, at that. They are the ones who are paid to make the company look good. So, make sure you get your information about the company through other means, such as the business press or independent analyst’s reports.

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Understanding Investment Management

Investment management firms manage the portfolios of individuals, partnerships, corporations, corporate and public retirement plans, non-profit entities and endowments.

These portfolios can be invested in individual stocks and bonds, mutual funds, outright ownership of property or commodities, foreign exchange and the futures markets. Deciding the mix, scope and concentration of a portfolio under management is one of the most crucial responsibilities of investment management.

In recent years, investment managers have had to face the additional challenges of major losses by investors in a bear market environment, lack of confidence by investors due to mutual fund scandals, and a host of resulting legislation such as the Sarbanes-Oxley Act. This has resulted in a shift in philosophy of the investment management community from edgy and “top gun” management styles to analytical styles emphasizing client involvement and understanding, computation, more sensible risk management, and more humility in seeking investment performance at acceptable risk/reward levels. It is this analysis of investment risks/rewards in a portfolio, that is, measuring the tolerance for risk against the desire for reward of each individual or company that an investment company manages, that determines the composition of that portfolio.

Each individual or company that uses an investment management firm should have a clear concept of its investment philosophy, and must clearly communicate it to the management firm. In general, companies will have clear, written statements of investment policies and guidelines that have been approved by the board of directors.  Individuals tend not to be as formal in their approach, but any reputable investment manager will make sure his individual clients have done an exercise outlining the kinds of risk they are willing to accept for a certain level of reward. It is in these documents that the company or individual will assign a level of “discretion” that the investment manager will have. Levels of discretion may range from full discretion over all purchases and sales in the portfolio, as long as they are within pre-ordained guidelines, to the requirement that every acquisition and divestiture needs direct approval. Within these two extremes, levels may be set according to size of investment or quality of investment.

A critical feature of proper investment management is continual review by the individual or, for a company, by its top management or board. Needs change, investment environments change, the amount under management changes, and therefore concentrations shift. All of these conditions have to be periodically examined, new investment policies have to be developed and the portfolio has to be adjusted to maintain compliance with the new policies.

To these tools (investment guidelines of the company and the underlying philosophy, and understanding the risk mentality and management style of the client), the investment manager will add the technical tools of his trade such as assessing markets, pricing capital assets, fundamental analysis to valuate stocks and bonds, cash flow analysis and various technical analyses to develop a tailored portfolio for each client.

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The Income Statement and Investor Information

If you’re an investor, and you are trying to make a determination about the financial health of a business, you would need to read the Financial Statements in order to correctly ascertain this condition.  Each year, publicly traded companies are required to publish an annual report; in this report, there are at least three financial statements:

An Income Statement, a Statement of Financial position and a Statement of Cash Flows must be included with the report.

What are investors looking for when they review the Annual Report, and examine the Income Statement? 

Net earnings figures in the operating activities information is hard to dispute; either the business was profitable, or it was not.  The Income Statement is intended to help investors accomplish the following objectives:

  •             Evaluate the past performance of the business
  •             Predict future performance of the business
  •             Assess the risk of achieving future cash flows

The Income Statement that is included with an Annual Report will be a compilation of the past year.  The income and expense figures shown are a composite of the immediate previous year; a review of several years worth of these statements will help you to assess the past performance and predict future performance for the business, so long as other important variables haven’t experienced extreme changes.  As noted in earlier articles, there are some items that are non-cash transactions that have an impact on the business operations, but cannot be reliably measured and reported in the Income Statement.  Some examples are goodwill, changes in inventory accounting methods, and equipment values that depend upon judgments and estimates to establish a market value.  These transactions are most often noted in the Statement of Cash Flows.

In assessing the risk of achieving future cash flows, the Income Statement and the Statement of Cash Flows must be reviewed simultaneously for significant changes, and any notations studied that are included and amended to the reports.

The analysis of the Annual report and the financial statements contained therein cannot be accomplished unless you have an education in accounting, finance, or have otherwise managed to educate yourself about the elements of the statements.  However, if you’re an investor, take the reports to your broker.  They are trained to examine and analyze these statements; they can provide you with the analysis and interpretation of information into a format you can understand and act upon.

As you can see, just from this short analogy, the importance of the Annual Report and the financial statements that are a part of the report, are a tremendous opportunity for the investor to examine public financial information and help make educated, sound investing decisions.

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Interview Tips for your First Job Interview

The thoughts of a job interview are enough to turn veteran job hunters to jelly. For a teen or someone similar in age, the thought of interviewing for a job is more frightening than having to tell Dad you lost the car keys—again.

Interviewing for a job doesn’t have to be that scary, though. Some thought and preparation go a long way in relieving your anxiousness over going for a job interview. You’ll still be nervous, everyone is, but using these quick tips will help.

