After I left the previous post, Bogart Beck, head of SL CapEx, and I had a nice discussion about RE, the Balance Sheet, and how things are supposed to be set up. Both approaches have their merits, but I wanted to explain his side of the story (as best I can), and show why the financial templates were set up as they were. (Note to Bo: If you were to post a current financial reporting template somewhere on CapEx, that would be much appreciated!)
In my previous post, I explained that
RE(t) = RE(t-1) + NI(t) - Div(t)
Which is still true, and it's how I learned it in my first accounting class. I believe this is also GAAP-compliant. Bogart, however, wanted to make it a little easier for the average investor to be able to "follow the money" through the financial statements from month to month, and in so doing, rather confused those who were more familiar with the previously stated method.
For SL CapEx, Bogart was trying to set up a system where the RE reported on the Income Statement was directly carried over to the Balance Sheet, and what was formerly in the place of the RE on the Balance Sheet was transferred to some other account, say Capital Surplus. So, at the end of the month, here's what the (simplified) journal would look like:
Account..................................DR....................CR
Retained Earnings................RE(t-1)...........................
Capital Surplus...............................................RE(t-1)
Net Income...........................NI(t)..................................
Dividends..............................Div(t)................................
Retained Earnings...................................RE(t) = NI(t) - Div(t)
This way, an investor can look and see how the Income Statement carries through to the Balance Sheet.
However, Bogart has confirmed (I believe) that the GAAP method is acceptable as well. At least, he hasn't stopped me from using it on SLR's finances, yet. I will continue using the GAAP method, as it is the one I understand best.
Saturday, November 22, 2008
Friday, October 3, 2008
Retained Earnings
One little description, so much power. The description of Retained Earnings on the SL CapEx template balance sheet formerly read
"TAKE DIRECTLY FROM LINE 523 of INCOME STATEMENT"
And this description can still be found on a few of the financial statements running around CapEx. The unfortunate part about this description is that it is wrong. (For one, the income statement only goes to row 53 in Excel, so that should be a first clue that something is odd.)
Retained Earnings is an account in the Equities Section of the Balance Sheet. It is a cumulative (read that word again - cumulative) account of all earnings that a company has retained since inception - hence the name "retained earnings." The tricky part about this account is that it is cumulative. In order to calculate Retained Earnings (RE) correctly, you must do it from the start.
Let's think about how to calculate RE. The first question is, "What is earnings?" Most would agree that earnings can be calculated as Revenues - Expenses. The Income Statement labels that number as "Net Income," so we'll refer to earnings as Net Income (NI).
The next question is, "How does a company retain earnings?" It's actually easier to address how a company does not retain earnings, and that is by paying dividends. When a company pays a dividend, then it is distributing part of its earnings out to its shareholders, who receive them. Therefore, the part NOT paid in dividends is the part of earnings that is retained. We'll call dividends "Div."
So, then we have a formula:
(The second equation is the same as the first, but in the shorthand I noted above.) This is the exact formula that is calculated on the Income Statement, Line 53 (in the template I'm using).
The problem is that this RE is not equal to the RE on the Balance Sheet. The RE on the income statement represents the CHANGE in RE for this period on the Balance Sheet. Here's an example:
April 2008: Retained Earnings is calculated to be L$1,200
May 2008:
In words: Retained Earnings this period equal Retained Earnings last period plus net income this period minus dividends this period.
I hope that clears up some of the mystery with this line on the Balance Sheet. I see a lot of companies with incorrectly calculated RE, and it's really a pretty simple line to do. If you have any questions, feel free to leave a comment - anyone can.
"TAKE DIRECTLY FROM LINE 523 of INCOME STATEMENT"
And this description can still be found on a few of the financial statements running around CapEx. The unfortunate part about this description is that it is wrong. (For one, the income statement only goes to row 53 in Excel, so that should be a first clue that something is odd.)
Retained Earnings is an account in the Equities Section of the Balance Sheet. It is a cumulative (read that word again - cumulative) account of all earnings that a company has retained since inception - hence the name "retained earnings." The tricky part about this account is that it is cumulative. In order to calculate Retained Earnings (RE) correctly, you must do it from the start.
Let's think about how to calculate RE. The first question is, "What is earnings?" Most would agree that earnings can be calculated as Revenues - Expenses. The Income Statement labels that number as "Net Income," so we'll refer to earnings as Net Income (NI).
The next question is, "How does a company retain earnings?" It's actually easier to address how a company does not retain earnings, and that is by paying dividends. When a company pays a dividend, then it is distributing part of its earnings out to its shareholders, who receive them. Therefore, the part NOT paid in dividends is the part of earnings that is retained. We'll call dividends "Div."
So, then we have a formula:
Retained Earnings = Net Income - Dividends
RE = NI - Div
RE = NI - Div
(The second equation is the same as the first, but in the shorthand I noted above.) This is the exact formula that is calculated on the Income Statement, Line 53 (in the template I'm using).
The problem is that this RE is not equal to the RE on the Balance Sheet. The RE on the income statement represents the CHANGE in RE for this period on the Balance Sheet. Here's an example:
April 2008: Retained Earnings is calculated to be L$1,200
May 2008:
- Company has NI = L$1,500 and pays Div = L$1,000
- RE on the Income Statement is calculated as NI - Div = L$1,500 - L$1,000 = L$500
- RE on the Balance Sheet is calculated as RE(old) + RE(new) = L$1,200 + L$500 = L$1,700.
