An anticipatory breach of contract is an action that shows one party’s intention to fail to fulfill its contractual obligations to another party. An anticipatory breach can end the counterparty’s responsibility to perform its duties.
Demonstrating the other party’s intention to breach the contract gives the counterparty grounds for beginning legal action. An anticipatory breach is also referred to as an anticipatory repudiation.
Key Takeaways
An anticipatory breach, or repudiation, preempts a failure of a party to meet its contractual obligations to another party.
Parties claiming an anticipatory breach are obliged to make every effort to mitigate their own damages if they wish to seek compensation in court.
The intent to break the contract must be an absolute refusal to fulfill the terms in order for it to qualify as an anticipatory breach.
Understanding Anticipatory Breaches
An anticipatory breach occurs when a party demonstrates its intention to break a contract. However, vocal or written confirmation is not required, and failure to perform any obligation in a timely matter can result in a breach.
By declaring an anticipatory breach, the counterparty may begin legal action immediately rather than waiting until the terms of a contract are actually broken.
Compensation Considerations
Parties claiming an anticipatory breach are obliged to make every effort to mitigate their own damages if they wish to seek compensation in court. That could include halting payments to the party that committed the breach and immediately looking for ways to minimize the effects of the breach. It also might mean seeking a third party who could perform the duties outlined in the original contract.
Requirements for an Anticipatory Breach
The intent to break the contract must be an absolute refusal to fulfill the terms for it to qualify as an anticipatory breach. The expected breach cannot be based solely on the assumption that the other party will not meet its obligations.
If the anticipatory breach involves the sale of goods, then section 2-609 of the Uniform Commercial Code (UCC) also lays down several requirements. The party anticipating a breach has the right to ask the other party to provide reassurance that the contract will be fulfilled. While awaiting assurance, payments and other duties can and should be stopped. If the other party does not offer the proper assurance within 30 days, the contract is officially breached.
The requirements for an anticipatory breach can vary. It is a good idea to consult an attorney before taking any action.
Example of an Anticipatory Breach
Let’s say a real estate developer contracts an architecture firm to create plans for a new building by a specific deadline. If the developer requests regular updates on the project and is not pleased with the latest results, this is not grounds to claim an anticipatory breach. The architects may be behind schedule while continuing to work on the project. Such a circumstance still leaves the possibility that the architects might meet their deadline if corrective steps are taken.
If the architects took actions that made it impossible to meet the deadline, it would constitute an anticipatory breach. For example, the architects might halt all work on the first project and commit all their resources to a new project with a different developer. That would preclude them from fulfilling the initial contract.
The adjusted closing price amends a stock’s closing price to reflect that stock’s value after accounting for any corporate actions. It is often used when examining historical returns or doing a detailed analysis of past performance.
Key Takeaways
The adjusted closing price amends a stock’s closing price to reflect that stock’s value after accounting for any corporate actions.
The closing price is the raw price, which is just the cash value of the last transacted price before the market closes.
The adjusted closing price factors in corporate actions, such as stock splits, dividends, and rights offerings.
The adjusted closing price can obscure the impact of key nominal prices and stock splits on prices in the short term.
Understanding the Adjusted Closing Price
Stock values are stated in terms of the closing price and the adjusted closing price. The closing price is the raw price, which is just the cash value of the last transacted price before the market closes. The adjusted closing price factors in anything that might affect the stock price after the market closes.
A stock’s price is typically affected by supply and demand of market participants. However, some corporate actions, such as stock splits, dividends, and rights offerings, affect a stock’s price. Adjustments allow investors to obtain an accurate record of the stock’s performance. Investors should understand how corporate actions are accounted for in a stock’s adjusted closing price. It is especially useful when examining historical returns because it gives analysts an accurate representation of the firm’s equity value.
Types of Adjustments
Adjusting Prices for Stock Splits
A stock split is a corporate action intended to make the firm’s shares more affordable for average investors. A stock split does not change a company’s total market capitalization, but it does affect the company’s stock price.
For example, a company’s board of directors may decide to split the company’s stock 3-for-1. Therefore, the company’s shares outstanding increase by a multiple of three, while its share price is divided by three. Suppose a stock closed at $300 the day before its stock split. In this case, the closing price is adjusted to $100 ($300 divided by 3) per share to maintain a consistent standard of comparison. Similarly, all other previous closing prices for that company would be divided by three to obtain the adjusted closing prices.
