ICAB Advanced Level Strategic Business Management Compilation of Chapterwise Theory by Optimal Management Solution

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Strategic Business Management Chapter- 1 Strategic analysis 1 1.1

Strategic management What is strategy? The question, 'What is strategy?' is a useful starting point for this Study Manual, but it is a very big question indeed. There are probably also nearly as many definitions as there are companies. A basic assertion is that business strategy is concerned with the long-term direction of an organisation. In their seminal text, Exploring Corporate Strategy, Johnson, Scholes and Whittington expand on this idea to suggest that: 'Strategy is the direction and scope of an organisation over the long term which achieves advantage in a changing environment through its configuration of resources and competences, with the aim of fulfilling stakeholder expectations.'

Characteristics of strategic decisions In addition to defining strategy, Johnson, Scholes and Whittington also describe some important characteristics of strategic decisions.

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(a)

Decisions about strategy are likely to be complex since there are likely to be a number of significant factors to take into consideration and a variety of possible outcomes to balance against one another.

(b)

There is likely to be a high degree of uncertainty surrounding a strategic decision, both about the precise nature of current circumstances and about the likely consequences of any course of action.

(c)

Strategic decisions have extensive impact on operational decision-making; that is, decisions at lower levels in the organisation.

(d)

Strategic decisions affect the organisation as a whole and require processes which cross operational and functional boundaries within it. An integrated approach is therefore required.

(e)

Strategic decisions are likely to lead to change within the organisation as resource capacity is adjusted to permit new courses of action. Changes with implications for organisational culture are particularly complex and difficult to manage.

Elements of strategic management Strategic management is concerned with taking and implementing strategic decisions. The perspective is the organisation as a whole, not just the view from that of individual business functions. Strategic management involves three types of activity which are often described as phases in a sequence. The table below summarises some of the terminology and follows, broadly, the sequence of the three types of activity: Analysis â&#x20AC;&#x201C; analysis of current strategic position, including objective setting and the influences on an organisation's strategy (external environment, internal capabilities, and the expectations of stakeholders). Choice â&#x20AC;&#x201C; formulation and evaluation of agreed strategies. Implementation, monitoring and control â&#x20AC;&#x201C; with control information feeding back into the system. The three elements of strategic analysis, strategic choice and strategic implementation respectively provide a framework for the first three chapters of this text. However, this linear sequence of analysis, choice and implementation is not necessarily an accurate description of how strategies are actually made and implemented in all organisations.

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In particular, although strategic planning addresses the long-term direction of an organisation, a strategic plan should not be set in stone. It is likely to require frequent adjustments, since circumstances may change, the competitive environment will evolve and some events simply cannot be foreseen. Moreover, strategic planning is not a process which involves a one-off implementation, but rather one that goes hand in hand with continuous improvement â&#x20AC;&#x201C; seeking to improve all the functions of a business in an ongoing manner. It is also important that the overall sequence of strategic management activities does not obscure the reality that different aspects of strategic management are likely to be important in different contexts. For example, strategic management in public sector organisations is likely to be very different to that in a multinational listed company. Nonetheless, the three types of activity (analysis, choice and implementation) provide a useful starting point to begin our study of strategic business management.

1.3

Prescriptive vs emergent approaches to strategy The structured 'process' of strategic management that we have illustrated in Section 1.2 is characteristic of the formal, rational model approach to strategic planning. However, there is a marked contrast between this prescriptive approach to strategic planning and the emergent approach. The rational planning model, originated by Ansoff, involves strategic analysis, strategic choice, implementation of the chosen strategy, followed by review and control. Strategy, in the context of the rational model, involves senior management setting goals initially and then designing strategies for the organisation to follow in order to try to achieve these goals. However, Mintzberg criticised this rigid approach to strategic management, and proposed an alternative emergent approach. The emergent approach views strategy as continuously and incrementally evolving from patterns of behaviour within an organisation. Managers have the power to develop and adapt strategies in response to changes in circumstances or as new opportunities and threats arise. The emergent approach still involves the same degree of strategic analysis as the rational planning model, but the processes of choice and implementation take place together rather than sequentially. In addition to formal and emergent approaches to strategy, it is also important to note a third potential approach to business planning: freewheeling opportunism. This approach suggests that firms should not bother with formal plans at all, and should simply exploit opportunities as they arise. The advantages of this approach are claimed to be: that good opportunities are not lost; it is easier to adapt to change; and it encourages a more flexible, creative attitude. However, the lack of formal planning in freewheeling opportunism means that there is no co-ordinating framework for an organisation, so that some opportunities get missed anyway. This approach can also mean that an organisation ends up reacting all the time, rather than developing its own strategies proactively.

2 Organisational goals and objectives 2.1

Brought forward knowledge One of the learning outcomes of the Business Strategy paper at Professional Level is that candidates should be able to 'Evaluate the purpose of a business in terms of its stated mission and objectives.' Therefore, candidates studying at Advanced level are assumed to already have this ability.

Organisational goals For profit-seeking organisations, the underlying organisational purpose is to deliver economic value to their owners, ie to increase shareholder wealth. Goals such as satisfying customers, building market share, cutting costs, and demonstrating corporate social responsibility are secondary objectives that enable economic value to be delivered. Not-for-profit organisations: The primary goals of not-for-profit organisations vary enormously, and include meeting members' needs, contributing to social well-being, and pressing for political and social change. Secondary goals will include the economic goal of not going bankrupt and, in some cases,

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generating a financial surplus to invest in research or give to the needy. Often the goals of not-for-profit organisations will reflect the need to maximise the benefit derived from limited resources, such as funds. Their objectives may be more heavily influenced by external stakeholders such as the government.

2.2

Mission and values The mission statement of an organisation describes its basic purpose, and what it is trying to achieve. The following are the mission statements for some well known companies: Coca-Cola – 'To refresh the world… To inspire moments of optimism and happiness… To create value and make a difference.'

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Google

– 'To organize the world's information and make it universally accessible and useful.'

Starbucks

– 'Our mission: to inspire and nurture the human spirit - one person, one cup and one neighbourhood at a time.'

eBay

– 'To provide a global trading platform where practically anyone can trade practically anything.'

Microsoft

– 'To help people and businesses throughout the world realise their potential.'

Goals, objectives and targets An understanding of an organisation's mission is invaluable for setting and controlling the overall functioning and progress of that organisation. However, mission statements themselves are open-ended and are not stated in quantifiable terms, such as profits or revenues. Equally, they are not time bound. Therefore, mission statements can only be seen as a general indicator of organisational strategy. In order to start implementing the strategy and managing performance, an organisation needs to develop some more specific and measurable objectives and targets. Most people's work is defined in terms of specific and immediate things to be achieved. If these things are related in some way to the wider purpose of the organisation, it will help the organisation to function more effectively. Loosely speaking, these 'things to be achieved' are the goals, objectives and targets of the various departments, functions, and individuals that make up the organisation. In effective organisations, goal congruence will be achieved, such that these disparate goals, objectives and targets will be consistent with one another and will operate together to support progress with the overall mission. However, whilst mission statements are high-level, open-ended statements about a firm's purpose or strategy, strategic objectives translate the mission into more specific milestones and targets for the business strategy to follow and achieve.

2.3.1

A hierarchy of objectives A simple model of the relationship between the various goals, objectives and targets is a pyramid analogous to the traditional organisational hierarchy. At the top is the overall mission; this is supported by a small number of wide ranging goals, which may correspond to overall departmental or functional responsibilities. Each of these goals is supported, in turn, by more detailed, subordinate goals that correspond, perhaps, to the responsibilities of the senior managers in the function concerned. This pattern is cascaded downwards until we reach the work targets of individual members of the organisation. As we work our way down this pyramid of goals, we will find that they will typically become more detailed and will relate to shorter timeframes. So, the mission might be very general and specify no time scale at all, but an individual worker is likely to have very specific things to achieve every day, or even every few minutes. Note that this description is very basic and that the structure of objectives in a modern organisation may be much more complex than this, with the pursuit of some goals involving input from several functions. Also, some goals may be defined in very general terms, so as not to stifle innovation, co-operation and informal ways of doing things. An important feature of any structure of goals is that there should be goal congruence; that is to say, goals that are related to one another should be mutually supportive. This is because goals and objectives drive actions, so if goals aren't congruent, then the actions of one area of the business will

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end up conflicting with those of another area of the business. Goals can be related in several ways: 

Hierarchically, as in the pyramid structure outlined above



Functionally, as when colleagues collaborate on a project



Logistically, as when resources must be shared or used in sequence



In wider organisational senses, as when senior executives make decisions about their operational priorities

A good example of the last category is the tension between short- and long-term priorities in such matters as the need to contain costs whilst at the same time increasing productivity by investing in new machinery, or trying to increase market share through marketing activity.

2.3.2

Primary and secondary objectives Some objectives are more important than others. In the hierarchy of objectives, there is a primary corporate objective and other secondary objectives which should combine to ensure the achievement of the overall corporate objective. For example, if a company sets itself an objective of growth in profits, as its primary aim, it will then have to develop strategies by which this primary objective can be achieved. An objective must then be set for each individual strategy. Secondary objectives might then be concerned with sales growth, continual technological innovation, customer service, product quality, efficient resource management or reducing the company's reliance on debt capital. Corporate objectives should relate to the business as a whole and can be both financial and nonfinancial:     

Profitability Market share Growth Cash flow Asset base

    

Customer satisfaction The quality of the firm's products Human resources New product development Social responsibility

Equally, when setting corporate objectives, it is important that an organisation considers the needs of all of its stakeholders, to try to ensure that these are met wherever possible.

Long-term and short-term objectives It is also important to remember that objectives may be long-term or short-term. A company that is suffering from a recession in its core industries and making losses in the short term, might continue to have a long-term primary objective of achieving a growth in profits, but in the short term, its primary objective might be survival.

Trade-offs between long-term and short-term objectives Just as there may have to be a trade-off between different objectives, so too might there be a need to make trade-offs between short-term objectives and long-term objectives. This is referred to as short/long (S/L) trade-off. Decisions that involve the sacrifice of longer-term objectives include the following: (a)

Postponing or abandoning capital expenditure projects (or marketing expenditure) that would eventually contribute to growth and profits, in order to protect short term cash flow and profits.

(b)

Cutting research and development (R&D) expenditure to save operating costs, thereby reducing the prospects for future product development. In this respect, cost leadership could be seen as a short term strategy, because it is looking to minimise operating costs rather than develop new products or capabilities as a basis for competitive advantage in the future.

(c)

Reducing quality control to save operating costs (but also adversely affecting reputation and goodwill).

(d)

Reducing the level of customer service to save operating costs (but sacrificing goodwill).

(e)

Cutting training costs or recruitment (so the company might be faced with skills shortages).

This relationship between short-term and longer-term objectives also has significant implications for the

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way organisations measure performance and the performance measures they use to do so. The phrase, 'What gets measured, gets done', is an important one in relation to performance measurement, and its implications are key here as well. For example, if Return on Investment (ROI) is one of a company's key financial performance measures, then its managers will have a keen interest in maximising the company's ROI. As a result, however, this choice of performance measure may also encourage the managers to focus on short-term, rather than longer term performance. For example, they may decide to dispose of some machinery that is not currently in use, thereby reducing depreciation charges and asset values, and in doing so, immediately increasing ROI. However, the potential flaw in such a short-term plan could be exposed if the managers later realise they need to use the machinery again and so have to buy some new equipment (at a higher cost than the equipment they had previously disposed of).

2.3.3

Financial objectives For commercial businesses, the primary objective is making a return; maximising the wealth of its ordinary shareholders. (a)

A satisfactory return for a company must be sufficient to reward shareholders adequately in the long run for the risks they take. The reward will take the form of profits, which can lead to dividends or to increases in the market value of the shares.

(b)

The size of return considered adequate for ordinary shareholders will vary according to the risk involved.

There are different ways of expressing a financial objective in quantitative terms. Financial objectives would usually include the following.    

Profitability Return on investment (ROI) or return on capital employed (ROCE) Share price, earnings per share, dividends Growth

We will look in more detail at how organisations measure their performance later in this text. However, as with business objectives, it is important to recognise that financial objectives may be shortterm as well as long-term. Maximising shareholder value is a long-term objective. However, short-term objectives, such as working capital management to ensure a business has sufficient cash to satisfy its dayto-day requirements, are equally important for the on-going success of the business.

2.3.4

Business strategy and financial strategy Highlighting the importance of financial and non-financial objectives also reminds us of the importance of considering how business and financial strategy interrelate. Although the primary focus of the early chapters of this Study Manual is on business strategy, it is important to remember that business strategy decisions must be taken in conjunction with financial ones. For example, does a company have sufficient funds to support a proposed business strategy, or how can it raise the additional funds needed to support that business strategy?

Delivering value for shareholders We can also highlight the importance of the interrelationship between business and financial strategy by reference to the underlying financial objective of companies – which is delivering value for their shareholders. As we will see in Chapter 12 later in this Study Manual, one of the ways a company can be valued is by discounting its expected future cash flows at an appropriate cost of capital. As such, value arises from creating competitive advantage through successful business strategy, in combination with a successful financial strategy, to increase those cash flows and reduce the cost of capital.

Value drivers

Definition Value drivers: In general terms, value drivers are crucial organisational capabilities that provide a competitive advantage to an organisation.

2.3.5

Financial management decisions In seeking to achieve the financial objectives of an organisation, a finance manager has to make Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

decisions on three inter-related topics:

(a) (b) (c)

Investment Financing Dividends

Investment decisions The financial manager will need to identify investment opportunities, evaluate them and decide on the optimum allocation of scarce funds available between investments. Investment decisions may be focused on the undertaking of new projects within the existing business, the takeover of, or merger with, another company or the selling off of a part of the business. Managers have to take decisions in the light of strategic considerations such as whether the business intends to expand internally (through investment in existing operations) or externally (through expansion).

Financing decisions Financing decisions include those concerned with both the long term (capital structure) and the short term (working capital management). The financial manager will need to determine the source, cost and effect on risk of the possible sources of long-term finance. A balance between profitability and liquidity (the ready availability of funds if required) must be taken into account when deciding on the optimal level of short-term finance.

Interaction of financing with investment and dividend decisions When taking financial decisions, managers will have to fulfil the requirements of the providers of finance, otherwise finance may not be made available. This may be particularly difficult in the case of equity shareholders, since dividends are paid at the company's discretion. However, if equity shareholders do not receive the dividends they want, they are likely to sell their shares, in which case the share price will fall and the company will have more difficulty raising funds from share issues in future. Although there may be risks in obtaining extra finance, the long-term risks to the business of failing to invest may be even greater and managers will have to balance these risks. Investment may have direct consequences for decisions involving the management of finance; extra working capital may be required if investments are made and sales expand as a consequence. Managers must be sensitive to this and ensure that a balance is maintained between receivables and inventory, and cash. A further issue managers will need to consider is the matching of the characteristics of investment and finance. Time is a critical aspect; an investment which earns returns in the long-term should be matched with finance that requires repayment in the long-term. Another aspect is the financing of international investments. A company which expects to receive a substantial amount of income in a foreign currency will be concerned that this currency may weaken. It can hedge against this possibility by borrowing in the foreign currency and using the foreign receipts to repay the loan. It may though be better to obtain finance on the international markets.

Dividend decisions Dividend decisions may affect the view that shareholders have of the long-term prospects of the company, and thus the market value of the shares.

Interaction of dividend with investment and financing decisions The amount of surplus cash paid out as dividends will have a direct impact on finance available for investment. Managers have a difficult decision here: how much do they pay out to shareholders each year to keep them happy, and what level of funds do they retain in the business to invest in projects that will yield long-term income? In addition, funds available from retained profits may be needed if debt finance is likely to be unavailable, or if taking on more debt would expose the company to undesirable risks.

2.4

Shareholder value and value based management In our discussion of value drivers in Section 2.3.5, we noted that a company's overall aim is to create value for its shareholders.

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Shareholders want managers to maximise the value of their investment in a company. Accordingly, the performance measure systems used in the company need to assess how well managers are carrying out this duty. Many of the performance measures used to assess performance are based on information from a company's published financial statements. However, these could give conflicting messages, or provide misleading information about the company's underlying performance. For example, the figure for earnings per share could be reduced by capital-building investments in research and development and in marketing. What is more, the financial statements themselves do not provide a clear picture of whether or not shareholder value is being created. The statement of comprehensive income, for example, reports the quantity but not the quality of earnings, and it does not distinguish between earnings derived from operating assets compared to earnings derived from non-operating assets. Moreover, it ignores the cost of equity financing, and only takes into account the costs of debt financing, thereby penalising organisations which choose a mix of debt and equity finance. The statement of cash flows (cash flow statement) may also fail to provide appropriate information; as large, positive cash flows are possible when organisations underspend on maintenance, or undertake little capital investment in order to increase short-term profits at the expense of long-term success. On the other hand, an organisation can have large negative cash flows for several years and still be profitable. A shareholder value approach to performance measurement involves a shift in focus away from shortterm profits to a longer-term view of value creation; the motivation being that this will help the business stay ahead in an increasingly competitive world. Individual shareholders have different definitions of shareholder value as different shareholders value different aspects of performance:

     

Financial returns in the short-term Short-term capital gains Long-term returns or capital gains Stability and security Achievements in products produced or services provided Ethical standards

(It is unlikely that the last two alone make a company valuable to an investor.) These factors, and others, will all be reflected in a company 's share price, but stock markets are notoriously fickle and tend to have a short-term outlook. Perhaps more important though, Johnson, Scholes & Whittington suggest that applying shareholder value analysis requires a whole new approach to performance management: value based management (VBM). Central to VBM is the identification of the cash generators of the business, or value drivers, resembling Rappaport's idea of value drivers. These drivers will be both external and internal. For example, competitive rivalry is a major external value driver because of its direct impact on margins.

2.5

Value based management Definition Value based management: A management process which links strategy, management and operational processes with the aim of creating shareholder value. Value based management (VBM) consists of three elements: (a)

Strategy for value creation – ways to increase or generate the maximum future value for an organisation

(b)

Metrics – for measuring value

(c)

Management – managing for value, encompassing governance, remuneration, organisation structure, culture and stakeholder relationships

Importantly, VBM starts from the premise that the value of a company is measured by its discounted future cash flows (not profits). Value is created only when companies invest capital at returns which exceed the cost of that capital. Consequently, VBM seeks to use the idea of value creation to align strategic, operational and management processes to focus management decision-making on what activities create value for the

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shareholders. However, VBM focuses on a company's ability to generate future cash flows, rather than looking at the profits the company has earned or will earn in the short term future. Proponents of VBM argue that profit has become discredited as a performance measure. Value based management highlights that management decisions which are designed to lead to higher profits do not necessarily create value for shareholders. Often, companies are under pressure to meet short term profit targets, and managers are prepared to sacrifice long term value in order to achieve these short term targets. For example, management might avoid initiating a project with a positive net present value if that project leads to their organisation falling short of expected profit targets in the current period. Consequently, value based management argues that profit-based performance measures may obscure the true state of a business. By contrast, VBM seeks to ensure that analytical techniques and management processes are all aligned to help an organisation maximise its value. VBM does this by focusing management decision-making on the key drivers of value, and making management more accountable for growing an organisation's intrinsic value. Therefore, whereas profit-based performance measures look at what has happened in the past, VBM seeks to maximise returns on new investments. What matters to the shareholders of a company is that they earn an acceptable return on their capital. As well as being interested in how a company has performed in the past, they are also interested in how it is likely to perform in the future.

2.5.1

Creating shareholder value Although it is easy to identify the logic that companies ought to be managed for shareholder value, it is much harder to specify how this can be achieved. For example, a strategy to increase market share may not actually increase shareholder value. Good quality information is essential in a VBM system, so that management can identify where value is being created â&#x20AC;&#x201C; or destroyed â&#x20AC;&#x201C; in a business. For example, continuing the previous example, there is no value in increasing market share if the market in question is not profitable. An organisation will need to identify its value drivers, and then put strategies in place for each of them. When identifying its value drivers, an organisation may also find that its organisational structure needs reorganising, to ensure its structure is aligned with the processes which create value.

2.5.2

Measurement Introducing VBM will require a change in the performance metrics used in a company. Instead of focusing solely on historical returns, companies also need to look at more forward-looking contributions to value: for example, growth and business sustainability. The performance measures used in VBM are often non-financial.

2.5.3

Managing value In today's companies, the intellectual capital provided by employees plays a key role in generating value. VBM attempts to align the interests of the employees who generate value and the shareholders they create value for. Otherwise VBM could drive a wedge between those who deliver economic performance (employees) and those who harvest its benefits (shareholders). In practice, companies try to improve the alignment between employees and shareholders by using remuneration structures which include some form of share-based payments. Successfully implementing VBM will also involve cultural change in an organisation. The employees in the organisation will need to commit to creating shareholder value. Value is created throughout the company as a whole, not just by senior management, so all employees need to appreciate how their roles add value.

Nonetheless, visible leadership and strong commitment from senior management will be essential for a shift to VBM to be successful. However, as with any change programme, implementing VBM could be expensive and potentially disruptive, particularly if extensive restructuring is required.

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2.5.4

Elements of VBM A comprehensive VBM programme should consider the following: 

Strategic planning – strategies should be evaluated to establish whether they will maximise shareholder value



Capital allocation – funds should be allocated to the strategies and divisions that will create most shareholder value



Operating budgets – budgets should reflect the strategies the organisation is using to create value



Performance measurement – the economic performance of the organisation needs to lead to increases in share prices, because these promote the creation of shareholder wealth



Management remuneration – rewards should be linked to the value drivers, and how well valuebased targets are achieved



Internal communication – the background to the programme and how VBM will benefit the business need to be explained to staff



External communication – management decisions, and how they are designed to achieve value, must be communicated to the market. The market's reaction to these decisions will help determine movements in the organisation's share price.

Adopting a value based approach to management is likely to have wide-ranging implications for a company. Culture: shareholder value must be accepted as the organisation's purpose. This may have greatest impact at the strategic apex, where directors may have had different ideas on this subject. However, the importance of creating shareholder value must be emphasised in all parts of the business. Nevertheless, it is crucial that management do not overlook underlying business processes in the quest for value based metrics. Core business processes (for example, quality management, innovation, and customer service) should still be monitored alongside value based metrics. Relations with the market: shareholder value should be reflected in share price. The company's senior managers must communicate effectively with the market so that their value-creating policies are incorporated into the share price. However, they must not be tempted to manipulate the market. This may be a difficult area to manage as executive rewards should reflect the share price. One way in which management can communicate performance to the market is through key performance indicators. These metrics should then, in turn, form the basis of the performance targets for divisional managers to achieve. Strategic choices: the maximisation of shareholder value must be the objective underlying all strategic choices. This will affect such matters as resource allocation and HR policies, and will have particular relevance to the evaluation of expensive projects such as acquisitions and major new product development.

2.6

Stakeholders and objectives Although we have spent the previous sections highlighting the importance of creating value for shareholders, and although shareholders are likely to be an important stakeholder group for most organisations, there are also a number of stakeholders whose interests need to be considered when a company plans its strategy and sets its objectives.

Definition Stakeholders: Groups or persons with an interest in the strategy of an organisation, and what the organisation does.

2.6.1

Stakeholder interests Organisations have a variety of stakeholders, each of which is likely to have its own interests: 

Managers and employees – typically interested in job security, career progression, salaries and benefits, job satisfaction



Shareholders – interested in maximising their wealth from holding shares (as measured by profitability, P/E ratios, market capitalisation, dividends and yield)

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

Lenders – interested in the security of loans given, and adherence to loan agreements



Suppliers – achieving profitable sales, payment for goods, developing long-term relationships



Customers – receiving goods and services as purchased, achieving value for money in their purchases



Government and regulatory agencies – jobs created, tax revenues, compliance with laws and regulations, investment and infrastructure, national competitiveness



Environmental and social bodies, and other non-governmental organisations – primarily interested in social responsibility



Industry associations and trades unions – interested in members’ rights



Local communities – interested in local jobs on one hand, but also environmental impact (noise, pollution etc.) on the other

When determining its strategy, an organisation needs to consider how well that strategy fits in with the interests of different stakeholders. The organisation should also consider how stakeholders could respond to strategies which do not uphold their interests; for example: shareholders could raise concerns at the company’s AGM, or even sell their shares; banks could refuse to lend money to a company or could demand higher interest charges; customers may choose to purchase goods and services from a competitor; and employees could resign or take part in industrial action (supported by trade unions).

Focus of stakeholders’ interests When considering stakeholders, organisations need to be aware of two important differences in stakeholder focus: Economic or social focus Some stakeholders' interests are primarily economic (for example, shareholders are interested in profitability; employees, about salaries) while other stakeholders will care more about social issues (such as social responsibility or environmental protection). Local or national focus Often, the interests of local stakeholder groups may be different from national (or international groups). Think, for example, of the debate about whether to build a third runway at Heathrow Airport. Local residents are concerned about increased noise, pollution and traffic, but at a national level politicians have highlighted the economic benefits of expansion.

2.6.2

Stakeholder management Conflict is likely between stakeholder groups due to the divergence of their interests. This is further complicated when individuals are members of more than one stakeholder group and when members of the same stakeholder group do not share the same principal interest. For example, if some members of a workforce are also shareholders while others are not, the interests of the two groups may be different. Different stakeholder groups are likely to have a range of responses to possible business strategies. When an organisation is evaluating a strategy, it should consider what impact that strategy will have on key stakeholder groups.

3 The external business environment 3.1

The external environment The business environment includes the wider political, economic, social, technological, environmental (green) and legal context in which an organisation operates, as well as the more immediate pressures of the business competition it faces. The business environment is both complex and subject to constant change, to the extent that it is unlikely that a business can ever have a complete understanding of its environment. However, by analysing the key environmental variables that might affect it, an organisation can identify the opportunities which are available to it and the threats that it is facing.

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3.2

Environmental and market analysis tools

4 Internal factors and strategic capability 4.1

Resource-based approaches to strategy In the previous section, we looked at the way the external environment influences strategies, through the opportunities and threats which it presents to organisations. Once an organisation has analysed its external environment, it can then establish an appropriate strategy to achieve a good strategic fit with that environment. This is the essence of the position-based approach to strategy: organisations seek to develop competitive advantage in a way that responds to the nature of the competitive environment, and position their strategy in response to the opportunities or threats they discern in the environment. However, an organisation's internal competences and capabilities also affect its ability to deliver value to customers and achieve competitive advantage in an industry. Resource-based approaches to strategy focus on these internal characteristics of an organisation. In resource-based approaches, rather than being developed in response to the external competitive environment, strategy is developed by looking at what makes a firm unique, and using an understanding of these unique competences to determine what to produce and what markets to produce for. The resource-based view is based on the idea that sustainable competitive advantage can only be attained as a result of possessing distinctive resources (either tangible or intangible). The resource-based approach also suggests that strategic advantage begins with a few key elements that the organisation must concentrate on – its core competences, those things that it does better than its rivals.

4.2

Resources and competences Different authors define the concepts of resources, competences and capabilities differently, so we are not going to provide definitions of them here, and you will not face an exam question specifically asking you to define them at this level either. However, what is important is to recognise: (i) the relationship between resources and competences; and (ii) the distinction between threshold resources or competences and unique resources and core competences. Resources are the assets that an organisation has (eg staff, equipment) or can call upon (eg partners or suppliers); while competences are the ways an organisation used or deploys those assets effectively. Resources, on their own, are not productive. Therefore organisational capability – an organisation's capacity to successfully deploy its resources to achieve a desired end result – is vital as a basis for achieving competitive advantage. These organisational capabilities could be in a range of different areas:

4.3

 

Corporate functions (financial control; multi-national co-ordination) Research and development, or innovative and adaptive capability

    

Product design Operations (operational efficiency; continuous improvement; flexibility) Marketing People and talent management Sales and distribution

Core competences and strategic capabilities Hamel & Prahalad suggest that an important aspect of strategic management is the determination of the competences the company will require in the future in order to be able to provide new benefits to customers. They say a core competence must have the following qualities: 

It must make a disproportionate contribution to the value the customer perceives, or to the efficiency with which that value is delivered



It must be 'competitively unique', which means one of three things: actually unique; superior to competitors; or capable of dramatic improvement



It must be extendable, in that it must allow for the development of an array of new products and services

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In many cases, a company might choose to combine competences. Bear in mind that relying on a competence is no substitute for a strategy. However, a core competence can form a basis for a strategy. Here it is important to reiterate that a core competence must be difficult to imitate if it is to confer lasting competitive advantage. In particular, skills that can be bought in are unlikely to form the basis of core competences, since competitors would be able to buy them in just as easily. Core competences are more about what the organisation is than about what it does. So it is possible to regard a strong brand as a kind of core competence: it is a unique resource that confers a distinct competitive advantage.

4.3.1

Strategic capabilities and competitive advantage Resources and competences are clearly important in creating and sustaining competitive advantage. However, if an organisation's strategic capabilities are going to deliver competitive advantage for it, then those capabilities must have four qualities: Valuable to buyers – They must produce effects or benefits that are valuable to buyers. Rarity – If a resource or competence is available to an organisation's competitors in the same way as it is to the organisation then it does not confer any advantage to the organisation over its rivals. Robustness – In order for a resource or competence to confer a sustainable benefit to an organisation, it must be difficult for competitors to imitate or acquire. Non-substitutability – A resource or competence is no longer a source of competitive advantage if the product or service it underpins comes under threat from substitutes.

4.4

Position audit The position audit is that part of the planning process which examines the current state of the business entity's strategic capability, in relation to:      

Resources of tangible and intangible assets and finance Products, brands and markets Operating systems, such as production and distribution Internal organisation Current results Returns to shareholders

The elements of the position audit are:    

4.5

Resource auditing Analysis of limiting factors Identification of threshold resources/competences Identification of unique resources/core competences

Resource audit As the name suggests, resource audits identify the resources available to an organisation. These resources can be categorised as financial, human, intangible or physical. By determining what resources they have, companies can identify what additional resources are required to pursue their chosen strategy.

4.6

Strategic capability An organisation's ability to survive and prosper, and to deliver future value, depends on its strategic capability.

Definition Strategic capability: the adequacy and suitability of an organisation’s resources and competences to contribute to its long-term survival or competitive advantage. When evaluating an organisation's strategic capability, the following questions are important: 

Does the organisation have a suitable business model to deliver future success, based on an understanding of the sources of competitive advantage that contribute to profitability and growth across the value system of the organisation?

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

Does it have the people, processes and resources it needs to be able to deliver this success?

When considering resources and competences, it is important to remember that companies often need to acquire assets or competences from outside their own controllable resources and competence- building activities. These 'external' resources can include:    

Integrated supply chains Networks of firms Longer-term alliances Acquisition of, or merger with, another company

Equally, a resource for a firm could include access to supplies and/or distribution networks, so resource management is not simply a matter of ownership and control.

4.6.1

Dynamic capabilities So far, when looking at resources and competences, we have tended to view them as long-term phenomena, since, for example, resources will be more valuable if they can be counted upon to last for a long time, or because it might take an organisation a long time to develop its core competences. However, if managers focus on internal resources alone, there is a danger they will overlook the importance of the external environment on their strategy. This could be a particular problem during periods of environmental uncertainty and change. Critics of resource-based approaches to strategy argue that while the resource-based view can help to explain how firms achieve competitive advantage in a static environment, it does not explain how and why firms can achieve and sustain competitive advantage in situations of rapid and unpredictable change. Therefore, we could suggest that the traditional resource-based view (of resources and competences) needs to be extended to acknowledge that, in order to sustain competitive advantage, firms may need to renew – or upgrade – their competences in line with the changing business environment. This ability to achieve new forms of competitive advantage, by developing and changing competences to meet the needs of rapidly changing environments is known as dynamic capability. In this context, the distinction between resources, competences and capabilities which we identified earlier is important because it enables us to develop a hierarchical order that we can use to analyse a firm's ability to create and sustain a competitive advantage. Resources form the base of the hierarchy, the 'zero-order' element. They are the foundation of the firm, and need to be in place before a firm can develop any higher capabilities. However, by themselves resources cannot be a source of sustainable competitive advantage. Competences or capabilities are the 'first-order' and represent the ability to deploy resources to attain a desired goal. In this way, capabilities are likely to result in improved performance. However, this improved performance will be manifest at an operational level – for example through the performance of business processes – rather than at a strategic level. Core competences or core capabilities are 'second-order', and consist of those resources and capabilities that are strategically important to a firm's competitive advantage at any given point. However, these core capabilities may not necessarily continue to confer a sustainable competitive advantage if (or when) the environment changes. Depending on the nature and extent of the change, capabilities might either become irrelevant or possibly even become 'core rigidities.' (That is, a potential down side of core capabilities is that they inhibit innovation, because managers prefer instead to concentrate on using resources in the current way, rather than combining them in different ways or re-purposing them for new use, such as producing new product lines.) Therefore 'third-order' dynamic capabilities emphasise a firm's constant pursuit of the renewal, reconfiguration and re-creation of resources, capabilities and core capabilities in order to address the changing environment. This ability to adapt to changes in markets or the environment sooner and more astutely than competitors is at the heart of dynamic capabilities, and is also a source of sustained competitive advantage.

5 Analysing strategic position and performance 5.1.1

Value system Activities that add value do not stop at the boundaries of the organisation. For example, when a restaurant serves a meal, the quality of the meat and vegetable ingredients is determined by the farmer who supplies them. The farmer has added value. The farmer's ability is as important to the customer's ultimate satisfaction

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as the skills of the chef. A firm's value chain is connected to what Porter calls a value system. The value system offers the potential to improve efficiency and reduce cost through negotiation, bargaining, collaboration and vertical integration. Vertical integration provides an opportunity to increase profitability by migrating to the part of the value system that has the most potential for adding value. Note also that Information Technology (IT) can transform the value chain, and a number of current improvements in value chain activities have been IT driven.

5.1.2

Strategic value analysis One of the benefits of value chain analysis for managers is that it enables them to understand how the processes they manage add value for the customer. In turn, they can then help identify where the amount of value added can be increased, or else costs lowered, with a view to enhancing the competitive position of their organisation. However, gaining and sustaining a competitive advantage requires an organisation to understand the entire value delivery system, not just the portion of the value system in which it participates. For example, the upstream value chain (suppliers) and the downstream value chain (distributors, retailers) are a crucial part of a manufacturer's value system. Moreover, the upstream and downstream portions of the value system also have profit margins that will be important when identifying a company's cost/differentiation positioning, since the end user consumer ultimately pays for the profit margins along the entire value chain. Strategic value analysis (SVA) highlights the need to analyse business issues and opportunities across the entire value chain for an industry. Such analysis is critical for multi-stage industries because change in one stage will almost inevitably have an impact on other businesses all along the chain. SVA prompts companies to ask four key questions: 

Are there any new or emerging players in the industry (in any portion of the value chain) that may be more successful than existing players?



Are these companies positioned in the value chain differently from existing players? (In particular, are companies emerging which specialise in single activities within the value chain, eg marketing or logistics, rather than trying to cover all activities?)



Are new market prices emerging across segments of the value chain?



If we used these market prices as transfer prices within our company, would it fundamentally change the way any of the operating units behave?

SVA is particularly relevant to vertically integrated companies, because it encourages them to consider whether it would be more profitable for them to outsource certain functions or activities rather than continuing to perform them all in-house.

5.2

Benchmarking Benchmarking enables organisations to meet industry standards by copying others. It is less valuable as a source of innovation but is a good way to challenge existing ways of doing things. It involves comparing your own performance with recognised targets, such as industry averages, and allows you to identify areas where you are performing relatively well as well as areas where your relative performance is below expectations.

5.3

Business process analysis This tool helps organisations improve how they conduct their functions and activities with a view to reducing costs, improving the efficient use of resources and giving better support to customers. The idea is to concentrate on and re-think activities that create value for customers whilst removing any activities that do not add value.

5.4

Strategic risk analysis This involves recognising and assessing risks faced by the organisation, developing strategies to manage them and mitigating risks using managerial resources. Strategies include transferring risk to other

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parties, avoiding the risk altogether, reducing negative effects of the risk and accepting some or all of the consequences of a particular risk.

Risk appetite Alongside risk analysis it is also important for companies to articulate their risk appetite. If companies do not articulate their risk appetite, how can they set suitable strategic goals? For example, can a company that is only prepared to take a very low level of risk expect to achieve as rapid growth as a company that is prepared to accept a higher level of risk?

5.5

Corporate reporting and management commentary Definition Management commentary: 'A narrative report that relates to financial statements that have been prepared in accordance with IFRSs. Management commentary provides users with historical explanations of the amounts presented in the financial statements, specifically the entity's financial position, financial performance and cash flows. It also provides commentary on an entity's prospects and other information not presented in the financial statements. Management commentary also serves as a basis for understanding management's objectives and its strategies for achieving those objectives.' [IFRS Practice Statement: Management commentary – A framework for presentation] Thus far, in Section 5 of this chapter, we have discussed a number of frameworks which can be used to analyse an organisation's position and performance. However we have not, so far, highlighted the link between an organisation's performance and strategy, and the financial information published in its financial statements. In this respect, the strategic report (or 'management commentary' under IFRS) in an entity's annual report is important. As the IFRS Practice Statement notes: The 'management commentary provides a context within which to interpret the financial position, financial performance and cash flows of an entity. It also provides management with an opportunity to explain its objectives, and its strategies for achieving those objectives.' Additionally, the management commentary complements the financial statements by explaining the main trends and factors that are likely to affect an entity's future performance, position and progress. Importantly, in this respect, the management commentary looks not only at the present, but also at the past and the future. In particular, the management commentary provides qualitative information that helps the users of financial statements to evaluate an entity's prospects and general risks. Equally, the disclosures contained in this kind of business review will help to inform stakeholders about an entity's strategy. Although the precise focus of the management commentary will depend on the circumstances of an individual entity, it should summarise a number of the key aspects of strategic management we have highlighted in this chapter. The IFRS Practice Statement indicates that the commentary should include information that is required to understand: 

The nature of the business (and of the markets and external environment in which it operates)



Management's objectives and their strategies for meeting those objectives (for example, how management intends to address market trends and the opportunities and threats presented by those trends)



The entity's most significant resources (financial and non-financial), risks and relationships (with key stakeholders)



The entity's results and prospects. The commentary should include a description of the entity's financial and non-financial performance, and the extent to which that performance may be indicative of future performance.



The critical performance measures and indicators that management uses to evaluate its

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performance against its objectives and in relation to its critical success factors. Again, the commentary should refer to both financial and non-financial performance measures that are used.

6 Levels of strategy in an organisation 6.1

Levels of strategy Strategies can exist at three main levels within organisations: corporate-level strategy, business-level strategy and operational/functional-level strategy. Corporate-level strategy – is concerned with the overall scope of an organisation and how value is added to the organisational whole. Corporate-level strategy issues include questions around geographical scope and which markets to enter; the diversity of products or services the organisation as a whole will offer; acquisitions of new businesses, or the divestment of existing businesses; and decisions about how resources are allocated between the different elements of the organisation. Business-level strategy – is concerned with how individual businesses or business units compete in their particular markets. For example, business-level strategy could address competitive strategy, or response to competitors' actions. Operational (or functional) strategy – is concerned with how the components of an organisation actually deliver the corporate-level or business-level strategies, in terms of resources, processes and people. Typical functional strategies are: 

Research and development



Operations – including purchasing, procurement and supply chain management; capacity management; production; quality management



Marketing – including marketing mix, market segmentation and customer relationship management



Human resources – including recruitment and selection; remuneration and reward; appraisal



Finance



Information systems and information technology (IS/IT)

In most businesses, successful business strategies ultimately depend, to a large extent, on decisions that are taken, or activities that occur, at operational level. Operational decisions are therefore vital to successful strategy implementation. Equally importantly though, operational strategies need to be properly aligned with business-level or corporate-level strategy if these higher level strategies are going to be successfully implemented. For example, if a business' competitive strategy is based on delivering the highest quality service to its customers, then its human resource management will need to ensure that it has sufficient, well-trained, and highly-motivated staff to deliver that level of service to its customers. Although operational strategy may appear to be at the bottom of the strategic hierarchy, this does not mean operational strategies are any less important than corporate strategies. Satisfying the customer is a key task to meet corporate objectives for most businesses; but the businesses will not be able to satisfy their customers if operations are poorly managed, meaning that their strategies will fail.

6.2

Contrasting strategic with operational decisions The contrasting decisions in organisations can be analysed as in the table below. The contrast between corporate-level and operational decisions is also important because it means that the type of information which is required for decision-making at corporate level is very different from that required at operational level.

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Strategic Business Management CHAPTER 2

Strategic choice 1 Strategic choices 1.1

Categories of strategic choice Once an organisation has identified the opportunities and threats in its external environment and its internal strengths and weaknesses, it must make choices about what strategies to pursue in order to achieve its goals and objectives. It is possible to classify strategic choice into three categories: (a)

Competitive strategies are the strategies an organisation will pursue for competitive advantage. They determine how an organisation competes.

(b)

Product-market strategies determine where an organisation competes and the direction of growth.

(c)

Institutional strategies determine the method of growth, and how an organisation gains access to its chosen products and markets.

2 Generating strategic options 2.1

Porter's generic strategies In any market where there are competitors, strategic and marketing decisions will often be taken in order to provide an organisation with a competitive advantage over its competitors.

Definition Competitive advantage: How a firm creates value for its buyers which is both greater than the cost of creating it and superior to that of rival firms. Porter argues that a firm should adopt a competitive strategy that is intended to achieve some form of competitive advantage for the firm. A firm that possesses a competitive advantage will be able to make profit exceeding its cost of capital: in terms of economic theory, this is 'excess profit' or 'economic rent'. The existence of excess profit tends to be temporary because of the effect of the five competitive forces (Porter's five forces). When a company can continue to earn excess profit despite the effects of competition, it possesses a sustainable competitive advantage. Porter highlighted that competitive strategy aims to establish a profitable and sustainable position against the forces that determine industry competition. As such, competitive strategy involves: taking offensive or defensive actions to create a defendable position in an industry, to cope successfully with ... competitive forces and thereby yield a superior return on investment for the firm. Firms have discovered many different approaches to this end, and the best strategy for a given firm is ultimately a unique construction reflecting [the firm's] particular circumstances. (Porter.)

The choice of competitive strategy Porter suggests there are three generic strategies for competitive advantage. To be successful, Porter argues, a company must follow only one of the strategies. If they try to combine more than one, they risk losing their competitive advantage and becoming 'stuck in the middle.' Remember that Porter identified the importance of cost leadership (not price leadership) as one of the generic strategies. Although companies which are pursuing a cost leadership strategy might then choose to compete on price, the focus of Porter's model is on how companies can produce goods or services at a lower cost than their rivals, rather than selling price per se.

2.1.1

Cost leadership A cost leadership strategy seeks to achieve the position of lowest-cost producer in the industry as a whole.

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By producing at the lowest cost, the manufacturer could either charge the same price as its competitors knowing that this would enable it to generate a greater profit per unit than them, or it could decide to charge a lower price than them. This could be particularly beneficial if the goods or services which the organisation sells are price sensitive. How to achieve overall cost leadership: 

Set up production facilities to obtain economies of scale



Use technology and high-tech systems to reduce costs and/or enhance productivity. (Supply Chain Management and Business Process Re-engineering, which can both be used to help achieve cost leadership, are discussed in Chapter 3)



Exploit the learning curve effect



Minimise overhead costs



Get favourable access to sources of supply and buy in bulk wherever possible (to obtain discounts for bulk purchases)



Product relatively standardised products



Relocate to cheaper areas (possibly in a different country)

Strategy and internal capabilities Value chain analysis, which we looked at in the previous chapter, could also be useful when considering which generic strategy to pursue. For example, if a business unit wishes to pursue a cost leadership strategy, it will need to ensure that its costs are as low as possible across all the different activities in its value chain (for example, by automating as many activities as possible). Benchmarking could also be important here. If a company is pursuing a cost leadership strategy, it will need to benchmark its costs or its processes against competitors to assess its cost efficiency compared to theirs.

2.1.2

Differentiation A differentiation strategy assumes that competitive advantage can be gained through particular characteristics of a firm's products. Products may be divided into three categories. (a)

Breakthrough products offer a radical performance advantage over competition, perhaps at a drastically lower price.

(b)

Improved products are not radically different from their competition but are obviously superior in terms of better performance at a competitive price.

(c)

Competitive products derive their appeal from a particular compromise of cost and performance. For example, cars are not all sold at rock-bottom prices, nor do they all provide immaculate comfort and performance. They compete with each other by trying to offer a more attractive compromise than rival models.

How to differentiate

2.2

(a)

Build up a brand image (eg Pepsi's blue cans are supposed to offer different 'psychic benefits' to Coke's red ones).

(b)

Give the product special features to make it stand out (eg Russell Hobbs' Millennium kettle incorporated a new kind of element, which boils water faster).

(c)

Exploit other activities of the value chain (for example, quality of after-sales service or speed of delivery).

Overall limitations of the generic strategy approach Problems in defining the 'industry' - Porter's model depends on clear notions of what the industry and firm in question are, in order to establish how competitive advantage derives from a firm's position in its industry. However, identifying the industry and the firm may not be clear, since many companies are part of larger organisations, and many 'industries' have boundaries that are hard to define. For example, what industry is a car manufacturer in? Cars, automotive (cars, lorries, buses), manufacturing, transportation? Defining the strategic unit – As well as having difficulties in defining the industry, we can also have difficulties in determining whether strategies should be pursued at SBU or corporate level, and in relation to exactly which category of products. For example, Proctor and Gamble have a huge range of

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products and brands: are they to follow the same strategy with all of them? Similarly, the VolkswagenAudi Group owns the Seat, Audi, Bentley and Skoda car marques. Porter's theory states that if a firm has more than one competitive strategy, this will dilute its competitive advantage. But does this mean that Volkswagen-Audi's strategy for its Skoda brand needs to be the same as for its Bentley brand? Clearly not, and this is a major problem with Porter's theory. It is impractical to suggest that a whole group should follow a single competitive strategy and so it seems more appropriate to suggest that the model should be applied at business unit level. Yet if the theory is only applied at individual SBU level, then it could lead managers to overlook sources of competitive advantage which emerge from being part of a larger group – for example, economies of scale in procurement. Another criticism which is sometimes levelled at Porter's model is that it doesn't look at how firms might use their competitive advantages and distinctive competences to expand into new industries, perhaps as the result of creative innovation. Porter only looks at how a firm might use its resources to develop strategy in its existing line of business. However, we could argue that this criticism isn't really valid. Although Porter doesn't talk about expansion into new industries, his model does not preclude it, and his arguments about following a competitive strategy would still ultimately need to be applied in the new industry.

2.3.1

Assurance and generic strategies In our discussion of cost leadership strategies (above) we noted that if an entity is pursuing a cost leadership strategy, it will need to benchmark its costs or its processes against competitors to assess its cost efficiency compared to theirs. Equally, however, if an entity is intending to pursue a differentiation strategy based, for example, on the quality of its product or the quality of service it provides customers, it will need some way of assessing the quality of its product or service compared to the quality of the offering provided by its competitors. In this respect, benchmarking could again be valuable, but equally, it could be useful for the entity to obtain some independent assurance of its quality performance indicators compared to those of its competitors. In turn, if the entity can be confident that the quality of its product exceeds that of its competitors, then it can make use of this point of differentiation in its marketing material. The 'Assurance Sourcebook' published by the ICAEW's Audit and Assurance Faculty includes the following short vignette to illustrate how assurance could be used in relation to benchmarking and performance indicators: A company wanted assurance to increase the credibility of the claims it was making about its performance relative to competitors. The company was using KPI data to benchmark its performance against other companies in the industry. The assurance set out criteria to regulate the methodology used for calculating the KPIs, and ensured that the KPIs were based on independently collated data.

2.3

Product/market matrix The product/market matrix is a short hand term for the products/services a firm sells (or a service which a public sector organisation provides) and the markets it sells them to.

2.4

Method of growth Once a firm has made its choice about which strategies it wants to pursue, it needs to choose an appropriate mechanism to deliver that strategy.   

Develop the business from scratch Acquire or merge with an already existing business Co-operate in some way with another firm

The main issues involved in choosing a method of growth are these. 

Resources. Does a firm have enough resources and competences to go it alone, or does it have plenty of resources to invest?



Two different businesses might have complementary skills



Speed. Does a firm need to move fast?

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

A firm might wish to retain control of a product or process



Cultural fit. Combining businesses involves integrating people and organisation culture



Risk. A firm may either increase or reduce the level of risk to which it is subject. External growth often involves more risk than organic (internal) growth.

The type of relationships between two or more firms can display differing degrees of intensity.   

Formal integration: Acquisition and merger Formalised ownership/relationship, such as a joint venture Contractual relationships, such as franchising

2.6 Organic Growth 2.6.1

2.6.2

Reasons for pursuing organic growth (a)

Learning. The process of developing a new product gives the firm the best understanding of the market and the product.

(b)

Innovation. It might be the only sensible way to pursue genuine technological innovations, and exploit them. (For example, compact disc technology was developed by Philips and Sony, who earn royalties from other manufacturers licensed to use it.)

(c)

There is no suitable target for acquisition.

(d)

Organic growth can be planned more meticulously and offers little disruption.

(e)

It is often more convenient for managers, as organic growth can be financed easily from the company's current cash flows, without having to raise extra money.

Problems with organic growth (a)

Time – sometimes it takes a long time to descend a learning curve.

(b)

Barriers to entry (eg distribution networks) are harder to overcome: For example, a brand image may be built up from scratch.

(c)

The firm will have to acquire the resources independently.

(d)

Organic growth may be too slow for the dynamics of the market.

Organic growth is probably ideal for market penetration, and suitable for product or market development, but it might be a problem with extensive diversification projects.

2.5

Acquisitions and mergers Definitions An acquisition: The purchase of a controlling interest in another company. A merger: The joining of two separate companies to form a single company.

2.7.1

The purpose of acquisitions and their effect on operations (a)

Marketing advantages (i) (ii) (iii) (iv) (v)

Buy in a new (or extended) product range Buy a market presence (especially true if acquiring a company overseas) Unify sales departments or rationalise distribution and advertising Eliminate competition or protect an existing market Combine adjoining markets

(b) Production advantages (i)

Economies of scale; increasing capacity utilisation of production facilities (ii) Buy in technology and skills

(iii) Obtain greater production capacity (iv) Safeguard future supplies of raw materials 4

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(v) (c)

Improve purchasing by buying in bulk

Finance and management (i) (ii) (iii) (iv) (v) (vi)

Buy a high quality management team, which exists in the acquired company Obtain cash resources where the acquired company is very liquid Obtain assets, including intellectual property Gain undervalued assets or surplus assets that can be sold off Turnaround opportunities Obtain tax advantages (eg purchase of a tax loss company)

(d)

Risk-spreading - diversification

(e)

Independence. A company threatened by a take-over might take over another company, just to make itself bigger and so a more expensive target for the predator company.

Many acquisitions do have a logic, and the acquired company can be improved with the extra resources and better management. Furthermore, much of the criticisms of takeovers has been directed more against the notion of conglomerate diversification as a strategy rather than takeover as a method of growth.

2.7.2

Problems with acquisitions and mergers (a)

Cost. They might be too expensive, especially if resisted by the directors of the target company. Proposed acquisitions might be referred to the government under the terms of anti-monopoly legislation.

(b)

Customers of the target company might resent a sudden takeover and consider going to other suppliers for their goods.

(c)

Incompatibility. In general, the problems of assimilating new products, customers, suppliers, markets, employees and different systems of operating might create 'indigestion' and management overload in the acquiring company. In 2011, UK supermarket Morrisons acquired the fast-growing, US online retailer Kiddicare for £70m. Morrisons was worried about its lack of online presence and experience in running an online business, and hoped that Kiddicare would give it a cut-price entry into online retailing. However, Kiddicare (which sells baby goods) had no grocery-related software. In March 2014, sold Kiddicare for £2m, after admitting it did not have a strategic role in Morrison’s core business.

(d)

Culture. Culture is one of the main barriers to effective integration following an acquisition. Companies with different cultures find it difficult to make decisions quickly and correctly, and to operate effectively. Culture affects decision-making style, leadership style, ability and willingness to change, and how people work together (eg formal structures or informal relationships).

(d) Poor success record of acquisitions. Takeovers often benefit the shareholders of the acquired company more than the acquirer. According to the Economist Intelligence Unit, there is a consensus that fewer than half of all acquisitions are successful. (e)

Driven by the personal goals of the acquiring company's managers, as a form of sport, perhaps, rather than as a result of underlying business benefits

(f)

Public opinion and reaction. For example, the value produced from foreign takeovers of UK companies came under intense scrutiny amid public anger of Kraft’s acquisition of Cadbury in 2010, and Kraft reversing its pledge to keep open a Cadbury plant at Somerdale, near Bristol. (Kraft’s acquisition of Cadbury prompted a tightening of the rules governing how foreign firms buy UK companies. A number of changes were made to the Takeover Code in 2011, demanding more information from bidders about their intentions for the target company post-acquisition, particularly on areas like job cuts.)

2.6

Joint ventures There are a number of other ways by which companies can co-operate, but which stop short of being mergers or takeovers. (a)

Consortia: Organisations co-operate on specific business areas such as purchasing or research.

(b)

Joint ventures: Two firms (or more) join forces for manufacturing, financial and marketing purposes and each has a share in both the equity and the management of the business.

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(i)

Share costs. As the capital outlay is shared, joint ventures are especially attractive to smaller or risk-averse firms, or where very expensive new technologies are being researched and developed (such as in the civil aerospace or petrochemical industries). Finding the right joint venture partner could be very important to companies with funding constraints but high development costs, especially if the venture partner brings credibility as well as providing the necessary finance.

(ii)

Reduce risk. As well as sharing costs, sharing risk is also a common reason to form a joint venture. Again, this could be particularly relevant to capital-intensive industries, or industries where high costs of product development increase the risk of product failure. A joint venture can reduce the risk of government intervention if a local firm is involved. In a number of countries, joint ventures with host governments or state-owned enterprises have also become increasingly important.

(iii) Participating enterprises benefit from all sources of profit. (iv) Close control over marketing and other operations. (v)

Overseas joint ventures provide local knowledge, quickly.

(vi) Synergies. One firm's production expertise can be supplemented by the other's marketing and distribution facility. Note that joint ventures are one of two kinds of joint arrangement as defined in IFRS 11 Joint Arrangements (see Section 2.8.2); the other being the looser arrangements known as joint operations. (c)

(d)

2.8.1

2.8.2

A licensing agreement is a commercial contract whereby the licenser gives something of value to the licensee in exchange for certain performances and payments. (i)

The licenser may provide rights to produce a patented product or to use a patented process or trademark as well as advice and assistance on marketing and technical issues.

(ii)

The licenser receives a royalty.

Subcontracting is also a type of alliance. Co-operative arrangements also feature in supply chain management, JIT and quality programmes.

Disadvantages of joint ventures (a)

Conflicts of interest between the different parties.

(b)

Disagreements may arise over profit shares, amounts invested, the management of the joint venture, and the marketing strategy.

(c)

One partner may wish to withdraw from the arrangement.

(d)

There may be a temptation to neglect core competences. Acquisition of competences from partners may be possible, but alliances are unlikely to create new ones.

Accounting for joint arrangements The terms of the contractual arrangement between parties to a joint arrangement are key to deciding whether the arrangement is a joint venture or a joint operation. IFRS 11, Joint Arrangements, details the issues that should be considered when determining the appropriate treatment.

Definitions Joint operation: A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets and obligations for the liabilities relating to the arrangement. Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Joint control: The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. (IFRS 11) 6

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IFRS 11 requires that a joint operator recognises line-by-line in its own financial statements the following in relation to its interest in a joint operation:     

Its assets, including its share of any jointly held assets Its liabilities, including its share of any jointly incurred liabilities Its revenue from the sale of its share of the output arising from the joint operation Its share of the revenue from the sale of the output by the joint operation, and Its expenses, including its share of any expenses incurred jointly.

However, for a joint venture, IFRS 11 requires that a joint venturer recognises its interest in a joint venture as an investment in its consolidated financial statements, and accounts for that investment using the equity method in accordance with IAS 28, Investments in Associates and Joint Ventures.

2.7

Franchising Franchising is a method of expanding the business on less capital than would otherwise be possible, because franchisees not only pay a capital lump sum to the franchiser to enter the franchise, but they also bear some of the running costs of the new outlets. For suitable businesses, it is an alternative business strategy to raising extra capital for growth. Probably the most well-known franchisers are McDonalds, but other franchisers include Dyno-Rod, Express Dairy, Holiday Inn, Kall-Kwik Printing, Kentucky Fried Chicken, Sketchley Cleaners and Body Shop. The franchiser and franchisee each provide different inputs to the business. (a)

The franchiser (i)

Name, and any goodwill associated with it

(ii)

Systems and business methods, business strategy and managerial know-how

(iii) Support services, such as advertising, training, research and development, and help with site decoration (b) The franchisee (i) Capital, personal involvement and local market knowledge (ii) Payment to the franchiser for rights and for support services (iii) Responsibility for the day-to-day running, and the ultimate profitability of the franchise

2.9.1

Advantages of franchising (a)

Reduces capital requirements. Firms often franchise because they cannot readily raise the capital required to set up company-owned stores. John Y. Brown, the former president of Kentucky Fried Chicken, maintained that it would have cost KFC $450 million to establish its first 2,700 stores if it had run them as company-owned stores, and this was a sum that was not available to the corporation in the early stages of its life.

(b)

Reduces managerial resources required. A firm may be able to raise the capital required for growth, but it may lack the managerial resources required to set up a network of company-owned stores. Recruiting and training managers and staff accounts for a significant percentage of the cost of growth of a firm. Under a franchise agreement, the franchisees supply the staff required for the day-to-day running of the operation.

(c)

Improves return on promotional expenditure through speed of growth. A retail firm's brand and brand image are crucial to the success of its stores. Companies often develop their brand through extensive advertising and promotion, but this only translates into sales if they have a number of stores that customers can visit after seeing their advertisements. As franchising provides quicker access to capital and managerial resources, a firm can expand more quickly through franchising than through opening new company-owned stores. Faster expansion through franchising, in turn, should allow companies to achieve a favourable return on their promotional campaigns.

(d)

Benefits of specialisation. As the franchisee and the franchiser both contribute different resources to the franchise, franchising provides an effective way of reducing costs: each party concentrates on their core areas, and increases their efficiency in those areas. For example, in the fast-food business, product development and national promotion are more efficiently handled on a large

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relatively smaller scale (by the franchisee). (e)

2.9.2

2.8

Low head office costs. The franchiser only needs a small number of head office staff because there is a considerable delegation of operational responsibility to the franchisees. For example, in the fast-food business, the franchisees provide the staff who work in the restaurants, and so the franchisees incur the HR and payroll costs associated with that.

Disadvantages of franchising (a)

Profits are shared. The franchisee receives the revenue from the customer at the point of sale and then pays the franchiser a share of the profits.

(b)

The search for competent candidates is both costly and time consuming where the franchiser requires many outlets (eg McDonald's in the UK).

(c)

Control over franchisees. (McDonald's franchisees in New York recently refused to co-operate in a marketing campaign.)

(d)

Risk to reputation. A franchisee can damage the public perception of a brand by providing inferior goods or services.

(e)

Potential for conflict. There may be disagreement over the respective rights and obligations of the franchiser and franchisee, for example over the level of support to be provided or the fees payable.

Alliances An alliance is a slightly looser form of collaboration. It will involve a detailed legal agreement setting out how firms will work together. Typically, alliances can be formed between industry rivals in order to reduce the competitive forces that they face, such as the Star Alliance of 27 airlines. In terms of airline alliances, the major benefit is 'code sharing' whereby two or more members are able to book customers onto the same flight, leading to cost sharing and a rationalisation of fleet sizes. A major problem with forming alliances is overcoming regulatory resistance, as such agreements are often viewed as anticompetitive because they typically reduce customer choice.

2.9

Potential use of assurance reports In either a joint venture or a franchise arrangement, profits have to be shared between the various parties. In this respect, it could be valuable for the parties to have assurance that profits have been calculated correctly. The Assurance Sourcebook (produced by ICAEW's Audit and Assurance faculty) suggests the following mini-scenario where assurance would be valuable: The criteria which define the split of profits in a joint venture are defined in the joint venture agreement but the profit allocation needs clarification with the two parties. Both parties want assurance that the profit allocation has been calculated properly and in accordance with the agreement. A second illustration from the sourcebook highlights a scenario which could apply to a franchise or a licensed operation: The management agreement made between hotel owners and operators includes a requirement for specific assurance over the reporting of management fee calculations. The hotel owners could benefit from an assurance report which verifies the way figures are extracted for use in the management fee calculation, and then also confirms that the calculation of the management fee is in accordance with the terms of the management contract.

2.11.1

Assurance reports on third party operations As well as the examples above about financial assurance, practitioners could be asked to undertake a wider range of assurance engagements in relation to third party operations. In any joint venture, franchise or strategic alliance, an organisation (the ‘user organisation’) will need to be confident that its business partners are delivering effectively the activities which they are responsible for. Equally, the business partners may wish to demonstrate that they are performing tasks as they have agreed to do. Professional accountants can help increase the confidence of either an organisation or its business partners in their relationships by providing assurance over the services provided by the business partners (so-called ‘responsible parties’).

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3 Strategic decision-making Once an organisation has identified its current strategic position, and the different potential strategic options available to it, it then it has to choose which of these options it wants to pursue. The rational model of strategic planning suggests that individual strategies have to be evaluated against a number of criteria before a strategy or a mix of strategies is chosen. Johnson et al in Exploring Strategy, narrow these criteria down to three: suitability, acceptability and feasibility. Suitability differs from acceptability and feasibility in that little can be done with an unsuitable strategy. However, it may be possible to adjust the factors that suggest a strategy is not acceptable or not feasible. Therefore, suitability should be assessed first.

3.1

Suitability Suitability relates to the strategic logic of the strategy. The strategy must fit the company's operational circumstances. Will the strategy: 

Exploit company strengths and distinctive competences?



Rectify company weaknesses?



Neutralise or deflect environmental threats?



Help the firm to seize opportunities?



Satisfy the goals of the organisation? (And, at a more general level, does it fit with the company's mission and objectives?)



Fill the gap identified by gap analysis?



Generate/maintain competitive advantage?



Involve an acceptable level of risk?



Suit the politics and corporate culture?

An organisation should also consider two overall important strategic issues when assessing the suitability of an option: 

Does it fit with any existing strategies that the company is already employing, and which it wants to continue to employ?



How well will the option actually address the company's strategic issues and priorities?

A number of the models which we have looked at in Chapters 1 and 2 of this Study Manual could be useful for assessing the suitability of a strategy: Porter's generic strategies – For example, if an organisation is currently employing a cost leadership strategy and the basis of a proposed strategy is differentiation, this might not be suitable. Value chain – Similar issues could be identified in relation to the activities in the organisation's value chain: will the activities required for the proposed strategy 'fit' with the nature of the activities in the organisation's current value chain? BCG matrix – How will any new products or business units fit with the existing ones in an organisation's portfolio? Will they improve the balance of the portfolio? Ansoff's matrix – Is the choice of product-market strategy suitable? For example, in order for a market development strategy to be suitable, there have to be unsaturated markets available which the organisation could move into. At the same time, the organisation's product or service has to be more attractive to customers than any existing competitor offerings so that the customers in the new market will want to switch to the organisation's product.

3.2

Acceptability (to stakeholders) The acceptability of a strategy relates to people's expectations of it. It is here that stakeholder analysis can be brought in. (a)

Financial considerations. Strategies will be evaluated by considering how far they contribute to meeting the dominant objective of increasing shareholder wealth.

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(i) (ii) (iii) (iv) (v) (vi) (vii)

3.3

Return on investment Profits Growth EPS Cash flow Price/Earnings Market capitalisation

(b)

Customers. Will the strategy give customers something they want? How will customers react to the strategy? Customers may object to a strategy if it means reducing service or raising price, but on the other hand, they may have no choice but to accept the changes.

(c)

Management have to implement the strategy via their staff.

(d)

Staff have to be committed to the strategy for it to be successful. If staff are unhappy with the strategy, they could leave.

(e)

Suppliers have to be willing and able to meet the input requirements of the strategy.

(f)

Banks are interested in the implications for cash resources, debt levels etc.

(g)

Government. A strategy involving a takeover may be prohibited under monopolies and mergers legislation. Similarly, the environmental impact may cause key stakeholders to withhold consent.

(h)

The public. The environmental impact may cause key local stakeholders to protest. Will there be any pressure groups who oppose the strategy?

(i)

Risk. Different shareholders have different attitudes to risk. A strategy that changed the risk/return profile, for whatever reason, may not be acceptable.

Feasibility Feasibility asks whether the strategy can, in fact, be implemented.     

Is there enough money? Is there the ability to deliver the goods/services specified in the strategy? Can we deal with the likely responses that competitors will make? Do we have access to technology, materials and resources? Do we have enough time to implement the strategy?

An evaluation of an organisation's resources or competences (akin to a resource audit) could also be useful for assessing feasibility. Does the organisation have the resources it needs to implement the strategy successfully? Strategies that do not make use of the existing competences, and which therefore call for new competences to be acquired, might not be feasible.  

Gaining competences via organic growth takes time Acquiring new competences can be costly

Aspects of feasibility are very important in relation to strategic choice because they may restrict the choices that are available to an organisation. For example, if an organisation does not have the finance available to support an expansion plan, it will not be able to implement that expansion plan.

3.4

Sustainability Some organisations may feel it is appropriate to consider the longer term prospects for a strategy under a separate heading of sustainability. This indicates that a firm should aim to adopt strategies that will deliver a long-term competitive advantage. Importantly, when thinking about 'sustainability', organisations need to consider not only environmental sustainability, but also whether their business model is economically and socially sustainable. We will look at these ideas of 'the triple bottom line' (of economic prosperity, environmental quality, and social equity)

1 Evaluating strategic options 1.1

Investment decisions Under the heading of 'Acceptable', particular consideration will be paid to the returns available to shareholders. In the context of a profit seeking organisation such as a listed company the financial

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returns will be of paramount importance. The techniques used to assess the likely returns on investment will include: (a) (b) (c) (d) (e) (f)

Net Present Value Internal Rate of Return Payback Period Return on Capital Employed Return on Investment Residual Income

If the organisation in question is a Non-profit making concern, such as a charity or government – owned institution, then Value for Money will be more relevant than the actual returns.

1.2

Risk analysis Definition Risk: Risk refers to the quantifiable spread of possible outcomes. All business opportunities will be exposed to risks of differing types and to differing degrees. When faced with competing investment opportunities, the degree of risk faced can be the deciding factor. This is because investors will want to be rewarded with a level of return that is commensurate with the degree of risk faced. As such, when assessing financial acceptability, riskier opportunities must deliver proportionally higher returns. Some of the investment appraisal methods highlighted earlier can be adjusted to factor in some of the risks by using an appropriate discount factor as an investment hurdle.

1.3

The importance of assurance and due diligence The nature of strategic evaluation means that businesses have to make choices and take decisions about what course of action, or what strategy, to pursue. In order to take these decisions, businesses need adequate, relevant and reliable information. However, in relation to key strategic choices (such as, whether or not a company should acquire another company) problems may arise when one party to a transaction has more, or better, information than the other party. In other words, there is information asymmetry. This problem is exacerbated by the fact that frequently there is an incentive for the party with greater information to use their superior position to gain an unfair advantage in a transaction. For example, if an acquisition target presents an optimistic forecast of its level of future earnings, this could lead to the purchase price for the company (and therefore the sale proceeds earned by its shareholders) being greater than if a less optimistic forecast had been presented. Although the company hoping to make the acquisition will be able to review the statutory audited financial statements of the target company, these may not be sufficient to narrow the information gap between the purchasers and vendors, because the financial statements are prepared for a different purpose. A greater, and more specific, level of assurance may therefore be required for acquisitions, mergers, or joint ventures. The most common type of assurance in this context is a report of due diligence. There are several different forms of due diligence, some of which are carried out by accountants and financial consultants, while other aspects require the expertise of other specialist skills. Due diligence will attempt to achieve the following:     

Confirm the accuracy of the information and assumptions on which a bid is based. Provide the bidder with an independent assessment and review of the target business. Identify and quantify areas of commercial and financial risk. Give assurance to providers of finance. Place the bidder in a better position for determining the value of the target company.

The precise aims will, however, depend upon the types of due diligence being carried out. Due diligence could be financial, commercial or operational, although ultimately due diligence shouldn’t only be focused on compliance – it is also about having confidence in the people you do business with, and having a better understanding of their business.

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4.3.1

Financial due diligence Financial due diligence is a review of the target company's financial position, financial risk and projections (for example, in relation to earnings and cashflows). However, it is not the same as a statutory audit: its purposes are more specific to an individual transaction and to particular user groups, and there is normally a specific focus on risk and valuation. Another difference between financial due diligence and a statutory audit concerns the importance of projections. The focus of a statutory audit is primarily historical – reporting on actual performance and results – whereas projections are, by definition, forward-looking. Therefore, an accountant undertaking financial due diligence may need to gain assurance over prospective financial information.

4.3.2

Commercial due diligence Commercial due diligence complements financial due diligence by considering the target company's markets and external economic environment. The information used in commercial due diligence work may come from the target company and its business contacts, but it may also come from external information sources. It is important that the people carrying out commercial due diligence have a good understanding of the industry in which the target company operates. In this respect, it may be appropriate for people other than accountants to carry out commercial due diligence work. The information that is relevant to commercial due diligence is likely to include the following:

4.3.3

    

Analysis of main competitors Marketing history/tactics Competitive advantages Analysis of resources Strengths and weaknesses

        

Integration issues Supplier analysis Market growth expectations Ability to achieve forecasts Critical success factors Key performance indicators Exit potential Management appraisal Strategic evaluation

Operational due diligence Operational due diligence considers the operational risks and possible improvements which can be made in a target company. In particular, it will:  

4.3.4

Validate vendor assumed operational improvements in projections Identify operational upsides that may increase the value of the deal

Technical due diligence In many industries the potential for future profitability, and thus the value of the company, may be largely dependent upon developing successful new technologies. A judgement therefore needs to be made as to whether any technological benefits that have been promised by the vendor are likely to be delivered. This is very common in a whole range of different industries, including electronics, IT, pharmaceuticals, engineering, biotechnology, and product development. Such technological judgements are beyond the scope of accounting expertise, but nevertheless the credibility of technological assumptions may be vital to the valuation process. Reliance will thus need to be placed upon the work of relevant experts.

4.3.5

Information technology due diligence IT due diligence assesses the suitability and risks arising from IT factors in the target company (for example, any issues surrounding IT security, or integrating IT systems post-acquisition). These risks are likely to be relevant to most companies, but have particular significance where the target company operates in the IT sector.

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4.3.6

Legal due diligence Legal issues arising on an acquisition are likely to be relevant to the following: 

Valuation of the target company – eg hidden (or pending) liabilities, uncertain rights, onerous contractual obligations.



The acquisition process – eg establishing the terms of the takeover (the investment agreement); contingent arrangements; financial restructuring; rights; duties and obligations of the various parties.



The new group – eg new articles of association, rights of finance providers, restructuring.

Reliance will need to be placed on lawyers for this process.

Human resources due diligence Protecting and developing the rights and interests of human resources may be key to a successful acquisition. There may also be associated legal obligations (for example, obligations under a pension scheme, or regulations which protect employees' terms and conditions of employment when a business is transferred from one owner to another).

4.3.7

Tax due diligence Information will need to be provided to allow the potential purchaser to form an assessment of the tax risks and benefits associated with the company to be acquired. Purchasers will wish to assess the robustness of tax assets, and gain comfort about the position regarding potential liabilities (including a possible latent gain on disposal due to the low base cost). Information relating to any tax warranties that the vendor might offer should also be made available with the due diligence report as part of the 'marketing' information. This should generally not form a part of the due diligence itself though.

2 International strategies 2.1

Internationalisation th

In the last half of the 20 century, and now into the 21 century, the volume of world trade has been increasing significantly. There have been several factors at work. (a)

Reduced protectionism. Historically, some countries tried to protect local producers by imposing tariffs or quotas on imported products. However, many countries are now members of trade associations (such as 1 EU, ASEAN, MERCOSUR ) that encourage international trade and restrict protection.

(b)

Export-led growth. The success of this particular strategy has depended on the existence of open markets elsewhere. Japan, South Korea and the other Asian 'tiger' economies (eg Taiwan) have chosen this route.

(c)

Market convergence. Transnational market segments have developed whose characteristics are more homogeneous than the different segments within a given geographic market. Youth culture is an important influence here.

(d)

Internet. Customers and markets are no longer restricted by time or geographical limitations. As such, the internet makes it much easier for consumers to make purchases from suppliers in other countries.

Internationalisation has meant a proliferation of suppliers exporting to, or trading in, a wider variety of places. In many domestic markets, it is now likely that the same international companies will be competing with one another. However, the existence of global markets should not be taken for granted in terms of all products and services, or indeed in all territories. (a)

Some services are still subject to managed trade (for example, some countries prohibit firms from other countries from selling insurance). Trade in services has been liberalised under the auspices of the World Trade Organisation.

(b)

Immigration. There is unlikely ever to be a global market for labour, given the disparity in skills between different countries and restrictions on immigration.

(c)

The market for some goods is much more globalised than for others. (i)

Upmarket luxury goods may not be required or afforded by people in developing nations.

(ii)

Some goods can be sold almost anywhere, but to limited degrees. Television sets are consumer durables in some countries, but still luxury or relatively expensive items in other ones.

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(iii) Other goods are needed almost everywhere. With oil a truly global industry exists in both production (eg North Sea, Venezuela, Russia, Azerbaijan, Gulf states) and consumption (any country using cars and buses, not to mention those with chemical industries based on oil). 1

EU: European Union; ASEAN: Association of South-East Asian nations (Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore; Thailand & Vietnam); MERCOSUR: an economic and political agreement to promote free trade among Argentina, Bolivia, Brazil, Paraguay, Uruguay & Venezuela, with Chile, Colombia, Ecuador, Guyana, Peru & Surinam as associate members.

2.2

Key decisions in international expansion There are two fundamental approaches to internationalising production: cost or competence-led, and market-led. Cost or competence-led location In this approach, production decisions are taken on the basis of the technology to be adopted, the scale of production (how many units per year) and the inherent characteristics of the location. Company choices are then determined by a desire to obtain the cheapest – or, rather, best value or most cost effective – place to obtain supplies. The cost reduction opportunities must be sufficient to overcome any cost and inconvenience incurred in subsequently transporting goods to market. With regard to location, labour is a major factor in terms of its cost, quality, productivity and its flexibility. This helps to explain why many clothing companies now use (cheap) labour in South East Asian countries to manufacture garments which are subsequently exported for sale to Western Europe and America. Market-led location Alternatively, a company may choose to locate some of its production activities inside a particularly attractive market, in order to benefit from customer demand in that market. International expansion is a major undertaking and firms must know their reasons for it, and be sure that they have the resources to manage it, both strategically and operationally. The decision about which overseas market to enter should be based upon assessment of market attractiveness, competitive advantage, and risk. Firms must deal with three major issues:   

5.2.1

Whether to market abroad at all Which markets to enter The mode(s) of entry

Deciding whether to market abroad Firms may be pushed into international expansion by domestic adversity, or pulled into it by attractive opportunities abroad. More specifically, some of the reasons firms expand overseas are the following, which can be classified as either internal or external factors.

(a)

Chance. Firms may enter a particular country or countries by chance. A company executive may recognise an opportunity while on a foreign trip or the firm may receive chance orders or requests for information from potential foreign customers.

(b)

Life cycle. Home sales may be in the mature or decline stages of the product life cycle. International expansion may allow sales growth, since products are often in different stages of the product life cycle in different countries. For example, if a product is at the mature stage of its life cycle in a firm's home market, it could be beneficial to expand into an emerging market where the product may be at the introductory or growth stages of the life cycle.

(c)

Competition. Intense competition in an overcrowded domestic market sometimes induces firms to seek markets overseas where rivalry is less keen.

(d)

Reduce dependence. Many companies wish to diversify away from an over-dependence on a single domestic market. Increased geographic diversification can help to spread risk.

(e)

Economies of scale. Technological factors may be such that a large volume is needed either to cover the high costs of plant, equipment, R&D and personnel or to exploit a large potential for economies of scale and experience. For these reasons firms in the aviation, ethical drugs, computer and automobile industries are often obliged to enter multiple countries.

(f)

Cheaper sources of raw materials. Access to cheaper raw materials, or cheaper labour, could be a source of competitive advantage for an organisation, particularly if it is pursuing a cost leadership strategy.

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(g)

Financial opportunities. Many firms are attracted by favourable opportunities such as: – – – –

The development of lucrative emerging markets (such as India and China) Depreciation in their domestic currency values (increasing the value of exports) Corporate tax benefits offered by particular countries Lowering of import barriers or other restrictions (such as tariffs and quotas)

International expansion Before getting involved in international expansion, the company must consider both strategic and tactical issues. (a)

Strategic issues (i)

Does the strategic decision fit with the company's overall mission and objectives? Or will 'going international' cause a mis-match between objectives on the one hand, and strategic and tactical decisions, on the other?

(ii)

Will the operation make a positive contribution to shareholders' wealth?

(iii) Does the organisation have (or can it raise) the resources necessary to exploit effectively the opportunities overseas? (b) Tactical issues (i)

How can the company get to understand customers' needs and preferences in foreign markets? Are the company's products appropriate to the target market?

(ii)

The company's performance will reflect the local economic environment, as well as management's control of the business. So the company needs to understand the economic stability and prospects of the target country before investing in it.

(iii) Cultural issues. Does the company know how to conduct business abroad, and deal effectively with foreign nationals? For example, will there be language problems? Are there any local customs to be aware of? (iv) Are there foreign regulations and associated hidden costs? (v)

Does the company have the necessary management skills and experience?

(vi) Have the foreign workers got the skills to do the work required? Will they be familiar with any technology used in production processes? we distinguished between resources and competences, and such a distinction could also be useful here. A number of the 'issues' listed above relate to resources and skills, but perhaps a more important overall consideration for a firm is whether it has the core competences required in order to expand internationally. Social responsibility Before moving to a foreign country, an organisation should also consider whether there are any corporate social responsibility (CSR) implications of such an expansion. For example, if local labour laws allow workers to be employed for low wages and in poor working conditions, does the organisation take advantage of this, or does it treat its workers better than it has to? Similarly, if pollution laws are not very strict, does the organisation comply with the minimum requirements or does it build more environmentally friendly facilities than it has to? In both cases, the socially responsible course of action may not be the one that maximises short-term profits. But the organisation needs to consider its reputation as a whole, and its CSR position as a whole. If it is seen to be exploiting workers in one country, this could damage its brand more widely. For example, over 1,100 workers were killed when three clothing factories in Savar, Bangladesh collapsed following a fire in April 2013. The factories supplied clothes to a range of international brands, including Primark, Mango and C&A, and labour groups and trade unions internationally began calling for immediate action to improve the working conditions in factories to reduce the risk of further, similar accidents occurring. The importance of considering the CSR implications of foreign expansion is reiterated by the increasing importance of social and environmental reporting in companies' annual reports. For example, in the UK, the Companies Act 2006 requires all listed companies to report on environmental and social issues, including issues down their supply chains. As a result, the potential social or environmental issues associated with the foreign expansion could

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become, in their own right, a significant factor in a company's decision about whether to expand internationally, and about how or where to expand.

5.2.2

Deciding which markets to enter In making a decision as to which market(s) to enter, the firm must start by establishing its objectives. Here are some examples. (a)

What proportion of total sales will be overseas?

(b)

What are the longer term objectives?

(c)

Will it enter one, a few, or many markets? In most cases, it is better to start by selling in countries with which there is some familiarity and then expand into other countries gradually as experience is gained. Reasons to enter fewer countries at first include the following: (i) (ii) (iii) (iv)

Market entry and market control costs are high Product and market modification costs are high There is a large market and potential growth in the initial countries chosen Dominant competitors can establish high barriers to entry

The best markets to enter are those located at the top left of the diagram. The worst are those in the bottom right corner. Obtaining the information needed to reach this decision requires detailed and often costly international marketing research and analysis. Making these decisions is not easy, and a fairly elaborate screening process will be instituted. In international business there are several categories of risk. (a)

Political risk relates to factors as diverse as wars, nationalisation, arguments between governments etc.

(b)

Business risk. This arises from the possibility that the business idea itself might be flawed. As with political risk, it is not unique to international marketing, but firms might be exposed to more sources of risk arising from failures to understand the market.

(c)

Currency risk. This arises out of the volatility of foreign exchange rates. Given that there is a possibility for speculation and that capital flows are free, such risks are increasing.

(d)

Profit repatriation risk. Government actions may make it hard to repatriate profits.

Market analysis Firms need to analyse different markets before deciding which ones to enter. The following questions should be considered within such analysis: 

Submarkets – What submarkets are there within the market; defined by different price points, or niches for example?



Size and growth – What are the size and growth characteristics of the market and submarkets within it? What are the driving forces behind trends in sales? What are the major trends in the market?



Profitability – How profitable is the market and its submarkets now, and how profitable are they likely to be in the future? How intense is the competition between existing firms? How severe are the threats from potential new entrants of substitute products? What is the bargaining power of suppliers and customers?



Cost structure – What are the major cost components for various types of competitor, and how do they add value for customers?



Distribution channels – What distribution channels are currently available? How are they changing?  Key success factors – What are the key success factors, assets and competences needed to compete successfully? How are these likely to change in the future? Can the organisation neutralise competitors' assets and competences?

5.2.3

Choosing modes of entry The most suitable mode of entry varies:

(a)

Among firms in the same industry (eg a new exporter as opposed to a long-established exporter)

(b)

According to the market (eg some countries limit imports to protect domestic manufacturers, whereas others promote free trade)

(c)

Over time (eg as some countries become more, or less, hostile to direct inward investment by foreign companies)

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2.3

Market entry modes Exporting Goods are made at home but sold abroad. It is the easiest, cheapest and most commonly used route into a new foreign market.

5.3.1

5.3.2

Advantages of exporting (a)

Exporters can concentrate production in a single location, giving economies of scale and consistency of product quality.

(b)

Firms lacking experience can try international marketing on a small scale.

(c)

Firms can test their international marketing plans and strategies before risking investment in overseas operations.

(d)

Exporting minimises operating costs, administrative overheads and personnel requirements.

Indirect exports Indirect exporting is where a firm's goods are sold abroad by other organisations who can offer greater market knowledge.

5.3.3

(a)

Export houses are firms that facilitate exporting on behalf of the producer. Usually the producer has little control over the market and the marketing effort.

(b)

Specialist export management firms perform the same functions as an in-house export department but are normally remunerated by way of commission.

(c)

UK buying offices of foreign stores and governments.

(d)

Complementary exporting ('piggy back exporting') occurs when one producing organisation (the carrier) uses its own established international marketing channels to market (either as distributor, or agent or merchant) the products of another producer (the rider) as well as its own.

Direct exports Direct exporting occurs where the producing organisation itself performs the export tasks rather than using an intermediary. Sales are made directly to customers overseas who may be the wholesalers, retailers or final users. (a)

Sales to final user. Typical customers include industrial users, governments or mail order customers.

(b)

Strictly speaking an overseas export agent or distributor is an overseas firm hired to effect a sales contract between the principal (ie the exporter) and a customer. Agents do not take title to goods; they earn a commission (or profit).

(c)

Company branch offices abroad. A firm can establish its own office in a foreign market for the purpose of marketing and distribution, as this gives greater control.

A firm can manufacture its products overseas, either by itself or by using an overseas manufacturer.

5.3.4

Overseas production Benefits of overseas manufacture 

A better understanding of customers in the overseas market.



Economies of scale in large markets.



Production costs are lower in some countries than at home.



Lower storage and transportation costs.



Overcomes the effects of tariff and non-tariff barriers.



Manufacture in the overseas market may help win orders from the public sector.

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5.3.5

Contract manufacture Licensing is a quite common arrangement as it avoids the cost and problems of setting up overseas. In the case of contract manufacture a firm (the contractor) makes a contract with another firm (the contractee) abroad whereby the contractee manufactures or assembles a product on behalf of the contractor. Contract manufacture is suited to countries where the small size of the market discourages investment in plants; and to firms whose main strengths are in marketing, rather than production. Advantages of contract manufacture     

No need to invest in plants overseas Lower risks associated with currency fluctuations Risk of asset expropriation is minimised Control of marketing is retained by the contractor Lower transport costs and, sometimes, lower production costs

Disadvantages of contract manufacture    

5.3.6

Suitable overseas producers cannot always be easily identified The need to train the contractee producer's personnel The contractee producer may eventually become a competitor Quality control problems in manufacturing may arise

Wholly owned overseas production Production capacity can be built from scratch, or, alternatively, an existing firm can be acquired. (a)

Acquisition has all the benefits and drawbacks of acquiring a domestic company.

(b)

Creating new capacity can be beneficial if there are no likely candidates for takeover, or if acquisition is prohibited by the government.

Advantages (a) (b) (c) (d) (e)

The firm does not have to share its profits with partners of any kind. The firm does not have to share or delegate decision-making. There are none of the communication problems that arise in joint ventures. The firm is able to operate completely integrated international systems. The firm gains a more varied experience from overseas production.

Disadvantages

5.3.7

(a)

The investment needed prevents some firms from setting up operations overseas.

(b)

Suitable managers may be difficult to recruit at home or abroad.

(c)

Some overseas governments discourage, and sometimes prohibit, 100% ownership of an enterprise by a foreign company.

(d)

This mode of entry forgoes the benefits of an overseas partner's market knowledge, distribution system and other local expertise.

Outsourcing and Off-shoring Although outsourcing or off-shoring are not primarily growth strategies, they are business strategies that could relate to an organisation relocating some of its activities. A number of companies in developed countries have outsourced some of their operations to foreign countries where they can be performed more cheaply. Outsourcing is the contracting out of specified operations or services to an external provider. By removing some of an organisation's work, outsourcing allows an organisation to devote more time to the activities which it continues to perform in-house. Generally speaking, outsourcing is appropriate for peripheral activities, meaning an organisation has more time to concentrate on its core activities and competences. A further advantage of outsourcing is that external suppliers may capture economies of scale and experience effects. This allows them to provide the function being outsourced at a lower cost than if the organisation had retained it in house. Getting the best out of outsourcing depends on successful relationship management, rather than through the use of formal control systems.

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Outsourcing of non-core activities is widely acknowledged as having the potential to achieve important cost savings. Advantages (a)

Can save on costs by making use of a specialist provider's economies of scale

(b)

Can increase effectiveness where the supplier deploys higher levels of expertise (eg in software development)

(c)

Allows the organisation to focus on its own core activities/competences

(d)

Can deliver benefits and change more quickly than business process reorganisation in-house

(e)

Service level agreements mean that the company knows the level of service they can expect

Disadvantages (a)

There may be problems finding a single supplier who can manage complex processes in full. If more than one supplier has to be used for a single process, then the economies of scale are likely to be reduced.

(b)

Firms may be unwilling to outsource whole processes due to the significance of those processes or the confidentiality of certain aspects of them. (This could be a particular problem if the contractor company is also working for competitors.) Again, if processes are fragmented in this way, the economies of scale may be reduced.

(c)

Outsourcing can lead to loss of control, particularly in relation to quality issues. This occurs when agreed service levels are not met. The firm that is outsourcing activities now has to develop competences in relationship management (with the outsourced suppliers) in place of its competences in the processes it has outsourced.

(d)

Firms may be tied to inflexible, long term contracts.

(e)

If there are specialist skills involved in the work, it may be difficult to switch to a new supplier if there are problems, or at the end of a contract period. This gives the external contractor significant bargaining power.

The outsourcing decision needs to be treated with care. The advantages it delivers will largely be seen in the short-term, but there could be longer-term disadvantages in relation to loss of control, quality or knowledge. Therefore, both the short-term and longer-term implications need to be considered before an organisation chooses to outsource.

5.3.8

Strategic alliances Alliances were discussed in Section 2.10 of this chapter, and the nature of alliances lends itself to crossborder cooperation.

5.3.9

Joint ventures Some governments discourage, or even prohibit, foreign firms setting up independent trading companies, and as such a joint venture with a domestic company may be the only route available. We looked at joint ventures at Section 2.8 earlier in the chapter, but should note here that international joint ventures are a popular way for companies to enter new markets. Joint ventures allow companies to gain access to a partner's resources, including markets, capital, technologies and people. International joint ventures can be a practical way for multinational companies to enter new markets, while the performance of local companies can also be enhanced by working with multinational partners (for example, as a result of knowledge transfer or technology transfer from the multinational partners). Forming a joint venture (with the right partner) can be an effective way of achieving access to efficient and effective distribution channels and established customer bases. While partnering with a local firm may be attractive to a foreign company if it doesn't have experience in such a market, in some cases establishing a joint venture may be necessary if there are barriers to foreign-owned or foreign-controlled companies in a country.

2.4

International value chain One of the key developments in the modern business world has been the internationalisation (or globalisation) of business markets and supply chains. The global supply chain presents opportunities and threats for organisations.

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Lower cost inputs â&#x20AC;&#x201C; Gaining access to low-cost products made abroad represents an opportunity for companies based in developed countries to lower their input costs. On the other hand, for organisations that fail to utilise low-cost foreign suppliers, the existence of these suppliers could represent a threat, which puts them at a competitive disadvantage. The purchasing activities of large companies have become increasingly complicated as a result of different countries around the world developing different skills and competences. It is in the best interests of companies to search out the lowest-cost, highest-quality suppliers, wherever they may be. Moreover, the internet and global communications make it possible for companies to co-ordinate complicated multinational sales or purchases. One commonly exploited opportunity for Western companies is global outsourcing.

Definition Global outsourcing: The purchase of inputs from foreign suppliers or the production of inputs in foreign countries to lower production costs or to improve product design and quality.

2.5

Foreign exchange rates and financial statements (IAS 21) For the accountant in business, an important consideration in relation to international expansion will be the potential impact that exchange differences could have on cash flows and profits, and on the financial statements. International strategies may expose an organisation to risks relating to foreign exchange gains and losses. In your exam you may need to advise a company on the financial reporting aspects of overseas trading; that is, the 'translation gains and losses'. The relevant International Accounting Standard is IAS 21, The Effects of Changes in Foreign Exchange Rates. The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity, and how to translate financial statements into a presentation currency. The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements.

Definitions Functional currency: The currency of the primary economic environment in which the entity operates. Presentation currency: The currency in which financial statements are presented. The basic steps in translating foreign currency transactions are: 1 2 3

5.6.1

The reporting entity determines its functional currency The entity translates all foreign currency items into its functional currency The entity reports the effects of translation and the associated tax impact in its financial statements

Foreign currency transactions: initial recognition An entity is required to recognise foreign currency transactions in its functional currency. The entity should achieve this by translating the foreign currency amount at the spot exchange rate between the functional currency and the foreign currency at the date on which the transaction took place. Average rate â&#x20AC;&#x201C; Where an entity has a high volume of transactions in foreign currencies, translating each transaction may be an onerous task, so an average rate may be used. For example, a duty-free shop at Heathrow airport may receive a large amount of dollars and euros every day and may opt to translate each currency into sterling using an average weekly rate. Similarly, a business whose sales occur relatively evenly throughout year (ie its business is not seasonal) could use an average rate for the year rather than using an actual rate for every transaction. (IAS 21 provides no further guidance on how an average rate should be determined, so an entity should develop a method which is easily implemented with regard to any limitations in its accounting systems).

5.6.2 20

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A foreign currency transaction may give rise to assets or liabilities which are denominated in a foreign currency. These assets and liabilities will need to be translated into the entity's functional currency at each reporting date. The basis on which they are translated depends on whether the assets or liabilities are monetary or non-monetary items.

Definitions Monetary items: Are units of currency held, and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. (Examples of monetary items include: cash and bank balances; trade receivables and payables; loan receivables and payables.) Non-monetary items: A non-monetary item does not give the right to receive, or create the obligation to deliver, a fixed or determinable number of units of currency. (Examples of non-monetary items include: amounts prepaid for goods and services; goodwill; intangible assets; inventories; property, plant and equipment.) At each subsequent reporting date the following rules should be applied.

5.6.3



Monetary items: Foreign currency monetary items should be translated and then reported using the closing rate.



Non-monetary items carried at historical cost are translated using the exchange rate at the date of the transaction when the asset or liability arose.



Non-monetary items carried at fair value are translated using the exchange rate at the date when the fair value was determined.

Recognition of exchange differences Exchange differences arise: 

On a re-translation of a monetary item at the year end (eg if a foreign currency receivable remains outstanding at the year end). The exchange difference is the difference between initially recording the items at the rate ruling at the date of the transaction and the subsequent retranslation of the monetary item to the rate ruling at the reporting date. Such exchange differences should be reported as part of the profit or loss for the year.



When a monetary item is settled in cash (eg a foreign currency payable is paid) These exchange differences should also be recognised as part of the profit or loss for the period in which they arise. There are two situations to consider here:



(a)

The transaction is settled in the same period as that in which it occurred: in this case, all the exchange difference is recognised in that period.

(b)

The transaction is settled in a settled in a subsequent accounting period: an exchange difference is recognised in each intervening period up to the period of settlement, determined by the change in exchange rates during that period. A further exchange difference is recognised in the period of settlement.

Where there is an impairment, revaluation or other fair value change in a non-monetary item These are recognised as follows:

5.6.4

(a)

When a gain or loss on a non-monetary item is recognised as other comprehensive income (for example, where property denominated in a foreign currency is revalued) any related exchange differences should also be recognised as other comprehensive income.

(b)

When a gain or loss on a non-monetary item (eg fair value change) is recognised in profit or loss, any exchange component of that gain or loss is also recognised in profit or loss.

Foreign currency translation and financial statements The previous section has looked at the requirements for the translation of foreign currency transactions. However, foreign currency translation will also be required when foreign activities are undertaken through foreign operations (eg foreign subsidiaries) whose financial statements are based on a different functional currency than that of the parent company.

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133

IAS 21 identifies the appropriate exchange rate which should be used for translating the financial statements of the foreign operation into the reporting entity's presentation currency. The following procedures should be followed to translate an entity's financial statements from its functional currency into a presentation currency: 

Translate all assets and liabilities (both monetary and non-monetary) in the current statement of financial position using the closing rate at the reporting date



Translate income and expenditure in the current statement of profit or loss and other comprehensive income using the exchange rates ruling at the transaction dates. (An approximation to actual rate is normally used; being the average rate.)



Report the exchange differences which arise on translation as other comprehensive income. (Where a foreign subsidiary is not wholly-owned, allocate the relevant portion of the exchange difference to the non-controlling interest.)

Note that the comparative figures are the presentation currency amounts as presented the previous year. The exchange differenced arising when translating the financial statements of foreign operations are reporting as other comprehensive income (rather than as part of the profit or loss for the year) because they have not resulted from any exchange risks to which the entity is exposed. The differences have arisen purely through changing the currency in which the financial statements are presented. To report these exchange differences in profit or loss would distort the results from the trading operations, as shown in the functional currency financial statements, since these differences are unrelated to the foreign operation's trading performance or financial operation.

5.6.5

Reporting foreign currency cash flows Statement of cash flows As we noted at the start of Section 5.6 exchange differences could also have an impact on an entity’s statement of cash flows. 

Where an entity enters into foreign currency transactions which result in an inflow or outflow of cash, the entity should translate cash flows into its functional currency at the transaction date.



Although transactions should be translated at the date that they occurred, for practical reasons IAS 21 permits the use of an average rate where it approximates to actual.

Foreign subsidiaries A similar approach is required where an entity has a foreign subsidiary. The transactions of the subsidiary should be translated into the reporting entity's functional currency at the transaction date.

Reporting translation differences Although the translation of foreign currency amounts does not affect the cash flow of an entity, translation differences relating to cash and cash equivalents are part of the changes in cash and cash equivalents during a period. Such amounts should therefore form part of the statement of cash flows. IAS 7 requires the effect of exchange rate movements to be reported separately from operating, investing and financing activities. Where an entity adopts the indirect method of calculating cash flows from operating activities and it has foreign currency amounts which have been settled during the period, no further adjustment is required at the period end. This is because any foreign exchange difference will already include the amount of the original foreign currency transaction and the actual settlement figure. An overseas purchase will be recorded using the purchase date exchange rate and a payable will be recorded. On settlement, any adjustment to the actual cash flow paid will be recognised in profit or loss as part of the entity's operating activities. Unsettled foreign currency amounts in relation to operating activities, such as trade receivables and payables, are not adjusted at the period end because such amounts are retranslated at the reporting date and the exchange difference is reported in profit or loss already. Where an entity uses the indirect method for calculating its operating cash flows, it starts with the profit figure which will include the retranslation difference, and the movement in the period for receivables and payables will also include a similar amount. Since the two amounts effectively eliminate each other, no adjustment is required.

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5.6.6

Exchange rates and financial performance It should be noted that, in your Strategic Business Management exam, your focus should be the consequences of business decisions, not simply the reporting mechanics. For instance you should be able to advise a company on the financial reporting impact of a decision to manufacture in a foreign country, versus manufacturing domestically and exporting abroad. Such a decision has a fundamental impact on the way foreign exchange gains or losses are reported. As we have seen in Sections 5.6.3 and 5.6.4 above, any exchange difference arising from individual transactions in foreign currencies is recognised in profit or loss. However, exchange differences arising from the translation of the accounts of foreign operations prior to consolidation are reported as other comprehensive income. Equally, you should be prepared to advise a company on how a decision to manufacture abroad could affect its performance. For example, if exchange rates in the foreign country appreciate against the rates in the countries where products are sold, what effect could this have on the sales price (or the margin which is earned on the products)? Exchange rate movements can affect the price of both imported goods and services, and exported goods and services. Importantly, this could apply not only to transactions with third parties, but also to 'internal' transactions within a supply chain. Companies can deal with currency fluctuations in a number of ways:

5.6.7



Currency matching – Trying to ensure that assets/liabilities and revenues/costs are incurred in the same currency.



Foreign currency hedging – Financial instruments (such as forward contracts, foreign currency futures, money market hedges or currency options) can be obtained from financial markets to reduce a company's exposure to unfavourable exchange rate movements. The detail of foreign currency hedging, and the appropriate accounting treatment for it (as prescribed by IAS 39) is covered in Chapter 15 of this Study Manual.



Market entry strategies – A company could use a market entry strategy (eg licensing) which takes account of local currencies. So, for example, the local agent could operate in a local currency, but remit their license fee in the company's 'home' currency – so the risk relating to any exchange movements rests with the local agent.

Multinational companies and taxation Although this issue does not relate to foreign exchange rates, one other important issue to consider in relation to multi-national businesses is transfer pricing. This could be particularly important in relation to tax planning, and there have been a number of high profile media stories in 2013 where it has been suggested that companies such as Starbucks have used transfer pricing to reduce the amount of tax they pay in the UK. For example, it has been suggested that Starbuck's corporation (based in the USA) charges its UK operation high prices for such things as the 'use of its logo' while the Swiss-based firm, Starbucks Coffee Trading Co. also earns a 'moderate profit' on the price it charges Starbucks UK for its coffee beans.

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133

Strategic Business Management Chapter- 3

Strategic implementation 1 Acquisitions and strategic alliances 1.1

Acquisitions Many companies consider growth through acquisitions or mergers. However, it is important for a company to understand its reasons for acquisition, and equally important that those reasons are valid in terms of its strategic plan. Acquisitions can provide a means of entering a market – or building up a market share – more quickly and/or at a lower cost than would be incurred if the company tried to develop its own resources. Corporate planners must, however, consider the level of risk involved. Acquiring companies in overseas markets is more risky for a number of reasons such as differences in culture and/or language, and differences in the way the foreign company is used to being managed. The acquirer should attempt an evaluation of the following:       

1.2

The prospects of technological change in the industry The size and strength of competitors The reaction of competitors to an acquisition The likelihood of government intervention and legislation The state of the industry and its long-term prospects The amount of synergy obtainable from the merger or acquisition The cultural fit between predator and target

The mechanics of acquiring companies As an accountant in business, you may be required to assess the value of an acquisition. We look in at the different valuation methods where we will also address the corporate reporting issues arising from acquisitions and mergers. However, at this point in the manual, we will simply note that there are a number of methods that could be used to value a company being acquired.

1.3.1

(a)

Price/earnings ratio: The market's expectations of future earnings. If it is high, it indicates expectations of high growth in earnings per share and/or low risk.

(b)

Accounting rate of return, whereby the company will be valued by estimated future profits over return on capital.

(c)

Value of net assets (including brands).

(d)

Dividend yield.

(e)

Discounted cash flows, if cash flows are generated by the acquisition. A suitable discount rate (eg the acquirer's cost of capital) should be applied.

(f)

Market prices. Shareholders may prefer to hang on for a better bid.

Takeovers or mergers financed by a share exchange arrangement Many acquisitions are paid for by issuing new shares in the acquiring company, which are then used to buy the shares of the company to be taken over in a 'share exchange' arrangement. An enlarged company might then have the financial 'muscle' and borrowing power to invest further so as to gain access to markets closed to either company previously because they could not individually afford the investment.

1.3.2

Acquisitions and earnings per share Growth in EPS will only occur after an acquisition in certain circumstances. (a)

When the company that is acquired is bought on a lower P/E ratio; or

(b)

When the company that is acquired is bought on a higher P/E ratio, but there is profit growth to offset this.

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1.3.3

Debt finance Another feature of takeover activities in the USA especially, but also in the UK, has been the debtfinanced takeover. This is a takeover bid where most or all of the purchase finance is provided by a syndicate of banks for the acquisition. The acquiring company will become very highly geared and will normally sell off parts of the target company. A leveraged buyout (LBO) is a form of debt-financed takeover where the target company is bought up by a team of managers in the company.

1.3.4

Assurance procedures and company valuations Accounting policies can have a significant impact on the valuation of acquisitions. They could be used to inflate the share price or to depress it. Optimistic accounting policies, valuing assets generously, bringing forward revenue recognition, and delaying provisions may inflate the company position and share price. On the other hand accelerating expenses or making very conservative estimates of future earnings may depress share prices. There may be agency issues with both approaches. Directors who wish to retain their own jobs may attempt to boost earnings, and hence share prices, to deter takeovers. On the other hand, directors who feel they can benefit if a takeover occurs may be tempted to depress a company's market valuation, even though shareholders may lose out as a result. These scenarios in which the interests of company directors (agents) may be different from those of the shareholders (principals), are indicative of the principal-agent problem.

The way companies are structured and operate means that managers and directors (agents) are placed in control of resources that are not their own, but have a contractual obligation to use those resources in the interests of their owners (the shareholders). The principal-agent problem arises when agents start using a company and its resources as a means to serve their own interests, rather than to maximise the total financial returns to the company's owners. Where actions taken by an agent deviate from the principal's best interest, this deviation is called an agency cost. With any acquisition or merger, shareholder value must be protected as far as possible, and thus it is essential to perform some level of due diligence. For example, it will be very important that management forecasts are evaluated critically to ensure they do not appear to be over- or under-stated. Assurance procedures in relation to acquisitions and mergers are considered in Chapter 12 of this Study Manual, although we have also already discussed due diligence in Chapter 2.

Definition Due diligence: Due diligence is a term that describes a number of concepts involving the investigation of a company prior to signing a contractual agreement. This assurance procedure is typically carried out by an external firm appointed by the purchasers. The provider of the due diligence will assume a duty of care towards the party that appoints them. The term due diligence is fairly wide in its application and extends far beyond a review of the target company's financial statements. For instance, specialist firms could be appointed to review the following areas:    

Information systems Legal status Marketing/brand issues Macro-environmental factors

   

Management capabilities Sustainability issues Production capabilities Plant and equipment

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1.3

Acquisitions and organic growth compared Advantages of acquisition Acquisitions are probably only desirable if organic growth alone cannot achieve the targets for growth that a company has set for itself. (a)

Acquisitions can be made to enter new product or geographical areas, or to expand in existing markets, much more quickly.