RE(t) = RE(t-1) + NI(t) - Div(t)
In words: Retained Earnings this period equal Retained Earnings last period plus net income this period minus dividends this period.
I hope that clears up some of the mystery with this line on the Balance Sheet. I see a lot of companies with incorrectly calculated RE, and it's really a pretty simple line to do. If you have any questions, feel free to leave a comment - anyone can.
Saturday, August 2, 2008
Where to Go?
Let's face it. Volumes on SL Capital Exchanges (all of them) are dismal, and liquidity is a major concern for investors. "Why should I plunk down several thousand of my hard-earn Linden Dollars if it'll take me months just to sell at a break-even price, and that's if I'm lucky?" With liquidity locked up, major investors will have a hard time realizing a profit on their investments, even if the market values of the particular stocks rise. So how do we fix this?
It seems that whenever a SL company goes belly-up, the CEO simply throws their hands in the air and walks away. That's because it's a possibility in Second Life. There is no chain connecting the CEO to the viewer which makes him or her responsible. Threats of legal action are simply idle talk, as even recovering something like $20,000 USD (about L$5.4 million) would be silly in the context of lawyers' and courts' fees (not to mention your time) to get it.
Certain exchanges have made progress in the realm of removing the complete anonymity of CEOs by requesting IDs for IPO clearance. Nevertheless, even if you know their ID, what good does it do you? Again, legal fees are too prohibitive.
I hesitate to say it, but I think it may be time to tie some more legal strings around the CEOs of SL companies. Some have suggested using promissory notes, but it sounds more like a fidelity bond issue to me, if there was an insurer who would ever cover it. The point remains the same, though: sending a message to CEOs that this is more than a game (in spite of the hypocritical boilerplate language at most exchanges), it is a responsibility which will reach out and slap you in real life if needed.
Before I let this tirade go too far, I do realize that this is not always something that a CEO wants to take on. I daresay that the salaries earned by most SL CEOs are nowhere near enough to compensate for the trouble which these legal ties could cause in real life. Maybe that's the answer, but I hope not.
I'd love to know how to restore investor confidence, but I'm just not seeing a way of doing it without giving investors some sort of recourse for CEO inadequacy or fraudulant activity.
Anyone else have other ideas? Comments?
It seems that whenever a SL company goes belly-up, the CEO simply throws their hands in the air and walks away. That's because it's a possibility in Second Life. There is no chain connecting the CEO to the viewer which makes him or her responsible. Threats of legal action are simply idle talk, as even recovering something like $20,000 USD (about L$5.4 million) would be silly in the context of lawyers' and courts' fees (not to mention your time) to get it.
Certain exchanges have made progress in the realm of removing the complete anonymity of CEOs by requesting IDs for IPO clearance. Nevertheless, even if you know their ID, what good does it do you? Again, legal fees are too prohibitive.
I hesitate to say it, but I think it may be time to tie some more legal strings around the CEOs of SL companies. Some have suggested using promissory notes, but it sounds more like a fidelity bond issue to me, if there was an insurer who would ever cover it. The point remains the same, though: sending a message to CEOs that this is more than a game (in spite of the hypocritical boilerplate language at most exchanges), it is a responsibility which will reach out and slap you in real life if needed.
Before I let this tirade go too far, I do realize that this is not always something that a CEO wants to take on. I daresay that the salaries earned by most SL CEOs are nowhere near enough to compensate for the trouble which these legal ties could cause in real life. Maybe that's the answer, but I hope not.
I'd love to know how to restore investor confidence, but I'm just not seeing a way of doing it without giving investors some sort of recourse for CEO inadequacy or fraudulant activity.
Anyone else have other ideas? Comments?
Saturday, July 26, 2008
It's been awhile...
So, it turns out I've been pretty bad at posting over the last few months. I've had things to keep me busy: one of my actuarial exams, work, RL moving, vacation, getting engaged, etc., so it's not like I'm short on excuses. Nevertheless, I think I should try to post and keep updating this thing periodically.
It seems like interest has waned in the market. I'm not entirely surprised, as most of the markets are rocked by scandal after scandal. New money coming in is kind of rare, as it seems that those who are involved with the markets currently are the only ones who would like to be involved. The lack of liquidity also frightens new investors, as the market value of securities is significantly more than the liquidation value (that is, if you sold all your shares as fast as you could) for almost every security, and even for modest amounts of shares.
For example, take SLR, the company I'm CFO for. (This is in no way a critique of my shareholders, but if I'm going to pick on a company, I might as well hit home.) Suppose I owned 10,000 shares of SLR right now. The market price shown on CapEx is L$6,500. However, if I actually tried to sell all 10,000 shares, I would receive (after commission) L$5,153.02, which is 79.3% of the displayed price. Make it 50,000 shares and I would only receive 12.9% of my displayed market value!!! And we're not talking vast sums of money here - 50,000 SLR shares at market is worth about $120 USD. Enough to care, but not enough to break most of us financially.
You can play this game with almost any stock on any market. There are exceptions, where management has taken care to set aside cash reserves to prevent this from happening, but by and large putting money into the market means you will need to take your time getting money out of the market.
