How Money Works - The Facts Visually Explained PDF

HOW MONEY WORKS £ € $ ¥ $  € $ $ $ ¥ % $ ¥ $ £ € $...

HOW MONEY WORKS £ € $ ¥ $  € $ $ $ ¥ % $ ¥ $ £ € $ $ £ $ €  £ € $ HOW ¥ $ MONEY $ WORKS THE FACTS VISUALLY EXPLAINED £ $  £ € $ ¥ $ $ Senior editor Kathryn Hennessy Publisher Liz Wheeler Project editor Sam Kennedy Publishing director Jonathan Metcalf Senior art editor Gadi Farfour Art director Karen Self Project art editor Saffron Stocker Senior jacket designer Mark Cavanagh UK Editors Alison Sturgeon, Allie Collins, Diane Pengelley, Jacket editor Clare Gell Georgina Palffy, Jemima Dunne, Tash Khan Jacket design Sophia MTT US Editors Christy Lusiak, Margaret Parrish development manager Designers Clare Joyce, Vanessa Hamilton, Pre-production producer Gillian Reid Renata Latipova Senior producer Mandy Inness Managing editor Gareth Jones Senior managing art editor Lee Griffiths  Contents PROFIT-MAKING AND FINANCIAL INSTITUTIONS 24 Introduction 8 Corporate accounting 26 Net income 28 Expensing vs capitalizing 30 MONEY BASICS 10 Depreciation, amortization, depletion 32 Smoothing earnings 34 Cash flow 36 The evolution of money 12 Gearing ratio and risk 40 Barter, IOUs, and money 14 How companies use debt 42 Artifacts of money 16 Financial reporting 44 Emergence of modern economics 20 Financial instruments 46 Economic theories and money 22 Shares 48 Bonds 50 Derivatives 52 Financial markets 54 The money market 56 Foreign exchange and trading 58 Primary and secondary markets 60 Predicting market changes 62 Arbitrage 64 Manipulating the stock market 66 Day trading 68 Financial institutions 70 Commercial and mortgage banks 72 Investment banks 74 Brokerages 76 Insurance risk and regulation 78 Investment companies 80 Nonbank financial institutions 82 First American Edition, 2017 All rights reserved. Published in the United States by DK Publishing Without limiting the rights under the copyright reserved 345 Hudson Street, New York, New York 10014 above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in Copyright © 2017 Dorling Kindersley Limited any form, or by any means (electronic, mechanical, DK, a Division of Penguin Random House LLC photocopying, recording, or otherwise), without the prior 17 18 19 20 21 10 9 8 7 6 5 4 3 2 1 written permission of the copyright owner. A WORLD OF IDEAS: 001–282964–March/2017 Published in Great Britain by Dorling Kindersley Limited. SEE ALL THERE IS TO KNOW A catalog record for this book is available from the Library of Congress. ISBN: 978-1-4654-4427-1 www.dk.com Printed in China GOVERNMENT FINANCE AND PUBLIC MONEY 84 The money supply 86 $ Increasing money circulation 88 $ Banking reserves 90 Recession and the money supply 92 Recession to depression 94 Managing state finance 96 Government and the money supply 98 The central bank 100 Budget constraint How tax works 104 106 $ Government borrowing 108 Public debt 110 Accountability 112 Attempting control 114 Reading economic indicators 116 Deciding on economic policy 118 Interest rates 120 Quantitative easing 124 The level of taxation 126 Government spending 128 How governments provide for the future 130 Inflation 132 Balance of payments 136 International currency fluctuations 138 Managing state pensions 140 Why governments fail financially 142 How governments fail: hyperinflation 144 How governments fail: debt default 146 Contributors Marianne Curphey is an award-winning financial writer, blogger, and columnist. She has worked as a writer and editor Beverly Harzog (consultant and writer) is a consumer at The Guardian, The Times, and The Telegraph, and a wide credit expert and best-selling author. Her articles have range of financial websites and magazines. appeared in The Wall Street Journal, New York Daily News, ABCNews.com, ClarkHoward.com, CNNMoney.com, and Emma Lunn is an award–winning personal finance journalist MSNMoney.com. Her expert advice has been featured in whose work regularly appears in high profile newspapers such numerous media outlets, including television, radio, print, as The Guardian, The Independent, and The Telegraph, as well and websites. as a number of specialty publications and websites. PERSONAL FINANCE 148 Wealth-building investments 174 Investing in property 176 Home equity 180 Worth, wealth, and income 150 Shares 182 Calculating and analyzing net worth 152 Managed funds 184 Income and wealth 154 Converting income into wealth 156 Managing investments 186 Generating income 158 Asset allocation and diversification 188 Generating wealth 160 Dollar cost averaging 190 Risk tolerance 192 Investments for income 162 The optimal portfolio 194 Dividends from shares 164 Earning income from savings 166 Pensions and retirement 196 Investing in managed funds 168 Saving and investing for a pension 198 Rental income from property 170 Converting pensions into income 202 Life assurance 172 Debt 204 Why we use debt 206 Interest and compound interest 208 Loans 210 Mortgages 212 Credit unions 216 Credit cards 218 Money in the digital age 220 Cryptocurrency 222 Bitcoin 224 Crowdfunding 226 Peer-to-peer lending 228 Money in the US 230 Index 248 Acknowledgments 256 James Meadway is an economist and policy advisor who has Alexandra Black studied business communications before worked at the New Economics Foundation—an independent writing for financial newspaper group Nikkei Inc. in Japan and British think tank—the UK Treasury, the Royal Society, and for working as an editor at investment bank JP Morgan. She has the Shadow Chancellor of the Exchequer. written numerous books and articles on subjects as diverse as finance, business, technology, and fashion. Philip Parker is a historian and former British diplomat and publisher, who studied at the Johns Hopkins School of Advanced International Studies. A critically acclaimed author, he has written books that focus on the history of world trade.  £ € $ ¥ $ $ $ $ $ $ $ $ $ $ $ SOLD  HOW MONEY WORKS Introduction 8 9 Introduction Money is the oil that keeps the machinery of our world turning. By giving goods and services an easily measured value, money facilitates the billions of transactions that take place every day. Without it, the industry and trade that form the basis of modern economies would grind to a halt and the flow of wealth around the world would cease. Money has fulfilled this vital role for thousands of years. Before its invention, people bartered, swapping goods they produced themselves for things they needed from others. Barter is sufficient for simple transactions, but not when the things traded are of differing values, or not available at the same time. Money, by contrast, has a recognized uniform value and is widely accepted. At heart a simple concept, over many thousands of years it has become very complex indeed. At the start of the modern age, individuals and governments began to establish banks, and other financial institutions were formed. $ Eventually, ordinary people could deposit their money in a bank ¥ account and earn interest, borrow money and buy property, invest their wages in businesses, or start companies themselves. Banks £ $ € € £ could also insure against the sorts of calamities that might devastate families or traders, encouraging risk in the pursuit of profit. ¥ Today it is a nation’s government and central bank that control a $ country’s economy. The Federal Reserve (known as “The Fed”) is the central bank in the US. The Fed issues currency, determines how much of it is in circulation, and decides how much interest it will charge banks to borrow its money. While governments still print and guarantee money, in today’s world it no longer needs to exist as physical coins or notes, but can be found solely in digital form. This book examines every aspect of how money works, including its history, financial markets and institutions, government finance, profit-making, personal finance, wealth, shares, pensions, Social $ $ Security benefits, and national and local taxes. Through visual explanations and practical examples that make even the most complex concept immediately accessible, How Money Works offers a clear understanding of what money is all about, and how it shapes modern society.  £ € $ ¥ $ $  % MONEY BASICS ❯ The evolution of money  The evolution of money People originally traded surplus commodities with each other in a process known as bartering. The value of each good traded could be debated, however, and money evolved as a practical solution to the complexities of bartering hundreds of different things. Over the centuries, money has appered in many forms, but, whatever shape it takes, whether as a coin, a note, or stored on a digital server, money always provides a fixed value against which any item can be compared. The ascent of money Money has become increasingly complex over time. What began as a means of recording trade exchanges, then appeared in the form of coins and notes, is now primarily digital. Barter Evidence of trade records Coinage (10,000–3000BCE) (7000BCE) (600BCE–1100CE) In early forms of trading, specific Pictures of items were used to record Defined weights of precious metals items were exchanged for others trade exchanges, becoming more used by some merchants were later agreed by the negotiating parties complex as values were established formalized as coins that were usually to be of similar value. See pp.14–15 and documented. See pp.16–17 issued by states. See pp.16–17  MONEY BASICS The evolution of money 12 13 $80.9 SUPPLY AND DEMAND The economic law of supply and demand states that when the price of a commodity trillion (such as oil) falls, consumers tend to use, or demand, more of it, and when its price rises, the demand decreases. One of the key factors affecting price is the amount of a commodity available—its supply. Low supply will push prices up, as consumers are willing to pay more for something that is difficult to estimated amount of money obtain, and high supply will push prices down as consumers will not pay a premium for something that is plentiful. in existence today Macro versus Microeconomics Macroeconomics studies the impact of changes in the economy as a whole. Microeconomics examines the behavior of smaller groups. Macroeconomics This measures changes in indicators that affect the whole economy. ❯❯Money supply The amount of money circulating in an economy. ❯❯Unemployment The number of people who cannot find work. ❯❯Inflation The amount by which prices rise each year. Microeconomics $ This examines the effects that decisions of firms and individuals have on the economy. ❯❯Industrial organization The impact of monopolies and cartels Bank notes Digital money on the economy. (1100–2000) (2000 onward) ❯❯Wages