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Ukrainian economy and Ukraine in the world economy

Following a decade of economic decline, Ukraine gradually turned to a
steady growth path. Macroeconomic stabilization and favorable external
conditions contributed to rapid economic recovery. After an impressive
economic performance, Ukraine’s economic growth slowed as external
conditions deteriorated. Nevertheless, the Ukrainian economy
demonstrated one of (he highest growth rates during the last years.
Strengthening domestic consumption, a gradually improving external
environment and continuing investment expansion contributed to 5% GDP
growth. The major sectors that drove, economic growth were industry,
wholesale and retail trade and agriculture.

Relatively rapid expansion of capital investments and continuous growth
of foreign direct investment inflow provided evidence of positive
development of the real sector. Although the overall level of FDI
(foreign direct investment) attracted into Ukraine’s economy was one of
the lowest in the region, its sustained growth since the financial
crisis of 1998 pro veil that the Ukrainian economy became more
attractive for foreign investment. On the other hand, an increase in
foreign direct investment inflow was more than offset -by massive
portfolio outflows, driven mostly ivy political instability and some
legislative deficiencies.

The current account surplus increased significantly, driven by strong
exports and a high level of transfers, and international reserves
continued to accumulate. Constant interventions by the National Bank of
Ukraine contributed to the stability of the national currency against
the US dollar, and to a rapid growth, of monetary aggregates that
accommodated high money demand during the following years. The growing
working capital needs of the real sector were partly satisfied by a
marked increase in commercial bank lending. At the same time, the cost
of loans and their maturity structure were not conducive to wide use of
loanable funds to finance long-term investment projects of enterprises.

Good harvest was the main reason for a substantial decline in inflation.
Consumer price followed a deflationary path that, in combination with a
sizeable shortfall in privatization revenues, led to fiscal expenditure
cuts and an increase in government borrowing in order to avoid
substantial fiscal deficit. Ukraine placed a new Eurobonds issue and
resorted to additional borrowing from domestic creditors to satisfy its
financing needs. As a result, the consolidated budget posted small
surplus and the stock of Ukraine’s public, debt increased. Nevertheless,
the country’s debt to GDP ratio remained relatively modest at 34% of
GDP.

Although the following years brought about positive economic and
political developments, as the external environment remained favorable,
the gradually unfolding presidential election campaign contributed to a
generally cautious investor attitude towards Ukraine. Among the
achievements of Ukraine were the following: 1) an impressive 7.5% GDP
growth; 2) real household incomes continued to grow, indicating an
improvement in living standards; 3) adoption of the new tax laws
reflected the government strong intentions to proceed with structural
reforms; 4) sound, external debt management led to successful Eurobonds
placement, which followed an increase in the country’s international
investment ratings; 5) the favorable external environment drove foreign
trade surpluses, which allowed for the National Bank’s international
reserves to reach record high levels; 6) improvement of the country’s
international image following cancellation of sanctions and warming
relations with the US government.

Even though Ukraine’s macroeconomic performance was improved
significantly over the last several years, a number of economic risks
are still in place. Despite the fact that, inflation accelerated to
almost 0%, monetary policy remained loose.

Renewal of suspended adjustment lending from the international financial
institutions remains uncertain as the government has yet to demonstrate
its ability to cope with outstanding problems, such as reduction of VAT
refund arrears and abolishment of tax privileges.

2. What is marketing and the marketing concept?

Marketing is an activity that surrounds our daily lives. Everywhere you
look on your way to school or work you will see the impact of marketing.
You will undoubtedly pass billboards advertising goods or services, you
will pass retail establishments, or you may see trucks or trains
transporting merchandise. Each of these is an important part of the
marketing system.

Marketing is a complex process, and marketing experts often disagree on
what marketing is and what it consists of. To avoid this controversy, we
will use the official American Marketing Association definition of
marketing.

Marketing is the process of planning and executing the conception,
pricing, promotion and distribution of ideas, goods and services to
create exchange that satisfy individual and organizational objectives.

Note several things about this definition. First, marketing is viewed as
a process of planning and executing, which suggests that marketing is a
managerial process. Second, this managerial process involves conception
(i.e., thinking of or deciding what idea, goods or service to market)
and the pricing, promotion, and distribution of ideas, goods, and
services. Third, the managerial process is directed at creating
exchanges that satisfy individual and organizational objectives.

A key point about this definition of marketing is that it views
marketing as an exchange process. For exchange to occur, five conditions
are necessary:

1. There must be two parties.

2. Each party must have something that could be of value to the other.

3. Each party must be capable of communication and delivery.

4. Each party must be free to accept or reject the offer.

5. Each party believed it is appropriate or desirable to deal with the
other party.

When these five conditions are met, a potential exchange relationship
has been established.

Marketing is part of our society. Its influence on society is more
than economic. Marketing has a cultural influence on society. As a
cultural phenomenon it can help shape our wants and desires. Marketing
is also important to an organization because it helps that organization
create successful exchange relationships with potential buyers. For this
to take place, the right products must be first to be produced and then
correctly distributed, promoted, priced. Note that these tasks relate to
our definition of marketing.

Marketing is important to each of us because it allows us to
specialize. To better appreciate this, imagine a society in which each
person must hunt, cook, and make his or her own clothing, shelter, and
tools. Predictably, not everyone in this society would be equally
proficient at all these activities. In fact, if the test hunter
concentrated on hunting, the best toolmaker on making tools, and soon,
then the society could create a higher level of wealth. However, this
system would only work if everyone could exchange their surpluses for
the goods and services they needed. By establishing a marketing system,
people are given the freedom to specialize.

The Marketing Concept

Now that we have introduced you to what marketing is end why you should
study it, let’s examine how organizations should practice marketing.
During the 1950s, a philosophy for the practice of marketing emerged
known as the marketing concept. The marketing concept viewed the
consumer as the focal point of all marketing activities. Organizations
that practice the marketing concept study the consumer to determine
consumer’s needs and wants then organize and integrate all activities
within the firm toward helping the consumer fulfill these needs and
wants while simultaneously achieving organizational goals. There are
three pillars to the marketing concept: (1) consumer orientation, (2)
integrated or total company effort, and (3) achievement of organization
goals.

Consumer orientation

The consumer orientation dimension of the marketing concept argues that
a firm can be more successful if it determines what the consumer needs
and wants before it decides what product to produce and/or sell. In the
past many firms would produce what they were good at producing. This
practice allowed them to turn out numerous products, many of which were
of extremely high quality however, these products often were difficult
to sell because they did not meet a consumer needs.

Integrated Effort

A second pillar of the marketing concept is the principle of integrated
effort, in which departments within their organization work together
toward the common goal to satisfy the customer. Integrated effort is
a systems point of view, in which all departments recognize
they are interdependent parts of an organization. Because they are
interdependent, they must cooperate to enable the firm to
achieve its objectives. Cooperation is often difficult because
one departments goals may conflict with those of another
deportment and with the organizations overall objectives.

Organization goals

The final pillar of the marketing concept states that the organization
should engage in exchanges based on their potential for helping the
organization achieve its goals. Organizations do not

participate without expecting something in return, and what they receive
should help them achieve their objectives.

3. Marketing management and strategic planning

Strategic marketing management is the analysis, strategy,
implementation, and control of marketing activities to achieve the
organization’s objectives. The two main components of strategic
marketing management process are planning and execution – key terms in
our definition of marketing. Planning is deciding today what to do in
the future and consists of analysis and strategy. Execution is
essentially making things happen and consists of implementation and
control.

The first step in the strategic marketing management process is
analysis. It consists of identifying the firms Strengths and Weaknesses
as well as Opportunities and Threats. Note that the first letters in
each of these words compose the acronym. SWOT. A SWOT analysis consists
of studying a firm’s performance trends, resources, and capabilities to
assess a firm’s strengths and weaknesses, explicitly stating a firm’s
mission and objectives, and scanning the external environments to
identify opportunities and threats facing the organization.

A firm’s strengths and weaknesses can be identified, and analyzed by
studying performance trends, resources, and capabilities. Past
performance typically is measured in financial terms, each as sales and
profits. Profits act as prophets, in a sense. For example, yearly
increases in profits are a sign of strength, while a steady decline in
profits indicates that the firm has a problem. Current resources and
capabilities also help to determine a firm’s strengths and weaknesses.
Resources and capabilities refer to various things: special talents
(i.e., the company has one of the most creative advertising departments
in the country), areas of expertise (i.e., the company is a beer
producer and is the industry leader in developing new brewery
technologies), unique assets (i.e. the company holds 12 patents on new
products or tins $ 50 million in available cash), or any other advantage
that can be drawn on for support (i.e., a pharmaceutical company may
have excellent working relationships with retail druggists).

Opportunities and threats can be identified by stating the
organization’s mission and objectives and engaging in the process of
environmental scanning.

A mission is a firm’s overall justification for existing. The marketer
can more easily identify opportunities and threats when the firm’s
mission has been clearly stated, because the mission provides a lens
through which the external environments can be viewed. Defining what
constitutes a threat – and an opportunity – depends on the nature of the
firm’s mission.

More specific direction is obtained by the statement of a firm’s
objectives, since objectives are specific, quantifiable results that a
firm wants to achieve in a given period. Most firms, even nonprofit
enterprises, develop financial objectives, which are objectives stated
in monetary or economic terms.

The marketer wants to identify market opportunities that exist because
there is an unmet or unsatisfied need or want in the marketplace and for
which the firm has an interest in and capability to satisfy. At the same
time the marketer should try to convert threats into opportunities. For
example, toy industry marketing managers should view the decline in
birth rates as an opportunity to broaden their market base to appeal to
adults by developing more sophisticated toys and games.

Once the SWOT analysis has been completed, the marketer can develop a
marketing strategy to pursue a market opportunity. The two primary
elements of a marketing strategy are selection of a target market and
development of a marketing mix to offer to the target market. A
marketing mix consists of product, distribution, promotion, and price
decisions.

4. Marketing mix

MARKETING – MIX – concrete combination (“displacement”) instruments of
HYPERLINK
“http://www.bashedu.ru/konkurs/luchenko/eng/base/marketing.htm”
marketing for achievement of the purposes, delivered by HYPERLINK
“http://www.bashedu.ru/konkurs/luchenko/eng/base/firma.htm” firm , (for
example, magnifying of the profit or growth of sales volumes). Select
four instruments of marketing: product, price, place, and promotion –
four “p”.

The marketing mix is generally accepted as the use and specification of
the 4 Ps describing the strategic position of a product in the
marketplace. One version of the origins of the marketing mix starts in
1948 when Culliton said that a marketing decision should be a result of
something similar to a recipe. This version continues in 1953 when Neil
Borden, in his American Marketing Association presidential address, took
the recipe idea one step further and coined the term ‘Marketing-Mix’. A
prominent person to take centre stage was E. Jerome McCarthy in 1960; he
proposed a four-P classification which was popularised. Philip Kotler
describes the concept well in his Marketing Management book (see
references below)

Definition

Although some marketers have added other Ps, such as personnel and
packaging, the fundamental dogma of marketing typically identifies the
four Ps of the marketing mix as referring to:

Product – An object or a service that is mass produced or manufactured
on a large scale with a specific volume of units. A typical example of a
mass produced service is the hotel industry. A less obvious but
ubiquitous mass produced service is a computer operating system. Typical
examples of a mass produced objects are the motor car and the disposable
razor.

Price – The price is the amount a customer pays for a product. It is
determined by a number of factors including market share, competition,
product identity and the customer’s perceived value of the product.

Place – Place represents the location where a product can be purchased.
It is often referred to as the distribution channel. It can include any
physical store as well as virtual stores on the Internet.

Promotion – Promotion represents all of the communications that a
marketer may use in the marketplace. Promotion has four distinct
elements – advertising, public relations, word of mouth and point of
sale. A certain amount of crossover occurs when promotion uses the four
principle elements together, which is common in film promotion.
Advertising covers any communication that is paid for, from television
and cinema commercials, radio and Internet adverts through print media
and billboards. Public relations are where the communication is not
directly paid for and includes press releases, sponsorship deals,
exhibitions, conferences, seminars or trade fairs and events. Word of
mouth is any apparently informal communication about the product by
ordinary individuals, satisfied customers or people specifically engaged
to create word of mouth momentum. Sales staff often play an important
role in word of mouth and Public Relations (see Product above).

Broadly defined, optimizing the marketing mix is the primary
responsibility of marketing. By offering the product with the right
combination of the four Ps marketers can improve their results and
marketing effectiveness. Making small changes in the marketing mix is
typically considered to be a tactical change. Making large changes in
any of the four Ps can be considered strategic. For example, a large
change in the price, say from $129.00 to $39.00 would be considered a
strategic change in the position of the product. However a change of
$129.00 to $131.00 would be considered a tactical change, potentially
related to a promotional offer.

Criticisms

Peter Doyle (Doyle, P. 2000) claims that the marketing mix approach
leads to unprofitable decisions because it is not grounded in financial
objectives such as increasing shareholder value. According to Doyle it
has never been clear what criteria to use in determining an optimum
marketing mix. Objectives such as providing solutions for customers at
low cost have not generated adequate profit margins. Doyle claims that
developing marketing based objectives while ignoring profitability has
resulted in the dot-com crash and the Japanese economic collapse. He
also claims that pursuing a ROI approach while ignoring marketing
objectives is just as problematic. He argues that a HYPERLINK
“http://en.wikipedia.org/wiki/Net_present_value” \o “Net present value”
net present value approach maximizing shareholder value provides a
“rational framework” for managing the marketing mix

Against the four Ps, some claim that they are too strongly oriented
towards consumer markets and do not offer an appropriate model for
industrial product marketing. Others claim it has too strong of a
product market perspective and is not appropriate for the marketing of
services.

