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0x Protocol | # 0x (ZRX) Protocol: What It Meant and How It Worked
## What Was the 0x (ZRX) Protocol?
The 0x (zero x) protocol enabled the peer-to-peer exchange of assets on the Ethereum blockchain. It was launched in 2017 by ZeroEx Labs, an organization based in San Francisco. The protocol itself was not, by the developer's definition, a decentralized exchange; it allowed for the creation of decentralized exchanges that can be used in broad applications.
However, the Commodities and Futures Trading Commission disagreed—it shut down the 0x protocol in September 2023 for operating as an unregistered exchange, and its developers were fined $200,000.
### Key Takeaways
* The 0x protocol was an open protocol that enabled the peer-to-peer exchange of assets on the Ethereum blockchain.
* The 0x protocol was open source and managed by the 0x decentralized autonomous organization.
* The 0z protocol was shut down, and as of June 26, 2024, it is no longer maintained.
## The History of 0x (ZRX) Protocol
0x was founded by Will Warren and Amir Bandeali in 2017, who launched an initial coin offering in 2017. The ICO was a success, raising $24 million and another $85 million between two fundraising rounds between 2021 and 2022.
The secondary protocol was created on Ethereum to act as a settlement layer for trading ERC 20 tokens. ERC 20 tokens are fungible (exchangeable) tokens that follow the standards set by Ethereum Request for Comment 20.
In 2021, 0x launched the 0x Decentralized Autonomous Organization (DAO), the organization that would allow participants to govern the progress of the project.
But in September 2023, the Commodities and Futures Trading Commission filed and settled charges against ZeroEx, Inc, along with two other digital asset exchanges, Opyn, Inc, and Deridex. Charges included failing to register as a futures commission merchant, failing to register as a swap execution facility, and illegally offering leveraged and margined retail commodity transactions.
ZeroEx was ordered to pay $200,000 in fines and cease operating as an exchange. As of June 26, 2024, the project community was very small, and the 0x Project's Reddit page had been abandoned.
As of this writing, 0x (the ZRX token) had a market cap of $307.6 million and a 24-hour trading volume of $10.5 million. It had a circulating supply of 847.5 million ZRX.
## How the 0x (ZRX) Protocol Worked
The protocol set up a system of makers, takers, and relayers. Makers were the users who placed orders on the exchange proxy and waited for a match (providing liquidity). Takers placed orders that were immediately matched (removing liquidity). Relayers were network participants who maintained the order book, acting similarly to an exchange.
The 0x protocol’s message format was composed of a set of data fields that carried vital information, such as the digital asset or token to be traded, the price value of the transaction, the expiration time, and the defined identities of the transacting parties.
Smart contracts took care of the necessary business logic for generating, sending, receiving, and processing the data linked to the trading activity. ZRX was 0x’s native governance and staking token. ZRX owners had a say in how the protocol evolved, and token holders could also stake their tokens to earn ETH (the Ethereum token ether) liquidity rewards.
## The Future of 0x (ZRK)
0x's future is somewhat unclear, as its market cap and price have continued a general downward trend since its introduction. Having been shut down by regulators in 2023, the protocol and its few remaining fans don't have many options unless it transitions from exchange services or registered with the CFTC.
## What Is the 0x Protocol?
0x was a protocol for the Ethereum blockchain. It facilitated peer-to-peer exchanges of assets built using Ethereum. The project was shut down by the CFTC for operating as an unregistered exchange and abandoned by its developers.
## What Is a 0x Exchange Proxy?
A 0x exchange proxy was an entity that allowed applications to be developed using the protocol.
## What Is the Price Prediction for 0x Protocol?
Although the project has been abandoned, there is still ZRX trading activity. However, as there is no active development, ZRX is likely to continue to decline in market value.
## The Bottom Line
The 0z protocol allowed users to exchange assets using the Ethereum blockchain. In 2023, the CFTC shut it down for operating as an unregistered exchange.
_The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our [warranty and liability disclaimer](https://www.google.com/url?q=https://www.investopedia.com/legal-4768893%23toc-warranty-and-liability-disclaimer&sa=D&source=editors&ust=1719413657792838&usg=AOvVaw0D_UGuH-JIbePg6j211pnx) for more info. As of the date this article was written, the author does not own ZRX._
> **Article Sources**
>
> 1. ICODrops. "[0x ZRX](https://icodrops.com/0x/)."
>
> 2. 0x Protocol. "[Introducing the 0x DAO](https://forum.0xprotocol.org/t/introducing-the-0x-dao/731)."
>
> 3. Commodities Futures Trading Commission. "[CFTC Issues Orders Against Operators of Three DeFi Protocols for Offering Illegal Digital Asset Derivatives Trading](https://www.cftc.gov/PressRoom/PressReleases/8774-23)."
>
> 4. Reddit. "[r|0xProject](https://www.reddit.com/r/0xProject/comments/1bdatc1/this_subreddit_not_actively_monitored_links_for/)."
>
> 5. 0xProtocol. "[Forum](https://forum.0xprotocol.org/)."
>
> 6. CoinMarketCap. "[0x Protocol (ZRX)](https://coinmarketcap.com/currencies/0x/)."
>
> 7. Github. "[0x Project | Whitepaper](https://github.com/0xProject/whitepaper/blob/master/0x_white_paper.pdf)," Page 6. |
1%/10 Net 30 | # What Does 1%/10 Net 30 Mean in a Bill’s Payment Terms?
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*— Paige McLaughlin / Investopedia*
> **Definition**
>
> The 1%/10 net 30 payment term offers a 1% discount to payees if they're willing to pay an invoice within the first 10 days of a 30-day payment period.
## What Is 1%/10 Net 30?
1%/10 net 30 is a payment term used to incentivize a payor to pay an invoice early to capture a [cash discount](https://www.investopedia.com/terms/c/cash-discount.asp) on purchases. This means that if the bill is paid within 10 days, a 1% discount will be applied to the purchase price. Otherwise, the full total amount is due within 30 days.
### Key Takeaways
* A 1%/10 net 30 deal contains two payment terms: a potential price discount for early payment and more general payment due terms.
* 1%/10 means a payee can take a 1% discount on services or products as long as they are paid within 10 days.
* At the same time, the payee must make payment on the invoice within 30 days, regardless whether they opt to make early payment or not.
* The cost of credit is used as a percentage and occurs when the buyer does not take the reduced cost, thus paying the higher cost, reflecting the discount loss.
* A vendor may offer incentives to pay early to accelerate the inflow of cash, which is especially important for businesses with no revolving lines of credit.
## Understanding 1%/10 Net 30
The 1%/10 net 30 calculation represents the [credit](https://www.investopedia.com/terms/c/credit.asp) terms and payment requirements outlined by a seller. The [vendor](https://www.investopedia.com/terms/v/vendor.asp) may offer incentives to pay early to accelerate the inflow of cash. This is particularly important for cash-strapped businesses or companies with no revolving [lines of credit](https://www.investopedia.com/terms/l/lineofcredit.asp). Companies with higher [profit margins](https://www.investopedia.com/terms/p/profitmargin.asp) are more likely to offer cash discounts.
Although the numbers are always interchangeable across vendors, the standard structure for offering a payment discount is the same. The first number will always be the percentage discount. This figure will indicate the total percentage discount on the invoice prior to shipping or taxes that may be discounted upon early payment.
## Special Considerations
Discount terms like 1%/10 net 30 are virtual [short-term loans](https://www.investopedia.com/terms/s/shorttermdebt.asp). This is because if the discount is not taken, the buyer must pay the higher price as opposed to paying a reduced cost. In effect, the difference between these two prices reflects the discount lost, which can be reported as a percentage. This percentage is called the cost of credit.
When the credit terms are 1%/10 net 30, the net result becomes, in essence, an [interest](https://www.investopedia.com/terms/i/interest.asp) charge of 18.2% upon the failure to take the discount.
> **Fast Fact**
>
> Companies with higher profit margins are more likely to offer cash discounts.
The [accounting](https://www.investopedia.com/terms/a/accounting.asp) entry for a cash discount taken may be performed in two ways.
The gross method of purchase discounts assumes the discount will not be taken and will only input the discount upon actual receipt of payment within the discount period. Therefore, the entire amount of receivable will be [debited](https://www.investopedia.com/terms/d/debit.asp). When payment is received, the receivable will be credited in the amount of the payment and the difference will be a credit to discounts taken.
The alternative method is called the net method. For a discount of 1%/10 net 30, it is assumed that the 1% discount will be taken. This results in a receivable being debited for 99% of the total cost.
## Example of 1%/10 Net 30
For example, if “$1,000 - 1%/10 net 30” is written on a bill, the buyer can take a 1% discount ($1,000 × 0.01 = $10) and make a payment of $990 within 10 days, or pay the entire $1,000 within 30 days.
> **Important**
>
> If the invoice is not paid within the discount period, no price reduction occurs, and the invoice must be paid within the stipulated number of days before late fees may be assessed.
The second number is always the number of days of the [discount period](https://www.investopedia.com/terms/d/discounting.asp). In the example above, the discount period is 10 days. Finally, the third number always reflects the invoice due date.
## What Does 1%/10 Net 30 Represent?
The 1%/10 net 30 calculation represents the credit terms and payment requirements outlined by a seller. The vendor may offer incentives to pay early to [accelerate the inflow of cash](https://www.investopedia.com/articles/personal-finance/061215/10-ways-improve-cash-flow.asp).
## Is 1%/10 Net 30 a Loan?
Yes. Discount terms like 1%/10 net 30 are virtual short-term loans. If the discount is not taken, the buyer must then pay the higher price as opposed to paying a reduced cost.
## What Do the Numbers in a 1%/10 Net 30-type Calculation Stand for?
The first number is always the percentage of the discount. The second number is always the number of days of the discount period. The third number always reflects the invoice due date.
## The Bottom Line
The 1%/10 net 30 calculation provides cash discounts on purchases. If the bill is paid within 10 days, there is a 1% discount. Otherwise, the total amount is due within 30 days. |
10-K | # 10-K: Definition, What's Included, Instructions, and Where to Find It
> **Definition**
>
> Form 10-K is a required annual filing where a company details its financial situation and circumstances for the prior year.
## What Is Form 10-K?
Form 10-K is an annual financial report that publicly-traded companies must file with the [U.S. Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp). Some of the data required in a 10-K includes the company's history, organizational structure, financial statements, earnings per share, subsidiaries, executive compensation, and other relevant data.
### Key Takeaways
* The 10-K is required by the U.S. Securities and Exchange Commission (SEC) and is far more detailed than the annual report.
* Information in the 10-K includes corporate history, financial statements, earnings per share, and any other relevant data.
* The 10-K is a useful tool for investors to make important decisions about their investments.
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*A company's Form 10-K can be found on the SEC's EDGAR database and on the company's investor relations website. — Investopedia / Yurle Villegas*
## Understanding Form 10-K
Because of the depth and nature of the information they contain, [10-Ks](https://www.investopedia.com/articles/fundamental-analysis/09/form-10k.asp) are fairly long and tend to be complicated. But [investors](https://www.investopedia.com/terms/i/investor.asp) need to understand that this is one of the most comprehensive and most important documents a public company can publish on a yearly basis. The more information they can gather from the 10-K, the more they can understand the company. Canadian companies will file [SEC Form 40-F](https://www.investopedia.com/terms/s/sec-form-40-f.asp) to provide this information.
The government requires companies to publish 10-K forms so investors have accurate information and can make informed investment decisions. This form gives a clearer picture of everything a company does and what kinds of risks it faces.
> **Important**
>
> Most companies publish their 10-Ks and other required filings on the Investor Relations section of their website. You can also find them using the company search function through the SEC's EDGAR database.
The 10-K includes five distinct sections:
* **Business**. This provides an overview of the company’s main operations, including its products and services (i.e., how it makes money).
* **Risk factors**. These outline any and all risks the company faces or may face in the future. The risks are typically listed in order of importance.
* **Selected financial data**. This section details specific financial information about the company over the last five years. This section presents more of a near-term view of the company’s recent performance.
* **Management’s discussion and analysis** of financial condition and results of operations. Also known as [MD&A](https://www.investopedia.com/terms/m/mdanalysis.asp), this gives the company an opportunity to explain its business results from the previous fiscal year. This section is where the company can tell its story in its own words.
* **Financial statements and supplementary data**. This includes the company’s audited financial statements including the income statement, [balance sheets](https://www.investopedia.com/terms/b/balancesheet.asp), and statement of cash flows. A letter from the company’s independent auditor certifying the scope of their review is also included in this section.
A 10-K filing also includes signed letters from the company’s chief executive officer and chief financial officer. In it, the executives swear under oath that the information included in the 10-K is accurate. These letters became required after several high-profile accounting fraud cases followed the dot-com bust.
## 10-K Filings and Deadlines
10-K filings are public information and readily available through a number of sources. In fact, the vast majority of companies include them in the [Investor Relations](https://www.investopedia.com/terms/i/investorrelations.asp) section of their website. The information included in a 10-K can be difficult to move through, but the more familiar investors become with the layout and the type of information included, the easier it is to identify the most important details.
Filing deadlines for the 10-K vary based on the size of the company. According to the SEC, companies with a public [float](https://www.investopedia.com/terms/f/float.asp)—shares issued to the public that are available to trade—of $700 million or more must file their 10-K within 60 days after the end of their fiscal year. Companies with a float between $75 million and $700 million have 75 days, while companies with less than $75 million in their float have 90 days.
## Purpose of Form 10-K
The primary purpose of filing a Form 10-K is to provide comprehensive, transparent information about how a company is doing. Because this information is useful to a variety of people, the SEC requires certain information to be presented in a certain way. At a very high level, it’s fair to say Form 10-K’s purpose can be broken down into the following five categories (which slightly overlap but are more high-level than the five categories listed above):
* **Transparency**: It offers [transparency](https://www.investopedia.com/terms/t/transparency.asp) into a company's financial health, including its financial statements, risks, and opportunities.
* **Disclosure**: It requires companies to disclose relevant information about their business operations, management, and financial condition, helping stakeholders make informed decisions.
* **Compliance**: It ensures [compliance](https://www.investopedia.com/terms/c/compliancedepartment.asp) with SEC regulations and provides a standardized format for reporting financial information, promoting consistency and comparability among companies.
* **Accountability**: It holds company management accountable to shareholders by providing a detailed overview of the company's performance and strategic direction.
* **Investor Confidence**: It helps build investor confidence by demonstrating the company's commitment to transparency and corporate governance practices.
> **Fast Fact**
>
> Form 10-K is prescribed by the 1934 Securities Exchange Act.
## Who Files Form 10-K
Form 10-K is required to be filed by all [publicly traded companies](https://www.investopedia.com/terms/p/publiccompany.asp) in the United States. This requirement applies to companies listed on U.S. stock exchanges such as the New York Stock Exchange. The SEC imposes this filing requirement to ensure transparency and accountability in the financial markets, allowing investors and other stakeholders to access relevant information about the company's operations, financial condition, and performance.
The filing of Form 10-K is not limited to [large corporations](https://www.investopedia.com/terms/l/large-cap.asp); it applies to companies of all sizes that meet the criteria for being publicly traded. This includes both domestic and foreign companies whose securities are listed on U.S. exchanges or are registered with the SEC. Additionally, certain smaller reporting companies may file a streamlined version of the Form 10-K, known as Form 10-KSB or Form 10-KT. Note that in order to file this alternative version, a company has to meet some eligibility requirements.
> **Fast Fact**
>
> Form 10-K is only used for U.S. companies trading on U.S. exchanges. If a foreign company lists its shares on a U.S. exchange, it files Form 20-F.
## Penalties for Form 10-K Noncompliance
There are penalties for not filing a Form 10-K on time. These penalties can vary depending on the severity of the violation and the circumstances surrounding the late filing. In most cases, companies pay a fee for non-compliance.
Failure to file required periodic reports can result in the loss of good standing with stock exchanges and other regulatory bodies. This could lead to delisting from stock exchanges or temporary suspensions of 10 [trading days](https://www.investopedia.com/ask/answers/06/stockexchangeclosed.asp). In addition, the SEC may take legal and regulatory actions against companies that repeatedly fail to meet filing deadlines or comply with disclosure requirements. These actions can include enforcement proceedings, investigations, fines, and sanctions against the company, its officers, directors, or other responsible parties.
On the softer side of the consequences, late or incomplete filings can erode investor confidence and trust in the company's management. Investors may perceive delayed filings as a red flag indicating potential financial problems, lack of transparency, or poor internal controls. There’s little reason for a Form 10-K to be filed late, and investors may (and probably should) be curious about the reasons behind any non-compliance.
## Limitations of Form 10-K
While Form 10-K reports a wealth of useful information, it does have its downsides. These limitations include but aren’t necessarily limited to:
* **Forward-Looking Statements**: Companies often include forward-looking statements in their Form 10-K, which are statements about future expectations, plans, or [financial projections](https://www.investopedia.com/ask/answers/difference-between-financial-forecasting-and-financial-modeling/). These statements are subject to various risks, uncertainties, and assumptions. They may be given in good faith, but this commentary may mislead investors as to what may actually happen.
* **Complexity and Length**: Form 10-K filings are long, complex documents. On one hand, that means it has a wealth of information. On the other hand, it’s easy to lose sight of important information that may get buried. Investors may find it challenging to navigate and interpret the vast amount of information provided in the Form 10-K.
* **Selective Disclosure**: The SEC requires certain information be given in a Form 10-K. However, companies may selectively disclose certain information or present it in a favorable light in their Form 10-K. This means they can control the narrative and potentially omit or downplay negative or unfavorable aspects of their business. Investors should critically evaluate the completeness and objectivity of the information provided.
* **Use of Estimates and Assumptions**: The financial statements and disclosures included in the Form 10-K may be based on management's estimates, assumptions, and judgments. After all, part of [GAAP reporting](https://www.investopedia.com/terms/g/gaap.asp) is based on accounting judgment and financial guesses. These estimates may be subjective and involve inherent uncertainties, meaning things may not always play out how the company is presenting them on the financial front.
* **Regulatory Compliance and Legal Risks**: Companies may face regulatory compliance issues, legal disputes, or other contingencies that are not fully disclosed or adequately addressed in the Form 10-K. This is because companies may choose to not disclose sensitive information, or they may be more defensive in having to disclose this type of information. Investors should consider the potential impact of regulatory and legal risks that may not be fully disclosed.
## Forms 10-Q vs. Form 8-K
Along with the 10-K, the SEC requires that public companies regularly file forms 10-Q and 8-K.
Form 10-Q must be submitted to the [SEC](https://www.investopedia.com/articles/fundamental-analysis/08/sec-forms.asp) on a quarterly basis. This form is a comprehensive report of a company's performance and includes relevant information about its financial position. Unlike the 10-K, the information in the 10-Q is usually unaudited. The company is only required to file it three times a year as the 10-K is filed in the fourth quarter.
Form 8-K is required by the SEC whenever companies announce major events that shareholders should be aware of. These events may include (but aren't limited to) sales, acquisitions, delistings, departures, and elections of executives, as well as changes in a company's status or control, bankruptcies, information about operations, assets, and any other relevant news.
## Form 10-K vs. Annual Report
The Form 10-K and the [annual report](https://www.investopedia.com/terms/a/annualreport.asp) serve distinct purposes and cater to different audiences. The Form 10-K is a regulatory filing mandated by the SEC. On the other hand, the annual report represents a broader communication tool utilized by companies to engage with a wider range of stakeholders. While it often includes Form 10-K as its core financial and regulatory component, the annual report also incorporates additional elements such as narrative descriptions, graphics, photos, and other visually appealing features.
These elements aim to provide a more reader-friendly and engaging format for shareholders, employees, customers, and other stakeholders. For example, companies may have high-quality photographs or graphic designs as part of the introduction to their annual report. The intention is to make the annual report visually attractive to entice readership; Form 10-K is not meant to look nearly as pretty.
Unlike the Form 10-K, which is subject to specific regulatory requirements and accounting standards, the annual report is not bound by such constraints. Instead, it allows companies greater flexibility in crafting a narrative that aligns with their objectives and corporate identity. Through the annual report, companies seek to showcase their accomplishments, [company values](https://www.investopedia.com/terms/m/missionstatement.asp), and vision to stakeholders. In many ways, it’s fair to call an annual report a marketing and communication tool, whereas the Form 10-K is much more of a regulatory compliance document.
## Explain Like I'm Five
If a company wants to sell its stock to the public, it must make certain disclosures and filings so that investors have accurate information and can decide if it's a good investment. One of those filings is SEC Form 10-K, which companies must file every year.
Form 10-K describes the company's business model and possible risk factors. It also describes the company's financial condition, including its debts, liabilities, operational costs, and revenue.
The company's executives must also make a sworn statement that the information in the 10-K is accurate. If they are wrong, they can face penalties.
## What Is Form 10-K?
Form 10-K is a comprehensive annual report filed by publicly traded companies with the U.S. SEC. It provides a detailed summary of the company's financial performance. This form is required by the SEC to ensure transparency and provide investors with essential information to make informed decisions.
## When Is Form 10-K Due?
The due date for Form 10-K depends on the size of the company. Large accelerated filers must file within 60 days after the end of their fiscal year. Other companies with smaller float may file within 75 days or 90 days after their fiscal year.
## Where Can I Find a Company's Form 10-K?
A company's Form 10-K can be found on the SEC's EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database, which is accessible to the public online. Additionally, companies often provide links to their 10-K filings on their investor relations websites.
## How Do I Read a Form 10-K?
Reading a Form 10-K involves understanding its structure and the significance of its various sections. Start with the business overview to get a sense of what the company does. Then, review the risk factors to understand potential challenges. Move onto the MD&A for insights into management’s perspective on financial results, then review the actual financial numbers to understand actual company performance.
## The Bottom Line
Form 10-K is an annual comprehensive report filed by publicly traded companies with the SEC, detailing their financial performance and business operations. It includes audited financial statements, management's discussion and analysis, risk factors, and other important disclosures. This document provides investors and stakeholders with crucial information to assess the company's financial health and is required by regulatory bodies.
> **Article Sources**
>
> 1. Securities and Exchange Commission. "[Using EDGAR to Research Investments](https://www.investor.gov/introduction-investing/getting-started/researching-investments/using-edgar-research-investments)."
>
> 2. Securities and Exchange Commission. "[How to Read a 10-K](https://www.investor.gov/introduction-investing/getting-started/researching-investments/how-read-10-k)."
>
> 3. Securities and Exchange Commission. "[How to Read a 10-K/10-Q](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/how-read)."
>
> 4. Securities and Exchange Commission. "[Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002](https://www.sec.gov/news/testimony/090903tswhd.htm)."
>
> 5. Securities and Exchange Commission. "[Form 10-K](https://www.investor.gov/introduction-investing/investing-basics/glossary/form-10-k )."
>
> 6. New York Stock Exchange. "[NYSE Regulation](https://www.nyse.com/publicdocs/nyse/markets/nyse/NYSE_2024_Annual_Guidance_Letter.pdf)."
>
> 7. Securities and Exchange Commission. "[General Instructions](https://www.sec.gov/files/form10-k.pdf)."
>
> 8. Securities and Exchange Commission. "[Form 10-KSB](https://www.sec.gov/Archives/edgar/data/96699/000092701602006084/d10ksb.htm)."
>
> 9. Securities and Exchange Commission. "[SEC Charges Five Companies for Failure to Disclose Complete Information On Form NT](https://www.sec.gov/enforce/34-98192-s)."
>
> 10. Securities and Exchange Commission. "[Investor Bulletin: Delinquent Filings](https://www.sec.gov/investor/alerts/ib-delinquent-filers)."
>
> 11. NASDAQ. "[Rules](https://listingcenter.nasdaq.com/rulebook/nasdaq/rules/nasdaq-5200-series)."
>
> 12. Securities and Exchange Commission. "[Form 10-Q](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/how-read)."
>
> 13. Securities and Exchange Commission. "[Form 8-K](https://www.sec.gov/fast-answers/answersform8khtm.html)." |
Value Reporting Form | # SEC Form 10-Q: Definition, Deadlines for Filing, and Components
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*— Investopedia / Michela Buttignol*
## What Is SEC Form 10-Q?
SEC Form 10-Q is a comprehensive unaudited report of financial performance that must be submitted quarterly by all public companies to the [Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp). It stands in contrast to SEC Form 10-K, which is required to be filed annually and is audited.
In the 10-Q, firms are required to disclose relevant information regarding their finances related to their business operations. A 10-Q must be filed for each of the first three quarters of the company's fiscal year.
### Key Takeaways
* SEC Form 10-Q is a comprehensive quarterly report of financial performance submitted by all public companies to the SEC.
* Form 10-Q contains financial statements, management discussion and analysis, disclosures, and internal controls for the previous quarter.
* Companies must file their 10-Qs 40 or 45 days after the end of their quarters, depending on the size of their public float.
* A snapshot of a company's financial position, Form 10-Q provides investors with information they can compare to previous periods and use to evaluate the outlook for the stock's performance.
* Form 10-Q is not an audited statement, unlike the annual Form 10-K that companies are also required to file.
> **Important**
>
> While 10-K reports are due annually and must include audited financial statements, 10-Q reports are due quarterly and are generally unaudited financial statements.
## Understanding SEC Form 10-Q
Federal securities laws mandate that publicly traded companies provide certain information to shareholders and the general public. These [disclosures](https://www.investopedia.com/terms/d/disclosure.asp) may occur periodically or as specific events occur.
A company utilizes Form 10-Q—one of many required by the SEC—upon the completion of each quarter to release unaudited financial statements and give an overview of the company’s financial situation.
The exact filing dates depend on the organization’s fiscal year, but it is necessary to file three 10-Q reports each year. A 10-Q for the final quarter of the year is not required: A company files Form 10-K, an annual report, instead. This report, unlike the 10-Q, is audited and tends to contain more details.
### Note
A company's Form 10-Q is public information. Anyone who wishes to examine a company's quarterly report can go to the SEC's [EDGAR database](https://www.sec.gov/edgar/searchedgar/companysearch). You can search by company name, ticker symbol, or SEC Central Index Key (CIK). Many companies also post their 10-Qs on their websites, in an "Investor Relations" section.
## SEC Form 10-Q Filing Deadlines
The deadline for filing a 10-Q varies and depends on the number of outstanding shares a company has.
A company filing a 10-Q is classified in one of three categories. Its category is determined by its public [float](https://www.investopedia.com/terms/f/float.asp)—that is, the portion of outstanding stock that is in the hands of the public, and not held by officers, owners, or the government. Essentially, the float is comprised of all of a company’s freely traded common stock shares.
The largest companies are classified as large accelerated filers. To fit this classification, an organization must have at least $700 million in public float. Large accelerated filers have 40 days after the close of the quarter to file a 10-Q.
Accelerated filers are companies with at least $75 million in public float but less than $700 million. They also have 40 days to file the 10-Q (they have a little more time to file the 10-K).
Finally, non-accelerated filers are companies with less than $75 million of public float. These companies have 45 days from the end of the quarter to file a 10-Q.
## Failure to Meet the Form 10-Q Filing Deadline
When a company fails to file a 10-Q by the filing deadline, it must make a non-timely (NT) filing of SEC Form [NT 10-Q](https://www.investopedia.com/terms/s/sec-form-nt-10-q.asp).
An NT filing must explain why the deadline has not been met. It includes a request for an additional five days to file.
As long as a company has a reasonable explanation, the SEC allows late filings within a specified time period. Common reasons why companies are not able to file on time include [mergers and acquisitions (M&A)](https://www.investopedia.com/terms/m/mergersandacquisitions.asp), corporate litigation, an ongoing review by corporate auditors, or lingering effects from bankruptcy.
A 10-Q filing is considered timely if it is filed within this extension period. Failure to comply with this extended deadline results in consequences, including the potential loss of the SEC registration, removal from stock exchanges, and legal ramifications.
## Components of SEC Form 10-Q
There are two parts to a 10-Q filing. The first part contains relevant financial information covering the period. This includes condensed financial statements, [management discussion](https://www.investopedia.com/sec-filings-as-a-news-source-11775623), analysis of the financial condition of the entity, disclosures regarding [market risk](https://www.investopedia.com/terms/m/marketrisk.asp), and internal controls.
The second part contains all other pertinent information. This includes legal proceedings, unregistered sales of equity securities, the use of proceeds from the sale of unregistered sales of equity securities, and defaults upon senior securities. The company discloses any other information—and includes exhibits—in this section.
### Note
Form 10-Q, and the requirement for filing it, was established by the [Securities and Exchange Act of 1934](https://www.investopedia.com/terms/s/seact1934.asp). The aim was to promote transparency in public companies' operations by providing investors with the financial position of companies on an ongoing basis.
## Importance of SEC Form 10-Q
The 10-Q provides a window into the financial health of a company. Investors can use the form to get a sense of its quarterly earnings and other elements of its operations and to compare them to previous quarters. Thus, it is a dependable performance-tracking tool.
Some areas of interest to investors that are commonly visible in the 10-Q include changes to working capital and/or accounts receivables, factors affecting a company's inventory, share buybacks, and even any legal risks that a company faces.
You can compare a close competitor's 10-Q to that of a company in which you are invested, or considering whether to invest, to see how its performance stacks up. This will give you an idea of whether it's a strong choice, where its weaknesses are, and how it could improve.
## Other Important SEC Filings
The 10-Q is one of many reports that public companies are required to file with the SEC. Other important and mandated filings include:
**[Form 10-K](https://www.investopedia.com/terms/1/10-k.asp):** The 10-K must be filed once per year and includes the final quarter of the company's performance (replacing a fourth-quarter 10-Q). The 10-K summarizes the year, often contains more detailed information than an annual report, and must be filed within 90 days of the end of a company's fiscal year. It generally includes a summary of the company's operations, management's financial outlook, financial statements, and any legal or administrative issues involving the company.
[**Form 8-K**](https://www.investopedia.com/terms/1/8-k.asp): This report is filed if there are any changes or developments to a business that didn't make the 10-Q or 10-K reports. The 8-K is considered an unscheduled document and may contain information such as press releases. If a company disposes of or acquires assets, has announcements of executive hiring or departures, or goes into receivership, this information is filed with an 8-K.
**[Annual report](https://www.investopedia.com/terms/a/annualreport.asp):** A company's annual report is filed every year, and contains a wealth of company news including—but not limited to—general information about the company, a letter to shareholders from the CEO, financial statements, and an auditors report. This report is submitted a few months after the end of a company's fiscal year. The report is available through a company's website or investor relations team, and can also be obtained from the SEC.
## Are Public Companies Required to File Form 10-Q?
Yes, all U. S. public companies issuing common shares of stock that trade on exchanges are required to file Form 10-Q. The date by which they have to file varies according to the number of shares, expressed in terms of dollar worth, that they have outstanding.
## Who Signs Form 10-Q?
According to the SEC, "At least one complete copy of the report filed with the Commission and one such copy filed with each exchange must be manually signed on the registrant’s behalf by a duly authorized officer of the registrant and by the principal financial or chief accounting officer of the registrant." More information is available in the instructions for Form 10-Q.
## Must Review Reports Accompany Financial Statements in a 10-Q?
10-Qs generally are not audited or accompanied by accountants' reports. SEC regulations prohibit companies from making materially false or misleading statements or omitting material information to make disclosures not misleading. The SEC staff reviews 10-Qs and may provide comments to a company where disclosures appear to be inconsistent with the disclosure requirements or deficient in explanation or clarity.
## The Bottom Line
SEC Form 10-Q is a report filed by public companies and sent to the SEC after the close of each of the first three quarters of every year. The final quarter is covered by SEC Form 10-K, an annual report.
Form 10-Q can be a valuable research tool for investors because it contains a substantial amount of financial data about a company's quarterly performance, as well as information regarding business operations, management discussions, pertinent market risks, and disclosures.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[How to Read a 10-K/10-Q](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/how-read)."
>
> 2. U.S. Securities and Exchange Commission, Investor.org. "[Form 10-K](https://www.investor.gov/introduction-investing/investing-basics/glossary/form-10-k)."
>
> 3. U.S. Securities and Exchange Commission, Investor.gov. "[Form 10-Q](https://www.investor.gov/introduction-investing/investing-basics/glossary/form-10-q)."
>
> 4. U.S. Securities and Exchange Commission. "[Form 12b-25: Notification of Late Filing](https://www.sec.gov/files/form12b-25.pdf)."
>
> 5. U.S. Securities and Exchange Commission. "[Form 12b-25: Notification of Late Filing](https://www.sec.gov/files/form12b-25.pdf)." Page 2.
>
> 6. U.S. Securities and Exchange Commission. "[Form 10-Q General Instructions](https://www.sec.gov/files/form10-q.pdf)."
>
> 7. U.S. Securities and Exchange Commission. "[Form 10-Q, General Instructions](https://www.sec.gov/files/form10-q.pdf)."
>
> 8. U.S. Securities and Exchange Commission. "[Fast Answers: How to Read a 10-K/10-Q](https://www.sec.gov/fast-answers/answersreada10khtm.html)." |
10-K Wrap: What It Is, How It Works, Elements | # 10-K Wrap: What It Is, How It Works, Elements
> **Definition**
>
> A 10-K wrap is a summary report that combines the performance data from a 10-K report with additional commentary, such as a letter to shareholders and corporate vision statement.
## What Is a 10-K Wrap?
A 10-K wrap is a summary report of a company's annual performance that bundles the [10-K](https://www.investopedia.com/terms/1/10-k.asp) report required by the [Securities and Exchange Commission](https://www.investopedia.com/terms/s/sec.asp) (SEC) with additional commentary from the company, covering such things as the corporate vision, letter to shareholders, and business overview, among other topics.
The 10-K wrap is often released instead of a traditional annual report and generally contains fewer images and comments from management.
### Key Takeaways
* A 10-K wrap is part of a larger annual performance document required by the SEC.
* The "wrap" is a short commentary covering the more personal side of the business, and usually includes a letter to the shareholders and a corporate vision statement.
* The 10-K wrap report is shorter than a company's annual report.
* While a 10-K wrap (typically) has a lower-value production budget with limited graphics, its cover may be extremely polished by comparison.
* The basic sections of a 10-K wrap summarize the company's financial status, plus an overview of the company's financial plans for upcoming quarters.
* Usually, a 10-K wrap provides debt and spending level forecasts, as well.
## Understanding a 10-K Wrap
Form 10-K is a detailed annual report that is required to be submitted to the U.S. Securities and Exchange Commission (SEC). The filing provides a comprehensive summary of a company’s performance for the year. It is more detailed than the annual report that is sent to shareholders during the annual meeting to elect directors. SEC filing 10-K outlines the company’s history, equity, subsidiaries, organizational structure, audited financial statements, and other relevant information.
The most significant difference between the traditional annual report and the 10-K wrap is how the information is presented and how much additional information is included above the required 10-K information.
The traditional annual report has a greater focus on comments from the company, and the document includes more images and graphs to communicate performance, as well as a list of corporate objectives of the company.
By contrast, the 10-K wrap is essentially the 10-K filed with the SEC and some additional editorial from the company—but not nearly as much as the annual report. It usually has a lower production cost because it is often printed on lower-quality paper.
> **Fast Fact**
>
> The 10-K wrap is typically made available in print and digital formats to maximize access for shareholders, investors, and analysts.
## Elements of a 10-K Wrap
The basic elements of a 10-K wrap typically include a summary of the company's financial results for the previous year and an overview of its plans for upcoming quarters, including spending and debt level forecasts.
A 10-K plan can also include an elaborate cover design, with perhaps a theme that focuses on investors and analysts involved in the company's projects for the upcoming year.
Graphics in the 10-K wrap will usually provide a brief overview of the company's financials, including revenue, net profit, costs, income, and any highlights from the previous year. The graphics may also outline the company's geographical reach or other elements of growth.
> **Important**
>
> 10-K: Due Monday, April 18, 2022, for the fiscal year ended on Jan. 31, 2022.10-Q: Due Tuesday, May 10, 2022, for the quarterly period ended on March 31, 2022.
## Special Considerations
As the 10-K wrap has evolved, it has come to include more images and content, such as a shareholder letter and high-quality photographs. However, pictures will often be kept to a minimum.
The 10-K wrap document is usually no more than four pages long and could be even shorter, depending on what company executives want to see from the 10-K wrap report.
> **Article Sources**
>
> 1. Thomson Reuters Practical Law. "[Annual Report to Stockholders](https://content.next.westlaw.com/practical-law/document/I0f9fe720ef0811e28578f7ccc38dcbee/Annual-Report-to-Stockholders?viewType=FullText&transitionType=Default&contextData=%28sc.Default%29&firstPage=true)." |
10-Year Treasury Note | # 10-Year U.S. Treasury Note: What It Is and Investment Advantages
> **Definition**
>
> A 10-year U.S. Treasury note is a debt security issued by the U.S. and is a loan made by the investor to the government with a maturity of 10 years from the date it's issued.
## What Is a 10-Year Treasury Note?
The 10-year Treasury note is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate every six months and pays the face value to the holder at maturity. The U.S. government partially funds itself by issuing these notes.
### Key Takeaways
* Treasury notes (T-notes) have maturities of up to 10 years. These can be appropriate for long-term saving or investing.
* You don't necessarily have to hold 10-year T-notes for the entire duration. You can sell them at any time in the secondary market.
* The 10-year T-note is the most widely tracked government debt instrument in finance.
* T-note prices typically move in the opposite direction from major stock market indexes.
## How 10-Year Treasury Notes Work
The U.S. government issues three types of debt securities to fund its obligations: [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp), Treasury notes, and Treasury bonds. Bills, bonds, and notes are distinguished by their length of maturity.
Treasury bills (T-bills) have the shortest lengths of time to maturity—one year or less. The Treasury offers T-bills with maturities of four, eight, 13, 26, and 52 weeks. Treasury notes have maturities ranging from one to 10 years. Bonds are Treasury securities with maturities longer than 10 years.
Treasury notes and bonds pay interest at a fixed rate every six months to maturity. They're then redeemed at [par value](https://www.investopedia.com/terms/p/parvalue.asp). The Treasury repays the principal it borrowed.
T-bills are issued at discounts to par, and they don't have coupon payments. The interest on T-bills is the difference between the face value repaid at maturity and the purchase price.
## The 10-Year Note Yield As a Benchmark
The 10-year T-note is the most widely tracked government debt instrument. Its [yield](https://www.investopedia.com/terms/t/treasury-yield.asp) is frequently used as a benchmark for other interest rates, like mortgage and corporate debt. Commercial interest rates don't follow the 10-year yield, however.
The chart below shows the historical 10-year Treasury yield from March 2022 to April 2025. Since March 2022, the 10-year Treasury yield has seen a general upward trajectory, blotted with fluctuations. The upward trajectory is a result of the Federal Reserve increasing interest rates to curb the high [inflation](https://www.investopedia.com/articles/01/021401.asp) experienced after the COVID-19 pandemic.
The interest rate set by the Fed increased from a range of 0.25% and 0.50% in March 2022 to a range of 5.25% and 5.50% in July 2023, with rates only starting to slightly come down in September 2024.
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**
The yield of the 10-year note went from about 1.7% in March 2022 to a peak of 4.98% in October 2023. As of April 2025, the rate is about 4.4%.
The 10-year note is undoubtedly a highly significant benchmark for global financial markets. A rising yield indicates investor confidence in the economy but also suggests higher borrowing costs, potentially slowing economic growth. Conversely, a falling yield may signal economic uncertainty.
## What Impacts the 10-Year Treasury Yield?
Several factors influence the 10-year Treasury yield. It's directly affected by investor [confidence](https://www.investopedia.com/ask/answers/09/consumer-confidence-sentiment-difference.asp) in the markets. When investors are optimistic about the economy's health, they tend to invest in riskier assets, reducing demand for Treasury notes, causing a need to increase their yield.
Conversely, in times of economic uncertainty, investors often flock to the safety of Treasury notes, driving up their prices and lowering them.
Inflation is another major influence, as we have seen more recently. Higher inflation can decrease the real return on Treasury notes, causing yields to rise as investors demand higher returns to offset the erosion of buying power. Conversely, low inflation can lead to lower yields.
Lastly, the yield is also affected by monetary policy decisions by the Federal Reserve. For instance, when the Federal Reserve chooses to raise interest rates, yields on Treasury notes also tend to increase, reflecting the higher cost of borrowing.
## The Advantages of Investing in Treasury Notes
Fixed-income securities offer important portfolio [diversification](https://www.investopedia.com/terms/d/diversification.asp) benefits because their returns aren't correlated with the performance of stocks.
**T-Notes Are Safe**: Government debt and the 10-year Treasury note, in particular, are considered among the safest investments. Its price often (but not always) [moves inversely](https://www.investopedia.com/articles/fundamental-analysis/09/intermarket-relations.asp) to the trend of the major stock market indexes. Central banks tend to lower interest rates in a recession, which reduces the coupon rate on new Treasuries. This then makes older Treasury securities with higher coupon rates more desirable.
**T-Notes Are Partially Tax-Exempt**: Another advantage of investing in 10-year Treasury notes and other federal government securities is that the coupon payments are exempt from state and local income taxes. They're still taxable at the federal level, however.
**There's No Minimum Holding Term**: Investors can choose to hold Treasury notes until maturity or sell them early in the secondary market. There's no minimum holding term.
## The Disadvantages of Investing in Treasury Notes
Investing in Treasury notes, while considered safe, comes with drawbacks.
**Lower Rate of Return**: Treasury notes can yield less than riskier assets like equity investments or higher-yielding corporate bonds. This makes them potentially less profitable for investors than alternatives.
**Inflation Risks**: During periods of high inflation, fixed-interest payments from Treasury notes can lose purchasing power. If inflation outpaces the yield, the real return can turn negative. If you are holding longer-running notes, you need to ensure you understand how inflation will affect your investment.
**Interest Rate Risk**: An uptick in interest rates could lower the value of existing Treasury notes. This could result in capital losses should you liquidate your holdings before their maturity date.
### Advantages and Disadvantages of Investing in Treasury Notes
Advantages
* Low risk because of government backing
* Easy to buy and sell
* Partially free from state and local taxes
Disadvantages
* Lower yield compared with other investments
* Vulnerability to inflation
* Potential capital loss if sold before maturity
## How to Buy 10-Year Treasury Bonds
The [U.S. Treasury](https://www.investopedia.com/terms/u/ustreasury.asp) sells its notes, bonds, and bills through the TreasuryDirect website. Sales are done through competitive or non-competitive bidding with a minimum purchase of $100, with bidding increasing in $100 increments. Treasury securities can also be bought through a bank or broker.
## How Are T-Notes Issued?
All T-notes are issued electronically, so investors cannot obtain paper certificates. Series I Savings Bonds are the only Treasury securities still issued on paper, and they can only be bought on paper with tax refund proceeds.
## When Are T-Notes Issued?
The Treasury issues new T-notes of shorter maturities every month. However, new 10-year notes are only issued in February, May, August, and November. The Treasury sells additional 10-year notes from the most recent issue in what is known as "reopenings" in other months.
Reopened notes have the same maturity date and coupon interest rate as the original issue, but they have a different issue date and a purchase price that reflects subsequent changes in the market's interest rates.
## Can I Buy Treasury Bills From My Bank?
Yes, you can purchase Treasury bills from many banks, but you may end up paying additional expenses such as sales commissions and other transaction charges. Over time, these fees and expenses can eat into your returns.
## The Bottom Line
A 10-year Treasury note pays interest at a fixed rate twice a year and will pay its face value at maturity. They are issued by the U.S. government and provide low-risk investments, and they're generally tax-exempt at the state and local levels. T-notes can be a good choice for those who prefer not to roll the dice with more iffy investments.
> **Article Sources**
>
> 1. TreasuryDirect. "[Treasury Bills](https://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm)."
>
> 2. TreasuryDirect. "[Treasury Notes](https://www.treasurydirect.gov/indiv/products/prod_tnotes_glance.htm)."
>
> 3. TreasuryDirect. "[Treasury Bonds](https://www.treasurydirect.gov/marketable-securities/treasury-bonds/)."
>
> 4. Board of Governors of the Federal Reserve System. "[Open Market Operations](https://www.federalreserve.gov/monetarypolicy/openmarket.htm)."
>
> 5. St. Louis Fed, FRED Economic Data. "[Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis](https://fred.stlouisfed.org/series/DGS10)."
>
> 6. IRS. "[Topic No. 403, Interest Received](https://www.irs.gov/taxtopics/tc403#:~:text=Interest%20income%20from%20Treasury%20bills,state%20and%20local%20income%20taxes.)."
>
> 7. TreasuryDirect. "[Using Your Income Tax Refund to Buy Paper Savings Bonds](https://www.treasurydirect.gov/indiv/research/faq/faq_irstaxfeature.htm)." |
100% Equities Strategy | # 100% Equities Strategy: What it Means, How it Works
## What Is a 100% Equities Strategy?
A 100% equities strategy is a strategy commonly adopted by pooled funds, such as a [mutual fund](https://www.investopedia.com/terms/m/mutualfund.asp), that allocates all investable cash solely to stocks. Only equity securities are considered for investment, whether they be [listed](https://www.investopedia.com/terms/l/listed.asp) stocks, [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) stocks, or private equity shares.
### Key Takeaways
* A 100% equities strategy involves only long positions in stocks.
* Such a strategy is common among mutual funds that allocate all investable cash solely to stocks, forgoing higher-risk instruments such as derivatives or riskier strategies such as short selling.
* With 100% equity strategies, a portfolio's style can be further subdivided into capital appreciation, aggressive growth, growth, value, capitalization, and income, among others.
## Understanding a 100% Equities Strategy
100% equities strategies represent portfolios that only select investments from the equities (i.e., stocks) universe. 100% equity strategies are predominant in the market and encompass a large majority of offerings.
> **Tip**
>
> Generally, very few funds would be able to deploy all available capital to equity market investments without holding some cash and cash equivalents for transactions and operating activities.
In practice, many 100% equity strategies will have an investment objective or mandate to invest at least 80% in equities. The 80% threshold is a formality used in regulatory or registration documentation for the majority of equity funds in the marketplace, with many funds deploying anywhere from 90% to 100% to equities.
100% equity means that there will be no bonds or other asset classes. Furthermore, it implies that the portfolio would not make use of related products like equity [derivatives](https://www.investopedia.com/terms/d/derivative.asp), or employ riskier strategies such as [short selling](https://www.investopedia.com/terms/s/shortselling.asp) or buying on margin. Instead, 100% equities implies a more focused, traditional approach to equity investment.
## Special Considerations
Equities are generally considered a riskier asset class over alternatives such as [bonds](https://www.investopedia.com/terms/b/bond.asp), money market funds, and cash.
A well-diversified portfolio of all stocks can protect against individual company risk, or even sector risk, but market risks will still persist that can affect the equities asset class. Thus, both systemic and idiosyncratic risks are important considerations for aggressive equity investors. As a result, most financial advice recommends a portfolio that includes both equity and fixed-income (bond) components.
## 100% Equities Strategy Types
In the 100% equity strategy category, an investor will find a wide range of sub-classes to choose from, including those that focus on one (or a combination of) labels like capital appreciation, aggressive growth, growth, value, and income. Outlined below are some of the characteristics investors can expect from some of the most prominent 100% equity strategies.
### Growth
Growth investing is a style used by many aggressive equity investors who are comfortable with higher-risk investments and seek to take advantage of growing companies. The [Russell 3000 Growth Index](https://www.investopedia.com/terms/r/russell3000-growth.asp) is a broad market index that helps to represent the growth category.
Growth companies offer emerging technologies, new innovations, or a significant sector advantage that gives them above average expectations for revenue and earnings growth.
### Value
Value stocks are often known as long term core holdings for an investor’s portfolio. These equity funds will rely on fundamental analysis to identify stocks that are undervalued in comparison to their fundamental value.
Investment metrics for value investing often include [price-to-earnings](https://www.investopedia.com/terms/p/price-earningsratio.asp), [price-to-book](https://www.investopedia.com/terms/p/price-to-bookratio.asp), and [free cash flow](https://www.investopedia.com/terms/f/freecashflow.asp).
### Income
Income investing is also a top category for core long-term holdings in a portfolio. Income funds will invest in equities with a focus on current income. Income from equity investments is primarily focused on mature companies paying steady [dividend](https://www.investopedia.com/terms/d/dividend.asp) rates.
In the income category, [real estate investment trusts](https://www.investopedia.com/terms/r/reit.asp) and [master limited partnerships](https://www.investopedia.com/terms/m/mlp.asp) are two publicly traded stock categories with unique incorporation structures that require them to pay high levels of income to equity investors.
### Market Capitalization
[Capitalization](https://www.investopedia.com/terms/c/capitalization.asp) is a popular investing strategy for all equity portfolios. Generally, capitalization is broken down by large cap, mid cap, and small cap.
[Large-cap](https://www.investopedia.com/terms/l/large-cap.asp) companies can offer the lowest volatility as they have established businesses and steady earnings that pay dividends. [Small-cap](https://www.investopedia.com/terms/s/small-cap.asp) companies, on the other hand, are usually considered to have the highest risk since they are typically in the early stages of their development.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[Publicly Traded REITs](https://www.sec.gov/oiea/investor-alerts-bulletins/ib_reits.html)." Accessed Aug. 31, 2021.
>
> 2. U.S. Securities and Exchange Commission. "[Master Limited Partnerships—An Introduction](https://www.sec.gov/oiea/investor-alerts-bulletins/ib_mlpintro.html)." Accessed Aug. 31, 2021. |
1040 U.S. Individual Tax Return Form | # Form 1040: U.S. Individual Tax Return Definition, Types, and Use
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*— Investopedia / Mira Norian*
## What Is Form 1040: U.S. Individual Tax Return?
Individual taxpayers use Form 1040, a standard [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) form, to file their annual income tax returns. Form 1040 is divided into sections that let you report your taxable income for the year, as well as your deductions, in order to calculate how much you owe in taxes or receive as a refund.
### Key Takeaways
* Form 1040 is what individual taxpayers use to file their taxes with the IRS.
* The form determines if additional taxes are due or if the filer will receive a tax refund.
* Taxpayers must include personal information on Form 1040, such as name, address, Social Security number, and the number of dependents.
* A filer also needs to report wages, salary, taxable interest, capital gains, pensions, Social Security benefits, and other types of income.
* Taxpayers may need to file supplemental tax 1040 forms depending on their situation.
## Who Can File Form 1040: U.S. Individual Tax Return?
Form 1040 needs to be filed with the IRS by April 15 in most years. Everyone who earns income over a certain threshold must file an [income tax](https://www.investopedia.com/income-tax-4427722) return with the IRS. Keep in mind that businesses have different forms to report their profits.
If a United States citizen wants or needs to file a federal income tax return, they need to file Form 1040 or a variation of Form 1040 (see "Types of Form 1040," below). Who must file is dependent upon three general conditions.
First, the IRS requires individuals with certain levels of [gross income](https://www.investopedia.com/terms/g/grossincome.asp) to file taxes. This threshold varies based on the individual's filing status and age. The table below lists the income limits for individuals under 65 years old. Keep in mind that older taxpayers tend to have higher thresholds, and the threshold changes if neither, one, or both individuals in a marriage are 65 or older.
Second, children and dependents may not be required to file if they can be claimed as a dependent. In 2024, if the dependent's unearned income is greater than $1,300 ($1,350 in 2025) but under $13,000 ($13,500 in 2025); their earned income is greater than $14,600 ($15,000 in 2025); or gross income meets certain thresholds, the dependent must file their own Form 1040. These rules are slightly different for single dependents as opposed to dependents who are married.
Third, some specific situations require an individual to file Form 1040. Regardless of their income or dependency status, some of those situations include but are not limited to:
* You owe additional special taxes such as alternative minimum tax
* You receive [health savings account (HSA)](https://www.investopedia.com/terms/h/hsa.asp) or other health account distributions
* You had net earnings from self-employment of at least $400
* You met the income threshold limits for [wages earned from a church](https://www.investopedia.com/terms/p/parsonageallowance.asp)
## How to File Form 1040: U.S. Individual Tax Return
Form 1040 is available on the IRS website and has two pages that must be filled out. Form 1040 can be mailed in or e-filed. Tax filers are asked for their [filing status](https://www.investopedia.com/terms/f/filingstatus.asp) along with their personal information, such as their name, address, Social Security number (some information on one's spouse may also be needed), and the number of their dependents.
The form also asks whether the taxpayer wishes to contribute $3 to presidential campaign funds.
The 1040 income section asks the filer to report wages, salary, taxable interest, capital gains, pensions, Social Security benefits, and other types of income. Tax legislation enacted at the end of 2017 [eliminated many deductions](https://www.investopedia.com/tax-deductions-that-are-going-away-4582165), including unreimbursed employee expenses, tax-preparation fees, and the cost of moving for a job (except for military on active duty).
The form uses what the IRS terms a building block approach and allows taxpayers to add only the [schedules](https://www.investopedia.com/terms/t/taxschedule.asp) they need to their tax returns. Some individuals may need to file one or more of six supplemental schedules with their 1040 in addition to long-standing schedules for items like [business income](https://www.investopedia.com/terms/b/businessincome.asp) or loss.
This depends on whether they're claiming tax credits or owe additional taxes. Many individual taxpayers, however, only need to file a 1040 and no schedules_._
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*— IRS*
[IRS Form 1040](https://www.irs.gov/pub/irs-pdf/f1040.pdf)
## Types of Form 1040
Taxpayers in certain situations may need to file a different variant of the 1040 form instead of the standard version. Below are the options.
### Form 1040-NR
Certain [nonresident aliens](https://www.investopedia.com/terms/n/nonresidentalien.asp) or their representatives need to file this form, including:
* Those who are engaged in trade or business in the United States
* Representatives of a deceased person who would have had to file a Form 1040-NR
* Those who represent an [estate or trust](https://www.investopedia.com/tax-form-1041-estates-and-trusts-5211109) that had to file a 1040-NR
The IRS also produces the 1040-SS and 1040-PR. The 1040-SS is for residents of American Samoa, the CNMI, Guam, Puerto Rico, or the U.S. Virgin Islands who have net [self-employment](https://www.investopedia.com/terms/s/self-employed.asp) income and do not have to file Form 1040 with the U.S. Form 1040-PR is the Spanish-language equivalent of Form 1040-SS.
### Form 1040-ES
This form is used to determine and pay estimated quarterly taxes. The estimated tax applies to income that isn’t subject to withholding, which includes earnings from self-employment, interest, dividends, and rents. This may also include [unemployment](https://www.investopedia.com/terms/u/unemployment.asp) compensation, pension income, and the taxable portion of Social Security benefits.
### Form 1040-V
This is a statement accompanying a taxpayer's payment for any balance on the "Amount you owe" line of the 1040 or 1040-NR.
### Form 1040-X
If a filer makes a mistake or forgets to include information on any 1040 form, [Form 1040-X](https://www.investopedia.com/terms/f/form1040x.asp) is used for making changes to previously filed 1040s.
### Form 1040-SR
The IRS introduced a new 1040 form in 2019, [Form 1040-SR](https://www.investopedia.com/taxes/seniors-get-new-simplified-tax-form/), which is designed for taxpayers over the age of 65. Changes include a larger font, no shading (shaded sections can be hard to read), and a standard deduction chart that includes the extra standard deduction for taxpayers over 65. Taxpayers in this age bracket who fill out their taxes online won't see a difference, but those who do it on paper will.
## Standard Deductions on Form 1040
The 1040 income section asks taxpayers for their filing status. This determines the taxpayer's [standard deduction](https://www.investopedia.com/terms/s/standarddeduction.asp). The table below highlights the deductions for the 2024 and 2025 tax years. Keep in mind that you file 2024 taxes in 2025 and 2025 taxes in 2026.
An additional deduction may be taken by those [who are age 65 or older or blind](https://www.investopedia.com/terms/b/blind-taxpayer.asp). Just like the standard deduction, these figures are adjusted annually for inflation.
* Aged or blind: $1,550 in 2024 increased to $1,950 if the individual is also unmarried and not a surviving spouse. These amounts increase to $1,600 and $2,000, respectively, in 2025.
> **Important**
>
> The standard deduction cannot be taken by an estate or trust, an individual who is filing a short return due to a change in accounting periods, an individual who was a nonresident alien part of the tax year, or a married individual whose spouse is filing separately and itemizing.
## Additional Schedules
As noted above, Form 1040 uses a variety of additional schedules to help taxpayers report their tax obligations. The following schedules are used to compile financial information away from Form 1040 to later use with Form 1040 as the primary source of reporting.
### Schedule 1
Schedule 1 is used to report additional income or adjustments to income. This may include [alimony](https://www.investopedia.com/terms/a/alimony.asp), disposition proceeds from the sale of a business, educator expenses, health savings account (HSA) contributions, or unemployment compensation.
It's important to note that:
* Other Income from Schedule 1: This is reported on Line 8 of Form 1040
* Adjustments to Income from Schedule 1: This is reported on Line 10 of Form 1040
### Schedule 2
Schedule 2 is used to report additional taxes. One part of Schedule 2 reports alternative minimum tax and repayment of excess premium tax credits for insurance bought through [health insurance marketplaces](https://www.investopedia.com/terms/h/health-insurance-marketplace.asp).
Another part of Schedule 2 is used to report self-employment taxes, Medicare taxes, taxes on [individual retirement accounts (IRAs)](https://www.investopedia.com/terms/i/ira.asp), household employment taxes, and other taxes. These two parts from Schedule 2 are reported on Line 17 and Line 23 on Form 1040.
### Schedule 3
Schedule 3 is used to report additional tax credits and payments. These credits include dependent care expense credits, [residential energy credits](https://www.investopedia.com/terms/e/energy-tax-credit.asp), excess Social Security taxes previously remitted, and excess federal income taxes previously remitted.
Nonrefundable credits from Schedule 3 are reported on Line 20 of Form 1040, while refundable credits from Schedule 3 are reported on Line 31 of Form 1040.
### Schedule A (Itemized Deductions)
Schedule A is used to figure out a taxpayer's [itemized deduction](https://www.investopedia.com/terms/i/itemizeddeduction.asp). A taxpayer's federal income liability is most often minimized when choosing the larger of their standard deduction or itemized deduction.
The itemized deduction calculation includes medical expenses, dental expenses, certain taxes, certain interest assessments, theft losses, and other expenses. Any input from Schedule A is entered into Line 12a on Form 1040.
### Schedule B (Interest and Ordinary Dividends)
Schedule B is used for taxpayers who received greater than $1,500 of taxable interest or ordinary dividends. It is also used to report interest from a [seller-financed mortgage](https://www.investopedia.com/terms/s/seller-financing.asp), accrued interest from a bond, interest or ordinary dividends as a nominee, and other similar types of interest. Input from Schedule B is entered into Line 2b and Line 3b on Form 1040.
### Schedule C (Net Profit From Business)
Schedule C is used to report business income or loss. An activity qualifies as a business if the taxpayer is engaged in the activity for the primary purpose of producing income or profit. The activity is also considered a business as long as the taxpayer is involved in the activity with regularity and continuity. Profit from Schedule C is entered on Schedule 1, Line 3. It is also used on Schedule SE.
> **Tip**
>
> If your business was a sole proprietorship or qualified joint venture and you meet other criteria, you can report your business operations using Schedule C.
### Schedule D (Capital Gains and Losses)
Schedule D is used to report taxable income from the sale or exchange of a capital asset. This gain may have arisen from an exchange or an [involuntary conversion](https://www.investopedia.com/terms/i/involuntary-conversion.asp). Schedule D is also used to report capital gain distributions not otherwise reported on Form 1040 as well as nonbusiness bad debts. Input from Schedule D is entered on Form 1040, Line 7.
### Schedule E (Supplemental Income and Loss)
Schedule E is used to report various types of additional income or losses. This supplemental financial activity includes real estate rental income, [royalties](https://www.investopedia.com/terms/r/royalty.asp), partnerships, estates, trusts, and residual interests in real estate mortgage investment conduits. Supplemental income figures from Schedule E are reported on Form 1040 in the "Income" section.
### Schedule EIC (Earned Income Credit)
Schedule EIC is quite different from other tax schedules. The earned income credit is calculated separately from this schedule. However, Schedule EIC is used to substantiate the qualification of your qualifying children by remitting to the IRS your child's name, [Social Security number](https://www.investopedia.com/terms/s/ssn.asp), birth year, relationship to you, and residency status. Information from Schedule EIC is not directly input into Form 1040.
> **Warning**
>
> The Earned Income Credit is maximized if a taxpayer has at least three children. Therefore, Schedule EIC only asks for information on three children; additional forms for children numbering more than three are not required.
### Other Schedules
Other notable supplementary schedules to Form 1040 include:
* Schedule F is used to report profits or losses from farming operations.
* Schedule H is used to report [household employment](https://www.investopedia.com/terms/h/household-employee.asp) taxes if you paid cash wages to household employees and those wages were subject to various federal taxes.
* Schedule J is used to report farming or fishing trade income by averaging taxable income over the previous three years.
* Schedule R is used to report a credit for the elderly or disabled.
* Schedule SE is used to report the tax due on net earnings from self-employment.
* Schedule 8812 is used to report potentially refundable credits for qualifying children (or other dependents).
## What Is Form 1040 Used for?
Form 1040 is the primary tax form used by U.S. taxpayers to file their annual income tax returns. Taxpayers input their personal information and tax information onto the form, then submit the form to the IRS for review.
## Is Form 1040 the Same As a W-2?
Form 1040 is different from a W-2. A W-2 is a wage and tax statement that an employee receives from a company they worked for during the tax year. The information listed on the W-2 is used to fill out Form 1040.
## Where Can I Find Form 1040?
Form 1040 is not a tax statement or form that gets distributed to taxpayers. Unlike a W-2 or 1099 statement that is mailed by an employer or party you've contracted with, Form 1040 is available for download on the IRS website. Free IRS filing platforms such as Free File Fillable Forms will provide digital copies. Some public courthouses or federal buildings in your community may offer paper copies available for pickup.
## What Is the Difference Between a 1040 and a 1099?
Form 1040 and Form 1099 are different components of an individual's [tax return](https://www.investopedia.com/terms/t/taxreturn.asp). There are many different types of Form 1099, but this form is most commonly given to independent contractors to remit tax information relating to payments they received during the tax year. This information is used to complete Form 1040, as the financial records listed on Form 1099 are input into Form 1040.
## The Bottom Line
Form 1040 is the central part of tax filing for United States citizens. It is the tax form that all taxpayer financial statements eventually feed into and support tax schedules branch out of. Regardless of an individual's filing status or income, taxpayers who file taxes will complete some version of Form 1040.
> **Article Sources**
>
> 1. Internal Revenue Service. "[1040 (and 1040-SR) Instructions](https://www.irs.gov/pub/irs-pdf/i1040gi.pdf)," Pages 6, 8-9.
>
> 2. Internal Revenue Service. "[Topic No. 407, Business Income](https://www.irs.gov/taxtopics/tc407)."
>
> 3. Internal Revenue Service. "[Here's Who Needs to File a Tax Return in 2024](https://www.irs.gov/newsroom/heres-who-needs-to-file-a-tax-return-in-2024)."
>
> 4. Internal Revenue Service. "[Check If You Need to File a Tax Retur](https://www.irs.gov/individuals/check-if-you-need-to-file-a-tax-return)n."
>
> 5. Internal Revenue Service. "[Publication 501, Dependents, Standard Deduction, and Filing Information](https://www.irs.gov/publications/p501)."
>
> 6. Internal Revenue Service. "[Rev. Proc. 2024-40](https://www.irs.gov/pub/irs-drop/rp-24-40.pdf)," Pages 7, 12.
>
> 7. Internal Revenue Service. "[Rev. Proc. 2023-34](https://www.irs.gov/pub/irs-drop/rp-23-34.pdf)," Pages 7, 12.
>
> 8. Internal Revenue Service. "[Dependents](https://apps.irs.gov/app/vita/content/globalmedia/4491_dependency_exemptions.pdf)."
>
> 9. Internal Revenue Service. "[1040 (and 1040-SR) Instructions](https://www.irs.gov/pub/irs-pdf/i1040gi.pdf)," Page 11.
>
> 10. Internal Revenue Service. "[Form 1040](https://www.irs.gov/pub/irs-pdf/f1040.pdf)."
>
> 11. Internal Revenue Service. "[Moving Expenses to and From the United States](https://www.irs.gov/individuals/international-taxpayers/moving-expenses-to-and-from-the-united-states)."
>
> 12. Internal Revenue Service. "[Tax Reform Affects if and How Taxpayers Itemize Their Deductions](https://www.irs.gov/newsroom/tax-reform-affects-if-and-how-taxpayers-itemize-their-deductions)."
>
> 13. National Archives, Federal Register. "[Agency Information Collection Activities; Submission for OMB Review; Comment Request; U.S. Individual Income Tax Return](https://www.federalregister.gov/documents/2018/10/11/2018-22180/agency-information-collection-activities-submission-for-omb-review-comment-request-us-individual)."
>
> 14. Internal Revenue Service. "[About Form 1040-NR, U.S. Nonresident Alien Income Tax Return](https://www.irs.gov/forms-pubs/about-form-1040-nr)."
>
> 15. Internal Revenue Service. "[Individuals Living or Working in a U.S. Territory](https://www.irs.gov/individuals/international-taxpayers/individuals-living-or-working-in-us-possessions)."
>
> 16. Internal Revenue Service. "[About Form 1040-SS, U.S. Self-Employment Tax Return (Including the Additional Child Tax Credit for Bona Fide Residents of Puerto Rico)](https://www.irs.gov/forms-pubs/about-form-1040-ss)."
>
> 17. Internal Revenue Service. "[About Form 1040-ES, Estimated Tax for Individuals](https://www.irs.gov/forms-pubs/about-form-1040-es)."
>
> 18. Internal Revenue Service. "[Form 1040-V](https://www.irs.gov/pub/irs-pdf/f1040v.pdf)."
>
> 19. Internal Revenue Service. "[Instructions for Form 1040-X](https://www.irs.gov/instructions/i1040x)."
>
> 20. Internal Revenue Service. "[About Form 1040-SR, U.S. Tax Return for Seniors](https://www.irs.gov/forms-pubs/about-form-1040-sr)."
>
> 21. Internal Revenue Service. "[IRS Releases Tax Inflation Adjustments for Tax Year 2025](https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025)."
>
> 22. Internal Revenue Service. "[IRS Provides Tax Inflation Adjustments for Tax Year 2024](https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024)."
>
> 23. Internal Revenue Service. "[Rev. Proc. 2024-40](https://www.irs.gov/pub/irs-drop/rp-24-40.pdf)," Page 12.
>
> 24. Internal Revenue Service. "[Rev. Proc. 2023-34](https://www.irs.gov/pub/irs-drop/rp-23-34.pdf)," Page 12.
>
> 25. Internal Revenue Service. "[Topic No. 551, Standard Deduction](https://www.irs.gov/taxtopics/tc551)."
>
> 26. Internal Revenue Service. "[Schedule 1 (Form 1040)](https://www.irs.gov/pub/irs-pdf/f1040s1.pdf)."
>
> 27. Internal Revenue Service. "[Schedule 2 (Form 1040)](https://www.irs.gov/pub/irs-pdf/f1040s2.pdf)."
>
> 28. Internal Revenue Service. "[Schedule 3 (Form 1040)](https://www.irs.gov/pub/irs-pdf/f1040s3.pdf)."
>
> 29. Internal Revenue Service. "[2024 Instructions for Schedule A](https://www.irs.gov/instructions/i1040sca#idm139916261908048)."
>
> 30. Internal Revenue Service. "[About Schedule B (Form 1040), Interest and Ordinary Dividends](https://www.irs.gov/forms-pubs/about-schedule-b-form-1040)."
>
> 31. Internal Revenue Service. "[About Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship)](https://www.irs.gov/forms-pubs/about-schedule-c-form-1040)."
>
> 32. Internal Revenue Service. "[About Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship)](https://www.irs.gov/forms-pubs/about-schedule-c-form-1040)."
>
> 33. Internal Revenue Service. "[About Schedule D (Form 1040), Capital Gains and Losses](https://www.irs.gov/forms-pubs/about-schedule-d-form-1040)."
>
> 34. Internal Revenue Service. "[About Schedule E (Form 1040), Supplemental Income and Loss](https://www.irs.gov/forms-pubs/about-schedule-e-form-1040)."
>
> 35. Internal Revenue Services. "[Publication 596, Earned Income Credit (EIC)](https://www.irs.gov/publications/p596)."
>
> 36. Internal Revenue Service. "[About Schedule EIC (Form 1040 or 1040-SR), Earned Income Credit](https://www.irs.gov/forms-pubs/about-schedule-eic-form-1040)."
>
> 37. Internal Revenue Service. "[Earned Income Credit Qualifying Child Information](https://www.irs.gov/pub/irs-pdf/f1040sei.pdf)."
>
> 38. Internal Revenue Service. "[About Schedule F (Form 1040), Profit or Loss From Farming](https://www.irs.gov/forms-pubs/about-schedule-f-form-1040)."
>
> 39. Internal Revenue Service. "[About Schedule H (Form 1040), Household Employment Taxes](https://www.irs.gov/forms-pubs/about-schedule-h-form-1040)."
>
> 40. Internal Revenue Service. "[About Schedule J (Form 1040), Income Averaging for Farmers and Fisherman](https://www.irs.gov/forms-pubs/about-schedule-j-form-1040)."
>
> 41. Internal Revenue Service. "[About Schedule R (Form 1040), Credit for the Elderly or the Disabled](https://www.irs.gov/forms-pubs/about-schedule-r-form-1040)."
>
> 42. Internal Revenue Service. "[About Schedule SE (Form 1040), Self-Employment Tax](https://www.irs.gov/forms-pubs/about-schedule-se-form-1040)."
>
> 43. Internal Revenue Service. "[About Schedule 8812 (Form 1040), Credits for Qualifying Children and Other Dependents](https://www.irs.gov/forms-pubs/about-schedule-8812-form-1040)." |
1040A Form | # Form 1040-A: U.S. Individual Tax Return: Overview
## What Was Form 1040-A: U.S. Individual Tax Return?
Form 1040-A of the Internal Revenue Service (IRS) was a simplified version of Form 1040 used by U.S. taxpayers to file an annual income tax return. To have been eligible to use Form 1040-A, an individual needed to meet certain requirements such as not itemizing deductions, not owning a business, and having a taxable income of less than $100,000. Unofficially known as the "short form," Form 1040-A was eliminated for the 2018 tax year in favor of the redesigned Form 1040 that debuted that year.
### Key Takeaways
* Form 1040-A was a simplified version of Form 1040 used for filing individual income tax.
* Filers using 1040-A were required to have less than $100,000 in taxable income and not have exercised any incentive stock options during the year.
* The IRS eliminated Form 1040-A for the 2018 tax year in favor of the redesigned Form 1040.
* Another variant of Form 1040 was Form 1040-EZ, which was even simpler than Form 1040-A and was also eliminated starting with the 2018 tax filing.
## Who Had to File Form 1040-A: U.S. Individual Tax Return?
Most U.S. taxpayers use IRS [Form 1040](https://www.investopedia.com/terms/1/1040.asp) to file their [income tax returns](https://www.investopedia.com/terms/t/taxreturn.asp). Form 1040 is a detailed form that offers taxpayers with complex investments, [itemized deductions](https://www.investopedia.com/terms/i/itemizeddeduction.asp), multiple [tax credits](https://www.investopedia.com/terms/t/taxcredit.asp), and more than $100,000 in annual income more opportunities to lower their tax liability. Because additional paperwork is usually required with Form 1040, individuals with simpler tax situations previously had the option to use Form 1040-A instead.
Form 1040-A was a simplified version of Form 1040. The two-page form allowed taxpayers to report ordinary income, some deductions, and credits. Individuals who fell under any of the five status options—single, head of household, married filing separately, married filing jointly, or widowed—could file their tax returns using the 1040-A. Though Form 1040-A was available to taxpayers of any age and filing status, not everyone qualified to use this form.
Tax filers who used 1040-A must have earned less than $100,000 taxable income and not have exercised any [incentive stock options](https://www.investopedia.com/terms/i/iso.asp) (ISO) during the tax year. The income reported must have been earned as a wage, salary, tip, capital gain, dividend, interest income, unemployment compensation, pension, annuity, taxable Social Security and railroad retirement benefit, taxable scholarship or grant, and [Alaska Permanent Fund](https://www.investopedia.com/terms/a/alaska-permanent-fund.asp) dividend. Any other form of income, such as business income, needed to be reported on the more complex Form 1040.
## How Did Form 1040-A Work?
Form 1040-A also gave taxpayers the opportunity to claim several tax deductions to reduce their [taxable income](https://www.investopedia.com/terms/t/taxableincome.asp). However, the only deductions they could claim included student loan interest, post-secondary tuition and fees, classroom expenses, and individual retirement account (IRA) contributions. Taxpayers using Form 1040-A could not claim itemized deductions. This limitation meant that if an individual qualified for other deductions from sources such as [charitable donations](https://www.investopedia.com/terms/c/charitabledonation.asp) or [mortgage interest](https://www.investopedia.com/terms/home-mortgage-interest.asp), and the total itemized deductible amount was more than the standard deductions, it would not have been advantageous for them to use 1040-A.
Form 1040-A also could be used to claim tax credits. Tax credits reduce the bottom line or total tax bill of a taxpayer. The credits that could be claimed using this form were the [American Opportunity Tax Credit](https://www.investopedia.com/terms/a/american-opportunity-tax-credit.asp) (AOTC), [Earned Income Credit](https://www.investopedia.com/terms/e/earnedincomecredit.asp) (EITC), child tax and [additional child tax credit](https://www.investopedia.com/terms/a/additional-child-tax-credit.asp), [child and dependent care credit](https://www.investopedia.com/terms/c/childanddependentcarecredit.asp), credits for the elderly or disabled, and [retirement savings contribution credit](https://www.investopedia.com/terms/c/credit-for-qualified-retirement-savings-contribution.asp).
## Form 1040-A vs. Form 1040-EZ
Another variant of Form 1040 was [Form 1040-EZ](https://www.investopedia.com/terms/1/1040ez.asp), which was even simpler and easier to fill out than Form 1040-A and was also eliminated starting with the 2018 tax filing. But with Form 1040-EZ, the individual had to file as either a single taxpayer or as married filing jointly; they could not claim deductions and could only claim the EIC.
Although Form 1040-A was slightly more complex than Form 1040-EZ, it was still relatively simple compared to 1040. Once their financial situation became complicated with dependents, special deductions, and credits—such as those associated with post-secondary education tuition—most taxpayers needed to switch from filing with the 1040-EZ to the 1040-A.
The redesigned Form 1040 that debuted with the 2018 tax year is designed to be much simpler to use than its predecessor. For this reason, the IRS eliminated both Form 1040-A and Form 1040-EZ.
> **Article Sources**
>
> 1. Internal Revenue Service. "[1040-A Instructions (2017)](https://www.irs.gov/pub/irs-prior/i1040a--2017.pdf)," Pages 13 & 14. Accessed Feb. 9, 2021.
>
> 2. Internal Revenue Service. "[About Form 1040: U.S. Individual Income Tax Return](https://www.irs.gov/forms-pubs/about-form-1040)." Accessed Dec. 6, 2019.
>
> 3. Internal Revenue Service. "[Form 1040-A](https://www.irs.gov/pub/irs-prior/f1040a--2017.pdf)." Pages 1 & 2. Accessed Dec. 7, 2019.
>
> 4. Internal Revenue Service. "[Instructions for Form 1040EZ (2017)](https://www.irs.gov/pub/irs-prior/i1040ez--2017.pdf)," Page 6. Accessed Dec. 6, 2019.
>
> 5. Internal Revenue Service. "[Questions and Answers about the 2018 Form 1040](https://www.irs.gov/forms-pubs/questions-and-answers-about-the-2018-form-1040)." Accessed Dec. 6, 2019. |
1040EZ Form | # What Was Form 1040EZ, and Why Is It No Longer Used?
:max_bytes(150000):strip_icc()/tax-time-182487017-c9ec848855c44554a064bedb50e7f318-9b5ece6fb52c403395224e8193978c0e.jpg)
*— Kameleon007 / Getty Images*
> **Definition**
>
> Form 1040EZ, which is no longer used, was the shortest and most straightforward version of Form 1040.
## What Was Form 1040EZ: Income Tax Return for Single and Joint Filers with No Dependents?
IRS Form 1040EZ: Income Tax Return for Single and Joint Filers with No Dependents was the shortened version of the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) Form 1040. This form was for taxpayers with basic tax situations and offered a fast and easy way to file income taxes.
The form was discontinued as of the 2018 tax year in favor of the redesigned [Form 1040](https://www.investopedia.com/terms/1/1040.asp).
### Key Takeaways
* Form 1040EZ was a shortened version of Form 1040 for taxpayers with basic tax situations.
* The form was discontinued as of the 2018 tax year and replaced with the redesigned Form 1040.
* Form 1040EZ could only be used by people with no dependents who were younger than age 65 and earned less than $100,000 per year.
* 1040EZ was about one-fifth as long as the full 1040 form, with fewer deductions and tax credits.
## Eligibility for Form 1040EZ
To use the form, a taxpayer had to have taxable income of less than $100,000, less than $1,500 of interest income, and claim no dependents. Other requirements for filing the Form 1040EZ included:c
* The taxpayer and their spouse, if married filing jointly, had to be under age 65 at the end of the relevant filing period.
* They could not be [blind as of the end of the relevant filing period](https://www.investopedia.com/terms/b/blind-taxpayer.asp).
* The filer could take no deductions for student loan interest, educator expenses, tuition and fees, or itemized deductions.
* If the filer received interest income, they could not have been required to file Schedule B, didn’t have amounts in boxes 11, 12, or 13 of Form 1099-INT or boxes 6 and 10 of Form 1099-OID, and didn’t earn any interest as a nominee.
* Tax credits for retirement savings, health coverage, and education were not allowed.
* The tax filer could not have received any advance [earned income](https://www.investopedia.com/terms/e/earnedincome.asp) credit (EIC) although they would have been allowed to claim the EIC when filing Form 1040EZ.
* The filer could not be a debtor in any Chapter 11 [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp) case that was filed after October 16, 2005.
* The filer (and their spouse, if married filing jointly), didn’t receive any advance payments of the premium tax credit offered for health coverage plans sold on the Marketplace.
* The filer didn’t owe any household employee taxes on wages paid to household employees.
## Limitations of Form 1040EZ
Form 1040EZ was ultimately scrapped due to the limitations of the form. The IRS opted for the building block approach of allowing taxpayers to more easily add allowances or credits as applicable to their return. In addition, Form 1040EZ had several other drawbacks.
First, the form could only be used by those who earned less than a certain amount of income. The types of eligible income was also limited. Anyone who had income from sources other than wages, salaries, tips, taxable scholarships, or fellowship grants could not use Form 1040EZ. This precluded any taxpayer who received foreign income (or filed using a foreign address) from using the form. In addition, any taxpayer hoping to claim a dependent could also not use Form 1040EZ.
With Form 1040EZ, taxpayers were not allowed to itemize their deductions nor were they able to take other types of deductions, such as the student loan interest deduction or deductions for [individual retirement account (IRA)](https://www.investopedia.com/terms/i/ira.asp) contributions.
## Form 1040EZ vs. Form 1040
Form 1040EZ had only a few credits or [deductions](https://www.investopedia.com/terms/t/tax-deduction.asp) available to taxpayers. Filers were able to include an [earned income credit](https://www.investopedia.com/terms/e/earnedincomecredit.asp) and elect nontaxable combat pay.
For most tax years, Form 1040 had 80% more lines than form 1040EZ. One significant difference was that Form 1040 had fields to include information about dependents, while 1040EZ did not allow individuals to claim [dependents](https://www.investopedia.com/terms/d/dependent.asp). Similar to the standard form, the EZ version had sections to record wages, salaries and tips, and taxable interest under $1,500. The filer was also able to include unemployment compensation payments.
### 1982
The first year that Form 1040EZ was introduced.
Form 1040EZ allowed filers to claim income from wages, tips, salaries, taxable grants or scholarships, the Alaska Permanent Fund, and unemployment compensation.
Form 1040, in contrast, had at least 16 income categories. Categories available on the standard form included [dividend](https://www.investopedia.com/terms/d/dividend.asp) payments, retirement account distributions, and farm and rental income. Form 1040 also allowed the entry of [Social Security benefits](https://www.investopedia.com/terms/s/social-security-benefits.asp), alimony, and other forms of income. This form also had a long list of deductions, ranging from education costs to healthcare savings plan contributions.
## Transition Away From Form 1040EZ
In 2018, the IRS replaced Forms 1040A and 1040EZ with a redesigned Form 1040. This new Form 1040 included six new numbered schedules in addition to the existing ones like Schedule A. Many people may only need to file the simplified Form 1040. Others can file Form 1040 with additional forms for their specific needs.
## Is the 1040EZ Tax Form Still in Use?
The 1040EZ tax form was eliminated in 2018 and was replaced with the redesigned Form 1040.
## Is There a Form 1040EZ for 2024 or 2025?
No. The IRS no longer publishes Form 1040EZ.
## What Was the 1040EZ Tax Form Used for?
Form 1040EZ was used by taxpayers with no dependents who were under age 65 and earned less than $100,000 per year. This form had fewer tax credits and deductions than the full-length 1040 form.
## What Is the Difference Between IRS Forms 1040, 1040A and 1040EZ?
[Form 1040A](https://www.investopedia.com/terms/1/1040a.asp) was a simplified tax form for taxpayers with an income below $100,000 who did not exercise any incentive stock options throughout the year. All three forms were eliminated in the 2018 tax year, and replaced with a redesigned Form 1040.
## The Bottom Line
The IRS previously allowed for taxpayers to select a specific Form 1040 to use based on the complexity of their tax return. The simplest form was Form 1040EZ. However, the form was discontinued in 2018. Since then, all taxpayers must use Form 1040 (or Form 1040-SR, for those age 65 or older) as part of their annual filing.
> **Article Sources**
>
> 1. Internal Revenue Service. "[All Taxpayers Will File Using 2018 Form 1040; Forms 1040-A and 1040-EZ No Longer Available](https://www.irs.gov/newsroom/all-taxpayers-will-file-using-2018-form-1040-forms-1040a-and-1040ez-no-longer-available)."
>
> 2. Internal Revenue Service. "[2017 Instruction 1040EZ](https://www.irs.gov/pub/irs-prior/i1040ez--2017.pdf)."
>
> 3. Internal Revenue Service. "[2017 Form 1040](https://www.irs.gov/pub/irs-prior/f1040--2017.pdf)."
>
> 4. Internal Revenue Service. "[2017 Form 1040EZ](https://www.irs.gov/pub/irs-prior/f1040ez--2017.pdf)."
>
> 5. Internal Revenue Service. "[1982 Instructions for Preparing Forms 1040EZ and 1040A](https://www.irs.gov/pub/irs-prior/i1040eza--1982.pdf)."
>
> 6. Internal Revenue Service. "[Here Are Five Facts About the New Form 1040](https://www.irs.gov/newsroom/here-are-five-facts-about-the-new-form-1040)."
>
> 7. Internal Revenue Service. "[2017 Instruction 1040A](https://www.irs.gov/pub/irs-prior/i1040a--2017.pdf)." |
SEC Release IA-1092 | # SEC Release IA-1092: What it is, History
> **Definition**
>
> SEC Release IA-1092 is a memo from the SEC that clarifies state and federal laws for investment advisers and financial planners, building on the Investment Advisers Act of 1940.
## What Is SEC Release IA-1092?
SEC Release IA-1092 is a release from the [Securities & Exchange Commission](https://www.investopedia.com/terms/s/sec.asp) (SEC) that provides uniform interpretations of how state and federal adviser laws apply to those that provide financial services.
SEC Release IA-1092 builds on the [Investment Advisers Act of 1940](https://www.investopedia.com/terms/i/investadvact.asp) or the Advisers Act that Congress enacted to protect persons who rely on investment advisers for advice on purchasing and selling securities.
### Key Takeaways
* SEC Release IA-1092 clarifies how state and federal securities laws apply to investment advisers and financial planners.
* This memo, which was issued in 1987, expands on the Investment Advisers Act of 1940.
* IA-1092 defines the roles and duties of investment advisers and pension consultants, in particular.
## Understanding SEC Release IA-1092
SEC Release IA-1092 is the result of a 1987 collaboration between the Securities & Exchange Commission (SEC) on the federal side and the [North American Securities Administrators Association](https://www.investopedia.com/terms/n/nasaa.asp) (NASAA) on the state side.
These organizations issued IA-1092 in 1987 as a memo in response to the proliferation of financial planning and investment advice professionals in the 1980s. The act reaffirmed the definition of an [investment adviser](https://www.investopedia.com/terms/i/investmentadvisor.asp) (IA) as described in SEC Release IA-770 and added some refinements:
* First, pension consultants and advisers to athletes and entertainers were included as providers of investment advice.
* Second, in some cases, firms that recommend investment advisers also had to register themselves.
* Even if an IA did not render investment advice as their principal business activity, simply doing so with some regularity in many cases was enough to require registration.
* If a registered representative of a broker-dealer set up a separate business entity to provide financial planning or investment advice for a fee, they were not allowed to rely on the [broker-dealer](https://www.investopedia.com/terms/b/broker-dealer.asp) (BD) exemption from registration. (This became known as a statutory investment adviser.)
* Compensation did not have to be monetary to fall under the definition. Simply the receipt of products, services, or even discounts was also considered compensation.
With regard to sports or entertainment agents, those individuals that negotiated contracts but did not render investment advice were excluded from the definition of an investment adviser.
## SEC Release IA-1092 and the Investment Advisers Act of 1940
The Investment Advisers Act of 1940 defines an investment adviser as any person who, either directly or indirectly through writings, engages in the business of advising others on the value or profitability of securities and receives compensation for this.
Guidelines for the Investment Advisers Act of 1940 can be found in Title 15 section 80b-1 of the United States Code, which notes that investment advisers are of national concern, due to:
* Their advice, counsel, publications, writings, analyses, and reports being in line with interstate commerce.
* Their work customarily relating to the purchase and sale of securities that trade on national securities exchanges and in interstate [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) (OTC) markets.
* Their connection with securities issued by companies engaged in interstate commerce.
* The volume of transactions often materially affecting interstate commerce, national securities exchanges, other securities markets, the national banking system, and even the economy as a whole.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[Interpretive Release: Applicability of the Investment Advisers Act to Financial Planners, Pension Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services](https://www.sec.gov/rules/interp/1987/ia-1092.pdf)." Accessed Aug. 13, 2021.