(b)

Acquisitions can avoid barriers to entry. If there are significant barriers to entry into a market (or if there is already intense competitive rivalry), then it might not be possible for a new entrant to join the market in its own right. However, acquiring an existing player in the market would enable a group to join that market.

(c)

Acquisitions can be made without cash, if share exchange transactions are acceptable to the company.

(d)

When an acquisition is made to diversify into new product areas, the company will be buying technical expertise, goodwill and customer contracts.

Disadvantages (or risks) of acquisitions (a)

Cost. They might be too expensive, and will involve high initial capital costs to acquire shareholdings in the target company. If the acquisition is resisted by the directors and shareholders of the target company, this may force the offer price to be increased further.

(b)

There could also be valuation issues here. The management of the target company are likely to know more about its true value than the acquiring company, and so it could be difficult to arrive at a fair price for the sale.

(c)

Customers of the target company might consider going to other suppliers for their goods.

(d)

Incompatibility. In general, the problems of assimilating new products, customers, suppliers, markets, employees and different systems of operating might create 'indigestion' and management overload in the acquiring company. One of the main reasons why acquisitions and mergers fail is because of the lack of 'fit' between the two companies.

(e)

Post-acquisition costs. Even if the acquisition goes ahead, there will be significant costs involved in integrating the acquired company's systems (production systems, IT systems etc) with those of the parent company.

(f)

Lack of information. Commentators have suggested that the 'acquisitions' market for companies is rarely efficient. This means that companies making an acquisition do not have perfect information about the company they are acquiring. This could mean that the price they pay for the acquisition is too high, and/or the future value the company brings to the group is lower than they had anticipated.

(g)

Cultural differences. There may be clashes if the culture and management style of the acquired company is different to the acquiring one. There is potential for human relations problems to arise after the acquisition.

(h)

Rationalisation costs. As the parent organisation looks to benefit from synergies after an acquisition, they often streamline the workforce, leading to redundancy costs, but possibly also damaging morale amongst the workforce.

It is worth considering the stakeholders in the acquisition process: (a)

Some acquisitions are driven by the personal goals of the acquiring company 's managers. For example, some managers may want to make the acquisition and increase the size of the firm as a means of increasing their own status and power. Alternatively, other managers may view an acquisition as a means of preventing their own company being taken over, thereby making their job safer.

(b)

Corporate financiers and banks also have a stake in the acquisitions process as they can charge fees for advice.

Takeovers often benefit the shareholders of the acquired company more than the acquirer. According to the Economist Intelligence Unit, there is a consensus that fewer than half of all acquisitions are successful. One of the reasons for failure is that firms rarely take into account non-financial factors. (a)

All acquirers conduct financial audits of target companies but many do not conduct anything approaching a management audit.

(b)

Some major problems of implementation relate to human resources and personnel issues such as

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morale, performance assessment and culture. If key managers or personnel leave, the business will suffer. Another common problem following a merger or acquisition is that the post-acquisition phase is not properly managed, so the two component companies are never properly integrated. In this way, the potential benefits of the deal cannot be fully realised. It may also be the case that an acquisition cannot be pursued due to a likely refusal by government on competition grounds.

1.4

Strategic alliances Some firms enter long-term strategic alliances with others for a variety of reasons. (a)

They share development costs of a particular technology.

(b)

The regulatory environment prohibits take-overs (eg most major airlines are in strategic alliances because in most countries – including the US – there are limits to the level of control an 'outsider' can have over an airline).

(c)

Complementary markets or technology.

(d)

Learning. Alliances can also be a 'learning' exercise in which each partner tries to learn as much as possible from the other.

(e)

Technology. New technology offers many uncertainties and many opportunities. Such alliances provide funds for expensive research projects, spreading risk.

Strategic alliances only go so far, as there may be disputes over control of strategic assets.

2 Aligning organisational structure and strategy Views about organisational structure have changed over time. Traditionally, management theorists have advocated formal structures, alongside a top-down, command-and-control approach to strategy, in which senior managers made the decisions and the rest of the organisation simply implemented them. However, this view of structure and strategy is now being challenged. In contemporary organisations, where key knowledge is held by employees at all levels within the organisation, and where change is constant, relying on formal top-down structures may no longer be sufficient. As a result, formal structures and processes need to be aligned with informal processes and relationships to create coherent configurations

Contingency approach In this context, it is important to note the contingency approach to organisational structure, which takes the view that there is no one best, universal structure. There are a large number of variables, or situational factors, which influence organisational design and performance. The contingency approach emphasises the need for flexibility. The most appropriate structure for an organisation depends on its situation. It is an 'if then' approach; in other words, if certain situational factors are present, then certain aspects of structure are most appropriate. Typical situational factors include:       

Type and size of organisation and purpose Culture Preferences of top management/power/control History Abilities, skills, needs, motivation of employees Technology (eg production systems) Environment

Formalisation makes employee behaviour more predictable, since whenever a problem or issue arises, employees know they have to refer to a handbook or a procedure guideline to find out how to deal with the issue. In this way, they respond to issues in a similar way across the organisation, which leads to consistency of behaviour. For example, McDonald's has a strongly bureaucratic structure, in which employee jobs are highly formalised, with clear lines of communication and very specific job descriptions. This kind of structure is an advantage for McDonald's because it seeks to produce a uniform product around the world at low cost. However, while formalisation reduces ambiguity and provides clear guidance to employees, it does have

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some disadvantages. A high degree of formalisation does not encourage innovation, because employees are not given any scope to innovate. Formalised structures are often also associated with reduced motivation and job satisfaction. In relation to decision-making, formalised structures often leads to a slower pace of decision-making. Employees have to refer any potential decisions to senior managers to make a decision, rather than having any authority to take decisions at a lower level. By contrast, Google adopts a structure and culture in which employees are encouraged to innovate and take decisions.

2.1

Organisational configuration Definition Organisational configuration: An organisation's configuration consists of the structures, processes and relationships through which it operates. (a)

Structure has its conventional meaning of organisation structure (that is, the formal roles, responsibilities and lines of reporting in an organisation).

(b)

Processes drive and support people: they define how strategies are made and controlled; and how the organisation's people interact and implement strategy.

(c)

Relationships are the connections between people within the organisation; and between those inside it and those on the outside. Relationships outside the organisation are becoming increasingly important in the context of outsourcing, supply chain management and strategic alliances.

Effective processes and relationships can have varying degrees of formality and informality and it is important that formal relationships and processes are aligned with the relevant informal ones. It is very important to be aware that structures, processes and relationships are highly interdependent: they have to work together intimately and consistently if the organisation is to be successful.

2.2

Types of structure An organisation's formal structure reveals much about it. (a)

It shows who is responsible for what.

(b)

It shows who communicates with whom, both in procedural practice and, to a great extent, in less formal ways.

(c)

The upper levels of the structure reveal the skills, the organisation values and, by extension, the role of knowledge and skill within it.

Johnson, Scholes and Whittington review seven basic structural types:       

2.3

Functional Multi-divisional Holding company Matrix Transnational Team Project

The functional structure Definition Functional structure: People are organised according to the type of work that they do. In a functional organisation structure, departments are defined by their functions, that is, the work that they do. It is a traditional, common sense approach and many organisations are structured like this. Primary functions in a manufacturing company might be production, sales, finance, and general administration. Sub departments of marketing might be selling, advertising, distribution and warehousing.

2.4.1

Advantages of functional departmentation   

It is based on work specialism and is therefore logical. The firm can benefit from economies of scale. It offers a career structure.

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2.4.2

Disadvantages    

2.4

It does not reflect the actual business processes by which value is created. It is hard to identify where profits and losses are made on individual products. People do not have an understanding of how the whole business works. There are problems of co-ordinating the work of different specialisms.

The multi-divisional and holding company structures Definition Multi-divisional structure: Divides the organisation into semi-autonomous divisions that may be differentiated by territory, product, or market. The holding company structure is an extreme form in which the divisions are separate legal entities. (a)

Divisionalisation is the division of a business into autonomous regions or product businesses, each with its own revenues, expenditures and profits.

(b)

Communication between divisions and head office is restricted, formal and related to performance standards. Influence is maintained by headquarters' power to hire and fire the managers who are supposed to run each division.

(c)

Divisionalisation is a function of organisation size, in numbers and in product-market activities.

The multi-divisional structure might be implemented in one of two forms. (a)

Simple divisionalisation Organisation's head office

Division A

Division B

Division C

Functions

This enables concentration on particular product-market areas, overcoming problems of functional specialisation at a large scale. Problems arise with the power of the head office, and control of the resources. Responsibility is devolved, and some central functions might be duplicated. (b)

The holding company (group) structure is a radical form of divisionalisation. Subsidiaries are separate legal entities. The holding company can be a firm with a permanent investment or one that buys and sells businesses or interests in businesses: the subsidiaries may have other shareholders. Holding company

Subsidiary A

Sub-subsidiary D

Subsidiary B

Sub-subsidiary E

Subsidiary C

Sub-subsidiary F

Divisionalisation has some advantages, despite the problems identified above. (a)

It focuses the attention of subordinate management on business performance and results.

(b)

Management by objectives is the natural control default.

(c)

It gives more authority to junior managers, and therefore provides them with work that grooms them for more senior positions in the future.

(d)

It provides an organisational structure which reduces the number of levels of management. The top executives in each division should be able to report direct to the chief executive of the holding company.

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2.5

The matrix structure Definition

Matrix structures: Attempt to ensure co-ordination across functional lines by the embodiment of dual authority in the organisation structure. Matrix structures provide for the formalisation of management control between different functions, whilst at the same time maintaining functional departmentation. It can be a mixture of a functional, product and territorial organisation. A golden rule of classical management theory is unity of command: an individual should have one boss. (Thus, staff management can only act in an advisory capacity, leaving authority in the province of line management alone.) Matrix and project organisation may possibly be thought of as a reaction against the classical form of bureaucracy by establishing a structure of dual command, either temporary (in the form of projects) or permanent (in the case of matrix structure).

2.6

Matrix organisation The matrix organisation imposes the multi-disciplinary approach on a permanent basis. For example, it is possible to have a product management structure superimposed on top of a functional departmental structure in a matrix; product or brand managers may be responsible for the sales budget, production budget, pricing, marketing, distribution, quality and costs of their product or product line, but may have to co-ordinate with the R&D, production, finance, distribution, and sales departments in order to bring the product on to the market and achieve sales targets. Production Dept

Sales Dept

Finance Dept

Distribution Dept

R&D Dept

Marke ting De pt

Product Manager A*

Product Manager B* Product Manager C*

* The product managers may each have their own marketing team; in which case the marketing department itself would be small or non-existent. The authority of product managers may vary from organisation to organisation. 100%

Product influence in decision-making Relative influence Functional influence in decision-making

0% Either: Functional departmentation structure Or: (matrix structure)

Dual authority (matrix)

Functional authority with product managers or departments having some influence

Product departmentation structure

Product authority structure with functional managers or departments having some influence

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Once again, the division of authority between product managers and functional managers must be carefully defined. Matrix management thus challenges classical ideas about organisation by rejecting the idea of one person, one boss. A subordinate cannot easily take orders from two or more bosses, and so an arrangement has to be established, perhaps on the following lines.

2.7.1

(a)

A subordinate takes orders from one boss (the functional manager) and the second boss (the project manager) has to ask the first boss to give certain instructions to the subordinate.

(b)

A subordinate takes orders from one boss about some specified matters and orders from the other boss about different specified matters. The authority of each boss would have to be carefully defined. Even so, good co-operation between the bosses would still be necessary.

Advantages of a matrix structure (a)

It offers greater flexibility. This applies both to people, as employees adapt more quickly to a new challenge or new task, and develop an attitude which is geared to accepting change; and to task and structure, as the matrix may be short-term (as with project teams) or readily amended (eg a new product manager can be introduced by superimposing his tasks on those of the existing functional managers). Flexibility should facilitate efficient operations in the face of change.

(b)

It should improve communication within the organisation.

(c)

Dual authority gives the organisation multiple orientation so that functional specialists do not get wrapped up in their own concerns.

(d)

It provides a structure for allocating responsibility to managers for end-results. A product manager is responsible for product profitability, and a project leader is responsible for ensuring that the task is completed.

(e)

It provides for inter-disciplinary co-operation and a mixing of skills and expertise.

A matrix organisation is most suitable in the following situations. (a)

There is a fairly large number of different functions, each of great importance.

(b)

There could be communications problems between functional management in different functions (eg marketing, production, R&D, personnel, finance).

(c)

Work is supposed to flow smoothly between these functions, but the communications problems might stop or hinder the work flow.

(d)

There is a need to carry out uncertain, interdependent tasks. Work can be structured so as to be task centred, with task managers appointed to look after each task, and provide the communications (and co-operation) between different functions.

(e)

2.7.2

There is a need to achieve common functional tasks so as to achieve savings in the use of resources â&#x20AC;&#x201C; ie product divisions would be too wasteful, because they would duplicate costly functional tasks.

Disadvantages of matrix organisation (a)

Dual authority threatens a conflict between managers. Where matrix structure exists it is important that the authority of superiors should not overlap and areas of authority must be clearly defined. Subordinates must know to which superior they are responsible for each aspect of their duties.

(b)

One individual with two or more bosses is more likely to suffer role stress at work.

(c)

It is sometimes more costly â&#x20AC;&#x201C; eg product managers are additional jobs which would not be required in a simple structure of functional departmentation.

(d)

It may be difficult for the management to accept a matrix structure. It is possible that a manager may feel threatened that another manager will usurp his or her authority.

(e)

It requires consensus and agreement which may slow down decision-making.

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2.7

The transnational structure Definition The transnational structure: Attempts to reconcile global scope and scale with local responsiveness. In international strategy it has been difficult to combine responsiveness to local conditions with the degree of co-ordination necessary to achieve major economies of scale. The essence of the extreme case of the problem is an enforced choice between a low-cost product originally specified for a single market (typically the USA), which is potentially uninteresting or even actively shunned in other markets, and a range of low volume, and therefore highcost, products, each specified for and produced in a single national market. These two cases are known as the global and the multi-domestic approaches to organisation and they have their own characteristic organisational structures. The global approach leads to global divisions, each responsible for the worldwide production and marketing of a related group of standardised products. The multi-domestic approach leads to the setting up or acquisition of local subsidiaries, each with a great deal of autonomy in design, production and marketing. The transnational structure attempts to combine the best features of these contrasting approaches in order to create competences of global relevance, responsiveness to local conditions and innovation and learning on an organisation-wide scale. Bartlett and Ghoshal describe it as a matrix with two important general features. (a)

It responds specifically to the challenges of globalisation.

(b)

It tends to have a high proportion of fixed responsibilities in the horizontal lines of management.

The transnational organisation has three specific operational characteristics: (a)

National units are independent operating entities, but also provide capabilities, such as R&D, that are utilised by the rest of the organisation.

(b)

Such shared capabilities allow national units to achieve global, or at least regional, economies of scale.

(c)

The global corporate parent adds value by establishing the basic role of each national unit and then supporting the systems, relationships and culture that enable them to work together as an effective network.

If it is to work, the transnational structure must have very clearly defined managerial roles, relationships and boundaries.

2.8.1

(a)

Managers of global products or businesses have responsibilities for strategies, innovation, resources and transactions that transcend both national and functional boundaries.

(b)

Country managers must feed back local requirements and build unique local competences.

(c)

Functional managers nurture innovation and spread best practice.

(d)

Managers at the corporate parent lead, facilitate and integrate all other managerial activity. They must also be talent spotters within the organisation.

Disadvantages of the transnational structure The transnational structure makes great demands on its managers, both in their immediate responsibilities and in the complexity of their relationships within the organisation. The complexity of the organisation can lead to the difficulties of control and the complications introduced by internal political activity.

2.8

The team-based structure Both transnational and project-based structures extend the matrix approach by using cross-functional teams. The difference is that projects naturally come to an end, and so project teams disperse at this point. A team-based structure extends the matrix structure's use of both vertical functional links and horizontal, activity-based ones by utilising cross-functional teams. Business processes are often used as the basis of organisation, with each team being responsible for the processes relating to an aspect of the business. Thus, a purchasing team might contain procurement specialists, design and production engineers and marketing specialists in order to ensure that outsourced sub-assemblies were properly specified and contributed to brand values as well as being promptly delivered at the right price.

2.9

The project-based structure Definition Project-based structure: Employees from different departments work together on a temporary basis to achieve a specific objective or to address a specific issue. Employees within the team perform specific job functions.

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The project-based structure is similar to the team-based structure except that projects, by definition, have a finite life and so, therefore, do the project teams dealing with them. This approach is very flexible and is easy to use as an adjunct to more traditional organisational forms. Management of projects is a well-established discipline with its own techniques. It requires clear project definition, if control is to be effective, and comprehensive project review, if longer-term learning is to take place.

2.10

Choosing a structure An organisational structure must provide a means of exercising appropriate control; it must also respond to the three challenges identified earlier: rapid change, knowledge management and globalisation.

2.11

Network structure A very modern idea is that of a network structure, applied both within and between organisations. Within the organisation, the term is used to mean something that resembles both the organic organisation and the structure of informal relationships that exists in most organisations alongside the formal structure. Such a loose, fluid approach is often used to achieve innovative response to changing circumstances. The network approach is also visible in the growing field of outsourcing (see Section 4.13) as a strategic method. Complex relationships can be developed between firms, who may both buy from and sell to each other, as well as the simpler, more traditional practice of buying in services such as cleaning. Writers such as Ghoshal and Bartlett point to the likelihood of network organisations becoming the corporations of the future, replacing formal organisation structures with innovations such as virtual teams. Virtual teams are interconnected groups of people who may not be in the same office (or even the same organisation) but who:   

Share information and tasks Make joint decisions Fulfil the collaborative function of a team

Organisations are now able to structure their activities very differently: (a)

Staffing. Certain areas of organisational activity can be undertaken by freelance or contract workers.

(b)

Leasing of facilities such as machinery, IT and accommodation (not just capital assets) is becoming more common.

(c)

Production itself might be outsourced, even to offshore countries where labour is cheaper. (This, and the preceding point, of course beg the question: which assets and activities do companies retain, and which ones do they 'buy-in'?)

Interdependence of organisations is emphasised by the sharing of functions and services. Databases and communication create genuine interactive sharing of, and access to, common data. Johnson, Scholes and Whittington give four examples of network organisational structures: (a)

Teleworking, which combines independent work with connection to corporate resources.

(b)

Federations of experts who combine voluntarily. This is common in the entertainment industry.

(c)

One-stop shops for professional services in which a package of services is made available by a coordinating entity. The point of access to such a conglomerate might be a website.

(d)

Service networks such as the various chains of franchised hotels that co-operate to provide centralised booking facilities.

Network structures are also discerned between competitors, where co-operation on non-core competence matters can lead to several benefits:   

Cost reduction Increased market penetration Experience curve effects

Typical areas for co-operation between competitors include R&D and distribution chains. The spread of the Toyota system of manufacturing, with its emphasis on just-in-time, quality and the elimination of waste has led to a high degree of integration between the operations of industrial customers and their suppliers.

3 Managing change It is very hard to ignore the impact of change on contemporary businesses. However, the visibility of change

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in this way also highlights the importance of understanding and managing the impact of change on businesses and the people who work for them. Change is often an integral part of strategy. It is very important to be aware that strategic change and change management issues may be implicit in a scenario rather than being the explicit subject of a question requirement. You must be able to recognise the factors that drive change and constrain the ways in which it may be managed. However, before we start to look at change management theories and models, we will look at some of the practical issues involved by using a case study. The McDonald's example illustrates how change occurs in a social context. This is an important point to recognise, because change management does not simply involve a choice between technological, organisational or people-oriented solutions. Rather, it involves finding solutions that combine these factors to provide integrated strategies, which help improve performance and results. Change management is a crucial part of any project, which leads or enables people to accept new processes, technologies, systems, structures and values. Change management consists of the set of activities that help people move from their present way of working to a new, and hopefully improved, way of working.

3.1

The need for change Definition Change management: 'The continuous process of aligning an organisation with its marketplace and doing it more responsively and effectively than competitors'. (Berger) Any organisation that ignores change does so at its own peril, because its inactivity is likely to weaken the organisation's ability to manage future scenarios. The management guru, Peter Drucker, argues that a 'winning strategy' will require information about events and conditions outside the organisation, because only once an organisation has that information can it prepare for the new changes and challenges which arise from shifts in the world economy. This does not, however, mean that implementing a strategic change will necessarily improve an organisation's performance.

3.2

The process of change In the same way that choosing a business strategy encourages an organisation to assess its current position, evaluate its strategic choices, and then decide upon a course of action to implement, we can also look at change management as a sequence of stages. For an organisation to respond to the need for change, it needs a way of planning for, and implementing changes. Although each situation should be considered individually, we can still identify some general steps which could be followed during a major change initiative. Change processes usually begin with a change 'trigger'. The trigger identifies the need or desire for change in a particular area. Triggers include: External events 

Changes in the economic cycle (for example, an economic downturn)



New laws or regulations affecting the industry



Stiffer competition from rivals or from new entrants



Arrival of new technology (for example, the impact of faster communications and digital downloads on music and film entertainment)

Internal events   

Arrival of new senior management with different strategies, priorities and styles Implementation of new technologies or working practices Relocation of the business to different city or country

These triggers will force change. The issue for management is whether to seek to manage the change to get the best outcome, or just to let the change event run its course with uncertain outcomes.

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In response to the trigger, some tentative plans about possible changes are prepared. Wherever possible, an organisation should consider a range of alternatives, and consider the advantages and disadvantages of each. Stakeholders' probable reactions to the changes should also be considered. A preferred solution should then be chosen from the range of alternative options, and a timetable for implementing the changes should be established. The speed at which change is implemented is likely to depend on the nature of the change and people's anticipated reactions to it. The plan for change then needs to be communicated to everyone who will be involved in implementing it, before the actual implementation stage gets underway. Having identified the need for change in an organisation, then plotted an outline strategy, it is important that managers can implement the desired change(s) successfully. We have identified a number of situations that might act as triggers for change in an organisation. However, it also important that organisations realise that change is an ongoing process and needs to be addressed all the time. In the modern market economy, change is inherent in society. Not only do technologies change, so too do social norms, tastes and trends, demographic profiles and people's expectations of employment. In fact, almost every aspect of collective human life is subject to constant change. In this respect, it is wrong to think a visionary 'future state' can always be reached through some highly programmed way. Moreover, successful change management requires more than simply recognising a change trigger and acting on it. Successful exploitation of a change situation requires:   

Knowledge of the circumstances surrounding a situation Understanding of the interactions in that situation Awareness of the potential impact of the variables associated with the situation

Nevertheless, many organisations do view change as a highly programmed process which follows a 'formula' and it is useful for us to consider a framework for change: Recognition – Identify the problem that needs to be rectified Diagnosis

– Break down the problem into component parts

Solution

– Analyse possible alternatives – Select preferred solution – Apply preferred solution

Alternatively, 'change management' could be approached from a project management perspective, in which the business dimensions of change can be broken down into the following elements:

3.3



Business need or opportunity is identified



Project is defined (scope and objectives of project identified)



Business solution is designed (for example, new processes, systems and organisational structure designed)



New processes and systems are developed



Solution is implemented into the organisation

Types of change When faced with a potential change situation, an organisation has to analyse the nature of the change, in order to identify the most appropriate way of managing the change. Change can be classified in relation to the extent of the change required and the speed with which that change needs to be achieved. Speed – Change can range from an all-at-once, 'big bang' change to a series of step-by-step, incremental changes. Extent – The extent of change can range from an overall transformation of an organisation's central assumptions, culture and beliefs to a realignment of its existing assumptions. Although a realignment may affect the way an organisation operates at a practical level, it will not lead to an underlying change in the organisation's culture.

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Again, however, a matrix can be used; change is either incremental or transformational, and the approach to managing change is described as being either reactive or proactive. Incremental change is characterised by a series of small steps, and does not challenge existing organisational assumptions or culture. It is a gradual process, and can be seen as an extension of the past. Management will feel that they are in control of the change process. There is also a feeling that incremental change is reversible. If the change does not work out as planned, the organisation can revert to its old ways of doing things. Transformational change is characterised by major, significant change being introduced relatively quickly. The existing organisational structures and the organisational culture are changed. Transformational change is likely to be a top-down process, initiated, and possibly imposed, by senior management. However, unlike incremental change, it requires new ways of thinking and behaving, and leads to discontinuities with the past. Consequently, it is likely to be irreversible. Transformational change may come about because:

3.4



The organisation is faced with major external events that demand large-scale changes in response.



The organisation anticipates major changes in the environment and initiates action to make shifts in its own strategy to cope with them.



Strategic drift has led to deteriorating performance and so leaves the organisation now requiring significant changes to improve performance.

Examples of change management In the previous chapter we looked at Ansoff's product/market matrix to highlight the types of strategy organisations can pursue to generate growth. However, it is important to remember that growth strategies – developing new products, entering new markets, diversification (either organically or through acquisition or joint venture for example) – are also likely to involve change processes in an organisation. Equally, strategies designed to improve profitability through operational restructuring within a company will also involve change management; as will any plans to dispose of business units or under-performing assets. Therefore, when thinking about the strategic options an organisation can implement in response to issues identified in a case study scenario, it is important to consider any change management issues the organisation may encounter in order to implement the strategy.

3.6.1

Turnaround One specific situation when change management will be required is a turnaround situation. When a business is in terminal decline and faces closure or takeover, there is a need for rapid and extensive change in order to achieve cost reduction and revenue generation. This is a turnaround strategy. Johnson, Scholes and Whittington identify seven elements of such a strategy.

Crisis stabilisation The emphasis is on reducing costs and increasing revenues. An emphasis on reducing direct costs and improving productivity is more likely to be effective than efforts to reduce overheads. (a)

Measures to increase revenue (i) (ii) (iii) (iv) (v)

Tailor marketing mix to key market segments Review pricing policies to maximise revenue Focus activities on target market segments Exploit revenue opportunities if related to target segments Invest in growth areas

(b) Measures to reduce costs (i) (ii) (iii) (iv) (v) (vi) (vii)

Cut costs of labour and senior management Improve productivity Ensure clear marketing focus on target market segments Financial controls Strict cash management controls Reduce inventory Cut unprofitable products and services

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Severe cost cutting is a common response to crisis but it is unlikely to be enough by itself. The wider causes of decline must be addressed.

Management changes It is likely that new managers will be required, especially at the strategic apex. There are four reasons for this. (a)

The old management allowed the situation to deteriorate and may be held responsible by key stakeholders.

(b)

Experience of turnaround management may be required.

(c)

Managers brought in from outside will not be prisoners of the old paradigm.

(d)

A directive approach to change management will probably be required.

Communication with stakeholders The support of key stakeholder groups â&#x20AC;&#x201C; groups with both a high level of power and a high degree of interest in an organisation â&#x20AC;&#x201C; such as the workforce and providers of finance, is likely to be very important in a turnaround; it is equally likely that stakeholders did not receive full information during the period of deterioration. A stakeholder analysis should be carried out so that the various stakeholder groups can be informed and managed appropriately.

Attention to target markets A clear focus on appropriate target market segments is essential; indeed a lack of such focus is a common cause of decline. The organisation must become customer-oriented and ensure that it has good flows of marketing information.

Concentration of effort Resources should be concentrated on the best opportunities to create value. It will almost certainly be appropriate to review products and the market segments currently served and eliminate any distractions and poor performers. A similar review of internal activities would also be likely to show up several candidates for outsourcing.

Financial restructuring Some form of financial restructuring is likely to be required. In the worst case, this may involve trading out of insolvency. Even where the business is more or less solvent, capital restructuring may be required, both to provide cash for investment and to reduce cash outflows in the shorter term.

Prioritisation The eventual success of a turnaround strategy depends, in part, on management's ability to prioritise necessary activities, such as those noted above.

4 Cost reduction, supply chain management and outsourcing 4.1

Introduction st

Cost reduction has become a key battle-cry in the 21 Century. As prices are slashed in a bid to remain competitive, companies have to find other ways of boosting profits. The only other way to affect the bottom line is to squeeze costs as far as possible and, hopefully, more effectively than competitors. One of the most quantifiable means of reducing costs is to tackle fixed costs. Fixed costs are those costs that cannot be avoided, regardless of activity levels â&#x20AC;&#x201C; if you can find a way of getting rid of some of the sources of fixed costs permanently, then you are on the way to a successful cost reduction programme. The best way to reduce costs is to develop a culture within the organisation whereby everyone thinks strategically about cost reduction. How do you reduce costs? In the simplest terms, by avoiding them as much as possible. Of course that is easier said than done but if employees can be educated to actively seek ways to reduce costs, then this will be a move in the right direction.

4.2

Cost reduction techniques As with all business decisions, there are right ways and wrong ways to approach cost reduction. The right techniques will result in greater efficiency of company spending; the wrong ones could lead to costs being cut that are in fact necessary for the maintenance of quality and company value. There is often a fine line between

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necessary costs and unnecessary ones but taking a systematic approach to cost reduction can help managers stay on the right side of that line. Effective cost reduction techniques start with establishing what the programme is trying to achieve. If a company does not know why it is cutting costs, then it will have no idea where to cut costs. Companies try to reduce costs for many reasons, such as to allow the price of a product or service to be cut without affecting margins, to eliminate unnecessary spending and to create additional cash reserves. Ultimately, the aim is to maximise shareholders' wealth, therefore it is important that the correct costs are targeted for reduction. There are numerous ways in which companies can institute plans to reduce costs, including across the board reductions, prioritised reductions and departmental reductions. Across the board reductions could include the implementation of a new travel policy whereby all staff must travel economy class (as we have seen in the case of IKEA) while prioritised reductions may include a strategy to reduce emissions in order to avoid pollution tax. Whatever techniques are used, if they are the right ones they can teach a company to be more economical while maintaining its levels of service and quality. By forcing companies to regularly review spending at all levels, cost reduction techniques allow companies to become more streamlined.

4.3

Supply chain management Definition Supply chain management: 'The planning and management of all activities involved in sourcing and procurement, conversion, and all logistics management activities. Importantly, it also includes coordination and collaboration with channel partners, which can be suppliers, intermediaries, third-party service providers and customers.' (The Council of Supply Chain Management Professionals) A key element of the above definition is its emphasis on the inter-organisational element of supply chain management. Effective supply chain management focuses on interactions and collaborations with suppliers and customers to ensure that the end customer's requirements are satisfied adequately. All activities in the supply chain should be undertaken with the customer's needs (or requirements) in mind; and, to this end, all supply chains ultimately exist to ensure that a customer's needs are satisfied.

4.3.1

Supply chain management and competitive advantage Supply chain activities – procurement, inventory management, production, warehousing, transportation, customer service, order management – have all been part of business operations since business began. However, it is only far more recently that companies have started to focus on logistics and supply chain management as a potential source of competitive advantage. The idea of capabilities and dynamic capabilities. Here, we could argue that supply chain management can now be seen as a capability for an organisation. For example, 7-Eleven Japan is a company that has used excellent supply chain design, planning and operation to drive growth and profitability. 7-Eleven has a very responsive replenishment system which, coupled with an excellent information system – ensures that products are available at each of its convenience stores to match customer needs. The responsiveness of 7-Eleven's system allows it to change the merchandising mix at each stores by time of day, to match precisely with customer demand. Similarly, Amazon is consistently rated as one of the top eCommerce companies in the world. However, critical to Amazon's on-going business success is maintaining the customer's trust that their orders will be delivered on time and with no errors. Amazon's supply chain and its warehouses are crucial to its performance in this respect. In their text, Supply Chain Management, Chopra and Meindl highlight the importance of the supply chain for organisations when they write: 'Supply chain design, planning, and operation decisions play a significant role in the success or failure of a firm. To stay competitive, supply chains must adapt to changing technology and customer expectations.' For example, in the 1990s, stores such as Borders and HMV dominated the sales of books and music by implementing a superstore concept. Compared to small independent local retailers, they were able to offer a much greater range of titles to customers, and at a lower cost by aggregating operations in large stores. This allowed the large retailers to achieve higher inventory turns than local retailers, and at higher operating margins. However, the large retailers' business model was itself under attack with the growth of online markets – in particular Amazon, which offered greater variety than Borders, or HMV and was able to sell at lower cost by selling online and stock its inventories in a few distribution centres. The inability of Borders, in particular, to adapt its supply chain to compete with Amazon led to a rapid decline. (Borders (UK) went into administration in 2009, and the Borders group as a whole filed for bankruptcy in 2011.)

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The appropriate design of a supply chain in any given context depends both on the customer's needs and market conditions. We can illustrate this with reference to Dell, noting that it has two different supply chain models: one for customers who want customised personal computers (PCs), and the other for customers who want standardised PCs. Unfortunately, however, supply chains which are not designed appropriately can precipitate the failure of a business. The demise of the online grocery retailer Webvan (which was launched in 1999) illustrates this. Webvan designed a supply chain with large warehouses based in several major cities in the United States. The plan was that groceries should then be delivered to customers' homes from these warehouses. However, the design of this supply chain meant that Webvan couldn't compete with traditional supermarket supply chains in terms of cost. The distribution networks used by traditional supermarket companies mean they use fully loaded lorries to bring products to a supermarket store close to the consumer, resulting in relatively low transportation costs. Although Webvan turned its inventory slightly faster than the supermarkets, it incurred much higher transportation costs for its home delivery system. Moreover, Webvan offered free delivery on all orders, regardless of the customer's location. As a result, it was estimated that the company was losing up to $130 on every order, and by July 2001, the company was declared insolvent after losing US $1.2bn. Ultimately, the objective of the supply chain is to maximise the overall value generated, or the supply chain profitability â&#x20AC;&#x201C; the difference between the revenue generated from the customer and the overall cost across the supply chain. Therefore, when analysing supply chain decisions, it is vital to consider what impact they will have on the profitability of the supply chain. Equally, however, it is important to remember that supply chain profitability has to be shared across all supply chain stages and intermediaries. Therefore, the more intermediaries there are in a supply chain, the more people the profit has to be shared between. In this context, the opportunities for disintermediation provided through IT and eBusiness can be very important. For example, if a customer can book the flights and accommodation for their holiday directly through the relevant airline and hotel's websites, the airline and the hotel no longer have to pay any commission to a travel agent for arranging the holiday for the customer.

4.3.2

Hierarchy of supply chain decisions There is a hierarchy of decision-making and control: at strategic; business- unit (or tactical); and operational levels. A similar hierarchy can be applied to supply chain management decisions, depending on the frequency of the decision and the time frame that it relates to.

4.3.3

Drivers of supply chain performance The contrast between 'push' and 'pull' processes also identifies a key balancing act at the heart of supply chain management: that is, achieving the balance between responsiveness and efficiency which best supports a company's competitive strategy. For example, holding high levels of inventory should enable a company to be very responsive to changes in customer demand, but will it be efficient? The goal for a company in relation to supply chain performance is to ensure that they achieve the desired level of responsiveness (to customer demand) at the lowest possible cost.

4.3.4

The scope of supply chain management The scope of decision-making for supply chain professionals has expanded from trying to optimise performance within a division or business unit, then throughout the entity, and now across the entire supply chain â&#x20AC;&#x201C; which includes trading partners both upstream (eg raw material suppliers, or wholesalers) and downstream (eg distributors and customers). This reflects the goal of supply chain management, which is to maximise the total profitability of the supply chain. The recognition of the importance of upstream and downstream processes reinforces the importance of supplier relationship management (the upstream interactions between an entity and its suppliers) and customer relationship management (the downstream interactions between an entity and its customers).

4.3.5

Information and supply chain management So far in this section we have focused mainly on the supply chain as a mechanism for providing goods and services to a customer.

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We will look at information strategy but it is worth noting here some of the ways information technology can help managers share and analyse information in the supply chain: 

Electronic data interchange (EDI) – Enabling instantaneous, paperless purchase orders with suppliers.



Enterprise resource planning (ERP) systems – Integrating an entity's systems and thereby help managers co-ordinate production, resources, procurement, inventory, customer orders and sales.

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Radio frequency identification (RFID) – RFID tags attached to materials or inventory enable an entity to track the movement of inventory between locations more accurately, and to get an exact count of incoming items and items in storage.



Supply chain management (SCM) software – Whereas ERP systems show an entity what is currently going on, SCM systems help a company decide what it should plan to do in the future.

We must add one word of caution, however. While good information can clearly help an entity improve both responsiveness and efficiency, this does not automatically mean that simply having more information is always better. As more information is shared across a supply chain, the complexity and cost of the infrastructure required and the follow-up analysis increase. However, the marginal value provided by information may diminish as more and more information becomes available. Hence, entities need to achieve a balance between providing sufficient information so that supply chain activities can be planned and controlled effectively, but without producing unnecessarily complex and detailed information.

4.3.6

Supplier selection If an entity has decided to buy in a product or service (rather than to make it in-house), then vendor selection becomes a critical sourcing decision: How many suppliers will the entity have for a particular activity? (If the entity uses only a small number of suppliers, they could have a high degree of bargaining power over the entity; but if too many are used, and the orders placed with each are small, there is little chance of economies of scale.) How will it choose its suppliers? Managers need to consider the performance objectives which are most important. For example, the following could be key performance characteristics when evaluating potential suppliers:     

Speed (or lead time) Quality Price Flexibility Reliability

In this respect, an entity should select suppliers with distinctive competences that are similar to its own. For example, a company selling high volume, low price products, will want suppliers who are able to supply large quantities of low price components. The financial stability of potential suppliers is also important, so when evaluating suppliers, an entity should take up credit references, and examine potential suppliers' published accounts. Supplier selection and assurance Nonetheless, a key element of any outsourcing decision will be the outsourced partner's ability to deliver contracted items to the standard required. In other words, an entity needs assurance over the effective business operation of the outsource service provider. We discussed Assurance reports on third party operations and the types of appropriate subject matter we mentioned there – systems and processes; compliance with contracts or agreed standards; financial or nonfinancial performance and conditions; physical characteristics; and behaviour – could equally be appropriate subject matter in relation to assurance over the supply chain.

4.4

Strategic procurement The traditional supply chain model (see diagram below) shows each firm as a separate entity reliant on orders from the downstream firm, commencing with the ultimate customer, to initiate activity. The disadvantages of this are: 

It slows down fulfilment of customer orders and so puts the chain at a competitive disadvantage.



It introduces the possibility of communication errors, delaying fulfilment and/or leading to wrong

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specification products being supplied. 

The higher costs of holding inventories on a just-in-case basis by all firms in the chain.



The higher transaction costs due to document and payment flows between the stages in the model.

Strategic procurement is the development of a true partnership between a company and a supplier of strategic value. The arrangement is usually long-term, single-source in nature and addresses not only the buying of parts, products, or services, but product design and supplier capacity. This recognises that increasingly, organisations are realising the need for, and benefits of, establishing close links with companies in the supply chain. This has led to the integrated supply chain model and the concept that it is whole supply chains which compete and not just individual firms. In an integrated supply chain, the responsibility for fulfilling the order from the ultimate customer is shared between all the stages in the chain and that the firms overlap operations by having integrated activities as business partners. This is consistent with the idea of a value system and the concept of supply chain networks.

4.5

Suppliers and e-procurement E-procurement involves using technology to conduct business-to-business purchasing over the internet. There are huge savings to be had, especially for large corporate organisations with vast levels of procurement. Siemens believes that, since it embarked on its fully-integrated e-procurement system, this purchasing strategy saved $15 million from material costs and $10 million from process costs in the one year alone, close to a 1,000% increase in savings from the previous year and only the second year into implementation.

4.5.1

Advantages of e-procurement for the buyer:           

4.5.2

Facilitates cost savings Easier to compare prices Faster purchase cycle Reductions in inventory Controls indirect goods and services Reduces off-contract buying Data rich management information to help reduce costs and predict future trends Online catalogues High accessibility Improved service levels Controlled costs by imposing limits on levels of expenditure

E-procurement from a supplier's perspective Traditionally the business of supplying goods has been about branding, marketing, business relationships, and so on. In the expanding e-procurement world, the dynamics of supplying are changing and, unlike the expectations of companies implementing e-procurement systems for cost savings, suppliers are expecting to feel profit erosions due to the e-procurement mechanism. Nevertheless, there are obvious advantages to suppliers:

4.6

   

Faster order acquisition Immediate payment systems Lower operating costs Non-ambiguous ordering

  

Data rich management information 'Lock-in' of buyers to the market Automated manufacturing demands

Efficient consumer response Efficient supply chain management is likely to be particularly important in the context of fast moving consumer goods industries. The concept of efficient consumer response (ECR) highlights the need to focus on customers, and suggests that sustained business success will stem from providing consumers with products and services that consistently meet or surpass their demands and expectations. In turn, ECR also suggests that the greatest consumer value can be offered only when organisations work together – both internally (for

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example, sales and marketing functions working with production and distribution functions) and externally (with their trading partners) to overcome barriers to efficiency and effectiveness. ECR seeks to enhance the value delivered to the consumers through identifying possible improvements to both demand and supply processes. In turn, these should help to improve profitability through a combination of increased revenues and reduced waste (costs). Improvements which can increase revenues: Effective promotions, Better mix of products, Fresher products, Increased availability of products in store. Improvements which can reduce waste: Reducing inventory, reducing inefficient use of space, reducing product failures.

4.7

Business Process Re-engineering Business process re-engineering (BPR) involves focusing attention inwards to consider how business processes can be redesigned or re-engineered to improve efficiency. It can lead to fundamental changes in the way an organisation functions. Properly implemented BPR may help an organisation to reduce costs, improve customer service, cut down on the complexity of the business and improve internal communication. 

At best, it may bring about new insights into the objectives of the organisation and how best to achieve them.



At worst, BPR is simply a synonym for squeezing costs (usually through redundancies). Many organisations have taken it too far and become so 'lean' that they cannot respond when demand begins to rise.

The main writing on the subject is Hammer and Champy's Reengineering the Corporation (1993), from which the following definition is taken:

Definition Business process re-engineering (BPR): Is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance, such as cost, quality, service and speed. The key words here are fundamental, radical, dramatic and process. 

Fundamental and radical indicate that BPR is somewhat akin to zero base budgeting: it starts by asking basic questions such as, 'Why do we do what we do?', without making any assumptions or looking back to what has always been done in the past.



Dramatic means that BPR should achieve 'quantum leaps in performance', not just marginal, incremental improvements.



Process. BPR recognises that there is a need to change functional hierarchies: 'existing hierarchies have evolved into functional departments that encourage functional excellence but which do not work well together in meeting customers' requirements' (Rupert Booth, Management Accounting, 1994).

A process is a collection of activities that takes one or more kinds of input and creates an output. For example, order fulfilment is a process that takes an order as its input and results in the delivery of the ordered goods. Part of this process is the manufacture of the goods, but under BPR the aim of manufacturing is not merely to make the goods. Manufacturing should aim to deliver the goods that were ordered, and any aspect of the manufacturing process that hinders this aim should be reengineered. The first question to ask might be, 'Do they need to be manufactured at all?' A re-engineered process has certain characteristics.       

4.8

Often several jobs are combined into one Workers often make decisions The steps in the process are performed in a logical order Work is performed where it makes most sense Checks and controls may be reduced, and quality 'built-in' One manager provides a single point of contact The advantages of centralised and decentralised operations are combined

Examples of business process re-engineering Some organisations have redesigned their structures on the lines of business processes, adopting BPR to avoid all the co-ordination problems caused by reciprocal interdependence.

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ď&#x201A;ˇ

A move from a traditional functional plant layout to a JIT cellular product layout is a simple example.

ď&#x201A;ˇ

Elimination of non-value-adding activities. Consider a materials handling process, which incorporates scheduling production, storing materials, processing purchase orders, inspecting materials and paying suppliers. This process could be re-engineered by sending the production schedule direct to nominated suppliers with whom contracts are set up to ensure that materials are delivered in accordance with the production schedule and that their quality is guaranteed (by supplier inspection before delivery). Such re-engineering should result in the elimination or permanent reduction of the non-valueadded activities of storing, purchasing and inspection. Be prepared to apply your knowledge of BPR to a particular scenario or to examples that you are aware of from your reading or own experience. The examiner has stated that good answers often draw on the candidate's own experience in the context of the question set.

4.9

Which costs should be cut? This depends on the type of business you are in, but the easiest way to cut costs is to focus firstly on those expenses that are common to all companies. Gas and electricity, postage, stationery and telephone charges are all obvious targets. The trick is to encourage all staff to participate, not demand it. For example, notices posted next to light switches asking staff to 'switch off after use' are likely to be more effective than a dictatorial memo demanding that staff should be more careful about using power. If cutting the more obvious costs does not achieve the required effect, management will have to adopt a more innovative approach, focusing on individual departments' spending. Whilst cutting such expenses as telephone charges and stationery can be fairly straightforward, dealing with departmental costs is more problematic. Not only do you have the issue that departments feel they are being victimised, but there is also the potential for seriously damaging the company's day-to-day operations and pursuit of objectives. If staffing levels are cut, for example, it will be more difficult to maintain product or service quality. Cutting inventory levels too far could result in the company being unable to fulfil delivery promises. That is why management must understand how different costs affect profitability and the extent to which each cost category can be reduced before the company's operations are adversely affected.

4.10

Implementing cost reduction programmes As with choosing techniques, there is a right way and a wrong way to implement cost reduction programmes. Cost reduction is inevitably a sensitive area and the wrong approach can alienate staff, reduce motivation and have a detrimental effect on company harmony. A good cost reduction programme is as much about damage limitation as cutting costs. Effective cost reduction programmes should result from thorough management planning, a detailed understanding of how company expenses can affect not just the bottom line, but the overall quality of the product or service and a vision of where the company is heading. Cost reduction is not about reporting smaller numbers in the income statement â&#x20AC;&#x201C; it should be the culmination of extensive planning, thought and participation by directors, management and employees. Directors should not automatically assume that the most obvious cuts are the right ones. An innovative approach is often more successful than the usual 'we have to cut costs by 10% across the board' requirement. Cost reduction programmes, as mentioned above, are ultimately implemented to improve profitability without improving revenue figures. Any improvements in revenue will further enhance profits. Programmes should be integrated into the overall company strategy, not introduced on an ad hoc basis.

4.11

Potential problems with cost reduction programmes While companies seek to reduce costs to remain competitive, taking the process too far can have adverse effects. Managers have to think about the extent to which cost reduction can be sustained before the business starts to suffer in other ways. Companies whose marketing strategies are based on low costs will probably get away with cost cutting for longer, but if you work in an organisation that has always promoted high quality goods and services, it is unlikely that extreme cost reduction programmes will be viewed positively, either by customers or the financial markets. Regardless of how it is marketed, cost reduction is seen by outsiders as not only reducing expenditure, but reducing quality and service as well. Entities need to bear in mind that while cost reduction may seem tempting in order to get ahead of competitors, it should only be undertaken to the extent that it adds value to the company. As soon as shareholders' wealth starts to suffer, the programme should be halted.

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4.11.1

Cost cutting and business sustainability The global economic slowdown after 2008 prompted companies to re-examine their operating models as they adjusted to capital becoming more scarce. In this context, many companies began to examine their cost structures in much greater detail. However, it is important that companies consider the longer-term implications of cost cutting, and do not make indiscriminate cuts simply to reduce costs in the short term. In this respect, PwC consultants encourage firms to differentiate between 'good costs' (which are necessary for the current and future growth of a company) and 'bad costs' (which do not support growth or are not part of the core infrastructure of the business). The target of cost management and cost cutting programmes should be these 'bad costs'. The danger for businesses (if they cut 'good costs' or stop investment in new projects and people during difficult times) is that there may be a longer-term price to pay in terms of customer loyalty, heightened risk and lower future profitability, as a result of short-term measures taken to cut costs. In this respect, any decisions to cut costs need to be evaluated in the wider context of the longer-term sustainability of the business, rather than merely being short-term measures to boost profit. A key element of business sustainability is that it may affect a business' ability to thrive in the long term. In this respect, before a business takes any decision to reduce costs in the short term, it also needs to consider what impact the decision will have on its customers, suppliers or staff in the longer term. For example, if measures to cut costs lead to reduction in the quality of a product, customers may stop buying that product. Therefore, the cuts will weaken the business' chances of being successful in the longer term. However, this need to focus on the longer term can create problems for corporate decision-makers and accountants. Corporate reporting and performance measurement is often biased towards the shortterm. The fact that companies report their results on a yearly basis, and may be under pressure from shareholders and market analysts to deliver results, means they may be forced into measures that boost profits in the short term, but which may create problems in the longer-term and, as a result, could potentially threaten the sustainability of the business.

4.12

The use of outsourcing in business We have already acknowledged the potential importance of outsourcing in our discussion of supply chain management earlier in this chapter. Outsourcing can be defined as the use of external suppliers as a source of finished products, components or services. The use of outsourcing has often been driven by it being the most costeffective way of providing a service, particularly for smaller organisations. In addition, the supplier of the outsourced service can provide specialist expertise which is not available inhouse or it would not be worth maintaining in-house. Outsourcing should also have the major advantage of reducing the workload of the organisation's managers, thus freeing up more time to concentrate on core competences. Business process outsourcing (BPO) is a subset of outsourcing which involves the contracting out of specific business functions (processes) to an external service provider. For example, the payroll function could be outsourced to a specialist payroll bureau, IT support could be outsourced to an IT services company, and a number of organisations have outsourced (and moved offshore) their customer service centres. Generally speaking, outsourcing is appropriate for peripheral activities: to attempt to outsource core competences, or activities which are strategically important, would be to invite the collapse of the organisation. However, it can sometimes be difficult to identify with clarity just what an organisation's core competences are. Moreover, it is not too difficult to imagine an organisation whose core competence is, in fact, outsourcing. Certainly, the motor manufacturing industry seems to be moving in this direction. A further advantage of outsourcing is that external suppliers may benefit from economies of scale and experience effects. Therefore, cost may be reduced by using services provided by external suppliers rather than trying to provide the equivalent services in-house. Getting the best out of outsourcing depends on successful relationship management rather than the use of formal control systems.

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4.13

Successful outsourcing Successful outsourcing depends on three things: 

The ability to specify with precision what is to be supplied: this involves both educating suppliers about the strategic significance of their role and motivating them to high standards of performance.



The ability to measure what is actually supplied and thus establish the degree of conformity with specification.



The ability to make adjustments elsewhere if specification is not achieved.

There are also practical considerations relating to outsourcing.    

It can save on costs by making use of supplier economies of scale. It can increase effectiveness where the supplier deploys higher levels of expertise. It can lead to loss of control, particularly over quality. It means giving up an area of threshold competence that may be difficult to reacquire.

Outsourcing of non-core activities is widely acknowledged as having the potential to achieve important cost savings. However, some organisations are wary of delegating control of business functions to outsiders because of the difficulty of assessing the cost-effectiveness of what is purchased. Cost should be fairly clear, but the quality of what is purchased is extremely difficult to assess in advance. The adoption of quality standards may help to overcome this problem. By utilising such standards, businesses will have more confidence in the quality of the service being provided and suppliers will know what is expected of them.

4.14

The value chain, core competences and outsourcing Core competences are the basis for the creation of value; activities from which the organisation does not derive significant value may be outsourced. The purpose of value chain analysis is to understand how the company creates value. It is unlikely that any business has more than a handful of activities in which it outperforms its competitors. There is a clear link here with the idea of core competences: a core competence will enable the company to create value in a way that its competitors cannot imitate. These value activities are the basis of the company's unique offering. There is a strong case for examining the possibilities of outsourcing non-core activities so that management can concentrate on what the company does best.

4.15

Outsourcing IT/IS services This section looks at a specific example of outsourcing – namely IT/IS services – and the advantages and disadvantages of outsourcing such a key business function. The arrangement varies according to the circumstances of both organisations. Managing such arrangements involves deciding what will be outsourced, choosing a supplier and the supplier relationship.

4.15.1

How to determine what will be outsourced? 

What is the system's strategic importance? A third party IT specialist cannot be expected to possess specific business knowledge.



Functions with only limited interfaces are most easily outsourced, eg payroll.



Do we know enough about the system to manage the arrangement?



Are our requirements likely to change?

The arrangement is incorporated in a contract sometimes referred to as the Service Level Contract (SLC) or Service Level Agreement (SLA).

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4.16

Current trends in outsourcing In an effort to cut costs, many organisations are now outsourcing activities both near shore (such as Eastern Europe) and offshore (such as the Far East and India). Improvements in technology and telecommunications and more willingness for managers to manage people they can't see have fuelled this trend. Before taking the decision to outsource overseas, a number of points should be considered. (a) (b) (c) (d)

4.16.1

Environmental (location, infrastructure, risk, cultural compatibility, time differences) Labour (experience in relevant fields, language barriers, size of labour market) Management (remote management) Bad press associated with the perception of jobs leaving the home country

Outsourcing to Eastern Europe The expansion of the EU eastwards is providing organisations in Western Europe with a range of outsourcing opportunities. The vast manufacturing facilities that had formerly been used to produce for the massive Soviet market, many of which have been re-equipped, provide the opportunity for manufacturing to be outsourced. For example, car production in the Czech Republic, Hungary, Poland and Slovakia is among the highest in Europe (in terms of cars produced per capita) as a result of investment from companies such as Volkswagen, Toyota-Peugeot-Citroen (joint venture), Hyundai, Kia, Audi, Renault and Fiat. At the moment, labour is relatively cheap in Eastern Europe, and it is closer than the Far East â&#x20AC;&#x201C; an important consideration in today's rapidly-moving environment. The fact that English is widely taught and the existence of a Westernised culture are added attractions. Outsourcing to Eastern Europe is not limited to manufacturing though. There has also been significant growth in bookkeeping and accounting, IT and HR service outsourcing. Many of the cities in Central and Eastern Europe offer highly educated, multi-lingual pools of talent â&#x20AC;&#x201C; relatively close to their potential clients (in Western Europe). Although labour costs are lower than in Western Europe (and cost remains a fundamental consideration in outsourcing decisions) outsourcing of services to Central and Eastern Europe has also been encouraged by the potential of the graduates there. And, by contrast to outsourcing destinations like India or the Philippines where English is the sole operating language, potential employees in Central and Eastern Europe speak a variety of languages, giving clients access to people who speak English, French, German, Russian as well as local languages. However, some analysts believe that the growth of service outsourcing may be limited by the future availability of skilled workers in the countries which are now the destinations for the outsourcing â&#x20AC;&#x201C; ironically due to the flow of workers from Eastern Europe to the West in search of work.

4.16.2

Outsourcing to India Moving back-office functions 'offshore' began in earnest in the early 1990s when organisations such as American Express, British Airways, General Electric and Swissair set up their own 'captive' outsourcing operations in India. The low labour cost in India has always made the outsourcing option attractive. But not only is it cheap, it is highly skilled. India has one of the most developed education systems in the world. One third of college graduates speak more than two languages fluently and of the two million graduates per annum, 80% speak English. These language skills, along with improved telecomms capabilities, make it an ideal choice for call centres. GE, Accenture and IBM have all set up call centres in India. The vast majority of service jobs being outsourced offshore are paper-based back office ones that can be digitalised and telecommunicated anywhere around the world, and routine telephone enquiries that can be bundled together into call centres.

4.16.3

Outsourcing and assurance reports One of the consequences of outsourcing is that many entities are now using outside service organisations to carry out tasks which affect the entity's internal controls. However, because many of the functions that are outsourced (in particular, IT) are integral to an entity's business operations, the entity's management will want to ensure that control procedures at the service organisation complement those they employ in-house.

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In addition, because many of the functions performed by service organisations (eg payroll, or pensions' administration) affect an entity's financial statements, the entity's auditors may also seek information about the control procedures at the service organisation. Accordingly, reporting accountants may be engaged by the service organisation to provide a report on specific control procedures undertaken by the service organisation, which can then be made available to the service organisation's customers and their accountants. Guidance on the related assurance reports is given by ISAE 3402, Assurance Reports on Controls at a Service Organisation. ISAE 3402 only applies when the service organisation is responsible for, or otherwise able to make assertions about, the suitable design of the controls. This means that it does not apply where the assurance engagement is to: (a)

Report only on whether controls at the service organisation operated as described; or

(b)

To report on controls at a service organisation other than those related to a service that is likely to be relevant to user entities' internal control, as it relates to financial reporting.

Objectives of the service auditor ISAE 3402 states that the objectives of the service auditor are: (a)

To obtain reasonable assurance about whether, in all material respects, based on suitable criteria: (i)

The service organisation's description of its system fairly presents the system, as designed and implemented throughout the specified period, or as at a specified date

(ii)

The controls, related to the control objectives stated in the service organisation's description of its system, were suitably designed throughout the specified period

(iii) Where included in the scope of the engagement, the controls operated effectively to provide reasonable assurance that the control objectives, stated in the service organisation's description of its system, were achieved throughout the period. (b)

To report on the matters in (a) above.

Requirements and procedures ISAE 3402 requires the service auditor to carry out the following procedures: 

Consider acceptance and continuance issues



Assess the suitability of the criteria used by the service organisation



Consider materiality with respect to the fair presentation of the description, the suitability of the design of controls, and in the case of a 'Type 2' report, the operating effectiveness of controls



Obtain an understanding of the service organisation's system



Obtain evidence regarding: – – –



The service organisation's description of its system Whether controls implemented to achieve the control objectives are suitably designed The operating effectiveness of controls (when providing a 'Type 2' report)

Determine whether, and to what extent, to use the work of the internal auditors (where there is an internal audit function)

Points to note:

4.16.4

A 'Type 1' report is a report on the description and design of controls at a service organisation.

A 'Type 2' report is a report on the description, design and operating effectiveness of controls at a service organisation.

Managing outsourced relationships Ultimately, the success of outsourcing relationships depends not only on the performance of the third party supplier, but also the relationship between the ‘user’ organisation and its suppliers. In a publication to promote their contract risk and assurance services, Grant Thornton summarise a number of aspects which organisations should consider when using third parties to deliver contracts. These could equally be useful in the context of a scenario in the SBM exam, if an organisation is considering outsourcing an activity or process, or if it has already outsourced an activity or process but is

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now concerned about the performance of its outsource partner.

5 Operations strategy and management 5.1

Operations management Definition

Operations management: Is concerned with the design, implementation and control of the processes in an organisation that transform inputs (materials, labour, other resources, information and customers) into output products and services. Operations management is the activity of managing the resources within an entity that produce and deliver products and services. As Slack, Chambers & Johnston in Operations Management express it ‘Operations management uses resources to appropriately create outputs that fulfil defined market requirements’. Equally importantly, though, operations management has the potential to ’make or break’ a business. Not only does the operations function employ the majority of the assets and people in many businesses, but it also gives an entity the ability to compete by responding to customers and developing the capabilities which will enable the entity to keep ahead of its competitors in the future. The overall objective of operations is to use a transformation process to add value and create competitive advantage. The operations function takes input resources and transforms them into outputs of products or services for customers. As such, operations management involves the design, implementation and control of these processes. Business processes and the operations agenda The business environment has a significant impact on what is expected from operations management. In recent years, there have been a number of changes in the business environment; and operations functions have needed to respond to them. When businesses have to cope with an increasingly challenging environment, they look to their operations function to help them respond. An operation might process a mix of materials, information and customers. However, it is often possible to categorise operations by the type or category of transformed resource that they process. (a)

Materials processors include manufacturing companies, retail businesses, mining and excavation operations, goods transportation services and postal services.

(b)

Information processors include firms of accountants and lawyers, many banking operations, newspaper publishing (although this has a strong element of materials processing too), management consultancy and market research.

(c)

Customer processors include education organisations, transport services, hotels, theatres, hospitals and hairdressers.

Operations can also be differentiated according to the transforming inputs they use. Some are more labour-intensive; and some more capital-intensive, than others.

5.2.1

The hierarchy of processes So far, we have looked at the transformation process (the 'input-transformation-output' model) as a single operation. In effect, we have adopted a macro perspective. However, while, for example, an operation in an advertising agency to produce a campaign for a client can be seen as a single overall operation, it can also be seen as a number of separate micro operations, that all have to be carried out successfully in order to transform the original input into the final finished output. The overall macro operation contains a number of micro operations, such as TV advertisement production, copy writing and editing for magazine advertisements, artwork design and production, media selection, media buying, and so on. Within each of these micro operations, there are other operations. Producing a TV advertisement, for example, involves micro operations such as story- boarding and script writing, film production, the shooting of the film, film editing, and so on. A macro operation can therefore be seen as a hierarchy of micro operations or sub-operations and sub- suboperations. (Equally, the input-transformation-output model can be used at a number of different levels of analysis.) Each micro operation, like the macro operation, can be analysed in terms of the transformation process model, transforming input materials, information or customers into an output product or service. However, either the customer or the supplier, and more commonly both the customer and the supplier, are other people within the same organisation. The terms internal supplier and internal customer are used to describe this relationship.

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For example, a road haulage company might have operational units for maintenance and servicing of vehicles, loading and driving. One micro process within the overall operation is the repair and servicing of vehicles. The mechanics servicing the vehicles are the internal suppliers in the process, and the drivers of the vehicles are the internal customers. Similarly, the team that loads the vehicles is an internal supplier in the loading operation, and the drivers are the internal customers. It can be useful in operations management to think in terms of micro processes and internal suppliers and internal customers. This can focus attention on the purpose of each micro process, the efficiency with which it is carried out, and the extent to which it satisfies the customer's needs. However, unlike external customers, internal customers cannot usually express their dissatisfaction with an internal supplier by taking their business to a different supplier. Nonetheless, by treating internal customers with the same degree of care as external customers, the effectiveness of the whole operation can be improved.

5.2.2

Operations and business processes For the purpose of operations management, it is also useful to remember that operations take place in all functions of an organisation, not just the operations function. The marketing function, for example, transforms information and materials, using staff and facilities, into marketing and sales operations. The accounting function transforms raw accounting data into usable management information and reports. Operations are, therefore, both a core function within an organisation, and activities within other functions. The principles of operations management apply to both.

5.2.3

Operations and competitive advantage As we noted at the start of this section, the overall objective of operations is to contribute to the competitive advantage of an organisation. Effective operations management can generate five types of advantage for an organisation:

5.2.4



It can reduce the costs of producing products and services.



It can increase customer satisfaction through good quality and service.



It can reduce the risk of operational failure, because well-designed and well-run operations should be less likely to fail. If they do fail, they should be able to recover faster and with less disruption than operations which are less well run.



It can reduce the amount of capital that has to be employed to provide the type or quantity of products and services which are required. The more effectively an organisation can use its resources and capacity, the less capital it should need to produce its products and services. Therefore, effective operations management can reduce the need for additional investment.



It can provide the basis for future innovation. Experiences learned from operating the processes can build a base of operations skills, knowledge and capability in the business, which can then enhance innovation.

Operations performance objectives In order for an organisation's operations to contribute to its competitive advantage and strategic success, the aims of its operations need to be aligned to its overall strategies. In this respect, Slack, Chambers and Johnston in Operations Management identify five basic 'performance objectives.' Slack et al stress that the objectives will mean different things for different operations, and some may be relatively more important than others in different contexts. Nevertheless, the five objectives can be used for evaluating operations to assess how well they are satisfying customers and contributing to competitiveness and strategic success. Quality – This entails the delivery of error-free goods or services, which are 'fit for the purpose' and provide a quality advantage. Quality is a major influence on customer satisfaction. If a customer perceives a product or service to be high quality, and is satisfied as a result, they are more likely to purchase the product or service again. Speed – The faster a customer can have the product or service, the more likely they are to buy it, the more they will be prepared to pay for it, or the greater the benefit they receive from it. In medical emergencies, for example, the speed at which a patient is treated could, literally, mean the difference between life and death. Dependability – This refers to the organisation consistently meeting its promises in relation to delivery of goods and services. For example, whether you can depend on your train arriving at its destination on time, and have seats available on it.

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Whilst speed, quality and cost (price) are all likely to be important operations performance objectives for McDonald's fast food restaurants, it could be said that customers are most attracted by the dependability factor. For example, customers can be confident that whichever McDonald's outlet they go to, they will be able to obtain a similar burger with a standard garnish. Dependability and speed are often linked, with the overall ‘delivery performance’ which a customer receives being the result of speed and dependability. There is a danger that companies try to avoid poor dependability results by increasing the lead-times they give to customers (ie reducing speed). However, such an approach is unlikely to be successful for two reasons: firstly, delivery times tend to expand to fill the time available; secondly, and more importantly, long delivery times are often the result of slow internal responses, complexity and lack of control within internal processes, which all contribute to poor dependability. Therefore, rather than increasing delivery times, an organisation should try to increase the speed and efficiency of its processes. Flexibility – the ability or willingness to change an operation in some way, for example either in relation to the range of products or services offered (range flexibility), or in relation to the time necessary to respond to changes in demand (response flexibility). We can identify four different types of flexibility, each of which can be shaped by range and response dimensions: 

Product/service flexibility – The ability or willingness to introduce new products/services, or to modify existing ones, and the time taken to do so.



Mix flexibility – The ability or willingness to adjust the range or mix of products/services.



Volume flexibility – The ability to change the aggregate level of activity or output, and to provide different quantities of a product or service over time.



Delivery flexibility – The operation's ability to change the timing of the delivery of products or services; for example, a car manufacturing plant's ability to reschedule manufacturing priorities, or a hospital's ability to reschedule appointments.

Cost – For companies which compete directly on price, cost is their major operating objective. The cheaper they can produce their goods or services, the lower the price they can charge their customers while still earning a profit margin. However, even companies which do not compete directly on price, will still be interested in keeping their costs low, because a reduction in costs should translate into an increase in profit (assuming other factors remain the same). All operations therefore have an interest in keeping their costs as low as possible whilst still meeting the levels of quality, speed, dependability and flexibility which their customers require. A measure often used to express how well an operation is achieving this is productivity – the ratio of the output produced by an operation in relation to the input required to produce it. Slack & Lewis point out that a broad definition of ‘cost’ is applied in relation to operations strategy. In this context ‘cost’ is any financial input to an operation which enables it to produce its products and services. Therefore an operations cost includes: operating expenditure, capital expenditure and working capital. Performance trade-offs At the start of this sub-section, we noted that some of the five performance objectives might be more important than others for specific organisations. For example, the speed with which a hospital can carry out a life-saving operation is likely to be more important than the cost. This idea of differential importance could be particularly relevant if an operation is faced with a trade-off between performance objectives. For example, if the cost of an operation needs to be reduced, this may only be possible by reducing the level of flexibility which can be offered. Conversely, there will also be occasions when improving the performance of the other four operations objectives leads to an improvement in cost performance. For example, improving operations quality will lead to a reduction in the time and cost spent correcting mistakes, re-producing faulty items, or dealing with customer complaints. Performance objectives and key performance indicators (KPIs) We will look at performance measurement and KPIs in more detail in the next chapter, but one of the problems organisations face when designing a performance measurement system is deciding which aspects of performance to measure. In this respect, considering an operation’s performance objectives, and which of them are most important for the continued success of that operation, could be a useful way of identifying key performance indicators for that operation. Slack and Lewis also note that a possible way for managers to drive improvements in operational

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performance is through benchmarking key elements of performance against ‘best in class’ competitors.

5.2.5

Performance objectives and competitive factors As we have already noted, operations play a key role in adding value and creating competitive advantage. However, both of these roles ultimately need to be referenced for the customer. As a result, performance objectives for the operations function must also be consistent with the needs and expectations of customers. For example, there is no point in producing a high-cost, high-quality product if the customers' needs are driven by speed and cost. Factors that are used to define customers' requirements are known as competitive factors. Depending on the perceived strength of each competitive factor in a particular market or market niche, a mix of performance objectives can be determined. 

If customers require a low-priced product, operational performance objectives will focus heavily on achieving a low cost of output.



If customers desire a high-quality product, and are willing to pay more to obtain it, operational performance objectives will focus on quality, perhaps within a cost constraint.



If customers need fast delivery of a product or service, operational objectives should be directed towards achieving or improving speed.



If customers want reliable delivery, operations should have a reliability objective. An example would be a courier service, where customers might want delivery of packages within a particular time. An operational objective for the courier company might therefore be to guarantee delivery by 9am on the following working day for all packages collected before 5pm the previous day.



Where customers prefer tailor-made or innovative products or services, operational objectives will be expressed in terms of flexibility in product manufacture or service delivery. If customers demand a wide range of products or services, operational objectives should be expressed in terms of flexibility to deliver the range of items demanded.



If customers want to change the timing or delivery of the products or services they receive, there should be operational objectives for flexibility in volume and speed.

Order-winning vs qualifying factors Another way of determining the relative importance of different competitive factors is to distinguish between those which are ‘order-winners’ and those which are ‘qualifying’ factors. Order-winners are factors which are regarded by customers as key reasons for purchasing a product or service (in preference to a rival product or service). Raising performance in an order-winning factor will either result directly in more business, or it will improve an organisation’s chance of gaining more business. Although qualifying factors are not the major competitive determinants of success, they are the aspects of competitiveness in which an operation’s performance has to achieve a certain level before it will even be considered by the customer. However, regardless of how well an organisation performs at its qualifiers, they, by themselves, are not going to generate any significant competitive benefits. By definition, customers expect qualifiers to be present, so an organisation cannot expect to achieve any competitive advantage by providing them. By contrast, however, if an organisation does not achieve satisfactory performance in its qualifiers, this is likely to result in considerable dissatisfaction among customers – which in turn could lead to an organisation losing customers. Therefore, while order-winners provide the greatest opportunity for competitive benefit, qualifiers have great potential to have a negative impact on performance. In effect, if we think back to the concepts of resource-based strategy we consider in Chapter 1 of this Study Manual, order-winners could be seen as an organisation’s critical success factors, or its core competences. In turn qualifying factors are more like threshold competences.

5.2.6

Decision areas Identifying performance objectives in relation to the five key performance areas of quality, speed, dependability, flexibility and cost, operations strategy decisions also have to be made in relation to capacity, supply networks, process technology, and development and organisation. (a)

Capacity strategy – This relates to how capacity and facilities should be configured, and deals with issues such as: 

What should the overall level of capacity be? (ie how big should an operation be?)

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

How many sites are required to deliver this capacity, and what size should they be?



Where should capacity be located? (eg close to customer locations, or according to the availability of required resources?)



Should each site carry out a range of activities, or should they specialise in a small number of activities?



When should capacity be changed, and by how much should it be changed?

In essence, when faced with decisions about capacity, organisations are faced with the following dilemma: too much capacity drives costs up, and leads to resources being under-utilised; too little capacity limits the operation’s ability to serve customers and therefore to earn revenues. Market requirements play a key role in determining capacity: in particular, forecast levels of demand. However, market demand is not static, so organisations have to plan their capacity levels against a backdrop of uncertainty of future demand (for example, due to change in customer tastes and trends, or competitor activity). As well as forecasting overall levels of demand, understanding the timing of that demand can also influence capacity. If demand is increasing, and competitive conditions dictate fast response times then an operation will be under greater pressure to increase capacity than if customers are willing to wait for a product or service. Once again though, organisations are faced with a dilemma: 

If they adopt a capacity-leading strategy (ie introduce additional capacity such that there is always sufficient capacity to meet forecast demand), revenue will be maximised and customers will be satisfied, but the increased capacity will require additional capital expenditure, and may actually result in over-capacity if demand does not reach forecast levels.



If they adopt a capacity-lagging strategy (ie manage capacity so that demand is always equal to, or greater than, capacity), an organisation ensures that its operations are always working at full capacity, but if there are increases in demand it may not be able to meet them fully – leading to lost revenue and dissatisfied customers.



Some organisations can use inventories to smooth capacity change, such that current capacity plus accumulated inventory can supply demand. However, such a strategy could lead to increases in working capital requirements and the cost of inventories held. Also, this kind of smoothing strategy is not possible for many service operations: for example, a hotel cannot satisfy demand for rooms in one month by using rooms that were vacant in the previous month.

An organisation’s capacity is also influenced by internal factors: for example, the availability of capital to support an expansion, or the cost structure associated with any expansion. The ideas of fixed costs and the break-even point are particularly important here. If an organisation has to invest in additional fixed costs to increase output, but the volume of output resulting from the incremental fixed costs is less thanits break-even point, an organisation may well choose not to increase its output (because it will operate more profitably by producing the lower level of output). Equally, however, the idea of economies of scale could encourage operations to increase their capacity and output in order to lead to a reduction in the unit cost of the products or service being produced. Similarly, economies of scale in production may encourage an organisation to concentrate output at a small number of large sites; but in turn, such an approach could lead to increased transportation costs and delivery times. (b)

Supply network strategy, including purchasing and logistics – This concerns how operations relate to the network of customers and suppliers (which we have already considered in the context of supply chain management earlier in this chapter). The decisions being made in relation to supply network strategy include: 

How much of the supply network does an entity wish to own (ie what degree of integration does it want within its supply chain network)?



Which operations should an organisation carry out in-house, and what should it buy from external suppliers (outsource)?



How does an entity predict and cope with dynamic disturbances and fluctuations within the network?



How many suppliers should it have?



Should the entity’s relationship with its suppliers be purely market-based (around individual transactions) or should it seek to develop long-term partnerships with suppliers?

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

Should the entity manage its supply chain network in different ways for different types of market?

(c) Process technology strategy – Process technology decisions relate to the choice and development of the systems, machines and processes which are used to transform input resources into finished products or services. However, process technology decisions also relate to the infrastructural and informational technologies which help control and co-ordinate processes. For example, in retail industries, inventory control systems link customer requirements and purchases with the supply chain; while in the airline industry, yield planning and pricing systems can play a key part of a company’s competitive strategy. The type of technology which is appropriate in different processes is likely to depend on the volume and variety in that process. 

High volume – low variety processes can use technology which is dedicated to a relatively narrow range of processing requirements. The technologies used in high volume– low variety processes are often highly automated, largescale, and closely coupled. (Coupling refers to the linking together of separate activities within a single piece of technology to form an interconnected processing system). They are usually designed to try to make production costs as low as possible. As a result, they tend to be capital intensive, rather than labour intensives.



High variety – Low volume processes demand technology which is general purpose, such that it can perform the wide range of processing activities involved in high variety processes. The high level of variety also means that these processes will require a higher degree of flexibility than high volume– low variety ones. Appropriate process technologies for high variety– low volume processes are likely to have relatively low degrees of automation because there will be a significant amount of human intervention (ie the processes will be relatively labour intensive). Similarly the technologies are likely to be smaller-scale and less closely coupled than those which are required for high volume– low variety processes.

Scale and scalability are also important considerations for process technologies, particularly for information processing technologies. Slack & Lewis define scalability as: 'the ability to shift to a different level of useful capacity quickly, cost-effectively and flexibly.’ The need for scalable process technologies is particularly strong if the process technology is customer facing and in a dynamic marketplace where there can be significant variations in demand. For example, if the capacity of e-commerce websites is too low, the technology (server etc.) can become swamped during periods of high demand, leading to customer dissatisfaction at the slowness of the website. Coupling and connectivity – We have already identified the importance of coupling in information processing technology in our discussion of supply chain management earlier in this chapter. For example, supermarkets allow key suppliers access to shared data portals which provide real time information about how products are selling in their stores. Such a system enables the supply companies to modify their production and delivery schedules in order to meet demand more precisely and to ensure fewer stock-outs. Another key issue in resource planning and control is managing the information generated from different functions within a business, which again highlights the potential importance of enterprise resource planning (ERP) systems, which we mentioned earlier in the chapter. (d)

Development and organisation – Development and organisation decisions are broad, long-term decisions about how an operation is run on an on-going basis. The sorts of decision being considered here are:  

How does an entity enhance and improve the processes within an operation over time? How should new product and service development be organised?

For many organisations, product and service development is becoming increasingly important as competition in their markets becomes more intense. In many markets, there are a number of competitors who are very similar to each other in terms of the products and services they offer. In such circumstances, even small improvements to product and service specifications can have a significant impact on competitiveness.

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In a number of places in this text already we have seen how technological developments have provided new opportunities for businesses and industries, but increasingly organisations are recognising that the responsibility for developing new products or services needs to be shared across the organisation as a whole. Every part of an organisation needs to challenge itself to think how it can deploy its competences and skills in order to develop better products and services, or – equally importantly – how to improve the processes which produce and deliver them. Product development Product development is often presented as a stage model, in which initial concepts are generated (either from within an organisation or from outside it – from customers or competitors) and then these initial concepts are screened in relation to whether they are consistent with an organisation’s market positioning, whether they are feasible technically and operationally, and whether they are financially viable. Following this concept screening, a preliminary design is made of the product/service, and this preliminary design is then evaluated, to see whether the design can be improved. After the design evaluation, the improved design is turned into a prototype so that it can be tested before the product is finally launched onto the market. For example, many retail organisations pilot new products in a small number of stores to test customers’ reactions to them, before launching the products across all their stores. Although Slack and Lewis acknowledge that stage models of product development are useful in identifying the activities which need to take place during the overall development activities, they suggest that in practice a more useful way of thinking about the product development process is as a funnel. Many concepts enter the development process (ie at the wide end of the funnel) but the process then screens alternative designs against criteria such as market acceptability, technical capability, financial return and so on, until ultimately one ‘best’ design emerges from the narrow end of the funnel. In many cases, the changes which operations experience are likely to be minor modifications or extensions to existing products/ processes. However, at times there will need to be substantial changes. As we have noted earlier in this chapter, the scope and nature of a change will affect the way it needs to be managed in order for it to be implemented successfully.

5.2.7

The operations strategy matrix In Figure 3.3 we identified the importance of the two perspectives of market requirements and operational resources in determining operations strategy. And while each perspective is important in its own right, the intersection between them is potentially more important. Slack & Lewis use the concept of the operations strategy matrix to define this relationship, with operations strategy being characterised as the intersection of a company’s performance objectives with its decision areas. In other words, the organisation needs to consider how its capacity strategy is going to affect quality, speed, dependability, flexibility and cost. Likewise, how will flexibility be influenced by capacity, supply networks, process technology and development and organisation decisions?

5.2

Operations: The four Vs The characteristics of different operations will also affect the way in which they are organised and managed. These characteristics can be summarised as 'the four Vs':    

The volume of their output The variety of their output The variation in the demand for their output The degree of visibility which customers have of the production of their output.

The four Vs and unit costs All four dimensions (the four Vs) have significant implications for the cost of producing products or services. In summary, high volume, low variety, low variation in demand, and low visibility all help to keep operations processing costs low. In contrast, low volume, high variety, high variation in demand, and high customer contact usually generate higher costs for the operation. For example, McDonald's restaurants epitomise high-volume burger production. Within this highvolume operation, the tasks carried out by McDonald's are systemised and repeated, and can be carried out using specialised fryers and ovens. The relatively narrow range of meals on the menu also reduces the level of variety in McDonald's output. All of these factors help McDonald's keep its unit costs low.

5.3

Capacity planning Various types of capacity plan may be used.

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5.4



Level capacity plan: Plan to maintain activity at a constant level over the planning period, and to ignore fluctuations in forecast demand. In a manufacturing operation, when demand is lower than capacity, the operation will produce goods for inventory. In a service operation, such as a hospital, restaurant or supermarket management must accept that resources will be under-utilised for some of the time, to ensure an adequate level of service during peak demand times. Queues will also be a feature of this approach.



Chase demand plan: Aim to match capacity as closely as possible to the forecast fluctuations in demand. To achieve this aim, resources must be flexible. For example, staff numbers might have to be variable and staff might be required to work overtime or shifts. Variations in equipment levels might also be necessary, perhaps by means of short-term rental arrangements.



Demand management planning: Reduce peak demand by switching it to the off-peak periods such as by offering off-peak prices.



Mixed plans: Capacity planning involves a mixture of level capacity planning, chase demand planning and demand management planning.

Capacity control Capacity control involves reacting to actual demand and influences on actual capacity as they arise. IT/IS applications used in manufacturing operations include:

5.5



Materials requirements planning (MRP I): Converts estimates of demand into a materials requirements schedule.



Manufacturing resource planning (MRP II): A computerised system for planning and monitoring all the resources of a manufacturing company: manufacturing, marketing, finance and engineering.



Enterprise resource planning (ERP) software: Encompasses a number of integrated modules designed to support all of the key activities of an enterprise. This may comprise managing the key elements of the supply chain such as product planning, purchasing, stock control and customer service, including order tracking.

Just-in-time systems Definition Just-in-time: An approach to planning and control based on the idea that goods or services should be produced only when they are ordered or needed. Just-in-time production can also be called lean production. The ‘lean’ approach aims to meet demand instantaneously, with perfect quality and no waste. In other words, the flow of products and services always matches exactly what customers want (in terms of quality, quantity, and timing) and at the lowest possible cost. Crucially, the trigger for any activity in just-in-time (or ‘lean’) systems is the request of a customer; activity is ‘pulled’ by the customer, rather than ‘pushed’ by a supplier.

5.6.1

JIT purchasing With JIT purchasing, an organisation establishes a close relationship with trusted suppliers, and develops an arrangement with the supplier for being able to purchase materials only when they are needed for production. The supplier is required to have a flexible production system capable of responding immediately to purchase orders from the organisation.

5.6.2

JIT and service operations The JIT philosophy can be applied to service operations as well as to manufacturing operations. Whereas JIT in manufacturing seeks to eliminate inventories, JIT in service operations seeks to remove queues of customers. Queues of customers are wasteful because:   

They waste customers' time. Queues require space for customers to wait in, and this space is not adding value. Queuing lowers the customer's perception of the quality of the service.

The application of JIT to a service operation calls for the removal of task specialisation, so that the work force can be used more flexibly and moved from one type of work to another, in response to demand and work flow requirements.

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5.6

Quality management Definitions Quality assurance: Focuses on the way a product or service is produced. Procedures and standards are devised with the aim of ensuring defects are eliminated (or at least minimised) during the development and production process. Quality control: Is concerned with checking and reviewing work that has been done. Quality control therefore has a narrower focus than quality assurance.

5.7.1

Cost of quality The cost of quality may be looked at in a number of different ways. For example, some may say that producing higher quality output will increase costs – as more costly resources are likely to be required to achieve a higher standard. Others may focus on the idea that poor quality output will lead to customer dissatisfaction, which generates costs associated with complaint resolution and warranties. The demand for better quality has led to the acceptance of the view that quality management should aim to prevent defective production, rather than simply detect it, because it reduces costs in the long run. Most modern approaches to quality have therefore tried to assure quality in the production process, (quality assurance) rather than just inspecting goods or services after they have been produced.

5.7.2

Total Quality Management (TQM) Total Quality Management (TQM) is a popular technique of quality assurance, and can be thought of as a philosophy for how to approach the organisation of quality improvement within an organisation. The main elements of TQM are: 

Customer-centric approach: Customers are the most important part of an organisation, and are vital to its success – or even its survival. The whole organisation needs to focus on meeting the needs and expectations of customers.



Internal customers and internal suppliers: All parts of the organisation are involved in quality issues, and need to work together. Every person and every activity in the organisation affects the work done by others. The work done by an internal supplier for an internal customer will eventually affect the quality of the product or service to the external customer.



Service level agreements: Some organisations formalise the internal supplier-internal customer concept by requiring each internal supplier to make a service level agreement with its internal customer, covering the terms and standard of service.



Quality culture within the firm: Every person within an organisation has an impact on quality, and it is the responsibility of everyone to get quality right.



Empowerment: Recognition that employees themselves are often the best source of information about how (or how not) to improve quality.

6 Evaluating functional strategies 6.1

Functional strategies Definition

Functional strategies: Are concerned with how the component parts of an organisation deliver effectively the corporate- and business-level strategies in terms of resources, processes and people. (Johnson, Scholes and Whittington)

6.2

Evaluating functional strategies in support of corporate strategy A change of corporate strategy will inevitably require new functional strategies. For instance, in Section 3.1 the case study on Marks & Spencer detailed some of the challenges faced by the new CEO in the year 2000. Perhaps more importantly, online sales grew as M&S embraced the idea of becoming a multichannel business. Online sales grew 31% in the financial year 2010-2011 following a number of enhancements to the website, improving customer experience and encouraging more shoppers to complete their transactions online. In its 2011 Annual Report, M&S also noted that 'The use of social media is enabling use to engage with our customers and gain further insights into their shopping habits and preferences.

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7 Business plans 7.1

Contents of a business plan A business plan is the foundation upon which a funding application will be made.

7.2

w finance issues

Constructing the business plan The starting point for constructing the plan will be to project forward the current financial statements. In doing so, the lender's major interest will be in cash generation, as it will be the ability to generate cash to repay the loan that will ultimately determine whether an offer to provide finance is made. Therefore, it is important that the logic behind a cashflow forecast can be demonstrated. The potential cashflows to be included would be: Cash outflows Cash inflows  Payments to payables  Cash sales  Capital expenditure  Cash from receivables  Loan repayments  Interest receipts  Interest payments  

Tax payments Dividend payments

It will also be expected that the borrower can reconcile these projections to the current and projected financial forecasts, ie you must be able to show how the forecast profit and cashflows reconcile. As you will be aware from your Financial Reporting studies, these differences arise from:

7.3



Timing differences – A sale or purchase is recorded in the financial statements when they are made, as opposed to when the cash is physically paid or received.



Non-cash movements – Accounting adjustments such as depreciation, amortisation and movements in provisions will not appear in a cashflow forecast.

Critiquing the business plan If a business plan is being used to start a new enterprise, the decision of the financier will rest in part on the credibility of the plans they are presented with. As such, it will be essential that the proprietor reviews their plan to ensure that they are able to present a compelling, but realistic case for finance. The questions that the proprietor should ask will include:

7.3.1



Are the sales and revenue forecasts reasonable/achievable? This could be assessed against external estimates of market growth, but also need to be considered in conjunction with an organisation's capacity, and consideration of any limiting factors.



Are the costs understated? Over time, costs will rise due to inflationary pressures. The headline government measure of inflation may be misleading, therefore the specific rates of inflation relevant to the raw materials used, or labour hired should be used instead. Do costs accurately reflect new initiatives (eg expansion plans)?



Are market share projections realistic? This could be assessed against external market research data.

Assurance over prospective financial information By definition, business plans represent prospective financial information. ISAE 3400, The Examination of Prospective Financial Information provides the following definition of this information: ‘Prospective financial information’ means financial information based on assumptions about events that may occur in the future and possible actions by an entity. It is highly subjective in nature and its preparation requires the exercise of considerable judgement. ISAE 3400 also reminds us that prospective financial information can be prepared: (a)

As an internal management tool, for example, to assist in evaluating a possible capital investment

(b)

For third parties, for example, as a prospectus to provide potential investors with information about future expectations, or as a document to provide potential lenders with information about cash flow forecasts.

In the context of business plans, any potential investor is likely to want prospective financial information

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which is understandable, relevant, reliable and comparable – so that they can evaluate whether or not to invest in the business under review. We could argue that prospective financial information is actually of more interest to users of accounts than historic information. That said, and as the ISAE definition identifies, prospective financial information is highly subjective in nature, and a significant amount of judgement has to be exercised in its preparation. Therefore, auditors do not produce a statutory report on prospective information in the way that they do on historic information – they can still provide an alternative service, in the form of a review or assurance engagement. Reporting on prospective financial information is covered by ISAE 3400, The Examination of Prospective Financial Information. ISAE 3400 states that the procedures the auditor carries out should be designed to obtain sufficient evidence as to whether: 

Management's best-estimate assumptions, on which the prospective financial information is based, are not unreasonable, and, in the case of hypothetical assumptions, such assumptions are consistent with the purpose of the information



The prospective financial information is properly prepared on the basis of the assumptions



The prospective financial information is properly presented and all material assumptions are adequately disclosed, including a clear indication as to whether they are best-estimate assumptions or hypothetical assumptions, and



The prospective financial information is prepared on a consistent basis with historical financial statements, using appropriate accounting principles.

ISAE 3400 identifies that the key issues that projections relate to are profit, capital expenditure and cash flows. In this context, it suggests the auditor should undertake procedures to:

7.3.2



Verify projected income figures to suitable evidence (for example, by reviewing the company's proposed prices against prices charged by competitors).



Verify project expenditure figures to suitable evidence (for example, by reviewing quotations provided to the organisation, or by reviewing current bills for existing services).



Check capital expenditure for reasonableness (for example, if the proposal relates to new premises, the cost of purchasing these should be reviewed against prevailing market rates).



Review cash forecasts to ensure the timings are reasonable, and the cash forecast is consistent with any profit forecasts (ie income/expenditure should be the same, just at different times).

Accepting an engagement to examine prospective financial information As well as identifying the procedures which an auditor should undertake in an engagement to examine prospective financial information, ISAE 3400 also identifies that there are a number of factors an auditor should consider before accepting the engagement. These include understanding: 

The intended use of the information



Whether the information will be for general or limited distribution



The nature of the assumptions used in the information: whether they are best-estimate or hypothetical



The elements to be included in the information



The period covered by the information

Importantly, ISAE 3400 warns that ‘the auditor should not accept, or should withdraw from, an engagement when the assumptions are clearly unrealistic or when the auditor believes that the prospective financial information will be inappropriate for its intended use.’

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Strategic Business Management Chapter- 4

Strategic performance management 1 Performance management 1.1

Performance measurement and control All systems of control can be analysed using the cybernetic model. The essence of this model is the feedback of control action to the controlled process: the control action itself being generated from the comparison of actual results with what was planned. Performance measurement has become such an accepted part of business life that sometimes we lose sight of its purpose.

1.1.1

(a)

Performance measurement is part of the overall cybernetic (or feedback) control system, providing the essential feedback spur to any necessary control action.

(b)

It is a major input into communications to stakeholder groups, including the widening field of corporate reporting.

(c)

It is intimately linked to incentives and performance management systems, providing evidence of results against agreed objectives.

(d)

Motivation may be enhanced since managers will seek to achieve satisfactory performance in areas that are measured.

Feedback loops To some extent, planning and controlling are two sides of a single coin, since a plan is of little value if it is not put into action, while a system of control can only be effective if the people running it know what it is they are trying to achieve. In the cybernetic system, an objective is established: for the organisation, this might be the current year's budget. Actual achievement is measured, perhaps by means of monthly reports, and a process of comparison takes place (for example, by comparing actual figures to budgeted ones). Managers can then take control action to try to make up for any failures to achieve the plan. This control action feeds back into the activity of the organisation and its effects should become apparent in the next monthly report. This kind of feedback loop is the essence of any control system, though sometimes it may be difficult to discern its existence and operation.

Definition Feedback: Feedback occurs when the results (outputs) of a system are used to control it, by adjusting the input or behaviour of the system. Businesses use feedback information to control their performance. However, when considering feedback loops, it is important to distinguish between single loop feedback and double loop feedback. In single loop feedback, changes are made to the system's behaviour in order to try to meet the plan. By contrast, double loop feedback can result in changes being made to the plan itself. Using a simple example, if an organisation's operating profit is below budget, managers could be asked to identify ways to reduce costs in order to help bring profits back in line with budget. This is single loop feedback. Alternatively, the organisation might realise that an adverse variance on costs is due to a rise in raw material costs which is outside its control. Therefore, the organisation could reforecast its original cost budget, but it could also consider whether it needs to revise its sales prices in the light of the change in costs. Any such changes to re-forecast the original budget would be double loop feedback.

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Organisations as open systems Importantly, the simple illustration above in relation to double loop feedback shows how external factors (in this case, a rise in raw material input costs) can affect an organisation's performance. However, external factors can affect performance more generally. 'PESTEL' analysis identifying opportunities and threats to an organisation, but the changing business environment and other external factors can equally have a significant influence on an organisation's current performance. The fact that performance is influenced by external and environmental factors highlights that organisations are open systems, and therefore, there are likely to be aspects of performance which are beyond an organisation's control. However, this can raise difficulties in relation to performance management in an organisation. Consider the following simple example. An organisation has noticed that it has been failing to meet revenue targets in recent weeks, and it has identified that problems with its website have meant that some customers have not been able to make orders online. Consequently, the organisation devoted a considerable amount of resources to improving its website to make it more reliable and user-friendly. However, when the improved website went live, the organisation noticed that its revenues were still behind budget. Now managers realised that one of the organisation's major competitors had reduced their prices and another competitor had launched a new market-leading product. Both of these initiatives had enabled the competitors to increase their market share at the organisation's expense. This simple example illustrates that the 'open system' nature of organisations means that, often, managers cannot attribute performance to a single issue, but need to look at it as a combined effect of many variables. Equally, the idea that different business units or functions within an organisation are also open systems, means that managers need to be aware of the inter-dependencies of different operations and processes within an organisation, as well as the overall environment in which the organisation operates.

1.1.2

Scope of performance management Our discussion of feedback and control has looked mainly at organisational performance. However, performance management can be applied at different levels within an organisation (corporate, business unit, team, individual). This highlights the issue of goal congruence when designing performance reward systems. In particular, reward systems need to be designed in such a way that individuals' goals (in order to earn their rewards) are aligned to team goals and the organisation's goals overall. It is also important to note that aspects of human resource management (HRM) (such as setting performance objectives and reward management) play an important role in the performance management and control of the organisation. In this respect, HRM follows a similar control model as is used for the overall strategic and operational control of an organisation:

Step Step Step Step

1: 2: 3: 4:

Goals are set (for individuals). Performance is measured and compared with target. Control measures are undertaken in order to correct any shortfall. Goals are adjusted in the light of experience.

However, it is crucial to recognise that the goals set for individuals should link to, and support the achievement of, the key strategic and operational success factors for an organisation. Effective performance management requires that the strategic objectives of the organisation are broken down into layers of more and more detailed sub-objectives, so that individual performance can be judged against personal goals that support and link directly back to corporate strategy.

1.2

Budgetary control systems Budgetary control systems are used by many companies to compel planning, co-ordinate activities and motivate employees, as well as to evaluate performance. Deviations from the plan are corrected via control action. A budget is a plan expressed in monetary terms. It is prepared and approved prior to the budget period and may show income, expenditure and capital to be employed.

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Purpose of budgets      

To compel planning To co-ordinate activities To communicate ideas To provide a framework for responsibility accounting To motivate employees and management To evaluate performance

Negative effects of budgets include     

Limited incentives if the budget is unrealistic A manager may add a percentage to his expenditure budget to ensure that he can meet the figure Manager achieves target but does no more A manager may go on a 'spending spree' Draws attention away from the longer term consequences

Problems with budgetary control   

The managers who set the budgets are often not responsible for attaining them The goals of the organisation as a whole, expressed in the budget, may not coincide with the personal aspirations of the individual managers Control is applied at different stages by different people

How to improve behavioural aspects of budgetary control      

Develop a working relationship with operational managers Keeping accounting jargon to a minimum Making reports clear and to the point Providing control and information with a minimum of delay Ensuring actual costs are recorded accurately Allow for participation in the budgetary process

Limitations to the effectiveness of participation   

1.3

Some people prefer tough management A manager may build slack into his own budget Management feels that they have little scope to influence the final outcome

Criticisms of traditional budgeting According to the co-founders of the 'Beyond Budgeting' movement, Jeremy Hope and Robin Fraser, traditional budgets hold companies back, restrict staff creativity and prevent them from responding to customers. Hope and Fraser quoted a 1998 survey which found that 88% of respondents were dissatisfied with the budgeting model. They also highlighted some surprising statistics: (a)

78% of companies do not change their budget during the annual cycle. Managers tend to 'manage around' their budgets.

(b)

60% do not link strategy and budgeting.

(c)

85% of management teams spend less than one hour a month discussing strategy.

Budgets tend to focus upon financial outputs rather than quantitative performance measures, and are not linked to employee performance.

1.4

Beyond Budgeting There is much debate about whether the traditional budgeting models evaluated above are suitable in many modern organisations. Much of this debate revolves around whether traditional models can operate effectively in a changing environment. 'Beyond Budgeting' is one response to the perceived weaknesses in traditional budgeting.

1.5

Traditional budgeting v 'Beyond Budgeting' Hope and Fraser argue that 'traditional' budgeting processes do not meet the purposes of performance management. The table below illustrates the ways in which Hope and Fraser feel Beyond Budgeting differs from 'traditional' budgeting, and also how 'Beyond Budgeting' meets the purposes of performance management better.

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2 Information for strategic decision making 2.1

Levels of information and decision making The hierarchy of performance in organisations depends on strategic, tactical and operational levels of performance. This idea of a hierarchy is also important in relation to the data and performance information required for decision-making and control in organisations.

2.2

Strategic information Strategic planning, management control and operational control may be seen as a hierarchy of planning and control decisions.

2.3

Strategic information systems Crucially in order for managers or accountants to be able to measure the performance of their organisations, the relevant performance information needs to be available to them. This highlights the importance of information systems. Strategic IT systems include Executive Information Systems (EIS), Management Information Systems (MIS) and Decision Support Systems (DSS). Value added networks facilitate the strategic use of information in order to add value.

2.3.1

Executive Information Systems (EIS) Definition Executive Information Systems (EIS): A system that pools data from internal and external sources and make information available to senior managers in an easy-to-use form. EIS helps senior managers make strategic, unstructured decisions. An EIS should provide senior managers with easy access to key internal and external information. The system summarises and tracks strategically critical information, possibly drawn from internal MIS and DSS, but also including data from external sources eg competitors, legislation, and external databases such as Reuters. An EIS is likely to have the following features.   

2.3.2

Flexibility Quick response time Sophisticated data analysis and modelling tools

Management Information Systems (MIS) Definition Management Information Systems (MIS): Systems that convert data from mainly internal sources into information (eg summary reports, exception reports). This information enables managers to make timely and effective decisions for planning, directing and controlling the activities for which they are responsible. An MIS provides regular reports and (usually) on-line access to the organisation's current and historical performance. MIS usually transform data from underlying transaction processing systems into summarised files that are used as the basis for management reports. MIS have the following characteristics:     

2.3.3

Support structured decisions at operational and management control levels Designed to report on existing operations Have little analytical capability Relatively inflexible Have an internal focus

Decision support systems (DSS) Definition Decision Support Systems (DSS): Systems that combine data and analytical models or data analysis tools to support semi-structured and unstructured decision making. DSS are used by management to assist in making decisions on issues which are subject to high levels of

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uncertainty about the problem, the various responses which management could undertake or the likely impact of those actions. Decision support systems are intended to provide a wide range of alternative information gathering and analytical tools with a major emphasis upon flexibility and user-friendliness. DSS have more analytical power than other systems, enabling them to analyse and condense large volumes of data into a form that helps managers make decisions. The objective is to allow the manager to consider a number of alternatives and evaluate them under a variety of potential conditions. Executives at small and medium sized companies are making critical business decisions every day based on the information available to them. This information can come from a variety of sources: opinions from peers and colleagues; a personal sense of intuition or business judgment; or data derived internally or externally to the organisation. This is worrying, however, given the lack of confidence in the data available to decision makers.

2.3.4

Value added networks Definition Value added networks: VANs are networks that facilitate the adding of value to products and (particularly) to services by the strategic use of information. Typically, VANs will link separate organisations together through electronic data interchanges (EDIs), contributing to the development of business networks. Also, they are often business ventures in their own right, with companies subscribing to the services available. Good examples are the SABRE, Amadeus and Galileo airline flight booking systems. A simpler example is the electronic data interchange systems between manufacturers and their suppliers that facilitate the operation of just-in-time (JIT) logistics. VANs give mutual competitive advantage to all their subscribers, but only so long as some competitors are left outside of the system. As soon as membership of the VAN (or a competing VAN) becomes a standard feature of the industry, the original competitive advantage is lost. Competitive advantage based on VAN membership can then only exist if there is more than one VAN and each VAN in the industry offers a different degree of benefit in terms of cost reduction or differentiation.

2.4

Strategic information systems Definitions Information Systems (IS) strategy is the long-term plan for systems to exploit information in order to support business strategies or create new strategic options. Information Technology (IT) strategy is concerned with selecting, operating and managing the technological element of the IS strategy. Information Management (IM) strategy deals with the roles of the people involved in the use of IT assets, the relationships between them and design of the management processes needed to exploit IT. Strategic Information Systems are systems at any level of an organisation that change goals, processes, products, services or environmental relationships with the aim of gaining competitive advantage. Michael Earl's analysis of information strategy into three elements (IS, IT and IM) is useful. The first distinction he made was between the strategies for information systems and information technology.

2.4.1

Levels of information strategy Information systems (IS) strategy An information systems (IS) strategy is concerned with specifying the systems (in the widest meaning of the word) that will best enable the use of information to support the overall business strategy and to deliver tangible benefits to the business (for example, through increased productivity, or enhanced profits). In this context, a 'system' will include all the activities, procedures, records and people involved in a particular aspect of the organisation's work, as well as the technology used. The information systems strategy is focussed on business requirements, the demands they make for information of all kinds and the nature of the benefits that information systems are expected to provide. This strategy is very much demand-led and business-driven: each SBU in a large organisation is likely to have its own information systems strategy.

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The IS strategy is supported by: Information technology (IT) strategy The information technology strategy, by contrast is technology-focussed and looks at the resources, technical solutions and systems architecture required to enable an organisation to implement its information systems (IS) strategy. IT strategies are likely to look at the hardware and software used by the organisation to produce and process information. They may also include aspects of data capture and data storage, as well as the transmission and presentation of information. Information management (IM) strategy (IM) Earl subsequently also highlighted the need for an information management strategy. The emphasis here is on management: managing the role and structure of IT activities within an organisation, and managing the relationships between IT specialists and the users of information. In this respect, a key feature of IM strategy is its focus on roles and relationships. IM strategy also plays an important part in ensuring that information can be accessed by all the people who need it, but, at the same time, access to information is restricted to those people who need access to it. We might sum up the three levels of information strategy in very simple terms by saying that: IS strategy defines what is to be achieved; IT strategy determines how hardware, software and telecommunications can achieve it; and the IM strategy describes who controls and uses the technology provided. This model of information strategy has the advantage of being internally consistent and quite simple to understand. Unfortunately, the picture is spoiled by a different use of the term information management. You may come across a rather narrow use of this term to mean 'the approach taken to storing and accessing data'. Since this is really just an aspect of the information technology strategy, as defined above, we do not recommend the use of the term in this way.

2.5

The challenge for accountants The availability and appreciation of the myriad of new information systems has challenged the role of the accountant in the control framework. These new systems, such as EIS, have highlighted a number of perceived failings in the traditional accounting systems organisations had relied upon. (a)

Direction towards financial reporting. Historical costs are necessary to report to shareholders, but the classifications of transactions for reporting purposes are not necessarily relevant to decision- making.

(b)

Misleading information â&#x20AC;&#x201C; particularly with regard to overhead absorption.

(c)

Neatness rather than usefulness.

(d)

Internal focus. Management accounting information has been too inward looking, (for example focusing on achieving internal performance targets, like budgets). However, organisations also need to focus on customers and competition.

(e)

Inflexibility and an inability to cope with change.

The challenge lies in providing more relevant information for strategic planning, control and decision making. Traditional management accounting systems may not always provide this.

2.5.1

(a)

Historical costs are not necessarily the best guide to decision making. However, management accounting information is often criticised for focusing on the past rather than the future.

(b)

Strategic issues are not easily detected by management accounting systems.

(c)

Financial models of some sophistication are needed to enable accountants to provide useful information.

Objectives of management accounting information Management accounting information is used by managers for a variety of purposes: (a)

To measure performance. Management accounting information can be used to analyse the performance of the business as a whole, and of the individual divisions, departments or products within the business. Performance reports provide feedback, most frequently in the form of comparison between actual performance and budget.

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(b)

To control the business. Performance reports are a crucial element in managing a business. In order to be able to control their organisation, managers need to know the following: (i) (ii)

What they want the business to achieve (targets or standards; budgets) What the business is actually achieving (actual performance)

By comparing the actual achievements with targeted performance, management can decide whether corrective action is needed, and then take the necessary action when required. Much control information is of an accounting nature because costs, revenues, profits and asset values are major factors in how well or how badly a business performs.

2.6

(c)

To plan for the future. Managers have to plan, and they need information to do this. Much of the information they use is management accounting information.

