Basic concepts for MBA

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Basic Study MaterialFor First Year Students


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Basic Study MaterialPUMBA

Instructions To Students

The content of this study material has been designed while keeping the

first year curriculum in mind. Important basic concepts relating to

Finance, Marketing, HR, Operations and Statistics have been introduced

here.

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Introduction to Financial Markets

Financial markets can be classified as follows:

By Nature of Claims

Debt Market

Equity Market

By Maturity of Claims

Money market - short term claims

Capital Market - long term claims

By Seasoning of Claims

Primary market - New claims

Secondary market - Outstanding claims

By Timing of Delivery

Cash / Spot Market

Forward / Futures Market

By Organization Structure

Exchange Traded

Over the counter

Financial Markets

Capital Markets Money Markets

Primary Market Secondary Market Bond Markets

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Financial markets

Organizations that facilitate the trade in financial products i.e. Stock exchanges facilitate

the trade in stocks, bonds and warrants.

The coming together of buyers and sellers to trade financial products i.e. stocks and

shares are traded between buyers and sellers in a number of ways including: the use of

stock exchanges; directly between buyers and sellers etc.

A good example of a financial market is a stock exchange. A company can raise

money by selling shares to investors and its existing shares can be bought or

sold.

Capital Markets

The capital market is the market for securities, where companies and governments can

raise long-term funds. The capital market includes the stock market and the bond

market. It consists of the primary market, where new issues are distributed to investors,

and the secondary market, where existing securities are traded.

Primary Market

The Primary market is that part of the capital markets that deals with the issuance of

new securities. Companies, governments or public sector institutions can obtain funding

through the sale of a new stock or bond issue. In the case of a new stock issue, this sale

is an Initial Public Offering (IPO).

Initial Public Offering (IPO)

IPO is an abbreviation for "Initial Public Offering" which signifies a company's first sale of

shares to the public. When a company declares an IPO, it is on its way to becoming a

"Public" company, hence the term "going public." With an IPO, a company raises money

from the public for the first time through sale of Shares and Debentures.

Important Points to consider in IPO:

1) At an IPO, a company can sell the shares at Par (at Nominal or Face Value) or at

a Premium (above Nominal or Face value) depending on how long the company has

been in existence, its profitability, current Assets and many other factors.

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2) If we apply for an IPO and are allocated some New Issues, we are said to be

purchasing from the Primary Market. However, if we purchase shares or debentures

already listed and trading at the Stock Exchange through Brokers, we are said to bepurchasing from the Secondary Market.

3) IPOs can be a risky investment. For the individual investor, it is tough to predict

what the stock or shares will do on its initial day of trading and in the near future

since there is often little historical data with which to analyze the company. Also,

most IPOs are of companies going through a transitory growth period, and they are

therefore subject to additional uncertainty regarding their future value.

Secondary Market

The secondary market is the financial market for trading of securities that have

already been issued in an initial private or public offering. Alternatively, secondary

market can refer to the market for any kind of used goods. The market that exists in a

new security just after the new issue is often referred to as the aftermarket. Once a

newly issued stock is listed on a stock exchange, investors and speculators can easily

trade on the exchange, as market makers provide bids and offers in the new stock.

Important points to note:

1) In the secondary market, securities are sold by and transferred from one

investor or speculator to another. It is therefore important that the secondary

market be highly liquid. (Originally, the only way to create this liquidity was for

investors and speculators to meet at a fixed place regularly; this is how stock

exchanges originated).

2) Secondary market is vital to an efficient and modern capital market. With

secondary markets, investors know that they can recoup some of their investment

quickly, if their own circumstances change because of high liquidity that it provides.

Bond Markets

The Bond market (also known as the debt, credit, or fixed income market) is a

financial market where participants buy and sell debtsecurities, usually in the form of

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bonds. Bond markets in most countries remain decentralized and lack common

exchanges like stock, future and commodity markets. This has occurred, in part,

because no two bond issues are exactly alike, and the number of different securitiesoutstanding is far larger.

Bond Market Participants:

Bond market participants are similar to participants in most financial markets and are

essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often

both. It includes:

Institutional investors;

Governments;

Traders; and

Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many

smaller issues, the majority of outstanding bonds are held by institutions like pension

funds, banks and mutual funds. In the United States, approximately 10% of the market

is currently held by private individuals

Terms used in the Bond or Debenture market

Coupon: It is the annual interest that is paid on the bond.

Expiry Date: It is the date on which the bond matures and the investor gets the

principal amount back.

Face Value: It is the actual worth of a bond.

Current Yield: The current yield considers the current market price of the bond,

which may be different from the par value and gives you a different return on that

basis.

Examples: For example, if you bought a $1,000 par value bond with an annual

coupon rate of 6% on the open market for $800, your yield would be 7.5% because

you would still be earning the $60, but on $800 instead of $1,000.

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Money Markets

In finance, the money market is the global financial market for short-term borrowing

and lending. It provides short-term liquid funding for the global financial system. The

money market is where short-term obligations such as Treasury bills, commercial paper

and bankers' acceptances are bought and sold.

Important Points to note

1) The money market consists of financial institutions and dealers in money or credit

who wish to either borrow or lend. Participants borrow and lend for short periods of

time, typically up to thirteen months.

2) Money market trades in short term financial instruments commonly called "paper".

This contrasts with the capital market for longer-term funding, which is supplied by

bonds and equity.

3) The core of the money market consists of banks borrowing and lending to each other

Link between Money Market and Debt Market

The money market is a market dealing in short-term debt instruments (up to one year)

while the debt market is a market for long-term debt instruments (more than one year).

The money market supports the long-term debt market by increasing the liquidity of

securities. A developed money market is a prerequisite for the development of a debt

market.

Important Terms and Definitions related to Financial Markets

1. Shares/Stocks

A company ownership is divided into small and equal portions, each of which is called

a Share (also referred to as a Stock). Each company will have different number of

shares at different prices (based on a number of factors) and these Shares or Stocks

are what we (as Individual Share Market investors) purchase and sell to make our

profit. We can become a shareholder in a company by purchasing shares of that

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company and we can transfer our ownership rights by selling our shares to others.

Since the company is an independent legal entity, it is not affected by any changes

in its owners.

2. Equity Shares and Preference Shares

The shares that we described above can also be referred to as Equity Shares (hence

the term Equity Market). It just specifies that the shares dont carry a fixed rate of

dividend. The company has the freedom to decide on the rate of dividend from time

to time to provide returns to it shareholders.

Preference Shares or Preferential Shares give a fixed rate of dividend. In case

the company runs in loss for a year and is not able to pay dividends even to the

Preference Shareholders, then the unpaid dividends can be carried over till the

company is able to clear all arrears on Dividend payment. Such preference shares

would be called Cumulative Preference Shares. A company is not allowed (in most

countries) to pay any dividends to its Equity Shareholders till all pending dividend

has been paid to the Preference Shareholders.

