Posts Tagged ‘Examples’

Acceleration Clause: Explanation and Examples

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Acceleration Clause: Explanation and Examples

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What Is an Acceleration Clause?

An acceleration clause is a contract provision that allows a lender to require a borrower to repay all of an outstanding loan if certain requirements are not met. An acceleration clause outlines the reasons that the lender can demand loan repayment and the repayment required.

It is also known as an “acceleration covenant.”

Key Takeaways

  • An acceleration clause or covenant is a contract provision that allows a lender to require a borrower to repay all of an outstanding loan if specific requirements are not met.
  • The acceleration clause clearly outlines the reasons that the lender can demand loan repayment and the repayment required, such as maintaining a certain credit rating.
  • An acceleration clause helps to protect lenders who extend financing to businesses in need of capital. 

Acceleration Clause Explained

An acceleration clause allows the lender to require payment before the standard terms of the loan expire. Acceleration clauses are typically contingent on on-time payments.

Acceleration clauses are most common in mortgage loans and help to mitigate the risk of default for the lender. They are usually based on payment delinquencies but they can be structured for other occurrences as well. In most cases, an acceleration clause will require the borrower to immediately pay the full balance owed on the loan if terms have been breached. With full payment of the loan the borrower is relieved of any further interest payments and essentially pays off the loan early at the time the acceleration clause is invoked.

An acceleration clause is usually based on payment delinquency, however the number of delinquent payments can vary. Some acceleration clauses may invoke immediate payoff after one payment is missed while others may allow for two or three missed payments before demanding that the loan be paid in full. Selling or transferring the property to another party can also potentially be a factor associated with an acceleration clause.

For example, assume a borrower with a five year mortgage loan fails to make a payment in the third year. The terms of the loan include an acceleration clause which states the borrower must repay the remaining balance if one payment is missed. The borrower would immediately be contacted by the lender to pay the remaining balance in full. If the borrower pays then they receive the title to the home and takes full ownership of the property. If the borrower cannot pay then they are considered in breach of contract and the lender can foreclose and seize the property for resale.

Invoking the Acceleration Clause

Acceleration clauses are most commonly found in mortgage and real estate loans. Since these loans tend to be so large, the clause helps protect the lender from the risk of borrower default. A lender may choose to include an acceleration clause to mitigate potential losses and have greater control over the real estate property tied to a mortgage loan. With an acceleration clause, a lender has greater ability to foreclose on the property and take possession of the home. This may be advantageous to the lender if the borrower defaults and the lender believes they can obtain value through a resale.

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Animal Spirits: Meaning, Definition in Finance, and Examples

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Animal Spirits: Meaning, Definition in Finance, and Examples

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What Are Animal Spirits?

“Animal spirits” is a term coined by the famous British economist, John Maynard Keynes, to describe how people arrive at financial decisions, including buying and selling securities, in times of economic stress or uncertainty. In Keynes’s 1936 publication, The General Theory of Employment, Interest, and Money, he speaks of animal spirits as the human emotions that affect consumer confidence.

Today, animal spirits describe the psychological and emotional factors that drive investors to take action when faced with high levels of volatility in the capital markets. The term comes from the Latin spiritus animalis, which means “the breath that awakens the human mind.” In some ways, Keynes’ insights into human behavior predicted the rise of behavioral economics.

Key Takeaways

  • Animal spirits come from the Latin spiritus animalis: “the breath that awakens the human mind.” It was coined by British economist, John Maynard Keynes in 1936.
  • Animal spirits refer to the ways that human emotion can drive financial decision-making in uncertain environments and volatile times.
  • Animal spirits essentially account for market psychology and in particular the role of emotion and herd mentality in investing.
  • Animal spirits are used to help explain why people behave irrationally, and are the forerunner to modern behavioral economics.
  • We may observe the concept of animal spirits in action during financial crises, including the Great Recession of 2007–2009.

Understanding Animal Spirits

The technical concept of spiritus animalis can be traced as far back as 300 B.C., in the fields of human anatomy and medical physiology. There, animal spirits applied to the fluid or spirit present in sensory activities and nerve endings in the brain that resulting in mass psychological phenomena like manias or hysterias.

Animal spirits also appeared in literary culture, where they referred to states of physical courage, gaiety, and exuberance. The literary meaning implies that animal spirits can be high or low depending on an individual’s degree of health and energy.

