Types Of Crisis With Special Reference Management Essay

Types Of Crisis With Special Reference Management Essay Natural crises, typically natural disasters considered as acts of God, are such environmental phenomena as earthquakes, volcanic eruptions, tornadoes and hurricanes, floods, landslides, tsunamis, storms, and droughts that threaten life, property, and the environment itself. Example: 2004 Indian Ocean earthquake (Tsunami) Technological crises Technological crises are caused by human application of science and technology. Technological accidents inevitably occur when technology becomes complex and coupled and something goes wrong in the system as a whole (Technological breakdowns). Some technological crises occur when human error causes disruptions (Human breakdowns). People tend to assign blame for a technological disaster because technology is subject to human manipulation whereas they do not hold anyone responsible for natural disaster. When an accident creates significant environmental damage, the crisis is categorized as mega damage. Samples include software failures, industrial accidents, and oil spills. Examples: Chernobyl disaster, Exxon Valdez oil spill Confrontation crises Confrontation crises occur when discontented individuals and/or groups fight businesses, government, and various interest groups to win acceptance of their demands and expectations. The common type of confrontation crises is boycotts, and other types are picketing, sit-ins, ultimatums to those in authority, blockade or occupation of buildings, and resisting or disobeying police. Example: Rainbow/PUSHs (People United to Serve Humanity) boycott of Nike Crises of malevolence An organization faces a crisis of malevolence when opponents or miscreant individuals use criminal means or other extreme tactics for the purpose of expressing hostility or anger toward, or seeking gain from, a company, country, or economic system, perhaps with the aim of destabilizing or destroying it. Sample crises include product tampering, kidnapping, malicious rumors, terrorism, and espionage. Example: 1982 Chicago Tylenol murders Crises of organizational misdeeds Crises occur when management takes actions it knows will harm or place stakeholders at risk for harm without adequate precautions. Lerbinger specified three different types of crises of organizational misdeeds: crises of skewed management values, crises of deception, and crises of management misconduct. Crises of skewed management values Crises of skewed management values are caused when managers favor short-term economic gain and neglect broader social values and stakeholders other than investors. This state of lopsided values is rooted in the classical business creed that focuses on the interests of stockholders and tends to disregard the interests of its other stakeholders such as customers, employees, and the community. Example: Sears sacrifices customer trust Crises of deception Crises of deception occur when management conceals or misrepresents information about itself and its products in its dealing with consumers and others. Example: Dow Cornings silicone-gel breast implant Crises of management misconduct Some crises are caused not only by skewed values and deception but deliberate amorality and illegality. Workplace violence Crises occur when an employee or former employee commits violence against other employees on organizational grounds. Example: DuPonts Lycra Rumors False information about an organization or its products creates crises hurting the organizations reputation. Sample is linking the organization to radical groups or stories that their products are contaminated. Example: Procter Gambles Logo controversy Government and crisis management Historically, government at all levels local, state, and national has played a large role in crisis management. Indeed, many political philosophers have considered this to be one of the primary roles of government. Emergency services, such as fire and police departments at the local level, and the United States National Guard at the federal level, often play integral roles in crisis situations. To help coordinate communication during the response phase of a crisis, the U.S. Federal Emergency Management Agency (FEMA) within the Department of Homeland Security administers the National Response Plan (NRP). This plan is intended to integrate public and private response by providing a common language and outlining a chain-of-command when multiple parties are mobilized. It is based on the premise that incidences should be handled at the lowest organizational level possible. The NRP recognizes the private sector as a key partner in domestic incident management, particularly in the area of critical infrastructure protection and restoration. The NRP is a companion to the National Incidence Management System that acts as a more general template for incident management regardless of cause, size, or complexity. FEMA offers free web-based training on the National Response Plan through the Emergency Management Institute. Common Alerting Protocol (CAP) is a relatively recent mechanism that facilitates crisis communication across different mediums and systems. CAP helps create a consistent emergency alert format to reach geographically and linguistically diverse audiences through both audio and visual mediums. Elected officials and crisis management Historically, politics and crisis go hand-in-hand. In describing crisis, President Abraham Lincoln said, We live in the midst of alarms, anxiety beclouds the future; we expect some new disaster with each newspaper we read. Crisis management has become a defining feature of contemporary governance. In times of crisis, communities and members of organizations expect their public leaders to minimize the impact of the crisis at hand, while critics and bureaucratic competitors try to seize the moment to blame incumbent rulers and their policies. In this extreme environment, policy makers must somehow establish a sense of normality, and foster collective learning from the crisis experience. In the face of crisis, leaders must deal with the strategic challenges they face, the political risks and opportunities they encounter, the errors they make, the pitfalls they need to avoid, and the paths away from crisis they may pursue. The necessity for management is even more significant with the advent of a 24-hour news cycle and an increasingly internet-savvy audience with ever-changing technology at its fingertips. Public leaders have a special responsibility to help safeguard society from the adverse consequences of crisis. Experts in crisis management note that leaders who take this responsibility seriously would have to concern themselves with all crisis phases: the incubation stage, the onset, and the aftermath. Crisis leadership then involves five critical tasks: sense making, decision making, meaning making, terminating, and learning. A brief description of the five facets of crisis leadership includes: Sense making may be considered as the classical situation assessment step in decision making. 2. Decision making is both the act of coming to a decision as the implementation of that decision. 3. Meaning making refers to crisis management as political communication. 4. Terminating a crisis is only possible if the public leader correctly handles the accountability question. 5. Learning, refers to the actual learning from a crisis is limited. The authors note, a crisis often opens a window of opportunity for reform for better or for worse. Models and theories associated with crisis management Crisis Management Model Successfully defusing a crisis requires an understanding of how to handle a crisis before they occur. Gonzalez- Herrero and Pratt found the different phases of Crisis Management. There are 3 phases in any Crisis Management are as below 1. The diagnosis of the impending trouble or the danger signals. 2. Choosing appropriate Turnaround Strategy. 3. Implementation of the change process and its monitoring. Management Crisis Planning No corporation looks forward to facing a situation that causes a significant disruption to their business, especially one that stimulates extensive media coverage. Public scrutiny can result in a negative financial, political, legal and government impact. Crisis management planning deals with providing the best response to a crisis. Contingency planning Preparing contingency plans in advance, as part of a crisis management plan, is the first step to ensuring an organization is appropriately prepared for a crisis. Crisis management teams can rehearse a crisis plan by developing a simulated scenario to use as a drill. The plan should clearly stipulate that the only people to speak publicly about the crisis are the designated persons, such as the company spokesperson or crisis team members. The first hours after a crisis breaks are the most crucial, so working with speed and efficiency is important, and the plan should indicate how quickly each function should be performed. When preparing to offer a statement externally as well as internally, information should be accurate. Providing incorrect or manipulated information has a tendency to backfire and will greatly exacerbate the situation. The contingency plan should contain information and guidance that will help decision makers to consider not only the short-term consequences, but the long-term effects of every decision. Business continuity planning When a crisis will undoubtedly cause a significant disruption to an organization, a business continuity plan can help minimize the disruption. First, one must identify the critical functions and processes that are necessary to keep the organization running. Then each critical function and or/ process must have its own contingency plan in the event that one of the functions/processes ceases or fails. Testing these contingency plans by rehearsing the required actions in a simulation will allow for all involved to become more sensitive and aware of the possibility of a crisis. As a result, in the event of an actual crisis, the team members will act more quickly and effectively. Structural-functional systems theory Providing information to an organization in a time of crisis is critical to effective crisis management. Structural-functional systems theory addresses the intricacies of information networks and levels of command making up organizational communication. The structural-functional theory identifies information flow in organizations as networks made up of members and links. Information in organizations flow in patterns called networks. Diffusion of innovation theory Another theory that can be applied to the sharing of information is Diffusion of Innovation Theory. Developed by Everett Rogers, the theory describes how innovation is disseminated and communicated through certain channels over a period of time. Diffusion of innovation in communication occurs when an individual communicates a new idea to one or several others. At its most elementary form, the process involves: (1) an innovation, (2) an individual or other unit of adoption that has knowledge of or experience with using the innovation, (3) another individual or other unit that does not yet have knowledge of the innovation, and (4) a communication channel connecting the two units. A communication channel is the means by which messages get from one individual to another. Unequal human capital theory James postulates that organizational crisis can result from discrimination lawsuits. Jamess theory of unequal human capital and social position derives from economic theories of human and social capital concluding that minority employees receive fewer organizational rewards than those with access to executive management. In a recent study of managers in a Fortune 500 company, race was found to be a predictor of promotion opportunity or lack thereof. Thus, discrimination lawsuits can invite negative stakeholder reaction, damage the companys reputation, and threaten corporate survival. Social media and crisis management Social media has accelerated the speed that information about a crisis can spread. The viral affect of social networks such as Twitter means that stakeholders can break news faster than traditional media making managing a crisis harder. This can be mitigated by having the right training and policy in place as well as the right social media monitoring tools to detect signs of a crisis breaking. Social media also gives crisis management teams access to real-time information about how a crisis is impacting stakeholder sentiment and the issues that are of most concern to them. Public Distribution System (PDS) The Public Distribution System (PDS) in India is an important public intervention for enhancing food security. The PDS provides subsidised food grains (and other essential commodities) through a network of fair price shops. Until 1992 access to the PDS was, at least in theory if not in practice, universal. Corruption and high operational costs were among the reasons that were used to justify the move to the Revamped Public Distribution System (based on a principle of geographic targeting) in tribal, arid, hill and remote areas in 1992 and then to a Targeted Public Distribution System (TPDS) in 1997. Under the TPDS, households were classi ¬Ã‚ ed as Above Poverty Line (APL) or Below Poverty Line (BPL), based on the economic status of households. BPL households continued to receive subsidised food grains through the TPDS whereas subsidies for APL households have been gradually phased out. The impact of these changes can be evaluated on several criteria including selection into or exclusion from the TPDS, utilisation of PDS quotas, e ¬Ã¢â€š ¬ect on the consumption patterns and so on. Correct identi ¬Ã‚ cation could mean that the programme may have improved in terms of better targeted subsidies. Access to cheap food grain could make a more diversi ¬Ã‚ ed and nutritious diet a ¬Ã¢â€š ¬ordable for poor households. Much depends, however, on the actual functioning of the PDS on the ground. Those with BPL cards made repeated trips to ration shop that were often quite far and queued in order to enjoy this small subsidy. In spite o this, they rarely got their full entitlement of 35kg. Having spent some time at ratio shops, I noticed that they were often cheated by their PDS dealer. Those who were aware of being cheated often complained to me, but did not protest in front of the PDS dealer. I find that though BPL cards have generally been given to the poorer households in the sample, utilisation is low. Among those who have access to the TPDS, one-third of the sample households do not utilise their quota at all and another half do not utilise their quota fully. Further, many of these households purchase the same items from the market at higher prices. This puzzle of under-purchase (purchasing less than ones entitlement and yet purchasing from the market at a higher price) from the PDS is examined using a dual pricing model. The dual-pricing model provides a framework within which government intervention in the wheat market and its associated problems can be analysed. However, in order to account for under-purchase from the PDS and related patterns, the standard dual-pricing model needs to be extended to take into account additional factors such as transaction costs, uncertainty, and quality variations. There could be various reasons for low utilisation levels. Demand-side bottlenecks include cash- ¬Ã¢â‚¬Å¡ow problems (that is, households may not have cash when foodgrain is available in government ration shops), inappropriate foodgrains being supplied through the PDS, and so on. There are also supply-side constraints in the form of diversion to the open market or just irregular functioning of ration shops. The article also examines the impact of the PDS on consumption patterns. While the PDS does not have much impact on the level of cereal consumption, it seems to a ¬Ã¢â€š ¬ect the composition of cereal consumption. Speci ¬Ã‚ cally, the TPDS tilts cereal consumption of households towards wheat , away from coarse cereals. This is possibly a matter of concern, since coarse cereals are generally more nutritious than wheat. Problems which headed in PDS Free Amenities Free Supplies: Many family card or ration card holders dont go to the Fair Price Shops to get the goods or benefits which is eligible to them. As a result rice, wheat, sugar, kerosene or any other form of PDS which needs to be settled or handed over to the real beneficiary is not properly distributed. Still there are issues of hoarding