Archives for July 2009

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How Turnover in Your Portfolio Affects Performance

I frequently mention that, when selecting mutual funds, it’s generally advantageous to look for funds with low turnover.

What I’ve noticed from comments on the blog and emails I’ve received is that some investors seem to miss the fact that the same thing applies to our own portfolios. Generally speaking, increased turnover is a bad thing.

Increased Costs

Most obviously, increased turnover leads to increased transaction costs:

  • If you purchase individual stocks or bonds, each transaction comes with a cost. Even if you’re using a discount brokerage firm, those $7 trades begin to add up.
  • If you jump between funds, there may be a transaction cost (depending upon which funds you use and how quickly you sell them after buying them).
  • If you’re investing in a taxable account, turnover means incurring capital gains taxes earlier, which is harmful to returns.

Increased Risk

Less obviously, increased turnover in your portfolio creates a cost in terms of extra risk you take on.

For example, there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.

Increased risk and increased costs, without an increase in expected return. What’s not to love?

The alternative: “Don’t just do something, sit there!”

July 9, 2009

What Does a Good Financial Advisor Do?

If you had a friend who had come out ahead each of the last 5 times he went to Vegas, would you feel comfortable giving him your life savings to use the next time he went? Of course not.

So why do we let financial advisors take our savings to Vegas, so to speak?

Admittedly, there probably are investment managers who have a genuine ability to earn above average returns without incurring above average risk. (Name your favorite: Buffett, Swenson, etc.) But they’re generally going to be very busy doing just that.

They’re not going to be available to take your phone calls. They’re not going to sit down with you to determine your appropriate asset allocation, how much money you’ll need in order to retire, or how much it will cost little Jenny to go to college in 14 years.

Any financial advisor who tells you that he can do both is either misinformed or misleading you. (In most cases, I’d bet on misinformed.)

Ben Graham on Financial Advisors

While reading Bogle’s Enough last week, I came across this delightful explanation by Benjamin Graham as to what a financial advisor’s job should be:

“A well-trained financial analyst can [justify his existence] by adhering to relatively simple principles of sound investment ; e.g., a proper balance between bonds and stocks; proper diversification; selection of a representative list; discouragement of speculative operations…And for this he does not need to be a wizard in picking winners from the stock list or in foretelling market movements.”

So what, according to Graham, should financial advisors be doing?

  • Helping clients with asset allocation decisions,
  • Selecting a “representative list” (that is, a group of stocks that will mimic the returns of the overall market–now made effortless via index funds), and
  • Discouraging speculative operations.

And what should financial advisors not be doing?

  • Trying to “pick winners from the stock list,” and
  • Trying to “foretell market movements.”

Sounds like a good financial advisor to me.

July 8, 2009

The 30-Day Rule (as Applied to Investing)

I know many frugally minded people like to use something called the “30-Day Rule” to help curb their spending. Here’s how Leo from ZenHabits once explained it:

Make a new rule: you can’t buy anything (except necessities) until a 30-day waiting period has passed. Put a 30-day list on your refrigerator, and when you have the urge to buy something, put it on the list with today’s date. After a month has passed, you can buy the item. Many times the urge will have passed and you can just cross the item off the list.

The reasoning is that when we see a shiny new toy, we want it. Our emotions kick in and attempt to overtake our more sensible lines of thinking. If we delay action, it gives the emotion a chance to subside somewhat, thereby allowing us to think clearly about whether making the purchase really does fit in well with our goals.

Let’s apply it to investing.

How about this: Every time you’re tempted to adjust your portfolio in some way, don’t. [Noteworthy exception: Regularly scheduled rebalancing.] Instead, write down your idea, your reasoning behind it, and the date. 30 days later, if the reasoning still makes sense, then (perhaps) give it a go.

For example…

  • Many investors are tempted to respond emotionally to big market swings.
  • Other investors are frequently tempted to “tinker” with their portfolios.