The impact that salary States began to use bank notes, Money can now exist “virtually,” on levels, which are affected by issuing paper IOUs that were traded computers, and large transactions can labor and production costs, as currency, and could be exchanged take place without any physical cash have on consumer spending. for coins at any time. See pp.18–19 changing hands. See pp.222–223  Barter, IOUs, and money Barter—the direct exchange of goods—formed the basis of trade for thousands of years. Adam Smith, 18th-century author of The Wealth of Nations, was one of the first to identify it as a precursor to money. re ct Trade Barter in practice Essentially, barter involves the exchange Di of an item (such as a cow) for one or more of a perceived equal “value” (for example a load of wheat). For the most part the two parties bring the goods Simple exchange with them and hand them over at the One party directly time of a transaction. Sometimes, one swaps its item (a cow) for the other party’s of the parties will accept an “I owe you,” goods (wheat) or IOU, or even a token, that it is agreed can be exchanged for the same goods or something else at a later date. PROS AND CONS g with IOUs OF BARTER din Pros ❯❯Trading relationships Fosters ra T strong links between partners. IOU ❯❯Physical goods are exchanged Barter does not rely on trust that money will retain its value. Cons Summer Wheat is ❯❯Market needed Both parties delivered in exchange COW must want what the other offers. for an IOU for a cow. ❯❯Hard to establish a set value on items Two goats may have a certain value to one party one IOU day, but less a week later. ❯❯Goods may not be easily divisible For example, a living animal cannot be divided. ❯❯Large-scale transactions can be difficult Transporting one goat is COW easy, moving 1,000 is not. Winter Once the cow is fully grown it is handed over to fulfill the IOU.  MONEY BASICS The evolution of money 14 15 How it works an IOU to be exchanged later for the physical goods. In its simplest form, two parties to a barter transaction Eventually these IOUs acquire their own value and the agree on a price (such as a cow for wheat) and physically IOU holder could exchange them for something else of hand over the goods at the agreed time. However, this the same value as the original commodity (perhaps may not always be possible—for example, the wheat apples instead of wheat). The IOUs are now performing might not be ready to harvest, so one party may accept the same function as actual money. x trading with le IO $ mp Us Co IOU Money A universal IOU that has an agreed value in terms of the goods it can be exchanged for. CLOTHES IOU IOU WHEAT FENCE BUILDING Trading in IOUs IOUs can be exchanged between different parties, or for a variety of items (not necessarily the one first agreed on). IOU IOU FIREWOOD COW IOU APPLES  Artifacts of money Characteristics of money Money is not money unless it has all of the following defining characteristics: Money must Since the early attempts at setting have value, be durable, portable, uniform, divisible, in limited supply, and be usable as values for bartered goods, “money” a means of exchange. Underlying all of these has come in many forms, from IOUs characteristics is trust—people must be to tokens. Cows, shells, and precious confident that if they accept money, they can use it to pay for goods. metals have all been used. How it works Bartering was a very immediate form of transaction. Once writing was invented, records could be kept detailing the “value” of goods traded as well as of the “IOUs.” Eventually tokens such as beads, colored cowrie shells, or lumps of gold were assigned a specific value, which meant that they could be exchanged directly for goods. It was a small step from this to making tokens explicitly to represent value Item of worth in the form of metal discs—the first coins—in Most money originally had Lydia, Asia Minor, from around 650 BCE. For an intrinsic value, such as that more than 2,000 years, coins made from of the precious metal that was precious metals such as gold, silver, and (for used to make the coin. This small transactions) copper formed the main in itself acted as some medium of monetary exchange. guarantee the coin would be accepted. Timeline of artifacts Sumerian Lydian gold coins cuneiform tablets In Lydia, a mixture of Scribes recorded gold and silver was transactions on clay formed into disks, tablets, which could or coins, stamped also act as receipts. with inscriptions. 5,000bce 4,000bce 1,000bce 600bce 600bce Barter Cowrie shells Athenian drachma Early trade involved Used as currency The Athenians used directly exchanged across India and the silver from Laurion items—often South Pacific, they to mint a currency perishable ones appeared in many used right across such as a cow. colors and sizes. the Greek world.  