Adjusting for Dividends
Common distributions that affect a stock’s price include cash dividends and stock dividends. The difference between cash dividends and stock dividends is that shareholders are entitled to a predetermined price per share and additional shares, respectively.
For example, assume a company declared a $1 cash dividend and was trading at $51 per share before then. All other things being equal, the stock price would fall to $50 because that $1 per share is no longer part of the company’s assets. However, the dividends are still part of the investor’s returns. By subtracting dividends from previous stock prices, we obtain the adjusted closing prices and a better picture of returns.
Adjusting for Rights Offerings
A stock’s adjusted closing price also reflects rights offerings that may occur. A rights offering is an issue of rights given to existing shareholders, which entitles the shareholders to subscribe to the rights issue in proportion to their shares. That will lower the value of existing shares because supply increases have a dilutive effect on the existing shares.
For example, assume a company declares a rights offering, in which existing shareholders are entitled to one additional share for every two shares owned. Assume the stock is trading at $50, and existing shareholders can purchase additional shares at a subscription price of $45. After the rights offering, the adjusted closing price is calculated based on the adjusting factor and the closing price.
Benefits of the Adjusted Closing Price
The main advantage of adjusted closing prices is that they make it easier to evaluate stock performance. Firstly, the adjusted closing price helps investors understand how much they would have made by investing in a given asset. Most obviously, a 2-for-1 stock split does not cause investors to lose half their money. Since successful stocks often split repeatedly, graphs of their performance would be hard to interpret without adjusted closing prices.
Secondly, the adjusted closing price allows investors to compare the performance of two or more assets. Aside from the clear issues with stock splits, failing to account for dividends tends to understate the profitability of value stocks and dividend growth stocks. Using the adjusted closing price is also essential when comparing the returns of different asset classes over the long term. For example, the prices of high-yield bonds tend to fall in the long run. That does not mean these bonds are necessarily poor investments. Their high yields offset the losses and more, which can be seen by looking at the adjusted closing prices of high-yield bond funds.
The adjusted closing price provides the most accurate record of returns for long-term investors looking to design asset allocations.
Criticism of the Adjusted Closing Price
The nominal closing price of a stock or other asset can convey useful information. This information is destroyed by converting that price into an adjusted closing price. In actual practice, many speculators place buy and sell orders at certain prices, such as $100. As a result, a sort of tug of war can take place between bulls and bears at these key prices. If the bulls win, a breakout may occur and send the asset price soaring. Similarly, a win for the bears can lead to a breakdown and further losses. The adjusted close stock price obscures these events.
By looking at the actual closing price at the time, investors can get a better idea of what was going on and understand contemporary accounts. If investors look at historical records, they will find many examples of tremendous public interest in nominal levels. Perhaps the most famous is the role that Dow 1,000 played in the 1966 to 1982 secular bear market. During that period, the Dow Jones Industrial Average (DJIA) repeatedly hit 1,000, only to fall back shortly after that. The breakout finally took place in 1982, and the Dow never dropped below 1,000 again. This phenomenon is covered up somewhat by adding dividends to obtain the adjusted closing prices.
In general, adjusted closing prices are less useful for more speculative stocks. Jesse Livermore provided an excellent account of the impact of key nominal prices, such as $100 and $300, on Anaconda Copper in the early 20th century. In the early 21st century, similar patterns occurred with Netflix (NFLX) and Tesla (TSLA). William J. O’Neil gave examples where stock splits, far from being irrelevant, marked the beginnings of real declines in the stock price. While arguably irrational, the impact of nominal prices on stocks could be an example of a self-fulfilling prophecy.
Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. All direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for when using this method.
Under generally accepted accounting principles (GAAP), U.S. companies may use absorption costing for external reporting, however variable costing is disallowed.
Key Takeaways
Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product produced in the period.
Absorption costing allocates fixed overhead costs to a product whether or not it was sold in the period.
This type of costing method means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
Because more expenses are included in ending inventory, expenses on the income statement are lower when using absorption costing.
Understanding Absorption Costing
Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.
In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.
Higher and Lower Items
Absorption costing means that ending inventory on the balance sheet is higher, while expenses on the income statement are lower.