I've heard the idea of market makers being tossed around before. For those of you who don't know, a market maker is a person/firm that makes money off the bid-ask spread in the market. They provide liquidity. However, from my previous actuarial exam (which I passed, by the way!), Modeling Financial Economics, market makers need options in order to protect themselves. There are techniques whereby market makers can insure themselves against large price changes, or even set themselves up to make money if the market doesn't move. However, these require options, which no exchange in SL has been willing to set up yet.
If any exchange in SL is seriously interested in setting up options and market making and similar techniques, please contact me. While I'm sure I'm not the only person in SL who understands how to make it work, I'm likely one of the few, and I would love to help.
I suppose the question is this: How do we revitalize the markets now? I think liquidity is the major issue, but I would like to hear what others think as well.
It seems like interest has waned in the market. I'm not entirely surprised, as most of the markets are rocked by scandal after scandal. New money coming in is kind of rare, as it seems that those who are involved with the markets currently are the only ones who would like to be involved. The lack of liquidity also frightens new investors, as the market value of securities is significantly more than the liquidation value (that is, if you sold all your shares as fast as you could) for almost every security, and even for modest amounts of shares.
For example, take SLR, the company I'm CFO for. (This is in no way a critique of my shareholders, but if I'm going to pick on a company, I might as well hit home.) Suppose I owned 10,000 shares of SLR right now. The market price shown on CapEx is L$6,500. However, if I actually tried to sell all 10,000 shares, I would receive (after commission) L$5,153.02, which is 79.3% of the displayed price. Make it 50,000 shares and I would only receive 12.9% of my displayed market value!!! And we're not talking vast sums of money here - 50,000 SLR shares at market is worth about $120 USD. Enough to care, but not enough to break most of us financially.
You can play this game with almost any stock on any market. There are exceptions, where management has taken care to set aside cash reserves to prevent this from happening, but by and large putting money into the market means you will need to take your time getting money out of the market.
I've heard the idea of market makers being tossed around before. For those of you who don't know, a market maker is a person/firm that makes money off the bid-ask spread in the market. They provide liquidity. However, from my previous actuarial exam (which I passed, by the way!), Modeling Financial Economics, market makers need options in order to protect themselves. There are techniques whereby market makers can insure themselves against large price changes, or even set themselves up to make money if the market doesn't move. However, these require options, which no exchange in SL has been willing to set up yet.
I suppose the question is this: How do we revitalize the markets now? I think liquidity is the major issue, but I would like to hear what others think as well.
Tuesday, June 10, 2008
Benevolent dictatorship
Noun: A dictatorship in which the leader has power only because the people choose to allow them to remain. This necessitates a wise use of power and generally prevents abuses since the benevolent dictator loses power if they are unsuitable. (From the Wiktionary)
Why this post? There is currently some debate going on here at Your2ndPlace and at the International Stock Exchange.
The debate seems to be "Bottom-Top Vs. Top-Bottom" management/regulation and according to someone the VSTEX has moved from the first to the second stance, effectively aligning with the WSE.
This post will be probably disappoint someone. It won't be a deep analysis of the pros and cons of both stances. Here I won't be trying to change anyone's mind. People have been arguing on issues since the human race was born. They'll still do after this post of mine.
First off, to me financial markets on Second Life could be related to the situation in the US before the Securities Act of 1933. You can translate that into "an unregulated situation" if you like. Since that Act, more steps were taken but we won't go over the whole process now.
Let's just say that in SL we lack a lot of things (when it comes to policies, regulations, governing bodies and applicable laws) that we can have in "real life".
When the VSTEX was started there was an optimistic view of a community wanting and willing to work together, in order to build a lively virtual stock exchange. That was the philosophy before I joined the VSTEX (which happened a few later of it going public) and I must admit I quite liked it.
It did not work that way though. Now one may say that we just changed our mind, that we woke up one day saying "To the hell with shareholders, we'll do what we want and so be it".
Over the time we found out (the hard way) that exchange users were of 2 kinds: educated and uneducated (with the latter group being apparently the majority). Educated users know what they do, they often know how to game the system, sometimes they are not so well intentioned and they may resort to practices that would be frowned upon in the real world (when those practices are not outright illegal).
Of course there is nothing wrong with educated users per se, on our exchange there is plenty of well intentioned, honest, educated users.
Maybe we failed to create the conditions to develop a thriving community capable of setting standards and rules. That's a possibility. At the beginning we were too new to have a significant amount of honest, well educated users. There were the WSE, the SLCAPEX, the ISE. Extablished, bigger markets.
It didn't take much time before we had to face the Jasper Tizzy issue. Everyone who's been following SL financial news for a while should know about it. That led us to the conclusion that extra steps had to be taken, steps that the community wasn't still asking for. Almost all the requests we got at that time were along the lines of "Where's my money, I want my money, give me back my money".
Following that, we had to take a decision (someone here may argue "You really had to?" to which I would answer "Hell, yes") because we really did not like the "The CEO has fled, there's no money left, the company is delisted. Have a nice day." attitude that was standard for other exchanges I believe, before WSE's WTF (World Traders Fund) was born.
