1

Case Assignment: Pivotal Foundational Concepts within Finance & Budgeting

Stacey Troup

Finance & Budgeting / MGT-314

May 19, 2017

Professor Joseph Moussa

Touro University Worldwide

2

Case Assignment: Pivotal Foundational Concepts within Finance & Budgeting

In this Week 4 midterm assignment, I will discuss the importance of ethical standards in

addition to laws in a business setting. An explanation of five of the GAAP principles including

an overall meaning and purpose of each will be done as well as an explanation of the key

concepts regarding the time value of money and how they can be used to solve financial

problems. Finally, I will discuss both the common and preferred stock characteristics as well as

how the concepts discussed during the first four weeks of class can have an impact on managing

personal finance goals.

Ethical Concerns in Business Environments

Ethical standards are an ever-present concern for businesses, particularly those within the

financial services sector. While laws such as The Securities Act of 1933 (The Securities Act of

1933, N.D.) and the Exchange Act of 1934 (Securities Exchange Act of 1934) are enacted to

ensure ethical standards within the business of finance and trade, it is imperative that financial

institutions maintain ethical standards to both ensure their public reputation as well as their

ability to continue business operations less they be heavily fined or closed by the Securities and

Exchange Commission (SEC).

In recent years, the banking industry has been under scrutiny for their failure to adhere to

ethics as well as laws. HSBC was found guilty of several violations yet simply pays fines and

continues its illegal activities both domestically and abroad. Despite being brought under

investigation by the SEC for Money Laundering and subsequently pleading guilty for allowing

Columbian and Mexican drug cartels to launder their money through their branch in Mexico,

HSBC paid fines of $1.92 Billion in 2012 and continued to go on with their illegal activities,

extending into terrorism financing during the same period (Viswanatha & Wolf, 2012), (United

3

States Senate, Subcommittee on Investigations. Committee on Homeland Security and

Governmental Affairs, 2012).

Since the landslide case against HSBC, they have been brought on charges relating to

their Swiss Private Banking unit’s servicing of U.S. clients while failing to register as a proper

broker/dealer in 2014 (Satter, 2014), fraudulent Pension/Trust Fund activities violations charges

in 2007 (Administrative Proceedings: HSBC Bank USA, N.A., 2007), alleged tax evasion

charges were filed in 2016 relating to HSBC India (HSBC Under Lens for Alleged Tax Evasion

by Indians, 2016), and last (but certainly not least), they reached a settlement with the Justice

Department to pay over $470 million in fines relating to mortgage operations and servicing

abuses committed by HSBC Bank (Department of Justice, Office of Public Affairs, 2016).

Laws are not enough to keep the financial services industry in check. Ethical standards

need to be not only considered but actually enacted upon to ensure that the laws are adhered to

on behalf of the company. By implementing ethical standards within a company you also secure

your corporate reputation for ethical standards while staying in good graces with the Department

of Justice, FBI, and SEC (respectively).

Five GAAP Principles

GAAP, or Generally Accepted Accounting Practices, are a set of principles or standards

that companies must follow when preparing their financial statements (Generally Accepted

Accounting Practices, N.D.). These practices ensure correct data recording of accounting

information while providing clarity for same within financial statements (Generally Accepted

Accounting Practices, N.D.).

The “Cost” Principle assumes that the amount of cash (or cash equivalent) spent when the

item is originally obtained, regardless of the age of purchase. There is to be no reflection of

4

profit or loss of sale of item a today’s value (notwithstanding any actively traded stocks)

(Accounting Principles (Explanation), N.D.).

The “Going Concern” Principle assumes a company will continue to exist long enough to

carry out their objectives and commitments without the need for liquidation of assets in the

foreseeable future (Accounting Principles (Explanation), N.D.). This principle allows for some

prepaid expenses to be held until future accounting period (for which they are actually in use)

(Accounting Principles (Explanation), N.D.).

The “Matching” Principle requires the use of accrual basis of accounting as well as

expenses to be matched to revenues in same periods. An example of this is commissions paid

should be reported in the same period that sales were made. This principle also allows for ad

expenses (prepaid) to be charged in the period in which they run (Accounting Principles

(Explanation), N.D.).

The “Revenue Recognition” Principle recognizes revenues as soon as a product is sold or

a service is rendered, regardless of when money is actually received (Accounting Principles

(Explanation), N.D.).