>
> 2. U.S. Government. "[U.S.C. Title 15, Section 80b-1: Findings](https://www.govinfo.gov/content/pkg/USCODE-2010-title15/pdf/USCODE-2010-title15-chap2D-subchapII-sec80b-1.pdf)." Accessed Aug. 13, 2021. |
12B-1 Fee | # Understanding 12b-1 Fees: What They Are and How They Impact Mutual Funds
> **Definition**
>
> A 12b-1 fee is an annual charge mutual funds assess against investors to cover the costs of selling shares in the mutual fund to other investors.
## 12B-1 Fee: What It Is and What You Should Know
A 12b-1 fee, named after a section of the Investment Company Act of 1940, is an annual marketing or distribution fee that [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) charge. This fee is part of the expense ratio and can range from 0.25% to 1% of the fund's net assets. Primarily, it compensates intermediaries who sell the fund's shares. Critics argue that while intended to lower costs through economies of scale, it mainly rewards salespersons without enhancing fund performance.
### Key Takeaways
* A 12b-1 fee is an annual marketing or distribution fee included in a mutual fund's expense ratio, often ranging from 0.25% to 0.75% of a fund's net assets.
* Originally intended to help investors by reducing overall fund expenses through increased asset growth, the 12b-1 fee is now primarily used to compensate intermediaries for selling fund shares.
* The 12b-1 fee is divided into two components: the distribution and marketing fee, which is capped at 0.75%, and a service fee that can be up to 0.25%.
* Class C shares are more likely to incur the maximum 1% 12b-1 fee, while Class A shares typically charge a front-end load with a lower or no 12b-1 fee.
* The Securities and Exchange Commission (SEC) began reviewing the application and disclosure of the 12b-1 fees in 2015 to ensure compliance with regulations.
## How 12b-1 Fees Impact Mutual Fund Investors
The 12b-1 fee gets its name from Rule 12b-1, which was adopted by the [Securities and Exchange Commission](https://www.investopedia.com/terms/s/sec.asp) (SEC) in 1980 under the [Investment Company Act of 1940](https://www.investopedia.com/terms/i/investmentcompanyact.asp). The rule's purpose was to enable a mutual fund to raise funds for marketing purposes while limiting its ability to charge existing investors for the cost of doing so.
One rationale for making it easier to raise funds for marketing was that gaining more investors meant a fund could achieve greater [economies of scale](https://www.investopedia.com/terms/e/economiesofscale.asp) and reduce transaction costs, thereby benefiting all investors. Critics of the 12b-1 rule argue there is no evidence that 12b-1 helps funds grow or that existing shareholders benefit from any such growth.
Under the rule, mutual funds are forbidden from using fund assets to pay for the marketing of the fund unless they submit a 12b-1 plan approved by the fund's directors, including independent directors, and disclose the fees as a separate line item their prospectuses. The 12b-1 fee for marketing purposes is limited to 0.75% of assets annually, and the fund’s board is obligated to regularly reevaluate the benefits of the plan to the fund shareholders.
Still, 12b-1 fees have come under fire over the years. After all, marketing the fund to new investors does little to enhance a fund's performance, and with total mutual fund assets in the U.S. topping $20 trillion, funds don't need to attract investors nearly as much as when Rule 12b-1 was passed.
## Components of the 12b-1 Fee Explained
The 12b-1 fee can be broken down into two distinct charges: the marketing fee, also known as the distribution fee, and the service fee. Total 12b-1 fees charged by a fund are limited to 1% annually. The marketing piece of the total fee is capped at 0.75%, while the service fee can be up to 0.25%. The 12b-1 fee is included in a fund's [expense ratio](https://www.investopedia.com/terms/e/expenseratio.asp).
The 12b-1 fee covers such expenses as advertising, printing and mailing prospectuses, but the bulk of the money goes to commissions for brokers who sell shares in the fund to other investors.
## What Is the Purpose of a 12B-1 Fee?
The 12b-1 fee was designed to enable mutual funds to gain investors via marketing and broker commissions while limiting the amount of money they could draw from the fund's assets to pay for it. It was created in 1980, following the long bear market of the 1970s, when mutual funds saw massive withdrawals.
## How Can a 12B-1 Fee Impact Long-Term Investment Returns?
Like all fees, the 12b-1 fee can have a significant impact on investment returns. A 12b-1 fee of just 0.75% can cost an investor $35,000 in lost returns on a $100,000 investment that returns 5% annually over 20 years.
## What Is the Maximum Allowable 12B-1 Fee a Mutual Fund Can Charge?
The total 12b-1 fee is capped at 1% of assets annually. That includes a maximum of 0.75% for marketing and up to 0.25% for a services fee.
## The Bottom Line
The 12b-1 fee, an annual marketing or distribution fee on mutual funds, is included in the fund’s expense ratio. Initially implemented to reduce costs through economies of scale, it now primarily compensates intermediaries for selling fund shares.
Critics argue it doesn’t enhance fund performance, and its necessity is questioned as mutual fund assets grow. The fee, limited to 1% annually, consists of a distribution and marketing charge and a service fee.
Investors should be aware of these fees in mutual fund shares, such as Class B and Class C, where they often appear, as they can increase the overall expense ratio and affect the fund's cost-effectiveness. Always review a fund’s prospectus for detailed fee disclosures, as these fees can have significant implications on investment returns.
> **Article Sources**
>
> 1. Securities and Exchange Commission. "[Guidance Update](https://www.sec.gov/investment/im-guidance-2016-01.pdf)."
>
> 2. Investment Company Institute. "[Rule 12b-1 Resource Center](https://www.ici.org/rule12b1fees)."
>
> 3. Securities and Exchange Commission. "[The Cost and Benefits to Fund Shareholders of 12b-1 Plans](https://www.sec.gov/files/rules/proposed/s70904/lwalsh042604.pdf)."
>
> 4. Securities and Exchange Commission. "[Mutual Fund Fees and Expenses](https://www.investor.gov/introduction-investing/investing-basics/glossary/mutual-fund-fees-and-expenses)." |
11th District Cost of Funds Index (COFI) | # 11th District Cost of Funds Index: What It is, How It Works
## What Is the 11th District Cost of Funds Index?
The 11th District Cost of Funds Index (COFI) was a monthly index that reflected the average interest rate paid by savings institutions in Arizona, California, and Nevada on checking and savings accounts. It was one of many indices used by mortgage lenders to adjust the interest rate on [adjustable rate mortgages](https://www.investopedia.com/terms/a/arm.asp) (ARM) and was launched in 1981. With an ARM mortgage, the interest rate on a mortgage moves up and down along with some standard interest rate chosen by the lender, and COFI was one of the most popular indices in the western states.
Published on the last day of each month, the COFI represented the [cost of funds](https://www.investopedia.com/terms/c/costoffunds.asp) for Western savings institutions that were members of [Federal Home Loan Bank](https://www.investopedia.com/terms/f/fhlb.asp) of San Francisco, a self-regulatory agency, and satisfied the Bank's criteria for inclusion in the index. The Federal Home Loan Bank of San Francisco stopped publishing the COFI on Jan. 31, 2022. The Federal Home Loan Mortgage Corporation ([Freddie Mac](https://www.investopedia.com/terms/f/freddiemac.asp)) created a replacement index called the Enterprise 11th District COFI Replacement Index.
## Understanding the 11th District COFI
The 11th District Cost of Funds Index (COFI) was computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. As a result, the index tended to have low volatility and follow market interest rate changes somewhat slowly; it was generally regarded as a two-month lagging indicator of market interest rates. The interest rate on a mortgage would not match the COFI, rather the ARM rate that was typically 2% to 3% higher than COFI, depending on the borrower's credit history, the size and terms of the loan, the ability of the borrower to negotiate with the bank, and many other factors.
Because was computed using data from three western states, the COFI was primarily used in the western U.S., while the 1-year Treasury index was the measure of choice in the eastern region. |
125% Loan | # 125% Loan: What It is, History, Pros and Cons
## What Is a 125% Loan?
A 125% loan is a type of leveraged loan, typically a [mortgage](https://www.investopedia.com/terms/m/mortgage.asp) used to [refinance](https://www.investopedia.com/mortgage/refinance/when-and-when-not-to-refinance-mortgage/) a home, which allows a homeowner to borrow an amount equal to 125% of their property’s appraised value.
For example, if a home is worth $300,000, then a 125% loan would give the borrower access to $375,000 in funds.
### Key Takeaways
* A 125% loan is a mortgage equal to 1.25 times the value of the property securing the loan.
* Popular in the 1990s, 125%, and similar loans became increasingly risky and unmanageable during the 2007–08 housing bubble.
* Due to the risk involved for the lender, 125% loans carry significantly higher interest rates than traditional mortgages.
* Today, 125% loans are less common but are still available from some lenders.
## How a 125% Loan Works
In financing terminology, a 125% loan has a [loan-to-value (LTV) ratio](https://www.investopedia.com/terms/l/loantovalue.asp) of 125%. The LTV ratio, which compares the size of a loan relative to the appraised value of the property that serves as security, is used by lenders to judge a loan’s default risk. A 125% loan is considered riskier than one with an LTV ratio of less than 100%. In fact, with conventional mortgages, the loan size does not typically exceed 80% of a property’s value.
Therefore, according to the [risk-based pricing method](https://www.investopedia.com/terms/r/risk-based_mortgage_pricing.asp) used by lenders, a loan with an LTV ratio of 125% will carry a higher interest rate than one with a lower LTV ratio—as much as double, in some instances.
## Using a 125% Loan for Refinancing
Homeowners who take out a 125% loan usually do so when refinancing their homes to gain access to more cash than they would have available from their home equity. Their motive might be to use the loan to pay off other debts that carry even higher interest rates, such as credit cards.
But because 125% loans have high interest rates and may also have additional fees, anyone who is considering one should plan to shop around for the best terms they can get.
If your goal is to obtain cash to pay off other debt, and you are unable to qualify for a 125% loan (or you decide that you simply don’t want one), then you might still consider a [home equity loan](https://www.investopedia.com/terms/h/homeequityloan.asp). You won’t get as much cash out of it, but the interest rate is likely to be considerably lower, and you can use it to pay off at least a portion of your high-interest debt. Another option would be to do a [cash-out refinance](https://www.investopedia.com/terms/c/cashout_refinance.asp).
## Advantages and Disadvantages of 125% Loans
The advantage of a 125% loan is that it can allow a homeowner, especially one who has not accumulated too much home equity or whose property has actually declined in value, to obtain more cash than they otherwise could.
The disadvantage—to borrower and lender alike—is the added risk compared with a smaller loan. The borrower will be on the hook for more debt, and the lender will face added risk in case of a default. If the borrower does [default](https://www.investopedia.com/terms/d/default2.asp), the lender can [foreclose](https://www.investopedia.com/terms/f/foreclosure.asp) on the property and sell it, but the lender is very unlikely to get all of its money back.
## History of 125% Loans
The 125% loans first became popular during the 1990s, in some cases geared toward low-risk borrowers with high credit scores who wanted to borrow more than their available home equity. Along with other factors, 125% loans played a role in the 2007–08 housing crisis. The crash of real estate markets around the country, kicked off by the [subprime mortgage meltdown](https://www.investopedia.com/terms/s/subprime-meltdown.asp), left many people “[underwater](https://www.investopedia.com/terms/u/underwater.asp)”—that is, they owed more money on their mortgage than their home was actually worth.
As home values dropped, some homeowners who wanted to refinance found that they no longer had enough equity in their homes to qualify for a new loan. Moreover, they could not recoup their losses even if they managed to sell the home.
The now-expired federal [Home Affordable Refinance Program (HARP)](https://www.investopedia.com/terms/h/home-affordable-refinance-program-harp.asp) was introduced in March 2009 as a way to offer relief. It allowed homeowners whose homes were underwater, but who were otherwise in good standing and current with their mortgages, to apply for refinancing. Through HARP, homeowners who owed up to 125% of the value of their homes could refinance at lower rates to help them pay off their debts and get on sounder financial footing.
Originally, homeowners who owed more than that percentage could not apply. But eventually, even the 125% LTV ceiling was removed, allowing still more homeowners to apply for HARP loans. After being extended several times, HARP ended in December 2018.
## What Does 125% Financing Mean?
Typically, when refinancing a home, a homeowner can take out a 125% loan, meaning that they can borrow an amount equal to 125% of the home's appraised value. This type of financing comes into play when the house is worth less than what is owed on it.
## Can You Get a 90% LTV?
A 90% LTV means a 90% loan-to-value ratio. This is a comparison between your mortgage and the value of your home. So for example, a $300,000 home and a $270,000 mortgage, would have a 90% loan-to-value ratio. To achieve this, you would need a downpayment of 10% of the home's value: $30,000. In the U.S., most homes require a 20% downpayment. In this example, that would result in an LTV of 80%.
## Can I Take Equity Out of My House Without Refinancing?
Yes, you can take equity out of your house without refinancing. Ways to do this include home equity loans, home equity lines of credit, and home equity investments.
## The Bottom Line
A 125% loan is an option for homeowners with properties that are valued at less than their outstanding mortgage, enabling them to refinance up to 125% of the value of their home. The loan was first offered during the housing crisis of 2008 when some homeowners found their properties underwater. Although the HARP program, as it was called, ended after nearly a decade in 2018, 125% loans are still available today.
> **Article Sources**
>
> 1. American Banker. "[A 125% LTV Loan Unlike Yesteryear's](https://www.americanbanker.com/news/a-125-ltv-loan-unlike-yesteryears)."
>
> 2. AwesomeFinTech. "[125% Loan](https://www.awesomefintech.com/term/125_loan/)."
>
> 3. Federal Reserve History. "[Subprime Mortgage Crisis](https://www.federalreservehistory.org/essays/subprime-mortgage-crisis)."
>
> 4. ABC. "[How Will the Federal Home Affordable Refinance Program Help Owners?](https://abcnews.go.com/Business/harp-home-affordable-refinance-program-hype/story?id=15972744)"
>
> 5. Federal Deposit Insurance Corporation (FDIC). "[Relief RefinanceSM/Home Affordable Refinance Program (HARP)](https://www.fdic.gov/resources/bankers/affordable-mortgage-lending-center/guide/part-1-docs/freddie-home-affordable-refinance-program.pdf)."
>
> 6. Federal Housing Finance Agency. “[Refinance Report: First Quarter 2019](https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/Refi_1Q2019.pdf),” Pages 1,4. |
12B-1 Plan | # Understanding 12B-1 Plans: Structure, Fees, and Disclosure Explained
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*— Investopedia / Michela Buttignol*
## What Is a 12B-1 Plan?
A 12B-1 plan is a plan structured by mutual fund companies for the distribution of funds through intermediaries. 12B-1 plans provide mapping for the partnerships between distributors and intermediaries who help to ensure the sale of a fund. Sales commission schedules and 12B-1 distribution expenses are the primary components driving a 12B-1 plan.
### Key Takeaways
* A 12B-1 plan is designed by mutual fund companies to manage the distribution of funds through intermediaries, focusing primarily on open-end mutual funds.
* The plan includes sales commissions and 12B-1 expenses, which help map partnerships between distributors and financial intermediaries.
* Sales loads, which are fees paid to brokers, can vary across share classes, including Class A, B, and C shares, and are not part of annual fund operating expenses.
* 12B-1 expenses can be up to 1% of an investment's value yearly, with fees usually ranging from 0.25% to 1%, aiding in compensating distributors and brokers.
* Full disclosure of sales load schedules and 12B-1 expenses is mandatory for mutual fund companies, and any changes must be approved by the fund's board and noted in the fund's prospectus.
## How the 12B-1 Plan Functions
12B-1 plans facilitate the partnerships between distributors and [intermediaries](https://www.investopedia.com/terms/f/financialintermediary.asp) offering mutual fund shares. 12B-1 plans are primarily focused on open-end mutual funds, which have multiple class structures for sales charges and distribution expenses. Mutual fund companies consider two types of 12B-1 charges in their 12B-1 plans, sales commissions, and [12B-1 expenses](https://www.investopedia.com/terms/1/12b-1fees.asp).
## Breakdown of Sales Commissions in 12B-1 Plans
Sales commission schedules are structured to provide compensation to intermediaries for transacting [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp). These partnerships can help to increase demand for funds by being marketed from a full-service broker-dealer who facilitates the transaction for a sales load fee. These fees are paid to the broker and are not associated with annual fund operating expenses.
Sales loads are structured to vary across share classes. Share classes can include front-end, back-end, and level-load sales charges. These sales charges are associated with individual retail share classes which typically include [Class A](https://www.investopedia.com/terms/c/classashares.asp), B, and C shares.
## Understanding 12B-1 Expenses: What Are They?
12B-1 expenses paid from the mutual fund to distributors and intermediaries are also a key part of a 12B-1 plan. To market and distribute open-end mutual fund shares, mutual fund companies work with distributors to get their funds listed with discount brokerages and financial advisor platforms. Distributors help fund companies partner with the full-service brokers that transact their funds at the agreed-upon sales load schedule.
Mutual fund companies will pay 12B-1 fees from a mutual fund to compensate distributors. In some cases, funds may also be structured with a low-level load that is paid to financial advisors annually during the course of an investor's [holding period](https://www.investopedia.com/terms/h/holdingperiod.asp).
Financial industry legislation typically restricts 12B-1 fees to 1% of the current value of the investment on an annual basis, but fees generally fall somewhere between 0.25% and 1%. In most cases, fund companies will have higher 12B-1 fees on share classes paying a lower [sales charge](https://www.investopedia.com/terms/s/salescharge.asp), and lower 12B-1 fees on share classes with higher sales charges. This helps to balance out the compensation paid to intermediary brokers while also providing for payment to distribution partners.
## Disclosure Requirements for 12B-1 Plans
Mutual fund companies are required to provide full disclosure on their sales load schedules and 12B-1 annual fund expenses in the fund’s prospectus. The prospectus is one aspect of documentation required for the mutual fund’s registration and is also the key offering document providing information on the fund for investors. 12B-1 plans and any changes to their expense structuring must be approved by the fund’s board of directors and amended in its prospectus filed with the Securities and Exchange Commission.
> **Article Sources**
>
> 1. U.S. Security And Exchange Commission. "[Mutual Fund Classes](https://www.investor.gov/introduction-investing/investing-basics/glossary/mutual-fund-classes)."
>
> 2. U.S. Securities and Exchange Commission. "[Distribution \[and/or Service\] (12b-1) Fees](https://www.investor.gov/introduction-investing/investing-basics/glossary/distribution-andor-service-12b-1-fees)."
>
> 3. U.S. Securities and Exchange Commission. "[Mutual Fund Fees and Expenses](https://www.investor.gov/introduction-investing/investing-basics/glossary/mutual-fund-fees-and-expenses)."
>
> 4. U.S. Securities and Exchange Commission. "[How to Read a Mutual Fund Prospectus (Part 2 of 3: Fee Table and Performance)](https://www.sec.gov/oiea/investor-alerts-bulletins/ib_mfprospectus2.html)." |
12B-1 Fund | # 12b-1 Fund: What It Means and how It Works
## What Is a 12b-1 Fund?
A 12b-1 fund is a mutual fund that charges its holders a 12b-1 fee. A [12b-1 fee](https://www.investopedia.com/terms/1/12b-1fees.asp) pays for a mutual fund’s distribution and marketing costs. It is often used as a commission to brokers for selling the fund.
12b-1 funds take a portion of investment assets held and use them to pay expensive fees and distribution costs. These costs are included in the fund's expense ratio and are described in the prospectus. 12b-1 fees are sometimes called a “[level load](https://www.investopedia.com/terms/l/levelload.asp).”
### Key Takeaways
* A 12b-1 fund carries a 12b-1 fee, which covers a fund's sales and distribution costs.
* This fee is a percentage of the fund's market value, as opposed to funds that charge a load or sales fee.
* 12b-1 fees include the cost of marketing and selling fund shares, paying brokers and other sellers of the funds, as well as advertising costs, such as printing and mailing fund prospectuses to investors.
* Once popular, 12b-1 funds have lost investor interest in recent years, particularly amid the rise of exchange-traded funds (ETFs) and low-cost mutual funds.
## Understanding 12b-1 Funds
The name 12b-1 comes from the [Investment Company Act of 1940](https://www.investopedia.com/terms/i/investmentcompanyact.asp)'s Rule 12b-1, which allows fund companies to act as distributors of their own shares. Rule 12b-1 further states that a mutual fund's own assets can be used to pay distribution charges.
Distribution fees include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. The SEC does not limit the size of [12b-1 fees that funds may pay](https://www.investopedia.com/articles/mutualfund/13/12b1-understanding-mutual-fund-fees.asp), but under [FINRA](https://www.investopedia.com/terms/f/finra.asp) rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75% of a fund’s average net assets per year.
## 12b-1 Fees
Some 12b-1 plans also authorize and include "shareholder service fees," which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in this category of the fee table.
If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the "Other expenses" category, discussed below. FINRA imposes an annual 0.25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan).
Originally, the rule was intended to pay advertising and marketing expenses; today, however, a very small percentage of the fee tends to go toward these costs.
> **Important**
>
> 0.75% is the current maximum amount of a fund's net assets that an investor can be charged as a 12b-1 fee.
## Special Considerations
12b-1 funds have fallen out of favor in recent years. The growth in [exchange-traded fund](https://www.investopedia.com/terms/e/etf.asp) (ETF) options and the subsequent growth of low-fee mutual fund options has given consumers a wide range of option. Notably, 12b-1 fees are considered a dead weight, and experts believe consumers who shop around can find comparable funds to ones charging 12b-1 fees. |
130-30 Strategy | # Understanding the 130-30 Strategy: Investing Benefits & Risks
## What Is the 130-30 Strategy?
The 130-30 strategy is a long/short equity strategy used by institutional investors. It allocates 130% of starting capital to long positions and shorts poor performing stocks for the required 30% extra investment. The 130-30 strategy targets capital efficiency with financial leverage by reinvesting the shorting proceeds in top-performing stocks. Investors often mimic indices like the [S&P 500](https://www.investopedia.com/terms/s/sp500.asp) to select stocks for this strategy.
### Key Takeaways
* The 130-30 strategy uses financial leverage by shorting poor-performing stocks to buy shares expected to yield high returns.
* Investors typically allocate 130% of starting capital to long positions and gain 30% from shorting stocks.
* This strategy mimics indices like the S&P 500 to optimize stock selection.
* Shorting stocks involves significant risks, including potential unlimited losses.
* While often providing lower volatility, 130-30 funds might not surpass major indexes in total return.
## How the 130-30 Strategy Works
To engage in a 130-30 strategy, an investment manager might rank the stocks used in the S&P 500 from best to worse on expected return, as signaled by past performance. A manager will use a number of data sources and rules for ranking individual stocks. Typically, stocks are ranked according to some set selection criteria (for example, total returns, risk-adjusted performance, or relative strength) over a designated look-back period of six months or one year. The stocks are then ranked best to worst.
From the [best ranking stocks](https://www.investopedia.com/best-performing-s-and-p-500-stocks-8720206), the manager would invest 100% of the portfolio's value and short sell the bottom ranking stocks, up to 30% of the portfolio's value. The cash earned from the [short sales](https://www.investopedia.com/terms/s/shortsale.asp) would be reinvested into top-ranking stocks, allowing for greater exposure to the higher-ranking stocks.
## The Role of Shorting Stocks in the 130-30 Strategy
The 130-30 strategy incorporates short sales as a significant part of its activity. Shorting a stock entails borrowing securities from another party, most often a broker, and agreeing to pay an interest rate as a fee. A negative position is subsequently recorded in the investor’s account. The investor then sells the newly acquired securities on the [open market](https://www.investopedia.com/terms/o/open-market.asp) at the current price and receives the cash for the trade. The investor waits for the securities to depreciate and then re-purchases them at a lower price. At this point, the investor returns the purchased securities to the broker. In a reverse activity from first buying and then selling securities, shorting still allows the investor to profit.
Short selling is much riskier than investing in long positions in securities; thus, in a 130-30 investment strategy, a manager will put more emphasis on long positions than short positions. Short-selling puts an investor in a position of unlimited risk and a capped reward. For example, if an investor shorts a stock trading at $30, the most they can gain is $30 (minus fees), while the most they can lose is infinite since the stock can technically increase in price forever.
Hedge funds and mutual fund firms have begun offering investment vehicles in the way of private equity funds, mutual funds, or even exchange-traded funds that follow variations of the 130-30 strategy. In general, these instruments have lower volatility than benchmark indexes but often fail to achieve greater total returns.
## The Bottom Line
The 130-30 strategy puts financial leverage to work by shorting underperforming stocks and reinvesting the capital received into higher-performing stocks. The strategy's goal is to achieve efficient capital allocation while addressing risk through a balance of long and short positions. Since stock selection is important, users of the strategy often adopt a methodology that's similar to that used for tracking indexes like the S&P 500. While the 130-30 strategy can limit drawdowns and provide better risk-adjusted returns, it may not consistently outperform the total returns provided by major market averages. Certain investments, such as hedge funds and mutual funds, implement variations of the 130-30 strategy, and typically offer lower volatility but varied performance outcomes.
> **Article Sources**
>
> 1. Armfelt, C. A. R. L., & Somos, D. A. N. I. E. L. (2008). _Performance, Benefits and Risks of Active-Extension Strategies_. Working Paper available at Stockholm School of Economics |
18-Hour City | # 18-Hour City: What it Means, How it Works, Examples
## What Is an 18-Hour City?
Economists and real estate investors use the term 18-hour city to describe a mid-size city with attractive amenities, higher-than-average population growth, and a lower [cost of living](https://www.investopedia.com/terms/c/cost-of-living.asp) and cost of doing business than the biggest urban areas. The 18-hour city generally has a population of under one million, making it a second-tier city.
Eighteen-hour cities in the U.S. are increasingly seen as viable alternatives for investment and living to the Big Six markets of Boston, Chicago, Los Angeles, New York, San Francisco and Washington, D.C that make up America's first-tier or 24-hour cities.
## Understanding the 18-Hour City
While loosely defined, the term 18-hour city most often refers to a city that has public services, amenities and job opportunities that are comparable in quality to those in the big six markets.
### Key Takeaways
* Eighteen-hour cities are vibrant smaller metro areas that are proving attractive to new residents, entrepreneurs and investors.
* They boast lower living costs along with solid infrastructure and appealing amenities.
* Many have emerged as alternatives to big cities for starting or relocating a business or investing in real estate.
Unlike the biggest cities, most of their services and amenities don't operate on a 24-hour basis. However, they boast comparable advantages, including solid public transportation systems, modern infrastructure and strong economies. Housing prices are moderate in comparison.
### The 18-Hour City Advantage
Eighteen-hour cities have emerged as an attractive alternative to big cities for starting a new business, relocating an existing one, or investing in real estate. They typically feature lower [capitalization rate](https://www.investopedia.com/terms/c/capitalizationrate.asp) compression, meaning property values tend to remain stable rather than spiking up or down significantly.
Like first-tier cities, 18-hour cities often boast low real estate vacancy rates along with favorable supply concentrations, rental growth and absorption trends—all indicators of long-term real estate investment potential.
Aside from the numbers, Forbes.com cites a distinctive and lovable culture as a key factor in creating and maintaining a vibrant 18-hour city: "Austin is the live music capital of the world. Denver and the Research Triangle are outdoor meccas. Portland is just plain weird (and residents would like to keep it that way."
One perceived downside is the increased risk inherent in cities that do not have the established track record of primary market cities.
## Examples of 18-Hour Cities in the U.S.
CrowdStreet, a site for crowd-sourced real estate investments, cites Austin, Denver, and Nashville as recent stars among 18-hour cities. In 2020, it identified Charleston, South Carolina, as the next big success story in the category.
> **Important**
>
> The stars among 18-hour cities are a draw for millennials turned off by big-city obstacles.
Realtor.com identified its top metropolitan areas for 2020 and beyond, with all of its top five picks squarely in the 18-hour city category. They include Boise, Idaho; Mc-Allen-Edinburg-Mission, Texas; Tucson, Arizona; Chattanooga, Tennessee, and Columbia, South Carolina.
The National Real Estate Investor website chose Charleston, Kansas City, and Columbus, Ohio, based on their stellar growth in jobs.
### Follow the Millennials
These and other frequently-cited 18-hour city stars have become targets for millennials whose goal is launching or advancing their careers. They are characterized by the availability of recreation and entertainment opportunities that extend well beyond what the typical second-tier affords.
Employers are drawn to 18-hour cities because doing business is less expensive in these markets and this, in turn, attracts large numbers of job seekers and entrepreneurs. |
183-Day Rule | # 183-Day Rule: Definition, How It's Used for Residency, and Example
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*— Investopedia / Julie Bang*
## What Is the 183-Day Rule?
The 183-day rule refers to a threshold used by most countries to determine whether an individual should be considered a resident for tax purposes. This number is often used in a tax context because it marks the point at which someone has spent more than half the calendar year in a particular jurisdiction.
In the U.S., the [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) (IRS) uses a formula to determine whether people who are neither U.S. citizens nor permanent residents should be considered residents for taxation. This is called the "substantial presence test." One of its criteria includes the question of whether an individual has spent 183 days in the U.S. based on a calculation that considers their combined physical presence in a given tax year and the two years prior.
### Key Takeaways
* The 183-day rule refers to criteria used in many countries to determine tax residency of individuals.
* In general, individuals are considered residents if they are physically present in a country for at least 183 days in a calendar year.
* The U.S. Internal Revenue Service uses a more complicated formula, which considers both presence in a given year, as well as a fraction of presence in the two prior years.
* The U.S. has [tax treaties](https://www.investopedia.com/terms/t/taxtreaty.asp) with other countries which concern what taxes individuals owe and to whom, as well as what exemptions may apply.
* U.S. citizens and residents may exclude up to $126,500 of their foreign-earned income in 2024 if they meet the physical presence test for and paid taxes in a foreign country.
## Understanding the 183-Day Rule
Many countries around the world use the 183-day threshold to broadly determine whether to tax someone as a resident, because it marks the majority of a year. These include Canada, Australia, and the United Kingdom, for example. Generally, this means that if you spent 183 days or more in the country during a given year, you are considered a [tax resident](https://www.investopedia.com/terms/t/taxhome.asp) for that year.
Each nation maintaining a 183-day rule has its own criteria for applying it in practice. For example, some use the calendar year for the accounting period, whereas others use a fiscal year. Some include the day the person arrives in the country, others do not.
Some countries have even lower thresholds that trigger tax residency. For example, Switzerland considers you a tax resident if you have spent more than 90 days there.
## The IRS and the 183-Day Rule
The IRS uses a more complicated formula to determine whether someone passes its substantial presence test, and is subject to U.S. taxes, as a result. The person in question must:
* Have been physically present for at least 31 days during the current year; and
* Be present for 183 days during the three-year period that includes the current year and the two years immediately preceding it.
The 183-day presence threshold is not based off a total sum of days present. Rather, it is calculated by adding the following:
* All of the days an individual was present during the current year
* One-third of the days they were present during the previous year
* One-sixth of the days they were present in the year before that
## Other IRS Terms and Conditions
The IRS generally considers someone to have been present in the U.S. on a given day if they spent any part of a day there. But there are some exceptions.
Days that do not count as days of presence include:
* Days that you commute to work in the U.S. from a residence in Canada or Mexico if you do so regularly
* Days you are in the U.S. for less than 24 hours while in transit between two other countries
* Days you are in the U.S. as a crew member of a foreign vessel
* Days you are unable to leave the U.S. because of a medical condition that develops while you are there
* Days in which you qualify as exempt, which includes foreign-government-related persons under an A or G visa, teachers and trainees under a J or Q visa; a student under an F, J, M, or Q visa; and a professional athlete competing for charity
## U.S. Citizens and Resident Aliens
Strictly speaking, the 183-day rule does not apply to U.S. citizens and permanent residents, who are required to file tax returns regardless of their country of residence or the source of their income.
However, such individuals may exclude at least part of their overseas earned income (up to $126,500 in 2024) from taxation provided they meet a physical presence test in a foreign country and paid taxes there. To meet this physical presence test, the person needs to be present in the country for 330 complete days in 12 consecutive months.
> **Important**
>
> Individuals residing in another country in violation of U.S. law will not be allowed to have their incomes qualify as foreign-earned.
## U.S. Tax Treaties and Double Taxation
The U.S. has [tax treaties](https://www.investopedia.com/terms/t/taxtreaty.asp) with other countries that help determine jurisdiction for income tax purposes and to avoid double taxation. These agreements contain provisions for the resolution of conflicting claims of residence.
## How Many Days Can You Be in the U.S. Without Paying Taxes?
The IRS considers you a U.S. resident if you were physically present in the U.S. on at least 31 days of the current year and 183 days during a three-year period. The three-year period consists of the current year and the prior two years. The 183-day rule includes all the days present in the current year (year 3), 1/3 of the days you were present in year 2, and 1/6 of the days you were present in year 1.
## How Long Do You Have to Live in a State Before You’re Considered a Resident?
Many states use the 183-day rule to determine residency for state tax purposes, and what constitutes a day varies among states. For instance, any time spent in New York, except for travel to destinations outside of New York (e.g., airport travel), is considered a day. So, [if you work in Manhattan but live in New Jersey](https://www.investopedia.com/investing/benefits-living-nj-while-working-nyc/), you may still be considered a New York resident for tax purposes even if you never spend one night there.
In addition, some states have special agreements whereby a resident who works in another state is only required to pay taxes in the state of their permanent residence, or where they are domiciled. It is important to consult the laws of each state that you frequent to determine if you are required to pay their income taxes.
## How Do I Calculate the 183-Day Rule?
For most countries that apply a 183-day rule, you are a tax resident of that country if you spend 183 or more there. The United States, however, has a different criteria for applying a tax residency test. You are a tax resident if you were physically present in the U.S. for 31 days of the current year and 183 days in the last three years, including all days present in the current year, 1/3 of the days from the previous year, and 1/6 of the days from the year before that.
## The Bottom Line
The 183-day rule refers to a common test used to determine tax residency. In most countries, individuals who are physically present for 183 days or more are considered residents for tax purposes. In the U.S., a "substantial presence test" is used to determine tax residency, and it's slightly more tricky than the common 183-day rule. It considers time spent in the U.S. in a given year, in addition to fractions of time spent in the U.S. in the two years prior. Lastly, many states use a 183-day rule to determine residency for local tax purposes. Consulting local and federal tax regulations and international tax treaties can help an individual determine their total tax obligations.
> **Article Sources**
>
> 1. IRS. "[Substantial Presence Test](https://www.irs.gov/individuals/international-taxpayers/substantial-presence-test)."
>
> 2. Internal Revenue Service. "[Figuring the Foreign Earned Income Exclusion](https://www.irs.gov/individuals/international-taxpayers/figuring-the-foreign-earned-income-exclusion)."
>
> 3. Globalization Guide. "[The Ultimate Guide to Tax Residencies & The 183-Day Rule](https://globalisationguide.org/tax/183-day-rule/)."
>
> 4. IRS. "[Foreign Earned Income Exclusion](https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion)."
>
> 5. Internal Revenue Service. "[Exceptions to the Bona Fide Residence and the Physical Presence Tests](https://www.irs.gov/individuals/international-taxpayers/exceptions-to-the-bona-fide-residence-and-the-physical-presence-tests)."
>
> 6. Monaeo. "[The 183-Day Rule: 5 Things to Know When Establishing State Residency and Fighting Audits](https://blog.monaeo.com/the-183-day-rule-5-things-to-know-when-establishing-state-residency-and-fighting-audits)." |
1979 Energy Crisis | # 1979 Energy Crisis: Definition, History, Causes, and Impact
> **Definition**
>
> The 1979 energy crisis was a global event marked by a sharp rise in oil prices and panic buying, mainly due to geopolitical turmoil in Iran that disrupted crude oil supply.
## What Was the 1979 Energy Crisis?
The 1979 energy crisis, the [second of two oil price shocks](https://www.investopedia.com/1973-energy-crisis-definition-5222090) in the '70s, resulted in a widespread panic about potential gasoline shortages, and far higher prices for both [crude oil](https://www.investopedia.com/terms/c/crude-oil.asp) and refined products. Oil output declined by only 7% or less, but the short-term supply disruption led to a spike in prices, panic buying, and long lines at gas stations.
### Key Takeaways
* The energy crisis of 1979 was one of two oil price shocks during the 1970s—the other was in 1973.
* Higher prices and concerns about supplies led to panic buying in the gasoline market.
* Crude oil prices nearly doubled to almost $40 per barrel in twelve months.
* The energy crisis of 1979 led to the development of smaller, more fuel-efficient vehicles.
* OPEC's market share fell sharply and utility companies moved toward alternative energy sources.
## Understanding the 1979 Energy Crisis
The 1979 energy crisis occurred in the aftermath of the Iranian Revolution, which started in early 1978 and ended in early 1979 with the fall of Shah Mohammad Reza Pahlavi, the state’s monarch. Turmoil in Iran, a major petroleum [exporting](https://www.investopedia.com/terms/e/export.asp) country, caused the global [supply](https://www.investopedia.com/terms/s/supply.asp) of crude oil to decline significantly, triggering noteworthy shortages, and a surge in panic buying—within 12 months, the price per barrel of this widely used resource almost doubled to $39.50.
Short-run disruptions in the global supply of gasoline and diesel fuel were particularly acute in the spring and early summer of 1979. Several states responded by [rationing](https://www.investopedia.com/terms/r/rationing.asp) gasoline, including California, New York, Pennsylvania, Texas, and New Jersey. In these populous states, consumers could only purchase gas every other day, based on whether the last digit of their license plate numbers was even or odd.
The gasoline shortage also led to fears that [heating oil](https://www.investopedia.com/terms/c/commoditiesexchange.asp) might be in short supply through the 1979-1980 winter. This prospect was especially concerning for New England states, where demand for home heating oil was the highest.
## Special Considerations
It would be erroneous to blame the crisis solely on the fall of the Shah. Notably, the U.S. faced more-acute pain from the crisis than other developed countries in Europe, which also depended on oil from Iran and other Middle East countries. Part of the reason behind the crisis had to do with [fiscal policy](https://www.investopedia.com/terms/f/fiscalpolicy.asp) decisions in the U.S.
### U.S. Fiscal Policy Also to Blame
In early 1979, the U.S. government [regulated](https://www.investopedia.com/terms/r/regulated-market.asp) oil prices. Regulators ordered refiners to restrict the supply of gasoline in the early days of the crisis to build [inventories](https://www.investopedia.com/terms/i/inventory.asp), directly contributing to higher [prices at the pump](https://www.investopedia.com/articles/economics/08/determining-oil-prices.asp).
Another factor was unintended supply restriction after the [Department of Energy](https://www.investopedia.com/insights/what-does-secretary-energy-do/) (DOE) decided to make a handful of large U.S. [refiners](https://www.investopedia.com/terms/o/oil-refinery.asp) sell crude to smaller refiners who could not find a ready supply of oil. Because smaller refiners had limited production capabilities, the decision further delayed gasoline supply.
[Monetary policy](https://www.investopedia.com/terms/m/monetarypolicy.asp) leading up to the crisis also seemingly played a role to a degree. The [Federal Open Market Committee](https://www.investopedia.com/terms/f/fomc.asp) (FOMC) was reluctant to raise target interest rates too quickly and this hesitation contributed to rising inflation late in the decade. The jump in inflation was accompanied by higher prices for energy and a range of other consumer products and services.
## Benefits of the 1979 Energy Crisis
Amid the crisis, politicians actively encouraged consumers to conserve energy and limit unnecessary travel. In subsequent years, the 1979 crisis led to the sale of more compact and subcompact vehicles in the U.S. These smaller vehicles had smaller engines and provided better fuel economy.
In addition, the crisis prompted [utility companies](https://www.investopedia.com/terms/u/utilities_sector.asp) worldwide to seek out alternatives to crude oil generators, including nuclear power plants, and governments to spend billions on the research and development (R&D) of [other fuel sources](https://www.investopedia.com/ask/answers/060415/what-are-main-substitutes-oil-and-gas-energy.asp).
Combined, these efforts resulted in daily worldwide oil consumption declining in the six years following the crisis. Meanwhile, the [Organization of Petroleum Exporting Countries](https://www.investopedia.com/terms/o/opec.asp) (OPEC) global [market share](https://www.investopedia.com/terms/m/marketshare.asp) fell to 29% in 1985, down from 50% in 1979. |
2-2-8 Adjustable-Rate Mortgage (2/28 ARM): Meaning, How It Works | # 2-2-8 Adjustable-Rate Mortgage (2/28 ARM): Meaning, How It Works
Homebuyers face may choices in types of mortgages, from longer-term fixed rate loans to shorter-term adjustable-rate loans. A 2/28 adjustable-rate mortgage is one type of adjustable rate mortgage that is less common than the traditional 30-year fixed mortgage, but it may suit some buyers' needs.
A 2/28 mortgage essentially offers a two-year [fixed interest rate](https://www.investopedia.com/terms/f/fixedinterestrate.asp) followed by a floating rate for 28 years. Learn how this type of mortgage works, and more about the pros and cons.
## What Is a 2/28 Adjustable-Rate Mortgage (2/28 ARM)?
A 2/28 [adjustable-rate mortgage](https://www.investopedia.com/terms/a/arm.asp) (2/28 ARM) is a type of 30-year home loan that has an initial two-year fixed interest rate period. After this two-year period, the rate floats based on an index rate plus a [margin](https://www.investopedia.com/terms/a/armmargin.asp).
The initial teaser rate is typically below the average rate of conventional mortgages, but the adjustable rate can then rise significantly. Since banks don’t make much money on the initial teaser rate, 2/28 ARMs include hefty [prepayment penalties](https://www.investopedia.com/terms/p/prepaymentpenalty.asp) during the first two years.
### Key Takeaways
* 2/28 adjustable-rate mortgages (ARMs) offer an introductory fixed rate for two years, after which the interest rate adjusts semiannually for 28 more years.
* When ARMs adjust, interest rates change based on their marginal rates and the indexes to which they’re tied.
* Homeowners generally have lower mortgage payments during the introductory period, but are subject to interest rate risk afterward.
## Understanding 2/28 Adjustable-Rate Mortgages (2/28 ARMs)
The 2/28 ARMs became popular during the real estate boom of the early 2000s, when soaring prices put [conventional mortgage](https://www.investopedia.com/terms/c/conventionalmortgage.asp) payments out of reach for many buyers.
Other ARM structures exist, such as [5/1](https://www.investopedia.com/terms/1/5-1_arm.asp), 5/5, and [5/6 ARMs](https://www.investopedia.com/terms/1/5-6_hybrid_arm.asp), which feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively. Notably, 15/15 ARMs adjust once after 15 years and then remain fixed for the remainder of the loan.
Less common are the 2/28 and [3/27 ARMs](https://www.investopedia.com/terms/1/327arm.asp). With the former, the fixed interest rate applies for only the first two years, followed by 28 years of adjustable rates. With the latter, the fixed rate is for three years, with adjustments in each of the following 27 years. In these cases, rates adjust semiannually.
## Example of 2/28 ARM
For example, let's say you are buying a $350,000 home and providing a down payment of $50,000. You have a $300,000 2/28 ARM mortgage with an initial interest rate of 5% and monthly payments of $1,906. (Total monthly mortgage payments vary when property taxes and insurance costs are factored in. This example assumes $230 per month in property tax and $66 per month in insurance costs.)
With a 2/28 ARM, your interest rate of 5% remains fixed for two years. Then, it can change based on changes in a [broader index rate](https://www.investopedia.com/terms/a/arm_index.asp). Let's say your interest rate then rises to 5.3%. Your total monthly costs would rise to $1,961. Your interest rate would continue to change over the remainder of the loan depending on the broader index. So, the total costs of the loan would be difficult to estimate.
In comparison, if you had a 30-fixed mortgage on the same loan with 5% interest, you would pay $1,906 per month and you can expect to pay $279,987 in total interest if you did not pay the loan off early.
## Risks of 2/28 ARMs
The risk with an adjustable-rate mortgages like an 2/28 ARM is the potential for the rate to increase. After two years, the rate is adjusted every six months, typically upward, by a margin above an index rate, such as the [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp) or the [Secured Overnight Financing Rate (SOFR)](https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954). 2/28 ARMs have some built-in safety features, such as a [lifetime interest rate cap](https://www.investopedia.com/terms/l/lifetimecap.asp) and limits on how much the rate can change with each period. But even with caps, homeowners can face significant payment spikes in [volatile](https://www.investopedia.com/terms/v/volatility.asp) markets.
During the boom, many homeowners failed to understand how a seemingly small rate increase could dramatically boost their monthly payment. And even many of those who were fully aware of the risks viewed 2/28 ARMs as a short-term financing vehicle. The idea was to take advantage of the low teaser rate, then [refinance](https://www.investopedia.com/terms/r/refinance.asp) after two years to either a conventional mortgage. Or, if their credit was not good enough, they would refinance to a new adjustable mortgage. Amid spiking real estate prices, this strategy kicked the debt further down the road. To many, this made a certain amount of sense since, after all, the borrower’s [home equity](https://www.investopedia.com/terms/h/home_equity.asp) was rising fast.
But with the [market collapse](https://www.investopedia.com/terms/c/credit-crisis.asp) in 2008, home values plummeted. Many owners with 2/28 ARMs found were unable to refinance, make their payments, or sell their homes for the value of the outstanding loan. The rash of [foreclosures](https://www.investopedia.com/terms/f/foreclosure.asp) led to stricter loan standards. Today, banks more carefully evaluate a borrower’s ability to make adjustable-rate payments.
## 2/28 ARM vs. Fixed Rate Mortgage
Adjustable-rate mortgages like a 2/28 ARM work differently than fixed-rate mortgages and this difference is important to understand for planning your long-term finances.
An adjustable rate mortgage will have an interest rate that can change. That means your monthly payments can change and the overall total interest you will pay is unpredictable. Because the interest can change, you will need to prepare for the possibility that you will have to make higher monthly payments.
In contrast, interest on a fixed-rate mortgage does not change. You can plan for the same monthly payment for the life of the loan. A 2/28 ARM offers the fixed rate for only the first two years, after which the rate can adjust.
## Is a 2/28 Adjustable-Rate Mortgage Right for You?
A 2/28 adjustable-rate mortgage has advantages and disadvantages that make it ideal for some buyers but not for others. Weigh the pros and cons with your own financial situation to determine if this type of mortgage is right for you.
You may benefit from a 2/28 ARM if you need a lower monthly payment at the beginning of your mortgage and if you believe you will be able to make higher monthly payments in the future. However if you can afford a higher monthly payment, you may save more money in total interest costs with other loan options, such as a 15-year fixed-rate loan.
## What Are the Disadvantages of an Adjustable-Rate Mortgage?
An adjustable-rate mortgage can provide lower monthly payments at the beginning of the loan, but borrowers need to prepare for the potential that their payments can increase. If the interest rate increases, then monthly costs and total borrowing costs increase.
## What Is a 5/1 ARM With a 30-Year Term?
With a 5/1 adjustable-rate mortgage (ARM), your interest rate is fixed, or remains the same, for the first five years. Then, it adjusts once a year. When these mortgages have a 30-year term, that means you will have a fixed interest rate for five years and an adjustable rate for the next 25 years. These loans are also known as [5/1 hybrid adjustable-rate mortgages](https://www.investopedia.com/terms/1/5-1_arm.asp).
## Can You Pay off an ARM Loan Early?
Whether you can pay off an adjustable-rate mortgage (ARM) early depends on the terms of your loan. With some ARMs, you may face a prepayment penalty if you pay the loan off early, including if you sell the home or refinance the loan.
## The Bottom Line
A 2/28 adjustable-rate mortgage (ARM) is a variable-rate home loan that has a set rate for the first two years and then a floating rate for the next 28 years. It is an alternative to a 30-year fixed mortgage that, while less common, can be more suitable for certain buyers. Like any mortgage, it has advantages and disadvantages.
> **Article Sources**
>
> 1. U.S. Department of Housing and Urban Development. “[Adjustable Rate Mortgages (ARM)](https://www.hud.gov/program_offices/housing/sfh/ins/203armt).”
>
> 2. Center for American Progress. “[The 2008 Housing Crisis](https://www.americanprogress.org/issues/economy/reports/2017/04/13/430424/2008-housing-crisis/).” |
2-1 Buydown | # What Is a 2-1 Buydown Loan and How Do They Work?
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*— Investopedia / Michela Buttignol*
A 2-1 buydown is a [mortgage](https://www.investopedia.com/terms/m/mortgage.asp) agreement that provides a low interest rate for the first year of the loan, a somewhat higher rate for the second year, and then the full rate for the third and later years. Borrowers or home sellers pay additional money upfront to earn the lower rate for those first two years.
### Key Takeaways
* A 2-1 buydown is a type of financing that lowers the interest rate on a mortgage for the first two years before it rises to the regular, permanent rate.
* The rate is typically two percentage points lower during the first year and one percentage point lower in the second year.
* Sellers, including home builders, may offer a 2-1 buydown to make a property more attractive to buyers.
* 2-1 buydowns can be a good deal for homebuyers, provided that they will be able to afford the higher monthly payments once those begin.
:max_bytes(150000):strip_icc()/2-1_buydown.asp-final-d03c18fb13aa44669cb2c713a3733844.png)
*— Investopedia / Mira Norian*
## How 2-1 Buydowns Work
A buydown is a real estate financing technique that makes it easier for a borrower to qualify for a mortgage with a lower interest rate. That lower rate can last for the duration of the mortgage (as is often the case when borrowers pay extra [points](https://www.investopedia.com/mortgage/mortgage-rates/points/) up ront to the lender) or for a particular period of time. A 2-1 buydown is one kind of temporary buydown, in this case lasting for two years.
In a 2-1 buydown, the interest rate increases from one year to the next until it settles into its permanent rate in year three. Lenders charge an additional fee to compensate for the interest they won’t be receiving in those early years.
Sellers, including home builders, often use 2-1 buydowns as an incentive for potential purchasers.
> **Fast Fact**
>
> Either a homebuyer or a home seller can pay for a buydown. That payment may be in the form of mortgage points or a lump sum deposited in an escrow account with the lender and used to subsidize the borrower’s reduced monthly payments.
## Example of a 2-1 Buydown Mortgage
Suppose a real estate developer offers a 2-1 buydown on its new home. If the prevailing interest rate on 30-year mortgages is 5%, a homebuyer could get a mortgage that charges just 3% in the first year, 4% in the second year, and 5% after that.
If the homebuyer took out a $200,000, 30-year mortgage, for example, their monthly payment would be $843 during the first year. In the second year, they would pay $995. After the end of the second year, their monthly payment would rise to $1,074, where it would stay for the remainder of the mortgage.
## 2-1 Buydown Pros and Cons
For home sellers, a 2-1 buydown can help by making it easier and sometimes faster to sell their homes for a good price. The downside, of course, is that it comes at a cost, which ultimately reduces their net profit from the sale.
For homebuyers, a 2-1 buydown has several potential benefits. It can help them afford a larger mortgage and a more expensive home than they might otherwise qualify for. It also buys them some time before their mortgage payments rise to the full amount, which can be helpful if their income is also rising from year to year.
> **Warning**
>
> The downside for homebuyers is the risk that their income won’t keep pace with those increasing mortgage payments. In that case, they might find themselves stretched too thin and even have to sell the home.
## When to Use a 2-1 Buydown
Home sellers who are having difficulty selling and need to provide an incentive to find a buyer may want to consider offering (and paying for) a 2-1 buydown.
Borrowers may benefit from a buydown if it allows them to buy the home they want at a price they can afford. However, they will also want to consider what would happen if their income doesn’t rise fast enough to keep up with their future monthly payments.
Buyers should also make sure that they are getting a fair deal on the home in the first place. That’s because some sellers might increase the home’s price to make up for the cost of the 2-1 buydown.
Note that buydowns may not be available under some state and federal mortgage programs or from all lenders. A 2-1 buydown is available on fixed-rate [Federal Housing Administration (FHA)](https://www.investopedia.com/terms/f/federal-housing-administration.asp) loans, but only for new mortgages and not for refinancing. Terms can also vary from lender to lender.
## What Is a Buydown?
A buydown is a means of [paying for a lower interest rate](https://www.investopedia.com/terms/b/buydown.asp), often on a mortgage. A 2-1 buydown is just one example of this type of transaction. There also are buydowns that will lower rates for different periods of time or even for the duration of the mortgage.
## Is a Buydown a Good Deal?
It depends on the circumstances. The most important factor with a 2-1 buydown is to be prepared for what mortgage payments will be after the first two years. That's the payment you'll be responsible for making for the bulk of the mortgage. If you plan for that, it definitely can be a good deal.
## Who Pays for a 2-1 Buydown?
Either the buyer or the seller can pay for the buydown. Buyers might be willing to pay for it to save on interest payments. Sellers might be willing to pay for it to make a home easier to sell.
## The Bottom Line
A 2-1 buydown lowers the interest rate on a mortgage for the first two years before it rises to the regular, permanent rate for the third year and beyond. A typical 2-1 buydown offers a reduction of two percentage points the first year and one percentage point the second year.
Borrowers can pay for a 2-1 buydown, but sellers, including home builders, may also offer one to make a property more attractive. These transactions can be a good deal for homebuyers if they can afford the higher monthly payments that will begin in year three.
> **Article Sources**
>
> 1. Federal Housing Finance Agency, Office of Inspector General. "[Temporary Interest Rate, Buydowns](https://www.fhfaoig.gov/sites/default/files/Temporary-Interest-Rate-Buydowns-Dashboard.pdf)." Page 3.
>
> 2. The Mortgage Reports. "[What Is a 2-1 Buydown Loan and How Does It Work?](https://themortgagereports.com/111375/what-is-a-2-1-buydown)" |
2000 Investor Limit: What It is, How It Works, Example | # 2000 Investor Limit: What It is, How It Works, Example
## What Is the 2000 Investor Limit?
The 2,000 Investor Limit is a stipulation required by the [Securities & Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp) that mandates a company that exceeds 2,000 individual investors, and with more than $10 million in combined assets, [must file its financials](https://www.investopedia.com/articles/fundamental-analysis/08/sec-forms.asp) with the commission. According to SEC rules, a company that meets these criteria has 120 days to file following its [fiscal year's](https://www.investopedia.com/terms/f/fiscalyear.asp) end.
### Key Takeaways
* The 2,000 investor limit or rule is a key threshold for private businesses that do not wish to disclose financial information for public consumption.
* A business with more than 2,000 distinct shareholders, totaling $10 million or more in capital, must file with the SEC even if it is a privately-held company.
* Congress raised the limit from 500 individual investors to 2,000 investors in 2016 as part of the JOBS and FAST Acts.
* The increased investor limit has opened greater possibility for equity crowdfunding.
## Understanding the 2000 Investor Limit
The 2,000 investor limit or rule is a key threshold for private businesses that do not wish to disclose financial information for public consumption. Congress [raised the limit](https://www.sec.gov/info/smallbus/secg/jobs-act-section-12g-small-business-compliance-guide) from [500 individual shareholders](https://www.investopedia.com/terms/5/500-shareholder-threshold.asp) in 2016 as part of the Jumpstart Our Business Startups ([JOBS](https://www.investopedia.com/terms/j/jumpstart-our-business-startups-act-jobs.asp)) Act and Title LXXXV of the Fixing America’s Surface Transportation (FAST) Act. The revised rules also specify a limit of 500 persons who are not [accredited investors](https://www.investopedia.com/terms/a/accreditedinvestor.asp) before public filing is required.
The prior threshold had been 500 [holders of record](https://www.investopedia.com/terms/h/holderofrecord.asp) without regard to accredited investor status. Congress began debating an increase in the limit in the wake of the 2008 recession and an explosion in online businesses (some of which complained that they were growing so fast that the disclosure rules had become a burden at too early a stage of their lifecycle).
The JOBS Act also set up a separate registration threshold for banks and bank [holding companies](https://www.investopedia.com/terms/h/holdingcompany.asp), allowing them to terminate the registration of securities or suspend reporting if that class of shares is held by less than 1,200 people.
## Investor Thresholds and Equity Crowdfunding
The JOBS Act revisions to SEC rules helped facilitate the growth of [crowdfunding](https://www.investopedia.com/terms/c/crowdfunding.asp) platforms. These platforms are able to raise money from individual investors online without providing detailed financial data. The rules established limits on how much individuals can invest in SEC-approved crowdfunding platforms as a percent of the lesser of their annual income or [net worth](https://www.investopedia.com/terms/n/networth.asp).
The individual limits for crowdfunding, through an investment portal approved by the SEC, as of May 2017:
* If either your annual income _or_ your net worth is under $107,000, during any 12-month period, you can invest up to the greater of either $2,200 or 5 percent of the lesser of your annual income or net worth.
* If both your annual income and net worth are $107,000 or more during any 12-month period, you can invest up to 10 percent of your annual income or net worth, whichever is less, not to exceed $107,000.
These calculations don't include the value of your home.
## Example
For example, suppose that your annual income is $150,000 and your net worth is $80,000. JOBS Act crowdfunding rules allow you to invest the greater of $2,200—or 5% of $80,000 ($4,000)—during a 12-month period. So in this case, you can invest $4,000 over a 12-month period.
> **Article Sources**
>
> 1. Securities and Exchange Commission. "[Exchange Act Reporting and Registration](https://www.sec.gov/smallbusiness/goingpublic/exchangeactreporting)." Accessed Dec. 14, 2020.
>
> 2. Securities and Exchange Commission. "[SEC Adopts Amendments to Implement JOBS Act and FAST Act Changes for Exchange Act Registration Requirements](https://www.sec.gov/news/pressrelease/2016-81.html)." Accessed Dec. 14, 2020.
>
> 3. Securities and Exchange Commission. "[Investor Bulletin: Crowdfunding Investment Limits Increase](https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_crowdfundingincrease)." Accessed Dec. 14, 2020.
>
> 4. Securities and Exchange Commission. "[Regulation Crowdfunding](https://www.sec.gov/smallbusiness/exemptofferings/regcrowdfunding)." Accessed Dec. 14, 2020. |
2011 U.S. Debt Ceiling Crisis: Meaning and Outcome | # 2011 U.S. Debt Ceiling Crisis: Meaning and Outcome
:max_bytes(150000):strip_icc()/GettyImages-951695678-9d8605c12bff4d0da3c464a899621b21.jpg)
*— Bloomberg Creative Photos / Getty Images*
> **Definition**
>
> The 2011 U.S. Debt Ceiling Crisis was a contentious debate in Congress that occurred in July 2011 regarding the maximum amount of debt that the federal government should be allowed.
## What Is the 2011 U.S. Debt Ceiling Crisis?
To resolve the 2011 U.S. Debt Ceiling Crisis over the amount of the national debt, Congress passed the Budget Control Act of 2011. This was one of a series of recurrent debates over increasing the total size of the U.S. national debt.
### Key Takeaways
* In 2008, the federal budget deficit stood at $458.6 billion, which widened to $1.4 trillion the following year as the government spent heavily to boost the economy.
* Congress passed a law to resolve the crisis that increased the debt ceiling by $2.4 trillion.
* As a result of the crisis, the United States’ credit rating was reduced from AAA to AA+ by Standard & Poor’s.
* The 2011 debt ceiling crisis had implications for future debt ceiling discussions.
## How the 2011 U.S. Debt Ceiling Crisis Unfolded
The federal government has rarely achieved a balanced budget, and its [budget deficit](https://www.investopedia.com/terms/b/budget-deficit.asp) ballooned following the [2007–08 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). In the 2008 fiscal year, the deficit stood at $458.6 billion, widening to $1.4 trillion in 2009 as the government engaged in a massive [fiscal policy](https://www.investopedia.com/terms/f/fiscalpolicy.asp) response to the economic downturn.
From 2008 to 2010, Congress raised the [debt ceiling](https://www.investopedia.com/terms/d/debt-ceiling.asp) from $10.6 trillion to $14.3 trillion. In 2011, as the [economy](https://www.investopedia.com/terms/e/economy.asp) showed early signs of recovery and federal debt approached its limit once again, negotiations began in Congress to balance spending priorities against the ever-rising debt burden.
A heated debate ensued, pitting proponents of spending and debt against fiscal conservatives. Pro-debt politicians argued that failing to raise the limit would require immediate cuts to spending already authorized by Congress, which could result in late, partial, or missed payments to [Social Security](https://www.investopedia.com/terms/s/socialsecurity.asp) and [Medicare](https://www.investopedia.com/terms/m/medicare.asp) recipients, government employees, and government contractors.
Moreover, they asserted that the [Treasury](https://www.investopedia.com/terms/u/ustreasury.asp) could suspend interest [payments on existing debt](https://www.investopedia.com/terms/t/trillion-dollar-coin.asp) rather than withhold funds committed to federal programs. The prospect of cutting back on already-promised spending was labeled a crisis by debt proponents.
On the other hand, the specter of a technical [default](https://www.investopedia.com/terms/d/default2.asp) on existing Treasury debt roiled financial markets. Fiscal conservatives argued that any debt limit increase should come with constraints on the growth of federal spending and debt accumulation.
> **Important**
>
> The U.S. has raised the debt limit 78 times since 1960. Most recently, it raised the debt limit in 2023.
## Outcome of the 2011 U.S. Debt Ceiling Crisis
Congress resolved the debt ceiling crisis by passing the [Budget Control Act of 2011](https://www.investopedia.com/terms/b/budget-control-act.asp), which became law on Aug. 2, 2011. This act allowed the debt ceiling to be raised by $2.4 trillion in two phases, or installments.
In the first phase, a $400 billion increase would occur immediately, followed by another $500 billion unless Congress disapproved it. The second phase allowed for an increase of $1.2 trillion to $1.5 trillion, subject to congressional disapproval as well.
In return, the law included $900 billion in slowdowns in planned spending increases over a 10-year period. It also established a special committee charged with finding at least $1.5 trillion in additional savings.
In effect, the legislation incrementally raised the debt ceiling from $14.3 trillion to $16.4 trillion by Jan. 27, 2012.
Following the passage of the act, [Standard & Poor’s (S&P)](https://www.investopedia.com/terms/s/sp.asp) took the radical step of downgrading the United States’ long-term credit rating from AAA to AA+, even though the U.S. did not default. The S&P report says, “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the (Obama) Administration recently agreed to fall short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” The credit rating agency cited the unimpressive size of deficit reduction plans relative to the likely future prospects for politically driven spending and debt accumulation.
## Debt Approval Process Leading to the 2011 U.S. Debt Ceiling Crisis
The U.S. Constitution gives Congress the power to borrow money. Before 1917, this power was exercised by Congress authorizing the Treasury to borrow specified amounts of debt to fund limited expenses, such as wartime military spending, which would be repaid after the end of hostilities. This kept the national debt directly linked to authorized spending.
In 1917, Congress imposed a limit on federal debt as well as individual issuance limits. In 1939, Congress gave the Treasury more flexibility in how it managed the overall structure of federal debt, giving it an aggregate limit. However, by delegating debt management authority to the Treasury, Congress was able to break the direct connection between authorized spending and the debt that finances it.
While allowing greater flexibility to raise spending, this practice also created a need for Congress to repeatedly raise the debt limit when spending threatens to overrun available [credit](https://www.investopedia.com/terms/c/credit.asp). Due to occasional political resistance to the idea of continually expanding the federal debt, this process of raising the debt limit has at times engendered controversy, which occurred during the 2011 Debt Ceiling Crisis.
## Longer-Term Implications of 2011 Debt Ceiling Crisis
The American economy, politics, and financial markets were all affected in the long run by the country’s 2011 debt limit issue. As mentioned before, Standard & Poor’s downgraded the United States’ credit rating for the first time ever (from AAA to AA+). This resulted in several longer-term implications.
First, the protracted debt ceiling talks and brinkmanship had an adverse effect on consumer and corporate confidence. On Aug. 8, 2011, the [S&P 500](https://www.investopedia.com/terms/s/sp500.asp) dropped 79.2 points while the [Nasdaq Composite Index](https://www.investopedia.com/terms/n/nasdaqcompositeindex.asp) dropped 174.72 points. Each of those two indexes lost over 6.6% of its value that day, with the [Dow Jones Industrial Average (DJIA)](https://www.investopedia.com/terms/d/djia.asp) dropping 634 points, or 5.55%.
Concerns about the long-term viability of U.S. government debt were raised as a result of the debt limit crisis’s failure to address the underlying fiscal issues. The nation’s fiscal stability and long-term economic prospects may be impacted by the unsolved concerns around budget deficits and the national debt. Most recently, the U.S. Senate has increased the debt ceiling limit to $31.4 trillion.
The debt limit issue and the ensuing credit rating cut had some effect on the [U.S. dollar](https://www.investopedia.com/terms/forex/u/usd-united-states-dollar.asp). Even while there may not have been much of an immediate impact, it prompted concerns about the strength and stability of the dollar in the long run.
The debt limit debate also sparked talks about possible adjustments to both the budgetary procedures and the debt ceiling mechanism. Measures have been taken to prevent similar crises in the future, such as changes to the budgeting schedule and discussions about prospective changes to the debt cap structure.
## What Could Happen If Congress Does Not Vote to Raise the Debt Ceiling?
According to U.S. Treasury Secretary [Janet Yellen](https://www.investopedia.com/articles/investing/101613/janet-yellen-background-and-philosophy.asp), failure to meet the government’s obligations would cause irreparable harm to the U.S. economy, the livelihood of all Americans, and global financial stability. She also mentioned that the U.S. would risk facing another credit rating downgrade, similar to that of 2011.
## Once the Debt Ceiling Is Reached, What Spending Will Be Cut?
In a letter to the U.S. House of Representatives, Yellen warned congressional leaders that the Treasury would implement extraordinary measures to prevent the U.S. from defaulting on its obligations. In the past, the Treasury has suspended new investments in the [Civil Service Retirement](https://www.investopedia.com/terms/c/csrs.asp) and Disability Fund and the Postal Service Retiree Health Benefits Fund. It also suspended reinvestment of the [Government Securities](https://www.investopedia.com/terms/g/governmentsecurity.asp) Investment Fund of the Federal Employees Retirement System [Thrift Savings Plan](https://www.investopedia.com/ask/answers/102714/thrift-savings-plan-tsp-qualified-retirement-plan.asp). Keep in mind that every debt ceiling debate cycle is unique and may be resolved using unique measures.
## Why Did Increasing the Debt Ceiling Cause Contentious Debate in 2011?
From 2008 to 2010, Congress raised the debt ceiling from $10.6 trillion to $14.3 trillion. In 2011, as the economy showed early signs of recovery and federal debt approached its limit again, negotiations began in Congress to decide spending priorities.
A heated debate ensued between pro-debt politicians and fiscal conservatives. Pro-debt politicians argued that failing to raise the limit could result in late, partial, or missed payments to Social Security and Medicare recipients, government employees, and government contractors. Fiscal conservatives argued that any debt limit increase should come with limits on federal spending and debt accumulation.
## The Bottom Line
Following the 2007–08 Financial Crisis, in an effort to slow down the [Great Recession](https://www.investopedia.com/terms/g/great-recession.asp) as well as the persistently high [unemployment rate](https://www.investopedia.com/terms/u/unemploymentrate.asp), the U.S. government increased federal spending. As a result, the federal debt reached its limit on multiple occasions from 2008 to 2011, which led to a series of increases in the debt limit. In 2011, the Treasury asked for its borrowing capacity to be extended.
The 2011 U.S. Debt Ceiling Crisis was a contentious debate in Congress that occurred in July 2011 regarding the maximum amount of debt that the federal government should be allowed. Congress resolved the debt ceiling crisis by passing the Budget Control Act of 2011, which became law on Aug. 2, 2011. This act allowed the debt ceiling to be raised by $2.4 trillion in two phases, or installments.
> **Article Sources**
>
> 1. The White House, Office of Management and Budget. “[Historical Tables](https://www.whitehouse.gov/wp-content/uploads/2020/02/hist_fy21.pdf),” Page 28.
>
> 2. House Budget Committee Democrats. “[Summary of the Budget Control Act of 2011](https://democrats-budget.house.gov/committee-report/summary-budget-control-act-2011).”
>
> 3. U.S. Government Accountability Office. “[Debt Limit: Analysis of 2011–2012 Actions Taken and Effect of Delayed Increase on Borrowing Costs](https://www.gao.gov/products/gao-12-701).”
>
> 4. FactCheck.org. “[Debt Limit Q&A](https://www.factcheck.org/2021/09/debt-limit-qa/).”
>
> 5. Reuters. “[Biden Signs Debt Limit Bill, Avoiding U.S. Default](https://www.reuters.com/world/us/biden-signs-bill-lifting-us-debt-limit-2023-06-03/).”
>
> 6. Congress.gov, U.S. Congress. “[S.365—Budget Control Act of 2011](https://www.congress.gov/bill/112th-congress/senate-bill/365?q=%7B%22search%22%3A%5B%22cite%3APL112-25%22%5D%7D&s=1&r=1).”
>
> 7. Standard & Poor’s, via The Washington Post. “[Research Update: United States of America Long-Term Rating Lowered to ‘AA+’ on Political Risks and Rising Debt Burden; Outlook Negative](https://www.washingtonpost.com/wp-srv/politics/documents/spratingreport_080611.pdf).”
>
> 8. Congressional Research Service, via Federation of American Scientists, Project on Government Secrecy. “[The Debt Limit Since 2011](https://fas.org/sgp/crs/misc/R43389.pdf),” Page 1 (Page 5 of PDF).
>
> 9. Investors Signals. “[Black Monday 2011, Revisited](https://www.investorsignals.com/2017/08/14/black-monday-2011-revisited/).”
>
> 10. Congress.gov, U.S. Congress. “[S.2168—No Default Act](https://www.congress.gov/bill/118th-congress/senate-bill/2168).”
>
> 11. U.S. Department of the Treasury. “[Debt Limit Letter to Congress 1/13/2023](https://home.treasury.gov/system/files/136/Debt-Limit-Letter-to-Congress-McCarthy-20230113.pdf?).” |
25% Rule: What it Means, How it Works, Rules | # 25% Rule: What it Means, How it Works, Rules
## What Is the 25% Rule?
There are two common uses of the "25% rule." One uses it to refer to long-term government debt in relation to its annual budget, and the second is to determine intellectual property royalties.
1. The 25% rule is the concept that a local government's long-term debt should not exceed 25% of its annual budget. Any debt beyond this threshold is considered excessive and poses a potential risk, as the municipality may have trouble servicing the debt.
2. The 25% rule also refers to a technique for determining [royalties](https://www.investopedia.com/terms/r/royalty.asp), which stipulates that a party selling a product or service based on another party's intellectual property must pay that party a royalty of 25% of the [gross profit](https://www.investopedia.com/terms/g/grossprofit.asp) made from the sale, before taxes. The 25% rule also commonly applies to trademarks, copyrights, patents, and other forms of [intellectual property](https://www.investopedia.com/terms/i/intellectualproperty.asp).
### Key Takeaways
* The 25% rule can refer to either public finance or intellectual property law.
* In public finance, the 25% rule prescribes that a public entity’s total debt should not exceed one-quarter of its annual budget.
* In intellectual property, the 25% rule suggests the reasonable royalty that a license should pay an intellectual property holder on profits.
## Understanding the 25% Rule
In both uses of the term, the 25% rule is more a matter of customary practice or [heuristic](https://www.investopedia.com/terms/h/heuristics.asp) (i.e., a [rule of thumb](https://www.investopedia.com/terms/r/rule-of-thumb.asp)), rather than an absolute or optimal threshold, or a strict legal requirement.
In the public finance setting, the 25% rule is a rough guideline for fiscal planning based on the confidence of bondholders and credit rating agencies. In the intellectual property arena, the 25% rule evolved from the customary rates negotiated between intellectual property holders and licensees.
## 25% Rule for Municipal Debt
Local or state governments looking to fund projects through [municipal bond](https://www.investopedia.com/terms/m/municipalbond.asp) issues have to make assumptions about the revenues they expect to bring in, often through taxation or projects like toll roads, which in turn will allow them to support bond payments. If revenue falls short of expectations, those municipalities may not be able to make bond payments, which can cause them to default on their obligations and hurt their [credit rating](https://www.investopedia.com/terms/c/creditrating.asp).
Municipal bondholders want to make sure that the issuing authority has the capacity to pay, which can be jeopardized by getting too deep in debt. Bondholders are thus cautious about purchasing bonds from local or state governments that are in violation of the 25% rule.
Tax-exempt [private activity bonds](https://www.investopedia.com/terms/p/privateactivitybond.asp)—bonds issued by municipalities on behalf of private or non-profit organizations—also have a 25% rule applied to the proceeds from the bonds. This rule states that no more than 25% of bond proceeds may be used for land acquisition.
## 25% Rule for Intellectual Property
[Patent](https://www.investopedia.com/terms/p/patent.asp) or trademark owners use the 25% rule as a yardstick for defining a reasonable amount of royalty payments. The rule assumes that a [licensee](https://www.investopedia.com/terms/l/licensee.asp) should retain at most 75% of the profits of a patented product given that s/he took on the bulk of the risks of developing the product and bringing the intellectual property to the market. The patent owner takes the remainder as a license royalty.
Setting the value of intellectual property is a complex matter. Although royalties are typically assessed against revenues, the 25% rule applies to profits. Furthermore, the 25% rule does not closely define what "gross profit" includes, which creates ambiguity in the valuation calculation. Because it's a simple rule, it does not take into account the costs associated with marketing the product. For example, the holder of a [copyright](https://www.investopedia.com/terms/c/copyright.asp) will receive a 25% royalty, though the party doing the selling usually incurs the cost of attracting demand in the market through advertising.
In the 2011 court case of _Uniloc USA, Inc. v. Microsoft Corp_, the [court of appeals](https://www.investopedia.com/terms/a/appellate-courts.asp) for the Federal Circuit ruled that the 25 percent rule may not be used as a starting point for a patent damage analysis bound for the courtroom. The appeals court concluded that the rule does not rise to an admissible level of evidence and may not be relied upon in a patent lawsuit in federal court. While the 25% rule may still be used by other parties in estimating a proposed patent royalty, it should not be considered a legal mandate.
> **Article Sources**
>
> 1. Internal Revenue Service. "[26 CFR 601.601: Rules and Regulations](https://www.irs.gov/pub/irs-drop/rp-17-13.pdf)," Page 7. Accessed Sept. 29, 2021.
>
> 2. Robert Goldscheider. "[The Classic 25% Rule and The Art of Intellectual Property Licensing](https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=1220&context=dltr)," Pages 1-2, 7-9, 14. _Duke Law & Technology Review._ Accessed Sept. 29, 2021. |
3-2-1 Buydown Mortgage: Meaning, Pros and Cons, FAQs | # 3-2-1 Buydown Mortgage: Meaning, Pros and Cons, FAQs
:max_bytes(150000):strip_icc()/3-2-1_buydown.asp-Final-fa9d408b7f784938979231ce2d84ca58.jpg)
*— Investopedia / Yurle Villegas*
A 3-2-1 buydown mortgage is a type of home loan that can help would-be homebuyers achieve their goal of homeownership when high mortgage rates threaten to [price them out](https://www.investopedia.com/terms/p/priced-out.asp#:~:text=Priced%20out%20refers%20to%20an,priced%20out%20of%20the%20market.) of the market. The loan interest rate is reduced for the first three years of the loan term. In the fourth year, the original rate is applied and remains for the life of the mortgage.
Read on to learn how a 3-2-1 buydown mortgage works and whether one may be right for your needs.
### Key Takeaways
* With a 3-2-1 buydown mortgage, the borrower pays a lower than normal interest rate over the first three years of the loan.
* The loan interest rate is reduced by 3% in the first year, 2% in the second year, and 1% in the third year; for example, a 5% mortgage would be just 2% in year one.
* After the buydown period ends, the lender charges the full interest rate for the remainder of the mortgage term.
* Buydowns are often used by sellers, including home builders, to help buyers afford a property.
## How 3-2-1 Buydown Mortgages Work
A [buydown](https://www.investopedia.com/terms/b/buydown.asp) is a mortgage-financing technique that allows a homebuyer to obtain a lower interest rate for at least the first few years of the loan, or possibly its entire life. It is similar to the practice of buying [discount points](https://www.investopedia.com/terms/d/discountpoints.asp) on a mortgage in return for a lower interest rate, except that it is temporary.
Typically, the seller or homebuilder (sometimes even the [mortgage lender](https://www.investopedia.com/best-online-mortgage-lenders-7372752)) covers the cost of the 3-2-1 buydown. The cost equates to the savings to the buyer in the first three years.
In general, 3-2-1 buydown loans are available only for primary and secondary homes, not for [investment properties](https://www.investopedia.com/terms/i/investment-property.asp). The 3-2-1 buydown is also not available as part of an [adjustable-rate mortgage (ARM)](https://www.investopedia.com/terms/a/arm.asp) with an initial period of fewer than five years.
The interest rate for a 3-2-1 buydown mortgage is reduced by 3% for the first year, 2% for the second year, and 1% for the third year. The original interest rate then kicks in for the remaining term of the loan. By contrast, with a [2-1 buydown](https://www.investopedia.com/terms/1/2-1_buydown.asp), the rate is reduced by 2% for the first year, 1% for the second year, and then rises to the original rate when the buydown period ends.
## Pros and Cons of a 3-2-1 Buydown Mortgage
### Pros
* A 3-2-1 buydown mortgage can be an attractive option for homebuyers when mortgage rates are high enough to discourage a home purchase.
* They give home sellers a way to entice buyers in challenging housing markets.
* Buydown loans can be advantageous for borrowers who may not have the needed funds today but expect to have higher incomes in future years.
* Over the first three years of lower monthly payments, borrowers can set aside cash for other expenses, such as home repairs or remodeling.
* When the loan finally resets to its permanent interest rate, borrowers have the certainty of knowing what their payments will be for years to come, which can be useful for budgeting.
* A fixed-rate 3-2-1 buydown mortgage is less risky than an ARM or a [variable-rate mortgage](https://www.investopedia.com/terms/v/variable-rate-mortgage.asp), where rising interest rates could mean higher monthly payments in the future.
### Cons
* A potential downside of a 3-2-1 buydown mortgage is that it may lull the borrower into buying a more expensive home than they can afford.
* The lower monthly costs are temporary and homebuyers must be prepared for a jump in payments.
* Borrowers who assume that their income will rise enough to afford future payments could find themselves in financial trouble if this fails to occur.
> **Fast Fact**
>
> A temporary interest rate buydown is an alternative to price cuts for sellers and homebuilders. This option is typically made available when mortgage interest rates have risen to levels that affect the affordability of home purchases.
## Who Subsidizes 3-2-1 Buydown Mortgages?
The savings experienced by the homebuyer in the first three years of a buydown mortgage term represent the cost of a 3-2-1 buydown mortgage. Typically, the cost is covered by someone other than the buyer—the seller, homebuilder, or even the lender. For example, motivated sellers might be willing to pay the cost to attract buyers and close the deal.
In some circumstances, a company that's moving an employee to a new city might cover the buydown cost to ease the expense of relocation. More commonly, real estate developers will offer buydowns as incentives to potential buyers of newly built homes.
## Is a 3-2-1 Buydown Mortgage Right for You?
As mentioned, it can be risky to get a 3-2-1 buydown mortgage on the assumption that your income will rise sufficiently over the next three years so that you’ll be able to afford the mortgage payments when they reach their maximum level.
For that reason, you must consider how secure your job is and whether unforeseen circumstances could make your house payments unmanageable once you reach the fourth year.
In addition, if by some chance you have to pay for the buydown on your own, then the key question to ask yourself is whether paying the cash upfront is worth the several years of lower payments that you’ll receive in return.
For example, you might have other uses for that money, such as investing it or using it to pay off other debts with higher interest rates (like credit cards or car loans). If you have the cash to spare and don’t need it for anything else, then a 3-2-1 buydown mortgage could make sense.
The question is easier to answer when another party foots the bill for the buydown. But even then, ask yourself whether the maximum monthly payments will be affordable. Could the enticingly low initial rates lead you to want a more expensive home and to take on a [larger mortgage](https://www.investopedia.com/articles/pf/05/030905.asp) than makes sense financially? You’ll also want to make sure that the home is fairly priced in the first place and that the seller isn’t padding the price to cover the buydown costs.
## What Does a 3-2-1 Buydown Mortgage Cost?
The cost of a 3-2-1 buydown mortgage is the total amount that the buyer saves over the three-year period of lower rates.
## Who Pays for a 3-2-1 Buydown Mortgage?
Usually the seller, homebuilder, or lender pays the cost of a buydown mortgage. Employers will sometimes pay for a buydown if they are relocating an employee to another area and want to ease the financial burden. Sometimes, the buyer/borrower may pay it.
## Is a 3-2-1 Buydown Mortgage a Good Deal?
A 3-2-1 buydown mortgage can be a good deal for the homebuyer, particularly if someone else, such as the seller, is paying for it. However, buyers need to be reasonably certain that they’ll be able to afford their mortgage payments once the full interest rate applies from the fourth year onward. Otherwise, they could find themselves stretched too thin—and, in a worst-case scenario, lose their homes.
## The Bottom Line
A 3-2-1 buydown mortgage offers homebuyers a financing option that can get them into a home despite a high interest rate environment. It offers them a way to save money on monthly loan payments in the first three years of the loan. However, borrowers must understand that their monthly payments will increase in the fourth year of the loan to the original interest rate and remain at that level for the life of the mortgage.
> **Article Sources**
>
> 1. American Pacific Mortgage. "[Understanding a 3-2-1 Interest Rate Buydown](https://www.apmortgage.com/blog/understanding-a-3-2-1-interest-rate-buydown)." |
3-6-3 Rule: Slang Term for How Banks Used to Operate | # 3-6-3 Rule: Slang Term for How Banks Used to Operate
## What Is the 3-6-3 Rule?
The 3-6-3 rule is a slang term that refers to an unofficial practice in the [banking](https://www.investopedia.com/personal-finance/banks-pay-highest-interest-rates-savings-accounts/) industry in the 1950s, 1960s, and 1970s that was the result of non-competitive and simplistic conditions in the industry.
The 3-6-3 rule describes how bankers would supposedly give 3% interest on their depositors' accounts, lend the depositors money at 6% [interest](https://www.investopedia.com/terms/i/interest.asp), and then be playing golf by 3 p.m. In the 1950s, 1960s, and 1970s, a huge part of a bank's business was lending out money at a higher interest rate than what it was paying out to its depositors (as a result of tighter regulations during this time period). The difference between what a bank earns on interest-accruing endeavors and what it pays out in interest-bearing accounts is known as the [net interest rate spread](https://www.investopedia.com/terms/n/net-interest-rate-spread.asp).
### Key Takeaways
* The 3-6-3 rule is a slang term from the 1950s, 1960s, and 1970s, which involved paying depositors 3% interest on account, lending money at 6% interest, and the ability to be playing golf by 3 p.m.
* The 3-6-3 rule describes the structure behind paying account holders a lower interest rate on deposits and changing a higher rate when loaning out the money
* The net interest rate spread is the difference between the rates a bank pays customers and what it receives in income-generating activities
* The government implemented tighter banking regulations after the Great Depression controlling the rate banks could lend money and reducing bank-to-bank competition
* Looser regulation after the 1970s allowed banks to operate in a more competitive and complex fashion and provide additional services to customers
## Understanding the 3-6-3 Rule
After the [Great Depression](https://www.investopedia.com/terms/g/great_depression.asp), the government implemented tighter banking regulations. This was partially due to the problems–namely corruption and a lack of regulation–that the banking industry faced leading up the economic downturn that precipitated the Great Depression. One result of these regulations is that it controlled the rates at which banks could lend and borrow money. This made it difficult for banks to compete with each other and limited the scope of the services they could provide clients. As a whole, the banking industry became more stagnant.
With the loosening of banking regulations and the widespread adoption of information technology in the decades after the 1970s, banks now operate in a much more competitive and complex manner. For example, banks may now provide a greater range of services, including retail and commercial banking services, [investment management](https://www.investopedia.com/terms/i/investment-management.asp), and [wealth management](https://www.investopedia.com/terms/w/wealthmanagement.asp).
## Types of Banking Services
For banks that provide retail banking services, individual customers often use local branches of much larger commercial banks. Retail banks will generally offer savings and checking accounts, mortgages, personal loans, debit/credit cards, and [certificates of deposit](https://www.investopedia.com/terms/c/certificateofdeposit.asp) (CDs) to their clients. In retail banking, the focus is on the individual consumer (as opposed to any larger-sized clients, such as an [endowment](https://www.investopedia.com/terms/e/endowment.asp)).
Banks that provide investment management for their clientele typically manage collective investments (such as pension funds) as well as oversee the assets of individual customers. Banks that work with collective assets may also offer a wide range of traditional and alternative products that may not be available to the average retail investor, such as [IPO](https://www.investopedia.com/terms/i/ipo.asp) opportunities and [hedge funds](https://www.investopedia.com/terms/h/hedgefund.asp).
For banks that offer wealth management services, they may cater to both high-net-worth and ultra-high-net-worth individuals. The [financial advisors](https://www.investopedia.com/terms/f/financial-advisor.asp) at these banks typically work with clients to develop tailored financial solutions to meet their needs. Financial advisors may also provide specialized services, such as [investment management](https://www.investopedia.com/terms/i/investment-management.asp), income tax preparation, and [estate planning](https://www.investopedia.com/terms/e/estateplanning.asp). Most financial advisors aim to attain the [Chartered Financial Analyst (CFA) designation](https://www.investopedia.com/terms/c/cfa.asp), which measures their competency and integrity in the field of investment management.
## Does the 3-6-3 Rule Still Apply?
The 3-6-3 rule was a slang term for banking conditions in the 1950s, 60s, and 70s when government regulations were stricter and bank lending practices were more uniform. The term suggested banks paid account holders 3% interest, loaned out money at 6% interest, and were done with their work day and playing golf by 3 p.m. Looser regulations in the 1970s changed this.
## Why Is the 3-6-3 Rule No Longer True?
When banking regulations changed in the 1970s, banks were allowed to operate in a more competitive manner, generating a different profit structure than the 3-6-3 rule would have allowed.
## What Does the Expression Banker's Hours Mean?
Banker's hours as an expression means a shorter work day than what most businesses have, which was once 9 a.m. to 5 p.m. By comparison, bankers were said to work between 10 a.m. and 3 p.m., the hours that banks used to be open.