MONEY BASICS The evolution of money 16 17 GEORG SIMMEL AND THE PHILOSOPHY OF MONEY Published in 1900, German sociologist Georg Simmel’s book The Philosophy of Money looked at the meaning of value in relation to money. Simmel observed that in premodern societies, people made Store of value objects, but the value they attached to each of them was difficult to Money acts as a means by fix as it was assessed by incompatible systems (based on honor, time, which people can store their and labor). Money made it easier to assign consistent values to objects, wealth for future use. It must not, which Simmel believed made interactions between people more therefore, be perishable, and it rational, as it freed them from personal ties, and provided greater helps if it is of a practical size freedom of choice. that can be stored and transported easily. Means of $ $ exchange It must be possible to Unit of exchange money freely and account widely for goods, and its value should be as stable as possible. Money can be used to record wealth possessed, traded, or € It helps if that value is easily spent—personally and nationally. divisible and if there are sufficient denominations so It helps if only one recognized change can be given. authority issues money—if $ anybody could issue it, then trust in its value would disappear. Han dynasty coin Byzantine coin Arabic dirham Often made of Early Byzantine Many silver coins bronze or copper, coins were pure from the Islamic early Chinese coins gold; later ones also empire were carried had holes punched contained metals to Scandinavia in their center. such as copper. by Vikings. 200bce 27bce 700ce 900ce 900ce Roman coin Anglo-Saxon coin Bearing the head of This 10th century the emperor, these silver penny has an coins circulated inscription stating throughout the that Offa is King Roman Empire. (“rex”) of Mercia. ARTIFACTS OF MONEY The economics of money By the early 20th century, money became separated From the 16th century, understanding of the nature of from its direct relationship to precious metal. The Gold money became more sophisticated. Economics as a Standard collapsed altogether in the 1930s. By the discipline emerged, in part to help explain the inflation mid-20th century, new ways of trading with money caused in Europe by the large-scale importation of appeared such as credit cards, digital transactions, silver from the newly discovered Americas. National and even forms of money such as cryptocurrencies and banks were established in the late 17th century, with financial derivatives. As a result, the amount of money the duty of regulating the countries’ money supplies. in existence and in circulation increased enormously. 1542–1551 1540-1640 The great Potosi inflation debasement The Spanish discovered England’s Henry VIII silver in Potosi, Bolivia, and debased the silver penny, caused a century of inflation making it three-quarters by shipping 350 tons of copper. Inflation the metal back to COPPER increased as trust GOLD AND SILVER FROM Europe annually. THE NEW WORLD dropped. 1970 FROM 1844 Great inflation Gold Standard In the US, inflation The British pound was tied accelerated quickly. to a defined equivalent The stock market amount of gold. Other plummeted 40% in an countries adopted a 18-month period. similar Gold Standard. 1970S 1990S Credit cards Digital money The creation of credit £ $ cards enabled consumers The easy transfer of to access short-term credit funds and convenience to make smaller purchases. This resulted in the ¥ of electronic payments became increasingly growth of personal popular as internet debt. use increased.  MONEY BASICS The evolution of money 18 19 GRESHAM’S LAW The monetary principle “bad money drives out good” was formulated by British financier Sir Thomas Gresham (1519-71). He observed that if a country debases its currency—reducing the precious metal in its coins—the coins would be worth 16 billion the number of bitcoins less than the metal they contained. As a result, people spend the “bad” coins and hoard the “good” undebased ones. in circulation in 2016— worth $9 billion 1553 1694 JOINT-STOCK Early joint-stock COMPANY companies Bank of England $ The Bank of England Merchants in England was created as a body that began to form companies in could raise funds at a low which investors bought interest rate and manage shares (stock) and national debt. shared its rewards. 1696 1775 US dollar The Royal Mint The Continental Congress authorized the Isaac Newton became issue of United States dollars Warden and argued that in 1775, but the first national debasing undermined currency was not minted confidence. All coins were by the US Treasury recalled and new silver until 1794. ones were minted. 1999 2008 Euro Bitcoin Twelve EU countries Bitcoin—a form of joined together and electronic money that replaced their national exists solely as encrypted currencies with the Euro. data on servers—is Bank notes and coins announced. The first were issued three transaction took place years later. in January 2009.  