(d)

To make decisions. As we have seen, managers are faced with several types of decision: (i)

Strategic decisions (which relate to the longer term objectives of a business) require information which tends to concern the organisation as a whole, is in summary form and is derived from both internal and external sources.

(ii)

Tactical and operational decisions (which relate to the short or medium term and to a department, product or division rather than the organisation as a whole) require information that is more detailed and more restricted in its sources.

What is strategic management accounting? The aim of strategic management accounting is to provide information that is relevant to the process of strategic planning and control.

Definition Strategic management accounting: A form of management accounting in which emphasis is placed on information about factors which are external to the organisation, as well as non-financial and internally-generated information.

2.6.1

External orientation The important fact, which distinguishes strategic management accounting from other management accounting activities, is its external orientation, towards customers and competitors, suppliers and perhaps other stakeholders. For example, whereas a traditional management accountant would report on an organisation's own revenues, the strategic management would report on market share or trends in market size and growth. (a)

Competitive advantage is relative. Understanding competitors is therefore of prime importance. For example, knowledge of competitors' costs, as well as a firm's own costs, could help inform strategic choices: a firm would be unwise to pursue a cost leadership strategy without first analysing its costs in relation to the cost structures of other firms in the industry.

(b)

2.6.2

Customers determine if a firm has competitive advantage.

Future orientation A criticism of traditional management accounts is that they are backward looking. (a) (b)

Decision making is a forward- and outward-looking process. Accounts are based on costs, whereas decision making is concerned with values.

Strategic management accountants will use relevant costs (ie incremental costs and opportunity costs) for decision making. We return to this topic later in this Study Manual.)

3 Performance measurement Performance measures must be relevant to both a clear objective and to operational methods, and their production must be cost-effective.

3.1

Deciding what measures to use Clearly different measures are appropriate for different businesses. Determining which measures are

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used in a particular case will require preliminary investigations along the following lines.

3.1.1

(a)

The objectives/mission of the organisation must be clearly formulated so that when the factors critical to the success of the mission have been identified, they can be translated into performance indicators.

(b)

Measures must be relevant to the way the organisation operates. Managers themselves must believe the indicators are useful.

(c)

The costs and benefits of providing resources (people, equipment and time to collect and analyse information) to produce a performance indicator must be carefully weighed up.

Critical success factors Organisations use critical success factors (CSFs) to determine their information requirements. However, CSFs are also relevant here. CSFs highlight the elements of performance that are vital to an organisation's success. In turn, however, this means it is important for organisations to measure how well they are performing in those key areas of performance. For example, if an organisation identifies that 'quality of service' is a CSF, then the organisation also needs to monitor the level of service it is providing its customers.

3.2

Financial modelling and performance measurement Financial modelling might assist in performance evaluation in the following ways.

3.3

(a)

Identifying the variables involved in performing tasks and the relationships between them. This is necessary so that the model can be built in the first place. Model building therefore shows what should be measured, helps to explain how a particular level of performance can be achieved, and identifies factors in performance that the organisation cannot expect to control.

(b)

Setting targets for future performance. The most obvious example of this is the traditional budgetary control system.

(c)

Monitoring actual performance. A flexible budget is a good example of a financial model that is used in this way.

(d)

Co-ordinating long-term strategic plans with short term operational actions. Modelling can reflect the dynamic nature of the real world and evaluate how likely it is that short-term actions will achieve the longer-term plan, given new conditions.

Profitability, activity and productivity In general, there are three possible points of reference for measurement. (a)

Profitability Profit has two components: cost and income. All parts of an organisation and all activities within it incur costs, and so their success needs to be judged in relation to cost. Only some parts of an organisation receive income, and their success should be judged in terms of both cost and income.

(b) Activity All parts of an organisation are also engaged in activities (activities cause costs). Activity measures could include the following. (i) (ii)

Number of orders received from customers, a measure of the effectiveness of marketing Number of machine breakdowns attended to by the repairs and maintenance department

Each of these items could be measured in terms of physical numbers, monetary value, or time spent. (c)

Productivity This is the quantity of the product or service produced in relation to the resources put in, for example, so many units produced per hour or per employee. It defines how efficiently resources are being used.

The dividing line between productivity and activity is thin, because every activity could be said to have some 'product'; or if not, can be measured in terms of lost units of product or service.

3.4

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relation to something else. Profits are higher than last year's; cashflow has improved compared with last quarter's and so forth. We can generalise the above and give a list of yard-sticks against which financial results are usually placed so as to become measures.       

3.5

Budgeted sales, costs and profits Standards in a standard costing system The trend over time (last year/this year, say) The results of other parts of the business The results of other businesses The economy in general Future potential (eg a new business in terms of nearness to breaking even)

The profit measure Profit has both advantages and disadvantages as a measure of performance. When evaluating the use of profit as a performance measure, also remember the concept of value based management. Value based management suggests that performance measures should show how well an organisation is creating value for its shareholders; however, this value should be measured in relation to discounted future cash flows, rather than profit.

3.5.1

Ratios Ratios are a useful way of measuring performance for a number of reasons.

3.6

(a)

It is easier to look at changes over time by comparing ratios in one time period with the corresponding ratios for periods in the past.

(b)

Ratios are often easier to understand than absolute measures of physical quantities or money values. For example, it is easier to understand that 'productivity in March was 94%' than 'there was an adverse labour efficiency variance in March of £3,600'.

(c)

Ratios relate one item to another, and so help to put performance into context. For example the profit/sales ratio sets profit in the context of how much has been earned per £1 of sales, and so shows how wide or narrow profit margins are.

(d)

Ratios can be used as targets. In particular, targets can be set for ROI, profit/sales, asset turnover, capacity fill and productivity. Managers will then take decisions which will enable them to achieve their targets.

(e)

Ratios provide a way of summarising an organisation's results, and comparing them with similar organisations.

Measuring performance in the new business environment As well as arguing that organisations need to rethink the basis on which they prepare budgets ('Beyond Budgeting', Hope and Fraser have also argued that if organisations are serious about gaining real benefits from decentralisation and empowerment, they need to change the way in which they set targets, measure performance and design reward systems. Hope and Fraser suggested the following scenario to highlight the relationship between targets and management responsibilities: A strategic business unit (SBU) manager is asked for a 'stretch target'. However, under the Beyond Budgeting model, the manager knows that 'stretch' really means their best shot with full support from the centre (including investment funds and improvement programmes) and a sympathetic hearing should they fail to get all of the way. Moreover, the manager alone carries the responsibility for achieving these targets. There is neither any micro-management from above, nor any monthly 'actual versus budget' reports. Targets are both strategic and financial, and they are underpinned by clear action plans that cascade down the organisation, building ownership and commitment at every level. Monthly reports comprise a balanced scorecard set of graphs, charts and trends that track progress (eg financial, customer satisfaction, speed, quality, service, and employee satisfaction) compared with last year and with other SBUs within the group and, where possible, with competitors. Quarterly rolling forecasts (using broad-brush numbers only) are also prepared to help manage production scheduling and cash requirements, but these forecasts are not part of the measurement and reward.

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Performance review. If there is a significant blip in performance (and the fast/open information system would flag this immediately), then a performance review would be signalled. Such reviews focus on the effectiveness of action plans and what further improvements need to be made. The review might even consider whether the targets (and measures) themselves are still appropriate. There are a number of reasons why this approach is successful.

3.7

(a)

Managers are not punished for failing to reach the full target.

(b)

The use of the balanced scorecard ensures that all key perspectives are considered.

(c)

Because managers set their own targets and plan the changes needed to achieve them, real ownership and commitment are built. Feedback and learning takes place as a result of the tracking of action plans. (Contrast this with numerical variances that tell managers nothing about what to do differently in the future.)

(d)

Beating internal and external competitors is a constant spur to better performance.

(e)

Managers share in a bonus pool that is based on share price or long-term performance against a basket of competitors. Resource and knowledge sharing is therefore encouraged.

Leading and lagging indicators An important element of performance management is developing appropriate performance metrics. As far as possible, performance measures should be linked to a company's strategy, value drivers and critical success factors, as well as short-term and long-term goals. Many companies now adopt the balanced scorecard concept â&#x20AC;&#x201C; or a similar multi-dimensional performance model â&#x20AC;&#x201C; with performance measures in a number of categories, such as financial, operations, customers, human resources. However, whilst it can be beneficial to monitor performance in a range of areas, managers should avoid measuring too many aspects of performance. Instead they must concentrate on the metrics that are most important, in order to avoid succumbing to information overload. Nonetheless, when identifying which metrics to measure, it is important to balance traditional financial measures with non-financial ones. In particular, measures should be selected to provide a balance of leading and lagging indicators. Most traditional, financial performance measures are lagging indicators, connected with past performance and past events. However, such indicators do not necessarily help managers or directors to understand the future challenges an organisation will face. By contrast, leading indicators can point to future performance successes or problems. For example, declining customer satisfaction levels could point to future revenue issues and a longer-term erosion of the value of a company's brand.

3.8

Non-financial performance measures Definition

Non-financial performance measures: These are measures of performance based on non-financial information which may originate in, and be used by, operating departments to monitor and control their activities without any accounting input. Non-financial performance measures may provide a more timely indication performance than financial measures do. The beauty of non-financial performance measures is that anything can be compared if it is meaningful to do so. The measures should be tailored to the circumstances so that, for example, the number of coffee breaks you take for every hour you study indicate to you how hard you are studying!

3.8.1

The advantages and disadvantages of non-financial measures Unlike traditional variance reports, non-financial measures can be provided quickly for managers, per shift or on a daily or hourly basis, as required. They are likely to be easy to calculate, and easier for non-financial managers to understand and therefore, to use effectively. There are problems associated with choosing the measures and there is a danger that too many such measures could be reported, overloading managers with information that is not truly useful, or that sends conflicting signals. There is clearly a need for the information provider to work more closely with the managers who will be using the information to make sure that their needs are properly understood.

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Research on more than 3,000 companies in Europe and North America has shown that the strongest drivers of competitive achievement are the intangible factors, especially intellectual property, innovation and quality. Non-financial measures have been at the forefront of an increasing trend towards customer focus (such as TQM), process re-engineering programmes and the creation of internal markets within organisations. Arguably, some non-financial measures may be less likely to be manipulated than traditional profitrelated measures and they should, therefore, offer a means of counteracting short-termism, since short-term profit at any expense is rarely an advisable goal. However, while there may be a danger of manipulation in financial information systems, which may be exacerbated by inappropriate reward systems (eg a 'bonus culture'), this does not mean that financial performance indicators are inherently more vulnerable to manipulation than non-financial performance indicators. For example, which are likely to be subject to the more stringent controls: financial, or nonfinancial information systems? Remember also, the ultimate goal of commercial organisations in the long run is likely to remain the maximisation of profit, and so the financial aspect cannot be ignored. A further danger of non-financial measures is that they might lead managers to pursue detailed operational goals and become blind to the overall strategy in which those goals are set. Consequently, using a combination of financial and nonâ&#x20AC;&#x201C;financial measures is likely to be most successful; as, for example, in the Balanced Scorecard.

3.8.2

The performance measurement manifesto Eccles argues that financial measures alone are inadequate for monitoring the progress of business strategies based on creating customer value, satisfaction and quality, partly because they are historical in nature and partly they cannot measure current progress with such strategies directly. He also notes the impulse to short-termism given by such measures. There is a need for a performance measurement system that includes both financial and non-financial measures. The measures chosen must be integrated, so that the potential for discarding non-financial measures that conflict with the financial ones is limited. Eccles argues that too often firms prioritise financial measures above non-financial ones, and if the two clash the financial priorities take priority. However, Eccles points out that non-financial measures such as quality, customer satisfaction and market share are now equally important as purely financial measures. Eccles says that the development of a good system of performance measurement requires activity in five areas.

3.9

(a)

The information architecture must be developed. This requires the identification of performance measures that relate to strategy and the gradual, iterative development of systems to capture the required data.

(b)

An appropriate information technology strategy must be established.

(c)

The company's incentives system must be aligned with its performance measures. Eccles proposes that qualitative factors should be addressed by the incentive system.

(d)

External influences must be acknowledged and used. For example, benchmarking against other organisations may be used, while providers of capital should be persuaded to accept the validity of non-financial measures.

(e)

Manage the implementation of the four areas above by appointing a person to be responsible overall as well as department agents.

Value for money (VFM) audits Value for money audits can be seen as being of particular relevance in not-for-profit organisations. Such an audit focuses on economy, efficiency and effectiveness. These measures may be in conflict with each other. To take the example of higher education, larger class sizes may be economical in their use of teaching resources, but are not necessarily effective in creating the best learning environment.

3.10

The Balanced Scorecard A key theme so far has been that financial measurements do not capture all the strategic realities of an entity, but, equally, it is equally important that financial measurements are not overlooked. A failure to attend to the 'numbers' can rapidly lead to a failure of the business. However, financial measurements do not capture all the strategic realities of a business, so businesses need to look at both financial and non-financial measures. The balanced scorecard seeks to translate mission and strategy into objectives and measures, and

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focuses on four different perspectives. For each of the four perspectives, the scorecard aims to articulate the outcomes an organisation desires, and the drivers of those outcomes. Performance targets are set once the key areas for improvement have been identified, and the balanced scorecard is the main monthly report. The scorecard is balanced in the sense that managers are required to think in terms of all four perspectives, to prevent improvements being made in one area at the expense of another.

3.11

Linkages Disappointing results might arise from a failure to view all the measures as a whole. For example, increasing productivity means that fewer employees are needed for a given level of output. Excess capacity can be created by quality improvements. However, these improvements have to be exploited (eg by increasing sales). The financial element of the balanced scorecard reminds executives that improvements in quality, response time, productivity or new products, only benefit a company when they are translated into improved financial results, or if they enable the company to achieve a sustainable competitive advantage.

3.12

Implementing the balanced scorecard The introduction and practical use of the balanced scorecard is likely to be subject to all the problems associated with balancing long-term strategic progress against the management of short-term tactical imperatives.

3.13

Strategic application of the balanced scorecard If an organisation decides to introduce and use a Balanced Scorecard, it will then have to decide what performance indicators (KPIs) should be collected, and how should these be reported in a way that helps the organisation make better decisions. The choice of KPIs could be informed via the hierarchy identified by Robert Anthony (see Section 2.1). Once the organisational strategy has been defined, this can be distilled into a sequence of vertically consistent objectives. These objectives should be orientated in a manner that allows the organisation to improve performance in the business critical processes that support its Critical Success Factors (those things the organisation must excel in to be competitive). The balanced scorecard can then be used to track performance against the CSFs via the KPIs selected. It follows therefore, that the balanced scorecard can be used to track performance at the hierarchical levels identified by Anthony. Thus, some KPIs will be derived to track operational efficiency; others, to assess management's tactical performance; and still others, to illustrate the success of the overall organisational strategy.

3.14

Example indicators The exact measures an organisation uses will depend on its context, but the indicators below suggest some possible measures for each scorecard category:

3.15

3.16

Using the balanced scorecard (a)

Like all performance measurement schemes, the balanced scorecard can influence behaviour among managers to conform to that required by the strategy. Because of its comprehensive nature, it can be used as a wide-ranging driver of organisational change.

(b)

The scorecard emphasises processes rather than departments. It can support a competence-based approach to strategy, but this can be confusing for managers and may make it difficult to gain their support.

(c)

Deciding just what to measure can be difficult, especially since the scorecard vertical vector lays emphasis on customer reaction. This is not to discount the importance of meeting customer expectations, purely to emphasise the difficulty of establishing what they are.

Strategy maps However, it is also important to recognise that the balanced scorecard only measures performance. It does not indicate that the strategy an organisation is employing is the right one. Therefore, if improvements in operational performance do not result in improved financial performance, managers may need to rethink the company's strategy or its implementation plans; for example, whether the areas which have been targeted for operational improvements really are the ones which are critical in delivering value for the organisation.

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3.17

Problems with using the balanced scorecard As with all techniques, problems can arise when the balanced scorecard is applied. It may also be worth considering the following issues in relation to using the balanced scorecard: 

It doesn't provide a single aggregate summary performance measure. For example, part of the popularity of ROI or ROCE comes from the fact that they provide a convenient summary of how well a business is performing.



In comparison to measures like economic value added (EVA), there is no direct link between the scorecard and shareholder value.



Culture: Introducing the scorecard may require a shift in corporate culture; for example, in understanding an organisation as a set of processes rather as departments.



Equally, implementing the scorecard will require an organisation to move away from looking solely at short-term financial measures, and focus on longer-term strategic measures instead.

The scorecard should be used flexibly. The process of deciding what to measure forces a business to clarify its strategy. For example, a manufacturing company may find that 50% – 60% of costs are represented by bought-in components, so measurements relating to suppliers could usefully be added to the scorecard. These could include payment terms, lead times, or quality considerations.

3.18

Assurance and performance indicators We have mentioned a number of potential performance measures in this chapter, but in order for an entity to use KPIs as a basis for management decision-making and control, it needs to be confident that the indicators are calculated reliably, and consistently, across different periods or divisions. Many companies now publish a selection of key performance indicators (KPIs) in their annual reports. By definition, these KPIs should focus on the aspects of performance that are most important to the continued success of the company. Some KPIs may be financial (such as ratios based on the financial statements) but the majority of KPIs should be non-financial. Therefore, despite the insight they can give into a company's performance – and the fact that they are likely to be picked up on and discussed by analysts and investors – these KPIs will not have been audited as part of the financial statements. Similarly, the systems which generate these non-financial KPIs are unlikely to have been scrutinised by internal or external auditors in the way that financial systems have been. Consequently, from both an internal (management) and external perspective it will be valuable for entities to seek additional assurance over these KPI figures. The assurance approach towards KPIs should consider how the KPIs have been defined, how they have been calculated, and why they are reported. The ICAEW Audit & Assurance Faculty’s paper ‘The journey milestone 1: assurance over key performance indicators’ suggests that the process of providing assurance over KPIs should be relatively straightforward. An entity’s management have already chosen the indicators, developed a rationale for the use of each indicator, and a method for calculating it. An independent practitioner can then gather evidence to support an opinion on whether the KPIs have been prepared in accordance with the disclosed method of calculation. The ICAEW paper suggests that there are three elements for an assurance provider to consider: 

The design of the methodology – Is the methodology used to prepare the KPI appropriate for providing an indicator that will give a robust measure of an aspect of performance?



The implementation of the methodology – Have the calculations in relation to the indicator been carried out correctly?



The quality of the raw data – Have the underlying inputs into the calculation been correctly derived from an appropriate source?

Definition of the KPI – When considering the design of the methodology, an assurance provider needs to assess whether the methodology used to measure the KPI is consistent with the definition of the KPI. The ICAEW paper illustrates this point with the following example: If a railway company decided to exclude cancelled trains from its definition of ‘delays’, and if it did so without amending its definition of the indicator, its apparent performance in relation to ‘train delays’ would be improved, despite passengers being left waiting on platforms for long periods due to trains being cancelled. Quality of the raw data – Even if the methodology used is appropriate and is implemented correctly, a KPI could still be misstated as the data being used to calculate it is inaccurate – either due to poorly

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designed systems, or ineffective controls over those systems. Therefore testing the design and operation of the systems which produce the underlying data can be an important part of gaining assurance over the fair presentation of KPIs. This testing can also provide a degree of on-going comfort over the presentation of the same KPIs over a period of time. Choice of KPIs In addition to checking the accuracy of the indicators disclosed, an assurance provider should also consider the choice of KPIs, together with the context in which they are presented. This could be complicated because the assurance provider will need to consider what other KPIs could have been included, and therefore whether the selection of KPIs reported on might distort a reader’s impression of an entity’s performance. In this context, an assurance provider might need to consider the following questions: 

Is each KPI described in a way which is not misleading, and allows an informed user to make worthwhile comparisons, year-on-year, and with other businesses?



Are KPIs linked in the narrative reporting to underlying strategic imperatives, as well as associated targets and trends, thereby giving the reader sufficient context to understand how they relate to value creation within an entity?

4 Rewards, behaviour and performance In this Section we look at a range of issues surrounding remuneration and reward. A key issue to consider in relation to performance management is how remuneration and reward packages influence directors' and employees' performance.

4.1

Executive pay The perception that some directors are being paid excessive salaries and bonuses has been seen as one of the major corporate abuses for a large number of years. It is thus inevitable that the corporate governance provisions have targeted it. The Greenbury Committee in the UK set out principles which are a good summary of what remuneration policy should involve. 

Directors' remuneration should be set by independent members of the board.



Any form of bonus should be related to measurable performance or enhanced shareholder value.



There should be full transparency of directors' remuneration, including pension rights, in the annual accounts.

What the Greenbury Report was, in part, recognising was one of the undesirable side-effects of agency theory and the principal-agent problem we mentioned in Chapter 3 of this Study Manual. In the context of executive pay, the directors are considered to be the agents of the company, and as such should be acting in the best interests of the principals (the shareholders) and not themselves. If the agents are allowed to set their own pay, there is an inevitable conflict of interest whereby the agent (directors) will be tempted to pay themselves far in excess of what their performance merits. As such, the remuneration committee acts as a barrier against the principal-agent problem.

4.2

The remuneration committee The remuneration committee plays the key role in establishing remuneration arrangements. In order to be effective, the committee needs both to determine the organisation's general policy on the remuneration of executive directors and specific remuneration packages for each director. Measures to ensure that the committee is independent include not just requiring that the committee is staffed by non-executive directors, but also placing limits on the members' connection with the organisation. Measures to ensure independence include stating that the committee should have no personal interests other than as shareholders, no conflicts of interest and no day-to-day involvement in running the business.

4.3

Remuneration packages Packages will need to attract, retain and motivate directors of sufficient quality, whilst at the same time taking into account shareholders' interests as well. However, assessing executive remuneration in an imperfect market for executive skills, may prove problematic. The link between remuneration and company performance is particularly important. Recent UK guidance has stressed the need for the performance-related elements of executive directors' remuneration to be stretching, designed to align their interests with those of shareholders and promote the long-term success of the company. Remuneration incentives should be compatible with risk policies and systems, and criteria for paying bonuses should be risk-adjusted.

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Discussion is often in terms of designing a remuneration package that encourages directors to avoid excessive risks. However, directors' remuneration can also be designed to encourage cautious directors to take more risks. Shareholders, who hold diversified portfolios, may be keener for a company that undertakes a risky investment than its directors, whose livelihood may be threatened if the investment is not a success.

4.4

Establishing remuneration arrangements Issues connected with remuneration policy may include the following: 

The pay scales applied to each director's package.



The proportion of the different types of reward within each package.



The period within which performance related elements become payable.



Determining what proportion of rewards should be related to measurable performance or enhanced shareholder value, and the balance between short and long-term performance elements.



Transparency of directors' remuneration, including pension rights. A simple scheme, such as basing a bonus on profit, may make directors' actions easier to understand than a more complicated scheme where the basis for the total reward is unclear. However, a simple scheme may be easier to manipulate through creative accounting.

When establishing remuneration policy, boards have to take into account the position of their company relative to other companies. However, the UK Corporate Governance Code points out the need for remuneration committees to treat such comparisons with caution, in view of the risk of an upward ratchet in remuneration levels, with no corresponding improvement in performance. As you can see, in line with other sections of the UK Code, the guidance provides only a framework for decision making, rather that a prescribed formula. Inevitably, giving such wide scope for setting pay has resulted in some controversial decisions. An illustration of shareholder conflict resulting from executive pay is detailed below.

4.5

Basic salary Basic salary will be in accordance with the terms of the directors' contract of employment, and is not related to the performance of the company or the director. Instead, it is determined by the experience of the director and what other companies might be prepared to pay (the market rate).

4.6

Performance related bonuses Directors may be paid a cash bonus for good (generally accounting) performance. To guard against excessive payouts, some companies impose limits on bonus plans as a fixed percentage of salary or pay. Transaction bonuses tend to be much more controversial. Some chief executives get bonuses for acquisitions, regardless of subsequent performance, and as well as further bonuses for spinning off acquisitions that have not worked out. Alternatively, loyalty bonuses can be awarded merely to reward directors or employees for remaining with the company. As we have already noted in Section 4.3, the link between remuneration and company performance is particularly important. However non-executive directors should not be remunerated by shares or other performance-related elements, to preserve their independence.

4.7

Shares Directors may be awarded shares in the company with limits (a few years) on when they can be sold in return for good performance.

4.8

Share options Share options give directors and possibly other managers and staff the right to purchase shares at a specified exercise price after a specified time period in the future. The options will normally have an exercise price that is equal to, or slightly higher than, the market price on the date that the options are granted. The time period (vesting period) that must pass before the options can be exercised is generally a few years. If the director or employee leaves during that period, the options will lapse. The options will generally be exercisable on a specific date at the end of the vesting period. The UK Corporate Governance Code states that shares granted, or other forms of remuneration, should not vest or be exercisable in less than three years. Directors should be encouraged to hold their shares for a further period after vesting or exercise. If directors or employees are granted a number of

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options in one package, these options should not all be able to be first exercised at the same date. If the price of the shares rises so that it exceeds the exercise price by the time the options can be exercised, the directors will be able to purchase shares at lower than their market value. Share options can therefore be used to align management and shareholder interests, particularly options held for a long time when value is dependent on long-term performance. The main danger is that the directors will have an incentive to manipulate the share price if a large number of options are due to be exercised. Options can also be used to encourage cautious directors to take positive action to increase the value of the company. Shareholders should be holding a wide portfolio that diversifies away unsystematic risk, but directors have less opportunity to diversify their careers and are dependent on their recommendations being successful. An investment opportunity that would attract shareholders because the returns are high relative to the systematic risk, may be rejected by directors because they are exposed to the total risks of it going wrong. Shareholders therefore need to find a way of encouraging directors to accept the same risks as they would tolerate themselves. Share options can assist in this process because for options, the upside risk is unlimited – there is no boundary to how much the share price can exceed the exercise price. However, initially at least, there is no corresponding downside risk. If the share price is less than the exercise price, the intrinsic value of options will be zero and the options will lapse. In these circumstances, it will make no difference how far the share price is below the exercise price. If directors are awarded significant options, the value of these options will rise if a risky investment succeeds and they will not suffer any loss on their options if the investment fails. However, if the options become inthe-money over a period of time, then directors may become risk averse as they stand to lose the accumulated gains on the options if an investment fails. The performance criteria used for share options are a matter of particular debate. Possible criteria include the company's performance relative to a group of comparable companies. There are various tricks that can be used to reduce or eliminate the risk to directors of not getting a reward through options. Possibilities include grants that fail to discount for overall market gains, or are cushioned against loss of value through compensatory bonuses or re-pricing. The UK Corporate Governance Code states that non-executive directors should not normally be offered share options, as options may impact upon their independence.

4.8.1

Share options and IFRS 2 Newly established entities with limited cash resources may use the promise of share growth as a way to attract and retain high calibre individuals. Before the publication of IFRS 2, Share-based Payment, the provision of, say, a share option was not recognised at all in the employing entity's income statement under international accounting standards. This led to significant employee benefits provided by an entity not being recognised in its financial statements. IFRS 2 requires an expense representing the fair value of the options to be recognised over the period from the grant date to the vesting date. The fair value is initially ascertained using a model such as Black-Scholes and includes the following variables:     

Market price of shares Exercise price Volatility Risk free rate of return Length of option

However, additional vesting conditions and long time periods make employee options more difficult to value than traded options.

4.8.2

Underwater options Whilst share options can be a useful tool in helping to motivate employees to work hard and stay loyal to a company, this will only be effective if the exercise price is below the market price at the date of maturity. For instance, an employee of A plc who holds the right to purchase 1,000 shares at £2.50 each, is left without any benefit if A's shares are trading at £2.20 on the date the option matures. In such circumstances, the option is worthless and is referred to as being 'underwater' (ie where it is significantly out-of-the-money). Of course, the employee is able to track the real-time share price versus the price of their options at all times and may therefore realise well in advance that the benefit will not come to

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fruition. In such circumstances, the motivational impact of the option scheme may be nil or negative. A further negative aspect of share options is that they may tie unhappy employees into an ongoing employment relationship past the point at which they wish to leave. For instance, an unhappy worker may stay in a post and be consequently unproductive, merely to stay on long enough to collect a share option pay-out.

4.9

Benefits in kind Benefits in kind could include transport (eg a car), health provisions, life assurance, holidays, expenses and loans. The remuneration committee should consider the benefit to the director and the cost to the company of the complete package. Also the committee should consider how the directors' package relates to the package for employees. Ideally, perhaps the package offered to the directors should be an extension of the package applied to the employees. Loans may be particularly problematic. Some high-profile corporate scandals have included a number of instances of abuses of loans, including a $408 million loan to WorldCom Chief Executive Officer, Bernie Ebbers. Using corporate assets to make loans when directors can obtain loans from commercial organisations seems very dubious, and a number of jurisdictions prohibit loans to directors of listed companies.

4.10

Pensions Many companies may pay pension contributions for directors and staff. In some cases however, there may be separate schemes available for directors at higher rates than for employees. The UK Corporate Governance Code states that, as a general rule, only basic salary should be pensionable. The Code emphasises that the remuneration committee should consider the pension consequences and associated costs to the company of basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement. The Walker report on UK financial institutions responded to concerns raised about aspects of pension arrangements. It recommended that no executive board member or senior executive who leaves early should be given an automatic right to retire on a full pension â&#x20AC;&#x201C; that is, through enhancement of the value of their pension fund.

4.10.1

Pensions and strategic decision making Increasingly pension fund liabilities are influencing strategic decisions. For private companies with their own pension schemes, the actuarial valuation of the company's pension plan can be a deal-breaker in relation to mergers and acquisitions, as any liability to pay future pensions will pass to the new owners in that any deficit will be charged to the company's future profits. Under UK pension regulations, employers operating schemes that have deficits have to agree with the scheme's trustees a plan to pay off the deficit, generally by making extra payments.

4.10.2

Accounting for Pensions One of the key financial reporting problems in recent years has been the issue of how to account for large pension deficits arising for example, from falling equity values, interest rate changes and changes in life expectancy. Although pension plans are generally operated by independent trustees, they are set up for the benefit of the employing entity's employees, with the employing entity often retaining significant obligations under the plans, which need to be accounted for. In some cases, pension plans may, in substance, be assets and liabilities of the employing entity itself. To ensure that all pension plans are accounted for and presented in a consistent manner, IAS 19, Employee Benefits sets out the accounting requirements. Employees generally receive a number of different benefits as part of their complete remuneration package, and these are also addressed in IAS 19. A key purpose of IAS 19 is to ensure that employer obligations in respect of future liabilities to pay pensions are recognised in the statement of financial position, less any funds specifically allocated to cover them, making the financial statements more transparent.

4.11

Considerations for pay at all levels An effective reward system should facilitate both the organisation's strategic goals and also the goals of individual employees. Within this, an organisation has to make three basic decisions about monetary reward:

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  

How much to pay Whether monetary rewards should be paid on an individual, group or collective basis How much emphasis to place on monetary reward as part of the total employment relationship

However, there is no single reward system that fits all organisations. Irrespective of what type of system is implemented, an organisation should pursue three behavioural objectives.

4.12



It should support recruitment and retention.



It should motivate employees to high levels of performance. This motivation may, in turn, develop into commitment and a sense of belonging, but these do not result directly from the reward system.



It should promote compliance with workplace rules and expectations.

Performance related pay Even below the executive level, it may be beneficial for an organisation to link pay to performance (PRP schemes). Should the company be able to find a way to link the personal objectives of its employees to the corporate objectives, then better goal congruence should result. If this is then linked to financial reward for the employees, perhaps in the form of bonuses or share-schemes, then there should be mutual benefits for employees, employer and owners. When designing PRP schemes, a company must be careful not to structure incentives in such a way that poor performance is also rewarded. The financial crisis of 2007–8 has showed the dangers of linking reward schemes to performance measures if those performance measures are poorly designed. For example, many commentators have suggested that bank bonus schemes in the past encouraged a focus on short-term decision making and risk taking. A European Commission report into the financial crisis suggested that, 'Excessive risk taking in the financial services industry…has contributed to the failure of financial undertakings…Whilst not the main cause of the financial crises that unfolded…there is widespread consensus that inappropriate remuneration practices…also induced excessive risk taking.' In this case, there appears to be a direct link between the profit measures (short term profitability) and the risk appetite of employees. Employees were prepared to take greater risks in the hope of making higher profits, and therefore getting larger bonuses. However, a second potential drawback for an organisation arises if it is unable to reward individuals for good performance (for instance, due to a shortage of funds) because then the link between reward and motivation may break down. If an individual's goals are linked to the objectives of the organisation, then it is clear to the individual how their performance is measured and why their goals are set as they are. However, on occasions there may be a problem in linking individual rewards directly to organisational outcomes, especially if the latter are uncertain. Another drawback is that, in striving to meet targets, some individuals may become cautious and reluctant to take risks, given that they have a stake in the outcome. Conversely, other individuals may choose riskier behaviour, especially if reward is linked to, say, revenue generation or levels of output.

4.13

Behavioural implications of performance targets In general terms, performance management acts as a control system for measuring people's achievement against targets. However, in order for the performance management to be beneficial, it is important to select the right measures or targets at the start when performance goals are set. There is an old adage (often attributed to the management guru, Peter Drucker): 'What gets measured, gets done.' The issue being identified here is that if particular performance targets or objectives are set, employees know that their performance is likely to be appraised against those targets and so they will concentrate on achieving them in preference to other possible aspects of their role. However, this could have negative side effects elsewhere. For example, in the UK in recent years, there have been concerns that airport passengers have had to wait too long to pass through passport control. If performance targets were set in relation to passenger waiting times (or the length of the queues), staff might respond by trying to speed up the passenger checks they carry out. However, this could lead to a reduction in the quality or thoroughness of the checks being carried out, and in turn could lead to an increased risk of failing to detect passengers who are trying to pass through passport control without valid documentation. The following two short examples also illustrate the potential negative side effects of setting inappropriate targets:

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4.13.1

(i)

The manager of a fast food restaurant was striving to achieve a bonus which was dependent on minimising the wastage of chicken or burgers. The manager earned the bonus by instructing staff to wait until the chicken or the burgers were ordered before cooking them. However, the long waiting time which resulted led to a huge loss of customers in the following weeks.

(ii)

Sales staff at a company met their target sales by offering discounts and extended payment terms, and in some cases, even selling to customers who they felt might never pay. As a result, the staff were meeting their targets at the expense of the company's profitability. However, the sales staff were motivated by a bonus scheme which was based solely on the level of sales they achieved.

Targets and motivation A key consideration when setting targets is the extent to which they will motivate staff. Too easy: If the targets set are too easy, employees will achieve their targets easily, but the targets will not serve to optimise their performance. Too hard: If the targets set are too hard, staff are likely to treat them as unrealistic, and will not be motivated to try to achieve them. In this respect, the most effective targets will be 'stretch' targets: targets that will be challenging for the staff, but which are potentially achievable. Employees will therefore be motivated to try to meet the targets, even if they ultimately fail to do so.

4.13.2

Controllability and responsibility accounting Responsibility centres in an organisation are usually divided into four categories: 

Cost centres – Where managers are accountable for the costs that are under their control. Cost centre managers are not accountable for sales revenues. (However, it is important to note that cost centres can still affect the amount of sales revenues generated if quality standards are not met, or if goods are not produced on time.)



Revenue centres – Where managers are only accountable for sales revenues, and possibly directlyrelated selling expenses (eg salesperson salaries). However, revenue centre managers are not accountable for the cost of the goods or services they sell.



Profit centres – Managers are given responsibility for both revenues and costs.



Investment centres – Managers are responsible not only for revenues and costs, but also for working capital and capital investment decisions.

When measuring the performance of a responsibility centre, a key issue is distinguishing which items the manager of that centre can control (and therefore they should be held accountable for) and those items over which they have no control (and therefore they should not be held accountable for). This principle of controllability underpins the idea of responsibility accounting: that managers should only be made accountable for those aspects of performance they can control. In this respect, the controllability principle suggests that uncontrollable items should either be eliminated from any reports that are used to measure managers' performance, or that the effects of these uncontrollable items are calculated and then the relevant reports should distinguish between controllable and uncontrollable items. As with unrealistic targets, it follows that if managers feel that their performance targets are based on factors or results which they cannot control, they are unlikely to be motivated to try to achieve them. In practice, the controllability principle can be very difficult to apply, because many areas do not fit neatly into controllable and uncontrollable categories. For example, if a competitor lowers their prices, this may be seen as an uncontrollable action. However, a manager could respond to the competitor's action by changing the company's own prices, which could then reduce the adverse effect of the competitor's actions. So, in effect, there are both controllable and uncontrollable actions here. Similarly, if a supplier increased the price of their product, this may be seen as an uncontrollable action. However, a manager could respond by looking to change supplier or using a different product in order to reduce the adverse impact of the supplier's actions. Again, there are potentially both controllable and uncontrollable actions here. Accordingly, any analysis of performance would need to consider the impact of the competitor's or supplier's actions as one element, and then the impact of the manager's response as a second element.

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Controllable costs Controllability can also be a particular issue when looking at costs within companies. Consider the following example: A company has three operating divisions and a head office. The divisional managers think it is unfair that a share of indirect costs â&#x20AC;&#x201C; such as central finance, HR, legal and administration costs â&#x20AC;&#x201C; are included in their divisional results because the divisional managers cannot control these costs. Importantly, there is a distinction here between considering the divisional manager's performance and the division's performance as a whole. In order to evaluate the performance of the divisional manager, then only those items which are directly controllable by the manager should be included in the performance measures. So, in our mini example, the share of indirect costs re-apportioned from the head office should not be included. These costs can only be controlled where they are incurred. Therefore, the relevant head office managers should be held accountable for them. As the divisional managers have suggested, it would be unfair to judge them for this aspect of performance. However, in order for the head office to evaluate the division's overall performance for decision-making purposes (for example, in relation to growth, or divestment) it is appropriate to include a share of the head office costs. If divisional performance is measured only on those amounts the divisional manager can control, this will overstate the economic performance of the division. If the divisions were independent companies, they would have to incur the costs of those services which are currently provided by the head office (for example, finance and HR costs). Therefore, in order to measure the economic performance of the division, these central costs, plus any interest expenses and taxes, should be included within the measure of the division's performance.

5 Corporate social responsibility and performance Although we have highlighted the importance of looking at non-financial aspects of performance as well as financial aspects, the non-financial elements look mainly at customers, business processes, quality, and learning and development. One potential criticism of the Balanced Scorecard we could make, however, is that it does not consider any aspects of social responsibility, sustainability and environmental matters. However, these elements of social responsibility and sustainability are becoming increasingly important in shaping an organisation's long-term success. The relevance here, though, is to remind us that when determining performance metrics, organisations should also consider social and environmental performance, as well as more conventional elements of 'business' performance. Promoting socially responsible behaviour can have commercial benefits for an organisation. For example, companies that set standards for social responsibility could be listed on the FTSE4Good Index. The Index is comprised of companies which sets standards for corporate social responsibility (CSR). Members are expected to meet its criteria, including those on environment, supply chain and anti-bribery. Fund managers are increasingly placing funds into responsible investments, including the FTSE4Good index. Similarly, Elkington, who developed the idea of the 'Triple Bottom Line', believes that environmental and social accounting will also develop our ability to see whether or not a particular company or industry is 'moving in the right direction.' However, the development of environmental management accounting, for example, will encourage the introduction of more environmental performance measures. There could also be a direct link between 'environmental' behaviour and performance. There are potentially a number of ways poor environmental behaviour can affect a firm: it could result in fines (for pollution or damage), increased liability to environmental taxes, loss in value of land, destruction of brand values, loss of sales, consumer boycotts, inability to secure finance, loss of insurance cover, contingent liabilities, law suits, and damage to corporate image. Moreover, although health and safety measures do not necessarily add value to a company on their own, they can help to protect a company against the cost of accidents which might otherwise occur. If a company has poor health and safety controls, this might result in, amongst other things, increased sick leave amongst staff and possible compensation claims for any work-related injuries, as well as higher insurance costs to reflect the higher perceived risks within the company. Triple bottom line and performance management In this respect, the idea of the triple bottom line has important implications for performance

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measurement and performance management. Instead of concentrating on financial performance, and particularly on short-term financial performance, companies should also pay greater attention to the longer-term social, environmental and economic impact that they have on society. In turn, this means that they need to develop performance measures that address these factors, as well as measures focusing on short term financial performance.

5.1

Measures of CSR performance Although corporate social responsibility initiatives and measures can be extremely broad, and will vary from industry to industry, some prevailing themes are likely to emerge.

5.2

Legal requirements and corporate reporting implications While some of the pressure on organisations to become more socially responsible has come from stakeholder expectations (including investors and the media who are paying closer attention to companies' social and environmental performance), perhaps more importantly many businesses now also face a legal requirement to report on social and environmental matters in their annual reports.

5.2.1

Strategic reports In the UK, the Companies Act 2006 (Strategic Report and Directors’ Reports) Regulations 2013 require quoted companies to report on environmental matters within the Strategic Report section of their Annual Report, to the extent that this environmental information is necessary for an understanding of the development, performance or position of the company’s business. The Report should include: 

The main trends and factors likely to affect the future development, performance and position of the company's business



Information about: (i)

Environmental matters (including the impact of the company's business on the environment);

(ii)

The company's employees;

(iii) Social, community and human rights issues including information about any company policies in relation to those matters and the effectiveness of those policies. Companies should include key performance indicators about environmental matters and employee matters in their Strategic Report, where appropriate.

5.2.2

Company employees The Companies Act 2006 (Strategic Report and Directors' Report) Regulations 2013 require that, in additional to general reporting on their employees, quoted companies report specifically on the number of men and women on their board, in executive committees and the organisation as a whole. These regulations also expand the requirements surrounding social and community issues to include specific consideration of human rights.

5.2.3

Greenhouse Gas emissions In conjunction with the general requirement for companies to include information about environmental matters in their business reviews, the Companies Act 2006 (Strategic Report and Directors' Reports) Regulations 2013 require that quoted companies have to report their annual greenhouse gas emissions in the directors' report. Mandatory reporting is seen as a vital first step in getting companies to reduce their greenhouse gas emissions. By measuring and reporting greenhouse gas emissions, companies can begin to set targets and put in place management initiatives to reduce emissions in the future. (The requirement covers all greenhouse gases, not just carbon dioxide emissions.) Commentators have suggested that by helping businesses to understand their carbon emissions, carbon reporting will help them identify opportunities to reduce costs, improve their reputation and potentially manage longer term business risks. However, the legislation also has important performance measurement and performance management implications for companies:

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The Companies Act Regulations apply to all emissions sources for which the reporting company is responsible, not just those sources in the UK. This means that multinational companies will have to have data collection systems for gathering information from global operations, as well as a set of global emissions factors to measure performance against. Perhaps equally importantly, the legislation could encourage companies to make energy efficiency part of their business strategy and, for example, when evaluating a new strategic option, to consider the energy implications of that option rather than focusing solely on financial or commercial factors.

5.2.4

Implications of the increased importance of environmental issues The increased focus on environmental issues and environmental performance also means that companies should introduce procedures to try to prevent non-compliance with environmental laws and regulations, and to avoid the fines or penalties which accompany such non-compliance. In this respect, companies should consider the following procedures: 

Monitoring legal requirements and ensuring that operating procedures are designed to comply with these requirements.



Implementing an appropriate system of internal controls and regularly reviewing the controls over environmental risks.



Developing and operating a code of practice for environmental issues, such as accidental spills and the disposal of waste, especially hazardous waste.

Environmental information A company's internal reporting system also needs to record information about environmental issues, and should be capable of providing sufficient information to enable the financial impact of any environmental issues to be estimated with a reasonable degree of reliability. In addition, it will be important to maintain regular communication between those responsible for environmental issues in a company and the accounting staff, so that the financial implications of any environmental issues are understood, and any necessary action can be taken promptly. Environmental issues and the supply chain Environmental issues are not confined within the normal financial reporting boundaries of an organisation. For example, supermarkets' concerns over supply chain issues are driving significant changes in supplier companies. To avoid a supplier's reputation being seriously damaged by sourcing products in a way which harms the environment, suppliers are manufacturing products sustainably and from sustainable sources.

5.3

Integrated reporting The increased importance of reporting about social and environmental aspects of performance, and of sustainability, could also be seen to support the need for integrated reporting. 1

The International Integrated Reporting Council (IIRC; www.theiirc.org) has defined an integrated report as ‘a concise communication about how an organisation’s strategy, governance, performance and prospects, in the context of its external environment lead to the creation of value in the short, medium and long term.’ According to IIRC, integrated reporting combines the different strands of reporting (financial, management commentary, governance and remuneration, and sustainability reporting) into a coherent whole that explains an organisation’s ability to create and sustain value. As such, integrated reporting (IR) also highlights the need to embed the concept of long-term business sustainability within the organisation. 1

The IIRC is a global coalition of regulators, investors, companies, standard setters, the accounting profession and nongovernment organisations.

By encouraging organisations to focus on their ability to create and sustain value over the longer term, IR should help them take decisions which are more sustainable and which ensure a more effective allocation of scarce resources. IR should also help providers of financial capital (primarily shareholders), and other stakeholders, to better understand how an organisation is performing and creating value over time. In particular, IR should help stakeholders make a meaningful assessment of the long-term viability of an organisation’s business model and its strategy.

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At the same time, IR could also help to simplify annual reports, by highlighting critical information and by removing excessive detail. However, it is also important to consider integrated reporting as a process, rather than an integrated report as a product. The report periodically delivered to stakeholders (reporting on an organisation’s current state and future prospects) requires a comprehensive understanding of the strategies being adopted, the risks the organisation is facing, the opportunities it is pursuing, details of its operations, as well as the organisation’s impact on the environment and the wider society. As such, the IIRC highlights that integrated reporting also reflects integrated thinking within an organisation – management’s ability to understand the interconnections between the range of functions, operations, resources and relationships which have a material effect on the organisation’s ability to create value over time.

5.3.1

Six capitals All organisations depend on different forms of capital for their success, and these different capitals should be seen as part of the organisation’s business model and strategy. These capitals are an important part of an organisation’s value creation. By implication, identifying these six different categories of capital suggests that an integrated report will describe an organisation’s performance in relation to the different capitals – in contrast to ‘traditional’ annual reporting which focuses primarily on financial performance. Similarly, an organisation will need information about its performance in relation to each of the different capitals, in order to be able to report on them. As a result, introducing IR could have important implications for the information systems in an organisation. For example, does the organisation currently record non-financial (social; environmental) performance in a way which provides it with suitable information to include in its integrated report?

5.3.2

Guiding principles of integrated reporting

5.3.3

Aspects of an integrated report In addition to the guiding principles (above), the IIRC has suggested that an integrated report should answer the following questions in general terms: 

Organisational overview and external environment – What does the organisation do, and what are the circumstances under which it operates?



Governance – How does the organisation's governance structure support its ability to create value in the short, medium and long term?



Business model – What is the organisation's business model, and to what extent is it resilient?



Risks and opportunities – What are the specific opportunities and risks which affect the organisation's ability to create value over the short, medium and long term; and how is the organisation dealing with them?



Strategy and resource allocation – Where does the organisation want to go, and how does it intend to get there?



Performance – To what extent has the organisation achieved its strategic objectives and what are the outcomes in terms of effects on the six capitals?



Future outlook – What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and its future performance?

An organisation's business model draws on various capitals as inputs and, through its business activities, converts them into outputs (product, services, by-products and waste). The outcomes of an organisation's activities and outputs also have an effect on the capitals. Some of the capitals belong to the organisation, but others belong to stakeholders or society more generally. The organisation and society therefore share both the cost of the capitals used as inputs and the value created by the organisation. In the context of this chapter on strategic performance management, one of the important implications of recognising these different 'capitals' is that when measuring and managing performance, an organisation needs to look beyond short-term financial performance, and to consider the wider consequences of its strategies and activities.

5.3.4

Implication of integrated reporting for accountants in business and management accountants As yet, there is no standard, accepted format for an integrated report, so the detailed implications of the information required for an integrated report will vary from organisation to organisation. However, the

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general principles and aims of IR suggest that a management accountant will need to consider the following issues when preparing information for an integrated report. Forward looking information In their 2012 report ‘What is Integrated Reporting?’ UBS noted that ‘there is a gap between the information currently being reported by companies and the information investors need to assess business prospects and value.’ The reference to ‘prospects’ highlights that integrated reporting information should be forward-looking as well as historical. The focus of IR is how an organisation’s strategy, governance and performance can lead to the creation of value in the future. Equally, therefore, the performance information produced by an organisation needs to give an insight into an organisation’s prospects and future performance – how it can create value in the future – as well as reporting its past performance. However, an organisation needs to think carefully about what kind of ‘forward looking’ information it discloses. Any material providing information about the future prospects and profitability of the entity (particularly a listed company) is likely to be regulated, and it could also be commercially sensitive. For example, an organisation needs to consider the balance between disclosure and the loss of competitive edge. Equally, the inherent danger of producing forward-looking information is that no-one can predict the future: forecasts are inevitably wrong to some degree, and are necessarily dependent on the assumptions an organisation’s management team have made about the future. While management is likely to have (and will want to have) the best information available to make such predictions, they still need to ensure that investors do not place undue reliance on that information. Long-term performance The idea of sustainability also highlights the need to evaluate performance and strategic decisions on a long-term basis as well as in the short term. The idea of the potential for conflict between long-term and short-term decisions has been one which we have highlighted already in this Study Manual, for example, in relation to the limitations of the use of profit-based performance measures for measuring an organisation’s performance. One of the key aims of IR is to reflect the longer-term consequences of the decisions which organisations make, in order that decisions should be sustainable and create value over time. Therefore, the IR process highlights that, when making a [strategic] decision, an organisation needs to consider the long-term consequences of that decision – and its effect on the six capitals, both positive and negative – as well as its short-term consequences. Similarly, in order to implement IR successfully, an organisation will need to select a range of performance measures which promote a balance between achieving short-term and long-term performance. Again, in this respect, the use of non-financial performance indicators is likely to be important, since aspects of non-financial performance (for example, environmental performance) have a long-term time frame. Non-financial information One of the main potential benefits of IR is that it helps organisations identify more clearly the links between financial and non-financial performance. In particular, by focusing on value generation in a broader sense (rather than focusing on narrower goals of revenue generation, for example) integrated reporting will also encourage organisations to review the set of performance measures they use to monitor and manage performance. Therefore, one of the main consequences of integrated reporting is likely to be the increased use of nonfinancial data to gain a clearer picture of an organisation and its performance. Introducing integrated reporting will reinforce the importance of looking at non- financial aspects of performance as well as financial ones. For example, IR highlights the need to obtain a wider understanding of value creation in an organisation, beyond that which can be measured through traditional financial terms. Equally, IR should also encourage greater attention being paid to non-financial data in strategic decision making. For example, investment appraisals may need to include non-financial costs and benefits (and sustainability information) as well as traditional financial costs and benefits. Strategy, not just reporting The guiding principles of IR note that an integrated report needs to provide insight into an organisation’s strategy rather than simply reporting figures. Therefore, rather than simply presenting the figures, an integrated report should highlight the significance of the figures being presented, and how they affect an organisation’s ability to create value.

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In their report 'Integrated Reporting: Performance Insight through Better Business Reporting' KPMG argue that 'Successful Integrated Reporting is not just about reporting, but about co-ordinating different disciplines within the business, and focusing on the organisation’s core strategy'. Connecting different teams within the business is an important step to achieving the integrated thinking necessary to underpin IR. The IIRC’s own website also notes that: ‘Businesses need a reporting environment that is conducive to understanding and articulating their strategy, which helps to drive performance internally and attract financial capital for investment. Investors need to understand how the strategy being pursued creates value over time.’ As such, the management accountant’s role should no longer be simply to report on financial performance, but also to provide information which can provide insight into an organisation’s strategy. This is also consistent with the wider change in the role of management accountants in organisations, in which the traditional view of the management accountant as focusing primarily on financial control and being distanced from an organisation’s operations has been replaced by a model in which they become more closely integrated with a business’ operations and commercial processes, providing business support to operating departments and becoming more actively involved in the decision-making of those departments. Focusing on key aspects of performance One of the guiding principles of IR is conciseness, and therefore one of the potential benefits of IR is that it encourages organisations to produce shorter, more streamlined communications. Crucially, integrated reporting should not be seen as a reason for simply producing more information or longer reports. Instead, it requires organisations to identify which aspects of performance are truly key to their future success – and then focus its performance metrics on them. Although we have noted that IR encourages the use of non-financial data as well as financial data, the range of data used needs to be considered within the context of brevity. Overall, organisations should be looking to reduce the amount of information which is published, in order to make their ‘story’ more accessible to stakeholders.

5.3.5

Potential benefits of Integrated Reporting Introducing IR could have the following benefits for an organisation: 

Streamlined performance reporting, and find efficiencies within the organisation, so that data sets can be used in a range of different ways.



Reduce duplication of information and ensure consistency of messaging.



Align and simplify internal and external reporting – for consistency and efficiency.

IR also leads to a greater focus on what is material to an organisation, and – perhaps equally importantly – helps an organisation identify what is not material to it. This should mean that less time and effort is wasted on reporting unimportant issues and, instead, the focus is given to those activities and processes through which an organisation creates value (for example, activities linked to its critical success factors). Selection of performance metrics One of the main benefits of IR is expected to come from the more rigorous preparation of performance metrics, and the insights those metrics can bring to an organisation’s stakeholders. Focusing on the performance metrics which truly deliver value, provides the managers of an organisation with both the ability and the incentive to improve performance. The saying ‘What gets measured, gets done’ – attributed to Peter Drucker – is pertinent here. If the areas being measured are those which are critical to the organisation’s continued success, then by implication, this should also focus attention to improving performance in these key areas. Accordingly, an important part of the management accountant’s role in relation to IR will be working with the board of directors or with operational managers to identify the issues which are critical for an organisation’s success (critical business issues) and then identifying appropriate KPIs which can be used to monitor performance in relation to those issues. IR should lead to an increased focus among the directors of an organisation on exactly what the organisation’s KPIs should be. In particular, additional non-financial KPIs can help to highlight areas of poor performance – or areas where there is scope for improvement – which financial metrics alone might not reveal.

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Recognition of stakeholder interests The guiding principles of IR highlight the importance of developing relationships with stakeholders and responding to their interests. In relation to performance measurement and performance management, as part of its preparation for producing an integrated report, an organisation could consult with its key stakeholders, to identify what they want to know about the performance and direction of the organisation. This consultation could then help to identify possible areas of performance which the organisation should monitor, and report on in its integrated report.

5.3.6

Information requirements If an organisation needs to include forward-looking information and information about its long-term performance in its integrated report, this could also have important implications for the information which the organisation’s management accountant produces. In particular, the introduction of IR may require management accounting information to become more ‘strategic’ (as we discussed earlier in this chapter), rather than simply reporting on historical, internal, financial performance. For example, since an integrated report should highlight the opportunities and risks an organisation faces, there is likely to be a need for external analysis in order to identify the opportunities, threats and risks presented by the external environment. Implications of increased importance of non-financial information Although including non-financial performance metrics in performance reports can help provide a clearer picture of an organisation and its performance, there could be a number of practical considerations linked to providing non-financial performance information. In particular: 

Can the organisation’s information systems supply the full range of non-financial data which stakeholders wish to see in an integrated report?



If this data cannot currently be obtained from an organisation’s information systems, how can the management accountant get the information wanted for the report?



Can non-financial issues be embedded into existing financial systems?



How can the organisation’s information systems be improved in order to allow the required nonfinancial information to be collected?



Can non-financial information be gathered and verified within financial reporting timelines?



How can the management accountant ensure that non-financial data is reliable, and more generally, what assurance is there over non-financial data in a report? (Non-financial data is typically not audited in the same way that financial data is; but, if stakeholders are going to rely on this data then should an organisation obtain some kind of assurance over the data?)

In its paper ‘Understanding Transformation: Building the Business Case for Integrated Reporting’ the IIRC notes that one organisation has developed a non-financial dashboard for its Executive Committee, linked directly to remuneration packages. If organisations are going to use non-financial information in this way, they will need assurance over the accuracy and robustness of the figures, given their potential impact the executives’ remuneration.

5.3.7

Integrated reporting and assurance If companies start to prepare integrated reports in place of traditional ‘financial’ Annual Reports this also presents a challenge in relation to the assurance of the information provided in the report. Traditionally, assurance in relation to financial reports has been provided by an audit, and users of financial reports can place a degree of reliance on the fact that an objective third party (ie the auditor) has reviewed the figures to ensure that they are not materially misstated and are prepared in accordance with relevant accounting standards. This framework helps to ensure not only the reliability of the information presented in financial reports, but also consistency in the way different companies present information which helps users of the accounts to compare the performance of different companies. However, as we have already mentioned, there is not currently any standard, agreed format for the presentation of integrated reports, and this is likely to reduce the level of consistency between reports. In turn, this could make it harder for readers of integrated reports to compare the performance of different companies. For example, how can a reader compare the ‘sustainability’ of different companies, if they measure different aspects of sustainability, and report on them in different ways?

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Controls over non-financial information – Perhaps even more importantly, however, the increased importance of non-financial information means that in order for users of the reports to rely on integrated reports in the same way that they can rely on financial reports some external assurance needs to be provided on them, in a similar way to the audit of financial reports. But this raises the question of how the concept of ‘materiality’ can be applied to non-financial information as well as financial information. Moreover, in the context of integrated reporting, will different stakeholder groups have different interpretations of materiality, depending on the degree to which they are interested in the different ‘capitals’ or the organisation’s ability to create value in the short term compared to the longer term? A further potential issue in relation to assurance of integrated reports is that the business processes producing non-financial information – and the controls over them – may be less sophisticated and robust than those producing financial data. For example, are the systems which produce information about sustainability subject to the same levels of control as the systems which produce financial information? Forward-looking information – The inclusion of forward-looking, strategic information in integrated reports also raises similar questions. What assurance reporting will be needed over such information and how can it be provided? Limits to the reliance can be placed on integrated reports – It is likely that the full value of integrated reporting will only be realised when appropriate assurance is also provided on the report. Otherwise, how far will investors be prepared to rely on the reports? Would investors rely on financial reports which were not audited? Equally, however, the ability of assurance providers to provide that assurance is likely to be impeded by the absence of any consistent standards for measuring and reporting non-financial information. The absence of these standards is also likely to make it very difficult to carry out any meaningful comparative analysis between the integrated reports produced by different companies.

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Strategic Business Management Chapter- 5

Strategic marketing and brand management 1 Marketing and marketing strategy 1.1

The nature of marketing 'Strategic management' and 'strategic marketing' share a number of ideas and models, although it is important to remember that 'marketing' contributes to strategic management and so an organisation's marketing strategies need to be properly aligned to its overall business strategy.

1.1.1

What is marketing? Definition Marketing: Is the management process responsible for identifying, anticipating and satisfying customer requirements profitably. (Chartered Institute of Marketing) Whilst this definition is useful, it is not the only one we could consider. In fact there are many. The marketing guru, Philip Kotler, offers the following definition of the marketing concept: The marketing concept holds that the key to achieving organisational goals lies in determining the needs and wants of target markets, and delivering the desired satisfactions, more efficiently and effectively than the competition. Kotler's statement is very important because it identifies four key concepts in marketing: (a) (b) (c) (d)

Identifying target markets. Determining the needs and wants of those markets. Delivering a product offering which meets the needs and wants of those markets. Meeting the needs of the market profitably â&#x20AC;&#x201C; more efficiently and effectively than the competition.

David Jobber (in his text Principles and Practice of Marketing) reinforces these points by highlighting that marketingorientated companies strive for competitive advantage by serving customers better than the competition. In this context, Jobber highlights the difference between organisations that are marketing-orientated, or market driven and those that are internally orientated or production orientated (ie organisations which focus on production and cost efficiency rather than customer satisfaction.) It is important to recognise that successfully implementing the marketing concept requires the whole organisation to be responsible for meeting customer needs. A focus on 'Satisfying customer needs' has to underpin everything that the organisation does; it is not solely the responsibility of the marketing department.

1.1.2

Marketing strategy Definition Marketing strategy: A marketing strategy specifies which markets an organisation intends to compete in, what customer needs it will meet, and how it intends to meet them. In turn, strategic marketing involves making crucial decisions about which customers and what customer needs an organisation will serve, and what means the organisation will employ to serve those needs. Strategic marketing is the creation and maintenance of a market-oriented strategy, focusing the organisation on the customers it serves and the needs it meets.

1.2

Strategic marketing and strategic management It is important to consider the relationship between strategic marketing and strategic management. The two are closely linked, since there can be no corporate plan which does not involve products/services and customers. Corporate strategic plans guide the overall development of an organisation. Marketing planning is subordinate to corporate planning but makes a significant contribution to it and is concerned with many of the same issues. The marketing department can also be a most important source of information for the development of corporate strategy. The corporate audit of product/market strengths and weaknesses (SWOT analysis), and much of its external environmental analysis, is likely to be directly informed by the marketing audit.

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Specific marketing strategies will be determined within the overall corporate strategy. To be effective, these plans will be interdependent with those for other functions of the organisation. (a)

The strategic component of marketing planning focuses on the direction which an organisation will take in relation to a specific market, or set of markets, in order to achieve a specified set of objectives.

(b)

Marketing planning also requires an operational component that defines tasks and activities to be undertaken in order to achieve the desired strategy. The marketing plan is concerned uniquely with products and markets.

Marketing management aims to ensure a company is pursuing effective policies to promote its products, markets and distribution channels. This involves exercising strategic control of marketing. A key mechanism for applying strategic control is known as the marketing audit, although the results of the marketing audit can also be used to provide much information and analysis for the overall corporate planning process.

1.3

Marketing audit Definition Marketing audit: 'A systematic examination of a business's marketing environment, objectives, strategies, and activities, with a view to identifying key strategic issues, problem areas and opportunities.' (Jobber, D. (2010) Principles and Practice of Marketing) In effect, therefore, a marketing audit is the marketing equivalent of the corporate strategic analysis which is carried out in the analysis stage of the rational model. The internal marketing audit focuses on those areas which are under the control of marketing management, whereas the external marketing audit looks at those forces over which marketing has no control (eg GDP growth). The results of the marketing audit are a key determinant of the future direction of a business, and may even give rise to a redefined mission statement for the business as a whole. We can expand on some elements of the market analysis section of the marketing audit: Market size: Refers to both actual and potential (forecast) size. A company cannot know whether its market share objectives are feasible unless it knows the market's overall size and the position of competitors. Forecasting areas of growth and decline is also important (eg what stage is a product at in its life cycle?; how durable is the market?). Customers: The analysis needs to identify who a company's (or a brand's) customers are, what they need, and characteristics of their buying behaviour (where, when and how they purchase products or services. For example, are there significant geographic variations in customer requirements or product usage?). This kind of customer analysis could help to point out opportunities for a company â&#x20AC;&#x201C; for example, to expand further into areas where product usage is currently low. Companies need to monitor changing customer tastes, lifestyles, behaviours, needs and expectations so that they can continue to meet existing customer needs effectively, as well as seeking out new customer needs which have not yet been met. Distribution channels: The company will need to evaluate its current arrangements for delivering goods or services to the customer. Changes in distribution channels can open up new fields of opportunity (most notably in the growth of e-commerce facilitated by the internet).

1.3.1

Links between marketing and business strategy frameworks Although we are looking at 'marketing' in this section of the Study Manual, there is still a clear link back to the business strategy ideas we have discussed in Chapters 1 and 2. For example, the market analysis section of a marketing audit will identify factors that will affect the nature of competition in an industry and will therefore affect the profitability of the industry. (Note the parallel here to the ideas of Porter's five forces model.) Similarly, the strategic issues analysis in the marketing audit relates to the competitive strategies which firms might select in order to try to meet their objectives. For example, do they try to differentiate themselves from their competitors on the basis of quality or service, or do they try to produce their products or services at a lower cost than any of their competitors can manage? (In other words, how are they applying the ideas of Porter's generic strategies model?) Marketing also has an explicit role in an organisation's value chain. The end result of a value chain is a product or service which both has a price in line with customers' perceptions of value and also a cost that allows the producer to make a profit margin. Equally importantly, though, the organisation's marketing mix needs to fit with its general strategy and the underlying approach to its value chain (for example, minimising costs, or maximising quality and customer service).

Corporate strategy and marketing strategy The table below illustrates the similarities (in terms of sequence) between the process of developing, and implementing, a marketing strategy and that of developing a corporate strategy:

1.3.2

Market sensing In order to maximise the benefit an organisation can get from external appraisal, the organisation needs its managers to be skilled in market sensing.

Definition Market sensing: How the people within a company understand and react to the external market place, and the way it is changing. Market sensing does not relate primarily to the gathering and processing of information about the market (market research) but instead, how this information is interpreted and understood by decision- makers in a company, so that that company can fulfil customer's requirements more successfully than its competitors. For example, some market signals may be hard to pick up, even though they may be of long-term significance. However, companies that are able to identify those signals should be in a better position to respond to them than companies which have failed to pick up the signals.

1.4

Competitor analysis The marketing concept highlights that, in order to be successful, an organisation must provide greater customer value and satisfaction than its competitors do. It is not sufficient for marketers simply to adapt their products or services to the needs of target customers; in order to gain strategic advantage, they also have to position their offering more strongly in the minds of consumers than their competitors do. However, in order to do this, marketers need to analyse their competitors. Competitor analysis helps an organisation understand its competitive advantages/disadvantages compared to its competitors. It can also provide valuable insights into competitors' strategies, which in turn, could help an organisation develop its own strategies to achieve (or sustain) an advantage over its competitors. An analysis of individual competitors will cover: who they are, their objectives, their strategies, their strengths and weaknesses, and how they are likely to respond to an organisation's strategies.

1.4.1

Key questions for competitor analysis One of the first questions an organisation needs to ask itself is: Who are the competitors? Once it has established this, an organisation then needs to identify: 

What are the competitors' goals or strategic objectives (eg maintaining profitability, building market share, or entering new markets? Are the competitors looking to build, hold, or harvest products or business units?)



What assumptions do the competitors hold about themselves and the industry (eg trends in the market, products and consumers)?



What strategies are the competitors currently pursuing? (eg are they looking to compete on the basis of low cost or product quality? Are they attempting to service the whole market, or a specific niche?)



What are the competitors' strengths and weaknesses? What key resources and capabilities do the competitors have (or not have)?

Understanding competitors' strengths and weaknesses Developing a good understanding of competitors' strengths and weaknesses, and what resources and capabilities they have (or do not have), can help locate areas of competitor vulnerability. In this way, an organisation might be able to achieve strategic success if it matches an area of its strength against an area in which a competitor is weak. Information which could be gathered about competitors' strengths and weaknesses includes: 

Financial performance, including profitability, and profit margins



Funding and availability of funds for future investment



Relative cost structure



Brand strengths, customer loyalty



Market share



Quality of management team

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1.4.2



Distribution networks



Product and service quality



Distinctive competences (eg customer awareness, customer service)

Competitor response profiles Once an organisation has analysed its competitors' future goals, assumptions, current strategies and capabilities, it can begin to ask the crucial questions about how a competitor is likely to respond to any competitive strategy the organisation itself might pursue. Trying to assess what competitors' responses are likely to be is a major consideration in making any strategic or tactical decision. Therefore an organisation needs to ask itself: 

How is the competitor likely to respond to any strategic initiatives that the organisation introduces?



Will the competitor's response be the same across all products/markets, or might it react more aggressively in some markets than others?

An organisation can build up a competitor response profile to help answer these questions. Key questions in the competitor response profile include:    

Is the competitor satisfied with its current position? What strategy shifts or moves is the competitor likely to make? Where is the competitor vulnerable? What will provoke the greatest and most effective retaliation by the competitor?

By analysing these issues, an organisation can then consider what its most effective strategy is likely to be, in the context of the competitors' likely response to that strategy.

1.4.3

Identifying competitors One of the dangers marketers face when identifying competitors is that they adopt too narrow a definition of who their competitors are. For example, an organisation might only consider other organisations offering technically similar products and services as its competitors. However, this ignores companies that produce substitute products which could perform a similar function, or those which solve a problem in a different way. In addition, as well as considering existing competitors, organisations need to continue to scan the environment for potential new entrants into the industry, either as direct or indirect competitors. Again, it is important to be aware that there could be different forms of competitor here: new entrants with products which are technically similar to existing ones; or, those entering the market with new substitute products. For example, Apple's skill in computer electronics enabled it to enter the portable music player market with its iPod brand, even though Apple had no previous experience in producing hi-fi systems or audio equipment.

Links to business strategy models Organisations analyse the external environment and also consider their own internal resources and capabilities as part of the strategic planning process. This highlights that competitor analysis is not only an important part of developing an organisation's marketing strategy, but is also, more generally, an important part of developing an organisation's overall corporate strategy. The different ways in which companies seek to achieve competitive advantage are also relevant in both a marketing context and an overall business strategy context: 1

The positioning approach The positioning approach to strategy is closely related to the traditional concept of marketing orientation. It starts with an assessment of the commercial environment and positions the business so that it fits with environmental requirements (in particular, customer requirements).

The resource-based approach The resource-based approach starts with the idea that competitive advantage comes from the possession of distinctive and unique resources within the organisation itself. This approach could be likened to production-oriented companies, compared to marketingoriented companies.

2 Developing a marketing strategy 2.1

The value proposition

In Section 1 of this chapter, we suggested that marketers can contribute to strategic analysis by helping an organisation understand its customers, competitors, markets and environmental forces and trends. However, marketers also play an important strategic role in helping organisations develop the value proposition they offer their customers: what is the value or benefit that the organisation (or its products, services or brands) will offer customers, now and in the future? A firm's value proposition dictates how the firm will serve its customers – how it will differentiate itself from its competitors and position itself in the marketplace. Accordingly, a firm's value proposition is the set of benefits or values it promises to deliver to consumers to satisfy their needs. It helps customers answer the question of why they should buy one particular firm's brand rather than a competitor's. For example, Red Bull Energy Drink's value proposition is that it helps consumers fight mental and physical fatigue. Red Bull captured a significant share of the energy drinks market by promising that it 'gives you wings!'

2.1.1

What is the value proposition? A customer can evaluate a company's value proposition on two levels: (i)

Relative performance: What the customer gets, relative to what he or she would get from a competitor

(ii)

Price: Payments made to acquire the product or service, relative to the price of competitor products

The company's marketing and sales efforts offer the value proposition, and its delivery and customerservice processes then fulfil it for the customer. The value proposition is crucial in identifying what differentiates a firm's product from its competitors. It is one of the key factors to consider when determining a marketing strategy. Marketing strategists can check how their value proposition works in the perception of customers, using market research, for example. In this respect, a value proposition could also encourage a firm to target particular market segments. Equally importantly, however, a firm needs to possess the necessary resources and competences to be able to deliver its value proposition successfully.

2.1.2

The value proposition and competitive advantage A firm's value proposition also has an important influence over the firm's position strategy. In turn, this strategy also needs to be defined in terms of competitive scope and Porter's generic strategies of differentiation or cost leadership. However, while Porter's argument remains valid – that the key to superior performance is developing a sustainable competitive advantage – it is important to appreciate that a lot of the benefit from delivering the value proposition is derived from perception. Business reputation for delivering on quality, price (or whatever the value proposition is) is strategically extremely important, as it can give a company valuable breathing space in the event of faltering actual performance, and is hard for competitors to break in to. For example, Toyota cars have maintained a favourable reputation for reliability, despite a number of models being subject to recalls in recent years.

C H A P T E R

Conversely, a solid value proposition may not hold up in the wake of changing perceptions or tastes.

2.2

Sources of competitive advantage Porter's generic strategies model (which we discussed in Chapter 2) highlights the importance of companies creating – and sustaining – some form of competitive advantage in order for them to be successful. In broad terms, Porter’s model argues this competitive advantage achieved through either cost leadership or differentiation. However, in practice there are a number of ways businesses can seek to establish a competitive advantage. For example: The quality player with the defined product The 'value' option The innovator A narrow product focus A target segment focus Being global

eg Swiss Army knives eg Ryanair, Aldi eg Apple eg Ferrari eg Harrods eg HSBC

The importance of the value chain In order to create a differentiated position or to become a cost leader, a firm needs to understand the resources and capabilities it has available to it, and how these resources and capabilities contribute to the firm's competitive advantage. Value chain analysis can be a useful tool for analysing the processes which

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help to achieve this, and for enabling the sources of costs or differentiation to be located and understood. The potential links back to ideas of supply chain management and operations management Operations management issues remind us that 'value' is actually delivered at an operational level, and therefore, the operational level is critical for the successful implementation of strategic or tactical plans.

2.2.1

Aligning marketing strategy and business strategy In order for a company's marketing strategy to be successful, that marketing strategy needs to be consistent with the company's overall business strategy. For example, if the company is pursuing a differentiation strategy, then its marketing strategy also needs to emphasise the way the company's products/services provide a premium value for its customers. The elements of a company's marketing mix (Product, Price, Place, Promotion) were discussed in your Business Strategy syllabus, but it is important to recognise that a company's competitive advantage will be derived from these 4 Ps and the way they are combined. (We will look at the marketing mix itself in more detail later in this chapter.)

2.3

Product-market strategies We have already considered Ansoff's matrix in relation to strategic choice, but it is equally appropriate to consider it in relation to marketing strategies. Ansoff's matrix could be used in conjunction with market research activities aimed at evaluating new markets and new products, and it could also lead to the deployment of the marketing mix in exploiting product-market opportunities for growth. (a)

Market penetration involves increasing sales of the existing products in existing markets. This may include: (i)

Persuading existing users to use a product or service more (a credit card issuer might try to increase credit card usage by offering higher credit limits or gifts based on expenditure)

(ii)

Persuading non-users to use it (for example, by offering free gifts with new credit card accounts)

(iii) Attracting consumers from competitors (for example, as credit card companies do with interest-free balance transfer services and an introductory period of interest-free purchase). Market penetration will, in general, only be viable in circumstances where the market is not already saturated. Market penetration is the lowest risk strategy of the four which Ansoff identified in his product-market matrix, but this may also mean the level of growth it affords may be lower than other strategies. (b)

Market development entails expansion into new markets, using existing products. New markets may be geographically new, or they may be new market segments (for example, selling to individual domestic consumers as well as to industrial consumers), new distribution channels (for example, selling organic vegetables in supermarkets as well as specialist food shops) or new uses for existing products. This strategy requires swift, effective and imaginative promotion, but can be very profitable if markets are changing rapidly. Also, this strategy carries relatively low risk because little capital investment is involved.

2.3.1

2.4

(c)

Product development involves the redesign or repositioning of existing products or the introduction of completely new ones in order to appeal to existing markets; for example, when television manufacturers introduced 'High Definition Ready' television sets.

(d)

Diversification is much more risky than the other three strategies, because the organisation is moving into areas (products and markets) in which it has little or no experience. Instances of pure diversification are consequently rare and as a strategic option, it tends to be used in cases when there are no other possible routes for growth available.

Market analysis

Segmentation, targeting and positioning as strategies The range of products and services available to contemporary consumers, coupled with the variety of needs and expectations which those consumers have, mean that very few products or services can satisfy all the consumers in a market. Marketing activity is therefore likely to be more effective if organisations direct different products or services to particular market segments (which can then be reached with a distinct marketing mix) rather than trying to sell to the total market as a whole.

Definition Market segmentation: The division of the market into homogeneous groups of potential customers who may be treated similarly for marketing purposes.

2.4.1

Bases for market segmentation

Buyers can be grouped into segments according to a range of social, cultural, and personal factors including: social class, age and life cycle stage, occupation, economic circumstances, lifestyle, personality, education, and beliefs and attitudes. Simple segmentation could be on any of the bases below:         

Geographical area Age Gender Life cycle stage Level of income Occupation Education Religion Ethnicity

        

Nationality Social class Personality Lifestyle Benefits sought Purchase occasion Purchase behaviour Usage (eg frequent v occasional user) Perceptions and belief

Importantly though, the same basis of segmentation will not necessarily be appropriate in every market, and sometimes, two or more bases might be valid at the same time. One segmentation variable might be 'superior' to another in a hierarchy of variables.

Lifestyle segmentation Lifestyle segmentation – or psychographics – seeks to classify people according to their values, opinions, personality, characteristics and interests. Importantly, lifestyle segmentation deals with the person as opposed to the product or service being sold, and attempts to discover the particular lifestyle patterns of customers, as reflected in their activities, interests and opinions. This offers a richer insight into customers' preferences for various products and services, and hence their propensity to buy them. For example, in marketing its television channels, Sky has used lifestyle segmentation to target groups with different interests: such as sports enthusiasts (Sky Sports), film fans (Sky Movies) and those people who want to keep up to date with news and current affairs (Sky News). Database marketing, which is becoming much more important in identifying and targeting market segments for direct selling, relies heavily on the theories underlying psychographic segmentation. However, a potential issue that arises with lifestyle segmentation is the extent to which general lifestyle patterns can predict purchasing behaviour in specific markets. Moreover, while lifestyle analysis may be relevant to advanced western economies, it could have little value for analysing markets in emerging economies where the majority of purchases are informed by basic physiological needs.

Behavioural segmentation

Definition Behavioural segmentation seeks to classify people and their purchases according to the benefits sought; the purchase occasion; purchase behaviour; usage; and perception, beliefs and values (Jobber, D. (2010), Principles and Practice of Marketing).

2.5

Evaluating market segments A market segment will only be valid if it is worth designing and developing a unique marketing mix for that specific segment. The following questions are commonly asked to decide whether or not the segment can be used for developing marketing plans.

2.5.1

Segment attractiveness A segment might be valid and potentially profitable, but this does not necessarily make it attractive to invest in. What factors affect the attractiveness of different market segments? (a)

A segment which has high barriers to entry might cost more to enter but will be less vulnerable to competitors.

(b)

For firms involved in relationship marketing, the segment should be one in which a viable relationship between the firm and the customer can be established.

The most attractive segments are those whose needs can be met by building on the company's strengths (and where it has sufficient resources and capabilities to do so) and where forecasts for demand, sales profitability and growth are favourable.

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2.5.2

Marketing strategies Targeting is a continuing process, since segments change and develop, and so do competitors. A company is, to some extent, able to plan and control its own development and it must respond to changes in the market place. The marketing management of a company may choose one of the following policy options. The choice between undifferentiated, differentiated or focused (concentrated) marketing as a marketing strategy will depend on the following factors: 

The extent to which the product and/or market may be considered homogeneous. Mass marketing may be sufficient if the market is largely homogeneous (for example, for safety matches).



The company's resources must not be over-extended by differentiated marketing. Small firms may succeed better by concentrating on only one segment.



The product must be sufficiently advanced in its life cycle to have attracted a substantial total market; otherwise segmentation and target marketing is unlikely to be profitable, because each segment would be too small in size.

The major disadvantage of differentiated marketing is the additional costs of marketing and production (more product design and development costs, the loss of economies of scale in production and storage, additional promotion costs and administrative costs and so on). When the costs of differentiation of the market exceed the benefits from further segmentation and target marketing, a firm is said to have over-differentiated. The major disadvantage of focused marketing is the business risk of relying on a single segment of a single market. On the other hand, specialisation in a particular market segment can give a firm a profitable, albeit perhaps temporary, competitive edge over rival firms.

2.5.3

Micromarketing Segmentation, as part of target marketing, looks likely to play an increasingly important role in the marketing strategies of consumer organisations in the years ahead. The move from traditional mass marketing to micromarketing is rapidly gaining ground as marketers explore more cost-effective ways to recruit new customers. This has been brought about by a number of trends: 

The ability to create large numbers of product variants without the need for corresponding increases in resources is causing markets to become over-crowded.



The growth in minority lifestyles is creating opportunities for niche brands aimed at consumers with very distinct purchasing habits.



The fragmentation of the media to service ever more specialist and local audiences is denying mass media the ability to assure market dominance for major brand advertisers.



The advance in information technology is enabling information about individual customers to be organised in ways that enable highly selective and personal communications.

3 Positioning strategies 3.1 3.1.1

Positioning and positioning strategies Positioning So far we have looked at market segmentation and target market selection. However, in order to develop an effective marketing strategy, a firm also has to decide how to position its product or service in the marketplace.

Definition Positioning: The 'act of designing the company's offer and image so that it occupies a distinct and valued place in the target customers' mind.' (Kotler & Keller, Marketing Management) Positioning strategies are based on the results of two key sets of choices: (a)

Target markets – Where a firm or brand wants to compete

(b)

Differential advantage – How a firm or brand wants to compete. (What advantages can it offer its customers that competitors cannot replicate?)

Link between marketing strategy and business strategy Notice how the bases of these positioning strategies reflect the same key sets of choices in the context of the business strategies, which firms should choose to achieve their objectives: how to compete (eg cost leadership vs differentiation), and where to compete (eg Ansoff's product-market matrix).

3.1.2

Positioning and strategy Once an organisation has decided which customer groups within which market segments to target, it has to determine how to present the product to this target audience. This allows it to address the needs and requirements of the target groups exactly, with a marketing mix that consists of product characteristics, price, promotional activities and distribution channels. TER

Positioning should be used to help a company or brand develop a strong and distinctive image which differentiates it from its competitors, in the minds of its target customers. Factors which could be used to help position a product include: price, quality, reliability, supporting services/after-sales service, and value for money.

However, because position is ultimately based on customers' perceptions, it is important that marketers focus most on the factors which are most important to the customers. For example, there are a range of product characteristics that car manufacturers could focus on, such as: speed, fuel efficiency, security, luxury interiors, and image. The factors which a manufacturer chooses to emphasise should be those that are most important to its target market, such that the positioning image of their car matches the aspirations of its target customers. However, another consequence of 'position' being ultimately based on customers' perceptions is that it is only partly within marketers' control. External developments could change the way customers think about a product: for example, as result of a change in the price of a competitor product, or the launch of a new rival product or substitute product, or test results by a consumer magazine or research institution which call into question some of the claims made about a product.

3.1.3

Issues with positioning Although positioning can help an organisation determine its marketing mix.

3.1.4

Perceptual maps A useful way of assessing the market positioning of a product or brand is through the use of perceptual maps (or positioning maps). These can be used to plot brands or competing products in terms of two key characteristics, such as price and quality. A perceptual map of market positioning can also be used to identify gaps in the market. The example above might suggest that there could be potential in the market for a low-price high-quality 'bargain brand'. A company that carries out such an analysis might decide to conduct further research to find out whether there is scope in the market for a new product which would be targeted at a market position where there are few or no rivals.

3.1.5

Mapping positions The 'natural' combinations of price and quality will be to sell a high quality product at a high price, an average quality product at a medium price, or a low quality product at a cheap price. However, a company might want to offer a product at a comparatively low price if it is trying to increase its market share (ie, it is pursuing a market penetration strategy). For example, a company trying to increase its market share could offer a high quality product at a medium price. By contrast, such a positioning exercise might indicate that some companies are charging a higher price for their products than the quality justifies. Such a strategy is unlikely to be successful in the longer term, so a company in this position will either need to increase the quality of their product, or reduce its price.

Positioning and strategy Once an organisation has selected its target segment in a market, the needs of the targeted segment can be identified, and the marketing mix strategy developed to provide the benefits package needed to satisfy them. Positioning the product offering then becomes a matter of matching and communicating appropriate benefits.

3.2

Repositioning Strategic managers must be prepared to deal with under-performance and failure. One possible response is repositioning of the market offering.

Definition Repositioning: A competitive strategy aimed at changing position in order to increase market share. Repositioning is a difficult and expensive process, though, since it requires the extensive remoulding of customer perceptions. The danger is that the outcome will be confusion in the mind of the customer

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and failure to impress the selected new market segments. An important implication of positioning is the potential impact that sales and discounts have on customers' perception of price and value. For example, if a retailer regularly offers money-off deals, will customers treat the discounted price as being a better indicator of the brand's position than the 'full' price, which is rarely used? Retailers need to be aware of the negative consequences of setting artificial 'sales' prices. The use of persistent 'sales' by retail outlets can lead to increasing scepticism about the integrity of the sales – especially sales which 'must end soon' but rarely do! The use of sales and discounts also has an impact on the profit margins that a company can achieve. Nonetheless, if a company is trying to break into a new market, or to increase market share, then setting a low price initially ('penetration pricing') may be an appropriate strategy. Although the low price may mean that the product generates a low profit at first (or even makes a loss), once consumers are locked in to using the product, then the price can be increased, allowing the product to generate higher profits in the longer term.

3.3

Pricing and revenue The axis of positioning maps (discussed in Section 3.1 above) highlight the importance of firms matching the price of their goods or services with the perceived quality of them; since many customers view price as an indicator of quality. Equally, however, the price which a firm charges for a product is likely to be strongly influenced by its positioning strategy as well as the firm's overall strategic objectives. For example, a firm pursuing a low cost strategy (eg Lidl) also sells its products at low prices (ie using a low price strategy). However, a low price strategy can also be used initially with a view to making money later. This is the logic behind penetration pricing: initially using a low price to break into a new market, and then increasing the price in the longer term. These points highlight that price is a key element of the marketing mix, and therefore it is vital for an organisation to consider how 'price' information aligns with the other elements of its marketing mix. (You should have already covered the fundamentals of pricing and pricing issues in the Business Strategy syllabus, although we revisit them briefly in Chapter 9 of this Study Manual.) Initiating price changes When analysing price in a competitive environment, it is important to remember that prices are dynamic. Managers need to know when to raise or lower prices, and whether or not to react to competitors' price moves. The following factors could all be reflected in rising prices: 

Excess demand for a product



Rising costs incurred in producing a product



Market research which reveals that customers place a higher value on a product than is reflected in its price

Conversely, prices may be reduced is there is excess supply of a product; if costs are falling; or if the current price is deemed to be high compared to the value customers give to a product. The idea of changing prices in relation to the relative levels of demand and supply has been particularly important in the transportation and hospitality industries, where prices are adjusted seasonally or after initial demand has been observed. For example, the price of tickets on a flight often varies according to the number of unsold seats remaining on the fight. Additionally, and similar to the idea of penetration pricing noted above, price cutting may be used to build sales and increase market share when customers are thought to be sensitive to price. (However, price cutting in this context may not be successful if competitors follow suit and a price war ensues.) As well as changing prices directly, there are other tactics companies can use which effectively change the price customers pay for products or services; for example, price bundling or unbundling, and applying discounts to the list price.

3.3.1

Bundling and unbundling Bundling Where a number of products and services that tend to be bought together are price separately, price bundling can be used to effectively lower the price. For example, a new car could be sold with 'free insurance for the first year' or a new television could be sold with a 'free two-year repair warranty'. In practice, the price of the car or the television may already include some allowance to cover the cost of the insurance or the warranty, but the bundled price is still likely to be lower than the cost of buying the car plus insurance separately.

Unbundling By contrast, price unbundling is a tactic which could be used to effectively raise prices. Many product offerings actually consist of a set of products for which an overall price is set (for example, computer hardware and software). Price unbundling allows each element of the product to be priced separately, in such a way that the total price is raised. In a similar way, companies could charge separately for services that were previously included in a product's price. For example, suppliers of office IT systems have the option of unbundling installation and training services, and charging for them separately. IFRS 15 – Revenue from Contracts with Customers The idea of bundling is discussed in a 2011 Exposure Draft, Revenue from Contracts with Customers – which has subsequently been adopted as IFRS 15, with the same name. (Note: Although IFRS 15 was issued in May 2014, it doesn’t become effective until 1 January 2017, whereupon it will replace IAS 18 Revenue and associated interpretation on revenue recognition, including IFRIC 13 Customer Loyalty Programmes.) The rationale behind the new standard is that IAS 18 provides limited guidance on revenue recognition for multiple-element arrangements (bundles): for example, when a consumer buying a new car also receives a year's motor insurance cover as part of the purchase price; or when a consumer books a holiday online, bundling together an air fare, hotel accommodation and travel insurance. IFRS 15 aims to establish a comprehensive framework for determining when to recognise revenue and how much revenue to recognise. The core principle of the Standard is that an entity 'should recognise revenue to depict the transfer of promised goods or services to the customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.' To achieve this, the entity would have to identify the separate elements of their contract with a customer, and then allocate the transaction price to the separate performance obligations in the contract (for example, allocating the price the customer has paid for the car between the cost of the car itself and the cost of the year's insurance). To allocate an appropriate amount to each separate performance obligation, an entity should determine the stand-alone selling price of each obligation at the time when the contract with the customer is signed, and then allocate the transaction price in proportion to the stand-alone selling prices of each obligation. IFRS 15 also highlights that an entity should only recognise revenue when it satisfies a performance obligation. So, for example, the 'revenue' from the two-year warranty sold with a new television should be spread over the two years, rather than all being recognised at the point the television was sold.

3.3.2

Discounts Another way companies can change the price of an item is through the use of discounts. A commonly used way of offering discounts is as a percentage of the list price of an item. For example, the list price of an item could be £50, but if a 20% discount is applied, the price to the customer will only be £40. Whilst this kind of discount is often used by retailers in relation to the goods they are selling to individual consumers, a similar idea can be applied to the volume discounts companies given to trade customers; where the actual price they pay for goods is discounted in recognition of the volume of purchases they make. This idea of volume discounting could equally be applied directly to purchases of individual products by individual customers: for example, the price of one bottle of wine might be £8, but customers could also buy two bottles for £15. For many products, a manufacturer will identify a recommended retail price (RRP). However, in practice a retailer may choose to sell the product at a lower price; highlighting the difference between its price and the RRP. Another way of applying discounts is to offer customers a monetary reduction in cost of their purchases if they spend a given amount; for example, £5 off if they spend £50. Discounts and positioning Whilst offering special promotions and discounts can boost sales by encouraging additional customers to buy a product, it is also important to think about their potential implications for positioning and the perceived value of a product. For example, if the price of a product is reduced from $50 to $40, will customers perceive the value of the item now also to be $40 or will they still be prepared to pay the full price once the discount period comes to an end? In this context, it is important to highlight the distinction between discounts and promotions and the notion of

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everyday low prices. This distinction again has important implications in the context of positioning. Promotions and discounts can be used to attract consumer to buy specific items at a specific time, but they are not usually designed to reposition the item or brand. However, an alternative to using specific promotions is to set lower prices on a regular basis; in effect, to introduce everyday low prices. This is the approach taken by Wal-Mart (Asda) supermarkets. Rather than focusing on specific promotional prices, they aim to attract customers on the basis of everyday low prices. As such, Asda (Wal-Mart's UK arm) has positioned itself differently to the majority of other supermarkets in the UK. Discounts and revenues An important issue for companies to consider in relation to any possible discounts and promotions will be the potential impact on revenues (and profits) which could arise from any changes in price or position. The logic of price promotion is that it enables companies to sell higher volumes of a product by temporarily decreasing the price. Nonetheless it is important to achieve a balance between volume growth and profitability; for example, to avoid offering too many discounts such that profits fall despite volume increasing. Discounts can also be used when a company's products are sold in the form of long-term commitments, such as phone or internet contracts. Promotional offers (for example, reduced prices for the first three months of a contract) help attract customers who then commit to contracts and produce revenue over a long term horizon. However, alongside this, companies also have to decide when to begin increasing contract fees and by how much fees can be raised in order to avoid losing customers. In effect, companies have to analyse how to maximise revenue while minimising churn (the rate of losing customers).

3.3.3

Markdowns One specific use of price reductions is in the fashion industry. Fashion clothes have very short life cycles: typically one season. Therefore, as the end of the season approaches the prices of clothes are marked down, and eventually the clothes are replaced by the new season's ranges. Whereas discounts and promotions only involve temporary price reductions, markdowns affect the price of an item permanently. After a markdown, the price of the item marked down will not typically increase again.

3.4

Revenue recognition and profit (IAS 18, Revenue) The use of price discounts and promotions (eg money off coupons) is one of the main techniques a company can use to try to boost sales (particularly in the short term). Ultimately the aim of marketing strategy as a whole is to boost revenue; meaning that revenue could also be viewed as the culmination of all an entity's marketing activities.

IAS 18, Revenue Revenue recognition in the financial statements is a measure of the success of the marketing strategy. Revenue recognition also considers accounting for some marketing initiatives such as discounts and other sales incentives. It may not, however, take full account of the success of longer-term marketing initiatives, such as building a brand. Some companies have adopted questionable practices concerning the reporting of revenue as part of aggressive earnings management policies. This has led to different companies, operating within the same business sector, adopting varying accounting policies on revenue. In turn, these variations in accounting policy have resulted in marked variations in the timing and measurement of revenue, and hence, profit. Some of the high profile accounting scandals have involved manipulation of revenue, such that revenue has been recognised in an inappropriate manner, resulting in reported profits also being hugely inflated. An effective and credible accounting standard on revenue is therefore essential to ensure that a company's success in selling into its markets is measured and reported appropriately. This is the purpose of IAS 18, Revenue. Revenue recognition A significant issue in accounting for revenue is determining when to recognise revenue (ie it is largely a timing issue). IAS 18, Revenue, states that revenue is recognised once it is probable that future economic benefits will flow to the entity, and these benefits can be measured reliably. Revenue is therefore generally recognised as being earned at the point of sale for goods. For services, revenue is, in general, recognised over the period that the service is delivered. The recognition criteria in IAS 18 are usually applied separately to each transaction. However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. For example, when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed.

Fair value IAS 18 states that revenue shall be measured at the fair value of the consideration received or receivable. Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Discounts IAS 18 identifies that the fair value of the consideration received or receivable, should take into account the amount of any trade discounts and volume rebates allowed by the entity. Therefore, an organisation which offers trade discounts would be expected to show a lower profit margin on its revenue than an organisation which did not offer similar discounts.

Customer retention and loyalty An important issue in marketing is customer retention, and one way that organisations try to encourage loyalty is through the use of loyalty schemes. However, these schemes create a potential issue around the recognition and measurement of obligations when companies have to provide customers with free or discounted goods or services, if and when they choose to redeem the credit they have accrued on their loyalty awards. IAS 18 requires that separately identifiable components of sales transactions are accounted for separately, if necessary, to reflect the substance of transactions. This suggests that when a loyalty card customer buys a product or service, the proceeds of the sale are split into two components: an amount reflecting the value of the goods or services delivered in the sale, and an amount that reflects the value of the loyalty award credits. Proceeds allocated to the first component are recognised as revenue at the time of the first sale. However, proceeds allocated to the award credits are deferred as a liability until the entity fulfils its obligations in respect of the award, either by supplying free or discounted goods when a customer redeems the credit, or engaging (and paying) a third party to do so. Accounting for customer loyalty programmes â&#x20AC;&#x201C; IFRIC 13 The rationale behind IFRIC 13 is that existing accounting standards (primarily, IAS 18 Revenue) lack any detailed guidance about how to account for customer loyalty programmes, and consequently current treatment varies in this respect. Some companies measure their obligation based on the value of the loyalty award credits to the customer (loyalty points); others measure their obligation as the cost to the entity of supplying the free or discounted goods or service when a customer redeems their points. IFRIC 13 is based on the view that customers are implicitly paying for the points they receive when they buy other goods or services, and therefore some of that revenue should be allocated to the points. Consequently, IFRIC 13 requires companies to estimate the value of the points to the customer, and defer that amount of revenue as a liability until they have fulfilled their obligation to supply the free or discounted goods or other awards. (Note: As we identified earlier, once IFRS 15, Revenue from Contracts with Customers becomes effective, replacing IAS 18, Revenue, it will also replace IFRIC 13.)

3 The marketing mix 3.1

The marketing mix and competitive advantage Our definition of 'positioning' in the previous section highlights the importance of creating a distinctive position for a product or brand within a target market. The way a firm looks to achieve this is through the marketing mix being applied to that product or brand. The role of the marketing mix is to develop a unique identity for a product or brand within the market place.

3.1.1

Elements of the marketing mix One of the learning objectives from the ICAEW Business Strategy syllabus at Professional Level is that candidates should 'Understand the marketing mix, its roles and limitations.' At Advanced Level, however, rather than simply 'understanding' the marketing mix, you will be expected to be able to demonstrate how a firm could use the different elements of the mix (product, price, place and promotion â&#x20AC;&#x201C; the 4Ps; plus, people, process, and physical evidence â&#x20AC;&#x201C; the 7Ps) to help generate competitive advantage. An important point to note here is that applying a unique (and appropriate) mix of the elements of the marketing mix within a given market allows a firm to compete more effectively, thereby helping it to generate a sustainable profit.

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Distribution (place) is often seen (wrongly) as the least important aspect of the traditional marketing mix, and therefore can tend to get over-looked. In companies where distribution involves the physical transport of goods and stores, undervaluing the importance of 'place' can be very costly as a lack of co- ordination often results in inadequate control over the distribution function, and inefficient inventory management. However, the increased importance of supply chain management, accompanied by the introduction of Just in Time (JIT) production and purchasing, should help to increase the profile of the 'place' element within the marketing mix.

3.1.2

Critical moments of truth One of the characteristics which distinguish service transactions from product sales or purchases are the 'moments of truth' between the customer and the firm (when the consumer comes into direct contact with the service provider). When consumers and service providers meet, the encounter between them might permanently shape the consumer's view of the firm. Moments of truth can be: 

Before the service is purchased, for example, enquiries and reservations



Before the service is actually consumed (eg check-in procedures at airports)



While the service is consumed (encounter with waiter at restaurant, quality of service on a train, assistance and information)



After the service has been consumed, (queries, staff saying 'goodbye', paying the bill if payment is made after the service is consumed). The rise of e-commerce is leading to an increase in on-line credit card fraud. Card fraud could be seen as a moment of truth after the service has been consumed.

Ultimately, customers decide what a moment of truth is. Some will be put off using a service provider by poor procedures in one aspect of the service, which could lead to any competitive advantage generated by other aspects of the marketing mix being undermined.

3.2

Co-ordinating the marketing mix Although we can look at how individual elements of the marketing mix can be used to differentiate a firm's products from a rival's, we also need to remember that the different elements in the mix need to be co-ordinated such that they portray a consistent message to customers. Each element of the marketing mix contributes to the total value proposition being offered to the customer. Therefore, all the elements of the mix need to be coherent and consistent, rather than conflicting with, or undermining, each other. For example, if an organisation wants to position a product as a luxury or high-quality 'premium' brand, it should price the product accordingly (on the grounds that consumers assume they 'get what they pay for'). It should also ensure a matching quality image in its intermediaries or dealerships, and should select promotional media and messages along the same lines (advertising in up-market media, and avoiding 'buy one, get one free' sales promotions). Moreover, the way the firm relates to all its stakeholders also needs to be coherent and consistent. For example, there is little merit in a firm marketing its products to customers on the basis of corporate social responsibility and ethics, if conflicting messages are given out by the firm's treatment of its suppliers, distributors or employees. The charity Oxfam, for example, had its credibility undermined when it was discovered that suppliers of its 'Make Poverty History' wristbands were themselves guilty of exploiting workers with minimal pay and poor working conditions.

The marketing mix and market segments Marketing mix decisions must be taken with the needs of a range of market segments in mind. The product mix or product portfolio, for example, can be adapted to cover a range of stakeholder and customer needs. For example, Nestlé's range of coffee brands covers luxury, economy, fair-trade and health-conscious (decaffeinated) brands. The distribution mix can similarly cover the needs of different regions, urban and rural lifestyles, isolated or less mobile consumers (eg internet buying and/or home delivery).

3.3

Global or local marketing mix The decision to enter foreign markets also requires companies to decide whether or not to adapt the marketing mix to local conditions. The choice is between standardising the product in all markets to reap the advantages of scale economies in manufacture and, on the other hand, adaptation which gives the advantages of flexible response to local market conditions.

Complete global standardisation could greatly increase the profitability of a company's products (through economies of scale) and simplify the task of the international marketing manager. However, the extent to which standardisation is possible is controversial in marketing. Much of the decision-making in an international marketing manager's role is concerned with assessing the need, or not, to adapt the product, price and communications to individual markets.

3.3.1

Standardisation or adaptation in international marketing mix The following factors encourage standardisation: 

Economies of scale – – – –

Production Marketing/communications Research and development Inventory holding



Easier management and control.



Homogeneity of markets; that is, world markets available without adaptation (eg denim jeans).



Cultural insensitivity, eg industrial components and agricultural products.



Consumer mobility means that standardisation is expected in certain products (eg hotel chains; memory cards for cameras).



Where 'made in' image is important to a product's perceived value (eg France for perfume, Sheffield for stainless steel).



For a firm selling a small proportion of its output overseas, the incremental adaptation costs may exceed the incremental sales value. Products that are positioned at the high end of the spectrum in terms of price, prestige and scarcity are more likely to have a standardised mix.



Adaptation Adaptation may be mandatory or discretionary. Mandatory product modification normally involves either adaptation to comply with government requirements or unavoidable technical changes. An example of the former would be enhanced safety requirements, while the requirements imposed by different climatic conditions would be an example of the latter. Discretionary modification is called for only to make the product more appealing in different markets. It results from differing customer needs, preferences and tastes. These differences become apparent from market research and analysis; and intermediary and customer feedback. 

Levels of customer purchasing power. Low incomes may make a cheap version of the product more attractive in some less developed economies.



Levels of education and technical sophistication. Ease of use may be a crucial factor in decision- making.



Standards of maintenance and repair facilities. Simpler, more robust versions may be needed.



'Culture-bound' products such as clothing, food and home decoration are more likely to have an adapted marketing mix.

These strategies can be exercised at global and national level, depending on the type of product. Not all products are suitable for standardisation. For example, although McDonald's is often seen as a global brand, the menus in its restaurants are adapted to fit with local tastes and cultures. For example, in India, McDonald's menu is typically 50% vegetarian because the Hindu majority cannot eat beef dishes, and Muslims avoid pork.

3.4

The impact of the internet on the marketing mix The internet has had a significant impact on the elements of the marketing mix, and companies need to recognise this when developing their marketing strategies, particularly strategies for online marketing.

3.4.1

Product What does buying products online offer which offline purchasing cannot? (a)

The ability to deliver interactivity and more detailed information through the internet is the key to

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enhancing the augmented or extended product offering online.

3.4.2

(b)

The buyer knows immediately about product features, the facts, not a sales person's interpretations.

(c)

The buying process is customised for returning visitors, making repeat purchases easier. Organisations can also offer immediately ancillary products along with the main purchase. EasyJet for example, can readily bundle its flights, hotels and car hire through suitable design of its web site.

(d)

The product can also be customised to consumers' needs. For example, Nike.com offer customised trainers to users online. Users can design and see their trainers online before they order.

Price The internet has made pricing very competitive. Many costs such as store cost and staff salaries have disappeared completely for online stores, placing price pressures on traditional retailers. (a)

The internet increases customer knowledge through increased price transparency, since it becomes much quicker to shop around and compare quoted prices by visiting supplier web sites. In this respect, the use of price comparison sites by consumers is very important. Sites such as Kelkoo.com (or Kelkoo.co.uk in the UK) give a single location that empowers the consumer to quickly find out the best price from a range of suppliers for a range of products. Such easy access to information is likely to increase price competition between retailers, and ultimately increase the bargaining power of customers.

(b)

Dynamic pricing gives retailers the ability to test prices or to offer differential pricing for different segments or in response to variations in demand. For some product areas, such as ticketing, it may be possible to dynamically alter prices in line with demand. Tickets.com adjusts concert ticket prices according to demand and has been able to achieve 45% more revenue per event as a result. Dynamic pricing is used widely in airline and hotel industries, but it is also increasingly used in restaurants; for example, by offering people a discount to eat at quieter times of the day, rather than at peak lunch time or evening services.

3.4.3

(c)

Different types of pricing may be possible on the internet, particularly for digital, downloadable products. Software and music has traditionally been sold for a continuous right to use. The internet offers new options such as payment per use; rental at a fixed cost per month, or a lease arrangement. Bundling options may also be more possible.

(d)

The growth of online auctions also helps consumers to dictate price. The online auction company eBay has grown in popularity, with thousands of buyers and sellers bidding daily.

(e)

ePricing can also easily reward loyal customers. Technology allows repeat visitors to be tracked, allowing loyalty incentives to be targeted towards them.