3. The Stock Exchange

The Stock Exchange (also called the Stock Market) is the marketplace where Sharesand Securities are traded. Securities is the broad term covering Shares/Stock and

Debentures/Bonds. So, a Stock Exchange would facilitate purchase and sale of all of

these. Unlike other markets, one is not permitted to buy and sell shares directly in

the Stock Market one has to do so through a Stockbroker. The Stockbroker is a

licensed member of the Stock Exchange and is authorized to buy and sell shares on

our behalf on a commission basis. This commission is called Brokerage.

Companies have to list their Securities with one or more Stock Exchanges for them

to be eligible for trading. At the time of writing, there are 23 Stock Exchanges in the

country. However the most popular ones are both in Mumbai, The Bombay Stock

Exchange (BSE) and the National Stock Exchange (NSE).

4. Face Value and Market Value

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The Face Value of a share (also called the Nominal Value or Par Value) is the term

used to describe the value of the share when the company was formed. These shares

are taken against the initial capital that goes into the company to make it aprofitable business. The price at which the Share is trading currently is called the

Market Value of the Share. Another term used to describe Market Value is CMP

(Current Market Price).

5. Dividend

When companies pay part of their profits to the Shareholders, this amount paid out

is called Dividend. This amount is decided by the Companys Board based on

performance and future plans of the company and the amount paid is proportional to

the no of shares one owns. These can be paid on a Quarterly, Half Yearly or

Annual Basis. Also, there is no compulsion to pay Dividends even if the Company is

making Profits if the Board decides that using the money for some other purpose

would be more beneficial in the long run. This amount can be paid in the form of

Money, Shares and in some rare cases in the form of Company Products or even

Property.

Dividend is calculated on the Face Value or Nominal Value. Which means if the

Company declares 30% dividend, and the Face value of the shares is Rs. 10, thenthe company will be paying all Shareholders Rs. 3/- per share.

6. Market Regulatory Body - SEBI (Securities and Exchange Board of India)

Securities & Exchange Board of India (SEBI) formed under the SEBI Act, 1992 - is

the body that is responsible for protecting the interests of investors in securities,

promoting the development of, and regulating, the securities market. The SEBI Act

came into force on 30th January, 1992 and with its establishment, all public issues

are governed by the rules & regulations issued by SEBI.

SEBI was formed to promote fair dealing in issue of securities and to ensure that the

capital markets function efficiently, transparently and economically in the better

interests of both the issuers and the investors. The promoters of a company should

be able to raise funds at a relatively low cost. At the same time, investors must be

protected from unethical practices and their rights must be safeguarded so that there

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is a steady flow of savings into the market. There must be proper regulation and

code of conduct and fair practice by intermediaries to make them competitive and

professional.

7. SENSEX

The Bombay Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index

that subsequently became the barometer of the Indian stock market. This was called

the SENSEX. The SENSEX is not only scientifically designed but also based on

globally accepted construction and review methodology. First compiled in 1986,

SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid

and representative companies.

8. NIFTY

The S&P CNX Nifty (called NIFTY for Short) is the Index used to represent the overall

performance of the stocks trading at NSE. The NIFTY was designed based upon solid

economic research. A trillion calculations were expended to evolve the rules for the

Nifty index. The results of this effort were remarkably simple: (a) the correct size to

use is 50 (b) stocks considered for the S&P CNX Nifty must be liquid by the ` impact

cost' criterion; (c) the largest 50 stocks that meet the criterion go into the index.

9. ARBITRAGE

The simultaneous purchase and sale of a financial asset (commodity, currency, or bill

of exchange etc.) in two different markets, in order to profit from a price

discrepancy. True arbitrage is risk-free. The arbitrage process plays a central role in

ensuring that prices are consistent in different markets.

10. MARKET CAPITALIZATION

The value ascribed to a listed company by the market place. This can be calculated

by multiplying the number of shares in issue by their current market price.

For e.g. If Market price of a share X is Rs. 1,000 and number of outstanding shares

is 200,000 then the market capitalization of share X would be 200,000*1,000.

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Reliance industries, ONGC, NTPC and Bharti are some of the companies with

substantial market capitalization in the SENSEX.

11. OVER-THE-COUNTER (OTC)

This refers to any transaction which is made outside of a regulated and organized

exchange. This means, inter alia, that due performance is not guaranteed beyond

the means of the parties to the transaction, and that the transaction may be difficult

to renegotiate in a secondary market. OTC deals are usually made over the

telephone rather than over a counter.

12. BETA

This is the second letter of the Greek alphabet which is used by Wall Street to

describe the volatility of a stock relative to a stock market index. Beta is regarded by

some as a measure of stock market risk. Higher the beta, higher the stock volatility.

13. BEAR Market

It describes a situation where the majority of shares are dropping in price and the

market is generally declining.

14.BULL Market

It describes a situation where the majority of shares are rising in price and the

market is generally rising.

15.Corporatization of stock exchanges

Corporatisation is the process of converting the organizational structure of the stock

exchange from a non-corporate structure to a corporate structure. Traditionally,

some of the stock exchanges in India were established as Association of persons,

e.g. the Stock Exchange, Mumbai (BSE), Ahmedabad Stock Exchange (ASE) and

Madhya Pradesh Stock Exchange (MPSE). Corporatisation is the process of

converting them into incorporated Companies.

16.Redemption Date

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The date on which redeemable preference shares, debentures or loans will be

redeemed by the company. These are really forms of long-term indebtedness, which

clearly have to be paid back on pre-determined dates.

17.Demutualization of stock exchanges

Demutualization refers to the transition process of an exchange from a mutually-

owned association to a company owned by shareholders. In other words,

transforming the legal structure of an exchange from a mutual form to a business

corporation form is referred to as demutualization. This means that after

demutualization, the ownership, the management and the trading rights at the

exchange are segregated from one another.

18.Delisting of securities

The term "delisting" of securities means permanent removal of securities of a listed

company from a stock exchange. As a consequence of delisting, the securities of that

company would no longer be traded at that stock exchange.

19. YIELD-TO-MATURITY (YTM)

The yield that an investor would get on an investment such as a bond, if the investor

kept the investment to maturity.

20. YIELD CURVE

A yield curve is a plot of yields-to-maturity against the term to redemption. The

normal (positively sloped) yield curve occurs when long-term securities give a higher

return than short-term securities. The inverse yield curve occurs when near-dated

stocks have a higher YTM than far-dated stocks

Basic Financial Instruments

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Mutual Fund

A mutual fund is a pool of money from numerous investors who wish to save or make

money just like you. Investing in a mutual fund can be a lot easier than buying andselling individual stocks and bonds on your own. Investors can sell their shares when

they want. You can make money from a mutual fund in three ways:

1) Income is earned from dividends on stocks and interest on bonds. A fund pays out

nearly all of the income it receives over the year to fund owners in the form of a

distribution.

2) If the fund sells securities that have increased in price, the fund has a capital gain.

Most funds also pass on these gains to investors in a distribution.

3) If fund holdings increase in price but are not sold by the fund manager, the fund's

shares increase in price. You can then sell your mutual fund shares for a profit.