Emergence of modern economics By the 18th century, people began to study the economy more closely, as thinkers tried to understand how the trade and investment decisions of individuals could have an effect on prices and wages throughout a country. How it works (laissez-faire) might improve their people’s economic With the massive expansion of trade that accompanied well-being. In the 18th century, economist Adam Smith the discovery of the Americas and the growth of proposed that government intervention—controlling nation states in Europe in the 16th and 17th centuries, wages and prices—was unnecessary because the individuals began to think in more detail about the self-interested decisions of individuals, who all want idea of economics. They variously suggested that to be better off, cumulatively ensure the prosperity controlling the level of imports (mercantilism), trading of their society as a whole. In addition, he believed that only in the goods a country made best (comparative in a freely competitive market, the impetus to make advantage), or choosing not to intervene in the markets profit ensures that goods are valued at a fair price. Adam Smith’s “invisible hand” NEW! In his book The Wealth of Nations (1776), the Scottish economist Adam SELLER A SELLER B $4 $2 Smith suggested that the sum of the decisions made by individuals, each of whom wanting to be better off, results in a country becoming more prosperous without those individuals ever having consciously desired that Seller A is charging too much Seller B sees an opportunity to end. According to Adam Smith, where for his goods but still makes sales enter the market and sets up her there is demand for goods, sellers will because he is the only seller and own stall, selling at a lower price enter the market. In the pursuit of enjoys an effective monopoly. in order to undercut A. profit they will increase the production of these goods, supporting industry. BUYER Furthermore in a competitive market, a seller’s self-interest limits the price rises they can demand in that if they charge too much, buyers will stop purchasing their goods or lose sales to competitors willing to charge less. This can have a deflationary effect on prices and ensures that the economy remains in balance. Smith referred to this market mechanism, Buyers reduce their As Seller B’s price is lower, which turns individual self-interest purchases as prices are buyers begin to buy from her into wider economic prosperity, as an prohibitively high. instead of Seller A. “invisible hand” guiding the economy.  MONEY BASICS The evolution of money 20 21 PROTECTIONISM AND MERCANTILISM Adam Smith’s encouragement decrease its imports, as exports of free trade and competition was at odds with the dominant brought money into a country, while imports enriched foreign “By pursuing his economic theories of his time. Most thinkers supported some merchants. This theory led to strict governmental trade own interests, he form of protectionism—an controls—the Navigation Acts economic policy in which a forbade trade between Britain frequently promotes government imposes high trade and its colonies in anything tariffs in order to protect its other than British ships. that of the society industry from competition. In Mercantilism began to go out Europe at the time this took the form of mercantilism, which of fashion in the late 18th century under the pressure of more effectually held that to be strong, a country must increase its exports and new ideas about economic specialization put forward by than when he really do everything possible to Adam Smith and David Ricardo. intends to promote it” Adam Smith, The Wealth of Nations (1776) NEED TO KNOW ❯❯Market equilbrium When SELLER A SELLER B the amount of certain goods $3 $3 demanded by buyers matches the amount supplied by sellers—the point at which all parties are satisfied with a good’s price. ❯❯Laissez-faire An economic theory that holds that the market Seller A drops his price slightly Seller B sees she can raise her will produce the best solutions in in order to regain customers price slightly and her goods will the absence of government and compete with Seller B. still be in demand. interference. Trade, prices, and wages do not need to be regulated, as the market itself will correct imbalances in them. ❯❯Comparative advantage The idea that countries should The goods have found a price specialize in those goods they at which buyers are happy can produce at the lowest cost. to continue to purchase. The By avoiding producing goods “invisible hand” has worked and in which they do not have a the market is now in equilibrium. comparative advantage, countries will become more efficient and therefore better off.  Economic theories and money Since the birth of modern economic thought, economists have tried to work out how the quantity of money in an economy affects prices and the behavior of consumers and businesses. DEFENSE E NG Keynes’ general CT UR LI CI PO theory of money RU ND ST RA , A In his 1935 book General Theory, John Maynard Keynes ION NF TRANSPORTATION I argued that government spending and taxation levels CARE, EDUCAT affect prices more than the quantity of money in the economy. He proposed that in times of recession a $ government should increase spending to encourage employment, and reduce taxes to stimulate the economy. ALTH , HE RE FA $ BU EL IL IN W D G: HO US ES, S LS CHOOLS, HOSPITA GOVERNMENT INVESTMENT AND SPENDING STIMULATING DEMAND When output is shrinking and As demand falls, firms reduce The government increases its spending, unemployment rising, a government production, which raises for example on infrastructure. This must decide how to react. unemployment and lowers demand. reduces unemployment. Fisher’s quantity theory of money Marx’s labor theory of value The most common version of this theory was articulated The German economist Karl Marx argued that the real by Irving Fisher, who argued that there is a direct link price (or economic value) of goods should be determined between the amount of money in the economy and price not by the demand for