English Course for Finance.pdf

Part 1 Accounting 5

COMPANY FINANCIAL STATEMENTS 6 MEASUREMENT PRINCIPLES 11

AAddrriiaannaa oofflleetteeaa MANAGERIAL ACCOUNTING 21

OTHER PURPOSES OF ACCOUNTING SYSTEMS 37

Part 2 Banks and Banking 39

The development of banking systems 41 The business of banking 45

EEnngglliisshh CCoouurrssee FFoorr FFiinnaannccee FUNCTIONS OF COMMERCIAL BANKS 45 INDUSTRIAL FINANCE 52

The principles of central banking 56

RESPONSIBILITIES OF CENTRAL BANKS 57 TECHNIQUES OF CREDIT CONTROL 67

The structure of modern banking systems 83 UNIT BANKING THE UNITED STATES 84 BRANCH BANKING: THE UNITED KINGDOM 88

HYBRID SYSTEMS 89

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Part 1 Accounting Part 3 Insurance 97

Kinds of insurance 99 The purpose of accounting is to provide information about the economic affairs of an organization. This information may be used in a number of ways: by the organization's managers to help them plan and control the organization's operations; by owners and legislative or regulatory bodies to help them appraise the organization's performance and make decisions as to its future; by owners, lenders, suppliers, employees, and others to help them decide how much time or money to devote to the organization; by governmental bodies to determine how much tax the organization must pay; and occasionally by customers to determine the price to be paid when contracts call for cost-based payments. Accounting provides information for all these purposes through the maintenance of files of data, analysis and interpretation of these data, and the preparation of various kinds of reports. Most accounting information is historical--that is, the accountant observes the things that the organization does, records their effects, and prepares reports summarizing what has been recorded; the rest consists of forecasts and plans for current and future periods. Accounting information can be developed for any kind of organization, not just for privately owned, profit-seeking businesses. One branch of accounting deals with the economic operations of entire nations.

PROPERTY INSURANCE 99

MARINE INSURANCE 106

LIABILITY INSURANCE 113

SURETYSHIP 128

LIFE AND HEALTH INSURANCE 132

Insurance practice 148

UNDERWRITING AND RATE MAKING 148 LEGAL ASPECTS OF INSURANCE 154

Historical development of insurance 165

Bibliography 171

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COMPANY FINANCIAL STATEMENTS Among the most common accounting reports are those sent to investors and others outside the management group. The reports most likely to go to investors are called financial statements, and their preparation is the province of the branch of accounting known as financial accounting. Three financial statements will be discussed: the balance sheet, the income statement, and the statement of cash flows.

The balance sheet.

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A balance sheet describes the resources that are under a company's control on a specified date and indicates where these resources have come from. It consists of three major sections: (1) the assets: valuable rights owned by the company; (2) the liabilities: the funds that have been provided by outside lenders and other creditors in exchange for the company's promise to make payments or to provide services in the future; and (3) the owners' equity: the funds that have been provided by the company's owners or on their behalf. The list of assets shows the forms in which the company's resources are lodged; the lists of liabilities and the owners' equity indicate where these same resources have come from. The balance sheet, in other words, shows the company's resources from two points of view, and the following relationship must always exist: total assets equals total liabilities plus total owners' equity. This same identity is also expressed in another way: total assets minus total liabilities equals total owners'

equity. In this form, the equation emphasizes that the owners' equity in the company is always equal to the net assets (assets minus liabilities). Any increase in one will inevitably be accompanied by an increase in the other, and the only way to increase the owners' equity is to increase the net assets. Assets are ordinarily subdivided into current assets and noncurrent assets. The former include cash, amounts receivable from customers, inventories, and other assets that are expected to be consumed or can be readily converted into cash during the next operating cycle (production, sale, and collection). Noncurrent assets may include noncurrent receivables, fixed assets (such as land and buildings), and long-term investments. The liabilities are similarly divided into current liabilities and noncurrent liabilities. Most amounts payable to the company's suppliers (accounts payable), to employees (wages payable), or to governments (taxes payable) are included among the current liabilities. Noncurrent liabilities consist mainly of amounts payable to holders of the company's long-term bonds and such items as obligations to employees under company pension plans. The difference between total current assets and total current liabilities is known as net current assets, or working capital. The owners' equity of an American company is divided between paid-in capital and retained earnings. Paid-in capital represents the amounts paid to the corporation in exchange for shares of the company's preferred and common stock. The major part of this, the capital paid in by the common shareholders, is usually divided into two parts, one representing the par value, or

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stated value, of the shares, the other representing the excess over this amount. The amount of retained earnings is the difference between the amounts earned by the company in the past and the dividends that have been distributed to the owners. A slightly different breakdown of the owners' equity is used in most of continental Europe and in other parts of the world. The classification distinguishes between those amounts that cannot be distributed except as part of a formal liquidation of all or part of the company (capital and legal reserves) and those amounts that are not restricted in this way (free reserves and undistributed profits). The income statement is usually accompanied by a statement that shows how the company's retained earnings has changed during the year. Net income increases retained earnings; net operating loss or the distribution of cash dividends reduces it.

The statement of cash flows. Companies also prepare a third financial statement, the statement of cash flows. Cash flows result from three major groups of activities: (1) operating activities, (2) investing activities, and (3) financing activities. The income statement differs from the cash flow statement in other ways, too. Cash was received from the issuance of bonds and was paid to shareowners as dividends; neither of those figured in the income statement. Cash was also paid to purchase equipment; this added to the plant and equipment asset but was not

subtracted from current revenues because it would be used for many years, not just this one. Cash from operations is not the same as net income (revenues minus expenses). For one thing, not all revenues are collected in cash. Revenue is usually recorded when a customer receives merchandise and either pays for it or promises to pay the company in the future (in which case the revenue is recorded in accounts receivable). Cash from operating activities, on the other hand, reflects the actual cash collected, not the inflow of accounts receivable. Similarly, an expense may be recorded without an actual cash payment. The purpose of the statement of cash flows is to throw light on management's use of the financial resources available to it and to help the users of the statements to evaluate the company's liquidity, its ability to pay its bills when they come due.

Consolidated statements. Most large corporations in the United States and other industrialized countries own other corporations. Their primary financial statements are consolidated statements, reflecting the total assets, liabilities, owners' equity, net income, and cash flows of all the corporations in the group. Thus, for example, the consolidated balance sheet of the parent corporation (the corporation that owns the others) does not list its investments in its subsidiaries (the companies it owns) as assets; instead, it includes their assets and liabilities with its own.

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Some subsidiary corporations are not wholly owned by the parent; that is, some shares of their common stock are owned by others. The equity of these minority shareholders in the subsidiary companies is shown separately on the balance sheet. For example, if Any Company, Inc., had minority shareholders in one or more subsidiaries, the owners' equity section of its Dec. 31, 19--, balance sheet might appear as follows:

The consolidated income statement also must show the minority owners' equity in the earnings of a subsidiary as a deduction in the determination of net income. For example:

Disclosure and auditing requirements. A corporation's obligations to issue financial statements are prescribed in the company's own statutes or bylaws and in public laws and regulations. The financial statements of most large and medium-size companies in the United States fall primarily within the jurisdiction of the federal Securities and Exchange

Commission (SEC). The SEC has a good deal of authority to prescribe the content and structure of the financial statements that are submitted to it. Similar authority is vested in provincial regulatory bodies and the stock exchanges in Canada; disclosure in the United Kingdom is governed by the provisions of the Companies Act. A company's financial statements are ordinarily prepared initially by its own accountants. Outsiders review, or audit, the statements and the systems the company used to accumulate the data from which the statements were prepared. In most countries, including the United States, these outside auditors are selected by the company's shareholders. The audit of a company's statements is ordinarily performed by professionally qualified, independent accountants who bear the title of certified public accountant (CPA) in the United States and chartered accountant (CA) in the United Kingdom and many other countries with British-based accounting traditions. Their primary task is to investigate the company's accounting data and methods carefully enough to permit them to give their opinion that the financial statements present fairly the company's position, results, and cash flows.