That decision was, to look for someone willing to take over the company (actually, the name and the listing with us since no money was left behind by the old CEO), trying to revive it and turn disgruntled shareholders into happy ones. At that time we did not realize it, but it was the first step for top-bottom management and regulation. Nobody ever asked for that (maybe because it was so unusual?), yet we did it. In the aftermath of the AVC history, I can tell we opened a canning of worms. However, I don't regret that decision. None of us VSTEX managers does.
Since then there have been issues with other companies and while the rules we've been adding have been implemented without directly asking the investors or running polls, the investors (of course, some of them) themselves have been asking us via emails and support tickets to build up our rules and make our control on listed companies more tight.
I'll quote Konner McDonnell:
"Evolving. Changing. Remembering. Like I expect all virtual exchanges SHOULD."
And Cocky Dagger:
"Sometimes issues can be more complicated than they appear and I would say the obvious choice is not always the best choice. I actually started out early on with one belief and time and experience has caused me to do a 180 from where I was at."
We reckon that some sections of our website should be updated and that we may want to rethink our strategies and goals. I could go on for miles here, however I'll cut it short here. I'll just invite everyone to our General Discussion forum (a VSTEX account is needed to login update: now everyone can browse our forums). We're always open to discussion.
Why this post? There is currently some debate going on here at Your2ndPlace and at the International Stock Exchange.
The debate seems to be "Bottom-Top Vs. Top-Bottom" management/regulation and according to someone the VSTEX has moved from the first to the second stance, effectively aligning with the WSE.
This post will be probably disappoint someone. It won't be a deep analysis of the pros and cons of both stances. Here I won't be trying to change anyone's mind. People have been arguing on issues since the human race was born. They'll still do after this post of mine.
First off, to me financial markets on Second Life could be related to the situation in the US before the Securities Act of 1933. You can translate that into "an unregulated situation" if you like. Since that Act, more steps were taken but we won't go over the whole process now.
Let's just say that in SL we lack a lot of things (when it comes to policies, regulations, governing bodies and applicable laws) that we can have in "real life".
When the VSTEX was started there was an optimistic view of a community wanting and willing to work together, in order to build a lively virtual stock exchange. That was the philosophy before I joined the VSTEX (which happened a few later of it going public) and I must admit I quite liked it.
It did not work that way though. Now one may say that we just changed our mind, that we woke up one day saying "To the hell with shareholders, we'll do what we want and so be it".
Over the time we found out (the hard way) that exchange users were of 2 kinds: educated and uneducated (with the latter group being apparently the majority). Educated users know what they do, they often know how to game the system, sometimes they are not so well intentioned and they may resort to practices that would be frowned upon in the real world (when those practices are not outright illegal).
Of course there is nothing wrong with educated users per se, on our exchange there is plenty of well intentioned, honest, educated users.
Maybe we failed to create the conditions to develop a thriving community capable of setting standards and rules. That's a possibility. At the beginning we were too new to have a significant amount of honest, well educated users. There were the WSE, the SLCAPEX, the ISE. Extablished, bigger markets.
It didn't take much time before we had to face the Jasper Tizzy issue. Everyone who's been following SL financial news for a while should know about it. That led us to the conclusion that extra steps had to be taken, steps that the community wasn't still asking for. Almost all the requests we got at that time were along the lines of "Where's my money, I want my money, give me back my money".
Following that, we had to take a decision (someone here may argue "You really had to?" to which I would answer "Hell, yes") because we really did not like the "The CEO has fled, there's no money left, the company is delisted. Have a nice day." attitude that was standard for other exchanges I believe, before WSE's WTF (World Traders Fund) was born.
That decision was, to look for someone willing to take over the company (actually, the name and the listing with us since no money was left behind by the old CEO), trying to revive it and turn disgruntled shareholders into happy ones. At that time we did not realize it, but it was the first step for top-bottom management and regulation. Nobody ever asked for that (maybe because it was so unusual?), yet we did it. In the aftermath of the AVC history, I can tell we opened a canning of worms. However, I don't regret that decision. None of us VSTEX managers does.
Since then there have been issues with other companies and while the rules we've been adding have been implemented without directly asking the investors or running polls, the investors (of course, some of them) themselves have been asking us via emails and support tickets to build up our rules and make our control on listed companies more tight.
I'll quote Konner McDonnell:
"Evolving. Changing. Remembering. Like I expect all virtual exchanges SHOULD."
And Cocky Dagger:
"Sometimes issues can be more complicated than they appear and I would say the obvious choice is not always the best choice. I actually started out early on with one belief and time and experience has caused me to do a 180 from where I was at."
We reckon that some sections of our website should be updated and that we may want to rethink our strategies and goals. I could go on for miles here, however I'll cut it short here. I'll just invite everyone to our General Discussion forum (a VSTEX account is needed to login update: now everyone can browse our forums). We're always open to discussion.
Saturday, May 17, 2008
Options: Lesson 2
Guardian's Note: This is a continuation (though much overdue) of a previous post which I wrote awhile ago. Reading that post will likely be necessary for a good understanding of this one.
Now that you have a good intuitive understanding of what a call and put option on a stock are, and how to use them, let's think about how to price them.
When building a model for options pricing, there tend to be a set of convenient assumptions made to simplify the process. First, there are no transaction costs or taxes. Secondly, you can buy or sell as much of any stock/option without altering the price. Thirdly, volatility (we'll get to that later) will be known and constant. I think that's all I'll need for this lesson.