Professional Management: Each fund's investments are chosen and monitored by

qualified professionals who use this money to create a portfolio. That portfolio could

consist of stocks, bonds, money market instruments or a combination of those.

Fund Ownership: As an investor, you own shares of the mutual fund, not the individual

securities. Mutual funds permit you to invest small amounts of money, however much

you would like, but even so, you can benefit from being involved in a large pool of cash

invested by other people. All shareholders share in the funds gains and losses on an

equal basis, proportionately to the amount they've invested.

Mutual Funds are Diversified: By investing in mutual funds, you could diversify your

portfolio across a large number of securities so as to minimize risk. By spreading your

money over numerous securities, which is what a mutual fund does, you need not worry

about the fluctuation of the individual securities in the fund's portfolio.

Mutual Fund Objectives: There are many different types of mutual funds, each with

its own set of goals. The investment objective is the goal that the fund manager sets for

the mutual fund when deciding which stocks and bonds should be in the fund's portfolio.

For example, an objective of a growth stock fund might be: This fund invests primarily in

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the equity markets with the objective of providing long-term capital appreciation

towards meeting your long-term financial needs such as retirement or a childs

education.

Certificate of Deposit (CD)

A certificate of deposit (CD) is a marketable document of title to a time deposit for a

specified period. CD is a receipt given to the depositor by a bank or any other institution

entitled to issue CD for funds deposited with it. CDs and conventional time deposits

differ in a few ways. CDs are negotiable while time deposits are not. CDs require stamp

duties while time deposits dont, etc.

Commercial PapersCommercial Papers (CPs) are debt instruments issued by Corporates for raising short-

term resources from the money market. These are unsecured debts of Corporates. They

are issued in the form of promissory notes redeemable at par to the holder at maturity.

Only Corporates who get an investment grade rating can issue CPs. as per RBI rules.

Though CP is issued by Corporates, they could be good investments if proper caution is

exercised.

Corporate bonds

A Corporate Bond is a bond issued by a corporation generally with a maturity date falling

at least a year after their issue date. Corporate bonds are different from commercial

papers in that they are issued for a longer duration.

Convertible Bonds

A convertible bond is a bond that gives the holder the right to "convert" or exchange the

par amount of the bond for common shares of the issuer at some fixed ratio during a

particular period. As bonds, they have some characteristics of fixed income securities.

Their conversion feature also gives them features of equity securities.

Government Securities (Gilt Edged Securities)

Government securities refer to the marketable debt instruments issued by the

government Central and States. A government security is a claim on the government.

It is a totally secure financial instrument ensuring safety of both capital and income.

That is why it is called gilt-edged security. Central Government securities are the safety

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amongst all securities. They may be dated Securities or Treasury bills. State

Governments in India also issue their securities.

Treasury bills

Treasury Bills are money market instruments to finance the short term requirements of

the Government of India. These are discounted securities and thus are issued at a

discount to face value. The return to the investor is the difference between the maturity

value and issue price.

For e.g., if face value is 1,000 and the bill is issued at 960, then 40 is the return that the

investor gets. There are different types of Treasury bills based on the maturity period

and utility of the issuance like, ad-hoc Treasury bills, 3 months, 12months Treasury bills

etc. In India, at present, the Treasury Bills are the 91-days and 364-days Treasury bills.

Derivatives

The emergence of markets for derivative products can be traced back to the willingness

of risk-averse economic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. Derivative is a product whose value is derived from the

value of one or more basic variables, called bases. Bases can be equity, forex,

commodity, index or a reference rate.

Difference in Shares and Derivatives

The difference is that while shares are assets, derivatives are usually contracts (the

major exception to this are warrants and convertible bonds, which are similar to shares

in that they are assets). We can define financial assets (e.g. shares, bonds) as: claims

on another person or corporation; they will usually be fairly standardized and governed

by the property or securities laws in an appropriate country.

On the other hand, a contract is merely: an agreement between two parties, where the

contract details may not be standardized.

Due to their great flexibility, many different types of investors use derivatives. A good

toolbox of derivatives allows the modern investor the full range of investment strategy:

speculation, hedging, arbitrage and all combinations thereof.

Important derivative products

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Forwards:

A contract that obligates one counter party to buy and the other to sell a specific

underlying asset at a specific price, amount and date in the future is known as a

forward contract. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a certain

specified price. The other party assumes a short position and agrees to sell the asset

on the same date for the same price.

Futures:

Future contracts are special type of forward contracts in the sense that the former

are standardized exchange-traded contracts. A future contract is one in which one

party agrees to buy from/ sell to the other party a specified asset at price agreed at

the time of contract and payable on future date. The agreed price is known as strike

price. The Futures are usually performed by payment of difference between strike

price and market price on fixed future date and not by the physical delivery and

payment in full on that date.

Options:

An option is a contract that gives the buyer the right, but not the obligation, to buy

or sell an underlying asset at a specific price on or before a certain date.

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific

period of time. Calls are similar to having a long position on a stock. Buyers of calls

hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific

period of time. Puts are very similar to having a short position on a stock. Buyers of

puts hope that the price of the stock will fall before the option expires.

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Introduction to Banking

Origin of Banking

The term Bank can be traced to Italian and French languages:

- In French, Banque means - chest (for safekeeping).

- In Italian, Banca means bench (for conducting transactions).

Similarly, the term bankrupt has come from the Italian phrase, banca rotta, which

referred to a bank that went out of business as its bench was physically broke. This

referred to the interesting practice of Italian money lenders who transacted in big rooms

or open areas, where every lender worked out of a table or bench.

The first bank to provide basic banking functions emerged in Spain in 1401. It

was called the Bank of Barcelona. Some of the other banks that served as

foundations of modern banking were:

Bank of Venice (1587)

Bank of Amsterdam (1609)

Bank of Hamburg (1619)

Other key developments in Europe were:

Bank of France set up by Napoleon in 1800.

Stock-issuing banks set up in the 19th century in Germany.

London goldsmiths were the originators of banking in the British isles.

How Does Bank Gain Revenue?

A bank earns profits from the interest spread.

Interest spread = (Interest charged on loans) (Interest offered on deposits)

In addition, banks perform several services for which they charge transaction fees.

Banks have historically followed lending long and borrowing short strategy.

They tend to borrow for short terms and lend for long terms. For example, most

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mortgages have a term of 15 to 20 years, but some of the funding comes from term

deposits with a term of less than a year. This creates problems, because banks are

lending money that they do not own or control. If the bank only controls the moneyfor 6 months lending it for a twenty year term is odd. Hence, bank management has

to ensure that it has adequate cash reserves.

What is NPA?

NPA stands for Non-Performing Assets. Alternatively, they are also termed as Non-

Performing Loans (NPL). NPA refers to those loans that have stopped making any

returns, i.e., defaulted loans. Formally, these are defined as loans on which debtors

have failed to make contractual payments for a predetermined time.

Different Types of Banks

Central Bank

A Central Bank, a bank regulator, generally controls monetary policy and acts as

a lender of last resort. It is the banker of banks. Some of the central banks are

the Reserve Bank of India, the US Federal Reserve Bank and the Bank of

England.