Give it 30 days. If it truly made sense in the first place, it should still make sense a month later. On the other hand, if the idea doesn’t seem so wise when considered again 30 days later, it’s likely that your emotions were getting the better of you originally (even if you were unaware of it).

Quick note: The rule only works when we’re talking about portfolios with a lengthy investing time frame. (An asset allocation that makes sense for 15 years is probably also a good one for 14 years and 11 months, but an investment that is ideal for a 3 month time frame may not be fitting for a 2 month time frame.)

It’s difficult–if not impossible–to eliminate the emotional urges to take unwise actions (whether buying some unnecessary luxury or pulling out of the market after a drop), but what we can do is put systems in place to help overcome those emotions.

July 7, 2009

Example Accounting Problems

These sample problems are intended as a supplement to my book Accounting Made Simple: Accounting Explained in 100 Pages or Less.

Chapter 1: The Accounting Equation

Question 1: Define the three components of the Accounting Equation.

Question 2: If a business owns a piece of real estate worth $250,000, and they owe $180,000 on a loan for that real estate, what is owners’ equity in the property?

Answer to Question 1:

  • Assets: All the property owned by a business.
  • Liabilities: A company’s outstanding debts.
  • Owners’ Equity: The company’s ownership interests in its property after all debts have been repaid.

Answer to Question 2: $70,000

Chapter 2: The Balance Sheet

Question 1: Categorize the following accounts as to whether they’re Asset, Liability, of Owners’ Equity accounts.

  • Common Stock
  • Accounts Receivable
  • Retained Earnings
  • Cash
  • Notes Payable

Question 2: For each of the following assets or liabilities, state whether it is current or non-current:

  • Accounts Payable
  • Cash
  • Property, Plant, and Equipment
  • Note Payable
  • Inventory

Answer to Question 1:

  • Common Stock: Owners’ Equity
  • Accounts Receivable: Asset
  • Retained Earnings: Owners’ Equity
  • Cash: Asset
  • Notes Payable: Liability

Answer to Question 2:

  • Accounts Payable: current liability
  • Cash: current asset
  • Property, Plant, and Equipment: non-current asset
  • Note Payable: non-current liability (Though if a portion of the note is due within the next twelve months, that portion should be shown as a current liability.)
  • Inventory: current asset

Chapter 3: The Income Statement

Question 1: Given the following information, calculate ABC Corp’s Net Income:

  • Sales: $260,000
  • Cost of Goods Sold: $100,000
  • Salaries and Wages: $20,000
  • Rent Expense: $15,000
  • Advertising Expense: $35,000
  • Cost of repairs resulting from fire: $50,000

Question 2: Using the above information, calculate ABC Corp’s Operating Income.

Question 3:Using the above information, calculate ABC Corp’s Gross Profit.

Answer to Question 1: $40,000 (Sales of $260,000 minus $220,000 of total expenses.)

Answer to Question 2: $90,000 (Operating Income is intended to represent income from typical business operations.  As a result, expenses resulting from a fire would certainly not be included when calculating Operating Income.)

Answer to Question 3: $160,000 (Sales minus Cost of Goods Sold)

Chapter 4: The Statement of Retained Earnings

Question 1: Using the following information, calculate the ending balance in Retained Earnings:

  • Beginning Retained Earnings: $10,000
  • Net Income: $5,000
  • Dividends Paid: $4,000

Question 2: Calculate Net Income given the following information:

  • Consulting Revenue: $50,000
  • Rent Expense: $5,000
  • Software Licensing Fees: $3,000
  • Dividends Paid: $6,000
  • Advertising Expense:$20,000

Question 3: Using the following information, calculate how much was paid out in dividends during the year:

  • Beginning Retained Earnings: $40,000
  • Net Income: $15,000
  • Ending Retained Earnings: $30,000

Answer to Question 1: $11,000

Answer to Question 2: $22,000 (Remember, dividends are not an expense! They are a distribution of net income rather than a reduction of net income.)

