Definition of solvency
solvency
Refers to the ability of a business to pay its liabilities on time
when they come due for payment. A business may be insolvent, which
means that it is not able to pay its liabilities and debts on time. The current
ratio and acid test ratio are used to evaluate the short-term solvency
prospects of a business.
Related Terms:
Total liabilities exceed total assets. A firm with a negative net worth is insolvent on
the books.
The risk that a firm will be unable to satisfy its debts. Also known as bankruptcy risk.
Ratios used to judge the adequacy of liquid assets for meeting short-term
obligations as they come due, including
1) the current ratio,
2) the acid-test ratio,
3) the inventory turnover ratio, and
4) the accounts receivable turnover ratio.
Default on a legal obligation of the firm. For example, technical insolvency occurs
when a firm doesn't pay a bill.
The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.
Calculated to assess the short-term solvency, or debt-paying
ability of a business, it equals total current assets divided by total current
liabilities. Some businesses remain solvent with a relatively low current
ratio; others could be in trouble with an apparently good current ratio.
The general rule is that the current ratio should be 2:1 or higher, but
please take this with a grain of salt, because current ratios vary widely
from industry to industry.
Situation in which a firm is unable to meet due bills; a period of "technical insolvency".
A collection of systems and processes used to record, report and interpret business transactions.
A broad, all-inclusive term that refers to the methods and procedures
of financial record keeping by a business (or any entity); it also
refers to the main functions and purposes of record keeping, which are
to assist in the operations of the entity, to provide necessary information
to managers for making decisions and exercising control, to measure
profit, to comply with income and other tax laws, and to prepare financial
reports.
Administrative proceedings or litigation releases that entail an accounting or auditing-related violation of the securities laws.
An alteration in the accounting methodology or estimates used in
the reporting of financial statements, usually requiring discussion in a footnote
attached to the financial statements.
Earnings of a firm as reported on its income statement.
A business for which a separate set of accounting records is being
maintained.
The representation of the double-entry system of accounting such that assets are equal to liabilities plus capital.
The formula Assets = Liabilities + Equity.
accounting equation
An equation that reflects the two-sided nature of a
business entity, assets on the one side and the sources of assets on the
other side (assets = liabilities + owners’ equity). The assets of a business
entity are subject to two types of claims that arise from its two basic
sources of capital—liabilities and owners’ equity. The accounting equation
is the foundation for double-entry bookkeeping, which uses a
scheme for recording changes in these basic types of accounts as either
debits or credits such that the total of accounts with debit balances
equals the total of accounts with credit balances. The accounting equation
also serves as the framework for the statement of financial condition,
or balance sheet, which is one of the three fundamental financial
statements reported by a business.
Accounting Errors
Unintentional mistakes in financial statements. Accounted for by restating
the prior-year financial statements that are in error.
Accounting exposure
The change in the value of a firm's foreign currency denominated accounts due to a
change in exchange rates.
Accounting Irregularities
Intentional misstatements or omissions of amounts or disclosures in
financial statements done to deceive financial statement users. The term is used interchangeably with fraudulent financial reporting.
Accounting liquidity
The ease and quickness with which assets can be converted to cash.
Accounting period
The period of time for which financial statements are produced – see also financial year.
Accounting Policies
The principles, bases, conventions, rules and procedures adopted by management in preparing and presenting financial statements.
Accounting rate of return (ARR)
A method of investment appraisal that measures
the profit generated as a percentage of the
investment – see return on investment.
accounting rate of return (ARR)
the rate of earnings obtained on the average capital investment over the life of a capital project; computed as average annual profits divided by average investment; not based on cash flow
Accounting system
A set of accounts that summarize the transactions of a business that have been recorded on source documents.
Accrual accounting
The recording of revenue when earned and expenses when
incurred, irrespective of the dates on which the associated cash flows occur.
accrual-basis accounting
Well, frankly, accrual is not a good descriptive
term. Perhaps the best way to begin is to mention that accrual-basis
accounting is much more than cash-basis accounting. Recording only the
cash receipts and cash disbursement of a business would be grossly
inadequate. A business has many assets other than cash, as well as
many liabilities, that must be recorded. Measuring profit for a period as
the difference between cash inflows from sales and cash outflows for
expenses would be wrong, and in fact is not allowed for most businesses
by the income tax law. For management, income tax, and financial
reporting purposes, a business needs a comprehensive record-keeping
system—one that recognizes, records, and reports all the assets and liabilities
of a business. This all-inclusive scope of financial record keeping
is referred to as accrual-basis accounting. Accrual-basis accounting
records sales revenue when sales are made (though cash is received
before or after the sales) and records expenses when costs are incurred
(though cash is paid before or after expenses are recorded). Established
financial reporting standards require that profit for a period
must be recorded using accrual-basis accounting methods. Also, these
authoritative standards require that in reporting its financial condition a
business must use accrual-basis accounting.