(f)

Payment is also easy â&#x20AC;&#x201C; PayPal or online credit cards allow for easy payments. However, the downside to this is internet fraud, which is growing rapidly around the world.

Place The internet clearly has significant implications for 'place' in the marketing mix, since it has a global reach, meaning that firms can now sell to a much wider geographical market that they have traditionally been able to. As well as its global reach, the fact that it is 'open' 24 hours a day, 7 days a week (24/7) is also a major impact the internet has had on marketing. Customers can search for, and buy, products at their own convenience, rather than being constrained by the opening hours of a traditional shop, for example. Channel structures The internet has also created new marketplaces and channel structures which affect the 'place' where online transactions take place. In some cases, the internet means buyers and sellers interact directly, rather than going through an intermediary. For example, rather than booking a holiday through a travel agent, customers can now go directly to hotel websites or airline websites and book their accommodation and flights themselves. Alternatively, however, customers could use online travel websites (such as Expedia) to book their holidays from a range of options that the website has sourced C from flight and hotel reservation systems. H For many companies, the notion of 'place' in the marketing mix is also linked to the supply chain (or value chain). For example, 'place' is closely related to the distribution and delivery of products or services. The internet has had a major impact on this aspect of the marketing mix. As well as reducing the need for physical stores from which to sell their products, companies are also looking to differentiate themselves from their rivals

A P E R

on the basis of the speed and efficiency of their deliveries. Moreover, many5companies no longer 'supply' the goods to their end customers; instead, the companies contract with third-party providers such as Fedex or UPS, which have superior logistical expertise and economies of scale in distribution.

3.4.4

Promotion Marketing communications are used to inform customers and other stakeholders about an organisation and its products. (a)

There are new ways of applying each of the elements of the communications mix (advertising, sales promotions, PR and direct marketing), using the internet and email. Most organisations today have some form of webpage used in most, if not all advertisements.

(b)

The internet can be used at different stages of the buying process. For instance, the main role of the web is often in providing further information, rather than completing the sale. Think of a new car purchase. Many consumers will now review models online, but most still buy in the real world. (We will look at social media in more detail later in the chapter, but social media can be an important source for potential customers to gauge other customers' feedback on a product or service, not just the 'official' promotional material from the seller.)

(c)

Promotional tools may be used to assist in different stages of customer relationship management from customer acquisition to retention. In a web context, this includes gaining initial visitors to the site and gaining repeat visits using, for example direct email reminders of site proposition and new offers. One of the tactics which companies have used to manage, and build, brands effectively in the internet era, is to increase their links with customers and enter into dialogue with them about products and services. The benefit of this two-way relationship is that, as well as providing customers with information about their products, it also enables companies to collect information about their customers which can then be analysed â&#x20AC;&#x201C; for example, through data mining. In this way, the internet encourages marketing that is based on direct, personalised relationships with customers â&#x20AC;&#x201C; 'relationship marketing.'

3.4.5

(d)

Targeted marketing â&#x20AC;&#x201C; The internet can enable companies to have direct access to individual customers, and in turn, this allows companies to collect more detailed information about their customers. This should help companies be able to target their marketing more precisely, and introduce products or services which better meet customers' needs.

(e)

The internet can be integrated into campaigns. For example, we are currently seeing many direct response print and TV ad campaigns where the web is used to manage entry into a prize draw and to profile the entrant for future communications.

People An important consideration for the people element of the mix is the consideration of the tactics by which people can be replaced or automated.

3.4.6

(a)

Autoresponders automatically generate a response when a customer emails an organisation, or submits an online form.

(b)

Email notification may be automatically generated by a company's systems to update customers on the progress of their orders. Such notifications might show, for example, three stages: order received; item now in stock; order dispatched.

(c)

Call-back facility requires that customers fill in their phone number on a form and specify a convenient time to be contacted. Dialling from a representative in the call centre occurs automatically at the appointed time and the company pays.

(d)

Frequently Asked Questions (FAQ) can pre-empt enquires. The art lies in compiling and categorising the questions so customers can easily find both the question, and a helpful answer.

(e)

On site search engines help customers find what they are looking for quickly. Site maps are a related feature.

(f)

Virtual assistants come in varying degrees of sophistication and usually help to guide the customer through a maze of choices.

Process The process element of the marketing mix refers to the internal methods and procedures companies use to achieve all marketing functions such as new product development, promotion, sales and

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customer service. The restructuring of the organisation and channel structures described for product, price, place and promotion all require new processes.

3.4.7

Physical evidence The physical evidence element of the marketing mix is the tangible expression of a product and how it is purchased and used. In an online context, physical evidence is customers' experience of the company through the web site and associated support. It includes issues such as ease of use, navigation, availability and performance. Responsiveness to email enquiries is a key aspect of performance. The process must be able to give an acceptable response within the notified service standards such as 24 hours.

3.5

Reinforcing the importance of the customer Customer-centric process – At an overall level, the internet increases the amount of control customers have over the marketing process. In particular, as a result of the internet reducing search costs to almost zero, consumers will increasingly only buy products which precisely match their needs.

C H A P T E R

This increased importance of the customer reinforces the need to place the customer (rather than the supplier's product or service) at the centre of the marketing relationship. As a result of this, in some text, the 4Ps of the traditional marketing mix have been renamed as the 4 Cs:    

Product becomes customer value Price becomes customer cost Place becomes customer convenience Promotion becomes customer communication

4 Databases and e-marketing Brought forward knowledge The concept of relationship marketing has been discussed in the Business Strategy syllabus at Professional Level, along with the differences between relationship marketing and transactions marketing. For many companies, approximately 80% of their sales come from 20% of their customers. This highlights how important it is for companies to retain their existing high-volume and highly profitable customers, as well as those with strong potential to become high-volume, high profit customers in the future. This emphasis on customer retention has led to an increasing focus on customer relationship management. Sales and marketing staff should no longer be looking solely to make a one-off sale, but to create a long term relationship, which is mutually beneficial for the company and the customer. Relationship marketing is the use of marketing resources to maintain and develop a firm's existing customers, rather than using marketing resources solely to attract new customers. Firms can implement their relationship marketing strategy through effective customer relationship management. At a tactical level, relationship marketing also needs to be supported by database marketing.

Definition Database marketing: An interactive approach which builds a database of all communications and interactions with customers (and other stakeholders) and then uses individually addressable marketing media and channels to contact them further (for promotional messages, help and support, or any other relationship-building contacts). Customer data held in computerised databases can be interrogated and manipulated in various ways, through the process of data mining.

Definition Data mining: The process of sorting through data to identify patterns and relationships between different items. Data mining software, using statistical algorithms to discover correlations and patterns, is frequently used on large databases. In essence, it is the process of turning raw data into useful information.

4.1

Database marketing Database marketing techniques can be used for a range of relationship marketing projects, including: 

Identifying the most profitable customers, using RFM analysis (Recency of the latest purchase, Frequency of purchases and Monetary value of all purchases).



Developing new customers (for example, by collecting data on prospects, leads and referrals).



Tailoring messages and offerings, based on customers' purchase profiles. (Actual customer buying preferences and patterns are a much more reliable guide to their future behaviour than market

research, which gathers their 'stated' preferences.)

4.2



Personalising customer service, by providing service staff with relevant customer details.



Eliminating conflicting or confusing communications: presenting a coherent image over time to individual customers. In this respect, it is important to differentiate the message to different customer groups. (For example, companies must avoid sending 'Dear first-time customer' messages to long-standing customers!)

Databases and new customers An organisation's customer database (and database of potential customers) represents a major source of trade. The company can use it to generate repeat business, or to stimulate new business. When advertising, companies don't only target new customers, but also the existing ones they already have listed in their databases. Keeping contact with existing customers is not only a crucial way to generate repeat business, but it also helps companies promote new products to the right people – the people who would be most interested in buying them. Obtaining names of potential new customers is now quite easy, because there are companies who specialise in selling the information of individuals who wish to be contacted by relevant businesses. However, there is a cost involved in this method, which is why it is also important for organisations to keep records of all the potential customers they come into contact with so that they can build up their own database. Ultimately, the aim of marketing databases is to generate revenues, so the more information organisations can hold about customers and potential customers, the better. The more the organisation knows about potential customers, the greater the chance it should have of targeting the right people in a marketing campaign. In an effort to target potential customers more effectively, organisations can use database marketing to build models of their target demographic group. These models then allow them to focus their advertising budgets on these target groups, in the hope that this will result in an improved return on investment (ROI) on their advertising spend.

C H A P T E R

Information gathering is therefore an important process, and organisations need to attract potential customers who are willing to divulge information about themselves. Offering prizes or promotional campaigns through newsletters or 'ezines' can help achieve this. If records are stored and organised effectively, an organisation should be able to implement new marketing strategies and (targeted) campaigns more quickly and easily. For example, by grouping individuals together according to shared characteristics (age, income, gender etc) organisations can generate targeted mailing lists of potential customers who share a set of desired characteristics.

Moreover, having a comprehensive database can also help with forecasting. Future trends for sales and marketing can be modelled based on the results of previous projects. By studying the past purchases of consumers, analytical software allows data analysts to predict broad trends in purchasing habits, which can give an insight into customers' future purchasing behaviour. However, it is important that organisations keep their database up to date, and well-organised. Having outdated or invalid entries could cause confusion and waste time. For example, there is no point in trying to contact business customers who have gone out of business. There is also an ethical/legal dimension to consider when managing databases. Often, unsolicited calls do not generate any business and can be annoying for the recipient. But more importantly, companies need to ensure their databases comply with the law. In the UK, data must be kept up to date, be relevant, and must only be used for the purpose the customer intended or can reasonably expect it to be used for.

Data warehouses and data mining However, effective data management is becoming increasingly important to sustaining an organisation’s competitive advantage as the volume and variety of the data available increases. We will look more at these aspects of the volume and variety in the context of Big Data.

4.3

Customer Relationship Management (CRM) Definition Customer relationship management (CRM): The use of database technology and ICT systems to help an organisation develop, maintain and optimise long-term, mutually valuable relationships between the organisation and its customers. CRM is a more comprehensive approach to the use of database technology, designed to:

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

Enable marketers to predict and manage customer behaviour, by allowing them to learn and analyse what customers value (eg about products, services, customer service and web experiences).



Segment customers based on their relative profitability or lifetime value to the organisation.



Enhance customer satisfaction and retention by facilitating seamless, coherent and consistent customer service across the full range of communication channels and multiple points of contact between the customer and the organisation.

A CRM system involves a comprehensive database that can be accessed from any of the points of contact with the customer, including website contacts, field sales teams, call centres and order processing functions. Information can be accessed and updated from any point, so that participants in customer-facing processes – sales, customer service, marketing, accounts receivable and so on – can coordinate their efforts and give consistent, coherent messages to the customer. Information can also be analysed (through data-mining) to determine profitability, purchasing trends, web browsing patterns and so on.

4.3.1

Customer loyalty programmes Customer loyalty or reward programmes are specifically designed to incentivise and reward loyal behaviour such as repeat purchases, escalating purchases and recommendations and referrals. They include schemes such as Air Miles, various retail discount/rebate/bonus/dividend cards (for example, Nectar cards and store loyalty cards) and voucher schemes.

4.3.2

The need for customer relationship management There are several reasons why CRM is an important consideration:

4.3.3



Customers are now inherently more willing to switch suppliers and are less likely to be loyal to a specific company or brand than they have been in the past. (The internet has had an impact on customer loyalty. For example, price comparison websites may reduce customer loyalty if customers see that an alternative supplier offers a product or service more cheaply than their current provider. However, by developing a relationship with its customers, an organisation will move away from competition based on price alone.)



It is cheaper to focus on retaining existing customers than to have to attract new ones. Attracting new customers is expensive, due to low initial prices or promotional expenses, for instance.



In mature markets, existing customers provide the most likely source of future earnings because there is little scope to attract 'new' customers, given the low growth rate in the market overall.



Strategies to widen the range of products available would make no sense if existing customers could not be retained.

Phases of CRM Customer acquisition is the process of attracting customers for their first purchases. Customer retention ensures that customers return and buy for a second time. The organisation keeps them as customers. The second phase is most likely to be the purchase of a similar product or service, or the next level of product or service. Customer extension introduces products and services to loyal customers that may not wholly relate to their original purchases. These are additional, supplementary purchases.

Links to customer profitability analysis

C H A P T E R

As the definition of CRM earlier in this section highlights, the aim of CRM is to develop mutually valuable relationships between an organisation and its customers. From the organisation's perspective, the relative 'value' of different customers, or groups of customers, will depend on how profitable they are over their customer lifecycle. Therefore, alongside CRM, organisations should also be monitoring customer profitability, because it will not be beneficial for an organisation to invest in, and develop, relationships with unprofitable customers.

Customer lifecycle value Customer lifecycle value (CLV) is the present value of the future cash flows attributed to the lifecycle of an organisation's relationship with a customer. In theory, CLV shows how much each customer is worth to an organisation, and therefore indicates how much the organisation should be prepared to spend on acquiring and retaining that customer. For example, it is not worth an organisation offering promotions and incentives whose value is greater than the customer's lifecycle value to that organisation. In practice, firms have to make two key assumptions in order to calculate CLV:

(a)

Churn rate: The percentage of customers that end their relationship with the organisation in any given period. Organisations tend to assume that churn rate remains constant, but if, for example, churn rate turns out to be lower than this assumed level, CLV should be higher than anticipated.

(b)

Retention cost. The amount of time and money the company has to spend in order to retain an existing customer, for example, through customer service, special offers, and other promotional incentives.

Any attempt to estimate lifecycle costs and revenues also needs to consider existing and potential environmental impacts, however, including the likely actions of competitors and the potential for product and process innovation. These external factors increase the degree of uncertainty in any customer value calculations over the longer term. For example, what is the probability of retaining customers in the future if competitors introduce new products? Or what is the probability that customers will buy additional products in the future if the company develops alternative new products which satisfy the same needs?

4.4

Customer relationship management strategies A number of strategies can be implemented in relation to CRM, and to develop customer loyalty towards an organisation.

4.5

E-marketing and the application of social media Definition E-marketing is 'the application of the internet and related digital technologies to achieve marketing objectives' (Dave Chaffey). Marketing objectives include identifying, anticipating and satisfying customer requirements profitably. Digital technologies are relevant to these objectives as follows: 

Identifying – Using the internet to find out customers' needs and wants



Anticipating – The demand for digital services



Satisfying – Achieving customer satisfaction raises issues over whether the site is easy to use, whether it performs adequately and how the physical products are dispatched

Although the media used in e-marketing are different to 'traditional' marketing, the basic principles behind it remain the same – creating a strategy to deliver the right messages to the right people. What has changed, however, are the number of media available to disseminate that message. These include: pay per click advertising, banner ads, email marketing and affiliate marketing, interactive advertising, search engine marketing (including search engine optimisation) and blog marketing. Although businesses will continue to make use of traditional marketing methods (such as press and television advertising, or direct mail-outs), e-marketing offers a new dimension to the promotion element of the marketing mix and is an increasingly valuable component of that mix. It gives businesses of any size access to the mass market at an affordable price and, unlike TV or print advertising, it allows truly personalised marketing.

4.5.1

Key marketing functions the internet can perform (a)

Creating company and product awareness – Communicating essential information about the company and its brands. Such information may have a financial orientation to help attract potential investors, or it may focus on the unique features and benefits of its product lines.

(b)

Branding – With the amount of advertising being devoted to the internet increasing each year, the frequency of visits to a site will also increase. Consequently, a company's web site will play a more prominent role in building its brand image. Online communications should therefore be similar in appearance and style to communications in the traditional media so as to present a consistent brand image. Similarly, any dealings a customer has with the online brand should be consistent in terms of positioning with the traditional (offline) brand.

(c)

Offering incentives – Many sites offer discounts for purchasing online. Electronic coupons, bonus offers, and contests are now quite common. Such offers are intended to stimulate immediate purchase before a visitor leaves a web site, and also to encourage repeat visits.

(d)

Lead generation – The internet is an interactive medium. Visitors to a site provide useful information about themselves when they fill in boxes requesting more information from a company (eg, name, address, telephone number, and email address). A site may also ask for demographic information that can be added to the company's database. This information is retained for future mailings about similar offers, or they can be turned over to a sales force for follow-up if it is a business-to-business marketing situation.

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(e)

Customer service – In any form of marketing, customer service is important. Satisfied customers hold positive attitudes about a company and are therefore more likely to return to buy more goods. Customer service is often perceived as a weak link in internet marketing. Customers are concerned about who they should call for technical assistance or what process to follow, should goods need to be returned. Some customer service tactics commonly used include frequently asked questions (FAQs) and return email systems. However, if a potential customer registers interest on a company's website and asks to be contacted, if the company does not respond to that request, the potential customer may take their business elsewhere.

(f)

Email databases – Organisations retain visitor information in a database. Emailing useful and relevant information to prospective and existing customers helps build stronger relationships. An organisation must be careful that it does not distribute spam (unsolicited/unwanted email) on the internet.

(g)

Online transactions – Organisations are capable of selling online if the website is user friendly. The ability to sell online could potentially be the most important benefit the internet provides for a company. However, if a company website is hard to navigate, and it proves difficult for customers to make a purchase online, this will reduce the company's ability to generate online sales. Websites and online ordering also enable organisations in the supply chain to link together to achieve efficiencies in business-to-business transactions. The ability to track and monitor orders via an extranet can also be valuable (particularly for B2B customers), so websites which provide this facility could play a part in customer retention.

Technology and website designs Developments in technology mean that companies have to continuously monitor the media through which they interact with potential customers. 'User experience' is very important for customers. Since potential customers no longer only access websites from PCs, but also from tablet computers or smartphones, they are likely to expect a user experience built around these different devices. Therefore, a well-designed 'app' or a web page designed for the screen size of the device it is being accessed from, could help enhance a mobile user's impression of a company.

4.5.2

Specific benefits of e-marketing (a)

Global reach – A website can reach anyone in the world who has internet access. This allows organisations to find new markets and compete globally with only a small investment required.

(b)

Lower cost – A properly planned and effectively targeted e-marketing campaign can reach the right customers at a much lower cost than traditional marketing methods.

(c)

The ability to track and measure results – Marketing by email or banner advertising makes it easier for companies to establish how effective their campaigns have been. You can obtain detailed information about customers' responses to your advertising.

(d)

24-hour marketing – With a website customers can find out about a company's products even if its physical shops or offices are closed.

(e)

Personalisation – If the customer database is linked to the website, then whenever someone visits the site, they can be greeted with targeted offers. The more they buy from an organisation, the more the organisation can refine the customer profile and market effectively to them.

(f)

One-to-one marketing – E-marketing helps to reach people who want to know about the products and services instantly. For example, many people take their mobile phones, tablets or Blackberry hand-held devices with them wherever they go. If the combine this instant

communication with the personalised aspect of e-marketing, companies can create very powerful, targeted campaigns. (g)

More interesting campaigns – E-marketing helps to create interactive campaigns using music, graphics and videos. For example, sending customers a game or a quiz – whatever will interest them.

(h)

Better conversion rate – Customers are only ever a few clicks away from completing a purchase. In contrast to other media which require people to get up and make a phone call, post a letter or go to a shop, e-marketing is seamless.

Together, all of these aspects of e-marketing have the potential to add up to more sales. As a component of e-commerce it can include information management; public relations; customer service and sales.

4.5.3

Developing an effective e-marketing plan

It is important to recognise that planning for e-marketing does not mean starting from scratch. Any online e-communication must be consistent with the overall marketing goals and current marketing efforts of the organisation. The key strategic decisions for e-marketing are common with strategic decisions for traditional marketing. They involve selecting target customer groups and specifying how to deliver value to these groups. Segmentation, targeting, differentiation and positioning all contribute to effective digital marketing.

4.5.4

E-marketing and CRM Earlier in this chapter, we discussed the concept of customer relationship management, and the three elements of customer acquisition, retention and extension. The internet and online techniques can play an important role in these, perhaps most extensively in relation to customer acquisition. The internet offers a number of methods for acquiring customers: Search engines – Search engines (such as Google) mean that when users search for relevant key words or phrases, links to the company's website will appear in their search results. In turn, search engine optimisation can be used as a technique for improving the company's position in the search engine listings. Pay per click (or cost per click) advertising – Companies can pay other websites to display a banner on their website, with the hope that potential customers will click on the banner, which then links through to the company's own website. Affiliate marketing – A company rewards affiliates for each visitor or customer who comes to the company's website through the affiliate's own marketing efforts. Amazon is probably the best known example of an affiliate network; with an extensive range of sites directing customers to Amazon to buy books or music tracks that the affiliates have mentioned on their web pages. Comparison sites – Comparison sites (such as www.moneysupermarket.com) allow potential customers to compare the price and features of different products, and if a product compares favourably to competitor products, this should encourage potential customers to buy it. Viral marketing – Social networks are used to increase brand awareness, for example through video clips or images being passed from one user to another. A marketer creates the initial promotion (eg a video clip) but then relies on people to distribute it voluntarily across their social network. Therefore, marketers need to make the promotion appeal to the people who have the highest propensity to pass it

C H A P T E R

Business blogs – Companies can use blogs to showcase the knowledge and expertise of their employees, and thereby hopefully attract new customers. Blog marketing follows a similar logic to viral marketing. If a business can get itself or its products mentioned on different blogs, that will help generate interest among prospective customers. However, it is important that marketers concentrate their efforts on blogs covering topics which are relevant to their product or service offering. Retention The internet can also be useful for helping to retain customers, for example through the use of personalised reminder emails, possibly with discount codes or other incentives, to customers who have not made any purchases recently. Online communities – The creation of online communities and forums could also help retain customers' interest in a product or service. However, these forums can also have an additional benefit for companies. By reading customers' feedback and comments, businesses can improve their understanding of customer needs, and can take steps to improve their products or services to address any issues which are currently attracting criticism on the forums. Extension Recommendations – Probably the best known examples of customer extension are the 'recommendations' that customers are given on Amazon. Amazon's data modelling software allows them to monitor products which customers often buy together. Therefore, when existing customers log back in to Amazon, they are given recommendations of other products they might like to buy, based on their previous purchases. However, recommendations are not only made when customers log on, they also occur at the point a customer makes a purchase. For example, if a customer purchases a television, they might then be asked at the checkout if they also want to buy a television stand to go with their television.

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4.6

Web 2.0 technologies and social media The phrase 'Web 2.0' has become synonymous not only with a new generation of web technologies and softwares, but also with changes in the ways users interact with content, applications, and each other. One of the key benefits of Web 2.0 technologies is that they increase opportunities for collaboration and the sharing of knowledge. The most commonly used technologies – such as blogs, microblogs (Twitter), wikis and podcasts – can help companies strengthen their links to customers, especially with the use of automatic information feeds such as RSS (Really Simple Syndication). Not only do Web 2.0 technologies allow companies to distribute information about their products or services, but, perhaps more critically, they invite customer feedback and even customer participation in the creation of products and services. Earlier in the chapter, we highlighted the importance of viewing marketing as a customer-centric process. By enabling marketers and sales staff to develop better insights into markets, or to interact with consumers, Web 2.0 technologies can be seen as being integral to a customer-centric process such as marketing.

Web 2.0 technologies and networked companies Interestingly, a podcast by McKinsey Quarterly in March 2013 ('How companies are benefiting from Web 2.0') suggested that Web 2.0 deployments are not confined to companies' relationships with customers, but can also contribute to work flows and knowledge sharing between employees, and help create more 'networked' companies – strengthening the links between companies and their suppliers and other business partners. If Web 2.0 technologies improve knowledge sharing and access to knowledge within and across companies, this may also be able to help companies innovate more effectively.

4.7

The potential impact of Web 2.0 technologies and business strategy Web 2.0 technologies can provide firms with opportunities in a range of activities – from market research to marketing, collaboration, innovation and design.

4.7.1

The importance of user experience and participation Web 2.0 allows internet users (and potential customers for businesses) no longer simply to be recipients of information, but to participate in the creation, sharing and evaluation of content. In other words, users can actively take part in 'many-to-many' communications. A crucial aspect of Web 2.0 is that it focuses on user experience and participation. This is important for businesses. Web 2.0 allows firms of all sizes to engage with customers, staff and suppliers in new ways. In particular, it allows firms to have a more customer-focused approach to new product development – because customers can be involved in the design of the new products. Web 2.0 has highlighted the significance of dynamic social interactions in the environment, rather than considering business and business transactions as a set of static business processes. We have already identified the importance of knowledge to businesses, and Web 2.0 plays an important role in this 'knowledge economy' through supporting collaboration, knowledge sharing, and ultimately, innovation. The idea of collaboration is also very important when considering how Web 2.0 technologies could affect business strategies. The potential impact could be significant if organisations find it becomes as efficient to do business through collaborating outside the organisation's structure, rather than doing business within the organisation's own structure. In effect, collaboration is an extension of the idea of outsourcing, although whereas with outsourcing, specific processes are outsourced to specific companies, in the case of collaboration, anybody can contribute to the discussion in progress. (The collaborative online encyclopaedia – Wikipedia – is probably the best known illustration of this, but Procter & Gamble has also promoted the idea of collaborative innovation through their 'Connect + Develop' programme, in which external innovators form partnerships with Procter & Gamble to develop new products.) We will now look at some of the key aspects of Web 2.0. Web-based communities Probably the most popular aspect of Web 2.0 has been social networking sites, such as Facebook, which now has more than 1 billion unique visitors. Web-based communities are enhanced by: 

Social networking – Social networks (such as Facebook) allow users to make contact with other

users. As well as mass market social networks, a number of smaller, more focused niche social networks have also begun to emerge. The value of these sites is that they allow users to connect with others whom they share a common interest with. For example, LinkedIn is a network for business people looking to build business contacts, and also to advertise their skills and experience to potential employers or clients. 

Blogs – Blogs provide an easy way for users to publish their own content. Blogs are usually text based. Users can publish audio and visual content as podcasts, and the growth of sites such as YouTube illustrates how popular podcasts have become. The microblogging site, Twitter, provides a platform for people who want to publish very short blogs – of up to 140 characters each.



Wikis – Wikis allow user groups to collaborate in contributing and editing educational or referencebased content. Wikipedia, the collaborative online encyclopaedia, is the best known example of this.



Instant messaging – This allows real time conversations between two or more participants using pop-up dialogue boxes (eg instant messaging is now available in Skype).

These web-based communities mean that web users are now participants in the web experience, rather than simply being observers. Moreover, these communities allow people to get to know each other and to interact, regardless of their physical or geographical location.

4.7.2

H A P T E R

Socialisation of knowledge sharing Web 2.0 technologies encourage the socialisation of knowledge sharing through: 

Tagging of information – A tag is a keyword assigned by a user to describe a piece of information (such as a file, an image, or an internet bookmark). Tagging is a key feature of many Web 2.0 applications and is commonly used on file storing and file sharing sites. Once a file has been tagged, the tag allows it to be found again when a relevant search enquiry is made. Tags are examples of metadata, which is 'data about other data'. The title, author and publication date of a book are examples of metadata about a book, and this data could help a user find the book he or she is looking for. Tagging also highlights an important point which businesses need to consider. The new technologies mean that the amount of information on the internet is rising constantly. However, information is no use if it can't be found. Search engine optimisation (SEO) is therefore, increasingly important for businesses – making sure that the information on the website of a business is findable and relevant.



Mashups – A mashup is a web publication that combines data from more than one source into a singe web page. For example, a restaurant review website could take the location details of all the local restaurants in an area and map them onto a single Google map page.



Feedback on sources of information.



Promoting collective intelligence – Collective intelligence refers to both structured and unstructured group collaboration. It describes the way people's opinions or behaviours can be aggregated so that others can learn from their collective decision making. The online auction site eBay uses collective intelligence to let potential buyers see how efficient and trustworthy vendors are. Equally, Amazon and a number of online sites include product reviews, allowing people who have purchased an item to comment on the item and rate its performance. Amazon also uses collective intelligence to make product recommendations based on purchasing patterns. When a user selects an item to buy, he or she is presented with a list of other items purchased by people who have already bought the current selection, which may encourage a user to make follow up purchases.

User generated content (UGC): Websites can now have sections of content created by their readers. One of the main ideas behind Web 2.0 technologies is that users can generate the content of sites themselves, and these technologies allow users to create, capture and share information across the web. The video streaming website, YouTube, and the image and video hosting website, Flickr, are popular examples of content sharing sites. Consumer generated content (CGC): Websites can now contain shared feedback from consumers; for example, product reviews. This has important implications for businesses, because it means customers can communicate with other (potential) customers very easily. If a customer receives poor customer

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service, they can now tell everyone else about it, which could damage the business' reputation, and lead to a decline in sales. The most widely known example of CGC is the user reviews developed by Amazon noted above. Many customers review users' product reviews when assessing prospective purchases.

4.7.3

Applications of Web 2.0 for business In recent years, we have seen the emergence of a number of new online companies. Most are probably also run by young entrepreneurs for whom technology will play a key role in their business strategy: 

The business can find partners, collaborators, customers and suppliers through social networks and blogs.



It can use blogs and social networks for publicity and to market itself, and it can encourage customers to leave feedback on its site (customer generated content).



It can manage the development, creation and delivery of its products through virtual workspaces and wikis that support collaboration, innovation and the management of workflow. The collaborative nature of Web 2.0 enables external third parties to participate in product development.



It can get market intelligence through blogs and online reference sites. It can also get feedback on how customers perceive its own products or services.

Staff – Importantly also, if a business wants to attract and retain young, dynamic employees, they will need to provide them with tools they are familiar with, and offer a work environment that fits in with their lifestyle. Marketing – Web 2.0 can have significant implications for marketing approaches. Teenagers and young adults can be an important demographic for many businesses, and sites such as Facebook and Twitter play an important part in their lives. In this way, running campaigns through popular social networking sites can offer businesses a way of engaging with these users, allowing them to reach a demographic that has traditionally been difficult to reach. Marketers can also use pre-existing social networks as a mechanism for promoting viral marketing campaigns. In these, a company will generate an initial marketing message, but people then pass it along to their friends and contacts through their social networks.

4.7.4

Web 2.0 and social media marketing Definition Social media marketing: refers to the process of acquiring customers, and attracting the attention of potential customers, through social media sites. Web 2.0 technologies have changed the way companies interact with customers, and have also changed the way customers (or potential customers) interact with content and each other. The development of web-based communities – and the associated social networking and social media sites – allows users to provide and share information about themselves. In turn, this information can be valuable to marketers. For example, marketers could analyse the people who 'like' their brands or products on Facebook, and identify those who fit their target demographic. By observing the chatter among those fans on social media, marketers could identify not only sentiments about their own brands, and competitor brands, but also the wider interests of its target demographic – for example, celebrities and TV shows talked about; events that are frequently discussed; topics (articles; video clips or photos) which are commonly shared; or websites which are commonly visited. In turn, marketers can use this information to help shape their own marketing activity – for example, buying banner adverts on websites which are frequently mentioned; buying advertising space in a TV show being discussed; getting a named celebrity to endorse their product or brand; or developing partnerships with other brands in other industries (where those brands are popular with the target demographic). Social media and targeted marketing More generally, social media marketing enables organisations to target relevant marketing messages to narrowly defined market segments, based on the data it has gathered and analysed about its customers and potential customers. This kind of data-powered, targeted marketing is likely to be not only more effective, but also more cost-efficient than traditional forms of mass (eg television or newspaper) advertising. However, if companies do engage in social networking or publish blogs, they need to monitor how these are perceived by the online communities. Brand management remains very important – perhaps even more so now, because of the way users can publish negative feedback on poorly designed or presented content. Conversely though, favourable customer review comments on products or services can be very useful PR material for an organisation. By allowing web users to provide feedback and share ideas, Web 2.0 is encouraging a model in which people from outside an organisation can have an impact on that organisation's strategy.

Moreover, the internet becomes, in effect, a research tool, where companies can find out about customers' opinions about products and services. Web 2.0 allows businesses to aggregate opinions from many different individuals to guide idea generation and strategic decision making. In this way, customer networks and social interaction have become much more important in marketing.

4.7.5

Potential limitations of social media In recent years, there has been considerable hype about the growth of social media. However, some commentators still urge caution about the impact of social media on purchasing decisions. In particular, questions are raised about the sort of information which people actually exchange on social networking sites. People use social media mainly to socialise, not to buy goods or services. As a result, much of the information that is exchanged is non-commercial in nature, and so may be of limited value to businesses. Clearly, there is some overlap between the conversations people have about their social lives and conversations about products, services and brands. In this respect, social networking platforms may be a good way for companies to 'listen' to what customers are saying about their brands. Similarly, social media can be very useful for networking, building relationships and engaging with customers and prospects. However, the actual expenditure generated through social media has, so far, been relatively low, so other marketing channels may remain more relevant and powerful for influencing customers' purchasing decisions. For example, many brands boast very large numbers of Facebook fans or 'likes'. But marketing directors could be justified in asking what benefits these 'likes' actually bring a brand. Simply 'liking' a brand on Facebook doesn't mean that someone is going to purchase that brand.

Potential issues with social media Potential threat to companies/brands – Social media gives customers the power to transmit/share messages which may not be the messages the companies actually want to be transmitted (for example, if a guest has had an unsatisfactory meal in a restaurant, or stay in a hotel, they can publicise this on review sites such as Trip Advisor). Equally, conversations between social networkers may not be in the best interests of a company. For example, many Facebook groups are set up to complain about organisations. In this way, the internet and social media are not simply increasing the role of the consumer in the marketing process, they could also be seen to be increasing consumers' power over the marketing process.

5 Brand management 5.1

Brands and strategic performance Traditionally, a brand is a name, term, sign, symbol or design intended to identify the product of a seller and to differentiate it from those of competitors. However, as Morgan Witzel stresses in his article, 'Strategy and Brands' (ICAEW, Finance & Management, October 2010) a brand is much more than just a name or marque. In his article, Witzel stresses that no company, whatever market or sector it operates in, will enjoy longterm strategic success unless it has a strong brand. Companies need strong brands in order to survive, and therefore, a key task for managers thinking about their company's strategy, is to understand what their brand is and how to strengthen it. In Chapter 1 of this Study Manual we considered the role of resources and capabilities shaping an organisation's strategy. However, as the business environment becomes increasingly dynamic, many sources of competitive advantage, such as technology, become increasingly short-lived. Despite this, brands remain one of the few assets that can provide and sustain long-term competitive advantage. Strong brands can enhance business performance through their influence on key stakeholder groups. For example: Customer – Influencing customer choice, and creating loyalty Employees – Attract, motivate and retain talent Investors – Lowering the cost of financing The influence of brands on customers is a particularly important driver of economic value. Strong brands help shape customer perceptions and therefore, purchase behaviour, making products and services less substitutable. In this

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way, brands help to create and sustain demand, allowing their owners to enjoy higher returns. The brand management consultancy, Interbrand, highlights two key concepts which influence the value of a brand: Role of brand â&#x20AC;&#x201C; The brand's influence on current purchase behaviour; the influence that brands can have on demand by encouraging customers to select one product in preference to another. Brand strength â&#x20AC;&#x201C; Brand strength is a brand's ability to sustain demand into the future by encouraging customer loyalty, and thereby reducing risk associated with the brand's financial forecasts (for example, arising from the risk that customers will switch to competitor products or services).

Brand identity Brand identity conveys a lot of information very quickly and concisely. This helps customers to identify the goods or services and thus helps to create customer loyalty to the brand. It is therefore a means of increasing or maintaining sales. (In some extreme cases, a strong brand could even act as a barrier to entry, preventing potential entrants from entering a market if they think customers will not be persuaded to move away from the brand.) Where a brand image promotes an idea of quality, a customer will be disappointed if their experience of a product or service fails to live up to expectations. Quality assurance and control is therefore of the utmost importance. It is essentially a problem for service industries such as hotels, airlines and retail stores, where there is less possibility than in the manufacturing sector of detecting and rejecting the work of an operator before it reaches the customer. Inappropriate or unhelpful behaviour by an employee in a face-to-face encounter with a customer will reflect on the entire company and possibly deter the customer from using any of the company's services again. Brand awareness is an indicator of a product's/organisation's place in the market. Recall tests can be used to assess the public's brand awareness.

5.1.1

Branding and strategy Branding messages are usually qualitative rather than focusing on price. One of the perceived advantages of branding is that by creating an 'identity' for a product, an organisation can reduce the importance of price differentials between their product and rival products. This may, in turn, allow an organisation to charge a higher price for their product. However, some brands will position themselves on the basis of value for money, so branding does not necessarily mean charging premium prices. Moreover, certain consumers reject 'branded products', especially when considering value for money. This can be seen in supermarkets where shoppers choose generic (own label) products in preference to brand names, because the own label products are seen as being cheaper but having the same use. In this respect, branding is perhaps most appropriate to organisations or products which are following a differentiation strategy. Branding is a form of product differentiation, which makes it possible for organisations to charge premium prices for a product (or service) and therefore earn higher profits than if products had to be sold at a lower price. (Think, for example, of designer clothes labels. The kudos attached to the brand means that the clothes can be sold for significantly higher prices than nonbranded equivalents.) Luxury brands use quality and exclusiveness to appeal to consumers. Recent reinventions of 'tired' brands include Burberry, where a new designer has extended the brand life by reinventing the house style and transferring this into new products. Extending the brand life in this way means the business can continue to benefit from the status of an existing brand. Burberry had a loyal customer base who bought the signature check products and these are still produced. However, it was also able to extend the brand life by attracting younger and high-spending customers who prefer modern interpretations but associated with established quality. This represents additional revenue. Another important aspect of branding is the creation of brand loyalty, thereby improving customer retention rates and encouraging repeat purchases. An example of the way organisations try to increase band loyalty is in the use of loyalty cards by supermarkets (for example, Tesco's Clubcard).

5.1.2

Reasons for branding The following are reasons for branding: (a)

It is a form of product differentiation, conveying a lot of information very quickly and concisely. This helps customers to identify the goods or services readily and thereby helps to create a customer loyalty to the brand. It is therefore a means of increasing or maintaining sales. In this way, a brand can also act as a barrier to entry. If a supplier has already established a strong brand in a market, it will discourage new entrants into that market.

C H A R P E

(b)

Advertising needs a brand name to sell to customers, so advertising and branding are very closely related aspects of promotion; the more similar a product (whether an industrial/commercial or consumer) is to competing goods, the more branding is necessary to create a separate product identity.

(c)

Branding leads to a readier acceptance of a manufacturer's products by wholesalers and retailers.

(d)

It facilitates self-selection of goods in self-service stores and also makes it easier for a manufacturer to obtain display space in shops and stores.

(e)

It reduces the importance of price differentials between products.

(f)

Brand loyalty in customers gives a manufacturer more control over marketing strategy and of choice of channels of distribution.

(g)

Other products can be introduced into a brand range to 'piggy back' on the articles already known to the customer (but ill-will as well as goodwill for one product in a branded range will be transferred to all other products in the range). Adding products to an existing brand range is known as brand extension strategy.

(h)

It eases the task of personal selling (face-to-face selling by sales representatives).

(i)

Branding makes market segmentation easier. Different brands of similar products may be developed to meet the specific needs of different categories of users.

The relevance of branding does not apply equally to all products. The cost of intensive brand advertising to project a brand image nationally may be prohibitively high. Products which are sold in large numbers, on the other hand, promote a brand name by their existence and circulation.

Brand strength When looking at strategies to maintain or develop their brands, companies should consider how well the proposed strategies will help to strengthen these factors. However, it is also important to ensure that the brand's position fits with the other elements of the marketing mix. Note: the link back to the idea of positioning which we covered in Section 3 of this chapter. Brands can be positioned against competitor brands on product maps defined in terms of how buyers perceive key characteristics of the brands.

5.2

Brand strategy and marketing strategy Brand positioning is a crucial part of marketing strategy. Positioning is the 'act of designing the company's offer and image so that it occupies a distinct and valued place in the target customer's mind.' As its name implies, positioning involves finding an appropriate position for a product or service in the market place so that consumers think about that product or service in the 'right' way. Equally, brand positioning involves identifying the optimal location of a brand in the minds of consumers, and in relation to its competitors, to maximise the potential benefit of the brand to the company which owns it. If we consider the general functions of a brand (per the bullet points below), we can see how closely they are also linked to the logic of positioning: 

To distinguish a company's offering, and to differentiate one particular product from competitor products



To deliver an expected level of quality and satisfaction



To help with promotion of the product and to develop awareness of it

Brand positioning should help to guide marketing strategy by clarifying: what a brand is; how it is unique or how it is different from competing brands; and why consumers should purchase and use the brand. Once a brand's positioning strategy has been determined, the brand's marketers can then develop and implement their marketing strategy to create, strengthen or maintain brand associations. In this respect, obtaining an appropriate combination of the 'marketing mix' elements (4 Ps, or 7 Ps) will be very important when designing the marketing campaigns to support the brand. Product – The product (or service) is central to brand equity because it is the primary influence on consumers' experience with a brand, as well as on what they hear about a brand from others, and about what a company can tell consumers about the brand in any marketing communications. Products must be designed, manufactured, marketed, sold, delivered and serviced in a way which creates a positive brand image with customers. If a company does not have a product or service which satisfies customer needs (particularly in relation to perceived quality and value), that company will not be able to develop a successful brand, or engender any customer loyalty to that brand.

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The importance of acquiring and retaining loyal customers has led to relationship marketing becoming a priority for branding. The marketers who are most successful at building customer-based brand equity will be those who ensure they understand their customers, and understand how to deliver value to their customers before, during and after purchase. Price – The price element of the marketing mix pricing policy for a brand is very important because it can play a key role in shaping consumers' perceptions of a product (eg. as being high-, medium, or lowpriced.) However, price often also has an association with quality; and consumers often infer the quality of a product or service on the basis of its price. In some cases, consumers are willing to pay a premium for certain brands because of what they represent. But in terms of preparing a marketing strategy to develop a brand, it is important to ensure that the price is consistent with the perceived quality or value of a product to the customer. The benefits delivered by a product, and its competitive advantages compared to rival products, can often have a significant impact on what consumers believe to be a fair price for a product. In this context, the concept of value pricing could be very useful. The objective to value pricing is to identify the right blend of product quality, product costs and product prices to satisfy both the needs and wants of consumers and also the profit targets of the company. Place – The manner in which a product is sold or distributed can have a profound impact on the sales success of a brand. In this respect, channel strategy (the way firms distribute their products to consumers) is important for building and maintaining a brand. In this respect, channel strategy involves deciding whether to sell directly to customers or to sell through third-party intermediaries (eg wholesalers, or retailers). In either case, however, it is important to ensure that the shop's image is aligned to the brand's image – for example, it would not seem appropriate to use a discount retailer for selling a brand which seeks to emphasise high quality and luxury as differentiating factors. Another important decision in relation to channel strategy is whether to sell online, offline, or through a combination of both. For many companies, the best channel strategies will be ones which develop an integrated shopping experience, combining physical stores and internet. For example, Nike sells its products through a range of department and clothes shops as well as through some of it own 'Nike Town' shops. Alongside this, Nike's own e-commerce website (store.nike.com) allows customers to buy directly from it online, while a number of the other shops which stock Nike products also have their own e-commerce websites. Promotion – It should be obvious that the aim of promotion and marketing communications should be to increase consumers' knowledge of a brand and to entice them to buy that brand. Companies have a wide range of potential communication options they could use for a marketing campaign: for example, broadcast media, print media, direct response (eg phone calls), online advertising; consumer and trade promotions; or event marketing and sponsorship. Crucially, however, when deciding on its promotion strategy, a company must evaluate the effectiveness and efficiency with which that strategy affects brand awareness, and how it creates or strengthens favourable brand associations.

5.3

Brands and strategic alignment In order for a business to be successful, there needs to be alignment between its strategy and its brand. Brands will ultimately only succeed if they are capable of delivering what they promise, day in and day out; year in year out. Although Toyota has had problems with product recalls in recent years, its sales figures have bounced back, because customers have offset the recent problems against their own long experience of reliable Toyota cars, and this experience has won in the long run. Although brand equity has been tarnished slightly by the product recalls, it has not been badly damaged.

Links between branding and operational strategy To deliver reliable brands, a company needs to ensure that its production and distribution systems are reliable, that its marketing staff are in touch with its customers, and that any faults get reported so that they can be repaired quickly. In short, in order to deliver a reliable brand, an organisation needs to ensure that all its staff members are focused on doing their best for the customer, and that senior managers within the organisation are also engaged with this customer-centric process. To be effective, brand marketing strategy and business strategy must be properly aligned; both internally and externally. Internally, employee commitment will be required to support internal service quality, while externally the brand quality will influence customer satisfaction and retention. If companies become complacent, or fail to cherish their brands, the results can be very damaging. Marks &

Spencer has historically been an iconic name in British retailing, but in the 1990s its senior managers took their eye off the ball, and by the time they realised how customers' opinions of the brand were falling, it was almost too late. It has subsequently taken many years, and a lot of hard work, to restore the M&S brand.

The social value of brands Although the economic benefit of brands to their owners is clear, the social value of brands may be less clear. For example, critics argue that brands only create value for their owners, rather than society at large. In this respect, the critics argue that brands lead to the exploitation of workers in developing countries, and the homogenisation of cultures. Furthermore, if brands establish monopoly positions in markets, they stifle competition and limit consumer choice. The counter argument is that brands create significant social as well as economic value, as a result of increased competition, improved product or service performance, and the pressure on brand owners to behave in socially responsible ways in order to uphold the image of the brand. Moreover, competition on the basis of performance as well as price, fosters product developments and improvement. The need to keep brands 'relevant' can therefore also act as an incentive for research and development. In this respect, there is evidence that companies which promote their brands more heavily than others in their market segments, also tend to be more innovative than their rivals.

5.3.1

Customers and brand value Brand value is created by customers' reactions to a brand. If a customer has a positive experience of a brand, they will be more likely to use that brand again and become loyal to it, so the brand's value increases. Conversely, if customers have a negative experience of a brand or are dissatisfied with it, then the brand's value will effectively go down. As with so many aspects of marketing we have discussed in this chapter, here again we can see the importance of customers in the success of a brand. The growth of social media reinforces this too. As Morgan Witzel notes in his article in Finance & Management: Today, every action a company takes, every experience people have of a brand, is likely to be discussed on the internet – often almost immediately. Take for example the popular website TripAdvisor, where people post their experiences of hotels and holiday destinations. Many people, before making a booking, look up the destination on TripAdvisor and make purchase decisions on what they read there. Brand value – both positive and negative – is created in the process. The reference to social media also highlights the importance of companies listening to customers and reacting to their views. However, this engagement and interaction between companies and customers is ultimately critical for creating brand equity.

5.3.2

Brand value We will look at the techniques for valuing brands later in this chapter, but in terms of developing strategies for managing brands, it is important to understand the sources of brand value: These sources of brand value suggest that customers play a key role in creating brand value. As the case example (earlier) of the 'blind test' between Coca-Cola and Pepsi shows, customers exhibit a subjective preference for a strong brand name, even though they cannot tell the difference between two products. However, brand equity doesn't solely come from customers. There are also two important sources of brand value which are controlled by the brand's company: (a)

Patents – Patents protect a brand from competitive threat over the lifetime of the patent. Patents are often used to protect pharmaceutical brands, but the value of the brand will fall as its patents expire and it becomes subject to competition from low-priced generic manufacturers.

(b)

Channel relationships – Close relationships with distributors and suppliers can enhance the value of company brands. This reinforces the importance of effective supply chain management.

6 Branding and marketing strategy 6.1

Branding strategies In the previous section, we looked at ways a company could manage or sustain its existing brand. However, companies may also want to use branding strategies to develop and expand their brands. Kotler has identified the following five strategies a company can use once it has established its brand(s): (a)

Line extension – An existing name is applied to new variants of existing products, for example

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Coca-Cola launching Diet Coke. (b)

Brand extensions – Using an existing brand to launch a product in a new category, for example chocolate bars such Mars or Galaxy and Mars/Galaxy ice creams.

(c)

Multi-branding – Launching several brands in the same category, for example Kellogg's offers a range of breakfast cereals with their own brands – for example, All-Bran, Cornflakes, CocoPops, Rice Krispies.

(d)

New brands – New products are launched under their own brand, for example Coke attempting to sell bottled water under the 'Dasani' brand.

(e)

Co-branding – Two brands are combined in an offer, for example Sony Playstations were offered in a package with a Tomb Raider game.

The decision as to whether a brand name should be given to a range of products, or whether products should be branded individually, depends on quality factors.

6.2

(a)

If the brand name is associated with quality, all goods in the range must be of that standard.

(b)

If a company produces different quality (and price) goods for different market segments, it would be unwise to give the same brand name to the higher and the lower quality goods because this could deter buyers in the high quality/price market segment.

Developing an effective position Deepening a brand means moving a brand, in the minds of consumers, from a defined product with differentiated features, to a product they identify with their personal goals and values. A brand's position can be strengthened by 'laddering' from functional to more emotional benefits – in effect, giving a customer multiple reasons to believe in the brand. Procter & Gamble grew the Pantene shampoo brand by emphasising how the ingredient, ProV, not only led to healthy hair, but could also make hair feel softer or thicker.

6.2.1

Strategic planning and brand development The 'classic' approach to developing brands is outlined below. Brands are developed from the strategic plan and are part of the hierarchy.

6.3

Global or local brand? International strategies and the idea of firms expanding internationally. International growth also has important implications for branding though: should there be one global brand for a product, or a range of different national brands? In most cases, firms will have to evaluate the benefits of having a single global brand (eg for advertising synergies) against the benefits of being able to meet specific needs more closely. However, there may also be specific practical issues – for example, if a brand name means something rude or offensive when translated into another language.

6.4

Off-line and on-line branding IT and the internet have particular implications for branding.   

The domain name is a vital element of the brand Brand values are communicated within seconds via the experience of using the brand website Online brands may be created in four ways – – – –

6.4.1

Migrate the traditional brand Extend the traditional brand Partner with an existing digital brand Create a new digital brand

Online brand options Migrate traditional brand online – This can make sense if the brand is well known and has a strong reputation eg, Marks & Spencer, Orange and Disney. However, there is a risk of jeopardising the brand's good name if the new venture is not successful. Extend traditional brand – A variant. For example, before the growth of online shopping, when Aspirin could only be bought over the counter in shops and pharmacies, Aspirin's brand positioning statement was 'Aspirin – provides instant pain relief'. However, management felt this didn't work as a meaningful statement in relation to e-commerce, because consumers can't get instant pain relief on the web. So the brand positioning statement was changed to 'Aspirin – your self help brand', and the website offered

C H A P T E R

'meaningful health oriented intelligence and self help'. Partner with an existing digital brand – Co-branding occurs when two businesses put their brand name on the same product as a joint initiative. This practice is quite common on the internet and has proved to be a good way to build brand recognition and make the product or service more resistant to copying by private label manufacturers. A successful example of co-branding is the Senseo coffeemaker, which carries both the Philips and the Douwe Egberts brands. Create a new digital brand – Because a good name is extremely important, some factors to consider when selecting a new brand name are that it should suggest something about the product (eg Betfair), be short and memorable, be easy to spell, translate well into other languages and have an available domain name.

7 Valuing brands and intangible assets 7.1

Brand equity and the brand asset One of the key aspects of branding is that branding and a firm's reputation are linked. The important thing to remember is that a brand is something which customers value: it exists in the customer's mind. A brand is the link between a company's activities and the customer's perception.

T E R

Brand equity is the asset the marketer builds to ensure continuity of satisfaction for the customer and profit for the supplier. The asset consists of consumer attitudes, distribution and so on. It is thus the public embodiment of the organisation's strategic capability. A strong brand should help to generate future cash inflows and higher profits for a company. Brands can build market share. They can be used to support higher prices (by differentiation) and enable manufacturers to exercise some control over distributors. Despite all of these attributes, however, internally generated brands are not recognised as intangible assets under IAS 38, Intangible Assets.

7.2

Valuing brand equity Brand equity is a way of expressing how much a brand is worth to a company. Although internally generated brands cannot be capitalised, IFRS 3 provides that brands should be measured as part of the intangible assets acquired in an acquisition. Therefore, in the context of an acquisition, a brand's value will affect the price that a company will be prepared to pay to acquire another company which owns valuable brands. We will look more generally at acquisitions and company valuation in Chapter 12 of this Study Manual. However, the key point to note here is that the fair value of any internally generated brands should be included when determining the value of the assets acquired, despite not being included in the financial statements of the company being acquired. Moreover, following the acquisition, the fair value of the brand acquired can be capitalised and included in the group accounts, and should subsequently be amortised or reviewed for impairment on an annual basis. The nature of this treatment, however, and the difference between the way internally generated and acquired brands are accounted for, could make it harder to compare the performance of companies. The value of acquired brands is included within consolidated statements of financial position, but the value of internally generated brands remains unaccounted for. This could be a significant issue when comparing groups which have grown organically (and in which brand-building expenditure is written off as incurred) against groups which have grown by acquisition.

7.3

IFRS 3 Business Combinations IFRS 3 contains detailed rules on how to determine the consideration transferred in a business combination and the fair value of the assets acquired and liabilities assumed to ensure the goodwill figure is accurate. The acquirer recognises (separately from goodwill) and measures the identifiable assets acquired and liabilities assumed at their acquisition-date fair values (measured in accordance with IFRS 13 Fair Value Measurement, see Section 8.3.2 below). To be recognised as part of applying the acquisition method, the assets and liabilities must: 

Meet the definitions of assets and liabilities in the Conceptual Framework, and



Be part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination, rather than the result of separate transactions.

These recognition rules include intangible assets that may not have been recognised in the subsidiary's separate financial statements, such as brands, licences, trade names, domain names, customer relationships and so on, where the acquiree had developed the assets internally and charged the related costs to expense.

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There are exceptions to the recognition and measurement rules, for example reacquired rights (eg a licence granted to the subsidiary before it became a subsidiary), assets held for sale (treated as per IFRS 5) and deferred tax assets.

7.3.1

Problems with valuing brands Although IFRS 3 recognises that the brands acquired should be valued at 'fair value' this remains a very complex tasks; not least because there are several different methodologies for valuing brands, and there is no general consensus as to which way is best.

Lack of active market Unlike other assets such as stocks or bonds, there is no active market for brands that could provide comparable values. Almost by definition, one brand should be differentiated from another brand, and thus, the two are not comparable. Therefore, a number of different models have been developed to try to provide authoritative brand values and to measure the performance of brands: Research-based approaches: These use consumer research into consumer behaviour and attitudes to assess the relative performance of brands. In particular, these approaches seek to measure how consumers' perceptions influence their purchase behaviour. However, such measures do not put a financial value on brands, so unless they are integrated with other approaches, they are insufficient for assessing the economic value of brands. Cost-based approaches: Cost-based approaches define the value of a brand as the aggregation of all the historic costs incurred to bring the brand to its current state; for example, development costs, marketing costs, advertising and other communication costs. However, the flaw in such approaches is that there is not necessarily any direct correlation between the costs incurred and the value added by the brand. Financial investment can be important in building brand value, provided it is effectively targeted, but if it isn't, it may have no impact at all. Moreover, the analysis of financial investment needs to go beyond obvious costs such as advertising and promotion, and also include research and development, product packaging and design, retail design, and employee training. Premium price: Under the premium price method, the value of the brand is calculated as the net present value of the price premiums that a branded product could command over an unbranded or generic equivalent. However, a difficulty with this method comes from finding an 'unbranded' product to compare to. Today, the majority of products are branded, and in some cases, store 'own-branded' products can be as strong as producer brands, charging similar prices. Economic use approach: This approach combines marketing and financial principles. Marketing principle â&#x20AC;&#x201C; First, brands help to generate customer demand, which translates into revenue through purchase volume, price and frequency. Second, brands help to retain customer demand in the longer term, through repurchase and loyalty. Financial principles â&#x20AC;&#x201C; The brand's future earnings are identified and then discounted to a net present value (NPV) using a discount rate which reflects the risk of the earnings being realised. Interbrand calculates brand valuations using this kind of approach. Interbrand's procedure for calculating the fair value of a brand can be summarised as follows: (a)

Prepare a five year forecast for the company's revenues and earnings (NOPAT).

(b)

Estimate the percentage of a company's earnings that can be attributed to the brand. This percentage of the company's profit represents the brand's earnings.

(c)

Assess the competitive strengths and weaknesses of the brand in order to determine the discount rate that should be applied to reflect the risk profile of the brand's expected future earnings.

(d)

Apply the discount rate to the brand's future earnings to calculate a net present value.

However, the difficulty in valuing a brand can be seen by the following statistic (reported in the January 2012 edition of Economia): Although Interbrand had valued the Coca Cola brand at $72 billion in October 2011, the previous month (September 2011), Brand Finance had placed its brand value at $27 billion. Interbrand and Brand Finance are both specialist brand valuation consultancies, so the fact that they can value the same brand so differently suggests there is significant scope for subjectivity in brand valuation.

C H A P T E R

7.3.2

IFRS 13 and brand valuation Although we noted in the previous section that a number of methodologies have been developed, the reference to 'fair value' is very important. If a brand, which has been acquired, is being included as an asset within a consolidated statement of financial position, it needs to be shown at fair value.

IFRS 13, Fair Value Measurement, defines fair value as 'the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.' IFRS 13 also requires the fair value to be determined on the basis of its 'highest and best use' from a market participant's perspective. This needs to consider what is physically possible, legally permissible and financially feasible. It also needs to take into account market conditions at the measurement date. The reference to the market participant's perspective is important. Even if a company acquires a brand but doesn't plan to continue using that brand name (because it intends to merge the acquired brand into its own brand), the acquired brand could still have a value – namely the highest and best use that could be made of it by a market participant (an alternative buyer of the brand). However, if the company which has acquired the brand, intends to use it, then (in the absence of any market factors to the contrary) the company's use of the brand can be taken to represent the highest and best use of it. Nevertheless, the post-acquisition strategy of the acquiring company may affect the subsequent value of the brand. For example, if a brand name becomes tarnished post-acquisition, its commercial value will fall. This would be dealt with under the rule of IAS 36, Impairment of Assets. Fair value hierarchy IFRS 13 requires that entities should maximise the use of relevant observable inputs when determining a fair value, and minimise the use of unobservable inputs. In relation to this, IFRS 13 uses a 'fair value hierarchy' which categories inputs into three levels: 

Level 1 inputs – Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.



Level 2 inputs – Inputs (other than quoted market prices included within Level 1) that are observable for the asset or liability, either directly or indirectly.



Level 3 inputs – Unobservable inputs for the asset or liability.

It is not normally possible to identify Level 1 inputs when dealing with brands, due to their unique nature. By definition, if all brands are different, or have different characteristics, it will not be possible to identify any identical assets. Therefore, the fair values of brands will have to be determined using the lower two levels of inputs (although a possible Level 2 input could be the value of similar brands which have already been valued). Bases of valuation Within the context of the three levels of the 'fair value hierarchy,' and the preference to use observable over unobservable inputs wherever possible, IFRS 13 sets out three possible valuation techniques which could be used when determining the fair value of an asset: (i)

Market approach – This uses prices and other relevant information generated by market transactions involving identical or comparable assets.

(ii)

Cost approach – This reflects the amount of cost that would be required to replace the service capacity of an asset (the current replacement cost).

(iii) Income approach – This converts future amounts (cash flows or income and expenses) generated by an asset to a single, current (discounted) amount, reflecting current market expectations about those future amounts. Given the unique nature of a brand, and the lack of an active market, it is likely to prove difficult to determine the fair value of a brand using the market approach. However, the income approach resembles Interbrand's 'economic use' approach we discussed in the previous suggestion and so may prove an appropriate technique for determining the fair value of a brand. For example, if a 'brand name' enables a product to be sold for a higher price than a generic equivalent, or if the strength of the brand enables additional units of a product to be sold, the incremental income from these sales can be used to determine the value of the brand.

7.3.3

Benefits of brand valuation Companies may find brand valuation useful for the following reasons:

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Making decisions on business investments: Treating the brand in a comparable way to other intangible and tangible assets will assist the company when making resource allocation decisions between different asset types (for example, on the basis of return on investment requirements). Organising and optimising the use of different brands in the business, according to the contributions they make to creating economic value. Making decisions about licensing the brand to subsidiary companies: If subsidiaries are granted a licence, they will be accountable for the brand's management and use. An asset that has to be paid for is likely to be managed more rigorously than one that is free. Transfer pricing: Assessing fair transfer prices for the use of brands in subsidiary companies. Acquisition: Most importantly, as we have already noted, brand valuation will be crucial for determining a price for brand assets in the context of an acquisition. Although IAS 38 dictates that internally generated brand value cannot be capitalised in a company's own statement of financial position, if a company is being taken over, then the value of its brands will need to be calculated when assessing the values of the net assets acquired. Brands can be a key driver of acquisition premiums in mergers and acquisitions, because 'brand' offers the potential to enter new markets and expand into adjacent categories.

7.3.4

Brand valuation and assurance As we have already noted in Section 8.2 above, brand valuation is required under IFRS 3 for all acquisitions made by companies reporting under International Financial Reporting Standards, and brand value is often the most valuable of the identifiable intangible assets. In their paper 'Brands: What's in a name' (published in March 2013), PwC note that, within the consumer products sector, brands are typically the most significant asset recognised in an acquisition deal. However, the recognition and measurement of intangible assets tends to be one of the most difficult areas of IFRS 3 to apply in practice. In this respect, carefully identifying the intangibles being acquired and considering their fair value is a vital step in determining the consideration to be paid for an acquisition. And obtaining a fair valuation for the intangible assets being acquired is a crucial part of ensuring that the company making an acquisition pays a fair price for the company they are acquiring. PwC's paper acknowledges that brand valuation requires significant industry-specific judgement and expertise to ensure supportable measurements are carried out, and to avoid audit surprises and the risk of subsequent re-statement. The issue of determining a fair value for a brand is also likely to be a key part of the due diligence process supporting any acquisition deal. PwC's paper also serves to promote its own valuation services team and the ways this team can help clients in valuation exercises. However, in this context, it is also important to remember the concept of auditor independence; and particularly the fact that an audit firm cannot offer valuation services to its own audit clients. In addition to accountancy firms there are also specialist valuation consultancies, such as Interbrand and Brand Finance, which could carry out valuation exercises. On its website, Brand Finance states emphatically that, 'We value brands, intangible assets and intellectual property in many jurisdictions for accounting, tax, corporate finance and marketing purposes.' The website goes on to explain how Brand Finance uses one or more of the three 'approaches' (market approach, cost approach or income approach) based on the circumstances of a particular assignment. The website concludes that, 'Our understanding of your business, the data available, and our technical expertise ensure that your brand will be robustly valued, using the most appropriate Approaches and Methods.' Consequently, a company that is seeking to value a brand (or seeking to gain assurance over the value already implicit in a brand) could either engage a valuation services team at a firm of accountants to carry out this valuation work for them or else it could engage the experience of a specialist consultancy to undertake the work. Equally, in the context of acquiring a brand, the company considering the acquisition will need to obtain assurance over any assumptions which have been made when arriving at the value â&#x20AC;&#x201C; for example, market assumptions, and the impact that market conditions could have on future income generated by the brand.

Due diligence However, the due diligence relating to brands acquired in acquisitions shouldn't be confined to narrow issues around valuation. It is also important to recognise the role of the brand in the business logic of the deal; for example to consider how the brand will contribute to the group post-acquisition, and how

it fits with the group's overall brand strategy. How will the brand affect the company's ability to achieve its long-term objectives? And what impact will it have on shareholder value in the future? If these strategic level issues are not considered in advance of a deal, then the acquirer risks overpaying for assets that are not used, or which have little value to it. One of the risks attached to brand valuation comes from valuing a brand in a way which has little or no relation to how a company plans to use it in the postacquisition business. The result could be a large asset write-down in future, or an equally significant constraint on future business strategy (if possible future strategic options don't 'fit' with the brand). Equally, if an acquiring company does not research a brand properly, it could risk overpaying for assets which have lost their lustre, or which may not translate effectively into the business environment facing the post-acquisition group. In this respect, we can suggest there is a need for some due diligence to take place before the final decision to acquire a brand is taken.

Therefore the scope of commercial due diligence in relation to acquiring brands and intangible assets more generally, needs to cover a number of areas which are important in strategic marketing. Commercial due diligence considers a target company's market and external economic environment, including analysis of information about the company's main competitors, its marketing history/tactics, competitive advantages, its strengths and weaknesses, and market growth forecasts. In this respect, the due diligence work will resemble a marketing audit.

Brand value and licensing Another situation in which it may be necessary to gain assurance over the value of a brand is in relation to franchising or licensing. Part of the franchise fee that a franchisor (such as McDonald's) charges its franchisees will relate to the value the franchisee gains from the brand name of the franchise. Therefore, for example, if the franchisor wishes to increase its franchise fees because it believes the brand has become stronger over a period of time, the franchisor's position would be strengthened by having an independent valuation of its brand.

7.4

IAS 38, Intangible Assets Although we have been focusing primarily on brands so far in this chapter, they are not the only intangible assets which could be a source of value or competitive advantage for a company. For example, research and development, and patents are also valuable intangible assets. And refer back to the case example of Microsoft's acquisition of Skype in Section 8.3.3. The intangible assets Microsoft acquired included technology-based and customer-related ones, as well as trade names. IFRS 3 provides a number of examples of intangible assets. In addition to contract-based intangible assets (eg licensing agreements, franchise agreements) and technology-based assets (eg patented technology, computer software), IFRS 3 also provides a number of marketing-related and customerrelated intangible assets. These include: 

Trademarks and trade names



Newspaper mastheads

   

Internet domain names Non-competition agreements Customer lists Customer contracts and related customer relationships

C H A P T E R

However, it is important that any intangible assets capitalised in a company's financial statements are done so in accordance with IAS 38, Intangible Assets. The key points in IAS 38 can be summarised as follows: 

An intangible asset is an identifiable non-monetary asset without physical substance, such as a licence, patent or trademark.



An intangible asset is identifiable if it is separable (ie it can be sold, transferred, exchanged, licensed or rented to another party on its own, rather than as part of a business) or it arises from contractual or other legal rights.



An intangible asset should be recognised if it is probable that future economic benefits attributable to the asset, will flow to the entity, and the cost of the asset can be measured reliably.

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

At recognition, the intangible should be recognised at cost (purchase price plus directly attributable costs). After initial recognition, an entity can choose between the cost model and the revaluation model. The revaluation model can only be adopted if an active market (as defined) exists for that type of asset.



An intangible asset (other than goodwill recognised in the acquiree's financial statements) acquired as part of a business combination, should initially be recognised at fair value.



Internally generated goodwill should not be recognised.



Expenditure incurred in the research phase of an internally generated intangible asset should be expensed as incurred.



Expenditure incurred in the development phase of an internally generated intangible asset must be capitalised, provided certain tightly defined criteria are met. Expenditure, incurred prior to the criteria being met, may not be capitalised retrospectively.



An intangible asset with a finite useful life should be amortised over its expected useful life, commencing when the asset is available for use in the manner intended by management.



Residual values should be assumed to be nil, except in the rare circumstances when an active market exists or there is a commitment by a third party to purchase the asset at the end of its useful life.



An intangible asset with an indefinite life should not be amortised, but should be reviewed for impairment on an annual basis. There must also be an annual review of whether the indefinite life assessment is still appropriate.



On disposal of an intangible asset, the gain or loss is recognised in profit or loss.

Crucially, though, IAS 38 stipulates that internally generated brands, mastheads, publishing titles, customer lists and items similar in substance must not be recognised as intangible assets within an individual company. Similarly, customer relationships are not recognised as intangible assets. Consequently, all expenditure relating to brand building or customer relationship management should be expensed as incurred, because the intangibles they relate to do not meet the criteria for recognition as identifiable intangible assets. Once again, it is important to note the difference in the way these 'assets' are treated in individual companies (where they are internally generated and have to be expensed as incurred) and in the context of an acquisition (where identifiable intangible assets can be capitalised).

7.4.1

Expected life of intangible assets acquired The summary points from IAS 38 above highlight that an intangible asset with a finite useful life should be amortised over its expected useful life, while an asset with an indefinite life should not be amortised but should be reviewed for impairment on an annual basis. Again, in the case example of Microsoft's acquisition of Skype (Section 8.3.3 above) the intangible assets acquired have been treated as having a finite life, and have been amortised accordingly. Brand assets acquired are often treated as having indefinite lives, however, and so are reviewed for impairment on a regular basis, rather than being amortised. IAS 36 prescribes that intangible assets with an indefinite useful life (such as brands) have to be subject to annual impairment tests regardless of whether there are any indications of impairment. IAS 36 Impairment of Assets prescribes that assets should be carried at no more than their recoverable amount, where recoverable amount is the higher of:  

Value in use Fair value less costs to sell

However, in the same way that valuing a brand is complex so is valuing a brand in relating to its ongoing value in use, or fair value. Intangibles acquired but not used The issue of impairment and useful lives could be particularly relevant in the context of brand names of logos where a company acquires the brand name or logo but has no intention of using it in the future. However, in such circumstance, the general principles for valuing the asset still apply, and its fair value is determined in accordance with its use by other market participants.

7.5 7.5.1

Intangible assets and intellectual capital Intangible assets and goodwill Definition Intangible assets are identifiable non-monetary assets without physical substance that are controlled by the entity as the result of past events and from which the entity expects a flow of future economic benefits. Goodwill (acquired) is future economic benefits arising from assets that are not capable of being individually identified and separately recognised. The above definition of intangible assets distinguishes: (a)

Intangible assets from tangible assets, by the phrase 'do not have physical substance'.

(b)

Intangible assets from goodwill, by the word 'identifiable', an identifiable asset is legally defined as one that can be disposed of separately without disposing of a business of the entity.

Certain intangible assets can be recorded at their historical cost. Examples include patents and trademarks being recorded at registration value, and franchises being recorded at contract cost. However, over time, these historical values may become poor reflections of the assets' value in use or of their market value.

7.5.2

Intellectual capital Definition Intellectual capital is knowledge which can be used to create value. Intellectual capital includes: (a)

Human resources: The collective skills, experience and knowledge of employees

(b)

Intellectual assets: Knowledge which is defined and codified such as a drawing, computer program or collection of data

(c)

Intellectual property: Intellectual assets which can be legally protected, such as patents and copyrights

As the demand for knowledge-based products grows with the changing structure of the global economy, knowledge plays an expanding role in achieving competitive advantage. Employees may therefore be extremely valuable to a business, and it has been argued that they should be included in a full assets based valuation. However, the IASB Conceptual Framework has a precise definition of an asset and sets very specific criteria that must be met for an asset to be recognised in the statement of financial position. The definition of an asset in the Conceptual Framework is: 'A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to an entity.' It can be argued that: 

Staff are a resource



There has been a past event – the staff were recruited under an employment contract



Future benefits are expected to flow – staff are expected to generate revenue for the entity either directly or indirectly

But: 

Control is very hard to prove. Even though a contract exists, an employee can leave, take time off sick, or not work to the best of their ability.

Also, the recognition criteria from the Framework must be met: 

There must be probable economic benefits – it is very hard to guarantee benefits from an employee.



The asset must be able to be reliably measured – it is very difficult to put an objective value on staff skills.

The principles of valuation discussed below could be applied to all assets, resources or property that are defined as intangible assets or intellectual capital.

7.6

Measurement of intangible assets of an enterprise The expanding intellectual capital of firms accentuates the need for methods of valuation for comparative purposes, for example when an acquisition or buy-out is being considered.

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Ramona Dzinkowski (in The measurement and management of intellectual capital, Management Accounting, February 2000) identifies the following three indicators, which are derived from audited financial statements and are independent of the definitions of intellectual capital adopted by the firm.   

7.6.1

Market-to-book values Tobin's 'q' Calculated intangible value

Market-to-book values This method represents the value of a firm's intellectual capital as the difference between the book value of tangible assets and the market value of the firm. For example, if a company's market value is £8 million and its book value is £5 million, the £3 million difference is taken to represent the value of the firm's intangible (or intellectual) assets. Although obviously simple, this method's simplicity merely serves to indicate that it fails to take account of real world complexities. There may be imperfections in the market valuation, and book values are subject to accounting standards that reflect historic cost and amortisation policies, rather than true market values of tangible non-current assets. In addition, the accounting valuation does not attempt to value a company as a whole, but rather as a sum of separate asset values computed under particular accounting conventions. The market, on the other hand, values the entire company as a going concern, following its defined strategy.

7.6.2

Tobin's 'q' The Nobel prize-winning economist, James Tobin, developed the 'q' method initially as a way of predicting investment behaviour. 'q' is the ratio of the market capitalisation of the firm (share price  number of shares) to the replacement cost of its assets. If the replacement cost of assets is lower than the market capitalisation, q is greater than unity and the company is enjoying higher than average returns on its investment ('monopoly rents'). Technology and so called 'human-capital' assets are likely to lead to high q values. Tobin's 'q' is affected by the same variables influencing market capitalisation as the market-to-book method. In common with that method, it is used most appropriately to make comparisons of the value of intangible assets of companies within an industry that serve the same markets and have similar tangible non-current assets. As such, these methods could serve as performance benchmarks by which to appraise management or corporate strategy.

7.6.3

E R

Calculated intangible values NCI Research has developed the method of calculated intangible value (CIV) for calculating the fair market value of a firm's intangible assets. CIV calculates an 'excess return' on tangible assets. This figure is then used in determining the proportion of return attributable to intangible assets. A step-by-step approach would be as follows. (a)

Calculate average pre-tax earnings and average year end tangible asset values, over a time period.

(b)

Divide earnings by average assets to get the return on assets.

(c)

Multiply the industry average return on assets percentage by the entity's average tangible asset values. Subtract this from the entity's pre-tax earnings to calculate the excess return.

(d)

Subtract tax from the excess return to give the after-tax premium attributable to intangible assets.

(e)

Calculate the NPV of the premium by dividing it by the entity's cost of capital.

Whilst this seemingly straightforward approach, using readily available information, seems attractive, it does have two problems. (a)

It uses average industry return on assets as a basis for computing excess returns, which may be distorted by extreme values.

(b) The choice of discount rate to apply to the excess returns to value the intangible asset needs to be made with care. To ensure comparability between companies and industries, some sort of average cost of capital should perhaps be applied. This, again, has the potential problems of distortion.

7.7

C H A P

Valuation of individual intangible assets

7.7.1

Relief from royalties method This method involves trying to determine: (a)

The value obtainable from licensing out the right to exploit the intangible asset to a third party, or

(b)

The royalties that the owner of the intangible asset is relieved from paying through being the owner, rather than the licensee.

A notional royalty rate is estimated as a percentage of revenue expected to be generated by the intangible asset. The estimated royalty stream can then be capitalised, for example, by discounting at a risk-free market rate, to find an estimated market value. This relatively simple valuation method is easiest to apply if the intangible asset is already subject to licensing agreements. If they are not, the valuer might reach an appropriate figure from other comparable licensing arrangements.

7.7.2

Premium profits method The premium profits method is often used for brands. It bases the valuation on capitalisation of the extra profits generated by the brand or other intangible asset in excess of profits made by businesses lacking the intangible asset or brand. The premium profits specifically attributable to the brand or other intangible asset may be estimated (for example) by comparing the price of branded products and unbranded products. The estimated premium profits can then be capitalised by discounting at a risk-adjusted market rate.

7.7.3

Capitalisation of earnings method With the capitalised earnings method, the maintainable earnings accruing to the intangible asset are estimated. An earnings multiple is then applied to the earnings, taking account of expected risks and rewards, including the prospects for future earnings growth and the risks involved. This method of valuation is often used to value publishing titles.

7.7.4

Comparison with market transactions method This method looks at actual market transactions in similar intangible assets. A multiple of revenue or earnings from the intangible asset might then be derived from a similar market transaction. A problem with this method is that many intangible assets are unique and it may therefore be difficult to identify 'similar' market transactions, although this might be done by examining acquisitions and disposals of businesses that include similar intangible assets. The method might be used alongside other valuation methods, to provide a comparison.

7.7.5

Compliance with IFRS 13, Fair value measurement As we discussed in Section 8.2 above, the fair value of any intangible assets shown in a company's financial statements needs to be measured in accordance with IFRS 13, Fair Value Measurement. However, as we saw earlier, the standard permits fair value to be calculated using a market approach, a cost approach or an income approach.

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Strategic Business Management Chapter- 6

Corporate governance 1 Principles of governance Definitions Corporate governance: The system by which companies are directed and controlled. Corporate governance: The set of processes, customs, policies, laws and institutions affecting the way in which an entity is directed, administered or controlled. Corporate governance serves the needs of shareholders, and other stakeholders, by directing and controlling management activities towards good business practices, objectivity and integrity in order to satisfy the objectives of the entity. The aim of corporate governance should be to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the entity in achieving its objectives. Key issues in corporate governance are the effectiveness of the leadership provided by the board of directors and the accountability of the board to the shareholders and other stakeholders for company performance and objectives. Although mostly discussed in relation to large quoted companies, good corporate governance is an issue for all corporate bodies, both commercial and not-for-profit. In the UK for example the UK Corporate Governance Code applies to listed companies, but there is also a Quoted Companies Alliance Code for smaller quoted companies, Institute of Directorsâ&#x20AC;&#x2122; guidelines for unquoted companies and codes of governance for central government, local government authorities and charities. There are a number of elements in corporate governance:

1.1

(a)

Creating an effective board of directors: an effective board depends on the leadership provided by the chairman (supported by the company secretary), the balance and composition of the board membership, and decision-making by the board.

(b)

The accountability of the board to the companyâ&#x20AC;&#x2122;s shareholders and other stakeholders, through financial reporting, other reporting and the AGM

(c)

The effectiveness of risk management (strategic risk) and internal control systems

(d)

Remuneration of directors and senior executives

(e)

Relationships between the company and its shareholders

(f)

The ethical conduct of the company, including its policies on corporate social responsibility and sustainability.

Reasons for governance developments Corporate governance issues came to prominence in the USA during the 1970s and in the UK and Europe from the late 1980s. The main, but not the only, drivers associated with the increasing demand for the development of governance were: (a)

Increasing internationalisation and globalisation meant that investors, and institutional investors in particular, began to invest outside their home countries. The King Report in South Africa highlights the role of the free movement of capital, commenting that investors are promoting governance in their own self-interest. Financial centres (stock exchanges) need to be seen as centres where the conduct of listed companies complies with high standards of governance: if financial centres are not trusted by international investors, they will not invest there.

(b)

The differential treatment of domestic and foreign investors, both in terms of reporting and associated rights/dividends caused many investors to call for parity of treatment.

(c)

Issues concerning financial reporting were raised by many investors and were the focus of much debate and litigation.

(d)

An increasing number of high profile corporate scandals and collapses, including Polly Peck International, BCCI, and Maxwell Communications Corporation prompted the development of governance codes in the early 1990s. The collapse of companies such as Enron and WorldCom in 2001/2002 have been attributed largely to poor governance. Similarly governance problems

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appear to have been a contributory factor to the financial crisis in 2007/2008 and the problems of companies such as Lehman Brothers, Bear Stearns and AIG. More recently (2014), governance issues have been involved in the collapse of the Espirito Santo group in Portugal.

1.2

The board of directors Boards that have failed to manage companies effectively have been a very significant aspect of governance scandals. Different scandals have highlighted certain key weaknesses.

1.2.1

Domination by a single individual A feature of many corporate governance scandals has been boards dominated by a single senior executive, with other board members merely acting as a rubber stamp. Sometimes, the single individual may bypass the board to action his own interests. Even if an organisation is not dominated by a single individual, there may be other weaknesses. The organisation may be run by a small group centred round the chief executive and chief financial officer, and appointments may be made by personal recommendation, rather than a formal, objective process.

1.2.2

Lack of involvement of board Boards that meet irregularly or fail to consider systematically the organisation's activities and risks, are clearly weak. Sometimes, the failure to carry out proper oversight is due to a lack of information being provided, or the directors lacking the knowledge or skills necessary to contribute effectively. A board of directors may delegate some aspects of decision making to executive management, when the decisions should more appropriately be taken by the board.

1.2.3

Lack of supervision Employees who are not properly supervised by the board can create large losses for the organisation through their own incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the employee who caused the collapse of Barings Bank was not challenged, because he appeared to be successful. He was, however, using unauthorised accounts to cover up his large trading losses. Leeson was able to do this because he was in charge of dealing and settlement, a systems weakness or lack of segregation of key roles that has featured in other financial frauds. A board of directors does not have direct responsibility for supervision and other internal controls, but the board is responsible for ensuring that the system of internal control is effective.

1.3

Directors' remuneration Complaints over remuneration levels and reward systems for directors and senior executives have been a common feature of corporate governance debates. Complaints have not only focused on remuneration levels, but on the unwillingness of those who can challenge remuneration packages effectively (nonexecutive directors, institutional shareholders) to do so. Various problems have been highlighted:

1.4

(a)

Remuneration levels that are excessive per se, and are not justified by the contribution directors have made.

(b)

Incentive schemes do not succeed in motivating executives to achieve levels of performance that are in the best long-term interests of shareholders.

(c)

Remuneration arrangements providing incentives for directors to allow risk-taking beyond levels that would be deemed acceptable by many shareholders.

(d)

Directors may be rewarded for failure, for example receiving bonuses when their companies have performed poorly and receiving significant compensation payments when they lose office.

Accounts and audit Inevitably, many companies involved in scandals have had glaring weaknesses in internal control â&#x20AC;&#x201C; weaknesses that have not been picked up by those monitoring the internal control system.

1.4.1

Lack of adequate control function Poor governance is often the result of ineffective internal control, and weaknesses in financial (reporting) controls, operational controls and compliance controls within a company. One control weakness may be a lack of an internal audit function. Another important control is lack of adequate technical knowledge in key roles, for example, in the audit committee or in senior compliance positions. A rapid turnover of staff involved in accounting or control may suggest inadequate resourcing, and will make control more difficult because of lack of continuity.

1.4.2 2

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External auditors may not carry out the necessary questioning of senior management because of fears of losing the audit. Often corporate collapses are followed by criticisms of external auditors, such as the Barlow Clowes affair, where poorly planned and focused audit work failed to identify illegal use of client monies.

1.4.3

Misleading accounts and information Often misleading figures are symptomatic of other problems but clearly, poor quality accounting information is a major problem if markets are trying to make a fair assessment of a company's value. Giving out misleading information was a major issue in the UK's Equitable Life scandal where the company gave contradictory information to savers, independent advisers, media and regulators. The ultimate risk from misleading financial reporting is that the company may become insolvent unexpectedly.

1.5

Perspectives on governance There are several different perspectives about corporate governance, which affect opinions about the relationship between a board of directors and the company’s shareholders and other stakeholders.

1.5.1

Stewardship theory Stewardship theory is based on the view that the directors and management of a company are the stewards of the company’s assets, charged with the deployment and protection of the assets in ways that are consistent with the overall strategy of the organisation. Shareholders should have the right to dismiss their stewards if they are dissatisfied with their stewardship, by means of a vote at an annual general meeting. Good governance is undermined if the shareholders do not take an active interest in their company, and do not exercise their right to vote. Good governance therefore needs active participation on the part of the shareholders.

1.5.2

Agency theory Agency theory is based on the view that the directors of a company act as agents for the shareholders, and have a responsibility to act as agents towards their principals. Unfortunately, there is a risk that the agents will act in their own self-interest rather than in the best interests of the shareholders, and good governance requires measures to prevent this from happening. Controls over self-interested activities by the company’s agents include the requirement for accountability (through financial reporting, other reports, the AGM and so on). In addition, the directors and senior management should be given incentives to act in the best interests of the shareholders, and this can be achieved by means of well-structured remuneration and incentive schemes.

1.5.3

Shareholder theory, enlightened shareholder theory and stakeholder theory There are different views about the approach that the directors of a company should take towards acting in the interests of shareholders and other stakeholders. At one extreme is the view that the board of directors should always act in the best interests of the shareholders. The interests and objectives of other stakeholders in the company (such as employees, customers, suppliers and lenders) are of no concern, except to the extent that the best interests of the shareholders are protected. Towards another extreme is the stakeholder approach to governance. This is based on the view that the directors of a company should act in the interests of all the major stakeholders in their company, not just the shareholders. This will involve making compromises between the conflicting interests of different stakeholder groups. However, the concerns of stakeholders such as employees are as important as those of shareholders. An approach to governance that lies somewhere between these two extremes is the enlightened shareholder approach. This is based on the view that a board of directors is required primarily to act in the interests of its shareholders, but it should also make compromises and take into consideration the concerns and objectives of other stakeholder groups. Directors and management have a duty of care, not just to the owners of the company in terms of maximising shareholder value, but also to other stakeholder interests, including the community or society as a whole. None of these approaches to governance is necessarily ‘right’ or ‘wrong’, but they can affect opinions about how corporate governance should be conducted.

1.6

Governance principles High standards of corporate governance should be based on a number of fundamental principles. (a)

Responsibility. The leaders of a company should accept responsibility for acting in the best interests of the company so as to achieve the company’s objectives (whatever these might be).

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(b)

Accountability. The board of directors should be fully accountable to the companyâ&#x20AC;&#x2122;s shareholders (and other stakeholders). Within the company, executive management should be properly accountable to the board of directors. Clear accountability must be established at senior levels within an organisation. However, one danger may be that boards become too closely involved with day-to-day issues and do not delegate responsibility to management.

(c)

Integrity and honesty. Companies should operate in a way that displays fairness and honesty in its dealings. Good corporate governance has a strong ethical element.

(d)

Transparency. It is not sufficient to provide sufficient reports to shareholders and other stakeholders. Through reporting or other methods of communication companies should be open and transparent about their policies and objectives, as well as past performance.

2 Stakeholders We discussed in Chapter 1 the impact of stakeholders on an organisation's strategic decision-making. This section focuses on the interests and claims of stakeholders in the context of corporate governance. The Organisation for Economic Co-operation and Development (OECD) principles include the principle that the rights of stakeholders should be protected. Stakeholders are both internal, within the company (such as the directors and employees) and external to the company (such as most shareholders in a public company, lenders, regulators, customers, suppliers and the general public). All stakeholder groups have some interest in companies, particularly large companies. Some stakeholders are more influential than others. The board of directors needs to recognise which stakeholder groups wield strong influence, and should deal with them accordingly.

2.1

Directors The powers of directors to run the company are set out in the company's constitution or articles. Within a single tier board structure, executive directors combine their role as a director with executive management responsibilities, but non-executive directors act solely in the capacity of a director. Under company law in most jurisdictions, the legal duties of directors and responsibility for performance, controls, compliance and behaviour apply to both executive and non-executive directors. Executive directors often have a conflict of interests, in matters such as remuneration, risk management and internal control, and financial reporting. Independent non-executive directors should act as a counter-balance to executive directors, and should help to ensure that conflicts of interest are avoided (or minimised). The role of directors is obviously central to good corporate governance, and we shall consider the role of the board in the next section.

2.2

Company secretary In the UK, all public companies must have a company secretary. The company secretary is an important figure in ensuring compliance with legal and other regulatory frameworks, including the governance code. Legislation in many regimes refers to the specific duties of the company secretary. The most important governance duties, however, are generally in the following areas:

2.3

(a)

Arranging meetings of shareholders and the board of directors

(b)

Providing advice and information to members of the board on legislative, regulatory and governance issues. Under companies' legislation, the secretary (as an officer of the company) is held responsible for numerous breaches of law. Directors' priorities and areas of expertise may not be in the areas of governance and compliance.

(c)

Assisting the chairman with the implementation of some governance practices, such as the induction of new directors and performance reviews of the board, its committees and individual directors

(d)

Providing information to board directors and acting as a communication link between the main board and the board committees

(e)

Providing administrative support to the board and its committees.

Executive management The interests of managers below board level are similar to those of the executive directors in many respects, and there is a risk that senior executives will seek to promote their personal interests even if these are in conflict with those of the shareholders and other stakeholders.

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Although management below board level does not have ultimate responsibility for decision-making within a company, their role in corporate governance is vital. In order to function effectively, the board needs to be supported by a strong senior management team, responsible for implementing strategy and controlling and co-ordinating activities. The management team will be responsible for: 

Helping to set the tone and ethical character of the company



Supervising the implementation of control and risk management procedures



Providing information that directors need to make decisions about strategy, risk management and control

Senior executives should also be accountable to the board for their performance, usually through the chief executive officer. Shortcomings in any of these areas could seriously undermine the effectiveness of governance. It is important to recognise that executive directors in a company serve two functions: one as directors of the company and the other as executives in the management team.

2.4

Employees Other employees need to comply with the corporate governance systems that are in place. Employees' contribution to corporate governance is to implement risk management and control procedures. The company's culture will impact significantly on this, so that if enforcement measures are lax or employees do not have the skills or knowledge necessary to implement procedures, governance will be undermined. Employees also have a role in giving regular feedback to management and of whistleblowing serious concerns. Again, poor communication, perhaps because employees are scared to raise issues or management won't listen, will impact adversely on governance. The OECD principles of corporate governance recommend that performance-enhancing mechanisms for employee participation should be permitted to develop. Employees will focus on how the company is performing and how the company's performance will impact on their pay and working conditions. UK company law requires the directors to have regard for the interests of the company's employees in general, as well as the interests of its members. As stakeholders in their company, employees have an interest in the company’s objectives and performance, including the way that the company treats them, in terms of pay and working conditions.

2.5

External auditors The external audit is one of the most important corporate governance procedures. It enables investors to have much greater confidence in the information that their agents, the directors/managers, are supplying. As you know, the main focus of the external audit is on giving assurance that the accounts give a true and fair view. However, external auditors can provide other audit services, such as social and environmental audits, and can also highlight governance and reporting issues of concern to investors. External auditors are employed to scrutinise the activities of managers, who are the shareholders' agents. Their audit fees can be seen as an agency cost. This means that external auditors are also the shareholders' agents. A balance is thus required between working constructively with company management and at the same time, serving the interests of shareholders. The external auditors must develop a relationship with both the management of the company and also the audit committee, which has responsibility for oversight of the conduct of the audit.

2.6

Regulators Definition Regulation: Any form of interference with the operation of the free market. This could involve regulating demand, supply, price, profit, quantity, quality, entry, exit, information, technology, or any other aspect of production and consumption in the market. Regulators can be important stakeholders in a company. The major regulators vary between different industries, and include government bodies, such as health and safety executives, and specific regulators such as the financial services authorities, utility regulators and charity commissioners, amongst many others relevant to specific types of industry.

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The interest of regulators in companies is to ensure that companies comply with legal and regulatory requirements, and to take action against those that do not.

2.6.1

Methods of regulation Legislators and regulators affect organisations' governance and risk management. They establish rules and standards that provide the impetus for management to ensure that risk management and control systems meet minimum requirements. They also conduct inspections and audits that provide useful information and recommendations regarding possible improvements. Regulators will be particularly interested in maintaining shareholder-stakeholder confidence in the information with which they are being provided. Regulation can only be effective if it is properly monitored and enforced. Direct costs of enforcement include the setting up and running of the regulatory agencies â&#x20AC;&#x201C; employing specialist staff, monitoring behaviour, prosecuting offenders (or otherwise ensuring actions are modified in line with regulations). Indirect costs are those incurred by the regulated (eg the firms in the industry) in conforming to the restrictions.

2.6.2

Regulation and stakeholders Where privatisation has perpetuated monopolies over natural resources, industry regulatory authorities are responsible for ensuring that consumers' interests are not subordinated to those of other stakeholders, such as employees, shareholders and tax authorities. The regulator's role may be 'advisory' rather than statutory. It may extend only to a part of a company's business, necessitating a fair allocation of costs across different activities of the company.

2.6.3

Regulation and corporate governance Regulation is important for corporate governance because companies should have an effective internal control system to ensure compliance with key regulatory requirements. All major banks, for example, have very large compliance departments. In addition, there are some regulations that apply to the conduct of corporate governance. These include criminal laws that apply to activities such as money laundering, insider dealing and bribery; statutory duties of directors; some of the listing rules and disclosure and transparency rules that are applied to listed companies by stock market regulators; and requirements for listed companies to comply with the provisions of a corporate governance code (such as the UK Corporate Governance Code) or explain any non-compliance in their annual report.

2.7

Government Most governments do not have a direct economic/financial interest in companies (except for those in which they hold shares). However, governments often have a strong indirect interest in companies' affairs, hence the way they are run and the information that is provided about them: (a)

Governments raise taxes on sales and profits and on shareholders' dividends. They also expect companies to act as tax collectors for income tax and sales tax. The tax structure might influence investors' preferences for either dividends or capital growth. Economic policies such as deregulation may be influenced by the desire for economic growth and increased efficiency.

(b)

Governments pass and enforce laws as well as establish and determine the overall regulatory and control climate in a country. This involves exertion of fiscal pressure, and other methods of state

intervention. Governments also determine whether the regulatory framework is principles or rules based (discussed later in the text). (c)

Governments may provide funds towards the cost of some investment projects. They may also encourage private investment by offering tax incentives.

(d)

In the UK, the government has made some attempts to encourage more private individuals to become company shareholders, by means of:

(e)

2.8

(i)

Attractive privatisation issues (such as in the electricity, gas and telecommunications industries)

(ii)

Tax incentives, such as ISAs (Individual Savings Accounts), to encourage individuals to invest in shares.

Governments also influence companies, and the relationships between companies, their directors, shareholders and other stakeholders.

Stock exchanges Stock exchanges provide a means for companies to raise money; and investors, to transfer their shares easily. They also provide information about company value, derived from the supply of, and demand for, the shares that they trade. Stock exchanges and other financial market organisations list companies whose shares can be held by the general public (called public companies in many

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jurisdictions). Many such companies have a clear separation between ownership and management, although in some countries even large listed companies may have a large shareholder who also acts as board chairman and/or chief executive officer. Stock markets and their regulators are important because they provide regulatory frameworks in principles-based jurisdictions. In most countries, listing rules apply to companies whose shares are listed on the stock exchange. Stock market regulation can therefore have a significant impact on the way corporate governance is implemented; and companies report. The UK is a good example of this, with the 'comply or explain' approach being consistent with the tendency toward self-regulation adopted by many London institutions. In America by contrast, a more legalistic and rules-based approach has been adopted, in line with the regulatory approach that is already in place.

2.9

Institutional investors Institutional investors have large amounts of money to invest. They are covered by fewer protective regulations, on the grounds that they are knowledgeable and able to protect themselves. They include investors managing funds invested by individuals and agents employed on the investors' behalf. Institutional investors are now the biggest investors in many stock markets but they might also invest venture capital, or lend directly to companies. UK trends show that institutional investors can wield great powers over the companies in which they invest. The major institutional investors in the UK are: 

Pension funds



Insurance companies



Investment and unit trusts (set up to invest in portfolios of shares)



Venture capital organisations (investors particularly interested in companies that are seeking to expand)

Their funds will be managed by a fund manager who aims to benefit investors in the funds or pension or policy holders. Although fund managers will use lots of different sources of information, their agency costs will be high because they have to track the performance of all the investments that the fund makes.

2.9.1

Advantages and disadvantages of institutional investment In some respects, the institutional investor fulfils a desirable role. People should ideally be in pensionable employment or have personal pension plans. The funds from which their pensions will be payable should be held separately from the companies by whom they are employed. Similarly, investors should have the opportunity to invest through the medium of insurance companies, unit trusts and investment trusts. However, the dominance of the equity markets by institutional investors has possibly undesirable consequences as well. (a)

Excessive market influence For capital markets to be truly competitive, there should be no investors who are of such size that they can influence prices. In the UK, transactions by the largest institutions are now on such a massive scale that considerable price movements can result.

(b) Playing safe Many institutions tend to avoid shares which are seen as speculative, as they feel that they have a duty to their 'customers' to invest only in 'blue chip' shares (ie those of leading commercially sound companies). As a result, the shares of such companies tend to be relatively expensive. (c)

Short-term speculation Fund managers are sometimes accused of 'short-termism' in that they will tend to seek short-term speculative gains or simply sell their shares and invest elsewhere if they feel that there are management shortcomings. Pension fund trustees are also accused of being over-influenced by short-term results because of the lack of time they have to go into the company's performance in detail.

(d) Lack of power of investors Investors in investment and pension funds cannot directly influence the policy of the companies in which their funds invest, since they do not hold shares themselves and cannot hold the company accountable at general meetings.

2.9.2

Role of institutional investors UK guidance has placed significant emphasis on the role of institutional investors in promoting good Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

corporate governance. The UK Corporate Governance Code states that shareholders should enter into a dialogue with companies based on the mutual understanding of objectives, taking into account the size and complexity of the companies and the risks they face. Their representatives should attend company annual general meetings and make considered use of their votes. UK guidance stresses that institutional investors should consider, in particular, companies' governance arrangements that relate to board structure and composition. They should enter a dialogue about departures from the Code if they do not accept the companies' position.

2.9.3

UK Stewardship Code Effective corporate governance calls for effort on the part of shareholders as well as boards of directors. In the UK, institutional investors are encouraged to state their commitment to a Stewardship Code, first published in 2010. This Code contains a number of principles that institutional investors should apply as shareholders in listed companies. Institutional investors are stewards of the funds that are invested in them, and so should be responsible for the stewardship of those funds and accountable to their fund providers. The Stewardship Code states that institutional investors should:

2.9.4

(a)

Disclose how they will discharge their responsibilities.

(b)

Operate a clearly disclosed policy for managing conflicts of interest.

(c)

Monitor performance of investee companies â&#x20AC;&#x201C; to gain assurance on the operation of the board and its committees by attending meetings of the board and the AGM. They should be particularly concerned with departures from the UK Corporate Governance Code, and also seek to identify threats to shareholder value at an early stage.

(d)

Establish clear guidelines on when they will actively intervene, when they are concerned about strategy and performance, governance or approach to risk.

(e)

Be willing to act collectively with other investors, particularly at times of significant stress or when the company's existence appears to be threatened.

(f)

Operate a clear policy on voting and disclosure of voting activity. They should not necessarily support the board.

(g)

Report to their clients on their stewardship and voting activities. They should consider obtaining an independent audit opinion on their engagement and voting processes.

Means of exercising institutional investors' influence A number of different methods may be effective. (a)

One-to-one meetings These discuss strategy, whether objectives are being achieved, how the company is achieving its objectives, the quality of management. However, new information cannot be divulged to any single analyst or investor in these meetings, as it would give that investor an information advantage over others.

(b) Voting Generally, institutional investors would prefer to work behind-the-scenes and to avoid voting against the board, if possible. If they are intending to oppose a resolution, they should normally state their intention in advance. Most corporate governance reports emphasise the importance of institutional investors exercising their votes regularly and responsibly. (c)

Focus list This means putting companies' names on a list of underperforming companies. Such companies' boards may face challenges.

(d) Contributing to corporate governance rating systems These measure key corporate governance performance indicators, such as the number of nonexecutive directors, role of the board and the transparency of the company.

2.9.5

Intervention by institutional investors In extreme circumstances, the institutional shareholders may intervene more actively, by for example, calling a company meeting in an attempt to unseat the board. The UK Institutional Shareholders' Committee has identified a number of reasons why institutional investors might intervene:

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2.10



Fundamental concerns about the strategy being pursued in terms of products, markets and investments.



Poor operational performance, particularly if one or more key segments has persistently underperformed.



Management being dominated by a small group of executive directors, with the non-executive directors failing to hold management to account.



Major failures in internal controls, particularly in sensitive areas such as health and safety, pollution or quality.



Failure to comply with laws and regulations or governance codes.



Excessive levels of directors' remuneration.



Poor attitudes towards corporate social responsibility.

Small investors Small investors include shareholders who hold small numbers of shares in companies, trusts and funds. They may not have the same ease of access to information that institutional investors possess, or the level of understanding of experts employed by institutional investors. Their portfolios are likely to be narrower and they may be less able to diversify risk away. These problems can handicap their position. The OECD suggests that a key principle of corporate governance is that all shareholders should be treated equally. For example in a takeover, minority shareholders should receive the same consideration and treatment as larger shareholders. The OECD guidelines also stress the importance of achieving shareholder protection by enforcing the basic rights of shareholders. These include the right to secure methods of ownership registration, convey or transfer shares, obtain relevant and material information, participate and vote in general meetings and share in the profits of the company. Under the OECD guidelines, shareholders should also have the right to participate in, and be sufficiently informed on, decisions concerning fundamental changes, such as amendments to the company's constitution.

3 Role of boards 3.1

Role of board The South African King Report provides a good summary of the role of the board: To define the purpose of the company and the values by which the company will perform its daily existence and to identify the stakeholders relevant to the business of the company. The board must then develop a strategy combining all three factors and ensure management implements that strategy. The UK Corporate Governance Code states that the board's role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls that enable risk to be assessed and managed. The board should set the company's strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance.

3.2

Set-up of board Worldwide there are a variety of governance models, based on different ways of formalising the distinction between those who manage a company (executives) and those who monitor the managers (the directors). Where some executive managers are also company directors, arrangements should be in place for the monitoring of the executive directors by their non-executive colleagues.

3.2.1

Unitary boards – UK and US The UK model of corporate governance is based on the idea of a unitary board, consisting of a mix of executive and non-executive directors. All directors participate in board decision-making. All participants in the single board have legal responsibility for management of the company and strategic performance. The US model is also based on a unitary board structure, although the proportion of non-executives on US boards may be higher than in UK companies.

3.2.2

Multi-tier boards – Germany Institutional arrangements in German companies are based on a dual board (two-tier structure). (a)

Supervisory board A supervisory board of non-executives includes workers' representatives and stakeholders' representatives, including banks' representatives. The supervisory board has no executive function,

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although it does review the company's direction and strategy and is responsible for safeguarding stakeholders' interests. It must receive formal reports of the state of the company's affairs and finance. It approves the accounts and may appoint committees and undertake investigations. The board should be composed of members who, as a whole, have the required knowledge, abilities and expert experience to complete their tasks properly and are sufficiently independent. (b) Management board A management or executive board, composed entirely of managers, will be responsible for the day-to-day running of the business. The supervisory board appoints the management board. Membership of the two boards is entirely separate.

3.3

Board effectiveness Guidance on board effectiveness was published by the UK Financial Reporting Council (FRC) in 2011. This stresses that an effective board: 'develops and promotes its collective vision of the company's purpose, its culture, its values and the behaviours it wishes to promote in conducting its business.' Key aspects include providing direction for management, creating a performance culture that drives value creation without exposing the company to excessive risk of value destruction, and making wellinformed and high-quality decisions based on a clear line of sight into the business. The guidance stresses that an effective board should not necessarily be a comfortable place, with challenge, as well as teamwork, being an essential feature. The FRC's guidance stresses the importance of well-informed and high-quality decision-making, with many of the factors leading to poor decision-making being predictable and preventable by boards taking the time to design effective decision-making policies and processes. The guidance lists factors that can facilitate good decision-making, for which the board chairman has responsibility as board leader: 

High-quality board documentation



Obtaining expert opinions if necessary



Allowing time for debate and challenge, especially for complex, contentious or business-critical issues



Achieving timely closure



Providing clarity on the actions required; and timescales and responsibilities

The FRC guidance also stresses that boards need to be aware of factors that can limit effective decisionmaking, such as:

3.3.1



A dominant personality or group of directors in the board, inhibiting contribution from other directors



Insufficient attention to risk, treating risk as a compliance issue, rather than as part of the decision- making process



Failing to recognise the value implications of running the business on the basis of self-interest and other poor ethical standards



Reluctance to involve non-executive directors, or matters being brought to the board for sign-off, rather than debate



Complacent or intransigent attitudes



Weak organisational culture



Inadequate information or analysis

Board size A board should be neither too large nor too small. A large board provides more opportunities for varied views to be put forward, and with a large board it is easier to divide responsibilities (such as membership of board committees) and to deal with personnel changes when they occur. However, a large board can make it difficult to reach quick decisions when these are needed and to achieve consensus in decision-making. A complex company operating in a complicated environment may need a bigger board to have access to a wide range of skills and experience. On the other hand, a company operating in a fast-moving

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environment where rapid decision-making is required may be better served by a smaller board.