MEASUREMENT PRINCIPLES In preparing financial statements, the accountant has several measurement systems to choose from. Assets, for example, may be measured at what they cost in the past or what they could be sold for now, to mention only two possibilities. To enable users to interpret statements with

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confidence, companies in similar industries should use the same measurement concepts or principles. In some countries these concepts or principles are prescribed by government bodies; in the United States they are embodied in "generally accepted accounting principles" (GAAP), which represent partly the consensus of experts and partly the work of the Financial Accounting Standards Board (FASB), a private body. The principles or standards issued by the FASB can be overridden by the SEC. In practice, however, the SEC generally requires corporations within its jurisdiction to conform to the standards of the FASB.

Asset value. One principle that accountants may adopt is to measure assets at their value to their owners. The economic value of an asset is the maximum amount that the company would be willing to pay for it. This amount depends on what the company expects to be able to do with the asset. For business assets, these expectations are usually expressed in terms of forecasts of the inflows of cash the company will receive in the future. If, for example, the company believes that by spending $1 on advertising and other forms of sales promotion it can sell a certain product for $5, then this product is worth $4 to the company. When cash inflows are expected to be delayed, value is less than the anticipated cash flow. For example, if the company has to pay interest at the rate of 10 percent a year, an investment of $100 in a one-year asset today will not be worthwhile unless it will return at least $110 a

year from now ($100 plus 10 percent interest for one year). In this example, $100 is the present value of the right to receive $110 one year later. Present value is the maximum amount the company would be willing to pay for a future inflow of cash after deducting interest on the investment at a specified rate for the time the company has to wait before it receives its cash. Value, in other words, depends on three factors: (1) the amount of the anticipated future cash flows, (2) their timing, and (3) the interest rate. The lower the expectation, the more distant the timing, or the higher the interest rate, the less valuable the asset will be. Value may also be represented by the amount the company could obtain by selling its assets. This sale price is seldom a good measure of the assets' value to the company, however, because few companies are likely to keep many assets that are worth no more to the company than their market value. Continued ownership of an asset implies that its present value to the owner exceeds its market value, which is its apparent value to outsiders.

Asset cost. Accountants are traditionally reluctant to accept value as the basis of asset measurement in the going concern. Although monetary assets such as cash or accounts receivable are usually measured by their value, most other assets are measured at cost. The reason is that the accountant finds it difficult to verify the forecasts upon which a generalized value measurement system would have to be based. As a result, the balance sheet does not pretend to show how much the company's assets are

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worth; it shows how much the company has invested in them. The historical cost of an asset is the sum of all the expenditures the company made to acquire it. This amount is not always easily measurable. If, for example, a company has built a special-purpose machine in one of its own factories for use in manufacturing other products, and the project required logistical support from all parts of the factory organization, from purchasing to quality control, then a good deal of judgment must be reflected in any estimate of how much of the costs of these logistical activities should be "capitalized" (i.e., placed on the balance sheet) as part of the cost of the machine.

Net income.

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From an economic point of view, income is defined as the change in the company's wealth during a period of time, from all sources other than the injection or withdrawal of investment funds. Income is the amount the company could consume during the period and still have as much real wealth at the end of the period as it had at the beginning. For example, if the value of the net assets (assets minus liabilities) has gone from $1,000 to $1,200 during a period and dividends of $100 have been distributed, income measured on a value basis would be $300 ($1,200 minus $1,000, plus $100). Accountants generally have rejected this approach for the same reason that they have found value an unacceptable basis for asset measurement: Such a measure would rely too much on estimates of what will happen in the future, estimates that would not be readily

susceptible to independent verification. Instead, accountants have adopted what might be called a transactions approach to income measurement. They recognize as income only those increases in wealth that can be substantiated from data pertaining to actual transactions that have taken place with persons outside the company. In such systems, income is measured when work is performed for an outside customer, when goods are delivered, or when the customer is billed. Recognition of income at this time requires two sets of estimates: (1) revenue estimates, representing the value of the cash that the company expects to receive from the customer; and (2) expense estimates, representing the resources that have been consumed in the creation of the revenues. Revenue estimation is the easier of the two, but it still requires judgment. The main problem is to estimate the percentage of gross sales for which payment will never be received, either because some customers will not pay their bills ("bad debts") or because they will demand and receive credit for returned merchandise or defective work. Expense estimates are generally based on the historical cost of the resources consumed. Net income, in other words, is the difference between the value received from the use of resources and the cost of the resources that were consumed in the process. As with asset measurement, the main problem is to estimate what portion of the cost of an asset has been consumed during the period in question. Some assets give up their services gradually rather than all at once. The cost of the portion of these assets the company uses to produce revenues in any period is that

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period's depreciation expense, and the amount shown for these assets on the balance sheet is their historical cost less an allowance for depreciation, representing the cost of the portion of the asset's anticipated lifetime services that has already been used. To estimate depreciation, the accountant must predict both how long the asset will continue to provide useful services and how much of its potential to provide these services will be used up in each period. Depreciation is usually computed by some simple formula. The two most popular formulas in the United States are straight-line depreciation, in which the same amount of depreciation is recognized each year, and declining-charge depreciation, in which more depreciation is recognized during the early years of life than during the later years, on the assumption that the value of the asset's service declines as it gets older. The role of the independent accountant (the auditor) is to see whether the company's estimates are based on formulas that seem reasonable in the light of whatever evidence is available and whether these formulas are applied consistently from year to year. Again, what is "reasonable" is clearly a matter of judgment. Depreciation is not the only expense for which more than one measurement principle is available. Another is the cost of goods sold. The cost of goods available for sale in any period is the sum of the cost of the beginning inventory and the cost of goods purchased in that period. This sum then must be divided between the cost of goods sold and the cost of the ending inventory:

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Accountants can make this division by any of three main inventory costing methods: (1) first in, first out (FIFO), (2) last in, first out (LIFO), or (3) average cost. The LIFO method is widely used in the United States, where it is also an acceptable costing method for income tax purposes; companies in most other countries measure inventory cost and the cost of goods sold by some variant of the FIFO or average cost methods. Average cost is very similar in its results to FIFO, so only FIFO and LIFO need be described. Each purchase of goods constitutes a single batch, acquired at a specific price. Under FIFO, the cost of goods sold is determined by adding the costs of various batches of the goods available, starting with the oldest batch in the beginning inventory, continuing with the next oldest batch, and so on until the total number of units equals the number of units sold. The ending inventory, therefore, is assigned the costs of the most recently acquired batches. For example, suppose the beginning inventory and purchases were as follows:

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Problems of measurement. The company sold 1,900 units during the year and had 1,100 units remaining in inventory at the end of the year. The FIFO cost of goods sold is:

Accounting income does not include all of the company's holding gains or losses (increases or decreases in the market values of its assets). For example, construction of a superhighway may increase the value of a company's land, but neither the income statement nor the balance sheet will report this holding gain. Similarly, introduction of a successful new product increases the company's anticipated future cash flows, and this increase makes the company more valuable. Those additional future sales show up neither in the conventional income statement nor in the balance sheet. Accounting reports have also been criticized on the grounds that they confuse monetary measures with the underlying realities when the prices of many goods and services have been changing rapidly. For example, if the wholesale price of an item has risen from $100 to $150 between the time the company bought it and the time it is sold, many accountants claim that $150 is the better measure of the amount of resources consumed by the sale. They also contend that the $50 increase in the item's wholesale value before it is sold is a special kind of holding gain that should not be classified as ordinary income. When inventory purchase prices are rising, LIFO inventory costing keeps many gains from the holding of inventories out of net income. If purchases equal the quantity sold, the entire cost of goods sold will be measured at the higher current prices; the ending inventory will be measured at the lower prices shown for the beginning-of-year inventory. The difference between

The ending inventory consists of 1,100 units at a FIFO cost of $5.50 each (the price of the last 1,100 units purchased), or $6,050. Under LIFO, the cost of goods sold is the sum of the most recent purchase, the next most recent, and so on, until the total number of units equals the number sold during the period. In the example, the LIFO cost of goods sold is:

The LIFO cost of the ending inventory is the cost of the oldest units in the cost of goods available. In this simple example, assuming the company adopted LIFO at the beginning of the year, the ending inventory cost is the 1,000 units in the beginning inventory at $5 each ($5,000), plus 100 units from the first purchase during the year at $5.25 each ($525), a total of $5,525.