5. Banking in the United States

United States Banking began in HYPERLINK
“http://en.wikipedia.org/wiki/1781” \o “1781” 1781 with an act of
HYPERLINK “http://en.wikipedia.org/wiki/United_States_Congress” \o
“United States Congress” United States Congress that established the
HYPERLINK “http://en.wikipedia.org/wiki/Bank_of_North_America” \o “Bank
of North America” Bank of North America in HYPERLINK
“http://en.wikipedia.org/wiki/Philadelphia” \o “Philadelphia”
Philadelphia . During the HYPERLINK
“http://en.wikipedia.org/wiki/American_Revolutionary_War” \o “American
Revolutionary War” American Revolutionary War , the Bank of North
America was given a monopoly on HYPERLINK
“http://en.wikipedia.org/wiki/Currency” \o “Currency” currency ; prior
to this time, HYPERLINK “http://en.wikipedia.org/wiki/Private_banks”
\o “Private banks” private banks printed their own HYPERLINK
“http://en.wikipedia.org/wiki/Bank_note” \o “Bank note” bank notes ,
backed by deposits of HYPERLINK “http://en.wikipedia.org/wiki/Gold” \o
“Gold” gold and/or HYPERLINK “http://en.wikipedia.org/wiki/Silver”
\o “Silver” silver .

HYPERLINK “http://en.wikipedia.org/wiki/Robert_Morris_%28merchant%29”
\o “Robert Morris (merchant)” Robert Morris , the first Superintendent
of Finance appointed under the HYPERLINK
“http://en.wikipedia.org/wiki/Articles_of_Confederation” \o “Articles of
Confederation” Articles of Confederation , proposed the Bank of North
America as a HYPERLINK “http://en.wikipedia.org/wiki/Commercial_bank”
\o “Commercial bank” commercial bank that would act as fiscal agent
for the HYPERLINK
“http://en.wikipedia.org/wiki/United_States_government” \o “United
States government” government . The monopoly was seen as necessary
because previous attempts to finance the Revolutionary War with paper
currency had failed; after the war, a number of banks were chartered by
the states under the Articles of Confederation, including the
HYPERLINK “http://en.wikipedia.org/wiki/Bank_of_New_York” \o “Bank of
New York” Bank of New York and the HYPERLINK
“http://en.wikipedia.org/wiki/Bank_of_Massachusetts” \o “Bank of
Massachusetts” Bank of Massachusetts , both of which were chartered in
HYPERLINK “http://en.wikipedia.org/wiki/1784” \o “1784” 1784 .

The Bank of North America was succeeded by the HYPERLINK
“http://en.wikipedia.org/wiki/First_Bank_of_the_United_States” \o “First
Bank of the United States” First Bank of the United States , which the
HYPERLINK “http://en.wikipedia.org/wiki/United_States” \o “United
States” United States Congress chartered in HYPERLINK
“http://en.wikipedia.org/wiki/1791” \o “1791” 1791 under HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Article_One&action=edit” \o
“Article One” Article One , Section 8 of the HYPERLINK
“http://en.wikipedia.org/wiki/United_States_Constitution” \o “United
States Constitution” United States Constitution , after the
Constitution replaced the Articles of Confederation as the foundation of
American government. However, Congress failed to renew the charter for
the Bank of the United States, which expired in HYPERLINK
“http://en.wikipedia.org/wiki/1811” \o “1811” 1811 . Similarly, the
HYPERLINK
“http://en.wikipedia.org/wiki/Second_Bank_of_the_United_States” \o
“Second Bank of the United States” Second Bank of the United States
was chartered in HYPERLINK “http://en.wikipedia.org/wiki/1816” \o
“1816” 1816 and shuttered in HYPERLINK
“http://en.wikipedia.org/wiki/1836” \o “1836” 1836 .

The era of free banking

Prior to HYPERLINK “http://en.wikipedia.org/wiki/1836” \o “1836” 1836
, a HYPERLINK “http://en.wikipedia.org/wiki/Bank” \o “Bank” bank
could only be chartered by a HYPERLINK
“http://en.wikipedia.org/wiki/Legislation” \o “Legislation” legislative
act . It has been speculated that this led to many abuses, with
proprietors lacking connections in their legislatures being effectively
barred from establishing banks. The dissoluting of the HYPERLINK
“http://en.wikipedia.org/wiki/Second_Bank_of_the_United_States” \o
“Second Bank of the United States” Second Bank of the United States in
1836 lead 18 states to establish clear rules for incorporation — any
individual or group that met a certain financial requirement was
permitted to issue bills of credit.

This led to many a period of fiscally irresponsible of HYPERLINK
“http://en.wikipedia.org/wiki/Wildcat_banking” \o “Wildcat banking”
Wildcat banking in many states, which partially destabilized the system
of financial intermediation, and lead in part to the massive panic in
1837-1838 in Michigan.

During this period, bills were not redeemable at face value, but could
be cashed according to certain common discount rates, which reflected
the reputation and solvency of the issuing banks. These bills were
commonly called “scrip.”

The dual banking system

In HYPERLINK “http://en.wikipedia.org/wiki/1863” \o “1863” 1863 ,
Congress passed the HYPERLINK
“http://en.wikipedia.org/wiki/National_Bank_Act” \o “National Bank Act”
National Bank Act in an attempt to retire the greenbacks that it had
issued to finance the North’s effort in the HYPERLINK
“http://en.wikipedia.org/wiki/American_Civil_War” \o “American Civil
War” American Civil War . This opened up an option for chartering banks
nationally. As an additional incentive for banks to submit to Federal
supervision, in 1865 Congress began taxing any issue of state bank notes
(also called “bills of credit” or “scrip”) a standard rate of 10%, which
encouraged many state banks to become national ones. This tax also gave
rise to another response by state banks — the invention of the demand
deposit account, also known as a checking account. By the 1880s, deposit
accounts had changed the primary source of revenue for many banks. The
result of these events is what is known as the “dual banking system.”

The dual system of banking has survived to this day. New banks may
choose either state or national charters (a bank also can convert its
charter from one to the other). Until 1989, banks with national charters
(national banks) were required to participate in the HYPERLINK
“http://en.wikipedia.org/wiki/FDIC” \o “FDIC” FDIC , while State Banks
either were required to obtain FDIC insurance by state law or they could
voluntarily join it (usually in an attempt to bolster their appearance
of solvency). After enactment of the Federal Deposit Insurance
Corporation Improvement Act of 1989 (“FDICIA”), all commercial banks
that accepted deposits were required to obtain FDIC insurance and to
have a primary federal regulator (the Fed for state banks that are
members of the Federal Reserve System, and the FDIC for “nonmembers”).

The Federal Reserve System

The Federal Reserve Act of 1913 established the present day HYPERLINK
“http://en.wikipedia.org/wiki/Federal_Reserve_System” \o “Federal
Reserve System” Federal Reserve System and brought all banks in the
United States under the authority of the federal government, creating
the twelve regional HYPERLINK
“http://en.wikipedia.org/wiki/Federal_Reserve_Bank” \o “Federal Reserve
Bank” Federal Reserve Banks which are supervised by the HYPERLINK
“http://en.wikipedia.org/wiki/Federal_Reserve_Board” \o “Federal Reserve
Board” Federal Reserve Board . Notwithstanding the HYPERLINK
“http://en.wikipedia.org/wiki/Glass-Steagall_Act” \o “Glass-Steagall
Act” Glass-Steagall Act of HYPERLINK
“http://en.wikipedia.org/wiki/1932” \o “1932” 1932 and the HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Banking_Act&action=edit” \o
“Banking Act” Banking Acts of HYPERLINK
“http://en.wikipedia.org/wiki/1933” \o “1933” 1933 and HYPERLINK
“http://en.wikipedia.org/wiki/1935” \o “1935” 1935 , which were
attempts to reform various banking abuses, the Federal Reserve System
has remained more or less unchanged through to the present day. The
Glass-Steagall Act was repealed in HYPERLINK
“http://en.wikipedia.org/wiki/1999” \o “1999” 1999 , whereas the
Banking Act of 1933 simply strengthened the supervisory powers of
federal authorities and created the HYPERLINK
“http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation” \o
“Federal Deposit Insurance Corporation” Federal Deposit Insurance
Corporation .

Deregulation

Legislation passed by the federal government during the HYPERLINK
“http://en.wikipedia.org/wiki/1980s” \o “1980s” 1980s , such as the
HYPERLINK
“http://en.wikipedia.org/wiki/Depository_Institutions_Deregulation_and_M
onetary_Control_Act” \o “Depository Institutions Deregulation and
Monetary Control Act” Depository Institutions Deregulation and Monetary
Control Act of HYPERLINK “http://en.wikipedia.org/wiki/1980” \o
“1980” 1980 and the HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Garn-St._Germaine_Depository_
Institutions_Act&action=edit” \o “Garn-St. Germaine Depository
Institutions Act” Garn-St. Germaine Depository Institutions Act of
HYPERLINK “http://en.wikipedia.org/wiki/1982” \o “1982” 1982 ,
diminished the distinctions between banks and other financial
institutions in the United States. This legislation is frequently
referred to as “deregulation,” and it is often blamed for the failure of
over 500 HYPERLINK
“http://en.wikipedia.org/wiki/Savings_and_loan_association” \o “Savings
and loan association” savings and loan associations between 1980 and
HYPERLINK “http://en.wikipedia.org/wiki/1988” \o “1988” 1988 , and the
subsequent failure of the HYPERLINK
“http://en.wikipedia.org/wiki/Federal_Savings_and_Loan_Insurance_Corpora
tion” \o “Federal Savings and Loan Insurance Corporation” Federal
Savings and Loan Insurance Corporation (FSLIC) whose obligations were
assumed by the FDIC in HYPERLINK “http://en.wikipedia.org/wiki/1989”
\o “1989” 1989 . However, some critics of this viewpoint, particularly
HYPERLINK “http://en.wikipedia.org/wiki/Libertarian” \o “Libertarian”
libertarians , have pointed out that the federal government’s attempts
at deregulation granted easy credit to federally insured financial
institutions, encouraging them to overextend themselves and (thus) fail.

6. Banking and financial system of Great Britain

A financial system is composed of institutions and markets which fulfil
a variety of economic functions. Central to all is arranging or
facilitating the lending of funds from one economic agent to another.
The lending of funds from one economic agent to another — from lender to
borrower — can be accomplished in many different ways; but all can be
classified into just two distinct approaches.

Firstly, the lender can lend direct to the borrower, albeit perhaps with
the assistance of brokers who act in an agency capacity. This may be
called direct finance.

The second approach, which may be called indirect finance, involves a
financial intermediary standing between borrower and lender. This form
of finance seems at first sight to be more roundabout, and to involve
the use of more real resources of capital and labour than direct
finance. But financial intermediaries are numerous and indirect finance
more common than direct finance. What, then, are its advantages? They
are many, and they derive from the ability of financial institutions to
use their size and expertise to transform financial claims, so that they
can offer savers a wider choice of assets than ultimate borrowers are
able to do. At the same time, they can offer borrowers a more varied
choice of credit terms than ultimate lenders are able to do. The law of
averages, in normal circumstances, ensures that the total sum of money
deposited does not vary greatly. In consequence, banks can allow
depositors the freedom to withdraw funds at little or no notice, whilst
at the same time making loans to borrowers which last for many years.
The banks are said to engage in maturity transformation, that is,” they
borrow short and lend long.

Banks, like other economic institutions, have been created out of
definite needs. The wide use of money and credit increased the
importance of financial institutions, which do not serve only as
depositories of funds, but also as sources of credit. Without the
services of the banks it is unlikely that our modern industrial order
could function efficiently.

The main functions of a bank are:

1 The provision of a safe deposit for money and valuables. This is the
oldest banking function, but by no means the most important.

2 The lending of money. This is the most profitable banking activity
and the major source of the bank’s income.

3 The issuing of bank-notes. This, as we have noted, was one of the
earliest functions of a bank. In England and Wales this right is now
restricted to the Bank of England.

4 The provision, by means of bank deposits subject to movement by
cheque, of a very efficient means of settling debts.

In addition to these basic functions, modern banks provide a wide range
of financial services.

Most countries now have a central bank which stands at the apex of, and
is responsible for, the operation of the banking system. In the UK the
central bank is the Bank of England which was taken into public
ownership in 1946. It has many responsibilities, the more important of
which are:

It is the government’s bank. It handles the income and expenditure of
the Exchequer and other government departments.

It manages the National Debt.

It is the bankers’ bank. The clearing banks maintain accounts at the
Bank of England and the balances they hold in these current accounts are
counted as part of their cash reserves.

It is the central note-issuing authority for the UK and the sole
note-issuing authority for England and Wales.

It is the lender of last resort.

It acts as the government’s agent in the foreign exchange market.

It has the responsibility for carrying out the government’s monetary
policy.