and creation of black markets. The one who deserves is deprived of the benefits. The Govt.s prime motive is to eradicate death which occurs due to starvation and poverty. As a result it was decided to introduce subsidized PDS goods and free PDS goods. Later on this PDS was taken as a political strategy by politicians for their success in elections As a result of providing free amenities and free PDS people become lazy. They dont go for any form of employment especially, marginalized sections of the people. In the case of a SSI or Tiny sector which is labour intensive in nature face the heat or crisis in the form of short supply of labour. The amount which is being spent from the States Treasury for PDS Free Amenities results in price rise for other articles, goods and services in the form of taxation and setting off the amount which has been infused / spended in the PDS Free Amenities. Due to short supply of labour and due to power crisis which is now seen in many parts of India the GDP with regard to manufacturing sector has declined. At present due to failure of monsoon and uneven monsoon rains the kharif crops are destroyed. This has resulted in a heavy loss to the farmers and this lead to reduced supply of food grains and increased prices in the market. Now this particular free PDS cannot apply due to short supply of grains. Now the people who are unemployed or underemployed face the crisis as they have enjoyed free benefits throughout these years. They dont have the mindset to go in search for any other alternative employment opportunities. These free amenities made people more greedy Suggestions to solve the crisis which was created due to free PDS free amenities: The BPL(Below Poverty Line) should be provided with these benefits. Proper survey and field work should be conducted to know the population which is in the BPL. It is better to reduce the issue of PDS to APL (Above Poverty Line) and at a later stage it is advisable to eradicate this PDS to APL as they prove to be self sufficient with their earnings. Free PDS other amenities should be provided to the marginalized sections of the society based on a condition that atleast one person either male / female in a family should make themselves employed in any organized or unorganized sector. Awareness camps on health, stress management and necessity of being employed should be given. If the above said measures were put into effect then the scarce supply of labour can be reduced. Crisis of Malevolence: Organizations face crisis of malevolence when some notorious employees take the help of criminal activities and extreme steps to fulfill their demands. Acts like kidnapping companys officials, false rumours all lead to crisis of malevolence. Malevolence Employees who behave illegally or unethically act with malevolence. Intentional harm to an individual or company is malevolence. This type of crises includes security breaches, product tampering, sabotage, extortion, lawsuits and employee scandals. Malevolence outside of an organization may include kidnapping, assault or spreading rumors. Malevolence may refer to: Evil Hostility Malice (law) Sadism Security breach An act from outside an organization that bypasses or contravenes security policies, practices, or procedures. A similar internal act is called security violation. Broadly speaking, a security breach is a violation of any policy or law that is designed to secure something. When people or vehicles bypass screening checkpoints, or enter secure buildings without presenting the appropriate credentials, security breaches are generally obvious. Less obvious are security breaches that involve data or information. In a data context, a security breach is any activity that compromises the confidential nature of certain information. Most of the time, what is or is not a security breach is defined by law. Statutes in many countries set out security measures for any number of things, from border crossings to data sharing and electronic commerce transactions. A breach is usually defined as any action, intentional or otherwise, that weakens a certain defined security interest. The best-known security breaches typically cause some noticeable harm. An airport security breach that allows a passenger to board a plane with a weapon, or a data loss that leads to identity theft are clear examples. Under most security breach laws, however, harm is not always a requirement. The threat of harm, or likelihood of harm, is usually enough. Product Tampering, the unauthorized altering of a consumer product without the knowledge of the products owner or eventual user, is almost always treated as a threat to human health or safety, because it typically changes the contents of ingested products, such as foods or drugs, in a harmful manner. An exception to this pattern is fraudulently decreasing the odometer settings on used automobiles in an effort to increase the apparent value of a vehicle to a prospective buyer. Product tampering began in the 1890s. An especially bad case was the cyanide poisoning of Bromo Seltzer containers. The worst case of product tampering in America in the twentieth century happened in Chicago in 1982, when poison placed in packages of Tylenol killed seven people. Congress responded with the Federal Anti-Tampering Act of 1983, making it a crime to tamper with products or to make false claims of tampering. Tampering motives have included revenge, financial gain, and publicity for various causes. Ta mpering incidents have triggered false reports and copycat cases, both of which occurred in 1993 in response to a fabricated story that syringes were found in Pepsi-Cola cans. To combat tampering, manufacturers use science and technology to generate tamper-evident packaging and DNA testing to identify suspected tamperers. Sabotage is a form of subversion which involves deliberate damage, interference, or disruption. In a classic example, ecological activists have disabled the engines of logging equipment in the Pacific Northwest to prevent loggers from working at various points in history. There are a number of different forms of sabotage, all of which are designed to obstruct an activity in some way, creating chaos and often generating economic problems as people struggle to resolve the damage. Many people are not familiar with the true origins of this word, although they may be acquainted with the folk etymology, which claims that the term is derived from the practice of throwing wooden shoes known as sabots into the workings of machines. Though a charming idea, this is not, in fact correct. Sabotage actually comes from the French word saboter, which means to walk clumsily, a reference to the self-same sabots discussed above; the term is actually meant to describe the work stoppage and disruption created by sabotage. One of the most infamous forms is military sabotage, in which saboteurs penetrate the defenses of an enemy and attempt to disrupt weapons systems, military strategy, and so forth. Sometimes, damage comes from within, with rebels sabotaging the military of their own nations in an attempt to help the enemy gain the upper hand. It can also take a political form, in which case it is primarily carried out through well-timed media releases and comments which are designed to undermine opposing political campaigns. Extortion is a crime that involves the illegal acquisition of money, property, or favors through the use of force, or the threat of force. Historically, the term was defined as an abuse of privilege on the part of a public official who used his or her position to get money or favors, but today, people at all levels of society could potentially commit extortion. Penalties vary, depending on the specifics of the crime. In some countries, it is treated especially seriously because it is linked with organized crime, and sometimes special laws are designed to make it easier to prosecute and punish extortion. To the casual ear, extortion can sound very similar to blackmail, in which people use a threat to demand payments or favors, and robbery, in which a criminal takes something by force. However, extortion is slightly different from both of these crimes. In blackmail, someone threatens to do something which is entirely legal, such as publishing a set of photographs, with the blackmailee offering payment to avoid exposure and humiliation. Extortion is entirely illegal, as it involves threats of violence or other illegal acts. A lawsuit or (very rarely) suit in law is a civil action brought in a court of law in which a plaintiff, a party who claims to have incurred loss as a result of a defendants actions, demands a legal or equitable remedy. The defendant is required to respond to the plaintiffs complaint. If the plaintiff is successful, judgment is in the plaintiffs favor, and a variety of court orders may be issued to enforce a right, award damages, or impose a temporary or permanent injunction to prevent an act or compel an act. A declaratory judgment may be issued to prevent future legal disputes. Although not as common, lawsuit may also refer to a criminal action, criminal proceeding, or criminal claim. A lawsuit may involve dispute resolution of private law issues between individuals, business entities or non-profit organizations. A lawsuit may also enable the state to be treated as if it were a private party in a civil case, as plaintiff, or defendant regarding an injury, or may provide the state with a civil cause of action to enforce certain laws. The conduct of a lawsuit is called litigation. One who has a tendency to litigate rather than seek non-judicial remedies is called litigious.The plaintiffs and defendants are called litigants and the attorneys representing them are called litigators. When Good Employees Do Bad: Seven Behaviors that May Precede a Scandal by David Gebler Good intentions can lead to bad outcomes in business. This is  especially true in organizations that have toxic cultures in which  leaders tout worthy valuesand then put up roadblocks that prevent  employees from living those values. The GSA scandal provides an apt example. With all the rampant spending  at the GSA, one has to ask if employees were afraid to speak up, lest  they upset their coworkers. Or perhaps they had become complacent in  an upbeat, backslapping culture that rewarded everyone early, often, and extravagantly. Time will tell. In the case of the GSA, the good  intention of employeesto be a solid team playerled to a very bad  result. But its poor leadership that created that toxic culture and  allowed it to drag good employees down. Gebler says desirable behaviors such as being team players (as in the  case of the GSA), or even meeting deadlines, being goal-oriented, and  staying on budget can get distorted and become destructive in a  company driven by weak leadership values and a weak culture. Thats  because leadership values drive success, not employee behaviors. When we look at companies that have faced scandals such as recalls,  ethical violations, or crimes, the problem often comes down to  employees whose surprisingly positive behavior was distorted by a  toxic culture and clueless leaders. Here are seven seemingly benign  behaviors that may come back to bite a company if they become  exaggerated and throw the organization out of alignment: Blind loyalty to the team. Loyalty is a good thing, right? Not when it  creates a culture of I know this is bad, but its not my decision.  The unethical spending at the GSA was a symptom of leadership without  values. Employees were rewarded with lavish perks provided by managers  who had their own interests at heart. This created a culture in which  employees received the greatest benefit by staying loyal to their  coworkers and generous bosses, rather than questioning their actions. Commitment to meeting deadlines. One would think that a company where  employees are encouraged to meet deadlines and rewarded for doing so  consistently would lead to super-productivity and efficiency. In fact,  it can lead to disaster. At Johnson Johnson, the understood  directive to get product to market on tough deadlines created a  culture of Dont ask too many questions and resulted in a series of  dangerous drug recalls that badly sullied the companys reputation. Excessive optimism. When a person is sick, optimism can buoy his  spirits and help healing. When a company is unhealthy, Everything is  going to be okay is not what you need to hear from those in authority  positions. Take David Myers, former controller of WorldCom. By his own account, he saw the problems of the now-defunct company through  rose-colored glasses. He simply kept believing-and telling his  frightened staff-that the problems would resolve themselves  eventually. By the time he came to his senses, he was under arrest for  accounting fraud. Staying focused on a goal.  Telling employees to keep their eye on the prize is not intrinsically a bad thing. But when the goal becomes more important to management  than the underlying values of the organization, it can lead to a  dysfunctional culture. For example, in the 1990s, Sears gave its auto  repair mechanics a mandatory sales goal of $147 per hour. It wasnt  long before customers began to be overcharged or sold unnecessary  repairs. Having a competitive mindset. Boeing is known for its highly  competitive employees and work culture. Thats a good thing, right?  Not so in 1996, when the company lost billions in government contracts  for ethics violations after an employee stole 25,000 pages of  proprietary documents from Lockheed. Flash forward to 2005, when  employees were still so competitive that their own work teams were  known to keep useful information secret from other teams in the  company to make sure they stayed on top. Too much competition can  erode cultural values, leading to disaster. Sticking to a budget. Most managers would be thrilled if their  employees were doggedly determined to stay on budget and not cost the  company any unnecessary money. But a good intention can go bad when  financial performance becomes the only metric that matters. That was  the case, many believe, behind the fatal mistake made on the BP oil  platform in the Gulf. Before the explosion in April 2012 caused by a  safety shortcut, BPs Macondo project was more than $40 million over  budget. You know the rest. Wanting to please higher

Never To Feel His Love Again :: Personal Narrative Essay Example

Never To Feel His Love Again "Early this morning tragedy struck West High School" Principal Simmons' somber voice echoed over the intercom just after the first period tardy bell on Tuesday, January 7, 1997. The grave tone of his voice immediately got my attention as I sat in Spanish class, and I listened for an explanation, expecting to hear that my World History teacher, who was struggling with cancer, had died. Mr. Simmons continued, "Mr. David Butler was killed in a house fire early this morning." Mr. Simmons still spoke, but I was oblivious to everything except the name "Mr. Butler." In total shock I sat motionless with my mind racing. Suddenly and uncontrollably the tears came. I could not speak. I could not feel. This man changed my life; he gave me a true love of learning. He was my friend, and I never even got a chance to tell him. I walked into Mr. Butler's class at Piedmont Open Middle School for the first time as a timid eighth grader eager to learn geometry, yet a little wary of the entire class of ninth graders I was joining. From day one, Mr. Butler demonstrated a love of math and an even deeper love of his students. Granted, Mr. Butler was hard on the students giving loads of homework and almost impossible tests, but he was also a friend who joked with us in class and cared about our lives. Respect was a must in his class, and those who crossed Mr. Butler found themselves on the floor listening as he counted out ten push-ups. He wasn't just a math teacher; he was a role model, a father-figure. Due to his passion for teaching and great love of his students, Mr. Butler decided to take a course over the summer so he could teach ten students, including myself, Algebra II Trig in the ninth grade. During this year our friendship blossomed and my true love of math began. All year long we fought over Duke and Carolina, and since I was such a "psycho-fan" he was the first to tease me those few times that UNC lost at football or basketball. I loved Mr. Butler; I loved his class, and from then on math was my favorite subject and my main focus in school. Mr. Butler instilled this love for math as his own love of the subject sparked mine.