those goods, but by the value of level, with more money in circulation increasing prices. the labor that went into producing it. $ 10 $ Low money Demand for High demand Money buys 1 pair 2 hours’ labor $20 supply money rises increases value more goods of shoes at $10 / hour $ 15 $ High money Demand for Low demand Money buys 1 dress 10 hours’ labor $100 supply money reduces decreases value fewer goods at $10 / hour  MONEY BASICS The evolution of money 22 23 How it works Scholars in the early 16th century were the first to note an equilibrium price by itself. By the early 20th century, that the abundance of silver coming into Spain from some economists believed that intervention by the the New World led to increased prices. Economists government was necessary to maintain a balanced of the 18th-century Classical School believed that the economy, arguing that government spending could market would correct for such imbalances, reaching boost employment by increasing overall demand. WAGES COMPANY MORE MONEY IN THE ECONOMY SALES FIGURES MULTIPLIERS COMPANY COMPANY GOODS MULTIPLIERS $ ESTMENT NV I PRODUCTION INCREASE BUSINESSES SPEND MORE ECONOMY IN BALANCE With more people in employment, With demand rising, firms invest With levels of investment and production high, and consumer spending rises. Increased more, opening more factories and employment and wages rising, the stimulation of demand leads to increased production. providing more employment. extra government spending is no longer needed. Hayek’s business cycle Friedman’s monetarism Austrian economist Friedrich Hayek noted a cycle in the Milton Friedman argued that governments could raise economy, in which interest rates fall during a recession. or lower interest rates to affect the money supply. Cuts This leads to an overexpansion of credit, necessitating would stimulate consumer spending; rises would restrict a rise in interest rates to counter excess demand. it and reduce the amount of money in the supply. LOW INTEREST $ 10 0 00 Interest rates $1 $100 REAL GDP Interest rates raised to 1% $ $ cut to 0.25% COR R Employee Spends Supermarket Supplier pays EC paid $100 $100 pays supplier $100 employees $100 TI ON RY HIGH INTEREST E OV 0 $5 $50 EC R $ $ $5 0 RECESSION EXPANSION RECESSION Employee Saves $50 and Supermarket Supplier pays paid $100 spends $50 pays supplier $50 employees $50 TIME  $ $ $ $ $ $ $ $ $ $ % € $ $  PROFIT- MAKING AND FINANCIAL INSTITUTIONS ❯ Corporate accounting ❯ Financial instruments ❯ Financial markets ❯ Financial institutions £ $ ¥ $  Corporate accounting Companies use money in different ways—some borrow to pay for investment to grow bigger, while others prefer to hold a lot of cash and to rely on income generation rather than borrowing in order to expand. Much depends on the type of business and the management style. Start-ups and smaller companies tend to need a lot of cash in the early days, while larger, more established companies are better at growing their income internally and may hoard cash. Cashflow Net income This indicates how much This is the income that a income a business is company reports at the end of generating, and how this the financial year after costs compares to its costs and and expenses have been the expenses that it has to deducted. It is calculated by pay out. A company is said starting with the revenue to have a positive cashflow earned and then taking away if its income exceeds its Smoothing earnings the cost of tax, expenses, expenses. See pp.36–39 banking and interest charges, This business practice, aimed at depreciation of assets, staff reducing volatility in income and costs, and any other expenses reported profit, uses accounting involved in operating the techniques to limit fluctuations business. See pp.28–29 $ in company earnings. $ $ $ See pp.34–35 Income = $10,000 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $  PROFIT-MAKING AND FINANCIAL INSTITUTIONS Corporate accounting 26 27 $216 billion cash reserves held by Apple in April 2016, out of $1.7 trillion held by US nonfinancial companies at that time Expenses Assets These are the costs a These are the items that a business incurs on a company owns, some of regular basis. They which generate income, might include staff and many of which may wages, insurance appreciate in value. premiums, utility bills, Businesses often choose and other expenses between buying assets involved in the running that will fall in value or of the company. leasing equipment. Gearing ratio Capital gearing is the balance between a company’s capital (its available money or assets) Expensing vs Capitalizing and its funding by short- or When a business incurs a cost or an expense it needs long-term loans, expressed to record it in the company accounts, either by showing as a percentage. A company the full amount at the time it happens, or by spreading with relatively low gearing is the cost over a number of years. See pp.30–31 regarded as being less risky and in a better position to cope with an economic downturn. Depreciation See pp.40–41 This is a measure of how much the value Debt = $2,000 of an asset falls over time, often due to use or “wear and tear.” Companies can record the reduction in the value of assets such as vehicles, machinery, or other equipment as depreciation in their accounts. This will then reduce