Answer to Question 3: $25,000

Chapter 5: The Cash Flow Statement

Question 1: Calculate cash flow from operating activities using the following information:

  • Cash sales: $10,000
  • Credit sales: $15,000
  • Cash received from prior credit sales: $8,000
  • Rent paid: $3,000
  • Inventory purchased: $6,000
  • Wages paid:$5,000

Question 2: Categorize the following cash flows as to whether they are operating, investing, or financing activities:

  • Taxes paid
  • Dividends paid to shareholders
  • Interest paid on loans
  • Dividends received on investments
  • Cash sales
  • Purchase of new office furniture

Answer to Question 1: Net cash inflow of $4,000. (Remember not to include the $15,000 of credit sales when calculating cash flow.)

Answer to Question 2:

  • Taxes paid: Operating Activities
  • Dividends paid to shareholders: Financing Activities
  • Interest paid on loans: Operating Activities (Note: Principal paid on loans is a financing activity.)
  • Dividends received on investments: Operating Activities
  • Cash sales: Operating Activities
  • Purchase of new office furniture: Investing Activities

Chapter 6: Financial Ratios

Questions 1-3: Use the following income statement and balance sheet to answer the following questions.

Income Statement
Sales 130,000
Cost of Goods Sold 26,000
Profit Margin 104,000
Salaries and Wages 15,000
Rent Expense 5,000
Licensing Expenses 20,000
Advertising Expense 4,000
Total Expenses 44,000
Net Income
 60,000
Balance Sheet
Assets
Cash 10,000
Inventory 15,000
Property, Plant, and Equipment 250,000
Accounts Receivable 5,000
Total Assets 280,000
Liabilities
Accounts Payable 20,000
Notes Payable 40,000
Total Liabilities 60,000
Owners’ Equity
Common Stock 120,000
Retained Earnings 100,000
Total Owners’ Equity 220,000

Question 1: Calculate the company’s current ratio and quick ratio.

Question 2: Calculate the company’s return on assets and return on equity.

Question 3: Calculate the company’s debt ratio and debt to equity ratio.

Answer to Question 1: Current ratio = 1.5 (30,000 current assets ÷ 20,000 current liabilities). Quick ratio = 0.75 (15,000 non-inventory current assets ÷ 20,000 current liabilities).

Answer to Question 2: Return on assets = 21.4% (60,000 net income ÷ 280,000 total assets). Return on equity = 27.3% (60,000 net income ÷ 220,000 shareholders’ equity)

Answer to Question 3: Debt ratio = 21.4% (60,000 liabilities ÷ 280,000 assets). Debt to equity ratio = 27.3% (60,000 liabilities ÷ 220,000 shareholders’ equity).

Chapter 7: What is GAAP?

Question 1: Who is required to follow GAAP?

Question 2: Who creates the rules for GAAP?

Question 3: What is the purpose of Generally Accepted Accounting Principles (GAAP)?

Answer to Question 1: Publicly-traded companies. (Governmental entities are required to follow GAAP as well, but the rules that make up GAAP for governmental entities are significantly different from the rules for publicly-traded companies.)

Answer to Question 2: The Financial Accounting Standards Board (FASB)

Answer to Question 3: To purpose of GAAP is to ensure that companies’ financial statements are prepared using a similar set of rules and assumptions. This helps to enable meaningful comparisons between the financial statements of multiple companies.

Chapter 8: Debits and Credits

Questions 1-3: Show how the following transactions would affect the Accounting Equation

Question 1: James purchases a $5,000 piece of equipment.

Question 2: James writes his monthly check for rent: $3,000.

Question 3: James takes out a $25,000 loan with his bank.

Questions 4-6: Create journal entries to record the following transactions

Question 4: James purchases a $5,000 piece of equipment.

Question 5: James writes his monthly check for rent: $3,000.

Question 6: James takes out a $25,000 loan with his bank.