Being An International Student in a Post 9/11 World :: Terrorism Terrorists Essays

Being An International Student in a Post 9/11 World "Give me your tired, your poor, your huddled masses yearning to be free," just not your students. "I knew what was going to happen after 9/11. It was understood," said Tariq Halela, a 21-year-old student at Boston University. What he understood was simple: for an international student, living in the United States would never be the same. Halela, an Indian born Kuwaiti native, has been studying stateside for over two years. He is an accounting major and speaks four languages -- English, Arabic, Hindi and Gujarati -- fluently. "I love it here in the states," he said. "That is why I was so worried when I got a call from the ISO [international student's office] saying I could be deported." Confusion over the new immigration rules and regulations is what gave Halela his first deportation scare. With stricter visas guidelines, the culmination of new policies the Bureau of Immigration and Customs Enforcement (ICE) have undertaken is the Student Exchange Visitor Information System, or SEVIS. Now, new international students can choose to study at any one of the over 7,000 SEVIS-certified universities in America. The schools, in turn, provide a plethora of information on the students ranging from the mundane - name, enrollment verification, date of birth - to the normally considered private information such as grades and field of study. Essentially, the SEVIS is a program designed to keep tabs on all the approximately one million international students studying here in the U.S. The SEVIS keeps a database housing all of a student's information to determine whether he or she can stay in the U.S. or can be allowed to come here in the first place. Although the program seems like a reaction to the 9/11 attacks, the birth of SEVIS dates back to the early '90s. One of the men convicted of the 1993 bombing of the World Trade Center, Eyad Ismoil, had gained access to the U.S. through a student visa. In an attempt to help regulate the student visas system, Congress passed the Illegal Immigration and Immigrant Responsibility Act, which commissioned the government to create a system that manages information on all international students but Congress never pressed to make that system operational. When it was learned that two of the 9/11 highjackers, Mohamed Atta and Marwan Alshehi, also came tot he U.S. through student visas, Congress changed their tune.

Ecn 204 Final Exam Notes

Macro Final Exam Chapter 10: The Money Systems What assets are considered â€Å"Money†? What are the functions of money and the types of money? * W/o money, trade would require barter > Exchanging one good/service for another * unlikely occurrence that two people e/ have a good that other wants * 3 functions * Medium of exchange: an item buyers give to sellers when they want to purchase g/s * Unit of account: the yardstick ppl use to post prices & record debts * Store of value: an item ppl can use to transfer purchasing power from the present to the future * 2 kinds Commodity money: commodity with intrinsic value, i. e. gold coins * Fiat money: money w/o intrinsic value, used as money b/c of gov’t decree, i. e. dollar bills * Money in Can’n economy * Money supply (Money stock): the quantity of money available in the economy * Two assets should be considers: * Currency: the paper bills & coins in the hands of the general public * Demand deposits: balances in bank accounts that despositors can access on demand by writing a cheque/using debit card * Money Supply = currency + depositsWhat is the bank of Canada and its role? How do Banks create money? * Central Bank: an institution designed to regulate the money supply in the economy * Bank of Canada: the central bank of Canada * Established in 1935, nationalized in 1938, owned by Can’n gov’t * Managed by board of directors appointed by minister of Finance, composed of: governor, the senior deputy governor (7 yr terms), 12 directors (3 yr terms) * Four primary functions: * Issue currency, act as banker to commercial banks & Can’n gov’t, control money supply * Commercial Banks and Money Supply Although Bank of Canada alone is responsible for Canadian monetary policy, the central bank can control the supply of money only through its influence on the entire banking system * Commercial banks include credit unions, caisses populaires, and trust companies * Commercial banks can influence the quantity of demand deposits in economy and money supply * Reserves: cash that commercial banks hold * Fractional banking system > Keeps fraction of deposits as reserves, rest is loaned * Banks may hold more than this minimum amt if they choose * The reserve ratio, R Fraction of deposits that banks hold as reserves * Total reserves as % of total deposits * Bank T-account * T-account – simplified accounting statement that shows bank’s Assets & liabilities * Banks liabilities: deposits(what we put in the bank), Assets: Loans and reserves(What bank keeps) * R= Reserves/Deposits * Banks & money supply * $100 of currency is in circulation, determining impact on money supply: Calculate in 3 different cases * No banking system Public holds the $100 as currency; Money supply= $100 * 100% reserves banking system: banks hold 100% of deposits as reserves make no loans * MS = Currency (loans) + deposits = 0 +100 = 100 * Bank does not affect size of money supply * Fractional reserve banking system * R=10%: Reserves: 10, Loans: 90, Deposits: 100 * MS= $190 * When banks make loans > create money * Borrower gets: 90 in currency(asset), 90 in new debt/loan (liability) * Money Multiplier: The amt of money the banking system generates with each dollar of reserves * Money multiplier = 1/R R =10, 1/R = 10, 100 x 10 = 1000 * The Bank of Canada’s tools of Monetary Control * 1. Open-market operations * When it buys gov’t bonds from/ sells to the public * Foreign exchange market operations: when it buy/sells foreign currencies * MS increase when bank of Canada buys foreign currency with Canadian Currency; and decrease when BoC sells foreign currency * 2. Changing the overnight rate * Central banks act as bankers to commercial banks Bank rate : interest rate charged by bank of Canada on loans to the commercial banks * Since 1998 Bank of Canada as allowed commercial banks to borrow freely at the bank rate, paid commercial banks the bank rate , minus half percent, on their deposits at bank of Canada * Commercial banks never need to pay more than bank rate for short term loans, b/c they can always borrow from the Bank of Canada instead * Conversely, commercial banks never need to accept less than the bank rate, minus half a percent, when they make short-term loans, because they can always lend to the bank of Canada instead * Overnight rate: the interest rate on very short-term loans between commercial banks * Bank of Canada can alter the money supply by changing the bank rate, which in turn causes an equal change in overnight rate * A higher bank rate discourages commercial banks from borrowing from the Bank of Canada * A higher overnight rate discourages commercial banks from borrowing from other commercial banks * An increase in the overnight rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply * Bank of Canada’s control of MS is not precise * Bank of Canada must wre stle w/ 2 problems that come from fractional-reserve banking * Does not control amt of money that: * Household choose to hold as deposits in banks * Commercial bankers choose to lend Chapter 11: Money Growth and Inflation How does the money supply affect the inflation & nominal interest rates? * Quantity theory of money: Price rises when gov’t prints too much money * Most economists believe the quantity theory is a good explanation of the long run behavior of inflation * Asserts that quantity of money determines value * 2 approaches: * Supply demand diagram MS determined by bank of Canada, banking system, consuers * In model, assume that BoC precisely controls MS & sets it at some fixed amt * MD (money demand) how much wealth ppl want to hold in liquid form * Depends on P: an increase in P reduces the value of money, so more money is required to buy goods & services * Thus: Quantity of money demanded is –vely related to the value of money +vely related to P, other thin gs equal (real income, interest rates, availability of ATMs) * * Results from Graph: Increasing MS causes P to rise * How does this work? Short version: * AT the initial P, an increase in MS causes excess supply of money * People get rid of their excess money by spending it on goods & services/ by loaning it to others who spent it * Result: increased demand of goods But supply of goods does not increase, so prices must rise * Other things happen in the short run, which we will study in later chapters) * Equation * Nominal Variables: are measured in monetary units * i. e. Nominal GDP, nominal interest rates (rate of return measured in $) nominal wage($ per/hour worked) * Real Variables: are measured in physical units * i. e. real GDP real interest rate (measured in output) real wage (measured in output) * Real vs. Nominal * Prices are normally measured in terms of money * Price of a compact disc: $15/cd * Price of a pepperoni pizza: $10/pizza A relative price: price of one good relat ive (divided by) another: * Relative price of CDs in terms of pizza: * Price of CD/Price of pizza = 15/10 = 1. 5 pizzas per cd * Relative prices are measured in physical units so they are real variables * Real vs. Nominal Wage * An important relative price is the real wage * W= nominal wage= price of labour $15/hr * P = price level = price of g&s $5/unit of output * Real wage is price of labour relative to price of output * W/P = 15/5 = 3 units output per hour * Classical theory of inflation: * Increase in overall level of prices * Over past 60 yrs, prices risen on avg of 4%/yr Deflation: people will wait for prices to drop on big ticketed items, dropped in the 20th century * In 1970s prices rose by 7%/yr * During 1990s, price rose at 2%/yr * Hyperinflation: extraordinary high rate * Quantity theory of money: explain long-run determinants of price lvl and inflation rate * Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange * Whe n the overall price level rises, value of money falls * Inverse relationship b/w price & value of money * Value of money: * P = Price lvl (CPI/ GDP deflator) * P = price of basket of goods measured in money * 1/P is value of $1, measured in goods * Example: basket contains one candy bar, P = $2, Value of $1 is ? candy bar * The Classical Dichotomy Classical dichotomy: theoretical separation of nominal & real variables * Hume & the classical economists suggested that monetary developments affect nominal variables but not real variables * If the central bank doubles the MS, Hume & classical thinkers contend * All nom variables (including prices) will double * All real variables (Including relative prices) will remain unchanged * The neutrality of Money * Monetary neutrality: the proposition that changes in the MS do not affect real variables * Doubling money supply causes all nominal prices to double, what happens to relative prices? * Initially, relative price of cd in terms of pizza is * Price of cd/price of pizza = 15/10 = 1. pizzas per cd * After nominal prices double * 30/20 = 1. 5 pizza per cd * Relative price is unchanged * Monetary neutrality: proposition that changes in the MS do not affect real variables * Similarly, the real wage W/P remains unchanged, so†¦ * Quantity of labour supplied/demanded, total employment does not change * The same applies to employment of capital & other resources * Since employment of all resources in unchanged, total output is also unchanged by the MS * Most economists believe the classical dichotomy & neutrality of money describe the economy in the long run Does the money supply affect real variables like real GDP or the real interest rate? The velocity of Money: the rate at which money changes hands * Notation: * PxY = nominal GDP = price level x real GDP * M = money supply * V = velocity * Velocity formula: V = PXY/M * Pizza, Y = real GDP = 3000 pizzas, P= price of pizza = $10, P*Y = $30,0000, M = $10,000 * V=30,000 /10,000= 3, avg dollar was used in 3 transactions * Quantity Equation * M*V = P*Y * V = stable * So, a change in M causes nominal GDP (P*Y) to change by the same % * A change in M does not affect Y: money is neutral, Y is determined by tech & resources * So, P changes by the same % as P*Y and M * Rapid money supply growth causes rapid inflation How is inflation like a tax? Hyperinflation is generally defined as inflation exceeding 50%/month * Excessive growth in the MS always causes hyperinflation * Inflation tax: * When tax revenue is inadequate and ability to borrow is ltd, gov’t may print money to pay for its spending * Almost all hyperinflations start this way * The revenue from printing money is the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money * The Fischer Effect * Rearrange definition of real interest rate: * Nominal interest rate = Inflation rate + real interest rate * Real interest rate is determined by saving & inve stment in the loanable funds market * MS growth determines inflation rate This equation shows how the nominal interest rate is determined * In long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate * So, nominal interest rate adjusts one-for-one with changes in the inflation rate * The inflation tax applies to people’s holdings of money, not their holdings of wreath * Fishcher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate is unchanged What are the costs of inflation? How serious are they? * The inflation fallacy: most ppl think inflation erodes real income * Inflation is a general increase in price of the things ppl buy & the things they sell (i. e. labour) * In long run, real incomes are determined by real variables, not inflation rate * Shoeleather costs: the resources wasted when inflation encourages ppl to reduce their money holdings * In cludes the time & transactions costs of more frequent bank withdrawals * Menu costs: the costs of changing prices Printing new menus, mailing new catalogs * Misallocation of resources from relative-price variability: Firms don’t all raise prices @ the same time, so relative prices can vary which distorts the allocation of resources * Confusion & inconvenience: inflation changes the yardstick we use to measure transactions, complicates long-range planning & the comparison of dollar amts over time * Tax distortions: inflation makes nominal income grow faster than real income, taxes are based on nominal income, & some are not adjusted for inflation, so†¦ inflation causes ppl to pay more taxes even when their real incomes don’t increase * Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors: debtors get to repay their debt w/ dollars that aren’t worth as much * Lower-than-expected inflation tran sfers purchasing power from debtors to creditors * High inflation is more variable & less predictable than low inflation * So, these arbitrary redistributions are frequent when inflation is high * Costs are high for economies experiencing hyperinflation * For economies w/ low inflation ( 0, â€Å"Capital outflow†, domestic purchases of foreign assets exceed foreign purchases of domestic assets * Capital is flowing out of country * When NCO < 0, â€Å"Capital inflow†, foreign purchases of domestic assets exceed domestic purchases of foreign