## The Bottom Line
The 3-6-3 rule is an outdated slang term from the 1950s through the 1970s that referred to the perception that banking at the time consisted of paying account holders 3%, charging 6% when lending money, and calling it a day and leaving by 3 p.m. when banks used to close. The term became less relevant after regulations changed in the 1970s and banks became more competitive with each other and offered a greater variety of rates. |
3/27 Adjustable-Rate Mortgage (ARM) | # 3/27 Adjustable-Rate Mortgage (ARM)
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*— Investopedia / Sydney Saporito*
A 3/27 adjustable-rate mortgage (ARM) is a 30-year loan that carries a fixed interest rate for the first three years, then a variable rate for the remaining 27 years. Borrowers often use a 3/27 ARM as a short-term financing vehicle that they can later refinance into a mortgage with more favorable terms.
### Key Takeaways
* A 3/27 adjustable-rate mortgage (ARM) is a 30-year mortgage with a three-year fixed interest rate period.
* The fixed interest rate is generally lower than the current rates on 30-year conventional mortgages.
* After three years, and for the remaining 27 years of the loan, the interest rate will float based on an index, such as the yield on one-year U.S. Treasury bills.
* Because their monthly payments can rise significantly once the interest rate adjusts, borrowers should plan carefully before taking out a 3/27 ARM to make sure it will still be affordable.
## How a 3/27 ARM Works
[Adjustable-rate mortgages (ARMs)](https://www.investopedia.com/terms/a/arm.asp) are a type of home loan in which the interest rate applied to the outstanding balance varies throughout the life of the loan. With an ARM, the initial interest rate is fixed for a period of time. After that, the rate resets periodically, at yearly, semiannual, or even monthly intervals.
ARMs differ from [fixed-rate mortgages](https://www.investopedia.com/mortgage/mortgage-rates/fixed-versus-adjustable-rate/), the other primary mortgage type, which charge a set rate of interest that remains the same for the entirety of the loan.
3/27 ARMs are a kind of hybrid. For the first three years, they have a fixed interest rate, which is generally lower than the current rates on 30-year conventional mortgages. But after that, and for the remaining 27 years of the loan, their interest rate will fluctuate based on a benchmark index, such as the yield on one-year U.S. [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp).
The lender also adds a [margin](https://www.investopedia.com/terms/a/armmargin.asp) on top of the index to set the interest rate that the borrower will actually pay. The total is known as the [fully indexed interest rate](https://www.investopedia.com/terms/f/fullyindexedinterestrate.asp). This rate is often substantially higher than the initial three-year fixed interest rate, although 3/27 ARMs usually have caps on how quickly they can increase.
Typically, the interest rate on a 3/27 ARM won’t increase more than 2% per adjustment period, which can occur every six or 12 months. That means the rate can increase by two full percentage points (not 2% of the current interest rate). So, for example, the rate might go from 4% to 6% in a single adjustment period.
There might also be a life-of-the-loan cap set at 5% or more. In that case, the interest rate on a mortgage that started at 4% might go no higher than 9%, regardless of what happens with the index on which it is based.
## 3/27 ARM Example
Say a borrower takes out a $250,000 3/27 ARM at an initial fixed rate of 3.5%. For the first three years, their monthly mortgage payment will be $1,123.
Then let’s assume that after three years, the benchmark interest rate is 3% and the bank’s margin is 2.5%. That adds up to a fully indexed rate of 5.5%.
If the borrower still has the 3/27 ARM and hasn’t refinanced into a different mortgage, their monthly payment will now be $1,483, an increase of $360.
> **Important**
>
> To avoid payment shock when the interest rate begins to adjust, borrowers with 3/27 ARMs should aim to refinance the mortgage within the first three years.
## Risks of a 3/27 ARM
The most serious risks for borrowers with a 3/27 mortgage are that they won’t be able to refinance their loan before the adjustable rate kicks in and that interest rates will have shot up in the meantime. That could happen if their credit score is too low, if their home has fallen in value, or simply if market forces have caused interest rates to rise across the board.
In that event, they would be stuck with the adjustable rate, which could mean considerably higher monthly payments, as in the example above.
## ARM Prepayment Penalties
Borrowers should also be aware that ARMs, including 3/27 mortgages, may carry [prepayment penalties](https://www.investopedia.com/terms/p/prepaymentpenalty.asp), which can make refinancing costly and defeat the purpose of taking out an ARM with the intention of switching to a different loan in a few years.
The Consumer Financial Protection Bureau (CFPB) suggests that borrowers check the lender’s Truth in Lending Act disclosure for any prepayment penalties before they sign a contract.
“Remember, many aspects of the loan are negotiable,” [the CFPB notes](https://www.consumerfinance.gov/ask-cfpb/can-i-prepay-my-loan-at-any-time-without-penalty-en-843/). “Ask for a loan that does not have a prepayment penalty if that is important to you. If you don’t like the terms of a loan and the lender won’t negotiate, you can always shop around for a different lender with terms that better suit your needs.”
## Is a 3/27 ARM a Good Investment?
A 3/27 ARM could be a good choice for you if you’re looking for a loan with relatively low monthly payments for the first several years. That could make buying a home more affordable if your budget is already stretched or could give you some extra cash to spend on home repairs, furnishings, or other purposes, compared with a more expensive loan.
However, you’ll want to be reasonably certain that you’ll be in a good position to refinance by the end of the initial three-year period. That means, for example, that you’ll have a strong [credit score](https://www.investopedia.com/terms/c/credit_score.asp) and a reliable source of income at that point.
A 3/27 ARM is not a good idea if there’s a strong possibility that you won’t be able to refinance (or sell the home) during those first three years and the new, adjustable-rate payments would be too much for you.
### FAQs
## What is a 3/27 adjustable-rate mortgage (ARM)?
A 3/27 adjustable-rate mortgage (ARM) charges a fixed interest rate for the first three years, followed by a variable interest rate for the remaining 27 years. Because it combines the features of a fixed-rate mortgage and an adjustable-rate mortgage, it is sometimes referred to as a [hybrid ARM](https://www.investopedia.com/terms/h/hybridarm.asp).
## What are the advantages of a 3/27 ARM?
A 3/27 ARM is likely to have a low interest rate for the first three years. But that rate can rise substantially starting in the fourth year.
## Is a 3/27 ARM right for me?
If you plan to sell the home or refinance it within the first three years, then a 3/27 ARM might make sense for you. However, look for a 3/27 ARM without any prepayment penalties. Otherwise, a prepayment penalty could make it very costly to get out of the mortgage. |
3C1 | # What Is 3C1 and How Is the Exemption Applied?
3C1 refers to a portion of the [Investment Company Act of 1940](https://www.investopedia.com/terms/i/investmentcompanyact.asp) that allows private investment companies to be considered exceptions to certain regulations and reporting requirements stipulated by the [Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp). However, these firms must satisfy specific requirements to maintain their exception status.
### Key Takeaways
* 3C1 refers to a portion of the Investment Company Act of 1940 that exempts certain private investment companies from regulations.
* A firm that's defined as an _investment company_ must meet specific regulatory and reporting requirements stipulated by the SEC.
* 3C1 allows private funds with 100 or fewer investors and no plans for an initial public offering to sidestep certain SEC requirements.
## Understanding 3C1
3C1 is shorthand for the 3(c)(1) exemption found in section 3 of the Act. To fully understand section 3C1, we must first review the Act's definition of an investment company and how it relates to earlier sections of the Act: 3(b)(1) and 3(c). An investment company, as defined by the Investment Company Act, are companies that primarily engage in the business of investing, reinvesting, or trading securities. If companies are considered investment companies, they must adhere to certain regulations and reporting requirements.
### 3(b)(1)
3(b)(1) was established to exclude certain companies from being considered an investment company and having to adhere to the subsequent regulations. Companies are exempt as long as they are not primarily in the business of investing, reinvesting, holding, owning, or trading in securities themselves, or through subsidiaries, or controlled companies.
### 3(c)
3(c) takes it a step further and outlines specific exceptions to the classification of an investment company, which include broker-dealers, pension plans, church plans, and charitable organizations.
### 3(c)(1)
3(c)(1) adds to the exceptions list in 3(c) citing certain parameters or requirements that, if satisfied, would allow private investment companies to not be classified as investment companies under the Act.
3(c)(1) exempts the following from definition of investment company:
> "Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons (or in the case of a qualifying venture capital fund, 250 persons) and that is not making and does not presently propose to make a public offering of such securities."
In other words, 3C1 allows private funds with 100 or fewer investors (and venture capital funds with fewer than 250 investors) and no plans for an [initial public offering](https://www.investopedia.com/terms/i/ipo.asp) to sidestep SEC registration and other requirements, including ongoing disclosure and restrictions on derivatives trading. 3C1 funds are also referred to as 3C1 companies or 3(c)(1) funds.
The result of 3C1 is that it allows [hedge fund](https://www.investopedia.com/terms/h/hedgefund.asp) companies to avoid the SEC scrutiny that other investment funds, such as mutual funds, must adhere to under the Act. However, the investors in 3C1 funds must be [accredited investors](https://www.investopedia.com/terms/a/accreditedinvestor.asp), meaning investors who have an annual income of over $200,000 or a net worth in excess of $1 million.
## 3C1 Funds vs. 3C7 Funds
Private equity funds are usually structured as 3C1 funds or [3C7](https://www.investopedia.com/terms/1/3c7.asp) funds, the latter being a reference to the 3(c)(7) exemption. Both 3C1 and 3C7 funds are exempt from SEC registration requirements under the Investment Company Act of 1940, but the nature of the exemption is slightly different. Whereas the 3C1 exemption hinges on not exceeding 100 accredited investors, a 3C7 fund must maintain a total of 2,000 or fewer qualified purchasers. However, qualified purchasers must clear a higher bar and have over $5 million in assets, but a 3C7 fund is permitted to have more of these people or entities participating as investors.
## 3C1 Compliance Challenges
Although 100 accredited investors sound like an easy limit to monitor, it can be a challenging area for fund compliance. Private funds are generally protected in the case of involuntary share transfers. For example, the death of an investor results in shares being split up among family members would be considered an involuntary transfer.
However, these funds can run into issues with shares given as employment incentives. Knowledgeable employees, including executives, directors, and partners, do not count against the fund's tally. However, employees who leave the firm carrying the shares with them will count against the 100 investor limit. The one hundred person limit is so critical to the investment company exemption and 3C1 status, that private funds put a great deal of effort into making certain they are in compliance.
> **Article Sources**
>
> 1. Govinfo.gov. "[Investment Company Act of 1940](https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf)," Pages 16-23. Accessed Aug. 17, 2021.
>
> 2. U.S. Securities and Exchange Commission. "[Accredited Investors—Updated Investor Bulletin](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-3)." Accessed Aug. 17, 2021.
>
> 3. U.S. Securities and Exchange Commission. "[Exchange Act Reporting and Registration](https://www.sec.gov/smallbusiness/goingpublic/exchangeactreporting)." Accessed Aug. 17, 2021.
>
> 4. Govinfo.gov. "[Investment Company Act of 1940](https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf)." Pages 15-16. Accessed Aug. 17, 2021. |
Understanding the 3(c)(7) Exemption From SEC Regulations | # Understanding the 3(c)(7) Exemption From SEC Regulations
## What Is the 3(c)(7) Exemption?
The 3(c)(7) exemption, part of the [Investment Company Act of 1940](https://www.investopedia.com/terms/i/investmentcompanyact.asp), enables qualifying private investment funds to avoid certain SEC regulations. By meeting criteria such as having qualified purchasers, these funds gain flexibility not available to publicly traded funds.
### Key Takeaways
* The 3(c)(7) exemption allows private funds to bypass certain SEC regulations if they meet specific criteria under the Investment Company Act of 1940.
* To qualify for the 3(c)(7) exemption, a fund's investors must be qualified purchasers who meet stringent investment criteria.
* Funds using the 3(c)(7) exemption can avoid registering with the SEC or issuing detailed disclosures, unlike public funds.
* A fund that exceeds 1,999 investors must register with the SEC, even under the 3(c)(7) exemption.
* Non-compliance with 3(c)(7) standards can lead to SEC enforcement and legal action against a fund.
## Evolution and Impact of the 3(c)(7) Exemption
The Investment Company Act of 1940 defines an "investment company" as an issuer that "holds itself out as being engaged primarily or proposes to engage primarily, in the business of investing, reinvesting or trading in securities." The Act regulates the organization of companies whose securities are offered to the public. Companies must disclose their financial condition and investment policies regularly.
However, 3C7 is one of two exemptions from the Investment Company Act of 1940, allowing [hedge funds](https://www.investopedia.com/terms/h/hedgefund.asp), venture capital funds, and other private equity funds to bypass SEC restrictions. This frees up these funds to use tools like leverage and derivatives that most publicly traded funds cannot. Typically, hedge funds, private equity funds, venture capital funds, and other private investment vehicles are structured to fall outside the Act's regulatory scope.
## How to Qualify for the 3(c)(7) Exemption
3C7 funds are not required to register with the Securities and Exchange Commission or provide ongoing disclosure. They don't need to issue a [prospectus](https://www.investopedia.com/terms/p/prospectus.asp) detailing investment positions.
> **Important**
>
> Section 3(c)(7) doesn't limit investors, but funds with 2,000 or more investors must register under the Securities Exchange Act of 1934.
To qualify for the 3C7 exemption, the private investment company must show that they have no plans of making an initial public offering (IPO) and that its investors are qualified purchasers. A qualified purchaser is a higher standard than an [accredited investor](https://www.investopedia.com/terms/a/accreditedinvestor.asp) and is defined as:
* Individuals or family-owned businesses that own no less than $5 million in investments
* A trust managed by qualified purchasers
* An individual acting for their account or the account of someone else who owns and invests at least $25,000,000 in investments
* Any entity solely owned by qualified purchasers.
## Comparing 3(c)(7) Funds and 3(c)(1) Funds
Both 3C7 and 3C1 funds are exempted from the requirements imposed on "investment companies" under the Investment Company Act of 1940 (the "Act"). However, there are differences between them. 3C7 funds take investments from qualified purchasers, whereas 3C1 funds work with accredited investors.
Investors in 3C7 funds must meet higher wealth criteria compared to 3C1 funds, possibly narrowing the investor pool. Regulations limit 3C1 funds to 100 investors, constraining their potential investor pool.
## What Happens to a Fund That Does Not Comply With 3C7 Rules?
3C7 funds must maintain their compliance to continue utilizing the exemption from the 1940 Act. If a fund were to fall out of compliance by taking in investments from non-qualified purchasers, it would open itself to SEC enforcement actions and litigation from its investors and any other parties it has contracts with.
## What Types of Investments Are Not Defined As an Investment Company?
Some investment pools that do not qualify as an “investment company” in Section 3(a) of the Investment Company Act include charitable organizations, pension plans, and church plans.
## What Is the Difference Between an Accredited Investor and a Qualified Purchaser?
Accredited investors typically must meet income and net worth requirements to purchase financial investments, such as securities or real estate. Companies such as financial institutions screen participants and must determine who is an accredited investor. The qualified purchaser is a legal term not based on net worth or income but on investment holdings. Qualified purchasers must meet higher standards so that funds with a small group of private equity investors can buy and sell public assets.
## The Bottom Line
The 3(c)(7) exemption, under the Investment Company Act of 1940, permits private funds like hedge funds and venture capital to bypass certain SEC regulations, including registration and public disclosure obligations. To qualify for this exemption, a fund must not intend to issue an IPO, and its investors must be qualified purchasers who meet higher financial thresholds than accredited investors.
While there is no limit on the number of investors, 3C7 funds must register with the SEC if they have over 1,999 investors. This exemption facilitates flexibility for private funds in using strategies like leverage and derivatives, which are not typically available to publicly traded funds.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[Investment Company Registration and Regulation Package](https://www.sec.gov/investment/fast-answers/divisionsinvestmentinvcoreg121504htm.html)."
>
> 2. U.S. Government Publishing Office. "[Investment Act of 1940](https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf)," Page 15.
>
> 3. U.S. Securities and Exchange Act. "[Exchange Act Reporting and Registration](https://www.sec.gov/smallbusiness/goingpublic/exchangeactreporting)."
>
> 4. Investor.gov. "[The Laws That Govern the Securities Industry](https://www.investor.gov/introduction-investing/investing-basics/role-sec/laws-govern-securities-industry#invcoact1940)."
>
> 5. Pillsbury Investment Fund. "[Is the Fund Relying on Section 3(c)(7) To Avoid Registration as an Investment Company? – Preserving the Exemption](https://www.investmentfundlawblog.com/resources/who-may-invest/fund-relying-section-3c7-avoid-registration-investment-company-preserving-exemption/)."
>
> 6. U.S. Securities and Exchange Commission. "[Private Fund](https://www.sec.gov/education/capitalraising/building-blocks/private-fund)." |
Understanding 3D Printing: Process, Uses, and Industry Examples | # Understanding 3D Printing: Process, Uses, and Industry Examples
## What Is 3D Printing?
Three-dimensional (3D) printing is revolutionizing how industries manufacture products. By creating objects from digital designs with thin, fused layers of materials, 3D printing enhances productivity and opens new avenues for innovation across various sectors, including automotive and healthcare. Though rapid mass production remains a challenge, the technology's potential to redesign supply chains makes it a focal point of modern manufacturing.
### Key Takeaways
* 3D printing is an additive manufacturing method that builds objects layer by layer from digital designs.
* Industries like automotive, aerospace, and medical are leveraging 3D printing for innovation and efficiency.
* While current speeds hinder mass production, 3D printing significantly reduces lead times and costs.
* Companies are exploring 3D printing for complex designs and materials, changing how products are created.
## How 3D Printing Enhances Manufacturing Efficiency
Since it was introduced, 3D printing technology has already increased manufacturing productivity. In the long term, it could greatly impact manufacturing, logistics, and [inventory management](https://www.investopedia.com/terms/i/inventory-management.asp), especially if integrated into [mass production](https://www.investopedia.com/terms/m/mass-production.asp).
3D printing is currently too slow for mass production, but it helps reduce [lead time](https://www.investopedia.com/terms/l/leadtime.asp) in making prototypes and necessary tools. This is hugely beneficial to small-scale manufacturers because it reduces their costs and the time to market, that is, the amount of time from a product being conceived until its being available for sale.
3D printing can create intricate and complex shapes using less material than subtractive manufacturing processes, such as drilling, welding, injection molding, and other processes. Quicker, cheaper, and easier prototype production fosters innovation, experimentation, and new product-based startups.
## Diverse Applications of 3D Printing in Industry
Car and aircraft manufacturers have taken the lead in 3D manufacturing, using the technology to transform unibody and fuselage design and production, and powertrain design and production. Boeing uses 3D-printed titanium parts to build its 787 Dreamliner. In 2017, General Electric made a helicopter engine with just 16 parts instead of 900, highlighting 3D printing's potential impact on [supply chains](https://www.investopedia.com/terms/s/supplychain.asp).
Several companies are using 3D printing technology [in many industries](https://www.investopedia.com/articles/investing/081515/three-biggest-3d-printing-companies.asp). In medical sciences, 3D printing is being used to customize implants. In the future, 3D printing might be used to create organs and body parts.
In the fashion world, Nike, Adidas, and New Balance are using 3D printing to create their shoes.
In the construction industry, companies around the world are making breakthroughs in 3D printing of the materials needed to build homes. Homes can be built in 24 hours using concrete layers, offering more strength than cinder blocks and costing less.
In the manufacturing of hearing aids, 3D printing is now customary. 3D printing speeds up manufacturing and allows for custom hearing aid production. Audiologists can use 3D scanners to create a custom prototype using reference points from the scan. Manufacturers can feed the scan into a 3D printing machine and after fine-tuning the materials and the ear shapes, print the entire hearing aids.
## The Bottom Line
3D printing, an additive manufacturing process, has revolutionized prototype development by using digital designs to create physical objects layer by layer. Industries such as automotive, aerospace, and medical devices leverage this technology for innovative product development and cost reduction. While still refining its speed for mass production, 3D printing offers significant benefits in terms of reducing lead times and material usage.
This evolving technology holds the potential to disrupt traditional manufacturing and supply chain logistics, positioning itself as a crucial tool for industry innovation and efficiency improvements.
> **Article Sources**
>
> 1. Norsk Titanium. "[Norsk Titanium to Deliver the World’s First FAA-Approved, 3D-Printed, Structural Titanium Components to Boeing](https://www.norsktitanium.com/media/press/norsk-titanium-to-deliver-the-worlds-first-faa-approved-3d-printed-structural-titanium-components-to-boeing)."
>
> 2. General Electric. "[An Epiphany Of Disruption: GE Additive Chief Explains How 3D Printing Will Upend Manufacturing](https://www.ge.com/news/reports/epiphany-disruption-ge-additive-chief-explains-3d-printing-will-upend-manufacturing)."
>
> 3. Nike. "[Nike Flyprint is the First Performance 3D Printed Textile Upper](https://news.nike.com/news/nike-flyprint-3d-printed-textile)."
>
> 4. Adidas. "[4DFWD: Data-Driven 3D Printed Performance Technology Designed to Move You Forward](https://news.adidas.com/running/4dfwd--data-driven-3d-printed-performance-technology-designed-to-move-you-forward/s/514baddb-1029-4686-abd5-5ee3985a304a)."
>
> 5. New Balance. "[New Balance Launches a Premium 3D Printing Platform](https://newbalance.newsmarket.com/latest-news/new-balance-launches-a-premium-3d-printing-platform/s/5c2b466a-13b7-4218-a18a-61d2889e6adc)."
>
> 6. Sonova. "[3D Printing Technology for Improved Hearing](https://www.sonova.com/en/story/innovation/3d-printing-technology-improved-hearing)." |
3P Oil Reserves: What it Means, How it Works | # 3P Oil Reserves: What it Means, How it Works
## What Are 3P Oil Reserves?
3P oil reserves are the total amount of reserves that a company estimates having access to, calculated as the sum of all [proven](https://www.investopedia.com/terms/p/proven-reserves.asp) and [unproven](https://www.investopedia.com/ask/answers/060115/what-difference-between-proven-and-probable-reserves-oil-and-gas-sector.asp) reserves. The 3Ps stand for proven, probable, and possible reserves.
The oil industry breaks unproven reserves into two segments: those based on geological and engineering estimates from established sources (probable) and those that are less likely to be extracted due to financial or technical difficulties (possible). Therefore, 3P refers to proven plus probable plus possible reserves. This can be contrasted with 2P oil, which includes only proven and probable reserves.
### Key Takeaways
* 3P oil reserves are the total amount of estimated reserves inclusive of all proven and unproven reserves that a company has access to.
* Each category of reserve used in the calculation has a probability assigned to it in terms of the viability of recovering crude oil.
* Most oil and gas companies provide rosy estimates of their 3P oil reserves; hence, investors rely on findings by independent consultants to assess their stock picks.
## Understanding 3P Oil Reserves
The 3P estimate is an optimistic estimate of what might be pumped out of a well by an oil company. The three different categories of reserves also have different production probabilities assigned. For example, the oil industry gives proven reserves a 90% certainty of being produced (P90). The industry gives [probable reserves](https://www.investopedia.com/terms/p/probable-reserves.asp) a 50% certainty (P50), and [possible reserves](https://www.investopedia.com/terms/p/possible-reserves.asp) a 10% certainty (P10) of actually being produced.
Another way to think about the concept of different reserve categories is to use a fishing analogy where proven reserves are the equivalent of having caught and landed a fish. It is certain and in hand. Probable reserves are the equivalent of having a fish on the line. The fish is technically caught, but is not yet on land and may still come off the line and get away. Possible reserves are a bit like saying, "there are fish in this river somewhere." These reserves exist, but it is far from certain that an oil company will ever fully discover, develop, and produce them.
Energy companies update their investors on the amount of oil and natural gas reserves they have access to through an annual reserve update. This update typically includes proven, probable, and possible reserves, and is similar to an inventory report that a retailer might provide to investors.
However, there is no legal obligation for companies to report their 3P reserves. In recent years, oil and gas startups and exploration companies have taken to reporting their 3P reserves. This is because the third "P" (i.e., possible reserves) can artificially inflate reserves figures and result in an acquisition by a bigger player. The cost benefits of investing in hiring a 3P reserve calculation versus putting money into a costly exploration operation works out in their favor.
## Independent Consultant Resource Assessment
Several consulting firms provide oil companies with independent assessments of their oil reserves. These audits are also beneficial to investors who want the assurance that a company has the reserves they claim. One such firm is DeGolyer and MacNaughton and another is Miller and Lents, who have served the [oil and gas industry](https://www.investopedia.com/investing/oil-gas-industry-overview/) with trusted upstream insights and reservoir evaluation for many years.
Investors in oil and gas companies, as well as independent oil projects, rely on consulting firms like these to provide accurate and independent assessments of a company's full reserve base, including 3P reserves. Crucial information includes things like estimations of reserves and resources to be recovered from discoveries and verification of hydrocarbon and mineral reserves and resources.
## Rapid Classification Changes in Proven Reserves
Understanding the natural resource extraction industry can be challenging because proven reserves are just one of three classifications. Most people assume proven oil and gas reserves should only go up when new exploratory wells are drilled, resulting in new reservoirs being discovered. In reality, there are often more significant gains and losses resulting from shifts between classifications than there are increases in proven reserves from truly new discoveries. For this reason, it is useful for investors to know a company’s proven, probable, and possible reserves rather than just the proven reserves.
If an investor does not have the data on probable reserves, proven reserves can suddenly change in a number of different situations. For example, if a company has a large amount of probable reserves and a relevant extraction technology improves, then those probable reserves are added to the proven reserves.
> **Article Sources**
>
> 1. U.S. Energy Information Administration. "[U.S. Crude Oil, Natural Gas Proved Reserves, Year-end 2019](https://www.eia.gov/naturalgas/crudeoilreserves/#:~:text=Proved%20reserves%20of%20crude%20oil,2017%20%2839.2%20billion%20barrels%29.)." Accessed Feb. 25, 2021.
>
> 2. U.S. Energy Information Administration. "[Natural Gas: Featured Analysis & Projections](https://www.eia.gov/naturalgas/reports.php#/T202)." Accessed Feb. 25, 2021. |
30-Year Treasury: Meaning, History, Examples | # 30-Year Treasury: Meaning, History, Examples
## What Is the 30-Year Treasury?
The 30-Year Treasury is a U.S. Treasury debt obligation that has a maturity of 30 years. The 30-year Treasury used to be the [bellwether](https://www.investopedia.com/terms/b/bellwether.asp) U.S. bond but now most consider the 10-year Treasury to be the benchmark.
### Key Takeaways
* 30-year Treasuries are bonds issued by the U.S. government and have a maturity of 30 years.
* Other securities issued by the U.S. government include Treasury bills, notes, and Inflation-Protected Securities (TIPS).
* 30-year Treasuries pay interest semiannually until they mature and at maturity pay the face value of the bond.
## Understanding the 30-Year Treasury
The U.S. government borrows money from investors by issuing debt securities through its Treasury department. Debt instruments that can be purchased from the government include [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp) (T-bills), notes, and Treasury Inflation-Protected Securities (TIPS). T-bills are [marketable securities](https://www.investopedia.com/terms/m/marketablesecurities.asp) issued for terms of less than a year, and [Treasury notes](https://www.investopedia.com/terms/t/treasurynote.asp) are issued with maturities from two to 10 years.
[TIPS](https://www.investopedia.com/terms/t/tips.asp) are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). When there is inflation, the principal increases. When deflation sets in, the principal decreases. U.S. Treasury securities with longer-term maturities can be purchased as U.S. Savings bonds or Treasury bonds.
## Special Considerations
[Treasury bonds](https://www.investopedia.com/terms/t/treasurybond.asp) are long-term debt securities issued with a maturity of 20 years or 30 years from the issue date. These marketable securities pay interest semi-annually, or every six months until they mature. At maturity, the investor is paid the [face value](https://www.investopedia.com/terms/f/facevalue.asp) of the bond. The 30-year Treasury will generally pay a higher interest rate than shorter Treasuries to compensate for the additional risks inherent in the longer maturity. However, when compared to other bonds, Treasuries are relatively safe because they are backed by the U.S. government.
The price and interest rate of the 30-year Treasury bond is determined at an [auction](https://www.investopedia.com/terms/a/auction.asp) where it is set at either par, premium, or [discount to par](https://www.investopedia.com/terms/a/at-a-discount.asp). If the [yield to maturity](https://www.investopedia.com/terms/y/yieldtomaturity.asp) (YTM) is greater than the interest rate, the price of the bond will be issued at a discount. If the YTM is equal to the interest rate, the price will be equal to par. Finally, if the YTM is less than the interest rate, the Treasury bond price will be sold [at a premium](https://www.investopedia.com/terms/a/at-a-premium.asp) to par. In a single auction, a bidder can buy up to $5 million in bonds by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding. In addition, the bonds are sold in increments of $100 and the minimum purchase is $100.
## 30-Year Treasury vs. Savings Bonds
[U.S. Savings bonds](https://www.investopedia.com/terms/u/ussavingsbonds.asp), specifically, [Series EE Savings bonds](https://www.investopedia.com/terms/s/serieseebond.asp), are non-marketable securities that earn interest for 30 years. Interest isn’t paid out periodically. Instead, interest accumulates, and the investor receives everything when they redeem the savings bond. The bond can be redeemed after one year, but if they are sold before five years from the purchase date, the investor will lose the last three months' interest. For example, an investor who sells the Savings bond after 24 months will only receive interest for 21 months.
Because the U.S. is seen as a very low-risk borrower, many investors see 30-year Treasury interest rates as indicative of the state of the wider bond market. Normally, the interest rate decreases with greater demand for 30-year Treasury securities and rises with lower demand. The S&P U.S. Treasury Bond Current 30-Year Index is a one-security index comprising the most recently issued 30-year U.S. Treasury bond. It is a market value-weighted index that seeks to measure the performance of the Treasury bond market.
> **Article Sources**
>
> 1. U.S. Department of the Treasury. "[Treasury Inflation-Protected Securities (TIPS)](https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm)." Accessed June 29, 2021.
>
> 2. U.S. Department of the Treasury. "[Treasury Bonds](https://www.treasurydirect.gov/indiv/products/prod_tbonds_glance.htm)." Accessed June 29, 2021.
>
> 3. U.S. Department of the Treasury. "[Treasury Bonds in Depth](https://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond.htm)." Accessed June 29, 2021.
>
> 4. U.S. Department of the Treasury. "[Series EE Savings Bond](https://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond.htm)." Accessed June 29, 2021.
>
> 5. S&P Dow Jones Indices. "[S&P U.S. Treasury Bond Current 30-Year Index](https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us-treasury-bond-current-30-year-index/#overview)." Accessed June 29, 2021. |
341 Meeting: What It Is, How It Works, Example | # 341 Meeting: What It Is, How It Works, Example
> **Definition**
>
> After you've filed for bankruptcy, there are several steps before the judge's decision. One of the first is the 341 meeting, or meeting of creditors. In this meeting, you'll meet with your case trustee and creditors to establish the facts of your case prior to appearing before a judge.
## What Is a 341 Meeting?
The term “341 meeting” refers to a meeting between creditors and debtors that is required to take place during a [Chapter 7 bankruptcy proceeding](https://www.investopedia.com/terms/b/bankruptcy.asp). Accordingly, its name is derived from section 341 of the bankruptcy code. A 341 meeting is typically scheduled roughly one month after a debtor files for bankruptcy.
### Key Takeaways
* A 341 meeting is intended to establish the facts of the bankruptcy in question and to facilitate the negotiation of a repayment plan between the debtor and their creditors.
* The meeting must include both the individual filing for bankruptcy and the court-appointed bankruptcy trustee to be considered legally valid.
* Generally, 341 meetings occur at the offices of the trustee, rather than in a courtroom.
## How 341 Meetings Work
The 341 meeting is one of many stages involved in declaring [Chapter 7](https://www.investopedia.com/terms/c/chapter7.asp) bankruptcy in the United States. Its primary purpose is to establish the facts of the bankruptcy in question and to ensure that all the paperwork necessary to carry out the bankruptcy proceedings is in order. Although the attorneys of the [debtor](https://www.investopedia.com/terms/d/debtor.asp) and [creditor](https://www.investopedia.com/terms/c/creditor.asp) are welcome to attend, the only parties whose presence at the 341 meeting is legally required are the debtor in question and the court-appointed [bankruptcy trustee](https://www.investopedia.com/terms/b/bankruptcy-trustee.asp).
Prior to the 341 meeting, the trustee would have already reviewed the bankruptcy paperwork and [financial records](https://www.investopedia.com/articles/basics/06/financialreporting.asp) submitted by the debtor. The purpose of the 341 meeting, therefore, is principally for the trustee to confirm the facts stated by the debtor and to collect any additional paperwork that may be required. In the event that the debtor is attempting bankruptcy [fraud](https://www.investopedia.com/terms/f/fraud.asp), this would likely be detected by the trustee during or prior to the 341 meeting.
From the debtor’s perspective, the objective of the 341 meeting is to provide the necessary documents in order to prove that their identity is authentic, while also establishing their current [assets](https://www.investopedia.com/terms/a/asset.asp), [liabilities](https://www.investopedia.com/terms/l/liability.asp), income, [expenses](https://www.investopedia.com/terms/e/expense.asp), and other relevant financial circumstances. If the creditors are in attendance, they will be able to ask clarifying questions, such as whether the debtor is entitled to any upcoming income sources (e.g., [tax rebates](https://www.investopedia.com/terms/t/taxcredit.asp) or [inheritances](https://www.investopedia.com/terms/i/inheritance.asp)) or owns undisclosed assets, such as shares in a private business or assets held overseas.
> **Important**
>
> Typically, discussion at 341 meetings will center on how the debtor plans to eventually repay their obligations.
## Real World Example of a 341 Meeting
Robin is a bankruptcy trustee currently presiding over a 341 meeting. The debtor, who declared bankruptcy over a $5,000 debt, attended the meeting along with their bankruptcy lawyer. Likewise, the creditor and their lawyer are also present.
Robin's priority is to verify the debtor's identity and financial status. Although Robin had already reviewed many documents prior to the meeting, the 341 meeting provided an occasion to ask follow-up questions about the documents provided and obtain any additional disclosures deemed necessary. In the unlikely event that the debtor attempted bankruptcy fraud, this would also likely be detected due to discrepancies or inadequacies in the documents provided.
During the meeting, the lawyers for the debtor and creditor engaged in a detailed conversation regarding the debtor’s assets, liabilities, and income sources. They were able to negotiate a general plan for the gradual repayment of the outstanding debt. As is the case with most 341 meetings, the meeting took place at Robin's office rather than in court before a judge.
> **Fast Fact**
>
> Declaring bankruptcy can help borrowers avoid the worst repercussions of failing to repay their debt, but the impact on their credit score can be severe. If you're struggling to pay back your loans, consider working with a debt relief company or credit counseling agency before filing for bankruptcy, which becomes your only viable option.
## What Happens if I Don't Come to My 341 Meeting?
According to the U.S. Bankruptcy Code, your [bankruptcy petition may be dismissed](https://www.investopedia.com/terms/i/involuntary-bankruptcy.asp) if you fail to appear at your 341 meeting. If you are married, both spouses must attend the meeting.
## When Does a 341 Meeting Take Place?
A 341 meeting typically occurs between 21 and 50 days after the initial bankruptcy filing. This gives the trustee time to review all the submitted documents and conduct any needed research.
## Who Is Present at a 341 Meeting?
The trustee on the case calls a 341 meeting, which should be attended by any parties seeking bankruptcy protection and their lawyers. Additionally, creditors may attend to ask the debtor about their assets and attempt to work out a plan for debt repayment.
## The Bottom Line
A 341 meeting allows the trustee overseeing a bankruptcy filing to meet and talk with the filers. It's an excellent opportunity to get a more personal take on their financial situation and perhaps work out a repayment plan prior to meeting with the judge.
> **Article Sources**
>
> 1. U.S. Government Printing Office. "[11 U.S.C. 341 -- Meetings of Creditors and Equity Security Holders](https://www.govinfo.gov/app/details/USCODE-2022-title11/USCODE-2022-title11-chap3-subchapIII-sec341)."
>
> 2. United States Bankruptcy Court. "[What Is a 341(a) Meeting of Creditors?](https://www.canb.uscourts.gov/faq/general-bankruptcy/what-341a-meeting-creditors)" |
401(a) Plan: What It Is, Contribution Limits, and Withdrawal Rules | # 401(a) Plan: What It Is, Contribution Limits, and Withdrawal Rules
> **Definition**
>
> A 401(a) plan is a retirement savings program created and managed by certain public-sector or non-profit employers, where contribution rules and investment choices are primarily set by the employer. It's generally mandatory for employees to partake.
## What Is a 401(a) Plan?
A 401(a) plan is an employer-sponsored money-purchase [retirement plan](https://www.investopedia.com/terms/r/retirement-planning.asp) that allows dollar or percentage-based contributions from the employer, the employee, or both. The sponsoring employer establishes eligibility and the [vesting](https://www.investopedia.com/terms/v/vesting.asp) schedule. The employee can withdraw funds from a 401(a) plan through a rollover to a different qualified retirement plan, a lump-sum payment, or an annuity.
### Key Takeaways
* A 401(a) plan is employer-sponsored, and both the employer and employee can contribute.
* 401(a) plans are usually used by government and non-profit organizations.
* 401(a) plans give the employer a larger share of control over how the plan is invested.
* An employee can withdraw funds from a 401(a) plan through a rollover to a different qualified retirement plan, a lump-sum payment, or an annuity.
* Investments in 401(a) plans are low risk and typically include government bonds and funds focused on value-based stocks.
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*— Investopedia / Ryan Oakley*
## How a 401(a) Plan Works
There are a variety of retirement plans that employers can offer their employees. Each comes with different stipulations, restrictions, and some are better suited for certain types of employers.
A 401(a) plan is a type of retirement plan made available to those working in government agencies, educational institutions, and non-profit organizations. Eligible employees who participate in the plan include government employees, teachers, administrators, and support staff.
A 401(a) plan's features are similar to a [401(k) plan](https://www.investopedia.com/terms/1/401kplan.asp), which is more common in profit-based industries. 401(a) plans do not allow employees to contribute to 401(k) plans, however.
If an individual leaves an employer, they do have the option of transferring the funds in their 401(a) to a 401(k) plan or [individual retirement account](https://www.investopedia.com/terms/i/ira.asp) (IRA).
Employers can form multiple 401(a) plans, each with distinct eligibility criteria, contribution amounts, and vesting schedules. Employers use these plans to create incentive programs for employee retention. The employer controls the plan and determines the contribution limits.
## Contributions for a 401(a) Plan
A 401(a) plan can have mandatory or voluntary contributions, and the employer decides if contributions are made on an after-tax or pre-tax basis. An employer contributes funds to the plan on an employee's behalf.
Employer contribution options include the employer paying a set amount into an employee's plan, matching a fixed percentage of employee contributions, or matching employee contributions within a specific dollar range.
The majority of voluntary contributions to a 401(a) plan are capped at a percentage of an employee's annual pay. For example, an employee may only be allowed to contribute no more than 25% of their pay.
## Investments for a 401(a) Plan
The plan gives employers more control over their employees' investment choices. Government employers with 401(a) plans often limit investment options to only the safest and most secure options to minimize risk.
A 401(a) plan assures a certain level of [retirement](https://www.investopedia.com/terms/r/retirement.asp) savings but requires due diligence by the employee to meet retirement goals.
While this focus on safety can protect employees' retirement savings from significant market downturns, it also limits the potential for higher returns that might be available through more diversified or aggressive investments.
Employees in a 401(a) plan may find their investment growth more modest compared to those in plans with broader investment options, such as a 401(k).
> **Fast Fact**
>
> Employees who contribute to a 401(a) plan may qualify for a tax credit. Employees can have both a 401(a) plan and an IRA at the same time. However, if an employee has a 401(a) plan, the tax benefits for traditional IRA contributions may be phased out depending on the employee's adjusted gross income.
## Vesting and Withdrawals for a 401(a) Plan
Any 401(a) contributions an employee makes and any earnings on those contributions are immediately fully vested.
Becoming fully vested in the employer contributions depends on the vesting schedule the employer sets up. Some employers, especially those who offer 401(k) plans, link vesting to years of service as an incentive for employees to stay with the company.
The [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) (IRS) subjects 401(a) withdrawals to income tax withholdings and a 10% early withdrawal penalty unless the employee is 59½, dies, is disabled, or rolls over the funds into a qualified IRA or retirement plan through a direct trustee-to-trustee transfer.
## 401(a) vs. 401(k) Plans
A 401(a) plan is [similar to a 401(k)](https://www.investopedia.com/ask/answers/060215/what-difference-between-401a-and-401k.asp), another type of employer-sponsored plan that provides a tax advantage for retirement investments.
The main difference is who participates: while 401(k) plans are intended for private sector employees, 401(a) plans are directed towards employees of government bodies, educational institutions, and charitable organizations. These plans also tend to offer fewer, more conservative investment options than those found in a 401(k) plan.
If you work in the private sector, you can contribute to a 401(k) plan after one year. But if your employer offers a 401(a) plan, it takes two years.
There are also important rule differences between the two types of plans. [With a 401(k) plan](https://www.investopedia.com/articles/retirement/08/401k-info.asp), participation is voluntary, and the employee can decide how much money to contribute towards the plan, so long as it is below the legal limit. Employers may match a portion of the employee's contribution, but many do not.
However, in a 401(a) plan, employers can make it mandatory for their employees to participate. However, employers are also required to contribute to their employees' accounts. They can also decide whether the 401(a) plan is to be funded with pre-tax or after-tax dollars.
### 401(a) vs. 401(k) plans
401(k)
* Offered by private sector employers
* Employees become eligible after one year
* Employees elect to participate in the plan
* Employers may match a portion of employee contributions
* More investment options
401(a)
* Offered by government bodies, educational institutions, and charities
* Employees become eligible after two years
* Employers can make participation mandatory
* Employers must contribute to their employees' plans
* Investment options tend to be fewer and more conservative than a 401(k)
## 401(a) Plans vs. 403(b) Plans
A [403(b) plan](https://www.investopedia.com/articles/retirement/10/top-9-benefits-403b-plans.asp) is another type of employer-sponsored retirement plan, similar to 401(a) and 401(k). It's specifically designed for employees of public schools, certain tax-exempt organizations, and ministers.
Like the 401(k), the 403(b) allows employees to contribute a portion of their salary to the plan on a tax-deferred basis, meaning taxes on contributions and earnings are deferred until withdrawal, typically at retirement.
One of the distinguishing features of a 403(b) plan is its investment options. Historically, 403(b) plans were limited to offering annuities as investment options, though now they typically offer a range of mutual funds as well.
However, compared to 401(k) plans, the investment choices in 403(b) plans might still be somewhat more limited. Compared to 401(a) plans, 403(b) plans traditionally would have more investment options (though the functionality and offerings under each specific plan may vary).
403(b) plans also share some similarities with 401(a) and 401(k) plans. All three can make tax-deferred contributions and the imposition of penalties for [early withdrawals before](https://www.investopedia.com/articles/personal-finance/111615/how-401k-works-after-retirement.asp) age 59½. Additionally, 403(b) plans often allow for catch-up contributions for employees who have worked for their employer for at least 15 years, offering an extra opportunity to boost retirement savings.
## Tips for a 401(a) Plan
As with other types of retirement plans, it is important to understand the rules and fees associated with a 401(a) before making a significant contribution. This caution can help reduce your costs and expenses further down the line.
Here are some ways to make the most out of a 401(a) or any other tax-advantaged retirement account:
* **Understand the rules.** As with other tax-advantaged retirement accounts, there are strict rules about what you can do with the money in a 401(a) account. If you take money out before you reach age 59½, you may face a 10% penalty, except for certain emergency expenses. It is important to understand the rules for holding and closing your account to avoid unexpected tax implications.
* **Understand the fees.** In addition to taxes, there are also fees associated with a 401(a) account that are used to offset the administrative costs of maintaining your investment account. High plan fees can easily eat into your portfolio gains, so it is important to talk to your employer and understand how much the plan will actually cost you.
## Limitations of a 401(a) Plan
The content below was discussed earlier in the article. Let's highlight the downsides of a 401(a) plan all in one section. The downsides to this type of retirement plan are:
* **Limited employee control**: In a 401(a) plan, the employer typically has significant control over the plan’s structure. This includes the contribution rates and investment options. Employees often have little to no say in how much they contribute or where their money is invested.
* **Mandatory participation**: Many 401(a) plans require mandatory participation, meaning employees have no choice but to contribute a certain portion of their salary to the plan.
* **Withdrawal restrictions**: Like other retirement plans, 401(a) plans impose penalties for early withdrawals before age 59½. However, 401(a) plans might have stricter rules regarding when and how you can access your funds.
* **Employer-specific plans**: 401(a) plans are typically offered by public sector employers, such as government agencies and educational institutions, meaning they are not available to everyone.
## What Happens to My 401(a) Plan When I Quit?
The money in your 401(a) or other employer-sponsored retirement account belongs to you, even after you leave the employer. When you lose your job, that money can be taken as a distribution (with a possible early withdrawal penalty) or rolled into a different retirement account, such as an IRA.
## What's the Difference Between a 401(a) and 403(b)?
A 401(a) plan and a 403(b) are both types of tax-advantaged retirement plans available to certain public-sector employees. Unlike a 401(a), a 403(b) plan is aimed at employees of public schools and tax-exempt organizations, and their investment options are limited to annuities or mutual funds. The main difference is that an employer can make participation in a 401(a) plan mandatory, while it remains voluntary for employees to participate in a 403(b).
## How Much Can I Invest in a 401(a) Plan?
A 401(a) plan does not have the same investment limits as a 401(k) plan. Most plans cap voluntary contributions to 25% of the employee's take-home pay.
## The Bottom Line
A 401(a) plan is a type of tax-advantaged account that allows public-sector employees to save for retirement. These plans typically offer fewer investment options than other types of plans, and they are also relatively low-risk. Although employers can make participation mandatory, there may also be a tax credit for those who contribute to a 401(a).
> **Article Sources**
>
> 1. Office of the Law Revision Counsel United States Code. "[26 USC 401: Qualified Pension, Profit-Sharing, and Stock Bonus Plan](https://uscode.house.gov/view.xhtml?req=%28title:26%20section:401%20edition:prelim%29%20OR%20%28granuleid:USC-prelim-title26-section401%29&f=treesort&edition=prelim&num=0&jumpTo=true%20-%20substructure-location_f_1)."
>
> 2. Internal Revenue Service. "[Retirement Topics - Exceptions to Tax on Early Distributions](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions)." |
403(b) Plan | # What Is a 403(b) Tax-Sheltered Annuity Plan?
:max_bytes(150000):strip_icc()/403bplan_final-67070c84b22b42478c5bb4c12792995c.png)
*— Investopedia / Michela Buttignol*
> **Definition**
>
> A 403(b) plan, also known as a Tax-Sheltered Annuity (TSA) plan, is a retirement savings account offered to employees of schools, the public sector, and non-profits.
## What Is a 403(b) Tax-Sheltered Annuity Plan?
A 403(b) tax-sheltered annuity plan (TSA) is a retirement savings plan for employees of public schools, government agencies, and certain other tax-exempt non-profit organizations.
Employees who are eligible to use a 403(b) include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.
### Key Takeaways
* The 403(b) Tax-Sheltered Annuity Plan (TSA) was designed for employees of tax-exempt organizations.
* As with a 401(k), contributions to a 403(b) are made through payroll deductions and come with tax benefits for the saver.
* Investment choices can be more limited in a 403(b) and some accounts offer less protection from creditors than 401(k)s.
## 403(b) Contributions
The 403(b) Tax-Sheltered Annuity Plan operates like a [401(k)](https://www.investopedia.com/articles/retirement/08/401k-info.asp) plan, allowing participants to save money for retirement through [payroll deductions](https://www.investopedia.com/terms/p/payroll-deduction-plan.asp) while enjoying certain tax benefits. Similarities include:
* Contributions through payroll deductions
* Annual contribution limits set by the [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) (IRS)
* An option for the employer to match part of the employee's contribution
* Participants must reach 59½ before withdrawing funds or face an [early withdrawal](https://www.investopedia.com/terms/e/earlywithdrawal.asp) penalty
Those who are eligible to contribute to a 403(b) include:
* Employees of public schools, state colleges, and universities
* Public school employees of Indian tribal governments
* Ministers, members of the clergy, and church employees
* Employees of other tax-exempt organizations
> **Important**
>
> If an employer offers a 403(b) and a 401(k), individuals can contribute to both, but their combined contribution cannot exceed the annual IRS limit of $23,500 in 2025 (up from $23,000 in 2024.) People aged 50 and over can contribute an additional $7,500 as a catch-up contribution, although some 403(b) plans base eligibility for the catch-up on length of service rather than age.
## Types of 403(b) Tax-Sheltered Annuity Plans
Like the 401(k), the 403(b) plan can give the employee a choice of a traditional plan or a Roth plan. Not all employers offer a Roth option.
With a traditional 403(b) plan, the employee has pretax money automatically deducted from each paycheck and paid into a personal retirement account. Thus, the employee's income and the taxes owed on it are reduced for the year. The taxes will be due only when the employee makes a withdrawal.
With a Roth 403(b) plan, [after-tax money](https://www.investopedia.com/terms/a/aftertaxincome.asp) is paid into the retirement account. There's no immediate tax advantage. But, the employee will not owe any more taxes on that money or the profit it accrues when it is withdrawn.
> **Fast Fact**
>
> Clergy can participate in a 403(b) but another plan, the 403(b)(9), is designed specifically for employees of religious institutions.
## Advantages of 403(b) Plans
The big advantages of a 403(b) are the same as those for a 401(k): The money contributed and the earnings that accrue in a traditional account are tax-deferred until they are withdrawn. Both the contributions and the earnings in a Roth 403(b) are free from further taxes.
Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate [vesting](https://www.investopedia.com/terms/v/vesting.asp) of funds, which is rare for 401(k)s.
An employee with 15 or more years of service with certain nonprofits or government agencies may be able to make additional catch-up contributions to a 403(b) plan. The usual eligibility for the catchup starts at age 50.
> **Fast Fact**
>
> According to a 2024 survey by AARP of age 50-plus adults who are regularly saving for retirement, just 33% expect to accumulate enough money in retirement to be financially secure if they continue saving at their current rate.
## Disadvantages of 403(b) Plans
People who withdraw money from a 403(b) plan before age 59½ owe income taxes on the money in the year it is withdrawn, plus a 10% tax penalty. (The same rule applies to a 401(k) plan.)
The penalty can be avoided under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled. The taxes owed cannot be avoided.
When the 403(b) was invented in 1958, it was known as a [tax-sheltered annuity](https://www.investopedia.com/terms/t/taxshelteredannuity.asp). True to its history, the modern 403(b) offers the [variable annuity](https://www.investopedia.com/terms/v/variableannuity.asp) contract as an option.
Otherwise, a 403(b) tends to offer a more limited choice of mutual fund investments than its cousins in private business. plans. Many other investments, such as Individual stocks and [real estate investment trusts](https://www.investopedia.com/terms/r/reit.asp) (REITs), are prohibited.
Pros
* Earnings and returns in regular 403(b) plans are tax-deferred until they are withdrawn
* Many plans vest in short periods or even immediately
* Generous eligibility for catch-up contributions based on length of service
Cons
* Early withdrawals are subject to a 10% tax penalty
* Narrower investment choices than similar plans
* Accounts may lack full protection from creditors
## What Are the Similarities Between 401(k) and 403(b)?
The 401(k) and the 403(b) are both long-term retirement savings plans offered through employers. Both are [tax-advantaged](https://www.investopedia.com/terms/t/tax-advantaged.asp) ways for employees to save for retirement.
The 403(b) tends to offer a smaller choice of investments. At least one of those choices will be an annuity plan.
Some employers in the non-profit sector offer their employees both a 401(k) and a 403(b).
## When Is Money in a 403(b) Tax-Sheltered Annuity Plan Taxed?
The deferred salary is not subject to federal or state income tax until the money is distributed. A 403(b) plan may offer a Roth account as an option. In that case, contributions are taxed immediately but the entire balance is tax-free when it is withdrawn.
## What Types of Employers Can Establish a 403(b) Plan?
Public educational institutions and 501(c)(3) tax-exempt organizations are the only types of employers that may establish a 403(b) plan.
## The Bottom Line
The 403(b) is offered by public schools and other tax-exempt organizations to many of their employees. It works just like a 401(k) plan offered by a company and may include contributions by employers. The IRS establishes limits to annual contributions to 403(b) plans, 401(k) plans, and IRAs.
> **Article Sources**
>
> 1. Internal Revenue Service. "[Retirement Topics - Exceptions to Tax on Early Distributions](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions)."
>
> 2. Internal Revenue Service. "[IRC 403(b) Tax-Sheltered Annuity Plans](https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans)."
>
> 3. Internal Revenue Service. "[401(k) limit increases to $23,500 for 2025, IRA limit remains $7,000](https://www.irs.gov/newsroom/401k-limit-increases-to-23500-for-2025-ira-limit-remains-7000)."
>
> 4. Internal Revenue Service. "[How Much Salary Can You Defer if You’re Eligible for More than One Retirement Plan?](https://www.irs.gov/retirement-plans/how-much-salary-can-you-defer-if-youre-eligible-for-more-than-one-retirement-plan)"
>
> 5. Internal Revenue Service. "[Retirement Topics - Designated Roth Account](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-designated-roth-account)."
>
> 6. Internal Revenue Service. "[Retirement Topics - 403(b) Contribution Limits](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-403b-contribution-limits)."
>
> 7. AARP. "[The Importance of Having a Plan for Retirement](https://www.aarp.org/content/dam/aarp/research/topics/work-finances-retirement/financial-security-retirement/financial-security-trends-january-2024-retirement-planning-50-plus.doi.10.26419-2fres.00525.047.pdf)."
>
> 8. Internal Revenue Service. "[Section 403(b) Tax-Sheltered Annuity Arrangements](https://www.irs.gov/pub/irs-tege/eotopici95.pdf)." Page 1.
>
> 9. Internal Revenue Service. "[Retirement Plan Investments FAQs](https://www.irs.gov/retirement-plans/retirement-plan-investments-faqs)."
>
> 10. Financial Industry Regulatory Authority. "[401(k) Basics](https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/401k-basics)."
>
> 11. Internal Revenue Service. "[IRC 403(b) Tax-Sheltered Annuity Plans](https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans#:~:text=A%20403%28b%29%20plan%20%28tax%2Dsheltered%20annuity%20plan,their%20salary%20into%20individual%20accounts.)." |
401(k) Plan | > **Definition**
>
> A 401(k) plan is a tax-advantaged retirement savings plan.
## What Is a 401(k) Plan?
A 401(k) plan is a tax-advantaged retirement savings plan. Named after a section of the U.S. Internal Revenue Code, the 401(k) is a defined-contribution plan provided by an employer. The employer may match employee contributions; with some plans, the match is mandatory.
There are two major types of 401(k): traditional and Roth. With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. With a Roth 401(k), employee contributions are made with after-tax income. There’s no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax free.
Below, you'll find detailed information on how 401(k) plans work, how to start one, and strategies for making the most of a plan.
### Key Takeaways
* A 401(k) plan is a company-sponsored retirement account in which employees can contribute a percentage of their income. Employers often offer to match at least some of these contributions.
* There are two basic types of 401(k)—traditional and Roth—which differ primarily in how they’re taxed.
* Employer contributions can be made to both traditional and Roth 401(k) plans; [solo 401(k) companies](https://www.investopedia.com/the-best-solo-401k-companies-11705501) provide plans for people without employers.
* There are rules governing when you can withdraw money from a 401(k) without penalty.
:max_bytes(150000):strip_icc()/401kplan.asp-4103bbcbcf0943068955a6c47d6eca0c.png)
*— Ellen Lindner / Investopedia*
“The most important thing to know when making any decision about your 401(k) is to use it. In a perfect world, you put the maximum amount in it, [but at a minimum](https://www.investopedia.com/ask/answers/100314/there-minimum-i-have-contribute-my-401k-plan.asp), you should contribute up to the point where your company matches what you put in,” said [Peter Lazaroff](https://www.investopedia.com/peter-lazaroff-7552540), financial advisor and chief investment officer at Plancorp.
In 2023 (the most recent data), Americans saved an average of 7.1% of their salaries in their 401(k)s, which was higher than the overall personal savings rate that year. Less than 12% of working-age Americans were on track in 2023 to max out their contributions.
The [401(k) employee contribution limit](https://www.investopedia.com/retirement/401k-contribution-limits/) for 2025 is $31,000 (including [“catch-up” contributions](https://www.investopedia.com/terms/c/catchupcontribution.asp)) for those 50 and older and $23,500 for those under 50.
## How 401(k)s Work
Traditional 401(k) plans were introduced in the early 1980s, allowing employees to make pretax contributions from their salaries up to certain limits.
When a worker signs up for a 401(k), they agree to deposit a percentage of each paycheck directly into an investment account. Employers often match part or all of that contribution.
Employees choose the specific investments held within their 401(k) accounts from a selection offered by their employer. Typically, investment offerings include stock and bond [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) and [target-date funds](https://www.investopedia.com/terms/t/target-date_fund.asp) designed to reduce the risk of losses as the employee approaches retirement.
### Note
An employee’s account holdings may include guaranteed investment contracts issued by insurance companies and sometimes the employer’s own stock.
## How Do You Start a 401(k)?
* Contact your employer. Ask if a 401(k) is available, and whether there is a company match. Some employers will make this clear when you're hired.
* If a 401(k) is available, the company will instruct you on how to sign up.
* Choose your investments. There should be a range of options, from conservative to aggressive. A popular option is the target date account, which automatically adjusts the asset mix to align with a preset retirement date. It typically becomes more conservative as you near retirement.
* If you are self-employed or run a small business with your spouse, you may be eligible for a [solo 401(k) plan](https://www.investopedia.com/the-best-solo-401k-companies-11705501), also known as an independent 401(k). These plans allow independent contractors to fund their own retirement. A [solo 401(k)](https://www.investopedia.com/ask/answers/100314/do-i-need-employer-set-401k-plan.asp) can be created through most online brokers.
## Traditional 401(k)s
With a traditional 401(k), employee contributions are deducted from [gross income](https://www.investopedia.com/terms/g/grossincome.asp). This means the money comes from your paycheck before income taxes have been deducted.
As a result, your taxable income is reduced by the total contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until you withdraw the money, usually in retirement.
## Roth 401(k)s
When 401(k) plans were first rolled out in the 1980s, companies and their employees had one choice: the traditional 401(k). Roth 401(k)s didn't arrive until 2006. These 401(k) plans are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible. At first, Roth 401(k)s caught on slowly, but now many employers offer them.
With a Roth 401(k), contributions are deducted from your after-tax income. This means you contribute from your pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When you withdraw the money during retirement, though, you don’t have to pay any additional taxes on your contribution or on the investment earnings.
As a general rule, employees who expect to be in a lower [marginal tax bracket](https://www.investopedia.com/terms/m/marginaltaxrate.asp) after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.
Employees anticipating a higher tax bracket after retiring might choose a Roth 401(k) to avoid paying taxes on their savings later. This decision could be especially worthwhile if the Roth has many years to grow, as all the money earned by the contributions over decades will be tax free upon withdrawal.
As a practical matter, a Roth reduces your immediate spending power more than a traditional 401(k) plan—something to consider if your budget is tight.
Even though contributions to a Roth 401(k) are made with after-tax money, there are, generally speaking, tax consequences if withdrawals are made before you’re 59½ years old. Always check with an accountant or qualified financial advisor before withdrawing money from either a Roth or traditional 401(k).
> **Tip**
>
> Order your copy of Investopedia’s What to Do with $10,000 magazine for more wealth-building advice.
## 401(k) Plan Contribution Limits
Traditional and Roth 401(k) plans are defined contribution plans. Both the employee and employer can contribute to the account up to the dollar limits set by the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp).
The maximum amount an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for [inflation](https://www.investopedia.com/terms/i/inflation.asp), which measures rising prices.
For 2025, the annual limit on employee contributions to a 401(k) is $23,500 for workers under age 50. Those age 50 or older can make an additional $7,500 catch-up contribution.
> **Tip**
>
> “Even though everyone has different circumstances, in general, you should try to put in the maximum allowable amount in your 401(k),” says Peter Lazaroff, an Investopedia 100 top financial advisor.
## Employer Matching
* For workers under 50 years old, the combined limit for both employee and employer contributions is $70,000 per year in 2025.
* If the catch-up contribution for those 50 or older is included, the combined limit is $77,500.
Employers who match employee contributions use various formulas to calculate that match.
An employer might match $0.50 for every $1 that the employee contributes, for example, up to a certain percentage of their salary. Vanguard estimates that about one in seven companies have 401(k) matching contributions that follow this formula on 6% of their employees’ wages.
Lazaroff, who hosts the investment education podcast The Long Term Investor, says that you should take advantage of your employer’s matching contributions if you can. It’s a risk-free way to grow your money and not leave part of your compensation on the table.
“Meeting the match doesn’t necessarily mean you have to sacrifice other financial goals, such as paying down debt or establishing an emergency fund,” he says. “You can still chip away at debt and put away small amounts in an emergency fund if necessary. But securing that employer match is crucial.”
## How Does Your 401(k) Earn Money?
When you contribute to your 401(k) account, your money is invested according to your choices from the options your employer offers. These typically include an assortment of target-date funds and mutual funds.
Target-date funds are the way “you’re least likely to make mistakes,” Lazaroff said. These accounts contain a mix of stocks, bonds, and other securities that are adjusted as your chosen date approaches, generally shifting toward more conservative investments as you near retirement.
“You might be different from the average, and you might accumulate enough wealth one day where a target-date fund isn’t the most appropriate. But for many people, it’s one of the easier and least risky routes to take,” Lazaroff says.
Several factors influence the pace and extent of your 401(k)’s growth, including the amount you contribute annually, any company matches, investment performance, and the time until you retire.
A significant benefit of a 401(k) is tax-deferred growth. With a traditional 401(k), you don’t have to pay taxes on investment [gains](https://www.investopedia.com/terms/g/gain.asp), interest, or [dividends](https://www.investopedia.com/terms/d/dividend.asp) until you withdraw money from the account. However, if you have a Roth 401(k), you won’t have to pay taxes on qualified withdrawals when you retire, as contributions are made with after-tax dollars.
[Opening a 401(k)](https://www.investopedia.com/how-to-set-up-a-401k-8655635) also allows your money to grow over time, thanks to the power of [compounding](https://www.investopedia.com/terms/c/compound.asp). Compounding occurs when the returns generated by your savings are reinvested into the account, generating returns of their own. Over many years, the compounded earnings in your 401(k) account can exceed the amount you contributed. This is why, as you continue to contribute to your 401(k), it can grow quite substantially by the time you retire.
## 401(k) Withdrawals
Once your money goes into a 401(k), it can be difficult to withdraw it without paying taxes on the amount.
“Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement,” says Dan Stewart, the head of Dallas-based Revere Asset Management. “Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary.”
For emergency funds, consider putting some of your savings into a [high-yield savings account](https://www.investopedia.com/high-yield-savings-accounts-4770633), where you can access it easily while still earning a decent interest rate. And for money you won't need for a while, look at the [best available CDs](https://www.investopedia.com/best-cd-rates-4770214) to lock in a strong rate for months or years at a time.
Earnings in a 401(k) account are tax-deferred for traditional 401(k) accounts and tax-free for Roth accounts. When you withdraw from a traditional 401(k), that money (which has never been taxed) will be taxed as ordinary income. With a Roth, you’ve already paid income tax on the money you contributed, so you won’t owe taxes on withdrawals if you satisfy [specific requirements](https://www.investopedia.com/terms/q/qualifieddistribution.asp).
You must be at least 59½—or meet IRS criteria for a [hardship withdrawal](https://www.investopedia.com/retirement/relief-401k-hardship-withdrawals/)—when you start making withdrawals, or you will face a 10% early withdrawal penalty on top of any other income tax you owe.
> **Fast Fact**
>
> Some employers allow employees to take out a loan against their 401(k) plan contributions, essentially borrowing from themselves.
## Required Minimum Distributions
Traditional 401(k) account holders have [required minimum distributions (RMDs)](https://www.investopedia.com/terms/r/requiredminimumdistribution.asp) after reaching a certain age or [face an IRS penalty](https://www.investopedia.com/worst-thing-if-you-dont-take-rmd-11735273). (Withdrawals are called distributions in IRS parlance.)
Investors who have retired must start taking [RMDs from their 401(k) plans](https://www.investopedia.com/required-minimum-distributions-impact-traditional-ira-balance-11711080) at age 73. The amount of the RMD is calculated based on your [life expectancy](https://www.investopedia.com/terms/l/lifeexpectancy.asp) at the time. Before 2020, the RMD age was 70½. After that, it was changed to 72. And it was updated to age 73 in the omnibus spending bill H.R. 2617 in 2022.
## What Are the Pros and Cons of a 401(k)?
### Pros
* Traditional 401(k) plans let you [reduce your tax burden](https://www.investopedia.com/should-max-out-401k-early-5324697) while saving for retirement.
* With Roth 401(k)s, qualifying withdrawals are tax free.
* Tax-deferred gains
* Hassle-free because contributions are automatically subtracted from your paycheck
* Employer might provide a match, boosting your retirement savings
### Cons
* 401(k)s can come with fees—though they’re typically modest.
* Traditional (not Roth) accounts are subject to required minimum distributions (RMDs).
* There are penalties for withdrawing funds early—if you’re younger than 59½ and you don’t qualify for a hardship withdrawal, you’ll need to pay a 10% penalty to the IRS.
* A 401(k) might not be enough on its own to sustain you in retirement, depending on your goals and circumstances. Consider talking to a financial professional who can walk you through other options.
> **Tip**
>
> Since it’s difficult to predict what tax rates will be decades from now, many financial advisors suggest putting money into both Roth and traditional 401(k) accounts.
## History of the 401(k)
The United States has undergone a significant shift in how Americans save for retirement, as illustrated below by our chart comparing the number of Americans (in millions) in defined benefit and [defined contribution plans](https://www.investopedia.com/terms/d/definedcontributionplan.asp), along with the total for both.
Defined contribution plans, most of which are 401(k)s, are [an alternative to the traditional pension](https://www.investopedia.com/terms/e/employee-savings-plan.asp), known as a defined benefit plan. With a [pension](https://www.investopedia.com/terms/p/pensionplan.asp), the employer is committed to providing a specific amount of money to the employee for life during retirement. In recent decades, as the chart below shows, defined contribution plans like 401(k)s have become far more common, and traditional pensions have become rare as employers have shifted the responsibility and risk of saving for retirement to employees.
### Comparing the Number of Americans in Defined Benefit vs. Defined Contribution Plans
:max_bytes(150000):strip_icc()/PresentationcreatedfromyourDoc-341f78abfdce4ebdbff053503922e07c.png)
*Congressional Research Service. — Investopedia*
Above, the number of Americans in defined benefit and defined contribution plans, along with the total of both, in millions.
Initially offered by employers to supplement other employee benefits, 401(k)s have become the most common private employer-sponsored retirement program in the U.S. About a third of working-age Americans have a 401(k), according to U.S. Census data, compared with one in nine who have a defined benefit pension plan. Meanwhile, as many as 4 in 10 [baby boomers](https://www.investopedia.com/terms/b/baby_boomer.asp) and half of [millennials](https://www.investopedia.com/terms/m/millennial.asp) have no retirement account at all.
Still, the 401(k) plan was designed to encourage Americans to save for retirement. Among its benefits are tax savings. If your employer offers both types of 401(k) plans, you can split your contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).
## 401(k)s vs. Brokerage Accounts
Both brokerage and 401(k) accounts are investment accounts, but they serve different purposes. A 401(k) is primarily for retirement savings, while a [brokerage account](https://www.investopedia.com/best-online-brokers-4587872) can be used for various financial goals and often offers more control over the investments.
A 401(k) is a type of qualified retirement plan. Within it, you can choose from a menu of investment options (generally mutual funds) where your money grows in a tax-advantaged manner.
A brokerage account, meanwhile, is a private account where you can buy, sell, and hold whatever securities your broker has access to, including mutual funds, stocks, bonds, and [exchange-traded funds (ETFs)](https://www.investopedia.com/terms/e/etf.asp). Brokerage accounts are taxable, meaning your [capital gains](https://www.investopedia.com/terms/c/capitalgain.asp) and dividends are subject to tax in the current period. There are also no contribution limits, early withdrawal considerations, or minimum distributions.
### 401(k)s vs. Brokerage Accounts
401(k)
* Retirement account
* Employer-sponsored
* Limited menu of investment options
* Tax-deferred
* Annual contribution limits
* Early withdrawal penalties
* RMDs
* Potential for employer matching
Brokerage Account
* Can be used for anything
* Self-sponsored
* Can buy or sell any investment
* Taxable
* No contribution limits
* No withdrawal penalties
* No RMDs
* No employer matching
## What Happens to Your 401(k) When You Leave a Job?
When you leave a company where you’ve been employed and you have a 401(k) plan, you generally have four options:
### 1\. Withdraw the Money
Withdrawing the money is usually a bad idea unless you urgently need it. The money will be taxable for the year it’s withdrawn. You will be hit with the additional 10% early distribution tax unless you are 59½ or older, permanently disabled, or meet the other IRS criteria [for an exemption from the rule](https://www.investopedia.com/articles/retirement/08/401k-info.asp).
With a Roth 401(k), you can withdraw your contributions (but not any earnings) tax-free and without penalty if you have had the account for at least five years or meet the IRS criteria mentioned previously. However, you’re still decreasing your retirement savings, which you may regret later.
### 2\. Roll Your 401(k) Into an IRA
Moving the money into an [individual retirement account (IRA)](https://www.investopedia.com/terms/i/ira.asp) at a brokerage firm or a bank means avoiding immediate taxes and maintaining the account’s tax-advantaged status. What’s more, you can choose from among a wider range of investment choices than you had with your employer’s plan.
The IRS has relatively [strict rules on IRA rollovers](https://www.investopedia.com/terms/i/ira-rollover.asp) and how they need to be accomplished. Not following them is costly. Typically, the financial institution in line to receive the money will help with the process to prevent any missteps.
> **Warning**
>
> Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and penalties.
### 3\. Leave Your 401(k) With Your Former Employer
In many cases, employers permit a departing employee to keep a 401(k) account indefinitely in their old plan, though the employee can’t contribute further. This generally applies to accounts worth at least $5,000. For smaller accounts, an employer may give the employee no choice but to move the money elsewhere.
Leaving the money where it is makes sense if the former employer’s plan is well-managed and you are satisfied with its investment choices. The danger is that employees who change jobs throughout their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their [heirs](https://www.investopedia.com/terms/h/heir.asp) might also be unaware of the existence of the accounts.
Capitalize, an investment platform specializing in rolling over forgotten or left-behind 401(k) accounts, estimates that in 2023, there were almost 30 million such accounts in the U.S., holding about a quarter of Americans’ total assets in 401(k) plans.
### 4\. Move Your 401(k) to Your New Employer
You can usually [move your 401(k) balance](https://www.investopedia.com/roll-over-old-401k-5324698) to a new employer’s plan. As with an IRA rollover, this maintains the account’s tax-deferred status and avoids immediate taxes.
If you aren’t comfortable with managing a rollover, you can leave some of the work to the new plan’s administrator.
## Frequently Asked Questions (FAQs)
## What Is the Maximum Contribution to a 401(k)?
The maximum contribution to a 401(k) plan is $23,500 in 2025 if you are younger than 50 years old. If you are 50 years old or older, you can make an additional catch-up contribution of $7,500. There are also limitations on the [employer’s matching contribution](https://www.investopedia.com/articles/retirement/09/employer-cuts-401k-match.asp): The combined employer-employee contributions cannot exceed $70,000 in 2025 for employees under 50 (or $77,500 for employees 50 or older).
## Is It a Good Idea to Take Early Withdrawals From Your 401(k)?
Typically, no. There are few advantages to [taking an early withdrawal](https://www.investopedia.com/ask/answers/101314/how-do-you-withdraw-money-your-401k.asp) from a 401(k) plan. If you withdraw before age 59½, you will face a 10% penalty in addition to any taxes you owe. However, some employers allow hardship withdrawals for sudden financial needs, such as certain medical costs, funeral costs, or buying a home. This can help you avoid the early withdrawal penalty, but you will still have to pay taxes on the withdrawal.
## How Can a Stock Sell-Off Impact Your 401(k)?
A plunging stock market may seem worrisome, but it’s almost always the right move to stay the course. Amid a big stock sell-off (a [bear market](https://www.investopedia.com/terms/b/bearmarket.asp)), stocks are essentially on discount, if you can weather some big emotions and ignore external pressures. Though the value of your 401(k) will dip as the market dips, it's likely that it won’t forever—or even for too long.
## The Bottom Line
A 401(k) plan is a workplace retirement plan that allows you to make annual contributions up to a specific limit, investing that money for your later years.
There are two major types of 401(k) plans: traditional and Roth. The traditional 401(k) involves [pretax contributions](https://www.investopedia.com/ask/answers/03/072903.asp) that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you won’t pay taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.
> **Article Sources**
>
> 1. Internal Revenue Service. “[Retirement Plans Definitions](https://www.irs.gov/retirement-plans/plan-participant-employee/definitions).”
>
> 2. Internal Revenue Service. “[Retirement Plans FAQs on Designated Roth Accounts](https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts).”
>
> 3. Capitalize. “[Average 401(k) Account Contributions in 2023](https://www.hicapitalize.com/resources/average-401k-contributions/)."
>
> 4. U.S. Bureau of Economic Analysis. “[Personal Saving Rate](https://www.bea.gov/taxonomy/term/746).”
>
> 5. Statista. “[Confidence in Progress Toward Retirement Goals for Individuals in the United States in 2023, by Respondent Type](https://www.statista.com/statistics/1422767/confidence-in-progress-toward-retirement-goals-for-individuals-us/).”
>
> 6. Internal Revenue Service. “[401(k) Limit Increases to $23,500 for 2025, IRA Limit Remains $7,000](https://www.irs.gov/newsroom/401k-limit-increases-to-23500-for-2025-ira-limit-remains-7000).”
>
> 7. U.S. Code. “[26 USC 401: Qualified Pension, Profit-sharing, and Stock Bonus Plans](https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section401&num=0&edition=prelim).”
>
> 8. U.S. Census Bureau. “[Who Has Retirement Accounts?](https://www.census.gov/library/stories/2022/08/who-has-retirement-accounts.html)”
>
> 9. U.S. Bureau of Labor Statistics. “[Retirement Plans for Workers in Private Industry](https://www.bls.gov/opub/ted/2023/retirement-plans-for-workers-in-private-industry-and-state-and-local-government-in-2022.htm).”
>
> 10. Financial Industry Regulatory Authority, via Internet Archive Wayback Machine. “[Investing in Your 401(k)](https://web.archive.org/web/20200913112846/https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/investing-your-401k).”
>
> 11. Financial Industry Regulatory Authority. “[Save the Date: Target-Date Funds Explained](https://www.finra.org/investors/insights/save-date-target-date-funds-explained).”
>
> 12. Internal Revenue Service. “[One-Participant 401(k) Plans](https://www.irs.gov/retirement-plans/one-participant-401k-plans).”
>
> 13. Internal Revenue Service. “[401(k) Plan Overview](https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview).”
>
> 14. Guideline. “[Evolution of the 401(k)](https://www.guideline.com/blog/evolution-of-401k).”
>
> 15. U.S. Bureau of Labor Statistics. “[Another Retirement Savings Option: Roth 401(k) Plan](https://www.bls.gov/opub/mlr/cwc/another-retirement-savings-option-roth-401k-plan.pdf).”
>
> 16. Congress.gov, U.S. Congress. “[S. 197—Savings and Investment Incentive Act of 1997: Summary](https://www.congress.gov/bill/105th-congress/senate-bill/197).”
>
> 17. Internal Revenue Service. “[Retirement Topics—Designated Roth Account](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-designated-roth-account).”
>
> 18. Vanguard. “[How America Saves 2024](https://institutional.vanguard.com/content/dam/inst/iig-transformation/insights/pdf/2024/has/how_america_saves_report_2024.pdf).”
>
> 19. Apple Podcasts. “[The Long Term Investor](https://podcasts.apple.com/do/podcast/the-long-term-investor/id1573028666).”
>
> 20. Internal Revenue Service. “[401(k) Resource Guide—Plan Participants—General Distribution Rules](https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules).”
>
> 21. Internal Revenue Service. “[Roth Comparison Chart](https://www.irs.gov/retirement-plans/roth-comparison-chart).”
>
> 22. Financial Industry Regulatory Authority. “[Taxation of Retirement Income](https://www.finra.org/investors/learn-to-invest/types-investments/retirement/managing-retirement-income/taxation-retirement-income).”
>
> 23. Internal Revenue Service. “[Considering a Loan from Your 401(k) Plan?](https://www.irs.gov/retirement-plans/considering-a-loan-from-your-401k-plan-2)”
>
> 24. Internal Revenue Service. “[Retirement Topics—Required Minimum Distributions (RMDs)](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds).”
>
> 25. Internal Revenue Service. “[Retirement Plan and IRA Required Minimum Distributions FAQs](https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions).”
>
> 26. Congress.gov, U.S. Congress. “[H.R.2617—Consolidated Appropriations Act, 2023: Text](https://www.congress.gov/bill/117th-congress/house-bill/2617/text),” Division T: Section 107.
>
> 27. Internal Revenue Service. “[Defined Benefit Plan](https://www.irs.gov/retirement-plans/defined-benefit-plan).”
>
> 28. Congressional Research Service Reports. “[A Visual Depiction of the Shift from Defined Benefit (DB) to Defined Contribution (DC) Pension Plans in the Private Sector](https://crsreports.congress.gov/product/pdf/IF/IF12007).”
>
> 29. U.S. Department of Labor. “[FAQs About Retirement Plans and ERISA](https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/faqs/retirement-plans-and-erisa-for-workers.pdf),” Page 2.
>
> 30. Internal Revenue Service. “[Retirement Topics—Termination of Employment](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-termination-of-employment).”
>
> 31. Internal Revenue Service. “[Rollovers of Retirement Plan and IRA Distributions](https://www.irs.gov/retirement-plans/plan-participant-employee/rollovers-of-retirement-plan-and-ira-distributions).”
>
> 32. Capitalize. “[The True Cost of Forgotten 401(k) Accounts (2023)](https://www.hicapitalize.com/wp-content/uploads/2023/06/The-true-cost-of-forgotten-401k-accounts-2023.pdf).”
>
> 33. Internal Revenue Service. “[2025 Limitations Adjusted](https://www.irs.gov/pub/irs-drop/n-24-80.pdf).”
>
> 34. Internal Revenue Service. “[Retirement Topics—401(k) and Profit-Sharing Plan Contribution Limits](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits).”
>
> 35. Internal Revenue Service. “[Hardships, Early Withdrawals and Loans](https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans#:~:text=A%20hardship%20distribution%20is%20a,back%20to%20the%20borrower's%20account.).” |
408(k) Plan: What it is, How it Works, Compared to 401(k) | # 408(k) Plan: What it is, How it Works, Compared to 401(k)
## What Is a 408(k) Plan?
The term 408(k) account refers to an employer-sponsored retirement savings plan. A 408(k) plan allows employees to put aside pretax dollars for retirement that grow on a tax-deferred basis, making it a type of [individual retirement account (IRA)](https://www.investopedia.com/terms/i/ira.asp). This means that individuals pay taxes when they make withdrawals after they turn 59½. The 408(k) is commonly referred to as a [simplified employee pension (SEP)](https://www.investopedia.com/terms/s/sep.asp) plan. In fact, it is the SEP version of the popular 401(k) plan.
### Key Takeaways
* A 408(k) is an employer-sponsored retirement plan akin to a 401(k).
* The plan is also referred to as a simplified employee pension, which is a type of individual retirement account.
* The 408(k) plan is available to companies of any size as well as self-employed individuals who are subject to the same contribution limits as employers.
* Only employer contributions are allowed into the 408(k) plan.
* The IRS limits how much employers can contribute to their employees' 408(k) plans.
## Understanding 408(k) Plans
Section 408(k) of the [Internal Revenue Code (IRC)](https://www.investopedia.com/terms/i/internal-revenue-code.asp) outlines the rules and regulations associated with SEP and salary reduction simplified employee pension (SARSEP) accounts, notably individual retirement accounts (IRAs) or individual retirement annuities. That is why SEP plans are often referred to as 408(k) plans.
The IRC highlights the requirements needed in order to participate in a 408(k) plan. Plans are available to small businesses of any size and to [self-employed individuals](https://www.investopedia.com/terms/s/self-employed-person.asp). Participants qualify if they are:
* Over the age of 21
* Worked for at least three of the last five years for the employer
* Were compensated at least $650 by the employer (for 2022; compensation requirements increase to $750 for 2023)
Annual employer contributions cannot exceed the lesser of 25% of the employee's pay or $61,000 for 2022 ($66,000 for 2023). The annual [compensation](https://www.investopedia.com/salaries-and-compensation-4689802) limit cannot be calculated on incomes exceeding $305,000 for 2022 ($330,000 in 2023). The maximum [deduction](https://www.investopedia.com/terms/d/deduction.asp) claimed on a business tax return for contributions is the lesser of the total contributions into employees' accounts or 25% of compensation.
Plan holders can make withdrawals from their 408(k) plans at any time—the same way they would from [traditional IRAs](https://www.investopedia.com/terms/t/traditionalira.asp). But there are certain conditions that apply. For instance, most individuals make withdrawals after they turn 59½. Any distributions from these plans before that age incur a 10% early withdrawal penalty. Withdrawals must be made as [required minimum distributions (RMDs)](https://www.investopedia.com/terms/r/requiredminimumdistribution.asp) as of April 1 the year after you turn 72 if you reached that age on or before Dec. 31, 2022. You must begin taking RMDs if you turn 73 on or after Jan. 1, 2023.
> **Fast Fact**
>
> Unlike traditional retirement plans, SEPs don't have the same start-up or administrative costs.
## 408(k) Plans vs. 401(k) Plans
As noted above, a 408(k) is one type of employer-sponsored retirement plan. The [401(k) plan](https://www.investopedia.com/average-401k-balance-60-years-old-8758007) is the most common option and is offered by the vast majority of American corporations. The plan allows taxpayers to make pre-tax contributions through automatic [payroll deductions](https://www.investopedia.com/articles/pf/08/payroll-deductions.asp) and employer matches for those that make them.
Plan reform has made several changes to benefit employees, including lower fees and investment options. The average 401(k) plan now offers over two dozen investment options by balancing [risk and reward](https://www.investopedia.com/articles/stocks/11/calculating-risk-reward.asp), in accordance with an employee's preferences. Unlike an SEP, employees may contribute to a 401(k) plan. A [solo 401(k) plan](https://www.investopedia.com/ask/answers/100314/do-i-need-employer-set-401k-plan.asp) is also available to self-employed individuals or couples, with the same total contribution limits as an employer-sponsored plan.
Participation in traditional [401(k) plans](https://www.investopedia.com/terms/1/401kplan.asp) continues to grow. These plans held roughly $6.3 trillion in assets by September of 2022, which represented more than half of the retirement [market](https://www.investopedia.com/terms/m/market.asp) in the United States. There were 625,000 active plans in the country with a total of 60 million former employees and retirees at the end of September 2022.
Here are a few other facts related to the 401(k) that taxpayers should know:
* Contribution limits for 401(k) plans are indexed to inflation. The [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) allowed employees to save up to $20,500 for 2022, rising to $22,500 for 2023. [Catch-up contributions](https://www.investopedia.com/terms/c/catchupcontribution.asp) of $6,500 per year (increasing to $7,500 in 2023) are also allowed for people 50 or older.
* Withdrawals before the age of 59½ often result in a 10% early withdrawal penalty, unless an exemption is applied. Taxes are imposed on any withdrawals made as contributions are made with [pretax earnings](https://www.investopedia.com/terms/p/pretax-earnings.asp).
* Individuals who turn 72 between Jan. 1, 2020, and Dec. 31, 2022, must begin taking RMDs the following April 1. The SECURE ACT 2.0 raised that age to 73 for anyone who turned that age on or after Jan. 1, 2023.
_Correction—Jan. 27, 2023:_ This article was corrected to list the company size restrictions for 408(k) plans.
> **Article Sources**
>
> 1. Office of the Law Revision Counsel. "[U.S. Code: Title 26, Subtitle A, Chapter 1, Subchapter D, Part 1, Subpart A, § 408(k)](https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section408&num=0&edition=prelim)."
>
> 2. Internal Revenue Service. "[Simplified Employee Pension Plan (SEP)](https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep)."
>
> 3. Internal Revenue Service. "[Retirement Topics — Required Minimum Distributions (RMDs)](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds)."
>
> 4. U.S. Congress. "[H.R.2617 - Consolidated Appropriations Act, 2023](https://www.congress.gov/bill/117th-congress/house-bill/2617/text)," Division T: Title I: Section 107.
>
> 5. Fidelity. "[SEP IRA: Plan Details](https://www.fidelity.com/retirement-ira/small-business/sep-ira)."
>
> 6. Fidelity. "[Fidelity Advantage 401(k): Pricing Overview](https://www.fidelityworkplace.com/s/401ksmallbusiness-pricing)."
>
> 7. U.S. Department of Labor. "[FAQs About Retirement Plans and ERISA](https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/faqs/retirement-plans-and-erisa-for-workers.pdf)," Page 2.
>
> 8. Vanguard. "[How America Saves 2022](https://institutional.vanguard.com/content/dam/inst/vanguard-has/insights-pdfs/22_TL_HAS_FullReport_2022.pdf)," Page 54.
>
> 9. Internal Revenue Service. "[401(k) Plan Overview](https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview)."
>
> 10. Investment Company Institute. "[401(k) Resource Center](https://www.ici.org/401k)."
>
> 11. Internal Revenue Service. "[Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits)."
>
> 12. Internal Revenue Service. "[Retirement Topics - Exceptions to Tax on Early Distributions](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions)." |
412(i) Plan | # 412(i) Plan: What it Means, How it Works
## What Was a 412(i) Plan?
A 412(i) plan was a [defined-benefit pension plan](https://www.investopedia.com/terms/d/definedbenefitpensionplan.asp) that was designed for small business owners in the U.S. It was classified as a tax-qualified [pension plan](https://www.investopedia.com/terms/p/pensionplan.asp), so any amount that the company contributed to it could immediately be taken as a tax deduction by the company. The employee could also deduct their contributions. Guaranteed annuities or a combination of [annuities](https://www.investopedia.com/terms/a/annuity.asp) and life insurance were the only things that could fund a 412(i) plan. The 412(i) plan was replaced by the 412(e)(3) plan after December 31, 2007.