Answer to Question 1:

Assets = Liabilities + Owners’ Equity
-5,000 no change no change
+5,000

Answer to Question 2:

Assets = Liabilities + Owners’ Equity
-3,000 -3,000

Answer to Question 3:

Assets = Liabilities + Owners’ Equity
+25,000 +25,000

Answer to Question 4:

Dr. Equipment 5,000
Cr. Cash 5,000

Answer to Question 5:

Dr. Rent Expense 3,000
Cr. Cash 3,000

Answer to Question 6:

Dr. Cash 25,000
Cr. Note Payable 25,000

Chapter 9: Cash vs. Accrual

Questions 1-5: Prepare journal entries to record each of the following events.

Question 1: Tom’s Tax Prep’s monthly rent is $3,500. At the end of February, they had not yet received their monthly rent invoice.

Question 2: In early March, Tom’s Tax Prep receives and pays their rent bill for February.

Question 3: Marla, a marketing consultant, performs services for a client. The agree-upon price was $10,000, due 30 days from the date the services were completed.

Question 4: ABC Hardware makes a sale (on credit) for $2,500 worth of lumber. The lumber originally cost them $1,300.

Question 5: Julie takes out a $10,000 loan for her business. Repayment is due in one year along with $1,200 interest.

Answer to Question 1:

Dr. Rent Expense 3,500
Cr. Rent Payable 3,500

Answer to Question 2:

Dr. Rent Payable 3,500
Cr. Cash 3,500

Answer to Question 3:

Accounts Receivable 10,000
Sales 10,000

Answer to Question 4:

Accounts Receivable 2,500
Sales 2,500
Cost of Goods Sold 1,300
Inventory 1,300

Answer to Question 5:

When the loan is taken out:

Cash 10,000
Note Payable 10,000

At the end of each month during the year:

Interest Expense 100
Interest Payable 100

When the loan is repaid:

Note Payable    10,000
Interest Payable    1,200
Cash    11,200

Chapter 10: The Accounting Close Process

Prepare closing journal entries for Mario’s Mobile Products, which has the following end-of-year trial balance:

Cash 40,000
Accounts Receivable 8,000
Property, Plant, and Equipment 150,000
Inventory 30,000
Accounts Payable 15,000
Wages Payable 22,000
Common Stock 50,000
Retained Earnings 60,000
Sales 380,000
Cost of Goods Sold 120,000
Rent Expense 60,000
Wages and Salary Expense 110,000
Advertising Expense 9,000

Answer:

Sales 380,000
Income Summary 380,000
Income Summary 120,000
Cost of Goods Sold 120,000
Income Summary 60,000
Rent Expense 60,000
Income Summary 110,000
Wages and Salary Expense 110,000
Income Summary 9,000
Advertising Expense 9,000

Alternatively, the above can be combined into one journal entry:

Sales 380,000
Cost of Goods Sold 120,000
Rent Expense 60,000
Wages and Salary Expense 110,000
Advertising Expense 9,000
Income Summary 81,000

In either case, the following closing journal entry is also required in order to close out the Income Summary account and transfer the balance — representing the business’s net income for the period — into Retained Earnings:

Income Summary 81,000
Retained Earnings 81,000

Chapter 11: Other GAAP Concepts and Assumptions

Question 1: Andy runs a real estate development firm. Five years ago, he purchased a piece of land for $250,000. This year, an appraiser tells Andy that the land is worth $300,000. At what value should Andy report the land on his balance sheet? Why?

Question 2: Andy is the sole owner of his firm. In June, he moves $30,000 from his business checking account to his personal checking account. If Andy wants his financial records to be in accordance with GAAP, should he record the transaction or not? Why?

Answer to Question 1: Andy should report the land at its original cost: $250,000. Under GAAP’s “Historical Cost” assumption, assets are reported at their historical cost rather than at their current market value. This is done in order to remove subjective asset valuations from the reporting process.