3.3.2

Board composition In order to carry out their roles effectively, directors collectively need to have relevant expertise in the industry, the company’s affairs, key functional areas and governance. The UK Corporate Governance Code states that ‘the board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively.’ No individual, or small group of individuals, should be allowed to dominate decision-making by the board.

3.3.3

Diversity The UK Corporate Governance Code states that when directors are appointed to the board, due regard should be given to the benefits of diversity of board membership, including gender diversity.

3.3.4

Independence Definition Independence: The avoidance of being unduly influenced by vested interests and being free from any constraints that would prevent a correct course of action being taken. It is an ability to stand apart from inappropriate influences and be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue. There are two aspects to independence of board directors. (a)

Independence, in particular freedom from conflict of interests and a willingness to consider issues objectively and in the best interests of their company, is important for all directors. All directors should be independent-minded.

(b)

However there is a risk that executive directors, and non-executives with a long association with the company, may find it difficult to be entirely independent. They may be inclined to side with executive management on certain matters, such as budgets and investments. In some areas of governance, such as executive remuneration, executive directors have a clear conflict of interests. It is therefore considered good governance practice for a certain number of board directors to be both non-executives and also clearly independent from the company. These are ‘officially’ recognised by the company as independent non-executive directors.

Independent non-executive directors should play a key role in challenging the views of their executive colleagues. It is generally recognised that the independence of independent NEDs will tend to erode over time as they become more familiar with the company. The UK Corporate Governance Code therefore includes a provision that when an independent NED has been on the board for six years or more, his or her independence should be questioned rigorously; and if a NED has been on the board for nine years or more, the board must state its reasons why they consider him or her still to be independent.

3.3.5

Matters reserved for decision-making by the board Most codes emphasise that the board should have a formal schedule of matters specifically reserved to it for decision at board meetings. Some decisions should clearly be taken by the board, such as decisions to approve the financial statements and annual report; decisions about dividends; and decisions about inviting new members to join the board. The board should also approve the annual budget and the company’s overall strategic objectives. It should monitor the company’s performance, and require management to present regular budgetary control reports for review and questioning by the board. However, unless there is a formal statement of decisions that should be taken by the board, there will be areas of uncertainty, where it is not clear whether board approval is required before the executive management team take certain courses of action. The board should normally expect to make decisions about: (a) (b) (c)

major acquisitions, but what constitutes a ‘major’ acquisition? major investments, but what constitutes a ‘major’ investment? policy on borrowing, and some specific borrowing decisions (such as bond issues or share issues)

(d) (e)

the company’s appetite for strategic and financial risk the use of financial derivatives, as a matter of financial policy.

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3.3.6

Board performance appraisal Experience has shown that bringing together a balanced and experienced group of successful individuals as a board of directors does not necessarily guarantee that the board will be effective and successful. Appraisal of the board's performance and effectiveness is an important control, aimed at improving board effectiveness, maximising strengths and tackling weaknesses. The UK Corporate Governance Code recommends that performance of the board, its committees and individual directors, should be formally assessed once a year. Ideally, the assessment should be by an external third party who can bring objectivity to the process. Board evaluation can bring benefits from improved performance by the board, its committees and individual board members, by identifying weaknesses and acting to deal with them. The UK Code states that the board chairman should act on the findings of the performance review. An annual performance review can also help the chairman and nomination committee to plan changes to the composition of the board, by comparing the range of skills and experience that the board and its committees need with the current composition and competences of the board membership. An ICAEW web site article (‘Board evaluation and effectiveness review’) suggests that subsidiary company boards are often training grounds in listed companies, and encouraging good governance through performance reviews at this subsidiary level can pay dividends at group level later on.

3.4

Chairman and chief executive officer The most important point in the leadership of a company is that there are two roles at its head:

3.4.1



Chairman – Leader of the board. The chairman's most important tasks include ensuring that the board is effective ‘in all aspects of its role’.



Chief executive (CEO) – Leader of the executive management team

Role of chief executive The CEO is responsible for running the organisation's business and for proposing and developing the group's strategy and overall commercial objectives, in consultation with the directors and the board. The CEO shapes the values, principles and major operating policies on which the internal control systems are based. The CEO will examine major investments, capital expenditure, acquisitions and disposals and be responsible for identifying new initiatives. The CEO manages the risk profile and control systems of the organisation. The CEO is also responsible for implementing the decisions of the board and its committees, developing the main policy statements and reviewing the business's organisational structure and operational performance. The CEO is the senior executive in charge of the management team and is answerable to the board for its performance. He will have to formalise the roles and responsibilities of the management team, including determining the degree of delegation.

3.4.2

Division of responsibilities One of the most controversial areas of corporate governance has been whether the roles of chairman and chief executive can be held by the same person. All governance reports acknowledge the importance of having a division of responsibilities at the head of an organisation to avoid the situation where one individual has unfettered control of the decisionmaking process. This can be achieved by the roles of chairman and CEO being held by two different people, which has the following advantages. (a)

Demands of roles It reflects the reality that both jobs are demanding roles and ultimately, the idea that no one person would be able to do both jobs well. The CEO can then run the company. The chairman can run the board and take the lead in liaising with shareholders.

(b) Authority There is an important difference between the authority of the chairman and the authority of the chief executive, which having the roles taken by different people, will clarify. The chairman carries the authority of the board, whereas the chief executive has the authority that is delegated by the board. Separating the roles emphasises that the chairman is acting on behalf of the board, whereas the chief executive has the authority given in his terms of appointment. Having the same person in both roles means that unfettered power is concentrated into one pair of hands. The 12

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board may be ineffective in controlling the chief executive, if it is led by the chief executive. (c)

Conflicts of interest The separation of roles avoids the risk of conflicts of interest. The Chairman can concentrate on representing the interests of shareholders.

(d) Accountability The board cannot make the CEO truly accountable for management if it is chaired by the CEO. (e)

Board opinions Separation of the roles means that the board is more able to express its concerns effectively by providing a point of reporting (the chairman) for the non-executive directors.

(f)

Control over information The chairman is responsible for obtaining the information that other directors require to exercise proper oversight and monitor the organisation effectively. If the chairman is also chief executive, then directors may not be sure that the information they are getting is sufficient and objective enough to support their work. The chairman should ensure that the board is receiving sufficient information to make informed decisions, and should put pressure on the chief executive if the chairman believes that the chief executive is not providing adequate information.

(g)

Compliance Separation enables compliance with governance best practice and hence, reassures shareholders.

That said, there are arguments in favour of the two roles being held by the same person: (a)

Creation of unity Having a single leader creates unity within the company. Having two leaders that disagree can create deadlock.

(b) Acquisition of knowledge The holders of both posts need considerable knowledge of the company. A non-executive chairman may struggle to acquire this knowledge due to constraints on his time. For a split role to work effectively, both board leaders need to understand and be happy with their roles. They need to have a consistent strategic vision, communicate frankly with each other and avoid giving differing messages to other board members.

3.5

Non-executive directors Definition Non-executive directors: Directors who have no executive (managerial) responsibilities. Under the UK unitary board system there is no legal distinction between executive and non-executive directors. Non-executive directors have the same legal duties, responsibilities and potential liabilities as executive directors, even though they are not expected to give the same continuous attention to the company's business. The UK Corporate Governance Code includes the following principles relating to non-executive directors.

3.5.1

(a)

Strategy: As part of their role, NEDs should ‘constructively challenge and help develop proposals on strategy’.

(b)

Scrutiny: NEDs should scrutinise the performance of management in meeting agreed objectives and targets, and should monitor the reporting of performance by management.

(c)

Risk: NEDs should satisfy themselves about the integrity of the financial information produced by the company and that the systems of financial control and risk management are ‘robust and defensible’.

(d)

People: NEDs are responsible for deciding the appropriate levels of remuneration for executive directors, and have a prime role in succession planning and in the appointment and (where necessary) removal of executive directors.

Contribution of non-executive directors Non-executive directors can contribute to a board of directors in various ways.

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(a)

Experience and knowledge They may have external experience and knowledge which executive directors do not possess. The experience they bring can be in many different fields. They may be executive directors of other companies and have experience of different ways of approaching corporate governance, internal controls or performance assessment. They may also bring knowledge of markets within which the company operates, the mechanisms of government or financial skills. With their experience, they may bring to the board a broad perspective that the executive directors do not possess.

(b) Varied roles The English businessman, Sir John Harvey-Jones, pointed out that there are certain roles nonexecutive directors are well-suited to play. These include 'father-confessor' (being a confidant for the chairman and other directors), 'oil-can' (intervening to make the board run more effectively) and acting as 'high sheriff' (if necessary, taking steps to remove the chairman or chief executive). The most important advantage perhaps lies in the dual nature of the non-executive director's role. Nonexecutive directors are full board members who are expected to have the level of knowledge that full board membership implies. At the same time, they are meant to provide the so-called strong, independent element on the board. This should imply that they have the knowledge and detachment to be able to monitor the company's strategy and affairs effectively. In particular, they should be able to assess fairly the remuneration of executive directors when serving on the remuneration committee, be able to discuss knowledgeably with auditors the affairs of the company on the audit committee, and be able to scrutinise strategies for excessive risks. The UK Corporate Governance Code suggests that at least half the members of boards of large listed companies, excluding the chairman, should be independent non-executive directors.

3.6

Board committees Many company boards establish a number of board committees with responsibility for supervising specific aspects of governance. A committee system does not absolve the main board of its responsibilities for the areas covered by the board committees. For a committee structure to work effectively, there needs to be effective communication and constructive relationships between the committees and the full Board. The committees with governance responsibilities consist entirely or mainly of independent non- executive directors and some NEDs are therefore likely to be members of more than one board committee.

3.6.1

Nomination committee The main task of the nomination committee is to recommend new appointments to the board. A very important consideration is whether the current board has the skills, knowledge and experience necessary to take sound strategic decisions and to run the company effectively. This must be balanced against wider factors such as the executive-non-executive balance, continuity and succession planning, and size and diversity of the board. The nomination committee may also take the lead in ensuring that each committee has members with the right skills and experience, and that board members understand their role(s) within the board structure. The board chairman also has responsibilities for ensuring that the composition of the board meets the requirements of the company, and in the UK it is common in listed companies for the board chairman also to be the chairman of the nomination committee.

3.6.2

Audit committee The audit committee is responsible for:

(a)

Liaising with the external auditors and monitoring auditor independence

(b)

Monitoring the external audit and reviewing the financial statements

(c)

Monitoring the effectiveness of the internal control system and risk management system (unless there is also a risk committee of the board, in which case the audit committee monitors the effectiveness of the internal control system for financial reporting)

(d)

Supervising the internal audit function (or if there is no internal audit function, considering each year the need for one).

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separate risk committee of the board. Particularly if there is no risk committee, the audit committee should play an important role in reviewing risk. This includes confirming that there is a formal policy in place for risk management and that the policy is backed and regularly monitored by the board. The committee should also review the arrangements, including training, for ensuring that managers and staff are aware of their responsibilities. Committee members should use their own knowledge of the business to confirm that risk management is updated to reflect current positions and strategy. The UK Corporate Governance Code states that the board of directors should at least annually review the effectiveness of the systems of risk management and internal control. Unless the board as a whole carries out the task, or unless some of the review of the effectiveness of risk management and internal control is delegated to a board risk committee, this task is delegated to the audit committee (which reports back on its findings and recommendations to the board). The audit committee is responsible for assessing the independence and objectivity of external audit and the effectiveness of the external audit process. Its roles in this area include:

3.6.3

(a)

Being responsible for recommending the appointment, re-appointment or removal of the external auditors, as well as fixing their remuneration.

(b)

Considering whether there are any other threats to external auditor independence. In particular, the committee should consider non-audit services provided by the external auditors, paying particular attention to whether there may be a conflict of interest.

(c)

Discussing the scope of the external audit prior to the start of the audit. This should include consideration of whether external audit's coverage of all areas and locations of the business is fair, and how much external audit will rely on the work of internal audit.

(d)

Acting as a forum for liaison between the external auditors, the internal auditors and the finance director.

(e)

Helping the external auditors to obtain the information they require, and in resolving any problems they may encounter.

(f)

Making themselves available to the external auditors for consultation, with or without the presence of the company's management.

(g)

Dealing with any serious reservations which the external auditors may express either about the accounts, the records or the quality of the company's management.

Remuneration committee The remuneration committee is responsible for: (a)

advising the board on executive director remuneration policy and

(b)

negotiating and agreeing the specific remuneration package for each executive director, and usually for senior executives below board level, in accordance with the boardâ&#x20AC;&#x2122;s remuneration policy.

Senior executive remuneration is a contentious issue. Some critics argue that executive remuneration is too high. Others suggest that remuneration packages do not provide suitable incentives, in the long- term as well as the short-term future, for improved performance and the achievement of company objectives. Areas of contention about senior executive remuneration may be: (a)

The proportion of remuneration that should be fixed salary and the proportion that should be performance related

(b)

The balance between short-term incentives (typically annual bonuses) and long-term incentives (typically share options or grants of shares)

(c)

The size of remuneration packages, especially the potential size of performance-related bonuses and share awards

(d)

The extent to which annual bonuses focus on short-term financial performance; alternatively the excessive diversity of multiple performance targets for annual bonuses

(e)

Rewards for failure: large payments to directors who are forced to resign.

A further problem is that the non-executive directors who make up the remuneration committee may be executive directors in other large companies. If so, they may have a personal interest in ratcheting up the general levels of executive pay. In the UK, quoted companies are now required to submit their remuneration policy to the shareholders for approval, at least every three years. The shareholdersâ&#x20AC;&#x2122; vote is binding, and companies are then

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required to ensure that remuneration packages for executives comply with the policy. As yet, it is too early to be certain what practical effect this recent law change will have on executive remuneration and shareholder influence over executive pay.

3.6.4

Risk committee Some listed companies have a risk committee of the board. The risk committee is responsible for overseeing the organisation's risk management systems. It is not a compulsory committee under most governance regimes. However, listed companies that are subject to significant financial market risk (such as banks) will usually have a risk committee. The potential for large losses through misuse of derivatives was demonstrated by the Barings Bank scandal. A risk committee can help provide the supervision required. Clearly though, to be effective, the committee members collectively will need a high level of expertise in finance and/or risk management.

3.7

Strategy setting and the board Boards are responsible for corporate strategy but they can manage strategic development in different ways.

3.7.1



Boards may be actively involved with executive management in strategic development. However non-executive directors in particular may have problems committing enough time to contribute effectively to a detailed strategic planning process. Also a primary role for non-executive directors is to monitor decision-making and performance by executive management. They may find it very difficult to monitor effectively if they are also significantly involved in decision-making.



Boards in larger companies usually adopt more of a stewardship role – Directors approve strategic plans, but strategic management and development and strategy implementation is the responsibility of the executive team. There can be a risk that the board will delegate too much responsibility for strategy to management. Good governance requires that major strategic decisions and overall guidance on risk should be the decision-making responsibility of the board.

Strategic development and the CEO Michael Porter has emphasised the importance of a clear strategic leader who ‘takes ownership’ of strategic development and is accountable to the board for its success or failure. The obvious strategic leader is the chief executive. However, if strategies are largely identified with chief executives, boards may respond to strategic difficulties by changing their chief executives, rather than examining the reasons for failure thoroughly. In addition, if chief executives are initially successful and then are allowed to continue without significant checks, they may become over-ambitious. In theory, other executive directors and managers should be able to assist the chief executive by providing the benefit of their own experience and knowledge. However they may find it difficult to constrain a determined and domineering chief executive. Below board level, the executives may have been appointed by the chief executive and so may lack the independence to challenge him or her and will go along with what the CEO wants.

3.8 3.8.1

Risk management and the board Board responsibilities The board has overall responsibility for the effectiveness of risk management in their company. The UK Corporate Governance Code states that the board is responsible for deciding the nature and extent of the significant risks it is willing to take in achieving its strategic objectives. In 2009 COSO (the Committee of Sponsoring Organizations of the Treadway Commission in the USA) published a paper, Strengthening Enterprise Risk Management for Strategic Advantage, which provides guidance on enhancing the board's risk management capabilities. (a)

Discuss risk management philosophy and risk appetite The board and senior management have to understand the level of risk that they want their company to take, including whether it is consistent with stakeholder expectations. Risk appetite should be a key element in objective setting and strategy selection, and will also determine risk management processes. The COSO guidance suggests that as a starting point, the board should consider the strategies that they would not be interested in pursuing, due to the level of risk involved or the inadequacy of returns for the risks incurred. It should also consider risk appetite for each of the main categories of risk. The guidance suggests a series of questions that can be used to help determine risk appetite: 

Do shareholders want us to pursue high risk/high return businesses, or do they prefer a more conservative, predictable business profile?

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

What is our desired risk rating?



What is our desired confidence level for paying dividends?



How much of our budget can we subject to potential loss?



How much earnings volatility are we prepared to accept?



Are there specific risks that we are not prepared to accept?



What is our willingness to consider growth through acquisitions?



To what extent are we willing to expand our product, customer or geographic coverage?



What amount of risk are we willing to accept on new initiatives to achieve a specified target?

(b) Understand risk management practices Boards need to ensure that an awareness of risk and a culture of risk management permeates the organisation, and that risk management practices and procedures are applied by all managers and staff. (c)

Review portfolio risks in relation to risk appetite Boards need to understand the portfolio of risk exposures facing their company so that they can determine whether these are consistent with stakeholders' tolerance of risk and the board’s appetite for risk. A portfolio view also helps the board to identify concentrations of risks that may affect specific strategies, or overlapping risk exposures.

(d) Be appraised of the most significant risks and related responses Since risks are continuously evolving and changing in character and significance, risk management processes need to ensure that timely and robust information about risks is provided. Boards need to understand how risks may affect the company and how management is responding to them. Board members need to have sufficient experience, training and knowledge of the business to discuss properly the risks that the business faces. The board also needs to be able to rely on key risk indicators that provide a clear view of risks, allow for comparisons over time and between business units, and provide opportunities to assess the performance of the ‘risk owners’ (the individual managers responsible for particular risks).

3.8.2

Strategic risks and operating risks A distinction can be made between strategic risks and operating risks. (a)

Strategic risks are risks that come from the environment in which the business operates. These include risks from competition, and risks from changes within the industry and in customer/consumer demand. They also include risks in the broader business environment, such as economic risks, financial market risks, risks from technological change or political or regulatory change.

(b)

Operating risks are risks of failure in processes and procedures within the company’s operating activities. These may be classified as financial reporting risks (risks of errors or failures in accounting systems and financial reports); compliance risks (risks of failure to comply with laws and regulations) and general operational risks (risks of failures due to human error, deliberate fraud, machine and technology failures and failures in procedures and processes).

Strategic risks should be recognised and monitored within the strategic management process. Operating risks should be controlled by an effective internal control system. The board is responsible for ensuring that there are effective systems for risk management and internal control. The implementation of controls including the design of internal controls, is the responsibility of management. The board is responsible for review of effectiveness, and should seek assurance that risk management and internal control systems remain effective, and ensure that measures are taken by management to rectify any weaknesses that are identified.

3.8.3 Review of risk The board should review on a regular basis: 

The nature of the risks facing the company and its business, and the systems for identifying and recording risks



The processes for risk assessment – the potential scale of the risk and the probability that adverse risk events will occur



The measures that are in place for managing risks – to keep business strategy within tolerable risk

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limits, to reduce the likelihood that risk events or operating failures will occur, to insure against adverse risk events or to avoid risks ď&#x201A;ˇ

The systems and procedures that are in place for the regular review/monitoring of risk and risk management by the executive management team

ď&#x201A;ˇ

The costs of operating particular controls, compared to their benefits

The board should focus on serious risks, whether they are long-term or short-term; and strategic or operational. Although the board will spend a lot of time on risks associated with strategy, it must gain assurance that serious operational risks are being appropriately managed. That said, too great a focus on immediate issues may mean longer-term trends, such as technological developments associated with serious strategic risks, may be neglected. Boards should review risks and internal control as a regular part of their agenda. The UK Corporate Governance Code for example states that the board should review the effectiveness of the risk management and internal control systems at least annually. A key aspect for the directors to consider is the frequency of monitoring of risks by management. Some risks may need to be monitored daily (for example, foreign exchange risks in a global company); others much less frequently. A board cannot rely entirely on the management monitoring processes and risk reports from management to discharge its responsibilities for risk. It should regularly receive and review reports on internal control to ensure that management has implemented an effective monitoring system. Internal control reports may be prepared by an internal audit function or by a firm of accountants that is appointed to carry out internal control assignments. Although the board need not understand the details of every management procedure, it should focus on controls performed directly by senior management, and controls designed to prevent or detect senior management override of controls. The COSO guidance states that ineffective monitoring results in control breakdowns, and materially impacts on the organisation's ability to achieve its objectives. Inefficient monitoring leads to a lack of focus on the areas of greatest need. The size of the organisation and the complexity of its operations and controls will be key determinants of the scale of monitoring required to obtain satisfaction as to the effectiveness of the risk management and internal control systems.

3.8.4 Review of internal control In order to carry out an effective review of internal control, the board (or the audit committee) should regularly receive and review reports and information on internal control, concentrating on: (a)

What the risks are, and strategies for identifying, evaluating and managing them

(b)

The effectiveness of the management and internal control systems in the management of risk; in particular, how risks are monitored and how any weaknesses have been dealt with

(c)

Whether actions are being taken to reduce the risks found

(d) Whether the results indicate that internal control should be monitored more extensively Annual reports should contain an assessment of the effectiveness of the internal control over financial reporting, and a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting. External auditors should report on this assessment, having carried out independent testing of the control system.

3.8.3

Role of assurance procedures To carry out its reviews effectively, the board is likely to have to rely on work by the internal audit function on the risk management and control systems. In the absence of an internal audit function, sufficient assurance should be obtained from other sources, such as internal audit assignments by an external accountancy firm. Stakeholders, particularly investors, need assurance that the risks taken by the company are acceptable to them and that their returns are consistent with the risks taken. Internal auditors will again be concerned to see that managers have made adequate responses to risks, have designed robust risk management processes and internal control systems, and that these risk management processes and controls operate to mitigate the risks. Having taken an overall view earlier in the audit, internal auditors will concentrate on the adequacy of

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risk management processes and controls for each area to be covered, determine whether these processes are operating as intended, and seek to promote improvements where processes are inadequate or not operating as required. Internal auditors will assess the operation and effectiveness of the risk management processes and the internal controls in operation to limit risks. A comprehensive risk audit will extend to the risk management and control culture. Internal auditors' work on controls would include:

3.9



Reviewing the processes for identifying risks



Identifying the procedures for identifying and assessing risks, and controls at a corporate and operational level



Reviewing the completeness of documentation of risks and risk management measures



Testing controls



Advising on the contents of the board’s statement to shareholders on the internal control system and the disclosure of material weaknesses

Performance monitoring and the board Boards should monitor the performance of the company and its management. Performance monitoring is carried out mainly by means of regular reporting to the board by executive management. Typically the CEO, supported by the finance director, will submit performance reports to the board for scrutiny. Actual performance should be compared with a benchmark, which may be a budget or a longer-term business plan or investment plan. Actual and plan are compared initially by means of key performance indicators or performance metrics.

3.9.1

Choice of metrics We shall discuss data analysis and choice of metrics in Chapter 8, but as a general principle, directors need to ensure that metrics link to the key value drivers of the business that relate to its strategy. For example, sales growth should be linked to new product sales or repeat business; and profit margin to prices, costs and sales volumes. Identification of leading indicators that can predict future difficulties is particularly important. For example falling customer satisfaction can result in future falls in revenue and a decline of the company's brand: however in order to monitor this threat to future performance the board would need performance reports on customer satisfaction. Much of the financial information the board receives will be historical, and so will often be a lagging indicator – a measure of problems that have already occurred. Some non-financial matters, for example customer and staff satisfaction, will be as important as financial matters. Many boards adopt a balanced scorecard approach, grouping key performance indicators into a number of different performance areas and setting targets for each performance indicator. A challenge for the board is to identify and select suitable performance metrics for assessing the performance of the company. They will be assisted in this task by management, but the directors need to remember that they are monitoring the performance of management. They need assurance that the performance metrics they are using are relevant and appropriate, and also that performance is reported accurately by management. Directors also need to be selective in the information they obtain from operational management and regularly consider whether they are receiving too much information on certain areas. The board may not see or see only rarely a lot of metrics that operational management use. Boards may be tempted to receive information about areas that have caused difficulties in the past, even though these areas are no longer a problem.

3.9.2

Setting performance targets Having identified the metrics, the board must then decide the targets for those metrics. There needs to be a mix of short and long-term targets and the targets may need to change if there are significant changes in external circumstances. Boards also need to be aware of investors' and analysts' views on what targets they expect companies to meet. A consistent failure to meet targets should trigger board action before investors exert pressure. The board may consider the following issues when deciding whether to investigate further or take action: (a)

Materiality – Small variations in a single period are bound to occur and are unlikely to be significant. Obtaining an 'explanation' is likely to be time-consuming and irritating for the manager concerned. The explanation will often be 'chance', which is not particularly helpful.

(b)

Controllability – Controllability must also influence the decision of whether to investigate further.

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If there is a general worldwide price increase in the price of an important raw material, there is nothing that can be done internally to control the effect of this. (c)

3.9.3

Variance trend – If, say, an efficiency variance is £1,000 adverse in month 1, the obvious conclusion is that the process is out of control and that corrective action must be taken. This may be correct, but what if the same variance is £1,000 adverse every month? The trend indicates that the process is in control and the standard has been wrongly set.

Analysing information about metrics: revising forecasts Directors need to obtain assurance from management that the metrics that are being reported are based on reliable data. Internal audit work may also provide assurance. Even if this assurance is obtained, directors should analyse the information critically, comparing it with their own knowledge of the company and external sources of information. Another approach to obtaining assurance about performance is to obtain revised forecasts of expected future results. Instead of simply comparing historical performance with planning or budget targets, the board can ask for new forecasts and compare these with the original plans and targets. A significant difference between a revised forecast and the original plan is likely to be much more significant than a comparison of performance to date with the plan, and may provide a much more reliable guide to performance. Listed companies often make announcements to the stock market about their expected results for the financial year, and update this information whenever the forecast changes. Forecasts are a source of assurance to shareholders and lenders, as well as to the board itself.

4 4.1

Organisational structures and strategies Organisational structure For governance purposes, an appropriate organisation structure depends on several factors.

4.2 4.2.1



The size of the organisation. Size may be measured by number of employees, total assets and resources, and scale of activities



Risks to which the organisation is exposed. Risk management systems are a core element in governance systems, and the design of risk management and internal control systems should depend on the severity of business risks



Centralisation/decentralisation. Governance systems depend on where decisions are taken, by the board or by management, and at what level of management. As a general guide, decentralisation is likely to be more necessary in large and complex businesses. The extent of decentralisation of decision-making should also affect the design of performance reporting systems.

Governance, organisational structure and strategy implementation Strategic planning decisions The key decisions about corporate strategy, including risk appetite, should be taken at board level, with the board fully accountable to shareholders for the success or failure of their chosen strategy. (a)

Within the framework of the overall corporate strategy, decisions must be taken about supporting functional strategies, such as strategies for sales, purchasing, production, IT, human resources and employment, research and development, and so on.

(b)

Functional strategies may be decided at board level, or planned by management and subject to board approval.

(c)

Functional strategies should be consistent with the overall corporate strategy. For example, the board may decide on a strategy for sales growth and decide on a target for 5% sales growth over each of the next five financial years. Management may then develop a sales strategy for achieving the board’s strategic targets, and submit this to the board for approval.

(d)

In very large organisations, the board may set an overall corporate strategy for the group, and divisional boards may then decide on strategy for their business unit. Within each business unit, functional strategy planning may then be delegated to management.

Arrangements and processes for strategic planning will therefore vary between organisations, but the general principle is that the board has overall responsibility for formal corporate planning. Detailed strategic planning will be delegated, but plans should be subject to final board approval. 20

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4.2.2

Strategic planning and unexpected change The process of strategic planning described above is a process for preparing and approving a formal business plan. The plan may cover a period of several years, during which changes will occur that were not envisaged when the plan was originally formulated. Companies need to respond to unforeseen changes – threats or opportunities – and develop new strategies to meet the change in circumstances. Strategic decisions for responding to change may have to be taken quickly, especially if there is a short- lived opportunity or if a major new risk has emerged that creates an immediate threat to the business. Quick decisions are often needed in particular in businesses that operate in a volatile and continually changing environment. A board of directors may be able to make quick (timely) strategic decisions in response to change. However some boards take time to reach decisions, and so may be considered ineffective. In such circumstances, new strategies may have to be decided at business unit or management level.

4.2.3

Implementing strategy Strategies are implemented by management. The level in the management hierarchy at which responsibility for strategy implementation rests will depend on the extent of centralisation or decentralisation of decision-making. Managers who are responsible for strategy implementation should be accountable to their senior and ultimately to the chief executive officer. The CEO is then accountable to the board. Accountability for strategy implementation should be a key feature of a risk management system and performance reporting system.

4.2.4

Monitoring strategy implementation Within a system of responsibility management, managers should monitor the implementation of strategy by their subordinates, and the board should monitor the implementation of strategy by the executive management. The quality of corporate governance within a company depends to a considerable extent on the quality monitoring by the board.

5 Legal framework of governance 5.1

Legal requirements relating to the company Companies are increasingly subject to laws and regulations with which they must comply. The most significant laws and regulations for companies differ according to the industry in which the company operates and the geographical reach of its operations. For the purpose of your examination, you should be aware of the nature of the legal framework within which a company operates, and the implications for corporate governance. You will not be required to know the law in detail. Much of the discussion in this section relates to UK law, but UK law is used here as a convenient example. It provides just one example of a governance regime and legal aspects of governance will vary according to country and jurisdiction.

5.1.1

Company law Company law is the source of much regulation about the way that companies are formed and governed, including rules relating to the annual report and accounts, the requirement for external audits, annual general meetings, and so on. The UK Companies Act also sets out seven statutory duties of directors, which have relevance to corporate governance and so are listed below. These duties apply to non-executive directors as well as executive directors. From a corporate governance perspective, it is also useful to recognise the legal provisions for the departure of directors from the board and the appointment of new directors. A director may leave office in the following ways: 

Resignation (written notice may be required): in some circumstances, a director may be forced to resign by the rest of the board, if the board declares its loss of confidence in the individual. When directors resign, either voluntarily or under pressure from colleagues, they may negotiate compensation for loss of office.



Not offering himself for re-election when his term of office ends: company law should include a requirement for directors to submit themselves for re-election every so often. (In the UK, directors should submit themselves for re-election every three years, but in larger listed companies, the UK Corporate Governance Code requires annual re-election of all directors.)

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

Failing to be re-elected: when shareholders are dissatisfied with decisions or actions by the board, one way in which they can express their dissatisfaction is to vote against the re-election of particular individuals, such as the chairman of the remuneration committee.

Resignations and not standing for re-election are the most common methods of making changes to the board. There are also other ways in which directors may leave the board, such as disqualification from office. From a governance perspective, however, these other methods of boardroom change are much less significant.

5.1.2

Criminal law: fraud Several aspects of criminal law have relevance to corporate governance. These include the laws against fraud, bribery, insider dealing and money laundering.

Definition Fraud: An intentional act by one or more individuals among management, those charged with governance (management fraud), employees (employee fraud) or third parties involving the use of deception to obtain an unjust or illegal advantage. Fraud may be perpetrated by an individual, or colluded in with people internal or external to the business. In the UK, the Fraud Act defines three classes of fraud:   

Fraud by false representation Fraud by failing to disclose information Fraud by abuse of position

An offence has occurred in any of these classes if a person has acted dishonestly and with the intent of making a gain for themselves or for someone else, or of inflicting a loss on someone else. Internal control systems should be designed so as to include checks and procedures for the prevention or detection of fraud. However fraud is a form of deceit that makes its prevention and detection difficult. The perpetrator of the fraud does not want to be detected and will go out of their way to be successful. Fraud should be distinguished from human error, which occurs as a result of a genuine mistake with no intention to deceive. Internal controls to prevent or detect errors may also help to prevent or detect fraud.

5.1.3

Bribery Some countries, including the UK, have a criminal law against giving or receiving bribes by a company and its officials or representatives. The key points of the UK Bribery Act 2010 are as follows: 

Bribery is an intention to encourage or induce improper performance by any person, in breach of any duty or expectation of trust or impartiality.



Bribery may amount to an offence for the giver ('active bribery') and the receiver ('passive bribery').



Improper performance will be judged in accordance with what a reasonable person in the UK would expect. This applies, even if no part of the activity took place in the UK and where local custom is very different.



Reasonable and proportionate hospitality is not prohibited.



Facilitation payments (payments to induce officials to perform routine functions they are otherwise obligated to perform) are bribes.



Bribing a foreign public official is an offence.



If companies (or partnerships) fail to prevent bribes being paid on their behalf, they have committed an offence punishable by an unlimited fine. A defence for a company against accusations of bribery is to have 'adequate procedures' in place for the prevention of bribery.



If a bribery offence is committed by a company (or partnership), any director, manager or similar officer will also be guilty of the offence if they consented or were involved with the activity which took place.

Guidance published in 2011 by the UK Ministry of Justice highlighted five areas where the risk of bribery and corruption may be high:



Country. Countries with high levels of corruption, lacking anti-bribery legislation and which fail to promote transparent procurement and investment policies.



Sectoral. Higher risk sectors include the extractive and large-scale infrastructure sectors.



Transaction. Risky transactions include charitable and political contributions, licences and permits,

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and transactions relating to public procurement. 

Business opportunity. Potentially risky projects include high-value projects, projects involving many contractors or intermediaries, and projects not apparently undertaken at market price or which lack a clear business objective.



Business partnership risk. Risky situations could include the use of intermediaries in transactions with foreign public officials, involvement with consortia or joint venture partners and relationships with politically exposed persons.

It remains to be seen how effective the UK Bribery Act will be in preventing bribery. It is also worth noting reports of investigations in China and the USA into alleged bribery. A notable example has been the investigations in 2013 and 2014 by the Chinese authorities, and subsequently the US authorities, into alleged bribery by British pharmaceuticals company GlaxoSmithKline (GSK). It has been reported that GSK was under investigation for alleged bribery of doctors and officials in order to boost the company’s sales of its drugs. This incident helps to illustrate the potential significance of criminal acts of bribery for a company’s worldwide business, and the importance of both corporate culture and internal controls for controlling such risks.

5.1.4

Insider dealing Insider dealing is a criminal offence. Essentially, insider dealing involves using confidential (undisclosed) information about a company to deal in a company’s shares (or to encourage someone else to deal in a company’s shares) for financial benefit. For directors, an obvious example of insider dealing would be using the advance knowledge they have of the company's results to make gains before the information is released to the market. Rules in many countries therefore include prohibition in directors dealing in shares during a close period, defined as a specific period (60 days, for example) before the publication of annual or period results.

5.1.5

Money laundering Money laundering is a form of fraud. It is essentially a process where the perpetrator attempts to legitimise the proceeds of any crime (dirty money made good). Proceeds of crime can include activities such as drug trafficking, terrorism, shoplifting, theft, tax evasion and other financial criminal activity. As a form of fraud, the emphasis is on concealing the illegal source of the money, which makes it difficult to detect, especially given that the transactions are rarely linked to one country. Relevant legislation in the UK includes: 

The Terrorism Act 2000: It is a criminal offence in the UK to finance or to facilitate the financing of terrorism.



The Proceeds of Crime Act 2002: Three money laundering offences under this Act are:

Section 327 – An offence is committed if a person conceals, disguises, converts, transfers or removes from the jurisdiction property which is, or represents, the proceeds of crime which the person knows or suspects represents the proceeds of crime. Section 328 – An offence is committed when a person enters into or becomes concerned in an arrangement which he knows or suspects will facilitate another person to acquire, retain, use or control criminal property and the person knows or suspects that the property is criminal property. Section 329 – An offence is committed when a person acquires, uses or has possession of property which he knows or suspects represents the proceeds of crime. Some companies are at greater risk than others of breaching the laws against money laundering, and anti-money laundering regulations are applied to certain types of company, such as banks. Affected companies must assess the risk of money laundering in their business and take necessary action by identifying the risks and taking measures, for example by refusing to enter into business transactions with customers who are suspected of money laundering.

5.1.6

Civil law Areas of commercial law which may impact upon businesses include:    

Carriage by land and sea Marine, fire, life and accident assurance Bills of exchange Manufacture and sale of consumer goods

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Businesses may also be affected by various aspects of property law including:    

5.1.7

Possession and rights over land Transfer of property Landlord and tenant law Manufacture and sale of consumer goods

Contract law Contract law will have a significant impact on a business. Contracts may be made with suppliers, customers, landlords and so on. It is almost invariably the case that the two parties to a contract bring with them differing levels of bargaining power. A contract may be made between a large retail company and an individual for example. In such cases, the agreement is likely to be in the form of a standard form contract, prepared by the dominant party and which the other party has no choice but to take or leave. Alternatively the parties to the contract will negotiate the terms between them. Risks Having entered into a contract a business faces the following risks: 

The contract is unenforceable A contract will be unenforceable where it is not in the correct form. Generally speaking a contract may be made orally or in writing and an oral agreement will be just as binding as a written contract. However in certain cases the law provides that an oral contract will not be sufficient, for example agreements for the transfer of land and consumer credit agreements (that are regulated by the Consumer Credit Act 1974 (as amended by the Consumer Credit Act 2006)) must be in writing. Note that, increasingly, contracts are made electronically and an electronic signature can be used as evidence of the validity of a contract in the same way as a written signature (s.8 Electronic Communications Act 2000).



The contract is void or voidable A contract may be void or voidable in the following situations: – – – – –



lack of capacity absence of free will illegality mistake misrepresentation

The contract is not discharged A contract is normally discharged by performance. Where a party does not perform his contractual obligation sufficiently, he is said to be in breach of contract, unless the contract has been discharged by frustration or he has some other lawful excuse. A lawful excuse may apply in the following circumstances: – – –

Where he has tendered performance but this has been rejected Where the other party has made it impossible for him to perform Where the parties have by agreement permitted non-performance

The majority of contractual disputes will not reach the courts and may be resolved by negotiation, arbitration or some other means such as mediation, adjudication or expert determination. However where this is not possible the court may award one of the following remedies: 

Damages (designed to compensate the claimant by putting him in the position he would have been in, if the contract had been performed)



Specific performance (where damages are not an adequate remedy)



Injunction (ie the defendant is directed to take positive steps to undo something he has already done in breach of contract)

Damages are the most common form of remedy to be awarded by the courts. A company in breach of contract may need to recognise a provision for damages or disclose a contingent liability depending on the specific nature of the situation and the assessment of the likely outcome of the court proceedings.

5.1.8

Agency Agency is a very important feature of modern commercial life and describes the relationship that exists Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

where one party, the agent, acts on behalf of another, the principal. In practice, there are many examples of agency relationships to which you are probably accustomed, such as estate agents and travel agents. However you should appreciate, in particular, how a director may be held to be an agent of the company and bind the company by his acts and also how a partner is an agent of the partnership and may bind the firm by his acts. Agency by consent An agency can be expressly created either orally or in writing. There is only one exception to this, which is that if the agent is to execute a deed on the principal's behalf (for example a conveyance of land or a lease exceeding three years) then the agency must be created by deed. Essentially this means that the agent is given a power of attorney. In commercial transactions it is usual (but not essential) to appoint an agent in writing, so that the terms and extent of the relationship are set down to avoid misunderstanding. In the case of a director the agency would be created by the contract of employment. Agency by estoppel Agency by estoppel arises by operation of law and is no less effective than an agency expressly created. It arises in the following situation: 

When the words or conduct of the principal give to a third party the impression that the person who purports to contract with the third party is the agent of the principal, and



The third party, as a result, acts upon this.

The principal is 'estopped', or prevented, from denying the existence of the agency. For example where a business presents an employee to customers and other entities it is in business with as a director he will be treated in law as such (shadow director) even if he is not officially registered at Companies House as a director of the company.

5.1.9

Negligence Negligence is the most important modern tort. To succeed in an action for negligence, the burden of proof is on the claimant to prove, on a balance of probabilities, that: – – –

The defendant owed a duty of care to the claimant to avoid causing injury, damage or loss There was a breach of that duty by the defendant In consequence the claimant suffered injury, damage or loss

Duty of care It is not possible to give a clear statement of the law as to when a duty of care exists for the purposes of negligence, since the law has evolved over many years as it has had to be applied to extremely varied situations and many factors have influenced the courts' decisions. In applying these tests, the court is essentially looking at the relationship between the claimant and the defendant in the context of the damage suffered. The Nicholas H case was concerned with economic loss, but the court held that the requirements would be equally applicable in cases of physical damage to property. Breach of duty Whether or not there has been a breach of duty is a question of fact. In certain circumstances where the reason for the damage is not known, but it can fairly be said that it would not have occurred without the defendant's lack of care, the claimant can argue res ipsa loquitur ('the facts speak for themselves') and the court will infer that the defendant was in breach of the duty of care. It will be necessary for the claimant to show that the thing which caused the damage was under the management and control of the defendant. In such cases, it will then be for the defendant to prove that the cause of the injury was not his negligence. The standard of care needed to satisfy the duty of care is a question of law. Broadly speaking, it is the standard of 'a reasonable man, guided upon those considerations which ordinarily regulate the conduct of human affairs' (Blyth v Birmingham Waterworks Co 1856). Loss caused by breach A person will only be compensated if he has suffered actual loss, injury, damage or harm as a consequence of another's actions. As a general rule, loss is represented by personal injury or damage to property, or financial loss directly connected to such injury (for example, loss of earnings) or property damage. Such consequential economic loss that is related in this way, is more readily recoverable than pure economic loss.

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5.1.10

Employment and social security law, and health and safety regulations An entity which employs individuals has a number of responsibilities under the terms of the employment contract in common law and in statute. One of the key distinctions which a business needs to be able to make therefore is between an employee and a contractor. An employee is someone who is employed under a 'contract of service', ie a contract of employment. An independent contractor is someone who works under a contract for services and is also described as 'self-employed'. There are three essential elements, or conditions, that must be present in order for the contract of service (and thus the employer/ employee relationship) to exist, namely: If these factors are not present there can be no contract of service. The fact that they are present, however, does not mean that there will be a contract of service. The level of service and degree of control will be taken into account along with a number of other factors. There are several other practical reasons why the distinction between a contract of service (employed) and a contract for services (self-employed) is important. With the current trend in increasingly flexible working practices in some cases this distinction is becoming more difficult to make. There is an increased risk that an entity has responsibilities for individuals under employment law which it is not aware of. This could increase the risk of penalties. Employer’s implied duties Legislation also imposes a number of implied duties on employers, often implementing European Directives on employment law issues. Many of these duties are concerned with 'family-friendly' employment and the 'work-life balance', for example provisions regarding maternity and paternity rights, flexible working arrangements and time off work. The principal duties implied by statute are as follows: Employee’s implied duties Common law implies a number of duties on the part of the employee into any contract of employment:

5.1.11

Environmental law and regulation Environmental law and regulation covers a number of different areas including:    

Air Chemicals Conservation Energy

    

Noise and nuisance Pesticides and biocides Radioactive substances Waste Water

Within each category, there is a range of legislation. For example, legislation on air quality includes regulations regarding aerosol dispensers, clean air acts, climate change acts and crop residues (burning) legislation. For any business, it is therefore critical that it identifies which regulations are relevant to its business and ensures that it complies with the provisions of these. The company may employ the services of a consultant in order to help it understand and apply the legislation with a view to avoiding any breaches and the potential penalties that may arise as a consequence. The consequences of breaches of environmental regulations can have significant consequences, both directly (as a result of the fines) and indirectly (as a result of the bad publicity).

5.2

Compliance with laws and regulations Directors and management should ensure that their company complies with relevant laws and regulations.

(a)

The consequences of failing to comply with laws and regulations will depend on the nature of the offence, and the jurisdiction in which the offence occurs. Fines for breaching the law or contractual arrangements could be very high, and there may also be a risk that offences could lead to a significant loss of business.

(b)

Large companies may establish a compliance department whose responsibility is to monitor compliance with relevant laws and regulations. The name given to a compliance department may vary: for example, compliance with health and safety regulations may be assigned to a health and safety department. When a company finds it necessary to establish one or more compliance departments, the costs of compliance can be high.

(c)

Compliance can be particularly complex for international companies that operate in different

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countries with differing jurisdictions. The following aspects of control systems are particularly important.

5.1.12

Establishing culture Board commitment to compliance with the law is an important overall control. Directors may seek to establish a commitment against breaches of specific laws by a formal statement, setting out a zero tolerance policy and spelling out the consequences for employees or managers who transgress. As with other areas, communication of the organisation's procedures and policies, and training in their application, will be very important in helping to establish the culture. Training should include general training on the threat of bribery on induction, and also specific training for those involved in higher risk activities such as purchasing and contracting. However, whilst establishing the right culture is an important part of taking effective action to combat corruption, a culture that is ambiguous or not enforced may adversely affect the success of other measures. This may occur if managers and staff feel that they are getting mixed messages. They may believe that they are expected to do what it takes to earn sufficient returns in environments where ethical temptations exist, or that ethically dubious conduct will be ignored or implicitly accepted.

5.1.13

Code of conduct As well as being central to communication with employees, a publicly-communicated code also reassures those doing business with the organisation and can act as a deterrent to misconduct. For example, a code may include provisions about dealing truthfully with suppliers and refraining from seeking or participating in questionable behaviour to secure competitive advantage. However, there may be the problem that staff do not feel the code is relevant to them.

5.1.14

Risk assessment Identification of circumstances where non-compliance with laws may be a problem, must be built into business risk assessments. Sensitive areas could include hazardous activities for health and safety laws, disputes with staff for employment law, or the activities of intermediaries or agents, or staff within the organisation responsible for hospitality or promotional expenditure for anti-bribery legislation. Risks may change over time (for example, as the business enters new markets) and so may need to be re-assessed. A poor internal control environment may also be a factor that contributes significantly to increased risk.

5.1.15

Operational compliance A strong tone at the top and the ethical code may be undermined by a lack of detailed guidance on the implementation of procedures to ensure compliance with laws. However detailed the procedures, they will not be able to give absolute assurance that corrupt activities will not take place. Staff may not understand why operational controls are required, how they should operate and who should be operating them. They may misinterpret the requirements, or may encounter dubious situations not covered by guidance. They may assume that conduct not forbidden by the guidance is legitimate. There is also the issue that detailed guidance is meant to ensure compliance with the law. However, the law may not be entirely clear.

5.1.16

Whistleblowing A business's guidance should make it clear that managers and staff should seek guidance about, and disclose, any activities that are questionable. Staff should also have the opportunity to make suggestions for improvement in prevention and compliance procedures.

5.1.17

Monitoring As part of their regular monitoring of risk management, the board should receive reports on compliance with significant legislation. The board must also consider whether systems need to be improved as the risk environment changes. Events that may result in changes to systems include changes of government, changes in legislation or changes in the activities of the business. The board's monitoring of compliance may be assisted by compliance audits. These may be carried out by internal auditors, or external specialists for areas in which there is a lack of in-house expertise, or external assurance is required or felt to be desirable.

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Strategic Business Management Chapter-7

Business risk management 1 Business risks 1.1

Risk and uncertainty Risk and uncertainty must always be taken into account in strategic planning. Many areas of risk and uncertainty are exogenous – that is, outside the control of the organisation.

1.1.1

Risk Risk is sometimes used to describe situations where outcomes are not known, but their probabilities can be estimated. (This is the underlying principle behind insurance.)

1.1.2

Uncertainty Uncertainty is present when the outcome cannot be predicted or assigned probabilities. For example, many insurance companies exclude 'war damage, riots and civil commotion' from their insurance cover.

1.2

Risk and business Risk is bound up with doing business. The basic principle is that 'you have to speculate to accumulate.' It may not be possible to eliminate risks without undermining the whole basis on which the business operates, or without incurring excessive costs and insurance premiums. Therefore, in many situations, there is likely to be a level of residual risk that is simply not worth eliminating. There are some benefits to be derived from the management of risk, possibly at the expense of profits such as: 

Predictability of cash flows



Limitation of the impact of potentially bankrupting events



Increased confidence of shareholders and other investors

However, boards should not just focus on managing negative risks, they should also seek to limit uncertainty and to manage speculative risks and opportunities in order to maximise positive outcomes and hence, shareholder value.

1.3

Risk and managers It is worth noting that shareholders and managers have different approaches to risk.

1.4



Shareholders can spread risk over a number of investments.



Managers' careers tend to be bound up with the success or failure of one particular company, so managers are therefore likely to be more risk-averse than shareholders might be.

Risk appetite Since risk management is bound up with strategy, how organisations deal with risk will not only be determined by events and the information available about events, but also by management perceptions or appetite to take risk. These factors will also influence risk culture, the values and practices that influence how an organisation deals with risk in its day-to-day operations.

1.4.1

Personal views Surveys suggest that managers acknowledge the emotional satisfaction from successful risk-taking, although this is unlikely to be the most important influence on appetite.

1.4.2

Response to shareholder demand Shareholders demand a level of return that is consistent with taking a certain level of risk. Managers will respond to these expectations by viewing risk-taking as a key part of decision-making.

1.4.3

Organisational influences Organisational influences may be important, and these are not necessarily just a response to shareholder

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concerns. Organisational attitudes may be influenced by significant losses in the past, changes in regulation and best practice, or even changing views of the benefits that risk management can bring.

1.4.4

National influences There is some evidence that national culture influences attitudes towards risk and uncertainty. Surveys suggest that attitudes to risk vary nationally according to how much people are shielded from the consequences of adverse events.

1.4.5

1.5

Cultural influences

Risk appetite and attitudes Definitions Risk appetite is the nature and strengths of risk that an organisation is prepared to bear. Risk attitude is the directors' views on the level of risk that they consider desirable. Risk capacity describes the nature and strengths of risk that an organisation is able to bear. Different businesses will have different attitudes towards taking risk. Risk-averse businesses are not businesses that are seeking to avoid risks. They are businesses that are seeking to obtain sufficient returns for the risks they take. Risk-averse businesses may be willing to tolerate risks up to a point, provided they receive an acceptable return, or if risk is 'two-way' or symmetrical, that it has both positive and negative outcomes. Some risks may be an unavoidable consequence of operating in a particular business sector. However, there will be upper limits to the risks they are prepared to take whatever the level of returns they can earn. Risk-seeking businesses are likely to focus on maximising returns and may not be worried about the level of risks that have to be taken to maximise returns (indeed, their managers may thrive on taking risks). Whatever the viewpoint, a business should be concerned with reducing risk where possible and necessary, but not eliminating all risks, whilst managers try to maximise the returns that are possible, given the levels of risk. Most risks must be managed to some extent, and some should be eliminated as being outside the business. Risk management under this view is an integral part of strategy, and involves analysing what the key value drivers are in the organisation's activities, and the risks tied up with those value drivers. For example, a business in a high-tech industry, such as computing, which evolves rapidly within everchanging markets and technologies, has to accept high risks in its research and development activities, but should it also be speculating on interest and exchange rates within its treasury activities? Another issue is that organisations that seek to avoid risks (for example, public sector companies and charities) do not need the elaborate and costly control systems that a risk-seeking company may have. However, businesses such as those that trade in derivatives, volatile share funds or venture capital companies, need complex systems in place in order to monitor and manage risk.

1.6

Conformance and performance The International Federation of Accountants (IFAC) has highlighted two aspects of risk management which can be seen as linking in with risk aversion and risk seeking. (a)

Conformance focuses on controlling pure (only downside) strategic risks. It highlights compliance with laws and regulations, best practice governance codes, fiduciary responsibilities, accountability and the provision of assurance to stakeholders in general. It also includes ensuring the effectiveness of the risk analysis, management and reporting processes, and that the organisation is working effectively and efficiently to achieve its goals.

(b)

Performance focuses on taking advantage of opportunities to increase overall returns within a business. It includes policies and procedures that focus on alignment of opportunities and risks, strategy, value creation and resource utilisation, and guides an organisation's decision-making.

IFAC guidance states that risk management should seek to reconcile performance and conformance â&#x20AC;&#x201C; the two enhance each other. Case studies and surveys commissioned by IFAC have shown that many people believe that organisations focus too much on compliance, and not enough on strategy and building a business.

1.7 1.7.1

Sources of risk Strategic risks Definition

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Strategic risk: Potential volatility of profits caused by the nature and type of the business's activities. The most significant risks are focused on the strategy the organisation adopts, including concentration of resources, mergers and acquisitions and exit strategies. The market segments that the business chooses will be a significant influence. These will have major impacts on costs, prices, products and sales, and also the sources of finance used. Risks are likely to be greatest for those in start-up businesses or cyclical industries. However, perhaps the most notable victim of the credit crunch over the last few years, Lehman Brothers, was not immune to business risks, even after 158 years of operating. Organisations also need to guard against the risks that business processes and operations are not aligned to strategic goals, or are disrupted by events that are not generated by business activities. Strategic risks can usefully be divided into: 

Threats to profits, the magnitude of which depends on the decisions the organisation makes about the products and services it supplies



Threats to profits that are not influenced by the products or services the organisation supplies.

Risks to products and services include long-term product obsolescence. Changes in technology also have long-term impacts if they change the production process. The significance of these changes depends on how important technology is in the production processes. Long-term macroeconomic changes, for example a worsening of a country's exchange rate, are also a threat. Non-product threats include risks arising from the long-term sources of finance chosen and risks from a collapse in trade because of an adverse event, an accident or natural disaster.

1.7.2

Operational risks Definition Operational risk: The risk of loss through a failure of business and internal control processes. Operational risks include:       

Losses from internal control systems or audit inadequacies Non-compliance with regulations or internal procedures Information technology failures Human error Loss of key-person risk Fraud Business interruptions

The main difference between strategic and operational risks is that strategic risks relate to the organisation's longer-term place in, and relations with, the outside environment. Although some of them relate to internal functions, they are internal functions or aspects of internal functions that have a key bearing on the organisation's situation in relation to its environment. Operational risks are what could go wrong on a day-today basis, and are not generally very relevant to the key strategic decisions that affect a business, although some (for example, a major disaster) can have a major impact on the business's future. You may also think that as strategic risks relate primarily to the outside environment that is not under the organisation's control, it is more difficult to mitigate these risks than it is to deal with the risks that relate to the internal environment, which is under the organisation's control. Many risk categories include strategic and operational risks.

1.8 1.8.1

(a)

For example, the legal risk of breaching laws in day-to-day activities (for example, an organisation's drivers exceeding the speed limit) would be classed as an operational risk. However, the legal risk of stricter health and safety legislation forcing an organisation to make changes to its production processes would be classed as a strategic risk, as it is a long-term risk impacting seriously on the way the business produces its goods.

(b)

The same is true of information technology risks. The risks of a system failure, resulting in a loss of a day's data would clearly be an operational risk. However, the risks from using obsolete technology would be a strategic risk, as it would affect the organisation's ability to compete with its rivals.

Business risk and financial risk Business risk Business risk, as the name suggests, is the risk associated with the day-to-day operations of a particular

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company. It relates to the variability of operating cash flows, the company's exposure to markets, competitors, exchange rates and so on. It is part of the company's overall systematic (or undiversifiable) risk.

1.8.2

Financial risk Financial risk can be seen from different points of view:

1.8.3



The company as a whole. If a company borrows excessively, it may have insufficient funds to meet interest and capital repayments, which may eventually force it into liquidation.



Lenders. If a company to whom money has been lent goes into liquidation, lenders may not be paid in full. Companies considered to be a risky investment will be charged higher rates of interest to compensate lenders for the possibility of default.



Ordinary shareholders. This group is at the bottom of the list for payment in the event of a company winding up. The lower the profits, and the higher the level of gearing, the greater the risk that is faced by ordinary shareholders.

Relationship between business and financial risk Business risk is borne by both the firm's equity holders and providers of debt, as it is the risk associated with investing in the firm in whatever capacity. The only way that either party can get rid of the business risk is to withdraw its investment in the firm. Financial risk, on the other hand, is borne entirely by equity holders, payment to debt holders (ie interest) taking precedence over dividends to shareholders. The more debt there is in the firm's capital structure, the greater the financial risk to equity holders as the increased interest burden coming out of earnings reduces the likelihood that there will be sufficient funds remaining from which to pay a dividend. Debt holders know there is a legal obligation on the firm to meet their interest commitments.

1.9

Continuous v event risk Continuous risk as the name suggests, is risk that companies face all the time, simply by virtue of being in business. Multinationals, for example, face the continuous risk of foreign currencies moving in the wrong direction and the political risks of operating in different countries. These risks must be continuously monitored as part of the company's general risk management policy. Event risk is the risk of suffering excessive financial losses due to severe and sudden shocks arising from, for example, human error, natural disasters or stock market crashes. Event risks are difficult to predict but once these events have happened, there will be inevitable consequences, such as liquidity problems. Event risk is often characterised by contagion – that is, one event can precipitate other events whose effects spread across markets and end up affecting everyone. Companies can prepare for event risk by carrying out regular stress testing, which involves generating credible worst-case scenarios that show how particular events could affect all relevant markets. It is essential for companies to have crisis management processes in place, covering such crucial areas as communication and leadership.

1.10

Managing risk in business strategy and financial strategy Traditionally, management teams tend to be risk-averse – that is, they prefer less risk and are prepared to take steps to reduce any potential risks arising from either being in business in general or from specific projects that the company undertakes. The objective of risk management is ultimately to have procedures in place that will reduce these risks to a level that is acceptable to the company and its shareholders. However, setting up and maintaining these procedures takes time, money and human resources, all of which are limited within any organisation. Risk averse managers may be willing to accept exposure to greater risks, but only if the expected returns are higher and sufficient to justify the additional risk.

1.11

Corporate reporting consequences The risks businesses face and the judgements made about those risks, may have a number of consequences for financial reporting.



Under IAS 10, Events after the Reporting Period, a business's view of risks will help determine which events are disclosed. Thus, for example, if there are significant exchange rate movements that could result in a risk of material foreign exchange losses, these movements would need to be disclosed.



Part of risk assessment is an analysis of the external business environment, including economic, technological and legal aspects. Adverse changes that are identified may not only require risk

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management action to be taken, they may also provide evidence of loss of value of assets that needs to be accounted for under the provisions of IAS 36, Impairment of Assets. 

Risk assessment is significant in a number of ways when applying the requirements of IAS 37, Provisions, Contingent Liabilities and Contingent Assets. IAS 37 requires that a transfer of resources embodying economic benefits, needs to be assessed as probable, if a provision is to be made. In addition, if the amount of the transfer may be affected by future events, then these should influence how much provision is made, if they are reasonably expected to occur. Allowance is to be made for uncertainty when the amount of a provision is calculated, so that if there are a large number of possible outcomes, the provision is estimated based on its expected value, by weighting outcomes with associated probabilities. If risk assessments are revised subsequently, then the amount of the provision may need to be revised as well.

2 Enterprise risk management 2.1

Nature of enterprise risk management Definition Enterprise risk management (ERM) is a process, effected by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity and manage risks to be within its risk appetite, in order to provide reasonable assurance regarding the achievement of entity objectives. (Committee of Sponsoring Organisations of the Treadway Commission (COSO)) The Committee of Sponsoring Organisations of the Treadway Commission (COSO) goes on to expand its definition. It states that enterprise risk management has the following characteristics. (a)

It is a process, a means to an end, which should ideally be intertwined with existing operations and exist for fundamental business reasons.

(b)

It is operated by people at every level of the organisation and is not just paperwork. It provides a mechanism for helping people to understand risk, their responsibilities and levels of authority.

(c)

It is applied in strategy setting, with management considering the risks in alternative strategies.

(d)

It is applied across the enterprise. This means it takes into account activities at all levels of the organisation, from enterprise-level activities such as strategic planning and resource allocation, to business unit activities and business processes. It includes taking an entity level portfolio view of risk. Each unit manager assesses the risk for his unit. Senior management ultimately consider these unit risks and also interrelated risks. Ultimately, they will assess whether the overall risk portfolio is consistent with the organisation's risk appetite.

(e)

It is designed to identify events potentially affecting the entity and manage risk within its risk appetite, as well as the amount of risk it is prepared to accept in pursuit of value. The risk appetite should be aligned with the desired return from a strategy.

(f)

It provides reasonable assurance to an entity's management and board. Assurance can, at best, be reasonable, since risk relates to the uncertain future.

(g)

It is geared to the achievement of objectives in a number of categories, including supporting the organisation's mission, making effective and efficient use of the organisation's resources, ensuring reporting is reliable, and complying with applicable laws and regulations.

As these characteristics are broadly defined, they can be applied across different types of organisations, industries and sectors. Whatever the organisation, the framework focuses on achievement of objectives. An approach based on objectives contrasts with a procedural approach based on rules, codes or procedures. A procedural approach aims to eliminate or control risk by requiring conformity with the rules. However, a procedural approach cannot eliminate the possibility of risks arising because of poor management decisions, human error, fraud or unforeseen circumstances arising.

2.2

Framework of enterprise risk management The COSO Framework consists of eight interrelated components.   

Objective setting Event identification Risk assessment

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    

Risk response Internal environment or control environment Control activities or procedures Information and communication Monitoring

2.3

Benefits of enterprise risk management

2.4

Criticisms of enterprise risk management There have been some criticisms made of COSO's framework: (a)

Internal focus One criticism of the ERM model has been that it starts at the wrong place. It begins with the internal and not the external environment. Critics claim that it does not reflect sufficiently the impact of the competitive environment, regulation and external stakeholders on risk appetite and management and culture.

(b) Risk identification The ERM model has been criticised for discussing risks primarily in terms of events, particularly sudden events with major consequences. Critics claim that the guidance insufficiently emphasises slow changes that can give rise to important risks, for example, changes in internal culture or market sentiment. (c)

Risk assessment The ERM model has also been criticised for encouraging an over-simplified approach to risk assessment. It has been claimed that the ERM encourages an approach which thinks in terms of a single outcome of a risk materialising. This outcome could be an expected outcome or it could be a worst-case result. Many risks will have a range of possible outcomes if they materialise, for example, extreme weather, and risk assessment needs to consider this range.

(d) Stakeholders The guidance fails to discuss the influence of stakeholders, although many risks that organisations face are due to a conflict between the organisation's objectives and those of its stakeholders.

2.5

Risk architecture In its 1999 report, Enhancing Shareholder Wealth by Better Managing Business Risk, the International Federation of Accountants argued for the development of a risk architecture within which risk management processes could be developed. The architecture involves designing and implementing organisational structures, systems and processes to manage risk. This is a slightly different framework to that of enterprise risk management. IFAC argued that developing a risk architecture is not just a response to risk but marks an organisational shift, changing the way the organisation:    

Organises itself Assigns accountability Builds risk management as a core competency Implements continuous, real-time risk management

Best practice, IFAC argued, is to develop a highly integrated approach to risk management, using a common language, shared tools and techniques and periodic assessments of the risk profile for the entire organisation. Integration is particularly important when most units have many risks in common, and when there is significant interdependency between units. It is vital when managers are trying to achieve a shared corporate vision. The risk architecture developed by IFAC has eight components:

    

Acceptance of a risk management framework Commitment from executives Establishment of a risk response strategy Assignment of responsibility for risk management process Resourcing



Communication and training

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 

Reinforcing risk cultures through human resources mechanisms Monitoring of the risk management process

IFAC identified four components of risk management:    

2.6

Structure – To facilitate the identification and communication of risk Resources – Sufficient to support implementation Culture – Reinforcing decision-making processes Tools and techniques – Developed to enable organisation-wide management of risk

The Turnbull report The UK Turnbull report (published 1999, revised 2005) aims to provide guidance on risk management and control systems to supplement the broad outlines set out in the Combined Code (now the UK Corporate Governance Code). Turnbull emphasises the importance of the evolution of a system of internal control to take account of new and emerging risks, control failures, market expectations or changes in the company's circumstances or business objectives. Evolution requires regular and systematic assessment of the risks facing the business.

2.7

Risk resourcing Whatever the division of responsibilities for risk management, the organisation needs to think carefully about how risk management is resourced; sufficient resources will be required to implement and monitor risk management (including the resources required to obtain the necessary information). Consideration will be given not only to the expenditure required, but also the human resources in terms of skills and experience.

3 Risk management responsibilities 3.1

Board responsibilities As we saw in Chapter 6, if effective risk management is to be embedded within a company, the board must oversee its establishment. The Walker report in 2009 highlighted that the monitoring role of the board in financial sector institutions was particularly important because of the speed and scale of change in this sector: 'The whole board needs to be attentive to developments in the risk space to a degree far exceeding that in non-financial business.' Ownership of the risk management and internal control system is a vital part of the chief executive's overall responsibility for the company. The chief executive must consider, in particular, the risk and control environment, focusing amongst other things, on how his or her example promotes a good culture. The chief executive should also monitor other directors and senior staff, particularly those whose actions can put the company at significant risk. As well as explicit responsibilities, the board's role in 'setting the tone' and demonstrating clearly that the directors respect the need for effective control systems is a very important part of risk management. This includes respecting the need for separation of duties between managers carrying out executive duties, and non-executive directors and staff responsible for monitoring them.

3.1.1

Review of board's role Following on from the revisions to UK corporate guidance in 2010, the Financial Reporting Council undertook a review of how boards were approaching their responsibilities, with a view perhaps to revising the Turnbull guidance originally published in 1999. The consultation found that boards' focus on risk had changed significantly over the last decade and the approaches and techniques that they used were developing rapidly. The main points arising from the consultation included the following: 

Boards should aim for better risk taking, but this does not necessarily mean less risk taking, as risk taking is essential to entrepreneurship.



Different board committees are appropriate for different industries. The decision on appropriate committee structure should be left to individual boards, rather than making a risk committee compulsory for everyone. A risk committee is appropriate for companies in the financial sector. Separate committees are commonly used by companies in the pharmaceutical and extractive industries, which are exposed to significant safety, environmental or regulatory risks. Examples in these industries include compliance committees and corporate responsibility committees.

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3.2



Responsibility for monitoring internal controls and risk management could be delegated to board committees, but the whole board should retain strategic responsibility for risk decision-taking. Boards need to understand how risk exposure might change as a result of changes in strategy and the operating environment.



Boards need to focus on individual risks capable of undermining the strategy or long-term viability of the company or damaging its reputation. Reputation risk requires greater attention, partly because failures can be publicised widely and quickly in the global information environment. Boards need to have robust crisis management plans.



Boards should not just focus on net or residual risk, but also need to understand exposure to the combination of risks faced, before risk management policies are implemented.



It could be difficult to decide how much information about risks boards need, and in particular, when a particular risk should be brought to the board's attention.



Organisations need transparency and clear lines of reporting and accountability.



Investors are increasingly seeking more meaningful reporting on risk, for example, an integrated discussion of business model, strategy, key risks and mitigation. Investors also want to know how companies' exposure to risk is changing.

Risk committee Boards need to consider whether there should be a separate board committee, with responsibility for monitoring and supervising risk identification and management. If the board doesn't have a separate committee, under the UK Corporate Governance Code, the audit committee will be responsible for risk management. Consideration of risk certainly falls within the remit of the audit committee. However, there are a number of arguments in favour of having a separate risk committee. (a)

A risk management committee can be staffed by executive directors, whereas an audit committee under corporate governance best practice should be staffed by non-executive directors. However, if there are doubts about the competence and good faith of executive management, it will be more appropriate for the risk committee to be staffed by non-executive directors.

(b) As a key role of the audit committee will be to liaise with the external auditors, much of their time could be focused on financial risks. (c)

A risk committee can take the lead in driving changes in practice, whereas an audit committee will have a largely monitoring role, checking that a satisfactory risk management policy exists.

Having a separate risk committee can aid the board in its responsibility for ensuring that adequate risk management systems are in place. The application of risk management policies will then be the responsibility of operational managers, and perhaps specialist risk management personnel.

3.2.1

Risk committees in the financial sector The UK Walker report recommended that FTSE 100 bank or life insurance companies should establish a risk committee. Reasons for this recommendation included the need to avoid over-burdening the audit committee, to draw a distinction between the largely backward-looking focus of the audit committee and the forward-looking focus of determining risk appetite; and from this, monitoring appropriate limits on exposures and concentrations. The committee should have a majority of non-executive directors. Walker recommended that the committee should concentrate on the fundamental prudential risks for the institution: leverage, liquidity risk, interest rate and currency risk, credit/counterparty risks and other market risks. It should advise the board on current risk exposures and future risk strategy, and the establishment of a supportive risk culture. The committee should regularly review and approve the measures and methodology used to assess risk. A variety of measures should be used. The risk committee should also advise the remuneration committee on risk weightings to be applied to performance objectives incorporated within the incentive structure for executive directors.

3.3 3.3.1

Risk management personnel Risk specialists Most individuals have little time for looking after their personal safety and security, still less for searching the market for the most suitable insurances. They frequently employ agents to help manage some of their risks.

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A specialist advising on management of personal risks can work only as well as the client allows. A good specialist will ask for information and for co-operation with the expert surveys that enable him to provide a proper service. He will ensure that the client understands what safety measures are required and he will see that they are put into practice.

3.3.2

Risk manager The risk manager will need technical skills in credit, market, and operational risk. Leadership and persuasive skills are likely to be necessary to overcome resistance from those who believe that risk management is an attempt to stifle initiative. Lam (Enterprise Risk Management) includes a detailed description of this role, and the COSO framework also has a list of responsibilities. Combining these sources, we can say that the risk manager is typically responsible for: (a)

Providing the overall leadership, vision and direction for enterprise risk management.

(b)

Establishing an integrated risk management framework for all aspects of risk across the organisation, integrating enterprise risk management with other business planning and management activities, and framing authority and accountability for enterprise risk management in business units.

(c)

Promoting an enterprise risk management competence throughout the entity, including facilitating the development of technical enterprise risk management expertise, helping managers align risk responses with the entity's risk tolerances and developing appropriate controls.

(d)

Developing risk management policies, including the quantification of management's risk appetite through specific risk limits, defining roles and responsibilities, ensuring compliance with codes, regulations and statutes, and participating in setting goals for implementation.

(e)

Establishing a common risk management language that includes common measures around likelihood and impact, and common risk categories. Developing the analytical systems and data management capabilities to support the risk management programme.

(f)

Implementing a set of risk indicators and reports including losses and incidents, key risk exposures, and early warning indicators. Facilitating managers' development of reporting protocols, including quantitative and qualitative thresholds, and monitoring the reporting process.

(g)

Dealing with insurance companies: An important task because of increased premium costs, restrictions in the cover available (will the risks be excluded from cover?) and the need for negotiations with insurance companies if claims arise. If insurers require it, demonstrating that the organisation is taking steps to actively manage its risks. Arranging financing schemes such as selfinsurance or captive insurance.

(h)

Allocating economic capital to business activities based on risk, and optimising the company's risk portfolio through business activities and risk transfer strategies.

(i)

Reporting to the chief executive on progress and recommending action as needed. Communicating the company's risk profile to key stakeholders such as the board of directors, regulators, stock analysts, rating agencies and business partners.

The risk manager's contribution will be judged by how much the value of the organisation is increased. The specialist knowledge a risk manager has should allow the risk manager to assess long-term risk and hazard outcomes and therefore decide what resources should be allocated to combating risk. Clearly, certain strategic risks are likely to have the biggest impact on corporate value. Therefore, a risk manager's role may include management of these strategic risks. These may include those having a fundamental effect on future operations, such as mergers and acquisitions, or risks that have the potential to cause large adverse impacts, such as currency hedging and major investments. In financial institutions, the Walker report highlighted the assessment of whether product launches or the pricing of risk in a particular transaction was consistent with the risk tolerance determined by the risk committee. The Walker report stressed the need for provisions enhancing the independence of the chief risk manager, for example, rights of access to the chairman of the risk committee and removal from office to require the agreement of the whole board. Walker also highlighted the need for effective reporting. The risk committee's report should be a separate report in the annual accounts and include details of risk exposures and risk appetite for banking and trading exposures, and the effectiveness of the risk management process. Some detail should be given with regards of the stress-testing of risk.

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3.3.3

Risk management function Larger companies may have a bigger risk management function whose responsibilities are wider than a single risk manager or risk specialist. The Institute of Risk Management's Risk Management standard lists the main responsibilities of the risk management function:

3.3.4



Setting policy and strategy for risk management



Primary champion of risk management at a strategic and operational level



Building a risk aware culture within the organisation, including appropriate education



Establishing internal risk policy and structures for business units



Designing and reviewing processes for risk management



Co-ordinating the various functional activities which advise on risk management issues within an organisation



Developing risk response processes, including contingency and business continuity programmes



Preparing reports on risks for the board and stakeholders

Internal audit The assurance work carried out by internal audit will play a significant part in the organisation's risk management processes, internal audit being required to assess and advise on how risks are countered. Internal auditors will be concerned to see that managers have made adequate responses to risks, have designed robust risk management processes and that these mitigate the risks. This approach can be refined to focus on particular areas, for example start-ups and other future-oriented activities, where core controls have not developed and which thus carry higher risks. The starting point for a risk audit is to identify business objectives and the risks that may prevent the organisation from achieving those objectives. Internal audit's work will be influenced by the organisation's appetite for bearing risks. Internal audit will assess: 

The adequacy of the risk management and response processes for identifying, assessing, managing and reporting on risk



The risk management and control culture



The appropriateness of internal controls in operation to limit risks



The operation and effectiveness of the risk assessment and management processes, including the internal controls, with a focus on processes aimed at risks that are classified as key risks



The reliability of reporting on risks and controls

The areas that auditors will concentrate on will depend on the scope and priority of the assignment and the risks identified. Where the risk management framework is insufficient, auditors will have to rely on their own risk assessment and will focus on recommending an appropriate framework. Where a framework for risk management and control is embedded in operations, auditors will aim to use management's assessment of risks and concentrate on auditing the risk management processes. A key part of internal audit's role in control systems is to provide feedback that influences the design and operation of internal control systems. Internal audit recommendations need to be seen in the context of the organisation's strategic objectives and risk appetite.

3.4

Procedures for embedding risk Employees cannot be expected to avoid risks if they are not aware that they exist in the first place. Embedding a risk management frame of mind into an organisation's culture requires top-down communications on what the risk philosophy is and what is expected of the organisation's employees.

3.4.1

Human resource procedures The COSO framework also recommends certain organisational measures for spreading ownership of risk management.

(a)

Enterprise risk management should be an explicit or implicit part of everyone's job description.

(b)

Personnel should understand the need to resist pressure from superiors to participate in improper activities, and channels outside normal reporting lines should be available to permit

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reporting such circumstances. (c)

3.4.2

Managers should provide appropriate incentives. This may entail setting performance targets and tying results to performance pay.

Training Aside from practical matters like showing employees which buttons to press or how to find out the information they need, training should include explanations of why things should be done in the way that the trainer recommends. If employees are asked to carry out a new type of check but are not told why, there is every chance that they won't bother to do it, because they don't understand its relevance. Instead, it will just seems to mean more work for them and to slow up the process for everyone.

3.4.3

Risk policy statement Organisations ought to have a statement of risk policy and strategy that is distributed to all managers and staff.

3.5

Control systems The UK Turnbull report emphasises the importance of control systems in effectively managing risks. The report provides a helpful summary of the main purposes of an internal control system. Turnbull comments that internal control consists of 'the policies, processes, tasks, behaviours and other aspects of a company that taken together: (a)

Facilitate its effective and efficient operation by enabling it to respond appropriately to significant business, operational, financial, compliance and other risks to achieving the company's

objectives. This includes the safeguarding of assets from inappropriate use or from loss and fraud and ensuring that liabilities are identified and managed. (b)

Help ensure the quality of internal and external reporting. This requires the maintenance of proper records and processes that generate a flow of timely, relevant and reliable information from within and without the organisation.

(c)

Help ensure compliance with applicable laws and regulations, and also with internal policies with respect to the conduct of business.

The Turnbull report also summarises the key characteristics of the internal control systems. They should: ď&#x201A;ˇ

Be embedded in the operations of the company and form part of its culture

ď&#x201A;ˇ

Be capable of responding quickly to evolving risks within the business

ď&#x201A;ˇ

Include procedures for reporting immediately to management, significant control failings and weaknesses, together with control action being taken

The system should include control activities, information and communication processes and methods for monitoring the continued effectiveness of the system of internal control. The Turnbull report goes on to say that a sound system of internal control reduces, but does not eliminate, the possibilities of losses arising from poorly-judged decisions, human error, deliberate circumvention of controls, management override of controls and unforeseeable circumstances. Systems will provide reasonable (not absolute) assurance that the company will not be hindered in achieving its business objectives and in the orderly and legitimate conduct of its business, but won't provide certain protection against all possible problems.

4 Stakeholders and risk Stakeholders can influence objectives and strategies. This section focuses on the impacts that stakeholders can have on the strategies that businesses develop for managing their risks. Businesses have to be aware of stakeholder responses to risk. They may take actions, or events could occur, that may generate a response from stakeholders. This response could have an adverse effect on the business. To assess the importance of stakeholder responses to risk, the organisation needs to determine how much leverage its stakeholders have over it.

4.1

Shareholders Shareholders can affect the market price of shares by selling them. They also have the power to remove management. It would appear that the key issue for management to determine is whether shareholders: (a)

Prefer a steady income from dividends, in which case, they will be alert to threats to the profits that generate the dividend income such as investment in projects that are unlikely to yield profits in the short term.

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(b)

Are more concerned with long-term capital gains, in which case they may be less concerned about a short period of poor performance, and more worried about threats to long-term survival that could diminish or wipe out their investment

However, the position is complicated by the different risk tolerances of shareholders themselves. Some shareholders will, for the chances of a higher level of income, be prepared to bear greater risks that their investments will not achieve a that level of income. Therefore, some argue that because the shares of listed companies can be freely bought and sold on stock exchanges, if a company's risk profile changes, its existing shareholders will sell their shares, but the shares will be bought by new investors who prefer the company's new risk profile. The theory runs that it should not matter to the company who its investors are. However, this makes the assumption that the investments of all shareholders are actively managed and that shareholders seek to reduce their own risks by diversification. These are not necessarily true in practice. It is also unlikely that the directors will be indifferent to who the company's shareholders are. Shareholders' risk tolerance may depend on their views of the organisation's risk management systems, how effective they are and how effective they should be. Shareholder sensitivity to this will increase the pressures on management to ensure that a risk culture is embedded within the organisation.

4.2

Debt providers and creditors Debt providers are most concerned about threats to the amount the organisation owes. They can take various actions, with potentially serious consequences such as denial of credit, higher interest charges or ultimately, putting the company into liquidation. When an organisation is seeking credit or loan finance, it will obviously consider what action creditors will take if it does default. However, it also needs to consider the ways in which debt finance providers can limit the risks of default by, for example, requiring companies to meet certain financial criteria, provide security in the form of assets that can't be sold without the creditors' agreement, or personal guarantees from directors. These mechanisms may have a significant impact on the development of an organisation's risk strategy. There may be a conflict between strategies that are suitable from the viewpoint of the business's longterm strategic objectives, but are unacceptable to existing providers of finance because of threats to cash flows, or are not feasible because finance suppliers will not make finance available for them, or will do so only on terms that are unduly restrictive.

4.3

Employees Employees will be concerned about threats to their job prospects (money, promotion, benefits and satisfaction) and ultimately, threats to the jobs themselves. If the business fails, the impact on employees will be great. However, if the business performs poorly, the impact on employees may not be so great if their jobs are not threatened. Employees will also be concerned about threats to their personal wellbeing, particularly health and safety issues. The variety of actions employees can take include pursuit of their own goals rather than shareholder interests, industrial action, refusal to relocate or resignation. Risks of adverse reactions from employees will have to be managed in a variety of ways:

4.4

ď&#x201A;ˇ

Legislation requires that some risks, principally threats to the person, should be avoided

ď&#x201A;ˇ

Businesses can limit employee discontent by good pay, conditions etc

ď&#x201A;ˇ

Businesses can take out insurance against key employees leaving. However, they may decide to accept that some employees will be unhappy but believe the company will not suffer a significant loss if they leave

Customers and suppliers Suppliers can provide (possibly unwillingly) short-term finance. As well as being concerned with the possibility of not being paid, suppliers will be concerned about the risk of making unprofitable sales. Customers will be concerned with threats to their getting the goods or services that they have been promised, or not getting the value from the goods or services that they expect. Suppliers can respond to risk of non-payment by refusing credit. Customers can shop elsewhere. The impact of customer-supplier attitudes will also depend on how much the organisation wants to build long-term relationships with them. A desire to build relationships implies involvement of the staff that are responsible for building those relationships in the risk management process. It also may imply a greater degree of disclosure about risks that may arise to these long-term partners in order to maintain the relationship of trust.

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4.5

The wider community Governments, regulatory and other bodies will be particularly concerned with risks where the organisation does not act as a good corporate citizen, implementing, for example, poor employment or environmental policies. A number of the resulting actions that might be taken could have serious consequences. Government can impose tax increases or regulation or take legal action. Pressure group tactics can include publicity, direct action, political sabotage or campaigning. Although the consequences can be serious, the risks that the wider community are concerned about are rather less easy to predict than for other stakeholders, being governed by varying political pressures. This emphasises the need for careful monitoring of changing attitudes and likely external responses to the organisation's actions as part of the risk management process.

5 Risk assessment 5.1

The risk management process A commonly used framework for assessing and managing risk involves the following processes.       

Establishing the context Risk identification Risk assessment Risk quantification Risk profiling Risk consolidation Risk responses

In real life, none of these processes are easy – what is considered to be a risk by some might not be seen as such by others, which can lead to disputes over which risks should be given priority. Quantification of an item that is essentially subjective is never going to be straightforward – in itself, putting a value on different risks is a subjective process. Having devised responses to risk (making decisions about how risks should be managed), the risk management plan should be implemented. Once implemented, there should be regular monitoring of the risk management system to check that it is working effectively, as planned.

5.2

Risk register Organisations should have formal methods of collecting information on risk and response. A risk register lists and prioritises the main risks an organisation faces, and is used as the basis for decision-making on how to deal with risks. It acts as a basic component of the risk and control assessment process in order to record identified risks. The existence of a risk register illustrates that risks have been identified and to what activities they relate. The risk register will typically include the following:       

Description of the risk When the risk might occur The impact, assuming that the risk does occur An assessment of the risk's likelihood or probability of occurrence A priority rating or score, obtained from the impact and probability assessment The management's strategy as to how the risk will be addressed The containment strategy, defining what exactly will happen if the risk occurs

In compiling the risk register, the firm must describe the risk in a clear manner so that everyone in the firm who needs to be aware of the risk, understands it and not just the person who is most directly involved in its management. A risk register would take an individual event and state what the loss of value might be, should the risk occur and then will apply an impact assessment to it.

5.3

Establishing the context Before any risk can actually be identified, the context within which that risk will be assessed must be established. For example, management may only be interested in identifying financial risks, which means that those responsible for gathering information will concentrate on that area of risk only.

5.3.1

Establishing the internal context Risk is essentially the chance that an event will occur which will prevent the company from meeting its

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objectives. Therefore, in order to understand the risks, you must first identify the objectives. By doing so you will ensure that decisions taken to reduce risk still support the overall goals of the organisation, thus encouraging long-term and strategic thinking. When trying to establish the internal context, business owners should also consider such issues as: ď&#x201A;ˇ ď&#x201A;ˇ

5.3.2

Internal culture. Are staff likely to be resistant to change? Existing business capabilities, such as people, equipment and processes.

Establishing the external context The external context is the overall environment in which the business operates, including an understanding of the perceptions that clients or customers have of the business. This could take the form of a SWOT analysis. It should also cover such issues as external regulations that the business must comply with.

5.3.3

Establishing the risk management context In order to correctly identify risks associated with a project, you must first define the project's limits, objectives and scope.

5.3.4

Developing risk criteria This step allows the business to identify unacceptable levels of risk, or, looking at it another way, to define acceptable levels of risk for a specific project. These risk levels can be more closely defined as the process progresses. In the case study above, for example, it would be completely unacceptable for the confidentiality and security of the examination papers to be compromised, so this documentation must therefore be kept in locked safes and transported using professional safe movers.

5.3.5

Defining the structure for risk analysis The final stage in the establishment of context is to define the structure for risk analysis. This involves isolating the risk categories that need to be managed, which can then be assessed individually. This will allow for greater depth and accuracy when identifying important risks.

5.4

Risk identification No-one can manage a risk without first being aware that it exists. Some knowledge of perils, what items they can affect and how, is helpful to improve awareness of whether familiar risks (potential sources and causes of loss) are present, and the extent to which they could harm a particular person or organisation. The risk manager should also keep an eye open for unfamiliar risks which may be present. Actively identifying the risks before they crystallise makes it easier to think of methods that can be used to manage them. Risk identification is a continuous process, so that new risks and changes affecting existing risks may be identified quickly and dealt with appropriately, before they can cause unacceptable losses.

5.4.1

Risk conditions Means of identifying conditions leading to risks (potential sources of loss) include:

5.4.2

(a)

Physical inspection, which will show up risks such as poor housekeeping (for example, rubbish left on floors, for people to slip on and to sustain fires)

(b)

Enquiries, from which the frequency and extent of product quality controls and checks on new employees' references, for example, can be ascertained

(c)

Checking a copy of every letter and memo issued in the organisation for early indications of major changes and new projects

(d)

Brainstorming with representatives of different departments

(e)

Checklists ensuring risk areas are not missed

(f)

Benchmarking against other sections within the organisation or external experiences

Event identification A key aspect of risk identification, emphasised by the Committee of Sponsoring Organisations of the Treadway Commission's report, Enterprise Risk Management Framework, is identification of events that could impact upon implementation of strategy or achievement of objectives.

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Events analysis includes identification of: (a)

External events such as economic changes, political developments or technological advances

(b)

Internal events such as equipment problems, human error or difficulties with products

(c)

Leading event indicators. By monitoring data correlated to events, organisations identify the existence of conditions that could give rise to an event, for example, customers who have balances outstanding beyond a certain length of time being very likely to default on those balances

(d)

Trends and root causes. Once these have been identified, management may find that assessment and treatment of causes is a more effective solution than acting on individual events once they occur

(e)

Escalation triggers, certain events happening or levels being reached that require immediate action

(f)

Event interdependencies, identifying how one event can trigger another and how events can occur concurrently. For example, a decision to defer investment in an improved distribution system might mean that downtime increases, and operating costs go up

Once events have been identified, they can be classified horizontally across the whole organisation and vertically within operating units. By doing this, management can gain a better understanding of the interrelationships between events, gaining enhanced information as a basis for risk assessment.

5.4.3

Key risk indicators COSO provides guidance on key risk indicators (KRIs), metrics that some organisations use to provide an early signal of increasing risk exposure. At their simplest, they can be key ratios that management uses as indications of evolving problems requiring actions. Sometimes they may be more elaborate, involving the aggregation of several risk indicators. The COSO guidance comments that KRIs are derived from specific events or root causes that can prevent performance goals from being achieved. Examples include the introduction of a new product by a competitor, a strike at a supplier's plant, proposed changes in the regulatory environment or input- price changes. The guidance points out that effective KRIs should be developed by risk managers and business unit managers working together. They should be developed in concert with strategic plans. Determining the frequency of reporting of KRIs will be important – operational management may need to see them in realtime; senior management on a less frequent, aggregated basis. The guidance highlights the following elements of well-designed KRIs:      

5.5

Based on established practices or benchmarks Developed consistently across the organisation Provide an unambiguous and intuitive view of the highlighted risk Allow for measurable comparisons across time and business units Provide opportunities to assess the performance of risk owners on a timely basis Consume resources effectively

Risk assessment It is not always simple to forecast the financial effect of a possible disaster, as it is not until after a loss that extra expenses, inconveniences and loss of time can be recognised. Even then, it can be difficult to identify all of them. Organisations will probably keep more detailed records of their activities and the unit costs involved, but it is unlikely that any organisation can predict the full cost of every loss that might befall it with certainty.

5.6

Risk quantification Risks that require more analysis can be quantified, where possible results or losses and probabilities are calculated and distributions or confidence limits added on. From this exercise is derived the following key data to which the organisation could be exposed by a particular risk:    

Average or expected result or loss Frequency of losses Chances of losses Largest predictable loss

The risk manager must also be able to estimate the effects of each possible cause of loss, as some of the effects that he needs to consider may not be insured against.

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The likely frequency of losses from any particular cause can be predicted with some degree of confidence, from studying available records. This confidence margin can be improved by including the likely effects of changed circumstances in the calculation, once they are identified and quantified. Risk managers must therefore be aware of the possibility of the increase of an existing risk, or the introduction of a new risk, affecting the probability and/or possible frequency of losses from another cause. Often, quantification of losses will not involve statistical techniques, but a simple single estimate of what would be lost if adverse events or circumstances occur. For example, if an accountancy firm had a client that generated a fixed fee each year, the loss would be their contribution (fees lost less labour and other variable costs saved). Ultimately, the risk manager will need to know the frequency and magnitude of losses that could place the organisation in serious difficulty.

5.6.1

Exposure of physical assets Exposures with physical assets may include:

5.6.2



Total value of the assets, for example, the value of items stolen from a safe



Costs of repair, if for example, an accident occurs



Change of value of an asset, for example, property depreciating in value because of a new airport development nearby



Decrease in revenues, for example, loss of rent through a rental property being unlettable for a period



Costs of unused capacity, costs incurred by spare capacity that is taken as a precaution but does not end up being used

Exposure of financial assets Whilst the risk of trading shares and most forms of debt might be that their values fall to zero, this is not necessarily true of futures (where losses could be unlimited) and options (whose losses are limited to the option premium). In addition, anyone who is exposed to loss as a result of price rises is, in theory, exposed to the risk of infinite loss, since prices could rise indefinitely.

5.6.3

Exposure of human assets The most severe risk to employees is the risk of death or serious injury. The loss to the employee's family, for which the organisation may be liable, could be the future value of their expected income stream, mitigated by any benefits available but enhanced by other losses that arise as a result of death, for example, loss of any available tax allowance. Alternatively, it could be measured by the expenditure required to fulfil the needs of the deceased's dependent family. For less serious injuries, the costs of medical care may be the relevant figure. Certain individuals may make a significant contribution to the office because of their knowledge, skills or business contacts. One measure of this loss will be the present value of the individual's contribution (attributable earnings less remuneration). Indirect costs may include the effect on other staff of the loss of the key person (decreased productivity or indeed, the costs of their own departure). If a director, partner or senior employee dies or departs, there may be costs of having to cope with the disruption, perhaps even including the costs of dissolution, if local law requires termination of a partnership on the departure of a single partner.

5.7

Risk profiling This stage involves using the results of a risk assessment to group risks into risk families. One way of doing this is a likelihood/consequences matrix. This profile can then be used to set priorities for risk mitigation.

5.8

Risk consolidation Risk that has been analysed or quantified at the division or subsidiary level, needs to be aggregated at the corporate level and grouped into categories. This aggregation will be required as part of the overall review of risk that the board needs to undertake. The process of risk categorisation also enables the risks categorised together to be managed by the use of common control systems.

6 Risk response Once risks have been identified, assessed and quantified, decisions must be taken as to how to respond to these risks. Methods of dealing with risk include avoidance, reduction, acceptance (retention) and transfer. 16

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Risk response can be linked into the likelihood/consequences matrix and also the organisation's appetite for risk-taking.

6.1

Avoidance of risk Organisations will often consider whether risk can be avoided and if so, whether avoidance is desirable – that is, will the possible savings from losses avoided be greater than the advantages that can be gained by not taking any measures and running the risk? An extreme form of avoiding business risk is terminating operations altogether – for example, operations in politically volatile countries where the risks of loss (including loss of life) are considered to be too great; or the costs of security, too high.

6.2

Reduction of risk Often, risks can be avoided in part, or reduced, but not avoided altogether. This is true of many business risks, where the risks of launching a new product can be reduced by market research, advertising and so on. Other risk reduction measures include contingency planning, loss control, internal control and, in the case of some financial risks, hedging.

6.2.1

Contingency planning Contingency planning involves identifying the post-loss needs of the business, drawing up plans in advance and reviewing them regularly to take account of changes in the business. The process has three basic constituents.

6.2.2

Loss control Control of losses also requires careful advance planning. There are two main aspects to good loss control: the physical and the psychological.

6.2.3



There are many physical devices that can be installed to minimise losses when harmful events actually occur. Sprinklers, fire extinguishers, escape stairways, burglar alarms and machine guards are obvious examples. It is not enough, however, to install such devices. They will need to be inspected and maintained regularly.



The key psychological factors are awareness and commitment. Every person in the business should be made aware that losses are possible and that they can be controlled.

Internal controls Operational risks, financial reporting risks and compliance risks are reduced through internal control systems and internal controls. The purpose of controls is to:   

Reduce the risks of failure to achieve organisational goals or targets (preventive controls) Identify variations between actual performance and target (detective controls), and/or Take corrective action when actual performance varies adversely from target (corrective controls).

A firm of accountants may be engaged to give advice on the adequacy of controls within a business plan, or to carry out a review of the adequacy and effectiveness of existing controls. An assurance engagement to assess the effectiveness of controls or a control system involves: 

Establishing the purpose and nature of the control system and of the controls within the system



Assessing the effectiveness of the design of the controls, and whether the controls as designed are sufficient for achieving the stated objectives of the control system



Assessing whether the controls, if suitably designed, are implemented effectively, or whether there appear to be failures in the operation of the controls.

By assessing the effectiveness of the design and application of controls, assurance engagements should help to manage risks by reducing the likelihood or the impact of adverse risk events. The work of internal auditors, and the review of internal control as part of an external audit, are examples of assurance procedures relating to risk and risk management.

6.3

Accepting risks Risk acceptance or retention is where the organisation bears the risk itself, and if an unfavourable outcome occurs, it will suffer the full loss. Risk retention is inevitable to some extent. However good the organisation's risk identification and assessment processes are, there will always be some unexpected

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risk. Other reasons for risk retention are that the risk is considered to be insignificant, or the cost of avoiding the risk is considered to be too great compared with the potential loss that could be incurred. The decision of whether to retain or transfer risks depends firstly on whether there is anyone to transfer a risk to. The answer is more likely to be 'no' for an individual than for an organisation, because: 

Individuals have more small risks than do organisations, and the administrative costs of transferring and carrying them can make the exercise impractical for the insurer; and



The individual has smaller resources to find a carrier.

In the last resort, organisations usually have customers to pass their risks or losses onto, up to a point; whilst individuals do not.

6.4

Transfer of risk Alternatively, risks can be transferred – to other internal departments or externally to suppliers, customers or insurers. Risk transfer can even be to the state. Decisions to transfer risk should not be made without careful checking to ensure that as many influencing factors as possible have been included in the assessment. A decision not to rectify the design of a product, because rectification could be as expensive as paying any claims from disgruntled customers, is, in fact, a decision to transfer the risk to the customers without their knowledge: it may not take into account the possibility of courts awarding exemplary damages to someone injured by the product, to discourage people from taking similar decisions in the future. Internal risk transfer can also cause problems if it is away from departments with more 'clout' (for example, sales) and towards departments, such as finance, that may be presumed to downplay risks excessively.

6.4.1

Legal and other restrictions on transferring risks The first restriction is that a supplier or customer may refuse to enter a contract unless the organisation agrees to take a particular risk. This depends on the trading relationship between the firms concerned, and not a little on economics: how many suppliers could supply the item or service in question, for example, and how great is the need for the item?

6.4.2

Risk sharing Risks can be partly held and partly transferred to someone else. An example is an insurance policy, where the insurer pays any losses incurred by the policyholder above a certain amount. Risk sharing arrangements can be very significant in business strategy. For example, in a joint venture arrangement, each participant's risk can be limited to what it is prepared to bear.

6.5

Risk pooling and diversification Risk pooling and diversification involves using portfolio theory to manage risks. You may remember that portfolio theory is an important part of an organisation's financial strategy, but its principles can be applied to non-financial risks as well. Risk pooling or diversification involves creating a portfolio of different risks based on a number of events, some of which may turn out well while others will turn out badly, the average outcome of which will be neutral. What an organisation has to do is to avoid having all its risks positively correlated, meaning that everything will either turn out extremely well or extremely badly. One means of diversification may be geographical – spreading risk across countries at different stages of the trade cycle. In addition, although diversification may sound good in theory, the company may have insufficient expertise in the product or geographical markets into which it diversifies leaving it vulnerable to competition from other companies that focus on a specific market or product type.

6.6

Implementation of risk management plans Implementation of the risk management process help to clarify what ongoing actions should be taken beyond the planning stage to ensure that the system is implemented in a manner that is beneficial to the management team. The implementation process helps to ensure that you get the best risk protection for the amount invested in the risk and other management processes. The implementation process focuses on the process itself rather than the risks of a particular project. This step should be ongoing, focusing on the performance of the risk management process and the way

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in which it is integrated with other processes relevant to the project in question. Organisations need to treat the implementation stage as a separate project with clear objectives and success criteria, clear planning, proper resourcing and effective monitoring and control.

6.7

Monitoring of risk management plans All risk management plans must be monitored to ensure that they are achieving the desired results and that changes to the project's risk profile are reflected. To assess the effectiveness of risk management plans, standards and benchmarks must be established against which results should be measured. Standards can come from such sources as industry regulations or the industry leader. Once the standards and benchmarks have been established, the risk management plan can be measured continually against them over time to allow actual performance to be compared with expected performance, which in turn can be used to adjust below-standard results. In order to determine when adjustments to performance should take place, a business needs to establish a threshold (or 'trigger point') which represents a sufficient change in risk exposure to warrant another risk analysis being carried out. Risk management is a continuous process and those responsible for handling risk should be prepared to treat it as such. As with any process, evaluation of risk management plans is essential to ensure they are performing to expectations. Managers and stakeholders in the risk management process should consider such areas as:   

How successful was the plan and were the benefits and costs at the predicted level? In the light of the above, are any changes needed to improve the plan? Would the plan have benefited from the availability of additional information?

Risk monitoring is similar to an audit of the risk management process. Various tests will be carried out to determine whether individual controls are working properly and recommendations made in the light of results. However, unlike auditing, risk management monitoring does not take place only on an annual basis. Risk monitoring is a continuous process. However, as we shall see in Chapter 19, the systems and controls that GSK had in place failed to prevent a police investigation into corrupt activities by some of its Chinese executives.

6.8

Board monitoring of control systems As well as monitoring specific plans, the board needs to review the effectiveness of systems taken as a whole. The UK Turnbull report suggests that boards should regularly receive and review reports and information on internal control, concentrating on: 

What the risks are and strategies for identifying, evaluating and managing them



The effectiveness of the management and internal control systems in the management of risk, in particular how risks are monitored and how any weaknesses have been dealt with



Whether actions are being taken to reduce the risks found



Whether the results indicate that internal control should be monitored more extensively

In addition, when directors are considering annually the disclosures they are required to make about internal controls, Turnbull states they should conduct an annual review of internal control. This should be wider-ranging than the regular review; in particular it should cover: 

The changes since the last assessment in risks faced, and the company's ability to respond to changes in its business environment



The scope and quality of management's monitoring of risk and internal control, and of the work of internal audit, or consideration of the need for an internal audit function if the company does not have one



The extent and frequency of reports to the board



Significant controls, failings and weaknesses which have, or might have, material impacts upon the accounts



The effectiveness of the public reporting processes

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6.9

Reporting on risk management The UK Turnbull Report laid down the minimum expected guidelines for disclosure on risk management and corporate governance. The report was intended to encourage best practices, and stated that publicly traded companies should report on the risks they faced and outline these risks in more detail. The Turnbull Report requires the following disclosures.

6.10



The governing body of the company (generally the board of directors) should acknowledge responsibility for internal control systems



An ongoing system should be in place for identifying, evaluating and managing significant risks



An annual process should be in place for reviewing the effectiveness of the internal control systems



There should be a process to deal with the internal control aspects of any significant problems disclosed in the annual report and accounts

Limitations of risk management plans As with all business processes, regardless of their quality, risk management plans have their limitations. They are only as good as the information that is used to construct them. If risks are not assessed properly, then a great deal of time and resources could be wasted in dealing with the risk of losses that, in fact, are highly unlikely to occur – time and resources that could have been more gainfully employed elsewhere. Some organisations over-estimate what risk management processes should be able to achieve, to the extent that work is suspended until the risk management process is considered to be complete. At the other extreme, there are organisations who believe themselves to be immune from losses resulting from business risk, simply because they have risk management processes in place. Complacency is one of the worst enemies of successful businesses. As mentioned above, risk management processes must be continually monitored for any weaknesses – just like the business environment itself, they are not static instruments. Such is the focus on risk and its consequences in today's business that there is a danger of management spending so long thinking about the negative aspects of projects that they forget about the positive aspects.

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Strategic Business Management Chapter- 8

Data analysis 1 Data and analysis The word 'data' has several meanings. It is commonly associated with input to a computer, or 'raw data' which is processed to obtain meaningful information. For the purpose of this chapter, a useful definition of data is: 'Facts from which other information may be inferred'. Professional accountants are often presented with reports and statements, from which they are expected to identify issues and draw conclusions. In other words, they have to analyse the data and consider its implications. Reports and statements vary in nature. They may be internally-produced business reports or financial reports, as well as published financial statements: (a)

Internally-produced business reports may cover internal operational issues, such as: – –

Performance reports, or External issues relating to markets and competition, or the business environment generally

Internal reports may be produced by any department section or unit of the business and may contain historical data or forward-looking forecasts and plans. (b)

Internally-produced financial reports may be management accounting reports, particularly performance reports on costs and profitability. The nature of management accounting reports varies with the type of business and the type of cost and management accounting system in use.

Data may also be provided in externally produced reports, such as reports by consultancy firms, government departments or international bodies.

1.1

Requirements for data analysis The Strategic Business Management examination expects you to be able to do the following: (a)

Study data on any business-related or finance-related topic, from internal or external sources.

(b)

Consider the implications of what the data appears to show, make inferences and draw tentative conclusions.

(c)

Consider the reliability of the data, and therefore your confidence in the conclusions you have drawn.

(d)

Where appropriate, recommend how additional data may be obtained to test the validity of your conclusions: where information may not be conclusive, the challenge is to identify what more you need to know and how to set about finding it.

This chapter does not set out to provide more technical content and knowledge. Instead, it suggests methods of approaching data analysis and using the technical knowledge that you already have. The skills required for data analysis may be summarised as follows: 

Choosing analytical tools that are appropriate in the context of the question, eg financial ratios, KPIs, break-even calculations



Carrying out the relevant calculations



Interpreting the resulting information to demonstrate an understanding of the story behind the numbers and communicating that analysis succinctly



Analysing the wider consequences and implications of the numerical data, for example, a fall in production costs, perhaps harming product quality



Exercising judgement to draw conclusions and/or produce sensible recommendations



Looking beyond the information provided at what additional information may be useful to generate a better analysis/understanding and at any reservations regarding the

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data/techniques/assumptions applied

1.2



Linking different pieces of data to explain trends or outcomes



Highlighting weaknesses or omissions in the data provided



Discussing cause and effect relationships – eg identifying underlying causes of changes in the data

Characteristics of data A useful starting point is an appreciation of the characteristics or qualities of data. Information should be reliable; but data often lacks reliability, for any of the following reasons. (a)

Incomplete. Data is often incomplete, in the sense that it does not tell the user everything that he or she needs to know. Incomplete information is a source of evidence, but not enough for the evidence to be conclusive. The user should want to learn more before reaching a conclusion. Incompleteness of data can be a particular problem with external reports, whose purpose may be only indirectly related to the interests and concerns of the report user.

(b)

Lacks neutrality. Information may lack neutrality. A report may contain opinions and recommendations that reflect the opinions and bias of the report writer. Professional scepticism may need to be applied in interpreting such data or placing reliance upon it.

(c)

Inaccurate. The data in a report or statement may be inaccurate, or the user of the report or statement may suspect that it is inaccurate. Alternatively, data may be insufficiently accurate for the requirements of the user. Without confidence in the accuracy of data, the user cannot make reliable conclusions.