### Key Takeaways
* A 412(i) plan was a defined-benefit pension plan that was designed for small business owners in the U.S.
* A 412(i) was a tax-qualified benefit plan, meaning the company's contributions to the plan became a tax deduction for the company.
* Guaranteed annuities or a combination of annuities and life insurance were the only things that could fund the plan.
* Due to tax avoidance schemes that were occurring under 412(i), the Internal Revenue Service (IRS) replaced it with 412(e)(3).
## Understanding a 412(i) Plan
Notably, 412(i) plans were developed for small business owners who often found it difficult to invest in their company while trying to save for employees' retirement. The 412(i) plan was unique in that it provided fully guaranteed retirement benefits.
Insurance companies backed and offered the 412(i) plans to employers, and only insurance products like annuities and life insurance policies could be held in the plan. Contributions to it provided large tax deductions.
An annuity is a financial product that an individual can purchase via a lump-sum payment or installments. The insurance company, in turn, pays the owner a fixed stream of payments at some point in the future. Annuities are primarily used as an income stream for retirees.
Due to the large [premiums](https://www.investopedia.com/terms/p/premium.asp) that had to be paid into the plan each year, a 412(i) plan was not ideal for all small business owners. The plan tended to benefit small businesses that were more established and profitable.
For example, a small business that had reached a stable, mature, and profitable state would have been better positioned to create a 412(i) plan than a bootstrapped startup or one that had only recently received [angel](https://www.investopedia.com/terms/a/angelinvestor.asp) or seed funding.
These companies also often don't generate enough [free cash flow](https://www.investopedia.com/terms/f/freecashflow.asp) (FCF) to put away consistently for employees’ retirement. Instead, the founding team members often re-invest any profits or outside funding back into their product or service to generate new sales and make updates to their core offerings.
## 412(i) Plans and Compliance Issues
* In February 2004, after noticing abuse and tax avoidance issues involving life insurance policies held in retirement plans such as the 412(i), the [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) (IRS) issued guidance to shut down these tax avoidance schemes. Specially designed life insurance policies for high income employees with a 412(i) plan were the focal point of the abuse.
## 412(e)(3)
Due to the abuses of the 412(i) plan resulting in tax avoidance schemes, the Internal Revenue Service (IRS) moved the 412(i) provisions to 412(e)(3), effective for plans beginning after December 31, 2007. 412(e)(3) functions similarly to 412(i), except that it is exempt from the minimum funding rule. According to the IRS, the requirements for 412(e)(3) are as follows:
* Plans must be funded exclusively by the purchase of a combination of annuities and life insurance contracts or individual annuities,
* Plan contracts must provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective),
* Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid,
* Premiums payable under such contracts for the plan year, and all prior plan years, have been paid before lapse or there is a reinstatement of the policy,
* No rights under such contracts have been subject to a security interest at any time during the plan year, and
* No policy loans are outstanding at any time during the plan year
> **Article Sources**
>
> 1. Association of International Certified Professional Accountants, Journal of Accountancy. "[The Section 412(i) Retirement Alternative](https://www.journalofaccountancy.com/issues/2003/sep/thesection412iretirementalternative.html)."
>
> 2. Internal Revenue Service. "[Fully Insured 412(e)(3) Plans](https://www.irs.gov/retirement-plans/fully-insured-412e3-plans)."
>
> 3. Internal Revenue Service. "[Employee Plans Abusive Tax Transactions](https://www.irs.gov/retirement-plans/employee-plans-abusive-tax-transactions)." |
457 Plan | # What Is a 457 Plan?
> **Definition**
>
> A 457 plan helps reduce an employee's annual income tax with pre-tax retirement savings.
## What Is a 457 Plan?
A 457 plan is a [tax-advantaged](https://www.investopedia.com/terms/t/tax-advantaged.asp) retirement savings plan for many state, local government, and some nonprofit organization employees. The 457(b) is the most common type. Like a [401(k) plan](https://www.investopedia.com/terms/1/401kplan.asp) in the private sector, the 457(b) allows employees to [save pre-tax earnings in an account](https://www.investopedia.com/terms/p/pretaxcontribution.asp), reducing their annual income taxes while postponing the taxes due until the money is withdrawn during retirement.
A [Roth version](https://www.investopedia.com/terms/r/roth-option.asp) of the 457(b) plan allows after-tax contributions. The 457(f) plan is a supplemental plan offered only to highly compensated executives in tax-exempt organizations.
### Key Takeaways
* The 457(b) is an IRS-sanctioned, tax-advantaged employee retirement plan.
* The plan is offered only to public service employees and employees at tax-exempt organizations.
* The interest and earnings in the account are not taxed until the funds are withdrawn.
:max_bytes(150000):strip_icc()/457plan.asp-final-f27170b983d0496e86a246a0c1cb4602.png)
*— Investopedia / Julie Bang*
## Contribution Limits
Employees commonly choose [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) and [annuities](https://www.investopedia.com/ask/answers/12/what-is-an-annuity.asp) with a 457 and can contribute up to 100% of their salary up to the IRS annual limit. The IRS adjusts 457(b) contribution limits annually for inflation. There is also an optional catch-up contribution allowed for people who are 50 and older if the plan permits it. This limit is also increased and adjusted annually.
The SECURE 2.0 Act allowed government plans to offer people in their early 60s an additional "super catch-up" contribution. So, people between 60 and 63 have the option to contribute more than the standard catch-up contribution. This limit is based on whichever is higher: a set dollar amount or a percentage of the standard catch-up.”
A 457 plan's "double limit" provision allows participants to contribute up to twice the annual limit for three years before the employee's normal retirement age.
> **Important**
>
> The SECURE 2.0 Act raised the age for taking required minimum distributions (RMDs) to 73. Those who reached age 72 in 2023 must take their first RMD on April 1, 2025.
## Advantages and Disadvantages
A traditional 457 deducts contributions pretax, lowering workers' annual taxes. All interest and earnings generated annually remain untaxed until the funds are withdrawn. Unlike other tax-advantaged retirement plans, there's no penalty for early withdrawals with a 457. Those who retire early or resign can withdraw funds without incurring a 10% penalty from the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp).
A 457 account holder can take a penalty-free withdrawal without changing jobs, like a 401(k) account holder under "unforeseeable emergencies."However, early withdrawals from a 457 are subject to a 10% penalty if the account holder rolls the funds over from a 457 to any other tax-advantaged retirement account, such as a 401(k).
One downside of a 457 plan is employers do not commonly match employee contributions. If they do, the employer contribution counts toward the maximum contribution limit. This is not the case for 401(k) plans.
Pros
* Looser rules for early withdrawals.
* Early distributions allowed for participants who leave a job.
* No taxes are due until money is withdrawn.
Cons
* Employer contributions count toward contribution limits.
* Employer contributions subject to a vesting schedule.
* Limited investment choices compared to private sector plans.
## 457(b) vs. 403(b)
The 403(b) plan, like the 457(b), is primarily available to public service employees, such as public school teachers. [The 403(b)](https://www.investopedia.com/articles/personal-finance/111615/457-plans-and-403b-plans-comparison.asp) began in the 1950s when it exclusively offered an [annuity](https://www.investopedia.com/terms/f/fixedannuity.asp) to participants.
Participants can still create an annuity or choose to invest in mutual funds. The 403(b) closely resembles the private sector's 401(k) plan. The annual contribution limits are identical to those of 457(b) and 401(k) plans.
## What Is the Difference Between a 457(b) Plan and a 457(f) Plan?
The 457(b) plan is a version of the 401(k) plan designed for public and nonprofit workers. It helps employees save for retirement while deferring the tax bill until they retire and withdraw the money. The 457(f) plan is also known as a [Supplemental Executive Retirement Plan (SERP)](https://www.investopedia.com/terms/s/serp.asp). It is a retirement savings plan for only the highest-paid executives in the tax-exempt sector. They are mostly employed in hospitals, universities, and credit unions. A 457(f) supplements a 457(b).
## Is a 457(b) Plan Better Than a 401(k) Plan?
A 457(b) plan compares to a 401(k) plan. Both allow workers to lower taxable income and invest in retirement savings. However, contributions made to a 457(b) may not be matched by the employer like a 401(k).
## How and When Can Employees Withdraw From a 457(b) Account?
Employees can withdraw without paying a tax penalty for any "unforeseeable emergency."
Retirees must take the [required minimum distribution (RMD)](https://www.investopedia.com/articles/personal-finance/020116/how-457-plan-works-after-retirement.asp) determined by the IRS. An RMD is a minimum amount that must be withdrawn from certain retirement plans, like a 457(b), each year once an individual reaches a certain age.
## The Bottom Line
A 457(b) plan is similar to a 401(k) but applies to employees of government agencies, public services, and nonprofit organizations such as hospitals, churches, and charitable organizations. The traditional version of this tax-advantaged retirement savings plan uses pretax contributions, whereas the Roth version uses post-tax contributions.
> **Article Sources**
>
> 1. Internal Revenue Service. "[IRC 457(b) Deferred Compensation Plans](https://www.irs.gov/retirement-plans/irc-457b-deferred-compensation-plans)."
>
> 2. Internal Revenue Service. “[Retirement Topics - 457(b) Contribution Limits](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-457b-contribution-limits).”
>
> 3. Thrift Savings Plan. "[SECURE Act 2.0, Section 109: Higher Catch-Up Limit to Apply at Age 60, 61, 62, and 63](https://www.tsp.gov/bulletins/24-2/)."
>
> 4. Mission Square Retirement. "[457(b) Retirement Plan Catch-Up Rules & Limits](https://www.missionsq.org/products-and-services/457%28b%29-deferred-compensation-plans/457%28b%29-retirement-plan-catch-up-rules-and-limits.html)."
>
> 5. Internal Revenue Service. "[Retirement Plan and IRA Required Minimum Distributions FAQs](https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs)."
>
> 6. Investor.gov. “[403(b) and 457(b) Plans](https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/403b-and-457b-plans)."
>
> 7. Internal Revenue Service. "[Comparison of Tax-Exempt 457(b) Plans and Governmental 457(b) Plans](https://www.irs.gov/retirement-plans/comparison-of-tax-exempt-457b-plans-and-governmental-457b-plans)."
>
> 8. United States Code. “[26 USC 457: Deferred Compensation Plans of State and Local Governments and Tax-Exempt Organizations](https://uscode.house.gov/view.xhtml?req=%28title:26%20section:457%20edition:prelim%29).”
>
> 9. Internal Revenue Service. "[Unforeseeable Emergency Distributions From 457(b) Plans](https://www.irs.gov/retirement-plans/employee-plans-news-december-17-2010-unforeseeable-emergency-distributions-from-457b-plans)."
>
> 10. Internal Revenue Service. "[Retirement Topics - Exceptions to Tax on Early Distributions](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions)."
>
> 11. Internal Revenue Service. "[Comparison of Tax-Exempt 457(b) Plans and Governmental 457(b) Plans](https://www.irs.gov/retirement-plans/comparison-of-tax-exempt-457b-plans-and-governmental-457b-plans)."
>
> 12. Internal Revenue Service. "[401(k) Plan Overview](https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview)."
>
> 13. Internal Revenue Service. "[Section 403(b) Tax-Sheltered Annuity Arrangement](https://www.irs.gov/pub/irs-tege/eotopici95.pdf)." Page 1.
>
> 14. Internal Revenue Service. "[403(b) Contribution Limits](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-403b-contribution-limits#:~:text=The%20limit%20on%20elective%20salary,%2419%2C500%20in%202021%20and%202020%29.)."
>
> 15. BoliColi. "[457(f) Supplemental Retirement Plans](https://www.bolicoli.com/457f-supplemental-retirement-plan/)."
>
> 16. CFI. “[Golden Handcuffs](https://corporatefinanceinstitute.com/resources/career/golden-handcuffs/).”
>
> 17. Internal Revenue Service. "[Retirement Topics — Required Minimum Distributions (RMDs)](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds)."
>
> 18. Internal Revenue Service. “[Retirement Topics — Required Minimum Distributions (RMDs)](https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds).”
>
> 19. National Society of Tax Professionals. “[SECURE Act 2.0 – When Does the RMD Start?](https://www.nstp.org/article/secure-act-2-0-%E2%80%93-when-does-the-rmd-start)” |
5/1 Hybrid Adjustable-Rate Mortgage (5/1 Hybrid ARM) | # 5/1 Hybrid Adjustable-Rate Mortgage (5/1 Hybrid ARM) Examples
## What Is a 5/1 Hybrid Adjustable-Rate Mortgage (5/1 ARM)?
A 5/1 hybrid [adjustable-rate mortgage](https://www.investopedia.com/terms/a/arm.asp) (5/1 ARM) begins with an initial five-year fixed interest rate period, followed by a rate that adjusts on an annual basis. The “5” in the term refers to the number of years with a fixed rate, and the “1” refers to how often the rate adjusts after that (once per year). As such, monthly payments can go up—sometimes dramatically—after five years.
### Key Takeaways
* 5/1 hybrid adjustable-rate mortgages (ARMs) offer an introductory fixed rate for five years, after which the interest rate adjusts annually.
* When ARMs adjust, interest rates change based on their marginal rates and the indexes to which they’re tied.
* Homeowners generally enjoy lower mortgage payments during the introductory period.
* A fixed-rate mortgage may be preferable for homeowners who prefer predictability with their mortgage payments and interest costs.
## How a Hybrid Adjustable-Rate Mortgage (Such as a 5/1 Hybrid ARM) Works
The 5/1 hybrid ARM may be the most popular type of adjustable-rate mortgage, but it’s not the only option. There are 3/1, 7/1, and 10/1 ARMs as well. These loans offer an introductory fixed rate for three, seven, or 10 years, respectively, after which they adjust annually.
Also known as a five-year fixed-period ARM or a five-year ARM, this mortgage features an interest rate that adjusts according to an index plus a margin. Hybrid ARMs are very popular with consumers, as they may feature an initial interest rate significantly lower than a traditional fixed-rate mortgage. Most lenders offer at least one version of such hybrid ARMs; of these loans, the 5/1 hybrid ARM is especially popular.
Other ARM structures exist, such as the 5/5 and [5/6 ARMs](https://www.investopedia.com/terms/1/5-6_hybrid_arm.asp), which also feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively. Notably, 15/15 ARMs adjust once after 15 years and then remain fixed for the remainder of the loan. Less common are [2/28](https://www.investopedia.com/terms/2/228arm.asp) and [3/27 ARMs](https://www.investopedia.com/terms/1/327arm.asp). With the former, the fixed interest rate applies for only the first two years, followed by 28 years of adjustable rates; with the latter, the fixed rate is for three years, with adjustments in each of the following 27 years. Some of these loans adjust every six months rather than annually.
> **Important**
>
> Hybrid ARMs have a fixed interest rate for a set period of years, followed by an extended period during which rates are adjustable.
## Example of a 5/1 Hybrid ARM
Interest rates change based on their marginal rates when ARMs adjust along with the indexes to which they’re tied. If a 5/1 hybrid ARM has a 3% margin and the index is 3%, then it adjusts to 6%.
But the extent to which the fully indexed interest rate on a 5/1 hybrid ARM can adjust is often limited by an [interest rate cap structure](https://www.investopedia.com/terms/i/capstructure.asp). The fully indexed interest rate can be tied to several different indexes, and while this number varies, the margin is fixed for the life of the loan.
A borrower can save a significant sum on their monthly payments with a 5/1 hybrid ARM. Assuming a home purchase price of $300,000 with a 20% down payment ($60,000), a borrower with very good/excellent credit can save 50 to 150 basis points on a loan and more than $100 per month in payments on their $240,000 loan. Of course, that rate could rise, so borrowers should anticipate a rise in their monthly payment, be prepared to sell their home when their rate goes up, or be ready to [refinance](https://www.investopedia.com/terms/r/refinance.asp).
### Note
When refinancing from an ARM to a fixed-rate mortgage, it’s important to consider the new loan term carefully, as it could have a significant impact on how much you pay in total interest to own the home.
## Advantages and Disadvantages of a 5/1 Hybrid ARM
In most cases, ARMs offer lower introductory rates than traditional mortgages with fixed interest rates. These loans can be ideal for buyers who plan to live in their homes for only a short period of time and sell before the end of the introductory period. The 5/1 hybrid ARM also works well for buyers who plan to refinance before the introductory rate expires. That said, hybrid ARMs like the 5/1 tend to have a higher interest rate than standard ARMs.
Pros
* Lower introductory rates than traditional fixed-interest mortgages
* Interest rates possibly drop before the mortgage adjusts, resulting in lower payments
* Good for buyers who will live in their homes for short periods of time
Cons
* Higher interest rates than standard adjustable-rate mortgages (ARMs)
* When mortgage adjusts, interest rates probably rise
* Could be trapped in unaffordable rate hikes due to personal issues or market forces
There’s also a chance that the interest rate might decrease, lowering the borrower’s monthly payments when it adjusts. But in many cases, the rate will rise, increasing the borrower’s monthly payments.
If a borrower takes out an ARM with the intention of getting out of the mortgage by selling or refinancing before the rate resets, then [personal finances or market forces might trap them in the loan](https://www.investopedia.com/mortgage/mortgage-rates/adjustable-rate-go-up/), potentially subjecting them to a rate hike that they can’t afford. Consumers considering an ARM should [educate themselves on how they work](https://www.investopedia.com/mortgage/mortgage-rates/fixed-or-variable-mortgage-rate-which-is-better-now/).
## 5/1 Hybrid ARM vs. Fixed-Rate Mortgage
A 5/1 hybrid ARM may be a good mortgage option for some homebuyers. But for others, a [fixed-rate mortgage](https://www.investopedia.com/terms/f/fixed-rate_mortgage.asp) may be more appropriate. A fixed-rate mortgage has one set interest rate for the life of the loan. The rate is not tied to an underlying benchmark or index rate and doesn’t change; the interest rate charged on the first payment is the same interest that applies to the final payment.
A fixed-rate mortgage could yield advantages for a certain type of homebuyer. If you’re interested in predictability and stability with mortgage rates, for example, then you might lean toward a fixed-rate loan instead of a 5/1 hybrid ARM. Comparing them side by side can make it easier to decide on a mortgage option.
## Is a 5/1 Hybrid ARM a Good Idea?
A 5/1 hybrid ARM could be a good choice for homebuyers who don’t plan to stay in the home long term or who are confident in their ability to refinance to a new loan before the rate adjusts. If interest rates remain low and adjustments to the index rate are relatively minor, then a 5/1 hybrid ARM could save you more money over time compared to a fixed-rate mortgage.
But it’s important to consider how feasible refinancing is and where interest rates might be when you’re ready to move to a new loan. If interest rates rise, then refinancing to a new fixed-rate loan or even to a new ARM may not yield that much in interest savings.
If you don’t plan to refinance and don’t plan to move, then it’s important to consider how realistic that might be for your budget if a rate adjustment substantially increases your monthly payment. If the payment becomes too much for your budget to handle, you may be forced into a situation where you have to sell the property or refinance. And in a worst-case scenario, you could end up facing [foreclosure](https://www.investopedia.com/terms/f/foreclosure.asp) if you default on the loan payments.
> **Important**
>
> If you’re interested in refinancing from a 5/1 hybrid ARM to a fixed-rate mortgage, consider the interest rates for which you’re likely to qualify, based on your credit history and income, to determine if it’s worthwhile.
> **Article Sources**
>
> 1. Freddie Mac. “[How It Works: Adjustable-Rate Mortgages (ARMs)](https://myhome.freddiemac.com/blog/homeownership/20160201_hiw_arm.page).” Accessed Nov. 28, 2021.
>
> 2. Consumer Financial Protection Bureau. “[The Federal Reserve Board: Consumer Handbook on Adjustable-Rate Mortgages](https://files.consumerfinance.gov/f/201204_CFPB_ARMs-brochure.pdf).” Accessed Nov. 28, 2021.
>
> 3. Consumer Financial Protection Bureau. “[With an Adjustable-Rate Mortgage (ARM), What Are Rate Caps and How Do They Work?](https://www.consumerfinance.gov/ask-cfpb/with-an-adjustable-rate-mortgage-arm-what-are-rate-caps-and-how-do-they-work-en-1951/)” Accessed Nov. 28, 2021.
>
> 4. Consumer Financial Protection Bureau. “[What Is the Difference Between a Fixed-Rate and Adjustable-Rate Mortgage (ARM) Loan?](https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-fixed-rate-and-adjustable-rate-mortgage-arm-loan-en-100/)” Accessed Nov. 28, 2021. |
48-Hour Rule | # 48-Hour Rule: What It is, How It Works, Example
## What Is the 48-Hour Rule?
The 48-hour rule is a requirement that sellers of [to-be-announced](https://www.investopedia.com/terms/t/tba.asp) (TBA) [mortgage-backed securities](https://www.investopedia.com/terms/m/mbs.asp) (MBS) communicate all pool information regarding the MBS to buyers before 3 p.m. Eastern Time, 48 hours before the settlement date of the trade. The [Securities Industry and Financial Markets Association](https://www.investopedia.com/terms/s/sifma.asp) (SIFMA) enforces this rule. SIFMA was formerly known as the Public Securities Association or Bond Market Association.
### Key Takeaways
* The 48-hour rule refers to a part of the mortgage allocation process related to the buying and selling of to-be-announced (TBA) mortgage-backed securities (MBS).
* The 48-hour rule stipulates that the seller of an MBS notifies the buyer with the details of the underlying mortgages that make up the MBS by 3 p.m. Eastern Time, 48 hours before the settlement date.
* The Securities Industry and Financial Markets Association (SIFMA) enforces the 48-hour rule.
* When an MBS is traded in the secondary market, the underlying mortgages are not known, which helps facilitate trading and liquidity.
* Certain information is agreed upon when an MBS trade is made, such as the price, par, and coupon, but not the underlying mortgages.
* The TBA market is the second most traded secondary market after the U.S. Treasury market.
## Understanding the 48-Hour Rule
An MBS is a bond that is [secured](https://www.investopedia.com/terms/s/secureddebt.asp), or backed, by mortgage loans. Loans with similar traits are grouped to form a pool. The pool is then sold as a security to investors. The issuance of interest and principal payments to investors is at a rate based on the principal and interest payments made by the borrowers of the underlying mortgages. Investors receive interest payments monthly rather than semiannually.
A to-be-announced (TBA) trade is effectively a contract to buy or sell mortgage-backed securities (MBS) on a specific date. It does not include information regarding the pool number, the number of pools, or the exact amount involved in the transaction, which means the underlying mortgages are not known to the parties. This exclusion of data is due to the TBA market assuming that MBS pools are more or less interchangeable. This interchangeability helps facilitate trading and [liquidity](https://www.investopedia.com/terms/l/liquidity.asp).
The 48-hour rule is part of the [mortgage allocation](https://www.investopedia.com/terms/m/mortgage_allocations.asp) process, the period when the underlying mortgages will be assigned and made available to a specific MBS, which was created to bring transparency to TBA trade settlements.
The 48-hour rule states that the seller of a specific MBS must make the buyer of that MBS aware of the [mortgages](https://www.investopedia.com/terms/m/mortgage.asp) that make up the MBS 48 hours prior to the trade settling. Because of the standard T+3 settlement date, this usually occurs on the day after the trade is executed.
## The 48-Hour Rule as Part of the TBA Process
The TBA process benefits buyers and sellers because it increases the liquidity of the MBS market by taking thousands of different mortgage-backed securities with different characteristics and trading them through a handful of contracts.
Buyers and sellers of TBA trades agree on a few necessary parameters such as issuer [maturity](https://www.investopedia.com/terms/m/maturity.asp), [coupon](https://www.investopedia.com/terms/c/coupon.asp), price, [par](https://www.investopedia.com/terms/p/parvalue.asp) amount, and settlement date. The specific securities involved in the trade are announced 48 hours before the settlement.
The TBA market was established in the 1970s to facilitate the trading of MBS issued by [Fannie Mae, Freddie Mac](https://www.investopedia.com/articles/economics/08/fannie-mae-freddie-mac-credit-crisis.asp), and [Ginnie Mae](https://www.investopedia.com/terms/g/ginniemae.asp). It allows mortgage lenders to [hedge](https://www.investopedia.com/terms/h/hedge.asp) their origination pipelines.
The TBA market is the most liquid [secondary market](https://www.investopedia.com/terms/s/secondarymarket.asp) for mortgage loans, resulting in high levels of market activity. In fact, the amount of money traded on the TBA market is second only to the [U.S. Treasury](https://www.investopedia.com/articles/investing/073113/introduction-treasury-securities.asp) market.
## Example of the 48-Hour Rule
Company ABC decides to sell a mortgage-backed security (MBS) to Company XYZ and Company XYZ accepts. The sale will take place on Tuesday. On Tuesday, when the sale is made, neither Company ABC nor Company XYZ knows the underlying mortgages that make up the mortgage-backed security (MBS).
The standard industry settlement is T+3 days, meaning this trade will settle on Friday. According to the 48-hour rule, on Wednesday before 3 p.m. Eastern Time, Company ABC will have to notify Company XYZ of the mortgage allocations it will receive when the trade settles.
> **Article Sources**
>
> 1. The Securities Industry and Financial Markets Association. "[Pool Notification Process](https://www.sifma.org/wp-content/uploads/2017/09/ch07.pdf)," Page 1.
>
> 2. The Securities Industry and Financial Markets Association. "[The TBA Market](https://www.sifma.org/wp-content/uploads/2018/01/SIFMA-TBA-Fact-Sheet.pdf)." |
5-6 Hybrid Adjustable-Rate Mortgage (5-6 Hybrid ARM) | # 5/6 Hybrid Adjustable-Rate Mortgage (ARM) Definition
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*— Drazen Zigic / Getty Images*
## What Is a 5/6 Hybrid Adjustable-Rate Mortgage (ARM)?
A 5/6 hybrid adjustable-rate mortgage (ARM) has a fixed interest rate for the first five years, after which the interest rate can change every six months. A 5/6 hybrid [adjustable-rate mortgage (ARM)](https://www.investopedia.com/terms/a/arm.asp) combines the characteristics of a traditional [fixed-rate mortgage](https://www.investopedia.com/terms/f/fixed-rate_mortgage.asp) with those of an adjustable-rate mortgage.
### Key Takeaways
* A 5/6 hybrid ARM has an interest rate fixed for the first five years, then adjusts every six months.
* The adjustable interest rate on 5/6 hybrid ARMs is usually tied to a common benchmark index.
* A risk associated with an adjustable interest rate is that a rising rate may make monthly payments unaffordable.
## How a 5/6 Hybrid Adjustable-Rate Mortgage (ARM) Works
A 5/6 hybrid ARM starts with a fixed interest rate and then the interest rate becomes adjustable for the remaining years of the loan. The adjustable rate is based on a benchmark index, such as the [prime rate](https://www.investopedia.com/terms/p/primerate.asp).
The lender will also add additional percentage points, known as a [margin](https://www.investopedia.com/terms/a/armmargin.asp). If the index is currently at 4% and the lender’s margin is 3%, then the [fully indexed interest rate](https://www.investopedia.com/terms/f/fullyindexedinterestrate.asp) for the borrower will be 7%.
A 5/6 hybrid ARM should have [caps](https://www.investopedia.com/terms/p/periodiccap.asp) on how much the interest rate can rise over the life of the loan. This offers protection against rising interest rates that could make the monthly mortgage payments unmanageable.
> **Tip**
>
> Discover how to find the best mortgage for you.
## How Are 5/6 Hybrid ARMs Indexed?
Lenders use different indexes to set interest rates on 5/6 hybrid ARMs. The U.S. [prime rate](https://www.investopedia.com/terms/p/primerate.asp) and [Constant Maturity Treasury (CMT)](https://www.investopedia.com/terms/c/constantmaturity.asp) rate are commonly used. In a rising interest-rate environment, the longer the period between interest-rate reset dates, the better it will be for the borrower. A [5/1 hybrid ARM](https://www.investopedia.com/terms/1/5-1_arm.asp) would be better than a 5/6 ARM because its interest rate would not rise as quickly. The opposite would be true in a falling interest-rate environment.
## 5/6 Hybrid ARM vs. Fixed-Rate Mortgage
### Advantages of a 5/6 Hybrid ARM
Many adjustable-rate mortgages, including 5/6 hybrid ARMs, start with lower interest rates than fixed-rate mortgages, providing the borrower with a significant savings advantage, especially if they expect to sell the home or [refinance](https://www.investopedia.com/mortgage/refinance/when-and-when-not-to-refinance-mortgage/) their mortgage before the fixed-rate period of the ARM ends. Borrowers should ensure that the lender doesn’t impose costly [prepayment penalties](https://www.investopedia.com/terms/p/prepaymentpenalty.asp) for getting out of the mortgage early.
### Disadvantages of a 5/6 Hybrid ARM
The 5/6 hybrid ARM comes with [interest rate risk](https://www.investopedia.com/terms/i/interestraterisk.asp). Because the interest rate can increase every six months after the first five years, the monthly payments may become unaffordable for the borrower. With a fixed-rate mortgage, the interest rate will never rise. The interest rate risk is mitigated if the 5/6 hybrid ARM has periodic and lifetime caps on any interest rate increases.
## What Is an Adjustable Rate Mortgage?
An adjustable-rate mortgage (ARM) is a home loan with a [variable interest rate](https://www.investopedia.com/terms/v/variableinterestrate.asp). With an ARM, the initial interest rate is fixed for a period. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.
## How Is the Interest Rate on a 5/6 ARM Determined?
The lender will set the five-year fixed rate based on [creditworthiness](https://www.investopedia.com/terms/c/credit-worthiness.asp) and the prevailing interest rates. When the adjustable rate kicks in after five years, it will be based on a benchmark index, such as the prime rate, plus an additional percentage added by the lender, known as the margin.
## Does Anything Prevent Interest Rates from Rising Too High on a 5/6 ARM?
Many 5/6 hybrid ARMs and other types of ARMs have caps that limit how much rates can rise in any given period and in total over the life of the loan.
## The Bottom Line
A 5/6 hybrid adjustable-rate mortgage has a fixed interest rate for the first five years, and then the rate adjusts every six months. The rate is commonly linked to a benchmark index, such as the prime rate.
> **Article Sources**
>
> 1. Consumer Financial Protection Bureau. “[Consumer Handbook on Adjustable-Rate Mortgages](https://files.consumerfinance.gov/f/documents/cfpb_charm_booklet.pdf),” Page 4. |
500-Shareholder Threshold | # 500 Shareholder Threshold: What it is, How it Works
## What Was the 500 Shareholder Threshold?
The 500 shareholder threshold for investors is an outdated rule required by the Securities and Exchange Commission ([SEC](https://www.investopedia.com/terms/s/sec.asp)) that triggered [public reporting requirements](https://www.investopedia.com/ask/answers/062415/private-company-required-disclose-financial-information-public.asp) of a company when it reached that many or more distinct shareholders. Section 12(g) of the [Securities Exchange Act of 1934](https://www.investopedia.com/terms/s/seact1934.asp) calls for issuers of securities to register with the SEC and begin public dissemination of financial information within 120 days of the end of a fiscal year.
New regulations now require a 2,000 shareholder threshold.
### Key Takeaways
* The 500 shareholder threshold was a rule mandated by the SEC that required companies to publicly disclose financial statements and other information if they achieved 500 or more distinct shareholders.
* The rule, in place from 1964-2012, was meant to discourage fraud, opacity, and misinformation alleged in the over-the-counter market.
* Today, the shareholder threshold is now 2,000, largely in response to the rapid growth of investment in tech start-ups that caused the 500 limit to be reached too quickly.
## Understanding the 500 Shareholder Threshold
The 500 shareholder threshold was originally introduced in 1964 to address complaints of fraudulent activity appearing in the [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) (OTC) market. Since firms with fewer than the threshold number of investors were not required to disclose their financial information, outside buyers were not able to make fully informed decisions regarding their investments due to a lack of transparency and allegations of stock fraud.
The 500 shareholder threshold forced companies that had more than 499 investors to provide adequate disclosure for the protection of investors and for oversight by regulators. Although the company could remain [privately-held](https://www.investopedia.com/terms/p/privately-owned.asp), it would have to file public documents in similar fashion to those of publicly traded companies. If the number of investors fell back below 500, then the disclosures would no longer be required.
Private companies generally avoid public reporting as long as possible by keeping the number of individual shareholders low, which is helpful because mandatory reporting can consume a great deal time and money and also places confidential financial data in the hands of competitors.
## The 2,000 Shareholder Threshold
With the ascendancy of [startup](https://www.investopedia.com/terms/s/startup.asp) firms in the technology sector in the 1990s and 2000s, the 500 shareholder threshold rule became an issue for swiftly growing companies like Google and Amazon that desired to remain private even as it attracted more private investors. While other factors were supposedly in play in the decision of these well-known giants to go public, the 500 rule was a key consideration, according to market observers.
The threshold was thus increased to 2,000 shareholders in 2012 with the passage of the Jumpstart Our Business Startups ([JOBS](https://www.investopedia.com/terms/j/jumpstart-our-business-startups-act-jobs.asp)) Act. Now, a private company is allowed to have up to 1,999 holders of record without the registration requirement of the Exchange Act. The current 2,000-shareholder threshold gives the new generation of super-growth companies a bit more privacy and breathing room before they decide to file for an [initial public offering](https://www.investopedia.com/terms/i/ipo.asp) (IPO). |
501(c)(3) Organizations | # 501(c)(3) Organization: What It Is, Pros and Cons, Examples
## What Is a 501(c)(3) Organization?
Section 501(c)(3) is a portion of the U.S. [Internal Revenue Code (IRC)](https://www.investopedia.com/terms/i/internal-revenue-code.asp) and a specific tax category for [nonprofit organizations](https://www.investopedia.com/terms/n/non-profitorganization.asp). Organizations that meet Section 501(c)(3) requirements are exempt from federal income tax. The [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) recognizes more than 30 types of nonprofit organizations but only those that qualify for 501(c)(3) status can say that donations made to them are [tax-deductible](https://www.investopedia.com/terms/d/deductible.asp).
Most of the organizations that may be eligible for 501(c)(3) status fall into one of three categories: charitable organizations, religious organizations, and private foundations.
### Key Takeaways
* 501(c)(3) nonprofit organizations are tax-exempt.
* Donations to 501(c)(3) nonprofits are tax-deductible.
* To receive its favorable tax treatment, the nonprofit must not deviate from its purpose or mission.
:max_bytes(150000):strip_icc()/501c3-organizations.asp-final-eca30b9299f8431393b563e5d440880b-a63faf3ed7b94780b7a7a3582c3cc7a1.png)
*— Investopedia / Mira Norian*
## How a 501(c)(3) Organization Works
To qualify for [tax-exempt](https://www.investopedia.com/financial-edge/0411/5-groups-that-dont-pay-taxes.aspx) status, a group must exist for one of these purposes: charitable, religious, educational, scientific, literary, testing for public safety, preventing cruelty to children or animals, or fostering national or international amateur sports competition.
A 501(c)(3) nonprofit must remain true to its founding purpose to stay tax-exempt under Section 501(c)(3). If the nonprofit decides to pursue a new mission, the organization must notify the IRS of the change. Failing to do so would result in the loss of its tax-exempt status.
In addition, an organization must not serve any private interests. These include the interests of the creator, the creator’s family, shareholders of the organization, and other designated individuals. None of the net earnings of the organization can be used to benefit any private shareholder or individual. All earnings must be used solely for the advancement of the organization's mission.
Some unrelated [business income](https://www.investopedia.com/terms/b/businessincome.asp) is allowed for a 501(c)(3) organization. However, the amount cannot be substantial. The majority of the nonprofits’s efforts must go toward its mission. Any unrelated business from sales of merchandise or rental properties must be limited, or the organization could lose its 501(c)(3) status.
> **Fast Fact**
>
> The IRS doesn’t specify exactly how much is too much unrelated business income, but the law firm of Hurwit & Associates, which specializes in representing nonprofits, estimates the amount at somewhere between 15% and 30%.
A 501(c)(3) organization cannot use its activities to influence legislation in a substantial way, including participating in any campaign activities to support or deny any particular political candidate. A 501(c)(3) nonprofit is typically cannot engage in [lobbying](https://www.investopedia.com/terms/l/lobby.asp) except in instances when its expenditures are below a certain amount.
Organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax but they're required to [withhold federal income tax](https://www.investopedia.com/terms/w/withholdingtax.asp) from their employees’ paychecks as well as withhold and pay Social Security and Medicare taxes.
People employed by the organization must be paid “reasonable compensation,” which is based on the [fair market value](https://www.investopedia.com/terms/f/fairmarketvalue.asp) that the job function requires.
> **Important**
>
> Once granted 501(c)(3) status, the 501(c)(3) designation remains for as long as the organization exists, unless it is revoked by the IRS.
## Special Considerations
Organizations that meet the 501(c)(3) tax category requirements can be classified into two categories: public charities and [private foundations](https://www.investopedia.com/terms/p/privatefoundation.asp). The [primary distinction](https://www.investopedia.com/financial-edge/1112/the-difference-between-private-foundations-and-public-charities.aspx) between these two categories is in how they get their financial support.
### Public Charities
A public charity is a nonprofit organization that receives a substantial portion of its income or revenue from the general public or the government. At least one-third of its income must be received from donations from the general public, including individuals, corporations, and other nonprofit organizations.
Individuals who donate to an organization that the IRS considers to be a public charity may qualify for certain tax deductions that can help them lower their taxable income. The total amount of donations to a tax-exempt public charity that an individual can claim is generally limited to 60% of their [adjusted gross income (AGI)](https://www.investopedia.com/terms/a/agi.asp) as of 2025.
### Private Foundations
A [private foundation](https://www.investopedia.com/articles/pf/12/private-foundation-start-up.asp) is typically held by an individual, a family, or a corporation. It typically receives most of its income from a small group of donors.
All 501(c)(3) organizations are automatically classified as private foundations unless they can prove that they meet the IRS standards to be considered a public charity. The deductibility of contributions to a private foundation is more limited than donations made to a public charity.
Most nonprofit organizations are required to file Form 1023 or Form 1023-EZ within 27 months from their date of incorporation to apply for tax-exempt status under Section 501(c)(3). The charitable organization must include its [articles of incorporation](https://www.investopedia.com/terms/a/articlesofincorporation.asp) and provide documents that prove that the organization's mission qualifies it for tax-exempt status.
However, not all organizations that qualify for the tax category must submit Form 1023. Public charities that earn less than $5,000 in revenue per year are exempt from filing this form. But they may still choose to file the form even though it's not required so they can ensure that donations made to their organization will be tax deductible for donors.
## Strengths and Challenges of 501(c)(3) Organizations
The 501(c)(3) status offers myriad benefits to the designated organizations and the people they serve. These organizations are exempt from paying federal income and unemployment taxes and patrons who donate to them are allowed to claim a tax deduction for their contributions.
These organizations are eligible to receive government and private grants to help with funding and to further their mission. These organizations also often receive discounts from retailers, free advertising by way of public service announcements, and food and supplies from other nonprofit organizations designed to help in times of need.
A 501(c)(3) organization must operate within the confines of the law pertaining to 501(c)(3) organizations to maintain its favorable tax treatment.
Because the organization serves the public, it must operate with full transparency. Its finances, including salaries, are available to members of the public.
Pros
* Exempt from federal taxes
* Contributions are tax-deductible
* Eligible for governmental funding and private grants
Cons
* Does not belong to those who created it
* Restricted to specific operations to receive tax exemptions
* Financial information is publicly accessible
## Example of a 501(c)(3) Organization
The American Red Cross, established in 1881 and congressionally chartered in 1900, is one of the United States’ oldest nonprofit organizations. Its mission statement states that the organization “prevents and alleviates human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors.” Since its inception, its goal has been to serve members of the armed forces and provide aid during disasters.
The Red Cross is located in 192 countries and operates the largest network of volunteers in the world. This 501(c)(3) organization is segmented into three divisions: the National Red Cross and Red Crescent Societies, the International Federation of Red Cross and Red Crescent Societies, and the International Committee of the Red Cross.
The National Red Cross and Red Crescent Societies include the American Red Cross. They aim to relieve human suffering globally by empowering subordinate organizations to operate within their nation’s borders to provide disaster relief, education, and other related services.
The International Federation of Red Cross and Red Crescent Societies provides global humanitarian aid during peacetime, such as assisting refugees. The International Committee of the Red Cross provides humanitarian relief for people who are affected by war or other armed conflicts.
Individuals who itemize their tax deductions can contribute to the Red Cross and claim the amount donated as a deduction.
## How Do You Start a 501(c)(3)?
To create a 501(c)(3), you must define the organization's purpose or mission. Ensure that a name isn't taken before selecting one. Secure the name by registering it with your state if it's available. Otherwise, secure the name when filing the articles of incorporation. The articles of incorporation must be filed with the state it will be organized in and according to the state's rules for nonprofit organizations.
Apply for the 501(c)(3) IRS exemption (Form 1023) and state tax exemption for nonprofit organizations after you've filed. Then create your organization’s bylaws, which specify how the organization will be structured and governed. Finally, appoint and meet with your board of directors.
## How Much Does It Cost to Start a 501(c)(3)?
The [costs associated with creating a 501(c)(3)](https://www.investopedia.com/articles/financial-theory/11/how-to-form-nonprofit-company.asp) can vary according to the needs of the organization, but some can be approximated. Filing the articles of incorporation with the state typically costs about $100. The IRS Form 1023 filing fee is $600 but Form 1023 EZ can be filed for $275 by organizations that expect less than $50,000 in annual earnings.
## How Long Does It Take to Get a 501(c)(3) Determination Letter?
A determination letter is sent after applying for the 501(c)(3) exemption. The IRS will only say that “applications are processed as quickly as possible” and “are processed in the order received by the IRS.” However, it does provide a [list of 10 tips](https://www.irs.gov/charities-non-profits/top-ten-reasons-for-delays-in-processing-exempt-organization-applications) that can shorten the process.
The website BoardEffect, which offers software designed “to make the work of their boards of directors easier, more efficient and more effective,” says it can take as little as two to four weeks if you can file Form 1023-EZ, but those who must (or choose to) file Form 1023 will likely wait for anywhere from three to six months to get their letter, while in some cases the wait can be as long as a year.
## Do You Have to Be a Corporation to Get a 501(c)(3)?
The organization must be formed “as a trust, a corporation, or an association” to qualify for 501(c)(3) status, according to the IRS.
## What Is the Difference Between a 501(c)(3) and a 501(c)(4)?
A 501(c)(3) organization is a nonprofit organization established exclusively for one of the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals. These organizations are mostly prohibited from engaging in lobbying.
501(c)(4) organizations, which are also nonprofit, are social welfare groups and are permitted to engage in lobbying.
## The Bottom Line
501(c)(3) organizations are nonprofit groups with a dedicated mission. Most people are familiar with them as churches and charities but they also include private foundations. They receive favorable tax treatment, such as avoiding federal income and unemployment taxes.
> **Article Sources**
>
> 1. IRS. "[Other Tax-Exempt Organizations](https://www.irs.gov/charities-non-profits/other-tax-exempt-organizations)."
>
> 2. IRS. "[Exempt Organization Types](https://www.irs.gov/charities-non-profits/exempt-organization-types)."
>
> 3. IRS. "[Exempt Purposes - Internal Revenue Code Section 501(c)(3)](https://www.irs.gov/charities-non-profits/charitable-organizations/exempt-purposes-internal-revenue-code-section-501c3)."
>
> 4. IRS. "[Compliance Guide for 501(c)(3) Public Charities](https://www.irs.gov/pub/irs-pdf/p4221pc.pdf)." Pages 20-21.
>
> 5. IRS. "[Exemption Requirements - 501(c)(3) Organizations](https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations)."
>
> 6. IRS. "[How to Lose Your 501(c)(3) Tax-Exempt Status (Without Really Trying)](https://www.irs.gov/pub/irs-tege/How%20to%20Lose%20Your%20Tax%20Exempt%20Status.pdf)." Page 2.
>
> 7. Hurwit & Associates. "[Q&A: Taxation of Unrelated Business Income](https://www.hurwitassociates.com/taxation-of-unrelated-business-income/q-a/)."
>
> 8. IRS. "[The Restriction of Political Campaign Intervention by Section 501(c)(3) Tax-Exempt Organizations](https://www.irs.gov/charities-non-profits/charitable-organizations/the-restriction-of-political-campaign-intervention-by-section-501c3-tax-exempt-organizations)."
>
> 9. IRS. "[Lobbying](https://www.irs.gov/charities-non-profits/lobbying)."
>
> 10. IRS. "[Exempt Organizations: What Are Employment Taxes?](https://www.irs.gov/charities-non-profits/exempt-organizations-what-are-employment-taxes)"
>
> 11. IRS. "[Intermediate Sanctions - Compensation](https://www.irs.gov/charities-non-profits/charitable-organizations/intermediate-sanctions-compensation)."
>
> 12. IRS. "[Revoked? Reinstated? Learn More](https://www.irs.gov/charities-non-profits/automatic-revocation-of-exemption)."
>
> 13. IRS. "[Instructions for Form 1023 (01/2020).](https://www.irs.gov/instructions/i1023)"
>
> 14. IRS. "[Exempt Organizations Annual Reporting Requirements - Form 990, Schedules A and B: Public Charity Support Test](https://www.irs.gov/charities-non-profits/exempt-organizations-annual-reporting-requirements-form-990-schedules-a-and-b-public-charity-support-test)."
>
> 15. IRS. "[Charitable Contribution Deductions](https://www.irs.gov/charities-non-profits/charitable-organizations/charitable-contribution-deductions)."
>
> 16. IRS. "[Private Foundations](https://www.irs.gov/charities-non-profits/charitable-organizations/private-foundations)."
>
> 17. IRS. "[Form 1023: Purpose of Questions About Organization Applying More Than 27 Months After Date of Formation](https://www.irs.gov/charities-non-profits/form-1023-purpose-of-questions-about-organization-applying-more-than-27-months-after-date-of-formation)."
>
> 18. IRS. "[Organizations Not Required to File Form 1023](https://www.irs.gov/charities-non-profits/charitable-organizations/organizations-not-required-to-file-form-1023)."
>
> 19. IRS. "[Public Inspection and Disclosure of Form 990-T](https://www.irs.gov/charities-non-profits/charitable-organizations/public-inspection-and-disclosure-of-form-990-t)."
>
> 20. American Red Cross. "[Our History](https://www.redcross.org/about-us/who-we-are/history.html)."
>
> 21. American Red Cross. "[Paying It Forward](https://www.redcross.org/content/dam/redcross/atg/Chapters/Division_2_-_Media/Santa_Cruz/Santa_Cruz_-_PDFs/252913_Rev4.pdf)."
>
> 22. American Red Cross. "[The Global Red Cross Network](https://www.redcross.org/about-us/who-we-are/history/global-red-cross-network.html)."
>
> 23. American Red Cross. "[Charitable Contributions](https://www.redcross.org/donations/ways-to-donate/charitable-contributions.html)."
>
> 24. IRS. "[Instructions for Form 1023-EZ](https://www.irs.gov/pub/irs-pdf/i1023ez.pdf)." Page 13.
>
> 25. IRS. "[Form 1023 and 1023-EZ: Amount of User Fee](https://www.irs.gov/charities-non-profits/form-1023-and-1023-ez-amount-of-user-fee)."
>
> 26. IRS. "[Frequently Asked Questions About Applying for Tax Exemption](https://www.irs.gov/charities-non-profits/frequently-asked-questions-about-applying-for-tax-exemption)."
>
> 27. BoardEffect. "[How Long Does It Take to Get 501(c)(3) Status From the IRS?](https://www.boardeffect.com/blog/how-long-does-it-take-to-get-501c3-status-from-the-irs/)"
>
> 28. IRS. "[Application Process](https://www.irs.gov/charities-non-profits/application-process)."
>
> 29. IRS. "[Social Welfare Organizations](https://www.irs.gov/charities-non-profits/other-non-profits/social-welfare-organizations)." |
501(c) | # Understanding 501(c) Organizations: Types, Benefits, and Examples
## What Is 501(c)?
501(c) is a subsection of the United States [Internal Revenue Code](https://www.investopedia.com/terms/i/internal-revenue-code.asp) (IRC) that confers tax-exempt status on [nonprofit organizations](https://www.investopedia.com/terms/n/non-profitorganization.asp). These can include charities, advocacy groups, religious entities, and more. Specifically, it identifies which nonprofit organizations are exempt from paying [federal income tax](https://www.investopedia.com/terms/f/federal_income_tax.asp). Tax-exempt status is vital to the public welfare because it supports the sole intentions of organizations to aid others. Therefore, it's important to understand the 501(c) eligibility criteria and requirements that must be met to maintain 501(c) status.
### Key Takeaways
* Section 501(c) of the IRC grants tax-exempt status to various nonprofit organizations, including charities and religious entities.
* To qualify for a 501(c) designation, organizations must apply and meet IRS stipulations.
* Donations to 501(c)(3) organizations can be tax-deductible for donors, offering financial incentives for contributions.
* The 501(c) designation includes various types of nonprofits, such as fraternal societies, teacher's associations, and credit unions.
:max_bytes(150000):strip_icc()/501c_final-1280123c54fe41fdad5c8281cdcbdf78.png)
*— Investopedia / Michela Buttignol*
## Exploring Different Types of 501(c) Organizations
Under subsection 501(c), there are multiple sections that delineate the different types of tax-exempt organizations, according to their purpose and operations.
The most common include:
* 501(c)(1): Any corporation that is organized under an act of [Congress](https://www.investopedia.com/government-and-policy-4689793) that is exempt from federal income tax
* 501(c)(2): [Corporations](https://www.investopedia.com/terms/c/corporation.asp) that hold a title of property for exempt organizations
* 501(c)(3): Corporations, funds, or foundations that operate for religious, charitable, scientific, literary, or educational purposes
* 501(c)(4): Nonprofit organizations that promote social welfare
* 501(c)(5): Labor, agricultural, or horticultural associations
* 501(c)(6): Business leagues, [chambers of commerce](https://www.investopedia.com/terms/c/chamber-of-commerce.asp), and others that are not organized for profit
* 501(c)(7): Recreational organizations
> **Fast Fact**
>
> Groups that fit these categories must apply for 501(c) classification and meet IRS requirements. Tax exemption is not automatic, regardless of the nature of the organization.
## Understanding 501(c)(3) Charitable Organizations
The [501(c)(3) organization](https://www.investopedia.com/terms/1/501c3-organizations.asp) is probably the most familiar tax category outlined in Section 501(c)(3) of the IRC. It covers the sort of nonprofits that people commonly come into contact with and donate money to.
In general, there are three types of entities that are eligible for 501(c)(3) status: charitable organizations, churches or religious entities, and [private foundations](https://www.investopedia.com/terms/p/privatefoundation.asp).
## Additional Categories of 501(c) Organizations
The 501(c) designation has expanded over time to encompass more types of organizations.
Other organizations that qualify for listing under this designation can potentially include:
* Fraternal beneficiary societies that operate under the lodge system and provide for the payment of life, illness, and other benefits for their members and dependents
* Teacher's retirement fund associations, so long as they are local in nature and none of their net earnings grow for the benefit of a private shareholder
* Benevolent life insurance associations that are local
* Certain mutual cooperative electric and telephone companies
* Nonprofit, co-op health insurers
* Cemetery companies that are owned and operated for the exclusive benefit of their members or are not operated for profit
* [Credit unions](https://www.investopedia.com/terms/c/creditunion.asp) that do not have capital stock organized
* Insurers—aside from life insurance companies—with gross receipts that are less than $600,000
* A variety of [trusts](https://www.investopedia.com/terms/t/trust.asp) for such purposes as providing supplement unemployment benefits and pensions
* Organizations whose membership is made up of current and former members of the armed forces of the United States or their spouses, widows, descendants, and auxiliary units in their support
> **Important**
>
> Tax-exempt organizations must file certain documents to maintain their status, as explained in IRS Publication 557.
## Making Tax-Deductible Donations to 501(c) Organizations
In addition to being tax-exempt themselves, 501(c) organizations offer a tax advantage to others: A portion of donations they receive may be deductible from a taxpayer's [adjusted gross income (AGI)](https://www.investopedia.com/terms/a/agi.asp). Organizations falling under section 501(c)(3)—which are primarily charities and educational or social-welfare-orientated nonprofits—are often qualified to offer this benefit to donors.
Generally, someone who itemizes [deductions](https://www.investopedia.com/terms/t/tax-deduction.asp) can deduct donations to most charities up to 50% (or 60% for cash) of their AGI. Individuals generally may deduct charitable contributions to other organizations up to 30% of their AGI.
> **Tip**
>
> The IRS provides a database to check an organization's exempt status.
To deduct your donation on a federal tax return, the charity must have 501(c)(3) status. The organization itself can often tell you which sorts of donations are deductible, and to what extent—for example, if you buy a one-year museum membership for $100, $50 might be deductible.
## What Is the Meaning of 501(c) Organization?
If an organization is labeled 501(c), it means it is a nonprofit organization concerned with providing a public benefit and is exempt from paying federal income taxes. The 501(c) designation encompasses many types of organizations, including charities, government entities, advocacy groups, educational and artistic groups, and religious entities.
## What Is the Difference Between a 501(c) and a 501(c)(3)?
501(c) and 501(c)(3) are two different tax categories in the Internal Revenue Code. Both are nonprofit organizations exempt from federal income tax. However, a 501(c)(3)—which consists of charitable organizations, churches/religious entities, and private foundations—can also tell its donors that they can deduct their contributions on their tax returns.
## What Are the Types of Nonprofits?
The IRS has issued a long list of the types of nonprofit organizations that can qualify for 501(c) status. Common examples include charitable organizations, churches and religious organizations, social advocacy groups, and trade organizations.
## The Bottom Line
501(c) organizations are nonprofit entities that aid public welfare and are an important presence in society. The U.S. government grants these entities 501(c) status as they ease state burdens and benefit people. The IRS recognizes dozens of different types of nonprofit organizations as 501(c)s, including charities, government entities, advocacy groups, educational institutions, and some credit unions and insurers. 501(c)(3) is a specific and widely recognized category within 501(c) that provide tax-deductibility of donations. Tax exempt status is not automatic. Organizations must apply and qualify for it by meeting IRS stipulations. When considering a donation to an organization, check the organization's status through the IRS's exempt organization database.
> **Article Sources**
>
> 1. U.S. Government Publishing Office. "[Title 26-Internal Revenue Code](https://www.govinfo.gov/content/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapF-partI-sec501.pdf)," Pages 1455-1456.
>
> 2. Internal Revenue Service. "[Application for Recognition of Exemption](https://www.irs.gov/charities-non-profits/application-for-recognition-of-exemption)."
>
> 3. U.S. Government Publishing Office. "[Title 26-Internal Revenue Code](https://www.govinfo.gov/content/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapF-partI-sec501.pdf)," Pages 1456-1459.
>
> 4. Internal Revenue Service. "[Publication 557](https://www.irs.gov/pub/irs-pdf/p557.pdf)."
>
> 5. Internal Revenue Service. "[Exemption Requirements—501(c)3 Organizations](https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations)."
>
> 6. Internal Revenue Service. "[Tax Exempt Organization Search: Deductibility Status Codes](https://www.irs.gov/charities-non-profits/tax-exempt-organization-search-deductibility-status-codes)."
>
> 7. Internal Revenue Service. "[Tax Exempt Organization Search](https://apps.irs.gov/app/eos/)." |
51% Attack | # What is a 51% Attack on Blockchain? Risks, Examples, and Costs Explained
:max_bytes(150000):strip_icc()/51-attack.asp-final-b97e967390ea40028ff9ddf30d2ee6c5.png)
*— Investopedia / Jessica Olah*
## What Is a 51% Attack?
A 51% attack occurs when an entity gains control over more than 50% of a blockchain network's hashing power, enabling the alteration of transactions and creating the risk of double-spending. While challenging and costly, such attacks primarily threaten smaller networks. Explore the mechanics, examples, and costs associated with 51% attacks.
### Key Takeaways
* A 51% attack occurs when an entity controls more than half of a blockchain's computing power, potentially altering transactions and blocking new ones.
* These attacks are mostly a threat to smaller cryptocurrency networks due to lower hash rates and participation.
* Despite the high cost and difficulty of executing a 51% attack, cloud services can allow attackers to rent necessary computing power, increasing vulnerability.
* Larger networks like Bitcoin and Ethereum are more secure against 51% attacks due to their size and complexity.
* If successful, a 51% attack allows for double-spending and denial-of-service, but it requires precise timing and significant resources to execute.
## How 51% Attacks Affect Blockchain Security
A [blockchain](https://www.investopedia.com/terms/b/blockchain.asp) is a distributed ledger—essentially a database—that records transactions and information about them. The blockchain's network reaches a majority consensus about transactions through a validation process. The blocks where the data is stored are sealed. The blocks are linked together via cryptographic techniques where previous block information is recorded in each block. This makes the blocks nearly impossible to alter once they are confirmed enough times.
The 51% attack is an attack on the blockchain, where a group controls more than 50% of the hashing power—the computing that solves the cryptographic puzzle—of the network. This group then introduces an altered blockchain to the network at a very specific point in the blockchain, which is theoretically accepted by the network because the attackers would own most of it.
Changing historical blocks—transactions locked in before the start of the attack—would be extremely difficult even in the event of a 51% attack. The further back the transactions are, the more difficult it is to change them. It would be impossible to change transactions before a checkpoint, where transactions become permanent in Bitcoin's blockchain.
### The High Costs of Launching a 51% Attack
A 51% attack is a very difficult and challenging task on a blockchain network with a large participation rate. In most cases, the group of attackers would need to be able to control the necessary 51% and have created an alternate blockchain that can be inserted at exactly the right moment. Then, they would need to out-hash the main network. The high cost is a key factor that prevents a 51% attack.
For example, the WhatsMiner M63S is an advanced ASIC miner costing over $10,000 and has a hash rate of 406 TH/s. A single or smaller group of miners would not be able to alter and mine the Bitcoin blockchain with only a few of these machines. It would take thousands of these ASICs to get ahead of the Bitcoin network. Smaller networks could be out-hashed using these mining rigs, but the benefits of doing so wouldn't outweigh the costs of funding the attack and setting it up.
> **Fast Fact**
>
> Hashing power rental services provide attackers with lower costs, as they only need to rent as much hashing power as they need for the duration of the attack.
After Ethereum transitioned to proof-of-stake, a 51% attack on the Ethereum blockchain became even more expensive. To conduct this attack, a user or group would need to own 51% of the staked ETH on the network. It is possible for someone to own that much ETH, but it's unlikely.
According to Beaconchain, more than 32.3 million ETH were staked on May 8, 2024. An entity would need to own and stake more than 16.5 million ETH (more than $49 billion as of May 8, 2024) to attempt an attack.
If an attack begins, the consensus mechanism would likely spot it and slash the staked ETH, costing attackers a lot. Additionally, the community can vote to restore the "honest" chain, so an attacker would lose all of their ETH just to see the damage repaired.
### The Crucial Timing of a 51% Attack
In addition to the costs, a group attempting to attack the network using a 51% attack must not only control 51% of the network but also introduce the altered blockchain at a very precise time. Even if they own 51% of the network hashing rate, they still might not be able to keep up with the block creation rate or get their chain inserted before valid new blocks are created by the 'honest' blockchain network.
This is possible on smaller networks due to fewer participants and lower hash rates. Large networks make introducing an altered blockchain almost impossible.
> **Fast Fact**
>
> You don't need 51% of a network's mining power to attack it, but without it, success is unlikely.
### Consequences of a Successful 51% Attack
In the event of a successful attack, the attackers could block other users' transactions or reverse them and spend the same cryptocurrency again. This vulnerability, known as [double-spending](https://www.investopedia.com/terms/d/doublespending.asp), is the digital equivalent of a perfect counterfeit. It is also the basic cryptographic hurdle blockchain consensus mechanisms were designed to overcome.
Successful 51% attackers may also implement a Denial-of-Service (DoS) attack, where they block the addresses of other miners for the period they control the network. This keeps the "honest" miners from reacquiring control of the network before the dishonest chain becomes permanent.
## Which Blockchain Networks Face a 51% Attack Risk?
Mining equipment affects vulnerability. [ASIC](https://www.investopedia.com/terms/a/asic.asp)\-secured networks are less at risk than GPU-mined networks because ASICs are faster. Cloud services such as NiceHash—which considers itself a "hash-power broker"—theoretically make it possible to launch a 51% attack using only rented hash power, especially against smaller, GPU-only networks.
Bitcoin Gold has been a common target for attackers because it is a smaller cryptocurrency by hashrate. Since June 2019, the Michigan Institute for Technology's Digital Currency Initiative has detected, observed, or been notified of more than 40 51% attacks—also called chain reorganizations, or reorgs—on Bitcoin Gold, Litecoin, and other smaller cryptocurrencies.
## Is Bitcoin Likely to Face a 51% Attack?
On May 8, 2024, the Bitcoin network's total hashrate was 569.29 exahashes per second (EH/s). The top three [mining pools](https://www.investopedia.com/terms/m/mining-pool.asp) by three-day hashrate were:
* FoundryUSA, at 175.76 EH/s; 30.9% of the total Bitcoin network hashrate
* AntPool, at 161.77 EH/s; 28.4% of the total Bitcoin network hashrate
* ViaBTC, at 73.11 EH/s; 12.8% of the total network hashrate
Combined, these three pools made up 72.1% of the network hashrate, a whopping 486.9 EH/s (486.9 million TH/s—the CPU in your computer might be able to hash at about 15 kilo hashes per second). If Foundry and ViaBTC were to collude, they could take over 51% of the hashrate (248 EH/s).
Foundry and Antpool together could control 69.3% of the network. Managers at these pools could order members to work on altered chains. The pool's miners would have no idea which chain they were working on since their mining rigs automatically work on whatever task they are given.
Even more concerning is that these three pools also monopolize the majority of the network hash rates for Bitcoin Cash, Litecoin, and Bitcoin SV.
These pools have been operating for several years without issue, but the fact remains that they already control most hashing power of the minable and profitable cryptocurrencies.
## What Does a 51% Attack Do?
A 51% attack alters blocks that are being added to the blockchain, giving the attackers the ability to create or alter transactions for the period they are in control.
## Has a 51% Attack Ever Happened?
Yes. Several blockchains have been attacked using this method, but they had small networks, were new, or had other vulnerabilities that made it possible.
## How Much Would a 51% Attack on BTC Cost?
If a large mining pool was directed by its managers to conduct an attack, it wouldn't cost the managers much at the time of the attack. However, it would likely lose its honest miners once they found out about it. For a single person or group to conduct a 51% attack, they would need more than 304 EH/s of computing power. This is an enormous cost considering the fastest miner hashes 406 TH/s and costs more than $10,000 per unit (about 84,000 units).
## The Bottom Line
A 51% attack occurs when a group gains control over more than half of a cryptocurrency network's hashing power, allowing them to alter transactions and engage in double-spending. While these attacks pose a significant threat to smaller networks, they are costly and challenging to execute on larger, more secure networks like Bitcoin and Ethereum. Understanding the mechanics and risks of 51% attacks is crucial for cryptocurrency users, as specific networks remain vulnerable, and users must be aware of potential risks.
_The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our [warranty and liability disclaimer](https://www.investopedia.com/legal-4768893#toc-warranty-and-liability-disclaimer) for more info._
> **Article Sources**
>
> 1. O'Reilly. "[Mastering Bitcoin: Chapter 8. Mining and Consensus](https://www.oreilly.com/library/view/mastering-bitcoin/9781491902639/ch08.html#consensus_attacks)."
>
> 2. MicroBT. "[WhatsMiner M63S](https://shop.whatsminer.com/products/details/67?skuId=132)."
>
> 3. Michigan Institute for Technology Digital Currency Initiative. "[51% Attacks](https://dci.mit.edu/51-attacks)."
>
> 4. Beaconchain. "[Open Source Ethereum Explorer](https://beaconcha.in/)."
>
> 5. CoinMarketCap. "[Ethereum](https://coinmarketcap.com/currencies/ethereum/)."
>
> 6. Ethereum. "[Proof-of-Stake](https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/#pos-and-security)."
>
> 7. NiceHash. "[Official Statement Regarding the Latest 51% Attack Allegations](https://www.nicehash.com/blog/post/official-statement-regarding-the-latest-51-percent-attack-allegations-aug-2020)."
>
> 8. BTC.com. "[Pool Distribution](https://btc.com/stats/pool)." |
52-Week High/Low | # Understanding 52-Week High/Low: Definition, Trading Role, and Examples
> **Definition**
>
> The 52-week high/low marks the highest and lowest prices a stock has traded in a year.
## What Is 52-Week High/Low?
The 52-week high/low is a key technical indicator for traders and investors that helps to determine trading entry and exit points. It plays a crucial role in identifying resistance and support levels. Volume spikes and strategies around these levels have trading implications that traders should take into consideration.
### Key Takeaways
* The 52-week high/low is a crucial technical indicator used by traders and investors to gauge a stock's performance over a year and suggest potential future price movements.
* A stock's 52-week high generally acts as a resistance level, while the 52-week low serves as a support level, aiding investors in deciding optimal entry and exit points for trades.
* Breaching a 52-week high/low can generate significant price moves due to increased trading volumes, leading traders to use strategies like buying above the high or selling below the low.
* Research shows that crossing a 52-week barrier affects small-cap stocks more than large-cap ones, impacting their subsequent price performance, especially when there is a significant volume increase.
* Reversal patterns such as the "shooting star" at a 52-week high or "hammer" at a 52-week low can indicate potential trend reversals, acting as signals for traders to lock in profits or limit losses.
## How the 52-Week High/Low Influences Trading Decisions
A 52-week high/low is a [technical indicator](https://www.investopedia.com/terms/t/technicalindicator.asp) used by some [traders](https://www.investopedia.com/terms/t/trader.asp) and investors who view these figures as [an important factor in the analysis of a stock's current value](https://www.investopedia.com/ask/answers/04/041604.asp) and as a predictor of its future price movement. Investors might become more interested in a stock as its price approaches either extreme of its 52-week range.
It’s based on the security’s daily [closing price](https://www.investopedia.com/terms/c/closingprice.asp). Often, a stock may actually breach a 52-week high intraday, but end up closing below the previous 52-week high, thereby going unrecognized. The same applies when a stock makes a new 52-week low during a trading session but fails to close at a new 52-week low. In these cases, the failure to register as having made a new closing 52-week high/low can be very significant.
One way that the 52-week high/low figure is used is to help determine an entry or exit point for a given stock. For example, [stock traders](https://www.investopedia.com/terms/s/stock-trader.asp) may buy a stock when the price exceeds its 52-week high, or sell when the price falls below its 52-week low. The strategy is based on the idea that if a price breaks its [52-week range](https://www.investopedia.com/terms/1/52-week-range.asp), it will likely continue moving in that direction due to strong momentum. When using this strategy, an investor may utilize [stop-orders](https://www.investopedia.com/terms/s/stoporder.asp) to initiate new positions or add on to existing positions.
It is not uncommon for the volume of trading of a given stock to spike once it crosses a 52-week barrier. In fact, research has demonstrated this. According to a study called "Volume and Price Patterns Around a Stock's 52-Week Highs and Lows: Theory and Evidence," conducted by economists at Pennsylvania State University, the University of North Carolina at Chapel Hill, and the University of California, Davis in 2008, small stocks crossing their 52-week highs produced 0.6275% excess gains in the following week. Correspondingly, large stocks produced gains of 0.1795% in the following week. Over time, however, the effect of 52-week highs (and lows) became more pronounced for large stocks. On an overall basis, however, these trading ranges had more of an effect on small stocks as opposed to large stocks.
## Recognizing and Using 52-Week High/Low Reversals
A stock that reaches a 52-week high intraday, but closes negative on the same day, may have topped out. This means that its price may not go much higher in the near term. This can be determined if it forms a daily [shooting star](https://www.investopedia.com/terms/s/shootingstar.asp), which occurs when a security trades significantly higher than its opening, but declines later in the day to close either below or near its opening price. Often, professionals, and institutions, use 52-week highs as a way of setting [take-profit](https://www.investopedia.com/terms/t/take-profitorder.asp) orders as a way of locking in gains. They may also use 52-week lows to determine [stop-loss](https://www.investopedia.com/terms/s/stop-lossorder.asp) levels as a way to limit their losses.
Due to the usual upward trend in stock markets, a 52-week high signals [bullish sentiment](https://www.investopedia.com/terms/b/bull.asp). There are usually plenty of investors prepared to give up some further price appreciation in order to lock in some or all of their gains. Stocks making new 52-week highs are often the most susceptible to profit taking, resulting in pullbacks and trend reversals.
Likewise, if a stock hits a new intra-day 52-week low but doesn’t close there, it might indicate a bottom. This can be determined if it forms a daily [hammer candlestick](https://www.investopedia.com/terms/h/hammer.asp), which occurs when a security trades significantly lower than its opening, but rallies later in the day to close either above or near its opening price. This can trigger [short-sellers](https://www.investopedia.com/terms/s/shortsale.asp) to start buying to cover their positions, and can also encourage bargain hunters to start making moves. Stocks that make five consecutive daily 52-week lows are most susceptible to seeing strong bounces when a daily hammer forms.
## Practical Example of 52-Week High/Low Impact
If stock ABC reaches $100 at its peak and $75 at its low in a year, these are its 52-week high and low, respectively. Typically, $100 is considered a resistance level while $75 is considered a support level. This means that traders will begin selling the stock once it reaches that level and they will begin purchasing it once it reaches $75. If it does breach either end of the range conclusively, then traders will initiate new long or short positions, depending on whether the 52-week high or 52-week low was breached.
## The Bottom Line
The 52-week high/low is a crucial technical indicator for investors and traders. It plays a significant role in identifying resistance and support levels. It influences trading volume and price movements, particularly for small stocks.
The 52-week high/low has the potential for significant price reversals when stocks breach these levels. Strategic use of 52-week highs and lows can set stop-loss and take-profit orders to manage risk and lock in gains. The 52-week high/low indicators can help in making informed trading decisions but treating them as standalone predictors of future performance can be counterproductive.
> **Article Sources**
>
> 1. SSRN. "[Volume and Price Patterns Around a Stock's 52-Week Highs and Lows: Theory and Evidence](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=353749)." |
52-Week Range | # 52-Week Range: Overview, Examples, Strategies
## What Is the 52-Week Range?
The 52-week range is a data point traditionally reported by printed financial news media, but more modernly included in data feeds from financial information sources online. The data point includes the lowest and highest price at which a stock has traded during the previous 52 weeks.
Investors use this information as a proxy for how much fluctuation and risk they may have to endure over the course of a year should they choose to invest in a given stock. Investors can find a stock's 52-week range in a [stock's quote summary](https://www.investopedia.com/articles/investing/093014/stock-quotes-explained.asp) provided by a broker or financial information website. The visual representation of this data can be observed on a price chart that displays one year's worth of price data.
### Key Takeaways
* The 52-week range is designated by the highest and lowest published price of a security over the previous year.
* Analysts use this range to understand volatility.
* Technical analysts use this range data, combined with trend observations, to get an idea of trading opportunities.
## Understanding the 52-Week Range
The 52-week range can be a single data point of two numbers: the highest and lowest price for the previous year. But there is much more to the story than these two numbers alone. Visualizing the data in a chart to show the price action for the entire year can provide a much better context for how these numbers are generated.
Since price movement is not always balanced and rarely symmetrical, it is important for an investor to know which number was more recent, the high or the low. Usually an investor will assume the number closest to the current price is the most recent one, but this is not always the case, and not knowing the correct information can make for costly investment decisions.
Two examples of the 52-week range in the following chart show how useful it might be to compare the high and low prices with the larger picture of the price data over the past year.
:max_bytes(150000):strip_icc()/dotdash_INV_final-52-Week-Range_Feb_2021-01-ea7af056b29e412f86eb714c23c0e4a9.jpg)
*— Image by Sabrina Jiang © Investopedia 2021*
These examples show virtually the same high and low data points for a 52-week range (set 1 marked in blue lines) and a trend that seems to indicate a short-term downward move ahead.
:max_bytes(150000):strip_icc()/dotdash_INV_final-52-Week-Range_Feb_2021-02-40c49fe9287645d5a2b8b0308b77fa5f.jpg)
*— Image by Sabrina Jiang © Investopedia 2021*
The overlapping range on the same stock (set 2 marked in red lines) now seems to imply that an upward move may be following at least in the short term. Both of these trends can be seen to play out as expected (though such outcomes are never certain). Technical analysts compare a stock's current trading price and its recent trend to its 52-week range to get a broad sense of how the stock is performing relative to the past 12 months. They also look to see how much the stock's price has fluctuated, and whether such fluctuation is likely to continue or even increase.
The information from the high and low data points may indicate the potential future range of the stock and how [volatile](https://www.investopedia.com/terms/v/volatility.asp) its price is, but only the trend and relative strength studies can help a trader or analyst understand the context of those two data points. Most financial websites that quote a stock’s share price also quote its 52-week range. Sites like Yahoo Finance, Finviz.com and StockCharts.com allow investors to scan for stocks trading at their 12-month high or low.
## Current Price Relative to 52-Week Range
To calculate where a stock is currently trading at in relations to its [52-week high and low](https://www.investopedia.com/terms/1/52weekhighlow.asp), consider the following example:
Suppose over the last year that a stock has traded as high as $100, as low as $50 and is currently trading at $70. This means the stock is trading 30% below its 52-week high (1-(70/100) = 0.30 or 30%) and 40% above its 52-week low ((70/50) – 1 = 0.40 or 40%). These calculations take the difference between the current price and the high or low price over the past 12 months and then [convert them to percentages](https://www.investopedia.com/ask/answers/04/041604.asp).
## 52-Week Range Trading Strategies
Investors can use a breakout strategy and buy a stock when it trades above its 52-week range, or open a [short position](https://www.investopedia.com/terms/s/short.asp) when it trades below it. Aggressive traders could place a stop-limit order slightly above or below the 52-week trade to catch the initial breakout. Price often retraces back to the breakout level before resuming its trend; therefore, traders who want to take a more conservative approach may want to wait for a [retracement](https://www.investopedia.com/terms/r/retracement.asp) before entering the market to avoid chasing the breakout.
Volume should be steadily increasing when a stock’s price nears the high or low of its 12-month range to show the issue has enough participation to break out to a new level. Trades could use indicators like the [on-balance volume](https://www.investopedia.com/terms/o/onbalancevolume.asp) (OBV) to track rising volume. The breakout should ideally trade above or below a psychological number also, such as $50 or $100, to help gain the attention of institutional investors. |
529 Savings Plan | > **Definition**
>
> Named for a section of the Internal Revenue Code (IRC), 529 plans are tax-deferred savings plans designed to help pay for college expenses. In some states, qualified withdrawals for these costs aren't subject to federal or state taxes.
## What Is a 529 Plan?
As higher education costs continue to rise and countless Americans are mired in student debt, many parents are turning to tax-advantaged 529 savings plans to help fund their children's education. Named after Section 529 of the Internal Revenue Code (IRC), these plans were originally designed to cover postsecondary education costs.
Their scope has greatly expanded in recent years. In 2017 and 2019, respectively, Congress passed legislation allowing 529 plans to cover the costs of K–12 education and apprenticeship programs. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 and the SECURE 2.0 Act of 2022 permitted 529 funds to be used for student loan repayment and Roth individual retirement account (IRA) contributions. In 2025, the One Big Beautiful Bill Act (OBBBA) made it so 529 plans can be used to pay for credentialing programs.
### Key Takeaways
* Section 529 plans are tax-advantaged accounts that can be used to pay educational expenses, including K–12 education, apprenticeship programs, credentialing programs, and [student loan](https://www.investopedia.com/the-best-student-loans-11785239) repayment.
* There are two basic types of 529 plans: educational savings plans and prepaid tuition plans.
* Section 529 plans are sponsored and run by the 50 states and the District of Columbia.
* The rules and fees of 529 plans differ from state to state.
## How 529 Plans Work
There are two main types of 529 plans:
1. College savings plans and prepaid tuition plans. These offer tax-deferred growth, and withdrawals are tax-free when used for qualified education expenses. These plans remain under the control of the donor, usually a parent.
2. Prepaid tuition plans enable account owners to lock in current tuition rates for future attendance at selected colleges and universities. Given the rising tuition costs, this generally means locking in lower prices for college later on.
Although 529 plans are named for Section 529 of the federal tax code, they're administered by the 50 states and the District of Columbia.
Anyone can open a 529 account, but parents or grandparents typically establish them on behalf of a child or grandchild, the account's [beneficiary](https://www.investopedia.com/terms/b/beneficiary.asp). In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.
The money in a 529 plan grows tax-deferred until it's withdrawn. What's more, as long as the money is used for qualified education expenses as defined by the Internal Revenue Service (IRS), withdrawals aren't subject to either state or federal taxes. In addition, some states may offer tax deductions on contributions.
Since tax benefits vary from state to state, you should check the details of any 529 plan to understand the specific tax benefits to which you may be entitled.
## Types of 529 Plans
### College Savings Plans
Of the two types, 529 savings plans are more common. The account holder contributes money to the plan, which is invested in a preset selection of investment options.
Account holders can choose which investments (usually mutual funds) they want to make. How those investments perform determines how much the account value grows over time.
Many 529 plans offer [target-date funds](https://www.investopedia.com/terms/t/target-date_fund.asp), which adjust their assets as the years go by, becoming more conservative as the beneficiary approaches college age. Withdrawals from a 529 savings plan can be used for qualified college and K–12 expenses.
The SECURE Act of 2019 expanded tax-free 529 plan withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for account beneficiaries and their siblings.
The SECURE Act of 2022, passed as part of the 2023 omnibus funding bill, permits rolling over up to $35,000 of unspent funds in a 529 account into a Roth IRA account. The account must be at least 15 years old to qualify.
The OBBBA of 2025 allows 529 funds to now be used to cover qualified expenses for eligible credentialing programs as well as a broader range of K–12 costs. It also increases the annual withdrawal limit for K–12 from $10,000 to $20,000, applying to taxable years beginning after December 31, 2025.
### Prepaid Tuition Plans
A few states and some higher education institutions offer prepaid tuition plans. They vary, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. Prepaid plans aren't available for K–12 education.
As with 529 savings plans, prepaid tuition plans grow in value over time. Eventual withdrawals from the account used to pay tuition aren't taxable. However, unlike savings plans, prepaid tuition plans don't cover the costs of room and board.
Prepaid tuition plans may limit the colleges they can be used for. By contrast, money in a savings plan can be used at almost any eligible institution.
In addition, the money paid into a prepaid tuition plan isn't guaranteed by the federal government and may not be guaranteed by certain states. Be sure you understand all aspects of the prepaid tuition plan before you use it.
> **Fast Fact**
>
> There are no limits on how much you can contribute to a 529 account each year. However, states cap the total amount you can contribute over time, ranging from $235,000 to $621,411.
## Tax Advantages of 529 Plans
Withdrawals from a [529 plan are exempt](https://www.investopedia.com/ask/answers/09/roll-ira-to-529-plan.asp) from federal and state income taxes, provided the money is used for qualified educational expenses. Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as after death or disability.
Contributions to a 529 plan aren't tax-deductible for federal income tax purposes. However, nearly 40 states provide tax deductions or credits of varying amounts for these contributions.
You need to invest in your home state's plan if you want a state tax deduction or credit. However, some states will allow you to invest in their plans as a nonresident if you're willing to forgo a tax break.
### Gift Tax Implications
As of 2025, the annual [gift tax](https://www.investopedia.com/terms/g/gifttax.asp) exclusion has increased to $19,000, up from $18,000 in 2024. This means that you can give up to $19,000 per year to any individual without it counting against your lifetime gift tax exemption, which has also increased to $13.99 million for single filers and $27.98 million for married couples filing jointly, up from $13.61 million and $27.22 million in 2024, respectively.
This background on gift taxes is important for 529 plans since there are additional tax advantages for those who wish to contribute to the savings of a future college student. You can contribute up to five years' worth of annual gift tax exclusions in a single lump sum without triggering gift tax consequences. For instance, in 2025, a grandparent could make a one-time contribution of $95,000 to their grandchild's 529 plan ($19,000 annual exclusion x five years).
As long as the grandparent doesn't make any additional contributions to the same beneficiary over the next five years, this lump-sum contribution won't count against their lifetime gift tax exemption.
## Benefits and Potential Drawbacks of 529 Plans
## 529 Plans vs. Brokerage Accounts
529 Plan
* Education savings account
* Institutionally-sponsored
* Limited investment options
* Tax-deferred growth
* Tax-exempt withdrawals for qualified education expenses
* Aggregate lifetime contribution limits
Brokerage Account
* General investment account
* Self-sponsored
* No limits on investment options
* Gains and dividends are taxed
* No tax-exemptions
* No contribution limits
529 plans and individual [brokerage accounts](https://www.investopedia.com/terms/b/brokerageaccount.asp) are two popular options when saving for college. A 529 plan is a tax-advantaged investment account designed specifically for education expenses. By contrast, a brokerage account is a general-purpose investment account with no specific tax benefits for education savings.
Section 529 plans are sponsored by a state or financial institution and have limited investment options, often through a menu of mutual funds or exchange-traded funds (ETFs). Your selection may [include age-based options](https://www.investopedia.com/using-etfs-in-clients-529-plans-and-education-savings-conversations-11775214) that automatically adjust the asset allocation as the beneficiary approaches college age.
They also offer tax-deferred growth and tax-free withdrawals for qualified education expenses, including tuition, fees, books, and room and board. Some states offer additional tax benefits, such as deductions or credits for contributions to in-state 529 plans. There are no annual contribution limits, but there are limits on the total in a given account, from $235,000 in Georgia to $621,411 in New Hampshire.
Meanwhile, brokerage accounts offer a wide range of investment options, including individual stocks, bonds, mutual funds, and ETFs. There are no contribution limits, but gains and dividends are taxable in the current period. There are also no additional benefits to using the proceeds for educational purposes.
Suppose your child doesn't end up going to college. In that case, funds in a 529 plan can be transferred to another qualifying family member or used for other education expenses, such as apprenticeships, graduate school, credentialing programs, or student loan repayments (up to $10,000). Nonqualified withdrawals or transfers, however, are fully taxable and may carry penalties. Brokerage account funds can be used for any purpose, including education, without restrictions or penalties.
## 529 Plan Transferability Rules
Section 529 plans have specific transferability rules governed by the federal tax code. The owner may transfer funds to another 529 plan once per year unless a beneficiary change is involved. You aren't required to change plans to change beneficiaries. You may transfer the plan to another family member, defined as one of the following:
* Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
* Brother, sister, stepbrother, or stepsister
* Father or mother or ancestor of either
* Stepfather or stepmother
* Son or daughter of a brother or sister
* Brother or sister of a father or mother
* Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
* The spouse of any individual listed above
* First cousin
> **Tip**
>
> You aren't restricted to investing in your state's 529 plan, but doing so may get you a tax break. Be sure to check out your state's plan before making a decision.
## Additional Tips for 529 Plans
As with other kinds of investing, the earlier you get started, the better. With a 529 plan, your money will have more time to grow and compound the sooner it's [opened and funded](https://www.investopedia.com/can-you-fund-a-529-plan-with-a-cd-5270289). Prepaid tuition plans offer the advantage of locking in current tuition rates, potentially saving you money compared with future prices, as many schools increase tuition annually.
If you have leftover funds in a 529 plan, such as when the beneficiary receives a significant scholarship or chooses not to go to college, you have several options. You can change the beneficiary to another qualifying relative, keep the current beneficiary in case they decide to pursue higher education later or attend graduate school, or use up to $10,000 to repay the original beneficiary's or their siblings' federal or private student loans.
You can also [transfer unused funds](https://www.investopedia.com/529-can-help-with-their-retirement-11738730) of up to $35,000 to a [Roth IRA](https://www.investopedia.com/terms/r/rothira.asp) if your account meets the necessary requirements. Lastly, you can always withdraw the money, although you will be subject to taxes and a 10% penalty on the earnings portion of the withdrawal.
## How Much Does a 529 Plan Cost?
States often charge an annual maintenance fee for a 529 plan, which ranges from $0 to $25. In addition, if you bought your 529 plan through a broker or advisor, they may charge you an additional fee for the assets under management. The individual investments and funds inside your 529 may also charge ongoing fees. Look for low-cost mutual funds and ETFs to keep management fees low.
## Who Maintains Control Over a 529 Plan?
A 529 plan is technically a [custodial account](https://www.investopedia.com/terms/c/custodialaccount.asp), as an adult custodian controls the funds for the benefit of a minor. The beneficiary can assume control over the 529 once they turn 18. However, the funds must still be used for qualifying education expenses.
## What Are Qualified Expenses for a 529 Plan?
Qualified expenses for a 529 plan can include the following:
* Tuition and fees
* Books and school supplies
* Room and board
* Computers, internet, and software used for schoolwork (student attendance required)
* Special needs and accessibility equipment for students
* Student loan payments
Depending on the education level, certain costs won't be considered qualified education expenses.
## The Bottom Line
A 529 plan gives you a tax-advantaged account to save for educational expenses from kindergarten to graduate school, in addition to apprenticeships and credentialing programs. There are a variety of 529 plans available, offering plenty of flexibility alongside the potential for tax-advantaged growth.
> **Article Sources**
>
> 1. Internal Revenue Service. "[Publication 970 (2024), Tax Benefits for Education](https://www.irs.gov/publications/p970)."
>
> 2. Congress.gov. "[SECURE 2.0 of 2022 Act](https://www.congress.gov/bill/117th-congress/house-bill/2954/text)."
>
> 3. Congress.gov. "[H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019](https://www.congress.gov/bill/116th-congress/house-bill/1994/text)."
>
> 4. Congress.gov. "[H.R.1 - One Big Beautiful Bill Act](https://www.congress.gov/bill/119th-congress/house-bill/1/text)."
>
> 5. Finaid. "[Section 529 Plans](https://finaid.org/savings/529plans/)."
>
> 6. 529 Savings Plans Network. "[What Is a 529 Plan?](https://www.collegesavings.org/what-is-529)"
>
> 7. National Association of State Treasurers. "[College Savings](https://nast.org/college-savings/)."
>
> 8. Internal Revenue Service. "[529 Plans: Questions and Answers](https://www.irs.gov/newsroom/529-plans-questions-and-answers)."