The “Arm’s Length” Assumption is defined as “a transaction that would be negotiated

between an independent buyer and an independent seller” (Jarnagin, 2008). Additionally,

Accounting Interpretation No. 1 of APB Opinion No. 28, Paragraph 3, states “that when the

investor has a majority interest in the voting stock fo the investee company, income and losses

from non arm’s-length transactions between investee and investor companies should not be

recognized until the profits or losses have been realized through an outside party transaction”

(Jarnagin, 2008).

5

In another example of “arms-length” transactions, the ruling requires commodities to be

accounted for at the fair value date for which they are acquired without an adjustment for

retrospective value unless an error is made in the entry. There should be no adjustment to the

Goodwill account for such transactions should they be sold at a later date for a lesser amount.

For traded commodities, the IFRS uses the “fair value” definition to such trades. Fair Value is

defined as “an amount for which an asset could be exchanged, or a liability settled, between

knowledgeable, willing parties in an arm's length transaction” (Ernst & Young, LLP, 2011). An

example of this transaction is an acquisition of oil at $60 per barrel vs an $80 per barrel future

value assumption. The transaction must be recorded at the $60 per barrel rate regardless of

future value estimates (Ernst & Young, LLP, 2011).

The simplest way to explain “arm's length” transactions is that it is a transaction

involving two or more parties in which each is trying to get the best deal possible. This can

involve selling an item or security for less than nominal value or an asset at below fair market

value in an attempt to raise capital from its sale (What Does Arms Length Transaction Mean,

n.d.).

These GAAP/IFRS principles are designed to provide full disclosure and proper reporting

standards in corporate bookkeeping and financial reporting. These principles ensure that

investors are being shown the full picture of a company’s financial health and are not having key

issues hidden from them before making investment decisions.

Key Concepts of Time Value of Money Principle

When explaining the Key Concepts of the Time Value of Money Principle to a

layperson, the most important factors to ensuring comprehension of the concept are the formula

6

to calculate and the understanding of how your money is worth more when invested. First, the

formula to determine the future value of money is as follows (The Time Value of Money, N.D.):

FV = PV x (1 + (i / n)) ^ (n x t)

To clarify this formula, we can assume the following key for the above formula (The

Time Value of Money, N.D.):

FV= Future Value

I = Interest Rate

PV = Present Value

N = Number of Compounding Periods Per Year

T = Numer of years

Putting this into basic terms, we can take a calculation example of a $10,000 investment

and explain to the investor that given the formula, the investment would have varying rates of

return based on the compounding interest period as follows (based on standard 10% interest rate)

(The Time Value of Money, N.D.):

FV= $10,000𝑥 (1 +10%

4)(4𝑥1)

= $11,038 when compounded quarterly

FV= $10,000𝑥 (1 +10%

12)(12𝑥1)

= $11,047 when compounded mothly

FV= $10,000𝑥 (1 +10%

365)(365𝑥1)

= $11,052 when compounded daily

Using these calculations to showcase how an investment of $10,000 would grow over a

year’s period given the compounding periods as examples, the investor can see how their money

can grow for them and be worth more over time when invested properly. Understanding how

these time values of money are calculated can help one see that the future value of the sum is

greater over time than it is today as well as help in determining payout structures for your

7

investments based on the future value of return given compounding interest periods as well as

the need for investing today for future financial stability (Carther, 2017).

By understanding the future value of money (FV) we can put our money to work for us in

ways that help secure financial stability as well as financial growth while understanding how

interest rates and compound periods affect our investments. Sticking $10,000 in a mattress earns

you nothing over time but investing in your future with sound investment strategies and advice is

sure to help you with future needs.

Common v. Preferred Stock

When considering an investment in a company through the availability of their stock, one

must consider all options relating to Common Stock v. Preferred Stock in order to make a sound

investment decision based on the level of risk they are willing to take.

Common stock, the most available and issued type of stock available from a company,

has varying rights and perks depending on the terms and conditions set forth by the issuing

company. With this level of stock, investors are entitled to profits and growth of the company

through the purchase of the stock. This growth delivers appreciation through increased profits

and dividend disbursement of same and may contain voting rights (Glen, 2017). A common

aspect of Common Stock is the “Pre-Emptive Rights” clause which requires investors to

maintain the same proportion of ownership (shares) should a company offer new shares of stock

through splits, mergers, acquisitions or other tools. This means that you can buy new shares

based on the availability of newly issued shares while taking advantage of “Ratchet Based

Provisions”. These ratchet based provisions allow for the purchase price of the new stock to be

purchased at the lower of the two rates an investor would pay based on purchase date. If the

stock is being sold at a higher level, the investor will be “grandfathered” into the ratchet based

8

provision allowing them to purchase the stock at their originally quoted price and not the inflated

cost offered (Preemptive Right, N.D.). Onn a case by case basis, common stock may come with

voting rights and the individual aspects of the rights of the investor should be reviewed prior to

determining your appropriate purchase of common stock.