The vast majority of ordinary banking business is handled by the
clearing banks. The business is dominated by the London clearing banks,
Barclays, Lloyds, Midland, National Westminster (the ‘Big Four’), Coults
and Co., and Williams and Glyn’s together with three Scottish clearing
banks, The Bank of Scotland, Clydesdale Bank, and the Royal Bank of
Scotland. Between them these banks have some 12000 branches. The Bank of
England, the Cooperative Bank and the Central Trustee Savings Bank are
also members of the Clearing House. There is a large number of
non-clearing banks in the money market. The strength of the large bank
with numerous branches derives from its ability to obtain economies of
scale.

Today the British banking is a complicated tripartite system like a
three-layer cake. The system is headed by the Bank of England.

The other two layers are:

— the commercial or joint stock clearing banks

— specialized banking institutions such as the discount houses and
merchant banks.

The commercial or joint-stock banks deal with the general public.
Commercial banks are designed to make a profit for their stockholders.
Commercial banks render various services to companies and individuals.
Some of the services are:

— to receive or accept from their customers the deposit of money

— to collect and transfer money both at home and abroad against deposit
and current accounts

— to provide overdrafts to both personal and business customers

— to lend loans to their customers

— to exchange money

— to supply economic information and to prepare economic reviews to be
published

— to make foreign exchange transactions, including spot transactions,
forward transactions and swap transactions

— to issue various banker’s cards.

The banks attract deposits from the public in three main forms: current
accounts, deposit accounts, large-term deposits

The Bankers’ Clearing House. The procedure for making payments by cheque
creates problems when the person making the payment keeps his account in
a different bank from that which holds the account of the person
receiving the payment. It is an obvious solution for each bank lo pay
(or receive) the net amount owing after the banks have totalled their
claims against each other. Cheques drawn on one bank but payable to
another arc sent to the clearing house where the mutual claims are
offset and the banks merely settle the outstanding amounts. These
payments from one bank to another are carried out by means of cheques
drawn on the bankers’ deposits at the Bank of England. The merchant
banks. The main activities of the merchant banks are: acceptance
businesses, financial advice to companies, share issues, investment
managers, wholesale banking.

The discount houses. The London discount market is an important part of
the financial structure of the City of London and is basically concerned
with dealings in short and very short-term loans. The business is in the
hands of the members of the London Discount Market Association (12 disc.
Houses). As the name implies, the main function of a discount house is
to ‘discount’ a variety of lOU’s or ‘promises to pay’ which are issued
by the government, local authorities, banks, and industrial and
commercial companies.

Foreign banks. The number of foreign banks in London has expanded
rapidly in recent years and there are now more than 200 of them. United
States and Japanese banks are the most numerous. One reason why banks
establish foreign networks is to meet the requirements’ of their
customers’ international operations and this is particularly important
in these days of large multinational companies.

Finance houses operate in a similar manner to banks by taking deposits
from the public and employing them in loans, but they tend to specialise
in providing hire purchase and other types of instalment credit.

Savings banks and the National Giro There are two major savings banks,
the National Savings Bank which is operated by the Post Office on behalf
of the Department for National Savings and the Trustee Savings Dank.
Both banks provide deposit facilities for small savers and these are
collected at 21000 post offices (in the case of the NSB) and at I 500
branches of the Trustees Saving Bank. The Trustees Savings Bank now
provides a current account service (i.e. payments may be made by
cheque); the National Savings Bank does not provide such a service, but
the National Giro provides money transmission services. People holding
giro accounts are provided with three basic services: transfer to other
account holders, deposits, payments.

The primary purpose of building societies has been to provide finance
for residential housing, and as such they provide a large proportion of
the finance for house purchase within the UK. As a consequence of the
need to raise funds to do tills, they are also major participants in the
market for savings, particularly retail savings. In more recent years,
however, they have started to provide a range of other services, to make
loans for purposes oilier than house purchase, and to reduce their
dependence on the retail savings market by raising an increasing
proportion of their funds from wholesale sources.

Unit trusts are long-term investment products sold by managers to
investors, often with charges of up to 5 % of the purchase price.
Investors in unit trusts are usually private. In many cases, these
investments were in unit trusts which the companies managed. Managers of
unit trusts are specialist companies, such as M & G or Save and Prosper,
or banks and insurance companies: they play an active role in selling
the units to investors, investing the proceeds and finding the cash to
repay investors wishing to withdraw (sell their units back to the
managers). In addition, there is always a second financial institution
involved in a unit trust — acting as trustee and holding the investments
(assets) on behalf of the unit-holders (as investors are called). The
advantages of unit trusts are principally that risks are pooled and that
specialist managers should enhance investors’ returns.

Investment trusts have a similar name to unit trusts, and they also pool
investments managed by specialists. However, the similarities end there.
Investment trusts are subject to lower charges and they are ‘closed
ended’ funds. This means that, if people want to buy more of them, and
because their quantity is limited then their share prices can rise above
the value of the assets they own.

In brief, investment trusts are limited companies which invest in other
limited companies. Investment trusts can borrow long term so as to
invest in more assets, rather than asking the shareholders for more
money.

Credit unions are, in general, very small scale savings and lending
societies. Members are usually linked by neighbourhood, religion or
employment, with members saving regular amounts each week: interest is
paid gross of tax. The other main activity is lending, with a statuary
maximum interest rate of 1 % per month.

Insurance companies. The assets of all insurance companies are grater
than those of pension funds, but for the purposes of the Insurance
Companies a distinction is made between the short-term and long-term
insurance business of insurance companies. Broadly, short-term business
is renewable annually, e.g. house or motor insurance.

To some extent, classification of financial institutions is becoming
progressively more difficult.

What is the difference between the retail and wholesale activities of
financial institutions? The major distinction between retail and
wholesale activities undertaken by financial institutions is in the size
of transactions involved. Retail activities are concerned with deposits
and loans that are of relatively low value, and wholesale activities are
concerned with high-value deposits and loans. While no hard distinction
between retail and wholesale is possible, a transaction of less than
F1000,000 would usually be regarded as a retail transaction.

The distinction between retail and wholesale activities also retails to
the type of customer involved. Predominantly, retail activities of banks
will involve taking in deposits from and making loans to personal
customers and small businesses.

A third aspect of the distinction between the retail and wholesale
activities of financial institutions relates to the distribution system
for the services provided. Included in this group there are (a) London
clearing banks (National Westminster Bank, Lloyds Bank, Barclays Bank,
Midland Bank, Courts & Co.), (b) Scottish clearing banks (Bank of
Scotland, Clydesdale Bank. Royal Bank of Scotland), (c) Northern Ireland
Banks (Allied Irish Banks, Bank of Ireland, Northern Bank, Ulster Bank),
(d) Trustee Savings Banks (TSB Bank, TSB Northern Ireland TSB Bank
Scotland), (e) Girobank, (f) other retail banks (Co- operative Bank,
Abbey National, Abbey National Treasury Services Yorkshire Bank), and
(g) the Bank of England Banking Department. All of the above are
involved in retail deposit-taking business and have access to their
local clearing system.

Wholesale activities, being concerned with high-value transactions,
typically involve customers that are larger businesses or else other
financial institutions. The wholesale banks represent a diverse group of
institutions within the UK financial system. They comprise three broad
groups:

— British merchant banks;

— Other British banks;

— Overseas banks, which in turn are divided into American, Japanese and
«other overseas banks».

Although the distinction between retail and wholesale activities is a
useful one, the distinction is in relation to activities rather than
institutions. Many financial institutions will be engaged in both
wholesale and retail activities.

6.1. THE BANKING SYSTEM OF UKRAINE

STRUCTURE OF THE BANKING SYSTEM OF UKRAINE

The evolution of the national banking system in Ukraine started in
March, 1991, after the adoption of the Law of Ukraine «On Banks and
Banking» by the Ukrainian Verhovna Rada. The Ukrainian banking system is
a two-tier structure consisting of the National Bank of Ukraine and
commercial banks of various types and forms of ownership including the
state-owned Export-Import Bank and a specialized commercial Savings
Bank.

The National Bank of Ukraine serves as the country’s central bank which
pursues a uniform state monetary policy to ensure the national currency
stability.

Commercial banks are formed as joint-stock companies or as companies on
an equal footing with both legal and natural persons involved. The range
of commercial banks activities includes: receiving deposits of
enterprises, institutions and households, crediting of economic entities
and households, investments in securities, formation of cash balance and
reserves, as well as other assets, cash and settlement servicing of the
economy, foreign exchange operations and other services to natural
persons and legal bodies.

The banks act in accordance with the Constitution of Ukraine, the Law of
Ukraine «On the National Bank of Ukraine», «On Banks and Banking)), the
Ukrainian legislation on joint-stock companies and other economic
entities, as well as with the normative regulations of the National Bank
of Ukraine and their Statutes. The major banks are Prominveslbank, the
«Privat» Bank, the Export-Import Bank, «Avah>, the Savings Bank of
Ukraine and Ukrsotsbank.

Five of the commercial banks are the former specialized state banks:
one is a savings bank (Oschadnybank), two are specialized lending banks
(Prominvestbank and Ukrsotsbank), and one is the Export-Import Bank of
Ukraine (Ukreximbank). Oschadnybank and Ukrcximbank are still stale
owned. Prominvestbank and Ukrsotsbank receive concessionary treatment
from the NBU and arc responsible for the vast majority of corporate
lending.

There are also ‘new banks’. Most of these are based in the major
industrial centers. They were generally formed by groups of companies to
manage their treasury and payment systems. There are currently six main
banking companies in Ukraine with foreign ownership: Credit Lyonnais,
Citibank, Bank Austria Creditanstalt, ING, Raiffeisenbank and First
Ukrainian International Bank.

Notwithstanding the banking sector’s difficulties, the procedures for
settlements, particularly relating to domestic transfers, have proven
efficient. Foreign investors no longer encounter delays in converting
currency and remitting profits in foreign currency as a result of the
banking system.

Numerous Ukrainian commercial banks have joined the Society for
Worldwide Interbank Financial Telecommunications (SWIFT). SWIFT provides
financial data communication and processing services supporting the
business activities of banks around the world.

BANKING SYSTEM

Banking system of Ukraine consists of two levels -— the National Bank of
Ukraine at the higher level and commercial banks at the lower level. The
National Bank of Ukraine activity is aimed at forming the system of
finance and credit of the state and controlling the credit system lower
level section activity. Lower level section activity is aimed an
available resources mobilization and their employment in crediting and
investing subjects of management as well as getting profits and capital
accumulation in order to refund economy. At the background of finance
and money stabilization the money reform was successfully carried out in
1996 — the own money unit — Ukrainian hrivna — was put into circulation.
Stability of national money laid the foundation of positive changes in
economy, having provided the proper financial conditions, stable
criteria, which must interest investors. Long-term credits of banking
system are growing.

RISE AND DEVELOPMENT OF THE BANKING SYSTEM OF UKRAINE

The rise and development of Ukraine, similar to that of the other
countries arising on the ruins of the USSR, is a unique phenomenon in
the modem history. From a single «public zone» the national monetary and
banking systems have separated. The elements and structure that earlier
have not existed were given birth and are progressing: these arc central
banks and commercial banks, the national currencies, the systems of
payments, currency exchanges, systems of the bodies engaged in
regulation and bank supervision.

Playing a special role in the economic system as a whole and on the
monetary-credit market, banks actively effect all the constituents of
economic reform.

It is the banking system that is to create the infrastructure, methods
and tools of the new market-oriented regulation of the economy to
replace the command-administrative methods and instruments.

The banking system in a market-oriented economy plays a triune role.
First, the structure of commercial banks administers the system of
payments.

Second, together with other financial intermediaries, banks direct the
savings of the public to firms and commercial enterprises.

Third, acting in accordance with monetary-credit policy of the central
bank, the banking system regulates the quantity of money in circulation.

Stable and temperate growth of money supply balanced along with the
growth of commodity supply is a guarantee of the provision of a steady
level of prices. As soon as this is achieved, market relations influence
the economic system in the most effectual and gainful manner.

The rise and development of Ukraine’s banking system has proceeded in
extremely adverse conditions.

BANKS AND THE ASSOCIATION OF UKRAINIAN BANKS

As of 1 January 1998, 227 banks were registered in the National Book
for Registration of Banks, Currency Exchanges and Other Financial-credit
Establishments, including two state-owned (Oshchad-bank of Ukraine and
Ukreximbank) and 17 banks with the involvement of foreign capital.
Within 1992—1998, 42 commercial banks were excluded from this book.

Currently, commercial banks of Ukraine fulfill the cash servicing of
legal persons, exchange business, servicing of traveler’s cheques,
transactions with T-bills, service the accounts of physical persons, and
service of plastic cards.

Ukrainian banks take part in different international programs to support
private entrepreneurship in Ukraine, such as EBRD credit lines,
German-Ukrainian fund, etc.

As the share market develops, and more specifically the T-bill market,
new services come into being, including the brokerage servicing of
clients, and management of T-bill portfolios. There is a new task ahead
— to work with municipal securities.

Credit activity of banks becomes more active. In addition to short-term
credits, the volume of long-term credits is increasing. There is a
tendency toward the decline of all kinds of interest rates on credits
granted to direct loan debtors. A positive trend is observed concerning
the improvement of the credit portfolios of banks.

