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## Prudence in accounting

Questions:

1.Does his Optimistic outlook for his Cash Position appear to be correct?

2.what would Eli’s ending Cash Balance be?

3.Argue why are Treasury bills a favorite place for Financial Managers to invest excess cash, as Compared to other Options? Your answer must be supported with examples and academic citations

1.In the given case, Eli Lilly is showing optimistic outlook for his cash position, since he is expecting it to be doubled in this year from \$600,000 to \$1,200,000. It can be seen that the net assets will remain at 50% of total sales and his firm is going to enjoy 8% return on total sales. Thus, being his cash balance started with \$ 120,000 in the current year, further cash balance or deficit for the year end is computed below.

Actual sale of previous year = \$ 600,000

Actual net asset remains 50% of the actual sale = \$ 600,000 * 50%

= \$ 300,000

Expected sale of next financial year = \$ 1,200,000

Expected net asset will be 50% of the expected sale = \$ 1,200,000 * 50%

= \$ 600,000

Assumed asset is 50% of sales increase. In this case, increase in sales is \$ 600,000, hence total asset is 50% of increased sale = \$ 300,000

Since Eli Lilly has started with cash of \$ 120,000 therefore rest asset is assumed to be fixed asset amounted to \$ 180,000 (\$ 300,000 - \$ 120,000).

Thus, it can be said that optimistic outlook of Eli for his cash balance is positive, because his expected sales is double of previous year’s sales.

2.In this case, if there would be no increment in sales, the ending cash balance is computed below.

Actual sale of previous year = \$ 600,000

Actual net asset remains 50% of the actual sale = \$ 600,000 * 50%

= \$ 300,000

Therefore, assumed total asset would be 50% of total sales, that is \$ 300,000 * 50%

= \$ 150,000, out of which his beginning cash balance is \$ 120,000. Therefore, his ending cash balance would be \$ 30,000.

Thus, based on the analysis of both the case examples, it can be said that prudence concept of accounting is to be maintained. Where anticipated loss to be booked first and anticipated gain should be ignored (Chase & Rice, 2014). Here in this situation, Eli has been found highly optimistic about his expected increment in sales and started to dream for buying luxury car and house, without even realizing that the increment in sales might not happen in future. Thus, Eli should realize the actual sale first and then brag for luxurious things.

## Features and benefits of Treasury bills

3.Treasury bills are offer a very low risk in the investment and to earn guaranteed return and this makes it more attractive to many investors. In treasury bills, the par value and the purchase price is interest, where option for purchasing T-Bills to the investors lies at auction and then it is discounted at par value. (Bodie, Kane & Marcus, 2014). This bill has maturity period for less than one year and is generally sold up to denomination of \$1000. However, the significant disadvantage of treasury bills is that it offers very low return in comparison of other investment opportunities in the market. (An & Zhang, 2013). Apart from this T-bills are associated with liquidity and absorbs amount of invested in business. These are issue for three-time periods basically, such as 91-day bill, one year note and 182 days bills (Krishnamurthy & Vissing-Jorgensen, 2012). Some of the features of T-bills are mentioned below-

• Eligibility: Any individuals, company, trust, bank, financial institutions, firms, insurance company can make investment in treasury bills
• Minimum bid: It requires minimum bidding price but have the capacity to yield higher return
• Issue price: One of the most important features of T-bill is that it is issued by government at discount rate but at the time of redemption it is redeemed at par (Nyawata, 2013)
• Repayment: As mentioned earlier, the T-bills are repaid by government at par
• Availability: These financial instruments are highly liquidated instrument and can be easily available from primary and secondary market

As financial managers are entrusted with the role of ensuring efficient financial position of company, they take investment decision focusing on three key areas such as tenure of investment, finance and dividends (Moser, 2017). Financial managers are stressed upon buying T-bill because within a short time period it provides maximum return (Nixon & Burns, 2012). In T-bills, the return is secured and guaranteed and have capacity to immune against risk like inflation, recessions and depressions.

Treasury bill yields more return to financial investors than that of other securities due to various reasons. Some of the reasons are mentioned below-

Nature of treasury bills: Earning from investment in Treasury bill has indirect relationship with the price. It can be observed from the secondary market, when demand for bond is higher in market, their bidding price also rise, but in case of Treasury bill, their coupon rate remains lower as compared to higher prices of other investments in the market. As financial investors prefer low risk, they are likely to make investments in T-bills, because this protects investors against market risk in uncertain financial condition of economy (Dungey & Hvozdyk, 2012).