(d)

Unclear. Information may lack clarity, especially when it comes from an external source. Lack of clarity may be due to: –

Poor expression of ideas in an external report by the report author, or lack of clarity about the assumptions on which information in the report is based

–

Deliberate lack of transparency by the information provider. An example of this might be press releases by a competitor organisation, whose statements about a particular item of news may be deliberately obscure without being untruthful

(e)

Historical. Historical data may be used to make forecasts or conclusions about the future. However, any historical-based prediction is inevitably based on the assumption that what has happened in the past is a valid guide to what will happen in the future. This may not be the case.

(f)

Not up to date. When events in the business environment are changing rapidly, information may get out of date very quickly. There is a risk that any data in a report or statement is no longer accurate because it is no longer up to date.

(g)

Not verifiable. Some data or information may not be verifiable. Management may want corroboration of a fact or allegation, but there may not be an alternative source for checking its accuracy. This is often the case in employment disputes at work: two individuals may contest claims made by the other, and there may be no way of checking whose allegations are correct.

(h)

Source. Information may come from a source that is not entirely reliable. This may be a particular problem with secondary data from external sources.

Accountants must use the data that is available to them, even though it is not 100% reliable. They may have to qualify their opinions or judgements according to their view about how much reliance they can place on it. A major problem is often incompleteness. Data may lack relevance as well as reliability. (a)

There may be a risk of drawing unjustified conclusions from available data, and interpreting data in ways that the facts do not properly justify. The data user may imagine that that there is evidence to justify a conclusion, when the evidence from the data is not at all conclusive.

(b)

With financial data, there may be a risk of using financial statements prepared under the accruals concept to make conclusions when cash flows and incremental costs should be used.

An accountant may want to use data to make comparisons, such as comparing the performance of different companies or different segments of a business. Unfortunately, data may not be properly comparable. For example, comparing sets of data about the performance of two rival companies may not be entirely reliable because the available data for the two companies: 582

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  

1.3

Has been collected in different ways, or Is based on different assumptions, or Is presented differently, under different headings

Making judgements about the quality of data If the information is not entirely reliable, you may have to make a judgement on the degree to which it may be trusted. It is not sufficient to decide that information is either 'reliable' or 'unreliable': there are degrees of reliability between the two ends of the scale. Having made a judgement about the reliability of data, the accountant must:  

Reach a conclusion, but possibly with some reservations, or Consider what additional information can be obtained before making a firm conclusion

This last point about consistent methodology is crucial for ensuring the comparability of the figures from one period to the next. If the basis for calculating the KPIs changes over time, then any apparent trends in the figures could be a reflection of the changes in the methodology, rather than trends in underlying performance.

1.4

Other aspects of data analysis It has already been suggested that an important aspect of data analysis is an understanding of the limitations of the data or information available for analysis. Other issues may also be relevant for consideration. (a)

Materiality and priorities When analysing data, it may be necessary to keep a sense of perspective. Some issues may be relatively insignificant and so immaterial for the purpose of analysis. When a report or statement raises several different issues, you may need to identify which is the most important, and prioritise them.

(b) Uncertainty When available data consists of numerical estimates, you should question the accuracy and reliability of the estimates. It may be possible to undertake some sensitivity analysis, such as considering a 'worst possible' scenario or a 'best possible' scenario, and commenting on these, as well as the 'most likely' scenario (based on the estimates provided).

1.5

Data and assurance In Section 1.3, we noted that accountants may need to make judgements about the quality or reliability of data. In essence, data only becomes valuable to an entity when it is converted into actionable information – which can be used to drive revenue goals, increase cost efficiencies, or inform business decisions more generally. However, before entities convert data into information they need to be confident in the data and the processes which produce it. Assurance reporting can be used to help provide this confidence. An independent professional accountant, with relevance experience, applying the highest standards to examine data, processes or information, and expressing an assurance conclusion on them, can provide a strong signal of reliability. We look at assurance in more detail in Section 6 of this Chapter, but the following extract from the ICAEW Assurance Sourcebook – A Guide to Assurance Services provides a useful overview summary: ‘Owners, management, investors, government, regulators and other stakeholders need to rely on the successful conduct of business activities, sound internal processes and the production of credible information. These operational and reporting processes enable users to make decisions and develop policies. Confidence diminishes when there are uncertainties around the integrity of information or of underlying operational processes.’ There could be a range of potential subject matters over which different stakeholders might require assurance, but they can be summarised into three broad categories: (a)

Data – extracted or calculated volumes, values or other items

(b)

Processes and controls – a series of organised activities designed to meet defined objectives

(c)

Reporting – all, or part, of a written report which may contain a combination of data, design of processes and narrative, including any assertions the reporting organisation has made.

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2 Strategic, financial and operational data You may be required to analyse information in a report or statement, and state opinions or reach judgements on the basis of what the report or statement contains. A suitable approach depends on the nature of the report or statement. These may conveniently be classified into three types: (a) (b) (c)

Strategic level reports Financial reports Operational reports

These classifications are useful for considering an approach to analysis, but it is possible to have strategic level financial reports and financial reports on operational aspects of a business.

2.1

Strategic level reports Strategic level reports contain information that is used to make strategic judgements or to guide strategic thinking by senior management. Some strategic reports are produced internally, but many are reports produced externally, which may have some relevance for an organisation's strategic thinking and choice of strategies. Examples of strategic reports are: (a)

A report produced by an independent research organisation or consultancy firm on the state of a particular industry and the future challenges facing that industry

(b)

A government report on the national economy and on monetary and fiscal policies for management of the economy

(c)

A report from an international organisation such as the World Trade Organisation on the current state of international trade

(d)

A general report on the business and financial markets infrastructure in a particular country or region

(e)

A market research report from an independent research agency into conditions in a particular product-market area

These are examples, but there are other types of report that may contain information of strategic relevance and interest. What they have in common is that the information within the report can be used to formulate strategic thinking within an organisation.

2.2

Financial reports Financial reports can have either strategic or operational value.

2.3

(a)

Published reports and accounts of rival quoted companies can provide useful insights into competitor organisations â&#x20AC;&#x201C; their strategies, revenues, profitability. Comparisons of a business with a rival company may suggest areas of difference where one company or the other appears to have a competitive advantage or enjoys superior performance.

(b)

A company should not have to rely on its own published financial statements for relevant information. More detailed financial reports should be produced internally for management. These may be strategic reports, linked to aspects of strategy but financial in nature. Most organisations have regular reports relating to annual budgets and monthly or quarterly budgetary control reports. Other financial reports may be operational in nature, such as reports on product costs and profitability, segmental profitability reports or customer profitability analysis.

Operational reports Accountants may produce or may be required to analyse a range of operational reports. Accountants may produce non-financial reports as well as financial reports, or reports that mix financial and non- financial data. In your examination, you may be required to analyse the information in an internally- produced performance report, which may have implications for the efficiency or effectiveness of operations.

2.4

An approach to analysing data in reports A basic approach to analysis should be the same for each type of report:

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(a)

Assess the information in the report or statement.

(b)

Identify the issues that it raises.

(c)

Consider the implications.

(d)

Consider the reliability of the data and whether it is sufficient to make conclusions with confidence.

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(e)

Consider the additional information that should be obtained before reaching a conclusion or making a recommendation.

(f)

When reaching conclusions or making recommendations, qualify your views by recognising the limitations of the data on which your views are based.

The approach to analysing data should differ to some extent according to the nature of the report or statement: strategic, financial or operational. This is because the issues that it raises may be strategic, financial or operational in nature.

3 Strategic data analysis Strategic decision-making is concerned with the formulation and review of strategies for achieving the objectives of the organisation. In a rational approach to planning, strategies are developed after analysing the external business environment and the internal resources and competences of the organisation. If you are required to analyse a strategic level report, you may be expected to identify any of the issues relating to environmental change, the state of the industry, competitiveness, resources and competences.

3.1

Risk analysis Strategic data analysis typically involves analysis of strategic risk. Risk may be described as the risk to an organisation from developments in the broad business environment, the industry in which the organisation operates or the competitive environment, such as the risk from strategic initiatives by major competitors. Where a report indicates the existence of a risk, you may be required to consider the:   

3.2

Scale or significance of the risk Need for urgent action to address the risk, or Potential implications of doing nothing about it

Internal analysis: strengths and weaknesses Although strategic data analysis may focus mainly on external analysis of the environment, industry and competition, internal analysis of resource strengths and weaknesses may also be relevant. Data may indicate strengths or weaknesses in the resources and competences of an organisation, which can give them a competitive advantage over rival organisations, or expose them to serious competitive disadvantage. Strengths and weaknesses could exist in any key resource, such as:     

Intellectual property Management Location or distribution channels Employee skills Business experience

In some industries, intellectual property is a major strategic asset. Patents help to protect sales and profits against inroads by competitors, provided that the patent can be enforced effectively or until an improved technology is developed by a competitor – and patented. When companies depend on the knowledge and talents of individual employees, they are exposed to the risk of defection by employees to rival organisations. During the early 2000s for example, it was fairly common for 'star traders' in the financial markets to defect from one bank to another, to obtain higher remuneration, often taking a whole team with them. Depending on the nature of a strategic report, you may find it useful to think about the implications of the information in the report using SWOT analysis – identifying internal strengths and weaknesses and external threats and opportunities that could have strategic implications for the organisation.

4 Financial data analysis At this stage of your studies, you should already be familiar with the basic tools of financial analysis, including key ratio analysis. If you are asked to comment on the implications of information in a financial statement or report, you will be expected to identify which ratios may be relevant and interpret the significance of any ratio that you measure. Even so, these would be basic tasks at this level of your studies. You could be expected to analyse financial data about any of the following areas:

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(a)

The financial markets. You may be asked to comment on data about conditions in the financial markets, such as interest rates or exchange rates, and implications of changes in market conditions for the organisation

(b)

Revenue, profitability and costs – and pricing

(c)

Cash flow or liquidity

(d)

Capital structure

If you are given financial data for analysis, you should consider the adequacy or limitations of the information and be aware of what the information does not tell you. What is missing could be more important than what the report or statement contains. (a)

Data about profitability may present product profitability, when you should be more concerned with customer profitability, distribution channel profitability or market segment profitability.

(b)

Data about profitability may be provided, when you should be more concerned about cash flow and funding.

(c)

Cost and management accounting information may be presented in a traditional format, such as an absorption costing or marginal costing statement, when you may consider that another approach to presenting information is needed – for example, an activity-based costing statement, or information about particular aspects of cost that traditional statements do not analyse, such as quality costs.

The challenge with analysing financial information may be not so much to demonstrate your knowledge of financial analysis as to demonstrate your understanding of the limits of financial analysis when insufficient or inappropriate data is available.

4.1

Users of financial analysis Different stakeholders have different expectations of a company, and therefore will require different information about its performance: (a)

Shareholders – Shareholders will be interested in the quality of their investment and the returns they can expect through dividends and capital growth. Ratios which could be particularly important to them are: Earnings per share (EPS), Price/Earnings (P/E), and Dividend yield.

(b)

Bankers and debt holders – Bankers and debt holders will be primarily interested in the risk attached to their investment in a company. Ratios which therefore could be important to them are: capital gearing, and interest cover.

(c)

Suppliers and employees – Suppliers and employees both depend on the company continuing in business in order that it continues to be a customer or an employer in the future. These stakeholders will be interested in a company's ability to meet its short term liabilities. Ratios such as the current ratio, and acid test ratio could be important in this respect.

(d)

Management – They may need to consider all the ratios noted above, because they are important to (and are therefore likely to be monitored by) other stakeholders. Additionally, the company's management need to consider the company's performance in relation to profitability, cost control and working capital management. Ratios such as gross and net profit margins, inventory turnover, and receivable and payable days could therefore be important performance measures.

Managers may also want to measure the performance of different divisions within an organisation. Return on Capital Employed (ROCE) and Residual Income (RI) are two methods of measuring divisional performance. However, there are potential problems with using ROCE and RI for evaluating and controlling business divisions: 

They are based on annual profit figures, and so disregard the future earnings of the division. Using BCG terminology, a cash cow might present a high ROCE; and a star, a low one, which would be a misleading guide to their true financial value, if assessed as the NPV of future earnings.



To boost ROCE or RI, assets with low book values will be used in preference to new assets. This could lead to short-termism, with divisions preferring not to invest in new assets, even though such an investment would be better for their longer-term future performance.

However, it is important that managers in an organisation do not focus solely on financial performance measures. As we have noted in Chapter 4, it is desirable to have performance metrics which look at key aspects of non-financial performance as well as financial performance. In the same way, it is advisable to use performance metrics which act as leading indicators, rather than focusing solely on lagging indicators.

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4.2

Approach to analysing financial data If you are given financial data for analysis, you should expect to carry out some numerical analysis. You will have to decide yourself how to do the analysis. (a)

If you are given data for more than one year, you should measure changes over time. If you are given financial data about a competitor, you should try to make a comparative analysis.

(b)

There may be value in carrying out cost-volume-profit analysis (breakeven analysis) on data that you are given, but you will need to state your assumptions about fixed and variable costs.

(c)

If you are given information about historical performance and targets, you should try to carry out numerical analysis of the extent to which the organisation is on track for meeting its targets.

Show all your numerical workings and state clearly the assumptions you have made.

5 Operational data analysis Although operational data may be financial, non-financial or a combination of both, much of it is likely to be non-financial. Data about operations should normally come from internal sources within the organisation. When analysing operational performance, it may be useful to have a checklist of areas of performance. Any problems or issues arising out of an operational report are likely to raise questions about one or more of the following areas.

5.1

Efficiency and effectiveness Efficiency is concerned with getting the maximum output from a given quantity of resources or achieving a given quantity of output with the minimum of resources. Efficiency is also known as productivity, and typical productivity measures are:        

Output per worker/hour Output per machine per hour Sales per square metre of floor space Average time to produce a unit or complete a task Average number of tasks completed per day Quantity of materials per unit of output Waste per unit of output Production cycle time

Effectiveness is concerned with achieving objectives with the resources that are used. Measures of effectiveness depend on what the organisation is trying to achieve, and they compare planned targets with actual achievements. Important aspects of effectiveness may be: 

Quality: Product quality, including product design and performance reliability, may be a key factor in providing customer satisfaction.



Delivery: Effectiveness in delivery of a product or service may relate to factors such as speed of delivery and reliability of delivery.

Resources may be used efficiently but ineffectively. Similarly, resources may be used effectively, but in an inefficient way.

5.2

Balanced scorecard A balanced scorecard approach to operational performance analysis links performance targets and performance measures through all levels of an organisation, from operational level to strategic level. The four perspectives of performance in the balanced scorecard are: 

Financial perspective: Achieving financial objectives in both the short and long term



Customer satisfaction perspective, and aspects of performance that have the biggest effect on providing customer satisfaction



Internal perspective, and critical aspects of the internal operations of an organisation



Innovation and learning perspective: Issues such as product innovation or innovation in service

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delivery, and the acquisition of learning and knowledge by employees Note, however, that none of the perspectives of Kaplan & Norton's balanced scorecard link directly to aspects of social responsibility or sustainability, which are becoming increasingly important elements of an organisation's overall performance. In this respect, in an article for ICAEW's Finance & Management faculty (The new thinking on key performance indicators, May 2006), David Parmenter suggested that in order to achieve a properly balanced view of performance, the number of perspectives of the balanced scorecard should be increased to six: financial; customer; internal process; employee satisfaction; learning and growth; environment and community.

5.3

Cost Cost is a financial aspect of performance. It is difficult to assess operational performance without also considering the cost incurred by a business. Kaplan & Norton (who devised the Balanced Scorecard) recommend that activity-based costing should be used to produce cost measures for important internal business processes. These costs, in conjunction with measurements about speed/time and quality, should be monitored over time, and benchmarked with a view to continuous improvement or process re-engineering. Benchmarking would allow managers to see not only how an organisation's costs vary over time (historical benchmarking), but also how costs vary in different parts of an organisation, or how an organisation's costs compare to competitors' costs. Monitoring costs and process efficiency against competitors could be particularly important for an organisation pursuing a low-cost (or cost leadership) strategy. Information about costs could also play an important part in any decisions about whether to outsource certain functions or processes, or whether to retain them in-house.

6 Obtaining more information You may be required to analyse a statement or report, and on the basis of the information available, provide an explanation of the position, prospects and risk of a business. Having made your analysis or given your explanation, you should go on to consider the risk that your explanation may be incorrect because of limitations in the data or information available. You would need to explain what these limitations are. Data available for analysis may be unreliable, possibly because it is incomplete or because it comes from an unreliable source. In this situation, the accountant should consider whether the quality of the information can be improved. The learning objectives for this subject call for an ability to 'assess the extent to which the limited assurance and reasonable assurance engagements can identify and mitigate information risks in this context'. In other words:

6.1



What additional information might you be able to obtain?



Where would the information be obtained?



How reliable would it be? What would be the limitations of any additional information you can obtain? Would your additional information be able to provide reasonable assurance, or only limited assurance?

Limitations of the available data Even though the exam question is unlikely to ask you specifically to comment on limitations in the data provided, you should be prepared to demonstrate that you are aware of any weaknesses in your analysis due to unreliable/incomplete information. You should also be prepared to indicate what information you would like to obtain, but make sure that your suggestions are realistic. 

It is inappropriate to suggest the need for information that could not be obtained for practical reasons or which would be too expensive to obtain and not worth the cost.



Any data obtainable on the industry and competitors will help to provide a benchmark for the performance of the business. However, the amount of information about competitors may be limited and you might need to indicate the sources of any such additional data.

Example The financial information in a case study or scenario is likely to be in the form of a summary. You might recommend that:

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6.2



More detailed information would be useful, such as a breakdown of revenues or profits by product, country or business unit.



Where you have been provided with historical information for analysis purposes at five-yearly intervals, data for the years in between would help assess the trend more accurately.



Where average figures have been given, information about variations around the average might be useful, to indicate variability and risk.

Assurance engagements Definition Assurance engagement: An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. The most common type of assurance engagement is the audit. However, there are a range of other assurance engagements an accountant can undertake. The basic principles and procedures for the performance of these assurance engagements are provided by International Standard on Assurance Engagements (ISAE) 3000, Assurance Engagements Other than Audits or Reviews of Historical Financial Information. You should already be familiar with this standard from the Audit & Assurance paper at the Professional Level; however, we will include a brief reminder of its key points here. ISAE 3000 distinguishes between two types of assurance engagement: 

Reasonable assurance engagements, which result in a positive expression of opinion and where the level of assurance given is deemed to be high (eg 'the management has operated an effective system of internal controls') and



Limited assurance engagements, which result in negative assurance and where the level of assurance given is deemed to be moderate (eg 'nothing has come to our attention that indicates significant deficiencies in internal control')

Assurance engagements performed by professional accountants are normally intended to enhance the credibility of information about a subject matter by evaluating whether the subject matter conforms in all material respects with suitable criteria, thereby improving the likelihood that the information will meet the needs of an intended user. In this regard, the level of assurance provided by the professional accountant's conclusion conveys the degree of confidence that the intended user may place on the credibility of the subject matter. There is a broad range of assurance engagements, which may include any of the following areas: 

Engagements to report on a wide range of subject matters covering financial and non-financial information



Engagements intended to provide high or moderate levels of assurance



Attest and direct reporting engagements



Engagements to report internally and externally



Engagements in the private and public sector

Specific examples of assurance assignments include:

6.2.1

   

Assurance attaching to special purpose financial statements Adequacy of internal controls Reliability and adequacy of IT systems Environmental and social matters

  

Risk assessment Regulatory compliance Verification of contractual compliance

Preconditions for an assurance engagement Before accepting an assurance engagement, a practitioner needs to establish that the preconditions for an assurance engagement are present. This means that the roles and responsibilities of the parties are suitable in the circumstances, and the

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engagement has the following characteristics: 

The underlying subject matter is appropriate



The criteria to be applied in preparing the subject matter information are suitable and will be available to the intended users



The practitioner will have access to the evidence needed to support their conclusion



The practitioner’s conclusion is contained in a written report



There is a rational purpose for the engagement.

In addition, the practitioner should only accept an assurance engagement where there is no reason to believe that relevant ethical requirements – including independence – will not be satisfied, and provided that the persons who will perform the engagement have the appropriate competences and capabilities to do so.

6.2.2

Elements of an assurance engagement An assurance engagement will normally exhibit the following elements. (a)

A three party relationship involving: (i) A professional accountant (the auditor or 'practitioner'); (ii) A responsible party (the client company); and (iii) An intended user (eg investors, regulators)

(b)

Subject matter (ie the information or issue to be attested)

(c)

Suitable criteria (ie standards or benchmarks to evaluate the subject matter)

(d)

An engagement process (the terms of the engagement and process)

(e)

A conclusion (ie a written assurance report)

Planning Planning an assurance engagement will normally include considering the following:      

Terms of the engagement Characteristics of the subject matter and the identified criteria The engagement process and sources of evidence Understanding the entity, the environment and the risks Identifying intended users and their needs Personnel requirements to complete the assignment

The practitioner should also:   

Obtain an understanding of the subject matter Assess the suitability of the criteria to evaluate or measure the subject matter Consider materiality and engagement risk

Obtaining evidence The practitioner should obtain sufficient, appropriate evidence on which to base the conclusion. This may include:  

Obtaining representations from responsible parties Considering the effect of subsequent events

Conclusions The professional accountant should express a conclusion that provides a level of assurance as to whether the subject matter conforms, in all material respects, with the identified suitable criteria. The ISAE does not require a standardised format for reporting. However, it states that the assurance report will normally include the following elements:

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

A title that indicates the report is an independent assurance report



An addressee



An identification of the subject matter (eg period covered, qualitative v quantitative; objective v subjective)



An identification of the criteria (assertions, measurement methods, interpretations, regulations)



Inherent limitations

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

Specific users and intended purposes



Responsible parties and responsibilities



Statement that the work was performed in accordance with ISAEs



Summary of work performed



Conclusion



Report date



Name and location of practitioner giving the report

The professional accountant's conclusion provides a level of assurance about the subject matter. Absolute assurance is generally not attainable as a result of such factors as: 

The use of selective testing



The inherent limitations of control systems



The fact that much of the evidence available to the professional accountant is persuasive, rather than conclusive



The use of judgement in gathering evidence and drawing conclusions, based on that evidence



In some cases, the characteristics of the subject matter

Therefore, professional accountants ordinarily undertake engagements to provide one of only two distinct levels: a reasonable and limited assurance. These engagements are affected by various elements, for example, the degree of precision associated with the subject matter, the nature, timing and extent of procedures, and the sufficiency and appropriateness of the evidence available to support a conclusion.

6.2.3

Consulting engagements Assurance engagements are associated with engagements that are initiated and paid for by one party, for the purpose of providing an independent opinion to someone else. In the context of data analysis, obtaining better-quality information could be a consulting engagement rather than an assurance engagement. The key issue remains: What additional information can be obtained, how reliable will it be, and how would the additional information enable me to re-consider or adjust my conclusions?

6.2.4

Illustration: Analysis of a financial forecast An accountant may be asked to comment on the implications of a financial forecast that has been prepared by the operations management of a client company. The initial judgement of the accountant may be to explain the financial or strategic implications of the forecast, but question the reliability of the forecast. It may be possible to carry out a consultancy engagement to assess the reliability of the forecast. The aim of the engagement would be to obtain sufficient appropriate evidence as to whether: 

Management's best-estimate assumptions on which the prospective financial information is based are not unreasonable, and



The prospective financial information is properly prepared on the basis of these assumptions

The accountant would need to consider: 

The likelihood of material misstatement



The competence of management regarding the preparation of financial forecasts (based, perhaps, on previous experience)



The extent to which the forecast is affected by management's judgement



The adequacy and reliability of the underlying data

The accountant should have sufficient knowledge of the business to be able to evaluate the significant assumptions that management have made. Information in a financial forecast is subjective information. It is impossible for an accountant to give the same level of assurance regarding forecasts as for historical financial information.

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Limited assurance can be given in the form of a negative opinion – there is nothing to suggest that the forecast is inappropriate. Where an assurance engagement is for the benefit of management of the client company, a consultancy engagement might be more appropriate. In this type of engagement, the accountancy firm assesses the degree of reliability in the forecast and perhaps provides an alternative forecast based on different assumptions. With any forecast, however, it is important to understand the assumptions and recognise that these may well prove incorrect.

6.2.5

Assurance over prospective financial information Financial forecasts – whether they are produced for internal management purposes or for external use – are the most common type of prospective financial information. ISAE 3400 The Examination of Prospective Financial Information deals with the issues an auditor should consider when accepting an assurance engagement of this sort, and the examination procedures they should carry out. We discussed ISAE 3400 in more detail in Chapter 3 earlier in this Study Manual, in the context of assurance over business plans.

6.3

Assurance and non-financial information Although the focus of corporate reporting has traditionally been financial reporting, companies now disclose a much broader range of information; information which goes far beyond traditional financial reporting. For example, companies regularly now report non-financial information including: 

The Strategic Report or management commentary (see Chapter 1 of this Study Manual), and other statements which are contained in their annual report: corporate governance statements; information on risk management policies; internal controls or wider operating data



Corporate responsibility reporting on environmental, social and economic performance ('triple bottom line')



Reporting on matters of public interest: for example, carbon emissions, or quality of service provision. For example, reporting requirements imposed by regulators in the UK require water companies to disclose detailed operating data relating to water quality, leakages and customer service

Moreover, although this non-financial information does not form part of a company's audited financial statements, stakeholders want to know the information is credible and reliable. Therefore, there is also demand for external assurance over this non-financial information. Providing this assurance over non-financial information will also help prevent an expectation gap. Such a gap could arise if stakeholders perceive that the auditors' work, and ultimately their opinion, extends beyond the information in the accounts to non-financial information contained in other elements of the annual report. Such information could include disclosures about oil and gas reserves, research and development pipelines (particularly for pharmaceutical companies) and audience size (for entertainment and media companies). This information is not audited, but nevertheless, it relates to key performance areas of the companies. Management information This demand for a broader range of non-financial information also means that companies may need to review or revise their management information systems. If, historically, these systems have been designed to provide financial information, they may not capture the additional non-financial information which companies now need to monitor and report. Therefore, information systems may be another area in which external companies can provide assurance. In this case, the assurance sought could be that the technology systems, and the processes they support, are functioning as intended. We will look at information and information systems in more detail in the next chapter of this Study Manual. However, in the context of data analysis, it remains important to consider whether the information systems that are generating the data being analysed, appear robust and reliable. The KPMG reporting partner's comments about 'cherry picking' in the Channel 4 example above highlight one of the key criteria for assurance engagements: neutrality. The criteria selected to measure performance should be free from bias. Another important criterion for assurance engagements is reliability – selecting measures which allow consistent evaluation of information. For example, if similar entities use different criteria to assess the same aspect of performance, it will make it very difficult to make any meaningful (or reliable) comparison of performance between the two entities. This issue reiterates the points made in the case example earlier in this

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chapter about 'like-for-like' sales. If different stores calculate 'like-for-like' sales on different bases, and if the calculations vary from year to year, it will be very difficult to benchmark performance on a reliable basis.

6.4

Agreed upon procedures Agreed upon procedures assignments are dealt with by International Standard on Related Services (ISRS) 4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial Information. (Note, however, that ISRSs have not been adopted in the UK.) In an engagement to perform agreed-upon procedures (AUP), an auditor is engaged to carry out those specific procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed, and to report on the factual findings of those procedures. The report also describes the purpose of the engagement and describes the procedures undertaken in sufficient detail to communicate the nature and extent of the work performed. Crucially, though – in contrast to engagements in which an auditor provides an opinion or a conclusion – no assurance is expressed in an AUP engagement, and the recipients of the report must form their own conclusions from the report by the auditor. The report is restricted to those parties that have agreed to the procedures to be performed, since others, unaware of the reasons for the procedures, may misinterpret the results. The value of AUP comes from the auditor objectively carrying out procedures and tests with relevant expertise, thus saving the engaging party from having to carry out the procedures and tests themselves. AUP are most effective where the engaging party is knowledgeable enough to identify the key matters to focus on, to discuss and agree the procedures to be performed, and to interpret the findings of the AUP in their own decision making.

6.5

Assurance in the Strategic Business Management exam We have referred to assurance engagements on several occasions throughout this Study Manual, and it is worthwhile considering how you might approach a requirement about an assurance engagement in your exam.

7 Data analysis in the Strategic Business Management exam 7.1

Issues with accounts When carrying out data analysis, you will need to use what you've learnt specifically about analysing financial statements, in particular:  

Distortions and creative accounting policies, such as income smoothing or understated provisions The factors determining important figures in the accounts, in particular, operating profit

Adjustments may be needed to the figures reported in the financial accounts before data analysis can be carried out. These may include re-measurement to market value and recognising assets or liabilities that are not included in the accounts. If you are analysing the income statement, you may need to strip out nonoperating or non-recurring items from results to be able to make a fairer comparison over time.

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Strategic Business Management Chapter-9 Information strategy 1 Information technology and strategy 1.1

Information and strategy Strategic information is used to plan the objectives of the organisation, and to assess whether the objectives are being met in practice. Therefore it is important that organisations have an information systems strategy so that it can meet its information requirements. Organisations have to consider three different strategies in relation to information: information systems (IS) strategy, information technology (IT) strategy and information management (IM) strategy. We can summarise these three strategies in very simple terms by saying that IS strategy defines what is to be achieved; IT strategy determines how hardware, software and telecommunications can achieve it; and the IM strategy describes who controls and uses the technology provided. The relationship between IS, IT and IM is important, however. In order for a company's IS strategy to be successful, the company will need sufficient IT resources (including hardware, software, network resources and suitably skilled staff) in order to implement and support the strategy. A company does not necessarily have to own resources in-house, though; an alternative would be to outsource IT services and departments to a specialist IT company. However, before making such a decision, an organisation needs to consider how critical its IT services are to its overall operations. If IT services are critical to the organisation's operations, and to its competitive advantage, the organisation should try to keep its IT services in-house rather than outsourcing them.

1.2

IS, IT and strategy An organisation's information systems may not only support business strategy, they may also help determine corporate/business strategy. In particular:

1.2.1

(a)

IS/IT/IM may provide a possible source of competitive advantage. This could involve new technology not yet available to others or simply using existing technology in a different way.

(b)

Information systems may help in formulating business strategy by providing information from internal and external sources.

(c)

Developments in IT may provide new channels for distributing and collecting information and/or for conducting transactions. The most fundamental illustration of this has been the way the internet has opened up opportunities for e-business and e-commerce.

Developing an IT strategy When formulating an overall information technology strategy, the following aspects should be taken into consideration: 

What are the key business areas which could benefit most from an investment in information technology, what form should the investment take, and how could such strategically important units be encouraged to use such technology effectively?



How much would the system cost in terms of software; hardware; management commitment and time; education and training; conversion; documentation; operational manning; and maintenance? The importance of lifetime application costs must be stressed – the costs and benefits after implementation may be more significant than the more obvious initial costs of installing an information technology function.



What criteria for performance should be set for information technology systems? Two areas can be considered: the technical standard the information system achieves and the degree to which it meets the perceived and often changing needs of the user.



What are the implications for the existing work force – have they the requisite skills to use the new systems, can they be trained to use the systems, and will there be any redundancies?

1.2.2

IT and its effect on management information The use of IT has permitted the design of a range of information systems. Executive Information Systems (EIS), Management Information Systems (MIS), Decision Support Systems (DSS), Knowledge Work Systems (KWS) and Office Automation Systems (OAS) can be used to improve the quality of management information. IT has also had an effect on production processes. For example, Computer Integrated Manufacturing (CIM) changed the methods and cost profiles of many manufacturing processes. The techniques used to measure and record costs have also adapted to the use of IT.

1.3

How IT is changing corporate strategy It should be obvious that information systems and information technology should support corporate strategy, but there are also a number of ways IS/IT can influence corporate strategy. In 1985, the Harvard Business Review published an article by Michael Porter and Victor Millar aimed at general managers facing the changes resulting from the rapid and extensive development of information technology. Although it was written a number of years ago, the article still has great relevance to the strategic employment of information systems and the use of information technology. It dealt with three main interlinked topics:   

1.3.1

The ways in which IT had become strategically significant How the nature of competition had changed How to compete in the new, IT-influenced environment

The strategic significance of IT IT transforms the value chain. Porter and Millar's article remarks that each of the value chain activities has both physical and informational aspects and points out that, while until quite recently technical advances were concentrated in the physical aspects, current improvements tend to be IT driven. Simple improvements are made by faster and more accurate processing of existing forms of data, and more dramatic ones by creating new flows of previously unavailable information. This has a particular effect on the linkages between the various activities and extends the company's competitive scope, which is the range of activities it can efficiently undertake. However, as well as thinking specifically how IT can affect the value chain, you should also be prepared to consider how IT and e-business have affected business more generally. For example: The use of computer aided design can lead to the faster production of new products and designs. Organisations could either use this speed as a basis for making designs cheaper (cost leadership) or, for example, in the clothing and fashion industry, as a means of getting the latest fashions to market more quickly than their rivals (differentiation). Websites and email have changed the nature of communication between organisations and customers. The internet has also changed the nature of the supply chain and channel structure – for example, by allowing customers to book flights and hotel rooms for their holidays directly from the airline company and the hotel online, rather than having to use travel agents.

1.3.2

IT and competitive strategy IT enhances competitive advantage in two principal ways:  

By reducing costs By making it easier to differentiate products

One example of IT-driven cost reduction is the way service industries (eg shops, airlines) have introduced self-service tills or check-in facilities in place of 'staffed' facilities. However, although IT can be used to reduce costs, it is perhaps debatable whether this generates a longterm competitive advantage. For example, businesses increasingly use virtual conferencing as a means of cutting costs and imposing operational efficiency due to the ease with which data can be shared. However, if all the firms in an industry start using virtual conferencing, will this actually generate any competitive advantage for any individual firms in that industry? Similarly, with the example of self- service check-in facilities, most, if not all, airlines now offer this facility and so it is no longer a source of 680

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competitive advantage. Differentiation. One way an organisation might seek to differentiate itself from its competitors is by meeting customers' needs and requirements more closely than their competitors. The greeting card company Moonpig has adopted such an approach by allowing customers to design their own cards online. IT could also enhance competitive advantage by forming the basis of complete new businesses. It makes new businesses technically feasible, it creates derived demand for new products, and it creates new businesses inside old ones. The impact of Apple's iPod gives examples of all three effects. The device itself is based on the MP3 file format, a large iPod ecosystem of accessories has been created, and the product itself represents a departure from Apple's previous hardware and software strategies.

1.4

IT networks 'Information technology' includes any devices which collect, manipulate, store or distribute information. Networking information technology In an IT context, networking means linking two or more devices together in some way so that data can be shared among them. These networks can be categorised in terms of the geographical area they cover: WAN: wide-area network. WANs are used to connect users and computers in one location with users in another location, so that users in different locations can relay data and information to each other. LAN: local-area network (usually within an office or department) In turn, LANs are connected to a WAN through a router, which can be either wired or wireless. Networks allow decentralised computers and devices to communicate with each other. This enables databases and applications software to be shared, and provides flexibility (for example, by allowing users to access information from different places). For example, home workers can connect up to an organisation's systems using virtual private network (VPN) links which treat the home workers as if they were on site. However, there are also constraints and risks around IT networks. The costs of installing wired networks can be very high, while there may be security issues with wireless networks. The increased importance of hardware, software and networks in supporting companies' strategies also highlights the importance of having proper controls over them – for example, to safeguard the integrity of corporate networks and databases.

Technology and data When considering the IT architecture in a company, it is important to distinguish between the following components: Technology platform – the internet, intranets, extranets and other computer systems and software which provide a platform which supports the strategic use of IT for e-business and e-commerce Data resources – databases which store data and information for business processes and decision support When considering whether a company's IT applications can support its business strategy, it is important to consider not only the technology platform but also its data resources. Nonetheless, developments in information technology have had a significant impact on the operations, costs, work environments and competitive positions of many companies. Enterprise software could be particularly useful to organisations in a business management context in relation to enterprise resource planning, supply chain management, and customer relationship management. Business intelligence software (eg data mining, analytics) could also be particularly useful for providing management with information.

Evaluating enterprise software The increased importance of IT and software to business operations means that selecting the right systems and software is becoming increasingly important for organisations. Aspects which an organisation should consider when selecting IT systems/software include: 

Reliability – assurance about the integrity and consistency of the application and all of its transactions



Interoperability – the system's ability to interface and share data with other systems (including external systems)

1.5



Leveragability – the ability to access stored data and other system resources at all times and from everywhere within the enterprise



Scalability – the ability to continue to provide the required quality of service as the load or usage increases



Security – the ability to allow certain users access to application functions and data while denying access to other users



Maintainability and manageability – the ability to correct flaws in the system and to ensure the continued health of the system without adversely affecting other components of the system



Portability – the ability of the software to run on a variety of hardware and operating systems

The internet, intranets and extranets The internet has been the most influential technology in the last few decades: e-commerce could simply not exist without the internet. Intranets use the same technologies as the internet, but access to them is restricted to computer networks within an organisation. The purpose of intranets is to allow the secure sharing of information to any part of an organisation, its system and its staff. Extranets link organisations together through secure business networks using internet technology. Extranets are particularly useful for various aspects of supply chain management; for example, details of orders placed with suppliers, orders received from customers, payments to suppliers or payments received from customers can all be transmitted through extranets. Similarly, banks can also be incorporated in these networks. Using networks in this way is often called Electronic Data Interchange (EDI).

1.5.1

e-business and e-commerce e-b usiness is the use of internet-based technology to either support existing business processes or to

create entirely new business opportunities. Where these internet-based operations or processes are connected to a buying or selling activity, they become e-commerce. e-c ommerce strategy

Most experts agree that a successful strategy for e-commerce cannot simply be bolted on to existing processes, systems, delivery routes and business models. Instead, management groups have, in effect, to start again by asking themselves fundamental questions.    

What do customers want to buy from us? What business should we be in? What kind of partners might we need? What categories of customer do we want to attract and retain?

In turn, organisations can visualise the necessary changes at three interconnected levels: Level 1 – The simple introduction of new technology to connect electronically with employees, customers and suppliers (eg through an intranet, extranet or website) Level 2 – Re-organisation of the workforce, processes, systems and strategy in order to make best use of the new technology Level 3 – Re-positioning of the organisation to fit it into the emerging e-economy So far, very few companies have gone beyond levels 1 and 2. Instead, pure internet businesses such as Amazon, have emerged from these new rules: unburdened by physical assets, their competitive advantage lies in knowledge management and customer relationships.

1.5.2

M-business In addition to e-business, we should also recognise the increasing importance of accessing computer- mediated networks from mobile devices while on the move (eg mobile phones, personal digital assistants or tablet computers).

1.5.3

Virtual arrangements Network technologies are used by organisations to integrate workers across sites and working at home. Developments in broadband, particularly improved capacity and better data security, have improved the ability to communicate across sites and from home. Broadband telecommunications systems allow

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'remote' computer users to communicate with each other, and to send and receive information. A virtual organisation can be seen as an extension of the idea of network organisations, although truly virtual organisations do not have any physical presence at all. There is some disagreement among academics as to a precise definition of the virtual organisation, but a consensus exists with regard to geographical dispersion and the centrality of information technology to the production process. Virtual organisations use networks to link people, assets and ideas, enabling a virtual organisation to ally with other organisations to create and distribute products and services without being limited by traditional organisation boundaries or physical locations. In a virtual network, one organisation can use the capabilities of another without being physically tied to that organisation. The virtual organisation model is useful when a company finds it is cheaper to acquire products, services or capabilities from an external vendor, or when it needs to move quickly to exploit new market opportunities but lacks the time and/or resources to respond to the opportunities on its own. An organisation is not a virtual organisation merely because it uses IT extensively and has multiple locations. Nevertheless, the ability to share information between members of a virtual organisation is likely to be critical to its operation.

1.6

e-business strategies We can identify three broad types of e-business strategy which a company can employ to help it gain a competitive advantage: Cost and efficiency improvements: focus on improving efficiency and lowering costs by using the internet and other digital technologies as a fast, low-cost way to communicate and interact with customers, suppliers and business partners (eg use of email to communicate with customers; or EDI to communicate with suppliers) Performance improvement in business effectiveness: make major improvements in business effectiveness â&#x20AC;&#x201C; for example, the use of intranets can substantially improve information sharing, collaboration and knowledge management within a business or with its trading partners Product and service transformation: developing new internet-based products and services, or supporting entry into new markets (including e-commerce which enables access to a global marketplace)

1.7

IT and competitive advantage Throughout this section, we have alluded to the potential which IT has as a source of competitive advantage for companies. However, it is important to note that companies only achieve competitive advantage by doing something different from their competitors, and they only achieve sustainable competitive advantage by doing something which their competitors cannot replicate over time. For example, the first airline company to introduce self-service check-in kiosks gained a competitive advantage (or source of differentiation) by doing so. However, all the major airlines companies now have self-service check-in kiosks so they are no longer a source of competitive advantage. By contrast, not having them would place a company at a competitive disadvantage. Equally, when the first logistics and shipping company allowed customers to track their packages via the Web, this innovation was seen as a source of competitive advantage. Now, however, we expect to be able to track orders with all logistics and shipping companies. Both of the examples above illustrate the importance of IT to modern business strategy. However, they also illustrate that the majority of innovations which confer competitive advantage on the companies which adopt them first are subsequently shared and become routine. In this respect, we can divide IT investments into two broad categories: strategic IT and utility IT. Strategic IT represents spending on new capabilities which directly supports new business strategies and innovations; all the remainder of IT spending is utility spending.

Customised applications and application platforms In the same way that we can distinguish between strategic IT and utility IT, we also need to distinguish between customised applications and generic software. Although packaged software is vital to many businesses, gaining any competitive advantage or differentiation from a generic package is very difficult (because competitors can also use the package).

Therefore, strategic IT investments are most often based on custom applications. Crucially, a company needs its application platform to support current technologies. Therefore, a company's choice of application platform (such as the Microsoft application platform) can be a key part of creating competitive advantage.

Extended case study In this section we have suggested a number of ways information systems and information technology can have an impact on, and can support, business strategy and operations. The following case study (about Tesco) illustrates how some of these ways have been manifest in practice. In particular, note how the impact of IS/IT affects strategic, tactical and operational levels within the company.

2 Information for strategic planning and control 2.1

Management information and strategy Managers need information for three main reasons:   

2.1.1

To make effective decisions To control the activities of the organisation To co-ordinate the activities of the organisation

Information and decisions Decision-making is a key element of management. For example, a marketing manager must decide what price to charge for a product, what distribution channels to use, and how to promote the product. Equally, a production manager must decide how much of a product to make, while a purchasing manager must decide how much inventory to hold and whom to buy inputs from. At a more strategic level, senior managers must decide how to allocate scarce financial resources among competing projects, how the organisation should be structured, or what business-level strategy an organisation should be pursuing. In order to make effective decisions, managers need information from both inside and outside the organisation. For example, when deciding how to price a product, marketing managers need information about the way consumer demand will vary in relation to different prices, the cost of producing the product and the organisation's overall competitive strategy (since its pricing strategy will need to be consistent with this overall strategy).

2.1.2

Information and control The management control process can be summarised in four key steps:    

Establish measurable standards of performance or goals Measure actual performance Compare actual performance against established goals Evaluate the results and take corrective action where necessary

In their text, Contemporary Management, Jones and George refer to the example of the package delivery company DHL. They note that DHL has a goal to deliver 95% of the packages it picks up by noon the next day. DHL has thousands of branch offices across the US which are responsible for the physical pickup and delivery of packages, and DHL managers monitor the delivery performance of these offices on a regular basis. If the 95% target is not being achieved, the managers analyse why this is and then take corrective action if necessary.

In order to control operational activity in this way, the managers have to have information about deliveries and performance. In particular, the managers need to know what percentage of packages each branch office delivers by noon, and this information is provided through DHL's IT systems. All packages to be shipped are scanned with handheld scanners by the DHL drivers, and details of the packages are sent wirelessly to a central computer at DHL's headquarters. The packages are scanned again when they are delivered, with the related delivery time being sent wirelessly back to the central computer. Therefore, managers can identify the percentage of packages which are delivered by noon the day after they were picked up, and can also break down this information to analyse delivery performance on a branch-by-branch basis.

2.1.3

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divisions in order to achieve organisational goals. One area where this is particularly important is in relation to managing global supply chains. Organisations are using increasingly sophisticated IT systems to co-ordinate the flow of materials, work in progress, and finished products throughout the world. Jones and George consider the example of Bose, the manufacturers of high quality music systems and speakers. Almost all of the components which Bose uses in its speakers are purchased from external suppliers, and about 50% of its purchases are from foreign suppliers, many in the Middle East. The challenge for Bose is to co-ordinate its globally dispersed supply chain in a way that minimises inventory and transportation costs. Bose employs a just in time production system, so it needs to ensure that component parts arrive at the relevant assembly plants just in time to enter the production process and not before. Equally, however, Bose has to be responsive to customer demands. This means that Bose and its supplier need to be able to respond quickly to changes in demand for different kinds of speakers, increasing or decreasing production as necessary. In order to co-ordinate its supply chain, Bose uses a logistics IT system which provides it with real-time information about parts as they move through the global supply chain. When a shipment of parts leaves a supplier it is logged onto the system, and from that point Bose can track the supplies as they move across the globe to the assembly plant. On one occasion, a significant customer unexpectedly doubled its order for Bose speakers, which meant that Bose had to increase its manufacturing output rapidly. Many of its components were stretched out across the supply chain. However, by using its logistics system Bose was able to locate the parts it needed, and accelerate them out of the normal delivery chain by moving them on air freight. In this way, Bose was able to get the parts it needed at the assembly plant in time to fulfil the customer's order.

2.2

Management accounting information Management accounting information is used by managers for a variety of purposes: (a)

(b)

To control the business. Performance reports are a crucial element in controlling a business. In order to be able to control their business, managers need to know the following: (i) (ii)

What they want the business to achieve (targets or standards; budgets) What the business is actually achieving (actual performance)

By comparing the actual achievements with targeted performance, and identifying variances, management can decide whether corrective action is needed, and then take the necessary action when required. Much control information is of an accounting nature because costs, revenues, profits and asset values are major factors in how well or how badly a business performs. (c)

To plan for the future. Managers have to plan, and they need information to do this. Much of the information they use is management accounting information.

(d)

To make decisions. As we have seen, managers are faced with several types of decision: (i)

Strategic decisions (which relate to the longer term objectives of a business) require information which tends to relate to the organisation as a whole, is in summary form and is derived from both internal and external sources.

(ii)

Tactical and operational decisions (which relate to the short or medium term and to a department, product or division rather than the organisation as a whole) require information which is more detailed and more restricted in its sources.

In the remainder of this section, we will look briefly at some of the management accounting information and management accounting tools which managers can use to evaluate aspects of business strategies.

2.3

Costs One of the most crucial elements of an organisation's performance management and control is to ensure that the value created by its activities is greater than the cost of carrying out those activities. (This is the point highlighted by the 'margin' element in Porter's value chain model.)

2.3.1

Costs and strategy A key element of performance measurement and control for a company will be ensuring that its costs remain under control. However, cost information is also important from a strategic perspective. For example: A company's choice of generic strategy interacts with cost and value. A company which is pursuing a cost leadership strategy needs to maintain a strict control of costs (and, wherever possible, also needs to benchmark its costs and the efficiency of its processes against its competitors to ensure its costs remain lower than theirs). However, a differentiation strategy will also have cost implications – for example, associated with product quality and customer service or after-sales service. Moreover, the structure of costs and value creation is likely to change over time, as illustrated, for example, in the product life cycle. As sales and production rise in the growth stage of the life cycle, unit costs could be expected to fall due to economies of scale. In the mature stage, prices become increasingly sensitive as firms compete with one another to try to increase their share of the market. Therefore cost reductions may be required to help firms sustain their profits.

Costs and decision-making Managers also need to know the cost of producing different products and services because they cannot make informed decisions about pricing or about whether or not to continue producing them without having accurate cost information. Sub-optimal decision making – Importantly, if managers do not have accurate and reliable cost information, this is likely to lead to sub-optimal decision making. For example, if the costs attributed to producing a product are understated, then a company may continue producing that product when it would actually be better advised to stop producing it. Short v long-term trade-off – Equally, managers may find themselves under pressure to reduce costs. However, it is important that decisions taken to reduce costs in the short term don't hinder an organisation's ability to achieve its strategic goals. For example, if marketing expenditure is reduced to cut costs in the short term this could be detrimental to an organisation's strategic goal to increase market share.

2.3.2

Costing systems One of the purposes of the following costing systems is to calculate the cost of a unit of output which can ultimately be used to set the selling price.

Absorption costing With absorption costing, a unit of output is valued at full cost – that is, the prime cost plus an absorbed share of production overhead costs.

Marginal costing Marginal costing is an alternative to absorption costing where only variable costs are included in the valuation of units. All fixed costs are treated as period costs and written off against sales revenue in the period in which they are incurred. The difference in unit valuations using the two methods lies in the treatment of the fixed costs. The absorption cost of sales will include some fixed costs from a previous period (included in opening inventory) while all fixed costs are written off as expenses in the year of incurrence with marginal costing.

2.3.3

Activity Based Costing (ABC) ABC is an alternative approach to absorption costing. Cost drivers – that is, those activities that cause costs in the first place – are identified and overheads are assigned to products or services based on the number of the cost drivers generated by each. More than one cost might have the same cost driver, so costs associated with the same driver are gathered into cost pools and then allocated using the appropriate driver. The product costs resulting from ABC should be more accurate than those under absorption costing as overheads are allocated on a more objective basis. Try the question below to make sure you remember the principles and procedures of ABC.

2.4

Break even analysis Break even analysis is the study of the inter-relationships between costs, volume and profit at various levels of activity. The study of break even analysis requires understanding, application and interpretation of various formulae which are summarised below.

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You will notice from the chart that break even analysis is also used for decision making purposes where there are limiting factors, such as make or buy decisions. Remember that the most important figure for decision making is contribution â&#x20AC;&#x201C; if a product is making a contribution towards fixed costs then production should continue, as overall profit will be reduced (or loss increased) if this contribution is lost.

2.5

Multi-product break even analysis The key issue with multi-product break even problems is determining the mix in which the products are sold and reducing it to the lowest common denominator. For example, if 500 units of Product X and 250 units of Product Y are sold, then the mix in which the two products are sold is 2:1. This mix is used to define a standard batch which can be used to determine a break even point in terms of number of batches. Once this has been determined, the number of batches can then be converted into the number of units of each product that must be sold at the break even point.

2.6

Price Price is a key element of the marketing mix, and you should have covered pricing and pricing issues in the Business Strategy syllabus. However, when evaluating pricing strategies, it is vital to consider how 'price' information fits with the other elements of the marketing mix. Price directly affects how well an organisation performs competitively, and is also closely linked to the perceptions of value for money held by the customers. If the price is too high, the exchange may not be perceived as worthwhile, and customers may not buy the product. If the price is too low, then one of two things could happen: (1) The product sells well, however the revenue per item is lower than it could be if the price were higher, so less revenue is earned which in turn means less profit than may be possible with a higher price. (2) The consumer perceives the price to be too low and interprets this as meaning quality has been compromised. The customer does not buy the product at all. Getting this balance right (and not setting a price either too high or too low) can be difficult and the organisation will have to take many factors into account when setting the price for their products and services.

2.7

Budgets Budget should provide an organisation with short-term targets within the framework of longer-term strategic plans. Budgets represent the short term targets which need to be achieved in order to fulfil strategic objectives. Budgets also provide a mechanism for controlling performance as they provide a yardstick against which to assess performance. This means finding out why actual performance did not go according to plan, and then seeking ways to improve performance for the future. Budgets enable managers to manage by exception, that is focus on areas where things are not going to plan (ie the exceptions). This is done by comparing the actual performance to the budgets to identify the variances. However, the reason a budget is not achieved may sometimes be because the budget itself was unrealistic. If this is the case, the budget may need to be revised. Only realistic budgets can form a credible basis for control.

2.8

Variance analysis When actual performance is compared to standards and budgeted amounts, there will inevitably be variances. They may be favourable or adverse depending on whether they result in an increase to, or a decrease from, the budgeted profit figure.

2.8.1

Sales variances Sales volume variance is the difference between the original and flexed budget profit figures. This is an important variance because losing sales generally means losing profit as well. If it has the effect of making profit lower than budgeted it is adverse and if it makes profit higher than budgeted it is favourable. Sales price variance is the difference between actual sales revenue and actual volume at the standard sales price. Higher sales prices (if all else remains constant) mean an increase in profit.

2.8.2

Materials variances Total direct materials variance is the difference between the actual and direct materials cost and the

direct materials cost according to the flexed budget. If the actual material cost is higher than budget, it has an adverse effect on profit. Direct materials usage variance is the difference between actual usage and budgeted usage for the actual volume of output, multiplied by the standard materials cost. If actual usage is higher than budgeted usage there will be an adverse effect on profit. Direct materials price variance is the difference between actual materials cost and the actual usage multiplied by the standard materials cost. Again, if actual costs are higher than those budgeted, there will be an adverse effect on profit.

2.8.3

Labour variances Total direct labour variance is the difference between the actual direct labour cost and the direct labour cost according to the flexed budget. If more is spent on labour than was budgeted, there will be an adverse effect on profit. Direct labour efficiency variance is the difference between the actual labour time and budgeted time, for the actual volume of output, multiplied by the standard labour rate. It looks at the actual versus the budgeted number of hours used to produce the output. If actual time is greater than budgeted time the effect on the profit will be adverse. The faster people work, the more profit can be made. Direct labour rate variance is the difference between the actual labour cost and the actual labour time multiplied by the standard labour rate. This means it compares the actual cost of the hours worked against the anticipated cost based on a standard hour. Where actual costs exceed the standard, profit will be adversely affected.

2.8.4

Fixed overhead variances Fixed overhead spending variance is the difference between the actual and budgeted spending on fixed overheads. Higher than budgeted overheads lead to less profit and have an adverse effect.

2.8.5

Reasons for variances Variances may occur for a number of reasons. One possible reason is that the budget itself was not realistic. Unless they are achievable, budgets are not a useful method of control. However, there are many other reasons why variances may arise, as shown by the table below.

2.9

Limiting factors Every organisation operates under resource constraints. Usually, an organisation's output is restricted by the level of demand rather than the organisation's ability to produce. However, sometimes there is a limit to the amount which can be produced due to a limiting factor within the organisation. Examples of limiting factors are:         

A shortage of production capacity A limited number of key personnel, such as salespeople with technical knowledge A restricted distribution network Limited shelf space or display space (for a retailer) Too few managers with knowledge about finance or overseas markets Inadequate research design resources to develop new products or services A poor system of strategic intelligence Lack of money A lack of adequately trained staff

Once the limiting factor has been identified, the planners should:  

In the short term, make best use of the resources available Try to reduce the limitation in the long term

The most profitable combination of products will occur where the contribution per unit of the scarce factor is maximised. When evaluating strategic plans, managers need to assess what the limiting factors (if any) are, and then assess whether the company is producing the combination of products which allows it to maximise its profits. For example, if labour is scarce then the company's priority should be on producing the products which generate the highest profit per unit of labour. 680

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Limiting factors could also be important in determining the feasibility of an organisation's strategy. If an organisation has a limited amount of labour available, the total amount of sales it can generate will be restricted by this labour. If the organisation is looking to grow, but isn't also looking to increase its staff levels, its strategy will not be feasible (unless it is able to prevent staff levels being a limiting factor in some other way – for example, by automating some processes which are currently carried out manually).

Limiting factors and make-or-buy decisions The issue of limiting factors could also have implications on a decision about whether to make or buy. If a factor is scarce and is preventing growth, then buying additional units of that resource might be justified, even if a traditional make-or-buy decision would not otherwise justify it.

Limiting factors and capacity The reference to limiting factors and capacity also highlights that organisations may need to adjust their capacity by some means. For example, if labour (or staff hours available) is the limiting factor, an organisation should consider how it can increase its labour capacity. Overtime – the quickest and most convenient way of increasing capacity is to increase the number of hours worked by the existing staff, by offering them overtime payments to work additional hours. However, this method is only useful if the timing of the extra capacity matches that of the demand. For example, there will be no benefit from asking retail staff to work longer hours in the evenings if the excess demand is occurring during normal daytime working hours. Conversely, at a micro level an organisation might be able to solve capacity issues by building flexibility into job design and job roles so that staff could be transferred from less busy areas into the busiest areas for short periods of time. For example, because they found that peak times for registering new customers coincided with the least busy times in the kitchen and restaurant areas, the hotel chain Novotel trained some of its kitchen staff to also escort customers from the reception area up to their rooms. Adjusting the size of the workforce – If capacity is largely governed by the size of the workforce, then one way to increase capacity is to take on extra staff in periods of high demand. These might often be temporary or part-time staff. A variation on this approach could be to use subcontractors. Demand management Instead of looking to resolve capacity issues through supply side solutions, it might also be possible to address them through demand management activities. Such an approach is popular among travel operators who offer cheaper holidays and flights at less busy times in order to try to stimulate off-peak demand and curtail peak demand.

2.10

Expected values An expected value (or EV) is a weighted average value based on probabilities. The expected value for a single event can offer a helpful guide for management decisions. Although the outcome of a decision may not be certain, there is some likelihood that probabilities could be assigned to the various possible outcomes from an analysis of previous experience. If the probability of an outcome of an event is p, then the expected number of times that this outcome will occur in n events (the expected value) is equal to n × p. The concepts of probability and expected value are vital in business decision-making. The expected values for single events can offer a helpful guide for management decisions. 

A project with a positive EV should be accepted.



A project with a negative EV should be rejected.



When choosing between options the alternative which has the highest EV of profit (or the lowest EV of cost) should be selected.

Where probabilities are assigned to different outcomes we can evaluate the worth of a decision as the expected value, or weighted average, of these outcomes. The principle is that when there are a number of alternative decisions, each with a range of possible outcomes, the optimum decision will be the one which gives the highest expected value. Expected values can be built into decision trees in order to aid decision making. The amount of

expected profit is likely to be conditional on the result of various decisions. However, remember the limitations of using expected values as a basis for decisions.

2.10.1

Limitations of expected values Evaluating decisions by using expected values has a number of limitations.

2.11

(a)

The probabilities used when calculating expected values are likely to be estimates. They may therefore be unreliable or inaccurate.

(b)

Expected values are long-term averages and may not be suitable for use in situations involving one-off decisions. They may therefore be useful as a guide to decision making.

(c)

Expected values do not consider the attitudes to risk of the people involved in the decision- making process. They do not, therefore, take into account all of the factors involved in the decision.

(d)

The time value of money may not be taken into account: $100 now is worth more than $100 in ten years' time.

Transfer pricing You should have looked at issues around transfer pricing in Business Strategy, but it is important to remember transfer pricing can have important strategic implications. Sales and prices Transfer prices can determine the overall price and sales of a product. Suppose Division A supplies an intermediary product to Division B for £12,000. Division B does additional work to the product (at a cost of £5,000) and the product's market price is set at a 15% mark-up on cost. If Division A transfers the intermediary product at cost, the final price will be £19,550: (£12,000 + £5,000)  1.15. However, if Division A sets a transfer price of £15,000 for the intermediary product, the final price would be £23,000: (15,000 + 5,000)  1.15. The difference in price is likely to have a significant effect on the volume of products sold, and therefore company profits. Tax liabilities If a multinational company has divisions in countries with different tax rates, the level at which transfer prices are set will influence the overall level of tax the company has to pay. Dysfunctional decision-making Transfer pricing could lead to dysfunctional decision-making. In the illustration above, if Division A believes it can achieve a higher price by selling on the open market (rather than selling to Division B) it should take the open market price. However, this might mean that Division B does not have a product to sell if it cannot obtain the component elsewhere. Equally, however, if Division B can obtain supplies of an equivalent product more cheaply from an external supplier than from Division A it should buy the product from the external supplier. However, this might leave Division A with unsold stock.

Transfer pricing and control As a means of control, the main concern is reconciling the need for transfer prices to be set at an appropriate level to assess performance with the need for goal congruence within the organisation. Ideally, pricing levels should be set at a level to avoid the complications and loss of resources of departments dealing unnecessarily with external sources rather than with internal 'suppliers'. Transfer pricing may also be a significant issue if one division of a company makes an investment that benefits all the other divisions. A transactions cost approach, taking into account costs associated with setting and administering the transfer price and also time commitments and obligations is an appropriate way to determine which transactions should take place within an organisation and which transactions should occur in the outside world.

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Transfer pricing and MNCs More generally, transfer pricing could be an important issue for multinational companies, and we will look at international transfer pricing in more detail in Chapter 16 of this Study Manual.

2.12

Balanced scorecard The scorecard was devised as a way of integrating the traditional financial indicators with nonfinancial measures such as operational performance quality, customer satisfaction and staff potential. It is balanced in the sense that managers are required to think in terms of all four perspectives in order to prevent improvements being made in one area at the expense of another. The aspects of the balanced scorecard can be as effective as financial measures (as indicators of long- term profitability), control mechanisms, business trends or benchmarks against other organisations. They can act as targets for employees, and will be more effective if linked to the organisation's reward schemes. The range of perspectives they provide can be a better link with strategy than a few financial measures.

3 Management information systems The idea of a hierarchy of decision-making within organisations, meaning that information is required for planning and control at strategic, tactical (management) and operational levels. The existence of this hierarchy means that different types of management information systems are required to provide the different types of information required at the different levels – although the higher level (strategic and tactical) applications, to some extent, still make use of data which has been produced by operational systems.

3.1

Information systems The following types of information systems firms can use to provide them with information about its performance and its processes:    

Executive information systems (EIS) Management information systems (MIS) Decision support systems (DSS) Value added networks (VAN)

As Laudon & Laudon note (in their text Management Information Systems) although different systems serve different management groups in a business, all of them ‘provide business intelligence that helps managers … make more informed decisions.’

3.1.1

Operational level Definition Transaction processing systems: a transaction processing system (TPS) performs and records the daily, routine transactions necessary to conduct business – for example, sales order entry or hotel reservations. TPS provide operational level data. Operational managers need systems which keep track of the everyday activities and transactions in an organisation such as sales, receipts, payroll, or the flow of materials in and out of inventory. The principal purpose of TPS is to provide answers to routine questions (for example, how many units of a product are in stock?) and to track the flow of transactions through an organisation (for example, what has happened to a supplier's payment?) However, TPS are often vital for the successful running of a business. For example, how would airline companies operate without their computerised reservation systems, and how would supermarkets operate without their computerised EPoS tills?

3.1.2

Tactical level Management Information Systems (MIS) provide middle managers with reports on an organisation's current performance. MIS summarise data from TPS and enable it to be presented in reports which can be used to monitor and control the business. Typically, MIS provide answers to routine questions which have been specified in advance and which have a predefined procedure for answering them. For example, MIS reports could be used to compare monthly sales figures for different products to planned targets. By contrast, decision-support systems (DSS) can be used for less routine decision-making. They focus on problems which are unique or rapidly change, and which may not have a pre-defined procedure for finding their solution. For example, DSS might be used to assess the impact on production schedules if

sales were double for a month. Although DSS use internal information from TPS and MIS, they often also incorporate information from external sources, such as, competitors' product prices.

3.1.3

Strategic level Senior managers need information systems which address strategic issues and long-term trends, both within an organisation and also in the external environment. They are concerned with questions such as where does our organisation fit in the industry? What new products should we be offering? What new acquisitions would help protect us from cyclical business swings? Executive information systems (EIS) or executive support systems (ESS) help senior managers make these decisions. ESS incorporate external data (about industry trends, forecasts, or external events such as tax changes or the emergence of new competitors) as well as summarised internal information from MIS and DSS. The outputs from ESS are often presented as graphs or charts, and are increasingly presented in the form of digital dashboards.

3.2

Enterprise applications One of the key issues facing an organisation and its managers is the question of how to manage all the information in the different systems within the organisation. In particular, if the organisation has a number of different operating systems, how can these systems share information and how can work or activities be co-ordinated? One solution is to implement enterprise applications – systems which span different functional areas and focus on executing business processes across the organisation. There are four main enterprise applications:    

Enterprise resource planning systems Supply chain management systems Customer relationship management systems Knowledge management systems

The presence of these integrated systems also serves as a reminder that management accounting information does not exist in isolation, but is part of the wider information system in an organisation.

3.2.1

Enterprise Resource Planning Systems Enterprise Resource Planning Systems (ERPS) are software systems designed to support and automate the business processes of medium and large enterprises. ERPS are accounting-oriented information systems which aid in identifying and planning the enterprise wide resources needed to schedule, make, account for and deliver customer orders. They aid the flow of information between all business functions within an organisation, and they manage connections to outside stakeholders (such as suppliers). ERPS handle many aspects of operations including manufacturing, distribution, inventory, invoicing and accounting. They also cover support functions such as human resource management and marketing. Supply chain management software can provide links with suppliers and customer relationship management with customers. ERPS thus operate over the whole organisation and across functions. All departments that are involved in operations or production are integrated into one system. In this way, adopting ERPS makes firms more agile in the way they use information, meaning they can process that information better and integrate it into business procedures and decision-making more effectively. Some ERPS software is custom-built, and ERPS software is now often written for organisations in particular industries. ERPS can be configured for organisations' needs and software adapted for circumstances. The data is made available in data warehouses, which can be used to produce customised reports containing data that is consistent across applications. Data warehouses can also support performance measures, such as balanced scorecard, and strategic planning. ERPS should result in lower costs (for example, through workforce analytics and workforce redeployment) and lower investment required in assets. ERPS should increase flexibility and efficiency of production, for example by co-ordinating procurement and logistics functions. They should also increase customer-to-cash processes, and thereby improve control of cash flow. Their disadvantages include cost, implementation time, and lack of scope for adaptation to the demands of specific businesses. Also a problem with one function can affect all the other functions. ERPS linked in with

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supply chains can similarly be vulnerable to problems with any links in the chain, and switching costs may be high. The blurring of boundaries can also cause accountability problems. As well as ERPS (which focus primarily on operational management), firms can also use Strategic Enterprise Management Systems (SEMS) for making high-level strategic decisions. SEMS focus primarily on strategic management – with a view to allowing organisations to improve their processes, procedures and decision-making – in order to achieve a competitive advantage in their business environment. SEMS can be seen as an extension of the Balanced Scorecard approach because they encourage senior managers to combine financial and strategic measures when formulating business decisions. Additionally, SEMS provide organisations with the capability to support financial consolidation and to manage strategy and performance through a single piece of software (such as SAP Strategic Enterprise Management: SAP SEM.) For example, SAP's SEMS supports:

3.3



Financial reporting – it can generate financial and management accounting information to allow managers to monitor the financial performance of business units and divisions.



Planning, budgeting, and forecasting



Corporate performance management and scorecards – the software allows managers to develop KPIs that support balanced scorecards and economic value-added scorecard methodologies. The software allows managers to link both operational and strategic plans and to develop scorecards and performance measures based on both financial and non-financial data.



Risk management – the software helps managers identify, quantify, and analyse business risks within their business units and thereby to identify risk-reducing activities.

Financial statement information So far in this chapter, we have concentrated on the hierarchy of data and information in the context of management information systems – for example, in the way that management information systems summarise data from transactions processing systems so that it can be presented in reports which can be used to monitor and control an organisation. However, the data from transactions processing systems not only feeds into management information and management accounts, it also forms the basis for the organisation's financial statements. For example, the sales figures from a retailer's shop tills will ultimately feed into the revenue figures in its financial statements. Therefore, while an organisation needs to be able to capture and summarise transactions data accurately in order that managers can make informed decisions and can control the business effectively, it equally needs accurate data to populate its financial statements. This not only highlights the inherent links between management accounting information and financial accounting information, it also reinforces the importance of the internal controls in organisations over their transactions processing systems to ensure that the data collected in them is accurate and reliable. In this respect, note that in the example of the SAP's SEMS which we mentioned above, the single piece of software generates both financial and management accounting information.

3.4

Sources of information On several occasions in this chapter we have noted that different levels of decision may require data or information from either internal or external sources. If an organisation is not able to capture reliable and accurate raw data then, even if it has sophisticated information systems, its managers will not have the quality of information they need to make informed decisions.

3.4.1

Internal information Capturing data and information from inside the organisation involves designing a system for collecting or measuring data and information which sets out procedures for:    

What data and information is collected By whom How frequently By what methods



How data and information is processed, filed and communicated

The accounting ledgers provide an excellent source of information regarding what has happened in the past. This information may be used as a basis for predicting future events. Transactions processing systems and enterprise systems can also be sources of internal information, such as, EPoS tills in retail stores. Equally, sales teams deal with customers and so are in a good position to obtain information about customers and competitors. Many companies also conduct market research. Although this generally deals with specific issues, it can indicate general environmental concerns (eg consumers' worries).

3.4.2

External information Sources of information from outside sources include the following:

3.5



Media. Newspapers, periodicals and television offer environmental information.



Sometimes more detailed country information is needed than that supplied by the press. Export consultants might specialise in dealing with particular countries, and so can be a valuable source of information. The Economist Intelligence Unit offers reports into particular countries.



Academic or trade journals might give information about a wide variety of relevant issues to a particular industry.



Trade associations also offer industry information.



Consultancy firms or analysts (eg MINTEL) can also provide industry reports, or reports about different market sectors.



The government can be a source of statistical data relating to money supply, the trade balance and so forth, which is often summarised in newspapers. In the UK, the Department for Business, Innovation and Skills publishes Overseas Trade, which concentrates on export opportunities for UK firms. Official statistical sources also include government censuses, and demographic and expenditure surveys.



Sources of technological environmental information can include the national patents office (because patents for new products are registered with the patent office).



Stockbrokers produce investment reports for their clients which involve analysis into particular industries.



The internet (for example, 'current awareness services' where subscribers can register particular key words related to their industry with media vendors and then receive automatic emails of articles and announcements that include those key words as tags). The websites of rival firms may also give an insight into their mission, objectives, strategy and financial performance.



Annual reports of competitors, suppliers or firms in a potential target market can also provide useful information.

Strategic management accounting and external information Two of the key features of strategic management accounting are the importance it places on external information and on non-financial information in addition to internally-generated financial information. This external orientation highlights the extent to which customers, competitors and the external environment, as well as the actions of the organisation itself, affect an organisation's performance. So, for example, whereas a traditional management accountant would report on an organisation's own revenues, the strategic management would report on market share or trends in market size and growth. (a)

Competitive advantage is relative. Understanding competitors is therefore of prime importance. For example, knowledge of competitors' costs as well as a firm's own costs could help inform strategic choices; a firm would be unwise to pursue a cost leadership strategy without first analysing its costs in relation to the cost structures of other firms in the industry. This also highlights the importance of benchmarking – comparing performance to competitors.

(b)

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Customers determine if a firm has competitive advantage.

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3.6

Linking strategic and operational information One of the key challenges that organisations face is linking their (long term) strategy to their day-to-day operations. For example, a strategic plan might set revenue growth targets for an organisation over the next five years, but the operational plan will need to consider what practical steps will be taken to generate these revenue increases, in effect creating a road map that defines the detail of how the overall strategies are going to be put into action.

Information and performance Management accounting models such as the performance pyramid (Lynch and Cross) and the balanced scorecard seek to align operational objectives and initiatives with an overall strategy and mission.

Practical steps in developing a balanced scorecard As with any other project or change, if an organisation is going to implement a scorecard successfully, it will need to think carefully about the steps involved in developing a scorecard: Identify key outcomes – Identify the key outcomes critical to the success of the organisation (this is similar to identifying the organisation's critical success factors) Key processes – Identify the processes that lead to those outcomes KPIs – Develop key performance indicators for those processes Data capture – Develop systems for capturing the data necessary to measure those key performance indicators Reporting – Develop a mechanism for communicating or reporting the indicators to staff (such as through charts, graphs or on a dashboard) Performance improvement – Develop improvement programmes to ensure that performance improves as necessary

Capturing performance information Importantly, these 'steps' highlight that an organisation needs to have systems in place to be able to capture the information it needs to assess how well it is performing. As the context of strategic management accounting highlights, this performance information is likely to include non-financial performance, and could also include external elements (such as competitor performance or market growth) as well as information about the organisation's own financial performance.

3.7

CSFs and information requirements The use of critical success factors (CSFs) can help to determine the information requirements of an organisation. Critical success factors are a small number of key operational goals vital to the success of an organisation. If these operational goals are achieved, the organisation should be successful. CSFs are measured by key performance indicators (KPI). The CSF approach is sometimes referred to as the strategic analysis approach. The philosophy behind this approach is that managers should focus on a small number of objectives, and information systems should be focused on providing information to enable managers to monitor these objectives. Two separate types of critical success factors can be identified: (a)

Monitoring CSFs are important for maintaining business. A monitoring CSF is used to keep abreast of existing activities and operations.

(b)

Building CSFs are important for expanding business. A building CSF helps to measure the progress of new initiatives and is more likely to be relevant at senior executive level.

One approach to determining the factors which are critical to success in performing a function or making a decision is as follows:   

List the organisation's corporate objectives and goals Determine which factors are critical for accomplishing the objectives Determine a small number of key performance indicators for each factor

Note that most KPIs will be quantitative. It is quite possible that CSFs will be quantitative as well. One of the objectives of an organisation might be to maintain a high level of service direct from inventory without holding uneconomic inventory levels. This is first quantified in the form of a goal,

which might be to ensure that 95 per cent of orders for goods can be satisfied directly from inventory, while minimising total inventory holding costs and inventory levels. CSFs might then be identified as the following.   

Supplier performance in terms of quality and lead times Reliability of inventory records Forecasting of demand variations

The determination of key performance indicators for each of these CSFs is not necessarily straightforward. Some measures might use factual, objectively verifiable data, while others might make use of 'softer' concepts such as opinions, perceptions and hunches. For example, the reliability of inventory records can be measured by means of physical inventory counts, either at discrete intervals or on a rolling basis. Forecasting of demand variations will be much harder to measure. Where measures use quantitative data, performance can be measured in a number of ways:   

3.7.1

In physical quantities, for example units produced or units sold In money terms, for example profit, revenues, costs or variances In ratios and percentages

Data sources for CSFs In broad terms, we can identify four general sources of CSFs (based on Rockart's work in this area in the 1970s and 1980s). (a)

The industry that the business is in. For example, in the supermarket industry, having the right product mix available in each store, and having products actually available on the shelves for customers to buy will be prerequisites for an organisation's success, regardless of the detailed strategy it is pursuing.

(b)

The company itself and its situation within the industry (eg market leader or small company; competitive strategy, geographic location).

(c)

The external environment, for example consumer trends, the economy, and political factors of the country in which the company operates (PEST factors).

(d)

Temporary organisational factors, which are areas of corporate activity that are currently unacceptable and represent a cause of concern, such as high inventory levels. New laws or regulations could also be seen as temporary factors: eg if a regulator has recently fined a financial services company for mis-selling its products, then a possible CSF for the company would be: to ensure that similar mis-selling does not occur again in the near future.

More specifically, possible internal and external data sources for CSFs include the following:

3.8

(a)

The existing system. The existing system can be used to generate reports showing failures to meet CSFs.

(b)

Customer service department. This department will maintain details of complaints received, refunds handled, customer enquiries etc. These should be reviewed to ensure all failure types have been identified.

(c)

Customers. A survey of customers, provided that it is properly designed and introduced, would reveal (or confirm) those areas where satisfaction is high or low.

(d)

Competitors. Competitors' operations, pricing structures and publicity should be closely monitored.

(e)

Accounting system. The profitability of various aspects of the operation is probably a key factor in any review of CSFs.

(f)

Consultants. A specialist consultancy might be able to perform a detailed review of the system in order to identify ways of satisfying CSFs.

Management information systems and competitive advantage Managers need information to make effective decisions and to control the activities of their organisation. Management information systems have a critical role in providing them with this information. As such, the main purpose of management information systems is to provide the right information, to the right people at the right time.

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In this respect, we can identify the following key benefits from management information systems: (a)

Implementation of Management by Objectives – MIS allow management and staff to view, analyse and interpret useful data to set goals and objectives, and then to assess performance against those objectives

(b) Identify strengths and weaknesses – Performance reports (for example, revenue reports, cost and productivity reports) can help managers identify strengths and weaknesses within an organisation, and consequently also improve its business processes and operations (c)

Generate competitive advantage: If implemented properly, MIS can provide a wealth of information to allow management to construct effective plans to enable their organisations to outperform their competitors – for example, by enabling an organisation to produce products more quickly or more cheaply than rival firms. Similarly, using customer data effectively can help an organisation align its products and its business processes to the needs of its customers. The effective management of customer data can also help an organisation with the segmentation and targeting aspects of its strategic marketing.

(d)

Fast reaction to market changes: As the environment in which organisations operate becomes increasingly complex and dynamic, the speed with which an organisation can respond to opportunities and threats in that environment could become a source of competitive advantage. As such, this speed of response is a dynamic capability for the organisation. An organisation’s potential to sense opportunities and threats, to make timely and market-oriented decisions in response to the changing environment, and to change its resource base accordingly can be a source of competitive advantage to it.

An organisation’s management information systems are likely to be crucial in providing an effective platform which enables it to make timely and informed decisions in response to environmental changes. If there is a sudden change in customer tastes or trends, firms with higher timely decision-making capacity can grasp the opportunities this presents more quickly than competitors. As such, the quicker the relevant information becomes available to management, and the faster the decision-making process, the more likely the organisation is to grasp the opportunities to gain competitive advantage over its rivals. In order for managers to be able to respond rapidly and appropriately to change in their external environment, however, they must be capable of collecting internal and external information, identifying key strategic issues and making strategic decisions in a timely manner. In this respect, by providing access to various external databases, executive information systems (EIS) enable senior managers to search and retrieve a large amount of external informaiton about suppliers, customers, competitors, and regulatory bodies and other stakeholders in a timely manner. EIS can also transform traditional management reporing systems to provide senior management with more non-financial performance information in critical area of their organisations. As such, the internal and external information which EIS can provide for senior managers can lead to improved productivity, improved decision-making in terms of quicker identification of potential problems and opporutnities and the more successful introduction of new products. Some writers have also noted that the use of EIS, along with decision support systems, help strategic decision maker to generate and analyse a greater number of alternatives – thereby increasing the comprehensiveness of the decision-making process.

4 The value of information 4.1

Factors that make information a valuable commodity Information is now recognised as a valuable resource and a key tool in the quest for a competitive advantage. Easy access to information, the quality of that information, and speedy methods of exchanging the information have become essential elements of business success. Organisations that make good use of information in decision making and which use new technologies to access, process and exchange information are likely to be best placed to survive in increasingly competitive world markets.

4.2

The value of obtaining information In spite of its value in a general sense, information which is obtained but not used has no actual value to the person who obtains it. It is only the action taken as a result of a decision which realises actual value for a company.

An item of information that leads to an actual increase in profit of £90 is not worth having if it costs £100 to collect. Businesses may also try to assess the costs of not having the information and also whether alternative (cheaper, more convenient) sources may be used instead.

4.3

Costs of information Costs of information include the costs of system development and set-up, day-to-day running and storage costs. Effective budgeting may be required to keep costs under control, particularly in the purchase of new equipment. An activity-based approach may be appropriate.

4.4

The value of information There are a number of theoretical models which can be used to value information. However, most of them highlight the same factors in determining the value of information: 

The extent of uncertainty faced by decision makers



The benefit of making the optimal decision compared to making a decision which is not optimal in the light of better information



The cost of making use of the information and incorporating it into decisions

Importantly, information only has a value if alternative courses of action are available, and if these alternative courses of action will result in different results for an organisation. Information is most valuable for an organisation when many alternative courses of action are available but the costs associated with a 'wrong' action are high. By contrast, if there are no alternative courses of action available or if a 'wrong' decision will not result in any net costs to an organisation, information relating to that decision has no value.

4.5

Cost-benefit analysis In effect, we can evaluate the value of having better information in the context of a cost-benefit analysis. Having relevant data and information available should improve the quality of decisions which are made, which in turn should improve an organisation's performance. However, there will also be a cost involved in capturing and analysing the data and information. The critical question for an organisation is whether the benefits from having the information are greater than costs involved in obtaining that information.

4.5.1

The benefits of a proposed information system In order to evaluate how the benefits of a proposed information system compare to the costs of the systems, an organisation needs to try to quantify the benefits in some way. Several factors need to be considered when trying to quantify the benefits: Improved data collection, storage and analysis tools may indicate previously unknown opportunities for sales. Such tools may include software that allows relationships to be discovered between previously unrelated data. New technology can be used to automate work which was previously manual. This saves staff time and may result in a smaller workforce being required. Systems such as inventory control can benefit as losses from obsolescence and deterioration are reduced. Computerised systems that create a more prompt and reliable service will increase customer satisfaction. In some cases it may be that providing decision makers with the most accurate and up-to-date information possible can have substantial benefits. The main areas of benefit are:

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

Models can be created to forecast sales trends and the likely effect on costs. Organisations that can make accurate forecasts are in a better position to plan their structure and finances to ensure longterm success.



Organisations facing uncertain times, or those which operate in dynamic, evolving environments, need to make complex decisions (often quickly) to take advantage of opportunities or to avoid threats. Scenario planning models enable a wide range of variables to be changed (such as inflation rates or sales numbers), the overall effect on the business to be identified and a business plan to be constructed.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

4.6



Modelling can be extended into the market that the organisation operates in. Trends such as sales volumes, prices and demand can be analysed. Relationships between price and sales volume can be identified. These can be used by an organisation when deciding on a pricing strategy. Setting the best price for a product can help drive up sales and profitability.



Organisations will benefit from improved decision making where systems can accurately evaluate a wide range of projects. Investment decisions often involve large capital outlays, and if the system prevents bad decisions it can prevent the organisation wasting large sums of money.



Systems can also prevent an organisation agreeing 'bad' deals. Tenders for suppliers or other longterm contracts can prove costly if the wrong choice is made.

Strategic implications of information systems When formulating an overall information technology strategy the following aspects should be taken into consideration: 

What are the key business areas which could benefit most from an investment in information technology, what form should the investment take, and how could strategically important units be encouraged to use such technology effectively?



How much would the system cost in terms of software; hardware; management commitment and time; education and training; conversion; documentation; operational manning; and maintenance?



The importance of lifetime application costs must be stressed – the costs and benefits after implementation may be more significant than the more obvious initial costs of installing an information technology function.



What are the implications for the existing work force – have they the requisite skills; can they be trained to use the systems; will there be any redundancies?

5 Evaluating management information and performance data 5.1

The objectives of management information The objective of management accounting and management accounting systems is to provide information for managers to use for planning, control and performance measurement. In order to evaluate how well the systems are providing this, managers need to assess whether the information available to them gives them what they need to know for planning, control and making decisions. The management accountant's role is to provide managers with feedback information in the form of periodic reports – suitably analysed and at an appropriate level of detail – to determine whether the business is performing according to plan. It may be the case that there is too much information available, or the information available is in a format unsuitable for managers to use. For instance, a production manager needs to know about outputs and costs in his or her department but not primarily about marketing data nor even necessarily summarised data that would go into a board report. Information overload can sometimes be as much of a problem as having too little information. Accounting information needs to be distilled in a manner that makes it clear and concise and does not overwhelm the user. In this context it is important to highlight that, while management accounting involves the process of transforming data about an organisation's performance into information that managers can use for many reasons, management accounting only produces good information if it is useful and relevant to its users.

5.1.1

Presenting performance information A number of developments in output reporting from information systems have been driven by the need to provide timely and tailored information, and also to avoid swamping the user with too much information.

Dashboards Increasingly, companies are looking at ways to reduce the number (and size) of paper reports, and to provide the necessary information to decision makers in an easy-to-read manner. One of the ways to do this is by using 'Executive Dashboards' which show current data, pictures, graphs and tables to illustrate how a business is performing and to help managers make better decisions. For example, a coffee and baked

goods chain has been looking to expand and is preparing to open a number of new stores. The chain managers use dashboards to see the status of the new stores. The dashboards display geographic areas and the new stores which are being developed. By clicking on an individual store, executives can see details of how the new stores are being constructed and if any are being delayed. Historically, much of the criticism of information systems and reports has focused on the difficulties users have faced when trying to produce the reports they wanted from the systems available. Reporting tools tended to be rigid and imposed many requirements about the way reports were produced. However, current reports offer more flexibility, and thereby allow managers to get the reports they actually need, or want.

Drill down reports Dashboards are often also combined with drill-down reports. Drill-down reports enable users to look at increasingly detailed data about a situation. For example, the sales managers could first look at data for a high level (such as sales for the entire company) and then drill down to a more detailed level (such as sales for individual departments of the company) if he or she is concerned about sales performance. The manager should then also be able to drill down to a very detailed level, possibly to look at sales for an individual sales representative. In this way, the manager can dictate the level of detail and information presented and can avoid being overloaded with too much initial detail.

Exception reports Another way of managing the amount of information being presented, and thereby preventing information overload, is through the use of exception reports. Exception reports are reports that are only triggered when a situation is unusual or requires management action. For example, the parameters could be set so that exception reports are generated for all capital projects which exceed budget by greater than $100,000. However, the key to using exception reports successfully is setting the parameters carefully. The aim of an exception report is only to highlight the situations which require management action. If the parameters are set too low (for example, all capital projects which exceed budget by over $100) then the manager will end up looking at too many items. Conversely, if the parameters are set too high (for example, capital projects which exceed budget by over $10 million) then situations which should receive management attention will not do so. Because the aim of exception reports is to highlight situations which require management attention or action, they are best used to monitor aspects of performance which are important to an organisation's success. In this respect, exception reports could be used to report against KPIs, or other aspects of an organisation's performance relating to its critical success factors. Finally, in relation to the outputs of information systems as a whole, users need to get involved when scoping what they require from their information systems. If a MIS has immense capacity but does not give users the data they need individually, then the system is making life harder for the user.

5.2

Qualities of good information The qualities of good information â&#x20AC;&#x201C; both financial and operational â&#x20AC;&#x201C; are outlined in the following table. You can use the mnemonic 'ACCURATE' to help you remember the qualities of good information. 'ACCURATE' can also be used as a framework when describing how poor information can be improved.

5.2.1

Improvements to information As well as being able to identify the qualities of good information, you may also need to identify the problems that an organisation has with the information it currently produces, and to suggest potential ways that information can be improved. The table below contains some suggestions as to how poor information can be improved.

5.3

Completeness, accuracy and credibility of data and information Another key feature which affects the quality and usefulness of information is the extent to which it accurately reflects real-world objects or events. For example, if an organisation's sales in a period are known to have decreased (such as due to a new competitor launching) but management information shows sales increasing, the management information's accuracy and usefulness for decision-making must be called into question. There are a number of factors which could potentially lead to poor quality data and information: Business dynamics change: A company expands into new markets but figures for the new markets are not incorporated into standard reports; a company purchases another company and has to consolidate

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figures from different software applications. System design changes: Over time the design of databases may change, such as when new fields are added. This will not prevent transactions being recorded accurately, but can affect management information. For example, it may mean that current information is no longer being compared to historical information on a like-for-like basis. Weak control over application changes: Cost (or time) pressure may lead business units to create or modify local applications despite not fully understanding the IT systems or software involved. As a result, these locally modified applications may no longer follow the same standards as applications in the rest of an organisation. This could lead to problems in consolidating or comparing data from the different systems. Lack of common data standards or meta-data: If an organisation doesn't have a standardised way of recording data, inconsistencies could arise if different operators record similar transactions or data differently. Legacy systems: As companies grow, they start building new systems with new system architectures. However, the way data is structured in these may be different to the way data is held in existing legacy systems. If the 'legacy' systems are not enhanced to bring them in line with the new systems, it will be difficult to manage data between the two systems. Time decay: Over time, the quality of data will decrease unless that data is updated. For example, customers on a customer database may change address or marital status. If a company is not aware of these changes, then the value of its data for marketing purposes declines. Data entry issues: In many systems, there will always be a risk of human error, but this can be reduced by well-designed entry forms. For example, the risk of data entry error can be reduced if there are controls that prevent a telephone number entry being posted with insufficient digits. Issues of accountability and quality control might also be relevant when considering the quality of information and data: Accountability â&#x20AC;&#x201C; Are managers held accountable for making certain that procedures (controls) are in place to ensure the completeness and reliability of data, and for making certain that those procedures are followed? Quality control â&#x20AC;&#x201C; Are there any systems tests to check the consistency and accuracy of the outputs from automated systems and databases? Are unexpected results investigated? A company's internal audit department could play an important role in providing assurance over these areas.

5.3.1

Business performance management software Although business performance management should not be primarily about software, organisations need to consider whether their performance management software is suitable for managing performance effectively and efficiently. Many organisations still rely on office tools (such as Microsoft Excel and PowerPoint) as their main technology to analyse and report performance data. However, particularly for large and complex organisations, spreadsheets may not be appropriate for performance management. For example, many spreadsheets contain significant errors. A lack of version control, and a lack of logging changes over time, lead to errors which could compromise the reliability of data in the spreadsheets and impede management's ability to make decisions based on data from the spreadsheets. Scalability: Large organisations are likely to find that the amount of data to analyse means that spreadsheets grow into big documents with colour coding, macros, calculations etc. In turn, this causes spreadsheet-based applications to become slow and prone to crashing. Often, there is just too much data and complexity in the spreadsheet. Equally, spreadsheet-based solutions are often manually fed and updated. As well as increasing the risk of human error, this makes them very time-consuming, as business analysts have to spend time updating the spreadsheets on a regular basis. Therefore, organisations should consider whether it may be more appropriate for them to use specialist performance management software rather than relying on standard office tools (such as Excel). For example, performance management software could provide managers with interactive drill-down capabilities to analyse performance data, and it could also provide business intelligence features such as trend analysis, root-cause and impact analysis, and simulation and scenario features.

5.4

Information risks The UK Government has published a paper 'Managing Information Risk' which includes a summary of the key areas of information risk an organisation needs to consider. Information risks are risks which affect an organisation's guardianship and management of information. In this respect, it is important to

note that information risks are not necessarily the same as IT risks, although managing IT security is likely to be a key component of any strategy to manage information risks.

Sources of internal assurance As well as identifying these risks, the Government paper also suggests potential sources of internal assurance over them. These include:

5.5



Identifying a Board-level senior information risk owner, supported by a team, to manage the organisation's information and information risks



Identifying key information assets across the organisation (in terms of both information content and information systems)



Producing and regularly updating a risk register for the organisation's information risks with key risks prioritised and action plans in place to address them



Compliance with legislation and key standards (eg Data Protection Act); spot checks to ensure data quality is being maintained



Clear guidance and rules about what information needs to be kept, how long it needs to be kept, and where it can (or cannot) be stored



Mandatory training in place for asset owners and users of information systems



Controls in place to restrict access to (or ability to change) key files; audit checks on inappropriate use of key systems, personnel security



Factoring information management into business and system design processes



Strong links between the information management team and IT teams



Back-ups of key information; back-up systems held in a secure, separate location



Strong, regular engagement of the Audit Committee with information risks



'Whistleblowing' procedures in place and understood by all staff



Mapping of key suppliers, their associated information assets linkages, and their risks



Clear standards and contractual obligations for suppliers to meet

Information systems and assurance In this chapter we have highlighted a number of ways in which organisations use information systems and information technology. Equally, however, we must recognise that the increasing use of computer systems brings certain risks to an organisation, which in turn could have an impact on the organisation's financial statements, or on the decisions made by management. Decision makers need to be confident in the credibility of the information they are using to make decisions. Two key risks of using computerised systems are: 

The system is put at risk by a virus or some other fault or breakdown which spreads across the system.



The system is invaded by an unauthorised user who could then disrupt the smooth operation of the system, or obtain commercially sensitive information from it.

Consequently, it is important for an organisation to ensure that its systems are as reliable as possible, and that they are the best systems at the given cost. If the organisation has purchased its information systems from an external service provider it might seek these assurances from its service provider. However, the service provider has a vested interest in believing that its system is reliable and the best available, because they are paid to supply it. Therefore, the organisation might seek an assurance service from its auditors to undertake work to ascertain whether the assertions made by the service provider are correct. In other words, the auditors might be asked to undertake an assurance assignment to report on the reliability and adequacy of an organisation's IT systems. If a firm of accountants is considering taking on such an assurance engagement, it must ensure that it has staff with sufficient skills and experience to undertake the procedures required. To this end, there must be an IT specialist on the engagement team. 680

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Information subject to assurance More generally, there is a wide range of information which could be subject to some form of external assurance. The following are examples of areas where an external assurance service might be requested: 

Quantitative information, including non-financial information and performance measures such as KPIs – the range of information which organisations now disclose (or have to disclose) about themselves has gone far beyond traditional financial reporting. However, if organisations are disclosing this information externally (for example, as part of their Annual Report) it follows that they also need external assurance on the quality of that information. In relation to business performance measurement an entity could seek assurance that its performance measurement systems contain relevant and reliable measures for assessing the degree to which its goals and objectives are achieved, or how its performance compares to that of its competitors.



Environmental information – for example, if an entity has stated a performance target to reduce greenhouse gas emissions, it will need someone to measure its level of emissions and verify the degree to which they have been reduced



Aspects of information technology such as information flows and security over those information flows. In particular, information system reliability – assurance that an entity’s internal information systems provide accurate and reliable information for operating and financial decisions.



Electronic commerce – assurance that systems and tools used in electronic commerce provide appropriate data integrity, security, privacy and reliability.



Compliance with contractual obligations



Risk assessment; Risk management systems and processes – assurance that an entity’s profile of business risks is comprehensive, and an evaluation of whether the entity has appropriate systems in place to effectively manage those risks.



Internal controls and the internal control environment



Governance, strategy and management processes

Few organisations can function effectively without IT systems supporting their key business processes, and many cannot function at all if their systems fail. However, organisations' systems may be vulnerable to attack or failure, either as a result of flaws in the design of the systems, failure to apply security patches, or poor security management. Unauthorised access to an organisation's systems and data could have serious financial or legal implications, as well as potentially damaging the reputation of the company. In this respect, the directors of the organisation might seek an assurance service from their auditors, or another firm of accountants, that the organisation's technology systems and the processes they support are functioning as intended. For example, are security systems designed to reduce the risk of unauthorised access to systems and data reliable? Systems audit An example of an assurance assignment might be a request to report on the adequacy of the internal controls in place. Internal control effectiveness is generally assessed by means of a systems audit. As part of any audit, auditors are required to assess the quality and effectiveness of an entity's accounting system, which necessarily includes a consideration of any computer systems in place within the entity which are linked to its accounting system. However, auditors could also accept an assurance engagement outside of the audit to report specifically on how reliable an entity's information systems are. Key areas which an assurance engagement is likely to concentrate on are: 



Management policy –

Does management have a written statement of policy in relation to computer systems and other information systems?

–

Is that policy compatible with management policy in other areas?

–

Is that policy sufficient and effective? Is it adhered to?

–

Is the policy updated when any systems are updated? Does it relate to the current systems?

Segregation of duties



–

Is there adequate segregation of duties in relation to data input?

–

Are there adequate systems controls (eg passwords) to enforce segregation of duties?

Security –

Is there a security policy in place covering physical security (locked doors/windows), access security (passwords), and data security (virus shields)?

–

Is the security policy sufficient and effective? Is it adhered to?

General controls and application controls When testing the control environment in an entity, an auditor should assess general controls as well as application controls. The areas covered by general IT controls include:     

Development of computer applications Prevention of and detection of unauthorised changes to programs Testing and documentation of program changes Controls to prevent unauthorised amendments to data files Controls to ensure continuity of operations (eg back-up and emergency procedures)

The purpose of application controls is to establish specific control procedures over accounting applications to provide reasonable assurance that all transactions are authorised and recorded, and are processed completely, accurately and on a timely basis. Application controls include data capture controls, data validation controls, processing controls, output controls and error controls. Controls and assurance over e-commerce Earlier in this Study Manual, we noted how e-commerce has provided new growth opportunities for entities. However, it is equally important to note that an entity using e-commerce also needs to have internal controls in place to mitigate against the risks associated with e-commerce. In particular these risks include security issues (eg ensuring customers transactions are secure) and process alignment (eg if a website is not automatically integrated with the internal systems of the entity, such as its accounting system and its inventory management system, the entity will need to ensure that it processes transactions completely and accurately). A key issue with e-commerce is trust. In many cultures, consumers grant their trust to business parties that have a close physical presence. On the internet this physical presence is simply not there. The seller's reputation, the size of the business, and the level of customisation in products and services also engender trust. Internet merchants need to elicit consumer trust when the level of perceived risk in a transaction is high. However, research has found that once consumers have built up trust in an internet merchant, such concerns are reduced. Internet merchants need to address issues such as fear of invasion of privacy and abuse of customer information (about their credit cards, for example) because these issues can stop people even considering the internet as a shopping channel. The parties involved in e-commerce need to have confidence that any communication sent gets to its target destination unchanged and without being read by anyone else. WebTrust and SysTrust are examples of assurance services developed in the last few years in relation to ecommerce. The underlying principles of these two services have been combined into one common set of principles known as Trust Services, which allow auditors to evaluate business systems and controls. WebTrust and SysTrust can be used to provide assurance on an organisation's website and on its systems respectively. Such assurance engagements are performed as reasonable assurance engagements in accordance with ISAE 3000.

6 Using information to develop competitive advantage Knowledge management is becoming increasingly important in helping organisations sustain competitive advantage.

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6.1

Knowledge management Knowledge management refers to the set of business processes developed in an organisation to create, store, transfer and apply knowledge. Knowledge management increases the ability of the organisation to learn from its environment and to incorporate knowledge into its business processes. (Laudon & Laudon, Management Information Systems) Knowledge management is a relatively new, but increasingly important, concept in business theory. It is connected with the theory of the learning organisation and founded on the idea that knowledge is a major source of competitive advantage in business. Studies have indicated that 20-30% of company resources are wasted because organisations are not aware of what knowledge they already possess. Lew Platt, former Chief Executive of Hewlett Packard, highlighted this when he said, 'If only HP knew what HP knows, we would be three times as profitable'. In effect, knowledge management has three phases: capturing knowledge, recording knowledge, and disseminating knowledge (across the organisation).

The importance of knowledge As organisations become more complex, there is more knowledge to manage. Moreover the importance of capturing and sharing it increases as job mobility increases. If staff leave, there is a danger that knowledge could leave with them if it has not been properly managed within the organisation. Also, organisations' external environments â&#x20AC;&#x201C; technology, competitors, markets â&#x20AC;&#x201C; are changing rapidly so organisations need to ensure they have up-to-date knowledge about these to take account of the opportunities and threats they represent. Knowledge is thus seen as an important resource, and knowledge management may in itself constitute a competence; it can certainly underpin many competences, and knowledge management should be seen as a strategy to achieve competitive advantage, for example through the sharing of cost reduction ideas across divisions, or through the diffusion of innovation. Companies are now starting to use Web technologies such as blogs and wikis for internal use to foster collaboration and information exchange between individuals and teams. Collaboration tools from commercial software vendors (such as Microsoft SharePoint) can also be used to share information between individuals and teams in an organisation. In a knowledge management system, an organisation will appoint knowledge managers who are responsible for collecting and categorising knowledge and encouraging other people in the organisation to use the available knowledge. The knowledge managers also monitor the use of knowledge in their organisation. Some companies are now taking the idea of knowledge sharing one stage further and are adopting the practice of knowledge brokering. In knowledge brokering, companies look externally to find ways of improving internal business processes. In effect, knowledge brokering resembles benchmarking by allowing companies to find world-class solutions to problems rather than having to invent their own solutions. For example, a bank faced frequent complaints from customers about the length of the queues in its local branches. The bank staff responsible for reducing queuing times identified three potential sources of brokers: amusement parks, supermarkets and department stores. In each of these environments, it is important to keep queuing times under control. In time, the bank worked with an amusement park and a supermarket to redesign layout of the windows in its branches and change the way it deployed staff between back office and customer-facing windows at busy times.

6.2

Organisational learning Organisational learning is particularly important in the increasing number of task environments that are both complex and dynamic. It becomes necessary for strategic managers to promote and foster a culture that values intuition, argument from conflicting views, and experimentation. A willingness to back ideas that are not guaranteed to succeed is another aspect of this culture; there must be freedom to make mistakes. The aim of knowledge management is to exploit existing knowledge and to create new knowledge so that it may be exploited in turn. This is not easy. All organisations possess a great deal of data, but it tends to be unorganised and inaccessible. It is often locked up inside the memories of people who do not realise the value of what they know. This is what Nonaka calls tacit knowledge. Even when it is made explicit (available to the organisation) by being recorded in some way, it may be difficult and time consuming to get at, as is the case with most paper archives. This is where knowledge management technology can be useful. Another important consideration is that tacit knowledge is inherently more robust than explicit knowledge.

6.2.1

Information, knowledge and competitive advantage Information and communications technologies have reduced the cost of storing and transmitting information, but they have also increased organisations' capacity for storing, processing and communicating information. As access to information becomes easier and less expensive, skills and competences relating to the selection and efficient use of information become increasingly important to organisations. This reinforces the idea that information and information management could become a core competence and a source of competitive advantage for an organisation. The resource-based approach to strategy highlights that a successful organisation acquires and develops resources and competences over time, and exploits them to create competitive advantage. The ability to capture and harness corporate knowledge has become critical for organisations as they seek to adapt to changes in the business environment, particularly those businesses providing financial and professional services. Therefore, as we have already mentioned, knowledge becomes a strategic asset. And organisation-specific knowledge, which has been built up over time, is a core competence that cannot easily be imitated. Therefore, knowledge management can help promote competitive advantage through:  

The fast and efficient exchange of information Effective channelling of the information to: – – –

Improve processes, productivity and performance Identify opportunities to meet customer needs better than competitors Promote creativity and innovation

However, the importance of meeting customer needs better than competitors means that organisations need to capture and analyse information about customers and potential customers rather than simply looking at internal processes. We consider some further illustrations of this when we discuss databases, 'Big Data' and analytics later in this chapter.

6.3

Learning organisations Peter Senge (who is one of the main proponents of the learning organisation concept) explains learning organisations as follows:

Definition Learning organisations are organisations where people continually expand their capacity to create the result they truly desire, where new and expansive patterns of thinking are nurtured, where collective aspiration is set free, and where people are continually learning to see the whole together. (Peter Senge) Johnson, Scholes and Whittington also highlight the importance of knowledge in learning organisations:

Definition A learning organisation is capable of continual regeneration from the variety of knowledge, experience and skills of individuals within a culture that encourages mutual questioning and challenge around a shared purpose or vision. (Johnson, Scholes and Whittington) The basic rationale for learning organisations is that in situations of rapid change, only those organisations which are flexible, adaptive and productive will be able to excel; and to achieve this flexibility and adaptability organisations need to harness people's commitment and capacity to learn at all levels. While all people have the capacity to learn, if they are not given the tools and capacity to make sense of the situations they face, they will not be able to learn from them. A learning organisation emphasises the sharing of information and knowledge both up and down the normal communication channels and horizontally through social networks and interest groups. It challenges notions of hierarchy and managers are facilitators rather than controllers. Such an organisation is inherently capable of change, because behaviours are adapted to reflect new knowledge (either about the external environment or about internal processes and performance). One of the main features of learning organisations is that they are continuously aware of, and interact with, their environments. The concept of the learning organisation has much in common with that of logical incrementalism. The challenge is to combine the advantages of rational planning with the resilience and adaptability 680

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provided by the learning approach.

6.3.1

Characteristics of learning organisations The basic idea behind the concept of the learning organisation is that learning should be treated as a core competence and a source of competitive advantage and, therefore, a learning organisation should be an environment where principles of learning can apply naturally. As a result, a learning organisation should exhibit features such as:

6.4



People are not blamed for taking calculated risks that do not work out (ie to encourage people to experiment with new approaches; creative tension is embraced as a source of energy and renewal).



People's workloads are managed so that they have time to try out new ideas, and/or to reflect on their experiences (ie to learn from their experiences, and from best practices of others).