>
> 9. Saving for College. "[Are 529 Contributions Tax Deductible? State-by-State Guide and What It’s Worth](https://www.savingforcollege.com/article/how-much-is-your-state-s-529-plan-tax-deduction-really-worth)."
>
> 10. U.S. Securities and Exchange Commission. "[An Introduction to 529 Plans](https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html)."
>
> 11. Congress.gov. "[H.R. 2617 - Consolidated Appropriations Act, 2023](https://www.congress.gov/bill/117th-congress/house-bill/2617/text)."
>
> 12. my529. "[SECURE Act 2.0](https://my529.org/secure-act-2-0/)."
>
> 13. 529 College Savings Plan. "[529 Plan Comparison by State](https://www.collegesavings.org/find-my-states-529-plan/)."
>
> 14. Internal Revenue Service. "[IRS Releases Tax Inflation Adjustments for Tax Year 2025](https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025)."
>
> 15. Internal Revenue Service. "[Gift Tax](https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax)."
>
> 16. Saving for College. "[529 Contribution Limits 2025: Maximums by State, Gift Tax Exclusion, and More](https://www.savingforcollege.com/article/maximum-529-plan-contribution-limits-by-state)."
>
> 17. Saving for College. "[529 to Roth IRA: Rollover Rules, Conversion Guide, and FAQs](https://www.savingforcollege.com/article/roll-over-529-plan-funds-to-a-roth-ira)."
>
> 18. Saving for College. "[529 Fee Study](https://www.savingforcollege.com/529_fee_study/)." |
Delinquent | # Understanding Delinquency: Definitions, Examples, and Key Statistics
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*You don't always need to be delinquent to short sale but it can help.*
## What Is Being Delinquent?
Being delinquent means being late on financial obligations like loans or credit card payments. Delinquent payments can lead to default if not resolved, and this applies to both individuals and corporations.
The term may also be used to describe the failure to perform a duty by financial professionals.
### Key Takeaways
* Delinquency in finance occurs when a borrower fails to make timely payments on debt obligations like loans or credit cards.
* Missed payments can lead to delinquency, which in turn negatively impacts a person’s credit score and can lead to default.
* Delinquency is not just limited to borrowers; financial professionals can also be considered delinquent if they neglect their fiduciary duties.
* Delinquency rates, which measure how many accounts in a lender's portfolio are overdue, offer insights into financial stability.
* Working with lenders to address delinquencies can prevent escalation to defaults, preserving one's creditworthiness.
## Understanding Financial Delinquency
As noted above, the meaning of the word delinquent depends on how it's being used. In finance, it commonly refers to a situation where a borrower is late or overdue on a payment, such as income taxes, a mortgage, an automobile loan, or a credit card account. An account that's at least 30 days past due is generally considered to be delinquent.
The consequences for being delinquent vary based on the account, contract, and [creditor](https://www.investopedia.com/terms/c/creditor.asp). Too many delinquencies in a row can lead a debtor into default. Factors include the type, duration, and cause of the delinquency.
If you miss a credit card payment, you might incur a [late fee](https://www.investopedia.com/terms/l/late-fee.asp). For mortgages, missing payments can lead to foreclosure proceedings if not resolved promptly.
Delinquencies impact your [credit score](https://www.investopedia.com/terms/c/credit_score.asp) since payment history constitutes 35% of it. While a few late payments may not have a large effect, consistently missing payments will harm your score significantly.
## Special Considerations in Financial Delinquency
Delinquency also describes a dereliction of duty or neglect by a financial professional. For example, a registered investment advisor who puts a conservative, income-oriented client into a highly speculative stock could be found delinquent in their fiduciary duties. If an insurance company fails to warn a [universal life](https://www.investopedia.com/terms/u/universallife.asp) policyholder that their policy is in danger of lapsing due to insufficient premium payments, it could be considered delinquent.
> **Fast Fact**
>
> Most people are familiar with the legal definition of delinquent, which is commonly used to describe someone (usually a younger individual) who commits minor crimes.
## Distinguishing Between Delinquency and Default
Delinquency occurs as soon as a borrower misses a payment on a loan. Being consistently [delinquent can lead to default](https://www.investopedia.com/ask/answers/062315/what-are-differences-between-delinquency-and-default.asp). Default occurs when a borrower fails to repay a debt as specified in the original contract. Most creditors allow borrowers to remain in delinquency for some time before it is considered to be in default. The length of time it takes to go into default varies based on the lender and the type of debt.
For example, the U.S. government allows student debt to be delinquent for 270 days before declaring it to be in default. Most lenders consider single-family mortgages [seriously delinquent](https://www.investopedia.com/terms/s/serious_delinquency.asp) if they are 90 days behind in payment, after which they are in default and subject to foreclosure.
Lenders often work with borrowers to resolve delinquencies, possibly allowing them to bring accounts current. However, significant delinquencies and defaults will still harm your credit score.
If you can't make a payment arrangement during default, the lender may proceed with further action. For instance, your account may be sent to a third-party agency for collection. If you still can't pay, the creditor may pursue legal action and seek judgment against you. If the [debt is secured](https://www.investopedia.com/terms/s/secureddebt.asp), the lender can sell the security and pay off the debt. You may still be liable for any remaining balance or additional fees.
> **Fast Fact**
>
> Read your contract to find out how long it takes for your lender to consider you in delinquency and in default.
## Trends in Delinquency Rates: Current and Historical Perspectives
The [delinquency rate](https://www.investopedia.com/terms/d/delinquency-rate.asp) is the amount of debt that is past due. This rate is expressed as a percentage and is generally used to characterize a financial institution's lending portfolio. Delinquency rates are calculated by dividing the total number of delinquent loans by the total number of loans held by a lender. Lower delinquency rates mean fewer people are late on their payments.
The Federal Reserve tracks delinquency rates in the United States every quarter. As of the first quarter of 2024, the average rate for all loans and leases was 1.43%. Residential real estate delinquencies were highest, with a rate of 1.72% while credit cards topped the list of delinquency rates for consumer loans at 3.16%.
Delinquency rates have steadily dropped since the [2007-2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). In Q1 2010, the rate was 7.4%, with residential real estate and credit cards at 11.54% and 5.78%, respectively.
## Understanding Credit Card Delinquency
[Credit card delinquencies](https://www.investopedia.com/articles/pf/11/intro-to-credit-card-delinquency.asp) happen when you fail to make your regular monthly payments. These intervals are normally divided into days. You are generally considered delinquent if you're 30 days past due, although some lenders wait until you're 45 or 60 days to report late payments as being delinquent.
Remember, being delinquent impacts your credit score. A few late payments here or there won't make a major dent in your rating, but multiple delinquencies will add up to a lower score. You can expect to take a big hit if you have three to four missed payments, especially if they occur in a row. This can prevent you from getting credit in the future.
## Navigating Loan Delinquency
Loans work a little differently than other types of debt. When you sign up for a loan, you agree to repay the lender a specific amount of money at regular intervals until the debt is paid off. The lender determines the due date and, in some cases, may allow you to set this date based on your personal financial situation.
Most lenders also include a grace period, which may be a few days after your due date. If you make your payment on or before this date, it may not be considered late but you may still incur interest but not a late payment fee. If you fail to make the payment before, you are considered delinquent. Your loan is in delinquent status even if you make your payment a day or two after the due date.
## Example of Loan Delinquency
As an example, in Q1 2024, 0.8% of the $1.6 trillion in student loan debt was over 90 days delinquent, according to the Federal Reserve Bank of New York.
As of Q1 2024, missed federal student loan payments will not be reported to credit bureaus. They will start being reported in Q4 2024. This means that less than 1% of aggregate student loans were reported 90+ days delinquent or in default in Q1 2024, meaning delinquency levels are much higher.
## What Is an Act of Delinquency?
The definition of being in delinquency depends on the context in which it's being used. In finance, it often refers to the state of being late on a debt. For instance, a borrower is considered delinquent if they don't make their credit card payment on time.
Being delinquent can also mean that a financial professional neglects to live up to their fiduciary responsibilities. An investment advisor who suggests that a retired client invest in a risky venture is deemed as being delinquent.
## Can a Delinquency Be Removed?
Delinquencies are reported to credit reporting agencies. But just because it appears on your history doesn't mean that it's impossible to remove it from your credit report.
Submit a report either online or in writing to the credit bureau disputing the delinquency. You should also contact the lender to see what can be done, especially if you had a good reason for allowing the account to go into delinquency status. You may have to offer to pay the account balance to have it deleted from your credit report.
## How Can You Prevent Delinquency?
There are several ways to prevent delinquencies. Some options include automatic payments, which help individuals who have a difficult time keeping up with payment schedules. Sign up for e-billing so you receive email invoices rather than paper copies from your lenders. You can also ask your lender to move due dates closer to your pay dates.
## What Is a Delinquent Status?
A delinquent status means that you are behind in your payments. The length of time varies by lender and the type of debt, but this period generally falls anywhere between 30 to 90 days.
## The Bottom Line
Financial delinquencies occur when individuals or entities fail to make timely payments on debts, such as loans and credit cards. This can harm credit scores and impede future financial opportunities, including obtaining new credit or renting property.
In the U.S., high consumer debt levels exacerbate the risk of delinquency. To mitigate these risks, it's crucial to manage debt effectively, remain current with payments, and understand the potential impacts on one's financial health.
> **Article Sources**
>
> 1. Consumer Financial Protection Bureau. "[The Early Effects of the COVID-19 Pandemic on Consumer Credit](https://files.consumerfinance.gov/f/documents/cfpb_early-effects-covid-19-consumer-credit_issue-brief.pdf)." Page 9. Footnote.
>
> 2. Experian. "[How Does Default Impact Your Credit?](https://www.experian.com/blogs/ask-experian/how-does-default-impact-credit/)"
>
> 3. U.S. Department of Housing and Urban Development. "[Foreclosure Process](https://www.hud.gov/topics/avoiding_foreclosure/foreclosureprocess)."
>
> 4. myFICO. "[What is Payment History?](https://www.myfico.com/credit-education/credit-scores/payment-history)"
>
> 5. U.S. Department of Labor. "[Fiduciary Responsibilities](https://www.dol.gov/general/topic/retirement/fiduciaryresp)."
>
> 6. Collins Dictionary. "[Delinquent](https://www.collinsdictionary.com/dictionary/english/delinquent)."
>
> 7. Experian. "[What’s the Difference Between Delinquency and Default?](https://www.experian.com/blogs/ask-experian/what-is-the-difference-between-delinquency-and-default/)"
>
> 8. Federal Student Aid. "[What are Loan Delinquency and Default?](https://studentaid.gov/help-center/answers/article/what-is-loan-delinquency-default)"
>
> 9. Consumer Financial Protection Bureau. "[2021 Mortgage Servicing Rule](https://files.consumerfinance.gov/f/documents/cfpb_2021-mortgage-servicing-rule_slides_2021-08.pdf)." Page 6.
>
> 10. Board of Governors of the Federal Reserve System. "[Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks](https://www.federalreserve.gov/releases/chargeoff/delallsa.htm)."
>
> 11. Experian. "[When Do Late Payments Become Delinquent?](https://www.experian.com/blogs/ask-experian/when-does-debt-become-delinquent/)"
>
> 12. Federal Reserve Bank of New York. "[Household Debt Rose by $184 Billion in Q1 2024; Delinquency Transition Rates Increased Across All Debt Types](https://www.newyorkfed.org/newsevents/news/research/2024/20240514)."
>
> 13. Federal Reserve Bank of New York. "[Quarterly Report on Household Debt and Credit: Q1 2024](https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2024Q1)," Page 2 of PDF. |
8-K (Form 8K) | # Understanding SEC Form 8-K: Key Events and Filing Guide
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*— Investopedia / Julie Bang*
> **Definition**
>
> SEC Form 8-K is one that public companies use to announce unscheduled material events or corporate changes.
Form 8-K is a mandatory filing that publicly traded companies must submit to the Securities and Exchange Commission (SEC) to announce significant or "material" events that shareholders are required to know.
Unlike mandated periodic reports such as annual (Form 10-K) or quarterly (Form 10-Q) filings, Form 8-K is designed to reveal essential matters in time for shareholders to react. Matters that must be reported on the form include acquisitions, bankruptcy, directors' resignations, or fiscal year changes.
Prior to the form's creation, corporate disclosure was inconsistent or nonexistent, creating an information gap between insiders and the public. [Insider trading](https://www.investopedia.com/terms/i/insidertrading.asp) was endemic, and retail investors were often exploited. Investors had limited access to timely and material information on mergers, acquisitions, executive changes, and financial troubles. Form 8-K was created in 1936 to address these issues. The form required companies to report major corporate events within 15 days. In 2004, the SEC significantly expanded the list of reportable events and shortened the filing deadline to four days.
### Key Takeaways
* SEC Form 8-K is a critical filing that publicly traded companies use to disclose significant events, ensuring investors have the necessary material information to make informed decisions promptly.
* Companies have four business days to file Form 8-K after major events, like acquisitions or bankruptcies, with certain exceptions for disclosures under Regulation Fair Disclosure, which might require even more immediate reporting.
* Despite its intention to provide timely and uniform information, there is evidence that institutional investors often gain advantageous insights before retail investors, highlighting an ongoing information asymmetry in financial markets.
* The structure and comprehensive nature of Form 8-K require companies to carefully assess events across nine main sections, ensuring a consistent reporting standard that aids investors in understanding significant corporate developments.
* Ongoing discussions about modernizing Form 8-K focus on reducing reporting timelines and improving disclosure methods to further bridge the information gap between institutional and retail investors.
The [SEC](https://www.investopedia.com/articles/investing/112914/understanding-sec.asp) created Form 8-K in 1936, requiring companies to promptly report major corporate events, aiming to equip investors with prompt information—"prompt" meaning 15 days at the time—to know whether to buy, hold, or sell shares in specific companies. Researchers have long confirmed its value for investors, linking their filings to abnormal volume and return volatility; some reduction in the differences among institutional, insider, and retail investors in the information they have; and far more substantive disclosures of crucial company information, especially after a 2004 regulatory change that greatly expanded what was to be reported via Form 8-K.
Over time, the SEC amended Form 8-K to boost transparency and protect investors. A major overhaul came in 2004 when the SEC significantly expanded the list of reportable events and shortened the filing deadline. Reportable items grew from five to nearly two dozen, covering more corporate events. The filing deadline was also reduced to four business days for most items—dramatically improving the timeliness of disclosures.
As time went on, regulators added further items as to what counted as a significant event, such as disclosing notice of a company being delisted from an exchange, major changes in executive compensation, and serious cybersecurity incidents.
Recent discussions focus on further modernizing Form 8-K. Topics of debate include whether the four-day filing window is still appropriate in an age of instant communication and whether additional events should be added to the list of reportable items. Below, we take you through what investors and other Wall Street stakeholders need to know about this form. We also discuss whether it's lived up to its promise to make the investing world more accessible beyond a network of insiders.
## Understanding Form 8-K
An 8-K is required to announce significant events relevant to shareholders. Companies usually have four business days to file an 8-K for most items.
While the general rule is that companies must file Form 8-K within four business days of a triggering event, there are important exceptions to the timeline. For example, some disclosures fall under Regulation Fair Disclosure ([Reg FD](https://www.investopedia.com/terms/r/regulationfd.asp)), which aims to prevent selective disclosure of material information. In these cases, companies must file Form 8-K or make a public disclosure simultaneously with or before any intentional disclosure to select individuals. For unintentional disclosures, the filing must be made promptly—no later than 24 hours or the start of the next trading day.
Companies must decide if the information is "material," meaning important for investment decisions. This assessment can impact both the decision to file and the timing. Companies can also use Form 8-K to voluntarily share important information.
Once filed, the SEC makes these reports publicly available through the Electronic Data Gathering, Analysis, and Retrieval ([EDGAR](https://www.investopedia.com/terms/e/edgar.asp)) platform.
In July 2024, as it scheduled a 10-for-one stock split, NVIDIA Corporation (NVDA) filed this Form 8-K with the SEC.
### Sections of Form 8-K
Form 8-K is organized into nine main sections. Each section covers specific types of events or changes that trigger a reporting obligation. Here's a breakdown:
1. **Registrant's business and operations**: Including material agreements, bankruptcy filings, and mine safety violations.
2. **Financial Information**: Covers acquisition or disposition of assets, material impairments, and changes in shell company status.
3. **Securities and trading markets**: These include delistings, failures to meet listing standards, and unregistered sales of equity securities.
4. **Matters related to accountants and financial statements**: These include changes in auditors and non-reliance on previously issued financial statements.
5. **Corporate governance and management**: Covers changes in control, director departures, executive officer appointments, and amendments to governing documents.
6. **Asset-backed securities**: Specific to issuers of asset-backed securities.
7. **Regulation FD Disclosure**: For disclosures made under Regulation Fair Disclosure.
8. **Other events**: A catchall for voluntary disclosure of events not explicitly required but that the company deems important.
9. **Financial statements and exhibits**: For including financial statements, pro forma financial information, and other exhibits as required.
Most of these main sections contain several subsections, totaling over 30 specific reporting requirements. Companies must carefully evaluate events against these criteria to determine if a Form 8-K filing is necessary. The particular item number under which information is reported provides immediate context for the nature of the disclosure.
This structured approach ensures Form 8-K filings are consistent, helping investors and analysts understand event significance.
> **Fast Fact**
>
> Form 8-K is sometimes referred to as the "current report" or the "material event report."
## Benefits of SEC Form 8-K for Investors and Companies
First, Form 8-K provides investors with timely notification of significant changes at listed companies. Many of these changes are defined explicitly by the SEC. In contrast, others are simply events that firms consider sufficiently noteworthy. In any case, the form allows firms to communicate directly with investors.
The information provided is not filtered through media organizations in any way. Furthermore, investors do not have to watch TV programs, subscribe to magazines, or even wade through financial news websites to get the 8-K, though most do.
Form 8-K also provides substantial benefits to listed companies. By filing an 8-K promptly, the firm's management can meet specific disclosure requirements and avoid insider trading allegations. Companies may also use Form 8-K to tell investors of any events that they consider to be important.
Finally, Form 8-K provides a valuable record for economic researchers. For example, academics might wonder what influence various events have on stock prices. Estimating these events' impact using [regression](https://www.investopedia.com/terms/r/regression.asp) analysis is possible, but researchers need reliable data. Because 8-K disclosures are legally required, they provide a more complete record than would otherwise be available.
> **Fast Fact**
>
> Companies in fast-changing industries, like technology and pharmaceuticals, often have more Form 8-K filings due to the rapid pace of significant events and changes that come their way.
## Understanding the Timing of Form 8-K Filings
There are two significant dates for Form 8-K: the date the event occurs and the date it's reported to the public.
Usually, companies are required to file Form 8-K within four business days of the event of interest occurring. For example, if the event happened on a Monday, it would need to be reported by Friday the same week. Likewise, if it happens on Tuesday, it would need to be reported by Monday of the following week.
There are a few exceptions to the four-business-day rule. Different deadlines may apply in certain circumstances. For example, a company may be given more time to report a material cybersecurity incident if disclosing it poses a risk to national security or if the breach involves customers' proprietary network information.
Alternatively, for information about earnings calls that are “complementary” to an earnings press release, a Form 8-K detailing this information must be shared no later than when the call begins. Voluntary disclosures, meanwhile, don't have a specific deadline.
### How Institutional Investors Use Form 8-K to Maintain an Edge
Form 8-K is supposed to protect [retail investors](https://www.investopedia.com/terms/r/retailinvestor.asp) and ensure they learn about important events at the same time as the industry's major players. However, researchers argue that the SEC’s efforts to create a level playing field haven't succeeded over time.
Recent studies, following work in previous decades, reveal a significant difference in how institutional and retail investors receive information, and this has given rise to very different kinds of trading around the events depicted in the 8-K.
Institutional investors, who typically use sophisticated and expensive tools like [Bloomberg terminals](https://www.investopedia.com/articles/active-trading/121114/bloomberg-terminal-step-step.asp#:~:text=The%20Bloomberg%20terminal%20is%20both,mainly%20used%20by%20professional%20investors.), show significant interest in Form 8-K information on both the event date and the filing date. In contrast, media coverage, which is where most retail investors get their information, tends to peak on the filing date.
A 2022 study used specific data that tracks retail and institutional investors and then juxtaposed that data with Bloomberg terminal search data as a proxy for institutional investor attention and media coverage data to gauge broader retail attention. The study found that much of the price discovery and gains were already off the table _before_ retail investors had a shot, concluding that Form 8-K filings "may have little direct informational benefit, particularly to retail investors."
### Pre-Filing Information Access: How Traders Stay Ahead of Form 8-K Filings
Other studies have found traders making major moves before or right as an event occurred, as well as in the time between the event and the SEC filing of the 8-K days later. What does that mean? Let's game out the possible ways that investors and traders might learn about events not yet reported to the SEC:
1. **Industry connections**: Institutional investors often have extensive networks within industries, allowing them to hear about significant events through word-of-mouth or informal communications.
2. **Expert networks**: Some firms pay for access to networks of industry experts who may have early knowledge of important events.
3. **Data analysis**: Advanced algorithms can detect unusual patterns in trading data, social media, or other sources that might indicate a significant event has occurred or is about to.
4. **Company leaks**: Despite laws against it, sometimes information is leaked by company insiders, either intentionally or unintentionally.
5. **Supplier or customer information**: Changes in orders or business practices at a company's suppliers or major customers can signal important events.
6. **Regulatory filings in other jurisdictions**: Sometimes, companies must file information in other countries before U.S. markets open.
7. **Conference calls or investor days**: Companies might disclose information in these settings that isn't immediately filed in a Form 8-K. This type of information, though, would likely be available through the financial media.
It's important to note that trading on material nonpublic information can be illegal if it violates [insider trading laws](https://www.investopedia.com/terms/i/insidertrading.asp#:~:text=Insider%20transactions%20are%20legal%20if,information%20is%20still%20non%2Dpublic.). However, many methods listed above often fall into gray areas or are considered legitimate forms of research by institutional investors.
When companies finally submit their Form 8-K, news outlets start talking about it more. This catches the eye of [retail investors](https://www.investopedia.com/terms/r/retailinvestor.asp). These investors often buy or sell based on this news, pushing the stock price further in the direction it was already moving. Big investment firms notice this pattern. They use it to their advantage by offering to buy or sell shares at just the right time, making money from the predictable way regular investors behave.
> **Fast Fact**
>
> While institutional investors include endowment funds, commercial banks, hedge funds, and insurance companies, institutional investors also include mutual and pension funds that manage money for ordinary individuals. This is something to keep in mind when considering the different advantages between institutional and retail investors.
## Challenges and Limitations of Form 8-K Disclosures
Let's summarize the problems researchers have identified:
* **There are still insiders and outsiders when it comes to major company news.** There's information asymmetry, with institutional investors gaining an advantage by accessing and acting on information before it's officially filed.
* **Retail investors end up trading only after many of the gains are gone**. Retail investors, in contrast, appear to be trading on "stale" news, which could lead to trades that disadvantage them while advantaging institutional investors.
* **Worse, they seem to be handing further gains to the very investors who already got a head start**: When retail investors react to news like the filing of a Form 8-K, they create price pressure, pushing the stock price in a specific direction. However, this price movement is often followed by a reversal, indicating that the initial move wasn't entirely justified by the fundamental information. If the market were efficient, we wouldn't expect to see these patterns of price pressure followed by reversals.
Taking these problems together, retail investors aren't just losing out on the news from before the filing; they are also providing added trading benefits to those who've already gotten a head start. It's like a race where one side is told to start days later. When they do, they're told they'll need to share any winnings with those who've already been out front.
> **Fast Fact**
>
> Form 8-K reports may also be issued based on other events up to the company's discretion that the registrant considers to be of importance to shareholders.
### Addressing Information Gaps in Form 8-K Filings
The key argument emerging from recent studies is that filing Form 8-K may not provide significant informational benefits for retail investors. Instead, it creates a sequence of events that sophisticated investors can anticipate and exploit.
Thus, the Form 8-K system may not be achieving its intended goal of providing equal and timely information to all investors. Despite regulatory intentions, institutional investors seem to maintain both an informational and strategic advantage over retail investors in the context of Form 8-K disclosures.
When this happens, institutional investors gain an unfair advantage over retail investors. They are able to get a head start and trade on the information ahead of everyone else. And they are able to know ahead of time that the share price will likely move up or down when retail investors get wind of the news.
Here are potential ways to address the concerns raised by researchers:
1. **Faster filing requirements**: Reducing the time between the event and the filing could help minimize the information gaps among investors.
2. **Improved [disclosure](https://www.investopedia.com/terms/d/disclosure.asp) methods**: Exploring alternative ways to disseminate information that reaches all investors more equally and quickly.
3. **Education for retail investors**: Programs to help retail investors understand the nature of Form 8-K filings and the potential for "stale" news.
4. **Enhanced monitoring**: Increased scrutiny of trading patterns around Form 8-K events to detect and discourage potential exploitation of information asymmetries.
5. **Real-time disclosure**: Implementing a system where material information is disclosed in real-time rather than allowing a delay between the event and the filing.
### The Retail Investor's Disadvantages in Form 8-K Dynamics
The fact that retail investors often react too late to the kind of news found in 8-Ks highlights a deeper issue in the financial world, one that fuels the derisive attitudes commonly found in certain corners of Wall Street and the financial media.
Over the past few decades, as retail investing has undergone significant changes, some of the more arrogant Wall Street players have coined dismissive terms for retail investors: "[dumb money](https://www.investopedia.com/investing/surprising-benefits-when-brokers-grade-their-customers/#:~:text=Consequently%2C%20the%20%E2%80%9Cdumb%20money%E2%80%9D,when%20prices%20start%20to%20decline.)," "sheep," or "noise traders."
### "Smart" vs. "Dumb" Money
"Smart money" refers to investments made by institutional investors and market professionals, believed to be based on superior information like data analytics and other expertise. "Dumb money" is a derogatory term for retail investors, implying less sophisticated, emotionally driven decisions. These labels reflect a dubious mindset in financial markets since they oversimplify the complex reality of investing.
Compounding the problem is that these pejorative terms have seeped into analysts' talk on major financial news networks. These platforms purport to guide retail investors with the latest, actionable news. However, researchers have been revealing a troubling reality. Major institutional players have already capitalized on the information by the time Form 8-Ks are filed and subsequently covered by these outlets. Thus, when financial news sources finally deliver this news to retail investors, the opportunity for significant returns might have passed.
This isn't just a matter of slightly delayed information; in many instances, detailed by recent studies, it's a fundamental disadvantage baked into the system.
## Additional Criticisms and Considerations for Form 8-K
Like any legally required paperwork, Form 8-K imposes costs on businesses. There is the cost of preparing and submitting the forms and possible penalties for failing to file on time. Although it is only one small part of the problem, the need to file Form 8-K also deters some small companies from going public in the first place. Requiring companies to provide information helps investors make better choices. However, it can reduce their investment options when the burden on businesses becomes too high.
Another critique centers on the complexity and volume of the information provided in Form 8-K filings. Institutional investors argue that while the form is comprehensive, it often includes jargon and detailed data that can be difficult for retail investors to parse quickly. This complexity can lead to delays in market response among less experienced investors, further widening the gap between them and institutional players who can quickly analyze and react to the information.
Lastly, the form's broad applicability and the range of events it covers mean that not all disclosed information is immediately relevant to the market. This can sometimes lead to information overload, where critical data might get buried under less significant updates, making it challenging for investors to discern what is truly important at any given time.
## What Is the Difference Between 8-K and 10-K Filing?
The 10-K is an annual report filed once a year that details the company’s financial condition and performance. Companies must submit this lengthy annual filing within 60 to 90 days of the close of their fiscal year. The 8-K, meanwhile, informs investors about a material development that occurs between filings of the [10-K](https://www.investopedia.com/terms/1/10-k.asp) or 10-Q, which is where the company breaks down its quarterly financial performance.
## Is Filing an 8-K Good or Bad?
An 8-K can contain good or bad news and be viewed as positive or negative. For companies, filing this form can be an inconvenience, both in terms of cost and time, but result in their valuation rising. For investors, it can represent trading opportunities as the news contained within these forms is sometimes capable of triggering increased buying or selling activity.
## How Often Is an 8-K Filed?
Unlike forms that must be filed annually or quarterly, there isn't a consistent time period when 8-Ks are filed. An 8-K form is filed whenever there are significant events that shareholders need to know about, such as acquisitions, bankruptcy, or resignations.
## The Bottom Line
Form 8-K is a mandated disclosure for significant corporate events that affect shareholders. It provides timely and complete information directly to investors, bypassing media filters. Companies have four business days to file a Form 8-K after a triggering event occurs.
Prior to the form's creation, insider trading was rampant, and disclosures were inconsistent or undisclosed. Form 8-K was created in 1936 to remove the information gap between insiders and the public. The form required companies to report major corporate events, such as mergers, acquisitions, executive changes, and financial troubles, within 15 days. The list of reportable events and the filing deadline were shortened to four days in 2004.
There are simultaneous challenges and opportunities the Form 8-K represents for retail and institutional investors, including access to non-public information and potential trading advantages. There are ongoing discussions about further modernizing and improving Form 8-K filing requirements, given the fast-paced financial markets and instant communication.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[How to Read an 8-K](https://www.sec.gov/oiea/investor-alerts-and-bulletins/how-read-an8-k)."
>
> 2. Rawson, Caleb and Twedt, Brady J. and Watkins, Jessica. "[Managers’ Strategic Use of Concurrent Disclosure: Evidence from 8-K Filings and Press Releases](https://ssrn.com/abstract=4254135)." _The Accounting Review_ (Oct. 4, 2022).
>
> 3. Watkins, J. "[Consequences of Prescribed Disclosure Timeliness: Evidence from Acceleration of the Form 8-K Filing Deadline](https://publications.aaahq.org/accounting-review/article/97/7/429/373/Consequences-of-Prescribed-Disclosure-Timeliness)," _The Accounting Review_, no. 7 (2022), pp. 429-463.
>
> 4. McMullin, J. L., Miller, B. P. and Twedt, B. J. "[Increased Mandated Disclosure Frequency and Price Formation: Evidence from the 8-K Expansion Regulation](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3151607)." _Review of Accounting Studies_, vol. 24, no. 1 (2019), pp. 1-33.
>
> 5. Noh, S., So E. C., and Weber, J. P. "[Voluntary and Mandatory Disclosure: Do Managers View Them as Substitutes?](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2939210)" _Journal of Accounting & Economics_, vol. 68, no. 1 (2019), pp. 1-18.
>
> 6. U.S. Securities and Exchange Commission. "[Additional Form 8-K Disclosure Requirements](https://www.sec.gov/rules-regulations/2004/08/additional-form-8-k-disclosure-requirements-acceleration-filing-date-correction)."
>
> 7. U.S. Securities and Exchange Commission. "[Fast Answers: Form 8-K](https://www.sec.gov/fast-answers/answersform8khtm.html)."
>
> 8. U.S. Securities and Exchange Commission. "[Investor Bulletin: How to Read an 8-K](https://www.sec.gov/investor/pubs/readan8k.pdf)."
>
> 9. U.S. Securities and Exchange Commission. "[Form 8-K](https://www.sec.gov/files/form8-k.pdf)."
>
> 10. Balakrishnan, Karthik, Panagiotis Ipeirotis, and Anindya Ghose. "[The Impact of Information Disclosure on Stock Market Returns: The Sarbanes- Oxley Act and the Role of Media as an Information Intermediary.](https://infosecon.net/workshop/downloads/2008/pdf/The_Impact_of_Information_Disclosure_on_Stock_Market_Returns:_The_Sarbanes-Oxley_Act_and_the_Role_of_Media_as_an_Information_Intermediary.pdf)" New York University, Stern School of Business (2009).
>
> 11. Ben-Rephael, A., Zhi Da, Peter Easton, and Ryan Israelsen. "[Who Pays Attention to SEC Form 8-K?](https://www3.nd.edu/~zda/8k.pdf)" _The Accounting Review_, vol. 97 (2022), pp. 59-88.
>
> 12. U.S. Securities and Exchange Commission. "[Form 10-K](https://www.sec.gov/fast-answers/answers-form10khtm.html)." |
80-10-10 Mortgage | # 80-10-10 Mortgage: Meaning, Benefits and Examples
## What Is an 80-10-10 Mortgage?
An 80-10-10 [mortgage](https://www.investopedia.com/terms/m/mortgage.asp) is a loan where first and second mortgages are obtained simultaneously. The [first mortgage](https://www.investopedia.com/terms/f/first_mortgage.asp) lien is taken with an 80% [loan-to-value (LTV) ratio](https://www.investopedia.com/terms/l/loantovalue.asp), meaning that it is 80% of the home’s cost; the [second mortgage](https://www.investopedia.com/terms/s/secondmortgage.asp) lien has a 10% LTV ratio, and the borrower makes a 10% [down payment](https://www.investopedia.com/terms/d/down_payment.asp).
This arrangement can be contrasted with the traditional single mortgage with a down payment amount of 20%.
The 80-10-10 mortgage is a type of [piggyback mortgage](https://www.investopedia.com/terms/p/piggy_back_mortgage.asp).
### Key Takeaways
* An 80-10-10 mortgage is structured with two mortgages: the first being a fixed-rate loan at 80% of the home’s cost; the second being 10% as a home equity loan; and the remaining 10% as a cash down payment.
* This type of mortgage scheme reduces the down payment of a home without having to pay private mortgage insurance (PMI), helping borrowers obtain a home more easily with the up-front costs.
* However, borrowers will face relatively larger monthly mortgage payments and may see higher payments due on the adjustable loan if interest rates increase.
## Understanding an 80-10-10 Mortgage
When a prospective homeowner buys a home with less than the standard 20% down payment, they are required to pay [private mortgage insurance (PMI)](https://www.investopedia.com/mortgage/mortgage-guide/mortgage-insurance/). PMI is insurance that protects the financial institution lending the money against the risk of the borrower [defaulting](https://www.investopedia.com/terms/d/default2.asp) on a loan. An 80-10-10 mortgage is frequently used by borrowers to avoid paying PMI, which would make a homeowner’s monthly payment higher.
In general, 80-10-10 mortgages tend to be popular at times when home prices are accelerating. As homes become less affordable, making a 20% down payment of cash might be difficult for an individual. Piggyback mortgages allow buyers to borrow more money than their down payment might suggest.
The first mortgage of an 80-10-10 mortgage is usually always a [fixed-rate mortgage](https://www.investopedia.com/terms/f/fixed-rate_mortgage.asp). The second mortgage is usually an [adjustable-rate mortgage](https://www.investopedia.com/terms/a/arm.asp), such as a [home equity loan](https://www.investopedia.com/terms/h/homeequityloan.asp) or [home equity line of credit (HELOC)](https://www.investopedia.com/mortgage/heloc/).
## Benefits of an 80-10-10 Mortgage
The second mortgage functions like a credit card, but with a lower interest rate since the [equity in the home](https://www.investopedia.com/terms/h/home_equity.asp) will back it. As such, it only incurs interest when you use it. This means that you can pay off the home equity loan or HELOC in full or in part and eliminate interest payments on those funds. Moreover, once settled, the HELOC remains. This credit line can act as an emergency pool for other expenses, such as home renovations or even education.
An 80-10-10 loan is a good option for people who are trying to buy a home but have not yet sold their existing home. In that scenario, they would use the HELOC to cover a portion of the down payment on the new home. They would pay off the HELOC when the old home sells.
HELOC [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) are higher than those for conventional mortgages, which will somewhat offset the savings gained by having an 80% mortgage. If you intend to pay off the HELOC within a few years, this may not be a problem.
When home prices are rising, your equity will increase along with your home’s value. But in a housing market downturn, you could be left dangerously [underwater](https://www.investopedia.com/terms/u/underwater-mortgage.asp) with a home that’s worth less than you owe.
## Example of an 80-10-10 Mortgage
The Doe family wants to purchase a home for $300,000, and they have a down payment of $30,000, which is 10% of the total home’s value. With a conventional 90% mortgage, they will need to pay PMI on top of the monthly mortgage payments. Also, a 90% mortgage will generally carry a higher interest rate.
Instead, the Doe family can take out an 80% mortgage for $240,000, possibly at a lower interest rate, and avoid the need for PMI. At the same time, they would take out a second 10% mortgage of $30,000. This most likely would be a HELOC. The down payment will still be 10%, but the family will avoid PMI costs, get a better interest rate, and thus have lower monthly payments. |
80-20 Rule | # The 80-20 Rule (aka Pareto Principle): What It Is and How It Works
> **Definition**
>
> The 80-20 rule is a principle stating that 80% of outcomes or outputs for a given event result from 20% of all causes or inputs.
## What Is the 80-20 Rule?
The 80-20 rule, also known as the [Pareto Principle](https://www.investopedia.com/terms/p/paretoprinciple.asp), is a familiar saying that asserts that 80% of outcomes happen because of 20% of inputs. The general guiding principle of the rule is that a smaller proportion of items cause a larger proportion of outcomes. In business, a goal of the 80-20 rule is to identify inputs that are potentially the most [productive](https://www.investopedia.com/terms/p/productivity.asp) and make them the priority. For instance, once managers identify factors that are critical to their company's success, they should give those factors the most focus.
### Key Takeaways
* The 80-20 rule maintains that 80% of outcomes are driven by just 20% of contributing factors.
* The 80-20 rule prioritizes the 20% of factors that will produce the best results.
* A principle of the 80-20 rule is to identify an entity's best assets and use them efficiently to create maximum value.
* This rule is a precept, not a hard-and-fast mathematical law.
* People sometimes mistakenly conclude that if 20% of factors should get priority, then the other 80% can be ignored.
:max_bytes(150000):strip_icc()/Term-Definitions_80-20-rule-e0f7f05b70d5479d8d4f8fcfd6a5286b.jpg)
*— Investopedia / Jessica Olah*
## How Does the 80-20 Rule Work?
You may think of the 80-20 rule as simple cause and effect: 80% of outcomes (outputs) come from 20% of causes (inputs). The rule is often used to point out that 80% of a company's revenue is generated by 20% of its customers.
Viewed in this way, it might be advantageous for a company to focus on the 20% of clients that are responsible for 80% of [revenues](https://www.investopedia.com/terms/r/revenue.asp) and market specifically to them. By doing so, the company may retain those clients, and acquire new clients with similar characteristics. However, there's a more fundamental meaning to the 80-20 rule.
### Core Principle
At its core, the 80-20 rule is about identifying an entity's best assets and using them efficiently to create maximum [value](https://www.investopedia.com/terms/v/value.asp). For example, a student should try to identify which parts of a textbook will create the most benefit for an upcoming exam and focus on those first. This does not imply, however, that the student should ignore the other parts of the textbook.
### Misinterpretations
People may not realize that the 80-20 rule is a precept, not a hard-and-fast mathematical law. Furthermore, it is isn't necessary that the percentages equal 100%. [Inputs and outputs](https://www.investopedia.com/terms/i/input-output-analysis.asp) simply represent different units. The percentages of these units don't have to add up to 100%. It's the concept behind the rule that matters.
There's another way in which the 80-20 rule is misinterpreted. Namely, that if 20% of inputs are most important, then the other 80% must not be important. This is a logical fallacy. The 80% can be important, even if the decision is made to prioritize the 20%.
> **Important**
>
> Business managers from all industries use the 80-20 rule to help narrow their focus and identify those issues that cause the most problems in their departments and organizations.
## 80-20 Rule Background
The 80-20 rule is also known as the Pareto principle and is applied in [Pareto analysis](https://www.investopedia.com/terms/p/pareto-analysis.asp). It was first used in macroeconomics to describe the distribution of wealth in Italy in the early 20th century. It was introduced in 1906 by Italian economist Vilfredo Pareto, who is best known for the concepts of [Pareto efficiency](https://www.investopedia.com/terms/p/pareto-efficiency.asp).
Pareto noticed that 20% of the pea pods in his garden were responsible for 80% of the peas. Pareto expanded this principle to [macroeconomics](https://www.investopedia.com/terms/m/macroeconomics.asp) by showing that 80% of the wealth in Italy was owned by 20% of the population.
In the 1940s, Dr. Joseph Juran, a prominent figure in the field of [operations management](https://www.investopedia.com/terms/o/operations-management.asp), applied the 80-20 rule to [quality control](https://www.investopedia.com/terms/q/quality-control.asp) for business production.
He demonstrated that 80% of product defects were caused by 20% of the problems in production methods. By focusing on and reducing the 20% of production problems, a business could increase the overall quality of its products. Juran referred to this phenomenon as "the vital few and the trivial many."
> **Tip**
>
> Read about Investopedia's 10 Rules of Investing by picking up a copy of our special issue print edition.
## Benefits of the 80-20 Rule
Although there is little scientific analysis that either proves or disproves the 80-20 rule's validity, there is much anecdotal evidence that supports the rule as being essentially valid, if not numerically accurate.
Performance results of salespeople in a wide range of businesses have demonstrated success by incorporating the 80-20 rule. In addition, external consultants who use [Six Sigma](https://www.investopedia.com/terms/s/six-sigma.asp) and other management strategies have incorporated the 80-20 principle in their practices with good results.
## Example of the 80-20 Rule
A Harvard graduate student, Carla, was working on an assignment for her digital communications class. The project was to create a blog and monitor its success during the course of a semester.
Carla designed, created, and launched the site. Midway through the term, the professor conducted an evaluation of the blogs. Carla's blog, though it had achieved some visibility, generated the least amount of traffic compared with her classmates' blogs.
### Define the Problem
Carla happened upon an article about the 80-20 rule. It said that you can use this concept in any field. So, Carla began to think about how she might apply the 80-20 rule to her blog project. She thought, "I used a great deal of my time, technical ability, and writing expertise to build this blog. Yet, for all of this expended energy, I am getting very little traffic to the site."
She now understood that even if a piece of content is spectacular, it is worth virtually nothing if no one reads it. Carla deduced that perhaps her [marketing of the blog](https://www.investopedia.com/terms/m/marketing.asp) was a greater problem than the blog itself.
### Apply the 80-20 Rule
To apply the 80-20 rule, Carla decided to assign her 80% to all that went into creating the blog, including its content. Her 20% would be represented by a selection of the blog's visitors.
Using [web analytics](https://www.investopedia.com/terms/d/data-analytics.asp), Carla focused closely on the blog's traffic. She asked herself:
* Which sources comprise the top 20% of traffic to my blog?
* Who are the top 20% of my audience that I wish to reach?
* What are the characteristics of this audience as a group?
* Can I afford to invest more money and effort into satisfying my top 20% readers?
* In terms of content, which blog posts constitute the top 20% of my best-performing topics?
* Can I improve upon those topics, and get even more traction from my content than I'm getting now?
Carla analyzed the answers to these questions, and edited her blog accordingly:
1. She adjusted the blog's design and persona to align with her top 20% target audience (a strategy common in [micromarketing](https://www.investopedia.com/terms/m/micromarketing.asp)).
2. She rewrote some content to meet her target reader's needs more fully.
Significantly, although her analysis did confirm that the blog's biggest problem was its marketing, Carla did not ignore its content. She remembered the common fallacy cited in the article—if 20% of inputs are most important, then the other 80% must be unimportant—and did not want to make that mistake. She knew it was necessary to address aspects of the content, as well.
### Results
By applying the 80-20 rule to her blog project, Carla came to understand her audience better and therefore targeted her top 20% of readers more purposefully. She reworked the blog's structure and content based on what she learned, and traffic to her site rose by more than 220%.
## What's the 80-20 Rule?
The 80-20 rule is a principle that states 80% of all outcomes are derived from 20% of causes. It's used to determine the factors (typically, in a business situation) that are most responsible for success and then focus on them to improve results. The rule can be applied to circumstances beyond the realm of business, too.
## What Does the 80-20 Rule Mean?
At its heart, the 80-20 rule simply underscores the importance of exerting your energy on those aspects of your business—or life, sports activity, musical performance, blog, etc.—that get you the best results. However, it does not mean people should then ignore the areas that are less successful. It's about prioritizing focus and tasks, and then solving problems that reveal themselves due to that focus.
## How Do I Use the 80-20 Rule to Invest?
When building a portfolio, you could consider investing in 20% of the stocks in the S&P 500 that have contributed 80% of the market’s returns. Or you might create an 80-20 allocation: 80% of investments could be lower risk index funds while 20% might could be growth funds. Of course, past performance doesn't necessarily correlate with future results. So, be sure to monitor your portfolio's performance to see how well the results match your intent and your goals.
> **Article Sources**
>
> 1. Econlib. "[Vilfredo Pareto](https://www.econlib.org/library/Enc/bios/Pareto.html)."
>
> 2. Six Sigma Daily. "[Remembering Joseph Juran and His Lasting Impact on Quality](https://www.sixsigmadaily.com/remembering-joseph-juran-quality-improvement/)." |
83(b) Election | # 83(b) Election: Tax Strategy and When and Why to File
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*An 83(b) election alerts the Internal Revenue Service to tax the elector for the ownership at the time of stock granting, rather than at the time of stock vesting. — Xiaojie Liu / Investopedia*
## What Is an 83(b) Election?
An 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee, or a startup founder, the option to pay taxes on the total fair market value of [restricted stock](https://www.investopedia.com/terms/r/restrictedstock.asp) at the time of granting.
An 83(b) election lets the employee or founder prepay taxes on the restricted stock to save money.
Benefits are tax savings, particularly if the stock's value will appreciate significantly; more favorable tax treatment on future gains; and the opportunity to deduct losses if the stock's value decreases before vesting. Risks include potential tax overpayment if the stock's value falls or the company files for bankruptcy, or the employee paying for shares they never receive if they leave the firm before vesting ends. Another risk is not making an 83(b) election, which could lead to higher taxes at vesting because future appreciations are taxed as ordinary income.
Read on to understand the related processes and implications before you make your 83(b) decision.
### Key Takeaways
* The 83(b) election allows individuals to pay taxes on the fair market value of restricted stock at grant time, not vesting time.
* Filing an 83(b) election can lead to significant tax savings if the stock's value increases in future years.
* The election is beneficial mainly when the reported income is small at the grant time and shares are expected to appreciate.
* Failing to file could result in higher taxes due upon vesting, as future appreciations are taxed as ordinary income.
* An 83(b) election can be detrimental if the company’s value drops or if the taxpayer leaves before the vesting period concludes.
## Understanding the 83(b) Election Process
The 83(b) election applies to equity that is subject to vesting, and it alerts the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) to tax the elector for the ownership at the time of granting, rather than at the time of stock vesting.
In effect, an 83(b) election means that you prepay your [tax liability](https://www.investopedia.com/terms/t/taxliability.asp) on a low valuation, assuming the equity value increases in the following years. However, if the value of the company instead declines consistently and continuously, this tax strategy would ultimately mean that you overpaid in taxes by prepaying on higher-equity valuation.
Typically, when a founder or employee gets equity as compensation, it's taxed based on its value. The tax is based on the [fair market value](https://www.investopedia.com/terms/f/fairmarketvalue.asp) of the equity at the time of grant, minus the cost to exercise or buy the shares. The tax must be paid in the year the stock is issued or transferred.
However, in many cases, the individual receives equity vesting over several years. Employees earn company shares as they stay employed. In that case, the tax on the equity value is due at the time of vesting. If the company's value grows during the vesting period, taxes will rise each year accordingly.
## Step-by-Step Guide to Filing an 83(b) Election
### 1\. Prepare Your Filing Document
* Include taxpayer's name, address, Social Security number, and details of awarded shares.
* Specify the calendar year and date of transfer, and note any restrictions.
* Calculate and include the fair market value and amount paid for shares.
### 2\. Mail the Document
Date, sign, and send the document to the IRS within 30 days of the restricted shares issuance. Use the appropriate IRS Service Center where you file your taxes.
### 3\. Notify Your Employer
Provide a copy of the election form to your employer to ensure compliance.
### 4\. Include in Tax Return
Attach a copy of the election with your income tax return for the year when the restricted stock was transferred.
## Illustrative Scenarios: With and Without an 83(b) Election
### With an 83(b) Election
Let's say a co-founder of a company is granted 1 million shares subject to vesting and valued at $0.001 at the time the shares are granted. At this time, the shares are worth the [par value](https://www.investopedia.com/terms/p/parvalue.asp) of $0.001 × number of shares, or $1,000, which the co-founder pays. The shares represent a 10% ownership of the firm for the co-founder and will be vested over a period of five years, which means that they will receive 200,000 shares every year for five years. In each of the five vested years, they will have to pay tax on the fair market value of the 200,000 shares vested.
If the total value of the company’s equity increases to $100,000, then the co-founder’s 10% value increases to $10,000 from $1,000. The co-founder's tax liability for year 1 will be deduced from ($10,000 - $1,000) × 20%; i.e., in effect, ($100,000 - $10,000) × 10% × 20% = $1,800.
* $100,000 is the Year 1 value of the firm
* $10,000 is the value of the firm at inception or the book value
* 10% is the ownership stake of the co-founder
* 20% represents the five-year vesting period for the co-founder's 1 million shares (200,000 shares/1 million shares)
If, in year 2, the stock value increases further to $500,000, then the co-founder's taxes will be ($500,000 - $10,000) × 10% × 20% = $9,800. By year 3, the value goes up to $1 million and the tax liability will be assessed from ($1 million - $10,000) × 10% × 20% = $19,800. Of course, if the total value of equity keeps climbing in Year 4 and Year 5, the co-founder’s additional taxable income will also increase for each of the years.
If at a later time, all the shares sell for a profit, the co-founder will be subject to a [capital gains tax](https://www.investopedia.com/terms/c/capital_gains_tax.asp) on their gains from the proceeds of the sale.
### Without an 83(b) Election
Now let's say that the co-founder decides instead not to pay taxes on the restricted stock before it begins to vest. In that case, they will be paying taxes on the shares at the end of the vesting period, five years later. If those million shares are now trading at $2 a share, they will be worth $2 million upon vesting. The co-founder will have to report that amount as ordinary income, minus the $1,000 they paid at the time the shares were granted, paying the highest possible tax rate on the entire gain during the vesting period.
> **Important**
>
> For restricted stock, you must file your 83(b) election within 30 days of receiving your shares. For stock options, you must file 83(b) within 30 days of exercising your options.
## 83(b) Election Tax Strategy
The 83(b) election gives the co-founder the option to pay taxes on the equity upfront before the vesting period starts. This tax strategy allows the co-founder to only pay taxes on the fair market value of the shares, minus the cost of exercising the options. If the fair market value of the shares is equal to their [strike price](https://www.investopedia.com/terms/s/strikeprice.asp), the taxable gain is zero.
The 83(b) election notifies the IRS that the elector has opted to report the difference between the amount paid for the stock and the fair market value of the stock as taxable income. The share value during the five-year [vesting](https://www.investopedia.com/terms/v/vesting.asp) period will not matter as the co-founder won’t pay any additional tax and gets to retain the vested shares. However, if the shares are sold for a profit, a capital gains tax will be applied.
Following our example above, if the co-founder makes an 83(b) election to pay tax on the value of the stock upon issuance, the [tax assessment](https://www.investopedia.com/terms/a/assessedvalue.asp) will be made on the difference between the shares' strike price and their [fair market value](https://www.investopedia.com/terms/f/fairmarketvalue.asp).
If the stock is sold after, say, 10 years for $250,000, the taxable capital gain will be on $249,000 ($250,000 - $1,000 = $249,000).
The 83(b) election makes the most sense when the elector is sure that the value of the shares is going to increase over the coming years. Also, if the amount of income reported is small at the time of granting, an 83(b) election might be beneficial.
In a reverse scenario where the 83(b) election was triggered, and the equity value falls or the company files for bankruptcy, then the taxpayer overpaid in taxes for shares with a lesser or worthless amount. Unfortunately, the IRS does not allow an overpayment claim of taxes under the 83(b) election. For example, consider an employee whose total tax liability upfront after filing for an 83(b) election is $50,000. Since the vested stock proceeds to decline over a four-year vesting period, they would have been better off without the 83(b) election, paying an annual tax on the reduced value of the vested equity for each of the four years, assuming the decline is significant.
Another instance where an 83(b) election would turn out to be a disadvantage will be if the employee leaves the firm before the vesting period is over. In this case, they would have paid taxes on shares that would never be received. Also, if the amount of reported income is substantial at the time of stock granting, filing for an 83(b) election will not make much sense.
## Advantages of Choosing an 83(b) Election
The 83(b) election has major benefits for those [receiving restricted stock](https://www.investopedia.com/articles/financial-advisors/110915/restricted-stock-units-what-know.asp) or property. They can pay taxes upfront on the property's fair market value at the time of grant, potentially lowering the rate compared to when it vests. This upfront taxation can lead to tax savings, especially if the property's value is expected to appreciate significantly.
Furthermore, making the election allows for more favorable tax treatment on future gains, taxing appreciation at the lower capital gains rate rather than ordinary income. Additionally, individuals who make the 83(b) election may have the opportunity to deduct losses if the property's value decreases before vesting, providing a level of tax flexibility and protection.
Overall, the 83(b) election provides a strategy for managing tax liabilities and optimizing tax treatment for restricted property recipients.
## When Is It Beneficial to File an 83(b) Election?
An 83(b) election allows for the prepayment of the tax liability on the total fair market value of the restricted stock at the time of granting. It is beneficial only if the restricted stock's value increases in the subsequent years. Also, if the amount of income reported is small at the time of granting, an 83(b) election might be beneficial.
## What Happens If You Don't Make an 83(b) Election?
Failing to make an 83(b) election can have significant tax consequences for individuals who receive restricted stock or other property subject to vesting. When restricted stock or property vests, you'll be taxed on its value as ordinary income at that time, potentially resulting in higher taxes. Without the election, any future appreciation in the property's value will be subject to capital gains tax upon sale, possibly leading to less favorable tax treatment overall.
## When Is It Detrimental to File an 83(b) Election?
If an 83(b) election was filed with the IRS and the equity value falls or the company files for bankruptcy, then the taxpayer overpaid in taxes for shares with a lesser or worthless amount. Unfortunately, the IRS does not allow an overpayment claim of taxes under the 83(b) election.
Another instance is if the employee leaves the firm before the vesting period is over; then the filing of an 83(b) election would turn out to be a disadvantage as they would have paid taxes on shares they would never receive. Also, if the amount of reported income is substantial at the time of the stock granting, filing for an 83(b) election will not make much sense.
## What Is Profits Interest?
Profits interest refers to an equity right based on the future value of a partnership awarded to an individual for their service to the partnership. The award consists of receiving a percentage of profits from a partnership without having to contribute capital. In effect, it is a form of equity compensation and is used as a means of incentivizing employees when monetary compensation may be difficult due to limited funds, such as with a startup limited liability company (LLC). Usually, this type of worker compensation requires an 83(b) election.
## The Bottom Line
An 83(b) election is a strategic, tax-related decision primarily used by startup founders and employees to manage future tax liabilities on restricted stock. It involves paying taxes upfront on the fair market value of the stock at the time of granting, which can be beneficial if the stock's value increases over time.
An 83(b) election allows the stock owner to take advantage of lower long-term capital gains tax rates rather than higher ordinary [income tax](https://www.investopedia.com/terms/i/incometax.asp) rates, which apply if the stock increases in value and is later sold.
While an 83(b) election provides tax benefits if the stock appreciates, it may lead to overpayment if the stock depreciates or is never fully vested, such as if an employee leaves the company early.
To take advantage of the benefits, it is important to file the 83(b) election form within 30 days of being granted the stock.
Consider your financial situation and the company's future outlook before opting for an 83(b) election, due to its potential risks and benefits.
_**Correction—June 14, 2023:**_ An older version of this article incorrectly stated that someone making an 83(b) election would be taxed according to the cost of exercising their shares. In fact, the tax is based on the difference between the fair market value of the shares and the exercise price.
> **Article Sources**
>
> 1. Internal Revenue Service. "[26 CFR 1.83-2: Election to Include in Gross Income in Year of Transfer](https://www.irs.gov/pub/irs-drop/rp-12-29.pdf)." Pages 1-3.
>
> 2. Internal Revenue Service. "[26 CFR 1.83-2: Election to Include in Gross Income in Year of Transfer](https://www.irs.gov/pub/irs-drop/rp-12-29.pdf)." Pages 1-6.
>
> 3. Internal Revenue Service. "[Topic No. 427, Stock Options](https://www.irs.gov/taxtopics/tc427)."
>
> 4. Fidelity. "[Instructions for Completing IRS Section 83(b) Form](https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/customer-service/instructions-for-completing-irs-section-83b.pdf)."
>
> 5. Internal Revenue Service. "[26 CFR 1.83-2: Election to Include Gross Income in Year of Transfer](https://www.irs.gov/pub/irs-drop/rp-12-29.pdf)."
>
> 6. Internal Revenue Service. "[26 CFR 1.83-2: Election to include in gross income in year of transfer](https://www.irs.gov/pub/irs-drop/rp-12-29.pdf)." Page 6.
>
> 7. Internal Revenue Service. "[Topic No. 409, Capital Gains and Losses](https://www.irs.gov/taxtopics/tc409)."
>
> 8. JPMorgan Chase. "[Stock-Based Compensation and the 83(b) Election](https://www.jpmorgan.com/wealth-management/wealth-partners/insights/stock-based-compensation)." |
8(a) Firm | # 8(a) Firm: Meaning, Purpose, Qualifications
## What is an 8(a) Firm?
An 8(a) firm is a [small business](https://www.investopedia.com/small-business-4427743) that is owned and operated by socially and economically disadvantaged citizens and that has been accepted into the 8(a) Business Development Program. This program is administered by the [Small Business Administration (SBA)](https://www.investopedia.com/terms/s/small-business-administration.asp), the United States agency charged with supporting the growth and development of small businesses. The 8(a) program is designed to help disadvantaged entrepreneurs get government contracts and access the economic mainstream in America.
### Key Takeaways
* 8(a) firms are small businesses that are owned and controlled by socially and economically disadvantaged individuals.
* The (8)a Business Development Program is run and administered by the SBA, or Small Business Administration, with the goal of giving a leg up to specially selected small businesses.
* The 8(a) program helps aspiring entrepreneurs obtain government contracts and also includes mentoring, procurement assistance, training, financial assistance, management assistance, and technical assistance, among other benefits.
* Applicants go through a rigorous application process for 8(a) status. 8 (a) status lasts up to nine years from when it is granted.
## How 8(a) Firm Status Works
The 8(a) status is specially granted by the SBA to any small business that qualifies, making it eligible for financial assistance, training, mentoring, and other forms of assistance. In order to qualify for this special status, businesses must be owned and operated by individuals who are considered socially and economically disadvantaged. These individuals may have been subject to racial or ethnic prejudice or cultural bias.
The 8(a) status is outlined specifically in Section 8(a) of the Small Business Act, and is designed to help small, disadvantaged businesses compete in the general market. The federal government has a stated goal of awarding at least 5% of federal contracting dollars every year to these businesses.
## The Purpose of the 8(a) Business Development Program
One of the main reasons behind the creation of the 8(a) status was to increase business involvement by a broader portion of society. The SBA identifies several groups that are eligible for 8(a) status, including Black Americans, Hispanic Americans, Native Americans, Asian Pacific Americans, and Subcontinent Asian Americans. Someone who is not a member of one of these groups may still get into the program if they can show significant evidence of having been socially disadvantaged—for instance, due to race, ethnic origin, gender, and physical handicap, among other causes.
Through the 8(a) Business Development Program, owners can compete for special contracts, such as sole-source government contracts for which there are no competitive bids, that help level the playing field for their small businesses. These small businesses can use the program to form [joint ventures](https://www.investopedia.com/terms/j/jointventure.asp) with already-established businesses to form mentor-protégé relationships, as well as for management and technical assistance. Businesses must meet certain requirements to be eligible to be a protégé.
## Qualifications for 8(a) Firm Status
In order to qualify to become an 8(a) firm under SBA guidelines, a business must meet the following criteria (effective July 15, 2020):
* It must be a small business.
* It must not have participated in the program before.
* At least 51% of the business must be owned and operated by U.S. citizens who are considered economically and socially disadvantaged.
* The owner's personal net worth must be no higher than $750,000
* The owner's average [adjusted gross income](https://www.investopedia.com/terms/a/agi.asp) (AGI) must be $350,000 or less.
* The owner must have no more than $6 million in assets.
* The owner must be of good character.
* It must show the potential for success and be able to perform successfully on contracts.
[Title 13 Part 124 of the Code of Federal Regulations (CFR)](https://www.ecfr.gov/cgi-bin/text-idx?SID=ee1595e6b78f39b1563ab8a8440bc7cc&mc=true&tpl=/ecfrbrowse/Title13/13cfr124_main_02.tpl) spells out who qualifies for the 8(a) program as well as what counts as being economically and socially disadvantaged.
> **Tip**
>
> Small businesses with 8(a) status can receive sole-source contracts, up to a ceiling of $4 million for goods and services and $6.5 million for manufacturing.
### The first step: getting certified
Owners interested in taking part in the program are encouraged to do an on-line training and self-evaluation course through the [8(a) Business Development Suitability Tool](https://web.sba.gov/sbtn/sbat/8aAssessmentTool.html). The course helps entrepreneurs determine whether or not their company meets the qualifications for the 8(a) program and if it does not, directs them to an appropriate SBA resource.
Before a firm can participate in the 8(a) program, it must first be certified at [certify.SBA.gov](https://certify.sba.gov/). And small businesses that want to use the certification website must have a profile at [SAM.gov](https://www.sam.gov/SAM/), which is where companies register to do business with the U.S. government. (Contact your [local SBA office](https://www.sba.gov/local-assistance/find?type=SBA%20District%20Office&pageNumber=1) if you have questions about applying.) Once you have applied, the administration will send a notification letter explaining whether the business was accepted into the 8(a) program. The certification lasts for nine years—the first four years are considered to be developmental, while the remaining five are deemed to be a transition phase.
Small businesses that gain 8(a) status are subject to annual reviews in order to keep the designation and their good standing in the program. During these reviews, the business owner has to draw up business plans and undergo systematic evaluations. Entrepreneurs who have secured 8(a) firm status say that the application process can be lengthy and rigorous, having prior experience with government contracts can be helpful, and working hard to take advantage of the program's benefits can make the experience very rewarding.
> **Article Sources**
>
> 1. Small Business Administration. "[8(a) Business Development Program](https://www.sba.gov/federal-contracting/contracting-assistance-programs/8a-business-development-program)." Accessed Mar. 9, 2021. |
90-Day Letter | # 90-Day Letter: What It Means, How it Works
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*— Investopedia / Ryan Oakley*
## DEFINITION of 90-Day Letter
90-Day Letter is an [IRS](https://www.investopedia.com/terms/i/irs.asp) notice stating that there was a discrepancy or error within an individual's taxes and they will be assessed unless petitioned. The taxpayer has 90 days to respond, otherwise the audit deficiencies will result in reassessment. Also known as a Notice of Deficiency.
## BREAKING DOWN 90-Day Letter
Once you receive your notice, you have 90 days (150 days if the notice is addressed to a person who is outside the country) from the date of the notice to [file a petition with the Tax Court](https://www.investopedia.com/articles/tax/09/tax-court-last-resort.asp), if you want to challenge the tax the IRS proposed, according to the agency. These notices are usually sent after or audit, in the case of people who fail to file a tax return or who have [unreported income](https://www.investopedia.com/terms/u/underreporting.asp).
## What The Notice Means
If you don't dispute the accuracy of the assessment the Internal Revenue Service has made, you won’t need to amend your tax return unless you have additional income, expenses, or credits that you want to report. In that case, all you need to do is sign [Form 5564, Notice of Deficiency](https://www.investopedia.com/terms/n/notice-of-deficiency.asp) and return it to the IRS with a check attached to avoid additional interest and or penalties.
If you agree with the findings but have additional income, expenses, or credits to claim, it will be necessary to amend your original tax return with Form 1040-X. You can do this through your online tax prep service or your tax professional or fill out the form yourself.
It gets more complicated if you disagree with the IRS findings. If you think the IRS notice is incorrect, incomplete or otherwise mistaken, you can contact them with additional information that will shed light on the case. You have 90 days from the date of the notice to dispute the claim. You can ask the [Tax Court](https://www.investopedia.com/terms/t/taxcourt.asp) to reassess or correct or eliminate the liability proposed by the deficiency notice. During the 90 days and any period the case is being reconsidered the IRS by law can't assess or put your account into collection.
Many taxpayers use a tax professional or attorney to handle the dispute process if the amount in question is significant.
If you lose the appeal and don't or can't pay, the government can file a federal tax lien against your wages, personal property, or your bank account. This is a claim against the assets, not the seizure of them. That happens when a federal tax levy occurs and the IRS actually seizes your property. Payment plans can also be worked out to avoid liens and seizure.
> **Article Sources**
>
> 1. Internal Revenue Service. "[Understanding Your CP3219A Notice](https://www.irs.gov/individuals/understanding-your-cp3219a-notice)." Accessed Nov. 3, 2020.
>
> 2. Internal Revenue Service. "[How Do I Avoid a Levy](https://www.irs.gov/businesses/small-businesses-self-employed/how-do-i-avoid-a-levy)?" Accessed Nov. 3, 2020. |
90/10 Strategy | # 90/10 Investment Strategy by Buffett: Definition, Pros, Cons, & Tips
## What Is the 90/10 Strategy?
Legendary investor [Warren Buffett](https://www.investopedia.com/articles/01/071801.asp) proposed the "90/10" strategy in his 2013 chairman's letter to Berkshire Hathaway shareholders. The strategy calls for putting 90% of one's investment capital into low-cost stock index funds and the remaining 10% in low-risk government bonds.
It differs from more traditional allocations like 60/40, which dedicate a larger portion to bonds, especially as investors age. By relying mostly on equities for growth, the 90/10 strategy offers higher potential rewards but also carries more risk, making it better suited for long-term investors with higher risk tolerance.
### Key Takeaways
* The 90/10 strategy suggests investing 90% in low-cost stock index funds and 10% in short-term government bonds.
* Warren Buffett highlighted this strategy in his 2013 letter to Berkshire Hathaway shareholders.
* This approach is aggressive and may not suit investors with low risk tolerance or nearing retirement.
* The simplicity of the 90/10 strategy makes it appealing for DIY investors seeking minimal maintenance.
* Despite its potential for higher returns, the 90% allocation to stocks can lead to significant market volatility.
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*— Alison Czinkota / Investopedia*
## Understanding the Mechanics of the 90/10 Strategy
Warren Buffett's shareholders and many investors eagerly await his annual letters for insights. His 2013 letter covered a variety of topics, with a single paragraph devoted to the 90/10 strategy. Nonetheless, that was sufficient to bring it to wide attention, which continues to this day. Here is what he had to say:
> My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I've laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife's benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals—who employ high-fee managers.
## Practical Application of the 90/10 Strategy
An investor with a $100,000 portfolio who wants to employ a 90/10 strategy could invest $90,000 in an S&P 500 index mutual fund or [exchange-traded fund (ETF)](https://www.investopedia.com/terms/e/etf.asp), with the remaining $10,000 going toward [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp).
Treasury bills, or T-bills, are short-term government debts, maturing within a year. They can be purchased directly from the government, through brokers, or in the form of a mutual fund or an ETF. Like Treasury notes and bonds, which have longer maturities, they are generally considered the safest of all investments.
To calculate the performance of a 90/10 portfolio, you would multiply each portion by its return for the year. For example, if the S&P 500 returned 10% for the year and Treasury bills paid 4%, the calculation would be 0.90 x 10% + 0.10 x 4%, resulting in a 9.4% return overall.
### Note
Exchange traded funds, or ETFs, work much like mutual funds but are traded on stock exchanges like stocks.
## Minimizing Investment Fees With the 90/10 Strategy
One reason Buffett advocates investing through index funds is that they typically have rock-bottom costs. That's because they are [passively managed](https://www.investopedia.com/terms/p/passivemanagement.asp). Rather than employ investment managers to make decisions on which stocks to buy and when to sell them, these funds simply try to replicate a particular stock index like the S&P 500, which is based on the stocks of 500 major U.S. corporations.
Studies show that few managers beat an index's performance annually, and even fewer do so consistently.
That doesn't mean all index funds are alike. Some do a better job than others at keeping their costs down. So in choosing among S&P 500 index funds, you should consider both their performance (which is likely to be pretty close) and their annual [expense ratios](https://www.investopedia.com/terms/e/expenseratio.asp) (which may be significantly different). All else being equal, a fund with a lower expense ratio will be a better deal.
In addition, some mutual funds, typically sold through brokers, charge sales commissions, or [loads](https://www.investopedia.com/terms/l/load.asp), when you invest. That will immediately take a cut out of your investment. You can avoid commissions by buying [no-load funds](https://www.investopedia.com/terms/n/no-loadfund.asp) directly from the fund company or from a discount broker that offers them.
## Evaluating the Risks and Criticisms of the 90/10 Strategy
The main criticism of the 90/10 allocation is its high risk and potential for volatility. By contrast, another well-known strategy suggests subtracting your age from 110 and putting that percentage into stocks, with the rest going into bonds. At age 40, for example, that would mean 70% stocks, 30% bonds. At age 65, it would be 45% stocks, 55% bonds. (Similar guidelines use 100 or 120 in place of 110.)
With such a heavy concentration in stocks, the 90/10 portfolio is exposed to market fluctuations and can experience significant short-term losses during market downturns. This can be emotionally challenging for investors and may not be suitable for those with a low risk tolerance or a shorter investment horizon.
As financial writer Walter Updegrave put it in a 2018 column, "what I believe is the major question anyone thinking of adopting this strategy needs to resolve before adopting it: Will you be willing, and able, to stick with such an aggressive stocks-bonds mix when the markets are in turmoil or even in the midst of a harrowing tailspin?"
That's an especially pertinent question for anyone nearing, or already in, retirement.
## Exploring Alternatives to the 90/10 Investing Strategy
The 90/10 strategy contrasts with the more [traditional 60/40 portfolio](https://www.investopedia.com/articles/financial-advisors/011916/why-6040-portfolio-no-longer-good-enough.asp), which allocates 60% to equities and 40% to bonds. Both strategies aim to balance growth and risk, but they do so in different ways.
The 60/40 portfolio is a popular choice for those seeking balance. By spreading investments across both stocks and bonds more evenly, it aims to provide steady growth while reducing volatility. The bonds in a 60/40 portfolio are intended to act as a larger buffer during [market downturns](https://www.investopedia.com/timeline-of-stock-market-crashes-5217820), cushioning the impact of stock market declines. This strategy has historically been favored by investors who want a moderate level of risk and are looking for a mix of income and capital appreciation.
One of the key differences between the two strategies is how they handle market risk. The 60/40 portfolio tends to be more conservative. The 90/10 strategy is more aggressive, with a stronger emphasis on growth, which can lead to higher returns over time but also comes with greater short-term risk. Investors holding a 90/10 allocation are embracing the risk as a profit opportunity, while investors holding a 60/40 allocation are shying away from risk a little more.
## Ideal Investors for the 90/10 Strategy
Here are the types of investors best suited for the 90/10 strategy:
* **Long-Term Investors**: The 90/10 strategy is ideal for individuals with a long investment horizon, such as those in their 20s, 30s, or 40s who are saving for retirement. These investors have time on their side, allowing them to ride out market volatility and benefit from the long-term growth potential of equities.
* **Investors with High Risk Tolerance**: The 90/10 strategy best suits those who can comfortably endure market fluctuations and are not easily rattled by [short-term losses](https://www.investopedia.com/terms/short-termloss.asp). By accepting a higher level of risk by investing heavier in equities, they position themselves for potentially higher returns compared to more conservative strategies like the 60/40 portfolio.
* **DIY Investors**: The simplicity of the 90/10 strategy makes it attractive to self-directed investors who prefer a hands-off approach. With 90% invested in low-cost index funds and 10% in cash or bonds, this strategy requires minimal maintenance and is easy to implement.
* **Investors with Confidence in Market Growth**: Individuals who strongly believe in the stock market's long-term growth are well-suited for the 90/10 strategy. They believe in the [economy's](https://www.investopedia.com/economy-4689801) future and in innovation and corporate profits boosting stock prices.
## What Are the Advantages of a 90/10 Investment Allocation?
The primary advantage of a 90/10 allocation is the potential for higher long-term returns due to the significant exposure to stocks. This strategy may be suitable for investors with a high risk tolerance and a long investment horizon, such as those saving for a retirement decades in the future.
## Is the 90/10 Allocation Suitable for Conservative Investors?
Generally, the 90/10 allocation is considered aggressive and is not suitable for conservative investors. Conservative investors typically prioritize capital preservation over potential growth and may find the strategy too risky or volatile.
## How Often Should I Rebalance a 90/10 Investment Portfolio?
Rebalancing should be done periodically, typically annually or when your portfolio deviates significantly from your target allocation. It involves adjusting your holdings to maintain the desired asset allocation (in this case, 90/10 stocks/bonds). Consider setting a threshold where you rebalance regardless of the passage of time; for example, anytime your portfolio drifts above 95% stock or below 85% stock, you rebalance.
## The Bottom Line
A 90/10 investment portfolio allocation, as Warren Buffett recommends, puts 90% in low-cost stock index funds and 10% in short-term government bonds. It offers strong long-term growth potential thanks to its heavy stock exposure, but comes with more volatility than traditional mixes like 60/40.
This strategy works best for long-term investors with high risk tolerance who can handle market swings and rebalance regularly, but it may suit conservative investors or those with shorter time horizons.
> **Article Sources**
>
> 1. Berkshire Hathaway Inc. "[2013 Annual Report](https://www.berkshirehathaway.com/2013ar/2013ar.pdf)." Page 20.
>
> 2. TreasuryDirect. "[Treasury Bills](https://www.treasurydirect.gov/marketable-securities/treasury-bills/)."
>
> 3. S&P Dow Jones Indices. "[SPIVA U.S. Scorecard](https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2022.pdf)." Page 5.
>
> 4. CNNMoney. "[Should I Follow Warren Buffett's 90/10 Investing Strategy?](https://money.cnn.com/2018/02/21/retirement/warren-buffett-investing-strategy/index.html)" |
A-B Trust | # A-B Trust: Definition, How It Works, and Tax Benefits
:max_bytes(150000):strip_icc()/GettyImages-13341458241-ff69fbb883674c309c1dad18e227d67b.jpg)
*— shironosov / Getty Images*
## What Is an A-B Trust?
An A-B trust is a joint trust created by a married couple in order to minimize estate taxes. It is formed with each spouse placing [assets](https://www.investopedia.com/terms/a/asset.asp) in the [trust](https://www.investopedia.com/terms/t/trust.asp) and naming the final [beneficiary](https://www.investopedia.com/terms/b/beneficiary.asp)—that is, anyone except the other spouse. The trust gets its name from the fact that it splits into two separate entities when one spouse dies. Trust A is the survivor's trust and trust B is the decedent's trust. A-B trusts have become less popular because the estate tax exemption covers most estates.
### Key Takeaways
* An A-B trust is a joint trust created by a married couple.
* Upon one spouse's death, the trust splits into a survivor portion (the A trust) and a bypass portion (the decedent's trust, or B trust).
* Via the split, the A-B trust effectively minimizes estate taxes and defers them until after the death of the surviving spouse.
* The surviving spouse has limited control over the decedent's trust but the terms of the decedent's trust can be set to allow the surviving spouse to access the assets, and even draw income from them.
* A-B trusts are no longer widely used as the estate tax exemption, which is now indexed to inflation, is sufficient for most estates.
## Understanding an A-B Trust
[Estate taxes](https://www.investopedia.com/terms/e/estatetax.asp) can take a sizable portion of a deceased person's assets. For example, consider a married couple who has an estate worth $20 million by the time one of the spouses dies. The surviving spouse is left with the whole $20 million, which is not taxed due to the [unlimited marital deduction](https://www.investopedia.com/terms/u/unlimited-marital-deduction.asp) for assets flowing from a deceased spouse to a surviving spouse.
But then, the other spouse dies, leaving the money to their children. The taxable portion of the estate (the amount that exceeds the 2025 exemption threshold of $13.99 million will be $6.01 million). This means that $6.01 million will be taxed at 40% ($3.61 million), leaving $17.6 million ($13.99 million + $3.61 million) for the beneficiaries.
To circumvent an estate from being subject to such steep taxes, many married couples set up a trust under their [last will and testaments](https://www.investopedia.com/terms/l/last-will-and-testament.asp) called an A-B trust. In the example above, if the couple instead had an A-B trust, the death of the first spouse would not trigger any estate taxes as a result of the lifetime exclusion; however, a sum of money equal to the current exemption amount ($13.99 million) will be transferred into an [irrevocable trust](https://www.investopedia.com/terms/i/irrevocabletrust.asp) called the bypass trust or B trust. This trust is also known as the decedent’s trust. The remaining amount, $6.01 million, will be transferred to a survivor’s trust, or A trust, which the [surviving spouse will have complete control](https://www.investopedia.com/terms/m/marital-trust.asp) over. The estate tax on the A trust is deferred until after the death of the surviving spouse.
It's important to note that if the surviving spouse elected portability when the first spouse died, the portion of the first spouse's exemption would pass to the surviving spouse, in this case, $13.99 million, which means that the entire $20 million would pass tax-free to the beneficiaries, as the combined exemption of both spouses would be $27.98 million. This removes the need for an A-B trust.
## Benefits of an A-B Trust
The A trust contains the surviving spouse’s property interests, but they have limited control over the assets in the deceased spouse's trust. However, this limited control over the B trust will still enable the surviving spouse to live in the couple's house and draw income from the trust, provided these terms are stipulated in the trust.
While the surviving spouse can access the bypass trust, if necessary, the assets in this trust will bypass their taxable estate after they die. After the surviving spouse dies, only the assets in the A trust are subject to estate taxes. If the [estate tax exemption](https://www.investopedia.com/estate-tax-exemption-2021-definition-5114715) for this spouse is also $13.99 million for 2025 and the value of assets in the survivor’s trust is still valued at $6.01 million, none of it will be subject to estate tax.
The federal tax exemption is transferable between married couples through a designation referred to as the portability of the estate tax exemption. If one spouse dies, the unused portion of their estate tax exemption can be transferred and added to the estate tax exemption of the surviving spouse. Upon the death of the surviving spouse, the property in the decedent's trust passes tax-free to the beneficiaries named in this trust.
This is because the B trust uses up the estate tax exemption of the spouse who died first, so any funds left in the decedent’s trust will be passed tax-free.
> **Important**
>
> The decedent’s trust is not considered part of the surviving spouse's estate for purposes of the estate tax, so double taxation is avoided.
## Who Uses an A-B Trust?
While A-B trusts are a great way to minimize estate taxes, they are not used much today. They were popular when the estate tax—which hadn't been adjusted for years—could be triggered on estates as small as $1 million or $2 million. Nowadays, each individual has a combined lifetime [federal gift tax](https://www.investopedia.com/terms/g/gifttax.asp) and estate tax exemption of $13.99 million ($27.98 million for married couples) in 2025.
So only people with estates valued over $13.99 million ($27.98 million for married couples) will opt for an A-B trust in 2025. With the portability provision, a surviving spouse can include the tax exemption of their late spouse, which can be transferred tax-free to beneficiaries if filed within the 9-month period.
## What Are the Benefits of an A-B Trust?
The benefits of an A-B trust include [death tax](https://www.investopedia.com/terms/d/death-taxes.asp) exemptions, built-in trust protection, and the portability of exemption. Disadvantages include maintenance costs, complex structure, and the possibility of large [capital gains](https://www.investopedia.com/terms/c/capitalgain.asp) taxes after both spouses die.
## Why Is an A-B Trust Obsolete?
A-B trusts aren't completely obsolete, but they aren't as common as they once were. This is due to changes in estate tax law—that is, couples now have high estate tax exemptions. (In 2025, it's $13.99 million for an individual, or $27.98 million for a married couple who uses portability of exemption.)
## What Is Another Name for an A-B Trust?
A-B trusts are also known as bypass trusts or credit shelter trusts. The goal of these trusts is to reduce married couples' estate taxes.
## The Bottom Line
A-B trusts are beneficial in [estate planning](https://www.investopedia.com/terms/e/estateplanning.asp) to reduce taxes. However, they are less popular now that there are higher estate tax exemptions. (In 2025, it's $13.99 million for an individual, and $27.98 million for a married couple who uses portability of exemption.) For those with [estates](https://www.investopedia.com/terms/e/estate.asp) that exceed these limits, though, it's likely worth it to work with an advisor who can help you find ways to minimize taxes when passing on your assets to your [heirs](https://www.investopedia.com/terms/h/heir.asp).
> **Article Sources**
>
> 1. Internal Revenue Service. "[Estate Tax](https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax)."
>
> 2. Internal Revenue Service. "[Frequently Asked Questions on Estate Taxes](https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-estate-taxes)." |
A-Shares | # Understanding China A-Shares: Definition, History & Differences from B-Shares
## What Are China A-Shares?
China A-shares are the stock shares of mainland [China-based companies](https://www.investopedia.com/10-biggest-chinese-companies-5077387) that trade on the two Chinese stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). Historically, China A-shares were only available for purchase by mainland citizens due to China's restrictions on foreign investment.
Since 2003, some foreign institutions have been allowed to buy these shares through the [Qualified Foreign Institutional Investor](https://www.investopedia.com/terms/q/qualified-foreign-institutional-investor-qfii.asp) (QFII) system. Established in 2002, the QFII program allows specified licensed international investors to buy and sell on mainland China's stock exchanges.
A-shares are also known as domestic shares because they use the Chinese renminbi (RMB) for valuation.
### Key Takeaways
* China A-shares are shares of mainland China-based companies traded in RMB on the Shanghai and Shenzhen Stock Exchanges.
* Initially restricted to local investors, A-shares opened to select foreign investors through the Qualified Foreign Institutional Investor (QFII) system in 2003.
* B-shares differ from A-shares by being quoted in foreign currencies and more accessible to foreign investors.
* The Shanghai Stock Exchange's SSE 180 Index measures key performance of A-shares, representing a diverse mix of sectors and sizes.
* Efforts to increase foreign access to A-shares continue as China transitions towards a more advanced economy.
## Comparing China A-Shares and B-Shares
China A-shares are different from B-shares. A-shares are only quoted in RMB, while B-shares are quoted in foreign currencies, such as the U.S. dollar, and are more widely available to foreign investors. Foreign investors may have difficulty accessing A-shares because of Chinese government regulations, and Chinese investors may have difficulty accessing B shares most notably for currency-exchange reasons. Some companies opt to have their stock listed on both the A-shares and B-shares market.
Due to the limited access of Chinese investors to B-shares, the stock of the same company often trades at much higher valuations on the A-shares market than on the B-shares market. Although foreign investors may now invest in A-shares, there is a monthly 20% limit on repatriation of funds to foreign countries.
The Shanghai Stock Exchange (SSE) publishes the key performance index for A-shares, known as the [SSE 180 Index](https://www.investopedia.com/terms/s/sse-composite.asp). In composing the index, the exchange selects 180 stocks listed on the SSE. The selection covers different sectors, sizes, and liquidity to ensure proper representation. As a result, the index's performance shows the overall state and operations of the Shanghai securities market.
## Evolution and Historical Context of China A-Shares
The index has experienced significant ups and downs since its start in 1990, including major changes in 2002. Despite fluctuations, it has grown as the Chinese economy developed. The years 2015 to 2016 were tough, with the index dropping 21.55% in one year by July 2016.
As China grows from an emerging market to an [advanced economy](https://www.investopedia.com/terms/a/advanced-economies.asp), there is substantial demand for Chinese [equity](https://www.investopedia.com/terms/e/equity.asp). Stock exchange regulators continue efforts to make A-shares more broadly available to foreign investors and have them recognized by the global investing community.
In June 2017, the MSCI Emerging Markets Index announced a plan to gradually add [222 China A large-cap stocks](https://www.cnbc.com/2017/06/20/msci-adds-mainland-chinese-a-shares-to-key-emerging-markets-index-on-fourth-review.html). In May 2018, the index began to [partially include China's large-cap A shares](https://www.msci.com/msci-china-a-inclusion), which make up 5% of the index. Full inclusion would make up 40% of the index.
Countries like China need to open their markets to global investors to remain competitive and succeed economically. China A-shares provide an alternative investment for those interested in [trading in Chinese securities](https://www.investopedia.com/ask/answers/05/foreignstocks.asp). |
AAA | # AAA Credit Rating Explained: Definition, Criteria, and Bond Types
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*— Investopedia / Joules Garcia*
## What Is a AAA Credit Rating?
The AAA credit rating is the highest rating possible for [bonds](https://www.investopedia.com/terms/b/bond.asp) and indicates a bond issuer's noteworthy [creditworthiness](https://www.investopedia.com/terms/c/credit-worthiness.asp) and financial strength. It communicates to investors a minimal risk of default. Leading agencies such as [Standard & Poor’s (S&P)](https://www.investopedia.com/terms/s/sp.asp) and [Fitch Ratings](https://www.investopedia.com/terms/f/fitch-ratings.asp) issue the AAA rating. [Moody’s](https://www.investopedia.com/terms/m/moodys.asp) issues its Aaa rating under the same circumstances. These ratings can change with changes in financial conditions. Both S&P and Fitch have downgraded the credit rating of the United States due to the agencies' views of the nation's financial stability and the government's questionable policy decisions.
### Key Takeaways
* AAA Credit Rating Defined: The AAA credit rating is the highest rating possible for bonds, indicating exceptional creditworthiness with minimal risk of default. It is assigned by leading agencies like Standard & Poor's and Fitch, and denotes the issuer's strong financial health.
* Benefits of AAA-rated Bonds: Bonds with AAA ratings are considered secure investments due to low default risk, but as a trade-off, they typically offer lower yields compared to bonds with lower credit ratings. This balance reflects the relationship between risk and return.
* Impact of Ratings on Borrowing Costs: High credit ratings, like AAA, allow issuers to borrow at lower costs, providing them with a competitive edge. Lower borrowing costs can enable companies to expand operations or undertake new projects more cost-effectively.
* Variety in AAA-Rated Bonds: AAA-rated bonds can include both municipal and corporate bonds, with some secured by collateral and others unsecured. Each type carries different risk profiles affecting yield and investor appeal.
* Credit Ratings and Financial Stability: The global credit crisis in 2008 affected many AAA ratings, illustrating the potential vulnerability of such ratings to economic conditions. High ratings are not immune to downgrades due to financial instability or policy decisions, as seen in the U.S. downgrade by S&P in 2011 and by Fitch in 2023.