Investment Banks

An Investment Bank refers to an individual or institution which acts as an

underwriter or agent for corporations and municipalities issuing securities, but

which does not accept deposits or make loans. Most also maintain broker/dealer

operations, maintain markets for previously issued securities, and offer advisory

services to investors.

Investment banks are essentially financial intermediaries, who primarily help

businesses and governments with raising capital, corporate mergers and

acquisitions, and securities trade. In USA such banks are the most important

participants in the direct market by bringing financial claims for sale. They help

interested parties in raising capital, whether debt or equity in the primary market

to finance capital expenditure.

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Merchant Banks

These often refer to banks involved in trade financing. In recent times though,

the definition also covers banks offering capital by way of shares not funds. They

do not invest in start-ups unlike venture capital firms.

Private and Offshore Banks

Private Banks are involved in asset management of wealthy clients (called High

Net worth clients). Offshore Banks refer to banks in low taxation/supervisory

locations such as Switzerland. A majority of these banks are private banks.

Union Bank of Switzerland is one of the largest private banks. Switzerland is the

hub for global private banking activities.

Swiss banks are legendary for their discreetness. They are prohibited by Swiss

law from divulging their client details to any third party including legal, national

or law enforcement agencies. The banking act has a special section introduced in

1934, in order to protect accounts of Germans, especially German Jews, from

Nazi confiscation. This act makes such confidentiality breaches criminal offense.

Savings Bank

Savings Bank is a traditional bank that accepts deposits. However, now its

functionalities have widened. In contrast, Postal Savings Bank refers to savingsbanking functions related with national postal systems.

Commercial Bank

This is a normal bank as opposed to an investment bank. However, now its

commonplace to give this name to a bank or a bank division that transacts with

corporations.

Universal Bank

This refers to a financial services organization offering a host of banking andnon-banking financial services. Most of the banks are involved in several

activities, e.g. Citigroup (now Citi). The trend is towards universal banking.

Where banks commercial or retail cannot diversify on their own, consolidation

is occurring, mostly through mergers or acquisitions.

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Virtual Bank

This is a new category of banks; they are completely online and hence are

termed Virtual Banks. E.g. Virtual Bank, Egg Bank.

Types of Deposits

Depending on the region and supervisory rules, there are several types of deposits.

However, the fundamental types of deposits are given below:

Demand Deposits Savings and Current

Time/Term deposits

Flexi deposits

Banks offer a number of deposits, which are nothing but combinations of the above

basic types of accounts. E.g. ICICI Banks Money Multiplier Account combines the

features of a fixed deposit and a savings account.

Demand Deposit

A demand deposit is one where the deposit amount needs to be paid to the

depositors on demand. This type of deposit account is also called operating

account. The types of demand deposits are:

Savings Account

Current Account

A demand deposit is also known by the following names, based on the country:

checking account (United States banks)

current account (United Kingdom banks)

share draft account (United States credit unions)

savings account (Australian banks)

cheque account (New Zealand banks)

o Savings Account

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Savings Deposit is a form of demand deposit, which is subject to restrictions

as to the number and amount of withdrawals allowed by the bank during a

given period.o Current Account

A current account is a running and active account opened by business

person / companies / partnership firms. Banks normally do not pay interest

for this account. This is a kind of demand deposit where withdrawals are

permitted any number of times subject to the account balance or up to a

specified amount. Generally, Current Account is meant for businesses or

certain high net-worth individuals characterized by high transaction volume.

Term Deposit

A term deposit, also called Time Deposit, is one which is invested for a fixed

term for a fixed rate of interest (applies for the duration of the term). When the

term is over it can be withdrawn or it can be renewed for another term. The

longer the term, the better the yield (returns) on the money. It includes deposits

such as Recurring, Cumulative, Annuity, Reinvestment deposits and Cash

Certificates, among others.

Notice Deposit

Notice Deposit is a interest-bearing term deposit for specific period, but

withdrawal is possible on giving at least one complete banking days notice. This

type of a deposit earns decent returns with reasonable liquidity.

Recurring Deposit

Recurring deposit is a kind of term/time deposit where cash is deposited into this

account every month for a specific period. Alternatively, the bank is authorized

to take money from savings account. At the end of the period, customer would

get the money deposited with the interest. The interest rate paid by the bank in

recurring deposit is usually higher than the saving account and almost on par

with the fixed deposit.

Important Functions of a Central Bank

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Following are the main functions of any Central Bank. The Central Bank

Acts as a Currency Authority.

Functions as a Banker to the Government.

Is a Banker of the Banks

Issues and maintains Public Debt.

Is involved in monetary regulation by declaring monetary policy.

Regulates and supervises commercial Banks and Non-Banking Financial

Institutions.

Manages and controls exchange management.

Is involved in developing and maintaining Payment Systems.

Plays developmental role by offering industrial, export and rural credit.

Plays a proactive role in market development.

Principal Functions of Investment Banks

Global investment banks typically have several business units, each looking after

one of the functions of investment banks.

For example:

Corporate Finance, concerned with advising on the finances of corporations,

including mergers, acquisitions and divestitures;

Research, concerned with investigating, valuing, and making

recommendations to clients - both individual investors and larger entities such

as hedge funds and mutual funds regarding shares and corporate and

government bonds.

Sales and Trading, concerned with buying and selling shares both on behalf of

the bank's clients and also for the bank itself.

In short the functions of Investment banks include:

1. Raising Capital

Corporate Finance is a traditional aspect of Investment banks, which involves

helping customers raise funds in the Capital Market and advising on mergers and

acquisitions. Generally the highest profit margins come from advising on mergers

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and acquisitions. Investment Bankers have had a palpable effect on the history

of global business, as they often proactively meet with executives to encourage

deals or expansion.

2. Brokerage Services

Brokerage Services, typically involves trading and order executions on behalf of

the investors. This in turn also provides liquidity to the market. These

brokerages assist in the purchase and sale of stocks, bonds, and mutual funds.

3. Proprietary trading

Under Investment banking proprietary trading is what is generally used to

describe a situation when a bank trades in stocks, bonds, options, commodities,

or other items with its own money as opposed to its customers money, with a

view to make a profit for itself. Though Investment Banks are usually defined as

businesses, which assist other business in raising money in the capital markets

(by selling stocks or bonds); they are not shy of making profit for itself by

engaging in trading activities.

4. Research Activities

Research, is usually referred to as a division which reviews companies and writes

reports about their prospects, often with "buy" or "sell" ratings. Although in

theory this activity would make the most sense at a stock brokerage where the

advice could be given to the brokerage's customers, research has historically

been performed by Investment Banks (JM Morgan Stanley, Goldman Sachs etc).

The primary reason for this is because the Investment Bank must take

responsibility for the quality of the company that they are underwriting Vis a Vis

the prices involved to the investor.

5. Sales and Trading

Often referred to as the most profitable area of an investment bank, it is usually

responsible for a much larger amount of revenue than the other divisions. In the

process of market making, investment banks will buy and sell stocks and bonds

with the goal of making an incremental amount of money on each trade. Sales

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are the term for the investment banks sales force, whose primary job is to call

on institutional investors to buy the stocks and bonds, underwritten by the firm.