Knowledge is transferred quickly and efficiently throughout the organisation.



Learning and development isn't seen as the preserve of a single organisational function (such as the HR department) but is regarded as a cross-departmental responsibility.



Individuals are provided with continuous learning opportunities (ie self-development is encouraged and training for this is provided).



There is an internal fit between learning activities and other aspects of performance management – such as the appraisal and reward structure – and the general culture of the organisation.



Individual performance is linked with organisational performance.

Knowledge management (KM) systems Laudon and Laudon highlight that one apt slogan of knowledge management is 'Effective knowledge management is 80% managerial and organisational, and 20% technology.' In other words, the culture and patterns of behaviour in an organisation need to support knowledge management. IT cannot support knowledge management by itself. For example, in order for knowledge to be shared between teams, members from different teams have to be prepared to share it. In terms of actually developing and implementing a knowledge management strategy, there are five main steps to consider:

6.4.1

(a)

Support from senior management. Senior management support will be needed not only to provide the necessary resources and to lead the development of a knowledge-based culture, but also because if senior managers are not seen to be supporting the strategy then other staff will not do so either.

(b)

Installing the IT infrastructure. IT hardware and software will need to be acquired to ensure that the organisation has the capabilities to capture, store and communicate knowledge.

(c)

Developing the databases. Advanced databases and database management systems may need to be developed, with the details of their design and structure being tailored to the type of knowledge the organisation is looking to capture.

(d)

Develop a sharing culture. Knowledge is widely known to represent power, and staff are likely to want to hoard the knowledge they have already accumulated rather than to share it. A culture of knowledge sharing must be developed.

(e)

Capturing and using the knowledge. Existing knowledge needs to be captured and recorded in the databases. Staff then need to be trained how to use the databases and encouraged to do so.

Potential issues in implementing a knowledge management system Structure and culture – The current structure and culture of an organisation may not be conducive to sharing knowledge; for example, if there is little communication between departments in an organisation, or if staff are reluctant to share knowledge for fear that it will reduce their power within the organisation. These inherent barriers will have to be overcome in order for the system to be successful. Technological infrastructure – If an organisation does not have a suitable network which allows information to be stored and accessed, one will have to be installed before knowledge can be shared across the organisation. There may be significant costs associated with installing such a network. Incompatible systems and sources of information – Problems could arise if some divisions or departments record data or information in systems which are incompatible with those used by other divisions or departments. Such a situation will mean that data or information must be transferred into a new common format before they can

be shared, and there is a risk that errors or omissions could result

from the resulting conversion process.

Equally, it is possible that some information is not stored in a digital form at all, and so the organisation will have to decide how this material can be indexed and archived such that it can be accessed when needed. Resistance to change â&#x20AC;&#x201C; Staff in different areas of an organisation may already have their own preferred ways of organising data. However, this may not be compatible with the common format in which data is held on the network. Staff may be reluctant to change their current practices, particularly if they are not given adequate training in any new systems or sufficient time to adapt to them.

6.4.2

IT and knowledge management systems Importantly, although there is an IT element to knowledge management systems and their infrastructure, a knowledge management strategy need not be IT-driven. IT should support rather than dominate the strategy. The cultural aspects of a knowledge management strategy (particularly encouraging staff to share knowledge) are likely to be just as critical to its success as the IT elements. Nonetheless, the IT elements (knowledge management systems) do play an important role in facilitating knowledge management. In this context, expert systems, databases and data warehouses all help to acquire and store information which can, in turn, be converted into knowledge.

6.4.3

Expert systems An expert system is a computer program that captures human expertise in a limited domain of knowledge. Such software uses a knowledge base that consists of facts, concepts and the relationships between them and uses pattern-matching techniques to solve problems. For example, many financial institutions now use expert systems to process straightforward loan applications. The user enters certain key facts into the system such as the loan applicant's name and most recent addresses, their income and monthly outgoings, and details of other loans. The system will then: (a)

Check the facts against its database to see whether the applicant has a good previous credit record.

(b)

Perform calculations to see whether the applicant can afford to repay the loan.

(c)

Make a judgement as to what extent the loan applicant fits the lender's profile of a good risk (based on the lender's previous experience).

(d)

A decision is then suggested based on the results of this processing.

IT systems can be used to store vast amounts of data in an accessible form. A data warehouse receives data from operational systems, such as a sales order processing system, and stores it in its most fundamental form, without any summarisation of transactions. Analytical and query software is provided so that reports can be produced at any level of summarisation and incorporating any comparisons or relationships desired. The value of a data warehouse is enhanced when data mining software is used. True data mining software discovers previously unknown relationships and provides insights that cannot be obtained through ordinary summary reports. These hidden patterns and relationships constitute knowledge, as described above, and can be used to guide decision making and to predict future behaviour. Data mining is thus a contribution to organisational learning. For example, the relationship between the weather and changes in peoples' purchasing habits in supermarkets can be viewed as knowledge discovery through data mining.

6.4.4

Databases and models The way in which data is held on a system affects the ease with which that data can be accessed and then analysed. Many modern software packages are built around a database. A database provides a comprehensive set of data for a number of different users. A database is a collection of data organised to service many applications. The database provides convenient access to data for a wide variety of users and user needs. A database management system is the software that centralises data and manages access to the database. It is a system which allows numerous applications to extract the data they need without the need for separate files. Databases can be used in conjunction with a variety of tools and techniques, eg Decision Support Systems, Executive Information Systems, data warehousing, and data mining.

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6.4.5

Data warehouses Definition Data warehouse: A data warehouse consists of a database containing data from various operational systems and reporting and query tools. A data warehouse is a large-scale data collection and storage area containing data from various operational systems, plus reporting and query tools which allow the data to be analysed. The key feature of a data warehouse is that it provides a single point for storing a coherent set of information which can then be used across an organisation for management analysis and decision making. Importantly, a data warehouse is not an operational system, so the data in it remains static until it is next updated. For example, if a supermarket introduces a customer credit card, the history of customers' transactions on their cards could be stored in a data warehouse so that management could analyse spending patterns. However, although the reporting and query tools within the warehouse should facilitate management reporting and analysis, data warehouses are primarily used for storing data rather than analysing data. A data warehouse contains data from a range of internal (eg sales order processing system, nominal ledger) and external sources. One reason for including individual transaction data in a data warehouse is that, if necessary, the user can drill-down to access transaction level detail. Increasingly, data is obtained from newer channels such as customer care systems, outside agencies or websites. Maintenance of a data warehouse is an iterative process that continually refines its content. Data is copied to the data warehouse as often as required â&#x20AC;&#x201C; usually daily, weekly or monthly. The process of making any required changes to the format of data and copying it to the warehouse tends to be automated. The result should be a coherent set of information available for use across the organisation for management analysis and decision making. The reporting and query tools available within the warehouse should facilitate management reporting and analysis. The reporting and query tools should be flexible enough to allow multidimensional data analysis also known as on-line analytical processing (OLAP). Each aspect of information (eg product, region, price, budgeted sales, actual sales, time period etc) represents a different dimension. OLAP enables data to be viewed from each dimension, allowing each aspect to be viewed and in relation to the other aspects.

Features of data warehouses A data warehouse is subject-oriented, integrated, time-variant, and non-volatile. (a)

Subject-oriented A data warehouse is focused on data groups, not application boundaries. Whereas the operational world is designed around applications and functions such as sales and purchases, a data warehouse world is organised around major subjects such as customers, suppliers, products and activity.

(b) Integrated Data within the data warehouse must be consistent in format and codes used â&#x20AC;&#x201C; this is referred to as integrated in the context of data warehouses. For example, one operational application feeding the warehouse may represent sex as'M' and 'F' while another represents sex as '1' and '0'. While it does not matter how sex is represented in the data warehouse (let us say that 'M' and 'F' is chosen), it must arrive in the data warehouse in a consistent, integrated state. The data import routine should cleanse any inconsistencies. (c)

Time-variant Data is organised by time and stored in time-slices. Data warehouse data may cover a long time horizon, perhaps from five to ten years. Data warehouse data tends to deal with trends rather than single points in time. As a result, each data element in the data warehouse environment must carry with it the time for which it applies.

(d) Non-volatile Data cannot be changed within the warehouse. Only load and retrieval operations are made.

Advantages of data warehouses Advantages of setting up a data warehouse system include the following. (a)

Supports strategic decision making. The warehouse provides a single source of authoritative data which can be analysed using data mining techniques to support strategic decision making.

(b)

Decision makers can access data without affecting the use of operational systems.

(c)

Data quality. Having a single source of data available will reduce the risk of inconsistent data being used by different people during the decision making process.

(d)

Having a wide range of data available to be queried encourages the taking of a wide perspective on organisational activities.

(e)

Speed. Data warehousing can enable faster responses to business queries, not only by storing data in an easily accessible central repository but also by using OLAP technologies.

(f)

Data warehouses have proved successful in some businesses for: (i) Quantifying the effect of marketing initiatives (ii) Improving knowledge of customers (iii) Identifying and understanding an enterprise's most profitable revenue streams

In this way, data warehouses (and data mining) allow organisations to use the data they hold to help improve their competitiveness.

Limitations of data warehouses Some organisations find they have invested considerable resources implementing a data warehouse for little return. To benefit from the information a data warehouse can provide, organisations need to be flexible and prepared to act on what they find. If a warehouse system is implemented simply to follow current practice, it will be of little value. Other limitations exist, particularly if a data warehouse is intended to be used as an operational system rather than as an analytical tool. For example: (a)

The data held may be outdated.

(b)

An efficient regular routine must be established to transfer data into the warehouse.

(c)

A warehouse may be implemented and then, as it is not required on a day-to-day basis, be ignored.

There is also an issue of security. The management aim of making data available widely and in an easily understood form can be at variance with the need to maintain confidentiality of, for example, payroll data. This conflict can be managed by encrypting data at the point of capture and restricting access by a system of authorisations entitling different users to different levels of access. For this to work, the data held must be classified according to the degree of protection it requires; users can then be given access limited to a given class or classes of data. Encryption at the point of capture also exerts control over the unauthorised uploading of data to the data warehouse.

6.4.6

Data mining While a data warehouse is effectively a large database which collates information from a wide variety of sources, data mining is concerned with the discovery of meaningful relationships in the underlying data. Data mining software looks for hidden patterns and relationships in large pools of data. Data mining is primarily concerned with analysing data. It uses statistical analysis tools to look for hidden patterns and relationships (such as trends and correlations) in large pools of data. The value of data mining lies in its ability to highlight previously unknown relationships. In this respect, data mining can give organisations a better insight into customer behaviours, and can lead to increased sales through predicting future behaviour. When a supermarket customer pays for their shopping using a loyalty card (see example about Tesco's Clubcard in the next section), the supermarket can create a record of the items the customer has bought. The purchasing behaviour of customers can be used to create a profile of what kinds of people the cardholders are. Data mining techniques could be applied to customers' purchasing information to identify patterns in the items which were purchased together, or what types of item were omitted from shopping baskets, and how the make-up of customers' baskets varied by different types of customer. The supermarket could then target its promotions to take advantage of these purchasing patterns.

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In this way, by identifying patterns and relationships, data mining can guide decision-making. True data mining software discovers previously unknown relationships. The hidden patterns and relationships the software identifies can be used to guide decision making and to predict future behaviour. Obtaining detailed customer information is an important element of customer relationship management. Obtaining detailed customer information allows a firm to identify customer needs and develop improved ways of meeting those needs, as well as targeting marketing campaigns to specific customers, bringing relevant new products or services to their attention. Customer loyalty/reward cards can provide valuable information about the buying habits and patterns of customers, but more generally the process of gathering and storing data about customers and then analysing patterns is an application of data warehousing and data mining.

6.5.1

Business intelligence Business intelligence (BI) refers to technologies, applications, and practices for collecting, integrating, analysing, and presenting business information. Analytics relates to the use of (a) data and evidence, (b) statistical, quantitative and qualitative analysis, (c) explanatory and predictive models, and (d) fact-based management to drive decision making. Together, they include approaches for gathering, storing, analysing and providing access to data that helps users to gain insights and make better fact-based business decisions, to improve performance, to help cut costs or to help identify new business opportunities. Examples of business intelligence and analytics applications include:        

Measuring, tracking and predicting sales and financial performance Budgeting, financial planning and forecasting Analysing customer behaviours, buying patterns and sales trends Tracking the performance of marketing campaigns Improving delivery and supply chain effectiveness Customer relationship management Risk analysis Strategic value driver analysis

Overall, a company also needs intelligence about its business environment to enable it to anticipate change and design appropriate strategies that will create business value for customers and be profitable in new markets and new industries in the future. Not only does a company have to anticipate the future, but it also needs the capability to react to that future successfully. (This reiterates the point we noted in Section 3.8 earlier, that the speed and effectiveness with which an organisation reacts to opportunities and threats could be a dynamic capability for it.)

6.5

Information, knowledge and competitive advantage The resource based view of strategy, discussed in Chapter 1, highlights that a successful organisation acquires and develops resources and competences over time, and exploits them to create competitive advantage. The ability to capture and harness corporate knowledge has become critical for organisations as they seek to adapt to changes in the business environment, particularly those businesses providing financial and professional services. Therefore, as we have already mentioned, knowledge becomes a strategic asset, and organisation- specific knowledge, which has been built up over time; it is a core competence that cannot easily be imitated. Therefore, knowledge management can help promote competitive advantage through: 

The fast and efficient exchange of information



Effective channelling of the information to: – – –

Improve processes, productivity and performance Identify opportunities to meet customer needs better than competitors Promote creativity and innovation

Importantly, however, the importance of meeting customer needs better than competitors means that organisations need to capture and analyse information about customers and potential customers rather than simply looking at internal processes.

6.6.1

Supply chain information Another context in which information can help generate competitive advantage is the supply chain, and

supply chain management, which we discussed in Chapter 3 of this Study Manual.

6.6.2

Bullwhip effect We have just suggested that supply chain management and networks should involve companies working together to meet customers' needs more effectively. In theory, collaboration and connectivity should enable this: customers order products, the vendor keeps track of what is being sold and orders enough materials or inputs from supplier to meet customers' demand and replenish inventory levels in line with expected future demand. However, in practice, the supply chains are not always this co-ordinated. Suppliers, manufacturers, sales people, and even customers often have an incomplete understanding of what the real demand is. These dynamics create inaccuracy and volatility in production levels, and these (inaccuracies and volatility) increase for operations further upstream in the supply chain. This increase is known as the bullwhip effect, because the increasingly large disturbances in the chain as they work their way to the end resemble the oscillations in a whip when it is cracked. Each group in the supply chain (suppliers, manufacturers, sales staff) only has control over part of the chain, but the decisions they take (for example, ordering too much or too little) affect production or inventories levels throughout the whole chain. Furthermore, each group in the chain is influenced by decisions that others are making. We can illustrate the effect using a very simple model of a supply chain, in which all the producers in the chain work on the principle that they keep one month's inventory in stock at any time. In the model, market (customer) demand has historically been running at 100 units per period (prior to period 1). However, demand starts to fluctuate from period 2. Although the bullwhip effect in our model is simply caused by movements in and out of stock working their way up the supply chain, the effects can be magnified by problems of communication or coordination in the supply chain. This can be illustrated by the story of a car manufacturer which found itself with surplus inventories of green cars. To help get these sold, the car manufacturer's sales department offered special deals on green cars, so demand for them increased. However, the production departments were unaware of the promotion, and so when they saw the increase in sales they increased the production of green cars. This simple 'car' example highlights one of the key problems behind the bullwhip effect: each operation in the supply chain only reacts to the orders placed by its immediate customer, but they have little overview of what is happening throughout the chain as a whole. Therefore, in order to improve supply chain performance (and reduce the bullwhip effect) organisations need to improve the co-ordination of all the activities in the chain and the knowledge sharing throughout the supply chain. For example, if retailers make information on sales available to their suppliers, suppliers are more aware of movements in final customer demand and manage production accordingly. In this context, one way to reduce the bullwhip effect is through better forecasts. However, a more important solution is to make sure that the strategies of all the firms in the supply chain are harmonised, and one way of doing this is through vendor-managed inventory.

6.6.3

Vendor-managed inventory One way of reducing fluctuations in demand and production throughout the supply chain is to allow an upstream supplier to manage the inventories of its downstream customer. This is known as vendor managed inventory (VMI). Under a VMI model, the (downstream) buyer of a product provides information about customer demand to the (upstream) supplier of that product, and the supplier manages production levels in order to maintain an agreed inventory of the product to meet demand. VMI encourages a closer relationship and understanding between buyer and supplier, and it helps reduce both the levels of inventory in the supply chain and the risk of stock-out situations. Because the vendor is responsible for supplying the buyer when items are needed, this removes the need for the buyer to hold significant levels of safety stock. However, a crucial element in VMI working effectively is the use of Electronic Data Interchange (EDI) between the buyer and supplier; for example, so that the supplier knows the quantity of a product the buyer has sold to end-user customers. Effective VMI also uses statistical methodologies and demandplanning tools to help forecast and maintain the correct levels of inventory in the supply chain (taking account of variables such as promotions or seasonality for example). Integrated supply chain management packages provide web-enabled visibility to suppliers so that they can

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review the on-hand inventory at their buyers' warehouses. The packages also allow buyers and suppliers to calculate buffer quantities, and when the buffer level is reached this triggers a new order from the supplier. A crucial difference between a VMI system and traditional supply chain arrangements is that the vendor receives data from the buyer rather than purchase orders. Instead of the downstream buyer making purchase orders and 'pulling' supply through the system, the upstream supplier now initiates the order (based on the purchase information they receive) and they 'push' supplies through the system.

7 Big Data and competitive advantage In a number of places in this chapter, and earlier in this Study Manual, we have looked at the way entities collect and use information to support their strategic and tactical decision-making. Equally, we highlighted the way organisations can use data mining to uncover hidden relationships and patterns in data, for example in the context of strategic marketing and discovering trends in customers' buying behaviours. Organisations today have more transactional data than they have had before â&#x20AC;&#x201C; about their customers, suppliers and about their operations. More generally, the growth of the internet, multimedia, wireless networks, smartphones, social media, sensors and other digital technology are all helping to fuel a data revolution. In the so-called 'Internet of Things', sensors embedded in physical objects such as mobile phones, motor vehicles, smart energy meters, RFID tags, tracking devices and traffic flow monitors all create and communicate data which is shared across wired and wireless networks that function in a similar way to the internet. The timing and location of cash withdrawals from ATM machines could also be a potential source of data; as could footage from data from webcams or footage from surveillance cameras. Consumers using social media, smartphones, laptops and tablets to browse the internet, to search for items, to make purchases and to share information with other users all create trails of data. Similarly, internet search indexes (such as Google Trends) can be a source of data for 'Big Data analytics'.

7.1

What is Big Data? In a June 2011 report, 'Big data: The next frontier for innovation, competition and productivity' McKinsey Global Institute defined big data as 'datasets whose size is beyond the ability of typical database software to capture, store, manage and analyse.' However, the most widely cited definition of Big Data is that given by the technology research firm, Gartner:

Definition Big Data: is 'high-volume, high velocity and high-variety information assets that demand cost-effective, innovative forms of information processes for enhanced insight and decision making.' (Gartner) In this respect, 'Big Data analytics' is likely to be crucial to making use of the potential value of big data. Big Data analytics refers to the ability to analyse and reveal insights in data which had previously been too difficult or costly to analyse â&#x20AC;&#x201C; due to the volume and variability of the data involved. The aim of big data analytics is to extract insights from unstructured data or from large volumes of data. Being able to extract insights from the data available is crucial for organisations to benefit from the availability of Big Data â&#x20AC;&#x201C; for example, to help them understand the complexity of the environment in which they are operating, and to respond swiftly to the opportunities and threats presented by it; or to develop new insights and understanding into what customers need or want. (Think back to the example in Section 6.5 of the way the supermarket, Morrisons, uses weather forecasts to predict customer purchasing patterns, and accordingly to manage the mix of products it stocks in its stores at any time.)

7.2

Making use of Big Data Historically, only the largest corporations have had sufficient resources to be able to process Big Data. Now, however, it is becoming possible for all organisations to access and process the volumes of Big Data potentially available to them, due to cost-effective approaches such as cloud-based architectures and open source software. McKinsey's Big Data report suggests that 'Big data has now reached every sector in the global economy. Like other essential factors of production such as [physical] assets and human capital, much of modern economic activity simply couldn't take place without it.' This suggests that the ability to capture and analyse Big Data, and the information gained by doing so, have become important strategic resources for organisations. Making effective use of Big Data could confer competitive advantage for an organisation. Alternatively, in time, competitors who fail to develop their

capabilities to use Big Data and information as strategic resources could be left behind by those who do. While these might initially seem to be quite bold claims, Big Data can certainly create value for organisations through its ability to drive innovation and by helping organisations gain greater and faster insights into their customers. Similarly, analysing data from as many sources as possible when making decisions, can also increase the amount of useful information available to managers when they are making decisions. However, the distinction between simply having ‘data’ and having ‘useful information’ is important here. Simply having more data available to them does not, in itself, benefit organisations. Instead, organisations benefit if that data is converted into valuable information and managers then use that information to make effective decisions – which, for example, improve operational efficiency and customer experience, or which enable new business models to be created.

7.3

The value of Big Data The case study above (about Big Data in the logistics industry) has illustrated some of the ways Big Data can help an organisation, but more generally, DHL’s report Big Data in Logistics, suggested that one of the main ways in which Big Data can create value for organisations is through improving operational efficiency. Data can be used to make better decisions, to optimise resource consumption and to improve process quality and performance. In this respect, Big Data provides similar benefits to automated data processing, although Big Data can increase the level of transparency in the data.

7.4

Data and customers So far in this section we have looked at the way organisations can use big data to improve their understanding of what their customers want. However, Web 2.0 technologies (which we discussed in Chapter 5) mean that data is increasingly available to customers as well as organisations. For example, online customer reviews are now commonplace, and smartphone applications (‘apps’) now enable customers to evaluate and compare product prices in real time. This increased availability of data creates a new market transparency which can give customers a greater insight into what they are buying, and who they are buying from. In this respect, the data helps customers to base purchasing decisions not only on price, but also on a company's social reputation – for example, in terms of customers' feedback in relation to the quality of service they have received.

7.5

Potential limitations of Big Data Some critics have argued that Big Data is simply a buzzword, a vague term which has turned into an obsession in large organisations and the media. However, the critics argue that very few instances exist where analysing vast amounts of data has resulted in significant new discoveries of performance improvements for an organisation. Correlation not causation – The primary focus within Big Data is on finding correlations between data sets, rather than focusing on the cause of any trends and patterns. It can often be easier to identify correlations between different variables than to determine what – if anything – is causing that correlation. Correlation does not necessarily imply causality. Similarly, if an organisation does not understand the factors which give rise to a correlation, it will equally not know what factors may cause the correlation to break down. Sample population – While the data sets available through Big Data are often very large, they are still not necessarily representative of the entire data population as a whole. For example, if an organisation uses 'tweets' from the social networking site Twitter to provide insight into public opinion on a certain issue, there is no guarantee the 'tweets' will accurately represent the view of society as a whole. (For example, according to the Pew Research Internet Project, in 2013, US-based Twitter users were disproportionately young, urban or suburban, and black.) Data vs relevant information – More generally, in their review article ‘Two dogmas of Big Data,’ Deloitte also note that there is a misconception that ‘more bytes yields more benefits’. In other words, management decisions are based on relevant information, not raw data. Therefore, by itself, increasing the volume of data available to an organisation does not necessarily provide managers with better information for decision-making. Deloitte’s article also suggests that, given the time and expense involved in gathering and using Big Data, entities need to consider whether ‘big data yields commensurately big value’. As the article points

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out, the paramount issue when gathering data is not volume, variety or velocity per se, but ‘gathering the right data that carries the most useful information for the problem at hand.’ Data silos – Furthermore, an organisation’s ability to maximise the value it obtains from Big Data could be restricted by ‘data silos’ within the organisation (although this issue represents a problem with the ways organisations share data and information between departments rather than a specific limitation of the value of Big Data). For example, insurance companies are aware that Big Data could have a significant effect on their industry – through helping to combat fraud or through enabling them to understand customers better and to price premiums more accurately. Equally, however, insurers are aware that data silos persist within their organisations which reduce the value they can extract from the data, with communication channels between the risk department and the sales and marketing departments, in particular, often being inadequate.

7.6 7.6.1

Ethics and governance Potential ethical issues Although Big Data can help entities gather more information about their customers and understand customer behaviour more precisely, gathering this data could also raise significant ethical and privacy issues. In particular, to what extent should information about individuals remain private (or confidential) rather than being shared across analytical systems? Organisations’ demand for Big Data has led to data itself becoming a business – with entities such as data brokers collecting massive amounts of data about individuals, often without their knowledge or consent, and being shared in ways they don’t want or expect. But, critics argue that in order for Big Data to work in ethical terms, the individuals whose data is being collected need to have a transparent view of how their data is being used or sold. On the one hand, if organisations have access to personal data – such as health records or financial records – this could help them to pinpoint the best medical treatment for a patient or the most appropriate financial products for a customer. On the other hand, however, these categories of personal data are those which consumers regard as being the most sensitive. In this respect, Big Data raises questions around how organisations and individuals will manage the trade-offs between privacy and utility of data. If companies are using Big Data properly, it will be vital for them to consider data protection and privacy issues. On the one hand, they must ensure they comply with any legislation about these areas. But even if they comply with prevailing laws, the large-scale collection and exploitation of data could still arouse public debate, which could subsequently damage corporate reputation and brand value. The issue of data security is also closely linked to issues of privacy. What steps – and technologies – are organisations taking to prevent breaches of data security which could expose either personal consumer information or confidential corporate information?

7.6.2

Potential governance issues The use of Big Data also requires organisations to maintain strong governance on data quality. For example, the validity of any analysis of that data is likely to be compromised unless there are effective cleansing procedures to remove incomplete, obsolete or duplicated data records. Similarly, it is very important for organisations to assure that the overall data quality from different data sources is high because the volume, variety and velocity characteristics of Big Data all combine to make it difficult to implement efficient procedures for validating data or adjusting data errors.

7.7

Big Data and digitalisation in knowledge-based organisations Earlier in this chapter, we discussed knowledge management and learning organisations, and these discussions of Big Data remind us how knowledge – and the use of technology to support knowledge creation – are becoming increasingly important components of organisations' potential competitive advantage. The increasing competitiveness of the global economy means that productivity gains or product improvements made by one company are often rapidly eliminated by their competitors' response. In this respect, a company's process of innovation – and its ability to derive value from the information it has about products and markets – is likely to be critical to maintaining its competitive advantage in the face of a constantly changing market and economic environment. Equally, in the 'information society' which exists today, information is one of the most valuable assets which organisations have, and information management and knowledge management are also likely to be essential parts of an organisation's competitive success, because they play a key role in value creation and productivity.

7.7.1

Knowledge-based organisations Many organisations focus primarily on the routine tangible and observable activities that they carry out on a daily basis. However, knowledge-based organisations also focus on two related processes which underlie these primary processes: the effective application of existing knowledge, and the creation of new knowledge to produce economic benefits. The success of knowledge-based organisations relies on their intangible assets – such as research, design, development, creativity, learning, and human capital. As we would expect, knowledge creation and knowledge sharing are key features of a knowledge-based organisation. And while it is important that knowledge is shared within an organisation – for example, between different departments – organisations are also realising that knowledge can often also be gathered and shared as a result of interactions with customers, suppliers, and possibly even competitors. In this respect, initiatives such as co-creativity and crowdsourcing have been important for the creation and sharing of knowledge. Procter & Gamble's 'Connect + Develop' programme illustrates this point. However, while technological developments such as data warehousing and data mining have already helped to promote knowledge management in organisations, and the advent of Web 2.0 technologies has helped organisations gather more information about customers, the volume and variety of 'Big Data' means it has the potential to act as a source of even more knowledge to be created and shared. In this context, Big Data presents two key challenges to organisations: (a)

Information strategy ̶ Organisations need to harness the power of information. Big Data is providing new ways to leverage information, but organisations need to be able to take advantage of them if they are going to be able to use the information to generate growth. How will they harness Big Data to improve strategic decision-making – for example in evaluating potential new investments? Organisations also have to have the infrastructural capacity to manage the volume, variety and velocity of the data available – and to process it – in order to maximise its value as a source of information and knowledge.

(b)

7.7.2

Data analytics – Organisations need to be able to draw insights from large and complex datasets, in order to understand and predict customer behaviours, and to improve customer satisfaction or to drive innovation.

Digitisation and business value When considering the potential impact of digitisation on business, it is also important to acknowledge the point highlighted in the report by McKinsey's: Finding your digital sweet spot. This report argues that 'while online sales, social networking and mobile applications have received most of the buzz when it comes to digital' the greatest bottom-line impact may come from cost savings and changes beyond the interface between company and customer. If organisations focus too narrowly on the impact of digitisation on distribution channels only and the end-user customer interface, they will only gain a small proportion of the value that digitisation could provide. Tools such as big-data analytics, apps, workflow systems and cloud platforms – all of which can enable business value – are too often applied selectively to certain parts of the organisation only, often around sales and marketing. However, they could also be used, equally beneficially, across a much wider range of activities: (a)

Connectivity with customers, colleagues and suppliers 

Customer experience – Seamless, multi-channel experience; 'Whenever, wherever' service proposition



Product and service innovation – New digital products and services; co-creation of new products

(b) Decision making – based on Big Data and advanced analytics  (c)

Innovation of product, business models and operating models   

7.7.3

Enhanced corporate control – improved real-time management information systems, supporting improved decision making

Distribution – digital augmentation of traditional distribution channels Marketing and sales – digital marketing; improved targeting with greater customer insights Fulfilment – digital fulfilment; virtual servicing and administration

Unlocking trapped value In our discussion of Big Data earlier, we mentioned how insights from Big Data could be used to adjust pricing in real time (in response to patterns of demand and inventory levels) but equally they could be

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used to forecast and manage operational capacity. Similarly, while 'app' technology is typically focused on improving customer interactions, it could also be applied to a range of internal interactions – for example, procurement requests with suppliers. Smarter and more complete application of digital investments can unlock 'trapped' value within an organisation, by improving information flows and reducing waste across it. McKinsey's report 'Finding your digital sweet spot' offers the following illustration of how 'digital' can benefit an organisation in different ways at an operational level. A bank found that upgrading its digital channel led to a significant improvement in the richness and quality of its customer data which, in turn, increased the bank's marketing effectiveness. However, the improved customer data also drove better lending decisions by reducing risk, and digitisation also enabled customers to apply for a number of products online whereas previously the fulfilment process had been labour intensive.

7.7.4

Digitisation and the ‘internet of things’ More generally, there are a number of ways which organisations can make use of digitisation and the information being created through the 'internet of things'. Information and analytics Monitoring behaviour ̶ When products are embedded with sensors, companies can track the movements of the products and business models can be fine-tuned to take advantage of this detail. For example, insurance companies offer to install location sensors in customers' cars. These capture data on how well a car is driven, as well as where it travels. As a result, prices can be customised to the actual risk associated with operating the car, rather than being based on proxies such as a driver's age, gender or place of residence. Similarly, radio-frequency identification (RFID) tags on products moving through the supply chain can be used to improve inventory management and to reduce working capital and logistics costs. Situational awareness – Logistics managers for freight companies can use information about traffic patterns, weather conditions and vehicle locations to make adjustments to their vehicles' routes in order to reduce the risk of delays. Decision analytics – Retail companies can monitor data from thousands of shoppers as they move through stores. Sensor readings and videos note how long shoppers spend at individual displays, while the stores also have information about what customers ultimately buy. Simulations based on the sensor readings, coupled with purchase records, can be used to increase revenues by optimising store layouts. In relation to healthcare, sensors can be fitted to patients with heart problems and can monitor key indicators such as heart rate, rhythm, and blood pressure which could give medics early warning of conditions which could otherwise lead to unplanned hospitalisation and emergency treatment costs. Automation and control Process optimisation – Sensors on production lines provide data about temperature, pressure or ingredient mixtures (for example) to computers which analyse the data and then send signals back to the production line to adjust the process – for example, to reduce the temperature if it has become too high. Similarly, sensors can be used to adjust the position of an object as it moves down an assembly line to prevent the damage to the object, or the process jamming. Resource consumption – 'Smart meters' can provide energy customers with visual displays showing their energy usage and the real-time costs of providing it. (Although customers may pay a fixed price per unit for their energy, the cost of producing energy varies substantially during a day.) Based on pricing and usage information, customers could then delay running energy-intensive processes from high-priced periods of peak energy demand to low-priced off-peak hours.

Strategic Business Management Chapter-10 Human resource management 1 Strategic human resource management (HRM) 1.1

Human resource management Human resources strategy involves two inter-related activities: 

Identifying the number and type of people needed by an organisation to enable it to meet its strategic business objectives



Putting in place the programmes and initiatives to attract, develop and retain appropriate staff

Human resource management (HRM) includes all the activities management engage in to attract and retain employees, and to ensure that they perform at a high level and contribute to achieving organisational goals. For some companies, particularly service companies, human resources may be a source of strategic advantage in their own right. After all, how many times are we told that a company's people are key assets?

Components of HRM Within the overall aims of attracting and retaining employees, and ensuring they perform at a high level, we can identify five major components for an organisation's HRM systems: 

Recruitment and selection – Attracting and hiring new employees who have the ability, skills and experience to help an organisation achieve its goals.



Training and development – To ensure that all staff develop the skills and abilities which will enable them to perform their jobs as effectively as possible in the present and in the future. In the context of knowledge management and learning organisations, the idea of learning and development should become increasingly important.



Performance appraisal and feedback – Appraisals serve two different purposes in HRM: judgement (in order to make decisions about pay, promotion, and work responsibilities) and development (assessing employees' training and development needs, and supporting their performance).



Pay and benefits – The level of pay and benefits offered to staff has to be appropriate to retain staff. By rewarding high-performing staff with pay rises, bonuses etc managers can increase the likelihood that an organisation's most valued human resources are motivated to continue their high levels of performance, and are more likely to stay with the organisation. Equally, offering attractive pay and benefits should help an organisation fill vacant positions with talented people.



Labour relations – Labour relations encompass the steps that managers take to develop and maintain good working relations with unions that may represent their employees' interests.

The following short example highlights the importance of human resource management by examining the problems which can occur when staff are not motivated to help an organisation perform successfully.

Definition Human resource management (HRM): 'A strategic and coherent approach to the management of an organisation's most valued assets: the people working there who individually and collectively contribute to the achievement of its objectives for sustainable competitive advantage.' (Armstrong) Human resource management (HRM): 'A strategic approach to managing employment relations which emphasises that leveraging people's capabilities is critical to achieving sustainable competitive advantage, this being achieved through a distinctive set of integrated employment policies, programmes and practices.' (Bratton and Gold)

1.1.1

Goals of strategic HRM    

Serve the interests of management, as opposed to employees Suggest a strategic approach to personnel issues Link business mission to HR strategies Enable human resource development to add value to products and services

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ď&#x201A;ˇ

Gain employees' commitment to the organisation's values and goals

It is important to recognise that the HR strategy has to be related to the business strategy. For many businesses, staff are key assets, and this reiterates the importance of HRM. HRM emphasises that employees are crucial to achieving sustainable competitive advantage, but also that human resources practices need to be integrated with the corporate strategy. In this respect, it is important to understand the links between HRM and an organisation's ability to achieve its objectives and its critical success factors. For example, if an organisation identifies excellent customer service as a CSR, then its recruitment process, training, appraisal and reward systems should all be geared towards promoting customer-service skills in its staff.

1.2

Roles of human resource management However, it is important to recognise that these different roles are inter-reliant. For example, there is little point in trying to change an organisation's culture and structure from an 'individualist' to a 'teambased' approach without also providing training and changing reward procedures. For example, if performance appraisals still focus on individual results rather than team performance there will be little incentive to move towards a team-based approach.

HRM and personnel management It is important to distinguish between human resource management (as a strategic activity) and personnel management. Personnel management deals with day-to-day issues such as hiring and firing, and industrial relations. Unlike HRM, it does not play a strategic role in an organisation.

1.3

Becoming an employer of choice One area in which HRM can play a particularly important role in an organisation is helping it become an employer of choice. Many organisations strive to become employers of choice. The status of being an 'employer of choice' implies that people will want to seek employment with the organisation and, once there, will contribute sustained high performance by remaining motivated and committed to the organisation. For the employer, being an employer of choice should help to attract a high number of well-qualified, suitable and able candidates for any vacancies. Equally, if employees are committed to the organisation and its objectives, this should improve corporate performance and make it a good place to work.

2 The impact of HRM on business strategy 2.1

Approaches to HRM Marchington and Wilkinson suggest that there are two main approaches to the relationship between business strategy and HRM strategy: the best fit (contingency) approach and the resource-based approach.

2.1.1

Best fit (contingency) approach to HRM This approach suggests that HRM strategy needs to be relevant to, and supportive of, the business strategy. This means the strategies need to 'fit' with the internal and external contexts of the organisation. So, for example, as an organisation moves through its life cycle, different HRM strategies become necessary to support the business strategies at each stage. Thus, HRM strategies are contingent on the life cycle stage. Similarly, an organisation's HRM strategy will be dependent on its competitive strategy â&#x20AC;&#x201C; whether it is pursuing a cost leadership or differentiation approach.

2.1.2

Resource-based approach to HRM The resource-based approach takes the opposite perspective. The best-fit approach argues that HRM must be flexed to align an organisation with outside factors in order to deliver effective performance. But the resource-based approach argues that HR activity itself can be strategic, and activities such as training and development can directly influence organisational performance. Therefore HRM can be used strategically in its own right as one of the resources available to an organisation.

In this way, the resource-based approach to HRM encourages organisations to identify those parts of the workforce which have the greatest impact on performance, and then focus attention on how those staff should be used within the organisation (for example, if there is any need to change processes or

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practices to increase the value they can add to the organisation). The resource-based approach also encourages organisations to look at the ways inter-personal and team relationships develop within the organisation, and how this can affect performance. In effect, this also highlights the importance of 'culture' in an organisation, helping staff to work productively and efficiently. Importantly, however, the resource-based approach does not contend that HRM strategy should only consider factors internal to an organisation. There is still a need to consider influences outside an organisation, and how they can affect HRM strategy: for example, education levels, and economic conditions in a country.

2.2

Human resources and generic strategies As Guest's model acknowledges, there is a close link between HR strategy and overall business strategy. The generic business strategy which an organisation pursues is likely to have a significant impact on human resources management. For example:

2.3



Cost leadership is often to be associated with terms such as: Theory X (autocratic) management, role culture, tall narrow organisational structures, task specialisation, close direction and control, repetitive tasks, and top-down information flows.



Differentiation is often to be associated with terms such as: Theory Y (participative) management, task culture, wide flat organisational structure, multi-skilled employees, autonomy and self direction, unique and creative tasks, and multi-directional information flows.

HR implications of business strategy When looking at strategic decisions an organisation is considering, it may initially seem as if they do not have much to do with HRM. However, this is not the case. Almost all objectives, and almost every issue facing an organisation, have HRM implications.

2.4

Human resources and the knowledge economy A knowledge economy is one in which knowledge is the prime source of competitive advantage. Remember, the source of competitive advantage is either cost leadership or differentiation (each with or without focus). Examples of businesses in the knowledge economy include: 

Engineering, such as Rolls-Royce jet engines. The engines are the result of very advanced research, design, development, testing and incremental modification.



Software, such as Autonomy Corporation Plc. This company specialises in pattern recognition: speech, faces, and car licence plates.



Hardware, such as Apple Inc. The invention and design of new concepts and knowing how to produce them (mainly by sub-contracting to suitable companies) reliably and efficiently.



Biotechnology, such as GlaxoSmithKline plc and the development of new pharmaceuticals.

The knowledge economy poses the following challenges to human resources managers: 

Finding and recruiting enough people with the right skills. The skills and abilities required can be very high and very scarce.



Providing an environment in which employees' skills and abilities are used to their maximum potential.



Motivating and developing employees.



Retaining employees. When an employee leaves, valuable knowledge can be lost and can be transferred to a competitor business.

Human resource planning Human resource planning must link back to the organisation's strategic plan. The number of staff needed with given skills will depend on business plans (for example, any plans to develop new products, or expand into new markets); the skills needed might depend on whether strategic advantage relies on cost leadership or differentiation. Personnel information systems can be of great help at this stage, if not essential, because these systems should hold information about current employees and their skills and be able to predict how many

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employees might be needed in the future. For example, assume that every branch of an organisation requires, ideally, one manager, two sales people, three part-qualified engineers and two qualified engineers. If the strategic plan says that 20 new branches are to be opened in the next three years, then the personnel information system can compare current numbers of personnel who have appropriate skills with the number that will be needed after three years. The personnel information system will also be able to identify any current employees who are due to retire, estimate the number who might leave, forecast how many part-qualified engineers should attain full qualification and also how many employees might achieve management status. From these calculations a recruitment and development budget can be identified. Managers Current Employees (100 branches) Due to retire Estimated leavers Promotion Employees needed (120 Branches) To be recruited

100 (5) (10)

Sales personnel 190 (1) (30)

85 120 35

159 240 81

Part-qualified engineers 310 0 (25) (100) 185 360 175

Qualified engineers 195 0 (70) 100 225 240 15

HRM and Gap analysis In the context of business strategy, we have seen that managers can use gap analysis to identify gaps between forecast performance and target performance, with a view to finding new markets, launching new products or finding other ways to close the gap. However, the idea of gap analysis can also be applied to human resources, as in the example above. The example shows that there is a shortfall between the future forecast number of engineers (if no additional recruitment takes place) and the number of engineers who will be needed to support the organisation's planned branch openings. In turn, this identifies the number of additional engineers who need to be recruited as a result of the planned openings. An alternative approach to filling a resource gap would be to consider whether some jobs which are currently done manually could be automated. In this way, an organisation might be able to use IT as a substitute for labour to overcome a staffing resource constraint.

Skills gap Instead of looking purely at the numbers of people employed, organisations also need to consider whether their staff members have the skill sets necessary to deliver a strategy. If there is a 'gap' between the current skill set of a person or group compared to the required skill set, this represents a skill gap. A strategy then needs to be devised to mitigate that gap; for example, by training staff to use a new software program.

2.6.1

The impact of increased job mobility on HR planning Historically, many employees looked for 'a job for life' and low employee turnover was expected. That pattern still exists in some economies, such as Japan, but in many countries moving from job to job, gaining skills as you go, is the norm. If more people leave, then there is a greater burden on recruitment to replace them. Furthermore, unless the organisation's knowledge management has been successful, people leaving take with them valuable knowledge and this impoverishes the organisation.

2.5

HR planning – overview HR planning should be based on the organisation's strategic planning processes, with relation to analysis of the labour market (internal and external), forecasting of the external supply and internal demand for labour, job analysis and plan implementation. Human resource planning concerns the acquisition, utilisation, development and return of an enterprise's human resources. HR planning may sometimes be referred to as 'workforce planning' or 'workforce strategy'. Human resource planning involves:      

Budgeting and cost control Recruitment Retention (company loyalty, to retain skills and reduce staff turnover) Downsizing (reducing staff numbers) Training and retraining to enhance the skills base Dealing with changing circumstances

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Human resources are hard to predict and control: (a)

Demand. Environmental factors (eg the economy) create uncertainties in the demand for labour. Estimating demand: Planning future HR needs requires accurate forecasts of turnover and productivity (eg if fewer staff are required for the same output). The demand can be estimated from:

(b)



Expansion plans in the current market. For example, growing market share from 18% to 22%



Expansion plans to enter new markets. For example, starting activities abroad



The possibility of withdrawing from markets



New products and services to be launched



Technology changes such as automation and process innovation



The need to gain efficiencies and cost savings



Generic strategy – cost leadership or differentiation



The possibility of relocation



The possibility of outsourcing some of the organisation's functions



The shape of the organisation (eg tall-narrow or wide-flat) will determine the amount of supervision that is possible and this will have implications for the type of employees needed

Supply. Factors such as education or the demands of competitors for labour create uncertainties in the supply of labour. The available supply of labour, competences and productivity levels may be forecast by considering internal and external factors. Internal factors 

The competences, skills, trainability, flexibility and current productivity level of the existing work force



The structure of the existing workforce in terms of age distribution, skills, hours of work, rates of pay and so on



The likelihood of changes to the productivity, size and structure of the workforce

External factors The present and potential future supply of relevant skilled labour in the external labour market will be influenced by a range of factors. These include general economic conditions, government policy and actions and the changing nature of work. In addition, the HR planner will have to assess and monitor factors such as those given below: 

Skill availability: locally, nationally and also internationally: labour mobility within the EU has had a major influence on the UK work force, for example.



Changes in skill availability, due to education and training trends, resources and initiatives (or lack of these), and rising unemployment (worker availability) due to economic recession.



Competitor activity, which may absorb more (or less) of the available skill pool.



Demographic changes: areas of population growth and decline, the proportion of younger or older people in the workforce in a particular region, the number of women in the workforce and so on.

 (c)

Wage and salary rates in the market for particular jobs. ('Supply' implies availability: labour resources may become more or less affordable by the organisation).

Goals. Employees have their own personal goals, and make their own decisions about whether to undertake further training. When large numbers of individuals are involved, the pattern of behaviour which emerges in response to any change in strategy may be hard to predict. There can sometimes be powerful resistance to change.

C H A P T E R

(d) Constraints. Legislation as well as social and ethical values constrain the ways in which human resources are used, controlled, replaced and Points to note based on the process of human

resource planning: HR strengths and weaknesses – An organisation's HR strengths and weaknesses need to be analysed so as to identify skills and competence gaps. HR planning is important not simply for analysing overall

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numbers of staff, but also for looking at the mix of skills within the workforce. While headcount numbers are always likely to be a concern, it is equally important to consider whether the current workforce has the skills and attitudes required to sustain organisational success in the future. Efficiency â&#x20AC;&#x201C; An organisation needs to know how effectively it is using its staff (for example, utilisation statistics, idle time). If staff are currently not fully utilised, how far can future growth be staffed by the existing staff, rather than having to recruit additional staff? Timescale â&#x20AC;&#x201C; If an organisation can identify a 'gap' in advance, this will allow recruitment and training to be planned in advance. However, an unplanned 'gap' which needs filling immediately will require instant recruitment.

The importance of human resource planning It is arguable that forecasting staff and skill requirements has become more difficult in recent times because of the increasing uncertainty and rate of change in the business environment. However, it has also arguably become more necessary, because the risks of 'getting it wrong' (particularly in an era of global economic recession) are correspondingly greater. In this respect, human resource planning can be seen as a form of risk management. It involves realistically appraising the present and anticipating the future (as far as possible) in order to get the right people into the right jobs at the right time and managing employee behaviour, organisational culture and systems in order to maximise the human resource in response to anticipated opportunities and threats. An attempt to look beyond the present and short-term future, and to prepare for contingencies, is increasingly important. Some manifestations of this are outlined below. (a)

Jobs in innovative and fast-changing contexts may require experience and skills which cannot easily be bought in the market place, and the more complex the organisation, the more difficult it will be to supply or replace highly specialised staff. The need will have to be anticipated in time to initiate the required development programmes. The decline of the 'job for life' and the common desire to gain wide and rounded experience have contributed to higher rates of employee attrition. Leavers must be replaced with suitable staff. At senior levels, succession planning should identify potential replacements, internal or external, for those expected to retire or simply move on.

(b)

Employment protection legislation and increasing public demand for corporate social responsibility make downsizing, redeploying and relocating staff (eg in response to economic recession) a slow and costly process.

(c)

Rapid technological change is leading to a requirement for human resources that are both more highly skilled and more adaptable. Labour flexibility is a major issue, and means that the career development and retraining potential of staff is at least as important as their actual qualifications and skills. Thus, 'trainability' is now a major criterion for selection.

(d)

Organisations that differentiate themselves in the market through superior customer service or other people-related activities need to place people at the centre of their corporate strategy. If their people are to be the difference they need to invest time and effort in finding and developing the right ones.

(e)

The scope and variety of markets, competition and labour resources are continually increased by environmental factors such as the expansion of the European Union, the globalisation of business and the explosive growth of e-commerce.

(f)

Information and Communication Technology (ICT) has made available techniques which facilitate the monitoring and planning of human resources over fairly long time spans: accessing of demographic and employment statistics, trend analysis, 'modelling' of different scenarios and variables, and so on.

(g)

Labour costs are a major proportion of total costs in many industries and must be carefully controlled. Cost control action will involve carefully planned remuneration schemes, strict control of headcount and avoidance of waste in such forms as over-staffing and unnecessary activity. Business process re-engineering and the de-skilling of jobs may lead to redundancies, especially among over-qualified staff.

Armstrong sums up the aims of human resource planning as follows: (a)

To attract and retain the number of people required with the necessary skills, expertise and competences

(b)

To anticipate potential surpluses or shortfalls which will need to be adjusted

(c)

To develop a well-trained and flexible workforce which will support organisational adaptation to external changes and demands

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2.6

(d)

To reduce dependence on external recruitment to meet key skill shortages (by formulating retention and development strategies)

(e)

To improve the utilisation of people (most notably by developing flexible working systems) C H A P T E R

Flexible workforces and network organisations It has been suggested that long-range, detailed people planning is a necessary form of risk management, preparing businesses for foreseeable contingencies. However, there has been some disillusionment about the feasibility and value of such planning, given the rapidly evolving and uncertain business environment and the kinds of highly flexible organisational structures and cultures that have been designed to respond to it. (a) The trend in organisation and job design is towards functional feasibility (multi-skilling), team working, decentralisation (or empowerment) and flexibly-structured workforces to facilitate flexible deployment of labour. (b)

However, perhaps the most significant change in organisation structure has come from the growth of network organisations or virtual organisations, with the increased use of freelance or contract workers in place of full-time employed staff. In this way, the role of HRM is to ensure that the appropriate people are brought together to complete a specific project or task. For example, the workforce could be made up of freelance workers who sell their services to a variety of organisations and work for them on a project by project basis. However, such a model fundamentally changes the nature of job vacancies, compared to a model in which organisations employ staff on a full-time basis.

2.7

Remote working (Home working) Another significant development in the way workforces are structured has been the increasing number of remote workers or home workers. An important factor in the development of remote working is the beneficial impact it can have on employees' work-life balance. Employees value the time and money savings which remote working offers them, compared to having to commute to work. Some employees may also value the autonomy and independence which working at home affords them. Since companies have increasingly recognised the importance of attracting and retaining talented staff, they have also realised the need to offer staff flexibility in their working arrangements. Remote working could also improve productivity. On the one hand, if remote working leads to higher job satisfaction, higher retention and lower absenteeism, these factors could contribute to increased productivity. On the other hand, remote workers could also be more productive than 'office-based' colleagues because they are able to work without interruption, for example, from office meetings. Nevertheless, while some employees value remote working, others may not want to work at home; for example, because they feel it isolates them from colleagues and shared knowledge; or because they would prefer to keep their 'private' lives separate from their 'work' lives. IT and remote working Developments in technology have been crucial in facilitating the growth of home working. For example, remote workers need a laptop or personal computer, with reliable internet access, and secure remote access to a company's internal networks and internal messaging systems (eg sharepoints) in order to work from home effectively. Video-conferencing (for example, through Skype or Google Video Chat) can also be valuable for contacting remote employees, particularly in relation to important matters which it may not be appropriate to discuss by email. In general, technology has been essential for the development of remote working, because it provides opportunities for exchanges of information between employees working remotely and their colleagues or managers in a different location. Communication and remote working Nonetheless, poor workplace communication is often seen as the biggest disadvantage of remote working. In this respect, the growth of remote working presents new issues for managers in relation to managing staff. Socialisation and relationship building are important aspects for helping remote employees to feel included within an organisation. As such, managers' communication skills and relationship building skills

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will be important in ensuring that remote workers do not feel isolated. Whilst many remote workers value the greater independence which they gain from working at home, it remains important for managers to communicate regularly with these workers in order to build trust and to maintain a relationship with them. Equally, managers will need to provide the employees with clear goals and expectations for their work, as for any other employee in the company. In order to manage remote employees effectively, managers should adopt a 'management by objectives' approach, as opposed to managing by observation. This will involve setting goals and action plans, and then evaluating employees' performance based on the outputs or results.

2.8

The people plan Once the analysis of human resource requirements has been carried out, and the various options for fulfilling them considered, the people plan will be drawn up. This may be done at a strategic level. It will also involve tactical plans and action plans for various measures, according to the strategy that has been chosen. Typical elements might include the following. (a)

The resourcing plan: approaches to obtaining skills/people within the organisation, and by external recruitment

(b)

The internal resource plan: availability of skills within the organisation; plans to promote/redeploy/develop

(c)

The recruitment plan: numbers and types of people, and when required; sources of candidates; the recruitment programme; desired 'employer brand' and/or recruitment incentives

(d)

The training plan: numbers of trainees required and/or existing staff who need training; training programme

(e)

The re-development plan: programmes for transferring or retraining employees

(f)

The flexibility plan: plans to use part-time workers, job-sharing, home-working, outsourcing, flexible hours arrangements and so on

(g)

The productivity plan: programmes for improving productivity, or reducing manpower costs; setting productivity targets

(h)

The downsizing plan: natural wastage forecasts; where and when redundancies are to occur; policies for selection and declaration of redundancies; redevelopment, retraining or relocation of employees; policy on redundancy payments, union consultation and so on

(i)

The retention plan: actions to reduce avoidable labour wastage

The plan should include budgets, targets and standards. It should allocate responsibilities for implementation and control (reporting, monitoring achievement against plan).

2.9

People and strategic success Bratton and Gold's definition of HRM (see Section 1 above) highlights that human knowledge and skills are a strategic resource for an organisation, and that they can play a vital role in achieving sustainable competitive advantage. The strategic significance of having the right people working effectively increases as technology becomes more complex, the importance of knowledge work increases and strategy relies more and more on the talents and creativity of human beings. An important aspect of human resource management (HRM), therefore, consists of the various activities that attempt to ensure the organisation has the people it needs when it needs them. These activities include recruitment, retention and, when necessary, reduction of headcount.

C H A P T E R

However, aspects of HRM (such as setting performance objectives and reward management) also play an important role in the performance management and control of the organisation. In this respect, HRM follows a similar control model as is used for the overall strategic and operational control of an organisation:

Step 1: Goals are set Step 2: Performance is measured and compared with target Step 3: Control measures are undertaken in order to correct any shortfall Step 4: Goals are adjusted in the light of experience Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

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However, it is crucial to recognise that these goals link to both strategic and operational success. Effective performance management requires that the strategic objectives of the organisation are broken down into layers of more and more detailed sub-objectives, so that individual performance can be judged against personal goals that support and link directly back to corporate strategy.

2.10

People and operational success Recruitment and selection Operational success relies on people's ability of people to do their jobs properly. This could include their ability to perform a range of activities such as being able to operate machinery correctly, use computers, manage others, or perform specific technical routines. In this respect, operational success requires the proper recruitment and selection of people with the right skills for the particular job, and the provision of further training as the requirements may dictate. An organisation's staff are a very important resource, and they are likely to play a crucial role in an organisation achieving its strategic objectives. Therefore, it is vital that an organisation has the right number (quantity) and the right quality of staff to achieve its objectives. In this respect, human resource planning is very important â&#x20AC;&#x201C; not only in forecasting the numbers and levels of staff an organisation is likely to need, but also in deciding whether, for example, the staff should all work 'in house' or whether it might be more appropriate to outsource some functions, or to move to a more 'network' based organisation rather than using a more formally structured one. In this way, recruitment and human resource planning play a vital role in ensuring that organisations have the necessary quantity and quality of staff to facilitate their success.

Objectives and performance targets Staff should also have individual work objectives and performance targets (for example the number of sales calls made) and their performance should be measured against these objectives. These individual objectives and targets should be derived from department and organisation objectives. This should mean that, in theory, if every individual achieves their objectives then their department will achieve its objectives, and if every department achieves its objectives then the organisation as a whole will achieve its objectives. Two factors which play an important role in determining whether employees achieve their objectives are management and motivation. We will look at a number of aspects of employee performance management later in this chapter, but in general terms we can highlight the link between performance and motivation by reference to the following equation (after Vroom): Performance = Ability Ă&#x2014; Motivation (where Motivation = Desire Ă&#x2014; Commitment) In this equation, desire is seen as enthusiasm for a task, and commitment is about putting in effort. Therefore, as well as ensuring that employees have the necessary abilities to carry out their jobs, managers also need to make sure that their staff have the desire and commitment to do so efficiently and successfully.

Staff retention Keeping staff motivated can also help an organisation retain staff more effectively, and in doing so can reduce the costs associated with staff turnover. These include the time and costs spent in advertising for and recruiting new staff; time and cost spent training new staff, and the 'learning curve' associated with new staff getting up to speed with their jobs; and the loss of organisational knowledge which occurs when individuals (particularly key employees) leave an organisation.

3 Appraisal and performance management While the need for some kind of performance assessment is widely accepted, appraisal systems are frequently criticised as bureaucratic, ineffective and largely irrelevant to the work of the organisation. Partly as a response to this view, modern approaches attempt to enhance the relevance of appraisal by linking it to organisational strategy and objectives. This emphasises the use of appraisal as an instrument of control over the workforce. However, running in parallel with this trend is an awareness, among HR professionals at least, that appraisal systems are fundamental to the aspirational model of HRM outlined above and to the co-operative psychological contract.

3.1

The purpose of appraisal Appraisal is a process that provides an analysis of a person's overall capabilities and potential. An important

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part of the appraisal process is assessment â&#x20AC;&#x201C; collecting and reviewing data on an individual's work. The purpose of appraisal is usually seen as the improvement of individual performance, but it may also be regarded as having close links to a wide range of other HR issues, including discipline, career management, identifying training and development opportunities, motivation, communication, selection for promotion and determining rewards. It is also fundamental to the notion of performance management, which may be regarded as trying to direct and support individual employees to work as effectively and efficiently as possible so that the individual's goals are aligned with the organisation's goals and business strategy. Within this wider view, regular appraisal interviews can be seen as serving two distinct purposes: (a)

Judgement: Judgemental appraisals are undertaken in order for decisions to be made about employees' pay, promotion and work responsibilities. These decisions have to be made on the basis of judgements about the appraisee's behaviour, talent, industry and value to the organisation. Such judgements can be uncomfortable for both appraiser and appraisee and lead to hostility and aggression.

(b)

Development: The focus of developmental appraisals is to assess employees' training and development needs.

C H A P T

Development appraisal can contribute to performance improvement by establishing individuals' development needs, progress and opportunities. This is the more supportive aspect of appraisal, but still requires the appraiser to make decisions about the appraisee.

'The tension between appraisal as a judgemental process and as a supportive development process has never been resolved and lies at the heart of most debates about the effectiveness of appraisal at work.'(Bratton & Gold) 10

Feedback on performance has been widely regarded as an important aspect of the participative style of management which, in turn, has been promoted as having potential to motivate higher performance. However, the link between feedback and motivation is not simple and an important aspect of the judgemental part of appraisal is its potential to demotivate. The classic study which highlighted this was carried out by Meyer et al at the General Electric Company (GEC) in 1965. Gold suggests that their findings are still relevant and provides a summary: (a)

Criticism often has a negative effect on motivation and performance.

(b)

Praise has little effect, one way or the other.

(c)

Performance improves with specific goals.

(d)

Participation by the employee in goal-setting helps to produce favourable results. (Don't forget the whole point of performance management is to improve performance!)

(e)

Interviews designed primarily to improve performance should not at the same time weigh salary or promotion in the balance.

(f)

Coaching by managers should be day to day rather than just once a year.

More recently, Campbell and Lee have pointed out the ways in which discrepancies may arise between people's own opinions of their performance and those of their supervisors. (a)

Information. There may be disagreement over what work roles involve, standards of performance and methods to be used.

(b)

Cognition. The complexity of behaviour and performance leads to different perceptions.

(c)

Effect. The judgemental nature of appraisal is threatening to the appraisee and, possibly, to the appraiser.

Since Meyer et al's study there has been a long search to find a way of appraising employees which reduces the feeling that feedback is about criticism. One approach to mitigating the undesirable effects of judgemental appraisal has been the use of multisource feedback, including 360 degree appraisal, in order to provide a demonstrably more objective review. Such approaches have tended to be used principally for appraisal of managers. Multisource feedback can be seen as empowering for staff. It may also be seen as reinforcing for good management behaviour (since it shows managers how they are seen by others) and likely to improve the overall reliability of appraisal. However, research has shown that the effects can vary significantly.

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3.1.1

Appraisal as control or development? The last of Meyer et al's findings 'coaching by managers should be day to day rather than just once a ear' highlights the role of managers in the development of their staff on a continual basis. However, any shift towards a more developmental view of appraisal sits uncomfortably with the traditional management objectives of having a means of measuring, monitoring and controlling performance. This somewhat rigid approach, based on the drive for rationality and efficiency in organisations, highlights what Mintzberg has called 'machine bureaucracy'. According to this approach, getting organised, being rational and achieving efficiency are the best bases on which to structure an organisation. This mechanistic view of organisations will, almost inevitably, mean that employees will view appraisals as control systems, and employees will feel they are being controlled by appraisal systems. Such a situation is unlikely to motivate employees or to generate trust, commitment and high productivity, though. Employees' trust and commitment to an organisation will come about through management creating a culture that supports people's long-term development. Assessment and appraisal could play a key part of this shift, but only if human resource managers can convince organisations that, while control remains important, development needs to play a much greater role in the appraisal process.

3.2

HRM and performance management Performance management systems attempt to integrate HRM processes with the strategic direction and control of the organisation. Remember the cycle of control we mentioned earlier:

Step 1 Step 2 Step 3 Step 4

Goals are set Performance is measured and compared with target Control measures are undertaken in order to correct any shortfall Goals are adjusted in the light of experience

You should be familiar with this kind of management control in business organisations, where the balanced scorecard, for example, is often used as the basis for such an approach. Performance management requires that the strategic objectives of the organisation are broken down into layers of more and more detailed sub-objectives, so that individual performance can be judged against personal goals that support and link directly back to corporate strategy.

C H A P T E R

The performance management system, although it emphasises the control aspects of appraisal, must also allow for the development aspect of appraisal, providing for coaching and training where needed.

3.3

Performance rating

Intimately linked with the definition of goals is the creation of suitable performance indicators. Several different approaches have been used at various times.

Inputs or personal qualities The diagnosis of personality traits such as loyalty, leadership and commitment really requires the use of valid psychometric methods by qualified specialists. When managers attempt to perform this task, bias, subjectivity, and other effects will tend to undermine the reliability of the output.

Results and outcomes Where the cybernetic model is implemented, objective assessment of performance against work targets can be a reliable method of rating. Performance against quantified work objectives, such as number of sales calls made, can be used alongside measures of progress within competence frameworks and the overall picture can be enriched with qualitative measures and comments. A fundamental problem with this approach is the importance of the way in which objectives are set. Ideally, they should be agreed at the outset, but this requires a degree of understanding of the complexity and difficulty of the work situation that neither party to the appraisal may possess.

Behaviour in performance Appraisal may be based more on how appraisees carry out their roles than on quantified measures of achievement. This is particularly relevant to managerial and professional activities such as communication, planning, leadership and problem resolution.

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Behaviour-anchored rating scales (BARS) enable numerical scoring of performance at such activities. A numerical scale from, say, one to seven, is 'anchored' against careful descriptions of the kind of behaviour that would lead to a maximum or minimum score. This is the kind of scale satirised by the well known parody that has 'leaps tall buildings at a single bound' at the top and 'walks into walls' at the bottom. Appraisers then judge just where the appraisee falls against each scale. Behavioural observation scales (BOS) are slightly different in two respects. (a)

They break down aspects of behaviour into sub categories: skill at developing people, for example, might be assessed against such activities as giving praise where due, providing constructive feedback and sharing best practice.

(b)

Appraisers assess the actual frequency with which such activities are performed against the frequency of opportunities to undertake them. The scores are recorded on numerical scales anchored by 'never' and 'always'.

Both BARS and BOS can enhance objectivity in appraisal and in self-appraisal.

3.4

Target selection We have noted how performance management acts as a control system in measuring people's achievement against targets. However, in order for performance management to be beneficial, it is important to select the right measures or targets at the outset when setting performance goals. The adage 'What gets measured, gets done' is often used in relation to corporate performance management, but it is equally relevant here. If the 'wrong' performance measures or targets are set, this could lead to staff behaviour being different to that originally intended, and ultimately adversely affecting performance. We looked at the behavioural implications of performance targets in Section 4.13 of Chapter 4, but they are also important here, in highlighting the impact that remuneration and reward structures can have on organisational behaviour. The individual performance measures selected should be relevant to the overall objectives of the organisation. Individuals' objectives must reflect the overall strategic initiatives management are taking. For example, if management is focusing on quality, performance measures must reflect this by measuring employees on their contribution to achieving quality targets. This sort of situation represents a contingency approach to reward: that the organisation's strategy is a fundamental influence on its reward system, and in turn the reward system should support the organisation's chosen strategy. Targets and motivation Some employees respond well to difficult targets and are motivated to attain them. Others may find the targets daunting and feel they are unachievable, and indeed there may be valid reasons why they believe this. For example, in an economic downturn, a number of businesses reduce the amount they spend on their IT budgets. Therefore if a salesperson in an IT company was given a target of increasing sales 25% on the prior year they would appear to be justified in thinking this target is unachievable. Equally, care must be taken when using certain measures, for instance numbers of sales, as the basis for rewarding employees. As an example, here are some possible negative consequences of using sales numbers as a primary performance measure: 

The salesman might offer potential customers large discounts in order to make the sale (but with the effect that the company makes a loss on the sale)



The salesman is concerned solely with the immediate sale, which may lead to poor after-sales service, low customer satisfaction levels and poor customer retention



The salesman might use expensive promotions that actually generate less in sales value than they cost, but which allow the salesman to register a number of sales



Once a salesman has reached his target figure for a period he might look to defer future sales into the next period

It may be better to use a balanced mix of targets – for example, setting customer care and customer profitability targets as well as the number of sales made. It is also important to make sure whatever goals are set that these are capable of being controlled by the individual, otherwise the individual is likely to become demotivated. In addition, if processes are being redesigned and job roles are changing, performance measures must

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be adapted to reflect the new jobs and responsibilities. However, it is important that people are not given too many objectives and targets. There is a danger that people could become overwhelmed by the sheer number of goals they are expected to meet, but with the result that they do not know what their priorities are or what aspects of their work they should give most attention to. Finally, it is useful to remember the acronym SMART when setting performance targets: are the targets specific, measurable, achievable, relevant and time-bound?

C H A P

4 The impact of remuneration and reward packages 4.1

Reward Employment is fundamentally an economic relationship; the employee works as directed by the employer and, in exchange, the employer provides reward. The relationship inevitably generates a degree of tension between the parties, since it requires co-operation if it is to function, but it is also likely to give rise to conflict since the employee's reward equates exactly to a cost for the employer.

Definition Reward: All of the monetary, non-monetary and psychological payments that an organisation provides for its employees in exchange for the work they perform. Rewards may be seen as extrinsic or intrinsic. (a)

Extrinsic rewards derive from the job context; such extrinsic rewards include pay and other material benefits as well as matters such as working conditions and management style.

(b)

Intrinsic rewards derive from job content and satisfy higher-level needs such as those for self esteem and personal development.

The organisation's reward system is based on these two types of reward and also includes the policies and processes involved in providing them. Reward is a fundamental aspect of HRM and the way an organisation functions. It interacts with many other systems, objectives and activities.       

It should support the overall strategy It is a vital part of the psychological contract It influences the success of recruitment and retention policies It must conform to relevant laws and regulations It consumes resources and must be affordable It affects motivation and performance management It must be administered efficiently and correctly

The dual nature of reward mentioned earlier – a benefit for the employee, a cost for the employer – means that the parties in the relationship have divergent views of its purposes and extent. Employees see reward as fundamental to their standard of living: inflation, comparisons with others and rising expectations put upward pressure on their notion of what its proper level should be. Employers, on the other hand, seek both to control their employment costs and to use the reward system to influence such matters as productivity, recruitment, retention and change.

4.2

A reward management model An effective reward system should facilitate both the organisation's strategic goals and also the goals individual employees. 10 Within this, an organisation has to make three basic decisions about monetary reward: (a) (b) (c)

How much to pay Whether monetary rewards should be paid on an individual, group or collective basis How much emphasis to place on monetary reward as part of the total employment relationship

However, there is no single reward system that fits all organisations.

4.2.1

The strategic perspective A contingency approach to reward accepts that the organisation's strategy is a fundamental influence on its reward system and that the reward system should support the chosen strategy. Thus, for example, cost leadership and differentiation based on service will have very different

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implications for reward strategy (and, indeed, for other aspects of HRM). This is because each strategy needs a reward which is appropriate for it. The closer the alignment between the reward system and the strategic context, the more effectively the organisation can implement its strategy. The following example illustrates this.

Example of strategic perspective Bratton and Gold in their text Human Resource Management provide an illustration of how two different businesses with different generic strategies have completely different rewards systems. The first business produces high-quality, custom-made machine tools for a high-tech industry. The production process is complex and workers are highly-skilled and capable of performing various jobs. They all work in self-managed teams. In contrast to the industry norm, these skilled machine operators are not paid an hourly wage, but instead they receive a base salary which is increased as they learn new skills. The employees receive an excellent benefits package and profit-sharing bonuses. Not surprisingly, staff turnover is very low. Labour costs at this company are above the industry average, but the company is successful nonetheless because its reward system is aligned to its strategy. It is following a differentiation strategy, and its reward system encourages commitment from its staff. The system also encourages higher productivity than its competitors because of the increased functional flexibility of having multi-skilled staff. The incentive of their salary increasing as they learn new skills encourages the staff to become multi-skilled. In turn, having a multi-skilled workforce reduces machine downtime and scrap rates. Because the teams are self-managed, the company does not need to employ supervisors or quality inspectors (the teams selfregulate their own quality). Because staff turnover is low, recruitment and training costs are similarly low. Therefore, although the company's labour costs are above the industry average, these additional costs deliver benefits elsewhere and support its differentiation strategy. Against this, Bratton and Gold contrast a production process producing frozen food. The work is lowskilled and monotonous, and requires little employee commitment. The production line is automated and managers â&#x20AC;&#x201C; not workers â&#x20AC;&#x201C; control the speed of the line. The workers are paid an hourly wage marginally above the minimum wage, and there are no additional payments or benefits. Not surprisingly, labour turnover is very high. However, again this company is successful, because its reward system is aligned to its strategy. It is following a cost leadership strategy and so low-cost production is essential. The high labour turnover is not a problem because unskilled workers are easy to recruit and training costs are low. Therefore, the company's policy of paying near-minimum wage only is appropriate to a strategy in which little commitment or loyalty is required from the employees. It is vital that reward systems are aligned to an organisation's objectives and its critical success factors, as well as to the job in question. As the scenarios above illustrate, if the organisation has highly-skilled employees who are crucial to its competitive success, then the reward system should be designed to try to retain such staff. However, it is also important to recognise the impact that implementing a reward system can have on employees' day-to-day performance. Once again, the idea that 'What gets measured, gets done' is relevant here. For example, if a reward system is based primarily around individual performance, then staff will focus on their own individual results and teamwork could suffer as a result. More generally, if a reward system is not appropriate for the context in which it is used, there is a danger it could have a negative impact on an organisation's performance.

4.2.2

Reward objectives The reward system should pursue three behavioural objectives: (a)

It should support recruitment and retention.

(b)

It should motivate employees to high levels of performance. This motivation may, in turn, develop into commitment and a sense of belonging, but these do not result directly from the reward system.

(c)

It should promote compliance with workplace rules and expectations.

Recruitment and retention The reward system should support recruitment and retention. Several influences are important here. Employees will certainly assess their pay and material benefits against what they believe to be the prevailing market rate. They will also take account of disadvantageous factors, such as unpleasant working conditions,

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in their assessment of the degree of equity their reward achieves for them. Finally, they will be very sensitive to comparisons with the rewards achieved by other employees of the same organisation. Failure to provide a significant degree of satisfaction of these concerns will lead to enhanced recruitment costs.

Motivation The reward system should motivate employees to high levels of performance. Despite the apparently tenuous link between performance and level of pay (for example, with Herzberg arguing that pay is a hygiene factor rather than a motivating factor), traditional pay systems have featured incentives intended to improve performance; there has also been a tendency for British and North American companies to adopt systems of individual performance related pay intended to support overall organisational objectives rather than simply to incentivise individual productivity.

Compliance The reward system should promote compliance with workplace rules and expectations. The psychological contract is complex and has many features, including material rewards. The incentives included in the reward system play an important role in signalling to employees the behaviour that the organisation values. It is also an important contributor to the way employees perceive the organisation and their relationship with it.

4.2.3

Methods of reward Material reward may be divided into three categories: (a)

Base pay is a simply established reward for the time spent working.

(b)

Performance pay is normally added to base pay and is intended to reward performance learning or experience.

(c)

Indirect pay is made up of benefits such as health insurance, child care and so on and is provided in addition to base pay or performance pay.

Base pay Base pay is usually related to the value of the job as established by a simple estimate, a scheme of job evaluation or reference to prevailing employment market conditions. It is easy to administer and shows a commitment by the employer to the employee that goes beyond simple compensation for work done. A distinction may be made between hourly or weekly paid wages and monthly paid salary. The latter is normally expressed as an annual rate.

Performance pay Performance pay takes many forms, including commission, merit pay and piecework pay. Performance pay differs from base pay in that it can be designed to support team working and commitment to organisational goals. Team working is supported by a system of bonuses based on team rather than individual performance. The size of the team may vary from a small work group to a complete office or factory. Overall organisational performance is supported by various schemes of profit sharing, including those that make payments into pension funds or purchase shares in the employing company. However, the extent to which an organisation emphasises performance pay will depend on whether this type of reward supports its strategy.

Indirect pay Indirect pay is often called 'employee benefits'. Benefits can form a valuable component of the total reward package. They can be designed so as to resemble either base pay or, to some extent, performance pay. A benefit resembling base pay, for example, would be use of a subsidised staff canteen, whereas the common practice of rewarding high- performing sales staff with holiday packages or superior cars looks more like performance pay. Again though, the extent to which an organisation offers indirect pay should reflect whether this type of reward supports its strategy. There is a trend towards a cafeteria approach to benefits. Employees select the benefits they require from a costed menu up to the total value they are awarded. This means that employees' benefits are likely to match their needs and be more highly valued as a result. Types of indirect pay include: ď&#x201A;ˇ

Private health care

ď&#x201A;ˇ

Discounted insurance

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  

Private dental care Pension plans Car allowance

  

Extra vacation days Child care Shopping/entertainment vouchers

Share options One further type of reward option we should consider is share options (or employee share option plans (ESOP)). Share options give directors – and possibly other managers and staff – the right to purchase shares at a specified exercise price after a specified time period in the future. The options will normally have an exercise price that is equal to, or slightly higher than, the market price on the date that the options are granted. The time period (vesting period) that must pass before the options can be exercised is generally a few years. If the director or employee leaves during that period, the options will lapse. In this respect, share options can be seen as a way of rewarding directors and employees for remaining with a company. In turn, this could mean that they are concerned with the longer-term success of the company, rather than simply focusing on short term performance. Share options will generally be exercisable on a specific date at the end of the vesting period. In the UK, the Corporate Governance Code states that shares granted, or other forms of remuneration, should not vest or be exercisable in less than three years. Directors should be encouraged to hold their shares for a further period after vesting or exercise. If directors or employees are granted a number of options in one package, these options should not all be able to be first exercised at the same date. If the price of the shares rises so that it exceeds the exercise price by the time the options can be exercised, the directors will be able to purchase shares at lower than their market value, which is clearly advantageous for the directors exercising the options. Share options can therefore be used to align management and shareholder interests, because the directors have an interest in ensuring that the share price increases over time such that it is higher than the exercise price when the options come to be exercised. This is particularly relevant for options held for a long time when value is dependent on long-term performance. However, the main danger with share options is that they could give directors an incentive to manipulate the share price if a large number of options are due to be exercised. Alternatively, granting options could be used as a way of encouraging cautious (or risk averse) directors to take positive action to increase the value of the company. Again, this could help align the interests of directors and shareholders, if the directors would not otherwise be prepared to accept the same risks which the shareholders would tolerate by themselves. The upside risk of share options is unlimited because there is no restriction on how much the share price can exceed the exercise price. However, there is no corresponding downside risk for the directors. If the share price is less than the exercise price, the intrinsic value of options will be zero and the options will lapse. In these circumstances it will make no difference how far the share price is below the exercise price. If directors hold options, the value of their options will rise if a strategic investment succeeds and they will not suffer any loss on their options if the investment fails. Therefore, granting the options might encourage the directors to take actions they would not otherwise be prepared to take.

Risk, reward and performance Although we have noted that share options could encourage cautious directors to be less cautious, it is equally important that reward structures do not encourage directors and managers to take excessive risks. Since the collapse of Northern Rock bank in 2007, and throughout the ensuing financial crisis, there has been much political and media interest in the issue of reward management. This has focused on the role which reward structures were perceived to have played in encouraging excessive risk-taking in the financial services sector and, in turn, what role this risk-taking played in the problems which have affected the sector.

C H A P T E R 10

Additionally, there has been increasing concern about the extent to which the level of remuneration given to senior executives reflects (or does not reflect) the value their companies generate for their shareholders. In the UK, in a speech to the High Pay Commission and the Institute for Public Policy Research (January 2012) the Labour MP Chuka Umunna highlighted the extent to which the value of incentive packages for executives has risen disproportionately to improvements in company performance. In the first decade of the 21st century, FTSE 350 firms increased their pre-tax profits by 50% and their earnings per

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share by 73%, while year end share prices fell by 5%. Over the same period, bonuses for executives in these companies rose by 187% and long term incentive plans by 254%. And, as Mr. Umunna pointed out, in the worst cases 'you end up with perverse incentive structures which encourage the wrong kind of decision-making, as the failures in many financial institutions in the wake of the 2008/9 financial crises so clearly illustrated.' Another issue which causes increasing anger and frustration among shareholders is the level of bonuses being awarded by companies that were rescued by taxpayer funds. This is perhaps symptomatic of a potentially wider issue: the extent to which companies are perceived to be rewarding failure. The senior executives of failed companies often walk away with significant payouts, while large numbers of other managers and staff lose their jobs and their incomes. Critics have argued that if companies are serious about improving performance, then they need to stop rewarding failure.

4.2.4

Reward techniques Reward systems must attempt to achieve internal equity. This means when employees make comparisons between their own rewards and those of others, they see the overall structure as fair. If internal equity is not achieved, employees will conclude that the psychological contract has been breached and their behaviour will be affected. They may become less co-operative or they may leave. Three techniques contribute to the establishment of internal equity.

Job analysis Job analysis is the 'systematic process of collecting and evaluating information about the tasks, responsibilities and the context of a specific job' (Bratton). The data collected during job analysis identifies the major tasks performed by the job-holder, the outcomes that are expected, and how the job links to other jobs in the organisation. This data is used to prepare job descriptions, job specifications and job performance standards. (Note that in practice the terms job description and job specification may be used loosely and a job specification is often referred to as a person specification.) This information is useful in itself for a range of HRM purposes, including recruitment and training needs analysis, and it also forms the basis for job evaluation. Note also that job analysis is an important aspect of quality and process re-design initiatives and is almost certainly required when e-business methods are adopted.

Job evaluation Job evaluation is a systematic process designed to determine the relative worth of jobs within a single work organisation. The process depends on a series of subjective judgements and may be influenced by organisational politics and personal preconceptions. In particular, it can be difficult to separate the nature of the job from the qualities of the current incumbent. Evaluation may be carried out in four ways. (a)

Ranking simply requires the arrangement of existing jobs into a hierarchy of relative value to the organisation.

(b)

Job-grading starts with the definition of a suitable structure of grades in a hierarchy. Definitions are based on requirements for skill, knowledge and experience. Each job in the organisation is then allocated to an appropriate grade.

(c)

Factor comparison requires the allocation of monetary value to the various factors making up the content of a suitable range of benchmark jobs. This method is complex and cumbersome.

(d)

Points rating is similar to factor comparison, but uses points rather than monetary units to assess the elements of job content.

Whichever method is used, the end point of a job evaluation exercise is the production of a hierarchy of jobs in terms of their relative value to the organisation. The pay structure is then set by reference to this hierarchy of jobs.

Performance appraisal Performance appraisal has already been discussed in Section 3 earlier in this chapter.

4.2.5

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The level of rewards an organisation offers will inevitably be subject to factors external to the organisation:

4.3

(a)

The labour market as it exists locally, nationally and perhaps globally, as relevant to the organisation's circumstances

(b)

The pressure for cost efficiency in the relevant industry or sector

(c)

Legislation such as the level of any applicable minimum wage

Setting reward levels in practice Many companies use commercially available survey data to guide the overall level of the rewards they offer. This approach can be combined with the reward techniques outlined above. An element of flexibility must be incorporated to reflect both the different levels of skill, knowledge and experience deployed by people doing the same work and their effectiveness in doing it. Governments influence pay levels by means other than outright legislative prescription:

4.3.1

(a)

They affect the demand for labour by being major employers in their own right:

(b)

They can affect the supply of labour by, for example, setting down minimum age or qualification requirements for certain jobs.

(c)

Their fiscal and monetary policies can lead them to exert downward pressure on public sector wage rates.

Problems with reward systems Reward systems are subject to a range of pressures that influence their working and affect the psychological contract.

4.4 4.4.1

(a)

Where trade unions are relatively weak, as in the UK, employers have more freedom to introduce performance related pay.

(b)

Economic conditions may prevent employers from funding the rewards they might wish to provide in order to improve commitment. The result would be disappointment and dissatisfaction.

(c)

Performance pay systems are prone to subjective and inconsistent judgement about merit; this will discredit them in the eyes of the employees.

Benefits and adverse consequences of linking reward schemes to performance measurement Benefits for the organisation It is clear how objectives set at higher levels can be translated into individual goals, thereby linking strategy to outcomes for the individual. This is illustrated in Bratton's model where the strategic perspective explains that the reward system should support strategy, and the two should be closely aligned. A reward scheme should also provide an incentive to achieve a good level of performance, and the existence of a reward scheme can help to attract and retain employees who make favourable contributions to the running of the organisation. A reward scheme can also help emphasise the key performance indicators of the business, if these are incorporated into the performance measures which underpin the scheme. This will help reinforce to employees the key aspects of their performance which contribute most to the organisation's success.

4.4.2

Drawbacks for the organisation However, the financial crisis of 2007-9 showed the dangers of linking reward schemes to performance measures if those performance measures are poorly designed. We highlighted this in the case study about bankers' bonuses earlier in the chapter, suggesting that the bonus culture encouraged a focus on short-term decision making and risk taking. A European Commission report into the financial crisis suggested that 'Excessive risk taking in the financial services industry…has contributed to the failure of financial undertakings…Whilst not the main cause of the financial crises that unfolded…there is widespread consensus that inappropriate remuneration practices…also induced excessive risk taking.' In this case, there appears to be a direct link between the profit measures (short term profitability) and the risk appetite of employees. Employees were prepared to take greater risks in the hope of making

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higher profits and therefore getting larger bonuses. However, a second potential drawback for an organisation arises if it is unable to reward individuals for good performance (for instance, due to a shortage of funds) because then the link between reward and motivation may break down.

4.4.3

Benefits and drawbacks for the individual If an individual's goals are linked to the objectives of the organisation, then it is clear to the individual how their performance is measured and why their goals are set as they are. However, on occasion there may be a problem in linking individual rewards directly to organisational outcomes, especially if the outcomes are uncertain. Another drawback is that in striving to meet targets some individuals may become cautious and reluctant to take risks given they have a stake in the outcome. Conversely, other individuals may choose riskier behavior especially if reward is linked to, say, revenue generation or levels of output.

4.4.4

Risk and reward Overall, a reward system needs to achieve a balance between risk and reward: Recruitment and retention: Rewards need to be structured in such a way that they attract and retain key talent. If an organisation's reward system is not deemed to be attractive, then there is a risk it will not be able to attract or retain the staff it needs to be successful. Alignment with business strategy and culture: If reward strategy is not aligned to organisational goals then there is a risk the organisation will not achieve those goals. Equally, the reward system needs to encourage styles of behaviour that fit with the organisation's culture. Reputation/brand: If the organisation's reward systems generate negative press coverage (as has been the case with some banks in the recent financial crisis) there is a risk this will adversely affect the organisation's reputation or brand.

4.5

Remuneration and corporate reporting In addition to considering the impact of proposed remuneration policies on employees and their organisations, and how shareholders and other stakeholders might react to any proposed benefit packages, we also need to consider how employee benefits will be accounted for in an organisation's financial statements. Two accounting standards are relevant here: IAS 19 – Employee Benefits, and IFRS 2 – Share-based Payment. We have already looked at these two standards in Chapter 4, where we noted the concern which British Airway's large pension deficit caused in relation to the merger between British Airways and Iberia. Crucially, British Airways' main pension scheme was a defined benefit scheme. As Section 4.5.1 below explains, the corporate reporting consequences of operating a defined benefit scheme are significantly different from operating a defined contribution scheme. Therefore, when deciding what type of pension scheme to offer employees (as part of their reward package) it will also be important for an organisation to consider the corporate reporting implications of that decision.

4.5.1

IAS 19 – Employee Benefits The objective of this Standard is to prescribe the accounting and disclosure for employee benefits, where employee benefits are all forms of consideration, for example cash bonuses, retirement benefits and private health care, given to an employee by an entity in exchange for the employee's services. The Standard requires an entity to recognise: (a)

A liability when an employee has provided service in exchange for employee benefits to be paid in the future; and

(b)

An expense when the entity consumes the economic benefit arising from service provided by an employee in exchange for employee benefits

However, accounting issues could arise due to: 

The valuation problems linked to some forms of employee benefits; and



The timing of benefits, which may not always be provided in the same period as the one in which the employee's services are provided

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Two elements of IAS 19 are particularly relevant to remuneration structures: 

Short-term employee benefits (falling due within 12 months from the end of the period in which the employees provide their services) such as wages, salaries, bonuses and paid holidays, nonmonetary benefits such as private medical care or company cars These benefits should normally be treated as an expense, with a liability being recognised for any unpaid balance at the year-end.



Post-employment benefits such as pensions and post-retirement health cover Pension schemes can either be defined contribution or defined benefit plans. The accounting for defined benefit plans is much more complex than for defined contribution plans.

Defined contribution plan Contributions by an employer into a defined contribution plan are made in return for services provided by an employee during the period. The employer has no further obligation for the value of the assets of the plan or the benefits payable. 

The entity should recognise contributions payable as an expense in the period in which the employee provides services (except to the extent that labour costs may be included within the cost of assets).



A liability should be recognised where contributions arise in relation to an employee's service, but remain unpaid at the period end.

Defined benefit plan Under a defined benefit plan, the amount of pension paid to retirees is defined by reference to factors such as length of service and salary levels (ie it is guaranteed). Contributions into the plan are therefore variable depending upon how the plan is performing in relation to the expected future obligation (ie if there is a shortfall contributions will increase and vice versa). Accounting treatment and impact on corporate reporting: IAS 19 requires that the defined benefit plan is recognised in the sponsoring entity's statement of financial position as either a liability or asset depending on whether the plan is in deficit or surplus. The deficit or surplus of the plan is determined by deducting the fair value of the plan assets from the present value of the defined benefit obligation. Components of the cost of defined benefit plans are broken down into constituent parts and accounted for separately: 

Service cost is included in profit or loss



Net interest on the net defined benefit liability (asset) is included in profit or loss



Re-measurements of the net defined benefit liability (asset) are included in other comprehensive income

Importantly, defined-benefit schemes in the UK are heavily in deficit at the moment, and companies are under increasing pressure to reduce the funding gaps. From an investment perspective, these deficits have been driven by a fall in equities (which have reduced the value of plan assets). At the same time, falling mortality rates and increasing life expectancy are also a problem – if people are living longer, the defined benefit obligations (and hence the deficit) also increase. An article in Economia (July 2012) reported that the aggregate FTSE 350 pension deficit increased from £43 billion to £67 billion during 2011.

4.5.2

IFRS 2 – Share-based Payment We have already mentioned IFRS 2 – Share-based Payment briefly in Chapter 4 in the context of performance management, recognising that share options could be used to encourage directors to focus on the longer-term performance of their companies and not just on short term results. However, if a company considers offering share options to its directors, it is important to weigh the potential impact these could have on its financial position.

IFRS 2 requirements Prior to the publication of IFRS 2 there appeared to be an anomaly to the extent that if a company paid its employees in cash, an expense was recognised in profit or loss, but if the payment was in share options, no expense was recognised. IFRS 2 resolved this anomaly by requiring an expense to be recognised in profit or loss in relation to

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share-based payments.

H A

However, the introduction of the IFRS (in 2004) and the requirement to recognise share-based payments as an expense caused huge controversy, with opposition especially strong among hi-tech companies. The arguments over expensing share-based payments polarised opinion, especially in the US.

P T E R



The main argument against recording an expense was that no cash changes hands as part of such transactions, and therefore there is no true expense.



The main argument for recording an expense was that share-based payments are simply another form of compensation that should go into the calculation of earnings for the sake of transparency for investors and the business community.

Practical application of IFRS 2 In practice, the implementation of IFRS 2 has resulted in earnings being reduced, sometimes significantly. It is generally agreed that as a result of the IFRS companies now focus more on the earnings effect of different rewards policies. Following the adoption of IFRS 2, some companies have admitted that they are re-evaluating the use of share options as part of employee remuneration.

Impact on earnings and financial position In the financial statements, entities should disclose information that enables users of the financial statements to understand the effect of share-based payment transactions on the entity's profit or loss for the period and on its financial position. 

The total expense recognised for the period arising from share-based payment transactions, including separate disclosure of that portion of the total expense that arises from transactions accounted for as equity-settled share-based payment transactions.



For liabilities arising from share-based payment transactions:



–

The total carrying amount at the end of the period

–

The total intrinsic value at the end of the period of liabilities for which the counterparty's right to cash or other assets had vested by the end of the period

Although not mentioned specifically by IFRS 2 in the context of disclosures, share-based payment transactions will have an impact on equity, being the other half of the double entry: DEBIT Expense CREDIT Equity (if equity settled)

Impact of share-based payments on Earnings per Share (EPS) IAS 33 Earnings per Share requires that for calculating diluted EPS all dilutive options need to be taken into account. Employee share options with fixed terms and non-vested ordinary shares are treated as options outstanding on grant date even though they may not have vested on the date the diluted EPS is calculated. All awards which do not specify performance criteria are treated as options.

4.5.3

Share-based transactions with employees (share options) Transactions with employees are normally:  

Measured at the fair value of equity instruments granted at grant date Spread over the vesting period (often a specified period of employment)

In accordance with IFRS 2 Share-Based Payment (paragraphs 16 and 17), where a transaction is measured by reference to the fair value of the equity instruments granted, fair value is based on market prices where available. If market prices are not available, the entity should estimate the fair value of the equity instruments granted using a suitable valuation technique (such as the Black-Scholes model, the Binomial model or Monte Carlo simulation).

4.5.4

Modifications and re-pricing Equity instruments may be modified before they vest. For example, a downturn in the equity market may mean that the original option exercise price set is no longer attractive. Therefore the exercise price is reduced (the option is 're-priced') to make it valuable again.

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Such modifications will often affect the fair value of the instrument and therefore the amount recognised in profit or loss. The accounting treatment of modifications and re-pricing is:

4.5.5



Continue to recognise the original fair value of the instrument in the normal way (even where the modification has reduced the fair value).



Recognise any increase in fair value at the modification date (or any increase in the number of instruments granted as a result of modification) spread over the period between the modification date and vesting date.



If modification occurs after the vesting date, then the additional fair value must be recognised immediately, unless there is, for example, an additional service period, in which case the difference is spread over the additional period.

Cancellations and settlements An entity may settle or cancel an equity instrument during the vesting period. Where this is the case, the correct accounting treatment is:

4.5.6



To immediately charge any remaining fair value of the instrument which has not been recognised to profit or loss (the cancellation or settlement accelerates the charge and does not avoid it).



Any amount paid to the employees by the entity on settlement should be treated as a buy-back of shares and should be recognised as a deduction from equity. If the amount of any such payment is in excess of the fair value of the equity instrument granted, the excess should be recognised immediately in profit or loss.

Market based and non-market based vesting conditions When share-based payments are offered to employees, there are likely to be some conditions (vesting conditions) which have to be satisfied before the employee is entitled to receive the share-based payment. IFRS 2 distinguishes between two different types of vesting conditions: Market based vesting conditions Market-based performance or vesting conditions are conditions linked to the market price of the shares in some way. Examples include vesting dependent on achieving:   

C H A P T E R

A minimum increase in the share price of the entity A minimum increase in shareholder return A specified target share price relative to an index of market prices

Non-market based vesting conditions These are conditions other than those relating to the market value of the entity's shares. Examples include vesting dependent on: 

The employee completing a minimum period of service (eg remaining with the company for a further three years) – also referred to as a service condition



Achievement of minimum sales or earnings target



Achievement of a specific increase in profit or earnings per share



Successful completion of a flotation



Completion of a particular project

The distinction between the two different types of vesting conditions has important implications for the accounting treatment of the shares:

Market-based vesting conditions 

These conditions are taken into account when calculating the fair value of the equity instruments at the grant date.



They are not taken into account when estimating the number of shares or share options likely to vest at each period end.



If the shares or share options do not vest, any amount recognised in the financial statements will remain.

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Non-market based vesting conditions 

These conditions are taken into account when determining the expense which must be taken to profit or loss in each year of the vesting period. (They are not taken into account when calculating the fair value of the equity instruments at the grant date.)



Only the number of shares or share options expected to vest will be accounted for.



At each period end (including interim periods), the number expected to vest should be revised as necessary. The movement in cumulative expense is charged to profit or loss.



On the vesting date, the entity should revise the estimate to equal the number of shares or share options that do actually vest.

Vested options not exercised If after the vesting date options are not exercised or the equity instrument is forfeited, there will be no impact on the financial statements. This is because the holder of the equity instrument has effectively made that decision as an investor. The services for which the equity instrument remunerated were received by the entity and the financial statements reflect the substance of this transaction. IFRS 2 does, however, permit a transfer to be made between reserves in such circumstances to avoid an amount remaining in a separate equity reserve where no equity instrument will be issued.

4.6

Executive remuneration and remuneration reports In Chapters 3 and 4 of this Study Manual we mentioned the principal-agent problem, and the importance of aligning directors' (agents') interests with those of their company's shareholders (principals). Granting share options to directors is one way of aligning directors' interests with those of the company's shareholders. More generally, however, there has been increasing pressure on companies to be more transparent about the way directors' pay is set, and to improve accountability to shareholders. In the UK, the 'Directors' Remuneration Report Regulations' (2002) required all quoted companies to produce a detailed annual directors' remuneration report, and to hold a shareholder vote on that report. The purpose of the Regulations was to:   

Enhance transparency in setting directors' pay Improve accountability to shareholders; and Provide for a more effective performance linkage

In this respect, the Regulations were also designed to enable shareholders to see the rationale behind directors' remuneration more clearly; although, perhaps surprisingly, the Regulations did not require companies to disclose information relating to their bonus policies. A company's bonus policy is likely to be an area of particular interest to shareholders. In the context of Strategic Business Management, the linkage between remuneration and performance is also particularly important. As the Foreword to the Department of Business, Innovation & Skills' (BIS) discussion paper 'Executive Remuneration' (2011) noted: 'Executive remuneration that is well-structured, clearly linked to the strategic objectives of a company, and which rewards executive directors who contribute to the long-term success of that company, is important in promoting business stability and growth. Shareholders want to see remuneration being used effectively to attract, incentivise and appropriately reward executives, so that the value of the companies they invest in increases over time.' Generous rewards can be justified when a company has delivered strong long-term performance and growth. However, as the BIS discussion paper highlights, the financial crisis in 2008-9 made shareholders, wider stakeholders (such as employees and customers), and the public at large more aware of the apparent disconnect between pay and performance. For example, one area of concern is that the remuneration of the highest paid executives in large companies seems to rise virtually every year, regardless of the performance of the company. The link between strategy, pay and performance should therefore be an important factor for shareholders to consider when assessing remuneration proposals. The BIS discussion paper proposed that companies should provide a clearer statement on how executive

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remuneration relates to a company's achievement of its strategic objectives over the previous year. However, as well as justifying its current payments, it is equally important for a company to describe its pay policy for the year ahead, so that shareholders can gauge how effectively future pay is linked to company strategy and performance. In this respect, the Directors’ Remuneration Report (DRR) Regulations (2013) which took effect from 1 October 2013 have important implications for the information which companies have to disclose in directors’ remuneration reports. The DRR Regulations aim to increase transparency over directors’ remuneration by requiring a company to separate its reports about Directors’ Remuneration into two parts: 

Policy Report – a forward looking report setting out the company’s future policy on directors’ remuneration. The policy report should cover the company’s approach to setting salary, pensions, bonus and incentive awards, as well as payments for loss of office and recruitment packages for new directors. The policy report must disclose a description of each element of pay, and how it links to the company’s strategy. The report must also provide performance scenarios showing fixed pay, total remuneration when performing in line with expectations, and maximum total remuneration.



Implementation Report – a retrospective report, setting out the actual payments made to directors in the financial year being reported on. The DRR Regulations also require a company to include, within the implementation report, a single total figure of remuneration for each director, along with tables showing that total figure broken down into its component parts (base salary; taxable benefits; bonuses; the value of share and share options awards; and any pension related benefits).

The Regulations also increase shareholder power by allowing shareholders a binding vote on the Policy Report at least once every three years.

C H A P T

E R 10

A company is then prohibited from making any remuneration payment which is not covered by an approved remuneration policy, or which is inconsistent with that policy.

4.6.1 Pay gaps The increased focus on the relationship between executive pay and company performance also reflects increasing concerns about the disparity (‘pay gap’) between the rewards paid to senior executives and the remuneration received by the workforce at large. Shareholders are becoming increasingly sensitive to the idea that it is unfair for executives to get significantly higher pay increases than everyone else. Similarly, shareholders are also starting to ask whether the package of rewards received by each director is fair and justified in the context of their contribution to the business. Both of these issues should also serve as a warning that shareholders could vote against executive pay deals if they believe them to be unfair or unjustified. However, the increased focus on performance and rewards could also pose some questions for the performance measures which are used to determine rewards, and how weightings are assigned to different measures. For example, should directors be rewarded for meeting environmental targets in a year when profits have decreased?

5 HRM and change management 5.1

HRM and change agents One of the four roles for HRM highlighted in Dave Ulrich's model (see Figure 10.2) is that of change agent. HR departments in nearly every business have a key role in managing change effectively. Although some changes occur as clearly-defined episodes in response to external environmental factors, change can also be a continuous process within organisations (as implied by the notion of the learning organisation). Learning new knowledge could itself be a catalyst for change. Moreover, change comes in different forms and can occur at different levels within an organisation:   

Individuals Structures and systems Organisational climate

Changing individuals involves changing their skills, values, attitudes and behaviours. Any such individual changes have to support the overall organisational changes required. However, ultimately organisational changes can only be achieved if the individual people working for an organisation change as necessary.

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Changing structures and systems involves changing the formal and informal organisational structures in place: for example, changing business processes, or changing roles, responsibilities and relationships. Changing the organisational climate involves changing the way people relate to each other in an organisation; the management style; and the overall culture of the organisation. For example, this might involve creating a culture of high interpersonal trust and openness between staff. The presence of these three levels means a change manager needs to ensure that appropriate methods exist in order that the desired change is achieved at each level.

5.1.1

HRM and organisational change Despite the range of possible change scenarios which might arise in an organisation, HR functions can still play a central role in the change process. Key activities might include: 

The recruitment and/or development of people with the necessary leadership skills to drive change, and staff with the necessary technical and operational skills to deliver the change



Advise project leaders about reward and job design



Communicating the benefits and effects of change to staff, and encouraging staff involvement in the change process



Identifying the appropriate medium of communication to reach different stakeholder groups



Understanding staff (or other stakeholders') concerns about changes, and helping to deal with them



Negotiating and dealing with conflict; engaging with various stakeholders; understanding stakeholder concerns in order to anticipate problems with change programmes



Assessing the impact which changes in one business area/department/location could have on other parts of an organisation



Providing a structured framework for change, and helping people cope with change



Constructing reward systems which underpin the change process and motivate staff to support the changes

Alongside these specific areas of activity we could also suggest, more generally, that HR managers can play a key role as change agents in leading change. H A P

In order to be effective, a change agent should have the following skills and attributes:  Communication skills – and the ability to communicate effectively with people at all levels within an organisation 

Networking skills to establish and maintain contacts, both within and outside an organisation



Negotiation and 'selling' skills – negotiating with stakeholders in the business to obtain resources for a project, or to resolve conflict; selling the vision of change to key stakeholders to increase support for a change programme. A change agent also needs to have influencing skills, to be able to convince potential sceptics about the benefits of a change programme, and thereby to overcome their resistance to it



An awareness of organisational 'politics'



Sensitivity to the impact changes will have on different stakeholders, and sensitivity in dealing with different stakeholders



An understanding of the relevant processes



Financial analysis skills: to assess the financial impacts of proposed changes, or to be able to look at how changes to operations and systems can deliver a desired financial goal



Flexibility to be able to respond to shifts in project goals or objectives, or to adapt in response to internal or external factors which affect the change process



An important point that Kanter highlights is that a change agent needs to be able to adapt to cope with the complexities of modern organisations

T E R

In particular, a change agent needs to: 

Be able to work across a range of business units and functions, and across a network of different stakeholders



Be an effective collaborator, able to work in ways that enhance collaboration across different functions and divisions

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These skills should resonate with the HRM competencies of an organisation. Importantly though, a change agent should not be selected just because they have good general project management skills. The change agent must be directly involved in the change process and must see clear linkages between their future success in an organisation and the effective implementation of the change. One additional factor which could jeopardise the success of a change management project is a lack of change management/implementation expertise and skills within an organisation's senior management team. Change does not just happen on its own; management need to define the change programme, ensure the necessary resources are allocated to it, and drive it forward. However, for example, if the senior management team do not have any previous experience of change programmes and do not allocate sufficient resources to a change programme, this could jeopardise its success.

5.2

Maintaining internal consistency When planning or implementing change in an organisation, it is important that the proposed changes 'fit' with the existing context of the organisation. Successful change management requires more than simply recognising a change trigger and acting on it. Instead, successful exploitation of a change situation requires: ď&#x201A;ˇ ď&#x201A;ˇ ď&#x201A;ˇ

Knowledge of the circumstances surrounding a situation Understanding of the interactions in that situation Awareness of the potential impact of the variables associated with the situation

There are three 'hard' elements of business behaviour (a)

Structure. The organisation structure refers to the formal division of tasks in the organisation and the hierarchy of authority from the most senior to junior.

(b)

Strategy. How the organisation plans to outperform its competitors, or how it intends to achieve its objectives. This is linked to shared values.

(c)

Systems. These include the technical systems of accounting, personnel, management information and so forth. These are linked to the skills of the staff.

These 'hard' elements are easily quantified and defined, and deal with facts and rules. 'Soft' elements are equally important. (a)

Style refers to the corporate culture that is the shared assumptions, ways of working, attitudes and beliefs. It is the way the organisation presents itself to the outside world.

(b)

Shared values are the guiding beliefs of people in the organisation as to why it exists. (For example, people in a hospital seek to save lives.)

(c)

Staff are the people in the organisation.

(d)

Skills refer to those things that the organisation does well. For example, the UK telecom company BT is good at providing a telephone service, but even if the phone network is eventually used as a transmission medium for TV or films, BT is unlikely to make those programmes itself.

All elements, both hard and soft, must pull in the same direction for the organisation to be effective. For example, an organisation will not benefit if it installs the most sophisticated, up-to-date management information systems, yet its managers continue to want to receive the same reports as they always have because they don't understand or trust the new technology. In this simple example, there is a mismatch between systems and staff/skills.