In 1990, the first 9 commercial banks united for the advocacy of their
interests into the Association of Ukrainian Banks, which now unites 124
banks and four regional bank unions.

During the period of its activity, the AUB became established as an
efficient and influential organization that contributed to the progress
and stabilization of the banking system.

The AUB considers participation in the legislative process one of most
essential directions of its activity. The Association was an active
contributor of the elaboration of the Law of Ukraine «On Banks and
Banking Activity» Tax legislation was and still is in the focus of the
AUB’s attention. The AUB. together with the NBU, achieved parity between
banks and other business entities in taxation.

It is necessary to mention that the sound activity of commercial banks,
to a considerable extent, depends on the quality of preparation of the
NBU’s decisions, and substantiation of these decisions. At AUB’s request
the National Bank issued directions, pursuant to which the regulatory
acts of the NBU must be submitted to the National Bank Board after their
treatment with the participation of banks and the Association of
Ukrainian Banks.

Now the Association takes direct part in the important work dealing with
the transition of the banking system of Ukraine to the system of
international accounting standards and reporting.

One direction of the AUB’s activity is establishing and maintaining
business-like relations with the President of Ukraine, the leadership of
the permanent Committees of the Verkhovna Rada of Ukraine, Prime
Minister, and other officials from government authorities.

The Association coordinates its work with other unions and professional
participants of the market.

For Ukraine to have a well prepared banking system capable of attacking
new challenges dealing with restructuring of the economy, the economic
policy should:

accelerate the growth of the economic potential of banks, by allowing
accumulation of their own capital and release of their balances from the
bad debts of state-owned enterprises

— defend banks from the interference of the state agencies that does not
meet the requirements of existing banking laws, create the reliable
system of insurance of banking deposits, and contribute to the formation
of high confidence in banks by legal and physical persons;

-—create an effective legislative and regulatory basis for the activity
of banks which would ensure a positive protection against risks and
achievement of a high degree of stability in operations.

Without banks that are economically powerful, that can operate in a
stable manner, are aware of their mission in the market-oriented
economy, and that have credibility in society — without such banks
market-oriented reform in Ukraine will not be able to provide those
beneficial impacts which are awaited by the public.

THE NATIONAL BANK OF UKRAINE

The National Bank, as the central bank, carries out the state’s monetary
policy using appropriate instruments. The National Bank of Ukraine keeps
the State Register of Banks, Foreign Currency Exchanges, and Other
Financial Institutions,

The National Bank maintains relations with other countries’ central
banks, international banks, and other financial institutions on behalf
of Ukraine.

Functions of the National Bank of Ukraine

The National Bank of Ukraine serves as:

the central bank which conducts a uniform state policy in the

area of monetary circulation and credit and ensures the stability of the

national currency;

issuing centre;

foreign exchange authority;

supervisory body;

bank of the banks;

bank of the State;

organizer of interbank settlements.

Issuing centre

The National Bank of Ukraine has the exclusive right to put currency
into circulation, and to introduce national banknotes and coins.

Cash supply to the economy (Hryvnia) is carried out through a network of
the National Bank’s regional departments commercial banks. The National
Bank supervises as requested by the State Treasury of Ukraine and builds
up gold and foreign exchange reserves for its own account.

Foreign exchange authority

The National Bank of Ukraine determines the foreign exchange policy.

In the sphere of foreign exchange regulation and control, the National
Bank:

—carries out foreign exchange policy based on the general principles of
Ukraine’s economic policy:

monitors observance of the limits of the external public debt;

accumulates, stores and uses foreign currency reserves to carry

out the national foreign exchange policy;

grants foreign exchange licenses;

determines the methods of ascertaining foreign exchange rates,

translated into the Ukrainian currency

monitors compliance with the rules of foreign exchange trans

actions in Ukraine.

Banking supervision

To protect the clients interests and to secure commercial banks’
financial reliability, the National Bank imposes the following
requirements on commercial banks:

required minimum statutory fund;

equity ratio;

—-balance sheet liquidity ratios;

minimum reserve requirements;

maximum risk for one borrower.

7. Stock exchange

A stock exchange, share market or bourse is a HYPERLINK
“http://en.wikipedia.org/wiki/Corporation” \o “Corporation” corporation
or HYPERLINK “http://en.wikipedia.org/wiki/Mutual_organization” \o
“Mutual organization” mutual organization which provides facilities
for HYPERLINK “http://en.wikipedia.org/wiki/Stock_brokers” \o “Stock
brokers” stock brokers and HYPERLINK
“http://en.wikipedia.org/wiki/Trader_%28finance%29” \o “Trader
(finance)” traders , to trade company HYPERLINK
“http://en.wikipedia.org/wiki/Stock” \o “Stock” stocks and other
HYPERLINK “http://en.wikipedia.org/wiki/Security_%28finance%29” \o
“Security (finance)” securities . Stock exchanges also provide
facilities for the issue and redemption of securities, as well as, other
financial instruments and HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Capital_event&action=edit” \o
“Capital event” capital events including the payment of income and
HYPERLINK “http://en.wikipedia.org/wiki/Dividend” \o “Dividend”
dividends . The securities traded on a stock exchange include:
HYPERLINK “http://en.wikipedia.org/wiki/Shares” \o “Shares” shares
issued by companies, HYPERLINK
“http://en.wikipedia.org/wiki/Unit_trust” \o “Unit trust” unit trusts
and other pooled investment products and HYPERLINK
“http://en.wikipedia.org/wiki/Bond_%28finance%29” \o “Bond (finance)”
bonds . To be able to trade a security on a certain stock exchange, it
has to be listed there. Usually there is a central location at least for
recordkeeping, but trade is less and less linked to such a physical
place, as modern markets are HYPERLINK
“http://en.wikipedia.org/wiki/Electronic_networks” \o “Electronic
networks” electronic networks , which gives them advantages of speed
and cost of transactions. Trade on an exchange is by members only. The
initial offering of stocks and bonds to HYPERLINK
“http://en.wikipedia.org/wiki/Investor” \o “Investor” investors is by
definition done in the HYPERLINK
“http://en.wikipedia.org/wiki/Primary_market” \o “Primary market”
primary market and subsequent trading is done in the HYPERLINK
“http://en.wikipedia.org/wiki/Secondary_market” \o “Secondary market”
secondary market . A stock exchange is often the most important
component of a HYPERLINK “http://en.wikipedia.org/wiki/Stock_market”
\o “Stock market” stock market . Supply and demand in stock markets is
driven by various factors which, as in all HYPERLINK
“http://en.wikipedia.org/wiki/Free_market” \o “Free market” free
markets , affect the price of stocks (see HYPERLINK
“http://en.wikipedia.org/wiki/Stock_valuation” \o “Stock valuation”
stock valuation ).

There is usually no compulsion to issue stock via the stock exchange
itself, nor must stock be subsequently traded on the exchange. Such
trading is said to be off exchange or HYPERLINK
“http://en.wikipedia.org/wiki/Over-the-counter_%28finance%29” \o
“Over-the-counter (finance)” over-the-counter . This is the usual way
that HYPERLINK “http://en.wikipedia.org/wiki/Bond_%28finance%29” \o
“Bond (finance)” bonds are traded. Increasingly, stock exchanges are
part of a global market for securities.

History of stock exchanges

In 12th century France the courratiers de change were concerned with
managing and regulating the debts of agricultural communities on behalf
of the banks. As these men also traded in debts, they could be called
the first brokers.

Some stories suggest that the origins of the term “bourse” come from the
Latin bursa meaning a bag because, in 13th century HYPERLINK
“http://en.wikipedia.org/wiki/Bruges” \o “Bruges” Bruges , the sign of
a purse (or perhaps three purses), hung on the front of the house where
merchants met.

However, it is more likely that in the late 13th century commodity
traders in Bruges gathered inside the house of a man called Van der
Burse, and in 1309 they institutionalized this until now informal
meeting and became the “Bruges Bourse”. The idea spread quickly around
Flanders and neighbouring counties and “Bourses” soon opened in Ghent
and Amsterdam.

In the middle of the 13th century, HYPERLINK
“http://en.wikipedia.org/wiki/Venice” \o “Venice” Venetian bankers
began to trade in government securities. In HYPERLINK
“http://en.wikipedia.org/wiki/1351” \o “1351” 1351 , the Venetian
Government outlawed spreading rumors intended to lower the price of
government funds. There were people in HYPERLINK
“http://en.wikipedia.org/wiki/Pisa” \o “Pisa” Pisa , HYPERLINK
“http://en.wikipedia.org/wiki/Verona” \o “Verona” Verona , HYPERLINK
“http://en.wikipedia.org/wiki/Genoa” \o “Genoa” Genoa and HYPERLINK
“http://en.wikipedia.org/wiki/Florence” \o “Florence” Florence who
also began trading in government securities during the 14th century.
This was only possible because these were independent city states ruled
by a council of influential citizens, not by a duke.

The Dutch later started HYPERLINK
“http://en.wikipedia.org/wiki/Joint_stock_company” \o “Joint stock
company” joint stock companies , which let HYPERLINK
“http://en.wikipedia.org/wiki/Shareholder” \o “Shareholder”
shareholders invest in business ventures and get a share of their
profits – or losses. In 1602, the HYPERLINK
“http://en.wikipedia.org/wiki/Dutch_East_India_Company” \o “Dutch East
India Company” Dutch East India Company issued the first shares on the
HYPERLINK “http://en.wikipedia.org/wiki/Amsterdam_Stock_Exchange” \o
“Amsterdam Stock Exchange” Amsterdam Stock Exchange . It was the first
company to issue HYPERLINK “http://en.wikipedia.org/wiki/Stock” \o
“Stock” stocks and HYPERLINK
“http://en.wikipedia.org/wiki/Bond_%28finance%29” \o “Bond (finance)”
bonds . In 1688, the trading of stocks began on a stock exchange in
HYPERLINK “http://en.wikipedia.org/wiki/London” \o “London” London .

The role of stock exchanges

Stock exchanges have multiple roles in the HYPERLINK
“http://en.wikipedia.org/wiki/Economy” \o “Economy” economy , this may
include the following:

Raising capital for businesses

The Stock Exchange provides HYPERLINK
“http://en.wikipedia.org/wiki/Company_%28law%29” \o “Company (law)”
companies with the facility to raise HYPERLINK
“http://en.wikipedia.org/wiki/Capital_%28economics%29” \o “Capital
(economics)” capital for expansion through selling HYPERLINK
“http://en.wikipedia.org/wiki/Shares” \o “Shares” shares to the
HYPERLINK “http://en.wikipedia.org/wiki/Investing” \o “Investing”
investing public.

Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to a more
rational allocation of resources because funds, which could have been
consumed, or kept in idle HYPERLINK
“http://en.wikipedia.org/wiki/Deposit_account” \o “Deposit account”
deposits with HYPERLINK “http://en.wikipedia.org/wiki/Bank” \o “Bank”
banks , are mobilized and redirected to promote HYPERLINK
“http://en.wikipedia.org/wiki/Business” \o “Business” business
activity with benefits for several economic sectors such as HYPERLINK
“http://en.wikipedia.org/wiki/Agriculture” \o “Agriculture” agriculture
, HYPERLINK “http://en.wikipedia.org/wiki/Commerce” \o “Commerce”
commerce and HYPERLINK “http://en.wikipedia.org/wiki/Industry” \o
“Industry” industry , resulting in a stronger HYPERLINK
“http://en.wikipedia.org/wiki/Economic_growth” \o “Economic growth”
economic growth and higher HYPERLINK
“http://en.wikipedia.org/wiki/Productivity_%28economics%29” \o
“Productivity (economics)” productivity levels.

Facilitating company growth

Companies view acquisitions as an opportunity to expand HYPERLINK
“http://en.wikipedia.org/wiki/Product_line” \o “Product line” product
lines , increase distribution channels, hedge against volatility,
increase its HYPERLINK “http://en.wikipedia.org/wiki/Market_share” \o
“Market share” market share , or acquire other necessary business
HYPERLINK “http://en.wikipedia.org/wiki/Asset” \o “Asset” assets . A
HYPERLINK “http://en.wikipedia.org/wiki/Takeover” \o “Takeover”
takeover bid or a HYPERLINK
“http://en.wikipedia.org/wiki/Mergers_and_acquisitions” \o “Mergers and
acquisitions” merger agreement through the HYPERLINK
“http://en.wikipedia.org/wiki/Stock_market” \o “Stock market” stock
market is one of the simplest and most common ways for a company to
grow by acquisition or fusion.

Redistribution of wealth

Stocks exchanges do not exist to redistribute wealth although casual and
professional HYPERLINK “http://en.wikipedia.org/wiki/Stock_investor”
\o “Stock investor” stock investors through HYPERLINK
“http://en.wikipedia.org/wiki/Stock_price” \o “Stock price” stock price
increases and HYPERLINK “http://en.wikipedia.org/wiki/Dividend” \o
“Dividend” dividends get a chance to share in the wealth of profitable
businesses.