the company’s tax liability and reduce their taxable profit. See pp.32–33 THE ACCOUNTANT  Net income When a business reports how it has fared financially over the year, it provides investors with a figure for its net income. This is a good way to understand how much real profit a business is making. How it works Net income is a good way to understand how much If businesses were simply to report the money they real profit a business is making, and whether that had earned, this would give an unrealistic picture of profit is likely to be sustained in the future. It is also the underlying health of the business. For example, a way of calculating earnings per share (see “Need a business could be earning plenty of revenue, but to know”), which investors use to weigh up the value also incurring a lot of expenses via investment in of a company and its shares. new markets, premises, or machinery at the same time. Analyzing the balance of revenue earned against In order for investors to work out whether a company the cost of tax, investment, and other expenses is one is financially healthy, therefore, they need to be able to of a number of ways to assess how a company is faring see how it is managing costs, and whether it is compared with its competitors, and if it has a sound spending money in the right way. financial basis going forward. Calculating net PROPERTY DEVELOPER income TO For investors trying to decide whether TA L a particular company represents a $1 REV 00 good investment opportunity, net ,00 ENU 0 E income helps them to understand the way the business is run and is a guide to the real profit the company is making, rather than just the revenues it is generating. Revenue earned is the starting point, and the cost of tax, banking and interest charges, $20,000 Materials depreciation of assets, staff costs, and any other expenses involved in operating the business are deducted $40,000 from this figure. Expenses Staff Bottom $5,000 Tax line REVENUE — EXPENSES = $35,000 Net income NET INCOME  PROFIT-MAKING AND FINANCIAL INSTITUTIONS Corporate accounting 28 29 $18.4 INFLATING EARNINGS Some companies omit certain expenses from their calculations to make net income billion appear higher, while others inflate earnings to make profits appear higher, for example by including projected future earnings. This is at best unethical, and potentially illegal. In 2014, British grocery chain Tesco launched an investigation after discovering its first-half earnings estimate had been inflated by around $407 million due to Apple’s first quarter COSTS alleged accounting errors. So, while net income is an important indicator of a net income in 2016 − company’s financial health, it should not be used as the only means of assessment. CO S TS the highest quarterly profits in history RETAILER NEED TO KNOW ❯❯Bottom line Refers to the UE VEN bottom of the income statement, RE 0 and is another expression for TAL 0,00 TO $10 net income. ❯❯Earnings per share Net income divided by the number of shares in issue; it is seen as an indicator $10,000 Rent of a company’s profitability. ❯❯Expenses The costs incurred in running a business that have to be settled immediately, rather than paid off gradually over a $30,000 Staff number of years. ❯❯Depreciation of assets The Expenses decline in value of assets that the company has bought; this may be a plant for manufacturing $22,000 Stock purchased processes, or specialty machinery. ❯❯Banking and interest charges The cost of finance, including loans, debts, mortgages, and $20,000 Tax other amounts owing. Bottom line $18,000 Net Income  Expensing vs capitalizing When a business incurs a cost it needs to record it in its company accounts. The company can do this for the full amount at the time it happens, or spread the cost over several years. Assets Capitalizing and expensing in practice All companies have costs and expenses. Some such as electricity and other utilities, insurance, staff wages, and food need to be paid for upfront, SKI LIFT SNOWPLOW FURNITURE PASSENGER so these are expensed. To qualify as BUS The significant The snowplow is Furniture appears capital expenditure, an asset must cost of building paid off over on the balance The passenger bus be useful for more than one year. the lift is spread several years, as sheet as a cost is recorded as a Businesses have to decide which over a number deductions from spread over depreciating asset option best fits their business model. of years. annual income. three years. as its value will fall. A ski resort buys a new ski lift, snowplow, and bus, as well as some Capitalizing furniture, and capitalizes the cost. A business may decide to capitalize a cost, and then spread it over a number of years. Capitalizing means recording an expense as an asset, and then allowing for WARNING its depreciation, or fall in value, over time. Accounting this way may be the difference between reporting a profit Whether a cost incurred can or a loss if the cost or expense is particularly large. legitimately be recorded as an asset is open to a degree of interpretation. Some recent THE BALANCE SHEET financial scandals have involved companies recording one-off When to capitalize When to expense business expenses as investments For businesses wanting to have a If a firm expenses some of its costs, in new markets that they