Preferred stock, with its vastly varying terms, is a stock choice preferred by those wishing

to take lower risks with their investments as well as guaranteeing first payment in the event of

solvency issues with the firm. While terms and return rates vary depending on the terms set forth

in the terms of trade, the dividend payment is guaranteed over that of common stockholders

should profits fall short of expectations and profits not be available to all investors. Holders of

preferred stock are first paid and do not generally have voting rights unless otherwise noted in

the terms (Glen, 2017)

When considering your options, consider the terms of transference of the stock and your

willingness to take risks in your portfolio before committing to preferred or common shares of

stock.

Concepts of Class Impact on Management of Personal Finance

Throughout this class, several concepts were discussed which could have a very positive

impact on your ability to grow your personal wealth in the future. Understanding of bond and

stock valuations as discussed in Week 4 will help you understand the differences between these

two investment vehicles in order to make sound investment decisions while diversifying your

portfolio.

Understanding the future value of money is the largest of the concepts discussed in this

course and the most important for your understanding of how to put your money to work for you.

By utilizing the formulas and understanding the compounding interest principles, you can

9

determine your dividend payouts and the best possible returns for same. Similarly, by

understanding some other concepts discussed during the course of the class will also help you in

your overall understanding of your personal investments. Things such as understanding financial

rates and financial statements (and management of) while having a firm grasp of the GAAP laws

and how financials are reported, you will more easily be able to determine the financial health of

a company you are looking at.

Once all of these concepts are understood, you will be able to move into more difficult

concepts such as tranches, swaps, contracts, private equity, hedge funds and investment banking

which will expand offerings based on your liquidity while helping you grow your portfolio for

future financial stability.

Conclusion

Now that we have successfully discussed the need for ethics in the business world as a

companion to laws, we can see the clarity of the necessity. Investment banks such as HSBC

have been guilty of violating laws and do not seem to maintain ethical standards within their

organization. Some lawmakers have questioned former U.S. President’s decisions to not jail

these clear violators of both trade law and legal law citing they are “too big to jail” or “too big to

fail” (U.S. House of Representatives, 2016). This notion, is, without question, one of the biggest

failures of our legal system to date.

HSBC and investment banks need to be held to higher ethical standards to prevent

securities fraud, investor fraud and another economic collapse in this country. By allowing

companies such as HSBC to just pay fines and continue to violate the laws (both domestically

and internationally) we are just perpetuating their bad behavior.

10

The GAAP/IFRS Principles outlined as part of this review help us showcase the need for

full disclosure and visibility into publically traded firms within their published (and audited)

financial statements.

By understanding the time value of money and its application into our own lives, we are

better able to not only review the financials of firms we are interested in but to better plan our

own financial success in the future. This is also true of the understanding of stock options such

as common and preferred shares and what rights and structures they possess. These things help

us diversify our own portfolios with some risk in certain areas and safety in others through things

such as blue chip stock purchases. All of these items discussed allow us to make sound financial

decisions for our future, be it personal or professional.

Financial services firms use these (and other) formulas to determine things such as

liquidity ratios, debt to asset ratios, and company stability to name a few. By understanding

these things for ourselves we are better informed for our own futures.

11

References

Accounting Principles (Explanation). (N.D.). Retrieved from Accounting Coach: https://www.accountingcoach.com/accounting-principles/explanation

Administrative Proceedings: HSBC Bank USA, N.A. (2007, 09 19). Retrieved from SEC.Gov: https://www.sec.gov/litigation/admin/2007/33-8844.pdf

Carther, S. (2017, 05 18). Understanding the Time Value of Money. Retrieved from Investopedia: http://www.investopedia.com/articles/03/082703.asp

Conroy, K. (N.D.). Why You Need Good Business Ethics. Retrieved from Edward Lowe

Foundation: http://edwardlowe.org/why-you-need-good-business-ethics/ Department of Justice, Office of Public Affairs. (2016, 02 5). Justice Department Reaches $470