Corporate governance

By having a wide and varied scope of owners, companies generally tend to
improve on their HYPERLINK “http://en.wikipedia.org/wiki/Management”
\o “Management” management standards and HYPERLINK
“http://en.wikipedia.org/wiki/Efficiency_%28economics%29” \o “Efficiency
(economics)” efficiency in order to satisfy the demands of these
shareholders and the more stringent rules for public corporations
imposed by public stock exchanges and the government. Consequently, it
is alleged that HYPERLINK
“http://en.wikipedia.org/wiki/Public_companies” \o “Public companies”
public companies (companies that are owned by shareholders who are
members of the general public and trade shares on public exchanges) tend
to have better management records than HYPERLINK
“http://en.wikipedia.org/wiki/Privately-held_company” \o “Privately-held
company” privately-held companies (those companies where shares are
not publicly traded, often owned by the company founders and/or their
families and heirs, or otherwise by a small group of investors).
However, some well-documented cases are known where it is alleged that
there has been considerable slippage in HYPERLINK
“http://en.wikipedia.org/wiki/Corporate_governance” \o “Corporate
governance” corporate governance on the part of some public companies
( HYPERLINK “http://en.wikipedia.org/wiki/E.g.” \o “E.g.” e.g.
HYPERLINK “http://en.wikipedia.org/wiki/Enron_Corporation” \o “Enron
Corporation” Enron Corporation , HYPERLINK
“http://en.wikipedia.org/wiki/MCI_WorldCom” \o “MCI WorldCom” MCI
WorldCom , HYPERLINK “http://en.wikipedia.org/wiki/Pets.com” \o
“Pets.com” Pets.com , HYPERLINK “http://en.wikipedia.org/wiki/Webvan”
\o “Webvan” Webvan , or HYPERLINK
“http://en.wikipedia.org/wiki/Parmalat” \o “Parmalat” Parmalat ).

Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay,
investing in shares is open to both the large and small HYPERLINK
“http://en.wikipedia.org/wiki/Stock_investor” \o “Stock investor” stock
investors because a person buys the number of shares they can afford.
Therefore the Stock Exchange provides the opportunity for small
investors to own shares of the same companies as large investors, and to
enjoy similar rates of return(s).

Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to
finance infrastructure projects such as sewage and water treatment works
or housing estates by selling another category of HYPERLINK
“http://en.wikipedia.org/wiki/Securities” \o “Securities” securities
known as HYPERLINK “http://en.wikipedia.org/wiki/Bond_%28finance%29”
\o “Bond (finance)” bonds . These bonds can be raised through the Stock
Exchange whereby members of the public buy them, thus loaning money to
the government. The issuance of such municipal bonds can obviate the
need to directly tax the citizens in order to finance development,
although by securing such bonds with the full faith and credit of the
government instead of with collateral, the result is that the government
must tax the citizens or otherwise raise additional funds to make any
regular coupon payments and refund the principal when the bonds mature.

Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on
HYPERLINK “http://en.wikipedia.org/wiki/Market_%28economics%29” \o
“Market (economics)” market forces. Share prices tend to rise or
remain stable when companies and the HYPERLINK
“http://en.wikipedia.org/wiki/Economy” \o “Economy” economy in general
show signs of stability and growth. An HYPERLINK
“http://en.wikipedia.org/wiki/Economic_recession” \o “Economic
recession” economic recession , depression, or HYPERLINK
“http://en.wikipedia.org/wiki/Financial_crisis” \o “Financial crisis”
financial crisis could eventually lead to a HYPERLINK
“http://en.wikipedia.org/wiki/Stock_market_crash” \o “Stock market
crash” stock market crash . Therefore the movement of share prices and
in general of the HYPERLINK “http://en.wikipedia.org/wiki/Stock_index”
\o “Stock index” stock indexes can be an indicator of the general
trend in the economy..

Major stock exchanges

The major stock exchanges in the world include:

HYPERLINK “http://en.wikipedia.org/wiki/American_Stock_Exchange” \o
“American Stock Exchange” American Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Australian_Stock_Exchange” \o
“Australian Stock Exchange” Australian Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Bermuda_Stock_Exchange” \o
“Bermuda Stock Exchange” Bermuda Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Bolsa_Mexicana_de_Valores” \o
“Bolsa Mexicana de Valores” Bolsa Mexicana de Valores

HYPERLINK “http://en.wikipedia.org/wiki/Bombay_Stock_Exchange” \o
“Bombay Stock Exchange” Bombay Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Euronext” \o “Euronext”
Euronext

HYPERLINK “http://en.wikipedia.org/wiki/Frankfurt_Stock_Exchange” \o
“Frankfurt Stock Exchange” Frankfurt Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Helsinki_Stock_Exchange” \o
“Helsinki Stock Exchange” Helsinki Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Hong_Kong_Stock_Exchange” \o
“Hong Kong Stock Exchange” Hong Kong Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Istanbul_Stock_Exchange” \o
“Istanbul Stock Exchange” Istanbul Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/JASDAQ” \o “JASDAQ” JASDAQ

HYPERLINK
“http://en.wikipedia.org/wiki/Johannesburg_Securities_Exchange” \o
“Johannesburg Securities Exchange” Johannesburg Securities Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Karachi_Stock_Exchange” \o
“Karachi Stock Exchange” Karachi Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Korea_Stock_Exchange” \o
“Korea Stock Exchange” Korea Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Kuwait_Stock_Exchange” \o
“Kuwait Stock Exchange” Kuwait Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/London_Stock_Exchange” \o
“London Stock Exchange” London Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Madrid_Stock_Exchange” \o
“Madrid Stock Exchange” Madrid Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Milan_Stock_Exchange” \o
“Milan Stock Exchange” Milan Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Nagoya_Stock_Exchange” \o
“Nagoya Stock Exchange” Nagoya Stock Exchange

HYPERLINK
“http://en.wikipedia.org/wiki/National_Stock_Exchange_of_India” \o
“National Stock Exchange of India” National Stock Exchange of India

HYPERLINK “http://en.wikipedia.org/wiki/NASDAQ” \o “NASDAQ” NASDAQ

HYPERLINK “http://en.wikipedia.org/wiki/New_York_Stock_Exchange” \o
“New York Stock Exchange” New York Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Osaka_Securities_Exchange” \o
“Osaka Securities Exchange” Osaka Securities Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Bovespa” \o “Bovespa” Sao
Paulo Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Shanghai_Stock_Exchange” \o
“Shanghai Stock Exchange” Shanghai Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Singapore_Exchange” \o
“Singapore Exchange” Singapore Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Stockholm_Stock_Exchange” \o
“Stockholm Stock Exchange” Stockholm Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Taiwan_Stock_Exchange” \o
“Taiwan Stock Exchange” Taiwan Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Tel_Aviv_Stock_Exchange” \o
“Tel Aviv Stock Exchange” Tel Aviv Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Tokyo_Stock_Exchange” \o
“Tokyo Stock Exchange” Tokyo Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Toronto_Stock_Exchange” \o
“Toronto Stock Exchange” Toronto Stock Exchange

HYPERLINK “http://en.wikipedia.org/wiki/Zurich_Stock_Exchange” \o
“Zurich Stock Exchange” Zurich Stock Exchange

Listing requirements

Listing requirements are the set of conditions imposed by a given stock
exchange upon companies that want to be listed on that exchange. Such
conditions sometimes include minimum number of shares outstanding,
minimum market capitalization, and minimum annual income.

Requirements by stock exchange

Companies have to meet the requirements of the exchange in order to have
their stocks and shares listed and traded there, but requirements vary
by stock exchange:

London Stock Exchange: The main market of the HYPERLINK
“http://en.wikipedia.org/wiki/London_Stock_Exchange” \o “London Stock
Exchange” London Stock Exchange has requirements for a minimum market
capitalization (F700,000), three years of audited financial statements,
minimum public float (25 per cent) and sufficient working capital for at
least 12 months from the date of listing.

NASDAQ Stock Exchange: To be listed on the HYPERLINK
“http://en.wikipedia.org/wiki/NASDAQ” \o “NASDAQ” NASDAQ a company
must have issued at least 1.25 million shares of stock worth at least
$70 million and must have earned more than $11 million over the last
three years ( HYPERLINK
“http://www.nasdaq.com/about/listing_information.stm” \o
“http://www.nasdaq.com/about/listing_information.stm” [1] ).

New York Stock Exchange: To be listed on the HYPERLINK
“http://en.wikipedia.org/wiki/New_York_Stock_Exchange” \o “New York
Stock Exchange” New York Stock Exchange (NYSE), for example, a company
must have issued at least a million shares of stock worth $100 million
and must have earned more than $10 million over the last three years (
HYPERLINK
“http://www.nyse.com/Frameset.html?displayPage=/listed/1022540125610.htm
l” \o
“http://www.nyse.com/Frameset.html?displayPage=/listed/1022540125610.htm
l” [2] ).

Bombay Stock Exchange: HYPERLINK
“http://en.wikipedia.org/wiki/Bombay_Stock_Exchange” \o “Bombay Stock
Exchange” Bombay Stock Exchange (BSE) has requirements for a minimum
market capitalization of Rs.250 Million and minimum public float
equivalent to Rs.100 Million( HYPERLINK
“http://www.bseindia.com/about/abintrobse/listsec.asp” \o
“http://www.bseindia.com/about/abintrobse/listsec.asp” [3] ).

Ownership

Stock exchanges originated as HYPERLINK
“http://en.wikipedia.org/wiki/Mutual_organization” \o “Mutual
organization” mutual organizations , owned by its member stock brokers.
There has been a recent trend for stock exchanges to demutualize, where
the members sell their shares in an HYPERLINK
“http://en.wikipedia.org/wiki/Initial_public_offering” \o “Initial
public offering” initial public offering . In this way the mutual
organization becomes a corporation, with shares that are listed on a
stock exchange. Examples are HYPERLINK
“http://en.wikipedia.org/wiki/Australian_Stock_Exchange” \o “Australian
Stock Exchange” Australian Stock Exchange (1998), HYPERLINK
“http://en.wikipedia.org/wiki/Euronext” \o “Euronext” Euronext (2000,
as of HYPERLINK “http://en.wikipedia.org/wiki/June_14” \o “June 14”
14 June HYPERLINK “http://en.wikipedia.org/wiki/2006” \o “2006” 2006
in talks to a proposed merger process with the New York Stock
Exchange), HYPERLINK “http://en.wikipedia.org/wiki/NASDAQ” \o “NASDAQ”
NASDAQ (2002) and the HYPERLINK
“http://en.wikipedia.org/wiki/New_York_Stock_Exchange” \o “New York
Stock Exchange” New York Stock Exchange (2005).

Other types of exchanges

In the 19th century, exchanges were opened to trade HYPERLINK
“http://en.wikipedia.org/wiki/Forward_contract” \o “Forward contract”
forward contracts on HYPERLINK
“http://en.wikipedia.org/wiki/Commodities” \o “Commodities” commodities
. Exchange traded forward contracts are called HYPERLINK
“http://en.wikipedia.org/wiki/Futures_contract” \o “Futures contract”
futures contracts . These commodity exchanges later started offering
future contracts on other products, such as interest rates and shares,
as well as HYPERLINK
“http://en.wikipedia.org/wiki/Option_%28finance%29” \o “Option
(finance)” options contracts. They are now generally known as
HYPERLINK “http://en.wikipedia.org/wiki/Futures_exchange” \o “Futures
exchange” futures exchanges .

The future of stock exchanges in the United States

This section does not cite any HYPERLINK
“http://en.wikipedia.org/wiki/Wikipedia:Citing_sources” \o
“Wikipedia:Citing sources” references or sources .

Please help HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Stock_exchange&action=edit”
\o
“http://en.wikipedia.org/w/index.php?title=Stock_exchange&action=edit”
improve this article by adding citations to HYPERLINK
“http://en.wikipedia.org/wiki/Wikipedia:Verifiability” \o
“Wikipedia:Verifiability” reliable sources . ( HYPERLINK
“http://en.wikipedia.org/wiki/Help:Contents” \o “Help:Contents” help ,
HYPERLINK
“http://en.wikipedia.org/wiki/Wikipedia:WikiProject_Fact_and_Reference_C
heck” \o “Wikipedia:WikiProject Fact and Reference Check” get involved!
)

Any material not supported by sources may be challenged and removed at
any time. This article has been tagged since March 2007.

The future of stock trading appears to be electronic, as competition is
continually growing between the remaining traditional HYPERLINK
“http://en.wikipedia.org/wiki/New_York_Stock_Exchange” \o “New York
Stock Exchange” New York Stock Exchange HYPERLINK
“http://en.wikipedia.org/wiki/Specialist” \o “Specialist” specialist
system against the relatively new, all HYPERLINK
“http://en.wikipedia.org/wiki/Electronic_Communications_Network” \o
“Electronic Communications Network” Electronic Communications Networks
, or ECNs. ECNs point to their speedy execution of large block trades,
while specialist system proponents cite the role of specialists in
maintaining orderly markets, especially under extraordinary conditions
or for special types of orders.

The ECNs contend that an array of special interests profits at the
expense of investors in even the most mundane exchange-directed trades.
Machine-based systems, they argue, are much more efficient, because they
speed up the execution mechanism and eliminate the need to deal an
intermediary.

Historically, the ‘ HYPERLINK
“http://en.wikipedia.org/wiki/Stock_market” \o “Stock market” market ‘
(which, as noted, encompasses the totality of stock trading on all
exchanges) has been slow to respond to technological innovation.
Conversion to all-electronic trading could erode/eliminate the trading
profits of floor specialists and the NYSE’s “upstairs traders.”