Another activity of the sales force is to call institutional investors to sell stocks,bonds, commodities, or other things the firm might have on its books.

Risk and Risk Management

Risk is defined as the volatility of a corporations market value. It is also defined as

the chance of something happening that will have an impact on objectives. It is

measured in terms of consequences and likelihood.

Risk Management is defined as the systematic application of management policies,

practices, and procedures to the task of identifying, analyzing, assessing, treating

and monitoring risk. The goal of the entire exercise is to ensure the following:

There is a clear understanding of risks within the bank.

Banks risk exposure is within the pre-determined levels.

Risk decisions comply with the banks business objectives.

Adequate capital is available as a buffer for risks.

As a financial intermediary, a bank inherently accepts and manages risk. In essence,

Risk Management is not about eliminating risk, but about optimizing the risk-return

trade-off.

Various Types of Risks Faced by a Bank

1. Liquidity Risk: Also known as funding risk. This is the risk that a firm cannot

obtain the funds necessary to meet its financial obligations, for example

short-term loan commitments.

2. Credit risk: The potential financial loss resulting from the failure of

customers to honor fully the terms of a loan or contract. Increasingly, this

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definition is being expanded to include the risk of loss in portfolio value as a

result of migration from a higher risk grade to a lower one.

3. Market risk: The risk to earnings arising from changes in interest rates or

exchange rates, or from fluctuations in bond, equity or commodity prices.

Banks are subject to market risk in both the management of their balance

sheets and in their trading operations.

4. Interest rate risk: Exposure to loss due to an absolute or relative change in

interest rates.

5. Operational risk: The potential financial loss as a result of a breakdown in

day-to-day operational processes. Operational risk can arise from failure to

comply with policies, laws and regulations, from fraud or forgery, or from a

breakdown in the availability or integrity of services, systems or information.

Islamic Banking

Islamic banking refers to a system of banking or banking activity, which is consistent

with Islamic law (Sharia, also know as Fiqh-al Muamalat) principles and guided by

Islamic economics. In particular, Islamic law prohibits the collection and payment of

interest, also commonly called riba in Islamic discourse.

Generally, Islamic law prohibits interest and trading in financial risk (which is seen as a

form of gambling). In addition, Islamic law prohibits investing in businesses that are

considered haram (such as businesses that sell alcohol or pork, or businesses that

produce un-Islamic media). While Islamic law prohibits the collection of interest, it does

allow a seller to resell an item at a higher price than it was bought for, as long as there

are clearly two transactions.

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Important Terms To Know

FDI

FDI is generally defined as a form of long-term international capital movement, made forthe purpose of productive activity and accompanied by the intention of managerial

control or participation in the management of a foreign firm. It seeks management

control and is motivated by profit.

Foreign Direct Investment (FDI) is the outcome of the mutual interests of

multinational firms and host countries. The essence of FDI is the transmission to the

host country of a package of capital, managerial, skill and technical knowledge. The FDI

relationship consists of a parent enterprise and a foreign affiliate which together form a

Multinational corporation (MNC). In order to qualify as FDI the investment must afford

the parent enterprise controlover its foreign affiliate. A recent United Nations report has

revealed that FDI flows are less volatile.

FII

Foreign Institutional Investment / Foreign Portfolio Investments are liquid in nature and

are motivated by international portfolio diversification benefits for individual and

institutional investors in industrial countries. They are usually undertaken by institutional

investors like pension funds and mutual funds. Such flows are, therefore, largely

determined by the performance of the stock markets of the host countries relative to

world markets. With the opening of stock markets in various emerging economies to

foreign investors, investors in industrial countries have increasingly sought to realize the

potential for portfolio diversification that these markets present.

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Difference between FDI and FII

FDI- Foreign Direct Investment refers to international investment in which the

investor obtains a lasting interest in an enterprise in another country.

Most concretely, it may take the form of buying or constructing a factory in a foreign

country or adding improvements to such a facility, in the form of property, plants, or

equipment.

On the other hand, FPI (Foreign Portfolio Investment) represents passive holdings

of securities such as foreign stocks, bonds, or other financial assets, none of which

entails active management or control of the securities' issuer by the investor.

Unlike FDI, it is very easy to sell off the securities and pull out the foreign portfolio

investment. Hence, FPI can be much more volatile than FDI. For a country on the rise,

FPI can bring about rapid development, helping an emerging economy move quickly to

take advantage of economic opportunity, creating many new jobs and significant wealth.

However, when a country's economic situation takes a downturn, sometimes just by

failing to meet the expectations of international investors, the large flow of money into a

country can turn into a stampede away from it.

GDP (Gross Domestic Product):-

The gross domestic product (GDP) or gross domestic income (GDI) is one of the

measures of national income and output for a given country's economy. GDP is defined

as the total market value of all final goods and services produced within the country in a

given period of time (usually a calendar year). It is also considered the sum of value

added at every stage of production (the intermediate stages) of all final goods and

services produced within a country in a given period of time, and it is given a money

value.

The components of GDP: GDP = C + I + G + (X-M)

C is private Consumption in the economy. This includes most personal expenditures of

households such as food, rent, and medical expenses and so on but does not include

new housing.

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I is defined as Investments by business or households in capital. Examples of

investment by a business include construction of a new mine, purchase of software, or

purchase of machinery and equipment for a factory. Spending by households on newhouses is also included in Investment. In contrast to its colloquial meaning, 'Investment'

in GDP does not mean purchases of financial products. Buying financial products is

classed as 'saving', as opposed to investment.

G is the sum ofGovernment expenditures on final goods and services. It includes

salaries of public servants, purchase of weapons for the military, and any investment

expenditure by a government. It does not include any transfer payments, such as social

security or unemployment benefits.

X is gross exports. GDP captures the amount a country produces, including goods and

services produced for other nations' consumption, therefore exports are added.

M is gross imports. Imports are subtracted since imported goods will be included in the

terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.

Difference between GDP and GNP:-

GDP- goods and services produced by Indian companies in India + goods and services

produced by foreign companies in India.

GNP- goods and services produced by Indian companies in India + goods and services

produced by Indian companies Abroad.

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Introduction to Monetary Policy

Monetary policy is the process by which the government, central bank, or monetary

authority of a country controls

I. The supply of money,

II. Availability of money, andIII. Cost of money or rate of interest,

In order to attain a set of objectives oriented towards the growth and stability of the

economy. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is generally referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of money

in the economy, and a contractionary policy decreases the total money supply.

Expansionary policy is traditionally used to combat unemployment in a recession by

lowering interest rates, while contractionary policy involves raising interest rates in order

to combat inflation. Monetary policy should be contrasted with fiscal policy, which refers

to government borrowing, spending and taxation.

Some Monetary Policy terms

Bank Rate: Bank rate is the minimum rate at which the central bank provides loans to

the commercial banks. It is also called the discount rate.