assets * Capital is flowing into the country * Variables that Influence NCO * Real interest rates paid on foreign assets or domestic assets * Perceived risks of holding foreign assets * Gov’t policies affecting foreign ownership of domestic assets * The equality of NX & NCO * An accounting identity: NCO = NX * Arises b/c every transactions that affects NX also affects NCO by the same amt (And vice versa) * When a foreigner pur chases a good from Canada, * Can’n exports & NX increase The foreigner pay w/ currency or assets, so the Can’n acquires some foreign assets, causing NCO to rise * An accounting identity: NCO=NX * Arises b/c every transaction that affects NX also affects NCO the same amt ( & vice versa) * When a Can’n citizen buys foreign goods, * Can’n imports rise, NX falls * The Can’n buyer pays w/ Can’n dollars or assets, so the other country acquires Can’n assets, causing Can’n NCO to fall * Saving, Investment, & international Flows of Goods & Assets * Y = C + I + G + NX accounting identity * Y – C – G = I + NX rearranging terms * S = I + NX since S = Y – C – G * S = I + NCO since NX = NCO * When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow, NCO >0 * When S e =P*/P implies that the nom exchange rate between 2 countries should equal the ratio of price lvls * If the 2 cou ntries have diff inflation rates, then e will change over time: * If inflation is higher in Mexico than in Canada, Then P* rises faster than P, so e rises – the dollar appreciates against the peso * If inflation is higher in Canada than in Japan, then P rises faster than P*, so e falls- the dollar depreciates against the yen * Limitations of PPP theory, why exchange rates do not always adjust to equalize prices across countries: * Many goods cannot easily be traded: * i. e. haircuts, going to movies * Price differences on such goods cannot be arbitraged away * Foreign, domestic goods not perfect substitutes: * i. e. some Can’n consumers prefer Toyatos over Chevys * Price differences reflect taste differences * Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends * i. e.PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like Canada) * Interest ra te determination in a small open economy w/ perfect Capital mobility * Why do interest rates in Canada & the U. S. tend to move up & down together? * Canada is a small open economy w/ perfect capital mobility * â€Å"small† = small part of the world economy * Canada is an economy w/ perfect capital mobility b/c * Can’ns have full access to world financial markets, * And the rest of the world has full access to the Can’n fin’l market * This means that the real interest rate in Canada should equal the real rate prevailing in the world U. S. r= r^w * Perfect Capital mobility: theory that real interest rate in Canada should equal that in the rest of the world is known as interest rate parity * Limitations: real interest rate in Canada is not always = to the real interest rate in the rest of the world b/c†¦ * Fin’l assets carry w/ them the possibility of default * Fin’l assets offered for sale in different Chapter 13: Macroeconomic theory of the open economy In an open economy, what determines the real interest rate? The real exchange rate? * Market of loanable Funds S=I + NCO * Supply of loanable funds = saving * A dollar of saving can be used to finance * The purchase of domestic capital * The purchase of foreign asset * So, demand for loanable funds=I + NCO * S depends +vely on the real interest rate, r * I depends –vely on r * Real interest rate, is the real return on domestic assets * A fall in r makes domestic assets less attractive relative to foreign assets * Can’ns purchase more foreign assets * Can’ns purchase fewer domestic assets * NCO rises * The supply & demand for loanable funds depend on the real interest rate * A higher real interest rate encourages ppl to save & raises the quantity of loanable funds supplied * The interest rate adjusts to bring the supply & demand for loanable funds into balance * At eq’m interest rate, the amt that ppl want to save exactly balances the des ired quantities of domestic investment & foreign investment * Loanable funds market diagram * R adjusts to balance supply & demand in the LF market * Both I & NCO depend –vely on r, so the D curve is downward-sloping * * In small open economy w/ perfect capital mobility, i. e. Canada, the domestic interest rate = world interst rate * As a result, the quantity of loanable funds made available by the savings of Can’ns does not have to equal the quantity of loanable funds demanded for domestic investment * The difference between these two amts is NCO * * How are the markets for loanable funds & foreign-currency exchange connected? The market for foreign-currency exchange exists b/c ppl want to trade w/ ppl in other countries, but they want to be paid in their own currency * 2 side of foreign-currency exchange market are represented by NCO & NX * NCO represents the imbalance between the purchases & sales of capital assets * NX represents the imbalance b/w exports & imports of goods & services * Another identity from preceding chapter: NCO = NX * In the market for foreign-currency exchange, * NX is the demand for dollars: foreigners need dollars to buy Can’n NX * NCO is the supply of dollars: Can’n residents provide/give dollars when they buy foreign assets * S=I + NCO > S – I =NX * What price balances the supply & demand in the market for foreign-currency exchange? * The real exchange rate (E) = e*P/P* The Can’n exchange rate(E) measures the quantity of foreign g/s that trade for one unit of Can’n g/s * E is the real value of a dollar in the market for foreign-currency exchange * The demand curve for dollars (NX) is downward sloping b/c a higher exchange rate makes domestic goods more expensive * The supply curve (NCO) is vertical b/c the quantity of dollars supplied for NCO is unrelated to the real exchange rate * Increase in E makes Can’n goods more expensive to foreigners, reduces foreign demand for Canâ⠂¬â„¢n goods & dollars, does not affect NCO/supply of dollars * The real E adjusts to balance the S & D for dollars * At Eq’m E, the demand for dollars to buy NX exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad * Disentangling S&D When can’n resident buys imported goods does the transaction affect s/d in foreign exchange market? * The demand for dollars decrease * The increase in imports reduce NX which we think of as demand for dollars (NX= net demand for dollars) * When foreigner buys Can’n asset, does the transaction affect supply/ demand in the foreign exchange market * The supply of dollars falls * NCO = Net supply of dollars How do gov’t budget deficits affect exchange rate & trade balance? * The effects of a budget deficit * National saving falls * The real interest rate rises * Domestic investment & net capital outflow both fall * The real exchange rate appreciates * Net export fall (or the trade de ficit increases) * Eq’m in the Open Economy NCO is the variable that links these two markets: S = I + NCO, NCO =NX * In the market for loanable funds, supply comes from national saving & demand comes from domestic investment & NCO * In the market for foreign-currency exchange, suplly comes from NCO & demand comes from BX * * * Eq’m in the open economy * Prices in the loanable funds market & the foreign-currency exchange market adjust simultaneously to balance supply & demand in these two markets * As they, they determine the macroeconomic variables of national saving, domestic investment, NCO, and NX How do other policies or events affect the interest rate, exchange rate, and trade balance? The magnitude & variation in important macroeconomic variables depend on the following: * Increase in world interest rates * Gov’t budget deficits & surpluses * Trade policies * Political & economic stability * Three steps in using the model to analyze these events * Determin e which of the s/d curves e/ event effects * Determine which way the curves shift * Examine how these shifts alter the economy’s equilibrium * * * Increase in world interest rates * Events outside Canada that cause world interest rates to change can have important effects on the Can’n economy * In a small open economy w/ perfect mobility, an increase in the world interest rate†¦ * Crowds out domestic investment, * Cause NCO to increase & * Causes the dollar to depreciate * The effects of an increase in the gov’t budget deficit * * Gov’t budget deficits & surpluses * b/c a gov’t budget deficit represents negative public saving, it reduces national saving, and therefore reduces†¦ * the supply of loanable funds * NCO * The supply of Can’n dollars in the market for foreign-currency exchange * Trade Policy: is a gov’t policy that directly influences the quantity of goods @ services that a country imports/exports * Tariff: a tax o n imported goods * Imported quota: a limit on quantity of a good produces abroad and sold domestically * Initial impact is on imports – which affects NX NX are the sources of demand for dollars in the foreign-currency exchange market * Imports are reduced at any exchange rate, & NX will rise * This increases the demand for dollars in the foreign currency exchange market * * * There is no change in the market for loanable funds, and therefore, no change in NCO * B/c foreigners need dollars to buy Can’n NX, there is an increased demand for dollars in the market for foreign-currency * This leads to an appreciation of the real exchange rate * Effect of an import quota * An appreciation of the dollar in the foreign exchange market discourages exports * This offsets the initial increase in NX due to import quota * Trade policies do not affect the trade balance Political Instability & Capital Flight * Capital flight * Is large & sudden reduction in demand for assets located i n a country * Has its largest impact on the country from which the capital is fleeing, but it also affects other countries * If investors become concerned about the safety of their investments, capital can quickly leave an economy * Interest rates increase & the domestic currency depreciates * When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to by assets of the other countries * This increased Mexican NCO An increased demand for loanable funds in the loanable funds market leads the interest rate to increase * This increased the supply of pesos in the foreign-currency exchange market * * Chapter 14: Aggregate Demand & Supply What are economic fluctuations? What are their characteristics? * Over LR, Real GDP grows about 2%/yr on avg * In SR, GDP fluctuates around its trend * Recessions: falling real incomes & rising unemployment * Depressions: severe recessions (very rare) * SR economic fluctuat ions are often called business cycles * 3 facts about economic fluctuations * Are irregular & unpredictable * Most macro’c quantities fluctuate together * As output falls, unemployment rises Use mode of AD & AS to study fluctuations * Short run, changes in nominal variables (Ms or P) can affect real variables (Y/U-rate) How does the model aggregate demand & supply explain economic fluctuations? * Aggregate-demand curve – shows the quantity of goods & services that households, firms, & the gov’t want to buy @ each price level * Aggregate-supply curve- shows the quantity of goods & services that firms choose to produce and sell at each price level * Why does the aggregate-demand curve slope downward? What shifts the AD curve? * AD curve shows quantity of g/s demanded in the economy at any given P * Y=C+I+G+NX * Assume G fixed by gov’t policy Increase in P reduces the quantity of g/s demanded b/c: * The wealth effect (c falls) * The dollars ppl hold buy fewe r g/s so real wealth is lower * Ppl feel poorer * i. e. a stock market boom makes households feel wealthier, C rises, the AD curve shifts right; preferences: consumption, saving tradeoff; tax hikes/cuts * Interest rate effect (I falls) * Buying g/s requires more dollars * To get these dollars, ppl borrow more * Drives up interest rates * i. e. firms buy new computers; expectations, optimism/pessimism; Interest rates, monetary policy; investment tax credit/other tax incentives * The exchange rate effect (NX falls) * Real exchange rate= exP/P* Increase real exchange rate, Can’n exchange rate appreciates * Can’n exports more expensive to ppl abroad, imports cheaper to Can’n residents * i. e. booms/recessions in countries that buy our exports (recession in the U. S. ); appreciation/depreciation resulting from int’l speculation in foreign exchange market * Changes in G * Federal spending i. e defense; provincial & municipal spending i. e roads, schools What is the slope of the aggregate-supply curve in the short run? Long run? What shifts AS curve? * AS curve shows the total quantity of g/s firms produce & sell at any given P * Upward-sloping in short run * Vertical in long run Natural rate of output (Yn) us the amt of output the economy produces when unemployment is at its natural rate * Yn is also called potential output/full-employment output * Yn determined by the economy’s labour (L) capital (K), and natural resources(N), and on the lvl of tech(A) * Changes in L/Natural rate unemployment: immigration, Baby-boomers retire, gov’t policies reduce natural u-rate * Changes in K/H: Investment in factories, more ppl get college degrees, factories destroyed by a hurricane * Changes in natural resources(N): discovery of new mineral deposits, reduction in supply of imported oil, changing weather patterns that affect agricultural production * Changes in tech (A): productivity improvements from technological progress * An increase in P does not affect any of these, it does not affect Yn (Classical dichotomy) * Any even that changes any of the determinants of Yn will shift LRAS * i. e. immigration increases L, causing Yn to rise * Over the LR, tech progress shifts LRAS to the right & growth in the MS shifts AD to the right * Ongoing inflation & growth in output * The SRAs curves is upward sloping: * Over the period of 1-2 yrs, an increase in P causes an increase in quantity of g/s supplied * If AS is vertical, fluctuations in AD do ot cause fluctuations in output/employment * If AS slopes up, then shifts in AD do affect output & employment * Three theories: * Sticky wage theory, Imperfection- nominal wages are sticky in the short run, they adjust sluggishly, due to labour contracts; firms & workers set the nominal wage in advance based on Pe, the price lvl expected to prevail * If P>Pe, revenue is higher, but labour cost is not. Productions is more profitable, so firms increase output & employment * Hence, hi gh P causes higher Y, so the SRAS curve slopes upward * Sticky price theory, Imperfection- many prices are sticky in the short run: due to menu costs, the costs of adjusting prices, i. e. ost of printing new menus, the time required to change price tags * Firms set sticky prices in advance based on Pe * Suppose the BoC increases the MS unexpectedly, in LR P will rise * In SR, firms w/o menu costs can raise their P immediately * Firms w/ menu costs wait to raise prices, meantime , their prices are relatively low, which increase demand for their products, so they increase output & employment * Hence, higher P is associated w/ higher Y, so the SRAS curve slopes upward * Misperceptions- imperfection: firms may confuse changes in P with changes in the relative price of the products they sell, if P rises above Pe- a firm sees its price rise before realizing all prices are rising. The firms may believe its relative price is rising & may increase output & employment, * An increase in P can cause an increase in Y, making the SRAS curve upward-sloping * What 3 theories have in common: Y deviates from Yn, when P deviates from Pe * Y(Output) = Yn + a(P-Pe) * Yn-Natural rate of output (LR) * a>0, measures how much Y responds to unexpected changes in P * P, actually price lvl; Pe, expected price lvl * SRAS & LRAS The imperfections in these theories are temp, over time†¦ * Sticky wages & prices become flexible * Misperceptions are corrected * In LR†¦ * Pe = P, Y=Yn, AS is vertical * Unemployment is at its natural rate * Why the SRAS curve might shift * Everything that shifts LRAS shifts SRAS too * Also, Pe shifts SRAS: * If Pe rises, workers & firms set higher wages * At e/ P production is less profitable, Y falls, SRAS shifts left * * Economic fluctuations * Caused by events that shift the AD/AS curves * 4 steps to analyzing economic fluctuations: * Determine whether the event shifts AD & AS * Determine whether curve shifts left/right Use AD-AS diagram to see how the shift changes Y & P in the short run * Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m * I. e. Stock market crash : C falls, so AD shifts left; SR eq’m at B, P & Y lower, unemp higher; Over time Pe fals, SRAS shifts right, until LR eq’m at C, Y and unemp back at initial lvls * * i. e. oil prices rises: increases costs, shifts SRAS Left, SR eq’m at point B, P higher, Y lower, unemp higher; from A to B, stagflation: a period of falling output & rising prices; if policymakers do nothing: low employment causes wages to fall SRAS shifts right until LR eq’m at A, or policymakers could use fiscal/ monetary policy to increase Ad & accommodate AS shift: Y back to Yn, but P permanently higher