projected smoother flow of reported income its profitability may be lower. This would pay off in the future. The and for start-up businesses, it may be useful in order to reduce companies did this to inflate or can be attractive to capitalize tax; lower profits mean lower “flatter” their profits rather than purchases because by keeping taxation. A company may also show the true figures. An order or costs down, a business can choose to expense a cost if it an expense that had not yet been report a higher income in its has had a good year and wants paid for was recorded as income early years. However, there are to show high profitability in earned, and as a result company tax implications if it is making a later years. Some costs, such as earnings appeared higher than larger profit as a result. staff payments, must be expensed. they actually were.  PROFIT-MAKING AND FINANCIAL INSTITUTIONS Corporate accounting 30 31 How it works provide value for more than one year, it can be Business owners and managers have a choice. They recorded as an asset once depreciation is accounted for. can record an expense as it occurs or at the time of Known as capitalizing, this practice has the advantage payment and reduce the annual profit accordingly. of taking costs out of the business gradually, rather This practice, known as expensing, will show up than in one lump sum. The profit-and-loss account is immediately in the account. If the expense will not as dramatically affected in this case. Expenses “Stressing accounting appearance over economic substance achieves neither” Warren Buffett INGREDIENTS Ingredients for the Expensing chalet meals must appear on the With ongoing expenses, a business balance sheet in full. will either record the cost at the time it is incurred, or at the time when it is ELECTRICITY/ actually paid. This is likely to lead to UTILITIES more volatility in reported earnings, Bills must be paid at once and can’t but may be useful if the company be capitalized. is trying to keep its profits down, for example for tax purposes. STAFF Staff are an ongoing cost, but they must be paid immediately and are therefore an expense. INSURANCE Insurance appears as an expense that is accounted for in full in the financial year.  Depreciation, amortization, depletion The cost of a company’s assets and its use of natural resources can be deducted from its income for accounting and tax purposes. Depreciation, amortization, and depletion allow the company to spread this cost. Calculating depreciation VALUE ($) A delivery company buys a van for $25,000. Over time, the 0 ,00 vehicle will need to be replaced. The company can record $25,000 $21 the reduction in the value of the vehicle in its accounts as depreciation. $20,000 PURCHASE − SCRAP $15,000 VALUE VALUE ANNUAL = $10,000 USEFUL ECONOMIC DEPRECIATION ($) LIFE (YEARS) $5,000 $25,000 − $5,000 = $4,000 5 0 1 Calculating amortization VALUE ($) A company buys the patent for a computer design. The initial ,0 00 $25,000 $21 ,0 00 cost of this intangible asset can be gradually written off over $18 several years and can be used to reduce the company’s taxable profit. $20,000 $15,000 INITIAL COST ANNUAL USEFUL LIFE = $10,000 AMORTIZATION ($) $5,000 $21,000 = $3,000 7 0 1 2 NUMBER Calculating depletion OF TREES A forestry company knows that it has a finite number of trees. 60,000 $10 ON 1 LLI $9. ION 2 Depletion records the fall in value of the forest with its MI ILL $8. ION 50,000 M LL remaining reserves, as the product—wood pulp—is extracted over time. MI 40,000 COST − SALVAGE VALUE X UNITS EXTRACTED = DEPLETION 30,000 TOTAL UNITS EXPENSE ($) 20,000 $10,000,000 − $1,000,000 X 6,000 = $900,000 0 1 2 3 60,000  PROFIT-MAKING AND FINANCIAL INSTITUTIONS Corporate accounting 32 33 How it works a physical presence, such as a patent) can be gradually Depreciation is used to calculate the declining value written off over a number of years. Depletion is the of tangible assets (such as a machine or vehicle). It reduction in value of an asset that is a natural is a measure of how much the value of an asset falls resource. Unlike amortization, which deals with over time, particularly due to use, or wear and tear. nonphysical assets, depletion records the fall in Amortization is a term used in accounting to describe value of actual reserves. It could be applied to coal or how the initial cost of an intangible asset (one without diamond mines, oil and gas, or forests, for example. WARNING 0 ,00 $17 ❯❯Country differences There 0 ,00 are different ways of allowing for $13 000 depreciation, and accounting $9, 000 methods vary from one country $5, to another. When working out how much a company is allowing for the cost of depreciation, it is 2 3 4 5 important to know which method TIME (YEARS) is being used in its accounts. ❯❯Purchasing vs leasing assets Business owners have to make a choice between buying assets that they own but that will fall in value over time, or leasing 00 equipment on which they will pay ,0 $15 rent. As they do not own leased ,0 00 $12 000 equipment, they cannot record its $9, depreciation in value over time 000 and there is no depreciation $ 6, 000 $ 3, charge to be used to reduce the company’s taxable profit. 3 4 5 6 7 TIME (YEARS) M I 3 $7. ION LL 4 $6. ION 60% the value the M ILL MI LL 5 $5. ION 6 $4. ION 7 average car