Animal Spirits in Finance and Economics

Today in finance, the term animal spirits arise in market psychology and behavioral economics. Animal spirits represent the emotions of confidence, hope, fear, and pessimism that can affect financial decision-making, which in turn can fuel or hamper economic growth. If spirits are low, then confidence levels will be low, which will drive down a promising market—even if the market or economy fundamentals are strong. Likewise, if spirits are high, confidence among participants in the economy will be high, and market prices will soar.

The Role of Emotion in Business Decisions

According to the theory behind animal spirits, the decisions of business leaders are based on intuition and the behavior of their competitors rather than on solid analysis. Keynes understood that in times of economic upheaval, irrational thoughts might influence people as they pursue their financial self-interests.

Keynes further posited in The General Theory that trying to estimate the future yield of various industries, companies, or activities using general knowledge and available insight “amounts to little and sometimes to nothing.” He proposed that the only way people can make decisions in an uncertain environment is if animal spirits guide them.

Animal Spirits Enter the 21st Century

In 2009, the term animal spirits returned to popularity when two economists—George A. Akerlof (Nobel laureate and professor of economics at University of California) and Robert J. Shiller (professor of economics at Yale University)—published their book, Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism.

Here, the authors argue that although animal spirits are important, it is equally important that the government actively intervene to control them—via economic policymaking—when necessary. Otherwise, the authors postulate, the spirits might follow their own devices—that is, capitalism could get out of hand, and result in the kind of overindulgence that we saw in the 2008 financial crisis.

Examples of Animal Spirits

The Dotcom Bubble

Animal spirits often manifest as market psychology defined by either fear or greed. For the latter, the term “irrational exuberance” has been used to describe investor enthusiasm that drives asset prices far higher than those assets’ fundamentals justify. Simply tacking on “dotcom” to the name of a company increased its market value to extraordinary levels, with startups showing zero earnings commanding ever-higher share prices.

The crash that followed saw the Nasdaq index, which had risen five-fold between 1995 and 2000, tumble from a peak of 5,048.62 on March 10, 2000, to 1,139.90 on Oct 4, 2002, a 76.81% fall. By the end of 2001, most dot-com stocks had gone bust.

The Great Recession

Another example was the lead-up to the 2008-09 financial crisis and the Great Recession, when the markets were rife with financial innovations. Creative use of both new and existing financial products—like collateralized debt obligations (CDOs)—abounded, particularly in the housing market. Initially, this trend was thought to be positive, that is until the new financial instruments were found to be deceptive and fraudulent. At this point, investor confidence plummeted, a sell-off ensued, and the markets plunged. A clear case of animal spirits run amok.

Critiques of Animal Spirits

“Animal spirits” refers to the tendency for investment prices to rise and fall based on human emotion rather than intrinsic value. This theory, however, has been critiqued by some economists who argue that markets are nonetheless efficient and that individual irrationality washes out in the aggregate. The animal spirits thesis, like behavioral economics, essentially throws a monkey wrench into the assumptions of efficiency and rationality.

Other critics argue that bubbles are not the result of mass psychology, but are due to the over-involvement of central banks and too much regulation, which stymie economic growth and throw markets out of equilibrium. These arguments often stem from Austrian economic theory or libertarianism that asserts that large increases in the money supply (“printed” by governments) are the cause of bubbles and their ultimate demise by encouraging malinvestment.

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Assemble-to-Order (ATO): Overview, Examples, Pros and Cons

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Accretive: Definition and Examples in Business and Finance

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What Is Assemble-to-Order (ATO)?

Assemble-to-order (ATO) is a business production strategy where products that are ordered by customers are produced quickly and are customizable to a certain extent. It typically requires that the basic parts of the product are already manufactured but not yet assembled. Once an order is received, the parts are assembled quickly and the final product is sent to the customer.

Key Takeaways

  • Assemble-to-order (ATO) is a business strategy where products are quickly produced from component parts once the order is confirmed.
  • Assemble-to-order is a combination of make-to-order and make-to-stock.
  • In a typical ATO approach, the costs of assembling the product from its components are negligible, but the costs of making the different components can be substantial.
  • A PC-maker that receives orders and then assembles customizable computers using components like keyboards, monitors, and motherboards is using an assemble-to-order strategy.