Fixed Assets

Accounting for Fixed Assets Accounting for Fixed Assets Second Edition Raymond H. Peterson John Wiley & Sons, Inc. Copyright  © 2002 by John Wiley and Sons, Inc. , New York. All rights reserved.No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744.Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc. , 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ @ WILEY. COM. This publication is designed to provide accurate and authori tative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services.If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-09210-X. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www. Wiley. com To a number of people who influenced my life and prepared me for the job of creating this book: First, my mother, who not only taught me to read, but allowed me to experience the enjoyment of reading.She opened up for me the vast knowledge available in libraries. Dr. Wade Moorehouse, retired Professor of Accounting and former Chairman of the Department of Business and Economics at California State University, Hayward, who many ye ars ago, when I was an undergraduate student in his accounting course, stimulated my excitement about the accounting function. Blessed with classes of fewer than six students in a new university, we spent many class hours discussing the theory of accounting.These discussions had a large impact on my career direction. Earl Malone, a District Accounting Manager, who early in my career forced me to develop my own thoughts and not just rely on past practice. He also forced me to aquire the skill of dictation, which made the creation of this book a possibility. Dodie Peterson, world’s best secretary, who converted my ramblings into a manuscript. Contents About the Author Preface Chapter 1 What Is Accounting for Fixed Assets?Introduction Consumption of Benefits Characteristics of Assets Need to Change Chapter 2 What Is an Asset? Introduction Historical Cost Matching Principle Fixed Assets Property Plant Equipment Defining Assets Government Accounting User Fees Not-for-Profit Accoun ting xv xvii 1 1 3 4 9 11 11 12 13 14 16 17 18 20 22 24 24 vii viii Contents Chapter 3 Classifications of Asset Transactions Introduction Classification Systems Accounting Policy Decisions Coding of Transactions Property Record Coding System 7 27 28 31 33 34 39 39 39 40 44 47 48 49 49 52 52 54 54 55 55 56 57 58 58 59 59 Chapter 4 Determining Base Unit Introduction Definition of Base Unit Purpose of a Base Unit Establishing Base Units Decision Rules Difficulties in Establishment Land Buildings Equipment Criteria for Establishing Base Units Examples Spare Parts Chapter 5 Control of Property, Plant, and Equipment Introduction Asset Accountant Asset Custodian Inventories Property Record System Identification of Assets Farm Owner Applied Numbers Contents ixIdentification of Specific Asset Items to Be Tagged Bar Coded Tags Security Chapter 6 Asset Policies Manual Introduction Purpose Creating the Manual Partial Sample Manual Use of the Manual Property, Plant, and Equipment Custodianâ€⠄¢s Responsibilities Responsibilities of Asset Accountant Procedures for Purchase of Physical Assets Approval Limits Minimum Capitalization Level Items Always Charged to Expense Account Transaction Reports Data Definitions Chapter 7 Establishing Value Introduction Historical Cost Other Values Uses of Values Insurance Collateral for a Loan Purchase or Sale of a Complete Business First Creation of Property Record 0 61 64 65 67 67 67 69 69 72 72 73 75 75 75 76 76 77 83 83 84 84 85 86 86 87 87 x ContentsValuation Techniques Management Information Periodic Assessment of Value Chapter 8 Allocation of Costs to Accounting Periods Introduction Costs of Using up Assets Depreciation Estimated Life Cost Basis Allocation Methods Accelerated Depreciation Other Depreciation Concerns Tax versus Book Depreciation Balance Sheet Disclosure Not-for-Profit Organizations Chapter 9 Regulated Utilities Introduction Differences in GAAP Telecommunications Accounting Basic Property Record Telecommunications P lant in Service Chart of Accounts Railroads Property Accounts Cost of Construction Units of Property List of Units of Property Accounting for Engineering Costs 88 89 90 93 93 94 95 95 96 97 98 99 100 101 101 105 105 106 106 107 109 110 111 111 114 114 115 Contents xiCommon and Contract Motor Carriers of Passengers Carrier Operating Property Depreciation Minor Items Uniform System of Accounts—Tangible Accounts Account Definitions Chapter 10 Government Accounting Introduction Measurement Focus Fund Accounting Funding for Government Assets Accounting Standard Setting Measuring Service Efforts and Accomplishments Current Government GAAP Property Records Infrastructure Assets Measurement of Utilization Establishing Property Record Establishing Property Record Units Infrastructure Property Units Planning Accounting Policies Software Selection Off-the-Shelf Software Chapter 11 Not-for-Profit Accounting Introduction Accounting Definition of Not-for-Profit Organizations 117 117 117 11 9 119 119 123 123 124 125 126 126 127 128 128 129 130 131 131 131 132 133 134 135 135 136 xii ContentsAccounting Problems of Not-for-Profit Organizations Formal Accounting Standards Need for Change in Not-for-Profit Accounting Accounting for Property, Plant, and Equipment Creating Property Records Property Record System Documentation Chapter 12 Creation and Verification of Property Records Introduction Purpose of Property Record New Concept Requirements for a Physical Asset Database Property Record Units Coding Systems Property Record Codes for Motor Vehicles Other Codes Required Property Record ID Number Maintenance of the Property Record Database Responsibilities of Asset Manager Updating Records Recording Maintenance Costs Verification of Physical Existence Military Commander Approach Foreign Corrupt Practices Act Fully Depreciated Assets Reports from the Property Record System Chapter 13 Computer Programs Introduction Asset Database Software 138 139 140 141 143 145 147 149 149 1 50 151 152 155 155 156 156 157 158 158 159 160 161 161 163 164 165 167 167 167One-Write Systems Existing Database Programs Software Selection Off-the-Shelf Property Record Database Packages Review Copies of Software Evaluation of Software Packages Program Review Checklist for Program Review Database Fields Bibliography Index 168 169 169 170 170 171 172 175 176 179 185 xiii About the Author Raymond (Ray) H. Peterson is currently the senior partner of Ray Peterson & Associates, a consulting firm offering business assistance in establishing and changing accounting systems. He has served as the treasurer of a number of nonprofit organizations. He has over thirty years experience as a management accountant with the Bell System. He retired as Director of Financial Accounting with Pacific Bell. Mr. Peterson has managed the design of Pacific Telephone and Telegraph Companies detail property records.During the three-year breakup of the Bell System, he was appointed to a Federal Communication s Commission task force to create a new uniform system of accounts for telephone companies. The proposed system was adopted by the FCC and was installed in all telephone companies. Mr. Peterson served for 12 years on the Institute of Management Accountants Financial Accounting Standards Committee and its predecessor Subcommittee on Management Accounting Statement Promulgation. He received a BS from California State University at Hayward and an MBA from Golden Gate University in San Francisco. He also taught accounting and management information systems at Golden Gate University. xv PrefaceSince the first edition of this book in 1994, not much change has occurred to accounting standards for Property, Plant, and Equipment in business. The GAAP promulgated by the Financial Accounting, FASB, has been to further the concept of identifying the cost of an asset and spreading that cost over the accounting periods that benefit. Accounting for contributions, impairments, and financing of asse ts have been addressed by the FASB. In contrast, much has happened in the areas of Not-for-Profit and Government accounting for fixed assets. FASB ordered the capitalization of assets and charging of depreciation by Not-for-Profits. The government Accounting standards Board was created as an equal to the FASB with the authority and responsibility to promulgate GAAP for governments.They replaced the Government Finance Officers Association and its â€Å"Blue Book†, Governmental Accounting, Auditing, and Financial Reporting as the â€Å"official† accounting rules for State and Local government. An early step by the new GASB was to suspend depreciation for â€Å"government† not-for-profit accounting. There was a determination of jurisdiction between FASB and GASB which are outlined in Chapter 10, â€Å"Government Accounting† and Chapter 11, â€Å"Not-For-Profit Accounting. † Then the GASB issued concept papers that moved government accounting toward th e practices long held as appropriate for businesses. These concept papers state that assets should be placed on the books at acquisition cost and that cost spread over the accounting periods they benefit. This is a major change in accounting for these groups.Past practice was for assets to be purchased and expensed in the current period, if purchased with general revenue, or not even recorded if purchased with bonds or other special revenue sources. There was considerable argument that these changes were not appropriate for governments. Implementation of GASB statement 33 and xvii xviii Preface 34 were delayed, but are now being implemented. The accounting for governments is not the subject of this book and government accountants are referred to GASB and GFOA publications in the bibliography for the details. However, some discussion is included because it will be of interest to the business accountant that is establishing accounting policy for business and not-for-profit organizatio ns.There has been considerable argument that fixed assets of businesses should be recorded on the books at something different than depreciated original cost, that adjustments should be made to reflect the market value up as well as down, and that book asset accounting should be changed from cost allocation to reflect some measurement of value. The public review and promulgation process of the GASB provide rebuttals to all of those arguments. I urge any accountant that holds those views to research the process that GASB statements 33 and 34 followed, much of which is available on the web site at http://www. gasb. org. This book is designed for accountants and managers who want to get the most from the physical assets of their organizations. Most readers are already familiar with the oncepts and practical application of total quality management (TQM) zero defects, and the other procedures that describe a continued process of improvement. Having made the process and management changes that brought about easy improvements in quality and cost reduction they are ready to answer the following questions: How are you applying the principles of continuous improvement to the management of property, plant, and equipment? Do you have a process in place that allows you to monitor the status of maintenance (or deferred maintenance) on your property, plant, and equipment? What is the age of the oldest piece of your production equipment? Do you have a plan in place for replacement of production facilities?Are there any quality problems in your production or service delivery system caused by property, plant, and equipment failures? What is the utilization percentage of the property, plant, and equipment? Can you determine the utilization of your most expensive piece of equipment? Do you have service or production problems attributable to equipment not being available at the place needed? Are all of your property, plant, and equipment being utilized to their fullest? Preface xi x Do you have in place a process that monitors the current condition, evaluates the future need for replacement, and brings to your attention needs to modify that plan? Do you manage your physical assets or do you put them in place, use them, and replace them when they are worn out?Do your plans include having the necessary cash to purchase replacement physical assets or will you have to do an extraordinary financing or fund-raising when you are surprised by their failure? Is there a plan in place for overall management or do you simply hope your assets will continue to allow you to produce your product or provide your service? The purpose of providing this book on accounting for property, plant, and equipment, is to provide the framework for you to install in your organization accounting processes and procedures that will allow you to manage long-term physical assets. How can a book on assets help answer these questions? All accounting students learn the basics bout assets within v arious accounting courses, however, there really is not much definitive information available on fixed assets in the accounting literature. The Accounting Principles Board and the Financial Accounting Standards Board are both silent on the subject of accounting standards for fixed assets. Lacking a primary source for accounting standards, it is necessary to look to secondary sources, which also contain very little information on the handling of assets. Most accounting textbooks devote only a single chapter to capitalization of assets, and do not cover the subject in depth. Accounting periodicals have focused on valuation of assets, but offer little on specific concepts of capitalization.The issue of valuing at historical cost versus current market price has received considerable interest