Answer to Question 2: Yes, in order to be in compliance with GAAP, Andy must record the transaction. GAAP’s “Entity Assumption” considers businesses to be separate entities from their owners. As such, transactions between a business and its owners must be recorded as if they were between the business and an entirely separate party.

Chapter 12: Depreciation of Fixed Assets

Questions 1-6: Prepare journal entries to record each of the following events:

Question 1: Liliana spends $20,000 (cash) on a piece of equipment for use in her restaurant. She plans to use the straight-line method to depreciate the equipment over 5 years. She expects it to have no value at the end of the 5 years.

Question 2: After 4 years,  Liliana sells the equipment for $4,000.

Question 3: Same as question 2, except she sells the equipment for $6,000.

Question 4: Same as question 2, except she sells the equipment for $2,000.

Question 5: Oscar is a self-employed electrician. He purchases a piece of equipment for $30,000 cash. He plans to use it for 10 years, at which point he plans to sell it for approximately $4,000.He elects to use the straight-line method of depreciation.

Question 6: Sandra runs a business making embroidered linens for wedding receptions. She purchases a new piece of equipment for $15,000 in credit. She plans to use the units of production method of depreciation. The equipment is expected to produce approximately 5,000 linens, at which point it will be valueless. During the first year after buying the equipment, Sandra uses it to produce 1,500 linens.

Answer to Question 1:

To record the purchase:

Equipment 20,000
Cash 20,000

To record depreciation every year:

Depreciation Expense 4,000
Accumulated Depreciation 4,000

Answer to Question 2:

Cash 4,000
Accumulated Depreciation 16,000
Equipment 20,000

Answer to Question 3:

Cash 6,000
Accumulated Depreciation 16,000
Gain on Sale of Equipment 2,000
Equipment 20,000

Answer to Question 4:

Cash 2,000
Accumulated Depreciation 16,000
Loss on Sale of Equipment 2,000
Equipment 20,000

Answer to Question 5:

To record the purchase:

Equipment 30,000
Cash 30,000

To record depreciation every year:

Depreciation Expense 2,600
Accumulated Depreciation 2,600

(Depreciable value is $26,000. If depreciated over 10 years, that’s $2,600 depreciation per year.)

Answer to Question 6:

To record the purchase:

Equipment 15,000
Accounts Payable 15,000

When the purchase is eventually paid for:

Accounts Payable 15,000
Cash 15,000

To record depreciation for the first year:

Depreciation Expense 4,500
Accumulated Depreciation 4,500

($15,000 depreciable value ÷ 5,000 units = $3 of depreciation per unit. 1,500 units produce x $3 per unit = $4,500 depreciation expense.)

Chapter 13: Amortization of Intangible Assets

Questions 1-2: Prepare journal entries to record each of the following events.

Question 1: Trent runs a business as an engineering consultant. He invents a new system for preparing bridges to deal with extreme weather conditions. He spends $28,000 securing a 14-year patent for his invention. He expects the system to be used for the next few decades at least.

Question 2: Tina runs a business creating medical supplies for surgeries. Her team develops a new tool for assisting in heart surgery. She spends $42,000 on getting it patented. She receives a 14-year patent, but she only expects the technology to be used for about 7 years before a newer technology comes along to replace it.

Answer to Question 1:

To record receiving the patent:

Patents 28,000
Cash 28,000

To record amortization expense each year:

Amortization Expense 2,000
Accumulated Amortization 2,000

Answer to Question 2:

To record receiving the patent:

Patents 42,000
Cash 42,000

To record amortization expense each year:

Amortization Expense 6,000
Accumulated Amortization 6,000

Chapter 14: Inventory and Cost of Goods Sold

Question 1: Using the following information, calculate Cost of Goods Sold:

  • Beginning Inventory: $3,000
  • Ending Inventory: $4,500
  • Purchases: $6,000

Question 2-4: Use the following information to answer questions 2-4.