Risk-free treasuries: Like all bonds, T-bills also provide return to investors at the time of maturity. As T-bill is issued by government there are least chances that government of economy will fail to meet their obligations related to debts (Bodie, Kane & Marcus, 2014).

Interest rate on Treasury bill and other bonds: Interest received on other bonds like loans, short-term investment, deposit accounts is always compared with interest rate received on treasuries. At present, it is seen that interest rate offered on T-bills is similar to bond issued by several corporate bonds (Huang & Huang, 2012). In order to evaluate by applying which policy financial investor invest in T-bills, the following example is taken to explain the scenario.

## Institutional investors reduce information asymmetries

For instance, interest rate on T-bill is 5% and on any other corporate bond is also same but an investor always selects T-bills because they are safer bond as compared to any other bonds also the expected return remains unaffected due to market fluctuations.

Easier liquidity facility: T-bill is easily convertible into cash due to their liquidity nature. In addition to this even if the time period does not elapse, an investor can withdraw the invested amount.

Not associated with any transaction cost: No transaction cost is associated with T-bills like other investments. Apart from this, a broker also does not charge any brokerage for purchasing T-bills (Jagric et al. 2015).

Thus, from above explanations it can be concluded that T-bills are best option to use in portfolio by a financial investor as it carries almost no or minimum risk. Apart from this, another reason for which financial investor opts for making investment in T-bill is that it does not have any provision for call. Thus, at the economic slowdown when corporate or municipal bonds are called, treasury investors can easily configure the holding period of security.

4.The term Institutional investors refer to any individual person or an organization which trades large shares of equities for lower commissions and preferential treatment. They face less regulation as compared to other investors because it is assumed that they are knowledgeable enough to protect themselves. Some example of institutional investor includes commercial banks, hedge funds, mutual funds, and endowment funds (McCahery, Sautner & Starks, 2016). As compared to retail investor they have extensive knowledge about investment options and have specialized knowledge because they are one of the largest forces for encouraging demand and supply in security market. Before analyzing importance if institutional investor in business world it is necessary to understand the difference between retail investors and institutional investors and their role in market.

In case of retail investors, they are bound to pay brokerage fees, distribution cost and marketing cost for every transaction carried out. However, institutional investors make transaction independently and avoid payment of marketing and distribution cost (McCauley, 2012). Both retail and institutional investors invest in stock, options, bonds and future contracts but some markets are basically for institutional investors only due to nature of market securities and risk. Such market includes forward market and swaps.

Institutional investors reduce information asymmetries: It is seen in financial market that flow of asymmetric information generates price discount. In order to understand this concept better, an example of car market is shown here. Rational buyers of car assume that they have better information about quality of car offered in sale and due to this situation, they will buy car which have lower quality (Dhiman & Raheja, 2017). So, the good quality of car seller will be driven out from the market. Therefore adverse selection of product through flow of asymmetric information is observed, it is also seen in stock market as well. It creates negative impact on share market but this negative impact is reduced by institutional investors by deploying book building method in stock market (Helwege, Intintoli & Zhang, 2012).

## Institutional investors increase liquidity

Increases liquidity: Liquidity refers to ease of asset to convert into cash without affecting its actual value. Prevalence of less liquidity in stock market reduces price of shares in stock market and affects negatively. If stocks are not regularly traded in market its underlying value will remain uncertain and thus liquidity will decrease as investors will take less interest on stock market (Manconi, Massa & Yasuda, 2012). But research conducted by economist revealed that liquidity in stock market is still going on due to presence of institutional investors. Presence of institutional investors affects cost of equity and stock price in market and also assists in reducing tax bill paid by company from the global context.

Improve corporate governance: Corporate governance implies developing performance of company operating in market. In order to develop structure and performance of company in market it is necessary to oversights of managers present in respective company. Thus, if shareholders or institutional investors of company remain dissatisfied with corporate government of company they will deploy two methods to improve corporate governance (Basak & Pavlova, 2013). They will either sell shares or raise the voice for showing their dissatisfaction which as a result will enhance company’s performance in market.