Certainly, the value of the option is determined by the value of the stock at some given point in time. If the option is European, then the only relevant value is the price at the end of the time period.
Suppose we have a stock at price S0 currently, and there is a European call option expiring at time 1 with strike price K = S0. Now, in this particular oversimplified world, the stock can only take on two values at time 1: Su and Sd, standing for an "up" movement and a "down" movement. Since the option is at strike K = S0, the option will pay (Su - S0) at Su and zero at Sd. We'll denote these values by Cu and Cd respectively (representing the value of the call at an up movement and the value of the call at a down movement).
The price of the option can then be calculated as
Where v is the present value factor to discount the payoff with interest back to time zero. We'll need an interest rate to do that, which we'll call r. We'll also need P(up movement) (the probability of an up movement) to calculate the price.
Through some mathemagic which I think I'll gloss over for now (but if you all want to see it, I'll happily spell it out), a probability which correctly calculates the price can be found using this formula:
Where r is the continuously compounded rate of return, d is the continuously compounded rate of dividend payments, h is the time period (in years), d is the multiplicative factor by which S can decrease over h, and u is the multiplicative factor by which S can increase over h.
There are also formulas for u and d, but if you need those I suggest reading this.
With all of that in place, there is now a formula for pricing a call option where the stock has only two movements, up or down. This model can be expanded to include more periods, use discrete dividends (say the stock pays $10 at time 0.75), handle American options, and do a variety of other nice tricks. However, the more important fact is that this is the backbone of the famed Black and Scholes model, which I will discuss in Lesson 3.
I hope you can see how this all gets very hairy mathematically very quickly. Some of the background I jumped over is done not by mathematical proof, but by economic logic, which may not sit well with some mathematicians. I have also tried to simplify a lot of this to be read by the general audience, whereas for the last four months I've been studying the specifics of this, and more complex models, extensively. If any of you readers are curious about this topic on a deeper level, feel free to post here, IM me in world, or email me at guardian.market@gmail.com. I can't guarantee I'll know the answer (it's a big world out there with options!) but I'll try to at least point you in the right direction.
Now that you have a good intuitive understanding of what a call and put option on a stock are, and how to use them, let's think about how to price them.
When building a model for options pricing, there tend to be a set of convenient assumptions made to simplify the process. First, there are no transaction costs or taxes. Secondly, you can buy or sell as much of any stock/option without altering the price. Thirdly, volatility (we'll get to that later) will be known and constant. I think that's all I'll need for this lesson.
Certainly, the value of the option is determined by the value of the stock at some given point in time. If the option is European, then the only relevant value is the price at the end of the time period.
Suppose we have a stock at price S0 currently, and there is a European call option expiring at time 1 with strike price K = S0. Now, in this particular oversimplified world, the stock can only take on two values at time 1: Su and Sd, standing for an "up" movement and a "down" movement. Since the option is at strike K = S0, the option will pay (Su - S0) at Su and zero at Sd. We'll denote these values by Cu and Cd respectively (representing the value of the call at an up movement and the value of the call at a down movement).
The price of the option can then be calculated as
Cu * P(up movement) * v
Where v is the present value factor to discount the payoff with interest back to time zero. We'll need an interest rate to do that, which we'll call r. We'll also need P(up movement) (the probability of an up movement) to calculate the price.
Through some mathemagic which I think I'll gloss over for now (but if you all want to see it, I'll happily spell it out), a probability which correctly calculates the price can be found using this formula:
P(up movement) = (e(r-d)*h-d)/(u-d)
Where r is the continuously compounded rate of return, d is the continuously compounded rate of dividend payments, h is the time period (in years), d is the multiplicative factor by which S can decrease over h, and u is the multiplicative factor by which S can increase over h.
There are also formulas for u and d, but if you need those I suggest reading this.
With all of that in place, there is now a formula for pricing a call option where the stock has only two movements, up or down. This model can be expanded to include more periods, use discrete dividends (say the stock pays $10 at time 0.75), handle American options, and do a variety of other nice tricks. However, the more important fact is that this is the backbone of the famed Black and Scholes model, which I will discuss in Lesson 3.
I hope you can see how this all gets very hairy mathematically very quickly. Some of the background I jumped over is done not by mathematical proof, but by economic logic, which may not sit well with some mathematicians. I have also tried to simplify a lot of this to be read by the general audience, whereas for the last four months I've been studying the specifics of this, and more complex models, extensively. If any of you readers are curious about this topic on a deeper level, feel free to post here, IM me in world, or email me at guardian.market@gmail.com. I can't guarantee I'll know the answer (it's a big world out there with options!) but I'll try to at least point you in the right direction.
Friday, May 2, 2008
My Lack of Posting
...has been due to studying for my next actuarial exam, Exam MFE (scroll down a little to the Financial Economics segment).
I'll be more active after the 15th.
My apologies for the lack of mathematical reading.
I'll be more active after the 15th.
My apologies for the lack of mathematical reading.