Usually, an increase in bank rate results in commercial banks increasing their lending

rates. Changes in bank rate affect credit creation by banks through altering the cost of

credit.

Cash Reserve Ratio: All commercial banks are required to keep a certain amount of its

deposits in cash with RBI. This percentage is called the cash reserve ratio. The current

CRR requirement is 8 per cent.

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Inflation: Inflation refers to a persistent rise in prices. Simply put, it is a situation of

too much money and too few goods. Thus, due to scarcity of goods and the presence of

many buyers, the prices are pushed up.The converse of inflation, that is, deflation, is the persistent falling of prices. RBI can

reduce the supply of money or increase interest rates to reduce inflation.

Money Supply: This refers to the total volume of money circulating in the economy,

and conventionally comprises currency with the public and demand deposits (current

account + savings account) with the public.

The RBI has adopted four concepts of measuring money supply. The first one is M1,

which equals the sum of currency with the public, demand deposits with the public and

other deposits with the public. Simply put M1 includes all coins and notes in circulation,

and personal current accounts.

The second, M2, is a measure of money, supply, including M1, plus personal deposit

accounts - plus government deposits and deposits in currencies other than rupee.

The third concept M3 or the broad money concept, as it is also known, is quite popular.

M3 includes net time deposits (fixed deposits), savings deposits with post office saving

banks and all the components of M1.

Statutory Liquidity Ratio: Banks in India are required to maintain 25 per cent of their

demand and time liabilities in government securities and certain approved securities.

These are collectively known as SLR securities. The buying and selling of these securities

laid the foundations of the 1992 Harshad Mehta scam.

Repo: A repurchase agreement or ready forward deal is a secured short-term (usually

15 days) loan by one bank to another against government securities.

Legally, the borrower sells the securities to the lending bank for cash, with the

stipulation that at the end of the borrowing term, it will buy back the securities at a

slightly higher price, the difference in price representing the interest.

Open Market Operations: An important instrument of credit control, the Reserve Bank

of India purchases and sells securities in open market operations.

In times of inflation, RBI sells securities to mop up the excess money in the market.

Similarly, to increase the supply of money, RBI purchases securities.

When is the Monetary Policy announced?

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Historically, the Monetary Policy is announced twice a year - a slack season policy (April-

September) and a busy season policy (October-March) in accordance with agricultural

cycles. These cycles also coincide with the halves of the financial year.Initially, the Reserve Bank of India announced all its monetary measures twice a year in

the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as

RBI reserves its right to alter it from time to time, depending on the state of the

economy.

However, with the share of credit to agriculture coming down and credit towards the

industry being granted whole year around, the RBI since 1998-99 has moved in for just

one policy in April-end. However, a review of the policy does take place later in the year.

Objectives of the Monetary Policy

The objectives are to maintain price stability and ensure adequate flow of credit to the

productive sectors of the economy.

Stability for the national currency (after looking at prevailing economic conditions),

growth in employment and income are also looked into. The monetary policy affects the

real sector through long and variable periods while the financial markets are also

impacted through short-term implications.

There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real output and price level

through changes in reserves money, money supply and credit aggregates).

Interest rate channel.

Exchange rate channel (linked to the currency).

Asset price.

Types of monetary policy

In practice all types of monetary policy involve modifying the amount of base currency in

circulation. This process of changing the liquidity of base currency through the open

sales and purchases of (government-issued) debt and credit instruments is called open

market operations.

Constant market transactions by the monetary authority modify the supply of currency

and this impacts other market variables such as short term interest rates and the

exchange rate.

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The distinction between the various types of monetary policy lies primarily with the set

of instruments and target variables that are used by the monetary authority to achieve

their goals.

Monetary Policy Target Market Variable Long Term Objective

Inflation TargetingInterest rate on overnightdebt

A given rate of change in the CPI

Price Level TargetingInterest rate on overnightdebt

A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange RateThe spot price of the

currencyThe spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the goldprice

Mixed Policy Usually interest rates Usually unemployment + CPI change

A consumer price index (CPI) is an index number measuring the average price of consumer goods

and services purchased by households.

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition

such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank

interest rate target. The interest rate used is generally the interbank rate at which

banks lend to each other overnight for cash flow purposes. Depending on the country

this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market

operations. Typically the duration that the interest rate target is kept constant will

vary between months and years. This interest rate target is usually reviewed on a

monthly or quarterly basis by a policy committee.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one

year is offset in subsequent years such that over time the price level on aggregate

does not move.

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Monetary aggregates

In the 1980s several countries used an approach based on a constant growth in the

money supply. This approach was refined to include different classes of money andcredit.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation

to how rigid the fixed exchange rate is with the anchor nation.

Under dollarisation, foreign currency (usually the US dollar, hence the term

"dollarisation") is used freely as the medium of exchange either exclusively or in

parallel with local currency. This outcome can come about because the local

population has lost all faith in the local currency, or it may also be a policy of the

government (usually to rein in inflation and import credible monetary policy).

Managed Float

Officially, the Indian Rupee (INR) exchange rate is supposed to be 'market

determined'. In reality, the Reserve Bank of India (RBI) trades actively on the

INR/USD with the purpose of controlling the volatility of the Rupee - US Dollar

exchange rate - within a narrow bandwidth. (i.e pegs it to the US Dollar)

Mixed policy

In practice a mixed policy approach is most like "inflation targeting". However some

consideration is also given to other goals such as economic growth, unemployment

and asset bubbles.

This type of policy was used by the Federal Reserve in 1998.

Fiscal Policy

Fiscal policy, taking the scope of budgetary policy, refers to government policy that

attempts to influence the direction of the economy through changes in government

taxes, or through some spending (fiscal allowances).

Fiscal policy can be contrasted with the other main type of economic policy, monetary

policy, which attempts to stabilize the economy by controlling interest rates and the

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supply of money. The two main instruments of fiscal policy are government spending

and taxation.

Government's revenue (taxation) and spending policy designed to1) Counter economic cycles in order to achieve lower unemployment,

2) Achieve low or no inflation, and

3) Achieve sustained but controllable economic growth

In a recession, governments stimulate the economy with deficit spending (expenditure

exceeds revenue). During period of expansion, they restrain a fast growing economy

with higher taxes and aim for a surplus (revenue exceeds expenditure). Fiscal policies

are based on the concepts of the UK economist John Maynard Keynes (1883-1946), and

work independent of monetary policy which tries to achieve the same objectives by

controlling the money supply.

3 Possible Stances of Fiscal Policy

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The

three possible stances of fiscal policy are neutral, expansionary and contractionary:

1. Neutral

A neutral stance of fiscal policy implies a balanced budget where G = T (Government

spending = Tax revenue). Government spending is fully funded by tax revenue and

overall the budget outcome has a neutral effect on the level of economic activity.

2. Expansionary

An expansionary stance of fiscal policy involves a net increase in government

spending (G > T) through a rise in government spending or a fall in taxation revenue

or a combination of the two. This will lead to a larger budget deficit or a smaller

budget surplus than the government previously had, or a deficit if the government

previously had a balanced budget. Expansionary fiscal policy is usually associated

with a budget deficit.