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the LIFO inventory cost and the replacement cost at the end of the year is an unrealized (and unreported) holding gain. In the inventory example cited earlier, the LIFO cost of goods sold ($10,275) exceeded the FIFO cost of goods sold ($9,750) by $525. In other words, LIFO kept $525 more of the inventory holding gain out of the income statement than FIFO did. Furthermore, the replacement cost of the inventory at the end of the year was $6,050 (1,100 $5.50), which was just equal to the inventory's FIFO cost; under LIFO, in contrast, there was an unrealized holding gain of $525 ($6,050 minus the $5,525 LIFO inventory cost). The amount of inventory holding gain that is included in net income is usually called the "inventory profit." The implication is that this is a component of net income that is less "real" than other components because it results from the holding of inventories rather than from trading with customers. When most of the changes in the prices of the company's resources are in the same direction, the purchasing power of money is said to change. Conventional accounting statements are stated in nominal currency units (dollars, francs, lire, etc.), not in units of constant purchasing power. Changes in purchasing power--that is, changes in the average level of prices of goods and services--have two effects. First, net monetary assets (essentially cash and receivables minus liabilities calling for fixed monetary payments) lose purchasing power as the general price level rises. These losses do not appear in conventional accounting statements. Second, holding gains measured in nominal currency units may

merely result from changes in the general price level. If so, they represent no increase in the company's purchasing power. In some countries that have experienced severe and prolonged inflation, companies have been allowed or even required to restate their assets to reflect the more recent and higher levels of purchase prices. The increment in the asset balances in such cases has not been reported as income, but depreciation thereafter has been based on these higher amounts. Companies in the United States are not allowed to make these adjustments in their primary financial statements.

MANAGERIAL ACCOUNTING Although published financial statements are the most widely visible products of business accounting systems and the ones with which the public is most concerned, they are only the tip of the iceberg. Most accounting data and most accounting reports are generated solely or mainly for the company's managers. Reports to management may be either summaries of past events, forecasts of the future, or a combination of the two. Preparation of these data and reports is the focus of managerial accounting, which consists mainly of four broad functions: (1) budgetary planning, (2) cost finding, (3) cost and profit analysis, and (4) performance reporting.

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Although plans can be either broad, strategic outlines of the company's future or schedules of the inputs and outputs associated with specific independent programs, most business plans are periodic plans--that is, they refer to company operations for a specified period of time. These periodic plans are summarized in a series of projected financial statements, or budgets. The two principal budget statements are the profit plan and the cash forecast. The profit plan is an estimated income statement for the budget period. It summarizes the planned level of selling effort, shown as selling expense, and the results of that effort, shown as sales revenue and the accompanying cost of goods sold. Separate profit plans are ordinarily prepared for each major segment of the company's operations.

Budgetary planning. The first major component of internal accounting systems for management's use is the company's system for establishing budgetary plans and setting performance standards. The setting of performance standards requires also a system for measuring actual results and reporting differences between actual performance and the plans.

Figure 1: Budget planning and performance reporting.

The simplified diagram in Figure 1 illustrates the interrelationships between these elements. The planning process leads to the establishment of explicit plans, which then are translated into action. The results of these actions are compared with the plans and reported in comparative form. Management can then respond to substantial deviations from plan, either by taking corrective action or, if outside conditions differ from those predicted or assumed in the plans, by preparing revised plans.

Figure 2: Relationship of company profit plan to responsibility structure.

The details underlying the profit plan are contained in departmental sales and cost budgets, each part identified with the executive or group responsible for carrying out

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that part. Figure 2 shows the essence of this relationship: the company's profit plan is really the integrated product of the plans of its two major product divisions. The arrows connecting the two divisional plans represent the coordinative communications that tie them together on matters of mutual concern. The exhibit also goes one level farther down, showing that division B's profit plan is really a coordinated synthesis of the plans of the division's marketing department and manufacturing department. Arrows again emphasize the necessary coordination between the two. Each of these departmental plans, in turn, is a summary of the plans of the major offices, plants, or other units within the division. A complete representation of the company's profit plan would require an extension of the diagram through several layers to encompass every single responsibility centre in the entire company. Many companies also prepare alternative budgets for operating volumes other than the volume anticipated for the period. A set of such alternative budgets is known as the flexible budget. The practice of flexible budgeting has been adopted widely by factory management to facilitate evaluation of cost performance at different volume levels and has also been extended to other elements of the profit plan. The second major component of the annual budgetary plan, the cash forecast or cash budget, summarizes the anticipated effects on cash of all the company's activities. It lists the anticipated cash payments, cash receipts, and amount of cash on hand, month by month throughout the year. In most companies, responsibility for cash management rests mainly in the head office rather than at

the divisional level. For this reason, divisional cash forecasts tend to be less important than divisional profit plans. Company-wide cash forecasts, on the other hand, are just as important as company profit plans. Preliminary cash forecasts are used in deciding how much money will be made available for the payment of dividends, for the purchase or construction of buildings and equipment, and for other programs that do not pay for themselves immediately. The amount of short-term borrowing or short-term investment of temporarily idle funds is then generally geared to the requirements summarized in the final, adjusted forecast. Other elements of the budgetary plan, in addition to the profit plan and the cash forecast, include capital expenditure budgets, personnel budgets, production budgets, and budgeted balance sheets. They all serve the same purpose: to help management decide upon a course of action and to serve as a point of reference against which to measure subsequent performance. Planning is a management responsibility, not an accounting function. To plan is to decide, and only the manager has the authority to choose the direction the company is to take. Accounting personnel are nevertheless deeply involved in the planning process. First, they administer the budgetary planning system, establishing deadlines for the completion of each part of the process and seeing that these deadlines are met. Second, they analyze data and help management at various levels compare the estimated effects of different courses of action. Third, they are responsible for collating the tentative plans and proposals coming from the

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individual departments and divisions and then reviewing them for consistency and feasibility and sometimes for desirability as well. Finally, they must assemble the final plans management has chosen and see that these plans are understood by the operating executives.

A second method, job order costing, is used when individual production centres or departments work on a variety of products rather than just one during a typical time period. Two categories of factory cost are recognized under this method: prime costs and factory overhead costs. Prime costs are those that can be traced directly to a specific batch, or job lot, of products. These are the direct labour and direct materials costs of production. Overhead costs, on the other hand, are those that can be traced only to departmental operations or to the factory as a whole and not to individual job orders. The salary of a departmental supervisor is an example of an overhead cost. Direct materials and direct labour costs are recorded directly on the job order cost sheets, one for each job. Although not traceable to individual jobs, overhead costs are generally assigned to them by means of overhead rates--i.e., the ratio of total overhead cost to total production volume for a given time period. A separate overhead rate is usually calculated for each production department, and, if the operations of a department are varied, it is often subdivided into a set of more homogeneous cost centres, each with its own overhead rate. Separate overhead rates are sometimes used even for individual processing machines within a department if the machines differ widely in such factors as power consumption, maintenance cost, and depreciation. Because output within a cost centre is not homogeneous, production volume must be measured by something other than the number of units of product, such as the number of machine hours or direct labour hours. Once the overhead rate has been determined, a

Cost finding. A major factor in business planning is the cost of producing the company's products. Cost finding is the process by which the company obtains estimates of the costs of producing a product, providing a service, performing a function, or operating a department. Some of these estimates are historical--how much did it cost?--while others are predictive--what will it cost? The basic principle in cost finding is that the cost assigned to any object--an activity or a product--should represent the amount of cost that object causes. The most fully developed methods of cost finding are used to estimate the costs that have been incurred in a factory to manufacture specific products. The simplest of these methods is known as process costing. In this method, the accountant first accumulates the costs of each separate production operation or process for a specified period of time. The total of these costs is then restated as an average by dividing it by the total output of the process during the same period. Process costing can be used whenever the output of individual processes is reasonably uniform or homogeneous, as in cement manufacturing, flour milling, and other relatively continuous production processes.