Wednesday, April 9, 2008
Mathematical Evangalism: The Monty Hall Problem
Every once in awhile, I have to go on a streak of public education for the betterment of society. The Monty Hall problem presents such an opportunity and just cause for such evangelism, as this non-intuitive probability problem routinely trips up even sharp-minded folk. So, I present to you a problem:
Suppose you're on a game show. You've made it to the final round, and there are three doors presented. Two of the doors have a goat behind them, meaning you win nothing, and the third holds a new car. Choose the door with the car, and you win that. You make your choice, and before revealing your choice, your host (Monty Hall, hence the name) opens one of the remaining two doors to reveal a goat. He then asks you if you'd like to switch. Is it advantageous to switch doors? What is your probability of winning if you do/do not switch?
...think about it...
...got an answer in mind yet?
The surprising answer is that switching gives you a 2/3 chance of winning. Most people guess 1/2 - there are two doors remaining, and one of them is right. However, let's think of this differently.
When you first choose, you have a 1/3 chance of getting the right door. Then, an incorrect door is revealed. If you were originally right and you switch, you're now wrong. But if you were originally wrong and you now switch, you're right. Because you had an initial chance of 2/3 of being wrong, by switching you now have a 2/3 chance of being right, hence the answer.
Don't believe me? Play a few rounds online and convince yourself.
Suppose you're on a game show. You've made it to the final round, and there are three doors presented. Two of the doors have a goat behind them, meaning you win nothing, and the third holds a new car. Choose the door with the car, and you win that. You make your choice, and before revealing your choice, your host (Monty Hall, hence the name) opens one of the remaining two doors to reveal a goat. He then asks you if you'd like to switch. Is it advantageous to switch doors? What is your probability of winning if you do/do not switch?
...think about it...
...got an answer in mind yet?
The surprising answer is that switching gives you a 2/3 chance of winning. Most people guess 1/2 - there are two doors remaining, and one of them is right. However, let's think of this differently.
When you first choose, you have a 1/3 chance of getting the right door. Then, an incorrect door is revealed. If you were originally right and you switch, you're now wrong. But if you were originally wrong and you now switch, you're right. Because you had an initial chance of 2/3 of being wrong, by switching you now have a 2/3 chance of being right, hence the answer.
Don't believe me? Play a few rounds online and convince yourself.
Tuesday, April 8, 2008
Land Prices
Linden Labs announced recently that it would be dropping prices of land sales significantly. New islands, for example, will only cost USD$1,000, down from USD$1,675 as last I recall.
Talk about a way to piss off your most loyal supporters! Everyone currently holding land just took a major hit to their resale value, and my understanding was that land prices had been dropping anyway. While this will certainly encourage new growth, I think there will be a painful period of losses for existing (especially startup) businesses as well. As the new land is sold, those owners can price their rents lower and simply outbid the current ones still paying off their $1,675.
Linden Labs is obviously placing a bet on the elasticity of demand for land. Elasticity, for the uninitiated, is how much the quantity demanded of a good changes with respect to a price change. Some goods, like (some) electronics, are very elastic - small drops in price will produce large sales and vice versa. Other goods, like salt, aren't elastic at all ("inelastic") - you can double the price of salt, and people will still buy about as much as they did before. A few very rare goods, like gasoline, are inelastic in the short run and elastic in the long run...but I'm getting off-topic...
If the demand for new land is elastic, LL will see a large jump in sales for their drop in price. My guess is they're hoping this outweights (a) the amount of anger they're generating, and (b) the amount of extremists who go researching into OpenSim projects.
Let's see how the bet pays off.
Talk about a way to piss off your most loyal supporters! Everyone currently holding land just took a major hit to their resale value, and my understanding was that land prices had been dropping anyway. While this will certainly encourage new growth, I think there will be a painful period of losses for existing (especially startup) businesses as well. As the new land is sold, those owners can price their rents lower and simply outbid the current ones still paying off their $1,675.
Linden Labs is obviously placing a bet on the elasticity of demand for land. Elasticity, for the uninitiated, is how much the quantity demanded of a good changes with respect to a price change. Some goods, like (some) electronics, are very elastic - small drops in price will produce large sales and vice versa. Other goods, like salt, aren't elastic at all ("inelastic") - you can double the price of salt, and people will still buy about as much as they did before. A few very rare goods, like gasoline, are inelastic in the short run and elastic in the long run...but I'm getting off-topic...
If the demand for new land is elastic, LL will see a large jump in sales for their drop in price. My guess is they're hoping this outweights (a) the amount of anger they're generating, and (b) the amount of extremists who go researching into OpenSim projects.
Let's see how the bet pays off.
Monday, March 24, 2008
A Balance Sheet in Motion
By popular demand (both of you), I am going to do an elongated article on balance sheets, what they measure, and perhaps more importantly for my readers, how they change. This article will be pretty basic, and isn't likely to solve your specific reporting needs, but hopefully will give you a better understanding of how these crazy financial templates are supposed to work.
The first question I had when I heard the name "Balance Sheet" was, "well, what does it balance?" The answer is that it is a demonstration the accounting equation is in balance, hence the name. This all-important accounting equation is highly important, and is written as:
Every transaction that a business does affects this equation. Let me go through a few examples. In each of these cases, the amount of the transaction is not important, and so will be represented by x.
Case 1: You spend money on land
Land is an asset. Cash is an asset. Therefore, the equation changes by
Case 2: You take out a loan to buy land
Land is an asset. A loan is a liability.