Accruals accounting
A method of accounting in which profit is calculated as the difference between income when it is earned and expenses when they are incurred.
Aggressive Accounting
A forceful and intentional choice and application of accounting principles
done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with generally accepted accounting principles or not. Aggressive
accounting practices are not alleged to be fraudulent until an administrative, civil, or criminal proceeding takes that step and alleges, in particular, that an intentional, material misstatement
has taken place in an effort to deceive financial statement readers.
Asset-specific Risk
The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as company-specific risk or
unsystematic risk.
Average accounting return
The average project earnings after taxes and depreciation divided by the average
book value of the investment during its life.
Bankruptcy risk
The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.
Basis risk
The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for
price risk.
Beta risk
risk of a firm measured from the standpoint of an investor who holds a highly diversified portfolio.
Business risk
The risk that the cash flow of an issuer will be impaired because of adverse economic
conditions, making it difficult for the issuer to meet its operating expenses.
Call risk
The combination of cash flow uncertainty and reinvestment risk introduced by a call provision.
Cash accounting
A method of accounting in which profit is calculated as the difference between income
when it is received and expenses when they are paid.
Change in Accounting Estimate
A change in accounting that occurs as the result of new information
or as additional experience is acquired—for example, a change in the residual values
or useful lives of fixed assets. A change in accounting estimate is accounted for prospectively,
over the current and future accounting periods affected by the change.
Change in Accounting Estimate
A change in the implementation of an existing accounting
policy. A common example would be extending the useful life or changing the expected residual
value of a fixed asset. Another would be making any necessary adjustments to allowances for
uncollectible accounts, warranty obligations, and reserves for inventory obsolescense.
Change in Accounting Principle
A change from one generally accepted accounting principle to another generally accepted accounting principle—for example, a change from capitalizing expenditures
to expensing them. A change in accounting principle is accounted for in most instances
as a cumulative-effect–type adjustment.
Commercial risk
The risk that a foreign debtor will be unable to pay its debts because of business events,
such as bankruptcy.
Company-specific risk
Related: Unsystematic risk
Companyspecific Risk
See asset-specific risk
Completion risk
The risk that a project will not be brought into operation successfully.
Constant dollar accounting
A method for restating financial statements by reducing or
increasing reported revenues and expenses by changes in the consumer price index,
thereby achieving greater comparability between accounting periods.
Contract Accounting
Method of accounting for sales or service agreements where completion
requires an extended period.
cost accounting
a discipline that focuses on techniques or
methods for determining the cost of a project, process, or
thing through direct measurement, arbitrary assignment, or
systematic and rational allocation
Cost Accounting Standards Board (CASB)
a body established by Congress in 1970 to promulgate cost accounting
standards for defense contractors and federal agencies; disbanded
in 1980 and reestablished in 1988; it previously issued
pronouncements still carry the weight of law for those
organizations within its jurisdiction
Counterparty risk
The risk that the other party to an agreement will default. In an options contract, the risk
to the option buyer that the option writer will not buy or sell the underlying as agreed.
Country economic risk Developments in a national economy that can affect the outcome of an international
financial transaction.
Country financial risk
The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.
Country risk General
Level of political and economic uncertainty in a country affecting the value of loans or
investments in that country.
Creative Accounting Practices
Any and all steps used to play the financial numbers game, including
the aggressive choice and application of accounting principles, both within and beyond
the boundaries of generally accepted accounting principles, and fraudulent financial reporting.
Also included are steps taken toward earnings management and income smoothing. See Financial
Numbers Game.
Creative Acquisition Accounting
The allocation to expense of a greater portion of the price
paid for another company in an acquisition in an effort to reduce acquisition-year earnings and
boost future-year earnings. Acquisition-year expense charges include purchased in-process research
and development and an overly aggressive accrual of costs required to effect the acquisition.