over the years. Now the FASB has issued statement 93 requiring not-for-profits to use historical cost less depreciation asset accounting. GASB has issued statements 33 and 34 that require that accou nting for all but a few assets. It is even more important to have this single reference to bring all these prospectives together. A number of organizations including the American Institute of Certified Public Accountants, the Institute of Management Accountants, and the Government Finance Officers Association offer courses on capitalization of assets. Most of these courses, however, cover either the tax implications of assets or the valuation question.Little in these courses describes how to establish asset policies, document them in a manual, and apply them within the company. xx Preface During 1989-1990, the National Association of Accountants (now the Institute of Management Accountants) replaced their original Statement on Management Accounting (SMA) on Fixed Assets with two statements relating to accounting for property, plant, and equipment. SMA 4J, published in 1989, described the accounting for property, plant, and equipment, and SMA 4L, published in 1990, covers control of property, plant, and equipment. A research issues publication called the Reporting, Control, and Analysis of Property, Plant, and Equipment was published in 1990.This collection of publications represents the majority of the available information on accounting for fixed assets. As a part of the IMA team coordinating those projects, I became convinced this book was needed. There is a need to emphasize that assets must be managed, not just purchased, used up, and replaced. The objective is to provide not only accounting for assets, but include that accounting in a process that will allow management to get the most out of the company’s investment. It is not always possible to create more debt in order to acquire assets. Therefore, some of our consumption must be sacrificed today in order to provide quality assets for tomorrow.In today’s complex business best quality and maximum utilization are going to give the best return on investment. Accounting for Fixed Assets contai ns more than the routine accounting processes. It also has the management framework that must surround the accounting process. The United States economy has been built since World War II as â€Å"a paper plate society. † We rapidly built our economy based on the philosophy of quick production without much concern for quality. We built automobiles that only lasted a few years, and, in fact, are still building houses in the same way that we did in the early 1950s. They require major renovation every fifteen or twenty years.Many of the houses of the early 1950s are currently the subject of redevelopment districts: they either require major repair or must be ripped out and replaced. We have built a tremendous economy and brought the majority of citizens to the highest standard of living of any culture with this â€Å"doit-quick† philosophy. It created many jobs, especially at the unskilled and semiskilled level, and brought the pleasure of accomplishment and the fruits of labor to the largest segment of U. S. citizens quickly. We have done so, however, for the sake of today and at the expense of tomorrow. But tomorrow has arrived, and we cannot continue to use up our assets. Those assets capable of bringing future benefits must be managed in a way that will allow those future benefits to occur. Preface xxiThe European and Japanese economies have grown much more slowly; jobs and the rewards that come from labors are just now reaching many segments of those cultures. However, the infrastructure base there, the assets like roads, houses, and other buildings, constructed in the 1950s is still in use and not in need of major repairs. A complete difference in philosophical approach was used in building the base for their economies. They have not sacrificed tomorrow for today, but in fact sacrificed yesterday for today—and today has arrived. Assets are those things we purchase today that will bring future benefits. But those assets must be managed to get those future benefits.To compete in a level playing field across the world, instead of in one where we make all the rules, we in the United States must evaluate our present practices. We can no longer afford to put two or three times the percentage of our gross national product into the nation’s dumps each year than competing countries do. We can no longer approach the building and operating of our businesses as we did during World War II. We learned there that we can build things quickly if they are only needed for a few years or are abandoned on the battlefield. Much of our managerial approach to business assets is alarmingly similar: build it, use it, and throw it away.To many, it is even worse than that; we buy it and don’t think about it again until it is worn out or disrupts the production line. Accounting managers must rethink their accounting processes for assets. To be value-added, accounting information must be simple and understandable, and must provide relevant, timely information to those who make decisions based on it. My goal in producing this book is not just to provide a comprehensive treatment of the details of accounting for fixed assets, but also to provide the management accountant with the processes to provide good relevant decision-making information for the officers of the company. Also, I provide the processes that are necessary to manage those assets.The book is organized to allow you to skip over the initial processes necessary to the system, and understand the principles and philosophy that are necessary in managing assets. I will also suggest a different approach to management of assets. An asset is current production that is not used up, and instead provides the means for future productivity. A hundred years ago, assets were known by business people as capital goods. Capital goods are something that must be managed for the future, not just to benefit current quarter earnings. Accounting for Fixed Assets 1 What I s Accounting for Fixed Assets? INTRODUCTION Most accounting professionals believe that all there is to be learned about asset accounting occurred in the introductory course on principles of accounting.Therefore, although this subject can become quite complex, it has not been explored in the accounting literature. In 1984 when the Federal Communications Commission (FCC) called for the rewriting of the uniform system of accounts for telephone companies, public utilities had not been following generally accepted accounting principles (GAAP) as outlined by the Financial Accounting Standards Board (FASB) and its predecessors, but instead used procedures that had been outlined in 1934 by the FCC. The team responsible for making recommendations on the rewriting of the system of accounts established a basic policy that what was to be recommended would comply with current GAAP.The subcommittee responsible for reviewing and recommending procedures for property, plant, and equipment was frustr ated by the lack of definitive information on accounting for assets. The primary sources are very limited. The Accounting Principles Board (APB) and the later FASB have been nearly silent on the subject beyond defining depreciation and historical costs. Accounting Research Bulletin (ARB) 43 was issued in 1953 to summarize all previous GAAP. It requires that depreciation be calculated 1 2 What Is Accounting for Fixed Assets? and disclosed. Most of the additional discussion on tangible assets involved explaining why depreciation is appropriately calculated using historical costs.It is true that management must take into consideration the probability that plant and machinery will have to be replaced at cost much greater than those of the facilities now in use; however, depreciation must not be calculated on the basis of this expected inflation. ARB 43 in paragraph C5 goes on to state: The cost of a reproductive facility is one of the costs of the services it renders during its useful e conomic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility.This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational matter. It is a process of allocation, not of valuation. After formation of the Accounting Principles Board, APB 6 was issued in 1964 continuing the authority outlined in ARB 43. The Board continued to support the use of historical cost as opposed to inflation accounting: The Board is of the opinion that property, plant, and equipment should not be written up by an entity to reflect appraisal, market or current values which are above cos t to the entity. APB 12, issued in 1967, requires the disclosure of depreciable assets and depreciation.In addition to total depreciation expense and the major classes of depreciable assets, it also requires disclosure of: †¢ Depreciation expense for the period. †¢ Balances of major classes of depreciable assets by nature of function, at the balance sheet date. †¢ Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date. Consumption of Benefits †¢ A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. CONSUMPTION OF BENEFITS 3 In 1984, the FASB issued Concept Statement 5, which included additional discussion of assets. However, it was also limited in scope, as one would expect in a concept statement.The discussion emphasized the recognition assumption of assets, clearly indicating that assets are consumed by their use and the cost shou ld be recognized in the accounting periods of their life. Consumption of economic benefits during a period may be recognized either directly or by relating it to revenues recognized during the period. Some expenses such as depreciation and insurance are allocated by systematic and rational procedures to the period during which the related assets are expected to provide benefits. â€Å"Any expense or loss (in future benefits) is recognized if it becomes evident that previously recognized future economic benefits of an asset have been reduced or eliminated. Since its creation, the FASB has entertained considerable discussion about assets, but the only statements issued cover specific assets: †¢ †¢ †¢ †¢ †¢ Expensing versus capitalizing research and development The accounting for software Depreciation in not-for-profit organization financial statements Impairment of Assets Involuntary Conversions FASB Concept Statement 6, Elements of Financial Statements, has more material than any other on the accounting for long-term tangible assets. However, it addresses itself primarily to the definition, the purpose of accrual accounting, and the characteristics of an asset. In 1985, Concept Statement 6 added a definition of assets: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 4 What Is Accounting for Fixed Assets?CHARACTERISTICS OF ASSETS Concept Statement 6 continues, enumerating the three essential characteristics of an asset: †¢ It embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to combine directly or indirectly to future net cash in flows. †¢ A particular entity can obtain the benefit and control others’ access to it. †¢ The transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. This is the first discussion in promu lgated accounting rules discussing the definition and characteristics of an asset. The major thrust is that probable future benefit is the definition of an asset.To reflect it on the balance sheet, the entity must be able to obtain benefit from the asset and control others’ access to the asset. This statement also reviews the concept of future economic benefit and service potential as it relates to not-for-profit organizations. It states: In a not-for-profit organization, the service potential or future economic benefit is used to provide desired or needed goods or services to beneficiaries or other constituents, which may or may not directly result in net cash inflows to the organizations. Some not-for-profit organizations rely significantly on contributions or donations of cash to supplement selling prices. . . This discussion introduces the argument that depreciation of tangible assets is an appropriate expense of not-for-profit organizations. In a discussion of accrual ac counting, Concept Statement 6 discusses assets under a heading â€Å"Recognition, Matching, and Allocation. † In paragraph 145, it states: Accrual accounting uses accrual, deferral, and allocation procedures whose goal is to relate revenues, expenses, gains, and losses to periods to reflect an entity’s performance during a period instead of merely listing its cash receipts and outlays . . . the goal of accrual accounting is to account in the periods in which they occur for the effects on an entity of transactions andCharacteristics of Assets other events and circumstances, to the extent that those financial effects are recognizable and measurable. 5 There is a discussion of costs and revenues to determine profits for periods. Depreciation and assets are excluded from the matching concept. Paragraph 149 of Concept Statement 6 explains: However, many assets yield their benefit to an entity over several periods, for example, prepaid insurance, buildings, and various kinds of equipment. Expenses resulting from their use are normally allocated to the periods of the estimated useful lives (the periods over which they are expected to provide benefits) by a rational allocation procedure, for example, by recognizing depreciation or other amortization.Although the purpose of expense allocation is the same as that of other expense recognition—to reflect the using up of assets as a result of transactions or other events or circumstances affecting an entity—allocation is applied if causal relations are generally, but not specifically, identified. For example, wear and tear from use is known to be a major cause of the expense called depreciation, but the amount of depreciation caused by wear and tear in a period normally cannot be measured. This discussion appears to make the distinction between the matching principle for revenues and expenses and the allocation of the cost of using up future benefits. Although this distinction is subtle, it is t he point of basic disagreement between those who argue for inflation accounting and the depreciating of assets based on current market value and those who argue for depreciating using a lesser historical cost.Appendix B of Concept Statement 6 further discusses characteristics of assets, defining assets as â€Å"probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. † Most of this discussion relates to intangible or nonphysical assets. The FASB, in issuing its Statement 2, Accounting for Research and Development Costs, also gives us some information on what makes up tangible physical assets. In their concern for the appropriate accounting for research and development costs, they conclude that all should be charged to expense accounts. However, they do give us their thoughts 6 What Is Accounting for Fixed Assets? bout which tangible assets should and should not be included in research and development costs. A prime consideration is that materials, equipment, and facilities that have an alternative future use (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. However, the costs of such materials, equipment, or facilities that are acquired or constructed for a particular research and development project and have no alternative future uses and therefore no separate economic values are research and development