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provision for overhead cost can be entered on each job order cost sheet on the basis of the number of direct labour hours or machine hours used on that job. For example, if the overhead rate is $3 a machine hour and Job No. 7128 used 600 machine hours, then $1,800 would be shown as the overhead cost of this job. Many production costs are incurred in departments that don't actually produce goods or provide salable services. Instead, they provide services or support to the departments that do produce products. Examples include maintenance departments, quality control departments, and internal power plants. Estimates of these costs are included in the estimated overhead costs of the production departments by a process known as allocation--that is, estimated service department costs are allocated among the production departments in proportion to the amount of service or support each receives. The departmental overhead rates then include provisions for these allocated costs. A third method of cost finding, activity-based costing, is based on the fact that many costs are driven by factors other than product volume. The first task is to identify the activities that drive costs. The next step is to estimate the costs that are driven by each activity and state them as averages per unit of activity. Management can use these averages to guide its efforts to reduce costs. In addition, if management wants an estimate of the cost of a specific product, the accountant can estimate how many of the activity units are associated with that product and multiply those numbers by the average costs per activity unit.

For example, suppose that costs driven by the number of machine hours average $12 per machine hour, costs driven by the number of production batches average $100 a batch, and the costs of keeping a product in the line average $100 a year for each kind of material or component part used. Keeping in the line a product that is assembled from six component parts thus incurs costs of 6 $100 = $600 a year, irrespective of volume and even if the product is not made at all during the period. If annual production amounts to 10,000 units, the unit cost of product maintenance is $600/10,000 = $.06 a unit. If this product is manufactured in batches of 1,000 units, then batch-driven costs average $100/1,000 = $.10 a unit. And, if a batch requires 15 machine hours, hour-driven costs average 15 $12/1,000 = $.18 a unit. At the 10,000-unit volume, then, the cost of this product is $.06 + $.10 + $.18 = $.34 a unit plus the cost of materials. Product cost finding under activity-based costing is almost always a process of estimating costs before production takes place. The method of process costing and job order costing can be used either in preparing estimates before the fact or in assigning costs to products as production proceeds. Even when job order costing is used to tally the costs actually incurred on individual jobs, the overhead rates are usually predetermined--that is, they represent the average planned overhead cost at some production volume. The main reason for this is that actual overhead cost averages depend on the total volume and efficiency of operations and not on any one job alone. The relevance of job order cost information will be impaired if these external fluctuations are allowed to change the amount of overhead cost assigned to a

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particular job. Many systems go even farther than this. Estimates of the average costs of each type of material, each operation, and each product are prepared routinely and identified as standard costs. These are then readily available whenever estimates are needed and can also serve as an important element in the company's performance reporting system, as described below. Similar methods of cost finding can be used to determine or estimate the cost of providing services rather than physical goods. Most advertising agencies and consulting firms, for example, maintain some form of job cost records, either as a basis for billing their clients or as a means of estimating the profitability of individual jobs or accounts. The methods of cost finding described in the preceding paragraphs are known as full, or absorption, costing methods, in that the overhead rates are intended to include provisions for all manufacturing costs. Both process and job order costing methods can also be adapted to variable costing in which only variable manufacturing costs are included in product cost. Variable costs are those that will be greater in total in the upper portions of the company's normal range of volumes than in the lower portion. Total fixed costs, in contrast, are the same at all volume levels within the normal range. Unit cost under variable costing represents the average variable cost of making the product. The main argument for the variable costing approach is that average variable cost is more relevant to short-horizon managerial decisions than average full cost. In deciding whether to manufacture goods in large lots, for example,

management needs to estimate the cost of carrying larger amounts of finished goods in inventory. More variable costs will have to be incurred to build the inventory to a higher level; fixed manufacturing costs presumably will be unaffected. Furthermore, when a management decision changes the company's fixed costs, the change is unlikely to be proportional to the change in volume; therefore, average fixed cost is seldom a valid basis for estimating the cost effects of such decisions. Variable costing eliminates the temptation to assume without question that average fixed cost can be used to estimate changes in total fixed cost. When variable costing is used, supplemental rates for fixed overhead production costs must be provided to measure the costs to be assigned to end-of-year inventories because generally accepted accounting principles in the United States and in most other countries require that inventories be measured at full product cost for external financial reporting.

Cost and profit analysis. Accountants share with many other people the task of analyzing cost and profit data in order to provide guidance in managerial decision making. Even if the analytical work is done largely by others, they have an interest in analytical methods because the systems they design must collect data in forms suitable for analysis. Managerial decisions are based on comparisons of the estimated future results of the alternative courses of action that the decision maker is choosing among.

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Recorded historical accounting data, in contrast, reflect conditions and experience of the past. Furthermore, they are absolute, not comparative, in that they show the effects of one course of action but not whether these were better or worse than those that would have resulted from some other course. For decision making, therefore, historical accounting data must be examined, modified, and placed on a comparative basis. Even estimated data, such as budgets and standard costs, must be examined to see whether the estimates are still valid and relevant to managerial comparisons. To a large extent, this job of review and restatement is an accounting responsibility. Accordingly, a major part of the accountant's preparation for the profession is devoted to the study of methods and principles of analysis for managerial decision making.

Performance reporting.

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Once the budgetary plan has been adopted, accounting's next task is to prepare information on the results of company activities and make it available to management. The manager's main interest in this information centres on three questions: Have his or her own actions had the results expected, and, if not, why not? How successful have subordinates been in managing the activities entrusted to them? What problems and opportunities seem to have arisen since the budgetary plan was prepared? For these purposes, the information must be comparative, relating actual results to the level of results that management regards as satisfactory. In each case, the standard for comparison is provided by the

budgetary plan. Much of this information is contained in periodic financial reports. At the top management and divisional levels, the most important of these is the comparative income statement. This shows the profit that was planned for this period, the actual results received for this period, and the differences, or variances, between the two. It also gives an explanation of some of the reasons for the difference between a planned and an actual income. The report in this exhibit employs the widely used profit contribution format, in which divisional results reflect sales and expenses traceable to the individual divisions, with no deduction for head office expenses. Company net income is then obtained by deducting head office expenses as a lump sum from the total of the divisional profit contributions. A similar format can be used within the division, reporting the profit contribution of each of the division's product lines, with divisional headquarters expenses deducted at the bottom. By far the greatest number of reports, however, are cost or sales reports, mostly on a departmental basis. Departmental sales reports usually compare actual sales with the volumes planned for the period. Departmental cost performance reports, in contrast, typically compare actual costs incurred with standards or budgets that have been adjusted to correspond to the actual volume of work done during the period. This practice reflects a recognition that volume fluctuations generally originate outside the department and that the department head's responsibility is ordinarily limited to minimizing cost while meeting the delivery schedules imposed by higher management.