3. Contractionary

Contractionary fiscal policy (G < T) occurs when net government spending is reduced

either through higher taxation revenue or reduced government spending or a

combination of the two. This would lead to a lower budget deficit or a larger surplus

than the government previously had, or a surplus if the government previously had a

balanced budget. Contractionary fiscal policy is usually associated with a surplus.

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Methods of funding

Governments spend money on a wide variety of things, from the military and police to

services like education and healthcare, as well as transfer payments such as welfare

benefits.

This expenditure can be funded in a number of different ways:

Taxation

Seignorage, the benefit from printing money.

Borrowing money from the population, resulting in a fiscal deficit.

Consumption of fiscal reserves.

Sale of assets (e.g., land).

Funding the deficit: A fiscal deficit is often funded by issuing bonds, like treasury bills

or consols. These pay interest, either for a fixed period or indefinitely. If the

interest and capital repayments are too great, a nation may default on its debts,

usually to foreign creditors.

Consuming the surplus: A fiscal surplus is often saved for future use, and may beinvested in local (same currency) financial instruments, until needed. When

income from taxation or other sources falls, as during an economic slump,

reserves allow spending to continue at the same rate, without incurring a deficit.

How is the Monetary Policy different from the Fiscal Policy?

Two important tools of macroeconomic policy are Monetary Policy and Fiscal Policy.

The Monetary Policy regulates the supply of money and the cost and availability of credit

in the economy. It deals with both the lending and borrowing rates of interest forcommercial banks.

The Monetary Policy aims to maintain price stability, full employment and economic

growth.

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The Reserve Bank of India is responsible for formulating and implementing Monetary

Policy. It can increase or decrease the supply of currency as well as interest rate, carry

out open market operations, control credit and vary the reserve requirements.The Monetary Policy is different from Fiscal Policy as the former brings about a change in

the economy by changing money supply and interest rate, whereas fiscal policy is a

broader tool with the government.

The Fiscal Policy can be used to overcome recession and control inflation. It may be

defined as a deliberate change in government revenue and expenditure to influence the

level of national output and prices.

For instance, at the time of recession the government can increase expenditures or cut

taxes in order to generate demand.

On the other hand, the government can reduce its expenditures or raise taxes during

inflationary times. Fiscal policy aims at changing aggregate demand by suitable changes

in government spending and taxes.

The annual Union Budget showcases the government's Fiscal Policy.

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Accounting Basics

Every organization needs to maintain good records to track how much money they have,

where it came from, and how they spend it. These records are maintained by using an

accounting system. These records are essential because they can answer such important

questions as:

Am I making or losing money from my business?

How much am I worth?

Should I put more money in my business or sell it and go into another

business?

How much is owed to me, and how much do I owe?

How can I change the way I operate to make more profit?

Even if you do not own or run a business, as an accountant you will be asked to provide

the valuable information needed to assist management in the decision making process. In

addition, these records are invaluable for filing your organizations tax returns.

The modern method of accounting is based on the system created by an Italian monk Fra

Luca Pacioli. He developed this system over 500 years ago. This great and scientific

system was so well designed that even modern accounting principles are based on it.

In the past, many businesses maintained their records manually in books hence the

term bookkeeping came about. This method of keeping manual records was

cumbersome, slow, and prone to human errors of translation.

A faster, more organized, and easier method of maintaining books is using Computerized

Accounting Programs.

Accounting and Business

Accounting is the system a company uses to measure its financial performance by noting

and classifying all the transactions like sales, purchases, assets, and liabilities in a

manner that adheres to certain accepted standard formats. It helps to evaluate a

Companys past performance, present condition, and future prospects.

A more formal definition of accounting is the art of recording, classifying, and

summarizing in a significant manner and in terms of money, transactions and

events which are, in part at least, of a financial character and interpreting the

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results thereof.

Types of Business Organizations

Three principal types of organizations have developed as ways of owning and operating

business enterprise.

In general, business entity or organizations are:

Sole proprietorship

Partnerships

Corporations

Let us discuss these concepts starting with the simplest form of business organization,the single or sole proprietorship.

1. Sole Proprietorship

A sole proprietorship is a business wholly owned by a single individual. It is the

easiest and the least expensive way to start a business and is often associated with

small storekeepers, service shops, and professional people such as doctors, lawyers,

or accountants. The sole proprietorship is the most common form of business

organization and is relatively free from legal complexities.

One major disadvantage of sole proprietorship is unlimited liability since the owner

and the business are regarded as the same, from a legal standpoint.

2. Partnerships

A partnership is a legal association of two or more individuals called partners and who

are co-owners of a business for profit. Like proprietorships, they are easy to form.

This type of business organization is based upon a written agreement that details the

various interests and right of the partners and it is advisable to get legal advice and

document each persons rights and responsibilities.

There are three main kinds of partnerships:

General partnership

Limited partnership

Master limited partnership

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- General Partnership

A business that is owned and operated by 2 or more persons where each

individual has a right as a co-owner and is liable for the businesss debts is termed

as a General Partnership. Each partner reports his share of the partnership profits

or losses on his individual tax return. The partnership itself is not responsible for

any tax liabilities.

A partnership must secure a Federal Employee Identification number from the

Internal Revenue Service (IRS) using special forms.

Each partner reports his share of partnership profits or losses on his individual tax

return and pays the tax on those profits. The partnership itself does not pay anytaxes on its tax return.

- Limited Partnership

In a Limited Partnership, one or more partners run the business as General

Partners and the remaining partners are passive investors who become limited

partners and are personally liable only for the amount of their investments. They

are called limited partners because they cannot be sued for more money than

they have invested in the business.

Limited Partnershipsare commonly used for real-estate syndication.

- Master Limited Partnership

Master Limited Partnerships are similar to Corporations trading partnership units

on listed stock exchanges.

They have many advantages that are similar to Corporations e.g. Limited liability,

unlimited life, and transferable ownership. In addition, they have the added

advantage if 90% of their income is from passive sources (e.g. rental income),

then they pay no corporate taxes since the profits are paid to the stockholderswho are taxed at individual rates.

3. Corporations

The Corporation is the most dominant form of business organization in our society.

A Corporation is a legally chartered enterprise with most legal rights of a person

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including the right to conduct business, own, sell and transfer property, make

contracts, borrow money, sue and be sued, and pay taxes. Since the Corporation

exists as a separate entity apart from an individual, it is legally responsible for itsactions and debts.

The modern Corporation evolved in the beginning of this century when large sums of

money were required to build railroads and steel mills and the like and no one

individual or partnership could hope to raise. The solution was to sell shares to

numerous investors (shareholders) who in turn would get a cut of the profits in

exchange for their money. To protect these investors associated with such large

undertakings, their liability was limited to the amount of their investment.

Since this seemed to be such a good solution, Corporations became a vibrant part ofour nations economy. As rules and regulations evolved as to what a Corporation

could or could not do, Corporations acquired most of the legal rights as those of

people in that it could receive, own sell and transfer property, make contracts, borrow

money, sue and be sued and pay taxes.