Components of Absorption Costing
The components of absorption costing include both direct costs and indirect costs. Direct costs are those costs that can be directly traced to a specific product or service. These costs include raw materials, labor, and any other direct expenses that are incurred in the production process.
Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance. Indirect costs are typically allocated to products or services based on some measure of activity, such as the number of units produced or the number of direct labor hours required to produce the product.
In absorption costing, both direct and indirect costs are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, but also a portion of the indirect costs that were incurred in the production process. The total manufacturing costs are then divided by the number of units produced to determine the cost of each unit. The formula for absorption costing can be written as follows:
Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead) / Number of units produced.
Absorption Costing vs. Variable Costing
Absorption costing and variable costing are two different methods of costing that are used to calculate the cost of a product or service. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and variable costing lie in how fixed overhead costs are treated.
Under absorption costing, all manufacturing costs, both direct and indirect, are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, such as raw materials and labor, but also a portion of the indirect costs that were incurred in the production process, such as overhead expenses. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements.
Variable costing, on the other hand, only includes direct costs in the cost of a product. Indirect costs, or overhead expenses, are not included in the cost of the product under variable costing. Instead, they are treated as a period expense and are recorded in the income statement in the period in which they are incurred. Variable costing is typically used for management decision-making and planning purposes, as it provides a more accurate representation of the incremental costs associated with producing an additional unit of a product.
Variable costing does not determine a per-unit cost of fixed overheads, while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.
Absorption costing results in a higher net income compared with variable costing.
Advantages and Disadvantages of Absorption Costing
Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.
Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation compared with variable costing calculations.
Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.
In addition, the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises, because the fixed-cost portion of the cost of goods sold will decrease.
Pros and Cons of Absorption Costing
Pros
Provides a more complete picture of the total cost of a product by including both direct and indirect costs.
Helps in determining the total actual cost of goods sold and the cost of inventory on the balance sheet.
Allows a company to understand the full cost of each product or service it provides.
Cons
May not accurately reflect the incremental costs associated with producing an additional unit of a product, as it includes fixed overhead costs that do not vary with production volume.
Can lead to distorted cost data if there are significant changes in production volume.
May not provide as much information for management decision-making as variable costing.
Example of Absorption Costing
Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).
The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).
What’s the Difference Between Variable Costing and Absorption Costing?
Absorption costing and variable costing treat fixed overhead costs differently. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, adds all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale. In other words, variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income, while absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.
What Are the Advantages of Absorption Costing?
The main advantage of absorption costing is that it complies with generally accepted accounting principles (GAAP), which are required by the Internal Revenue Service (IRS). Furthermore, it takes into account all of the costs of production (including fixed costs), not just the direct costs, and more accurately tracks profit during an accounting period.
What Are the Disadvantages of Absorption Costing?
The main disadvantage of absorption costing is that it can inflate a company’s profitability during a given accounting period, as all fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold. Additionally, it is not helpful for analysis designed to improve operational and financial efficiency or for comparing product lines.
When Is It Appropriate to Use Absorption Costing?
Absorption costing is typically used in situations where a company wants to understand the full cost of producing a product or providing a service. This includes cases where a company is required to report its financial results to external stakeholders, such as shareholders or regulatory agencies.
Absorption costing is also often used for internal decision-making purposes, such as determining the selling price of a product or deciding whether to continue producing a particular product. In these cases, the company may use absorption costing to understand the full cost of producing the product and to determine whether the product is generating sufficient profits to justify its continued production.
What Are the Types of Absorption Costing?
There are two main types of absorption costing: full absorption costing and partial absorption costing:
Full absorption costing includes all of the costs associated with producing a product or providing a service, including both fixed and variable costs. Under full absorption costing, the total cost of a product or service is absorbed, or spread out, over the units produced. This means that the cost of each unit produced includes a portion of the fixed costs, as well as the variable costs associated with that unit.
Partial absorption costing includes only some of the costs associated with producing a product or providing a service. Under partial absorption costing, only a portion of the fixed costs are included in the cost of each unit produced. The remainder of the fixed costs are treated as a period cost and are expensed in the period in which they are incurred.
The Bottom Line
Absorption costing is a method of costing that includes all manufacturing costs, both fixed and variable, in the cost of a product. It is also known as full costing or full absorption costing. Absorption costing is used to determine the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to calculate the profit margin on each unit of product and to determine the selling price of the product.
Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product. The fixed manufacturing overhead costs are allocated to each unit of product based on a predetermined overhead allocation rate, which is calculated by dividing the total estimated fixed manufacturing overhead costs by the total number of units that are expected to be produced. In addition to the fixed manufacturing overhead costs, absorption costing also includes the variable manufacturing costs in the cost of a product. These costs are directly traceable to a specific product and include direct materials, direct labor, and variable overhead.
An alternative trading system (ATS) is a trading venue that is more loosely regulated than an exchange. ATS platforms are often used to match large buy and sell orders among its subscribers. The most widely used type of ATS in the United States are electronic communication networks (ECNs)—computerized systems that automatically match buy and sell orders for securities in the market.
Key Takeaways
Alternative trading systems (ATS) are venues for matching large buy and sell transactions.
They are not as highly regulated as exchanges.
Examples of ATS include dark pools and ECNs.
SEC Regulation ATS establishes a regulatory framework for these trading venues.
Understanding an Alternative Trading System (ATS)
ATS account for much of the liquidity found in publicly traded issues worldwide. They are known as multilateral trading facilities in Europe, ECNs, cross networks, and call networks.Most ATS are registered as broker-dealers rather than exchanges and focus on finding counterparties for transactions.
Alternative trading system (ATS) is the terminology used in the U.S. and Canada. In Europe, they are known as multilateral trading facilities.
Unlike some national exchanges, ATS do not set rules governing the conduct of subscribers or discipline subscribers, other than by excluding them from trading. They are important in providing alternative means to access liquidity.
Institutional investors may use an ATS to find counterparties for transactions, instead of trading large blocks of shares on national stock exchanges. These actions may be designed to conceal trading from public view since ATS transactions do not appear on national exchange order books. The benefit of using an ATS to execute such orders is that it reduces the domino effect that large trades might have on the price of an equity.
Between 2013 and 2015, ATS accounted for approximately 18% of all stock trading, according to the Securities and Exchange Commission (SEC). That figure represented an increase of more than four times from 2005.
Criticisms of Alternative Trading Systems (ATS)
These trading venues must be approved by the SEC. In recent years, regulators have stepped up enforcement actions against ATS for infractions such as trading against customer order flow or making use of confidential customer trading information. These violations may be more common in ATS than national exchanges because ATS face fewer regulations.
Dark Pools
A hedge fund interested in building a large position in an equity may use an ATS to prevent other investors from buying in advance. ATS used for these purposes may be referred to as dark pools.
Dark pools entail trading on ATS by institutional orders executed on private exchanges. Information about these transactions is mostly unavailable to the public, which is why they are called “dark.” The bulk of dark pool liquidity is created by block trades facilitated away from the central stock market exchanges and conducted by institutional investors (primarily investment banks).
Although they are legal, dark pools operate with little transparency. As a result, dark pools, along with high-frequency trading (HFT), are oft-criticized by those in the finance industry; some traders believe that these elements convey an unfair advantage to certain players in the stock market.
Regulation of Alternative Trading Systems (ATS)
SEC Regulation ATS established a regulatory framework for ATS. An ATS meets the definition of an exchange under federal securities laws but is not required to register as a national securities exchange if the ATS operates under the exemption provided under Exchange Act Rule 3a1-1(a). To operate under this exemption, an ATS must comply with the requirements in Rules 300-303 of Regulation ATS.
To comply with Regulation ATS, an ATS must register as a broker-dealer and file an initial operation report with the Commission on Form ATS before beginning operations. An ATS must file amendments to Form ATS to provide notice of any changes to its operations, and must file a cessation of operation report on Form ATS if it closes. The requirements for filing reports using Form ATS is in Rule 301(b)(2) of Regulation ATS. These requirements include mandated reporting of books and records.
In recent times, there have been moves to make ATS more transparent. For example, the SEC amended Regulation ATS to enhance “operational transparency” for such systems in 2018. Among other things, this entails filing detailed public disclosures to inform the general public about potential conflicts of interest and risks of information leakage. ATS are also required to have written safeguards and procedures to protect subscribers’ trading information.
The SEC formally defines an alternative trading system as “any organization, association, person, group of persons, or systems (1) that constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 under the Exchange Act; and (2) that does not (i) set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system, or (ii) discipline subscribers other than by exclusion from trading.”