costs at the time the costs are incurred. All research and development costs encompassed by the statement are charged to expense when incurred.This reflects the concept that research and development costs will be used up during the span of the research project. Tangible assets that have a life beyond the current project, however, should be capitalized and depreciated over their useful lives. The preceding paragraphs summarize the present state of GAAP relating to property, plant, and equipment. Many subjects in acco unting have not been covered at length within the promulgated statements. Most with the significance of longterm tangible assets have been covered in more detail in secondary accounting material, but few secondary publications provide any indepth discussion on fixed assets.Research bulletins and disclosure drafts having to do with inflation accounting have not been allowed to creep into generally accepted accounting principles. Therefore, in determining the details of an accounting system for property, plant, and equipment with the FCC study in 1984 and 1985, the committee felt it necessary to use the secondary documents on assets. The documents were used to establish current practice and to form a model that telecommunications companies should use instead of the 1934 FCC regulations. The only additional definitive document discussing accounting for property, plant, and equipment was issued by the Institute of Management Accountants (IMA, formerly the National Association of Account ants) as Statement on Management Accounting (SMA) 4.SMA 4 was issued in October 1972 with the title, Fixed Asset Accounting: The Capitalization of Cost. Several concepts outlined in the twenty-four-page statement include the following: Costs through preparation for use Extraordinary repairs Base unit Characteristics of Assets Extended life or increased capacity Written policies Capitalization policy Life greater than one year Self-constructed assets that include direct overhead No initial development cost Depreciation 7 The SMA 4 discusses a number of concepts which were then, and still are, common practice. All Costs to Prepare Item for Use All costs in addition to the invoice price to make an item of property, plant, and equipment ready for use should be capitalized in its historical cost.Extraordinary Repairs Normal repairs are charged to expense when incurred; however, extraordinary repairs that extend the life, increase the capability, or increase efficiency of the item should be capitalized during its life, the historical cost increased, and depreciation recalculated from that date forward. Base Unit The base unit concept is not dealt with in any other document. It outlines the concept that property units should have a policy determination as to what constitutes the property record entity that is capitalized. The base unit might be a complete machine or the individual components of that machine. This concept is important when establishing a usable property record system for a particular company. For example, entities that use light trucks as maintenance vehicles may wear out a number of trucks during the lives of hydraulic lifts, welding equipment, and utility beds.Written Policies It is important for each company to have an asset manual with written policies. Determinations of appropriate base units and other policies unique to a company must be described and documented. Without written policies, asset accounting will not be consistent over a period of time. 8 What Is Accounting for Fixed Assets? Capitalization Policy A minimum level of capitalization should be identified. Accounting records that cost more than the items are worth are not cost effective. Life Greater than One Year Policy should emphasize that items with a life restricted to one accounting period should be expensed no matter what their cost.Self-Constructed Assets All costs of preparing assets for use should be capitalized; however, only directly attributable or traceable overhead costs should be included. General and administrative overhead costs should not be capitalized. If a company is not in the business of constructing assets, overhead costs are not likely to be increased by an individual construction project. Therefore, if those costs were capitalized, expenses in the accounting period that the asset was being constructed would be improperly reduced. Additionally, the initial development cost of making a decision on which project to construct should not be i ncluded in capitalizable costs. Subsequent costs for a specific project, once the decision has been made, are capitalized.Depreciation The idea of the relative permanence of assets that are â€Å"fixed† is questioned by SMA 4. The statement notes that periods of nonuse should be excluded from the depreciation schedule: â€Å"Until these assets can be said to have completely satisfied the purpose for which they are intended— normal or acceptable production capability—they are, for the time being, suspended accounting-wise in a sort of hiatus, not producing income, hence not triggering depreciation against which it is to be set. † SMA 4 was replaced in 1989 and 1990 by Statements 4J, Accounting for Property, Plant, and Equipment, and 4L, Control of Property, Plant, and Equipment.These two documents were prepared from a research project published by the IMA Research Committee, reporting control and analysis of property, plant, and equipment. In other documen ts the discussion of accounting for fixed or physical assets is limited to a chapter, or a few paragraphs in accounting textbooks. No lengthy document has been published that brings all the concepts of accounting for property, plant, and equipment together. Need to Change 9 There are many articles on fixed assets in accounting magazines such as Strategic Finance, published by the Institute of Management Accountants (IMA) and the Journal of Accountancy, published by the American Institute of Certified Public Accountants (AICPA). Most of these articles discuss theoretical issues of inflation accounting and depreciation.There are a number of accounting courses offered by such organizations as the IMA, AICPA, and the American Management Association, as well as by a number of accounting and appraisal firms. However, these courses are mostly directed toward the tax requirements of accounting for depreciation. Similarly, there are numerous off-the-shelf personal computer programs aimed at fixed asset accounting. Again, the primary purpose is to fulfill tax requirements and generate depreciation entries. Only a few provide for comprehensive property records. NEED TO CHANGE It has become obvious that management must change the manner in which they approach long-term tangible assets. The many production facilities built in the United States are wearing out.Government infrastructures of roads, sewers, sidewalks, and utilities are all suffering from the concept of â€Å"put it in place and forget about it. † The need is to get the most use out of these tangible assets. Much of the discussion having to do with inflation accounting for assets revolves around the problem that depreciation is not sufficient to cover the replacement costs of assets. The high cost of replacements, the dwindling supply of capital available, and high interest rates all require that new management control systems be put into place. With adequate control, management, and measurement of asset utilization, organizations can maximize the benefits from their investment in long-lived, tangible assets. 2 What Is an Asset?INTRODUCTION According to the Financial Accounting Standards Board Concepts Statement 6, assets are â€Å"probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. † The Institute of Management Accountants’ Accounting Glossary adds a second definition as â€Å"any owned physical object (tangible) or right (intangible) having economic value to its owners; an item or source of wealth with continuing benefits for future periods, expressed, for accounting purposes, in terms of its cost, or other value, such as current replacement cost. Future periods refers to the following year or years. † (SMA 2A) In its broadest sense, an asset is anything that will probably bring future economic benefit.In looking at assets, the focus will be on longlived tangible assets, sometimes referre d to as fixed assets or property, plant, and equipment. Assets are classified into two categories: tangible and intangible. Tangible assets are assets that one can touch, hold, or feel. Typically called fixed assets in accounting literature, tangible assets are the physical things that a business uses in the production of goods and services. They constitute the production facilities, buildings, equipment, and vehicles. These operational assets of a business include furniture, computers, and similar items not used up within a year. Intangible assets are primarily financing items: stocks, bonds, mortgages, etc.These assets are outside the scope of this book. 11 12 What Is an Asset? Assets that are converted into cash during the normal production cycle are current. Current physical assets are referred to as financial assets. These are physical assets such as raw materials, work-in-progress inventories, finished goods, and goods held for resale. Physical items can be financial assets, h eld in inventory, in one business, whereas in other businesses or applications they may be fixed assets. An example of such a financial asset would be real estate held in inventory by a real estate investment and sales organization or builder, which would be a fixed asset for everyone else.Equipment manufacturers have financial assets in finished goods or inventory held for sale, as well as plant and equipment that will be sold to other businesses. The inventory is a financial asset; when sold for use in a production line it becomes a fixed asset to the purchaser. HISTORICAL COST Historically, asset accounting has not stimulated the interest of accountants and managers in the United States. Assets have been analyzed in depth in terms of alternatives and appropriateness of the investment prior to purchase. However, once acquired and put in place, assets such as buildings, furniture, production equipment, and motor vehicles are given little attention.Where management attention has bee n focused, it has been in terms of return on investment and major tax benefits, such as investment tax credits and accelerated depreciation expense allowed on tax returns. In fact, these government tax incentives to buy new equipment in order to stimulate the economy have influenced management to replace still-useful assets that have been depreciated on the tax records. But there is a new perspective emerging on the part of managers and accountants with respect to fixed assets. The high initial cost to purchase, as well as the high carrying costs of debt, require a rethinking of the management of fixed assets.Many of the same factors that are bringing about just-in-time accounting philosophies and zerodefect quality control within the manufacturing process are also influencing managers’ perspectives on asset management. Zero defects and quality circles of employees are aimed to reduce the high cost of lessthan-perfect products and reflect today’s need for greater preci sion. To accomplish this higher quality production, it is necessary to have highquality production equipment. This requires preventative maintenance to keep closer tolerances and less downtime. Equipment that Matching Principle 13 fails during a production run leads to extremely high cost when the line stops.Preventative maintenance is being regularly scheduled on either an hours-of-use or calendar basis. This approach has begun to replace the attitude of put it in, use it, if it breaks repair it; if it breaks too many times, discard it and replace it. In addition to the requirements of modern processing, a new perspective on the need to manage assets—those things that you have saved and paid for which will bring future benefits to the business— has come about as a result of the significant debt held by many businesses. The public’s attention has been caught by the high government deficit, which must be financed by acquiring increasingly more debt.Large existing debt and the threat of higher interest rates on new debt due to the lower financial ratings are causing many managers to reconsider how to manage the assets they already have. Getting the maximum future value out of existing buildings and production equipment has become a more important aspect of management. In addition to process requirements and debt concerns, the cost of disposal is also growing at an alarming rate. Replacing individual parts instead of entire machines will reduce the production of refuse. In the past, accounting records of assets have been kept primarily for the purpose of establishing balance sheet amounts. The historical cost of purchasing or constructing the physical asset is included in the accounting property record.This amount, less depreciation, provides the basis for a return on investment calculation, the division of net assets (original cost less book depreciation) by net income. MATCHING PRINCIPLE The matching principle of accounting calls for the ma tching of costs with the accounting period those costs benefit. The purpose of the historical cost record is to ensure that the costs incurred in the purchase of assets in a past accounting period will be spread over the future accounting periods that benefit. The costs recorded for each asset acquired include the purchase price and anything necessary to make it ready for production. All expenditures involved in the acquisition of an asset and getting it ready for use are capitalized as part of original cost.Included are the invoice price for the asset, transportation charges, and installation costs, including any construction or changes to the building necessary to house it. Other incidental costs are sales or use tax, duties on imported items, 14 What Is an Asset? and testing and initial setup costs. The total costs of acquiring and putting the asset into actual production use should be capitalized. The use in production at a reasonable production rate (as opposed to limited use d uring testing) is also the point where capitalization stops on the new asset and depreciation begins. The cost of an asset must be spread on a rational, systematic basis over the periods of its useful life. This limited accounting application of historical cost records has led to many incorrect decisions regarding asset management.Recognizing this limitation, however, does not mean historical costs records are not necessary. Records must be established to provide information on location, maintenance history, and future usefulness of assets. Today’s high costs of debt and the need to safeguard physical assets requires going beyond the matching principle in creating property records. FIXED ASSETS Historically, even the term that accountants use for the long-lived tangible assets of business, that is, fixed assets, expressed the opinion that once purchased it is fixed, long term, and does not require management attention. In the last few years, the more common â€Å"property, p lant, and equipment† has been used to describe the operational assets of a business.Managers have found it necessary to provide additional information about property, plant, and equipment and created records separate from the accounting property record. Additional information