The strength of a Corporation is that its ownership and management are separate. In

theory, the owners may get rid of the Managers if they vote to do so. Conversely,

because the shares of the company known as stock can sold to someone else, the

Companys ownership can change drastically, while the management stays the same.The Corporations unlimited life span coupled with its ability to raise money gives it

the potential for significant growth.

A Company does not have to be large to incorporate. In fact, most corporations, like

most businesses, are relatively small, and most small corporations are privately held.

Some of the disadvantages of Corporations are that incorporated businesses suffer

from higher taxes than unincorporated businesses. In addition, shareholders must

pay income tax on their share of the Companys profit that they receive as dividends.

This means that corporate profits are taxed twice.

There are several different types of Corporation based on various distinctions, the first

of which is to determine if it is a public, quasi-public or Private Corporation. Federal or

state governments form Public Corporations for a specific public purpose such as

making student loans, building dams, running local school districts etc. Quasi-public

Corporations are public utilities, local phones, water, and natural gas. Private

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Corporations are companies owned by individuals or other companies and their

investors buy stock in the open market. This gives private corporations access to

large amounts of capital.

Public and private corporations can be for-profit or non-profit corporations. For-profit

corporations are formed to earn money for their owners. Non-profit Corporations have

other goals such as those targeted by charitable, educational, or fraternal

organizations. No stockholder shares in the profits or losses and they are exempt

from corporate income taxes.

Professional Corporations are set up by businesses whose shareholders offer

professional services (legal, medical, engineering, etc.) and can set up beneficial

pension and insurance packages.

Limited Liability Companies (LLCs as they are called) combine the advantages of S

Corporations and limited partnerships, without having to abide by the restrictions of

either. LLCs allow companies to pay taxes like partnerships and have the advantage

of protection from liabilities beyond their investments. Moreover, LLCs can have over

35 investors or shareholders (with a minimum of 2 shareholders). Participation in

management is not restricted, but its life span is limited to 30 years.

The Business Entity Concept

It is an important accounting principle that the business is treated as an entity separate

and distinct from its owners and any other people associated with it. This principle is

called the Business Entity Concept. It simply means that accounting records and

reports are concerned with the business entity, not with the people associated with the

business. Now, lets us review the two main accounting methods.

Types of Accounting

The two methods of tracking your accounting records are:

Cash Based Accounting

Accrual Method of Accounting

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Cash Based Accounting

Most of us use the cash method to keep track of our personal financial activities. The

cash method recognizes revenue when payment is received, and recognizes expenses

when cash is paid out.

For example, your personal checkbook record is based on the cash method. Expenses are

recorded when cash is paid out and revenue is recorded when cash or check deposits are

received.

Accrual Accounting

The accrual method of accounting requires that revenue be recognized and assigned to

the accounting period in which it is earned. Similarly, expenses must be recognized and

assigned to the accounting period in which they are incurred.

A Company tracks the summary of the accounting activity in time intervals called

Accounting periods. These periods are usually a month long. It is also common for a

company to create an annual statement of records. This annual period is also called a

Fiscal or an Accounting Year.

The accrual method relies on the principle of matching revenues and expenses. This

principle says that the expenses for a period, which are the costs of doing business to

earn income, should be compared to the revenues for the period, which are the income

earned as the result of those expenses. In other words, the expenses for the period

should accurately match up with the costs of producing revenue for the period.

In general, there are two types of adjustments that need to be made at the end of the

accounting period. The first type of adjustment arises when more expense or revenue

has been recorded than was actually incurred or earned during the accounting period. An

example of this might be the pre-payment of a 2-year insurance premium, say, for

$2000. The actual insurance expense for the year would be only $1000. Therefore, an

adjusting entry at the end of the accounting period is necessary to show the correct

amount of insurance expense for that period.

Similarly, there may be revenue that was received but not actually earned during the

accounting period. For example, the business may have been paid for services that will

not actually be provided or earned until the next year. In this case, an adjusting entry at

the end of the accounting period is made to defer, that is, to postpone, the recognition of

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revenue to the period it is actually earned.

Although many companies use the accrual method of accounting, some small businesses

prefer the cash basis. The accrual method generates tax obligations before the cash has

been collected. This benefits the Government because the IRS gets its tax money sooner.

Accounts

The accounting system uses Accounts to keep track of information. Here is a simple way

to understand what accounts are. In your office, you usually keep a filing cabinet. In this

filing cabinet, you have multiple file folders. Each file folder gives information for a

specific topic only. For example you may have a file for utility bills, phone bills, employee

wages, bank deposits, bank loans etc.

A chart of accounts is like a filing cabinet. Each account in this chart is like a file folder.

Accounts keep track of money spent, earned, owned, or owed. Each account keeps track

of a specific topic only. For example, the money in your bank or the checking account

would be recorded in an account called Cash in Bank. The value of your office furniture

would be stored in another account. Likewise, the amount you borrowed from a bank

would be stored in a separate account.

Each account has a balance representing the value of the item as an amount of money.

Accounts are divided into several categories like Assets, Liabilities, Income, and Expenseaccounts. A successful business will generally have more assets than liabilities. Income

and Expense accounts keep track of where your money comes from and on what you

spend it. This helps make sure you always have more assets than liabilities.

Account Types

In order to track money within an organization, different types of accounting categories

exist. These categories are used to denote if the money is owned or owed by the

organization. Let us discuss the three main categories: Assets, Liabilities, and Capital.

Assets

An Asset is a property of value owned by a business. Physical objects and intangible

rights such as money, accounts receivable, merchandise, machinery, buildings, and

inventories for sale are common examples of business assets as they have economic

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value for the owner. Accounts receivable is an unwritten promise by a client to pay later

for goods sold or services rendered.

Assets are generally listed on a balance sheet according to the ease with which they canbe converted to cash. They are generally divided into three main groups:

Current Asset

A Current Asset is an asset that is either:-

Cash includes funds in checking and savings accounts

Marketable securities such as stocks, bonds, and similar investments.

Accounts Receivables, which are amounts due from customers

Notes Receivables, which are promissory notes by customers to pay a definite

sum plus interest on a certain date at a certain place.

Inventories such as raw materials or merchandise on hand

Prepaid expenses supplies on hand and services paid for but not yet used

(e.g. prepaid insurance)

In other words, cash and other items that can be turned back into cash within a year are

considered a current asset.

Fixed Assets

Fixed Assets refer to tangible assets that are used in the business. Commonly, fixed

assets are long-lived resources that are used in the production of finished goods.

Examples are buildings, land, equipment, furniture, and fixtures. These assets are often

included under the title property, plant, and equipment that are used in running a

business. There are four qualities usually required for an item to be classified as a fixed

asset. The item must be:

Tangible

Long-lived Used in the business

Not be available for sale

Certain long-lived assets such as machinery, cars, or equipment slowly wear out or

become obsolete. The cost of such as assets is systematically spread over its estimated

useful life.

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Basic concepts for MBA

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