## Exploring the Benefits and Implications of AAA Credit Ratings
[Credit ratings](https://www.investopedia.com/terms/c/creditrating.asp) are assessments or opinions of the creditworthiness of a business or government. They indicate how likely the subject is to meet financial obligations and pay bills. Investors can use these ratings to decide whether countries and bond offerings are safe investments. These ratings are assigned by credit rating agencies, notably S&P, Moody's, and Fitch.
AAA and Aaa ratings are considered to be [investment grade](https://www.investopedia.com/ask/answers/what-does-investment-grade-mean/). Because they are seen as low-risk for [default](https://www.investopedia.com/terms/d/default2.asp), these bonds offer investors lower [yields](https://www.investopedia.com/terms/y/yield.asp) compared to others with similar [maturity](https://www.investopedia.com/terms/m/maturity.asp) dates. Default means a bond [issuer](https://www.investopedia.com/terms/i/issuer.asp) fails to make [interest](https://www.investopedia.com/terms/i/interest.asp) payments or repay the [principal](https://www.investopedia.com/terms/p/principal.asp) on time.
AAA ratings are given to government [debt](https://www.investopedia.com/terms/d/debt.asp) and companies’ corporate bonds. The 2008 [credit crisis](https://www.investopedia.com/terms/c/credit-crisis.asp) caused many companies, including General Electric ([GE](https://www.investopedia.com/markets/quote?tvwidgetsymbol=GE)), to lose their AAA ratings. As of August 2023, only two companies held the AAA rating outright: Microsoft ([MSFT](https://www.investopedia.com/markets/quote?tvwidgetsymbol=MSFT)) and Johnson & Johnson ([JNJ](https://www.investopedia.com/markets/quote?tvwidgetsymbol=JNJ)). Apple ([AAPL](https://www.investopedia.com/markets/quote?tvwidgetsymbol=AAPL)) is split, with an Aaa rating by Moody’s and an AA+ (one notch below AAA) from S&P.
Even the United States suffered a ratings cut by S&P, to AA+ in 2011—losing its vaunted AAA status due to political infighting over raising the [debt ceiling](https://www.investopedia.com/terms/d/debt-ceiling.asp). Moody’s and Fitch maintained the U.S. at Aaa and AAA ratings, respectively. Fitch downgraded the U.S. rating from AAA to AA+ in August 2023. The agency cited potential issues with financial deterioration over the next three years and rising [national debt](https://www.investopedia.com/updates/usa-national-debt/).
> **Important**
>
> Investors should balance AAA-rated bonds with higher-yield options like corporate bonds to diversify fixed-income exposure.
## Examining Different Types of AAA-Rated Bonds
### Municipal
[Municipal bonds](https://www.investopedia.com/terms/m/municipalbond.asp) can be issued as either revenue bonds or general obligation bonds, with each type relying on different sources of income.
Revenue bonds, for example, are paid using fees and other specific income-generating sources, like city pools and sporting venues. On the other hand, general obligation bonds are backed by the issuer’s ability to raise [capital](https://www.investopedia.com/terms/c/capital.asp) through levying taxes. State bonds rely on state income taxes, while local school districts depend on property taxes.
### Secured and Unsecured
Issuers can sell both secured and unsecured bonds. Each type of bond carries with it a different risk profile.
A [secured bond](https://www.investopedia.com/terms/s/securedbond.asp) means that a specific asset is pledged as [collateral](https://www.investopedia.com/terms/c/collateral.asp) for the bond, and the [creditor](https://www.investopedia.com/terms/c/creditor.asp) has a claim on the [asset](https://www.investopedia.com/terms/a/asset.asp) if the issuer defaults. Secured bonds might be backed by assets like equipment, machinery, or real estate. Secured collateralized offerings may have a higher credit rating than unsecured bonds sold by the same issuer.
Conversely, [unsecured](https://www.investopedia.com/terms/u/unsecured.asp) bonds are simply backed by the issuer’s promise to pay. Therefore, the [credit rating](https://www.investopedia.com/terms/c/creditrating.asp) of such instruments relies heavily on the issuer’s income sources and business outlook.
## Advantages of Holding a AAA Credit Rating
A high credit rating reduces borrowing costs for issuers. Therefore, it stands to reason that companies with high ratings are better positioned to borrow large sums of money than [fixed-income](https://www.investopedia.com/terms/f/fixedincome.asp) instruments with lesser credit ratings. And a low cost of borrowing affords firms a substantial competitive advantage by letting them easily access credit to grow their businesses.
For example, a business may use the incoming funds from a new bond issue to launch a new product line, set up a shop in a new location, or acquire a competitor. All of these initiatives can help a company increase its market share and thrive over the long haul.
## Why Is a Credit Rating So Important?
The level of credit rating that an issuer receives has significant implications on the cost of borrowing in the open market. The better the credit rating—with AAA being the best—the lower the cost to borrow, and vice versa.
As an [investor](https://www.investopedia.com/terms/i/investor.asp), you’ll need to balance the risk you’re willing to take against the yield you’re seeking.
## Who Decides What Credit Rating a Debt Issuer Receives?
There are three major credit rating agencies: Standard & Poor’s (S&P), Moody’s, and Fitch. They assess a debt issuer’s creditworthiness and ability to pay interest and principal on bonds based on multiple factors, such as the company’s cash flow, the amount of other outstanding debt, and the business outlook for the issuer, to name just a few criteria.
## What Does the AAA Credit Rating Mean?
The AAA credit rating is only given to the most creditworthy debt issuers and allows investors to gauge the amount of risk in their fixed-income [portfolio](https://www.investopedia.com/terms/p/portfolio.asp). Conservative investors will typically sacrifice return or yield to own the highest credit rating issues available.
## Conclusion: The Impact of AAA Ratings on Borrowing Costs
AAA/Aaa ratings are the highest ratings issued by the credit-rating agencies for bonds by S&P, Moody’s, and Fitch. They indicate the lowest risk of default and the highest degree of creditworthiness and can mean lower borrowing costs (and, unfortunately, yields). Conservative investors look to AAA ratings despite their lower return potential as compared to issues with lower ratings and higher yields. The AAA rating can change if economic factors or financial conditions affect the financial stability, safety, and outlook of a company or organization. For instance, the credit rating of the U.S. government was dropped in 2011 and 2023 due to its policy decision-making and financial position.
> **Article Sources**
>
> 1. Fitch Ratings. “[Fitch Downgrades GE and GE Capital to ‘BBB’; Outlook Stable](https://www.fitchratings.com/research/non-bank-financial-institutions/fitch-downgrades-ge-ge-capital-to-bbb-outlook-stable-12-04-2020).”
>
> 2. Investor's Business Daily. "[2 Remaining AAA-Rated Companies Shine As U.S. Gets Downgraded](https://www.investors.com/etfs-and-funds/sectors/sp500-companies-cling-to-aaa-rating-as-u-s-risks-being-a-deadbeat/)."
>
> 3. Microsoft. “[Investor Relations: Frequently Asked Questions: What Is the Credit Rating of Microsoft?](https://www.microsoft.com/en-us/Investor/FAQ.aspx)”
>
> 4. Yahoo! “[Johnson & Johnson—Moody’s Affirms J&J’s Aaa Rating; Negative Outlook](https://www.yahoo.com/now/johnson-johnson-moodys-affirms-j-152705591.html).”
>
> 5. S&P Global Ratings. "[Apple Inc.'s Senior Unsecured Notes Assigned 'AA+' Issue-Level Rating](https://disclosure.spglobal.com/ratings/jp/regulatory/article/-/view/type/HTML/id/2983149)."
>
> 6. National Credit Union Administration. "[Impact of US Debt Downgrade](https://ncua.gov/regulation-supervision/letters-credit-unions-other-guidance/impact-us-debt-downgrade)."
>
> 7. Fitch Ratings. "[Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from "AAA"; Outlook Stable](https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023)." |
AARP | # AARP: Overview, Affiliates, Lobbying for Members Age 50+
> **Definition**
>
> AARP is a nonprofit organization that addresses and advocates for the needs of people who are 50 and older.
## What Is AARP?
AARP is America's leading organization for people aged 50 and older. It is an association that provides benefits, marketing services, and lobbying on behalf of members. Previously known as the American Association of Retired Persons, it was founded in 1958 by retired educator Dr. Ethel Percy Andrus. AARP is a [nonprofit](https://www.investopedia.com/terms/n/non-profitorganization.asp), nonpartisan association with a membership of nearly 38 million.
### Key Takeaways
* AARP is a nonprofit, nonpartisan organization with a mission to empower retired people to choose how they live as they age.
* The organization offers membership benefits including discounts, healthcare options, insurance products, and learning resources.
* AARP is a powerful organization, with nearly 38 million active members and a strong lobbying presence in Washington and state capitals.
## How AARP Works
AARP provides information, education, research, advocacy, and community services through a nationwide network of local chapters and experienced volunteers. It focuses on consumer issues, economic security, work, health, and independent living issues. AARP engages in legislative, judicial, and consumer advocacy in these areas, but it does not make campaign contributions to endorse political candidates.
It is considered a powerful lobbying group as well as a successful business, selling life and health insurance, [investment products](https://www.investopedia.com/terms/i/investment-product.asp), and other financial and non-financial services. It is also an independent publisher, offering _Modern Maturity_ magazine and the monthly _AARP Bulletin_.
AARP produced $1.85 billion in revenue in 2023, which came from a variety of endeavors, including advertising revenue from its publications and royalties for licensing its name and logo. However, membership fees represent the most significant source of [revenue](https://www.investopedia.com/terms/r/revenue.asp).
It is registered as a 501(c)(4) nonprofit by the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp), which means it is permitted to engage in lobbying. It also administers some 501(c)(3) public charity operations, such as the AARP Foundation, while some of its other operations are for-profit.
> **Fast Fact**
>
> AARP members can be found in every congressional district in the U.S.
## AARP Affiliates
There are several AARP-affiliated organizations, and they include the following:
* The AARP Foundation is a nonprofit charity that assists people over age 50 who may be at economic and social risk. There are other divisions within the organization, including the AARP Experience Corps, which encourages tutoring and the mentorship of children, and the AARP Institute, which holds its gift annuity funds.
* AARP Services develops and manages new products and services and is for-profit.
* Legal Counsel for the Elderly is a nonprofit that provides legal services for seniors in Washington, D.C.
* AARP Financial Services holds AARP real estate and is for-profit.
* The AARP Insurance Plan administers some AARP group insurance plans.
AARP also has many other initiatives, including:
* Promoting driver safety (AARP Driver Safety)
* Producing television programming that targets seniors
* Tax advising and assistance
* Fraud prevention and consumer protection
* Sponsorships that support social causes, such as food insecurity
* Nonpartisan voter engagement
AARP manages outreach programs that address housing issues and social isolation among seniors. AARP has also initiated and managed programs that advocate for the strengthening of [Social Security](https://www.investopedia.com/terms/s/socialsecurity.asp) and [Medicare](https://www.investopedia.com/terms/m/medicare.asp).
## Criticism of AARP
AARP is one of the strongest lobbying groups in America. Its efforts often receive attention for exerting its influence in Washington, D.C., and in state capitals. Its nonprofit operations also receive millions of dollars per year in the form of federal grants.
Though the organization is nonpartisan, some argue that its positions fall into the more liberal part of the political spectrum. These include things like AARP's support for government assistance programs for retirees, opposition to privatizing Social Security, and commitment to diversity, equity, and inclusion in its workforce.
## What Does AARP Stand for?
The acronym AARP originally stood for the American Association of Retired Persons. The organization officially changed its name to AARP in 1999 as a way of recognizing that many members were not yet retired or continued to work part time.
## How Old Do You Need to Be to Join AARP?
Though the mission of AARP focuses on serving and advocating for the needs of those ages 50 and above, adults 18 years and older are eligible for membership. All members can access AARP benefits except those that are legally or contractually restricted by age, such as age-restricted insurance plans.
## What Political Candidates Does AARP Support?
AARP is a nonpartisan organization that does not make contributions to campaigns or political parties and does not endorse candidates. The organization advocates for voter engagement and lobbies on issues that impact Americans over the age of 50. Some of these issues include legislation to regulate Social Security, Medicare, health insurance access, tax deductions, prescription drug costs, and age discrimination in the workplace.
## The Bottom Line
AARP is a nonprofit organization that promotes the well-being and interests of those over age 50. It is nonpartisan, meaning it doesn't support political campaigns or endorse political candidates. It does, however, have a robust lobbying presence at the state and federal levels on issues that impact older Americans and retirees, such as Social Security and health insurance access. It also offers many benefits to members, such as tax assistance, retail and travel discounts, insurance products, fraud prevention, and education.
> **Article Sources**
>
> 1. AARP. "[About AARP](https://www.aarp.org/what-we-do/)."
>
> 2. AARP. "[About AARP Our Social Impact](https://www.aarp.org/about-aarp/company/social-impact/)."
>
> 3. AARP Press Room. "[Key Dates in AARP History](https://press.aarp.org/timeline)."
>
> 4. AARP. "[AARP 2023 Annual Report](https://www.aarp.org/content/dam/aarp/about_aarp/annual_reports/aarp-2023-annual-report.pdf)." Page 50.
>
> 5. AARP. "[IRS Definition](https://www.aarp.org/about-aarp/info-03-2011/irs_definition.html)."
>
> 6. AARP Foundation. "[Help Struggling Seniors Now](https://foundation.aarp.org/site/Donation/opportunity-builder)."
>
> 7. Open Secrets. "[Top Spenders](https://www.opensecrets.org/federal-lobbying/top-spenders)."
>
> 8. AARP. "[What Is AARP's Membership Age Requirement To Join?](https://www.aarp.org/membership/age-requirement/)" |
Abenomics | # Abenomics: Definition, History, and Shinzo Abe's Three Arrows
:max_bytes(150000):strip_icc()/GettyImages-1163340944-5e1ade02c0ce4f28b15e3ccab0e3a884.jpg)
*— Tomohiro Ohsumi / Getty Images*
## What Is Abenomics?
Abenomics is the nickname for the economic policies set out for Japan in 2012 when prime minister Shinzo Abe came into power for a second time. Abenomics involved increasing the nation’s [money supply](https://www.investopedia.com/terms/m/moneysupply.asp), boosting government spending, and enacting reforms to make the Japanese economy more competitive. The Economist outlined the program as a "mix of [reflation](https://www.investopedia.com/terms/r/reflation.asp), government spending, and a growth strategy designed to jolt the economy out of suspended animation that has gripped it for more than two decades."
### Key Takeaways
* Abenomics is a set of economic policies championed by Japanese prime minister, Shinzo Abe, when he came into power a second time in 2012.
* Abenomics was originally described as a three arrow approach of increasing the money supply, undertaking government spending to stimulate the economy, and undertaking economic and regulatory reforms to make Japan more competitive in the global market.
* Abenomics has grown as prime minister Abe continues to govern Japan, and now encompasses goals for female employment, sustainable growth, and a concept known as Society 5.0 which is aimed at the further digitalization of Japan.
## Understanding Abenomics
Abenomics refers to the economic policies of a particular politician, in the same way, that [Reaganomics](https://www.investopedia.com/terms/r/reaganomics.asp) or [Clintonomics](https://www.investopedia.com/terms/c/clintonomics.asp) does. Abenomics was promoted as a way to shake Japan's economy out of a period of minimal growth and overall deflation. Japan's economic troubles dated back to the 90s, also known as [the Lost Decade](https://www.investopedia.com/terms/l/lost-decade.asp). It was a period of marked economic stagnation in Japan, following a massive real estate bubble burst in the 1980s, and Japan's asset price bubble burst in the early 90s.
The Japanese government responded to the economic fallout by running massive budget deficits to fund pubic works projects. In 1998, economist [Paul Krugman](https://www.investopedia.com/terms/p/paul-krugman.asp) argued in a paper titled "[Japan's Trap](http://web.mit.edu/krugman/www/japtrap.html)" that Japan could raise inflation expectations by committing to an irresponsible monetary policy for a period of time, thereby cutting long-term interest rates and promoting the spending needed to break out of economic stagnation.
Japan adopted some of Krugman's recommendations, expanding the [money supply](https://www.investopedia.com/terms/m/moneysupply.asp) domestically and keeping interest rates remarkably low. This facilitated an economic recovery, beginning in 2005, but it ultimately did not stop deflation.
In July 2006, Japan ended its zero-rate policy as Abe took power in his first term as prime minister. Abe would resign as prime minister suddenly in 2007, but continued to serve in the ruling party. Though still having the lowest interest rates in the world, Japan could not stop deflation. The country saw the [Nikkei](https://www.investopedia.com/terms/n/nikkei.asp) 225 drop more than 50% between the end of 2007 and the beginning of 2009. In part due to the economic malaise Japan seemed unable to shake, Abe's party, the Liberal Democratic Party of Japan (LDP), lost power to the Democratic Party of Japan.
## Abenomics and the Three Arrows
Abe began a second term in December 2012. Soon after resuming office, he launched his Abenomics plan to bolster Japan’s stagnant economy. In a speech following his election, Abe announced that he and his cabinet would "vigorously launch the "three prongs" of economic revival, namely bold monetary policy, flexible fiscal policy, and a growth strategy that encourages private sector investment."
Abe’s program consisted of three “arrows.” The first was printing additional currency – between 60 trillion yen to 70 trillion yen – to make Japanese [exports](https://www.investopedia.com/terms/e/export.asp) more attractive and generate modest [inflation](https://www.investopedia.com/terms/i/inflation.asp)—roughly 2%. The second arrow was new government spending programs to stimulate demand and consumption—to stimulate short-term growth, and to achieve a budget surplus over the long term.
The third component of Abenomics was more complex—a reform of various regulations to make Japanese industries more competitive and to encourage investment in and from the private sector. This included corporate governance reform, easing of restrictions on hiring foreign staff in special economic zones, making it easier for companies to fire ineffective workers, liberalizing the health sector, and implementing measures the help domestic and foreign entrepreneurs. The proposed legislation also aimed to restructure the utility and pharmaceutical industries and modernize the agricultural sector.
Most important, perhaps, was the [Trans-Pacific Partnership (TPP)](https://www.investopedia.com/terms/t/transpacific-partnership-tpp.asp), which was described by economist Yoshizaki Tatsuhiko as potentially the "linchpin of Abe's economic revitalization strategy," by making Japan more competitive through free trade.
## Did Abenomics Work?
Like all Japanese economic policy since the bubble burst, Abenomics has worked well at times and stalled at others. Inflation targets have been met and Japan's unemployment rate is more than 2% lower than when Abe came to power for the second time. Similarly, nominal GDP has increased and corporate pre-tax profit and tax revenues have both seen significant rises. However, Japan's periods of success have been halted at times by global economic forces and the country's most significant economic problem - a rapidly aging population - has increasingly taken the forefront.
> **Article Sources**
>
> 1. The Economist. "[Abe's Master Plan](https://www.economist.com/leaders/2013/05/18/abes-master-plan)."
>
> 2. Krugman, Paul. "[Japan's Trap](https://www.princeton.edu/~pkrugman/japans_trap.pdf)." _Princeton University_, 1998, pp. 1-15.
>
> 3. Bowman, David and Brian Doyle. "[Effects of the Bank of Japan’s Communication Strategy at the Zero Lower Bound](https://www.federalreserve.gov/monetarypolicy/files/FOMC20081212memo05.pdf)." _Board of Governors of the Federal Reserve System_, December 2008, pp. 2.
>
> 4. The New York Times. "[The Legacy of Shinzo Abe, Japan’s Departing Prime Minister](https://www.nytimes.com/2020/08/28/world/asia/who-is-shinzo-abe.html)."
>
> 5. Macrotrends. "[Nikkei 225 Index - 67 Year Historical Chart](https://www.macrotrends.net/2593/nikkei-225-index-historical-chart-data)."
>
> 6. Ito, Takatoshi. "[An Assessment of Abenomics: Evolution and Achievements](https://onlinelibrary.wiley.com/doi/full/10.1111/aepr.12353)." _Asian Economic Policy Review_, vol. 16, no. 2, July 2021, pp. 190-219.
>
> 7. Prime Minister’s Office of Japan. "[Policy Speech by Prime Minister Shinzo Abe to the 183rd Session of the Diet, Thursday, February 28, 2013](https://japan.kantei.go.jp/96_abe/statement/201302/28siseuhousin_e.html)."
>
> 8. Nippon. "[What the TPP Process Means to Japan](https://www.nippon.com/en/in-depth/a02002/)." |
Abnormal Return | # Abnormal Return: Definition, Causes, Example
> **Definition**
>
> An abnormal return is the difference between the actual return of an investment and its expected return, indicating unusually large profits or losses over a specified period.
## What Is an Abnormal Return?
An abnormal return describes the unusually large profits or losses generated by a given investment or portfolio over a specified period. The performance diverges from the investments' [expected](https://www.investopedia.com/terms/e/expectedreturn.asp), or anticipated, [rate of return](https://www.investopedia.com/terms/r/rateofreturn.asp) (RoR)—the estimated risk-adjusted return based on an asset pricing model, or using a [long-run](https://www.investopedia.com/terms/l/longrun.asp) historical average or multiple valuation techniques.
Returns that are abnormal may simply be anomalous or they may point to something more nefarious such as fraud or manipulation. Abnormal returns should not be confused with "[alpha](https://www.investopedia.com/terms/a/alpha.asp)" or [excess returns](https://www.investopedia.com/terms/e/excessreturn.asp) earned by actively managed investments.
### Key Takeaways
* An abnormal return is one that deviates from an investment's expected return.
* The presence of abnormal returns, which can be either positive or negative in direction, helps investors determine risk-adjusted performance.
* Abnormal returns can be produced by chance, due to some external or unforeseen event, or as the result of bad actors.
* A cumulative abnormal return (CAR) is the sum total of all abnormal returns and can be used to measure the effect lawsuits, buyouts, and other events have on stock prices.
## Understanding Abnormal Returns
Abnormal returns are essential in determining a security or portfolio's [risk-adjusted performance](https://www.investopedia.com/terms/r/riskadjustedreturn.asp) when compared to the overall market or a [benchmark index](https://www.investopedia.com/terms/b/benchmark.asp). Abnormal returns could help to identify a portfolio manager's skill on a risk-adjusted basis. It will also illustrate whether investors received adequate compensation for the amount of investment risk assumed.
An abnormal return can be either positive or negative. The figure is merely a summary of how the actual returns differ from the predicted yield. For example, earning 30% in a [mutual fund](https://www.investopedia.com/terms/m/mutualfund.asp) that is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, in this same example, the [actual return](https://www.investopedia.com/terms/a/actualreturn.asp) was 5%, this would generate a negative abnormal return of 5%.
> **Important**
>
> The abnormal return is calculated by subtracting the expected return from the realized return and may be positive or negative.
## Cumulative Abnormal Return (CAR)
Cumulative abnormal return (CAR) is the total of all abnormal returns. Usually, the calculation of cumulative abnormal return happens over a small window of time, often only days. This short duration is because [evidence has shown](https://pdfs.semanticscholar.org/302a/a5b66054c0d8b954f71f7d0dcf5061fe03b7.pdf) that [compounding](https://www.investopedia.com/terms/c/compounding.asp) daily abnormal returns can create bias in the results.
Cumulative abnormal return (CAR) is used to measure the effect lawsuits, buyouts, and other events have on stock prices and is also useful for determining the accuracy of asset pricing models in predicting the expected performance.
The [capital asset pricing model](https://www.investopedia.com/terms/c/capm.asp) (CAPM) is a framework used to calculate a security or portfolio's expected return based on the [risk-free rate of return](https://www.investopedia.com/terms/r/risk-freerate.asp), beta, and the expected market return. After the calculation of a security or portfolio's expected return, the estimate for the abnormal return is calculated by subtracting the expected return from the realized return.
## Example of Abnormal Returns
An investor holds a [portfolio](https://www.investopedia.com/terms/p/portfolio.asp) of securities and wishes to calculate the portfolio's abnormal return during the previous year. Assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%.
The investor's portfolio returned 25% and had a [beta](https://www.investopedia.com/terms/b/beta.asp) of 1.25 when measured against the benchmark index. Therefore, given the amount of risk assumed, the portfolio should have returned 18.25%, or (2% + 1.25 x (15% - 2%)). Consequently, the abnormal return during the previous year was 6.75% or 25 - 18.25%.
The same calculations can be helpful for a stock holding. For example, stock ABC returned 9% and had a beta of 2, when measured against its benchmark index. Consider that the risk-free rate of return is 5% and the benchmark index has an expected return of 12%. Based on the CAPM, stock ABC has an expected return of 19%. Therefore, stock ABC had an abnormal return of -10% and [underperformed](https://www.investopedia.com/terms/u/underperform.asp) the market during this period. |
Ability-to-Pay Taxation | # What Is Ability-to-Pay Taxation?
:max_bytes(150000):strip_icc()/Soneva-in-Aqua-Yacht-Maldives-Vacation-59a87a00845b340011119df0.jpg)
*Maldives vacationer can combine time on the Soneva in Aqua sailing yacht with a Soneva resort stay.*
> **Definition**
>
> The ability-to-pay principle is also known as progressive taxation.
## What Is Ability-To-Pay Taxation?
The [ability-to-pay](https://www.investopedia.com/terms/a/abilitytopay.asp) philosophy of taxation maintains that taxes should be levied according to an individual's ability to pay. The idea argues people, businesses, and corporations with [higher incomes](https://www.investopedia.com/terms/v/vertical_equity.asp) can and should pay more taxes.
### Key Takeaways
* The ability-to-pay principle holds that those with more income and wealth should pay more taxes.
* One argument for "ability to pay" is those with success should be willing to give back to society.
* Proponents of ability-to-pay taxation argue that a single dollar ultimately means less to a wealthy individual than an average taxpayer.
## Progressive Taxation
A [progressive tax](https://www.investopedia.com/terms/p/progressivetax.asp) has a tax rate that increases or progresses as taxable income increases. It imposes a lower tax rate on low-income earners and a higher rate on those with higher incomes. Ability-to-pay taxation argues that those who earn higher incomes should pay a greater percentage of those incomes in taxes than those who earn less.
In 2024, individuals in the United States with taxable [income](https://www.investopedia.com/terms/i/income.asp) less than $11,600 ($11,925 in tax year 2025) faced a 10% income tax rate, while those with taxable income of more than $609,350 ($626,350 in tax year 2025) faced a rate of 37%, the nation's top individual rate. Earnings between those amounts face tax rates as set by income brackets.
The ideals of ability-to-pay taxation promote the notion that people with more money who pay more taxes are not heavily burdened. To a person earning $1 million a year, $10,000 will make very little difference in their life, while it will make a big difference to a person earning only $60,000 a year.
> **Fast Fact**
>
> Standard deductions help reduce an individual's taxable income. In 2024, the deduction for single filers is $14,600 and will increase to $15,000 in 2025.
## History
A progressive income tax was endorsed by [Adam Smith](https://www.investopedia.com/updates/adam-smith-economics/) in 1776. Smith wrote: “The subjects of every state ought to contribute toward the support of the government, as near as possible, in proportion to their respective abilities; that is in proportion to the revenue which they respectively enjoy under the protection of the state."
To support efforts in World War I, the U.S. passed The Revenue Act of 1918 which codified all tax laws and imposed a progressive income-tax rate structure of up to 77 percent. A progressive tax structure is evident in the tax brackets for the tax year 2025:
## Arguments and Criticism
Advocates of ability-to-pay taxation argue that those who have benefitted most from the nation’s way of life in the form of higher incomes and greater wealth can afford and should be obligated to give back more. Tax revenues build [infrastructure](https://www.investopedia.com/terms/i/infrastructure.asp), a strong military, and public schools.
Critics of [progressive taxation](https://www.investopedia.com/terms/p/progressivetax.asp) argue that it is [fundamentally unfair](https://www.hoover.org/research/inequity-progressive-income-tax). They say it penalizes hard work and success and reduces the incentive to make more money. While the U.S. maintains a progressive tax system, tax rates for the wealthy have plummeted over several decades. When President Ronald Reagan took office in 1981, the highest income [tax bracket for individuals was 70%](https://www.investopedia.com/terms/e/economic-recovery-tax-act.asp). In 2024, the top rate is 37%.
## What Is a Tax Levied Equally?
Flat taxes are levied at the same rate for all payers. This is the inverse of the ability-to-pay principle or a [regressive tax](https://www.investopedia.com/terms/r/regressivetax.asp) system.
## What Are Types of Taxes?
Common types of taxes include income, corporate, sales, and property taxes. Income tax is levied on an individual's earnings, while corporate tax on a company's. Sales taxes are collected at points of sale. Property taxes are based on the value of a home.
## When Did Income Tax Collection Begin?
President Lincoln passed a revenue-raising measure to pay for Civil War expenses in 1862. It created a Commissioner of Internal Revenue and the United States' first income tax.
## The Bottom Line
Ability-to-pay refers to a principle holding that taxes should be levied according to one's ability to pay them. Higher earners and wealthier individuals pay higher tax rates than those with lower or middle income.
> **Article Sources**
>
> 1. Internal Revenue Service. "[IRS Releases Tax Inflation Adjustments for Tax Year 2025](https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025)."
>
> 2. Internal Revenue Service. "[IRS Provides Tax Inflation Adjustments for Tax Year 2024](https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024)."
>
> 3. Adam Smith Works. "[Adam Smith on Fiscal Policy](https://www.adamsmithworks.org/speakings/adam-smith-on-fiscal-policy)."
>
> 4. Internal Revenue Service. "[Historical Highlights of the IRS](https://www.irs.gov/newsroom/historical-highlights-of-the-irs)."
>
> 5. Brookings. "[What We Learned from Reagan’s Tax Cuts](https://www.brookings.edu/articles/what-we-learned-from-reagans-tax-cuts/)." |
Absolute Advantage | # Absolute Advantage: Definition, Benefits, and Example
> **Definition**
>
> An entity establishes an absolute advantage over its competitors when it can produce more with the same inputs they're using.
## What Is Absolute Advantage?
Absolute advantage is accomplished by creating a good or service at a [lower](https://www.investopedia.com/terms/l/low-cost-producer.asp) [absolute cost per unit](https://www.investopedia.com/terms/u/unitcost.asp) using a smaller number of inputs. It can also be achieved by a more [efficient process](https://www.investopedia.com/terms/e/efficiency.asp).
### Key Takeaways
* Absolute advantage is when a producer can provide a good or service in greater quantity for the same cost, or the same quantity at a lower cost, than its competitors.
* A concept developed by Adam Smith, absolute advantage can be the basis for large gains from trade between producers of different goods with different absolute advantages.
* By specialization, division of labor, and trade, producers with different absolute advantages can always gain more than producing and consuming in isolation.
* Absolute advantage can be contrasted with comparative advantage, which is the ability to produce goods and services at a lower opportunity cost.
:max_bytes(150000):strip_icc()/ABSOLUTE-ADVANTAGE-FINAL-edit-32a9742eecf944bc870f2de10a452ec5.jpg)
*While absolute advantage focuses on efficiency, comparative advantage focuses on opportunity cost. — Investopedia / Yurle Villegas*
## Understanding Absolute Advantage
The concept of absolute advantage was developed by 18th-century economist [Adam Smith](https://www.investopedia.com/updates/adam-smith-economics/) in his book "[The Wealth of Nations](https://www.investopedia.com/updates/adam-smith-wealth-of-nations/)" to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the generated funds to purchase goods and services from other countries.
Smith argued that specializing in the products in which they have an absolute advantage and then trading the products can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.
Absolute advantage explains why it makes sense for individuals, businesses, and countries to [trade](https://www.investopedia.com/terms/t/trade.asp) with each other. Since each has advantages in producing certain goods and services, both entities can benefit from the exchange.
This mutual gain from trade forms the basis of Smith’s argument that [specialization](https://www.investopedia.com/terms/s/specialization.asp), the division of labor, and subsequent trade lead to an overall increase in prosperity from which all can benefit. This, Smith believed, was the root source of the eponymous "Wealth of Nations."
## Absolute Advantage vs. Comparative Advantage
Absolute advantage can be contrasted with [comparative advantage](https://www.investopedia.com/terms/c/comparativeadvantage.asp), which is when a producer has a lower [opportunity cost](https://www.investopedia.com/terms/o/opportunitycost.asp) to produce a good or service than another producer. An opportunity cost is the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.
Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an absolute advantage in producing some good. If a producer lacks any absolute advantage, then Adam Smith’s argument would not necessarily apply.
However, the producer and its trading partners might still be able to realize gains from trade if they can specialize based on their respective comparative advantages instead. In his book _On the Principles of Political Economy and Taxation,_ [David Ricardo](https://www.investopedia.com/terms/d/david-ricardo.asp) argued that even if a country has an absolute advantage over trading many kinds of goods, it can still benefit by trading with other countries that have different comparative advantages.
## Assumptions of the Theory of Absolute Advantage
Both Smith's theory of absolute advantage and Ricardo's theory of comparative advantage, rely on certain assumptions and simplifications to explain the benefits of trade.
### Barriers to Trade
Both theories assume that there are no barriers to trade. They do not account for any costs of shipping or additional tariffs that a country might raise on another's imported goods. In the real world, though, shipping costs impact how likely both the importer and exporter are to engage in trade. Countries can also leverage tariffs to create advantages for themselves or disadvantages for competitors.
### Factors of Production
Both theories also assume that the factors of production are immobile. In these models, workers and businesses do not relocate in search of better opportunities. This assumption was realistic in the 1700s.
In modern trade, however, [globalization](https://www.investopedia.com/terms/g/globalization.asp) has now made it easy for companies to move their factories abroad. It has also increased the rate of immigration, which impacts a country's available workforce. In some industries, businesses will work with governments to create immigration opportunities for workers that are essential to their business operations.
### Consistency and Scale
More crucially, these theories both assume that a country's absolute advantage is constant and scales equally. In other words, it assumes that producing a small number of goods has the same per-unit cost as a larger number and that countries are unable to change their absolute advantages.
In reality, countries often make strategic [investments to create greater advantages](https://www.investopedia.com/ask/answers/09/law-comparative-advantage.asp) in certain industries. Absolute advantage can also change for reasons other than investment. Natural disasters, for example, can destroy farmland, factories, and other factors of production.
## Pros and Cons of Absolute Advantage
One advantage of the theory of absolute advantage is its simplicity: The theory provides an elegant explanation of the benefits of trade, showing how countries can benefit by focusing on their absolute advantages.
However, the theory of comparative advantage does not fully explain why nations benefit from trade. This explanation would later fall to Ricardo's theory of comparative advantage: Even if one country has an absolute advantage in _both_ types of goods, it will still be better off through trade. In other words, if one country can produce all goods more cheaply than its trading partners, it will still benefit by trading with other countries.
Also, as explained earlier, the theory also assumes that absolute advantages are static—a country cannot change its absolute advantages, and they do not become more efficient with scale. Actual experience has shown this to be untrue: Many countries have successfully created an absolute advantage by investing in strategic industries.
In fact, the theory has been used to justify exploitative economic policies in the postcolonial era. Reasoning that all countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing countries to focus on agricultural exports, rather than industrialization. As a result, many of these countries remain at a low level of economic development.
### Pros and Cons of the Theory of Absolute Advantage
Pros
* Simple illustration of why countries can benefit by trading on their advantages.
Cons
* Lacks the explanatory power of the theory of comparative advantage.
* Does not account for costs or barriers to trade.
* Has been used to justify exploitative policies.
## Example of Absolute Advantage
Consider two hypothetical countries, Atlantica and Pacifica, with equivalent populations and resource endowments, with each producing two products: butter and bacon. Each year, Atlantica can produce either 12 tubs of butter or six slabs of bacon, while Pacifica can produce either six tubs of butter or 12 slabs of bacon.
Each country needs a minimum of four tubs of butter and four slabs of bacon to survive. In a state of [autarky](https://www.investopedia.com/terms/a/autarky.asp), producing solely on their own for their own needs, Atlantica can spend one-third of the year making butter and two-thirds of the year making bacon, for a total of four tubs of butter and four slabs of bacon.
Pacifica can spend one-third of the year making bacon and two-thirds making butter to produce the same: four tubs of butter and four slabs of bacon. This leaves each country on the brink of survival, with barely enough butter and bacon to go around. However, note that Atlantica has an absolute advantage in producing butter and Pacifica has an absolute advantage in producing bacon.
If each country were to specialize in its absolute advantage, Atlantica could make 12 tubs of butter and no bacon in a year, while Pacifica makes no butter and 12 slabs of bacon. [By specializing](https://www.investopedia.com/ask/answers/040615/what-are-economic-impacts-specialization.asp), the two countries divide the tasks of their labor between them.
If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each. Both countries would now be better off than before, because each would have six tubs of butter and six slabs of bacon, as opposed to four of each good which they could produce on their own.
## How Can Absolute Advantage Benefit a Nation?
The concept of absolute advantage was developed by Adam Smith in _The Wealth of Nations_ to show how countries can gain by specializing in producing and exporting the goods that they produce more efficiently than other countries, and by importing goods that other countries produce more efficiently. Specializing in and trading products that they have an absolute advantage in can benefit both countries as long as they each have at least one product for which they hold an absolute advantage over the other.
## How Does Absolute Advantage Differ From Comparative Advantage?
Absolute advantage is the ability of an entity to produce a product or service at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same good or service. Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume or quality.
## What Are Examples of Nations With an Absolute Advantage?
A clear example of a nation with an absolute advantage is Saudi Arabia, a country with abundant oil supplies that provide it with an absolute advantage over other nations.
Other examples include Colombia and its climate—ideally suited to growing coffee—and Zambia, possessing some of the world’s richest copper mines. For Saudi Arabia to try and grow coffee and Colombia to drill for oil would be an extremely costly and, likely, unproductive undertaking.
## The Bottom Line
The theory of absolute advantage represents Adam Smith's explanation of why countries benefit from trade, by exporting goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple illustration of the benefits of trade, it doesn't fully explain the benefits of international trade. That would later fall to David Ricardo's theory of comparative advantages.
> **Article Sources**
>
> 1. Project Gutenberg. "[The Project Gutenberg eBook of An Inquiry Into the Nature and Causes of the Wealth of Nations, by Adam Smith](https://www.gutenberg.org/files/3300/3300-h/3300-h.htm)."
>
> 2. Britannica. "[Comparative Advantage](https://www.britannica.com/money/comparative-advantage)."
>
> 3. Britannica. "[Absolute Advantage](https://www.britannica.com/money/topic/absolute-advantage)."
>
> 4. Britannica. "[David Ricardo](https://www.britannica.com/biography/David-Ricardo#ref138680)."
>
> 5. International Monetary Fund. "[Joint Statement by the Heads of the Food and Agriculture Organization, International Monetary Fund, World Bank Group, World Food Programme, and World Trade Organization on the Global Food Security Crisis.](https://www.imf.org/en/News/Articles/2022/07/15/pr22259-joint-statement-heads-fao-imf-wbg-wfp-wto-global-food-security-crisis)"
>
> 6. The World Bank. "[Agriculture and Food](https://www.worldbank.org/en/topic/agriculture/overview)."
>
> 7. U.S. Energy Information Administration. "[Saudi Arabia](https://www.eia.gov/international/overview/country/sau)."
>
> 8. The World Bank. "[Zambia Overview](https://www.worldbank.org/en/country/zambia/overview)."
>
> 9. U.S. Department of Agriculture, Foreign Agricultural Service. "[Colombia: Coffee Annual](https://www.fas.usda.gov/data/colombia-coffee-annual-7)." |
Absolute Return | # Absolute Return: Definition, Example, Vs. Relative Return
> **Definition**
>
> Absolute return is the percentage change in an asset's value over a period, without comparing it to benchmarks.
## What Is Absolute Return?
Absolute return is the return that an [asset](https://www.investopedia.com/terms/a/asset.asp) achieves over a specified period. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period.
Absolute return [differs from relative return](https://www.investopedia.com/ask/answers/118.asp) because it is concerned with the return of a particular asset and does not compare it to any other measure or [benchmark](https://www.investopedia.com/terms/b/benchmark.asp).
### Key Takeaways
* Absolute return is the return that an asset achieves over a certain period.
* Returns can be positive or negative and may be considered unrelated to other market activities.
* Absolute return, unlike relative return, does not make any comparison against other possible investments or to a benchmark.
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*— Investopedia / Sydney Saporito*
## How Absolute Return Works
Absolute return refers to the amount of funds that an investment has earned. Also referred to as the total return, the absolute return measures the gain or loss experienced by an asset or [portfolio](https://www.investopedia.com/terms/p/portfolio.asp) independent of any benchmark or other standard. Returns can be positive or negative and may be considered uncorrelated to other market activities.
### Relative and Absolute Returns
In general, a [mutual fund](https://www.investopedia.com/terms/m/mutualfund.asp) seeks to produce returns that are better than its peers, its [fund category](https://www.investopedia.com/terms/f/fundcategory.asp), and the market as a whole. This type of fund management is referred to as a [relative return](https://www.investopedia.com/terms/r/relativereturn.asp) approach to fund investing. The success of the asset is often based on a comparison to a chosen benchmark, industry standard, or overall market performance.
As an investment vehicle, an absolute return fund seeks to make positive returns by employing investment management techniques that differ from traditional mutual funds. Absolute return investment strategies include using [short selling](https://www.investopedia.com/terms/s/shortselling.asp), [futures](https://www.investopedia.com/terms/f/futures.asp), [options](https://www.investopedia.com/terms/o/option.asp), [derivatives](https://www.investopedia.com/terms/d/derivative.asp), [arbitrage](https://www.investopedia.com/terms/a/arbitrage.asp), leverage, and unconventional assets. Absolute returns are examined separately from any other performance measure, so only gains or losses on the investment are considered.
### The History of Absolute Return Funds
Alfred Winslow Jones is credited with forming the first absolute return fund in New York in 1949. In recent years, the absolute return approach to fund investing has become one of the fastest-growing [investment products](https://www.investopedia.com/terms/i/investment-product.asp) in the world and is more commonly referred to as a [hedge fund](https://www.investopedia.com/terms/h/hedgefund.asp).
### Hedge Funds
A hedge fund is not a specific form of investment; it is an investment structured as a pool and set up as either a [limited partnership](https://www.investopedia.com/terms/l/limitedpartnership.asp) or [limited liability company](https://www.investopedia.com/terms/l/llc.asp) (LLC). A hedge fund manager raises funds by working with outside investors. The manager uses the funds to invest based on a declared strategy involving only the purchase of [long equities](https://www.investopedia.com/terms/l/long-shortequity.asp), such as common stock.
Hedge funds may specialize in specific areas, such as real estate or [patents](https://www.investopedia.com/terms/p/patent.asp), and may also engage in [private equity](https://www.investopedia.com/terms/p/privateequity.asp) activities. While anyone may invest in a hedge fund, participants are traditionally accredited and sophisticated investors.
## Example of Absolute Return
As a historical example, the Vanguard 500 Index ETF (VOO) delivered an absolute return of 150.15% over the 10-year period ending Dec. 31, 2017. This differed from its 10-year annualized return of 8.37% over the same period. Further, because the S&P 500 Index had an absolute return of 153.07% over the same period, absolute return differed from the relative return, which was -2.92%. |
Absorption Costing | # Absorption Costing Explained, With Pros and Cons and Example
> **Definition**
>
> Absorption costing is a managerial accounting method for capturing all the costs related to manufacturing a product.
## What Is Absorption Costing?
Absorption costing, also known as full costing, is an accounting method that assigns all [direct](https://www.investopedia.com/terms/d/directcost.asp) and indirect costs to a product. This includes direct materials, direct labor, variable manufacturing [overhead](https://www.investopedia.com/terms/o/overhead.asp), and fixed manufacturing overhead.
Unlike [variable costing](https://www.investopedia.com/ask/answers/052515/what-are-differences-between-absorption-costing-and-variable-costing.asp), which only considers direct variable costs and not fixed costs, absorption costing ensures that fixed overhead costs are spread across all units produced. This method is required under [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) for external financial reporting.
Absorption costing impacts financial statements by assigning fixed manufacturing costs to inventory, which means that unsold goods retain these costs on the balance sheet rather than being immediately expensed on the income statement. This can affect reported income, especially when production levels fluctuate.
### Key Takeaways
* Absorption costing includes both fixed and variable manufacturing costs in a product’s total cost.
* Unlike variable costing, which expenses fixed costs in the period incurred, absorption costing spreads these costs over all units produced.
* The absorption costing method can result in higher reported profits when inventory levels increase since some fixed costs remain capitalized in unsold inventory.
* Under GAAP, companies must apply absorption costing for external financial statements.
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*— Investopedia / Michela Buttignol*
## How Absorption Costing Works
Absorption costing allocates all manufacturing costs to products, thereby ensuring that each unit carries a proportionate share of fixed overhead expenses. This differs from variable costing, which treats fixed costs as period expenses.
The cost components under absorption costing include:
* **Direct materials:** [Raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) used in production.
* **Direct labor:** Wages paid to workers directly involved in manufacturing.
* **Variable manufacturing overhead:** Costs like electricity and indirect materials that fluctuate with production levels.
* **Fixed manufacturing overhead:** Expenses such as rent, insurance, and equipment depreciation that remain consistent regardless of output.
By capitalizing fixed costs within inventory, absorption costing ensures that unsold products retain a portion of these expenses on the balance sheet, rather than being immediately expensed in the income statement.
## Absorption Costing Formula
The cost per unit under absorption costing is calculated using the formula:
Absorption Cost per Unit = (Direct Materials + Direct Labor + Variable Overhead + Fixed Overhead) / Total Units Produced
For example, if a company incurs $100,000 in direct materials, $50,000 in direct labor, $30,000 in variable overhead, and $80,000 in fixed overhead while producing 10,000 units, the absorption cost per unit would be:
($100,000 + $50,000 + $30,000 + $80,000) / 10,000 = $26 per unit
## Absorption Costing vs. Variable Costing
The key distinction between absorption costing and variable costing is how fixed overhead costs are treated. Variable costing is often preferred for internal decision-making because it highlights the incremental costs of production. However, absorption costing is essential for financial reporting, as it aligns expenses with revenue recognition.
Absorption Costing
* Fixed overhead included in inventory cost
* Higher income when inventory increases
* Required for GAAP compliance
Variable Costing
* Fixed overhead expensed in the period incurred
* More accurate profit margin for decision-making
* Not permitted for external reporting under GAAP
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*— Image by Sabrina Jiang © Investopedia 2021*
## Advantages and Disadvantages of Absorption Costing
Absorption costing has both benefits and drawbacks depending on how a company uses it for financial reporting and decision-making. While it ensures compliance with accounting standards and provides a more complete view of product costs, it may not always be the most effective method for internal cost analysis.
Pros
* Required for GAAP financial reporting and tax purposes.
* Captures total production costs, allowing for more accurate product costing.
* Fixed costs remain in inventory until products are sold, providing a clearer view of asset values.
Cons
* Holding inventory can defer some fixed costs, making net income appear higher.
* Variable costing offers better insights into incremental production costs.
* Managers may be incentivized to overproduce to spread fixed costs, increasing inventory levels unnecessarily.
## Example of Absorption Costing
A company manufactures 5,000 units of a product in January, with the following cost structure:
* Direct materials: $10 per unit
* Direct labor: $5 per unit
* Variable overhead: $3 per unit
* Fixed overhead: $50,000 total
The absorption cost per unit is:
($10 + $5 + $3 + ($50,000 ÷ 5,000)) = $28 per unit
If the company sells only 4,000 units, the remaining 1,000 units retain a portion of fixed costs in inventory, delaying some expense recognition until those units are sold.
Under variable costing, only direct materials, direct labor, and variable overhead are included in the cost per unit, while fixed overhead is fully expensed in the period incurred, so using the same data:
Variable cost per unit: $10 (materials) + $5 (labor) + $3 (variable overhead) = $18 per unit
Now using variable costing, the total fixed overhead cost of $50,000 is expensed immediately in the period it is incurred, which means net income will be lower in periods of high production if inventory remains unsold.
This approach provides clearer insights into incremental production costs and profitability per unit but does not comply with GAAP for external reporting.
## The Bottom Line
Absorption costing is essential for GAAP-compliant financial reporting, and it ensures that all manufacturing costs—both fixed and variable—are included in product costs. This method provides a more complete view of total production costs, which is valuable for external [stakeholders](https://www.investopedia.com/terms/s/stakeholder.asp).
However, businesses should carefully assess its impact on reported income and inventory levels, particularly when making internal management decisions.
While absorption costing aligns expenses with revenues, it may not always be the best approach for pricing and cost control, for example, because it can inflate profits and potentially mask production expenses by deferring fixed costs into inventory. |
Accelerated Depreciation | # Accelerated Depreciation: What It Is and How to Calculate It
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*— NoNo Flores / Investopedia*
## What Is Accelerated Depreciation?
Accelerated depreciation is any method of [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) used for accounting or income tax purposes that allows greater depreciation expenses in the early years of the life of an asset.
Accelerated depreciation methods, such as double-declining balance (DDB), mean there will be higher depreciation expenses in the first few years and lower expenses as the asset ages. This is unlike the [straight-line depreciation](https://www.investopedia.com/terms/s/straightlinebasis.asp) method, which spreads the cost evenly over the life of an asset.
### Key Takeaways
* Accelerated depreciation is any depreciation method that allows for the recognition of higher depreciation expenses during the earlier years.
* The key accelerated depreciation methods include double-declining balance and sum of the years’ digits (SYD).
* Accelerated depreciation is unlike the straight-line depreciation method, where the latter spreads the depreciation expenses evenly over the life of the asset.
* Companies may use accelerated depreciation for tax purposes, as these methods result in a deferment of tax liabilities since income is lower in earlier periods.
## Understanding Accelerated Depreciation
Accelerated depreciation methods tend to align the recognized rate of an [asset](https://www.investopedia.com/terms/a/asset.asp)’s depreciation with its actual use, although this isn’t technically required. This alignment tends to occur because an asset is most heavily used when it’s new, functional, and most efficient.
Because this tends to occur at the beginning of the asset’s life, the rationale behind an accelerated method of depreciation is that it appropriately matches how the underlying asset is used. As an asset ages, it is not used as heavily, since it is slowly phased out for newer assets.
## Special Considerations
Using an accelerated depreciation method has financial reporting implications. Because depreciation is accelerated, expenses are higher in earlier periods than in later periods. Companies may utilize this strategy for taxation purposes, as an accelerated depreciation method will result in a deferment of [tax liabilities](https://www.investopedia.com/terms/t/taxliability.asp) since [income](https://www.investopedia.com/terms/i/income.asp) is lower in earlier periods.
Alternatively, public companies tend to shy away from accelerated depreciation methods, as [net income](https://www.investopedia.com/terms/n/netincome.asp) is reduced in the short term.
## Types of Accelerated Depreciation Methods
### Double-Declining Balance Method
The [double-declining balance (DDB)](https://www.investopedia.com/terms/d/double-declining-balance-depreciation-method.asp) method is an accelerated depreciation method. After taking the reciprocal of the [useful life](https://www.investopedia.com/terms/u/usefullife.asp) of the asset and doubling it, this rate is applied to the depreciable base—also known as the [book value](https://www.investopedia.com/terms/b/bookvalue.asp), for the remainder of the asset’s expected life.
For example, an asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset’s current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base each period.
### Sum of the Years’ Digits (SYD)
The [sum-of-the-years’-digits (SYD)](https://www.investopedia.com/terms/s/sum-of-the-years-digits.asp) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1 + 2 + 3 + 4 + 5 = 15.
In the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.
## What Do Accelerated Depreciation Methods Do?
Accelerated depreciation methods usually align the recognized rate of an asset’s depreciation with its actual use, but this isn’t technically required. This alignment usually occurs because an asset is most heavily used when it’s new, functional, and at its most efficient.
## What Is the Rationale Behind Accelerated Depreciation Methods?
The rationale behind an accelerated depreciation method is that it appropriately matches how the asset is used. As an asset ages, it is not used as heavily—it is slowly being phased out for newer assets.
## How Does the Accelerated Depreciation Method Affect Financial Reporting?
Because depreciation is accelerated, expenses are higher in earlier periods compared to later periods. Companies may utilize this strategy for taxation purposes, because an accelerated depreciation method will result in deferred tax liabilities since income is lower in earlier periods.
## What Are the Types of Accelerated Depreciation Methods?
There are two main types:
* **Double-declining balance (DDB)**, also known as the reducing balance method. It counts an expense more rapidly than straight-line depreciation, which uses the same amount of depreciation each year over an asset’s useful life. It also depreciates assets twice as quickly as the standard declining balance method.
* **Sum of the years’ digits (SYD)**, which takes an asset’s expected life and adds together the digits for each year. Each digit is then divided by this sum to determine the percentage by which the asset should be depreciated each year, starting with the highest number in year one.
## The Bottom Line
Accelerated depreciation refers to any depreciation method used for accounting or income tax purposes that allows greater depreciation expenses in an asset’s early years. Accelerated depreciation methods mean higher depreciation expenses in the first few years and lower expenses as the asset gets older. |
Absorption Rate | # Understanding Absorption Rate in Real Estate: A Complete Guide
## What Is Absorption Rate in Real Estate?
The absorption rate measures how quickly homes are sold in a [market](https://www.investopedia.com/terms/m/market.asp) during a specific period. It's calculated by dividing the number of homes sold by the total number of available homes. This equation can also be reversed to identify the time it would take for the supply to be sold.
### Key Takeaways
* The absorption rate in [real estate](https://www.investopedia.com/terms/r/realestate.asp) is a vital metric used to gauge how quickly homes are sold in a specific market, calculated by dividing the number of homes sold by the number of available homes.
* Absorption rates above 20% generally indicate a seller's market, where homes sell quickly, while rates below 15% suggest a buyer's market with slower home sales.
* Real estate agents, appraisers, and lenders use absorption rates to adjust pricing strategies, evaluate property values, and make informed lending decisions.
* High absorption rates might signal developers to consider new construction due to increased demand, whereas low rates indicate a potential slowdown in building activities.
## Understanding High and Low Absorption Rates in Real Estate
The absorption rate provides insight into how quickly or slowly houses sell in the real estate market. The absorption rate does not include additional homes that enter the market at various times. It is based on currently available data and actual inventory.
A high absorption rate suggests that homes are selling fast, which means a homeowner may sell their property quickly. However, it's important to consider the time frame used in the absorption rate calculation.
Traditionally, a rate above 20% indicates a [seller's market](https://www.investopedia.com/terms/s/sellersmarket.asp) with quick home sales, while below 15% suggests a buyer's market with slower sales.
> **Fast Fact**
>
> Real estate professionals use the absorption rate in pricing homes. During periods of higher absorption rates, homes are often priced higher.
## How Absorption Rates Influence Real Estate Market Dynamics
When absorption rates are low, real estate agents might lower the listing price to attract buyers. Alternatively, the agent can increase the price without sacrificing [demand](https://www.investopedia.com/terms/d/demand.asp) for the home if the market has a high absorption rate. The absorption rate is also important for buyers and sellers as they decide on the timing of purchases and sales.
The absorption rate can signal developers to start building new homes. During market conditions with a high absorption rate, demand may be high enough to warrant the further development of properties. Periods with lower absorption rates indicate a cooling period for construction.
[Appraisers](https://www.investopedia.com/terms/a/appraiser.asp) monitor market conditions and absorption rates to determine property values. Some procedures require that absorption rates be considered in [appraisal](https://www.investopedia.com/terms/a/appraisal.asp) calculations. Lenders and banking institutions also consider market conditions when evaluating loan and credit terms.
## Real Estate Absorption Rate Example: Calculation and Implications
To find the absorption rate in real estate, divide the total number of homes sold in a specific period by the total number of homes available in that market.
Suppose a city has 1,000 homes currently on the market to be sold. If buyers purchase 100 homes in one month, the absorption rate is 10% (100 homes sold per month divided by 1,000 homes available for sale). This also indicates that the supply of homes will be exhausted in 10 months (1,000 homes divided by 100 homes sold/month).
> **Important**
>
> New rules for the National Association of Realtors, expected to take effect in July 2024, may lower commissions for home buyers and sellers. If a federal court approves the changes, the standard 6% commission ends and sellers no longer have to propose compensation to prospective buyers and their agents. NAR will also require brokers to enter into written agreements with their buyers to help consumers understand what services will be provided, and at what cost.
## What Does a High Absorption Rate Mean?
A high absorption rate means a higher proportion of houses are being purchased. Otherwise, a low absorption rate means a lower proportion of houses are being purchased. This information is used by relators, financial institutions, and appraisers as the rate at which houses are being bought drives a home's value and price.
## How Does Absorption Rate Apply to Accounting?
In accounting, the absorption rate is when companies calculate and allocate their overhead [expenses](https://www.investopedia.com/terms/e/expense.asp). These are the costs associated with providing goods and services to their customers, though these expenses aren't directly traceable to end products. As such, it's also often called an overhead absorption rate.
## How Is a Monthly Absorption Rate Calcuated?
In order to determine a monthly absorption rate, take the total number of homes sold in the market and divide that by 12. Then, divide this monthly average number of homes sold by the total number of homes available for sale.
## The Bottom Line
Realtors use absorption rate to determine how many homes are sold in a particular area at any given time. These professionals can also use the rate to determine market trends. This rate is also important for the construction industry to indicate when developers should start buying.
> **Article Sources**
>
> 1. Rocket Mortgage. "[Measuring Absorption Rate in Real Estate](https://www.rocketmortgage.com/learn/absorption-rate#:~:text=Put%20simply%2C%20the%20absorption%20rate,home%20demand%20and%20home%20prices.)."
>
> 2. Fortune Builders. "[Real Estate Absorption Rate and What it Means for Investors](https://www.fortunebuilders.com/absorption-rate-real-estate/)."
>
> 3. National Association of Realtors. "[National Association of REALTORS® Reaches Agreement to Resolve Nationwide Claims Brought by Home Sellers](https://www.nar.realtor/newsroom/nar-reaches-agreement-to-resolve-nationwide-claims-brought-by-home-sellers)."
>
> 4. Accounting Tools. "[Rate of Absorption Definition](https://www.accountingtools.com/articles/what-is-the-rate-of-absorption-in-accounting.html)." |
Acceptable Quality Level (AQL) | # Understanding Acceptable Quality Level (AQL) in Quality Control
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*— Investopedia / Mira Norian*
## What Is Acceptable Quality Level (AQL)?
The acceptable quality level or limit (AQL) is a crucial measure in quality control. It applies to products and is defined in ISO 2859-1 as the maximum number of defective items that can be considered acceptable during random sampling inspections of a production batch. ISO 2859-1 defines AQL as the "worst tolerable" quality level, helping manufacturers and buyers agree on defect limits. AQL is usually shown as a percentage or ratio of defects to the total number produced.
AQL prevents batch rejection and ensures product consistency. For example, if a production run of 5,000 units has an AQL of 1%, no more than 50 defective items (1% of 5,000) would be acceptable for the batch. Any amount over 50 defective items would lead to a rejection. AQL standards differ by industry. Stricter levels apply to products with significant risk from defects, like medical items, where even one defect is critical.
### Key Takeaways
* AQL, or Acceptable Quality Level, is a standard in quality control that determines the maximum number of permissible defective items in a manufacturing batch.
* Different industries apply various AQL standards, especially with higher-stakes items; for example, the medical field often requires near-zero defects.
* AQL standards are used during pre-shipment inspections to decide whether a batch meets the agreed-upon quality specifications or should be rejected.
* AQL is a crucial metric for companies aiming for high efficiency and minimal defects, often utilizing methodologies like Six Sigma to achieve these quality targets.
* Understanding AQL helps businesses align buyer and seller expectations, ensuring product satisfaction and maintaining production efficiency.
## Understanding the Mechanisms of AQL in Quality Control
AQL is a global standard used to check product quality by sampling from each batch. It sets the maximum number of defective units that are allowed before the entire batch is rejected.
Random samples are tested. If defects are below a set number, the product meets AQL. If the AQL isn't reached for a particular sampling of goods, manufacturers will review the various parameters in the production process to determine the areas causing the defects.
For example, consider an AQL of 1% on a production run. This percentage means no more than 1% of the batch can be defective. If a production run comprises 1,000 products, only 10 (1%) of the products can be defective. If 11 products are defective, the entire batch is scrapped. This figure of 11 or more defective products is the rejectable quality level (RQL).
The AQL is an important statistic for companies seeking a [Six Sigma](https://www.investopedia.com/terms/s/six-sigma.asp) level of [quality control](https://www.investopedia.com/terms/q/quality-control.asp), a methodology developed in 1986 by Motorola, Inc. It aims to minimize defects and reduce variability to achieve near-perfect quality levels.
## Exploring Industry Variations in AQL Standards
The AQL of a product can vary from [industry to industry](https://www.investopedia.com/the-5-largest-u-s-product-liability-cases-4773418). For example, medical products are more likely to have more stringent AQL because defective products can result in health risks.
In contrast, a product with benign side effects from a possible defect may have a less strict AQL, such as the remote control for a TV. Companies have to weigh the added cost associated with stringent testing and potentially higher spoilage due to a lower defect acceptance against the [potential cost](https://www.investopedia.com/articles/investing/010815/how-do-recalls-affect-company.asp) of a [product recall](https://www.investopedia.com/terms/p/product_recall.asp).
Customers prefer zero-defect products or services, which is the ideal quality level. However, sellers and customers usually try to [arrive at and set acceptable quality](https://www.investopedia.com/terms/a/acceptance-testing.asp) limits based on factors typically related to business, financial, and safety concerns.
> **Important**
>
> A product's AQL varies across industries. Medical products have low AQLs because defects can pose health risks. General consumer goods might have an AQL around 2.5%, but in pharmaceuticals, it can be as low as 0.065% due to safety needs.
## How to Utilize AQL Tables for Quality Assessment
AQL tables (also called AQL charts) are designed to allow users to reference a standard for what qualifies as an acceptable number of defects in manufacturing. These ISO 2859 tables help determine how many defects are allowed for a specific AQL standard.
For example, let's say a company orders 30,000 hats from a clothing manufacturer that will be produced in one batch, and the buyer and producer have agreed on AQL 0.0 for critical defects, AQL 3.0 for major defects, and AQL 5.0 for minor defects. The AQL tables would guide them in determining how many hats need to be inspected to ensure compliance with these standards during production.
### Categorizing Defects Using AQL Standards
Instances of failure to meet customer quality requirements are termed as defects, which fall into three categories:
1. **Critical defects**: These are defects that could harm users and are entirely unacceptable, with an AQL set at 0%.
2. **Major defects**: Defects usually not acceptable by the end-users, as they'll likely result in failure. The AQL for major defects is typically set at 2.5%.
3. **Minor defects**: These defects do not significantly impact the product's usability but deviate from specified standards. Some end-users might still accept these products, with an AQL usually set at 4%.
### Applying AQL in Real-World Scenarios
**Acceptable quality level (AQL)**: AQL is typically considered the worst quality level still considered satisfactory. It's the maximum percent defective that can be considered satisfactory. The probability of accepting an AQL lot should be high. A probability of 0.95 translates to a risk of 0.05. This means there's a 95% chance of accepting the lot, with a 5% risk of rejecting it.
**Rejectable quality level (RQL)**: This is considered unsatisfactory and sometimes known as lot tolerance percent defective (LTPD). Some tables have standardized the consumer’s risk as 0.1. meaning there's a 10% chance that a lot with defects at the RQL level will be mistakenly accepted. The probability of accepting an RQL lot is low.
**Indifference quality level (IQL)**: This quality level is between AQL and RQL. Different companies maintain different interpretations of each defect type. However, buyers and sellers agree on an AQL standard that's appropriate to the level of risk each party assumes. These standards are used as a reference during a pre-shipment inspection.
## What Factors Are Used to Determine if AQL Is Being Met?
To calculate AQL, you need the lot or batch size, the inspection type, the inspection level, and the desired AQL. AQL calculators are available online. If your lot or batch size is 50,000, your inspection type is general, your inspection level is 2, and your AQL level is 2.5, you would need a sample size of 500 units with only 21 defects. If more than 21 defects are found in this sample, the batch would be rejected.
## What Does an AQL of 2.5 Mean?
An AQL of 2.5 means that only 2.5% of an order can be defective to be acceptable. If more than 2.5% of the order is defective, the batch doesn't meet the agreed-upon quality standard between the buyer and producer. For example, if 20,000 pairs of shorts are ordered, 500 defective items would be acceptable under an AQL of 2.5%.
## What Is the Standard AQL?
There's no standard AQL, as it varies by product and industry. For example, in the medical industry, AQL must be very low because defects in medical equipment or products can harm consumers. In clothing manufacturing, AQL might be higher. Ultimately, the acceptable AQL is determined by the agreement between the buyer and producer during the order process.
## The Bottom Line
Acceptable Quality Level (AQL) is the measure that balances the acceptable number of defects in a product batch against quality standards agreed upon by both manufacturers and buyers. AQL is an industry-recognized standard referenced in ISO 2859-1, which helps buyers and sellers set and respect defect thresholds to avoid rejections and ensure customer satisfaction.
AQL standards vary across different industries, with stricter AQLs applying to industries where defects can lead to significant risks, such as the medical or pharmaceutical fields. They minimize defects, ensure quality control, and maintain efficiency in large-scale production while meeting customer specifications.
Manufacturers and buyers use AQL tables or charts to determine permissible defect levels, aiding in pre-shipment inspections and reducing the likelihood of product recalls. AQL supports both high-quality production and mutual satisfaction between buyers and producers by enabling effective communication and agreement on product quality expectations.
> **Article Sources**
>
> 1. International Organization for Standardization. "[ISO 2859-1:1999(en)](https://www.iso.org/obp/ui/#iso:std:iso:2859:-1:ed-2:v1:en)."
>
> 2. Critical Manufacturing. "[AQL in Medical Device Manufacturing and the Role of MES in Its Implementation](https://www.criticalmanufacturing.com/blog/aql-in-medical-device-manufacturing-and-the-role-of-mes-in-its-implementation/)."
>
> 3. Tetra Inspection. "[How to Choose a Suitable AQL Level?](https://tetrainspection.com/aql-level/)"
>
> 4. Motorola Solutions. "[Help Improve Company Performance with Motorola Solutions’ Lean Six Sigma Program](https://www.motorolasolutions.com/newsroom/press-releases/help-improve-company-performance-with-motorola-solutions-lean-six-sigma-pro.html)."
>
> 5. Six Sigma Development Solutions, Inc. "[What Is an Acceptable Quality Level?](https://sixsigmadsi.com/what-is-an-acceptable-quality-level/)"
>
> 6. Insight Quality Services. "[What Is AQL and What Do You Need to Know About It?](https://insight-quality.com/what-is-aql-and-what-do-you-need-to-know-about-it/)"
>
> 7. Tetra Inspection. "[AQL Calculator Acceptable Quality Limit](https://tetrainspection.com/aql-calculator-acceptable-quality-limit/)." |
Accepting Risk | # Accepting Risk: Definition, How It Works, and Alternatives
## What Does Accepting Risk Mean?
Accepting risk, or risk acceptance, occurs when a business or individual acknowledges that the potential loss from a risk is not great enough to warrant spending money to avoid it. Also known as "[risk retention](https://www.investopedia.com/terms/c/complete-retention.asp)," it is an aspect of [risk management](https://www.investopedia.com/terms/r/riskmanagement.asp) commonly found in the business or investment fields.
Risk acceptance posits that infrequent and small risks—ones that do not have the ability to be catastrophic or otherwise too expensive—are worth accepting with the acknowledgment that any problems will be dealt with if and when they arise. Such a trade-off is a valuable tool in the process of prioritization and budgeting.
### Key Takeaways
* Accepting risk, or risk retention, is a conscious strategy of acknowledging the possibility for small or infrequent risks without taking steps to hedge, insure, or avoid those risks.
* The rationale behind risk acceptance is that the costs to mitigate or avoid risks are too great to justify given the small probabilities of a hazard, or the small estimated impact it may have.
* Self-insurance is a form of risk acceptance. Insurance, on the other hand, transfers risk to a third-party.
## Accepting Risk Explained
Many businesses use risk management techniques to identify, assess and prioritize risks for the purpose of minimizing, monitoring, and [controlling](https://www.investopedia.com/terms/r/risk-control.asp) said risks. Most businesses and risk management personnel will find that they have greater and more numerous risks than they can manage, mitigate, or avoid given the resources they are allocated. As such, businesses must find a balance between the potential costs of an issue resulting from a known risk and the expense involved in avoiding or otherwise dealing with it. Types of risks include uncertainty in financial markets, project failures, legal [liabilities](https://www.investopedia.com/terms/l/liability.asp), [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp), accidents, natural causes and disasters, and overly aggressive competition.
Accepting risk can be seen as a form of [self-insurance](https://www.investopedia.com/terms/s/selfinsurance.asp). Any and all risks that are not accepted, transferred or avoided are said to be "retained." Most examples of a business accepting a risk involve risks that are relatively small. But sometimes entities may accept a risk that would be so catastrophic that insuring against it is not feasible due to cost. In addition, any potential losses from a risk not covered by insurance or over the insured amount is an example of accepting risk.
## Some Alternatives to Accepting Risk
In addition to accepting risk, there are a few ways to approach and treat risk in risk management. They include:
* [**Avoidance**](https://www.investopedia.com/terms/r/regret-avoidance.asp): This entails changing plans to eliminate a risk. This strategy is good for risks that could potentially have a significant impact on a business or project.
* [**Transfer**](https://www.investopedia.com/terms/t/transferofrisk.asp): Applicable to projects with multiple parties. Not frequently used. Often includes insurance. Also known as "risk sharing," insurance policies effectively shift risk from the insured to the insurer.
* [**Mitigation**](https://www.investopedia.com/ask/answers/040315/what-difference-between-risk-avoidance-and-risk-reduction.asp): Limiting the impact of a risk so that if a problem occurs it will be easier to fix. This is the most common. Also known as "optimizing risk" or "reduction," [hedging](https://www.investopedia.com/terms/h/hedge.asp) strategies are common forms of risk mitigation.
* **Exploitation**: Some risks are good, such as if a product is so popular there are not enough staff to keep up with sales. In such a case, the risk can be exploited by adding more sales staff. |
Acceleration Clause | # Acceleration Clause: Explanation and Examples
## What Is an Acceleration Clause?
An acceleration clause is a contract provision that allows a lender to require a borrower to repay all of an outstanding loan if certain requirements are not met. An acceleration clause outlines the reasons that the lender can demand loan [repayment](https://www.investopedia.com/terms/r/repayment.asp) and the repayment required.
It is also known as an "[acceleration covenant.](https://www.investopedia.com/terms/a/accelerationcovenant.asp)"
### Key Takeaways
* An acceleration clause or covenant is a contract provision that allows a lender to require a borrower to repay all of an outstanding loan if specific requirements are not met.
* The acceleration clause clearly outlines the reasons that the lender can demand loan repayment and the repayment required, such as maintaining a certain credit rating.
* An acceleration clause helps to protect lenders who extend financing to businesses in need of capital.
## Acceleration Clause Explained
An acceleration clause allows the lender to require payment before the standard terms of the [loan](https://www.investopedia.com/terms/l/loan.asp) expire. Acceleration clauses are typically contingent on on-time payments.
Acceleration clauses are most common in mortgage loans and help to mitigate the risk of default for the lender. They are usually based on payment delinquencies but they can be structured for other occurrences as well. In most cases, an acceleration clause will require the borrower to immediately pay the full balance owed on the loan if terms have been breached. With full payment of the loan the borrower is relieved of any further [interest](https://www.investopedia.com/terms/i/interest.asp) payments and essentially pays off the loan early at the time the acceleration clause is invoked.
An acceleration clause is usually based on payment delinquency, however the number of [delinquent](https://www.investopedia.com/terms/d/delinquent.asp) payments can vary. Some acceleration clauses may invoke immediate payoff after one payment is missed while others may allow for two or three missed payments before demanding that the loan be paid in full. Selling or transferring the property to another party can also potentially be a factor associated with an acceleration clause.
For example, assume a borrower with a five year mortgage loan fails to make a payment in the third year. The terms of the loan include an acceleration clause which states the borrower must repay the remaining balance if one payment is missed. The borrower would immediately be contacted by the lender to pay the remaining balance in full. If the borrower pays then they receive the title to the home and takes full ownership of the property. If the borrower cannot pay then they are considered in breach of contract and the lender can foreclose and seize the property for resale.
## Invoking the Acceleration Clause
Acceleration clauses are most commonly found in mortgage and real estate loans. Since these loans tend to be so large, the clause helps protect the lender from the risk of borrower default. A lender may choose to include an acceleration clause to mitigate potential losses and have greater control over the [real estate](https://www.investopedia.com/terms/r/realestate.asp) property tied to a mortgage loan. With an acceleration clause, a lender has greater ability to foreclose on the property and take possession of the home. This may be advantageous to the lender if the borrower defaults and the lender believes they can obtain value through a resale. |
Accidental Death Benefits | # Accidental Death Benefit Explained: Coverage and Key Examples
## What Is an Accidental Death Benefit?
An accidental [death benefit](https://www.investopedia.com/terms/d/deathbenefit.asp) is a payment due to the [beneficiary](https://www.investopedia.com/terms/b/beneficiary.asp) of an accidental death insurance policy. It enhances financial protection by providing an additional payout to beneficiaries if the insured dies from an accident. Offered as a rider to standard insurance policies, it covers incidents like car crashes or slips. This plan is crucial for workers in high-risk environments or those with significant commuting needs.
### Key Takeaways
* An accidental death benefit (ADB) is a supplementary insurance payment made to beneficiaries when the insured dies in an accident, in addition to the standard life insurance payout.
* ADB is frequently purchased as an optional rider on a life insurance policy and often comes with specific exclusions, such as deaths from illnesses or risky activities.
* The benefit can be crucial for individuals in dangerous jobs or environments and typically involves an additional premium.
* Insurance companies typically have strict definitions for what constitutes an "accidental" death, focusing on events like car crashes or machinery accidents.
* Some accidental death policies may also include dismemberment coverage, offering payouts for severe injuries.
## Exploring the Details of Accidental Death Benefits
Accidental death benefits are riders or provisions that may be added to basic life insurance policies at the request of the insured party. Some people add accidental death benefit riders to their policies to protect their beneficiaries if an accident occurs. This is crucial because accidents are unpredictable and can cause financial hardship if death occurs suddenly.
Accidental death benefits are important for people who work in or around potentially hazardous environments. Even those who drive more than average—either professionally or as a commuter—should consider accidental death benefit riders.
As an optional feature, the insured party must pay an additional fee on top of their regular [premiums](https://www.investopedia.com/terms/p/premium.asp) to purchase this benefit. Then, the accidental death benefit increases the payout to a policy's beneficiary. So, the beneficiary essentially receives the death benefit paid by the policy itself, plus any additional accidental death benefit covered by the rider. These riders generally expire when the insured person reaches a certain age, like 60, 70, or 80.
## Defining Accidental Death in Insurance Policies
Insurance companies define accidental death as an event that strictly occurs as a result of an accident. Deaths from car crashes, slips, choking, drowning, machinery, and any other situations that can't be controlled are deemed accidental. For a fatal accident, death typically has to happen within a period specified by the policy.
Some policies' accidental death benefits may also include coverage for dismemberment, burns, paralysis, and similar events. These riders are called [accidental death and dismemberment (AD&D) insurance](https://www.investopedia.com/terms/a/accidental-death-dismemberment-insurance.asp).
> **Important**
>
> Accidents typically exclude things like acts of war and death caused by illegal activities. Death from an illness is also excluded. Any hazardous hobbies that the insured regularly engages in—race car driving, bungee jumping, or other risky activities—are often excluded as well.
## Different Types of Accidental Death Benefit Plans
### Group Life Supplement
A group life supplement includes the accidental death benefit as part of a [group life insurance](https://www.investopedia.com/terms/g/group-life-insurance.asp) contract, often offered by employers. The benefit amount is usually the same as that of the group life benefit.
### Voluntary
A voluntary accidental death benefit plan is an elective option for group members. Employers offer it, but you pay the premiums. You generally pay these premiums through regular payroll deductions. Employees are covered for accidents that occur while on the job. Policies pay out benefits for [voluntary accident insurance](https://www.investopedia.com/terms/v/voluntary-life-insurance.asp) even if the insured party isn't at work.
### Travel Accident
The accidental death benefit plan with travel accident insurance is provided through an employee benefit plan and provides supplemental accident protection to workers while they are traveling on company business. Unlike voluntary accident insurance, the employer usually pays the entire premium for this coverage.
### Dependents
Some group accidental death benefit plans also provide coverage for [dependents](https://www.investopedia.com/terms/d/dependent.asp). If you have a spouse or partner, or children who depend on your salary to pay bills and other costs, it may be a good idea to enroll in an accidental death benefit.
This additional insurance could help them out by providing money to pay bills, pay off a mortgage, or provide money to your children for future events, like college. In addition, if you co-own a business, your business partner could be listed on your insurance policy to cover any outstanding debts in the event of your death.
## Example of Accidental Death Benefit Payout
As a hypothetical example, assume you have a $500,000 life insurance policy with a $1 million accidental death benefit rider. If you die due to a heart attack—a natural cause—the insurance company will pay your beneficiary $500,000. If you die as a result of a car accident, your beneficiary will receive the $500,000 life insurance benefit plus the $1 million accidental death benefit for a total [payout](https://www.investopedia.com/terms/p/payout.asp) of $1.5 million.
## What Is Considered Accidental Death for Insurance Purposes?
Insurance companies consider accidental death to be an event that causes your death as the result of an accident. For example, most car crashes, falls down the stairs, machinery, choking, and even drowning are circumstances beyond your control, and thus counted as accidental.
## What Is Accidental Death and Dismemberment Insurance?
Accidental death and dismemberment insurance covers you in the case of accidental death, or if you lose a limb (or other significant injuries) in an accident that causes you to stop working. Besides being dismembered, the insurance may include workplace injuries, injuries caused by a fire or flood, accidents with firearms, or a serious fall.
## Are Accidental Death and Dismemberment (AD&D) Insurance and Accidental Death Benefit (ADB) the Same Thing?
Accidental death and dismemberment (AD&D) and accidental death benefit (ADB) policies both pay a benefit. The main difference is that an AD&D policy will pay if the insured is dismembered or injured, whereas the ADB only pays a benefit if the insured dies.
## The Bottom Line
Accidental death benefits are paid to beneficiaries of an accidental death insurance policy. They provide financial protection to beneficiaries when an insured person dies due to an accident. This coverage is typically an optional rider to basic life insurance, often expiring at a specific age determined by the insurance provider. It's crucial to understand what constitutes an accident as defined by insurers, as this affects eligibility. Individuals working in hazardous settings or engaging in activities with higher risks should strongly consider adding this rider to safeguard their beneficiaries. |
Accidental Death and Dismemberment Insurance (AD&D) | # Understanding Accidental Death & Dismemberment (AD&D) Insurance
## What Is Accidental Death and Dismemberment (AD&D) Insurance?
Accidental death and dismemberment (AD&D) insurance is insurance—usually added as a rider to a health or [life insurance policy](https://www.investopedia.com/the-best-life-insurance-companies-8763666)—that covers the unintentional death or dismemberment of the insured due to an unforeseen accident. Dismemberment includes the loss, or the loss of use, of body parts or functions (such as limbs, speech, eyesight, and hearing).
Because of coverage limitations, prospective buyers should carefully read the terms of the policy. For instance, AD&D insurance is limited and generally covers unlikely events. Events not covered include, but are not limited to are suicide or death from illness or natural causes. Also, it is [supplemental life insurance](https://www.investopedia.com/articles/company-insights/090116/when-should-you-get-supplemental-life-insurance.asp) and is not an acceptable substitute for a full life insurance policy. However, the cost is typically low, particularly if offered by an employer.
### Key Takeaways
* AD&D insurance covers accidental death and dismemberment, not natural deaths like heart disease or cancer.
* Often added as a rider to life insurance, AD&D provides additional coverage for accidental events.
* AD&D policies usually have exclusions, such as covering accidents but not terrorist attacks or suicides.
* Voluntary AD&D offers optional coverage typically purchased by those in high-risk occupations.
* Premiums for AD&D insurance are generally lower than for full life insurance policies.
:max_bytes(150000):strip_icc()/Accidental-Death-and-Dismemberment-ADD-Insurance-v3-745262583fd74ebf9964311fd9bcaf29.png)
*— Investopedia / Lara Antal*
## Understanding AD&D Insurance: Coverage and Limitation
AD&D insurance contains a schedule that details the terms and percentages of the various benefits and covered special circumstances. If an insured person dies from accident injuries, the death must occur within a set time to get benefits.
## Coverage for Accidental Death in AD&D Plans
When adding an AD&D rider, also known as a “double indemnity” rider, to a life insurance policy, the designated [beneficiaries](https://www.investopedia.com/terms/b/beneficiary.asp) receive benefits from both the rider and the underlying policy if the insured dies accidentally.
Benefits usually have a maximum limit outlined in the rider. As most AD&D insurance payments mirror the [face value](https://www.investopedia.com/ask/answers/013015/how-do-i-determine-face-value-life-insurance-policy.asp) of the original life insurance policy, the beneficiary normally receives a benefit twice the amount of the life insurance policy’s face value upon the accidental death of the insured.
Typically, accidental death covers exceptional circumstances, such as exposure to the elements, traffic accidents, homicide, falls, drowning, and accidents involving heavy equipment.
> **Warning**
>
> AD&D insurance is supplemental life insurance and not an acceptable substitute for a full life insurance policy.
### Coverage for Dismemberment: What AD&D Plans Include
Most AD&D policies pay a percentage for the loss of a limb, partial or permanent paralysis, or the loss of use of specific body parts, such as the loss of sight, hearing, or speech. The types and extent of injuries covered are particular to and defined by each insurer and policy.
### Exploring Voluntary AD&D Insurance
[Voluntary accidental death and dismemberment (VAD&D)](https://www.investopedia.com/terms/v/voluntary-accidental-death-and-dismemberment-insurance-vadd.asp) insurance is an optional financial protection plan that provides a beneficiary with cash if the policyholder is accidentally killed or loses certain body parts. VAD&D is also a limited form of life insurance and is generally less expensive than a full life insurance policy.
Premiums are based on the amount of insurance purchased. VAD&D insurance is typically purchased by workers in occupations that place them at high risk of physical injury. Most policies are renewed periodically with revised terms.
How much such a policy pays depends not only on the amount of coverage purchased but also on the type of claim filed. For example, the policy might pay 100% if the policyholder is killed or becomes quadriplegic, but only 50% for the loss of a hand or the permanent loss of hearing in one ear or sight in one eye.
## Exclusions in AD&D Insurance: What's Not Covered
Each insurance provider includes a list of exclusions. In most instances, the list includes suicide, death from illness or natural causes, and [wartime injuries](https://www.investopedia.com/terms/w/war-exclusion-clause.asp).
Other common exclusions include death resulting from the overdose of toxic substances, death while under the influence of nonprescription drugs, suicide, certain recreational activities, and the injury or death of a professional athlete during a sporting event.
Usually, if the insured’s loss occurs because of a felonious act on his or her part, no benefit is payable. People working in high-risk jobs (such as public safety and the military) may not qualify for AD&D coverage.
> **Important**
>
> As of the 2022 report, accidents are the third leading cause of death in the U.S. (latest data available).
## Pros and Cons of AD&D Coverage
### Advantages
**Financial assistance:** An accidental death impacts the surviving loved ones emotionally as well as financially, as they must now deal with a sudden loss of income. The death benefit from an AD&D policy can add peace of mind by [lessening that burden](https://www.investopedia.com/articles/pf/07/beneficiary_form.asp).
**Supplements lost income:** Because the loss of income will carry forward, AD&D policies provide funds in addition to the death benefit offered through the traditional life insurance on the insured. The death benefit amount is usually equal to or some multiple of the traditional policy's death benefit amount. This extra benefit, called [double indemnity](https://www.investopedia.com/articles/pf/07/life_insurance_rider.asp), often doubles the death benefit.
**Lower premiums:** Since coverage is limited to certain accidental events, premiums are usually low. When offered by an employer, it might cost employees just a few dollars a month. Even if bought individually, AD&D costs are much lower than term insurance for the same coverage.
**No medical exam:** Most insurers don't require a medical exam for AD&D coverage, especially for group plans from employers.
### Disadvantages
**Only pays for certain incidents:** This limited coverage can be disadvantageous to policyholders because it only pays for certain events. If death occurs outside of these limitations, the AD&D policy does not pay. Premiums paid are forfeited and remain with the insurer.
For example, if someone dies as a result of a terrorist attack, no benefit is paid because that is considered a wartime act. Insurers have the ability to make exceptions to this, as was done for victims of the 9/11 terrorist attacks in the United States.
**Low likelihood of payout:** Heart-related issues are the leading cause of death in the U.S., with accidents ranking third. Therefore, it is more likely that someone will die from natural causes than from an accident, especially older adults and those not engaged in risky work.
**Group coverage lost when you change jobs:** Group or employer-sponsored plans might not be [portable](https://www.investopedia.com/terms/p/portable-benefits.asp) if you leave the group or employer. Often, coverage ends upon the termination of the insured's affiliation with the sponsor, leaving them unprotected until new coverage is issued.
**False sense of security:** Including AD&D in total life insurance can give a false sense of security during planning. Because AD&D only pays upon certain events, it should not be used to determine whether your life insurance portfolio is sufficient. [Traditional life insurance](https://www.investopedia.com/whole-life-insurance-pros-and-cons-5079309) should be adequate to provide the necessary financial support to the beneficiaries. AD&D supplements that payout in the unlikely event that death occurs from an accident. Still, it adds an extra benefit with the sudden and unexpected departure of the insured.
## What Is AD&D Insurance?
Accidental death and dismemberment (AD&D) insurance pays benefits in the case of a person’s accidental death or dismemberment. While it is usually added as a rider on a life insurance policy, it can also be purchased as standalone coverage.
## What Is the Difference Between Life Insurance and AD&D Insurance?
Accidental death and dismemberment (AD&D) coverage only pays a benefit if death results from a covered accident or upon the loss (or loss of use) of a limb. In contrast, coverage is broader with life insurance. Life insurance policies pay benefits upon the death of the insured, despite how the death occurred. (Note: Exceptions apply depending on policy terms.)
## What Is Voluntary AD&D Insurance?
Voluntary accidental death and dismemberment (VAD&D) insurance is an optional financial protection plan typically sold in the workplace that covers the same situations that regular AD&D insurance does. It is often purchased by workers in occupations that come with physical risk.