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For example, a factory department's output consists entirely of a single product, with a standard materials cost of $3 a unit and standard labour cost of $16. Materials cost represents three pounds of raw materials at $1 a pound; standard labour cost is two hours of labour at $8 an hour. Overhead costs in the department are budgeted at $10,000 a month plus $2 a unit. Under normal conditions, volume is 7,000 units a month, but during October only 6,000 units were produced. The cost standards for the month would be as follows:

The actual cost this month was $17,850 for materials (17,000 pounds at $1.05), $101,250 for labour (12,500 hours at $8.10 an hour), and $23,000 for overhead. A summary report would show the following:

These variances may be analyzed even further in order to identify the underlying causes. The labour variance, for example, can be seen to be the result of both high wage rates ($8.10 instead of $8.00) and high labour usage (12,500 hours instead of 12,000). The factory accountant ordinarily would measure the effect of the rate change in

the followingway:

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In most cases, the labour rate variance would not be reported to the department head, because it is not subject to his or her control. Standard costing systems no longer have the central importance they commanded in many industries up to the 1970s. One reason is that significant changes in management technology have shifted the focus of cost control from the individual production department to larger, more interdependent groups. Just-in-time production systems require changes in factory layouts to reduce the time it takes to move work from one station to the next. They also reduce the number of partly processed units at each work station, thereby requiring greater station-to-station coordination. At the same time, management's emphasis has shifted from cost control to cost reduction, quality enhancement, and closer coordination of production and customer deliveries. Most large manufacturing companies and

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OTHER PURPOSES OF ACCOUNTING SYSTEMS

many service companies have launched programs of total quality control and continuous improvement, and many have replaced standard costs with a more flexible approach using prior period results as current performance standards. Management is also likely to focus on the amount of system waste by identifying and minimizing activities that contribute nothing to the value that customers place on the product. Reducing set-up time, inspection time, and time spent moving work from place to place while maintaining or improving quality are some of the results of these programs. Advances in computer-based models have enabled companies to tie production schedules more closely to customer delivery schedules while increasing the rate of plant utilization. Some of these changes actually increase variances from standard costs in some departments but are undertaken because they benefit the company as a whole. The overall result is that control systems are likely to focus in the first instance on operational controls (real-time signals to operating personnel that some immediate remedial action is required), with after-the-fact analysis of results focusing on aggregate comparisons with past performance and the planned results of current improvement programs.

Accounting systems are designed mainly to provide information that managers and outsiders can use in decision making. They also serve other purposes: to produce operating documents, to protect the company's assets, to provide data for company tax returns, and, in some cases, to provide the basis for reimbursement of costs by clients or customers. The accounting organization is responsible for preparing documents that contain instructions for a variety of tasks, such as payment of customer bills or preparing employee payrolls. It also must prepare documents that serve what might be called private information purposes, such as the employees' own records of their salaries and wages. Many of these documents also serve other accounting purposes, but they would have to be prepared even if no information reports were necessary. Measured by the number of people involved and the amount of time required, document preparation is one of accounting's biggest jobs. Accounting systems must provide means of reducing the chance of losses of assets due to carelessness or dishonesty on the part of employees, suppliers, and customers. Asset protection devices are often very simple; for example, many restaurants use numbered meal checks so that waiters will not be able to submit one check to the customer and another, with a lower total, to the cashier. Other devices entail a partial duplication of effort or a division of tasks between two individuals to reduce the opportunity for unobserved thefts.

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Part 2 These are all part of the company's system of internal controls. Another important element in the internal control system is internal auditing. The task of internal auditors is to see whether prescribed data handling and asset protection procedures are being followed. To accomplish this, they usually observe some of the work as it is being performed and examine a sample of past transactions for accuracy and fidelity to the system. They may insert a set of fictitious data into the system to see whether the resulting output meets a predetermined standard. This technique is particularly useful in testing the validity of the programs that are used to process data through electronic computers. The accounting system must also provide data for use in the completion of the company's tax returns. This function is the concern of tax accounting. In some countries financial accounting must obey rules laid down for tax accounting by national tax laws and regulations, but no such requirement is imposed in the United States, and tabulations prepared for tax purposes often diverge from those submitted to shareholders and others. "Taxable income" is a legal concept rather than an accounting concept. Tax laws include incentives to encourage companies to do certain things and discourage them from doing others. Accordingly, what is "income" or "capital" to a tax agency may be far different from the accountant's measures of these same concepts. Finally, accounting systems in some companies must provide cost data in the forms required for submission to customers who have agreed to reimburse the companies for the costs they have incurred on the customers' behalf.

Banks and Banking The principal types of banking in the modern industrial world are commercial banking and central banking. A commercial banker is a dealer in money and in substitutes for money, such as checks or bills of exchange. The banker also provides a variety of financial services. The basis of the banking business is borrowing from individuals, firms, and occasionally governments--i.e., receiving "deposits" from them. With these resources and also with the bank's own capital, the banker makes loans or extends credit and also invests in securities. The banker makes profit by borrowing at one rate of interest and lending at a higher rate and by charging commissions for services rendered. A bank must always have cash balances on hand in order to pay its depositors upon demand or when the amounts credited to them become due. It must also keep a proportion of its assets in forms that can readily be converted into cash. Only in this way can confidence in the banking system be maintained. Provided it honours its promises (e.g., to provide cash in exchange for deposit balances), a bank can create credit for use by its customers by issuing additional notes or by making new loans, which in their turn become new deposits. The amount of credit it extends may considerably exceed the sums available to it in cash. But a bank is able to do this only as long as the public believes the bank can and will honour its obligations, which are then accepted at face

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The development of banking systems value and circulate as money. So long as they remain outstanding, these promises or obligations constitute claims against that bank and can be transferred by means of checks or other negotiable instruments from one party to another. These are the essentials of deposit banking as practiced throughout the world today, with the partial exception of socialist-type institutions. Another type of banking is carried on by central banks, bankers to governments and "lenders of last resort" to commercial banks and other financial institutions. They are often responsible for formulating and implementing monetary and credit policies, usually in cooperation with the government. In some cases--e.g., the U.S. Federal Reserve System--they have been established specifically to lead or regulate the banking system; in other cases--e.g., the Bank of England--they have come to perform these functions through a process of evolution. Some institutions often called banks, such as finance companies, savings banks, investment banks, trust companies, and home-loan banks, do not perform the banking functions described above and are best classified as financial intermediaries. Their economic function is that of channelling savings from private individuals into the hands of those who will use them, in the form of loans for building purposes or for the purchase of capital assets. These financial intermediaries cannot, however, create money (i.e., credit) as the commercial banks do; they can lend no more than savers place with them.

Banking is of ancient origin, though little is known about it prior to the 13th century. Many of the early "banks" dealt primarily in coin and bullion, much of their business being money changing and the supplying of foreign and domestic coin of the correct weight and fineness. Another important early group of banking institutions was the merchant bankers, who dealt both in goods and in bills of exchange, providing for the remittance of money and payment of accounts at a distance but without shipping actual coin. Their business arose from the fact that many of these merchants traded internationally and held assets at different points along trade routes. For a certain consideration, a merchant stood prepared to accept instructions to pay money to a named party through one of his agents elsewhere; the amount of the bill of exchange would be debited by his agent to the account of the merchant banker, who would also hope to make an additional profit from exchanging one currency against another. Because there was a possibility of loss, any profit or gain was not subject to the medieval ban on usury. There were, moreover, techniques for concealing a loan by making foreign exchange available at a distance but deferring payment for it so that the interest charge could be camouflaged as a fluctuation in the exchange rate. Another form of early banking activity was the acceptance of deposits. These might derive from the deposit of money or valuables for safekeeping or for purposes of transfer to another party; or, more straightforwardly, they might represent the deposit of