includes current market value for insurance and security purposes, and utilization and maintenance records. A single accounting record of tangible assets with normal accounting controls is far superior to multiple records. This integrated record with accounting controls has been made much simpler with the advent and widespread use of small computers. For example, recording maintenance expenses for large equipment items is now easy. In a motor vehicle fleet, actual maintenance costs can be recorded in the property record of each vehicle.This allows review to ensure preventative maintenance is scheduled and also to establish criteria for disposing of older motor vehicles when they are no longer economical t o maintain. It then becomes possible to evaluate motor vehicles based on their entire maintenance record, rather than retiring vehicles based on age or mileage alone. What are assets fixed in? Are they fixed in time, space, or value? It is doubtful that they are fixed at all. IMA defines fixed assets as Fixed Assets 15 â€Å"noncurrent, nonmonetary tangible assets used in normal operations of a business. † See property, plant, and equipment in SMA 2A. Past practice has been to handle fixed assets as a â€Å"sunk cost,† a past cost which cannot now be reversed and, hence, should not enter into current decisions.Differential cost is â€Å"the cost that is expected to be different if one course of action is adopted as compared with the costs of an alternative course of action; used in decision making. Contrast with sunk costs. † (SMA 2A) If it is a fixed cost, then it is also a sunk cost. Is it really an asset if you cannot sell it? If you cannot move it, modify it , or maintain it? Those are alternative actions; therefore, historical cost of property, plant, and equipment are differential costs, not sunk costs. The term â€Å"fixed† cost implies a sunk cost. This management treatment of fixed costs as sunk costs may encourage hostile takeovers using junk bonds.If the current management and stockholders ignore the alternative uses of their long-term tangible assets, an outsider may see a much greater short-term value. In a case like this the current managers and owners are treating the fixed assets as a sunk cost instead of a differential cost. Few assets are fixed in any way. Most are mobile, and will disappear if not accounted for or deteriorate if not maintained. Many increase in value just because of inflation. If they do not increase in value, their replacement cost certainly increases. Typically, insurance policies require that coverage be at least 80 percent of replacement cost or recovery is limited to market value prior to the loss.Even the government is learning that their fixed asset theory for infrastructure assets needs amendment. Roads, bridges, sewer plants, and buildings seem to be in need of replacement at the same time, because they were put in place and ignored. No plan was prepared to manage them, to determine the best maintenance practice. Now they are not assets, but sources of liability. While government has a limited liability from suits due to personal injury resulting from improper maintenance of roads, etc. , businesses do not enjoy this limitation. If an employee or customer is injured by one of your bridges, roads, or other holdings, you are responsible for the costs.Is that driveway or parking lot really a fixed asset? Or one to be managed so it will not become a liability? It is difficult to imagine something that should be called a fixed asset. Assets are not fixed in any way—not in place, time, or future income 16 What Is an Asset? or expense. The exception might be a work o f art or historical treasure; however, even these items, if not protected, will deteriorate. In defining assets, therefore, we shall use the terms property, plant, and equipment and avoid future use of the term fixed assets, which is in reality an obsolete term for property, plant, and equipment. PROPERTY Property includes lands and improvements thereon.Land is not depreciated and its cost lasts in our theoretical business model forever. The cost of land includes its acquisition cost—costs of appraising, recording, and obtaining title. It also includes the initial costs of making changes to it so that it can be used for the purpose intended. This cost includes removing old buildings, leveling, and perhaps cleaning up any toxic residue. When land is acquired together with buildings, the cost will be apportioned between the land and the buildings in proportion to their appraised value. If the acquisition plan contemplates the removal of the buildings, then the total cost includ ing removal is accounted for as cost of land. Any salvage value of the emoved buildings, when disposed of, is deducted from the cost of the land. Toxic residue cleanup provides a particular problem in accounting for land. If the extent of the toxic cleanup costs are known prior to purchase, it is assumed that the purchase price has been reduced accordingly. Then it is correct to include those cleanup costs in the cost of the land. However, where land is owned and toxic residues from past practice are discovered, the cleanup of these items provides no future value. Cleaning up these toxic wastes is similar to washing a rental car or limousine. You may not be able to generate any rental revenue without a clean and polished automobile, but it does not provide future value beyond that.Cleaning up toxic wastes makes the property usable; however, it does not provide future benefit: It can only restore the usefulness of the property to its level of use prior to recognizing the toxic proble m. Improvements that theoretically have an indefinite life are also added to the cost of land. Grading, drainage, sewers, and utilities are examples. These items are put in once and unless damaged by force or disrupted by plans for new uses of the land, they do not require maintenance. Therefore, their life is assumed to be that of land forever in the accepted business model. The proper treatment of property costs is an area that must be spelled out in the accounting manual for the firm so that all similar Plant 17 transactions are handled in the same way.The manual should translate these principles into specific accounting practices for the firm. For example, electric and gas utility installation to the meter or distribution point are usually a part of the land cost. Beyond this, location utilities and part of the individual building investment are to be included in the plant category. The acquisition of property may bring about other expenditures which should be added to its histo rical cost. Some of these are as follows: Contract price Real estate broker commissions Legal fees involved in the transaction Cost of title guaranty insurance policies Cost of real estate surveys Cost of an option that has been exercised Special government assessments Fees harged by government for changes in land use or zoning Cost of removing buildings Cost of cancellation of unexpired lease Cost to move tenant if payable by purchaser Payment of past due taxes if payable by purchaser Cost of easements or rights of way Assessments for the construction of public improvements Deduction of salvage value from buildings removed and sold Toxic waste cleanup Grading land and providing drainage Placing utilities PLANT The term plant has its origin in manufacturing, where the plant is literally used to house the production equipment. This includes buildings and other structures or improvements that have a limited life. Paved parking lots and sprinkler systems, as well as recreational and la ndscaping improvements, are included.Also included in plant are fences, roads, and grading and excavation costs necessary to construction of the buildings. The distinction between property (land) and plant is the 18 What Is an Asset? duration of usefulness. Improvements to the property that will have a measurable or estimated life should be depreciated over that life. Therefore, they are charged to the plant account. If they are of indefinite life, they are treated as property. All expenditures directly related to the purchase or construction of buildings or other physical plant are included in plant cost. Land includes the cost of preparation of a construction site. All costs for a specific construction are included in the cost of the product.Some of the other expenditures that should be added to the capitalized cost of the asset acquired are as follows: Contract price or cost of construction Cost of grading and excavation for the specific building Expenses incurred in removing tre es and other foliage for the specific building Costs of remodeling or altering a purchased building to make it ready for use Costs for architect’s fees, plans, and other planning events Cost of government fees and building permits Payment of prior year taxes accrued on the building if payable by purchaser Other costs such as security or temporary fencing, temporary buildings used during construction, or other costs directly attributable to the construction or purchase of the specific building Capitalized interest EQUIPMENT Equipment includes the machinery, computers, office equipment, and all other long-lived items necessary for the operation of the business.These items require more managerial control because of their portability and general usefulness for other than the purpose intended when acquired. They range in price from a minimum capitalization level to many millions of dollars for complex production machinery. Because of the wide variety of requirements for different items of equipment, we shall discuss them in several categories, including: Tools Building systems (heating, cooling, elevators) Equipment Irrigation equipment Furniture and office equipment Computers Printing presses Automobiles Tractors Trucks Trailers Aircraft Livestock Furniture and Office Equipment 19 Furniture and office fixtures are long-lived assets needed to run a business.In the service industries, except for buildings, these will be the major tangible assets of the business. The establishment of a reasonable minimum capitalization level has to be weighed against the other factors of managing this class of equipment. Office desks and chairs that are personally used by one manager will receive the attention necessary to safeguard and ensure proper maintenance as required. Many companies establish a $5,000 minimum capitalization level for these items. However, telephone equipment purchased may become obsolete or require significant maintenance after a short period of time. A lso, office copiers, fax machines, and computers have a need for greater management and future planning.It is important that these items not all have a requirement for replacement in the same future year. Inclusion in the property record, which subjects such items to the controls provided in that system, may in fact reduce the dollar value at which it is desirable to maintain capitalization. These items should be included in a detailed policy and outlined in the handbook on asset capitalization or its chapter in the accounting policy manual of the business. When the decision is made to capitalize a particular item of equipment, all costs involved in putting it into a condition ready for use should be included in the asset value. Some of the costs that may be incurred are: Contract price Commissions paid 20 What Is an Asset?Legal fees and other contract costs Cost of title guaranty insurance policies Cost of transferring title Freight, handling, and storage costs Sales or use tax and other taxes or fees assessed Costs of preparation of the space for installation (foundations, special walls, removal of windows) Use of cranes or other means of installation Installation charges Cost of testing and preparation for use Costs of reconditioning used equipment purchased DEFINING ASSETS Assets are not always easily defined. For example, a Berkeley, California, producer of â€Å"baby† vegetables for New York City upscale restaurants could not function without the regular and dependable inexpensive air shuttle of the crop each morning.The New York restaurants pay a premium for the product, but it must be picked that morning and delivered to New York City by noon for serving in restaurants that evening. Is the transportation link from San Francisco airport to New York an asset of this Berkeley producer? From an accounting sense, it is not; however, it continues to deliver future benefits to the company. Without that transportation link being available, there would b e no business; but it would be impossible to establish any value to that transportation link without a sale. If the business were to be sold, it is likely to command as an operating business more than the value of its individual components. This additional value will be included on the purchaser’s balance sheet as goodwill.Much of that goodwill can be a result of an existing working transportation system from the producer’s garden to the upscale restaurants. Goodwill is an intangible asset. Accounting recognizes it only because there has been an actual payment for it. It must be recognized somehow as its usefulness is used up over future periods. The asset exists whether it is recognized in the book of accounts as goodwill or not. However, this emphasizes the accounting concept of recognizing asset value in accounting systems for the purpose of measuring the decrease in its future usefulness in relationship to its original cost. In this Defining Assets 21 case, it is n ot a problem in defining the asset, but in establishing the asset’s value. There are other difficulties in defining an asset.In industries where investment in property, plant, and equipment is low in comparison to return on products, there has been no need to closely manage the investment in assets. Examples are restaurants where investment is limited to leasehold improvements. The concern of restaurant managers is keeping their lease and labor costs down. The investment in fixed assets required to run a substantial restaurant is small in comparison to its gross sales. The investment in leasehold improvements for a restaurant many times are sunk costs. They have value only to the end of the lease. It may also be desirable for marketing purposes to substantially alter them prior to the end of their useful life.Here the value is easily established based on what they cost to install. However, they might not be providing future benefits and therefore require replacement before th eir costs have been recognized. A different management problem exists when investment in capital items is large relative to the cost of production or when there are few other opportunities to use the assets for different purposes. Examples are oil refineries and pharmaceutical laboratories. Once the refinery or drug production facilities are constructed, they are not readily usable for any other purpose. There is also little opportunity to make decisions relative to alternative use of these assets.A grocery store location could be altered to become a restaurant or a hardware store, but an oil refinery would cost more to dismantle than it originally cost to construct. These cases raise the question of the value of alternative uses. The accounting principle of recognizing decline in service value through depreciation takes this into account in the concept of salvage value. Salvage value is the value which the asset has at the end of its useful life. The oil refinery would have a nega