Case 3: You sell some stock for cash.
Cash is an asset. Stock is an equity.
You'll notice that in all of these cases, the balance equation doesn't change. The x's always cancel out. This is important, because it keeps the equation in balance. The equation should never be out of balance - it indicates an error. This is one of the fastest ways to show if someone knows what they're doing with a balance sheet - if it doesn't balance, it's clearly wrong.
So, you might ask, if the balance equation never changes, how do I show that my business is growing or (hopefully not) shrinking? The answer comes with Retained Earnings (RE). Retained Earnings is an equity account and is basically equal to Net Income - Dividends Paid. Say, for example, that you make some profits and receive them in cash. Your balance equation changes by
You'll notice that even though the entire equation grew by x, the equation is still in balance.
The balance sheet shows the composition of your company, and RE is the mechanism through which the whole company grows or shrinks. There are other accounts which can do this as well, but RE is by far the most common.
I thought it might be instructive to give a series of examples of how a balance sheet for a fictional company might change over time. Therefore, I've developed a Google Document with different tabs, each tab showing a different step in this company's development. At each step, I will only list non-zero accounts, and will provide a proof that the balance equation is working. As a commentary, I'll also post step-by-step comments here that you can read along.
Spreadsheet Link
The first step is boring. A new company is born! However, this company is nothing more than an idea.
All accounts are zero, and the equation is an exciting 0 = 0 + 0. At least it works.
Step 2: The company issues 1,000,000 shares of stock and gets L$1,000,000 cash.
Equities increase and cash increases. Note that I'm not messing with Par Value for this example.
Step 3: The company buys a small plot of land for L$100,000 and builds a store on it for L$50,000.
Plant, Property, and Equipment is the store, but they had to pay cash for it so this decreases.
Step 4: The company pays a designer L$30,000 cash for the right to sell their designs in the store.
Since the company now has some inventory to sell, the company needs to record the cost of this inventory. Notice that inventory is not equal to the potential revenue from this product, but rather the cost in obtaining it.
Step 5: The company meets another designer and wants to buy their design for L$20,000. However, the company decides to wait and pay this designer at some point later, instead of right now. The designer is OK with this and gives the company the designs.
Now the company has a liability, called "Accounts Payable" because they will at some point have to pay this new designer. However, they also got inventory to sell in exchange for taking on this liability. Notice that this is the first point in this exercise where the company has actually changed value from their original L$1,000,000. This is because they are leveraging themselves using debt, which will eventually need to be paid back with another asset (probably cash). When this happens, the liability will disappear, along with the corresponding amount of cash to go with it.
Step 6: The company spends L$100,000 advertising their wonderful new business.
Marketing is not an asset. It is temporary, and thus is recorded on the income statement. However, we lost cash, and so we still have to make the balance equation work. In order to do this, imagine an income statement with just one entry on it: marketing expense of L$100,000. This would carry down through to net income, where it would then go to Retained Earnings! That's what's happening here. Because I'm doing this step-by-step this may seem a little strange, but this is what happens every day in business. It's just that the reporting periods clump groups of transactions into time periods, which are easier to understand.
Step 7: The company's advertising pays off! They get L$200,000 worth of sales!
Now Retained Earnings will increase by the revenue they received. Cash will also increase to balance this out.
Step 8: The company decides to pay off that second designer, now they they've sold some of his designs. They send him L$20,000.
Now the liability will go away and cash will decrease.
Step 9: The company issues a dividend for L$50,000 to its shareholders.
Dividends come out of Retained Earnings. The formula for RE is actually
Cash decreases, and so does RE.
Step 10: The company pays L$10,000 worth of tier payments on their land.
This costs cash, and tier payments are on the income statement, meaning they will come out of retained earnings. Therefore, cash and RE both decrease.
Notice how at every transaction, the balance equation is kept in balance. This is demonstrated on every step throughout this elongated example. If at any point the equation is out of balance, something funny is going on or a transaction hasn't been recorded properly, and so it's time to examine the process.
Now I know it's not practical to keep a running balance sheet for most SL businesses. However, I think that most CEOs should at least be aware of how the transactions they're doing affect the balance sheet.
I also know that there are a myriad of topics and situations I have not covered here. Some of these topics get rather involved and can have different meanings depending on what the management is intending. A great example of this is buying back stock. Although it's easy to see that cash decreases, what happens to balance it? Equities should decrease, but how? That's a tricky topic, one which I don't want to touch here.
And now, a word about my accounting partnership:
SLFR Group does not (in my mind) exist to force people who have the unfortunate circumstance of not understanding financial statements into paying for them. Rather, it is to aid in the preparation of these statements and to serve as a check for those who are unsure of their own abilities. I'm here to help, not harm.
iVentures (my partner in SLFR Group) and I are both familiar with the exchange reporting standards and would be happy to assist you in preparing your company's statements.
The first question I had when I heard the name "Balance Sheet" was, "well, what does it balance?" The answer is that it is a demonstration the accounting equation is in balance, hence the name. This all-important accounting equation is highly important, and is written as:
Assets = Liabilities + Equity
Every transaction that a business does affects this equation. Let me go through a few examples. In each of these cases, the amount of the transaction is not important, and so will be represented by x.