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money in a current account. A balance in a current account could also represent the proceeds of a loan that had been granted by the banker, perhaps based on an oral agreement between the parties (recorded in the banker's journal) whereby the customer would be allowed to overdraw his account. English bankers in particular had by the 17th century begun to develop a deposit banking business, and the techniques they evolved were to prove influential elsewhere. The London goldsmiths kept money and valuables in safe custody for their customers. In addition, they dealt in bullion and foreign exchange, acquiring and sorting coin for profit. As a means of attracting coin for sorting, they were prepared to pay a rate of interest, and it was largely in this way that they began to supplant as deposit bankers their great rivals, the "money scriveners." The latter were notaries who had come to specialize in bringing together borrowers and lenders; they also accepted deposits. It was found that when money was deposited by a number of people with a goldsmith or a scrivener a fund of deposits came to be maintained at a fairly steady level; over a period of time, deposits and withdrawals tended to balance. In any event, customers preferred to leave their surplus money with the goldsmith, keeping only enough for their everyday needs. The result was a fund of idle cash that could be lent out at interest to other parties. About the same time, a practice grew up whereby a customer could arrange for the transfer of part of his credit balance to another party by addressing an order to the banker. This was the origin of the modern check. It was only a short step from making a loan in specie or

coin to allowing customers to borrow by check: the amount borrowed would be debited to a loan account and credited to a current account against which checks could be drawn; or the customer would be allowed to overdraw his account up to a specified limit. In the first case, interest was charged on the full amount of the debit, and in the second the customer paid interest only on the amount actually borrowed. A check was a claim against the bank, which had a corresponding claim against its customer. Another way in which a bank could create claims against itself was by issuing bank notes. The amount actually issued depended on the banker's judgment of the possible demand for specie, and this depended in large part on public confidence in the bank itself. In London, goldsmith bankers were probably developing the use of the bank note about the same time as that of the check. (The first bank notes issued in Europe were by the Bank of Stockholm in 1661.) Some commercial banks are still permitted to issue their own notes, but in most countries this has become a prerogative of the central bank. In Britain the check soon proved to be such a convenient means of payment that the public began to use checks for the larger part of their monetary transactions, reserving coin (and, later, notes) for small payments. As a result, banks began to grant their borrowers the right to draw checks much in excess of the amounts of cash actually held, in this way "creating money"--i.e., claims that were generally accepted as means of payment. Such money came to be known as "bank money" or "credit." Excluding bank notes, this money consisted of no more than figures in bank ledgers;

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The business of banking it was acceptable because of the public's confidence in the ability of the bank to honour its liabilities when called upon to do so. When a check is drawn and passes into the hands of another party in payment for goods or services, it is usually paid into another bank account. Assuming that the overdraft technique is employed, if the check has been drawn by a borrower, the mere act of drawing and passing the check will create a loan as soon as the check is paid by the borrower's banker. Since every loan so made tends to return to the banking system as a deposit, deposits will tend to increase for the system as a whole to about the same extent as loans. On the other hand, if the money lent has been debited to a loan account and the amount of the loan has been credited to the customer's current account, a deposit will have been created immediately. One of the most important factors in the development of banking in England was the early legal recognition of the negotiability of credit instruments or bills of exchange. The check was expressly defined as a bill of exchange. In continental Europe, on the other hand, limitations on the negotiability of an order of payment prevented the extension of deposit banking based on the check. Continental countries developed their own system, known as giro payments, whereby transfers were effected on the basis of written instructions to debit the account of the payer and to credit that of the payee.

The business of banking consists of borrowing and lending. As in other businesses, operations must be based on capital, but banks employ comparatively little of their own capital in relation to the total volume of their transactions. The purpose of capital and reserve accounts is primarily to provide an ultimate cover against losses on loans and investments. In the United States capital accounts also have a legal significance, since the laws limit the proportion of its capital a bank may lend to a single borrower. Similar arrangements exist elsewhere.

FUNCTIONS OF COMMERCIAL BANKS The essential characteristics of the banking business may be described within the framework of a simplified balance sheet. A bank's main liabilities are its capital (including reserves and, often, subordinated debt) and deposits. The latter may be from domestic or foreign sources (corporations and firms, private individuals, other banks, and even governments). They may be repayable on demand (sight deposits or current accounts) or repayable only after the lapse of a period of time (time, term, or fixed deposits and, occasionally, savings deposits). A bank's assets include cash (which may be held in the form of credit balances with other banks, usually with a central bank but also, in varying degrees, with correspondent banks); liquid assets (money at call and short notice, day-to-day money, short-term government paper such as treasury bills and notes, and commercial bills of exchange, all of which can be

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converted readily into cash without risk of substantial loss); investments or securities (substantially medium-term and longer term government securities--sometimes including those of local authorities such as states, provinces, or municipalities--and, in certain countries, participations and shares in industrial concerns); loans and advances made to customers of all kinds, though primarily to trade and industry (in an increasing number of countries, these include term loans and also mortgage loans); and, finally, the bank's premises, furniture, and fittings (written down, as a rule, to quite nominal figures). All bank balance sheets must include an item that relates to contingent liabilities (e.g., bills of exchange "accepted" or endorsed by the bank), exactly balanced by an item on the other side of the balance sheet representing the customer's obligation to indemnify the bank (which may also be supported by a form of security taken by the bank over its customer's assets). Most banks of any size stand prepared to provide acceptance credits (also called bankers' acceptances); when a bank accepts a bill, it lends its name and reputation to the transaction in question and, in this way, ensures that the paper will be more readily discounted.

Deposits.

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The bulk of the resources employed by a modern bank consists of borrowed money (that is, deposits), which is lent out as profitably as is consistent with safety. Insofar as an increase in deposits provides a bank with additional cash (which is an asset), the increase in cash supplements its loanable resources and permits a more than

proportionate increase in its loans. An increase in deposits may arise in two ways. (1) When a bank makes a loan, it may transfer the sum to a current account, thus directly creating a new deposit; or it may arrange a line of credit for the borrower upon which he will be permitted to draw checks, which, when deposited by third parties, likewise create new deposits. (2) An enlargement of government expenditure financed by the central bank may occasion a growth in deposits, since claims on the government that are equivalent to cash will be paid into the commercial banks as deposits. In the first instance, with the increase in bank deposits goes a related increase in the potential liability to pay out cash; in the second case, the increase in deposits with the commercial banks is accompanied by a corresponding increase in commercial bank holdings of money claims that are equivalent to cash. Taking one bank in isolation, an increase in its loans may result in a direct increase in deposits. This may occur either as a result of a transfer to a current account (as above) or a transfer to another customer of the same bank. Once again, there is an increase in the potential liability to pay out cash. On the other hand, if there has been an increase in loans by another bank (including an increase in central bank loans to the government), this may give rise to increased deposits with the first bank, matched by a corresponding claim to cash (or its equivalent). For these reasons a bank can generally expect that, if there is an increase in deposits, there will also be some net acquisition of cash or of claims for receipt of cash. It is in this way that an increase in deposits usually provides the basis for further bank

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lending. Except in countries where banks are small and insecure, banks as a whole can usually depend on their current account debits being largely offset by credits to current accounts, though from time to time an individual bank may experience marked fluctuations in its deposit totals, and all banks in a country may be subject to seasonal variations. Even when deposits are repayable on demand, there is usually a degree of inertia in the deposit structure that prevents sharp fluctuations; if money is accepted contractually for a fixed term or if notice must be given before its repayment, this inertia will be greater. On the other hand, if a significant proportion of total deposits derives from foreign sources, there is likely to be an element of volatility arising from international conditions. In banking, confidence on the part of the depositors is the true basis of stability. Confidence is steadier if there exists a central bank to act as a "lender of last resort." Another means of maintaining confidence employed in some countries is deposit insurance, which protects the small depositor against loss in the event of a bank failure. Such protection was the declared purpose of the "nationalization" of bank deposits in Argentina between 1946 and 1957; banks receiving deposits acted merely as agents of the government-owned and government-controlled central bank, all deposits being guaranteed by the state.

Reserves.