## Does AD&D Cover Heart Attacks?
Although unexpected, a heart attack is considered a natural cause of death and is, therefore, typically excluded from AD&D coverage. There is one exception to this exclusion. If the heart attack was precipitated by the accident, most AD&D policies will pay the stated benefit. For example, if an insured with no underlying heart issues has a heart attack immediately after a catastrophic car accident and subsequently dies, the policy may pay.
## How Much Does AD&D Insurance Cost?
AD&D coverage is relatively inexpensive compared to traditional (term) and whole life insurance. Costs can be as little as a few dollars per month. However, rates vary according to the type of AD&D coverage issued and the insurer.
## The Bottom Line
Accidental death and dismemberment (AD&D) is a supplemental insurance policy that pays a benefit upon the accidental death of an insured or upon the loss of a limb due to an accident. Often added as a rider, AD&D is designed to supplement regular life insurance, as coverage is limited to certain types of accidents and deaths not caused by natural causes like illness or heart attacks. Common exclusions include suicide or deaths from natural causes; however, if a heart attack is triggered by accidents, then it may be covered under the policy.
For those working in high-risk occupations, a voluntary AD&D can help cover financially devastating accidents. Still, AD&D can serve as an affordable insurance option with lower premiums, offering [financial support](https://www.investopedia.com/articles/personal-finance/091014/who-needs-life-insurance-who-doesnt.asp) to beneficiaries without the need for a medical exam. You should always carefully review policy details and understand what's covered and what's excluded to ensure the policy meets your insurance needs.
> **Article Sources**
>
> 1. Thompson, Cynthia. “[Compensation for Death and Dismemberment](https://www.bls.gov/mlr/1989/09/art2full.pdf).” _U.S. Bureau of Labor Statistics, Monthly Labor Review_, September 1989, pp. 13-16.
>
> 2. International Risk Management Institute. “[Double Indemnity](https://www.irmi.com/term/insurance-definitions/double-indemnity).”
>
> 3. Progressive. "[Life Insurance vs. AD&D Insurance](https://www.progressive.com/answers/life-insurance-vs-accidental-death-insurance/)."
>
> 4. Abrams Insurance Solutions, Inc. "[What is Voluntary AD&D (Accidental Death & Dismemberment)?](https://abramsinc.com/voluntary-add/)"
>
> 5. Centers for Disease Control and Prevention. "[Mortality in the United States, 2022](https://www.cdc.gov/nchs/products/databriefs/db492.htm)." Figure 4. Age-adjusted death rate for the 10 leading causes of death in 2022: United States, 2021 and 2022.
>
> 6. RAND Corporation. "[Compensating the Victims of 9/11](https://www.rand.org/pubs/research_briefs/RB9087.html)."
>
> 7. Munich Re Life US. “[Accidental Death Benefits – What Makes an Accident an Accident?](https://www.munichre.com/us-life/en/insights/best-practices/accidental-death-benefits-what-makes-an-accident-an-accident.html)” |
Account Balance | # What Is an Account Balance?
## What Is an Account Balance?
An account balance is the amount of money in a financial repository, such as a savings or checking account, at a specific time. It factors in all debits and credits. Account balances are also shown on billing statements for credit cards, utilities, and loans.
### Key Takeaways
* An account balance represents the current value of a financial account, such as a checking, savings, or investment account.
* Financial institutions provide account balances on paper statements and online.
* The account balance for investments in brokerage accounts can change daily as security prices rise and fall in the market.
## Calculating Account Balances
An account balance reflects total [assets](https://www.investopedia.com/ask/answers/12/what-is-an-asset.asp) minus total liabilities. In banking, the account balance is the money available in a [checking](https://www.investopedia.com/best-high-yield-checking-accounts-5070332) or savings account. It's the net amount available after all deposits and credits have been balanced with any charges or debits.
An account balance for investments in brokerage accounts can change daily as [security](https://www.investopedia.com/terms/s/security.asp) prices rise and fall in the market. Other types of accounts also have an account balance, such as a utility bill or a mortgage loan. The account balance for these accounts shows the amount owed.
> **Warning**
>
> A bank account balance can be inaccurate if a check has yet to clear the bank or a pending transaction has not yet gone through.
## Examples of Account Balances
For example, a credit card might have several purchases and a refund charge. The amounts posted might be $100, $50, and $25, and a returned item that costs $10. The account balance includes purchases totaling $175 and items returned for $10. The net of the debits and credits is $165, or $175 minus $10, which is the account balance.
[For a checking account](https://www.investopedia.com/personal-finance/6-different-types-checking-accounts/), if the starting balance is $500, and a check for $1,500 is received, but an automatic payment is scheduled for $750, the account balance might show $2,000 immediately, but the actual account balance is $1,250.
## Account Balance vs. Available Credit
For credit cards, account balances represent the total debt owed at the start of the statement date and include any debt rolled over from previous months with interest charges. Available credit is the term used alongside the account balance to indicate [how much of the credit line is left to spend](https://www.investopedia.com/ask/answers/102814/what-difference-between-available-credit-and-credit-limit.asp).
## How Can Individuals Check a Bank Account Balance?
Account holders can check balances by signing in to their bank's app or website, looking at their latest transactions, or visiting the local branch and speaking with a representative.
## What Kinds of Accounts Have Account Balances?
Checking, savings, and brokerage accounts all have account balances. However, expenses like utility bills, mortgage loans, or credit cards also have account balances.
## What's Available Credit?
Available credit refers to the amount remaining on the credit line. It can be determined by subtracting the account balance from the credit limit.
## Can You Withdraw Your Bank Account Balance?
Yes, because your bank account balance shows you how much money you have available in your account. The money is there for you to withdraw or leave in the account, possibly to earn interest payments.
## The Bottom Line
An account balance represents the available funds in a financial account, such as a checking, savings, or investment account. A brokerage account balance can change daily as security prices rise and fall in the market. A bank account balance can be inaccurate if pending transactions exist but haven't yet been posted or recorded.
> **Article Sources**
>
> 1. AccountingTools. "[Account Balance Definition](https://www.accountingtools.com/articles/what-is-an-account-balance.html)."
>
> 2. Bank of America. "[Managing Your Investment Account](https://healthaccounts.bankofamerica.com/managing-your-investments.shtml)." |
Account in Trust | # Account in Trust: Definition, Types, Benefits, How to Set One Up
:max_bytes(150000):strip_icc()/Account-in-trust_final-77724c8a25804394a6889152b7527625.png)
*— Investopedia / Michela Buttignol*
## What Is an Account in Trust?
The term account in trust refers to a financial account opened by an individual and managed by a designated [trustee](https://www.investopedia.com/terms/t/trustee.asp) for the benefit of a third party per agreed-upon terms. The trustee who manages the funds and assets in the account generally acts as a [fiduciary](https://www.investopedia.com/terms/f/fiduciary.asp), which means they have a legal responsibility to manage the account and assets in the best interests of the [beneficiary](https://www.investopedia.com/terms/b/beneficiary.asp).
### Key Takeaways
* Trust accounts are managed by a trustee on behalf of a third party.
* Parents often open trust accounts for minor children.
* An account in trust can include cash, stocks, bonds, and other types of assets.
* Totten or Payable on Death (POD) trust accounts allow beneficiaries to claim the account's assets upon the death of the account holder.
* Account in Trust accounts generally avoid probate, making it easier and faster for the account to be settled.
## How an Account in Trust Works
Accounts in trust are also called trust accounts. They are created for the benefit of an individual and managed by a trustee. Trusts often come with certain conditions for use. For example, a parent can open a bank account for their minor child and stipulate rules as to when the child can access the funds/assets in the account as well as any [income](https://www.investopedia.com/terms/i/income.asp) they generate.
They can hold different assets like cash, stocks, bonds, [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp), and real estate among others. Trustees can vary, as well. They can be the person opening the account, someone else designated as a trustee, or a [financial institution](https://www.investopedia.com/terms/f/financialinstitution.asp), such as a bank or brokerage firm.
Trustees have the option to make certain changes to the account in trust. These can include naming a successor trustee or another beneficiary. A trustee may close the account or open a subsidiary account to which they can transfer some or all of the assets in the account in trust. The trustee is obligated to follow the instructions of the document that established the account in trust.
## Types of Accounts in Trust
The specifics of accounts in trust can vary depending on the type of account, terms outlined in any trust agreements, as well as applicable state and federal laws.
### Uniform Gifts to Minors Act (UGMA)
A [Uniform Gifts to Minors Act (UGMA)](https://www.investopedia.com/terms/u/ugma.asp) account allows minors to legally own the assets held within it. However, they can't access the account's principal and income until they reach legal age. This type of account in trust is typically opened by parents to fund their children's higher education and to secure certain tax protections.
UGMA accounts are managed by a custodian, who is appointed by the donor. The [custodian](https://www.investopedia.com/terms/c/custodian.asp) must manage the account for the benefit of the minor. They can invest the funds and withdraw money(within limits) for the minor's care and needs. Contributions can also be made to the account with no limits.
> **Fast Fact**
>
> A UGMA account is different from a Uniform Transfers to Minors Act (UTMA). A UTMA account allows for the donation of non-basic assets, such as life insurance and stocks.
### Payable on Death (POD)
Another type of account in trust is a [payable on death (POD)](https://www.investopedia.com/terms/p/payableondeath.asp) trust also called a Totten Trust. These accounts are essentially [bank accounts with named beneficiaries](https://www.investopedia.com/what-happens-to-your-bank-account-after-death-5217555) who can legally assume the trust's assets and income when the grantor dies. In addition, this type of account does not need to clear [probate](https://www.investopedia.com/terms/p/probate.asp) for assets to transfer to the rightful beneficiary upon the death of the initial owner.
There are events, however, that prevent the named beneficiary from obtaining the full value of the account upon the death of the account owner. In [community property](https://www.investopedia.com/terms/c/communityproperty.asp) states, the spouse of the decedent may be entitled to half of the account. The spouse is not entitled to funds accumulated before marriage. Also, the beneficiary does not receive a benefit from a jointly owned account if the joint owner is still living. The benefit is payable upon the death of the last surviving owner.
> **Fast Fact**
>
> POD trusts are protected by the Federal Deposit Insurance Corporation (FDIC) as are traditional bank accounts.
### Housing Accounts in Trust
A housing account in trust is opened by a [mortgage company](https://www.investopedia.com/terms/m/mortgage-company.asp). The lender uses this account to pay property taxes and insurance on a homeowner's behalf. This type of account in trust is also called an [escrow](https://www.investopedia.com/terms/e/escrow.asp) account, and funds to be deposited into it are usually included in the monthly mortgage payment.
The two main types of escrow accounts are the purchase escrow account and refinance escrow account. A purchase escrow account holds funds related to the purchase of a home and is managed by an escrow agent. [Earnest money](https://www.investopedia.com/terms/e/earnest-money.asp), presented by the buyer to the seller, and other real estate transaction fees, such as loan fees, agent commissions, and [appraisal](https://www.investopedia.com/terms/a/appraisal.asp) fees, are held in a purchase escrow account.
A refinance escrow account, much like a purchase escrow account, holds fees related to the transaction, which, in this case, is the refinance of a home. Such fees include appraisal and attorney fees.
## How to Set Up an Account in Trust
Before setting up an account in trust, review your available options and choose the one that best suits your needs. Consider the following details:
* Identify who you want to manage the trust and how you want it managed during your life and upon death
* Identify who you want as your beneficiary(s) and how you want them to receive the assets
* Determine what assets the trust will hold and under what condition they can be [disbursed](https://www.investopedia.com/terms/d/disbursement.asp)
Once the details are confirmed, complete and file the appropriate paperwork as per the rules of your state. It might be best to consult an attorney to ensure that the account is in line with your expectations.
## Benefits of an Account in Trust
Some individuals like accounts in trust because they avoid probate, enabling a quicker and easier distribution of assets. These accounts also may provide favorable tax benefits. For instance, the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) considers income as trust income (for irrevocable trusts), which usually results in a lower tax liability.
These accounts also allow the donor's wishes to be carried out during their lifetime and/or upon death. They can specify how they want their assets managed, how and when they will be dispersed, and who will manage them.
## Example of an Account in Trust
Mr. and Mrs. Q. Sample are school teachers who want to retire in 15 years. They have three adult children and two infant grandchildren. Hoping to secure their assets and create [college funds](https://www.investopedia.com/articles/pf/08/affordable-college-education.asp) for their grandchildren, they explore accounts in trust as options.
After meeting with an attorney, they decide to protect their assets in a [revocable trust](https://www.investopedia.com/terms/r/revocabletrust.asp), whereby they serve as co-trustees and their eldest child as a successor trustee. Their assets, including real estate, stocks, and other investments, will be managed in the trust. Upon death, all assets will be distributed equally among their children, who are named as the beneficiaries.
They also establish education trust accounts for each grandchild with an initial deposit of $5,000 into each account. Their goal is to invest $2,000 per account each year until the grandchildren reach the age of majority. The funds can only be used for educational purposes. However, if the grandchild does not attend college or trade school, the funds will be dispersed in monthly installments beginning at age 25.
## Should I Set Up a Trust Account?
If you have assets and specific preferences in how and to whom they are distributed, a trust account might be beneficial. Speak with an expert, such as an estate planner, advisor, or attorney to explore what trust accounts are available and which ones are advantageous for you.
## How Do I Create a Trust Account?
After deciding which trust account to establish, outline the conditions you want to be specified within the trust. Draft the trust document, according to the rules for your state. Be sure to name the parties (trustees) to manage the trust, as well as the beneficiaries. Then, create an account for and transfer assets into the trust, which can be done with most banks and financial institutions. Keep in mind that it may be helpful to seek advice and guidance from a professional before you consider setting up a trust.
## What Is the Difference Between a Revocable and Irrevocable Trust?
A revocable trust can be modified or revoked by the grantor. An irrevocable trust, on the other hand, is a trust that cannot be modified or revoked without the written consent of the beneficiaries.
## What's the Difference Between a Will and a Trust?
The terms [will and trust](https://www.investopedia.com/articles/personal-finance/051315/will-vs-trust-difference-between-two.asp) are often used interchangeably, but they are quite different. A will is a legal document outlining the final wishes of a person upon their death. It is only effective after its originator dies. Trusts are effective when they're created. They can outline how assets are treated during the grantor's life and upon their death.
An executor or executrix is appointed to ensure that a will is executed according to its specifications. A trustee, though, is appointed to ensure that the conditions of the trust are met. Unlike wills, trusts are not subject to probate and cannot be contested.
## The Bottom Line
[Estate planning](https://www.investopedia.com/terms/e/estateplanning.asp) can help you make important decisions about how your assets are distributed in certain situations, including after you die. Setting up an account in trust is one of the options available. This is an account that is set up to be managed by a trustee of your choice. You can name which assets are held in the trust, how they're managed, and when they're distributed. As with any financial decision, it's always a good idea to consult a financial professional to see if an account in trust is right for you.
> **Article Sources**
>
> 1. FINRA. "[College Savings Accounts: Types](https://www.finra.org/investors/investing/investment-accounts/college-savings-accounts#types)."
>
> 2. The American College of Trust and Estate Counsel. "[Pitfalls of Pay on Death (POD) Accounts](https://www.actec.org/resource-center/video/pitfalls-of-pay-on-death-accounts-pod/)."
>
> 3. Federal Deposit Insurance Corporation. "[Are My Deposit Accounts Insured by the FDIC?](https://www.fdic.gov/resources/deposit-insurance/financial-products-insured/index.html)" Select "Trust Account."
>
> 4. Better. "[What is an Escrow Account?](https://better.com/content/what-is-an-escrow-account/)"
>
> 5. University of Minnesota Extension. "[Trusts: Definitions, Types and Taxation](https://extension.umn.edu/transfer-and-estate-planning/trusts-definitions-types-and-taxation)."
>
> 6. Cornell Law School, Legal Information Institute. "[12 CFR § 330.10 - Revocable Trust Accounts](https://www.law.cornell.edu/cfr/text/12/330.10)."
>
> 7. American Bar Association. "[Revocable Trusts](https://www.americanbar.org/groups/real_property_trust_estate/resources/estate_planning/revocable_trusts/)."
>
> 8. American Bar Association. "[Introduction to Wills](https://www.americanbar.org/groups/real_property_trust_estate/resources/estate-planning/intro-wills/)." |
Account Number | # Understanding and Protecting Your Bank Account Number
:max_bytes(150000):strip_icc()/account-number.asp-FINAL-887f9ae4a2eb402e9d4beeaa55f29ca5.png)
*— Joules Garcia / Investopedia*
> **Definition**
>
> A bank account number is a unique set of digits used to identify and access a particular bank account.
## What Is a Bank Account Number?
A bank account number is a unique string of numbers that identifies a particular bank account and grants access to it. There may be instances where letters or other characters are a part of the account number. The bank account number is the middle set of numbers at the bottom of a paper check. This is one of the most important numbers for doing business transactions.
Bank account numbers are vulnerable to fraud and identity theft. To keep the account number safe, security measures like multifactor authentication and password managers are used.
### Key Takeaways
* Bank account numbers are crucial identifiers that work with routing numbers to facilitate the correct processing of transactions.
* With the advent of online banking, protecting your bank account numbers against identity theft and fraud is vital, using strategies like multifactor authentication.
* Your bank account number can be found on a paper check between the routing number and the check number, or on your bank statement.
* Safeguarding your bank account number is essential as financial fraud has become more sophisticated, demanding robust password practices and security measures.
## Understanding How Bank Account Numbers Function
A bank [checking account](https://www.investopedia.com/terms/c/checkingaccount.asp)’s number is located at the bottom of the [paper check](https://www.investopedia.com/articles/personal-finance/112515/top-5-reasons-banks-wont-cash-your-check.asp). At the bottom of the check, you'll see three sets of numbers in a computer-readable font:
* The first set of numbers on the left is the nine-digit bank routing number.
* The middle numbers are your account number.
* The third number set is the number of the check.
Payroll processing offices use checking account numbers to set up [direct deposit](https://www.investopedia.com/terms/d/directdeposit.asp) payments for employees.
## Essential Tips for Safeguarding Your Bank Account Number
Bank account numbers are vulnerable to [identity theft](https://www.investopedia.com/terms/i/identitytheft.asp) and [fraud](https://www.investopedia.com/terms/f/fraud.asp). This is why you have to answer questions about your mother’s maiden name when you try to make routine changes to an account like your bank account. Recently, password managers and [multifactor authentication (MFA)](https://www.investopedia.com/terms/t/twofactor-authentication-2fa.asp) systems have made it harder for hackers to steal account numbers.
Businesses now often employ a hard-to-hack master password to unlock an electronic vault of customers’ bank account numbers and other sensitive data. Consumers are getting used to multifactor authentication, which adds another step, like a fingerprint or a time-sensitive code sent to your phone, before accessing a bank account.
These are just some of the means of protecting users’ bank account numbers in an increasingly vulnerable online environment.
> **Important**
>
> The traditional check layout applies to most personal checks, but some business checks and bank-printed checks have other formats.
## Bank Account Numbers vs. Routing Numbers: What’s the Difference?
On a paper check, the nine-digit [routing number](https://www.investopedia.com/terms/r/routing_transit_number.asp) identifies specific financial institutions within the United States. The number identifies the check as having been issued by a federal- or state-chartered bank that maintains an account with the [Federal Reserve](https://www.investopedia.com/articles/economics/08/federal-reserve.asp).
This system dates back to 1910 and was developed initially as a way to help bank clerks sort through piles of checks and assign them to the correct drawer. Today, electronic services use routing numbers for [wire transfers](https://www.investopedia.com/terms/w/wiretransfer.asp) to ensure payments go to the right institution.
The individual’s bank account number works together with the routing number to identify the right account holder at the right institution.
## Finding Your Bank Account Number: A Quick Guide
You can find your bank account number on your monthly [bank statement](https://www.investopedia.com/terms/b/bank-statement.asp) or by visiting a [branch of your bank](https://www.investopedia.com/terms/b/branch-banking.asp).
If you are using a checking account, the account number is also printed on your paper checks. You can find it printed between the bank’s routing number and the check number, as shown below.
:max_bytes(150000):strip_icc()/dotdash_Final_Routing_Number_vs_Account_Number_Whats_the_Difference_Aug_20202-5d1e68ee4bba4714baace78ea019ee12.jpg)
**
## How Do You Find the Account Number on a Check?
You can find your bank account number printed at the bottom of your paper check. This is the second sequence of numbers, printed between the nine-digit routing number and the shorter check number. This number can also be found on your account statement.
## How Long Is a Bank Account Number?
A bank account number is usually eight to 12 digits long, but some account numbers have up to 17 digits. Note that this is not the same as your debit card number or credit card number.
## How Do You Find Out Your Account Number?
You can find your bank account number on your bank statements, printed at the bottom of a paper check, or by logging on to the bank’s website. If you can’t find it in these ways, try visiting a bank branch in person.
## The Bottom Line
The unique and critical roles of a bank account number are managing financial transactions, identifying bank accounts, and facilitating payments and deposits. To ensure proper account management, it's important to understand how bank account numbers work, including identifying them on checks and bank statements.
There are vulnerabilities associated with bank account numbers in online environments, calling for the need for robust security measures to prevent identity theft and fraud. Ways to protect bank account numbers include using multifactor authentication, strong passwords, and being vigilant about sharing sensitive information. Protecting one's bank account number is essential for securing personal financial information in today's digital age.
> **Article Sources**
>
> 1. American Bankers Association. “[ABA Routing Number™](https://www.aba.com/about-us/routing-number).”
>
> 2. U.S. Cybersecurity & Infrastructure Security Agency. “[Multi-Factor Authentication (MFA)](https://www.cisa.gov/resources-tools/resources/multi-factor-authentication-mfa).” Download PDF.
>
> 3. American Bankers Association. “[Routing Number Policy & Procedures](https://www.aba.com/news-research/analysis-guides/routing-number-policy-procedures#:~:text=The%20routing%20number%2C%20devised%20by,payment%20of%20a%20negotiable%20instrument.).”
>
> 4. Chase. “[What Is a Bank Account Number?](https://www.chase.com/personal/banking/education/basics/bank-account-number)” |
Account Statement | # Account Statement: Definition, Uses, and Examples
## What Is an Account Statement?
An account statement is a periodic summary of [account activity](https://www.investopedia.com/terms/a/account-activity.asp) with a beginning date and an ending date. The most commonly known are checking account statements, usually provided monthly, and brokerage account statements, which are provided monthly or quarterly. Monthly credit card bills are also considered account statements.
### Key Takeaways
* An account statement is a periodic statement summarizing account activity over a set period of time.
* Account statements can be thought of as a summary of the account and include statements of services provided, fees charged, and money owed.
* Account statements should be scrutinized for accuracy, and historical statements are critical for budgeting.
* Account statements may often be received electronically, as distributors may charge fees for paper copies.
* Account statements usually contain a unique identifier, starting information, ending information, and transactions.
## Understanding Account Statements
Account statements refer to almost any official summary of an account, wherever the account is held. Insurance companies may provide account statements summarizing paid-in [cash values](https://www.investopedia.com/terms/c/cash-value-life-insurance.asp), for example. Statements can be generated for almost any type of accounts that represent ongoing transactions where funds are repeatedly exchanged. This can include online payment accounts such as PayPal, credit card accounts, brokerage accounts, and savings accounts.
Utility companies, as well as telephone and subscription television service providers, usually generate account statements for their customers detailing their usage and any overages during the payment cycle. Such statements typically list debits paid, incoming funds or credits received by the account holder, and fees associated with maintaining the account. For example, certain types of savings accounts might incur regular maintenance fees unless a certain minimum balance of funds is maintained in the account. Cable television subscriptions may include state taxes and other surcharges that are included in providing regular service.
> **Important**
>
> Account statements don't necessarily need to be financial. Consider an account statement that tracks a company's environmental impact from one period to the next.
## Elements of Account Statements
Though account statements may vary based on the issuer and underlying service, you may come across the same elements across statements. These elements may include but aren't limited to:
* **A Unique Identifier.** Account statements are often tied to a unique identifier such as an account number or [bank account number](https://www.investopedia.com/terms/a/account-number.asp). The statement may only display part of the account number for security reasons.
* **Personal Information.** Your account information, including your account number, the name of the account holder, and any contact information that is associated with the account, will typically be displayed on the statement.
* **A Start Date and/or End Date.** This is the timeframe that is covered by the statement, such as a particular month or a quarter. It can also be referred to as the statement period.
* **Opening and Closing Balances:** Both the opening and closing balances of your account will be displayed on the statement that is sent to you at the end of the billing cycle.
* **Transactions:** The transaction history is a comprehensive description of all of the activities that took place on the account during the billing cycle. This includes all deposits, withdrawals, purchases, payments, and other types of account activity. Typically, the date, a brief description, and the total amount are recorded next to each transaction.
* **Fees and Service Charges:** The statement may list any fees or service charges that are associated with your account, such as monthly maintenance fees, [ATM fees](https://www.investopedia.com/terms/a/atm.asp), or overdraft costs. In some contexts, this account statement may be the only instance in which the fees are communicated to the account holder.
* **Information About Entity:** The statement issuer could send you crucial messages or notifications regarding your account, forthcoming changes to the business, or promotional offers.
## How Account Statements Are Used
Account statements should be scrutinized for accuracy, and historical statements are critical for budgeting. A credit or loan account statement, for example, may show not only the outstanding balance due but the interest rate charged on that debt and any fees that have been added during the payment cycle. This can include late charges for payments not received by their due date as well as overdraft fees when bank account holders overspend. Your account statements are a window into your finances.
The statement may also list financial information that relates to the account holder such as their credit score, or the estimated time it will take to completely pay off a debt via installment payments. Alerts and notices to the account holder may also appear on these statements, calling attention to matters with the account that need to be addressed, such unusual charges that should be reviewed and verified.
> **Tip**
>
> Account statements are often recurring and should arrive at a set cadence. Contact your account administrator to best understand when statement periods occur and when you may expect statements.
## Red Flags on Account Statements
Anomalous items on an account statement may be a sign the account has been compromised, perhaps through a stolen credit or debit card or through [identity thieves](https://www.investopedia.com/terms/i/identitytheft.asp) who gained access to account information. For example, an account holder or the financial institution might spot a charge for concert tickets or a luxury item that seems out of the ordinary.
Account holders may be able to dispute such out-of-place charges and file a claim that they did not make the purchase themselves. Reviewing your account statements as they come in is a good financial habit that can catch these red flags before they become a financial disaster.
## Electronic Statements vs. Paper Statements
Account statements may be delivered electronically or via paper. Electronic account statements are delivered digitally in formats like PDF, HTML, or through [online portals](https://www.investopedia.com/best-online-brokers-4587872). They offer convenience, reduce impacts to the environmental, and can often be easily stored.
The primary aim of electronic statements is to reduce paper usage, save space, and reduce the risk of unauthorized access compared to paper statements. Electronic statements may be password-protected and delivered through secure channels, reducing the risk of theft or interception. Electronic statements may also be more easily shared by other individuals needed copies
Paper account statements are printed on paper and sent via postal mail to the account holder's physical address. Proper disposal of paper statements is crucial to protect sensitive information and prevent unauthorized access to personal financial information.
Paper statements do not require an internet connection or electronic device to access. This can be beneficial for individuals in areas with limited connectivity or those who prefer to review their financial information offline. In case of technical issues or loss of access to electronic records (both temporarily or permanently), individuals can rely on their paper statements as a secondary source of information.
## What Should I Do If I Notice an Error or Discrepancy on My Account Statement?
If you notice an error or discrepancy on your account statement, contact your bank immediately. Provide them with the details of the incorrect transaction, and they will initiate an investigation to rectify the issue and ensure your account is accurate.
## How Long Should I Keep My Account Statements?
The recommended duration for keeping account statements varies, but it's generally advised to retain them for a minimum of one to three years. However, consult with a financial advisor if you're unsure what account information should be retained especially related to tax statements, investment statements, or banking statements.
## Are There Any Fees Associated with Receiving Paper Account Statements?
Some financial institutions may charge fees for providing paper account statements. Electronic statements are often offered as a free alternative or may have lower associated costs. Check with your bank for their specific fee structure and any incentives for switching to electronic statements.
## How Can I Use My Account Statements for Budgeting and Financial Planning?
Account statements can be used for budgeting and financial planning by analyzing income, expenses, and patterns of spending. Review your statements to track where your money goes, identify areas for potential savings, and make informed decisions about budget adjustments or financial goals.
## The Bottom Line
Account statements provide a comprehensive overview of transactions, balances, and activities in a bank, financial, or other account. They include details such as deposits, withdrawals, interest earned, fees charged, and the current balance (if applicable). Account holders can access statements electronically or in paper format, and they play a crucial role in tracking finances, reconciling records, identifying errors, and aiding in budgeting and financial planning. |
Accountability | # Accountability: Definition, Types, Benefits, and Example
:max_bytes(150000):strip_icc()/https-www.investopedia.com-terms-a-accountability-primary-FINAL-2be10e089f5d42629803cea7885a023d.png)
*— Madelyn Goodnight / Investopedia*
> **Definition**
>
> Accountability is the acknowledgment by a company, an individual, or another entity that they're responsible for their actions.
## What Is Accountability?
Accountability refers to the acceptance of responsibility for honest and [ethical conduct](https://www.investopedia.com/terms/b/business-ethics.asp) toward others. A company’s accountability extends to its shareholders, employees, and the wider community in which it operates. Accountability also implies a willingness to be judged on performance.
### Key Takeaways
* Accountability is the acceptance of responsibility for one’s actions.
* Financial accountability includes a requirement in the U.S. that public corporations make accurate financial records available to all stakeholders.
* Accountability in the workplace can include setting deadlines, delegating tasks, defining ownership, and rewarding success.
* Accountability can help invoke confidence from external investors, loyalty from employees, and better company returns.
* There's been an increased focus on other elements of corporate accountability such as ethical conduct, environmental impact, a commitment to diversity, and fair treatment of employees.
## How Accountability Works
Accountability is an essential concept in corporate finance. It's defined as an entity’s steps to take responsibility for its actions. This can range from accounting for financial discrepancies, conduct toward employees, financial mismanagement, or losing [shareholder](https://www.investopedia.com/terms/s/shareholder.asp) confidence.
The concept is particularly relevant to the [accounting](https://www.investopedia.com/terms/a/accounting.asp) practices a company adopts when it prepares the financial reports that are submitted to shareholders and the government. A company can't retain the confidence of its customers, regulators, or the markets without checks, balances, and consequences for wrongdoing,
Corporate accountability has come to encompass a company’s activities as they affect the community. A company’s environmental impact, investment decisions, and treatment of its employees have all come under public scrutiny.
> **Important**
>
> Each industry has its own standards and rules for accountability that may evolve over time, such as the rules for social media accountability.
## Types of Accountability
The concept of accountability runs throughout all [industries](https://www.investopedia.com/terms/i/industry.asp), [sectors](https://www.investopedia.com/terms/s/sector.asp), [companies](https://www.investopedia.com/terms/c/company.asp), and professions.
### Corporate accountability
Accountability is about numbers. Every public company must publish a quarterly and annual financial report detailing its income and expenses. An independent [auditor](https://www.investopedia.com/terms/a/auditor.asp) is responsible for reviewing a company's financial statements and obtaining reasonable assurance that the financial statements are free from any material misstatements caused by error or fraud. This auditor holds the company accountable for its reporting.
Accountability requires that corporate [accountants](https://www.investopedia.com/terms/a/accountant.asp) be careful and knowledgeable because they can be held legally liable for negligence. An accountant is responsible for the integrity and accuracy of the company’s [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) even if an error or misstatement was made by others in the organization. Public companies are required to have an audit committee within the board of directors. Their job is to oversee the [audit](https://www.investopedia.com/terms/a/audit.asp).
### Political accountability
Political accountability can relate to political contributions and how candidates use resources. The nonpartisan Center for Political Accountability and the Wharton School at the University of Pennsylvania publish a joint annual index that rates major public corporations' disclosure and oversight policies regarding their donations to political causes and candidates.
The Center for Political Accountability shines a spotlight on corporate spending that aims to influence politicians. KFF Health News reported in-depth in 2021 on a campaign by the pharmaceutical industry to head off a proposal to allow [Medicare](https://www.investopedia.com/terms/m/medicare.asp) to negotiate drug prices with vendors. The report named members of Congress who accepted political donations from drugmakers.
The Center for Political Accountability noted that 218 large public companies had adopted political disclosure policies by 2023.
> **Fast Fact**
>
> Accountability is subjective. Merck was named the most responsible company in 2024. HHP was the highest-rate company regarding responsibility in 2023, however, according to Newsweek. McKinstry was top-rated in terms of a Corporate Equality Index. There's a spectrum of accountability that companies land on and where they land can constantly change.
### Government accountability
The role of corporate cash is only one of the global issues regarding government accountability. The U.S. Agency for International Development (USAID), the federal agency that administers civilian foreign aid, measures government accountability by the following key factors:
* A free and fair political justice system
* The protection of human rights
* A vibrant civil society
* Public confidence in the police and courts and security sector reform
The Government Accountability Project protects federal, state, and local [whistleblowers](https://www.investopedia.com/terms/w/whistleblower.asp) who spot problems and report them to appropriate agencies. Governments are held accountable through unofficial internal audits.
> **Important**
>
> The U.S. State Department took over USAID operations in February 2025. More than 80% of U.S. foreign aid contracts were canceled a month later. Some future accountability measures and efforts are uncertain.
### Media accountability
The media in the U.S. is uniquely protected from interference by Congress by the First Amendment. This doesn't mean that it's free from accountability, however.
The media has long been under the constant scrutiny of several watchdogs, both internal and external. These have been augmented by independent fact-checking organizations such as FactCheck.org, Snopes, and PolitiFact in the internet era. They and other organizations monitor the media for bias and errors and publish their findings.
Individuals can easily contribute to the conversation thanks to social media. There's debate whether platforms like [Facebook](https://www.investopedia.com/ask/answers/120114/how-does-facebook-fb-make-money.asp) are publishers or if the users are the publishers, however. Social media continues to be under fire for spreading dangerous misinformation in either case, for providing a platform for hate speech, and for having a generally lacking sense of accountability.
## Accountability in the Workplace
Employees must conduct themselves with accountability for their companies to be successful. This is accomplished in several ways.
The soft skills of accountability include showing up to work when expected and being prepared for the tasks of the day. Accountability extends to every department and every employee because it begins with being present, honest, and engaged in everyday tasks outside of one’s job.
There's also a deep-rooted sense of accountability in specific positions. Professionals who handle physical or [digital money](https://www.investopedia.com/terms/d/digital-money.asp) have a standard of accountability to be honest and responsible with funds that don't belong to them personally. Managers have a duty of accountability to properly oversee employees, treat them well, and guide them through growth opportunities.
A company builds, manages, and sustains accountable practices in a few ways:
* Making employees verbally commit to completing certain tasks and ensuring that they follow through with them
* Having upper management set expectations on the duties to be completed and the associated deadlines
* Creating a safe environment where taking risks is rewarded and learning occurs in a natural, non-threatening way
* Defining ownership of tasks, projects, or other aspects of work so the owner of that task or project must be held accountable should there be a problem
## Internal vs. External Accountability
Internal accountability refers to the practices within a company. This type of accountability is maintained through [internal controls](https://www.investopedia.com/terms/i/internalcontrols.asp), performance evaluations, audits, and a strong corporate culture. Regular performance reviews and audits help identify areas where employees and departments may need improvement.
External accountability pertains to a company's obligations and responsibilities to outside parties such as regulators, investors, customers, and the general public. It's often enforced through legal requirements, industry standards, and public scrutiny. Companies must regularly disclose financial information, comply with environmental regulations, and meet consumer protection laws or there may be legal consequences that are detrimental to the company's ability to function.
Both forms of accountability must be present for a company's success and sustainability but there are different risks to each. Internal accountability ensures that the organization operates efficiently and ethically from within. External accountability is the most detrimental and costly but it doesn't happen on its own. Failure to uphold internal accountability leads to problems with external accountability.
## Benefits of Accountability
Accountability is different at every company but there are overarching benefits that it can provide when a business can appropriately execute accountability practices.
### Operational excellence
Accountability promotes operational excellence. Employees are more likely to put forth stronger effort when they understand that their work is being looked at and evaluated. It's understood that what they do matters, especially when they're rewarded for strong accountability with raises, promotions, and public recognition.
### Company resources
Accountability isn't limited to just doing your job. It's the practice of being honest and responsible for your actions in all situations. Accountable employees are held to a standard that company resources are to be respected. They're less likely to mistreat company assets because they understand that there will be consequences.
### Materiality
Companies with a standard of accountability will have boundaries for acceptable deviation. A company might allow for a certain dollar threshold of financial misstatement due to immateriality. It won't accept larger errors, unexplainable variances, or delays in reporting if it holds itself accountable to a low threshold of materiality.
### Investor trust
Accountability builds external investor trust. An [investor](https://www.investopedia.com/terms/i/investor.asp)’s confidence in a company is only driven so far based on the prospect of financial success. Investors must believe that a company is well-run, honest, competent, and efficient with its resources. It will be seen more favorably, especially compared with an untrustworthy adversary, if a company can demonstrate its accountability.
> **Fast Fact**
>
> A 2022 research study by Pew Research found that 51% of the so-called “cancel culture” was a movement to hold people accountable for their actions while 45% saw the movement as punishment for people who didn’t deserve it.
## Example of Accountability
Corporate accountability can be hard to quantify but that doesn’t stop anyone from trying. One real-world example is the Volkswagen emissions scandal, often referred to as "Dieselgate." It exposed how Volkswagen had deliberately installed software in its diesel vehicles to cheat on emissions tests.
The United States Environmental Protection Agency (EPA) found in 2015 that many VW cars sold in America had a "defeat device" in diesel engines that could detect when they were being tested. Cars normally emit up to 40 times the allowed levels of nitrogen oxides, pollutants that contribute to the formation of smog and acid rain and are linked to various respiratory diseases.
The ultimate fallout was that Volkswagen faced hefty fines and settlements. The company agreed to spend up to $25 billion in the U.S. alone to address claims from regulators, car owners, and dealers. This included buying back affected vehicles, funding environmental programs, and compensating owners. Several executives were charged and Volkswagen pleaded guilty to criminal charges and agreed to pay $4.3 billion in penalties in 2017.
The scandal led to significant changes in Volkswagen's leadership. CEO Martin Winterkorn resigned and other top [executives](https://www.investopedia.com/terms/c/ceo.asp) were suspended or left the company. VW undertook various internal reforms to improve compliance and transparency. They implemented stricter environmental standards and compliance measures to prevent future misconduct. Volkswagen also issued public apologies, acknowledging their misconduct and committing to making amends.
## How Is Accountability Defined in the Workplace?
Accountability in the workplace goes beyond giving each employee a task to complete in a project. It also means making each individual accountable for the success or failure of their contribution to the overall project. It’s all about the ownership of success or failure.
## What Does the Government Accountability Office (GAO) Do?
The Government Accountability Office (GAO) is the audit agency of the U.S. government.
It evaluates the effectiveness of U.S. programs and proposed programs. One of its ongoing reviews examined the effectiveness of $4.7 trillion in federal spending related to the COVID-19 pandemic. It made recommendations for changes to prevent the misuse of funds, fraud, and errors in relief payments.
## What Is the Difference Between Accountability and Responsibility?
A responsibility is an assigned or self-assigned task or project. Accountability implies a willingness to be judged on the performance of the project. It doesn’t exist in a vacuum. It requires transparency and effective communication of results with all parties that may be affected.
## The Bottom Line
Accountability can be a management buzzword or it can be a real framework for evaluating the success or failure of an individual or an entity. The concept of corporate accountability has always meant honest and transparent financial reporting. That concept has expanded to encompass a corporation’s performance and responsiveness to environmental, social, and community issues.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. “[Exchange Act Reporting and Registration](https://www.sec.gov/education/smallbusiness/goingpublic/exchangeactreporting).”
>
> 2. Public Company Accounting Oversight Board. “[AS 1001: Responsibilities and Functions of the Independent Auditor](https://dev-pws.pcaobus.org/oversight/standards/auditing-standards/details/AS1001).”
>
> 3. Deloitte. “[Audit Committee Requirements](https://www2.deloitte.com/us/en/pages/center-for-board-effectiveness/articles/audit-committee-requirements.html).”
>
> 4. Center for Political Accountability. “[CPA-Zicklin Index: A Focus on Transparency](https://www.politicalaccountability.net/cpa-zicklin-index/).”
>
> 5. KFF Health News. “[Pharma Campaign Cash Delivered to Key Lawmakers with Surgical Precision](https://kffhealthnews.org/news/article/pharma-campaign-cash-delivered-to-key-lawmakers-with-surgical-precision/).”
>
> 6. Center for Political Accountability. "[2023 CPA-Zicklin Index of Corporate Political Disclosure and Accountability.](https://www.politicalaccountability.net/wp-content/uploads/2024/02/2023-CPA-Zicklin-Index.pdf)"
>
> 7. Newsweek. "[America's Most Responsible Companies (2024).](https://www.newsweek.com/rankings/americas-most-responsible-companies-2024)"
>
> 8. Newsweek. "[America's Most Responsible Companies.](https://www.newsweek.com/rankings/americas-most-responsible-companies-2023)"
>
> 9. McKinstry. "[McKinstry Earns Top Score In Human Rights Campaign Foundation’s 2023-2024 Corporate Equality Index.](https://www.mckinstry.com/news/mckinstry-earns-top-score-in-human-rights-campaign-foundations-2023-2024-corporate-equality-index/)"
>
> 10. Government Accountability Project. "[Our Story](https://whistleblower.org/our-story/)."
>
> 11. NPR. "[Rubio Announces That 83% of USAID Contracts Will Be Canceled](https://www.npr.org/sections/goats-and-soda/2025/03/10/g-s1-52964/rubio-announces-that-83-of-usaid-contracts-will-be-canceled)."
>
> 12. Pew Research Center. “[A Growing Share of Americans Are Familiar with ‘Cancel Culture’](https://www.pewresearch.org/short-reads/2022/06/09/a-growing-share-of-americans-are-familiar-with-cancel-culture/).”
>
> 13. United States Environmental Protection Agency. "[Learn About Volkswagen Violations](https://www.epa.gov/vw/learn-about-volkswagen-violations)."
>
> 14. ProPublica. "[How VW Paid $25 Billion for Dieselgate - And Got Off Easy](https://www.propublica.org/article/how-vw-paid-25-billion-for-dieselgate-and-got-off-easy)."
>
> 15. Car and Driver. "[Everything You Need to Know about the VW Diesel-Emissions Scandal](https://www.caranddriver.com/news/a15339250/everything-you-need-to-know-about-the-vw-diesel-emissions-scandal/)."
>
> 16. U.S. Government Accountability Office. “[Federal Response to COVID-19](https://www.gao.gov/coronavirus)." |
Accountant | # What Does an Accountant Do?
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*— Investopedia / Joules Garcia*
> **Definition**
>
> An accountant reviews financial records, tracks income and expenses, and provides insights for financial decisions, often requiring certification and ethical compliance.
## What Is an Accountant?
An accountant is a financial professional who reviews and analyses financial records and keeps track of a company's or individual's income, expenditures, and liabilities. An accountant may also work in project planning, cost analysis, auditing, and financial decision-making. Some specialize in tax preparation and tax planning. Accountants may work for large companies or external accounting firms. They must meet state-specific educational and testing requirements and are certified by national professional associations.
### Key Takeaways
* Accountants are financial professionals employed by accounting firms or in the accounting departments of large companies.
* Their roles include monitoring and recording expenses and income, and projecting the costs of proposed new projects.
* Tax preparation and tax planning are specialized roles for accountants.
* Many accountants choose to become certified public accountants because the CPA designation is considered the gold standard in the accounting profession.
## History of Accountants
The first professional association for accountants, the American Association of Public Accountants, was formed in 1887, and CPAs were first licensed in 1896. Accounting grew as a profession during the Industrial Revolution. This was largely due to the growing complexity of businesses and the demands of [shareholders](https://www.investopedia.com/terms/s/shareholder.asp) and bondholders for evidence of the financial well-being of the companies in which they invested.
After the [Great Depression](https://www.investopedia.com/terms/g/great_depression.asp) and the formation of the [Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp), all publicly traded companies were required to issue reports written by accredited accountants. This change further increased the need for corporate accountants. Today, accountants remain a ubiquitous and crucial part of any business.
## Duties and Skills of Accountants
Accountants work with companies, governments, and non-profits, or set up private practices. They may perform account analysis, review [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) and other reports to ensure they are accurate, conduct routine and annual [audits](https://www.investopedia.com/terms/a/audit.asp), review financial operations, prepare [tax returns](https://www.investopedia.com/terms/t/taxreturn.asp), advise on areas that require efficiencies and cost-savings, and provide [risk analysis](https://www.investopedia.com/terms/r/risk-analysis.asp) and forecasting.
An accountant's duties often depend on the type of educational background and designation they receive. Most professionals in the field possess bachelor's degrees and, if employed by a corporation, may require certification to move up within the firm.
Certification requirements vary, with some roles requiring additional educational requirements above the bachelor's degree and successful completion of rigorous examinations. Accountants can have more than one designation. The most common are the [certified internal auditor (CIA)](https://www.investopedia.com/terms/c/certified-internal-auditor.asp), [certified management accountant (CMA)](https://www.investopedia.com/terms/c/cma.asp), and [certified public accountant (CPA)](https://www.investopedia.com/terms/c/cpa.asp).
Many accountants choose to become CPAs because the designation is considered the gold standard in the accounting profession. In the United States, certification requirements for accountants vary from state to state. But one requirement is universal—the passing of the Uniform Certified Public Accountant Examination. This exam is written and graded by the [American Institute of Certified Public Accountants (AICPA)](https://www.investopedia.com/terms/a/american-institute-of-certified-public-accountants.asp).
> **Important**
>
> There are 671,855 certified public accountants in the U.S. as of August 2024, according to the National Association of State Boards of Accountancy.
## Ethical Standards and Guiding Principles for Accountants
Accountants must abide by the [ethical standards](https://www.investopedia.com/terms/a/accountant-responsibility.asp) and guiding principles of the region where they practice, such as the [International Financial Reporting Standards (IFRS)](https://www.investopedia.com/terms/i/ifrs.asp) or [Generally Accepted Accounting Principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp).
The IFRS is a set of rules issued by the International Accounting Standards Board. These rules promote consistency and [transparency](https://www.investopedia.com/terms/t/transparency.asp) in financial statements. GAAP is a set of standards that accountants must adhere to when they complete financial statements for [publicly traded companies](https://www.investopedia.com/terms/p/publiccompany.asp) in the U.S.
Certified public accountants have a [fiduciary duty](https://www.investopedia.com/ask/answers/042915/what-are-some-examples-fiduciary-duty.asp) to their clients. They are legally and ethically responsible to be honest and trustworthy and must avoid negligence in their duties. CPAs have real influence over their clients, which means their judgment and work can affect not just an individual but an entire [company](https://www.investopedia.com/terms/c/company.asp)—including its employees, its board, and its investors.
[Accountants can be held liable](https://www.investopedia.com/terms/a/accountant-liability.asp) under the common law doctrine if they:
* Are negligent in their duties
* Mispresent themselves or their clients
* Commit fraud
* Are guilty of [breach of contract](https://www.investopedia.com/terms/b/breach-of-contract.asp), which occurs when a professional doesn't fulfill their obligations as per the agreement
They can also be held liable under [statutory law](https://www.investopedia.com/terms/s/statutory-liability.asp) by state or federal securities regulatory bodies. This happens when an accountant fails to provide their clients with appropriate services or gives them bad advice.
## How Much Money Does an Accountant Make?
The median annual pay for an accountant in the U.S. was $79,880 in 2023, according to the Bureau of Labor Statistics.
## What Is the Difference Between an Accountant and a Certified Public Accountant?
Accountants and certified public accountants are two different types of professionals. While all CPAs are accountants, not all accountants are CPAs. Accountants typically have a degree in accounting and don't necessarily require a license to practice their profession. They are usually responsible for account reconciliation, analyzing financial statements, budgeting, and reporting financial transactions. CPAs, on the other hand, is a licensed professional. This professional must adhere to standards and codes of conduct and must maintain continuing educational requirements. In addition to some of the duties of the accountant, a CPA must also conduct audits and file reports with the SEC among other duties.
## How Do I Become a Certified Public Accountant?
A certified public accountant is a professional who has passed a four-part examination known as the Uniform CPA Examination, conducted by the American Institute of Certified Public Accounts with input from the National Association of State Boards of Accountancy and state boards of accountancy.
Accountants need both a bachelor's degree in accounting or finance and experience in the field to take the exam. The exam is tailored to each state's requirements and is administered by the state boards of accountancy.
## The Bottom Line
Accountants are always in demand because every company of any size needs one or more of them. They are the ones tracking, analyzing, and auditing the company's income and expenditures. They also have a key role in planning, decision-making, and forecasting, based on their ability to accurately estimate the cost of future projects.
> **Article Sources**
>
> 1. Association of International Certified Professional Accountants. "[History](https://www.aicpa-cima.com/resources/article/history)."
>
> 2. Roberts, Diane. "[Follow in Footsteps: the First CPAs of 1896-1897 and Accounting Occupation Adoption by the Next Generation](https://publications.aaahq.org/ahj/article-abstract/49/2/73/406/Follow-in-Footsteps-The-First-CPAs-of-1896-1897?redirectedFrom=PDF)." _Accounting Historians Journal,_ vol. 49. no 2., Winter 2022, pp. 73-89.
>
> 3. American Institute of Certified Public Accountants. "[Everything You Need To Know About the CPA Exam](https://www.aicpa-cima.com/resources/toolkit/cpa-exam)."
>
> 4. NASBA. "[How Many CPAs Are There?](https://nasba.org/licensure/howmanycpas)"
>
> 5. Congressional Research Service. "[Introduction to Financial Services: Accounting and Auditing Regulatory Structure, U.S. and International](https://crsreports.congress.gov/product/pdf/IF/IF10701)."
>
> 6. PIA. "[Accountant’s Liability: How It Works and What It Means for You](https://piainsagency.com/accountants-liability/)."
>
> 7. U.S. Bureau of Labor Statistics Occupational Outlook Handbook. "[Accountants and Auditors](https://www.bls.gov/ooh/business-and-financial/accountants-and-auditors.htm)."
>
> 8. American Institute of Certified Public Accountants. "[CPA Licensure](https://us.aicpa.org/becomeacpa/licensure)."
>
> 9. NASBA. "[What Is the Uniform CPA Examination?](https://nasba.org/exams/becomingacpa/whatistheuniformcpaexam/)" |
Accountant Responsibility | # Accountant Responsibility: Overview and Examples
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*— Investopedia / Paige McLaughlin*
## What is Accountant Responsibility?
Accountant responsibility is the ethical responsibility an [accountant](https://www.investopedia.com/terms/a/accountant.asp) has to those who rely on their work. According to the [American Institute of Certified Public Accountants (AICPA)](https://www.investopedia.com/terms/a/american-institute-of-certified-public-accountants.asp), accountants have a duty to serve the public interest and uphold the public trust in the profession. An accountant has a responsibility to his clients, his company's managers, investors, and creditors, as well as to outside regulatory bodies. Accountants are responsible for the validity of the [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) they work on, and they must perform their duties following all applicable principles, standards, and laws.
### Key Takeaways
* Accountant responsibility is the ethical responsibility an accountant has to those who rely on their work.
* An accountant's responsibility may vary depending on the industry and type of accounting, auditing, or tax preparation being performed.
* All accountants must perform their duties following all applicable principles, standards, and laws.
## Understanding Accountant Responsibility
Accountant responsibility varies slightly based on the accountant's relationship with the tax filer or business in question. Independent accountants with some clients see confidential information, ranging from personal Social Security numbers to business sales data, and must observe accountant-client privilege. They cannot share private personal or business data with competitors or others.
Accountants who work for accounting firms also have a responsibility to keep information private, but they also have a responsibility to their firm. Namely, they must accurately track their hours and tasks completed. For example, an accountant performing an audit should only record items he has actually completed, rather than pretending he has completed items he has not in order to speed up the process or bolster his logged hours.
If an accountant works directly for a business, as an in-house accountant, he has access to information many others in the company do not, ranging from payroll figures to news about staff layoffs, and he also has to treat this information discretely. In addition to having a responsibility to the people who work at the company, in-house accountants are also responsible to stockholders and [creditors](https://www.investopedia.com/terms/c/creditor.asp). If accountants do not uphold their responsibilities, it can have a broad effect on the accounting industry and even the [financial markets](https://www.investopedia.com/terms/f/financial-market.asp).
## Accountant Responsibility and the Internal Revenue Service
Although accountants have a great deal of responsibility to their clients, if the [Internal Revenue Service](https://www.investopedia.com/terms/i/irs.asp) finds an error in an individual's tax return, it does not hold the tax preparer or accountant responsible. Rather, the IRS adjusts the return and holds the taxpayer responsible for the additional tax, fees, and penalties. However, an individual who has been wronged by an accountant's misconduct can bring a claim of negligence against the accountant based on the fact the accountant breached his duty to the client and caused personal or financial damages.
The IRS also accepts complaints about tax return preparers who have committed fraud, and anyone with an issue may submit a complaint using Form 14157, Complaint: Tax Return Preparer. In-house accountants who cook the books or purposefully include erroneous data in their company's tax returns or accounting documents are responsible for misconduct and may even be [criminally liable](https://www.investopedia.com/terms/a/accountant-liability.asp).
## Accountant Responsibility and External Audits
According to the [Public Company Accounting Oversight Board (PCAOB)](https://www.investopedia.com/terms/p/pcaob.asp), accountants performing external audits have the responsibility to obtain reasonable assurance about whether the client's financial statements are free of material misstatement, whether caused by error or fraud. The Sarbanes-Oxley Act of 2002 (SOX) added new audit responsibilities relating to fraud. External auditors now have to certify that a client's internal controls are adequate in addition to expressing an opinion on the financial statements. |
Accounting | > **Definition**
>
> Accounting is the process of tracking the income and expenses of a business or other organization.
## What Is Accounting?
Accounting tracks a company's finances, including what comes in, what goes out, and how it all balances. It helps business owners and investors track the company's performance over time, ensuring that financial reports meet legal and regulatory standards.
### Key Takeaways
* Regardless of the size of a business, accounting is a necessary function for decision-making, cost planning, and measurement of economic performance.
* A bookkeeper can handle basic accounting needs, but a Certified Public Accountant (CPA) should be utilized for larger or more advanced accounting tasks.
* Managerial accounting helps management teams make business decisions, while cost accounting helps business owners decide how much a product should cost.
* In the United States, accountants follow a set of standards known as the generally accepted accounting principles (GAAP) when preparing financial statements.
* Accounting is an important function of strategic planning, external compliance, fundraising, and operations management.
:max_bytes(150000):strip_icc()/Accounting-FINAL-e01e0f2d93264a989c19357a99d7bffd.jpg)
*— Investopedia / Jiaqi Zhou*
## Understanding Accounting
Accounting is one of the key functions of almost any business. A bookkeeper or an accountant may handle it at a small firm. At larger companies, there might be sizable finance departments guided by a unified [accounting manual](https://www.investopedia.com/terms/a/accounting-manual.asp) with dozens of employees.
The reports generated by various streams of accounting, such as cost accounting and managerial accounting, are invaluable in helping management make informed business decisions.
The financial statements that summarize a large company's operations, financial position, and cash flows over a particular period are concise and [consolidated reports](https://www.investopedia.com/terms/c/consolidatedfinancialstatement.asp) based on thousands of individual financial transactions.
As a result, all professional accounting designations are the culmination of years of study and rigorous examinations combined with a minimum number of years of practical accounting experience.
## History of Accounting
The history of accounting has been around almost as long as money itself. Accounting history dates back to ancient civilizations in Mesopotamia, Egypt, and Babylon. For example, during the Roman Empire, the government had detailed records of its finances. However, modern accounting as a profession has only been around since the early 19th century.
Luca Pacioli is considered "The Father of Accounting and Bookkeeping" due to his contributions to the development of accounting as a profession. An Italian mathematician and friend of Leonardo da Vinci, Pacioli published a book on the double-entry system of bookkeeping in 1494.
By 1880, the modern profession of accounting was fully formed and recognized by the [Institute of Chartered Accountants in England and Wales](https://www.investopedia.com/terms/i/institute-chartered-accountants-england-wales-icaew.asp).
This institute created many of the systems by which accountants practice today. The formation of the institute occurred in large part due to the Industrial Revolution. Merchants not only needed to track their records but sought to avoid bankruptcy as well.
> **Important**
>
> The Alliance for Responsible Professional Licensing (ARPL) was formed in August 2019 in response to a series of state deregulatory proposals making the requirements to become a CPA more lenient. The ARPL is a coalition of various advanced professional groups including engineers, accountants, and architects.
## What Are the Different Types of Accounting?
Accountants may be tasked with recording specific transactions or working with specific sets of information. For this reason, there are several broad groups that most accountants can be grouped into.
### Financial Accounting
[Financial accounting](https://www.investopedia.com/terms/f/financialaccounting.asp) refers to the processes used to generate interim and annual financial statements. The results of all financial transactions that occur during an accounting period are summarized in the balance sheet, income statement, and cash flow statement. The financial statements of most companies are audited annually by an external CPA firm.
Audits are a legal requirement for companies that trade on the stock exchange. However, lenders also typically require the results of an external audit every year as part of their debt covenants. Therefore, most companies will have annual audits for one reason or another.
### Managerial Accounting
[Managerial accounting](https://www.investopedia.com/terms/m/managerialaccounting.asp) uses much of the same data as financial accounting, but it organizes and utilizes information in different ways. In managerial accounting, an accountant generates monthly or quarterly reports that a business's management team can use to make decisions about how the business operates.
[Managerial accounting also](https://www.investopedia.com/ask/answers/041015/how-does-financial-accounting-differ-managerial-accounting.asp) encompasses many other facets of accounting, including budgeting, forecasting, and various financial analysis tools. Any information that may be useful to management falls under this umbrella.
### Cost Accounting
Just as managerial accounting helps businesses make management decisions, cost accounting helps businesses make decisions about costing. Essentially, cost accounting considers all of the costs related to producing a product.
Analysts, managers, business owners, and accountants use this information to determine what their products should cost. In cost accounting, money is cast as an economic factor in production, whereas in financial accounting, money is considered to be a measure of a company's economic performance.
### Tax Accounting
While financial accountants often use one set of rules to report the financial position of a company, tax accountants often use a different set of rules. These rules are set at the federal, state, or local level based on what return is being filed.
Tax accounts balance compliance with reporting rules while also attempting to minimize a company's tax liability through thoughtful strategic decision-making.
A tax accountant often oversees the entire tax process of a company: the strategic creation of the organization chart, the operations, the compliance, the reporting, and the remittance of tax liability.
## What Types of Careers Are in the Accounting Field?
While basic accounting functions can be handled by a bookkeeper, advanced accounting is typically handled by qualified accountants who possess designations such as [Certified Public Accountant](https://www.investopedia.com/terms/c/cpa.asp) (CPA) or [Certified Management Accountant](https://www.investopedia.com/terms/c/cma.asp) (CMA) in the United States.
In Canada, the three legacy designations—the [Chartered Accountant](https://www.investopedia.com/terms/c/ca.asp) (CA), Certified General Accountant (CGA), and Certified Management Accountant (CMA)—have been unified under the Chartered Professional Accountant (CPA) designation.
A major component of the accounting profession is the "Big Four". These four largest accounting firms (Ernst & Young, KPMG, PricewaterhouseCoopers, Deloitte) conduct audit, consulting, tax advisory, and other services. These firms, along with many other smaller firms, comprise the public accounting realm that generally advises financial and tax accounting.
Careers in accounting may vastly differ by industry, department, and niche. Some relevant job titles may include:
* **Auditor (internal or external):** Ensures compliance with reporting requirements and safeguarding of company assets.
* **[Forensic accountant](https://www.investopedia.com/terms/f/forensicaccounting.asp):** Monitors internal or external activity to investigate the transactions of an individual or business.
* **Tax accountant:** Strategically plans the optimal business composition to minimize tax liabilities as well as ensures compliance with tax reporting.
* **Managerial accountant:** Analyzes financial transactions to make thoughtful, strategic recommendations often related to the manufacturing of goods.
* **Information and technology analyst/Accountant:** Maintains the system and software in which accounting records are processed and stored.
* **[Controller](https://www.investopedia.com/terms/c/controller.asp):** Oversees the accounting functions of financial reporting, accounts payable, accounts receivable, and procurement.
> **Fast Fact**
>
> As of October 2025, the average Certified Public Accountant in the United States made $239,000 per year.
## What Are Accounting Standards?
In most cases, accountants use [generally accepted accounting principles](https://www.investopedia.com/terms/g/gaap.asp) (GAAP) when preparing financial statements in the U.S. GAAP is a set of standards and principles designed to improve the comparability and consistency of financial reporting across industries.
Its standards are based on double-entry accounting, a method in which every accounting transaction is entered as both a debit and credit in two separate [general ledger](https://www.investopedia.com/ask/answers/030915/how-do-you-calculate-credits-and-debits-general-ledger.asp) accounts that will roll up into the balance sheet and income statement.
In most other countries, a set of standards governed by the International Accounting Standards Board named the [International Financial Reporting Standards](https://www.investopedia.com/terms/i/ifrs.asp) (IFRS) is used.
Tax accountants overseeing returns in the United States rely on guidance from the Internal Revenue Service. Federal tax returns must comply with tax guidance outlined by the Internal Revenue Code (IRC).
Tax accounts may also lean in on state or county taxes as outlined by the jurisdiction in which the business conducts business. Foreign companies must comply with tax guidance in the countries in which they must file a return.
## What Are Major Accounting Software Platforms?
Accountants often leverage software to aid in their work. Some accounting software is considered better for small businesses such as QuickBooks, Quicken, FreshBooks, Xero, or Sage 50.
Larger companies often have much more complex solutions to integrate with their specific reporting needs. This includes add-on modules or in-home software solutions. Large accounting solutions include Oracle, NetSuite, or Sage products.
## What Is the Accounting Cycle?
Financial accountants typically operate in a cyclical environment with the same steps happening in order and repeating every reporting period. These steps are often referred to as the accounting cycle, the process of taking raw transaction information, entering it into an accounting system, and running relevant and accurate financial reports. The steps of the [accounting cycle](https://www.investopedia.com/terms/a/accounting-cycle.asp) are:
1. Collect transaction information such as invoices, bank statements, receipts, payment requests, uncashed checks, credit card statements, or other mediums that may contain business transactions.
2. Post journal entries to the general ledger for the items in Step 1, reconciling to external documents whenever possible.
3. Prepare an unadjusted trial balance to ensure all debit and credit balances and material general ledger accounts look correct.
4. Post adjusting journal entries at the end of the period to reflect any changes to be made to the trial balance run in Step 3.
5. Prepare the adjusted trial balance to ensure these financial balances are materially correct and reasonable.
6. Prepare the financial statements to summarize all transactions for a given reporting period.
## Cash Method vs. Accrual Method of Accounting
Financial accounts have two different sets of rules they can choose to follow. The first, the [accrual basis](https://www.investopedia.com/terms/a/accrualaccounting.asp) method of accounting, has been discussed above. These rules are outlined by GAAP and IFRS, are required by public companies, and are mainly used by larger companies.
The second set of rules follows the [cash basis](https://www.investopedia.com/terms/c/cashbasis.asp) method of accounting. Instead of recording a transaction when it occurs, the cash method stipulates a transaction should be recorded only when cash has been exchanged.
Because of the simplified manner of accounting, the cash method is often used by small businesses or entities that are not required to use the accrual method of accounting.
Imagine a company buys $1,000 of inventory on credit. Payment is due for the inventory in 30 days.
* Under the accrual method of accounting, a journal entry is recorded when the order is placed. The entry records a debit to inventory (asset) for $1,000 and a credit to accounts payable (liability) for $1,000. When 30 days have passed and the inventory is actually paid for, the company posts a second journal entry: a debit to accounts payable (liability) for $1,000 and a credit to cash (asset) for $1,000.
* Under the cash method of accounting, a journal entry is only recorded when cash has been exchanged for inventory. There is no entry when the order is placed; instead, the company enters only one journal entry at the time the inventory is paid for. The entry is a debit to inventory (asset) for $1,000 and a credit to cash (asset) for $1,000.
The difference between these two accounting methods is the treatment of accruals. Naturally, under the accrual method of accounting, accruals are required. Under the cash method, accruals are not required and not recorded.
> **Important**
>
> The Securities and Exchange Commission has an entire financial reporting manual outlining the reporting requirements of public companies.
## Why Accounting Is Important
Accounting is a back-office function where employees may not directly interface with customers, product developers, or manufacturing. However, accounting plays a key role in the strategic planning, growth, and compliance requirements of a company.
* **Accounting is necessary for company growth.** Without insight into how a business is performing, it is impossible for a company to make smart financial decisions through forecasting. Without accounting, a company wouldn't be able to tell which products are its best sellers, how much profit is made in each department, and what overhead costs are holding back profits.
* **Accounting is necessary for funding.** External investors want confidence that they know what they are investing in. Prior to private funding, investors will usually require financial statements (often audited) to gauge the overall health of a company. The same rules pertain to debt financing. Banks and other lending institutions will often require financial statements in compliance with accounting rules as part of the underwriting and review process for issuing a loan.
* **Accounting is necessary for owner exit.** Small companies that may be looking to be acquired often need to present financial statements as part of acquisition or merger efforts. Instead of simply closing a business, a business owner may attempt to "cash out" of their position and receive compensation for building a company. The basis for valuing a company is to use its accounting records.
* **Accounting is necessary to make payments.** A company naturally incurs debt, and part of the responsibility of managing that debt is to make payments on time to the appropriate parties. Without positively fostering these business relationships, a company may find itself with a key supplier or vendor. Through accounting, a company can always know who it has debts to and when those debts are coming due.
* **Accounting is necessary to collect payments.** A company may agree to extend credit to its customers. Instead of collecting cash at the time of an agreement, it may give a customer [trade credit](https://www.investopedia.com/terms/t/trade-credit.asp) terms such as net 30. Without accounting, a company may have a hard time keeping track of who owes it money and when that money is to be received.
* **Accounting may be required.** Public companies are required to issue periodic financial statements in compliance with GAAP or IFRS. Without these financial statements, a company may be delisted from an exchange. Without proper tax accounting compliance, a company may receive fines or penalties.
## Example of Accounting
To illustrate double-entry accounting, imagine a business sending an invoice to one of its clients. An accountant using the double-entry method records a debit to accounts receivables, which flows through to the balance sheet, and a credit to sales revenue, which flows through to the income statement.
When the client pays the invoice, the accountant credits accounts receivables and debits cash. Double-entry accounting is also called balancing the books, as all of the accounting entries are balanced against each other. If the entries aren't balanced, the accountant knows there must be a mistake somewhere in the general ledger.
## Explain Like I'm Five
Accounting is the profession of tracking a company's or other large organization's assets or cash flows, and recording how its finances are spent. Accounting statements are regularly used by management, investors, and tax authorities to get a clear picture of how well an organization is managing its finances.
Because their reports are regularly scrutinized by oversight agencies, accountants are required to adhere to a uniform set of accounting standards. These rules specify how to record income, expenditures, assets, and losses, so that auditors have an objective view of the organization's financial health.
## What Are the Responsibilities of an Accountant?
Accountants help businesses maintain accurate and timely records of their finances. Accountants are responsible for maintaining records of a company’s daily transactions and compiling those transactions into financial statements such as the balance sheet, income statement, and statement of cash flows. Accountants also provide other services, such as performing periodic audits or preparing ad-hoc management reports.
## What Skills Are Required for Accounting?
Accountants hail from a wide variety of backgrounds. Generally speaking, however, attention to detail is a key component in accountancy, since accountants must be able to diagnose and correct subtle errors or discrepancies in a company’s accounts. The ability to think logically is also essential, to help with problem-solving. Mathematical skills are helpful but are less important than in previous generations due to the wide availability of computers and calculators.
## Why Is Accounting Important for Investors?
The work performed by accountants is at the heart of modern financial markets. Without accounting, investors would be unable to rely on timely or accurate financial information, and companies’ executives would lack the transparency needed to manage risks or plan projects. Regulators also rely on accountants for critical functions such as providing [auditors’ opinions](https://www.investopedia.com/terms/a/auditors-opinion.asp) on companies’ annual 10-K filings. In short, although accounting is sometimes overlooked, it is absolutely critical for the smooth functioning of modern finance.
## The Bottom Line
Accounting is essential to every business, providing the structure and insight needed to stay compliant, profitable, and informed. Due to its importance, accountants enjoy strong pay, steady demand, and career flexibility across nearly any industry.
> **Article Sources**
>
> 1. Gary J. Previts, Peter Walton, and Peter Wolnizer. "Global History of Accounting, Financial Reporting and Public Policy: Eurasia, Middle East and Africa," Pages 1-29. Emerald Group Publishing, 2012.
>
> 2. Jane Gleeson-White. "Double Entry: How the Merchants of Venice Created Modern Finance," Pages 28, 47 and 91. W. W. Norton & Company, 2012.
>
> 3. The Institute of Chartered Accountants in England and Wales. "[Timeline: 1853-1880](https://www.icaew.com/library/historical-resources/timeline/1853-1880)."
>
> 4. Alliance for Responsible Professional Licensing. "[AICPA, NASBA Help Launch New Coalition to Protect Professional Licensing](http://www.responsiblelicensing.org/aicpa-nasba-help-launch-new-coalition-to-protect-professional-licensing/)."
>
> 5. U.S. Securities and Exchange Commission. "[All About Auditors: What Investors Need to Know](https://www.sec.gov/reportspubs/investor-publications/investorpubsaboutauditorshtm.html)."
>
> 6. American Institute of Certified Public Accountants. "[Frequently Asked Questions FAQs - Become a CPA](https://www.aicpa.org/becomeacpa/gettingstarted/frequentlyaskedquestions.html)."
>
> 7. Institute of Management Accountants. "[CMA Certification](https://www.imanet.org/cma-certification?ssopc=1)."
>
> 8. Chartered Professional Accountants Canada. "[The CPA Profession](https://www.cpacanada.ca/en/the-cpa-profession/)."
>
> 9. Glassdoor. "[CPA Salaries](https://www.glassdoor.com/Salaries/cpa-salary-SRCH_KO0,3.htm)."
>
> 10. Financial Accounting Foundation. "[About GAAP](https://www.accountingfoundation.org/accounting-and-standards/about-gaap)."
>
> 11. International Financial Reporting Standards Foundation. "[Who Uses IFRS Standards?](https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#use-of-ifrs-standards-by-jurisdiction)"
>
> 12. Internal Revenue Service. "[Tax Code, Regulations, and Official Guidance](https://www.irs.gov/privacy-disclosure/tax-code-regulations-and-official-guidance)."
>
> 13. U.S. Securities and Exchange Commission. "[Financial Reporting Manual](https://www.sec.gov/corpfin/cf-manual)." |
Accounting Conservatism | # Accounting Conservatism: Definition, Advantages and Disadvantages
> **Definition**
>
> Accounting conservatism is a principle that mandates companies report financial information with a great level of care and factor in the worst-case scenarios of their financial futures.
## What Is Accounting Conservatism?
In financial reporting, accounting conservatism plays an important role by requiring companies to act cautiously and have strong evidence before claiming profits, which helps maintain accuracy and prevent overstating financial health.
The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain [liabilities](https://www.investopedia.com/terms/l/liability.asp) are to be recognized as soon as they are discovered. In contrast, [revenues](https://www.investopedia.com/terms/r/revenue.asp) can only be recorded when they are assured of being received.
### Key Takeaways
* Accounting conservatism urges businesses to be careful and thorough when recording financial information, ensuring all figures are well substantiated before being reported.
* All probable losses are recorded when they are discovered, while gains can only be registered when they are fully realized.
* If an accountant has two solutions to choose from when facing an accounting challenge, the one that gives the least optimistic view of the situation should be selected.
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*By prioritizing caution, accounting conservatism can influence how businesses make decisions and manage their financial expectations over time. — Ryan Oakley / Investopedia*
## How Accounting Conservatism Works
[Generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) insist on a number of [accounting conventions](https://www.investopedia.com/terms/a/accounting-convention.asp) being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s [bottom line](https://www.investopedia.com/terms/b/bottomline.asp) in situations of uncertainty.
Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.
Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.
A cautious approach generally presents financial statements in the least optimistic light. There is a danger that [assets](https://www.investopedia.com/terms/a/asset.asp) and revenue would be overstated, so where the accountant has two acceptable options, the principle of conservatism would recommend presenting the lower of the two options. There is a danger that liabilities and [expenses](https://www.investopedia.com/terms/e/expense.asp), on the other hand, will be understated.
Conservatism dictates that if it is more probable than not that the loss will be incurred, accountants are encouraged to record it immediately, regardless of whether it has actually been paid out yet. In contrast, if there is a possibility of a gain coming the company’s way, they are advised not to record it in the financial statements until virtually certain of receiving some benefit.
### Recording Revenue
Since there is a danger that companies will manipulate revenue numbers to record higher profits, there are very stringent rules around revenue recognition. There are many ways in which revenue could be manipulated that lie in an accounting “gray area.” Recording legitimate revenues before they are really true sales is one such risk. For this reason, before a sale can be recorded, there are several criteria that must be met:
* There must be a customer contract.
* Accountants must identify performance obligations within that contract to break down clearly what goods will be sold and what services will be rendered.
* Determine the transaction price for goods sold and services rendered.
* Allocate the transaction price to the different parts of the contract, identifying what the customer should pay for goods and services if both are being sold.
* Recognize revenue when you’ve fulfilled each performance obligation and not before. For goods, this is when they are transferred, and for services rendered, this is when the service is performed.
The fulfillment of the performance obligations is an example of conservatism in action. No revenue should be recorded before these events take place, even if business managers are very sure that a customer is going to want products or services.
## Advantages of Accounting Conservatism
Understating gains and overstating losses means that accounting conservatism will always report lower [net income](https://www.investopedia.com/terms/n/netincome.asp) and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.
Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.
## Disadvantages of Accounting Conservatism
On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. This means that some companies will always find ways to manipulate them to their advantage.
Another issue with accounting conservatism is the potential for [revenue shifting](https://www.investopedia.com/terms/i/incomeshifting.asp). If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods being overstated, making it difficult for an organization to track business operations internally.
## Using Accounting Conservatism
Accounting conservatism may be applied to [inventory valuation](https://www.investopedia.com/articles/02/060502.asp). When determining the reporting value for inventory, conservatism dictates the lower of [historical cost](https://www.investopedia.com/terms/h/historical-cost.asp) or net realizable value is the amount that should be included on the balance sheet as an asset.
Estimations such as uncollectable [accounts receivable (AR)](https://www.investopedia.com/terms/a/accountsreceivable.asp) and [casualty losses](https://www.investopedia.com/terms/c/casualty-loss.asp) also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all [revenue recognition](https://www.investopedia.com/terms/r/revenuerecognition.asp) principles.
However, if a litigation claim is expected to be lost, an estimated economic impact is required in the [notes to the financial statements](https://www.investopedia.com/terms/f/footnote.asp). [Contingent liabilities](https://www.investopedia.com/terms/c/contingentliability.asp) such as royalty payments or [unearned revenue](https://www.investopedia.com/terms/u/unearnedrevenue.asp) are to be disclosed, too.
## What Does Accounting Conservatism Take Into Account?
Accounting conservatism records all probable losses when they are discovered and registers gains only when they are fully realized.
## What Does Accounting Conservatism Provide?
Accounting conservatism provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias. It establishes the rules when deciding between two financial reporting alternatives. The one that yields inferior numbers should be selected.
## Does Accounting Conservatism Have a Bright Side?
It does. Accounting conservatism encourages management to use greater care in decision making. It also means more scope for positive surprises instead of disappointing upsets, which drive share prices. Finally, it also makes it easier for investors to compare financial results across different industries and time periods.
## The Bottom Line
Accounting conservatism is a set of bookkeeping guidelines. It requires company accounts to be prepared with caution and high degrees of verification. The point is to factor in the worst-case scenario for a company’s financial future. |
Accounting Cycle | # Complete Guide to the Accounting Cycle: Steps, Timing, and Utility
## What Is the Accounting Cycle?
The accounting cycle systematically tracks and records financial transactions from occurrence to inclusion in financial statements and closing of books. This eight-step process ensures accuracy, leveraging automation to minimize manual errors.
The key steps include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.
### Key Takeaways
* The accounting cycle is an 8-step process that begins with recording transactions and ends with closing the books.
* This cycle ensures the accurate recording of financial transactions and preparation of financial statements.
* Accounting software often automates this cycle, reducing manual errors and simplifying the process.
* The accounting cycle typically operates within an accounting period, which is often an annual timeframe.
* While widely used, the accounting cycle is not universally applied by all businesses, such as sole proprietorships.
:max_bytes(150000):strip_icc()/accounting-cycle-4202225-55b4e93d325f490aa6e7bd3a13fd1304.jpg)
*— Investopedia / Joules Garcia*
## Understanding the Functioning of the Accounting Cycle
The accounting cycle is a methodical set of rules that can help ensure the accuracy and conformity of [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp). Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors.
Today, most software automates the accounting cycle, reducing human effort and manual errors.
### Detailed Walkthrough of the Accounting Cycle
There are [eight steps to the accounting cycle](https://www.investopedia.com/ask/answers/050815/what-are-most-important-steps-accounting-cycle.asp).
1. **Identify Transactions:** An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
2. **Record Transactions in a Journal:** Next comes the recording of transactions using [journal entries](https://www.investopedia.com/terms/j/journal.asp). The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
3. **Posting**: Once a transaction is recorded as a journal entry, it should post to an account in the [general ledger](https://www.investopedia.com/terms/g/generalledger.asp). The general ledger provides a breakdown of all accounting activities by account.
4. **Unadjusted Trial Balance**: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The [trial balance](https://www.investopedia.com/terms/t/trial_balance.asp) ensures that total debits equal total credits in the financial records.
5. **Worksheet**: The fifth step is to create and analyze a worksheet of debits and credits to identify necessary adjusting entries, if there are discrepancies.
7. **Adjusting Journal Entries:** At the end of the period, [adjusting entries](https://www.investopedia.com/terms/a/adjusting-journal-entry.asp) are made. These result from corrections made on the worksheet and the passage of time. For example, an adjusting entry may involve interest revenue that has been earned over time.
8. **Financial Statements**: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual, formal financial statements.
9. **Closing the Books**: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using [closing entries](https://www.investopedia.com/terms/c/closing-entry.asp). These closing entries include transferring net income to [retained earnings.](https://www.investopedia.com/terms/r/retainedearnings.asp) Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.
> **Fast Fact**
>
> An accounting cycle is used by most but not all businesses. Sole proprietorships, other small businesses, and entrepreneurs may not follow it.
## When to Execute the Accounting Cycle
The accounting cycle is started and completed within an [accounting period](https://www.investopedia.com/terms/a/accountingperiod.asp), the time in which financial statements are prepared. Accounting periods vary and depend on different factors. However, the most common type of accounting period is the annual period.
Many transactions are recorded during the accounting cycle. At the fiscal year's end, financial statements are prepared, often required by regulation.
For example, public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycles are tied to reporting requirement dates.
## Distinguishing Between Accounting Cycle and Budget Cycle
The accounting cycle is different from the budget cycle. The accounting cycle focuses on historical events and ensures that incurred financial transactions are reported correctly.
Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle provides information for external users, while the budget cycle is for internal management.
## Why Is the Accounting Cycle Important?
It's important because it can help ensure that the financial transactions that occur throughout an accounting period are accurately and properly recorded and reported. This can provide businesses with a clear understanding of their financial health and ensure compliance with federal regulations.
## What Are Benefits of the Accounting Cycle?
The accounting cycle can aid a company in keeping accurate books (and not losing important financial information), analyzing financial events, preparing required financial statements, and, overall, managing a business successfully.
## Who Is Responsible for Performing the Accounting Cycle?
Usually, accountants are employed to manage and conduct the accounting tasks required by the accounting cycle. If a small business or one-person shop is involved, the owner may handle the tasks, or outsource the work to an accounting firm.
## The Bottom Line
The accounting cycle is a fundamental process for accurately recording and reporting a company's financial activities. This eight-step cycle—from identifying transactions to closing the books—ensures financial statements reflect true financial health and compliance with regulations. With modern accounting software, many tasks are automated, reducing errors and increasing efficiency. Understanding and implementing this cycle empowers business owners to maintain precise financial records and make informed decisions.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[Filings & Forms](https://www.sec.gov/edgar.shtml)." |
Accounting Equation | # Accounting Equation: What It Is and How You Calculate It
> **Definition**
>
> The accounting equation is a core concept of modern accounting that states that a company's assets are the sum of its liabilities and its shareholder equity.
## What Is the Accounting Equation?
The accounting equation is a fundamental concept that states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. This straightforward relationship between assets, liabilities, and equity is the foundation of the [double-entry](https://www.investopedia.com/terms/d/double-entry.asp) accounting system.
The accounting equation ensures that the balance sheet remains balanced. Each entry made on the debit side has a corresponding entry or coverage on the credit side.
The accounting equation is also known as the basic accounting equation or the balance sheet equation.
### Key Takeaways
* The accounting equation is considered to be the foundation of the double-entry accounting system.
* It shows on a company’s balance sheet that a company’s total assets are equal to the sum of its liabilities and shareholders’ equity.
* Assets represent the valuable resources controlled by a company and the liabilities represent its obligations.
* Both liabilities and shareholders’ equity show how the assets of a company are financed.
* Financing through debt shows as a liability and financing through issuing equity shares appears in shareholders’ equity.
:max_bytes(150000):strip_icc()/Accounting-Equation-9f2308e5c1f24bb1a5a2a65c35a22556.png)
*— Daniel Fishel / Investopedia*
## How the Accounting Equation Works
The financial position of any business is based on two key components of the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp): assets and liabilities. Owners’ equity or shareholders’ equity is the third section of the balance sheet. The accounting equation is a representation of how these three important components are associated with each other.
Assets represent the valuable resources controlled by a company and liabilities represent its obligations. Both liabilities and shareholders’ equity detail how the assets of a company are financed. It will show as a liability if it’s financed through debt but in shareholders' equity if it’s financed through issuing [equity](https://www.investopedia.com/terms/e/equityfinancing.asp) shares to investors.
> **Important**
>
> The accounting equation helps to assess whether business transactions carried out by the company are being accurately reflected in its books and accounts.
### Assets
Assets include [cash and cash equivalents](https://www.investopedia.com/terms/c/cashandcashequivalents.asp) or [liquid assets](https://www.investopedia.com/terms/l/liquidasset.asp). These may include Treasury bills and certificates of deposit (CDs).
[Accounts receivable](https://www.investopedia.com/terms/a/accountsreceivable.asp) lists the amounts of money owed to the company by its customers for the sale of its products. Inventory is also considered to be an asset.
The major and often largest value assets of most companies are their machinery, buildings, and property. These are fixed assets that are usually held for many years.
### Liabilities
Liabilities are debts that a company owes and costs that it must pay to keep running. Debt is a liability whether it's a long-term loan or a bill that's due to be paid. Costs can include rent, taxes, utilities, salaries, wages, and [dividends](https://www.investopedia.com/terms/d/dividend.asp) payable.
### Shareholders’ Equity
The shareholders’ equity number is a company’s total assets minus its total liabilities. It can be defined as the total number of dollars that a company would have left if it liquidated all its assets and paid off all of its liabilities. This would then be distributed to the shareholders.
[Retained earnings](https://www.investopedia.com/terms/r/retainedearnings.asp) are part of shareholders’ equity. This number is the sum of total earnings that weren't paid to shareholders as dividends.
Think of retained earnings as savings. It represents the total profits that have been saved and put aside or “retained” for future use.
## Accounting Equation Formula and Calculation
The balance sheet holds the elements that contribute to the accounting equation:
1. Locate the company’s total assets on the balance sheet for the period.
2. Total all liabilities which should be a separate listing on the balance sheet.
3. Locate total shareholders’ equity and add the number to total liabilities.
4. Total assets will equal the sum of liabilities and total equity.
$\text{Assets}=(\text{Liabilities}+\text{Owner's Equity})$
Say leading retailer XYZ Corp reported the following on its balance sheet for its latest full [fiscal year](https://www.investopedia.com/terms/f/fiscalyear.asp):
* Total assets: $170 billion
* Total liabilities: $120 billion
* Total shareholders’ equity: $50 billion
We arrive at ($50 billion + $120 billion) = $170 billion if we calculate the right side of the accounting equation (equity + liabilities). This matches the value of the assets reported by the company.
## What Is the Purpose of the Double-Entry System?
The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. The representation essentially equates all uses of capital or assets to all sources of capital where debt capital leads to liabilities and equity capital leads to shareholders’ equity.
Every business transaction will be represented in at least two of its accounts if a company is keeping accurate accounts. The borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability if a business takes a loan from a bank.
It will result in an increase in the company’s [inventory](https://www.investopedia.com/terms/i/inventory.asp) which is an asset while reducing cash capital which is another asset if a business buys [raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) and pays in cash. Two or more accounts are affected by every transaction carried out by a company so the accounting system is referred to as double-entry accounting.
The double-entry practice ensures that the accounting equation always remains balanced. The left-side value of the equation will always match the right-side value. The total amount of all assets will always equal the sum of liabilities and shareholders’ equity.
The global adherence to the double-entry accounting system makes the account-keeping and -tallying processes more standardized and foolproof.
The accounting equation ensures that all entries in the books and records are vetted and a verifiable relationship exists between each liability or expense and its corresponding source or between each item of income or asset and its source.
## Limits of the Accounting Equation
The balance sheet always balances out but the accounting equation can’t tell investors how well a company is performing. Investors must interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets or perhaps too many assets, or whether its financing is sufficient to ensure its long-term growth.
## Real-World Example of the Accounting Equation
This is a portion of Exxon Mobil Corp.’s ([XOM](https://www.investopedia.com/markets/quote?tvwidgetsymbol=xom)) balance sheet in millions as of March 31, 2024:
* Total assets were $377,918
* Total liabilities were $164,866
* Total equity was $213,052
The accounting equation is calculated as follows:
$164,866 (total liabilities) + $213,052 (equity) = $377,918 (which equals the total assets for the period)
## Why Is the Accounting Equation Important?
The accounting equation captures the relationship between the three components of a balance sheet: assets, liabilities, and equity. A company’s equity will increase when its assets increase and vice versa. Adding liabilities will decrease equity and reducing liabilities such as by paying off debt will increase equity. These basic concepts are essential to modern accounting methods.