Understanding Assemble-to-Order (ATO)

The assemble-to-order strategy is a hybrid between the make-to-stock strategy (MTS) and the make-to-order strategy (MTO). A make-to-stock strategy is one where products are fully produced in advance. The idea is to build an inventory that matches expected or anticipated consumer demand. This method would consist of setting a production level, building up inventory, and then attempting to sell as much assembled product as possible. It’s used mostly for high-volume goods, consumables, and items that can be bought in bulk or as a single unit.

A make-to-order strategy is one where products are manufactured once the order has been received. Production is driven by demand and items are only produced when orders are confirmed. In other words, the supply chain operation does not begin until there is evidence of sufficient customer demand. This strategy is often employed for high-end goods or items made individually or in small batches.

The ATO strategy attempts to combine the benefits of both make-to-order and make-to-stock—getting products into customers’ hands quickly while allowing for the product to be adapted or altered in certain ways, as per customer request. In most cases, the time and costs associated with building the product from its components are minimal. However, the time and costs to build the components, which are usually ordered from a supplier, can be considerable.

Enabled by technology, advancements in production processes and inventory management systems have played a big part in making assemble-to-order strategies a reality. Add cheaper methods of shipping products, and the strategy has been a boon for product customization opportunities.

Pros and Cons Assemble-to-Order (ATO)

Like many methods that chart a middle course, assemble-to-order has both advantages and disadvantages.

Pros

  • No need to invest in materials and supplies, and storage for them

  • Orders made to customer specifics

  • Less risk of having unsold units on hand

Example of Assemble-to-Order (ATO)

Consider a manufacturer of personal computers. It might have all of the essential parts of a computer—motherboards, graphic cards, processors, monitors, keyboards—in stock and already manufactured. The company depends on various suppliers for these components.

When orders for new PCs arrive, it is easy for the company to assemble and customize the computers using the various components. The process is driven by customer demand, however, and until the order arrives, the components sit on shelves.

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Auditor’s Report: Necessary Components and Examples

Written by admin. Posted in A, Financial Terms Dictionary

Appraisal: Definition, How It Works, and Types of Appraisals

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What Is Audit Risk?

Audit risk is the risk that financial statements are materially incorrect, even though the audit opinion states that the financial reports are free of any material misstatements.

Key Takeaways

  • Audit risk is the risk that financial statements are materially incorrect, even though the audit opinion states that the financial reports are free of any material misstatements.
  • Audit risk may carry legal liability for a certified public accountancy (CPA) firm performing audit work.
  • Auditing firms carry malpractice insurance to manage audit risk and the potential legal liability.
  • The two components of audit risk are risk of material misstatement and detection risk.

Understanding Audit Risk

The purpose of an audit is to reduce the audit risk to an appropriately low level through adequate testing and sufficient evidence. Because creditors, investors, and other stakeholders rely on the financial statements, audit risk may carry legal liability for a certified public accountancy (CPA) firm performing audit work.

Over the course of an audit, an auditor makes inquiries and performs tests on the general ledger and supporting documentation. If any errors are caught during the testing, the auditor requests that management propose correcting journal entries.

At the conclusion of an audit, after any corrections are posted, an auditor provides a written opinion as to whether the financial statements are free of material misstatement. Auditing firms carry malpractice insurance to manage audit risk and the potential legal liability.

Types of Audit Risk

The two components of audit risk are the risk of material misstatement and detection risk. Assume, for example, that a large sporting goods store needs an audit performed, and that a CPA firm is assessing the risk of auditing the store’s inventory.

Risk of Material Misstatement

Material misstatement risk is the risk that the financial reports are materially incorrect before the audit is performed. In this case, the word “material” refers to a dollar amount that is large enough to change the opinion of a financial statement reader, and the percentage or dollar amount is subjective. If the sporting goods store’s inventory balance of $1 million is incorrect by $100,000, a stakeholder reading the financial statements may consider that a material amount. The risk of material misstatement is even higher if there is believed to be insufficient internal controls, which is also a fraud risk.

Detection Risk

Detection risk is the risk that the auditor’s procedures do not detect a material misstatement. For example, an auditor needs to perform a physical count of inventory and compare the results to the accounting records. This work is performed to prove the existence of inventory. If the auditor’s test sample for the inventory count is insufficient to extrapolate out to the entire inventory, the detection risk is higher.

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