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Since the banker undertakes to provide depositors with cash on demand or upon prior notice, it is necessary to

hold a cash reserve and to maintain a "safe" ratio of cash to deposits. The safe ratio is determined largely through experience. It may be established by convention (as it was for many years in England) or by statute (as in the United States and elsewhere). If a minimum cash ratio is required by law, a portion of a bank's assets is in effect frozen and not available to meet sudden demands for cash from the bank's customers. In order to provide more flexibility, required ratios are frequently based on the average of cash holdings over a specified period, such as a week or a month. In addition to holding part of the bank's assets in cash, a banker will hold a proportion of the remainder in assets that can quickly be converted into cash without significant loss. No banker can safely ignore the necessity of maintaining adequate reserves of liquid assets; some prefer to limit the sum of loans and investments to a certain percentage of deposits, not allowing their loan-deposit ratio to run for any length of time at too high a level. Unless a bank held cash covering 100 percent of its demand deposits, it could not meet the claims of depositors if they were all to exercise in full and at the same time their rights to demand cash. If that were a common phenomenon, deposit banking could not long survive. For the most part, the public is prepared to leave its surplus funds on deposit with the banks, confident that they will be repaid if needed. But there may be times when unexpected demands for cash exceed what might reasonably have been anticipated; therefore, a bank must not only hold part of its assets in cash but also must keep a proportion of the remainder in assets that can be quickly converted into cash without significant loss.

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Indeed, in theory, even its less liquid assets should be self-liquidating within a reasonable time. A bank may mobilize its assets in several ways. It may demand repayment of loans, immediately or at short notice; it may sell securities; or it may borrow from the central bank, using paper representing investments or loans as security. Banks do not precipitately call in loans or sell marketable assets, because this would disrupt the delicate debtor-creditor relationships and increase any loss of confidence, probably resulting in a run on the banks. Ready cash may be obtainable in this way only at a very high price. Banks must either maintain their cash reserves and other liquid assets at a high level or have access to a "lender of last resort," such as a central bank, able and willing to provide cash against the security of eligible assets. In a number of countries, the commercial banks have at times been required to maintain a minimum liquid assets ratio. But central banks impose such requirements less as a means of maintaining appropriate levels of commercial bank liquidity than as a technique for influencing directly the lending potential of the banks. Among the assets of commercial banks, investments are less liquid than money-market assets such as call money and treasury bills. By maintaining an appropriate spread of maturities, however, it is possible to ensure that a proportion of a bank's investments is regularly approaching redemption, thereby producing a steady flow of liquidity and in that way constituting a secondary liquid assets reserve. Some banks, particularly in the United States and Canada, have at times favoured the "dumbbell" distribution of maturities, a significant

proportion of the total portfolio being held in long-dated maturities with a high yield, a small proportion in the middle ranges, and another significant proportion in short-dated maturities. Following redemption, the banks usually reinvest all or most of the proceeds in longer-term maturities that in due course become increasingly short-term. Interest-rate expectations frequently modify the shape of a maturity distribution, and, in times of great uncertainty with regard to interest rates, banks will tend to hold the bulk of their securities at short term, and something like a T-distribution may then be preferred (mainly shorts, supported by small amounts of medium to longer dated paper). Investments and money-market assets merge into each other. The dividing line is arbitrary, but there is an essential difference: the liquidity of investments depends primarily on marketability (though sometimes it also depends on the readiness of the government or its agent to exchange its own securities for cash); the liquidity of money-market assets, on the other hand, depends partly on marketability but mainly on the willingness of the central bank to purchase them or accept them as collateral for a loan. This is why money-market assets are more liquid than investments.

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INDUSTRIAL FINANCE

Long-term and medium-term lending. Banks that do a great deal of long-term lending to industry must ensure their liquidity by maintaining relatively large capital funds and a relatively high proportion of long-term borrowings (e.g., time deposits, or issues of bonds or debentures), as well as valuing their investments very conservatively. Such banks, notably the French banques d'affaires and the German commercial banks, have developed special means of reducing their degree of risk. Every investment is preceded by a thorough technical and financial investigation. The initial advance may be an interim credit, later converted into a participation. Only when market conditions are favourable is the original investment converted into marketable securities, and an issue of shares to the public is arranged. One function of these banks is to nurse an investment along until the venture is well established. Even assuming its ultimate success, a bank may be obliged to hold such shares for long periods before being able to liquidate them. In addition, they often retain an interest in a firm as an ordinary investment as well as to ensure a degree of continuing control over it. The long-term provision of industrial finance in Britain and the Commonwealth countries is usually handled by specialist institutions, with the commercial banks providing only part of the necessary capital. In Japan the long-term financial needs of industry are met partly by special industrial banks (which also issue debentures as well as accepting deposits) and partly by

the ordinary commercial banks. In Germany the commercial banks customarily handle long-term finance. Since World War II the commercial banks in the United States have developed the so-called term loan, especially for financing industrial capital requirements. The attempt to popularize the term loan began in the economic depression of the 1930s, when the banks tried to expand their business by offering finance for a period of years. Most term loans have an effective maturity of little more than five years, though some run for 10 years or more. They are usually arranged between the customer and a group of lending banks, sometimes in cooperation with other institutions such as insurance companies, and are normally subject to a formal term loan agreement. Banks in Britain, western Europe, the Commonwealth, and Japan began during the 1960s to give term loans both to industry and to agriculture.

Short-term lending. Short-term loans are the core of the banking business even in countries where commercial banks make long-term loans to industry. Much short-term lending consists in the provision of working capital, but the banks also provide temporary finance for fixed capital development, aiding a customer until long-term finance can be found elsewhere. Much of this short-term lending is done by overdraft, particularly in the United Kingdom and a number of the Commonwealth countries, or by way of "current account lending" in many western European countries. The overdraft permits a depositor to overdraw an account up to an agreed limit. In theory, overdrafts are repayable on

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demand or after reasonable notice has been given, but often they are allowed to run on indefinitely, subject to a periodic review. An advance is reduced or repaid whenever the account is credited with deposits and recreated when new checks are drawn upon it, interest being paid only on the amount outstanding. An alternative method of short-term lending is to debit a loan account with the amount borrowed, crediting the proceeds to a current account; interest is usually payable on the whole amount of the loan, which normally is for a fixed period of time. (In Britain arrangements are sometimes more flexible, and the term of the loan may be set by oral agreement.) In a number of countries, including the United States, the United Kingdom, France, Germany, and Japan, short-term finance is often made available on the basis of discountable paper--commercial bills or promissory notes. Some of this paper is usually rediscountable at the central bank, thus becoming virtually a liquid asset, unlike a bank advance or loan. Credit may be offered with or without formal security, depending on the reputation and financial strength of the borrower. In many countries, a customer may use a number of banks, and these institutions usually freely exchange information about joint credit risks. In Britain and The Netherlands, however, most concerns tend to use a single banking institution for most of their needs.

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Traditionally bankers took the view that the liabilities of a bank (in particular, its deposits) were more or less stable and concerned themselves primarily with the investment of these funds. Since the late 1950s and '60s, especially in North America and latterly in the United

Kingdom, there has been a change in emphasis. Banks began to find it more difficult to obtain deposits. Interest rates rose to high levels, and banks were obliged to compete with each other and with other institutions for funds. At the same time, there was little point in paying a high rate of interest for money unless it could be employed profitably. Bankers began to relate the cost of borrowed money directly to the return on loans and investments. Previously the main limitation on a bank's expansion had been its ability to find profitable new business, but now the determining factor became the availability of funds to lend out. The essence of assets and liabilities management, as it came to be called, was deciding what kinds of new money to buy and what to pay for it. In the United States the liabilities side of bank balance sheets now included, inter alia, in much larger proportion than during the 1960s, repurchase agreements (under which securities are sold subject to an agreement to repurchase at a stated date), federal funds purchases (on the assets side, federal funds sales), excess balances of commercial banks and other depository institutions (regularly traded throughout the United States), negotiable certificates of deposit (which can be traded on a secondary market), and, for the larger banks, Eurocurrency borrowings, mostly Eurodollars (dollar balances held abroad). In the United Kingdom, "bought" money consisted of wholesale (i.e., large) deposits (on which money market rates were paid), negotiable certificates of deposit, interbank borrowings, and Eurocurrency purchases. This bought money could then be used to finance the loan demand, including term loans, long favoured in the United States but a more recent

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innovation in the United Kingdom and elsewhere, where they were developed considerably in the 1970s. Although much of the lending financed by bought money was by way of term loans, these could be "rolled over," with an interest rate adjustment, every three or six months, and there could therefore be a measure of interest-rate matching and also sometimes a matching of maturities. In less sophisticated environments than North America and the United Kingdom, there was again an increasing emphasis on bought money to meet any expansion in loan demands (much of which was now term lending), with an adjustment at the margin when more funds were needed--e.g., wholesale deposits, certificates of deposit, interbank borrowings, and purchases of Eurocurrencies.