  • Beginning Inventory: 1,000 units at $4/unit.
  • Purchases: 600 units at $5/unit.
  • Ending Inventory: 900 units.

Question 2: Calculate Cost of Goods Sold using First-In-First-Out (FIFO)

Question 3: Calculate Cost of Goods Sold using Last-In-First-Out (LIFO)

Question 4: Calculate Cost of Goods Sold using the Average Cost Method

Answer to Question 1: CoGS = $4,500

Answer to Question 2: CoGS = $2,800

Explanation:

The first thing to calculate is how many units were sold. In this case, 700 units must have been sold. Now we just have to figure out the cost for each unit of sold inventory.

Using FIFO, we assume that the first units purchased were the first units sold. Therefore, all 700 sold units must have been from the older ($4 per unit) inventory. 700 units x $4 per unit = $2,800

Answer to Question 3: CoGS =$3,400

Again, we know that 700 units were sold. Under LIFO, we assume that the most recently purchased units are sold first. Therefore, all 600 of the $5 units must have been sold. The remaining 100 sold units must have been from the older ($4/unit) inventory.

(600 units x $5 per unit) + (100 units x $4 per unit) = $3,400

Answer to Question 4: CoGS =$3,062.50

Using the Average Cost Method, we have to calculate the average cost per unit of inventory. We know that there were a total of 1,600 units available for sale and that–in total–they cost $7,000. That gives us an average cost per unit of $4.38 (or $4.375 to be precise).

To calculate CoGS, we multiply this average cost per unit by the number of units sold. 700 units x $4.375 per unit = $3,062.50

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less
Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "
July 7, 2009

Periodic vs. Perpetual Method of Inventory

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

Under GAAP, there are two primary methods of keeping track of inventory: the perpetual method and the periodic method.

Perpetual Method of Inventory

Any business that keeps real-time information on inventory levels and that tracks inventory on an item-by-item basis is using the perpetual method. For example, retail locations that use barcodes and point-of-sale scanners are utilizing the perpetual inventory method.

There are two main advantages to using the perpetual inventory system. First, it allows a business to see exactly how much inventory they have on hand at any given moment, thereby making it easier to know when to order more. Second, it improves the accuracy of the company’s financial statements because it allows very accurate recordkeeping as to the Cost of Goods Sold over a given period. (CoGS will be calculated, quite simply, as the sum of the costs of all of the particular items sold over the period.)

The primary disadvantage to using the perpetual method is, of course, the cost of implementation.

Periodic Method of Inventory

The periodic method of inventory is a system in which inventory is counted at regular intervals (at month-end, for instance). Using this method, a business will know how much inventory it has at the beginning and end of every period, but it won’t know precisely how much inventory is on hand in the middle of an accounting period.

A second drawback of the periodic method is that the business won’t be able to track inventory on an item-by-item basis, thereby requiring assumptions to be made as to which particular items of inventory were sold.

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less
Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "
July 7, 2009

Is your fund manager gambling with your money?

According to Morningstar, the average annual turnover within domestic stock funds is 104%. In other words, on average, domestic equity funds hold a stock for just 351 days before selling it.

Of course, such high turnover has a negative impact on returns in that it substantially increases costs. But even leaving that issue aside for a moment, doesn’t this level of turnover strike anyone else as a bit frightening?

I’m not a stock picker, and I never have been. Nor do I want to pay anyone to pick stocks for me. That said, if I was forced to choose between:

  1. A fund manager engaging in the Warren Buffett/Ben Graham “my-favorite-holding-period-is-forever”-type of investing, or
  2. A fund manager who holds stocks for less than one year before selling…

…I’d have very little hesitation about going with option #1.

I’m not here to say that it’s impossible to be a successful short-term trader. I am, however, concerned that many fund investors think they’re using a long-term buy & hold strategy, when in reality, all they’re doing is paying somebody to engage in short-term stock picking with their money.

July 6, 2009
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