Credit risk
The risk that an issuer of debt securities or a borrower may default on his obligations, or that the
payment may not be made on a negotiable instrument. Related: Default risk
Credit Risk
Financial and moral risk that an obligation will not be paid and a loss will result.
Cross-border risk
Refers to the volatility of returns on international investments caused by events associated
with a particular country as opposed to events associated solely with a particular economic or financial agent.
Cumulative Effect of a Change in Accounting Principle
The change in earnings of previous years
based on the assumption that a newly adopted accounting principle had previously been in use.
Cumulative Effect of Accounting Change
The change in earnings of previous years assuming
that the newly adopted accounting principle had previously been in use.
Currency risk
Related: Exchange rate risk
Currency risk sharing
An agreement by the parties to a transaction to share the currency risk associated with
the transaction. The arrangement involves a customized hedge contract embedded in the underlying
transaction.
Default risk
Also referred to as credit risk (as gauged by commercial rating companies), the risk that an
issuer of a bond may be unable to make timely principal and interest payments.
Diversifiable risk
Related: unsystematic risk.
double-entry accounting
See accrual-basis accounting.
Economic risk
In project financing, the risk that the project's output will not be salable at a price that will
cover the project's operating and maintenance costs and its debt service requirements.
Equilibrium market price of risk
The slope of the capital market line (CML). Since the CML represents the
return offered to compensate for a perceived level of risk, each point on the line is a balanced market
condition, or equilibrium. The slope of the line determines the additional return needed to compensate for a
unit change in risk.
Event risk
The risk that the ability of an issuer to make interest and principal payments will change because
of rare, discontinuous, and very large, unanticipated changes in the market environment such as (1) a natural
or industrial accident or some regulatory change or (2) a takeover or corporate restructuring.
Exchange rate risk
Also called currency risk, the risk of an investment's value changing because of currency
exchange rates.
Exchange risk
The variability of a firm's value that results from unexpected exchange rate changes or the
extent to which the present value of a firm is expected to change as a result of a given currency's appreciation
or depreciation.
Fallout risk
A type of mortgage pipeline risk that is generally created when the terms of the loan to be
originated are set at the same time as the sale terms are set. The risk is that either of the two parties, borrower
or investor, fails to close and the loan "falls out" of the pipeline.
Financial accounting
The production of financial statements, primarily for those interested parties who are external to the business.
financial accounting
a discipline in which historical, monetary
transactions are analyzed and recorded for use in the
preparation of the financial statements (balance sheet, income
statement, statement of owners’/stockholders’ equity,
and statement of cash flows); it focuses primarily on the
needs of external users (stockholders, creditors, and regulatory
agencies)
Financial risk
The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.
financial risk
risk to shareholders resulting from the use of debt.
Firm-specific risk
See:diversifiable risk or unsystematic risk.
Flat price risk
Taking a position either long or short that does not involve spreading.
Force majeure risk
The risk that there will be an interruption of operations for a prolonged period after a
project finance project has been completed due to fire, flood, storm, or some other factor beyond the control
of the project's sponsors.
Foreign exchange risk
The risk that a long or short position in a foreign currency might have to be closed out
at a loss due to an adverse movement in the currency rates.
Funding risk
Related: interest rate risk
Gain-on-Sale Accounting
Up-front gain recognized from the securitization and sale of a pool
of loans. Profit is recorded for the excess of the sales price and the present value of the estimated
interest income that is expected to be received on the loans above the amounts funded on the loans
and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.
Generally Accepted Accounting Principals (GAAP)
A technical accounting term that encompasses the
conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.
Generally accepted accounting principles
The rules that accountants follow when processing accounting transactions and creating financial reports. The rules are primarily
derived from regulations promulgated by the various branches of the AICPA Council.
generally accepted accounting principles (GAAP)
This important term
refers to the body of authoritative rules for measuring profit and preparing
financial statements that are included in financial reports by a business
to its outside shareowners and lenders. The development of these
guidelines has been evolving for more than 70 years. Congress passed a
law in 1934 that bestowed primary jurisdiction over financial reporting
by publicly owned businesses to the Securities and Exchange Commission
(SEC). But the SEC has largely left the development of GAAP to the
private sector. Presently, the Financial accounting Standards Board is
the primary (but not the only) authoritative body that makes pronouncements
on GAAP. One caution: GAAP are like a movable feast. New rules
are issued fairly frequently, old rules are amended from time to time,
and some rules established years ago are discarded on occasion. Professional
accountants have a heck of time keeping up with GAAP, that’s for
sure. Also, new GAAP rules sometimes have the effect of closing the barn
door after the horse has left. accounting abuses occur, and only then,
after the damage has been done, are new rules issued to prevent such
abuses in the future.
generally accepted accounting principles (GAAP)
Procedures for preparing financial statements.