Millin Joint State-Federal Settlement with HSBC to Address Mortgage Loan Origination, Servicing and Forclosure Abuses. Retrieved from U.S. Department of Justice: https://www.justice.gov/opa/pr/justice-department-reaches-470-million-joint-state-

federal-settlement-hsbc-address-mortgage Ernst & Young, LLP. (2011). International GAAP 2012. In Generally Accepted Accounting

Practice Under International Financial Reporting Standards. John Wiley & Sons. Retrieved from https://books.google.com/books?id=JE7b-9YRVUgC&pg=PT3813&lpg=PT3813&dq=assumption+of+arm%27s+length+GAAP&s

ource=bl&ots=coVUzKFFqJ&sig=UyTrlOfQikM9ybDSY6uMXqXlWJs&hl=en&sa=X&ved=0ahUKEwjI_ZjVxobUAhWC8oMKHTKWAbQQ6AEIVjAI#v=onepage&q=assu

mption%20of%20arm's% Generally Accepted Accounting Practices. (N.D.). Retrieved from Investopedia:

http://www.investopedia.com/terms/g/gaap.asp

Glen, J. (2017). Common vs. Preferred Stock. Retrieved from Investor Guide: http://www.investorguide.com/article/15593/common-stock-vs-preferred-stock-d1412/

HSBC Under Lens for Alleged Tax Evasion by Indians. (2016, 02 22). Retrieved from NDTV: http://profit.ndtv.com/news/budget/article-hsbc-under- lens-for-alleged-tax-evasion-by-indians-1279999

Jarnagin, B. D. (2008). 2009 U.S. Master GAAP Guide. CCH. Retrieved from https://books.google.com/books?id=8cPd7NxnpWUC&pg=PA151&lpg=PA151&dq=GA

AP+Arms+Length&source=bl&ots=egk7weqnIu&sig=4Jo0S-YMX9eHuAhMcq80eO6Vr58&hl=en&sa=X&ved=0ahUKEwjdjK6124bUAhWK5YMKHUskDAIQ6AEINDAC#v=onepage&q=GAAP%20Arms%20Length&f=false

Preemptive Right. (N.D.). Retrieved from Investopedia: http://www.investopedia.com/terms/p/preemptiveright.asp

Satter, M. (2014, 11 26). SEC Enforcement: HSB to Pay $12M Over Cross-Border Breaches. Retrieved from Think Advisor: http://www.thinkadvisor.com/2014/11/26/sec-enforcement-hsbc-to-pay-12m-over-cross-border

SEC v. HSBC Lit Rel 20038. (2007, 10 12). Retrieved from SEC: https://www.sec.gov/litigation/litreleases/2007/lr20328.htm

Securities Exchange Act of 1934. (n.d.). Retrieved from SEC.Gov: https://www.sec.gov/about/laws/sea34.pdf

The Securities Act of 1933. (N.D.). Retrieved from SEC.GOV:

https://www.sec.gov/answers/about-lawsshtml.html#secact1933

12

The Time Value of Money. (N.D.). Retrieved from Investopedia:

http://www.investopedia.com/terms/t/timevalueofmoney.asp?lgl=myfinance-layout U.S. House of Representatives. (2016). Too Big to Jail: Inside the Obama Justice

Administrations Decision Not To Hold Wall Street Accountable. Retrieved from

https://financialservices.house.gov/uploadedfiles/07072016_oi_tbtj_sr.pdf United States Senate, Subcommittee on Investigations. Committee on Homeland Security and

Governmental Affairs. (2012). U.S. Vulnerabilities to Money Laundering, Drugs, and Terrorist Financing: HSBC Case Study. Retrieved from https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact

=8&ved=0ahUKEwjl3sbd84PUAhVB1oMKHaiMD94QFggnMAA&url=https%3A%2F%2Fwww.hsgac.senate.gov%2Fdownload%2Freport-us-vulnerabilities-to-money-

laundering-drugs-and-terrorist-financing-hsb Viswanatha, A., & Wolf, B. (2012, 12 11). HSBC to Pay 1.9 Billion in Fines for Money

Laundering Case. Retrieved from Reuters: http://www.reuters.com/article/us-hsbc-probe-

idUSBRE8BA05M20121211 What Does Arms Length Transaction Mean. (n.d.). Retrieved from Accounting Coach:

https://www.accountingcoach.com/blog/arms- length-transaction