William Lupien, founder of the HYPERLINK
“http://en.wikipedia.org/w/index.php?title=Instinet&action=edit” \o
“Instinet” Instinet trading system and the HYPERLINK
“http://en.wikipedia.org/w/index.php?title=OptiMark&action=edit” \o
“OptiMark” OptiMark system, has been quoted as saying “I’d definitely
say the ECNs are winning… Things happen awfully fast once you reach
the tipping point. We’re now at the tipping point.”

Congress mandated the establishment of a national market system of
multiple exchanges in 1975. Since then, ECNs have been developing
rapidly.

One example of improved efficiency of ECNs is the prevention of
HYPERLINK “http://en.wikipedia.org/wiki/Front_running” \o “Front
running” front running , by which manual Wall Street traders use
knowledge of a customer’s incoming order to place their own orders so as
to benefit from the perceived change to market direction that the
introduction of a large order will cause. By executing large trades at
lightning speed without manual intervention, ECNs make impossible this
illegal practice, for which several NYSE floor brokers were investigated
and severely fined in recent years. Under the specialist system, when
the market sees a large trade in a name, other buyers are immediately
able to look to see how big the trader is in the name, and make
inferences about why s/he is selling or buying. All traders who are
quick enough are able to use that information to anticipate price
movements.

ECNs have changed ordinary stock transaction processing (like brokerage
services before them) into a commodity-type business. ECNs could
regulate the fairness of initial public offerings (IPOs), oversee
Hambrecht’s OpenIPO process, or measure the effectiveness of securities
research and use transaction fees to subsidize small- and mid-cap
research efforts.

Some, however, believe the answer will be some combination of the best
of technology and “upstairs trading”— in other words, a hybrid model.

Trading 25,000 shares of Lucent stock (recent quote: $2.80; recent
volume: 49,069,700) would be a relatively simple e-commerce transaction;
trading 100 shares of Berkshire Hathaway Class A stock (recent quote:
$88,710.00; recent volume: 450) may never be. The choice of system
should be clear (but always that of the trader), based on the
characteristics of the security to be traded.

Even with ECNs forming an important part of a national market system,
opportunities presumably remain to profit from the spread between the
bid and offer price. That is especially true for investment managers
that direct huge trading volume, and own a stake in an ECN or specialist
firm. For example, in its individual stock-brokerage accounts, “Fidelity
Investments runs 29% of its undesignated orders in NYSE-listed stocks,
and 37% of its undesignated market orders through the Boston Stock
Exchange, where an affiliate controls a specialist post.”

Fidelity says these arrangements are governed by a separate brokerage
“order-flow management” team, which seeks to obtain the best possible
execution for customers, and that its execution is highly rated.

The “upstairs market”

Recent research by Kumar Venkataraman, finance professor at SMU’s Cox
School of Business, and Hendrik Bessembinder offers insight and evidence
into new possibilities and difficult issues facing stock exchanges. In
HYPERLINK
“http://www.google.com/url?sa=t&ct=res&cd=1&url=http%3A%2F%2Fjfe.rochest
er.edu%2F03109.pdf&ei=jUFhRKjmFM_u4QGLgNmLCQ&sig2=efHHhIBVUlqOMobppXAJaw
” \o
“http://www.google.com/url?sa=t&ct=res&cd=1&url=http%3A%2F%2Fjfe.rochest
er.edu%2F03109.pdf&ei=jUFhRKjmFM_u4QGLgNmLCQ&sig2=efHHhIBVUlqOMobppXAJaw
” “Does an electronic stock exchange need an upstairs market?” from
the July, 2003 issue of Journal of Financial Economics, the authors find
that a large proportion of institutional trading in electronic exchanges
is executed away from the HYPERLINK
“http://www.weforum.org/site/knowledgenavigator.nsf/Content/_S4902?open=
” \o
“http://www.weforum.org/site/knowledgenavigator.nsf/Content/_S4902?open=
” centralized book in the informal ‘upstairs market’, thus presenting
new challenges.

Despite the efficiencies of computerized markets, virtually every stock
market is accompanied by a parallel “upstairs” market, where larger
traders employ the services of brokerage firms to locate counterparties
and negotiate trade terms. Upstairs markets are based on relationships.
Rather than submitting an electronic order to effortlessly attract
counterparties, the upstairs brokers seek out counterparties (from
traders known to them who might be interested). They then negotiate
transactions that might otherwise be executed at an inordinate cost or
delay. An electronic trading system lowers the fixed costs of trading
for relatively liquid stocks in block sizes not likely to overwhelm the
current market. However, it does not allow for the informal exchange of
information (?) that is important for certain types of large trades and
for illiquid stocks.

In electronic markets, HYPERLINK
“http://en.wikipedia.org/wiki/Trader_%28finance%29” \o “Trader
(finance)” traders don’t get a sense of who they’re trading with, how
much more the other party is trading, etc., and that information can be
very important to some traders. Large (institutional) traders therefore
seek other trading venues such as the ‘upstairs market’ to lower the
risk of exposing their order positions, to ensure symmetric transfer of
information, and to retain some of the give and take of the old
HYPERLINK “http://en.wikipedia.org/wiki/Open_outcry” \o “Open outcry”
open outcry market. Approximately 70% of block-size trade transactions
are executed in the upstairs market in Paris.

The Paris Bourse provides an excellent illustration of the use of
upstairs intermediation markets, because its electronic limit order
market closely resembles the downstairs (electronic) markets envisioned
by theorists. The best evidence from the Paris Bourse is that:

Upstairs brokers lower the risk of HYPERLINK
“http://en.wikipedia.org/wiki/Adverse_selection” \o “Adverse selection”
adverse selection by “certifying” block orders as uninformed (i.e., as
not having access to nonpublic information).

Upstairs brokers are able to tap into pools of hidden or unexpressed
liquidity (they frequently ‘go looking’ for buyers or sellers not
currently in the market).

Traders strategically choose across the upstairs and downstairs markets
to minimize expected execution costs (including HYPERLINK
“http://en.wikipedia.org/wiki/Slippage” \o “Slippage” slippage , etc.).

Trades are more likely to be routed upstairs if they are large or are in
stocks with low overall trading activity.

The second result is the most novel and arguably the most important. The
upstairs broker completes transactions by searching for institutional
investors who may be interested in the stock, but who have not as yet
formally expressed their trading intentions. It is documented that
executions costs of transactions completed by the upstairs broker
average only 35% of what they would have paid if completed against limit
orders in the centralized electronic exchange, suggesting that trading
relationship and the informal exchange of information between upstairs
brokers and institutional traders helps lower execution costs. One major
challenge facing electronic markets is the lack of a comparable
mechanism of certification of traders and information exchange.

The HYPERLINK “http://en.wikipedia.org/wiki/Euronext” \o “Euronext”
Euronext market allows large transactions in some stocks to be executed
outside the quotes. Such outside-the-quote transactions are not
permitted in United States markets. For eligible stocks in Paris, market
participants agree to outside-the-quote execution mainly for more
difficult trades and at times when downstairs liquidity is lacking.
These likely represent trades that probably could not have been
otherwise completed, suggesting that market quality can be enhanced by
allowing participants more flexibility to execute blocks at prices
outside the quotes. These findings are particularly relevant to U.S.
markets because quoted spreads and depths have decreased substantially
in the wake of decimalization.

The upstairs market in the HYPERLINK
“http://en.wikipedia.org/wiki/Paris_Bourse” \o “Paris Bourse” Paris
Bourse completes two-thirds of block trading volume, compared with 20%
on the New York Stock Exchange (NYSE). A likely explanation is that the
NYSE floor allows large traders to execute customized strategies through
a floor broker, while avoiding the risks of order exposure. If orders
submitted to electronic markets do not allow block initiators to limit
order exposure and trade strategically, then order flow is likely to
migrate to alternative trading venues such as the upstairs market. If
you’re a liquidity trader, you don’t want the system to be anonymous. If
you’re an informed trader you like anonymity because you can hide in the
order flow.

To compete with broker-intermediated markets, the next generation of
electronic trading systems needs to include features that better meet
the needs of large traders, particularly the lack of anonymity. To allow
large investors to manage order exposure in an electronic exchange, a
wider range of order types that include state contingent exposure and
execution algorithms need to be made available. The NYSE’s recently
introduced “Conversion and Parity” ( HYPERLINK
“http://www.google.com/url?sa=t&ct=res&cd=4&url=http%3A%2F%2Fwww.sec.gov
%2Frules%2Fsro%2Fnyse%2F34-52362.pdf&ei=dUlhRP_LM5bIswHVnbHeCg&sig2=0SoJ
qs6h9sP6Gf9ctFklmg” \o
“http://www.google.com/url?sa=t&ct=res&cd=4&url=http%3A%2F%2Fwww.sec.gov
%2Frules%2Fsro%2Fnyse%2F34-52362.pdf&ei=dUlhRP_LM5bIswHVnbHeCg&sig2=0SoJ
qs6h9sP6Gf9ctFklmg” CAP ) orders which are intended to be “smart”
orders for large lots of stocks that are executed gradually through the
day, contingent on market conditions, are a step in this direction.

The future role of the specialist

The specialist trades in circumstances when others do not or will not,
and therefore takes on a risk which warrants compensation. The current
debate centers on the model of compensation. The specialist at the Paris
Bourse is compensated in cash and with investment banking business. In
contrast, the NYSE specialist is compensated in the form of privileged
information on order flow. In recent months, several U.S. institutions
have alleged that the NYSE trading abuses is an outcome of this
compensation structure. The Paris model overcomes this criticism and
presents an alternative for the NYSE to consider. Results show, however,
that there continues to be a role for the specialist (or, at least, an
‘upstairs trader’) in electronic markets. Investors value the presence
of a specialist because they can get in and out of a stock with greater
ease.

8. WHAT IS ACCOUNTING?

Accounting is often characterized as «the language of business». The
acceleration of change in our complex society has contributed to
ever-increasing complexities in this «language», which is used in
recording and interpreting basic economic data for individuals,
businesses, governments, and other entities. Sound decisions, based on
reliable information, are essential for the efficient distribution and
use of scarce resources. Accounting, therefore, plays a very important
role in our economic and social system.

Because of the wide range of accounting activity, there is no concise
description of accounting. Accounting is concerned with recording,
sorting, and summarizing data related to business transactions and
events. Such data are to a large extent, but not exclusively, of a
financial nature and are frequently, but not always, stated in monetary
terms. Accounting is also concerned with reporting and interpreting the
data. Accounting has been defined broadly as the process of identifying,
measuring, and communicating economic information to permit informed
judgments and decisions by users of the information.

Accounting is a service activity. Its function is to provide
quantitative information about economic entities. The information,
essentially financial in nature, is primarily provided by reports
referred to as financial statements and is intended to be useful in
making economic decisions. These reports are used in describing the
activities and financial status of many different kinds of economic
entities. They include hospitals, schools, cities, governmental
agencies, and profit-oriented businesses.

The objective of financial statements is to communicate information that
is useful to investors, creditors and other users in making resource
allocation decisions and/or assessing management stewardship.
Consequently, financial statements provide information about:

(a) an entity’s economic resources, obligations and equity;

(b) changes in an entity’s economic resources, obligations and equity;
and

(c) the economic performance of the entity.

In making decisions about an economic entity, individuals’
generally must begin by asking questions about the entity. The answers
to many such questions are found in accounting reports. If, for example,
the entity is a business, the managers of the business would look to
accounting for answers to questions such as:

What are the resources of the business?

What debts does it owe?

Does it have earnings?

Are expenses too large in relation to sales?

Is too little or too much merchandise being kept?

Are amounts owed by customers being collected rapidly?

Will the business be able to pay its debts as they mature?

Should the plant be expanded?

Should a new product be introduced?

Should selling prices be increased?

In addition, grantors of credit such as banks, wholesale houses, and
manufacturers use accounting information in answering such questions as:

Are the customer’s earning prospects good? What is its debt-paying
ability? Has it paid its debts promptly in the past? Should it be
granted additional credit?

Likewise, governmental units use accounting information in regulating
businesses and collecting taxes. Labour unions use it in negotiating
working conditions and wage agreements. And last but certainly not least
among the users of accounting information are individual investors, who
make wide use of accounting data in their investment decisions.

Accounting and Bookkeeping

Many people confuse accounting and bookkeeping and look on them as one
and the same. In effect, they identify the whole with one of its parts.
Actually, bookkeeping is only part of accounting, the record-making
part. To keep books is to record transactions, and a bookkeeper is one
who records transactions either on a computer or manually or with a
bookkeeping machine. Accounting includes much more than this. The
accountant should have the ability to design the accounting system; to
analyze and record complex, nonroutine transactions; and to analyze and
interpret accounting information.

Accounting and Computers

Computers are used for many tasks in our modem society, including the
processing of accounting data. A computer can accept and store
accounting data, sort and rearrange it, perform arithmetic calculations
on it, and prepare reports from the data. Furthermore, a computer can
perform these functions very rapidly and with little or no human
intervention. However, before a computer can do this, a set of detailed
instructions must be prepared and entered into the computer to tell it
how to process the data. The person who prepares these instructions must
have a thorough understanding of accounting procedures and accounting
principles. Thus, while computers have had a tremendous impact on
accounting, they are not substitutes for understanding the fundamental
concepts and principles of accounting.