Generally Accepted Accounting Principles (GAAP)
A common set of standards and procedures
for the preparation of general-purpose financial statements that either have been established
by an authoritative accounting rule-making body, such as the Financial accounting
Standards Board (FASB), or over time have become accepted practice because of their universal
application.
Generally Accepted Accounting Principles (GAAP)
GAAP is the term used to describe the underlying rules basis on which financial statements are normally prepared. This is codified in the Handbook of The Canadian Institute of Chartered Accountants.
Geographic risk
risk that arises when an issuer has policies concentrated within certain geographic areas,
such as the risk of damage from a hurricane or an earthquake.
Herstatt risk
The risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial institution will fail to deliver its end of the contract. It is also referred to as settlement risk.
High-Risk Small Business
Firm viewed as being particularly subject to risk from an investors perspective.
Idiosyncratic Risk
Unsystematic risk or risk that is uncorrelated to the overall market risk. In other words,
the risk that is firm specific and can be diversified through holding a portfolio of stocks.
Inflation risk
Also called purchasing-power risk, the risk that changes in the real return the investor will
realize after adjusting for inflation will be negative.
Interest rate risk
The risk that a security's value changes due to a change in interest rates. For example, a
bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that
spread income will suffer because of a change in interest rates.
Interest Rate Risk
Possibility that interest rates will rise during the term of a loan thereby increasing the annual cost of borrowing.
internal accounting controls
Refers to forms used and procedures
established by a business—beyond what would be required for the
record-keeping function of accounting—that are designed to prevent
errors and fraud. Two examples of internal controls are (1) requiring a
second signature by someone higher in the organization to approve a
transaction in excess of a certain dollar amount and (2) giving customers
printed receipts as proof of sale. Other examples of internal
control procedures are restricting entry and exit routes of employees,
requiring all employees to take their vacations and assigning another
person to do their jobs while they are away, surveillance cameras, surprise
counts of cash and inventory, and rotation of duties. Internal controls
should be cost-effective; the cost of a control should be less than
the potential loss that is prevented. The guiding principle for designing
internal accounting controls is to deter and detect errors and dishonesty.
The best internal controls in the world cannot prevent most fraud
by high-level managers who take advantage of their positions of trust
and authority.
judgmental method (of risk adjustment)
an informal method of adjusting for risk that allows the decision maker
to use logic and reason to decide whether a project provides
an acceptable rate of return
Liquidity risk
The risk that arises from the difficulty of selling an asset. It can be thought of as the difference
between the "true value" of the asset and the likely price, less commissions.
Management accounting
The production of financial and non-financial information used in planning for the future; making decisions about products, services, prices and what costs to incur; and ensuring that plans are implemented and achieved.
management accounting
a discipline that includes almost
all manipulations of financial information for use by managers
in performing their organizational functions and in
assuring the proper use and handling of an entity’s resources;
it includes the discipline of cost accounting
Management Accounting Guidelines (MAGs)
pronouncements of the Society of Management Accountants of
Canada that advocate appropriate practices for specific
management accounting situations
Market price of risk
A measure of the extra return, or risk premium, that investors demand to bear risk. The
reward-to-risk ratio of the market portfolio.
Market risk
risk that cannot be diversified away. Related: systematic risk
Market Risk
The amount of total risk that cannot be eliminated by portfolio
diversification. The risk inherent in the general economy as a
whole. Also known as systemic risk.
market risk
Economywide (macroeconomic) sources of risk that affect the overall stock market. Also called systematic risk.
Market Risk
The part of security's risk that cannot be eliminated by diversification. It is measured by the beta coefficient.
market risk premium
risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.
Mortgage-pipeline risk
The risk associated with taking applications from prospective mortgage borrowers
who may opt to decline to accept a quoted mortgage rate within a certain grace period.
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