  1. You know about yourself, but finding out as much as possible about a potential employer will help you feel more secure in what you have to offer that employer as an employee. So research the company for as many facts about it as possible.
  2. Ask a friend or parent who has been through a job interview (or several) to be the employer and act out (in this case, acting out is a good thing) an interview session. Have them be a tough interviewer and you’ll be even better prepared.
  3. Be sure you have great directions to the interview site. The last thing you want to have to worry about the day of the interview is how to get there or, worse, to get lost and be late.
  4. Yes, be on time. Being late may not cost you the job, but it will definitely make it harder to get the job. Especially when Jacks and Jane, numbers 1-250, were 30 minutes early!
  5. Take several clean copies of your resume along. Three is a good number of copies to take with you. Even when an employer already has a copy of your resume, you want to be prepared to give him or her a new one, plus ones for anyone the person may report to or share the decision-making process with.
  6. Get plenty of rest the night before. Don’t go into an interview tired and worn out. You want to be fresh and ready to tackle the world! At least that’s the impression you want a potential employer to have of you.
  7. Dress up. This cannot be stressed enough. Even if the company where you’ll be interviewing has a relaxed dress code, you want to look professional when you interview and want to dress at least one level above the company’s dress code (if you don’t know about a company’s dress code, research or go all out in dressing up). No jeans, shirt tails hanging out, flip-flops or tongue rings, nose rings, etc. And if you have tattoos, it’s best that they’re covered up when you go for the interview.
  8. Turn your cell phone off! Having your cell phone ring during a job interview is even worse than having it go off during class or church services. It’s a big no-no and will make you seem thoughtless in the “ears” of a potential employer.

Finally, expect to be nervous. Rather than fight your nervousness, use it to energize yourself. Remind yourself of all the things you do, and have done, well. Believe in yourself and the interviewer is sure to believe in you too!

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How to Properly Write a Check: Basic Step by Step Instructions

A check is a written order to pay someone a specific amount of money on a certain date. Here are the basic steps of how to properly write out a personal check with dollars and cents.

 

STEP 1


DATE
Today’s date. Include the month, day, and year.

 

STEP 2


PAY TO
The name of the recipient: the individual or company that you are writing the check to.

 

STEP 3


$ AMOUNT
The amount of the check in numerals, with cents after the decimal.  Begin as close as possible to the $.  If cents are zero, be sure to write .00

 

STEP 4


AMOUNT
The amount of the check in long-form in words, the word ‘and’, and then cents, which is written as a fraction as cents/100.  Start at the left edge, and draw a line through the remaining space.

 

STEP 5


MEMO/FOR
Optional field to describe the reason for the check, or an account number.

 

STEP 6


SIGNATURE
Your signature.  Use the same signature on all your bank documents.

 

 

More Check Writing Lessons

More Checking Account and Check Writing Lessons.

 

 

 

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Financial Audits – Basic Tests

Financial audits are intended to provide some assurance to the public that a company’s financial statements are presented fairly and accurately, in accordance with the established or stated criteria.  The public may include the shareholders of the company, debtors such as bondholders, banks or other financial institutions and some government entities. In general, a financial audit will seek to confirm that the company used “generally accepted accounting principles” (GAAP) in the scope of the audit (all material information has been revealed), how the finances of the company have been managed and what are the kind and strength of the company’s internal financial control structures for reporting and protecting assets.  A proper audit will seek to confirm that all the financial data of the company has been reliably obtained, maintained and disclosed in the reports, and that the resources of the firm are properly protected against losses arising from fraud, theft, error or mismanagement.

There are three authoritative bodies for establishing accounting principles and financial reporting standards: the Federal Accounting Standards Advisory Board for the federal government, the Governmental Accounting Standards Board for state and local governments, and the Financial Accounting Standards Board (FASB) for nongovernmental entities.  GAAP has been developed by the American Institute of Certified Public Accountants’ (AICPA) to assure some uniformity in financial procedures; the audit process has a special section that applies to audit field work and reporting.

There are standard tests that are typically used in every audit. They will usually include:

Cash
Bank reconciliations are checked and confirmed, the reported balances in each account are confirmed with the banks, interest rates are confirmed, gains and losses from marketable securities are verified, and petty cash is inventoried.

Equity
The documents regarding equity are checked and any variation in equity or retained earnings is properly explained.

Receivables
The outstanding debt with large debtors is confirmed to be in accordance with the books of the company and a review of the aged receivables account and bad debt receivable item is conducted to make sure it is realistic.

Payables
The outstanding credit with large creditors is confirmed to be in accordance with the books of the company, and notes and terms issued are reviewed.

Debts
Outstanding debt is reviewed for adherence to terms, payment track records.

Overheads
Operating costs are analyzed and it is made sure they are properly reflected.

Fixed Assets
An examination of the schedule of capital additions and improvements is conducted to make sure they are properly reflected.

Taxes
Tax returns are reviewed and verified.

Inter-company Operations
The treatment of any transactions between subsidiaries, affiliates, etc. are examined for proper reporting. Any consolidations are reviewed for accuracy and relevancy.

Payroll
Payroll records are examined, including samplings of time sheets, payroll reports, payroll checks issued, etc.

Balance Sheet Review and Financial Results
The presentation of the profit and loss statement, balance sheet and cash flow statement are reviewed for compliance with GAAP and the financial results are deemed to be properly presented.

The financial audit is considered one of, if not THE most important tool in judging a company’s worth, and therefore is highly valued to all parties concerned with investing in, lending to or even just transacting business with the company.  The public relies on the integrity of audit, and needs to consider that one of the main problems in the audit process is the conflict between the objectivity an auditor should exhibit and the business relationship between the audit firm and the company being audited. On one hand, the audit firm should be ruthless in thoroughly checking the books, but on the other hand, it wants to keep its customer happy since it is a chief source of revenue.

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