FOUNDATIONS OF ACCOUNTING

Accounting contains elements both of science and art. The important
thing is that it is not merely a collection of arithmetical techniques
but a set of complex processes depending on and prepared for people. The
human aspect, which many people, especially accountants, forget, arises
because:

1. Most accounting reports of any significance depend, to a greater or
lesser extent, on people’s opinions and estimates.

2. Accounting reports are prepared in order to help people make
decisions.
Hit

3. Accounting reports are based on activities which have been carried
out by people.

But what specifically is accounting? It is very difficult to find a
pithy definition that is all-inclusive but we can say that accounting is
concerned with.

The provision of information in financial terms that will help in
decisions concerning resource allocation, and the preparation of reports
in financial terms describing the effects of past resource allocation
decisions.

Examples of resource allocation decisions are:

Should an investor buy or sell shares?

Should a bank manager lend money to a firm?

How much tax should a company pay?

Which collective farm should get the extra tractor?

As you can see, accounting is needed in any society requiring resource
allocation and its usefulness is not confined to ‘capitalist’ or
‘mixed’ economies.

An accountant is concerned with the provision and interpretation
of financial information. He does not, as an accountant, make decisions.
Many accountants do of course get directly involved in decision-making
but when they do they are performing a different function.

Accounting is also concerned with reporting on the effects of past
decisions. But one should consider whether this is done for its own sake
or whether it is done in order to provide information which it is hoped
will prove helpful in current and future decisions. We contend that
knowledge of the past is relevant only if it can be used to help in
making current and future decisions, for we can hope that we shall be
able to influence the future by making appropriate decisions but we
cannot redo the past. Thus the measurement of past results is a
subsidiary role, but because of the historical development of accounting
and, perhaps, because of the limitations of the present state of the
art, ‘backward looking’ accounting sometimes appears to be an end
in itself and not as a means that help in achieving a more fundamental
objective.

WHY STUDY ACCOUNTING?

Considering the wide range of questions that are answered by referring
to accounting information, perhaps every educated person in our society
should be regarded as a user of accounting information. If you are to
use accounting information effectively, you must have some understanding
of how the data are gathered and the figures are put together. You must
appreciate the limitations of the data and the extent to which portions
are based on estimates rather than on precise measurement. And, you
must understand accounting terms and concepts. Needless to say, this
knowledge is gained in a study of accounting.

For the information provided in financial statements to be useful, ii
must be capable of being understood by investors, creditors and other
users. Investors, creditors and other users are assumed to have a
reasonable understanding of business and economic activities and
together with a willingness to study the information with reasonable
diligence.

Another reason to study accounting is to make it one’s lifework. A
career in accounting can be very interesting and highly rewarding.

Accountancy as a profession

Over the past half century, accountancy as a profession has attained a
stature comparability with that of law or medicine. Most provinces
license public accountants just as they license doctors and lawyers. The
licensing helps ensure a high standard of professional service. Only
individuals who have passed a rigorous examination of their accounting
and related knowledge, met other education and

experience requirements, and have received a license may designate
themselves as public accountants.

There are a number of accounting organizations providing education and
professional training. These include the provincial institutes of
Chartered Accountants, the Certified General Accountants’ Association,
and the Society of Management Accountants (SMA). Successful completion
of the prescribed courses of instruction and practical experience lead
to the following appellations:

Chartered Accountant (CA)

Certified General Accountant (CGA)

Certified Management Accountant (CMA)

An activity of the three accounting organizations that has shaped
accounting thought has been the education and the publication program.
Each has an extensive educational program and has maintained the
publication of journals which enjoy wide readership.

In the past decade reliance on post-secondary accounting education has
become a significant part of the educational process and complements the
extensive correspondence and lecture programs of both the Certified
General Accountants’ Association, and the Society of Management
Accountants — The Institute of Chartered Accountants requires a
university degree with specified course content.

Accountancy is the fastest growing of the professions. The growth is in
response to the expansion and complexity of the economy, the increasing
involvement of the accountant in the process of management decision
making, and a growing number of financial reporting activities.

Short 9.BUSINESS TRANSACTIONS

Basic Terminology for Accounting Information

Money resources and economic or service resources are the assets of a
company. Initially creditors and owners are the sources of the assets of
a business. These sources of assets are known as the equities of a
business. They represent claims upon the assets if the business is
dissolved.

Expenses are the assets used up or spent to provide revenue. Revenue is
the payment made by customers for the product or service purchased.
Income is the excess of the assets received (revenue) over the assets
used up to provide the revenue (expense); it is the net increase in
assets. Income increases the owners’ equity in the business because the
owners’ claim to assets is increased.

A distinct feature of traditional accounting information is that it
relies heavily on a transfer or exchange between the business and
outsiders and between areas within the company. Accountants tend to
assume for recording purposes that an activity takes place when an
exchange occurs. These exchanges are known as transactions. In a sense,
traditional accounting information is information on either past or
future transactions.

Transactions

A transaction provides a means for measuring activity. By a transaction
is meant the flow of economic resources, or rights to the resources,
from one accounting entity to another. Since substantially all business
or economic activities culminate in an exchange rather than in
consumption by the entity, a record of an entity’s transactions will
reveal its significant activities, for the idea of an exchange underlies
the concept of a transaction.

There are limitations to the transaction concept, for not all business
activities are immediately reflected in a transaction. Specifically,
changes in the market price of economic resources often occur without
regard to business activities aimed at a future transaction. Similarly,
some business activities are directed toward objectives which cannot be
related to a specific future transaction, such as the production of a
product having an unknown future sales (transaction) price. In an effort
to overcome limitations such as these, the accounting discipline has
stretched the concept of a transaction to include the concept of an
accrued transaction which, as we shall see, includes measurements of
changes in wealth and rights to wealth prior to the time the exchange
transaction occurs.

Types of Transactions

The procedures of accounting largely represent means for measuring and
communicating information on transactions. The development of these
procedures involves problems of measuring and communicating information
on three types of transactions. It is important to distinguish them, for
different measurement and communication methods are appropriate for each
type.

Future Transactions. By measuring and communicating information on
possible future transactions, accounting reveals those activities which
appear to be the most desirable for the entity to carry out in the
future. By measuring and communicating information on planned future
transactions, accounting reveals those actions which will have to be
taken at appropriate times to carry out the plans most effectively.

Current Transactions. By measuring and communicating information on
current transactions, accounting reveals the current state of the
entity’s activities. When these current transactions are compared with
the budgeted or planned transactions, the information disclosed will
enable management to take actions which will bring current activities in
line with planned activities and thus control the activities of the
entity.

Past Transactions. Measurement and communication of past transactions
provide a description of the entity’s activities over a period of time.
Systematic study and analysis of these descriptions afford insights into
the nature of an entity’s operations which enable governments to
establish tax collection methods, owners to control general managerial
direction of the entity, and creditors to evaluate managerial
performance over a period of time and in varying situations.

Classification of Transactions

Transactions may be classified in a number of ways. Possibly the most
useful classification for accounting purposes is the following:

1. External transactions involve activities between an entity and
someone outside the entity. They are of two main types:

a. Exchange transactions, wherein there is an exchange of economic
resources or rights between the company or other entity and someone
outside the entity, such as the sale of merchandise to a customer for
cash.

b. Accrued transactions, wherein there is continuous gradual transfer or
receipt of economic rights or services by the company to or from an
outside party with the understanding that payment for the services will
be made later. An example is the continuous transfer of electricity to a
customer by an electric utility company, for which payment is made at
the end of the month. 2. Internal transactions involve the activities
within the company. These activities also are of two main types:

a. Transfer transactions, wherein there is a transfer of economic
resources or rights from one area of the company to another in exchange
for relief from responsibility for the resources or rights. The transfer
of material from the storeroom to the factory is an example.

b. Accrued transactions, wherein the transfer of economic resources or
rights is a continuous process. An example is the gradual using up of a
machine over a period of time to make a product. The daily wearing out
of the machine would be an accrued transaction.

Transactions and Accounting Data Collection Procedures

The study of accounting procedures is largely the study of means for
collecting data on transactions. A record of data on past, present, and
future transactions provides a means for describing business activities.
Since business activities are directed toward the objectives of
acquiring and using economic resources, traditional accounting
procedures normally measure transactions in terms of the monetary worth
of the resources involved in the transactions. They provide for the
classification of the transactions in such a way as to reveal the nature
of the business activity involved. In communicating measured information
to others, accounting procedures represent means for disclosing
transactions in terms of business efforts and business accomplishments
and the resulting economic resources and rights in the entity. While the
following discussion is primarily a description of historically
conventional methods for collecting data on external exchange
transactions, it is applicable to all types of transactions.

Transactions and Business Activity

The validity of the assumption that business activities of all types
ultimately result in transactions is most important to the double-entry
recording process. If the «lag» between a business activity (e.g.,
making shoes for a customer) and the transaction (delivery of the shoes
to the customer) were substantial, the criticism could be made that the
accounting recording process is inadequate and should abandon the
transaction concept. However, there is no reason to think that the lag
between a business activity and the resulting transaction is so great
that the transaction concept cannot be used. Undoubtedly, as electronic
data processing develops, it will be possible by the accrual process to
eliminate much of the lag when it does exist.

To prevent the development of a «lag» between a business activity and a
transaction, accountants have defined a transaction in a special way:
they have adopted the concept of an accrued transaction and use it to
record business activity prior to the date the actual transaction
occurs. External Exchange Transactions

The idea of an exchange, or a trading between two parties, underlies the
concept of a transaction. While the description is satisfactory for most
general purposes, for accounting purposes a transaction is defined in
several special ways. One way, an external exchange transaction, refers
to the exchange between the company and someone outside of the company.

External Accrued Transactions

The concept of an accrued (external) transaction, refers to those
activities which result in a continuous transfer of services from one
company to another.

Internal Transfer Transactions

To expand on the concept of internal transactions^ note that it does not
refer to an exchange with another company; it refers to the transfer of
resources from one internal area to another internal area. Typically,
internal transfer transactions refer to the transfer of resources from
one department to another, or of responsibility for them from one person
to another.

Internal Accrued Transactions

Internal accrued transactions represent the continuous transfer of
resources from one area to another within the company. They are
recognized periodically, generally at the end of each month, in the
manually maintained accounting record.

Summary

Relying on the observation that business activities ultimately result in
an exchange of some type, the accounting discipline for recording data
on business activity uses the concept of a transaction to indicate when
an activity has occurred.

THE ANALYSIS OF FINANCIAL STATEMENTS

The objective of public accounting reports is to reveal or describe the
economic activities of a company. In this sense, accounting reports
represent raw material to be used in developing an understanding of a
company and its operations. The statements provide much useful
information, but by analysis, and study of them additional relationships
and activities may be revealed. The underlying principles of accounting
analysis are to be found in information theory and communication theory.
But the practice is best revealed by a study of what analysts do, and in
practice ratio analysis and trend studies are widely used analytical
techniques. While analysis of all types of accounting reports is
desirable for disclosure of information on a company’s activities, the
process can best be explained by emphasizing methods of analyzing the
public accounting.

The purposes for which information is needed will indicate the types of
analyses to be made. In broad terms, there are three types of analyses:

1. General-purpose analysis, which aims merely to reveal more completely
the information in accounting statements, and to relate it to other
factors in the company and the economy.

2. Analysis for credit or investment, which aims to disclose
relationships which bear upon the financial effectiveness of the
company.

3. Analysis for management purposes, which aims to disclose successful
and unsuccessful plans and operations.

Preliminary Arrangements

Regardless of the purpose for which an analysis is made, certain
preliminary steps must be taken to arrange the data in suitable form.
They include the following tasks:

1. Selecting and collecting relevant standards for evaluating an
analysis.

2. Rounding off amounts, e.g., to the nearest hundreds or thousands of
dollars.

3. Reclassifying accounts especially if comparative statements over a
period of time are used, so that a uniform classification will be used
in all analyses.

4. In some instances, segregating and grouping accounts according to
different classification systems.

5. Selecting computing, and interpreting various statistical measures,
economic indicators, ratios, comparisons, and relationships which reveal
significant information.

Standards for Comparison. There is limited significance to any analysis
which does not provide a basis for determining whether the information
developed by the analysis is favorable or unfavorable. If comparative
data are not available or cannot be developed, other analyses should be
made for which comparative data will be available.

For every analysis, there should be some type of standard against which
the resulting information may be compared. These standards maybe:

1. Informal — sometimes only a «feeling» on the part of the reader of
the analyzed data.

2. Past results against which current results may be compared.

3. Results of other companies in the same industry (there are a number
of limitations to this type of standard, because companies are seldom
entirely comparable).

4. Budgeted or planned standards reflecting the stated objectives of
management before the period was started.

Rounded Dollar Valuation. Computations are made easier by rounding off
all amounts in the statements to the nearest $1,000 ($100 for a small
company). While procedural in nature, this step is important in that it
calls attention to the generalized nature of many of the results of data
developed by analysis, for analysis involves reducing a mass of
information to a generalized figure.

Reclassification of Amounts. If analyzed data are to be compared, a
uniform classification system should be used for all amounts compared.
For example, if depreciation has been computed on the assumption of an
average 20-year life, this policy should be followed consistently; and
if the current year’s depreciation has been computed on a 10-year
instead of the 20-year life, the excess depreciation should be
reclassified as part of the asset, for purposes of comparison.