The principles of central banking The principles of central banking grew up in response to the recurrent British financial crises of the 19th century and were later adopted in other countries. Modern market economies are subject to frequent fluctuations in output and employment. Although the causes of these fluctuations are various, there is general agreement that the ability of banks to create new money may exacerbate them. Although an individual bank may be cautious enough in maintaining its own liquidity position, the expansion or contraction of the money supply to which it contributes may be excessive. This raises the need for a disinterested outside authority able to view economic and financial developments objectively and to exert some measure of control over the activities of the banks. A central bank should also be capable of

acting to offset forces originating outside the economy, although this is much more difficult.

RESPONSIBILITIES OF CENTRAL BANKS The first concern of a central bank is the maintenance of a soundly based commercial banking structure. While this concern has grown to comprehend the operations of all financial institutions, including the several groups of nonbank financial intermediaries, the commercial banks remain the core of the banking system. A central bank must also cooperate closely with the national government. Indeed, most governments and central banks have become intimately associated in the formulation of policy.

Relationships with commercial banks.

One source of economic instability is the supply of money. Even in relatively well-controlled banking systems, banks have sometimes expanded credit to such an extent that inflationary pressures developed. Such an overexpansion in bank lending would be followed almost inevitably by a period of undue caution in the making of loans. Frequently the turning point was associated with a financial crisis, and bank failures were not uncommon. Even today, failures occur from time to time. Such crises in the past often threatened the existence of financial institutions that were essentially sound, and the authorities sometimes intervened to prevent complete

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collapse. The willingness of a central bank to offer support to the commercial banks and other financial institutions in time of crisis was greatly encouraged by the gradual disappearance of weaker institutions and a general improvement in bank management. The dangers of excessive lending came to be more fully appreciated, and the banks also became more experienced in the evaluation of risks. In some cases, the central bank itself has gone out of its way to educate commercial banks in the canons of sound finance. In the United States the Federal Reserve System examines the books of the commercial banks and carries on a range of frankly educational activities. In other countries, such as India and Pakistan, central banks have also set up departments to maintain a regular scrutiny of commercial bank operations. The most obvious danger to the banks is a sudden and overwhelming run on their cash resources in consequence of their liability to depositors to pay on demand. In the ordinary course of business, the demand for cash is fairly constant or subject to seasonal fluctuations that can be foreseen. It has become the responsibility of the central bank to protect banks that have been honestly and competently managed from the consequences of a sudden and unexpected demand for cash. In other words, the central bank came to act as the "lender of last resort." To do this effectively, it was necessary that the central bank be permitted either to buy the assets of commercial banks or to make advances against them. It was also necessary that the central bank have the power to issue money acceptable to bank depositors. But if a central bank was

to play this role with respect to commercial banks, it was only reasonable that it or some related authority be allowed to exercise a degree of control over the way in which the banks conducted their business. Most central banks now take a continuing day-to-day part in the operations of the banking system. The Bank of England, for example, has been increasingly in the market to ensure that the banks have a steady supply of cash, even during periods of credit restriction. It also lends regularly to the discount houses, supplementing their resources whenever the commercial banks feel the need to call back money they have on loan to them. In the United States the Federal Reserve System has operated in a similar way by buying and selling securities on the open market and by lending to dealers in government securities on the basis of repurchase agreements. The Federal Reserve may also discount paper submitted by the commercial banks through the Federal Reserve banks. The various techniques of credit control in use are discussed in greater detail below. The evolution of those working relations among banks implies a community of outlook that in some countries is relatively recent. The whole concept of a central bank as responsible for the stability of the banking system presupposes mutual confidence and cooperation. For this reason, contact between the central bank and the commercial banks must be close and continuous. The latter must be encouraged to feel that the central bank will give careful consideration to their views on matters of common concern. Once the central bank has formulated its policy after a full consideration of the facts and of the views expressed, however, the commercial

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banks must be prepared to accept its leadership. Otherwise, the whole basis of central banking would be undermined.

The central bank and the national economy.

Relationships with other countries. Since no modern economy is self-contained, central banks must give considerable attention to trading and financial relationships with other countries. If goods are bought abroad, there is a demand for foreign currency to pay for them. Alternatively, if goods are sold abroad, foreign currency is acquired that the seller ordinarily wishes to convert into the home currency. These two sets of transactions usually pass through the banking system, but there is no necessary reason why, over the short period, they should balance. Sometimes there is a surplus of purchases and sometimes a surplus of sales. Short-period disequilibrium is not likely to matter very much, but it is rather important that there be a tendency to balance over a longer period, since it is difficult for a country to continue indefinitely as a permanent borrower or to continue building up a command over goods and services that it does not exercise. Short-period disequilibrium can be met very simply by diminishing or building up balances of foreign exchange. If a country has no balances to diminish, it may borrow, but normally it at least carries working balances. If the commercial banks find it unprofitable to hold such

balances, the central bank is available to carry them; indeed, it may insist on concentrating the bulk of the country's foreign-exchange resources in its hands or in those of an associated agency. Long-period equilibrium is more difficult to achieve. It may be approached in three different ways: price movements, exchange revaluation (appreciation or depreciation of the currency), or exchange controls. Price levels may be influenced by expansion or contraction in the supply of bank credit. If the monetary authorities wish to stimulate imports, for example, they can induce a relative rise in home prices by encouraging an expansion of credit. If additional exports are necessary in order to achieve a more balanced position, the authorities can attempt to force down costs at home by operating to restrict credit. The objective may be achieved more directly by revaluing a country's exchange rate. Depending on the circumstances, the rate may be appreciated or depreciated, or it may be allowed to "float." Appreciation means that the home currency becomes more valuable in terms of the currencies of other countries and that exports consequently become more expensive for foreigners to buy. Depreciation involves a cheapening of the home currency, thus lowering the prices of export goods in the world's markets. In both cases, however, the effects are likely to be only temporary, and for this reason the authorities often prefer relative stability in exchange rates even at the cost of some fluctuation in internal prices. Quite often governments have resorted to exchange controls (sometimes combined with import licensing) to allocate foreign exchange more or less directly in

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payment for specific imports. At times, a considerable apparatus has been assembled for this purpose, and, despite "leakages" of various kinds, the system has proved reasonably efficient in achieving balance on external payments account. Its chief disadvantage is that it interferes with normal market processes, thereby encouraging rigidities in the economy, reinforcing vested interests, and restricting the growth of world trade. Whatever method is chosen, the process of adjustment is generally supervised by some central authority--the central bank or some institution closely associated with it--that can assemble the information necessary to ensure that the proper responses are made to changing conditions. Economic fluctuations. As noted above, monetary influences may be an important contributory factor in economic fluctuations. An expansion in bank credit makes possible, if it does not cause, the relative overexpansion of investment activity characteristic of a boom. Insofar as monetary policy can assist in mitigating the worst excesses of the boom, it is the responsibility of the central bank to regulate the amount of lending by banks and perhaps by other financial institutions as well. The central bank may even wish to influence in some degree the direction of lending as well as the amount. An even greater responsibilit