Case 1: You spend money on land
Land is an asset. Cash is an asset. Therefore, the equation changes by
Assets - x + x = Liabilities + Equity
Case 2: You take out a loan to buy land
Land is an asset. A loan is a liability.
Assets + x = Liabilities + x + Equity
Case 3: You sell some stock for cash.
Cash is an asset. Stock is an equity.
Assets + x = Liabilities + Equity + x
You'll notice that in all of these cases, the balance equation doesn't change. The x's always cancel out. This is important, because it keeps the equation in balance. The equation should never be out of balance - it indicates an error. This is one of the fastest ways to show if someone knows what they're doing with a balance sheet - if it doesn't balance, it's clearly wrong.
So, you might ask, if the balance equation never changes, how do I show that my business is growing or (hopefully not) shrinking? The answer comes with Retained Earnings (RE). Retained Earnings is an equity account and is basically equal to Net Income - Dividends Paid. Say, for example, that you make some profits and receive them in cash. Your balance equation changes by
Assets + x = Liabilities + Equity + x
You'll notice that even though the entire equation grew by x, the equation is still in balance.
The balance sheet shows the composition of your company, and RE is the mechanism through which the whole company grows or shrinks. There are other accounts which can do this as well, but RE is by far the most common.
I thought it might be instructive to give a series of examples of how a balance sheet for a fictional company might change over time. Therefore, I've developed a Google Document with different tabs, each tab showing a different step in this company's development. At each step, I will only list non-zero accounts, and will provide a proof that the balance equation is working. As a commentary, I'll also post step-by-step comments here that you can read along.
Spreadsheet Link
The first step is boring. A new company is born! However, this company is nothing more than an idea.
All accounts are zero, and the equation is an exciting 0 = 0 + 0. At least it works.
Step 2: The company issues 1,000,000 shares of stock and gets L$1,000,000 cash.
Equities increase and cash increases. Note that I'm not messing with Par Value for this example.
Step 3: The company buys a small plot of land for L$100,000 and builds a store on it for L$50,000.
Plant, Property, and Equipment is the store, but they had to pay cash for it so this decreases.
Step 4: The company pays a designer L$30,000 cash for the right to sell their designs in the store.
Since the company now has some inventory to sell, the company needs to record the cost of this inventory. Notice that inventory is not equal to the potential revenue from this product, but rather the cost in obtaining it.
Step 5: The company meets another designer and wants to buy their design for L$20,000. However, the company decides to wait and pay this designer at some point later, instead of right now. The designer is OK with this and gives the company the designs.
Now the company has a liability, called "Accounts Payable" because they will at some point have to pay this new designer. However, they also got inventory to sell in exchange for taking on this liability. Notice that this is the first point in this exercise where the company has actually changed value from their original L$1,000,000. This is because they are leveraging themselves using debt, which will eventually need to be paid back with another asset (probably cash). When this happens, the liability will disappear, along with the corresponding amount of cash to go with it.
Step 6: The company spends L$100,000 advertising their wonderful new business.
Marketing is not an asset. It is temporary, and thus is recorded on the income statement. However, we lost cash, and so we still have to make the balance equation work. In order to do this, imagine an income statement with just one entry on it: marketing expense of L$100,000. This would carry down through to net income, where it would then go to Retained Earnings! That's what's happening here. Because I'm doing this step-by-step this may seem a little strange, but this is what happens every day in business. It's just that the reporting periods clump groups of transactions into time periods, which are easier to understand.
Step 7: The company's advertising pays off! They get L$200,000 worth of sales!
Now Retained Earnings will increase by the revenue they received. Cash will also increase to balance this out.
Step 8: The company decides to pay off that second designer, now they they've sold some of his designs. They send him L$20,000.
Now the liability will go away and cash will decrease.
Step 9: The company issues a dividend for L$50,000 to its shareholders.
Dividends come out of Retained Earnings. The formula for RE is actually
Old Retained Earnings + Net Income - Dividends = New Retained Earnings
Cash decreases, and so does RE.
Step 10: The company pays L$10,000 worth of tier payments on their land.
This costs cash, and tier payments are on the income statement, meaning they will come out of retained earnings. Therefore, cash and RE both decrease.
Notice how at every transaction, the balance equation is kept in balance. This is demonstrated on every step throughout this elongated example. If at any point the equation is out of balance, something funny is going on or a transaction hasn't been recorded properly, and so it's time to examine the process.
Now I know it's not practical to keep a running balance sheet for most SL businesses. However, I think that most CEOs should at least be aware of how the transactions they're doing affect the balance sheet.
I also know that there are a myriad of topics and situations I have not covered here. Some of these topics get rather involved and can have different meanings depending on what the management is intending. A great example of this is buying back stock. Although it's easy to see that cash decreases, what happens to balance it? Equities should decrease, but how? That's a tricky topic, one which I don't want to touch here.
And now, a word about my accounting partnership:
SLFR Group does not (in my mind) exist to force people who have the unfortunate circumstance of not understanding financial statements into paying for them. Rather, it is to aid in the preparation of these statements and to serve as a check for those who are unsure of their own abilities. I'm here to help, not harm.
iVentures (my partner in SLFR Group) and I are both familiar with the exchange reporting standards and would be happy to assist you in preparing your company's statements.
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