## What Are the 3 Elements of the Accounting Equation?
The three elements of the accounting equation are assets, liabilities, and shareholders’ equity. The formula is straightforward: A company’s total assets are equal to its liabilities plus its shareholders’ equity. The double-entry bookkeeping system is designed to accurately reflect a company’s total assets.
## What Is an Asset in the Accounting Equation?
An [asset](https://www.investopedia.com/terms/a/asset.asp) is anything with economic value that a company controls and can be used to benefit the business now or in the future. Assets include fixed assets such as machinery and buildings as well as financial assets such as investments in stocks and bonds. They may also be intangible assets like patents, trademarks, and goodwill.
## What Is a Liability in the Accounting Equation?
A company’s [liabilities](https://www.investopedia.com/terms/l/liability.asp) include every debt it has incurred. These may include loans, accounts payable, mortgages, deferred revenues, bond issues, warranties, and accrued expenses.
## What Is Shareholders’ Equity in the Accounting Equation?
[Shareholders’ equity](https://www.investopedia.com/terms/s/stockholdersequity.asp) is the total value of the company expressed in dollars. It's the amount that would remain if the company liquidated all its assets and paid off all its debts. The remainder is the shareholders’ equity which would be returned to them.
## The Bottom Line
The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity. It's a core concept in modern accounting that provides the basis for keeping a company’s books balanced across a given accounting cycle.
> **Article Sources**
>
> 1. UCSD Rady School of Management. "[The Accounting Equation, Explained](https://career.rady.ucsd.edu/blog/2022/11/22/the-accounting-equation-explained/)."
>
> 2. CFI Education. "[Double Entry](https://corporatefinanceinstitute.com/resources/accounting/double-entry/)."
>
> 3. U.S. Securities and Exchange Commission, via ExxonMobil Investor Relations. “[ExxonMobil Form 10-Q for the Quarterly Period Ended March 31, 2024](https://investor.exxonmobil.com/sec-filings/all-sec-filings/content/0000034088-24-000029/0000034088-24-000029.pdf).” Page 5. |
Accounting Information System (AIS) | # Accounting Information System (AIS): Definition and Benefits
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*— Ryan Oakley / Investopedia*
## What Is an Accounting Information System (AIS)?
An accounting information system (AIS) involves the collection, storage, and processing of financial and accounting data used by internal users to report information to [investors](https://www.investopedia.com/terms/i/investor.asp), [creditors](https://www.investopedia.com/terms/c/creditor.asp), and tax authorities. It is generally a computer-based method for tracking accounting activity in conjunction with information technology resources.
An AIS combines traditional [accounting practices](https://www.investopedia.com/terms/a/accounting-practice.asp), such as the use of [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp), with modern information technology (IT) resources.
### Key Takeaways
* An accounting information system (AIS) involves the collection, storage, and processing of financial and accounting data used by internal users to report information to investors, creditors, and tax authorities.
* An AIS contains various elements that are important in the [accounting](https://www.investopedia.com/terms/a/accounting.asp) cycle.
* An AIS is often a highly secured platform, with preventative measures taken against viruses, hackers, and other external sources attempting to collect information.
* The benefits of an AIS include interdepartmental interfacing and internal controls.
## How an Accounting Information System (AIS) Is Used
An accounting information system contains various elements that are important in the [accounting cycle](https://www.investopedia.com/terms/a/accounting-cycle.asp). Although the information contained in a system varies among industries and business sizes, a typical AIS includes data relating to [revenue](https://www.investopedia.com/terms/r/revenue.asp), [expenses](https://www.investopedia.com/terms/e/expense.asp), customer information, employee information, and tax information. Specific data includes sales orders and analysis reports, purchase requisitions, invoices, check registers, inventory, payroll, ledger, trial balance, and financial statement information.
An accounting information system must have a database structure to store information. This database structure is typically programmed with query language that allows for table and data manipulation.
An AIS has numerous fields to input data and edit previously stored data. In addition, accounting information systems are often highly secured platforms, with preventative measures taken against viruses, hackers, and other external sources attempting to collect information.
The various outputs of an accounting information system exemplify the versatility of its data manipulation capabilities. An AIS produces reports including [accounts receivable](https://www.investopedia.com/terms/a/accountsreceivable.asp) aging reports based on customer information, [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) schedules for fixed assets, and [trial balances](https://www.investopedia.com/terms/t/trial_balance.asp) for financial reporting. Customer lists, taxation calculations, and inventory levels may also be reproduced.
However, correspondences, memos, or presentations are not included in the AIS because these items are not directly related to a company’s financial reporting or bookkeeping.
## Benefits of an AIS
### Interdepartmental Interfacing
An accounting information system strives to interface across multiple departments. Within the system, the sales department can upload the sales budget, for example. This information is used by the inventory management team to conduct [inventory](https://www.investopedia.com/terms/i/inventory.asp) counts and purchase materials.
Upon the purchase of inventory, the system can notify the [accounts payable](https://www.investopedia.com/terms/a/accountspayable.asp) department of the new invoice. An AIS can also share information about a new order so that the manufacturing, shipping, and customer service departments are aware of the sale.
### Internal Controls
An integral part of accounting information systems relates to [internal controls](https://www.investopedia.com/terms/i/internalcontrols.asp). Policies and procedures can be placed within the system to ensure that sensitive customer, vendor, and business information is maintained within a company. Through the use of physical access approvals, login requirements, access logs, authorizations, and segregation of duties, users can be limited to only the relevant information necessary to perform their business function.
## How Does an Accounting Information System (AIS) Incorporate Technology?
An AIS combines modern information technology (IT) resources with traditional accounting practices, such as the use of generally accepted accounting principles (GAAP).
## Why Is It Important That Accounting Information Systems Are Highly Secured?
[Cybersecurity](https://www.investopedia.com/terms/c/cybersecurity.asp) is increasingly important as more and more companies store their data electronically. Because of this, accounting information systems are often highly secured against viruses, hackers, and other external sources attempting to collect information.
## What Does an Accounting Information System (AIS) Produce?
AIS reports include:
* Accounts receivable aging reports based on customer information
* Customer lists
* Depreciation schedules for fixed assets
* Inventory levels
* Taxation calculations
* Trial balances for financial reporting
## The Bottom Line
An accounting information system (AIS) involves collecting, storing, and processing financial and accounting data used by internal users to report information to investors, creditors, and tax authorities. In general, it is a computer-based method to track accounting activity in conjunction with information technology (IT) resources. |
Accounting Policies | # What Are Accounting Policies and How Are They Used? With Examples
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*— Investopedia / Julie Bang*
## What Are Accounting Policies?
Accounting policies are the specific procedures implemented by a company's management team that are used to prepare its [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp). These include any accounting methods, [measurement systems](https://www.investopedia.com/terms/a/accounting-measurement.asp), and procedures for presenting disclosures. Accounting policies differ from [accounting principles](https://www.investopedia.com/terms/a/accounting-principles.asp) in that the principles are the accounting rules, and the policies are a company's way of adhering to those rules.
### Key Takeaways
* Accounting policies are procedures that a company uses to prepare financial statements.
* Unlike accounting principles, which are rules, accounting policies are the standards for following those rules.
* Accounting policies may be used to manipulate earnings legally.
* A company's choice in accounting policies will indicate whether management is aggressive or conservative in reporting its earnings.
* Accounting policies still need to adhere to generally accepted accounting principles (GAAP).
## How Accounting Policies Are Used
Accounting policies are a set of standards that govern how a company prepares its financial statements. These policies are used to deal specifically with complicated accounting practices such as [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) methods, recognition of [goodwill](https://www.investopedia.com/terms/g/goodwill.asp), preparation of research and development (R&D) costs, inventory valuation, and the consolidation of financial accounts. These policies may differ from company to company, but all accounting policies are required to conform to [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) and/or [international financial reporting standards (IFRS)](https://www.investopedia.com/terms/i/ifrs.asp).
Accounting principles can be thought of as a framework in which a company is expected to operate. However, [the framework is somewhat flexible](https://www.investopedia.com/ask/answers/102714/how-should-change-accounting-principle-be-recorded-and-reported.asp), and a company's management team can choose specific accounting policies that are advantageous to the financial reporting of the company. Because accounting principles are lenient at times, the [specific policies of a company](https://www.investopedia.com/terms/a/accounting-manual.asp) are very important.
Looking into a company's accounting policies can signal whether management is conservative or aggressive when reporting [earnings](https://www.investopedia.com/terms/e/earnings.asp). This should be taken into account by investors when reviewing earnings reports to assess the [quality of earnings](https://www.investopedia.com/terms/q/qualityofearnings.asp). Also, external auditors who are hired to review a company's financial statements should review the company's policies to ensure they conform to GAAP.
> **Important**
>
> Company management can select accounting policies that are advantageous to their own financial reporting, such as selecting a particular inventory valuation method.
## Example of an Accounting Policy
Accounting policies can be used to legally manipulate earnings. For example, in the United States, companies are allowed to value inventory using the [average cost](https://www.investopedia.com/terms/a/averagecostmethod.asp), [first in first out (FIFO)](https://www.investopedia.com/terms/f/fifo.asp), or [last in first out (LIFO)](https://www.investopedia.com/terms/l/lifo.asp) methods of accounting. Under the average cost method, when a company sells a product, the weighted average cost of all inventory produced or acquired in the [accounting period](https://www.investopedia.com/terms/a/accountingperiod.asp) is used to determine the [cost of goods sold (COGS)](https://www.investopedia.com/terms/c/cogs.asp). Under the FIFO inventory cost method, when a company sells a product, the cost of the inventory produced or acquired first is considered to be sold first. Under the LIFO method, when a product is sold, the cost of the inventory produced last is considered to be sold first.
In periods of rising inventory prices, a company can use these accounting policies to increase or decrease its earnings. For example, a company in the manufacturing industry buys inventory at $10 per unit for the first half of the month and $12 per unit for the second half of the month. The company ends up purchasing a total of 10 units at $10 and 10 units at $12 and sells a total of 15 units for the entire month.
If the company uses FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. If it uses average cost, its cost of goods sold is: (15 x $11) = $165. If it uses LIFO, its cost of goods sold is: (10 x $12) + (5 x $10) = $170. In the US, where companies are able to choose between FIFO and LIFO, a company wishing to maximize profits will use the FIFO method in periods of rising prices in order to minimize the cost of goods sold and increase earnings. A company wishing to lower taxable income will use the LIFO method if prices are rising to increase the cost of goods sold and decrease earnings.
## What Is the Difference Between Accounting Policies and Principles?
While an accounting principle is the standardized rule set forth by a governing body, an accounting policy is the method or guideline used by management to adhere to the rule and generate financial statements.
In the United States, generally accepted accounting principles (GAAP) are the accounting standards accepted by the [Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp). Certain accounting principles allow for management discretion, and that is where accounting policies come into play.
## What Are Some Examples of Accounting Policies?
Accounting policies appear in a business when accounting principles allow leeway in how the rules are applied to a situation. Situations that involve management discretion include:
* Valuation of inventory
* Valuation of investments
* Valuation of fixed assets
* Depreciation methods
* Costs of R&D
* Translation of foreign currency
## What Is the Difference Between Conservative and Aggressive Accounting?
Conservative accounting uses accounting policies that result in a lower revenue and/or a higher expense. On the other hand, aggressive accounting uses policies that tend to increase revenue and/or reduce expenses.
A company using conservative accounting policies will have lower earnings in the current year, while a company using aggressive accounting policies will show better financial performance in the current year. Conservative accounting policies will tend toward better financial performance in the long run, while aggressive accounting policies tend to lead to a decline in financial performance over the long run.
## The Bottom Line
Accounting policies are different from accounting principles, which are the accounting rules to which all accounting policies must conform. A company's management team can choose specific accounting policies that are advantageous to the firm's financial reporting. The team might use either conservative or aggressive accounting policies, which will determine how a company's financial performance appears in a given year.
> **Article Sources**
>
> 1. Fasb.org. "[About the FASB (Financial Accounting Standards Board)](https://www.fasb.org/info/facts)."
>
> 2. Businessnewsdaily.com. "[What Are Accounting Standards?](https://www.businessnewsdaily.com/2664-accounting-standards.html)" |
Accounting Method | # Mastering Accounting Methods: Accrual vs. Cash Explained
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*— Sydney Saporito / Investopedia*
## What Is an Accounting Method?
An accounting method details how companies report their revenues and expenses, with a focus on accrual versus cash accounting. Accrual accounting records transactions when they occur, while cash accounting handles them upon receiving or spending cash. Understanding these approaches is essential due to IRS requirements and their impact on financial statements.
[Cash accounting](https://www.investopedia.com/terms/c/cashaccounting.asp) reports revenues and expenses as they are received and paid through cash inflows and outflows; [accrual accounting](https://www.investopedia.com/terms/a/accrualaccounting.asp) reports them as they are earned and incurred through sales and purchases on credit and by using accounts receivable and accounts payable. [Generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) require accrual accounting.
### Key Takeaways
* Accounting methods determine how a company reports its revenues and expenses, with the main types being cash accounting and accrual accounting.
* Cash accounting records transactions when cash changes hands, whereas accrual accounting records them when they are incurred, offering a clearer financial picture.
* The IRS requires businesses with over $25 million in annual average sales to use accrual accounting, and switching methods requires IRS approval.
* Companies may use a hybrid accounting method if they meet specific IRS criteria, although individuals must stick to one method.
* Accurate accounting is crucial for financial management and compliance, affecting everything from tax reporting to loan eligibility.
## Why Accurate Accounting Methods Matter
All businesses need to keep accounting records. Public [companies](https://www.investopedia.com/terms/c/company.asp) are required to do so. Accounting allows a business to monitor every aspect of its finances, from revenues to costs to taxes and more. Without accurate accounting, a business would not know where it stands financially, most likely resulting in its demise.
Accounting is also needed to pay accurate taxes to the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp). If the IRS ever conducts an audit on a company, it looks at a company’s accounting records and methods. Furthermore, the IRS requires [taxpayers](https://www.investopedia.com/terms/t/taxpayer.asp) to choose an accounting method that accurately reflects their income and to be consistent in their choice of accounting method from year to year.
This is because switching between methods would potentially allow a company to manipulate [revenue](https://www.investopedia.com/terms/r/revenue.asp) to minimize its tax burdens. As such, IRS approval is required to change methods. Companies may use a hybrid of the two methods, which is allowable under IRS rules if specified requirements are met.
## Comparing Cash and Accrual Accounting: Key Differences
### Cash Accounting
Cash accounting is simple and commonly used by small businesses. In cash accounting, transactions are only recorded when cash is spent or received.
In cash accounting, a sale is recorded when the payment is received and an expense is recorded only when a bill is paid. Most people use cash accounting for personal finances, and it's suited for smaller businesses.
If a business generates more than $25 million in average annual gross receipts for the preceding three years, however, it must use the accrual method, according to IRS rules.
### Accrual Accounting
Accrual accounting is based on the matching principle, which is intended to match the timing of revenue and expense recognition. The accrual method matches revenues with expenses to give a clearer picture of a company's financial condition.
Under the accrual method, transactions are recorded when they are incurred rather than awaiting payment. A purchase order is recorded as revenue immediately, and expenses are recorded even if not paid.
## Example: How Accounting Methods Impact Financial Reporting
Accrual accounting is especially valuable for large, complex businesses. For example, a construction company may undertake a long-term project and may not receive complete cash payments until the project is complete.
With cash accounting, expenses are incurred but revenue isn't recognized until the customer pays. So, the accounting book of the company would look weak until the revenue actually came in. If this company was looking for [debt financing](https://www.investopedia.com/terms/d/debtfinancing.asp) from a bank, for example, the cash accounting method makes it look like a poor bet because it is incurring expenses but no revenue.
In accrual accounting, a construction company records part of its revenue and expenses as each project phase completes. This is known as the [percentage of completion method](https://www.investopedia.com/terms/p/percentage-of-completion-method.asp). How much actual cash is coming into the company, however, would be evident in the cash flow statement. This method would show a prospective lender a much more complete and accurate picture of the company’s revenue pipeline.
## What Do the 2 Primary Accounting Methods Report?
Accrual accounting reports revenues and expenses as they are earned and incurred through sales and purchases on credit and by using accounts receivable and accounts payable.
Cash accounting reports revenues and expenses as they are received and paid through cash inflows and outflows.
## What Does the IRS Require for Accounting Methods?
The IRS requires businesses making an average of $25 million or more in sales for the preceding three years to use accrual accounting. As for individual taxpayers, the IRS mandates that they choose an accounting method that accurately reflects their [income](https://www.investopedia.com/terms/i/income.asp) and be consistent in their choice of accounting method from year to year.
## Can a Hybrid of the 2 Primary Accounting Methods Be Used?
Yes, by companies but not individuals. Companies may use a hybrid of accrual accounting and cash accounting under IRS rules if specified requirements are met. Switching between methods is not allowed because it would potentially allow a business to manipulate revenue to minimize its tax burdens.
## Conclusion: Choosing the Right Accounting Method
Choosing the right accounting method is crucial for accurately reporting revenues and expenses. Accrual accounting, preferred by large businesses and required by GAAP and the IRS for companies with substantial revenues, matches revenues with expenses incurred. Cash accounting, simpler and used by many small businesses, records transactions only when cash changes hands.
Organizations must select an accounting method that accurately reflects their financial activities and adhere to it consistently unless officially approved for change. Large businesses must use accrual accounting if annual gross receipts exceed $25 million. Understanding these methods enables companies to manage their finances effectively and comply with regulatory requirements.
> **Article Sources**
>
> 1. Internal Revenue Service. “[Publication 538: Accounting Periods and Methods](https://www.irs.gov/pub/irs-pdf/p538.pdf),” Page 9. |
Accounting Principles | # Accounting Principles: What They Are and How GAAP and IFRS Work
> **Definition**
>
> Accounting principles, such as GAAP or IFRS, are standards set by regulatory bodies that public companies must adhere to for financial reporting disclosures.
## What Are Accounting Principles?
Accounting principles are guidelines companies must follow when recording and reporting accounting transactions. They bring uniformity to [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp), making it harder for firms to hide information and inflate their numbers. These principles also make it easier to understand a business’s health and compare one or several companies' financials over different periods. In the U.S., the standards to follow are generally accepted accounting principles ([GAAP](https://www.investopedia.com/terms/g/gaap.asp)). In many other countries, companies are guided by international financial reporting standards ([IFRS](https://www.investopedia.com/terms/i/ifrs.asp)).
### Key Takeaways
* Accounting principles are the rules that public companies must use when preparing and disclosing their financial statements.
* Accounting principles are dictated by core practices; for example, the matching principle dictates revenue and expenses should be recorded at the same time.
* External auditors are hired to review whether or not a company has been following accounting principles.
* Because different standards boards favor specific treatment in certain cases, there are multiple prevalent accounting principles (GAAP and IFRS).
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*These principles ensure consistency, comparability, and reliability of financial statements. — Ryan Oakley / Investopedia*
## Understanding Accounting Principles
Accounting principles explain how transactions, such as sales, purchases, and payments, should be reported. Before accounting principles were introduced, companies were free to record and report financial data as they saw fit. This made financial statements harder to compare and made it far easier for companies to skew their numbers positively. For investors and regulators, it was a nightmare.
The roots of modern accounting principles trace back to the [Stock Market Crash of 1929](https://www.investopedia.com/terms/s/stock-market-crash-1929.asp) and the subsequent Great Depression. Before then, companies had free rein to report their finances however they wished, often hiding losses and inflating profits through creative bookkeeping. In the aftermath of the crash, as investigators uncovered widespread accounting manipulation that had helped fuel speculation, Congress passed the Securities Acts of 1933 and 1934 to protect investors.
These laws established the [Securities and Exchange Commission (SEC)](https://www.investopedia.com/terms/s/sec.asp) and mandated standardized financial reporting for public companies. During the same decade, the [American Institute of Certified Public Accountants (AICPA)](https://www.investopedia.com/terms/a/american-institute-of-certified-public-accountants.asp) worked with the SEC to develop the first formal accounting standards. In many other countries, these guidelines fall to the IFRS, established by the International Accounting Standards Board (IASB).
## The Core Principles
Here is a list of the most common accounting principles:
### Conservatism Principle
Expenses and [liabilities](https://www.investopedia.com/terms/l/liability.asp) should be recognized as soon as possible, even if uncertainty exists, while revenues and assets should only be recognized if they are certain. The goal is to be open about future losses and cautious about acknowledging future gains.
### Consistency Principle
Once a company adopts an accounting principle or method, it should stick to it so that future changes are easily compared.
### Cost Principle
An [asset](https://www.investopedia.com/terms/b/business-asset.asp), liability, or equity investment must be recorded at its original purchase cost.
### Economic Entity Principle
The financial transactions of a company and its owners should be separate and thus report separate accounting records and bank accounts for each.
### Full Disclosure Principle
Companies must reveal all relevant and material information in their financial statements. For example, if there were significant [write-downs](https://www.investopedia.com/terms/w/writedown.asp), a breakdown of how depreciation was calculated should be provided.
### Going Concern Principle
Companies are able to defer the recognition of some expenses, such as depreciation, to later periods because it is assumed they will continue to operate in the future.
### Matching Principle
All expenses related to a revenue-generating transaction should be recorded at the time the revenue is recognized. That is, you can't boost your supposed profits by recording your gains at one time and the costs to get them at another.
### Materiality Principle
All information deemed reasonably likely to impact investors’ decision-making should be reported in detail in a company’s financial statements.
### Monetary Unit Principle
Financial statements should only record things that can be expressed in terms of a currency. This principle prevents companies from inflating their numbers with overly optimistic estimations for aspects of a business that are hard to ascribe value to, such as employee quality.
### Objectivity Principle
Accounting should be based on facts and objective evidence and free of bias and personal opinion.
### Reliability Principle
Only transactions supported by evidence, such as a receipt or invoice, should be recorded.
### Revenue Recognition Principle
Revenues should be recognized on the income statement in the period they are realized and earned—not necessarily when the cash is received.
### Time Period Principle
Companies should report their financial activities over a standard time period, such as quarterly or annually.
## Generally Accepted Accounting Principles (GAAP)
GAAP are the accounting principles that all regulated U.S. entities, including publicly traded companies, government agencies, and nonprofits, must follow. These rules were set and are periodically revised by the [Financial Accounting Standards Board](https://www.investopedia.com/terms/f/fasb.asp), an independent nonprofit organization whose members are chosen by the [Financial Accounting Foundation](https://www.investopedia.com/terms/f/financial-accounting-foundation.asp). Compliance is verified by an external audit conducted by a [certified public accountant](https://www.investopedia.com/terms/c/cpa.asp).
Companies often accompany GAAP-compliant measures with [non-GAAP](https://www.investopedia.com/articles/financial-analysis/062716/gaap-vs-nongaap-which-should-you-consider-evaluation.asp) figures in their financial statements. When a figure is non-GAAP, the company must say so and investors should pay heed to that fact.
## International Financial Reporting Standards (IFRS)
IFRS standards are used in 168 jurisdictions, including the European Union, the U.K., Canada, India, Russia, South Korea, South Africa, and Chile. The standards are issued and maintained by the IASB, an independent, private-sector body headquartered in London.
The IFRS’s 17 standards cover everything from how a company should recognize revenues from contracts to accounting for insurance contracts and leases. These rules are underpinned by four core principles: clarity, relevance, reliability, and comparability.
The type of entities IFRS is enforced on depends on the country or territory. In the EU, for example, all companies are required to conform. Meanwhile, in other countries, the IFRS might be compulsory for only certain types of companies, like banks or those over a certain valuation.
> **Warning**
>
> Investors should be cautious when comparing the financial statements of companies from different countries as not all accounting principles are the same.
## IFRS vs. GAAP
While GAAP and IFRS have differences, they share the same core goal that emerged from the 1930s reforms—protecting investors through transparency and consistency. IFRS is [principles-based](https://www.investopedia.com/ask/answers/06/rulesandpriciplesbasedaccounting.asp), while GAAP (despite the name) is rules-based. The former leaves greater room for interpretation, while the latter dictates exactly how financial statements should be prepared.
They also differ in how they want companies to record and report certain transactions, including the formatting of balance sheets and the treatment of interest, asset revaluations, inventory, intangibles, research and development expenses, liabilities, and revenue.
For example, GAAP permits using last-in, first-out inventory accounting methods but doesn’t allow for inventory reversals, while IFRS has banned the former but allows the latter under certain conditions.
## The Bottom Line
Accounting principles ensure companies are as transparent, consistent, and objective as possible when reporting their financials and that all metrics and valuation approaches used are the same. For investors, this results in all financial statements being similar and consequently easier to understand, analyze, and compare.
Accounting principles vary by region. However, they generally share the same fundamentals and objectives, which include being conservative about estimating income and forthcoming about expenses.
> **Article Sources**
>
> 1. U.S. Securities and Exchange Commission. "[A U.S. Imperative: High-Quality, Globally Accepted Accounting Standards](https://www.sec.gov/newsroom/speeches-statements/white-2016-01-05)."
>
> 2. International Financial Reporting Standards (IFRS) Foundation. “[Who Uses IFRS Accounting Standards?](https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#use-of-ifrs-standards-by-jurisdiction)”
>
> 3. The New York State Society of CPAs, The CPA Journal. "[History of the Auditing World, Part 1](https://www.cpajournal.com/2020/11/25/history-of-the-auditing-world-part-1/)."
>
> 4. U.S. Securities and Exchange Commission. "[Statutes and Regulations](https://www.sec.gov/rules-regulations/statutes-regulations)."
>
> 5. Financial Accounting Foundation. "[GAAP and Public Companies](https://www.accountingfoundation.org/accounting-and-standards/about-gaap/gaap-and-public-companies)."
>
> 6. Harvard Law School Forum on Corporate Governance. "[The Long and Winding Road to Financial Reporting Standards](https://corpgov.law.harvard.edu/2022/07/20/the-long-and-winding-road-to-financial-reporting-standards/#:~:text=The%20formalization%20of%20standard%20setting,away%20its%20rule%2Dmaking%20authority.)."
>
> 7. Financial Accounting Standards Board. “[About the FASB](https://www.fasb.org/about-us/about-the-fasb).”
>
> 8. U.S. Department of Justice, Office of Justice Programs . "[Generally Accepted Accounting Principles (GAAP) Guide Sheet](https://www.ojp.gov/sites/g/files/xyckuh241/files/media/document/GAAP_Guide_Sheet_508.pdf)."
>
> 9. U.S. Securities and Exchange Commission. "[Non-GAAP Financial Measures](https://www.sec.gov/corpfin/non-gaap-financial-measures.htm)."
>
> 10. International Financial Reporting Standards Foundation (IFRS). “[IFRS Accounting Standards Navigator](https://www.ifrs.org/issued-standards/list-of-standards/).”
>
> 11. U.S. Securities and Exchange Commission. "[A Comparison of U.S. GAAP and IFRS](https://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-paper-111611-gaap.pdf)." Pages 8-11.
>
> 12. American Institute of Certified Public Accountants. “[Is IFRS That Different from U.S. GAAP?](https://www.ifrs.com/overview/General/differences.html)”
>
> 13. Harvard Business School Online. "[GAAP vs. IFRS: What Are the Key Differences and Which Should You Use?](https://online.hbs.edu/blog/post/gaap-vs-ifrs)" |
Accounting Profit | # Accounting Profit: Definition, Calculation, Example
## What Is Accounting Profit?
Accounting profit is a company's total [earnings](https://www.investopedia.com/terms/e/earnings.asp), calculated according to [generally accepted accounting principles](https://www.investopedia.com/terms/g/gaap.asp) (GAAP). It includes the [explicit costs](https://www.investopedia.com/terms/e/explicitcost.asp) of doing business, such as operating expenses, depreciation, interest, and taxes.
### Key Takeaways
* Accounting profit shows the amount of money left over after deducting the explicit costs of running the business.
* Explicit costs include labor, inventory needed for production, and raw materials, together with transportation, production, and sales and marketing costs.
* Accounting profit differs from economic profit as it only represents the monetary expenses a firm pays and the monetary revenue it receives.
* Accounting profit also differs from underlying profit, which seeks to eliminate the impact of nonrecurring items.
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*— Investopedia / Ellen Lindner*
## How Accounting Profit Works
[Profit](https://www.investopedia.com/terms/p/profit.asp) is a widely monitored financial [metric](https://www.investopedia.com/terms/m/metrics.asp) that is regularly used to evaluate the health of a company.
Firms often publish various versions of profit in their [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp). Some of these figures take into account all [revenue](https://www.investopedia.com/terms/r/revenue.asp) and [expense](https://www.investopedia.com/terms/e/expense.asp) items**,** laid out in the income statement. Others are creative interpretations put together by management and their accountants.
Accounting profit, also referred to as bookkeeping profit or financial profit, is [net income](https://www.investopedia.com/terms/n/netincome.asp) earned after subtracting all dollar costs from total revenue. In effect, it shows the amount of money a firm has left over after deducting the explicit costs of running the business.
The costs that need to be considered include the following:
* Labor, such as wages
* Inventory needed for production
* Raw materials
* Transportation costs
* Sales and marketing costs
* Production costs and overhead
## Accounting Profit vs. Economic Profit
Like accounting profit, economic profit deducts explicit costs from revenue. Where they differ is that economic profit also uses [implicit costs](https://www.investopedia.com/terms/i/implicitcost.asp); the various opportunity costs a company incurs when allocating resources elsewhere.
Examples of implicit costs include:
* Company-owned buildings
* Plant and equipment
* Self-employment resources
For example, if a person invested $100,000 to start a business and earned $120,000 in profit, their accounting profit would be $20,000. [Economic profit](https://www.investopedia.com/terms/e/economicprofit.asp), however, would add implicit costs, such as the [opportunity cost](https://www.investopedia.com/terms/o/opportunitycost.asp) of $50,000, which represents the salary they would have earned if they kept their day job. As such, the business owner would have an economic loss of $30,000 ($120,000 - $100,000 - $50,000).
Economic profit is more of a theoretical calculation based on alternative actions that could have been taken, while accounting profit calculates what actually occurred and the measurable results for the period. Accounting profit has many uses, including for tax declarations. Economic profit, on the other hand, is mainly just calculated to help management make a decision.
## Accounting Profit vs. Underlying Profit
Companies often choose to supplement accounting profit with their own subjective take on their profit position. One such example is underlying profit. This popular, widely-used metric often excludes [one-time charges](https://www.investopedia.com/terms/o/one-time-charge.asp) or infrequent occurrences and is regularly flagged by management as a key number for investors to pay attention to.
The goal of underlying profit is to eliminate the impact that random events, such as a natural disaster, have on earnings. Losses or gains that do not regularly crop up, such as [restructuring charges](https://www.investopedia.com/terms/r/restructuring-charge.asp) or the buying or selling of land or property, are usually not taken into account because they do not occur often and, as a result, are not deemed to reflect the everyday costs of running the business.
## Example of Accounting Profit
Company A operates in the manufacturing industry and sells widgets for $5. In January, it sold 2,000 widgets for a total monthly revenue of $10,000. This is the first number entered into its income statement.
The [cost of goods sold](https://www.investopedia.com/terms/c/cogs.asp) (COGS) is then subtracted from revenue to arrive at gross revenue. If it costs $1 to produce a widget, the company's COGS would be $2,000, and its net sales would be $8,000, or ($10,000 - $2,000).
After calculating the company's gross revenue, all operating costs are subtracted to arrive at the company's operating profit, or earnings before interest, taxes, [depreciation](https://www.investopedia.com/terms/d/depreciation.asp), and [amortization](https://www.investopedia.com/terms/a/amortization.asp) ([EBITDA](https://www.investopedia.com/terms/e/ebitda.asp)). If the company's only overhead was a monthly employee expense of $5,000, its operating profit would be $3,000, or ($8,000 - $5,000).
Once a company derives its operating profit, it then assesses all [non-operating expenses](https://www.investopedia.com/terms/n/non-operating-expense.asp), such as interest, depreciation, amortization, and taxes. In this example, the company has no debt but has depreciating assets at a [straight line depreciation](https://www.investopedia.com/terms/s/straightlinebasis.asp) of $1,000 a month. It also has a corporate tax rate of 35%.
The depreciation amount is first subtracted to arrive at the company's earnings before taxes ([EBT](https://www.investopedia.com/terms/e/ebt.asp)) of $1,000, or ($2,000 - $1,000). Corporate taxes are then assessed at $350, to give the company an accounting profit of $650, calculated as ($1,000 - ($1,000 \* 0.35). |
Accounting Rate of Return (ARR) | # What Is Accounting Rate of Return (ARR)?
## What Is Accounting Rate of Return (ARR)?
The accounting rate of return is a capital budgeting metric to calculate an investment's profitability. Businesses use ARR to compare multiple projects to determine each endeavor's expected rate of return or to help decide on an investment or an [acquisition](https://www.investopedia.com/terms/a/acquisition.asp).
The accounting rate of return (ARR) formula divides an asset's average revenue by the company's initial investment to derive the ratio or return generated from the net income of the proposed capital investment.
### Key Takeaways
* The accounting rate of return (ARR) helps determine the rate of return of a project.
* ARR is the average annual profit divided by the initial investment.
* Businesses use ARR when comparing the return on multiple projects.
* ARR differs from the required rate of return (RRR), or the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.
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*— Investopedia / Dennis Madamba*
## Calculating ARR
1. Calculate the annual net profit from the investment as revenue minus any annual costs or expenses of implementing the project or investment.
2. If the investment is a fixed asset such as [property, plant, and equipment (PP&E)](https://www.investopedia.com/terms/p/ppe.asp), subtract any [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) expense from the annual revenue to achieve the net profit.
3. Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return.
$ARR = \frac{Average\, Annual\, Profit}{Initial\, Investment}$
## Example
A business is considering a project with an initial investment of $250,000 and forecasts it will generate revenue for the next five years. ARR is calculated as:
* Initial investment: $250,000
* Expected revenue per year: $70,000
* Time frame: 5 years
* ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
* ARR = 0.28 or 28%
## Advantages and Disadvantages of ARR
The accounting rate of return is a simple calculation that does not require complex math and allows managers to compare ARR to the desired minimum required return. For example, if the minimum required return of a project is 12% and ARR is 9%, a manager will know not to proceed with the project.
However, ARR does not consider the [time value of money](https://www.investopedia.com/terms/t/timevalueofmoney.asp) or cash flows. The time value of money is the concept that money available at present is worth more than an identical sum in the future because of its potential [earning capacity](https://www.investopedia.com/terms/e/earning-potential.asp). ARR does not assign a higher value to a project that returns profits sooner. The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.
Pros
* Determines a project's annual rate of return
* Simple comparison to minimum rate of return
* Ease of use
Cons
* Does not consider the time value of money
* Does not factor in long-term risk
* Does not account for cash flow timing
> **Tip**
>
> The time value of money is the main concept of the discounted cash flow model, which better determines the value of an investment as it seeks to determine the present value of future cash flows.
## Accounting Rate of Return vs. Required Rate of Return
The ARR is the annual percentage return from an investment based on its initial outlay. The [required rate of return (RRR)](https://www.investopedia.com/terms/r/requiredrateofreturn.asp), or the [hurdle rate](https://www.investopedia.com/terms/h/hurdlerate.asp), is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk. It is calculated using the [dividend discount model](https://www.investopedia.com/terms/d/ddm.asp), which accounts for stock price changes, or the [capital asset pricing model](https://www.investopedia.com/terms/c/capm.asp#:~:text=The%20capital%20asset%20pricing%20model%2C%20or%20CAPM%2C%20is%20a%20financial,to%20the%20market%20%28beta%29.), which compares returns to the market.
The RRR can vary between investors as they each have a different tolerance for [risk](https://www.investopedia.com/terms/r/risk.asp). For example, a risk-averse investor requires a higher rate of return to compensate for any risk from the investment. Investors and businesses may use multiple financial metrics like ARR and RRR to determine if an investment would be worthwhile based on [risk tolerance](https://www.investopedia.com/terms/r/risktolerance.asp).
## How Does Depreciation Affect the Accounting Rate of Return?
Depreciation will reduce the accounting rate of return. Depreciation is a direct cost that reduces the value of an asset or profit of a company. As such, it will reduce the return on an investment or project like any other cost.
## What Are the Decision Rules for Accounting Rate of Return?
When a company is presented with the option of multiple projects to invest in, the decision rule states that a company should accept the project with the highest accounting rate of return as long as the return is at least equal to the cost of capital.
## What Is the Difference Between ARR and Internal Rate of Return (IRR)?
The main difference between ARR and IRR is that [IRR](https://www.investopedia.com/terms/i/irr.asp) is a discounted cash flow formula while ARR is a non-discounted cash flow formula. ARR does not include the present value of future cash flows generated by a project. In this regard, ARR does not include the time value of money, where the value of a dollar is worth more today than tomorrow.
## The Bottom Line
The accounting rate of return (ARR) is a simple formula that allows investors and managers to determine the profitability of an asset or project. Because of its ease of use and determination of profitability, it is a handy tool to compare the profitability of various projects. However, the formula does not consider the cash flows of an investment or project or the overall timeline of return, which determines the entire value of an investment or project.
> **Article Sources**
>
> 1. University of Groningen-Pure. "[Economic and Accounting Rates of Return](https://pure.rug.nl/ws/portalfiles/portal/3138080/00E42.pdf)," Page 3-5. |
Accounting Ratio | # Accounting Ratio: Definition and Types
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*— Investopedia / NoNo Flores*
> **Definition**
>
> An accounting ratio is an analysis tool used to evaluate a company's financial health by measuring the relationship between two figures from its financial statements.
## What Is an Accounting Ratio?
Accounting ratios, an important subset of financial ratios, are a group of metrics used to measure the management aptitude, efficiency, and [profitability](https://www.investopedia.com/financial-ratios-4689817) of a company based on its financial reports. They provide a way of expressing the relationship between one accounting data point to another and are the basis of [ratio analysis](https://www.investopedia.com/terms/r/ratioanalysis.asp). They also serve as a way to compare the firm's performance to its competitors.
### Key Takeaways
* An accounting ratio compares two line items in a company’s financial statements that are made up of its income statement, balance sheet, and cash flow statement.
* These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.
* Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.
* Accounting ratios are used by the company to make improvements or monitor progress, as well as by investors.
## Why Accounting Ratios Matter
An accounting ratio compares two line items in a company’s [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp). These consist of its income statement, balance sheet, and cash flow statement. The ratios can be used to evaluate a company’s [fundamentals](https://www.investopedia.com/terms/f/fundamentals.asp) and provide information about the performance of the company over the last quarter or fiscal year.
Analyzing accounting ratios is an important step in determining the financial health of a company. They can often point out areas that are dragging the profitability of a company down and therefore need improvement. The effectiveness of new management plans, new products, and changes in operational procedures can all be determined by analyzing accounting ratios.
Accounting ratios also work as an important comparison tool. The company and its investors can see how it stacks up against its competitors.
> **Important**
>
> A thorough accounting analysis can be a complex task. Calculating an accounting ratio, on the other hand, is a simple process of dividing two line items found on a financial statement.
## Types of Accounting Ratios
### Gross Margin and Operating Margin
The [income statement](https://www.investopedia.com/terms/i/incomestatement.asp) contains information about a company's sales, expenses, and net income. It also provides an overview of earnings and the number of [shares outstanding](https://www.investopedia.com/terms/o/outstandingshares.asp) used to calculate [earnings per share](https://www.investopedia.com/terms/e/eps.asp) (EPS). These are some of the most popular data points that analysts use to assess a company’s profitability.
[Gross profit](https://www.investopedia.com/terms/g/grossprofit.asp) as a percent of sales is referred to as [gross margin](https://www.investopedia.com/terms/g/grossmargin.asp). It's calculated by dividing gross profit by sales. If gross profit is $80,000 and sales are $100,000, the gross profit margin would be 80%. The higher the gross profit margin, the better. It indicates that a company is keeping a higher proportion of [revenues](https://www.investopedia.com/terms/r/revenue.asp) as profit rather than using them to meet expenses.
[Operating profit](https://www.investopedia.com/terms/o/operating_profit.asp) as a percentage of sales is referred to as [operating margin](https://www.investopedia.com/terms/o/operatingmargin.asp). It's calculated by dividing operating profit by sales. If the operating profit is $60,000 and sales are $100,000, the operating profit margin would be 60%.
### Debt-to-Equity Ratio
The [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) provides you with a snapshot of a company’s capital structure. One of the most important measures of capital structure is the [debt-to-equity](https://www.investopedia.com/terms/d/debtequityratio.asp) (D/E) ratio.
It's calculated by dividing debt by [equity](https://www.investopedia.com/terms/e/equity.asp). If a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio would be two to one. The debt-to-equity ratio shows how much a business is leveraged—that is, how much debt it's using to finance operations rather than its internal funds.
### The Quick Ratio
The [quick ratio](https://www.investopedia.com/terms/q/quickratio.asp) is also known as the [acid-test ratio](https://www.investopedia.com/terms/a/acidtest.asp). It's an indicator of a company’s short-term [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) and measures a company’s ability to meet its short-term obligations with its most liquid assets. The ratio excludes inventories from current assets because we're only concerned with the most liquid assets in this case.
### Dividend Payout Ratio
The [cash flow statement](https://www.investopedia.com/investing/what-is-a-cash-flow-statement/) provides data for ratios dealing with cash. The [dividend payout ratio](https://www.investopedia.com/terms/d/dividendpayoutratio.asp) is the percentage of net income paid out to investors through [dividends](https://www.investopedia.com/terms/d/dividend.asp). Both dividends and [share repurchases](https://www.investopedia.com/terms/s/sharerepurchase.asp) are considered outlays of cash and can be found on the cash flow statement.
If dividends are $100,000 and income is $400,000, the dividend payout ratio is calculated by dividing $100,000 by $400,000, which works out to 25%. The higher the dividend payout ratio, the higher the percentage of income a company pays out as dividends rather than reinvesting back into the company.
## What Are Shares Outstanding?
Shares outstanding are those that are available to investors. They include shares held by company employees and institutional investors. The number can fluctuate when employees exercise stock options or if the company issues more shares.
## What Are Some Examples of Liquid Assets?
Liquid assets include cash and anything that can be easily converted to cash. They include marketable securities, government bonds, foreign currencies, and treasury bills.
## How Can an Investor Use Accounting Ratios?
Accounting ratios provide a view of a company's financial health. However, they're only one type of tool when you're assessing investments. They can measure a company's liquidity and profitability, but this information should be taken in light of other factors to get a complete picture of a company's sustainability and potential earnings.
## The Bottom Line
Accounting ratios can provide an accurate assessment of the profitability of a company over the last quarter or fiscal year. They include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.
These are just a few examples of the many accounting tools that corporations and analysts use to evaluate a company; however. Many other tools highlight different aspects of a company, so you’ll want to explore and potentially use them as well. |
Accounting Standard | # Accounting Standard Definition: How It Works
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*Accounting standards improve the transparency of financial reporting in all countries. — Investopedia / Ryan Oakley*
> **Definition**
>
> An accounting standard outlines an integrated framework that guides how financial transactions are recorded and reported.
## What Is an Accounting Standard?
An accounting standard provides a common structure that governs how financial data is classified, recorded, and presented in financial reports, ensuring consistency in accounting methods and principles across organizations.
### Key Takeaways
* Accounting standards apply to the full breadth of an entity’s financial picture, including assets, liabilities, revenue, expenses, and shareholders' equity.
* They help promote consistency and comparability across organizations, enabling investors and stakeholders to make informed decisions based on uniform financial information.
* Banks, investors, and regulatory agencies count on accounting standards to ensure information about a given entity is relevant and accurate.
#### GAAP
## Understanding Accounting Standards
Accounting standards improve the transparency of financial reporting in all countries. In the United States, the [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) form the set of accounting standards widely accepted for preparing financial statements. International companies follow the [International Financial Reporting Standards (IFRS)](https://www.investopedia.com/terms/i/ifrs.asp), which are set by the International Accounting Standards Board and serve as the guideline for non-U.S. GAAP companies reporting financial statements.
The generally accepted accounting principles are used widely among public and private entities in the United States. The rest of the world primarily uses IFRS. Multinational entities are required to use these standards. The [International Accounting Standards Board (IASB)](https://www.investopedia.com/terms/i/ias.asp) establishes and interprets the international community's accounting standards when preparing financial statements.
Accounting standards relate to all aspects of an entity’s finances, including assets, liabilities, revenue, expenses, and shareholders' equity. Specific examples of accounting standards include [revenue recognition](https://www.investopedia.com/terms/r/revenuerecognition.asp), asset classification, allowable methods for [depreciation](https://www.investopedia.com/terms/d/depreciation.asp), what is considered depreciable, lease classifications, and outstanding share measurement.
The American Institute of Accountants, which is now known as the American Institute of Certified Public Accountants, and the New York Stock Exchange attempted to launch the first accounting standards in the 1930s. Following this attempt came the [Securities Act of 1933](https://www.investopedia.com/terms/s/securitiesact1933.asp) and the [Securities Exchange Act of 1934](https://www.investopedia.com/terms/s/seact1934.asp), which created the Securities and Exchange Commission. Accounting standards have also been established by the Governmental Accounting Standards Board for accounting principles for all state and local governments.
Accounting standards specify when and how economic events are to be recognized, measured, and displayed. External entities, such as banks, investors, and [regulatory agencies](https://www.investopedia.com/terms/a/accounting-standards-committee/asc.asp), rely on accounting standards to ensure relevant and accurate information is provided about the entity. These technical pronouncements have ensured transparency in reporting and set the boundaries for financial reporting measures.
## U.S. GAAP Accounting Standards
The [American Institute of Certified Public Accountants](https://www.investopedia.com/terms/a/american-institute-of-certified-public-accountants.asp) developed, managed, and enacted the first set of accounting standards. In 1973, these responsibilities were given to the newly created [Financial Accounting Standards Board](https://www.investopedia.com/terms/f/fasb.asp). The Securities and Exchange Commission requires all listed companies to adhere to U.S. GAAP accounting standards in the preparation of their financial statements to be listed on a U.S. securities exchange.
Accounting standards ensure that the financial statements from multiple companies are comparable. Because all entities follow the same rules, accounting standards make the financial statements credible and allow for more economic decisions based on accurate and consistent information.
## Financial Accounting Standards Board (FASB)
An independent nonprofit organization, the Financial Accounting Standards Board (FASB) has the authority to establish and interpret generally accepted accounting principles (GAAP) in the United States for public and private companies and nonprofit organizations. GAAP refers to a set of standards for how companies, nonprofits, and governments should present their financial statements.
## Why Are Accounting Standards Useful?
Accounting standards improve the transparency of financial reporting in all countries. They specify when and how economic events are to be recognized, measured, and displayed. External entities, such as banks, investors, and regulatory agencies, rely on accounting standards to ensure relevant and accurate information is provided about the entity. These technical pronouncements have ensured transparency in reporting and set the boundaries for financial reporting measures.
## What Are Generally Accepted Accounting Principles (GAAP)?
In the United States, the generally accepted accounting principles (GAAP) form the set of accounting standards widely accepted for preparing financial statements. Its aim is to improve the clarity, consistency, and comparability of the communication of financial information. Basically, it is a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants compile their financial statements.
## What Are International Financial Reporting Standards (IFRS)?
International companies follow the International Financial Reporting Standards (IFRS), which are set by the International Accounting Standards Board and serve as the guideline for non-U.S. GAAP companies reporting financial statements. They were established to bring consistency to accounting standards and practices, regardless of the company or the country. IFRS is thought to be more dynamic than GAAP in that it is regularly being revised in response to an ever-changing financial environment.
> **Article Sources**
>
> 1. Financial Accounting Foundation. "[What Is GAAP?](https://accountingfoundation.org/accounting-and-standards/about-gaap/what-is-gaap)"
>
> 2. International Financial Reporting Standards (IFRS). "[Why Global Accounting Standards?](https://www.ifrs.org/use-around-the-world/why-global-accounting-standards/)"
>
> 3. International Financial Reporting Standards (IFRS). "[Who Uses IFRS Accounting Standards?](https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/)"
>
> 4. The New York State Society of CPAs. "[History of the Auditing World, Part 1](https://www.cpajournal.com/2020/11/25/history-of-the-auditing-world-part-1/)."
>
> 5. U.S. Securities and Exchange Commission, Investor.gov. "[The Laws That Govern the Securities Industry](https://www.investor.gov/introduction-investing/investing-basics/role-sec/laws-govern-securities-industry)."
>
> 6. U.S. Securities and Exchange Commission. "[Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, i. Development of Promulgated Standards](https://www.sec.gov/news/studies/principlesbasedstand.htm#2ai)."
>
> 7. U.S. Securities and Exchange Commission. "[A U.S. Imperative: High-Quality, Globally Accepted Accounting Standards](https://www.sec.gov/news/statement/white-2016-01-05.html)."
>
> 8. Financial Accounting Standards Board (FASB). "[About the FASB](https://www.fasb.org/facts/)." |
Accounting Theory | # What Is Accounting Theory in Financial Reporting?
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*— Investopedia / Xiaojie Liu*
## What Is Accounting Theory?
Accounting theory is a set of assumptions, frameworks, and methodologies used in the study and application of financial reporting principles. The study of accounting theory involves a review of both the historical foundations of [accounting practices](https://www.investopedia.com/terms/a/accounting-practice.asp), as well as the way in which accounting practices are changed and added to the regulatory framework that governs [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) and financial reporting.
### Key Takeaways
* Accounting theory provides a guide for effective accounting and financial reporting.
* Accounting theory involves the assumptions and methodologies used in financial reporting, requiring a review of accounting practices and the regulatory framework.
* The Financial Accounting Standards Board (FASB) issues generally accepted accounting principles (GAAP) which aim to improve comparability and consistency in accounting information.
* Accounting theory is a continuously evolving subject, and it must adapt to new ways of doing business, new technological standards, and gaps that are discovered in reporting mechanisms.
## Understanding Accounting Theory
All theories of accounting are bound by the conceptual framework of accounting. This framework is provided by the [Financial Accounting Standards Board](https://www.investopedia.com/terms/f/fasb.asp) (FASB), an independent entity that works to outline and establish the key objectives of financial reporting by businesses, both public and private. Further, accounting theory can be thought of as the logical reasoning that helps evaluate and guide accounting practices. Accounting theory, as regulatory standards evolve, also helps develop new accounting practices and procedures.
> **Important**
>
> Accounting theory is more qualitative than quantitative, in that it is a guide for effective accounting and financial reporting.
The most important aspect of accounting theory is usefulness. In the [corporate finance](https://www.investopedia.com/terms/c/corporatefinance.asp) world, this means that all financial statements should provide important information that can be used by financial statement readers to make informed business decisions. This also means that accounting theory is intentionally flexible so that it can produce effective financial information, even when the legal environment changes.
In addition to usefulness, accounting theory states that all accounting information should be relevant, reliable, comparable, and consistent. What this essentially means is that all financial statements need to be accurate and adhere to U.S. [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp). Adherence to GAAP allows the preparation of financial statements to be both consistent to a company's past financials and comparable to the financials of other companies.
Finally, accounting theory requires that all accounting and financial professionals operate under four assumptions. The first assumption states that a business is a separate entity from its owners or creditors. The second affirms the belief that a company will continue to exist and not go bankrupt. The third assumes that all financial statements are prepared with dollar amounts and not with other numbers like units of production. Finally, all financial statements must be prepared on a monthly or annual basis.
## Special Considerations
Accounting as a discipline has existed since the 15th century. Since then, both businesses and [economies](https://www.investopedia.com/terms/e/economy.asp) have greatly evolved. Accounting theory is a continuously evolving subject, and it must adapt to new ways of doing business, new technological standards, and gaps that are discovered in reporting mechanisms.
For example, organizations such as the International Accounting Standards Board help create and revise practical applications of accounting theory through modifications to their [International Financial Reporting Standards](https://www.investopedia.com/terms/i/ifrs.asp) (IFRS). Professionals such as [Certified Public Accountants](https://www.investopedia.com/terms/c/cpa.asp) (CPAs) help companies navigate new and established accounting standards.
> **Article Sources**
>
> 1. Financial Accounting Standards Board. "[About the FASB](https://www.fasb.org/facts/)." Accessed April 17, 2021.
>
> 2. International Financial Reporting Standards Foundation. "[Who We Are](https://www.ifrs.org/about-us/who-we-are/)." Accessed April 17, 2021. |
Accounts Payable (AP) | # Understanding Accounts Payable (AP) With Examples and How To Record AP
> **Definition**
>
> Accounts payable is a company’s obligation to pay for goods and services received on credit, typically within 30 to 90 days.
Accounts payable (AP), or simply "payables," is the amount still outstanding that a business owes for goods and services purchased on credit.
If payables are increasing, this can indicate the business is taking greater advantage of favorable vendor credit. However, rising payables might also signal financial distress—a company might be delaying payments because it doesn't have enough cash on hand to meet its obligations.
### Key Takeaways
* Accounts payable (AP) is a short-term liability representing a company's obligation to pay off outstanding debts to creditors or suppliers.
* It is important to differentiate between AP and accounts receivable since they represent opposite sides of a credit transaction.
* Properly recording AP involves understanding double-entry bookkeeping and the associated credit and debit entries.
* Managing AP well can improve cash flow and keep up good vendor relationships.
:max_bytes(150000):strip_icc()/accountspayable.asp-Final-e4e5efa448a94289b6b17189aa72f10e.jpg)
*— Investopedia / Alison Czinkota*
## What Are Accounts Payable (AP)?
Companies often buy things on credit, and when they do, they record outstanding amounts as AP. This item appears on the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) as a [current liability](https://www.investopedia.com/terms/c/currentliabilities.asp), which typically comes due at intervals of 30, 45, 60, or 90 days, depending on the repayment terms.
AP is short-term financing that helps a company conserve cash by deferring payments for a time. Nevertheless, paying AP on time is essential for building strong relationships with vendors and getting the best credit terms. AP terms usually follow a standard structure, with formats such as the following:
* **Net 30**: Full payment is required within 30 days of the invoice date or delivery date. This is a common payables structure across many business sectors.
* **1/10 or 2/10 Net 30**: Paying the invoice [within 10 days](https://www.investopedia.com/terms/1/1-10net30.asp) provides buyers a discount of 1% (or 2%, etc.) off of the invoice total. If the buyer misses the discount period deadline, they owe the full amount within 30 days.
If AP is increasing, this suggests the company is buying more goods or services on credit rather than cash payments. Declining AP indicates that the business is clearing past obligations faster than it takes on new credit purchases. The effective management of AP is essential so that a company has enough to pay its bills and has a stable cash flow.
> **Important**
>
> Accounts payable is not classified among expenses, which are found on the income statement. Instead, payables are booked as liabilities and are found on the balance sheet.
## Examples of Accounts Payable
AP includes these business obligations:
1. **Supplier invoices**: When a company buys inputs or raw materials on credit.
2. **Contractor payments**: Businesses often contract external service providers—for instance, cleaning services or IT support.
3. **Subscription services**: Subscriptions often provide services (such as media content or provision of some service) and then invoice them later.
4. **Utility bills**: Monthly bills are due at the end of the month (after their use), such as those for electricity, water, phone, and the internet.
5. **Professional services**: Legal fees, consulting services, and accounting work paid at the end of each quarter.
6. **Maintenance**: Upkeep for equipment or facilities paid on a semiannual basis.
For example, when a restaurant orders $2,000 worth of ingredients from a food supplier and has a payment due in 30 days, it creates an AP entry for the same amount. The restaurant can then use those supplies to generate revenue (e.g., by selling meals to patrons) before the payment is due.
> **Tip**
>
> AP essentially functions as a form of interest-free short-term credit offered by suppliers.
## The Role of Accounts Payable in Financial Statements
AP appears in a company's [financial statements](https://www.investopedia.com/terms/f/financial-statement-analysis.asp) on the balance sheet under current liabilities. Because AP represents obligations due within one year, it is a handy indicator of a company’s short-term liquidity and [working capital](https://www.investopedia.com/terms/w/workingcapital.asp). If not managed carefully, a growing AP balance could signal potential cash flow problems or indicate that the company is relying too heavily on supplier credit.
Managing AP well does more than simply record liabilities; it's also an important variable used in [managerial accounting](https://www.investopedia.com/terms/m/managerialaccounting.asp) and fundamental analysis to understand a company's financial position.
### AP Turnover Ratio
The [payables turnover](https://www.investopedia.com/terms/a/accountspayableturnoverratio.asp) ratio can reveal how efficient a company is at paying what it owes over the course of a year. A higher ratio suggests that the company is quickly and consistently settling its liabilities, which can signal efficient cash management. Here is the formula:
> AP Turnover Ratio = Net Credit Purchases ÷ Average Accounts Payable
**Example**:Suppose a company’s net credit purchases for the year total $130 million. Its beginning AP balance was $25 million, and its ending AP was $15 million (so its average AP is $20 million):
> AP Turnover Ratio = $130M ÷ $20M = 6.5 times per year.
### Days Payable Outstanding (DPO)
[Days payable outstanding](https://www.investopedia.com/terms/d/dpo.asp) (DPO) is the average number of days a company needs to pay its bills and obligations. Companies with longer DPOs might be delaying payments to increase their working capital and [free cash flow](https://www.investopedia.com/ask/answers/111714/what-difference-between-cash-flow-and-free-cash-flow.asp), or they might be struggling to come up with the cash. Here's the formula:
> DPO= (Average Accounts Payable ÷ Cost of Goods Sold) × 365 days
>
**Example**:If the average AP is $15 million and the [cost of goods sold](https://www.investopedia.com/terms/c/cogs.asp) is $100 million:
> DPO = ($15M ÷ $100M) × 365 ≈ 55 days.
### Cash Conversion Cycle (CCC)
The [cash conversion cycle](https://www.investopedia.com/terms/c/cashconversioncycle.asp) (CCC) estimates the number of days it takes for a company to convert its inventory into cash flows from sales. Here's the formula:
> CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – DPO
By subtracting the DPO from [DIO](https://www.investopedia.com/terms/d/days-sales-inventory-dsi.asp) (how long it takes to clear inventory) and [DSO](https://www.investopedia.com/terms/d/dso.asp)(how long it takes to collect from customers), the CCC provides an overview of how well a company manages its working capital. A shorter CCC means it converts products into cash more quickly.
## Recording Accounts Payable
Proper [double-entry bookkeeping](https://www.investopedia.com/terms/d/double-entry.asp) requires that there must always be an offsetting debit and credit for all entries made into the general ledger. In double-entry bookkeeping, asset accounts like cash decrease with a credit entry. When you pay an invoice, you debit the AP account (reducing the liability) and credit the cash account, which reflects that cash has decreased.
Even though cash is leaving, the credit entry is used because that's how reductions in asset accounts are recorded in accounting: [debits](https://www.investopedia.com/terms/d/debit.asp) increase assets and decrease liabilities, while [credits](https://www.investopedia.com/terms/c/credit.asp) decrease assets and increase liabilities.
**Initial recording (when receiving goods/services)**:
* **Debit**: (+)Expense or asset account
* **Credit**: (+)Accounts payable
**Payment recording (when paying the bill)**:
* **Debit**: (-)Accounts payable
* **Credit:** (-)Cash
### Example
Suppose a company purchases office furniture invoiced at $10,000 on credit, with payment due in 45 days:
**Step 1: Initial Recording**
* **Debit**: Assets +$10,000
* This records the addition of the equipment as an asset.
* **Credit**: Accounts Payable +$10,000
* But the company now has a liability that it still hasn't paid for that asset.
**Step 2: Payment Recording (45 days later)**
* **Debit**: Accounts Payable -$10,000
* The original liability is canceled when the bill is ultimately paid
* **Credit**: Cash -$10,000
* The payment is made in cash, so it's deducted from the company's cash position.
This method ensures that all transactions are properly tracked and the company's financial position is accurately represented.
### Trade Payables
Trade payables are the subset of AP that specifically relate to the purchases of goods used in production or resale.
## Accounts Payable Management
When AP is managed well, companies can postpone payments to suppliers with set terms to save cash for immediate investments or prospects while preventing late payment charges and credit problems. This involves the following:
* **Timely invoice processing**: Modern accounting systems make timely invoicing straightforward, which should cut down on mistakes and automate timely payments to prevent penalties.
* **Negotiating favorable payment terms**: Negotiate extended payment periods or early payment discounts to improve [cash flow](https://www.investopedia.com/terms/c/cashflow.asp).
* **Regular reconciliation:** Perform routine reconciliations between the AP ledger and [general ledger](https://www.investopedia.com/terms/g/generalledger.asp) to detect discrepancies and maintain accurate records.
* **Monitoring key metrics**: Use the AP turnover ratio and DPO to assess payment efficiency and liquidity.
* **Maintaining vendor relationships:** Establishing trust helps both sides negotiate better terms and flexibility.
## Accounts Payable vs. Accounts Receivable
While AP is the money a company owes to its vendors, [accounts receivable](https://www.investopedia.com/terms/a/accounts-receivable-aging.asp) is the money owed to the company by its customers.
The two are essentially a mirror image on a company’s balance sheet—AP is a current liability, while accounts receivable is a [current asset](https://www.investopedia.com/terms/c/currentassets.asp).
### Accounts Payable vs. Accounts Receivable
Payables
* Money the company owes to vendors/suppliers
* Current liability
* Short-term credit obligations
Receivables
* Money owed to the company by customers
* Current asset
* Earned revenue not yet received in cash
## The Bottom Line
AP is more than a set of bills to be paid since it's a key element of business accounting and financial management. Effectively managing AP can strengthen vendor relationships, improve cash flow, and contribute to a company's overall financial health. |
Accounts Payable Turnover Ratio | # Accounts Payable Turnover Ratio: Definition, Formula, and Examples
> **Definition**
>
> The accounts payable turnover ratio is a short-term liquidity metric that quantifies the rate at which a company pays its suppliers.
## What Is the Accounts Payable Turnover Ratio?
The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. It shows how many times a company pays off its accounts payable during a particular period.
Accounts payable is short-term debt that a company owes to its suppliers and creditors. The accounts payable turnover ratio can reveal how efficient a company is at paying what it owes in the course of a year.
### Key Takeaways
* The accounts payable turnover ratio is a [short-term liquidity](https://www.investopedia.com/terms/q/quickratio.asp) measure used to quantify the rate at which a company pays what it owes in the short term.
* The ratio shows how many times a company pays off its accounts payable during a period.
* Ideally, a company wants to generate enough revenue to pay off its accounts payable quickly.
* At the same time, the company doesn't want to miss opportunities to invest available funds in other worthwhile endeavors.
* Investors can use the AP turnover ratio to compare possible investments.
:max_bytes(150000):strip_icc()/Accountspayableturnoverratio_final-d17fff78f8f24fc9bb4b1fd8697d41f7.png)
*— Investopedia / Michela Buttignol*
## Formula and Calculation of the AP Turnover Ratio
$\begin{aligned} &\text{AP Turnover}=\frac{\text{TSP}}{(\text{BAP + EAP})/2}\\ &\textbf{where:}\\ &\text{AP = Accounts payable}\\ &\text{TSP = Total supply purchases}\\ &\text{BAP = Beginning accounts payable}\\ &\text{EAP = Ending accounts payable}\\ \end{aligned}$
Calculate the average [accounts payable](https://www.investopedia.com/terms/a/accountspayable.asp) for the period by adding the accounts payable balance at the beginning of the period to the balance at the end of the period. Divide the result by two.
Then, divide the total supplier purchases for the period by the average accounts payable for the period.
## What the AP Turnover Ratio Can Tell You
The accounts payable turnover ratio shows investors how many times per period a company [pays its accounts payable](https://www.investopedia.com/ask/answers/030515/how-are-accounts-payable-listed-companys-balance-sheet.asp). In other words, the ratio measures the speed at which a company pays its suppliers.
Investors can use the accounts payable turnover ratio to determine if a company has enough cash or revenue to meet its short-term obligations. Creditors can use the ratio to measure whether to extend a line of credit to the company.
### A Decreasing AP Turnover Ratio
Measured over time, a decreasing figure for the AP turnover ratio indicates that a company is taking longer to pay off its suppliers than in previous periods. This could signal that a company is in [financial distress](https://www.investopedia.com/terms/f/financial_distress.asp). Alternatively, a decreasing ratio could also mean the company has negotiated different payment arrangements with its suppliers.
### An Increasing AP Turnover Ratio
When the figure for the AP [turnover ratio](https://www.investopedia.com/terms/t/turnoverratio.asp) increases, the company is paying off suppliers at a faster rate than in previous periods. It means the company has plenty of cash available to pay off its short-term debts in a timely manner. This can indicate that the company is managing its debts and cash flow effectively.
However, an increasing ratio over a long period of time could also indicate that the company is not reinvesting money back into its business. This could result in a lower growth rate and lower [earnings](https://www.investopedia.com/terms/e/earnings.asp) for the company in the long term.
Ideally, a company wants to generate enough revenue to pay off its accounts payable quickly, but not so quickly that the company lacks the cash needed to take advantage of opportunities to invest in its growth.
> **Tip**
>
> The accounts payable is listed on the balance sheet under current liabilities.
## Example of How To Use the AP Turnover Ratio
Here's an example of how an investor might consider an AP turnover ratio comparison when investigating companies in which they might invest.
Company A purchased its materials and inventory from one supplier and calculated an AP turnover ratio for the past year with the following numbers:
* Total supplier purchases were $100 million for the year.
* Accounts payable was $30 million at the start of the year and $50 million at the end of the year.
* The average accounts payable for the entire year was ($30 million + $50 million) / 2, or $40 million.
* The accounts payable turnover ratio was $100 million / $40 million, or 2.5 for the year.
* Company A paid off their accounts payable 2.5 times during the year.
During the same year, Company B, a competitor of Company A, calculated its AP turnover ratio as shown below:
* Total supplier purchases were $110 million for the year.
* Accounts payable was $15 million at the start of the year and $20 million at the end of the year.
* The average accounts payable for the entire year was ($15 million + $20 million) / 2, or $17.5 million
* The accounts payable turnover ratio was $110 million / $17.5 million, or 6.29 for the year.
* Company B paid off their accounts payable 6.9 times during the year.
The investor can see that Company B paid off its suppliers at a faster rate than Company A. That could mean that Company B is a better candidate for an investment. However, the investor may want to look at a succession of AP turnover ratios for Company B to determine in which direction they've been moving.
That, in turn, may motivate them to look more closely at whether Company B has been managing its cash flow as effectively as possible.
In addition, before making an investment decision, the investor should review other financial ratios as well to get a more comprehensive picture of the company's financial health.
## AP Turnover Ratio vs. AR Turnover Ratio
The [accounts receivable turnover ratio](https://www.investopedia.com/terms/r/receivableturnoverratio.asp) is an accounting measure used to quantify a company's effectiveness in collecting its receivables, or the money owed to it by its customers. The ratio demonstrates how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or paid.
So, while the accounts receivable turnover ratio shows how quickly a company gets paid by its customers, the accounts payable turnover ratio shows how quickly the company pays its suppliers.
> **Fast Fact**
>
> An industry could have a standard AP turnover ratio that is unique to it.
## Limitation of the AP Turnover Ratio
As with all [financial ratios](https://www.investopedia.com/financial-ratios-4689817), it's useful to compare a company's AP turnover ratio with companies in the same industry. That can help investors determine how capable one company is at paying its bills compared to others.
On the other hand, a consistently high or increasing ratio, especially when compared to the industry standard, could alert creditors and investors to a situation in which a company isn't managing its cash properly and failing to reinvest in its growth.
Consequently, a high or low ratio shouldn't be taken at face value. Instead, investors who note the AP turnover ratio may wish to do additional research to determine the reason for it.
## What Is a Good Accounts Payable Turnover Ratio?
An AP ratio between six and 10 is considered ideal. A ratio below six indicates that a business is not generating enough revenue to pay its suppliers in an appropriate time frame. Bear in mind, that industries operate differently, and therefore they'll have different overall AP turnover ratios.
## Is a Higher Accounts Payable Turnover Ratio Better?
Yes, a higher AP turnover ratio is better than a lower one because it shows that a business is bringing in enough revenue to be able to pay off its short-term obligations. This is an indicator of a healthy business and it gives a business leverage to negotiate with suppliers and creditors for better rates.
## How Can You Improve Your Accounts Payable Turnover Ratio?
To improve your accounts payable turnover ratio you can improve your cash flow, renegotiate terms with your supplier, pay bills before they're due, and use automated payment solutions.
## The Bottom Line
The accounts payable turnover ratio is a measurement of how efficiently a company pays its short-term debts. Normally, the higher the ratio, the better the company is at paying its bills.
The ideal AP turnover ratio should allow it to pay off its debts quickly and reinvest money in itself to grow its business. A higher ratio also means the potential for better rates on purchases and loans. |
Receivable | # Accounts Receivable (AR): Definition, Uses, and Examples
> **Definition**
>
> Accounts receivable (AR) refers to the money owed to a business for goods or services that have been delivered but not yet paid for, and it is recorded as a current asset on the company's balance sheet.
## What Is Accounts Receivable (AR)?
Accounts receivable (AR) is an accounting term for money owed to a business for goods or services that it has delivered but not been paid for yet. Accounts receivable is listed on the company's [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) as a [current asset](https://www.investopedia.com/terms/c/currentassets.asp).
### Key Takeaways
* Accounts receivable (AR) is an item on a company's balance sheet that represents money due the company for products or services it has already delivered.
* Accounts receivable is considered an asset to the company.
* The opposite of accounts receivable is accounts payable, which reflects money that a company owes but has not yet paid.
:max_bytes(150000):strip_icc()/accounts-receivable-4202182-2-f6c551bb43d44a56b0950f1af70d1e05.png)
*— Joules Garcia / Investopedia*
## Understanding Accounts Receivable (AR)
Accounts receivable represents money that a business is owed by its clients, often in the form of unpaid invoices. "Receivable" refers to fact that the business has earned the money because it has delivered a product or service but is, at that point in time, still waiting to receive the client's payment.
Accounts receivable, or receivables, can be considered a line of credit extended by a company and normally have terms that require payments be made within a certain period of time. If effect, the company has accepted an [IOU](https://www.investopedia.com/terms/i/iou.asp) from the client. Depending on the agreement between company and client, the payment might be due in anywhere from a few days to 30 days, 60 days, 90 days, or, in some cases, up to a year. At some point along the way, interest on the debt might also begin to accrue.
Companies record accounts receivable as assets on their balance sheets because the customer has a legal obligation to pay the debt and the company has a reasonable expectation of collecting it. They are considered [liquid assets](https://www.investopedia.com/terms/l/liquidasset.asp) because they can be used as [collateral to secure a loan](https://www.investopedia.com/terms/a/accountsreceivablefinancing.asp) to help the company meet its short-term obligations. Receivables are part of a company's [working capital](https://www.investopedia.com/terms/w/workingcapital.asp).
Furthermore, accounts receivable are classified as current assets, because the account balance is expected from the debtor in one year or less. Other current assets on a company's books might include [cash and cash equivalents](https://www.investopedia.com/terms/c/cashandcashequivalents.asp), [inventory](https://www.investopedia.com/terms/i/inventory.asp), and readily marketable securities.
Assets that could not easily be converted into cash within a year are recorded as [noncurrent assets](https://www.investopedia.com/terms/n/noncurrent-assets.asp). That category often includes things like physical property, long-term investments, and intellectual property, such as trademarks.
## Accounts Receivable vs. Accounts Payable
When a company owes debts to its suppliers or other parties, those are [accounts payable](https://www.investopedia.com/terms/a/accountspayable.asp). Accounts payable are the opposite of accounts receivable. To illustrate, Company A cleans Company B's carpets and sends a bill for the services.
Company B now owes Company A money, so it lists the invoice in its accounts payable column. While Company A waits to receive the money, it records the amount in its accounts receivable column.
## What Accounts Receivable Can Tell You
Accounts receivable are an important element in [fundamental analysis](https://www.investopedia.com/terms/f/fundamentalanalysis.asp), a common method investors use to determine the value of a company and its securities. Because accounts receivable is a current asset, it contributes to a company's liquidity or ability to cover short-term obligations without additional cash flows.
Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as the [accounts receivable turnover ratio](https://www.investopedia.com/terms/r/receivableturnoverratio.asp). It measures the number of times a company has collected its accounts receivable balances during an accounting period and is considered an indicator of both how efficient the company is in collecting its debts and the credit quality of its customers.
Further analysis would include assessing [days sales outstanding (DSO)](https://www.investopedia.com/terms/d/dso.asp), which measures the average number of days that it takes a company to collect payments after a sale has been made.
## Example of Accounts Receivable
An everyday example of accounts receivable would be an electric company that bills its clients after the clients receive and consume the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills.
Most companies operate by allowing a portion of their sales to be on credit. Sometimes, businesses offer such credit to frequent or special customers, who receive periodic invoices rather than having to make payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay within some reasonable period after receiving the products or services.
## When Does a Debt Become a Receivable?
A receivable is created any time money is owed to a business for services rendered or products provided that have not yet been paid for. For example, when a business buys office supplies, and doesn't pay in advance or on delivery, the money it owes becomes a receivable until it's been received by the seller.
## Where Do I Find a Company's Accounts Receivable?
Accounts receivable are recorded on a company's balance sheet. Because they represent funds owed to the company (and that are likely to be received), they are booked as an asset.
## How Are Accounts Receivable Different From Accounts Payable?
Accounts receivable represent funds owed to a company and are booked as an asset. Accounts payable, on the other hand, represent funds that a company owes to others and are booked as liabilities.
## What Happens If Customers Never Pay What's Due?
When it becomes clear that a receivable won't be paid by the customer, it has to be written off as a [bad debt expense](https://www.investopedia.com/terms/b/bad-debt-expense.asp) or a one-time charge. Companies might also sell this outstanding debt to a third party debt collector for a fraction of the original amount—creating what accountants refer to to as [accounts receivable discounted](https://www.investopedia.com/terms/a/accounts-receivable-discounted.asp).
## What Are Net Receivables?
[Net receivables](https://www.investopedia.com/terms/n/netreceivables.asp) is an accounting term for a company's accounts receivable minus any receivables it has reason to believe it will never collect. It is typically expressed as a percentage of uncollectible debts relative to collectible ones, and the lower the percentage, the better.
## The Bottom Line
Accounts receivable is one of the most important line items on a company's balance sheet. It reflects the money owed to a company from the sale of its goods or services that remains to be paid by the buyer. Even though it is not yet in hand, it is considered an asset because the company expects to receive it in due course. The shorter the period of time a company has accounts receivable balances, the better, as it means the company can use that money for other business purposes.
> **Article Sources**
>
> 1. Office of the Comptroller of the Currency. ["Accounts Receivable and Inventory Financing"](https://www.occ.treas.gov/topics/supervision-and-examination/credit/commercial-credit/accounts-receivable.html) |
Accounts Receivable Aging | # Accounts Receivable Aging: Definition, Calculation, and Benefits
## What Is Accounts Receivable Aging?
Accounts receivable aging is a periodic report that categorizes a company's [accounts receivable](https://www.investopedia.com/terms/a/accountsreceivable.asp) according to the length of time an invoice has been outstanding. It is used as a gauge to determine the financial health and reliability of a company's customers.
If the accounts receivable aging shows a company's receivables are being collected much more slowly than normal, this is a warning sign that business may be slowing down or that the company is taking on greater credit risk in its sales practices.
### Key Takeaways
* Accounts receivable aging is the process of distinguishing open accounts receivables based on the length of time an invoice has been outstanding.
* Accounts receivable aging is useful in determining the allowance for doubtful accounts.
* The aged receivables report tabulates those invoices owed by length, often in 30-day segments, for quick reference.
* Accounts receivable aging is used to estimate the value of receivables that the company does not expect to collect.
* This information is used to adjust the company's financial statements to avoid overstating its income.
:max_bytes(150000):strip_icc()/Accounts-receivable-aging_4-3-v2-8c823f2f60bf482aa28afec66f16a660.jpg)
*— Investopedia / Michela Buttignol*
## How Accounts Receivable Aging Works
Accounts receivable aging, as a management tool, can indicate that certain customers are becoming credit risks. It can be used to help determine whether the company should keep doing business with customers who are chronically late payers.
Accounts receivable aging has columns that are typically broken into date ranges of 30 days each and shows the total receivables that are currently due, as well as those that are past due for each 30-day time period.
### Allowance for Doubtful Accounts
Accounts receivable aging is useful in determining the allowance for doubtful accounts. When estimating the amount of [bad debt](https://www.investopedia.com/terms/b/baddebt.asp) to report on a company’s financial statements, the accounts receivable aging report is used to estimate the total amount to be [written off](https://www.investopedia.com/terms/w/write-off.asp).
The primary useful feature is the aggregation of receivables based on the length of time the invoice has been past due. Accounts that are more than six months old are unlikely to be collected, except through collections or a court judgment.
Companies apply a fixed percentage of default to each date range. Invoices that have been past due for longer periods of time are given a higher percentage due to increasing default risk and decreasing collectibility. The sum of the products from each outstanding date range provides an estimate regarding the total of uncollectible receivables.
> **Fast Fact**
>
> The IRS allows companies to write off aged receivables, but only if the company has given up on collecting the debt.
### Aged Receivables Report
The aged receivables report is a table that provides details of specific receivables based on age. The specific receivables are aggregated at the bottom of the table to display the total receivables of a company, based on the number of days the invoice is past due.
The typical column headers include 30-day windows of time, and the rows represent the receivables of each customer. Here's an example of an accounts receivable aging report.
## Benefits of Accounts Receivable Aging
The findings from accounts receivable aging reports may be improved in various ways. First, accounts receivable are derivations of the extension of credit. If a company experiences difficulty collecting accounts, as evidenced by the accounts receivable aging report, problem customers may be required to do business on a cash-only basis. Therefore, the aging report is helpful in laying out credit and selling practices.
Accounts receivable aging reports are also required for writing off bad debts. Tracking delinquent accounts allows the business to estimate the number of accounts that they will not be able to collect. It also helps to identify potential credit risks and cash flow issues.
Companies will use the information on an accounts receivable aging report to create collection letters to send to customers with overdue balances. Accounts receivable aging reports may be mailed to customers along with the month-end statement or a collection letter that provides a detailed account of outstanding items. Therefore, an accounts receivable aging report may be utilized by internal as well as external individuals.
## How Do You Calculate Accounts Receivable Aging?
Accounts receivable aging sorts the list of open accounts in order of their payment status. There are separate buckets for accounts that are current, those that are past due less than 30 days, 60 days, and so on. Based on the percentage of accounts that are more than 180 days old, a company can estimate the expected amount of [unpaid accounts receivables](https://www.investopedia.com/terms/a/accounts-receivable-discounted.asp) for future write-offs.
## Why Is Accounts Receivable Aging Important?
There are two main reasons to track accounts receivable aging. First, to track overdue or delinquent accounts so that the company can continue to decide what to do with old debts. These may be sold to collections, pursued in court, or simply written off. The second reason is so that the company can calculate the number of accounts for which it does not expect to receive payment. Using the [allowance method](https://www.investopedia.com/terms/b/bad-debt-expense.asp), the company uses these estimates to include expected losses in its financial statement.
## What Is the Typical Method for Aging Accounts?
The aging method is used to estimate the number of accounts receivable that cannot be collected. This is usually based on the aged receivables report, which divides past due accounts into 30-day buckets. Each bucket is assigned a percentage, based on the likelihood of payment. By multiplying the total receivables in each bucket by the assigned percentage, the company can estimate the expected amount of uncollectable receivables.
## The Bottom Line
Accounts receivable aging is a type of financial report used by businesses. It distinguishes open accounts receivables—or customers with outstanding balances—based on how long an invoice has been unpaid. It usually tabulates invoices owed in 30-day segments.
This report can be used in a variety of ways. Businesses can use accounts receivable aging to decide whether to continue doing business with a certain customer or whether to require them to pay in advance or in cash. It can be used to decide whether to pursue an invoice in court or through a collections agency. If the company cannot collect the amount owed, the accounts receivable aging report is used to write off the debt.
> **Article Sources**
>
> 1. Internal Revenue Service. "[Tax Guide for Small Business](https://www.irs.gov/pub/irs-pdf/p334.pdf)." Pages 30-31.
>
> 2. Accounting Tools. "[Accounts Receivable Aging](https://www.accountingtools.com/articles/what-is-accounts-receivable-aging.html)." |
Accounts Receivable Financing | # What Is Accounts Receivable Financing? Definition and Structuring
:max_bytes(150000):strip_icc()/Accounts_Recievable_Financing_Final_3-2-edit-dec189e1d9ad417aac35c681a3c98f4e.png)
*— Investopedia / Candra Huff*
> **Definition**
>
> Accounts receivable financing provides a company with financing capital based on a portion of its accounts receivable.
## What Is Accounts Receivable Financing?
Accounts receivable (AR) financing is a type of financing arrangement in which a company receives financing capital related to a portion of its accounts receivable. Accounts receivable financing agreements can be structured in multiple ways usually with the basis as either an asset sale or a loan.
## Understanding Accounts Receivable Financing
Accounts receivable financing is an agreement that involves capital principal in relation to a company’s accounts receivables. Accounts receivable are assets equal to the outstanding balances of invoices billed to customers but not yet paid. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payment required within one year.
Accounts receivable are one type of liquid asset considered when identifying and calculating a company’s quick ratio which analyzes its most liquid assets:
Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable Due within One Year) / Current Liabilities
As such, both internally and externally, accounts receivable are considered highly liquid assets which translate to theoretical value for lenders and financiers. Many companies may see accounts receivable as a burden since the assets are expected to be paid but require collections and can’t be converted to cash immediately. As such, the business of accounts receivable financing is rapidly evolving because of these liquidity and business issues. Moreover, external financiers have stepped in to meet this need.
The process of accounts receivable financing is often known as factoring and the companies that focus on it may be called factoring companies. The best factoring companies will usually focus substantially on the business of accounts receivable financing but factoring in general may be a product of any financier. Financiers may be willing to structure accounts receivable financing agreements in different ways with a variety of different potential provisions.
### Key Takeaways
* Accounts receivable financing provides financing capital in relation to a portion of a company’s accounts receivable.
* Accounts receivable financing deals are usually structured as either asset sales or loans.
* Many accounts receivable financing companies link directly with a company’s accounts receivable records to provide fast and easy capital for accounts receivable balances.
## Structuring
Accounts receivable financing is becoming more common with the development and integrations of new technologies that help to link business accounts receivable records to accounts receivable financing platforms. In general, accounts receivable financing may be slightly easier for a business to obtain than other types of capital financing. This can be especially true for small businesses that easily meet accounts receivable financing criteria or for large businesses that can easily integrate technology solutions.
Overall, there are a few broad types of accounts receivable financing structures.
_Asset Sales_
Accounts receivable financing is typically structured as an asset sale. In this type of agreement, a company sells accounts receivable to a financier. This method can be similar to selling off portions of loans often done by banks.
A business receives capital as a cash asset replacing the value of the accounts receivable on the balance sheet. A business may also need to take a write-off for any unfinanced balances which would vary depending on the principal to value ratio agreed on in the deal.
Depending on the terms, a financier may pay up to 90% of the value of outstanding invoices. This type of financing may also be done by linking accounts receivable records with an accounts receivable financier. Most factoring company platforms are compatible with popular small business bookkeeping systems such as Quickbooks. Linking through technology helps to create convenience for a business, allowing them to potentially sell individual invoices as they are booked, receiving immediate capital from a factoring platform.
With asset sales, the financier takes over the accounts receivable invoices and takes responsibility for collections. In some cases, the financier may also provide cash debits retroactively if invoices are fully collected.
Most factoring companies will not be looking to buy defaulted receivables, rather focusing on short-term receivables. Overall, buying the assets from a company transfers the [default risk](https://www.investopedia.com/terms/d/defaultrisk.asp) associated with the accounts receivables to the financing company, which factoring companies seek to minimize.
In asset sale structuring, factoring companies make money on the principal to value spread. Factoring companies also charge fees which make factoring more profitable to the financier.
[BlueVine](https://www.bluevine.com/invoice-factoring/) is one of the leading factoring companies in the accounts receivable financing business. They offer several financing options related to accounts receivable including asset sales. The company can connect to multiple accounting software programs including QuickBooks, Xero, and Freshbooks. For asset sales, they pay approximately 90% of a receivables value and will pay the rest minus fees once an invoice has been paid in full.
_Loans_
Accounts receivable financing can also be structured as a loan agreement. Loans can be structured in various ways based on the financier. One of the biggest advantages of a loan is that accounts receivable are not sold. A company just gets an advance based on accounts receivable balances. Loans may be unsecured or secured with invoices as collateral. With an [accounts receivable loan](https://www.investopedia.com/terms/a/assignment-of-accounts-receivable.asp), a business must repay.
Companies like [Fundbox](https://fundbox.com/), offer accounts receivable loans and lines of credit based on accounts receivable balances. If approved, Fundbox can advance 100% of an accounts receivable balance. A business must then repay the balance over time, usually with some interest and fees.
Accounts receivable lending companies also benefit from the advantage of system linking. Linking to a companies accounts receivable records through systems such as QuickBooks, Xero, and Freshbooks, can allow for immediate advances against individual invoices or management of line of credit limits overall.
## Underwriting
Factoring companies take several elements into consideration when determining whether to onboard a company onto its factoring platform. Furthermore, the terms of each deal and how much is offered in relation to accounts receivable balances will vary.
Accounts receivables owed by large companies or corporations may be more valuable than invoices owed by small companies or individuals. Similarly, newer invoices are usually preferred over older invoices. Typically, the age of receivables will heavily influence the terms of a financing agreement with shorter term receivables leading to better terms and longer term or delinquent receivables potentially leading to lower financing amounts and lower principal to value ratios.
## Advantages and Disadvantages
Accounts receivable financing allows companies to get instant access to cash without jumping through hoops or dealing with long waits associated with getting a business [loan](https://www.investopedia.com/terms/l/loan.asp). When a company uses its accounts receivables for asset sales it does not have to worry about repayment schedules. When a company [sells its accounts receivables](https://www.investopedia.com/terms/a/accounts-receivable-discounted.asp) it also does not have to worry about accounts receivable collections. When a company receives a factoring loan, it may be able to obtain 100% of the value immediately.
Although accounts receivable financing offers a number of diverse advantages, it also can carry a negative connotation. In particular, accounts receivable financing can cost more than financing through traditional lenders, especially for companies perceived to have poor credit. Businesses may lose money from the spread paid for accounts receivables in an asset sale. With a loan structure, the interest expense may be high or may be much more than discounts or default write-offs would amount to. |
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