From the above discussion importance of institutional investors in today’s world has been drawn below-

Firstly, these investors have huge amount of cash and can easily finance large projects for economic development of companies (Nixon & Burns, 2012). Apart from this, company can utilize the money to build their respective company financially strong.

Second, they are entrusted with large power when they invest large amount of fund in company. The board of director of respective company gives importance to their decision based on their investment capacity.

Thirdly, majority of institutional investors control stock market of country and thus they have the ability to control stock market (Jagric et al. 2015). Thus, they expand their activity areas to trade in overseas market and make the economy of country strong.

Fourthly, institutional investors control corporate governance of company by regulating and mitigate the agency problems (An & Zhang, 2013). They stress upon management of company to pay interest to the profitability of shareholders of company and address their problems by exercising their bargaining power.

Lastly, they play important role in allocation of capital in different companies by regulating corporate governance. Moreover, they monitor the risk by providing proper information about stock market.

References

An, H., & Zhang, T. (2013). Stock price synchronicity, crash risk, and institutional investors. Journal of Corporate Finance, 21, 1-15.

Basak, S., & Pavlova, A. (2013). Asset prices and institutional investors. The American Economic Review, 103(5), 1728-1758.

Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments, 10e. McGraw-Hill Education.

Chase, A. F., & Rice, P. M. (Eds.). (2014). The Lowland Maya Postclassic. University of Texas Press.

Dhiman, B., & Raheja, S. (2017). Does personality traits and emotional intelligence influence investment decisions of investors?. Asian Journal of Research in Social Sciences and Humanities, 7(7), 99-110.

Dungey, M., & Hvozdyk, L. (2012). Cojumping: Evidence from the US Treasury bond and futures markets. Journal of Banking & Finance, 36(5), 1563-1575. Retrieved from https://www.repository.cam.ac.uk/bitstream/handle/1810/236114/wp39.pdf?sequence=1 [Accessed on 22nd July 2017]

Helwege, J., Intintoli, V. J., & Zhang, A. (2012). Voting with their feet or activism? Institutional investors’ impact on CEO turnover. Journal of Corporate Finance, 18(1), 22-37. Retrieved from https://jacobslevycenter.wharton.upenn.edu/wp-content/uploads/2014/06/14.12.Keim_.pdf [Accessed on 21st July 2017]

Huang, J. Z., & Huang, M. (2012). How much of the corporate-treasury yield spread is due to credit risk?. The Review of Asset Pricing Studies, 2(2), 153-202. Retrieved from https://archive.nyu.edu/bitstream/2451/26484/2/02-40.pdf [Accessed on 22nd July 2017]

Jagric, T., Podobnik, B., Strasek, S., & Jagric, V. (2015). Risk-adjusted performance of mutual funds: some tests. South-eastern Europe journal of Economics, 5(2). 1- 12.

Krishnamurthy, A., & Vissing-Jorgensen, A. (2012). The aggregate demand for treasury debt. Journal of Political Economy, 120(2), 233-267.

Manconi, A., Massa, M., & Yasuda, A. (2012). The role of institutional investors in propagating the crisis of 2007–2008. Journal of Financial Economics, 104(3), 491-518. Manconi, A., Massa, M., & Yasuda, A. (2012). The role of institutional investors in propagating the crisis of 2007–2008. Journal of Financial Economics, 104(3), 491-518. Retrieved from https://www.newyorkfed.org/medialibrary/media/research/conference/2013/fire_sales/Paper_Yasuda_Ayako_et_al.pdf [Accessed on 21st July 2017]

McCahery, J. A., Sautner, Z., & Starks, L. T. (2016). Behind the scenes: The corporate governance preferences of institutional investors. The Journal of Finance, 71(6), 2905-2932.

McCauley, R. N. (2012). Risk-on/risk-off, capital flows, leverage and safe assets.

Moser, J. (2017). Failed Delivery and Daily Treasury Bill Returns.Evolution, 5, 17.

Nixon, B., & Burns, J. (2012). The paradox of strategic management accounting. Management Accounting Research, 23(4), 229-244.

Nyawata, O. (2013). Treasury bills and/or central bank bills for absorbing surplus liquidity: the main considerations. Journal of International Commerce, Economics and Policy, 4(02), 135-145.

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