In developing a uniform classification system, all offsets — where
liabilities are reduced by assets so that only the net liability is
reported, or vice versa — should be removed and all assets and
liabilities revealed., In the same way, all reductions in liabilities
and assets which have occurred should be recorded. Thus, treasury stock
should not be treated as an asset but as a reduction in the
stockholders’ equity, because it is a reduction in an equity and not an
asset. Also, bond discount should be deducted from the liability.

In many instances, information will not be available to allow a
satisfactory reclassification or even to know whether reclassification
is appropriate. If the statements have been certified by a certified
public accountant as a fair presentation of the accounting facts, it is
appropriate to assume that for a particular company no material
inconsistencies exist in the classification of amounts from period to
period.

Classification for Different Purposes. For particular analyses,
different classifications of amounts may be appropriate. That is, since
the purpose of analysis is to reveal information, and since information
enables a decision maker correct past actions or improve future
decisions, only by analyzing reports in terms of different managerial
objectives can the maximum amount of accounting information be
transmitted. It follows, then, that analyses to develop information
useful for different purposes will require different aggregations of the
basic data. For example, the ratio of variable expenses to sales
normally must be preceded by a reclassification of expenses into the
categories of variable and fixed items, and this involves regroupings
and rearrangements of the basic data.

Appropriate Ratios, Comparisons, Trends, and Relationships. The
selection of the statistical measures, ratios, comparisons, trends, and
relationships to be computed in analyzing statements and supporting data
depends upon the specific purpose of the analysis. It is impossible to
list all of the comparisons which may be made. Different situations and
different purposes may require any number of different analyses. In
general, the analyst should determine in detail the purpose for which
the information is to be used before selecting the types of ratios and
comparisons to be made.

Analysis for credit and investment purposes:

Typical analyses used in determining whether to loan or invest money in
a company include:

1. Balance-sheet ratios.

2. Income-statement ratios.

3. Cross statement ratios.

4. Percentage statements.

5. Comparative statements.

Summary

The analysis of accounting reports is undertaken to achieve an
understanding of a company and its activities. It is an involved process
and the detailed study of this topic falls in the area of advanced
accounting where statistical and mathematical methods and external, as
well as internal, data are used. But this introduction to the subject
provides a basic understanding of the process. It is based on the
assumption that masses of data are often best understood when reduced to
one significant figure. Consequently, a number of financial ratios may
be used to reveal information in accounting reports. However, effective
analysis of accounting reports can seldom be reduced to a process of
computing 8 or 10 ratios. The more informative analyses depend upon the
use that is to be made of the information. Broadly, accounting report
analysis may develop information for either management or investors.

Effective analysis requires that the data available be unambiguously
defined. Non-comparable data should be adjusted. If broad
interpretations are to be made, data may be rounded off and reclassified
to disclose only the significant information needed.

Selected ratios, comparisons, trends, and relationships which may be
developed to reveal information to investors are:

1. Balance-sheet ratios: Current ratio, Acid-test ratio,
Shareholders’-equity ratio, Book value per share of stock

2. Income-statement ratios: Operating ratio, Number of times fixed
charges earned, Net income to sales ratio

3. Cross-statement ratios: Inventory turnover, Number of days’ sales in
receivables, Return on investment

4. Percentage statements

5. Comparative statements over time

For management purposes, analyses are usually more precise. Three
conventional techniques used for these purposes are:

1. Analysis of rate of return on investment

2. Volume sensitivity analysis

3. Analysis of changes in income over time

10. BUDGETS AND BUDGETING

All businesses need to plan for the future. In large businesses such
planning, usually known as corporate planning, is very formal while, for
smaller businesses, it will be less formal. Planning for the future
falls into three time scales:

— long-term: from about three years up to, sometimes, as far as twenty
years ahead.

— medium-term: one to three years ahead.

— short-term: for next year.

Clearly, planning for these different time scales needs different
approaches: the further on in time, the less detailed can be the plans.
In the medium and longer term, a business will establish broad corporate
objectives. Such corporate objectives do not have to be formally written
down, although in a large organization they are likely to be; for
smaller businesses, corporate objectives will certainly be thought about
by the owners or managers. This is very similar to ea6h one of us having
personal objectives, which we are likely to think about, rather than
write down.

In this unit we are concerned with planning for the more immediate
future, i.e. the next financial year. Such planning takes the broader
corporate objectives and sets out how these are to be achieved in the
form of detailed plans known as budgets.

A budget can be defined as a planning and control tool relevant to the
management of a business.

The main purposes of budgeting are:

— to assist in the assessment and evaluation of different courses of
possible action;

— to create motivation by expressing a proposed plan of action in terms
of targets;

— to monitor the effectiveness of performance being accomplished against
the budget, and to report variances. Most budgets are prepared for the
forthcoming financial year, and are usually broken down into shorter
time periods, commonly monthly.

This enables control to be exercised over the budget: as time passes by,
so the business’ actual results can be compared to the budget;
discrepancies between the two can be investigated.

The end result of the budgeting process is the production of a master
budget which takes the form of estimated operating statements
(manufacturing account, trading account, and profit and loss account)
together with an estimated balance sheet at the end of the budgetary
period. However, before the master budget can be produced, a number of
subsidiary budgets covering all aspects of the business need to be
prepared, e.g. sales, purchases, production, overheads, and cash. It can
be seen that sales is, for most businesses, the starting point for the
budget; this is because sales is often the limiting factor. A limiting
factor is some aspect of the business which prevents further expansion.
Other limiting factors include shortages of: raw materials skilled
labour factory space capital expenditure on research and development.

Whatever the limiting factor, the budget needs to be designed to
incorporate any restrictions imposed by the factor.

The planning of a budget is coordinated by a member of the accounts
department. However, managers of individual departments are made
responsible for preparing budgets for their own departments. Many larger
organizations take a highly formal view of planning the budget and form
a budget committee.

An important aspect of budgetary planning is to test for feasibility
before submitting the master budget for the approval of the owner or
board of directors. The test of feasibility would check, for example,
that the sales budget and the production budget are linked together (so
that stock-piling or stock shortages do not occur), that the production
budget is within the capacity of the facilities available, that the cash
budget does not show excessive short-term borrowing which could be
avoided by rescheduling major purchases.

Once a budget has been approved by the owner or, in the case of a
limited company, by the board of directors it becomes the official plan
of the business for the period of the budget. There is no point in a
business spending a lot of time and effort in preparing a budget if it
is not used as a control mechanism throughout the period: this aspect is
known as budgetary control.

The main aspect with which budgetary control is concerned is in
comparing actual results with what was planned to happen in the budget.

Advantages of Budgets Performance targets are established. The process
of budgeting establishes targets:

for the business as a whole — in the form of a master budget

— for section managers — in the form of subsidiary budgets

— Comparisons can be made of budget and actual performance

— By comparing the budget with what happens in reality allows:

— management to know that a variance has occurred

— an investigation to take place into the causes of the variance

— action to take place to correct the reason for the variance.

Planning is beneficial

It is too easy for a business to meander along from day-to-day and
week-to-week without any real idea of where it is going. A budget forces
the management to think ahead and this, in turn, leads to better use of
the resources of the business.

For a budget to be useful to business, it must be a realistic forecast
of what can be achieved. If it is not, then the people who have to work
to the budget will simply ‘give up’ and will not try to achieve the
targets set. At the same time, the senior management of the business,
starting at the top with the owner or board of directors, must be
convinced of the usefulness of the budget. If budgeting is seen as a
necessary chore to be undertaken without much enthusiasm, then this
attitude will soon permeate down through the organization.

Fixed and Flexible Budgets. A fixed budget is one that is set at the
start of the budgetary period and remains unchanged whatever the level
of activity. For example, a budget is set for production of 10 000 units
each month; actual production is 9 000 units per month. A fixed budget
will compare the budgeted costs of producing 10 000 units with the
actual costs of 9 000. Therefore the total variable costs, i.e. the
actual figures, will be different from those budgeted for.

A way of overcoming the difficulty caused by a fixed budget is to use a
flexible budget. This recognizes the different behaviour patterns of
fixed costs and variable costs, depending on the level of output. Thus,
an amended budget is produced on the basis of costs expected to be
incurred at different production levels. For instance, in the example
given above, a flexible budget would be produced for a production level
of 9 000 units per month — the variable costs, e.g. materials, labour,
and parts of the overhead, would be altered or ‘flexed’ to a level of 9
000 units. Then the actual costs can be directly compared with those of
the flexible budget.

Zero-based Budgeting. The starting point for most budgets is to commence
with last year’s budget and then to add a few per cent to allow for
inflation’. Such a policy, which is particularly prevalent in local and
public authorities, has the major disadvantage that inefficiencies,
provided they take place within the terms of the budget, remain in the
system.

One way to avoid this is to use zero-based budgeting. With this system,
the budget starts from zero, and each item going into the budget has to
be justified on the basis of business activity. For example, a
stationery budget for an office, instead of starting with last year’s
figure and ‘adding a bit’, will start at zero and the manager of the
office must justify each item which goes into the budget. The advantage
of such a system is that managers have to justify their own budget.

Cash Budget. The cash budget is the subsidiary budget that brings
together all the other individual budgets. From a cash budget (which is
often known as a cash flow forecast) can be produced the master budget.
(This takes the form of forecast financial statements, i.e. projected
trading and profit and loss account, and balance sheet.

The purpose of a cash budgets to detail the expected cash and bank
receipts and payments, usually on a month-by month basis, for the next
three, six, twelve months (or even longer), in order to show the
estimated bank balance at the end of each month throughout the period.
From the cash budget, the managers of a business can decide what I
action to take when a surplus of cash is shown to be available or, as is
« more likely, when a bank overdraft needs to be arranged.

Limitations. While a cash budget is a very useful guide, it is only as
good as the estimates on which it is based. A cash budget which is based
on optimistic sales for the next six or twelve months will show an
equally optimistic picture of the bank balance; a budget that looks too
far into the future will probably prove to be inaccurate in later many
cash budget and cash flow forms have. To supplement the cash budget, it
is quite usual to prepare a master budget, in the form of forecast final
accounts.

As we have seen just now, a cash budget is prepared on the basis of
certain assumptions, for example:

— debtors pay, in full, in the month following sale

— purchases from suppliers are paid for two months after the month of
purchase

Often the managers of a business will wish to change the assumptions on
which the cash budget is based by saying ‘what if?’ For example:

— we buy a new machine three months earlier than planned?

— What if we What if half our debtors take two months to pay?

— What if take advantage of cash discounts offered by our creditors and
pay within, say, 14 days of purchase?

Each of these examples will change the cash budget substantially, and
any two of the three, or all three together, is likely to have a
considerable effect on a previously calculated budget, and may lead to
an increased bank overdraft requirement.

To answer ‘what if questions, the whole cash budget has to be reworked
on the basis of the new assumptions. The reason for this is that, as the
estimates of receipts and payments change each month, so the estimated
closing month-end bank balance changes. This is where a computer
spreadsheet is ideal for the preparation of cash budgets: each change
can be put in, and the computer can be used to rework all the
calculations. A printout can be taken of each assumption and then passed
to the managers for their consideration.

Cash: a limiting factor. It might be that the cash budget shows, for
certain months, a potential bank overdraft which is beyond the limits of
the business. It might be unacceptably high for the business because of
the interest cost, or the bank may not be prepared to allow such
overdraft facilities. Thus a shortage of cash may be the limiting factor
for a business, and it may have to rethink the other budgets in order to
change its plans so as to work within its cash resources. After all, it
is a shortage of cash that forces most companies into liquidation, even
if they provide a good product or service: thus the efficient use of
cash resources is one of the most important control aspects for the
management of a business.

Points to note when preparing forecast final accounts:

— The sales figure shown in the trading account is the total amount of
goods sold, whether paid for or not (sales made, but not yet paid for,
are recorded as debtors in the balance sheet).

— Likewise, the figure for purchases is the total of goods bought, with
amounts not yet paid for recorded as creditors in the balance sheet.

— Depreciation, which never appears in the cash budget, is shown amongst
the expenses in the profit and loss account, and deducted from the cost
of the fixed asset in the balance sheet.

(Note that, in the example above, depreciation is for a period of six
months.)

Comments on Cash Budgets and the Master Budget

Besides preparing the cash budget and master budget, you may need to
comment on them, either to the owner of the business, or to a potential
lender. It is therefore vitally important that the subsidiary budgets
used in the preparation of the cash budget are accurate, as anything
that follows will be ‘thrown’ by an inaccurate budget.

You may need to prepare answers to the following questions:

— Will bank finance be needed at any time during the period covered by
the cash budget? If so, how long will it take to repay such borrowing?

— Is there a build-up of cash that needs to be invested on a short-term
basis?

— Is the business profitable?

— Are the credit terms allowed to debtors similar to those received from
creditors?

— How much is the owner taking out of the business in relation to the
forecast net profit?

— If the purchase of fixed assets creates a large overdraft, could other
forms of finance be considered, e.g. hire purchase, or leasing?

In addition to these points, ratio analysis can be used to analysis the
forecast final accounts, and comparisons can be made with what was
achieved by the same business in the previous year or half-year
(assuming it was then trading).

PAGE

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