5.3

Leadership and change Change management is a comprehensive effort to lead an organisation through transformation. To be successful, the transformation effort must be actively led and managed with a clear set of objectives and an agreed plan for achieving these objectives. A crucial problem organisations have to address is how they can manage change in the fast-moving environment of contemporary business while also maintaining control and their core competencies. Designing, evaluating and implementing successful change strategies depends to a significant extent on the quality of the senior management team, and in particular that team's ability to design the

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organisation in a way to facilitate the change process.

5.4.1

Who leads change? Although a CEO plays an important role in leading strategic change, leading change is not only the responsibility of the CEO. Whetten and Cameron have pointed out: '…the most important leadership demonstrated in organisations usually occurs in departments, divisions, and with teams and with individuals who take it upon themselves to enter a temporary state of leadership...' Inevitably, though, leading change will also require competencies in influencing and conflict handling, because people may need to be persuaded of the value and benefits of change. Change may create conflict between individuals and their environment – and, often, within individuals themselves. Change can often make people uncomfortable, which is why many people resist it. Organisational change also creates potential conflict between management (who may be identified as the causes or agents of change) and employees (who often feel like the 'victims' of it). Managing change is in essence a process of facilitating internal and external conflict resolution. So change leaders have to play a dual role of not only leading a business forward, but also resolving any conflicts which are created during the course of the change process.

5.4.2

Change roles We can identify a number of key players in the change process. Change leader: The success of the change programme is based on a key, pivotal figure. This leader may be the CEO, the MD, or another senior manager acting as an internal change agent. Change advocate: who proposes the change. Change sponsor: who legitimises the change. Change agent: who implements the change. Change agents seek to initiate and manage a planned change process. Change targets/recipients: although they do not lead the change, it is important in any change programme to remember the change targets – these are the people who undergo the change. Other change roles to consider are: External facilitators: External consultants may be appointed to help co-ordinate the change process. Change action team: A team of people within the organisation may be appointed to lead the changes. This team may take the form of a steering committee. If the team does not include any influential senior managers it will need the backing of more powerful individuals to support any major change efforts. Functional delegation: The responsibility for managing change may be assigned to a particular function – often the HR department. This approach is probably most suitable when the skills needed to manage the change reside within a particular department. However, unless the department head is a powerful authority figure, he or she will need the backing of a more powerful figure to spearhead major change efforts.

5.4

Strategy, change management and HRM Ultimately, change is inevitable in any progressive organisation. Any business that wants to thrive in an ever-changing world needs to adapt to its environment. One of the key responsibilities for an organisation's management is to detect trends inside and outside the organisation to identify changes that are needed and then to initiate a change management process to introduce those changes. The change management process can be summarised in three steps: (a)

Strategic planning and design: form a change management team, define the vision and strategy, design a programme from which to manage the change and determine the tools needed for implementation

(b)

Strategy implementation: communicate the vision and implementation to staff, manage staff

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responses and lead them through the change; maintain momentum (c)

Evaluation and readjustment: look at the results, track performance against targets, modify structure if necessary, plan for the future but continue to monitor performance

However, it is important to remember that change can affect all the aspects of an organisation and, in turn, how implementing a business strategy could require changes in all the aspects of an organisation.

5.5

HRM and acquisitions Although we have so far looked at the role of HRM in managing internal changes within an organisation, HRM is also a crucial part of an acquisition or merger. Managing the 'human' side of an acquisition or merger is critical for maximising the value of the deal, and a number of the key issues involved in any such deal relate directly to HR issues:       

5.6.1

Determining the organisational structure of the new company Integrating the organisational cultures of the different companies Retaining key talent and key managers Communicating to staff in both companies, and addressing any concerns they may have Dealing with any redundancies which may be necessary Aligning the remuneration and reward systems of both companies Deciding on HR policies and practice for the new company

HRM and due diligence Not only could protecting and developing the rights and interests of human resources be crucial to a successful acquisition, there may also be legal obligations associated to it (for example, obligations relating to a pension scheme, or obligations arising if employees' terms and conditions of employment are protected when a business is transferred from one owner to another). In this respect, human resource due diligence will be an important element of a take-over. The functions which are relevant to HR due diligence are likely to include the following: 

HR audit: – – – – – –

Benefits and compensation programmes Recruitment process Practices for recruitment and dismissal Exit procedures Employee contracts and employee handbooks

– – – –

Organisation charts Performance reviews, and guidelines for how employee performances are evaluated Training and education programmes HR strategy

C H A P T E R

Personnel files



Obligations under the pension scheme



Union contracts/union memberships



Evaluation of synergies, gaps and duplications in numbers and skills



Review of potential redundancies (and redundancy costs, including senior management compensation plans) and cost savings post-acquisition



Talent retention



Legal compliance (eg group insurance, employment legislation, health and safety)

As we have already noted, the pre-acquisition process also needs to review organisational structure (eg number of management layers, centralisation vs decentralisation) and the organisational 'fit' (culture and values) between the two companies.

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Strategic Business Management Chapter-11 Finance awareness 1 Financial strategy 1.1

Financial strategy decisions Definition Strategic financial management: The identification of the possible strategies capable of maximising an organisation's net present value, the allocation of scarce capital resources among the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. We discussed here financial objectives and the strategies for achieving them.

1.1.1

Financial objectives It is often assumed that the overall financial objective of a company should be to increase, or even maximise, the wealth of its shareholders. The financial strategies for achieving this objective involve strategies for investing and returns, and for dividends. If a company's shares are traded on a stock market, the wealth of shareholders is increased when the share price goes up. The price of a company's shares should go up when the company is expected to make additional profits, which it will pay out as dividends or re-invest in the business to achieve future profit growth and dividend growth. Maximising the wealth of shareholders generally implies maximising profits consistent with long-term stability. Sometimes short-term gains must be sacrificed in the interests of the company's long-term prospects. In addition, to increase the share price the company should achieve its profits without taking excessive business risks and financial risks that worry shareholders.

1.2

Factors affecting choice of financial strategy The following general considerations will have significant impacts upon the strategies chosen.

1.2.1

Profits The effect of strategies chosen on profits will be a critical influence on how strategies are perceived, as a business's accounts present the public face of its financial strategies.

1.2.2

Cash Though financial strategies should hopefully enhance long-term profitability, cash flow considerations will often be shorter-term but possibly more pressing. It's easy to just concentrate on operating and investing cash flows and ignore financing cash flows (interest and dividends). However a critical, and often finely balanced, question will be whether operating cash flows will be sufficient to pay the servicing costs of finance.

1.2.3

Shareholders Enhancing shareholder value is of course a key objective. Although this is connected with dividend policy, you also need to assess the effect on value of shares (which we shall see later is not just a function of current and future dividends).

1.2.4

Other stakeholders Many financial strategies will have major impacts upon stakeholders other than shareholders with whom the organisation wishes to maintain good relations. These include: ď&#x201A;ˇ

Managers and employees, who will be affected by any fundamental decision about a business's direction such as a merger or acquisition

ď&#x201A;ˇ

Other suppliers of finance, who will be affected by decisions on capital structure. Suppliers of finance such as banks and bondholders, together with the companyâ&#x20AC;&#x2122;s shareholders, are the main financial stakeholders in a company.

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1.2.5



The government, who might be concerned that major investment decisions have an adverse impact upon the outside environment (not just the natural environment but also the competitive environment)



Customers. Businesses need to be sensitive not only to actions which directly affect customers (product pricing) but how other actions may indirectly impact (for example redundancies meaning that fewer staff are available to deal with customer demands)

Economic and market considerations Business decisions are never taken in isolation in a perfect world. Therefore you have to evaluate the impact of factors such as key economic indicators. For this paper as well you need to consider the international implications, including exchange rates and conditions for investment abroad. In addition, the organisation's achievements may be assessed from distorted viewpoints that place excessive emphasis upon certain factors and do not have all the necessary information. Thus an assessment of market efficiency will often be helpful. Assessing market efficiency involves considering to what information the market is responding.

1.2.6

Restrictions Bear in mind that a business may not always be able to do what it wants. Legal restrictions may be a powerful restraining force, and also restrictions imposed by suppliers of finance (restrictions imposed by loan arrangements or the need to maintain dividend levels to keep shareholders happy). Particularly for small companies, there may also be restrictions on the funds available to the business.

1.2.7

Risks Remember that it is not necessarily just financial risk you are considering. Another area where risks should be considered is investment in information technology. Firms also need to be aware of risk issues such as limited data and how the changing environment can be measured, and also the impact of uncertainty (how difficult it is to measure the likelihood of outcomes). Various measures of risk may need to be considered (possible outcomes, likelihood of an unsatisfactory outcome, worst possible outcome). The organisation's (and its directors') attitude to risk will also be important. It may be a good textbook answer to say that the business should obtain debt finance, but the current directors may be unwilling to put the business at risk by taking on extra debt.

1.2.8

Timescale We've already mentioned timescale, but it's worth considering separately:

1.3



Strategy is primarily concerned with long-term direction. Businesses have to maximise shareholder value in the long-term. However, you also should consider what objectives or conditions have to be fulfilled in the short-term (such as making enough money to carry on trading!).



Decisions relating to a particular strategy are not always made at a single time. In real option theory, which takes into account that businesses may choose one course, and then later decide on a different course of action depending on how the first course of action has gone.

Financial management decisions We discussed the main decisions (investment financing and dividend decisions) , investment decisions, sources of finance and financing decisions.

1.4

Financial strategy decision-making Here we shall look briefly at how these elements apply to financial strategy decisions. In Chapter 14 we discuss in detail their application to the capital structure decision. Financial strategies must also be clear, which means they need to specify certain things.

1.4.1

Suitability Suitability relates to the strategic logic of decisions. Financial strategy should fit the situation of the business. The financial decisions taken should help businesses generate and maintain competitive advantages, seize opportunities and exploit company strengths and distinctive competences. When considering the suitability of an option, you might also think about whether there are any better alternatives not specified in the question. For example, if a business is looking to acquire another, would it be better off trying to grow internally instead? It may be necessary to create a framework for ranking alternatives.

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1.4.2

Acceptability Shareholders will obviously be concerned with how far the chosen strategy contributes to meeting the dominant objective of increasing shareholder wealth. Other suppliers of finance will be concerned with whether the organisation is able to meet its commitments to them. All stakeholders may be concerned with the potential risks of the strategies. Financial acceptability will need to be demonstrated by investment appraisal and by analysis of the effect on profitability, liquidity and gearing indicators. These may need to be supplemented by risk analysis. Don't forget the other conditions (legal, loan covenant etc) imposed by other stakeholders. Acceptability may not be just a matter of fulfilling a set of rules, but also being a good citizen (acting sensitively towards the natural environment, paying suppliers on time).

1.4.3

Feasibility Specification of required resources is a key aspect of clear strategy exposition. These resources have to be available in order for strategies to be feasible. Obviously for financial strategy decisions, financial resources will be critical, but businesses will also need to have access to technology, materials and other natural resources. Businesses must also be able to generate sufficient returns to compensate resource providers for the resources consumed. They will need to be able to supply sufficient goods and services and be able to withstand competitor threats. Again it will be important to demonstrate financial feasibility with supporting financial data. Cash and funds flow forecasts will be central to this. Feasibility also relates to the conditions that must be fulfilled if a strategic decision is to be successful. If, for example, the success of an acquisition depends upon the key staff of the acquired company staying, how feasible is it that they will?

1.4.4

Clarity The considerations listed below will apply to strategies of investment. The focus of financing strategies will be on the provision of sufficient resources, although the resources required must also be spelt out for investment strategies. (a)

Benefits The benefits to the organisation and principal stakeholders of strategies need to be spelt out â&#x20AC;&#x201C; for example, higher revenues or falling interest commitments meaning more funds available for distribution to shareholders.

(b) Direction The activities required to implement the strategy must be directed towards providing the benefits. Direction also means setting financial targets, enabling better control when the strategy is implemented. (c)

Resource specification and management The financial resources needed to implement investment strategies should be specified in detail. Remember also the need to ensure that resources are managed carefully. In your previous studies you encountered the concept of over-trading, where a business expands too quickly and fails to manage its working capital and cash flows properly.

(d) Changes in the environment The strategy chosen should enable the business to cope with environmental changes and complexity. If environmental changes are likely to be a significant factor, it may be important to specify the responses that may be required, for example obtaining contingency funding. (e)

Timescale The strategy chosen should be relevant for the long-term that is going beyond short-term profit targets. What constitutes long-term will vary, but for an investing strategy it is likely to mean the life-time of the investment, and for a financing strategy perhaps the duration of long-term debt instruments.

1.5

Strategic cash flow planning Strategic cash flow planning ensures that sufficient funds are available for investment and that surplus funds are used to best advantage.

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In order to survive, any business must have an adequate inflow of cash. Cash flow planning at a strategic level is similar to normal cash budgeting, with the following exceptions: (a)

The planning horizon (the furthest time ahead plans can be quantified) is longer.

(b)

The uncertainties about future cash inflows and cash outflows are much greater.

(c)

The business should be able to respond, if necessary, to an unexpected need for cash. Where could extra cash be raised, and in what amounts?

(d)

A company should have planned cash flows that are consistent with: (i) (ii)

1.5.1

Its dividend payment policy, and Its policy for financial structuring, debt and gearing

New investments and product developments Investments in new projects, such as new product developments, use up cash in the short term. It will not be for some years perhaps that good profits and cash inflows are earned from them. One aspect of strategic cash flow planning is to try to achieve a balance between the following:

1.5.2

(a)

Making and selling products that are still in their early stages of development, and are still 'soaking up' cash

(b)

Making and selling products that are 'cash cows' â&#x20AC;&#x201C; ie established products that are earning good profits and good cash inflows

Cash surpluses A company should try to plan for adequate cash inflows and be able to call on 'emergency' sources of cash in the event of an unforeseen need, but it might be unwise to hold too much cash. When a company is cash-rich it can invest the money, usually in short-term investments or deposits such as the money market, to earn interest. However, for companies which are not in financial services or banking, the main function of money is to be spent. A cash-rich company could do one of the following:

1.6

(a)

Plan to use the cash, for example for a project investment or a takeover bid for another company

(b)

Pay out the cash to shareholders as dividends and let the shareholders decide how best to use the cash for themselves

(c)

Re-purchase its own shares

Strategic fund management Strategic fund management involves asset management to make assets available for sale if cash deficiencies arise. Strategic fund management is an extension of cash flow planning that takes into consideration the ability of a business to overcome unforeseen problems with cash flows, recognising that the assets of a business can be divided into three categories: (a)

Assets that are needed to carry out the 'core' activities of the business. A group of companies will often have one or several main activities, and in addition will carry on several peripheral activities. The group's strategy should be primarily to develop its main activities. There has to be enough cash to maintain those activities and to finance their growth.

(b)

Assets that are not essential for carrying out the main activities of the business and could be sold off at fairly short notice. These assets will mainly consist of short-term marketable investments.

(c)

Assets that are not essential for carrying out the main activities of the business and could be sold off to raise cash, although it would probably take time to arrange the sale and the amount of cash obtainable from the sale might be uncertain. These assets would include: long-term investments (for example, substantial shareholdings in other companies); subsidiary companies engaged in 'peripheral' activities, which might be sold off to another company or in a management buyout; and land and buildings.

If an unexpected event takes place which threatens a company's cash position, the company could also meet the threat by:

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(a)

Working capital management to improve cash flows by reducing stocks and debtors, taking more credit, or negotiating a higher bank overdraft facility

(b)

Changes to dividend policy

1.7

Corporate reporting implications of investment and financing decisions The investment and financing decisions will have a number of consequences for the contents of its accounts. In this chapter we provide an overview on how investment and financing decisions relate to the requirements of financial reporting standards. In later chapters, where relevant, we will cover some of the corporate reporting consequences in more detail. The consequences of many decisions will be significant for the financial statements, equity and profits of a company, affecting in turn analysts' measures of return and gearing that investors will use to make financial decisions themselves. As mentioned above, the Corporate Reporting Study Manual discusses fully the accounting issues that this text treats selectively. This section also revises topics that were covered in the Financial Accounting and Financial Reporting Study Manuals. For the purposes of this chapter, we shall group the accounting requirements under the following headings:    

1.8

Investment in entities Other investment issues Financing Other issues

Investment in entities The economic reality is that many businesses take on complex forms, often establishing themselves as a number of companies that act coherently, or are centrally directed and managed. Large groups of companies emerge. Investors need to know, if their investments are at group level, exactly how the group as a whole is performing. Financial statements normally set out the financial position and performance of a single entity. If that entity is controlled by another entity (its parent) and there are intragroup transactions, then its financial statements may not reveal a true picture of its activities. As a consequence, consolidated financial statements are prepared by aggregating the transactions, assets and liabilities of the parent and all its subsidiaries on the basis that the group is a single economic entity. Without consolidated financial statements, the shareholders in the parent entity would receive its single entity financial statements, which would recognise the income of subsidiaries only to the extent of the dividends receivable from them. The information provided to such shareholders would not reflect the economic realities. Consolidated financial statements provide useful information about all of the activities carried out by the management of the parent entity. Their preparation is an application of the IASB's Conceptual Framework requirement that transactions are accounted for in accordance with their substance, not just their legal form. The introduction to IFRS 12, Disclosure of Interests in Other Entities highlights the importance that financial statement users place on disclosure of interests in other entities to help identify the profit or loss and cash flows available to the investor company. As you will remember from earlier studies, the extent of control that an investor has over its investment will determine how it is treated in the investor's accounts.

1.8.1

Subsidiaries If an investment has subsidiaries, it is subject to the requirement of IFRS 10 to prepare consolidated financial statements. A parent-subsidiary relationship is based on control, which an investor has if it has:

1.8.2



Power over the investment – existing rights that give the investor the ability to direct the activities of the investment that significantly affect its returns. These may come through voting rights, the power to govern financial and operating policies or the power to appoint and remove a majority of the board of directors



Exposure or rights to variable returns from the investment



Ability to use the power over the investment to affect the returns it obtains

Joint ventures Investments can take a number of different forms. It is not always appropriate to acquire the majority of the voting rights of another entity in order to gain control. In some industries and in particular circumstances, it is more beneficial to share such investment and control with other parties. By sharing the investment each investor brings with them different skills. Consequently the arrangement may benefit all parties through reduced costs. Such arrangements are commonly known as joint ventures.

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If a firm makes an investment jointly with another party, it may be subject to the requirements of IFRS 11 Joint Arrangements to recognise the rights and obligations arising from the investment. The standard only applies to joint arrangements where the parties have joint control. Joint control is the contractually agreed sharing of control where strategic decisions require the unanimous consent of the parties sharing control (majority control, where decisions require the consent of a majority of owners, is not joint control). Joint arrangements are of two types, depending on the rights each party has:

1.8.3

ď&#x201A;ˇ

Joint operations include, but are not confined to, arrangements that are not structured through a separate entity (a separately identifiable financial structure, for example a limited liability company). The parties share their activities and pool their resources. In joint operations the parties provide and have rights to their own assets, and obligations for the liabilities relating to the arrangement. The accounts include the reporting entity's own assets and liabilities, its share of the revenues and the expenses it incurs relating to its interest in the joint operation (known as gross accounting).

ď&#x201A;ˇ

Joint ventures are arrangements where the parties that have joint control have rights to the net assets of the arrangement. The arrangement holds assets and incurs liabilities on its own account and the parties to the arrangement are only liable to the extent of their investment. Each party treats its interest in the joint venture as an investment in the arrangement using the equity method of accounting, in accordance with the requirements of IAS 28 Investments in Associates and Joint Ventures.

Associates Outright control is not always the most appropriate form of investment for an entity to have. There may be circumstances where although an entity does not control another entity, the business operated by that other entity is still of significant importance to it. In such circumstances an investor may obtain sufficient ownership of the entity to have the power to influence decisions of its governing body (eg its board of directors) but not to have control over it. Investments that meet these criteria will generally be classed as associates. As the investor has significant influence over such an investee, it is appropriate to report its share of the investee's results rather than just the dividends receivable. After all, it is partly answerable for the investee's performance. Such accounting requirements provide more useful information about the financial performance and position of the investor. Interests in associates are common in real-life, particularly where a controlling interest is built up over time rather than being purchased in one step. As you will remember, the accounting treatment of associates differs from subsidiaries, even if the investor eventually wishes to gain control. IAS 28 also applies to investments in associates. Remember that holding 20% of voting power creates a presumption of significant influence. The equity method means that the investment will be recognised initially at cost and then adjusted for the post-acquisition change in the share of the investment's net assets. Distributions will reduce the carrying value of the investment. A firm may make an associate investment in a business whose viability and success will play an integral part in an entity's own success. For example, where an entity uses distributors or agents in foreign countries, it may wish to take an equity stake in them. This strengthens the relationship between the parties and allows a level of influence and communication greater than could be obtained through a contractual agreement alone. Alternatively, a non-controlling stake may be the initial stage of a larger plan to obtain control of the target entity. The investor is able to gain board representation and strengthen its business relationships with the target. If the relationship is successful, further investment can be facilitated.

1.8.4

Business combinations Entities may increase their market share, diversify their business or improve vertical integration of their activities in a number of ways, including by organic growth or through acquisitions. The acquisition of a competitor may offer rapid expansion or access to new markets and is often seen as more attractive than expansion through organic growth. To ensure that users of financial statements are able to distinguish between organic growth and growth through acquisition, detailed financial reporting requirements should be applied and comprehensive disclosures should be presented.

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The process of acquisition will mean that the investor is subject to IFRS 3 Business Combinations. The accounting consequences will be that the investor recognises the assets acquired and liabilities assumed, including those that may not have been recognised by the entity being acquired, such as brand names. Since the assets and liabilities being acquired are recognised at fair value, the investment is included at an amount that reflects the market's expectation of the value of its future cash flows.

1.8.5

Discontinued operations A key business event arises when an entity closes or discontinues a part of its overall business activity. Management will have assessed the impact of the closure on its future profitability, but users of the financial statements, be they investors or other stakeholders, will want to make their own assessment. IFRS 5 Non-current Assets Held for Sale and Discontinued Operations provides an analysis not of future profit but of the contribution of the discontinued element to the current year's profit (or loss), ie the part that will not be included in future years' profits. Showing separate information about discontinued operations allows users of financial statements to make relevant future projections of cash flows, financial position and earnings-generating capacity. In addition, an asset is held for sale when the entity does not intend to use it as part of its on-going business, but instead intends to sell it. The separate identification of assets that are held for sale, rather than to generate continuing economic benefits for the entity on an ongoing basis, substantially improves the information made available to users as it provides information on the entity's plans and likely future performance. If at the end of the accounting period some business assets are no longer needed, they will be classified as held for sale in accordance with IFRS 5 if their carrying amount will be recovered principally through a sale transaction, they are available for immediate sale and the sale is highly probable. Abandoned assets cannot be classified as held for sale. If the assets fulfil the definition of held for sale, they will be subject to the requirements of IFRS 5 and not depreciated. They will be held at the lower of fair value less costs to sell and carrying amount.

1.8.6

Disclosure of interests Investments in any subsidiaries, joint arrangements, associates or unconsolidated structured entities will mean that the investor has to apply the requirements of IFRS 12 Disclosure of Interests in Other Entities. As well as interests (including non-controlling interests in subsidiaries) IFRS 12 has other disclosure requirements depending on the nature of the investments. These include disclosure of restrictions on assets, liabilities and the movement of funds and details about the nature of, and changes in, risks associated with the investments.

1.8.7

Separate financial statements In jurisdictions where an entity must present separate financial statements in addition to the consolidated financial statements, or if an entity chooses to do so voluntarily, the requirements of IAS 27 Separate Financial Statements apply. The entity making the investment in subsidiaries, joint ventures or associates must account for these either at cost or in accordance with the fair value requirements of IFRS 9 Financial Instruments.

1.8.8

Segments Most large entities sell different products and services in a number of different markets or geographical locations, which may be regarded as different business segments. The total profitability of the entity will depend upon the performance of each of these segments. For some entities the key segments will be based on products and services; for others it will be by geographical area. In each case, the separate management and performance measurement of individual segments is essential, as while one product or geographical area may be performing well, another may be failing. While management will have access to management accounting performance data on each separate part of the business, the published accounts, in the absence of segmental reporting, would only report the aggregate performance of the entity. Overall profitability is important, but additional information is needed by external users to fully understand the separate businesses hidden below this top level reporting. IFRS 8 Operating Segments provides a link between the business operations and the main components of the financial statements by requiring information to be disaggregated. Investors can therefore make better assessments of the performance of each part of the business, leading to a better understanding of the business as a whole.

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Operating segment: This is a component of an entity: (a)

That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity)

(b)

Whose operating results are regularly reviewed by the entity's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and

(c)

For which discrete financial information is available

Significant new investments, for example a large diversification into a new geographical area or product, may mean that a listed company becomes subject to the requirements of IFRS 8. The standard will apply if there is separate financial information available about the investment and senior management regularly evaluates it as part of the overall process of deciding how to allocate resources and also when assessing performance. Under IFRS 8 information must be given about determination of the operating segments, the products and services they provide, profit or loss, significant income and expense items and segment assets and liabilities.

1.9

Other investment issues Even if a company does not invest in another entity, a major investment may include substantial investment in non-current assets.

1.9.1

Tangible assets Businesses operating in certain industries, for example manufacturing, typically have ownership of substantial property, plant and equipment (PPE). PPE are tangible assets such as freehold and leasehold land and buildings, plant and machinery, fixtures and fittings, which are held for use in the production or supply of goods or services or for administrative purposes. The management of these resources underpins the continued viability of businesses and therefore represents a key feature of business prosperity. It is important that users of financial statements understand how businesses utilise their PPE and how such assets are accounted for. Any investment in tangible assets will be subject to the requirements of IAS 16 Property, Plant and Equipment relating to capitalisation, depreciation, revaluation and measurement of fair value and impairment. In order to be capitalised, it has to be probable that future economic benefits associated with the item will flow to the entity. Therefore if the asset purchase is part of a project, the entity has to expect that the project will be successful. Under IAS 16 costs include: 

Purchase price



Costs directly attributable to bringing the asset to the location and condition required for operation including employee costs in construction or acquisition, site preparation costs, initial delivery and handling costs, installation and assembly costs, testing costs and professional fees



Costs of dismantling and removing the item and site restoration costs

Depreciation policy will depend on the use to which the asset is put, based on the expectations of how economic benefits will be derived from it. Factors that will determine the useful life that is used in calculating depreciation include:    

1.9.2

Expected usage of the asset Expected physical wear and tear Possible technical or commercial obsolescence Limits on the use of the asset

Intangible assets Brand names, such as Coca-Cola or Microsoft, are in many cases an entity's most valuable asset but they are extremely difficult to value when they have been generated internally and over a long period of time. Brands are one example of an intangible asset. If they cannot be reliably measured, they cannot be recognised in the financial statements. Such a problem calls into question the quality of information financial statements contain and, consequently, potentially diminishes the power of financial statements in providing information for a business on which economic and investment decisions are made. However, an entity that has acquired, as opposed to internally generated, an equally valuable brand will recognise it, since a fair value can be attributed to it. An intangible asset may be recognised by the

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acquirer that was not recognised by the acquiree, for example an internally generated brand may be recognised by the acquirer. This is because the acquisition provides sufficient evidence that: 

There will be future economic benefits attributable to it – otherwise, why would the acquirer buy it?



The cost can be measured reliably; the acquirer will have built up the total purchase consideration by estimating values (= costs) for each asset.

This inconsistent treatment has led to difficulties in valuing entities and assessing their performance. An investment in a major IT project, for example, may involve investment in intangibles such as computer software or licences. These will be subject to the requirements of IAS 38 Intangible Assets. They can only be carried on the statement of financial position if it is probable there will be future economic benefits from the assets. Their useful life may be determined by the life of the investment. It may be difficult to decide whether the firm has control of some intangible assets and it may also be problematic to assess their fair value or impairment, particularly if there is no active market for them and they are part of a specific investment.

1.9.3

Impairment of assets Asset availability and usage in a business is one of the key drivers in business success. Any assessment of assets, therefore, should consistently reflect their worth to the business and financial reporting of their value should be accurate, particularly when there exists the possibility that an asset may have diminished in value. At the very least, an asset recognised in the statement of financial position should not be reported at a value above the amount that could be recovered from it. During periods where general prices increase there is an assumption that recoverability of the reported value of such assets will not be an issue. However, it is important that all the assets are considered in relation to business decisions that are made by the entity. For example, some intangible assets which are highly technical in nature may attract premium valuations which may not be recoverable as technology continues to be developed or competitors enter the market. Assets will be subject to the requirements of IAS 36 Impairment of Assets if their carrying amounts exceed the amount expected to be recovered from their use or sale. The firm must reduce the carrying amount of the asset to its recoverable amount and recognise an impairment loss. The recoverable amount is the higher of fair value less costs of disposal and value in use.

Definition Value in use: The present value of the future cash flows expected to be derived from an asset or cashgenerating unit. The following elements should be reflected in the calculation of an asset's value in use: 

An estimate of the future cash flows the entity expects to derive from the asset



Expectations about possible variations in the amount or timing of those future cash flows



The time value of money (represented by the current market risk-free rate of interest)



The price for bearing the uncertainty inherent in the asset



Other factors that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset

The standard could therefore apply if the expected future cash flows associated with the asset are worse than was forecast when the initial investment was made. The cash flow projections used to assess whether impairment has occurred should be the most recent management-approved budgets or forecasts, generally covering a maximum period of five years. The net cash flows expected to arise on the asset's ultimate disposal should be taken into account. Indicators of impairment include the following: External 

Significant decline in market value of the asset below that expected due to normal passage of time or normal use



Significant changes with an adverse effect on the entity in: – –

Technological or market environment Economic or legal environment

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com



Increased market interest rates or other market rates of return affecting discount rates and thus reducing value in use



Carrying amount of net assets of the entity exceeds market capitalisation

Internal  

Evidence of obsolescence or physical damage Significant changes with an adverse effect on the entity: – – – –



1.10

The asset becomes idle Plans to discontinue/restructure the operation to which the asset belongs Plans to dispose of an asset before the previously expected date Reassessing an asset's useful life as finite rather than indefinite

Internal evidence available that asset performance will be worse than expected

Financing A number of standards are linked to the decisions managers make about how operations and investments should be financed.

1.10.1

Financial instruments All companies have financial instruments in their statements of financial position. Receivables and cash are, after all, financial instruments. In particular, there are trillions of dollars of financial instruments outstanding in the financial markets. Prior to the standards on financial instruments, many were off balance sheet until the gain or loss became realised. Users can now better judge the impacts on future profits and liquidity and the risks businesses face as a result of the following standards being implemented: 

IAS 32 Financial Instruments: Presentation



IAS 39 Financial Instruments: Recognition and Measurement



IFRS 7 Financial Instruments: Disclosures



IFRS 9 Financial Instruments (not yet examinable in detail)

Relevant requirements of these standards are covered in more detail in Chapters 14 to 16, but for now you should keep the following principal points in mind.

1.10.2



The requirement to split financial instruments into financial assets, financial liabilities and equity instruments, with the distinction between liabilities and equity being that liabilities are instruments that embody an obligation to deliver cash whereas equity instruments contain residual interests in net assets



Classification as a liability or equity determines whether interest, dividends, losses or gains are treated as income and expense (liability) or as changes in equity



Special hedge accounting requirements, recognising the offsetting effects of changes in value of a hedged item and an instrument that hedges it may apply to hedges of asset or liability fair value, hedges of variable cash flows and hedges of net investments



Under IFRS 7, the firm needs to explain the significance of financial instruments for its financial position and performance, and provide qualitative and quantitative disclosures about exposures to risk and risk management

Foreign investment and finance Business is becoming increasingly international in terms of trading goods and services and in the operation of capital markets. One measure of the significance of globalisation is that most developed countries have external trade in the range 15% to 30% of their gross domestic product. International activity can vary enormously from relatively straightforward import and export transactions through to financing arrangements in multiple currencies or maintaining operations overseas, for example, in the form of a subsidiary or branch. Operating in multi-currency locations presents a number of accounting challenges, including:

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

Conversion – accounting for transactions where one currency has been physically changed into another currency



Translation – restating assets/liabilities initially recognised in more than one currency into a common currency



Exchange gains and losses – where relative currency values change, gains and losses arise which

need to be appropriately measured and accounted for Carrying on any trade abroad, making investments or seeking finance in other currencies will mean that the firm is subject to IAS 21 The Effects of Changes in Foreign Exchange Rates. We looked at some requirements of this standard in Chapter 2 and will return to it again in Chapter 16. For now, the standard allows exchange differences on monetary items (loans) relating to a net investment in a foreign operation to be treated as other comprehensive income in the statement of comprehensive income. They are treated as a component of equity and only taken to profit or loss on disposal of the investment.

1.10.3

Borrowing costs Inventories that require a number of manufacturing processes and the construction of non-current assets such as manufacturing plant or investment properties can take a significant time to complete. These activities may be financed by borrowings on which the entity incurs finance costs during the manufacturing/construction periods. These finance costs can be considered as part of the cost of the asset. The requirements of IAS 23 Borrowing Costs may apply to this type of investment (qualifying asset). If borrowing costs can be directly attributed to the acquisition, construction or production of a qualifying asset, then the borrowing costs should be capitalised. Borrowing costs eligible for capitalisation are those that would have been avoided otherwise. Judgement will be required when the firm uses a range of debt instruments for general finance. In these circumstances the amount of borrowing costs to be capitalised should be calculated by reference to the weighted average cost of the general borrowings.

1.10.4

Leasing Businesses may obtain financing from a number of different sources. Such financing arrangements may vary significantly in nature, from a simple bank overdraft to a complex sale and leaseback transaction. Leases can be a major source of finance to a business. The accounting treatment adopted must thus provide sufficient information for users of the financial statements to be able to understand the substance of such transactions. The accounting treatment for leases has caused much debate among national standard setters, with important issues such as gearing and off-balance sheet (ie 'hidden') financing at the centre of the debate. IAS 17 Leases sets out the accounting treatment for reporting lease transactions and provides a framework for investors to understand how an entity deals with the financing it accesses in the form of leases. The debate on the accounting for lease transactions is continuing, with the IASB currently reconsidering lease accounting. The outcome of the current debate is expected to result in a fundamental change in the accounting treatment for leases. Currently, if a business decides to lease assets it uses, the requirements of IAS 17 Leases will apply. You will remember the distinction IAS 17 draws:

1.11



Finance leases – where substantially all the risks and rewards of ownership of the leased asset are transferred to the lessee and the asset is a resource for which future economic benefits will flow Both the asset acquired and the obligation to make lease payments are recognised in the statement of financial position and the effective 'interest' expense is taken to profit or loss.



Operating leases – other leases where the transfer of risks and rewards does not take place. Lease payments are recognised in profit or loss and the lessee does not recognise the asset or obligation in the statement of financial position.

Other issues A number of other standards may be of general relevance, whatever strategic decisions the firm makes.

1.11.1

Fair values Investments and financial liabilities are now subject to the requirements of IFRS 13 Fair Value Measurement. Generally fair value should be determined on a market basis, making maximum use of observable market prices. It may alternatively be determined using a cost approach or income approach. The cost approach reflects the amount that would currently be required to replace the service capacity of an asset. A number of techniques could be employed if the income approach is used, for example present value techniques, option pricing models and the multi-period excess earnings model.

1.11.2

Events after the reporting period Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

In assessing business performance, pertinent information sometimes arises following the cut-off date for which financial statements are prepared and may have important implications for judging financial position and performance in the year just gone. The end of the reporting period is a cut-off date and events that happen after this point in time should not generally be recognised in the financial statements of the period just ended. However, information that comes to light after the reporting date sometimes provides additional information about events that actually occurred before the end of the reporting period, in which case it is appropriate to recognise it. The objective is to prepare a set of financial statements that reflect the most up to date information about events that existed at the end of the reporting period. However, it is sometimes difficult to establish whether the event happening after the end of the reporting period is new information about an existing event or a new event. Guidance is therefore provided to ensure there is consistency of treatment of such events across all financial statements. IAS 10 Events after the Reporting Period includes a number of examples of investment and financing issues for which accounts would need to be adjusted or for which disclosure would need to be made. These disclosures provide investors with additional important information that may significantly impact upon investment decisions. Examples of issues which would require accounts to be adjusted include:  

Subsequent evidence of impairment of assets Subsequent determination of the costs of assets

Examples of events requiring disclosure include:     

1.11.3

A major business combination Announcing a plan to discontinue an operation Major purchases of assets Destruction of assets Abnormally large changes in asset prices or foreign exchange rates

Provisions and contingencies One of the key creative accounting devices used in the past by businesses that wish to manipulate their financial results has been to 'smooth' earnings and thus provide a false indication that the business was more stable than was the case. One way this has been undertaken in the past has been through the creation of a provision. For example, in periods where performance exceeded expectations an entity might be tempted to make what has been commonly referred to as a 'rainy day' provision. The provision set up during prosperous times would be released in periods where results were not quite up to expectations. This provided management with some flexibility over the smoothing of results. Also a number of unrelated provisions could be grouped together to form a 'big bath' provision which provided some flexibility over its release or reversal. As a consequence IAS 37 Provisions, Contingent Liabilities and Contingent Assets restricted entities from making large 'general' provisions which can have a significant impact on the results of an entity. Guidance is provided on the type of provisions that can be made and on the general principles surrounding recognition. In so doing, the requirements of IAS 37 limit the provisions that can be made. No provision can be made for future losses of an investment, as these do not represent obligations of the firm at the period-end. However, expectations of losses may be an indication of an impairment of value of assets used in an investment. If the firm is to undertake a major restructuring of an investment, it can only make a provision for that restructuring if it has a detailed formal plan and has either started to implement the plan or announced its main features to those affected. Contingent liabilities or assets that relate to investments should be disclosed in the accounts.

2 Impact of financial crises 2.1

History of financial crises The economic outcome of the financial crisis 2007-2008 has been called the most serious recession since the 1930s. Financial crises go back at least to the 18th century and the South Sea bubble. The most serious financial crisis in the 20th century was the Wall Street crash in 1929. This was triggered by panic selling of shares in Autumn 1929 after a long speculative boom in the years up to 1929. There had been a smaller crash earlier in 1929 and other signs of economic problems, including declines in the US steel

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and construction sectors and consumers building up high debt because of easy credit. After the crash there was a prolonged period of volatility, with the stock market reaching a 20th century low in July 1932. The crash was followed by the Great Depression and mass unemployment in the US in the 1930s, although how big a contribution the crash made to the Depression has been debated since. Some commentators have argued that a bigger contributory factor was the collapse of the US banking system in a number of panics in the early 1930s. Perhaps as much as anything the crash contributed to a fall in business confidence that finance would be available for investments. This in turn fuelled job insecurity and a fall in consumer spending, which was also affected by the ending of the credit boom. The Asian contagion was a series of currency devaluations and other problems that many Asian markets experienced in 1997. The crisis initially started in Thailand, when the government decided to float the baht and no longer peg it to the US dollar. Thailand at the time had a severe foreign debt burden and large exposure to foreign exchange risk. Currency devaluations then spread through other countries, resulting in stock market declines and reduced imports. Although intervention by the International Monetary Fund mitigated the crisis, contagion was felt in market declines in Europe and America. Many financial crises are not only followed by a period of retrenchment but a period of increased regulation, reining back what have become regarded as excesses, particularly in the financial sector. The Wall Street crash resulted in the Glass-Steagall Act of 1933, limiting commercial bank activities in securities' markets and affiliations between commercial banks and securities firms. The Enron crisis prompted the Sarbanes-Oxley Act of 2002 in the United States, increasing compliance costs for internal controls and, some argue, reducing flexibility in corporate decision-making. In the UK, the banking crisis prompted the Vickers report (2011)and subsequent legislation, the Banking Reform Act 2013. The Banking Reform Act:

2.2



introduces a ‘ring-fence’ around the deposits of individuals and small businesses, to separate retail banking from their wholesale and investment operations, including the trading floor (and in doing so, protecting taxpayers when things go wrong)



imposes higher standards of conduct on banks by means of a criminal sanction for reckless misconduct that leads to bank failure.

Impact on business of the global financial crisis The onset of the global financial crisis is often associated with the collapse of the investment bank Lehman Brothers in the USA in 2008, although the crisis had begun to emerge as early as 2007. The crisis was triggered by problems in the securitisation market and credit default swaps market; several major banks faced the threat of imminent financial collapse. Some were rescued in takeovers by stronger banks; others needed substantial government financial support to remain afloat (for example, The Royal Bank of Scotland and Lloyds Bank in the UK). As banks became uncertain about the credit status of other banks, they became reluctant to lend to each other without security, even short-term, and the interbank market – which had been very liquid – dried up for a time. Banks also came under pressure from financial regulators to strengthen their balance sheets and improve their capital base. A consequence was that banks became more reluctant to lend to business, contributing to economic recession. The banking crisis led to economic recession, initially in the USA and Europe, but over time the problems extended worldwide.

2.3

A longer-term perspective Writing in Harvard Business Review, John Seaman and George David Smith highlighted the need for organisations to find in their history their 'usable past.' One part of this is to use history constructively but be prepared to jettison the parts that no longer serve your purpose. Above all though, Seaman and Smith argue that history can contribute to a sense of present corporate purpose. Conversely, though, history is not valuable if it becomes just an excuse for celebrations or irrelevant values.

3 Recent developments in the Eurozone Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

3.1 3.1.1

Introduction of the Euro Maastricht treaty 1991 The main points of the Maastricht Treaty on Economic and Monetary Union (EMU) were: 

Agreement to economic and monetary union by 1999 for countries which fulfilled the economic criteria



The establishment of the European Central Bank (ECB)

The Maastricht Treaty established three basic principles regarding fiscal policy: 1 2 3

No excessive budget deficits No monetary financing of budget deficits, ie unlimited credit from the central bank No bail outs of bankrupt governments

These principles were intended to ensure that fiscal mismanagement by one or more member states did not happen in the future. It was accepted that fiscal profligacy could undermine the monetary union. The Maastricht Treaty laid down the following official convergence criteria for member state participation: 

Inflation – No more than 1.5% above the average of the lowest three country rates in the European Union



Stable exchange rates – To be within exchange rate mechanism bands for the previous two years



Sustainable government finances – Budget deficit within 3% of gross domestic product and total government debt within 60% of gross domestic product



Interest rates – No more than 2% above the average on government bonds in the three EU countries enjoying lowest inflation

The convergence criteria were essential to ensure that participants' economies were operating as a single economy regarding inflation, interest rates and budgetary position. Any new or existing EU members wishing to join the Eurozone had to meet the above convergence criteria.

3.1.2

Benefits and costs Benefits Prior to the establishment of the Eurozone in 1999, the European Commission's economic/financial experts identified five specific advantages in relation to EMU: 1

Growth and efficiency It was believed that reduced transaction costs for business via the elimination of costs associated with changing currencies would generate a gain of 0.4% of EMU GDP on a once and for all basis. It was also expected that the removal of exchange risk within the Eurozone would encourage more intra-trade and investment between EMU participants and increased inward investment into the Eurozone. However, exchange rate uncertainty was not completely eliminated since the euro still fluctuates against non-member currencies. However, this was partially offset by external trade being a far lower percentage of GDP post-EMU than it was for individual EMU countries. Completion of the single market was to be assisted by use of the euro, as it reduced the possibility of differential product pricing between countries. It makes prices more transparent and hopefully adds to competitive downward pressure on prices in high-cost countries. An additional benefit of closer trading links via EMU is that it should increase the correlation of business cycles between participating countries in the Eurozone and thereby assist further economic convergence.

Price stability Low inflation is advantageous for efficient resource allocation. It is also associated with low variability of prices.

Public finance The Stability and Growth Pact was expected to enhance budgetary discipline so that excessive budget deficits financed by inflationary increases in money supply were not permitted. At the same time, it was hoped that increased budgetary stringency would encourage governments to improve the efficiency of tax collection and the provision of public goods and services.

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Adjustment without exchange rate changes

Exchange rate changes with the rest of the world were expected to influence the competitiveness of the Eurozone in relation to the USA, Japan and emerging economies. Within EMU, real exchange rates (competitiveness between participants) would still be possible even with the use of a single currency if individual countries experienced and permitted wage/price flexibility to offset differentials in productivity gains between member states such as Germany and Italy. 5

Reserve currency status It was anticipated that the euro would become a major vehicle/reserve currency in the global economy, which was expected to benefit EMU participants. More euro-denominated trade and finance transactions should generate gains via reduced foreign exchange risk and hedging costs. The Eurozone countries might also have more influence in international financial institutions such as the International Monetary Fund.

Costs Despite the above benefits, the European Commission's experts recognised that certain specific disadvantages could have a profound effect on EMU participants. 1

Loss of exchange rate flexibility This is the most complex issue raised by EMU and is probably the most 'political'. When allowed to float freely, an exchange rate will tend to respond to economic shocks. In theory, such movement is helpful. An uncompetitive country, due to inflation above other union members or a decline in a major industry, will be unable to restore its competitiveness via devaluation in a single currency zone. Such member state imbalances could damage growth and cause high unemployment over a prolonged time period, with resultant political pressures leading to a breakdown of the monetary union. Only real economic convergence could avoid such a possibility in the Eurozone. However, while devaluation may be a useful economic tool to deal with some specific economic shocks, it is less than successful in dealing with cost price differentials arising from higher inflation. In the latter situation, the benefits of devaluation tend to be short lived due to cost push inflation rapidly eroding any price advantage. In the past, competitive currency devaluations by the UK and Italy did not make them more successful in growth terms than countries which stuck to an exchange rate and used alternative methods to improve their competitiveness.

No independent interest rate policy Adopting a single currency entailed countries giving up control of monetary policy to the ECB which sets interest rates and other aspects of monetary policy for the Eurozone rather than for any one country. This has two implications:

ď&#x201A;ˇ

A loss of power by EMU countries to choose their own short term inflation/unemployment trade-off.

ď&#x201A;ˇ

An inability to deal with country-specific economic shocks via monetary policy. The ECB only responds to shocks affecting all or most members.

Fiscal adjustment limited In theory, EMU prevents countries using excessive budget deficits and borrowing to try and cure unemployment. Another longer term constraint on fiscal policy is that EMU is likely to increase pressure for tax harmonisation throughout the Eurozone.

Lack of adjustment It was widely acknowledged that the EU and Eurozone were beset by structural issues such as largescale state ownership, excessive subsidies, high structural unemployment and too much regulation. Labour mobility is restricted by culture and language, and national labour markets have been rigid. Despite such problems, no machinery exists for transferring income from countries whose demand is high to countries where it is weak, apart from very limited EU regional/cohesion funds. If adjustment through the EU budget, wage flexibility and migration is limited, then it must come through variations in employment levels. Such adjustment could be prolonged and highly painful via associated economic and social costs. The alternative is EMU participants reforming their labour markets to promote greater mobility and real wage flexibility.

3.2

The European sovereign debt crisis Although the European debt crisis has no single cause, some of its roots lie in the introduction of the European single currency, the euro. This meant that member countries were able to borrow at a

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

cheaper rate than they previously could. This was due to the assumption that these countries were following the economic rules of the single currency. This effectively meant that the good credit rating of Germany was improving the credit rating of countries such as Greece, Portugal and Italy. Some of the European countries used the increased credit offered to increase consumption and build up large balance of payments deficits. The increased borrowing was based on the assumption of certain levels of growth which then did not occur due to the financial crisis of 2007. Governments also securitised future government revenues to avoid violating debt and deficit targets. With the onset of the banking/financial crisis and subsequent recession in 2008-09, the financial markets began to worry about the size of some Eurozone countries' debts and their ability to service them. This was reflected in widening interest rate spreads on ClubMed (Italy, Spain, Portugal, Greece) bonds offered in auctions to global investors. Several Eurozone governments found it necessary to obtain emergency funding. This was provided by the European Commission and the International Monetary Fund, initially to Greece and Portugal, but only under strict conditions requiring the imposition of austerity measures by the governments of the borrowing countries.

3.2.1

Austerity measures In response to the economic crisis, the Eurozone countries (as well as other countries such as the UK) put austerity measures in place in an attempt to reduce their spiralling debts. The initial effect of austerity measures, involving substantial cuts in government spending, has been to increase the economic problems of the countries concerned. The benefits claimed for austerity policies are medium- to long-term, but there are short-term disadvantages, such as loss of jobs (especially among government employees). Unemployment reached very high levels in a number of Eurozone countries such as Greece, Portugal, Spain and even France. In time, the private sector is expected to provide the economic growth that governments want but without ever-increasing and unsustainable sovereign debt.

3.2.2

Financial contagion The European Sovereign Debt crisis is a classic example of financial contagion. The initial problems encountered by Greece and Portugal spread throughout Europe as confidence fell in other European economies. Inter-trading amongst European countries meant that as one country experienced financial difficulties and reduced its imports, those countries providing the imported goods also suffered due to a downturn in trade. For example, the value of Ireland's exports to the UK is approximately 10.6% of Irish Gross Domestic Product (GDP). If the UK cut its spending on exports by 20%, not only would Ireland lose income amounting to 2% of GDP, it would also be forced to reduce production of the goods and services that are exported to the UK. Economic growth is affected not just in the UK but also in Ireland. This will then have an effect on Ireland's spending on exports and so on. However, it is not just Europe that is suffering. European countries trade worldwide. As their economic growth slows and austerity measures take effect, economies worldwide will be affected. This leads to greater borrowing to fund spending (due to less income from exports and a general slowdown in the economy), leading to increased interest payments on debt and eventually potential downgrade of debt.

3.3

Action taken in the Eurozone

3.3.1

European Financial Stability Facility In May 2010 the European Union (EU) created the European Financial Stability Facility (EFSF) which is guaranteed by the Eurozone countries and provides bailout loans to countries in severe financial difficulty. In January 2011 the European Financial Stabilisation Mechanism (EFSM) was created to raise funds by using the EU budget as security. The funds raised can be lent to the IMF or the EFSF.

3.3.2

Eurozone rescue plan The Brussels Accord was agreed in October 2011. It was aimed at protecting the single currency union, preventing a deeper recession in the EU and stabilising the banking system. The Accord had three main financial elements plus a proposal to work towards fiscal union within the Eurozone. 1

Greek debt It was agreed to write off 50% of Greek government debt. This is aimed at reducing Greek debt from 160% to 120% of GDP by 2020. It was acknowledged that Greece was effectively bankrupt and could never pay off its debt. Banks that had lent to Greece had incurred a 50% loss. Private investors in bonds in principle faced a similar loss.

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Bank protection It was agreed that European banks must raise about €115 billion in new capital by mid-2012 in order to insulate themselves against sovereign debt exposure to ClubMed countries. The fear was that a major default by one or all of these countries could result in a new banking crisis. If selling bank shares to investors failed, then government injections of capital will be required, which will entail the partial or full nationlisation of some major Eurozone banks. Some commentators believe that the sum involved is inadequate in relation to potential problems faced

EU bail-out fund The European Financial Stability Facility (EFSF), which was established at a previous euro summit meeting, was to have its funds increased to €1 trillion to deal with any future crises in big economies such as Italy and/or Spain.

3.3.3

Fiscal compact The treaty establishing the fiscal compact was signed in March 2012 with only the UK and the Czech Republic opting out. The compact will be binding only on the countries that use the euro, while other countries can decide to comply with its guidelines. The fiscal compact provides tighter budgetary rules to restrain government deficits with automatic penalties for spendthrift member states. The fiscal compact is more intrusive than the Stability and Growth Pact as regards taxation and spending policies of the Eurozone members. If a deficit exceeds 3% of GDP, it will result in automatic penalties unless other euro member states vote against such action. Structural deficits are to be capped at 0.5% of GDP. Any member state with a deficit will have to submit plans on how this is to be eliminated, and such plans will be monitored by the EU Commission.

3.3.4

ECB liquidity support In mid-December 2011, the ECB took action to improve the liquidity position of Eurozone banks and try to avoid a new credit crunch. It provided €490 billion through a three year liquidity operation which resulted in 523 banks accepting cut-price loans (funding) secured against sovereign bonds in their asset portfolios. In September 2012, the ECB announced a programme of unlimited buying of government bonds of economically-troubled countries such as Spain or Italy, aiming to depress the costs of borrowing in those countries. However, the ECB's terms put pressure on these countries to continue to impose austerity programmes. The ECB's actions appeared to have positive effects and interest rates on debt issued by the governments of Greece, Portugal, Spain and Italy have all fallen sharply (at the time of writing).

3.3.5

Further developments On 21 February 2012, Eurozone finance ministers agreed upon another bail-out for Greece in an attempt to save the country from bankruptcy. Under this second bail-out, Greece received further loans from Eurozone governments and the International Monetary Fund (IMF). In return for these loans, the Greek government promised to reduce its debt ratio from 160% of GDP in 2012 to 120% by 2020. In May 2012 the Spanish government announced a €23bn bail-out of Bankia, Spain's largest mortgage lender. Bankia had suffered from a collapse in the property sector in Spain. In addition, regional governments in Spain were struggling to service unsustainable levels of debt. In June the Spanish government requested up to €100 billion from the EU to recapitalise its banks. The loans would come from the European Financial Stability Facility and the European Stability Mechanism. In June 2012 Cyprus applied for bailout assistance for its undercapitalised banking sector. Cyprus was strongly linked and exposed to its neighbour Greece's problems. Like Spain, Cyprus also suffered from the deflation of a property bubble. Cyprus's situation was also complicated by having a large offshore banking sector. At the end of November 2012 the Cypriot government agreed to a bailout, including strong austerity measures such as cuts in public sector salaries, social benefits and pensions and higher taxes and health care charges.

3.4 3.4.1

The future of the euro Possible developments Perhaps the central flaw in the euro and Eurozone is the exchange rate and interest rate philosophy/policy of 'one size fits all', which was always going to pose a problem among 18 diverse member states. The reality has been that unit labour costs have risen much less in most countries of

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northern Europe, most notably Germany, whereas in the ClubMed countries labour costs have risen much more. Without the possibility of exchange rate depreciation, Germany’s wealth increased whereas Greece and other Southern European countries became poorer through their deteriorating balance of payments current account positions. At the moment, Eurozone countries share the same monetary policy, controlled by the European Central Bank. The only ways in which governments can control their economy are through fiscal policy (which differs between countries) and through austerity measures. One solution to the problem may be to accept that a single currency requires a unified fiscal policy, i.e. a pan-European budget on public spending, taxation and government borrowing. This would require centralisation of tax policies. However, such fiscal centralisation in Brussels for the survival of a crisis-free Eurozone in the future may not be matched by the democratic accountability of Brussels to the citizens of the 18 member states. This could prove to be troublesome from a political perspective as framing fiscal policy without political representation could question the legitimacy of Brussels edicts.

3.4.2

Exit from the Eurozone With large external debts, a lack of competitiveness and a decline in economic activity, some peripheral Eurozone countries have two options: stay the course, which means austerity and high unemployment for the foreseeable future with all important economic decisions affecting them taken in Brussels or Berlin, or default on their debt, exit the euro and go back to their own national currency. At the moment it seems more likely that countries will remain within the euro, in spite of the short-term problems. However the situation is by no means settled, and further developments in the euro and the Eurozone are inevitable. You should monitor the financial news for developments.

3.5 Impact on business A survey by the ICAEW in May 2012 found that a worsening of the Eurozone crisis would be expected to have a negative impact extending beyond those companies with direct business contacts in the Eurozone. Predictably, larger companies with direct interactions with the Eurozone were the most concerned about the crisis, fearing loss of customers, reduction in consumer confidence and increased costs of supply. However, smaller companies feared the impact of a Eurozone collapse on UK customer confidence. The ICAEW's survey also highlighted the contingency measures which companies had either already put in place, or had planned in the event that the Eurozone crisis worsened. These measures include:        

Building cash reserves Converting cash reserves back from euros to £ or $ Reducing number of staff Exit strategy from the Eurozone countries Selling assets in the Eurozone countries Looking for new suppliers outside Eurozone countries Looking for new customers outside Eurozone countries Changing the payment terms for Eurozone customers

Guidance issued by PwC suggested a number of ways in which companies could try to minimise surprises caused by Eurozone uncertainties. Short-term measures to deal with problems in the business environment included reinforcing distressed vendors that may interrupt supply chains, updating IT architectures for flexibility if currencies change, and refining continuity plans for strikes, civil unrest or cyber attacks. PWC also suggested that businesses need to try to forecast changes in the competitive landscape, and to try to find opportunities to build new revenue and develop new innovation models. Alongside this, businesses should continue to review operations and supply chains to assess whether there are opportunities for them to reduce costs. Short-term steps recommended by PwC to deal with issues in the financial environment included assessing liquidity of Euro assets, updating credit and hedging strategies, addressing potential working capital strains, and revising contracts vulnerable to currency changes. Businesses should be aware of the tax implications of the currency gains or losses of activities they undertake to manage risks and should also manage exposures to debt-reduction tax reforms. Over the longer-term businesses should prepare for financial market gyrations and should monitor Eurozone capital flows, since these are a key indicator of expectations of the ongoing investment environment.

4 Other current issues in finance 780

4.1

Access to credit The problems in the banking sector that begun in 2007 resulted in banks themselves finding it more difficult to borrow money, with the result that they have had less money to lend. Regulators require UK banks to hold more than twice the capital they were holding before the credit crunch. Banks will have to increase capital held in stages until 2019, under the requirements of the EU capital directive. The limitations on bank lending have applied equally to public-owned banks and the private sector. Fully-nationalised Northern Rock was told to significantly reduce the risks associated with its lending activities, but subsequently came under government and media pressure to lend more generously. Small businesses have faced particular problems in accessing bank finance in recent years.

4.2

Dark pool trading Dark pools are off-exchange facilities, operated by banks, that allow secondary market trading of large blocks of shares. They allow brokers and fund managers to place and match large orders anonymously to avoid influencing the share price. The transactions are only made public after the trades have been completed. Their popularity has increased as electronic trading has resulted in the reduction of the average size of trades. Traders placing large orders on the transparent exchanges risk signalling that they are large buyers or sellers. Such signals could cause the markets to move against them and put the order at risk. The proportion of trading that takes place outside the regulated exchanges is difficult to estimate. The Securities and Exchange Commission in the US estimates that dark pools and other alternative platforms accounted for approximately 22% of trade volumes in 2009. In the UK, the London Stock Exchange has lost more than 25% of the market to alternative platforms. In Asia, however, stricter regulation and structural differences in the markets mean that dark pools do not pose such a large threat and account for only 1 â&#x20AC;&#x201C; 3% of trades in the larger, more liquid markets. The main problem with dark pool trading is that the regulated exchanges do not know about the transactions taking place until the trades have been completed. As a result, the prices at which these trades are executed remain unknown until after the event. Such a lack of information on significant trades makes the regulated exchanges less efficient. Although the prices in dark pools are based on those in the regulated exchanges, the dark pool trades do not contribute to the changes in prices as their liquidity is not displayed. Dark pools also take trade away from the regulated exchanges, resulting in reduced transparency as fewer trades are publicly exposed. Such a practice could reduce liquidity in the regulated exchanges and hinder efficient price-setting. Transactions in dark pools can almost be viewed as 'over the counter' as prices are not reported and financial risks are not effectively managed. There is the danger that such risks spread in a manner similar to those attached to credit default swaps and collateralised debt obligations, which triggered the global financial crisis. Dark pools and their lack of transparency arguably defeat the purpose of fair and regulated markets with large numbers of participants and threaten the healthy and transparent development of these markets. They could lead to a two-tier system whereby the public would not have fair access to information regarding prices and volumes of shares that is available to dark pool participants. Dark pools can have other problems. In June 2014 it was reported that some investors in the USA had accused Barclays of providing them with misleading information about its dark pool trading platform. It was alleged that Barclays had given preferential treatment to so-called high-frequency traders, as a result of which other customers had incurred losses because they could have obtained better prices on regular stock exchanges. In other words, the anonymity of dark pool trading was working against the interests of many investors rather than in their favour. Barclays denied the allegations, but it was reported that in July 2014, a large number of customers had taken their business away from Barclaysâ&#x20AC;&#x2122; dark pool trading platform, and a class action against the bank had been started by a US investor.

4.3

Islamic finance Islamic finance has undergone rapid growth over recent years up to the point today where it is an industry worth more than $1 trillion. Islamic financing is not only the preserve of Islamic banks, but it is also becoming an important revenue stream for some of the world's biggest lenders and many of the major conventional banks, including HSBC and Standard Chartered, have Islamic banking arms also known as 'Islamic Windows'. Islamic finance may be used for either cultural/religious or commercial reasons. Commercial reasons include the fact that Islamic finance may be available when other sources of finance are not. Islamic finance may also appeal to companies due to its more prudent investment and risk philosophy.

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Conventional banks aim to profit by taking in money deposits in return for the payment of interest (Riba) and then lending money out in return for the payment of a higher level of interest. Islamic finance does not permit the charging of interest and instead invests under arrangements which share the profits and losses of the enterprises. Taken from the perspective of Sharia'a (Islamic religious law and moral code), the taking of deposits which are subsequently lent out for interest which is paid whether or not the project is profitable is not justifiable. The Islamic bank arranges its business in such a way that the bank's profitability is closely tied to that of the client. The bank stands to take profit or make loss in line with the projects it is financing and as such must be more involved in the investment decision making. The bank acts in some ways more like a fund manager than a conventional lending institution. Speculation is not allowed and conventional derivative products are deemed to be un-Islamic. The main advantages of Islamic finance are as follows: (a) (b) (c)

Gharar (uncertainty, risk or speculation) is not allowed, reducing the risk of losses. Excessive profiteering is also not allowed; only reasonable mark-ups are allowed. Banks cannot use excessive leverage and are therefore less likely to collapse.

The use of Islamic finance does not remove all commercial risk. Indeed there may even be additional risk from the use of Islamic finance. There are the following drawbacks from the use of Islamic finance: (a)

There is no international consensus on Sharia'a interpretations, particularly with innovative financial products.

(b)

There is no standard Sharia'a model for the Islamic finance market, meaning that documentation is often tailor-made for the transaction, leading to higher transaction costs than for the conventional finance alternative.

(c)

Due to governmental and Sharia'a restrictions, Islamic finance institutions are subject to additional compliance work which can also increase transaction costs.

(d)

Islamic banks cannot minimise their risks in the same way as conventional banks as hedging is prohibited.

5 Social responsibility and environmental matters The UK Companies Act requires that: â&#x20AC;Ś a director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have (amongst other matters) regard to... the impact of the company's operations on the community and the environment.

5.1

Corporate responsibility We mentioned corporate responsibility (CR) or corporate social responsibility earlier in this chapter. Businesses face a number of pressures to widen the scope of their accountability. (a)

Stakeholder pressures Businesses face pressures from different stakeholder groups to consider their wider responsibilities. Stakeholders include communities (particularly where operations are based), customers (product safety issues), suppliers and supply chain participants and competitors. Issues such as plant closures, pollution, job creation, sourcing, etc can have powerful social effects for good or ill on these stakeholders. Without the support of stakeholders a business will find its ability to operate is impaired and this will damage performance. Stakeholders also include governments facing political pressures. Adopting CR voluntarily may be more flexible, and in the end less costly, than having it imposed by statute.

(b) Corporate reputation Increasingly a business must have the reputation of being a responsible business that enhances long-term shareholder value by addressing the needs of its stakeholders â&#x20AC;&#x201C; employees, customers, suppliers, the community and the environment. Sponsorship and community involvement can reflect well on the business and attract ethical customers. (c)

Staff motivation A commitment to CR helps establish values and mission within the organisation, which may help attract and retain staff.

(d) Business issues CR initiatives may provide opportunities to enter new markets or build new core competencies. Businesses can achieve lower costs through using resources more efficiently, and not having to incur costs of remediation if they have negatively affected the environment.

780

5.1.1

Scope of corporate responsibility The scope of CR varies from business to business. Factors frequently included are:

5.1.2



Health and safety: This includes workplace injury, customer and supplier injury and harm to third parties



Environmental protection: Energy use, emissions (notably carbon dioxide), water use and pollution, impact of product on environment, recycling of materials and heat



Staff welfare: Issues such as stress at work, personal development, achieving work/life balances through flexibility, equal opportunities for disadvantaged or minority groups



Customer welfare: Through content and description of products, non-exclusion of customer groups, fair dealing and treatment



Supply-chain management: Insisting that providers of bought-in supplies also have appropriate CR policies, ethical trading, elimination of pollution and un-recycled packaging, eliminating exploitative labour practices amongst contractors



Ethical conduct: Staff codes for interpersonal behaviour, prohibitions on uses of data and IT, management forbidden from offering bribes to win contracts, ensuring non-exploitation of staff



Engagement with social causes: This includes secondment of management and staff, charitable donations, provision of free products to the needy, involvement in the local community, support for outreach projects such as cultural improvement or education

Corporate responsibility and stakeholders Pressures on organisations to widen the scope of their corporate public accountability come from increasing expectations of stakeholders and knowledge about the consequences of ignoring such pressures. The South African King report stresses the importance of engagement with external stakeholders, and individual workers and stakeholders being able to communicate openly. Whatever the organisation's view of its stakeholders, certain problems in dealing with them on corporate social responsibility may have to be addressed.

5.2

(a)

Collaborating with stakeholders may be time-consuming and expensive.

(b)

There may be culture clashes between the company and certain groups of stakeholders, or between the values of different groups of stakeholders with companies caught in the middle.

(c)

There may be conflict between company and stakeholders on certain issues when they are trying to collaborate on other issues.

(d)

Consensus between different groups of stakeholders may be difficult or impossible to achieve, and the solution may not be economically or strategically desirable.

(e)

Influential stakeholders' independence (and hence ability to provide necessary criticism) may be compromised if they become too closely involved with companies.

(f)

Dealing with certain stakeholders (eg public sector organisations) may be complicated by their being accountable to the wider public.

Corporate citizenship Corporate citizenship is the: 'business strategy that shapes the values underpinning a company's mission and the choices made each day by its executives, managers and employees as they engage with society. Three core principles define the essence of corporate citizenship, and every company should apply them in a manner appropriate to its distinct needs: minimising harm, maximising benefit, and being accountable and responsive to stakeholders.' (Boston College Carroll School of Management Center for Corporate Citizenship). However, some argue that corporate citizenship should not be seen as a business strategy nor a way of developing the business. Instead, it should be seen as a matter of fact. A corporation has a legal personality and operates within a society which places rights and obligations upon its members (recognising them as citizens). Consequently, these rights and obligations also extend to corporate members. Much of the debate in recent years about corporate responsibility has been framed in terms of corporate citizenship, partly because of unease about using words like ethics and responsibility in the context of business decisions. Discussion of corporate citizenship also often has political undertones, with corporations acting instead of governments that cannot – or will not – act to deal effectively with problems.

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5.3

Sustainability Much of the discussion about corporate responsibility has focused on businesses' commitment to sustainability, ensuring that development meets the needs of the present without compromising the ability of future generations to meet their own needs. The influential Brundtland report of 1987 emphasised that sustainability should involve developing strategies so that the organisation only uses resources at a rate that allows them to be replenished (in order to ensure that they will continue to be available). At the same time emissions of waste should be confined to levels that do not exceed the capacity of the environment to absorb them. The Brundtland report defined sustainable development as 'not a fixed state of harmony, but rather a process of change in which the exploitation of resources, the direction of investments, the orientation of technological development and institutional change are made consistent with future as well as present needs.' One approach to sustainability is known as the triple bottom line (or TBL, 3BL, or People, Planet, Profit) approach. 

People means balancing up the interests of different stakeholders and not automatically prioritising shareholder needs



Planet means ensuring that the business's activities are environmentally sustainable



Profit is the accounting measure of the returns of the business

A similar approach to thinking about sustainability issues is to differentiate three different types of sustainability:

5.4

Issues

Examples

Social

Health and safety, workers' rights (in the business itself and its supply chain), pay and benefits, diversity and equal opportunities, impacts of product use, responsible marketing, data protection and privacy, community investment, and bribery/corruption

Environmental

Climate change, pollution, emissions levels, waste, use of natural resources, impacts of product use, compliance with environmental legislation, air quality

Economic

Economic stability and growth, job provision, local economic development, healthy competition, compliance with governance structures, transparency, long-term viability of businesses, investment in innovation/NPD

Control systems Many companies have been forced to act on environmental issues because of shocks such as environmental disasters or attention from pressure groups. To reduce the chances of these happening, organisations must not only monitor their internal performance, but also include within their monitoring of the external situation assessment of the impact of environmental issues. It will be particularly important to monitor:      

780

Emerging environmental issues Likely changes in legislation Changes in industry best practice Attitudes of suppliers, customers, media and the general public Activities of environmental enforcement agencies Activities of environmental pressure groups

5.5

Management accounting and performance issues Most conventional accounting systems are unable to apportion environmental costs to products, processes and services and so they are simply classed as general overheads. 'Consequently, managers are unaware of these costs, have no information with which to manage them and have no incentive to reduce them.' Environmental management accounting (EMA), on the other hand, attempts to make all relevant significant costs visible so they can be considered when making business decisions. The major areas for the application of EMA are 'in the assessment of annual environmental costs/expenditures, product pricing, budgeting, investment appraisal, calculating costs and savings of environmental projects, or setting quantified performance targets'.

5.5.1

Input/output analysis Input/output analysis records material flows and balances them with outflows on the basis that what comes in must go out, or be stored. This approach is similar to process costing where all materials in a process are accounted for either as good output or scrap/waste. This forces the business to look at how it uses its resources and focuses it on environmental cost. The difficulty with adopting this technique is putting monetary values on waste, non-accounted materials and scrap if these previously haven't been accounted for. It also requires additional reporting of factors included, such as water use and energy, which may be difficult to attribute to individual units.

5.5.2

Flow cost accounting Flow cost accounting takes material flows and combines them with the organisational structure. It evaluates material flows in terms of physical quantities, cost and value. Material flows are classified into material, system and delivery and disposal. The values and costs of each of these are then calculated. This system requires additional reporting which may be unavailable on existing systems and time consuming to accomplish.

5.5.3

Environmental activity-based costing Traditional activity-based costing allocates all the internal costs of a business to cost centres and cost drivers on the basis of the activities that caused the costs. Environmental activity-based costing distinguishes between environment-related costs and environment-driven costs. Environment-related costs are costs specifically attributed to joint environmental cost centres, such as a sewage plant, or a waste filtration plant. By contrast, environment-driven costs are hidden in general overhead costs and do not relate specifically to a joint environmental cost centre, although they do relate to environmental drivers. For example, a company may shorten the working life of a piece of equipment in order to avoid excess pollution in the later years of its working life. As a result, the company's annual depreciation charge will increase. This is an environment-driven cost. In order for environmental activity-based costing to provide 'correct' information, the choice of allocation basis is crucial. The difficulty in allocating costs correctly could be a major complication in using this method. Four main bases of allocation are:    

5.5.4

Volume of emissions or waste Toxicity of emissions or waste Environmental impact added volume of the emissions treated The relative costs of treating different kinds of emissions

Life cycle costing Life cycle costing records the complete costs of a product 'from cradle to grave' taking into account the environmental consequences across the whole life of the product. Organisations need to have the recording systems to capture all costs, especially those incurred prior to production and after production ceases (for example, the costs of cleaning and decontaminating industrial sites when they are decommissioned at the end of a profit). It is important that potential decommissioning costs and other post-production costs are identified at the start of a project, so that they can be included in the investment appraisal (or similar cost-benefit analysis) to determine whether or not to undertake the project.

792

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792

5.6

Corporate reporting implications Businesses face legal requirements in many jurisdictions to report on environmental matters, and environmental issues may impact upon a number of areas in their financial reports.

5.6.1

Business review The UK Companies Act 2006 requires directors to report on environmental issues in the business review within the directors' report. This should include reporting the impact of the company's business on the environment as well as information about the company's employees and social and community issues. The main aspects of these disclosures are risks and uncertainties, policies and effectiveness and key performance indicators, including nonfinancial indicators. Previous guidance has suggested disclosures on spillage, emissions and waste.

5.6.2

Tangible assets The valuation of tangible assets may be reduced by contamination, physical damage or non-compliance with environmental regulations. Their carrying amounts should be reduced to value in use or net realisable value. Measurement of an environmentally-impaired asset can be affected by:

5.6.3

ď&#x201A;ˇ

Delayed disposal of the asset, due to the need to decontaminate it, resulting in cleanup costs and interest charges

ď&#x201A;ˇ

Uncertainties surrounding changes in technology or legislation

ď&#x201A;ˇ

Reputation risks including the risks of deterring potential purchasers resulting in a restricted market

Intangible assets Intangible assets are subject to an impairment test on their carrying value if they exceed the recoverable amount from use or realisation. Goodwill, for example, may be impaired by environmental issues. IFRIC 3 Emission Rights required businesses to treat emission allowances as intangible assets, recorded at fair value. Actual emissions then would give rise to a liability. When allowances were given by the government for less than fair value, the difference would be treated as a government grant. IFRIC 3 was withdrawn by the IASB, but the accounting treatment it recommends remains acceptable. Other possible methods for accounting for emission rights include cost of settlement approach based on initial market value and cost of settlement approach where provision is only made for the costs of buying emission rights not covered by allowances. Whatever method is used, the market value of purchased emissions may become lower than their cost if there is a glut of allowances in the market.

5.6.4

Inventories Inventories may be affected by environmental issues such as physical leakage or deterioration. Their valuation needs to be written down to net realisable value.

5.6.5

Provisions Provisions may be required under IAS 37 as a result of activities connected with the environment, including waste disposal, pollution, decommissioning and restoration expenses. Companies in certain industries such as vehicle manufacture may be involved in activities relating to that industry that give rise to the need for provisions.

5.7

Environmental and social reporting As well as legal requirements, businesses face peer pressure to provide increasing amounts of information about environmental and social performance. Organisations such as Trucost benchmark companies' environmental disclosures. Environmental and social reports generally include narrative and numerical information about impact. Narrative information includes objectives, explanations and reasons why targets have or have not been achieved. Reports can also address concerns of specific internal or external stakeholders. Useful numerical measures can include pollution amounts, resources consumed or land use.

5.7.1

Global Reporting Initiative You will have come across the Global Reporting Initiative (GRI) in your previous studies. This is a reporting framework that arose from the need to address the failure of current governance structures to respond to changes in the global economy.

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The GRI aims to develop transparency, accountability, reporting and sustainable development. Its vision is that reporting on economic, environmental and social importance should become as routine and comparable as financial reporting. It also seeks to achieve as much standardisation as is possible in sustainability reporting by organisations. The main section of the GRI Guidelines sets out the framework of a sustainability report. It consists of five sections:

5.7.2

(a)

Strategy and analysis. Description of the reporting organisation's strategy with regard to sustainability, including a statement from the CEO. In addition, there should be a description of key impacts, risks and opportunities. This section should focus firstly on key impacts on sustainability and associated challenges and opportunities, and how the organisation has addressed the challenges and opportunities. It should secondly focus on the impact of sustainability risks, trends and opportunities on the long-term prospects and financial performance of the organisation.

(b)

Organisational profile. Overview of the reporting organisation's structure, operations, and markets served and scale.

(c)

Report parameters. Details of the time and content of the report, including the process for defining the report content and identifying the stakeholders that the organisation expects will use the report. Details should also be given of the policy and current practice for seeking external assurance for the report.

(d)

Governance, commitments and engagement structure and management systems. Description of governance structure and practice, and statements of mission and codes of conduct relevant to economic, environmental and social performance. The report should give a description of charters, principles or initiatives to which the organisation subscribes or which the organisation endorses. The report should also list the stakeholder groups with which it engages and detail its approaches to stakeholder engagement.

(e)

Performance indicators. Measures of the impact or effect of the reporting organisation divided into integrated indicators. The GRI provides extensive lists of performance measures and indicators that organisations could use. It is for each organisation to decide which performance measures are most relevant to its own particular operations.

Integrated reporting In 2013, after a period of consultation, the International Integrated Reporting Council published an Integrated Reporting Framework, and is encouraging organisations to publish integrated reports. The Framework states as the purpose of integrated reporting: ‘The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates value over time. An integrated report benefits all stakeholders interested in an organization’s ability to create value over time, including employees, customers, suppliers, business partners, local communities, legislators, regulators, and policy- makers.’ An integrated report should explain, using both quantitative and qualitative information, how an organisation creates value. The Integrated Reporting Framework looks at the way value is created, maintained and increased through the development of six ‘capitals’: financial; manufactured; intellectual; human; social and relationship; and natural capital.

5.8

Auditing environmental issues As well as audits and assurance reviews that focus specifically on environmental matters, auditors are likely to consider environmental matters in several areas of the audit of the financial statements. Guidance on the audit work required has been provided by the ICAEW and the Environment Agency in Environmental issues and annual financial reporting. Environmental issues should be considered as part of audit planning if they are likely to have a significant impact on the financial statements. Environmental indicators may be used within initial analytical review processes. Potential impacts on the financial statements may arise from:

794



The application of laws and regulations



Participation in a carbon trading scheme



Activities and processes of the business, particularly processes involving pollution, the use of hazardous substances or the avoidance of hazardous waste



Holding an interest in land or buildings that could have been contaminated by a previous user

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794



Climate change and potential flood risks



Fines or penalties



Dependence on a major customer or segment whose business is threatened by environmental pressures

To obtain an understanding of the business, auditors may need to consider: 

Extent to which business is based on the use of environmentally sensitive materials



Environmental obligations arising from laws and regulations affecting specific businesses



Risks of carrying out construction work in flood plains



Effects of market issues such as compliance with environmental legislation, customer perceptions of environmental performance or the impact of environmental pressures on suppliers

As part of the auditors' review of controls and systems, auditors should consider whether management is competent to deal with environmental issues and systems and processes designed to identify and monitor environmental risks. What constitutes adequate control systems will vary by company. Where exposure to environmental risk is high, companies may operate a specific environmental management system or deal with environmental issues within an integrated control system. Although some environmental issues have clear financial outcomes, others will be dependent on the judgement of the directors. Work on estimates relating to environmental matters could therefore be a significant part of the audit. Auditors will be particularly concerned with environmental laws and regulations if non-compliance would be central to the core operation of the business and irregularities could result in closure, either due to the loss of an operating licence or a huge fine. If a company participates in an emissions trading scheme, the auditors will need to see that the company complies with the requirements of the scheme, systems are operating to measure emissions and process data and measurement and disclosures comply with international financial reporting standards. Auditors may face a number of difficulties in assessing the effects of environmental matters in the financial statements:

5.8.1



Delays between activities causing environmental issues such as contamination of a site due to industrial activity and its identification by the business or regulator



Accounting estimates not having an established pattern and exhibiting a wide range of reasonableness because of the number and nature of assumptions underlying them



Interpretation of evolving environmental laws may be difficult or ambiguous



Liabilities can arise out of voluntary agreements as well as legal or contractural obligations

Environmental auditing An environmental audit is an evaluation of how well an entity, its management and equipment are performing, with the aim of helping to safeguard the environment by facilitating management control of environmental practices and assessing compliance with entity policies and external regulations. Environmental auditing is also used for auditing the truth and fairness of an environmental report rather than the organisation itself. An environmental audit may be undertaken as part of obtaining or maintaining external accreditation, such as the BSI's ISO 14001 standard. In practice, environmental audits may cover a number of different areas. The scope of the audit will depend on each individual organisation. Often the audit will be a general review of the organisation's environmental policy. On other occasions the audit will focus on specific aspects of environmental performance (waste disposal, emissions, water management, energy consumption) or particular locations, activities or processes. There are other specific aspects of the approach to environmental auditing which are worth mentioning. (a)

Environmental Impact Assessments (EIAs) These are required, under an EU directive, for all major projects which require planning permission and have a material effect on the environment. The EIA process can be incorporated into any environmental auditing strategy.

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(b) Environmental surveys These are a good way of starting the audit process, by looking at the organisation as a whole in environmental terms. This helps to identify areas for further development, problems, potential hazards and so forth. (c)

Environmental SWOT analysis A 'strengths, weaknesses, opportunities, threats' analysis is useful as the environmental audit strategy is being developed. This can only be done later in the process, when the organisation has been examined in more detail.

(d) Environmental Quality Management (EQM) This is seen as part of TQM (Total Quality Management) and it should be built into an environmental management system. Such a strategy has been adopted by companies such as IBM, Dow Chemicals and by the Rhone-Poulenc Environmental Index, which has indices for levels of water, air and other waste products. (e)

Eco-audit The European Commission has adopted a proposal for regulation of a voluntary community environmental auditing scheme, known as the eco-audit scheme. The scheme aims to promote improvements in company environmental performance and to provide the public with information about these improvements. Once registered, a company will have to comply with certain ongoing obligations involving disclosure and audit.

(f)

Eco-labelling Developed in Germany, this voluntary scheme will indicate those EU products which meet the highest environmental standards, probably as the result of an EQM system. It is suggested that eco-audit must come before an eco-label can be given.

(g)

BS 7750 Environmental Management Systems BS 7750 also ties in with eco-audits and eco-labelling and with the quality BSI standard BS 5750. Achieving BS 7750 is likely to be a first step in the eco-audit process.

(h) Supplier audits These ensure that goods and services bought in by an organisation meet the standards applied by that organisation.

5.8.2

796

Auditor concerns (a)

Board and management having good understanding of the environmental impact and related legislation of the organisation's activities in areas such as buildings, transport, products, packaging and waste

(b)

Adoption and communication of adequate policies and procedures to ensure compliance with relevant standards and laws

(c)

Adoption of appropriate environmental information systems

(d)

Adoption and review of progress against quantifiable targets

(e)

Assessment of whether progress is being made economically and efficiently

(f)

Implementation of previous recommendations of improvements to processes or systems

(g)

True, fair and complete reporting of environmental activities

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Strategic Business Management Chapter-12 Business and securities valuation 1 Valuation methods 1.1

Why value a company and what is it worth?

In the context of strategic business management, the need to value a company usually arises when: 

A would-be acquirer wants to take over another company: the would-be acquirer needs to decide on an offer price and the target company board and shareholders need to decide whether the offer price is worth accepting



Two companies are discussing a merger and so need to agree the relative value of each of the two companies



When a company is planning the sale of a part of its business, for example to a management buyout team.

So what is a company worth? There is no precise answer to this question. The value of the company will often depend on the purpose for which it is valued. Companies could be worth:   

1.1.1

The tangible assets The assets plus goodwill Whatever someone is prepared to pay for them

What affects the value of a company? Company valuations may be affected by asset valuations, or by estimates of future profits, dividends or cash flows. Company value is not just affected by sales and profit forecasts. Value can be influenced by the type of industry the company operates in, the level of competition faced by the company and the customer base. If a company has a popular product or product range that the public will want to buy, its value will increase, provided of course that the people who want to buy it can actually afford to do so. Remember also that valuations are affected by judgements and opinions. Views about what a company is worth can vary enormously due to differences of opinion or differences in expectations about future cash flows or earnings.

1.2

Distortions in accounting figures Anyone undertaking a valuation using accounting figures will need to be aware of possible distortions in those figures. These may involve distortions in assets, liabilities, equity or earnings. To combat problems with earnings, it may be necessary to produce a normalised earnings figure to reflect the sustainable earnings of a company. This figure excludes profits from discontinued operations, changes in estimates and fair values, profits/losses from the sale of non-current assets and start-ups, restructuring and redundancy costs amongst other adjustments.

1.3

Income and cash flow models

You should be familiar with the different methods of valuing the equity in a business and when they might be used. The rest of this section goes over some of the basic valuation methods briefly. For the purpose of company share valuations, a P/E ratio valuation may be used to value: 

The shares of a quoted company, where it is recognised that the offer price for the shares in a takeover must be higher than the current market price, in order to gain acceptance of the offer from the target company’s shareholders



The shares of an unquoted company, where the P/E ratio multiple is derived from the current P/E ratios for similar quoted companies.

IAS 33 Earnings Per Share prescribes principles for the determination and presentation of EPS. Before the EPS can be considered to be useful by analysts trying to value the company, the earnings figure must be adjusted to reflect the sustainable earnings of the company. The result of this process is a normalised earnings figure or adjusted earnings figure.

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The P/E ratio valuation method for equity is conceptually very simple, but it has no ‘scientific’ rationale to justify its use. It is not a discounted cash flow valuation, and there are many different assumptions that can be used to reach a valuation. As a result, many different valuations for a share can be estimated from the P/E ratio model. 

Earnings should be an estimate of future annual earnings, but how should future expected earnings be estimated?



The valuation of shares is made by applying a P/E ratio to the earnings figure, but what is the appropriate P/E ratio figure?

Note: The P/E ratio is the reciprocal of the earnings yield. (The earnings yield = Earnings per share/Share price, expressed as a percentage.) The earnings yield could possibly be used as a rough guide to the cost of equity when there is zero expected future dividends or earnings growth. In these circumstances, there would be a rational connection between a P/E ratio-based valuation and the dividend valuation model or a DCF-based valuation.

1.3.1

Income-based valuation – discounted cash flow method This method of valuation is based on the present value of future cash flows generated by the company. 

The value of a company is basically the present value of all its future expected cash flows, discounted at the company’s weighted average cost of capital.



The value of a company’s equity is the present value of all future cash flows attributable to equity shareholders, discounted at the cost of equity.

This method of valuation may be appropriate when one company intends to buy the assets of another company and to make further investments in order to improve cash flows in the future. Problems with this method of valuation are: 

Difficulties in estimating future cash flows, especially beyond the next few years: it may therefore be assumed that annual cash flows after a given future year will be constant



The time period over which a valuation should be made. If expected annual cash flows in perpetuity are used for the valuation, most of the company’s valuation will come from the (uncertain estimates) about cash flows beyond the next few years.

For example, suppose that a company is considering the acquisition of an all-equity company and it is expected that the annual cash flows from the acquisition will be £100,000. The company’s cost of capital is 10% and it usually expects to achieve payback on its investments within five years. 

The PV of an annuity at 10% for years 1 – 5 is 3.791, so the PV of expected future cash flows in Years 1 – 5 after the acquisition will be £100,000 × 3.791 = £379,100.



The PV of an annuity at 10% from years 6 onwards in perpetuity is (1/0.10) – 3.791 = 6.209, so the PV of expected future cash flows from Year 6 onwards after the acquisition will be £100,000 × 6.209 = £620,900.



The total valuation of the company will be £1,000,000, of which about 62% is value attributed to expected earnings from Year 6 onwards, and this estimate may be unreliable.

Another method of DCF valuation is to estimate a future disposal value of the company at the end of a given investment period, and discount this to a present value for inclusion in the equity valuation. In the previous example, it might be estimated that the disposal value of the company at the end of the fifth year will be £500,000: if so, this value should be discounted to a PV and included in the equity valuation.

1.4

Asset-based valuation models If the net asset method of valuation is used, the value of a share in a particular class is equal to the net tangible assets attributable to that class divided by the number of shares in the class. The net assets basis of valuation might be used in the following circumstances: (a)

As a 'floor value' for a business that is up for sale – shareholders will be reluctant to sell for less than the NAV. However, if the sale is essential for cash flow purposes or to realign with corporate strategy, even the asset value may not be realised. Similarly, a loss-making company that is close to insolvency, that cannot easily dispose of its assets separately, may struggle to sell the business for its net asset value.

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(b)

As a measure of the 'security' in a share value. The asset backing for shares provides a measure of the possible loss if the company fails to make the expected earnings or dividend payments. Valuable tangible assets may be a good reason for acquiring a company, especially freehold property which might be expected to increase in value over time.

(c)

As a measure of comparison in a business combination. For example, if company A, which has a low asset backing, is planning a merger with company B, which has a high asset backing, the shareholders of B might consider that their shares' value ought to reflect this. It might therefore be agreed that something should be added to the value of the company B shares to allow for this difference in asset backing.

There are a number of issues with the net asset basis of valuation that assurance work done on valuation will need to consider: (a)

Do the assets need professional valuation? If so, how much will this cost?

(b)

Have the liabilities been accurately quantified, for example deferred taxation? Are there any contingent liabilities? Will any balancing tax charges arise on disposal?

(c)

How have the current assets been valued? Are all receivables collectable? Is all inventory realisable? Can all the assets be physically located and brought into a saleable condition? This may be difficult in certain circumstances where the assets are situated abroad.

(d)

Can any hidden liabilities be accurately assessed? Would there be redundancy payments and closure costs?

(e)

Is there an available market in which the assets can be realised (on a break-up basis)? If so, do the balance sheet values truly reflect these break-up values?

(f)

Are there any prior charges on the assets?

(g)

Does the business have a regular revaluation and replacement policy? What are the bases of the valuation? As a broad rule, valuations will be more useful the better they estimate the future cash flows that are derived from the asset.

(h) Are there factors that might indicate that the going concern valuation of the business as a whole is significantly higher than the valuation of the individual assets? (i)

1.4.1

What shareholdings are being sold? If a minority interest is being disposed of, realisable value is of limited relevance as the assets will not be sold.

Impact of IFRS 13 The main difficulty in an asset valuation method is establishing appropriate values for the assets. Values ought to be realistic. The figure attached to an individual asset may vary considerably depending on the valuation basis that is used. One criticism of asset-based measures has been their reliance on historical cost, not representing market value and incorporating future earnings potential. However, IFRS 13 Fair Value Measurement now provides guidelines that may be used in assessing the fair values of assets (and which should be used for the purpose of financial reporting). IFRS 13 defines fair value as 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date'. The standard requires that the following are considered in measuring fair value: (a)

The asset or liability being measured

(b)

The principal market for the asset (i.e. that where the most activity takes place) or where there is no principal market, the most advantageous market (i.e. that in which the best price could be achieved) in which an orderly transaction would take place for the asset or liability

(c)

The highest and best use of the asset or liability and whether it is used on a standalone basis or in conjunction with other assets or liabilities

(d)

Assumptions that market participants would use when pricing the asset or liability

IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient data are available. Entities should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure fair value: Level 1

Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

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Level 2

Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, e.g. quoted prices for similar assets in active markets or for identical or similar assets in non-active markets. Other observable inputs that may be used for valuation include interest rates and yield curves, credit spreads and/or implied volatilities.

Level 3

Unobservable inputs for the asset or liability, i.e. using the best available information, which may include the entity’s own data and assumptions about market exit value

The IFRS identifies three valuation approaches. (a)

Income approach. Valuation techniques that convert future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts

(b)

Market approach. A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business

(c)

Cost approach. A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost)

The requirements of IFRS 13 are particularly relevant for valuing a business in a business combination, as discussed below.

1.5 1.5.1

Value-based models: shareholder value analysis (SVA)

Value-based management (VBM) VBM starts with the philosophy that the value of a company is measured by its discounted future cash flows. Value is created only when companies invest capital at returns that exceed the cost of that capital. VBM extends this philosophy by focusing on how companies use the idea of value creation to make both major strategic and everyday operating decisions. So VBM is an approach to management that aligns the strategic, operational and management processes to focus management decision-making on what activities create value.

1.5.2

Value drivers A value driver is any variable that affects the value of the company. They should be ranked in terms of their impact on value and responsibility assigned to individuals who can help the organisation meet its targets. Value drivers can be difficult to identify as an organisation has to think about its processes in a different way. Existing reporting systems are often not equipped to supply the necessary information. A good way of relating a range of value drivers is to use scenario analysis. It is a way of assessing the impact of different sets of mutually consistent assumptions on the value of a company or its business units.

1.5.3

Shareholder value analysis (SVA) The SVA method of valuation of a business is based on the present value of estimated future free cash flows earned by the business. There are seven factors or ‘drivers’ that affect the valuation: 

Sales growth. Sales growth in the valuation model is usually expressed as a percentage annual revenue growth rate.



Operating profit margin. Expected operating profit is expressed as a percentage of sales revenue.



The tax rate on profits.



Changes in working capital. With sales growth, there is likely to be an increase in working capital each year, and the incremental working capital investment (IWCI) reduces free cash flow.



Fixed capital investment, which may be analysed into replacement financial capital investment (RFCI) and incremental fixed capital investment (IFCI). RFCI is capital investment that is required to replace existing assets that have worn out and need replacement: it is often assumed that RFCI is equal to the annual depreciation charge. IFCI is incremental capital investment in addition to RFCI. Capital investment reduces free cash flow.



The cost of capital. This is the discount rate for converting free cash flows to a present value.



The competitive advantage period. This is the period of time in the future during which the business is expected to achieve growth in its current form or condition. After this period of time, which may be for three to five years or so, it is often assumed that annual free cash flows will be a constant amount.

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Assumptions about all seven of these value drivers will affect the valuation of the business.

1.6

Value-based models: EVA and MVA

1.6.1 Economic Value Added (EVA®) Economic value added or EVA® is a trademark of the consultancy firm Stern Stewart. It is an alternative measure for calculating the value created in a given period of time (typically a year) by a business. It is based on the view that accounting measures are not a reliable measure of value creation, and value creation should be based on economic principles rather than accounting methods. In practice, annual EVA® is calculated by making adjustments to accounting costs and values to obtain an estimate of economic cost and value. It is also based on the idea that a business must cover both its operating costs and its capital costs. Capital employed should be the economic value of capital employed, not the accounting value of capital employed. Examples of adjustments to accounting profit and asset values to derive economic profit and economic value of capital employed are as follows:

1.6.2



Spending on some intangible assets is typically written off against accounting profit in the year that the expenditure is incurred. Examples are research expenditure, training expenditure and advertising expenditure which develops the value of a brand name. The approach is to capitalise all such expenditures on intangibles that create long-term value, and charge against profit only an amount for the consumption of the asset’s economic value in the year. This adjustment affects both profit and capital employed.



Provisions or allowances are not real costs and should be excluded from profit. For example, any increase in the allowance for irrecoverable receivables should be added back to both profit and capital employed.



Finance leases should not be capitalised. The lease rental is a measure of the economic cost of the lease in the reporting period. The charge against profit should therefore be the lease rental charge, not depreciation on the leased asset plus a finance charge.



The charge for depreciation should be an economic cost rather than an accounting charge. However, calculating economic depreciation from accounting figures can be a very complex process, and it is often assumed therefore that accounting depreciation is a reasonable approximation for economic depreciation; therefore no adjustment for depreciation charges is required.

Market value added (MVA) The MVA of a company is a measure of how much the management of a company has added to the value of the capital contributed by the capital providers. MVA may be measured for the company as a whole, or just from the perspective of the equity shareholders.

2 Acquisitions and mergers 2.1

Asset-based model

When a valuation of a company is made for the purpose of a merger or acquisition, it makes good sense to use a number of different valuation methods to obtain estimates of what a suitable valuation might be. The different estimated valuations can then be compared, to establish whether they are similar or whether they differ substantially. If they differ, the reasons for the differences may help to provide some insights into an appropriate valuation and give the buyer an idea of how high the offer price might reasonably be taken. When making several valuations of a potential takeover target, a useful starting point is an assets-based valuation. Unless the target company is in serious financial difficulty, an assets-based valuation should indicate the absolute minimum price that shareholders in the target company are likely to accept. The asset-based approach to valuation was reviewed above, but this section considers some issues in further detail. However, it may be inappropriate to accept without question the figures in the statement of financial position. So an initial question should be to ask how reliable are the valuations of assets and liabilities in the target company’s accounts.

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2.1.1

Fair values The accounting rules affecting acquisitions are particularly important in the context of asset valuations. The presumption in IFRS 3 Business Combinations is that: 

An acquirer carefully reviews the value of the net assets to be acquired as part of the process of deciding how much to offer for the acquiree.



The purchase consideration is the result of a transaction between a willing buyer and a willing seller in an arm's length transaction, so it is at fair value.



This fair value can be reliably allocated across the identifiable assets and liabilities assumed.

The general rule under IFRS 3 is that the subsidiary's assets and liabilities must be measured at fair value except in limited, stated cases. The assets and liabilities must: (a)

Meet the definitions of assets and liabilities in the Conceptual Framework

(b)

Be part of what the acquiree (or its former owners) exchanged in the business combination rather than the result of separate transactions

As discussed above, IFRS 13 provides extensive guidance on how the fair value of assets and liabilities should be established.

2.1.2

Examples of fair values and business combinations Non-current assets For non-financial assets, fair value is decided based on the highest and best use of the asset as determined by a market participant. Restructuring and future losses An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as a result of the business combination. IFRS 3 (revised) explains that a plan to restructure a subsidiary following an acquisition is not a present obligation of the acquiree at the acquisition date. Neither does it meet the definition of a contingent liability. Therefore, an acquirer should not recognise a liability for a restructuring plan as part of allocating the cost of the combination unless the subsidiary was already committed to the plan before the acquisition. This prevents creative accounting. An acquirer cannot set up a provision for restructuring or future losses of a subsidiary and then release this to profit or loss in subsequent periods in order to reduce losses or smooth profits. Contingent liabilities Contingent liabilities of the acquiree are recognised in a business combination if their fair value can be measured reliably. A contingent liability must be recognised even if the outflow is not probable, provided there is a present obligation. This is a departure from the normal rules in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, under which contingent liabilities are not normally recognised, but only disclosed. After their initial recognition, the acquirer should measure contingent liabilities that are recognised separately at the higher of: (a) (b)

2.1.3

The amount that would be recognised in accordance with IAS 37 The amount initially recognised

Intangible assets The acquiree may have intangible assets. IFRS 3 states that these can be recognised separately from goodwill only if they are identifiable. An intangible asset is identifiable only if it: (a)

Is separable, i.e. capable of being separated or divided from the entity and sold, transferred, or exchanged, either individually or together with a related contract, asset or liability, or

(b) Arises from contractual or other legal rights The problem with these principles is that they may exclude many intangible assets that are important to the acquirer. This renders this method unsuitable for the valuation of most established businesses, particularly those in the service industry or industries where intellectual capital may be a significant feature.

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Remember the business's intellectual capital will include:

        

Patents, trademarks and copyrights Franchises and licensing agreements Research and development Brands Technology, management and consulting processes Know-how, education, vocational qualification Customer loyalty Distribution channels Management philosophy

Some of these will fulfil the IFRS 3 definition of intangible assets. Others will not, although they may be considered as separate valuable assets by the parties to the acquisition. The valuation of brands, which may have a big influence on acquisition price.

2.1.4

Exceptions to the IFRS 13 principles (a)

Deferred tax: use IAS 12 values

(b)

Employee benefits: use IAS 19 values

(c)

Indemnification assets: measurement should be consistent with the measurement of the indemnified item, for example an employee benefit or a contingent liability

(d)

Reacquired rights: value on the basis of the remaining contractual term of the related contract regardless of whether market participants would consider potential contractual renewals in determining its fair value

(e)

Share-based payment: use IFRS 2 values

(f)

Assets held for sale: use IFRS 5 values

2.2

Market relative model (the P/E ratio)

The P/E ratio method produces an earnings-based valuation of shares. This is done by deciding a suitable P/E ratio and multiplying this by the EPS for the shares which are being valued. The EPS could be a historical EPS or a prospective future EPS. For a given EPS figure, a higher P/E ratio will result in a higher price. A high P/E ratio may indicate: (a)

Optimistic expectations EPS is expected to grow rapidly in the years to come, such that a high price is being paid for future profit prospects. Many small but successful and fast-growing companies are valued on the stock market on a high P/E ratio. Some stocks (for example, those of some internet companies in the late 1990s) have reached high valuations before making any profits at all, on the strength of expected future earnings.

(b) Security of earnings A well-established low-risk company would be valued on a higher P/E ratio than a similar company whose earnings are subject to greater uncertainty. (c)

Status If a quoted company (the predator) made a share-for-share takeover bid for an unquoted company (the target), it would normally expect its own shares to be valued on a higher P/E ratio than the target company's shares. A quoted company ought to be a lower-risk company, but in addition, there is an advantage in having shares which are quoted on a stock market as the shares can be readily sold. The P/E ratio of an unquoted company's shares might be around 50% to 60% of the P/E ratio of a similar public company with a full Stock Exchange listing (and perhaps 70% of that of a company whose shares are traded on stock markets for smaller companies, such as the UK's Alternative Investment Market).

2.3

EVA® approach ®

As we discussed above, EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk. It can be relevant in valuing acquisitions, as an alternative to a P/E multiple valuation or a free cash flow valuation. It has already been explained that estimates of future annual EVAs can be discounted to a present value to obtain a company valuation.

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2.4

Adjusted present value approach

The adjusted present value (APV) approach to company valuation is another method based on discounting expected future cash flows to a present value. It may be used to value large acquisitions, where the method of financing the acquisition means that the acquirer’s weighted average cost of capital is inappropriate as the discount rate. For example if an all-equity company proposes to make a large acquisition financed by one-third equity and two-thirds new debt, its existing cost of capital should not be used as a discount rate because it does not reflect the change in financing structure that the acquisition would entail. An APV valuation may therefore be appropriate when an acquisition will require new financing, such as an increase in debt. The APV approach is to divide the valuation into two stages. (a)

First, discount the expected future cash flows from the acquisition at an ungeared cost of equity. This is the cost of equity that would apply if the acquiring company were all-equity financed. Discounting the future cash flows at an ungeared cost of equity produces a ‘base case NPV’.

(b)

The base case NPV ignores the benefit of tax relief on any debt capital that will be used to finance the acquisition. It also ignores the costs of raising any new capital to finance the acquisition. These are the financing effects of the acquisition, and the PV of these financing effects should be calculated separately.

(c)

The financing effects are likely to include the benefits of tax relief on future interest payments. These should be discounted to a present value. If in doubt, discount these financing benefits at the pre-tax cost of debt, because this is the cost that best reflects the systematic risk associated with these cash flows. You should not discount these future tax benefits at the ungeared cost of equity.

(d)

If the company is planning to issue new capital to pay for the acquisition, a financing cost will be the issue costs for the new capital. You should generally assume that issue costs associated with new equity do not attract tax relief, whereas issue costs associated with the issue of new debt capital does attract tax relief. Since these costs will occur at the beginning of the investment they do not need to be discounted.

(e)

The APV of the acquisition is the base case NPV plus (or minus, if negative) the PV of the financing effects of the acquisition. The APV is a valuation for the target company.

The APV approach is consistent with Modigliani and Miller’s views of capital structure and the effect of gearing on the cost of capital.

2.5

Other aspects of valuation of a takeover

When a company is considering the acquisition of another company a number of factors may affect the valuation. These include: (a)

Synergy: this is considered below.

(b)

Risk. An acquisition may affect the financial risk or business risk profile of the acquiring company. Changes in the risk profile should be considered and, where appropriate, the discount rate for a valuation should be adjusted.

(c)

Real options. A real option is an option to take a new or different course of action in the future, that will arise if the current investment is undertaken. In a takeover, a real option may be the opportunity that the takeover creates for the company to develop its business in the future, for example by expanding into new geographical markets, if the opportunity would not exist if the takeover did not occur. Real options can have a positive value and the valuation of a target company may be affected by a valuation of any real options that may exist.

(d)

Financing. It has already been explained that the method of financing an acquisition, and its cost, will affect the valuation of a takeover target.

2.6

Synergy

The existence of synergies may increase shareholder value in an acquisition. The identification, quantification and announcement of these synergies are essential as shareholders of the companies involved in the acquisition process may need persuasion to back the merger. The two examples below show how estimates of synergies may be announced.

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Unfortunately the actual value of synergy benefits from a takeover cannot be established until after the takeover has occurred, and sometimes not even then. This means that claims by management that a takeover will provide synergy benefits may be unrealistic, and simply an excuse to justify a higher bid price for a takeover target, to increase the probability that the bid will be accepted. Claims of synergy benefits resulting from a takeover should be scrutinised carefully, and with professional scepticism.

2.7.1

Revenue synergy Revenue synergy exists when the acquisition of the target company will result in higher revenues for the acquiring company, higher return on equity or a longer period of growth. Revenue synergies arise from: (a) (b) (c)

Increased market power Marketing synergies Strategic synergies

Revenue synergies are more difficult to quantify relative to financial and cost synergies. When companies merge, cost synergies are relatively easy to assess pre-deal and to implement post-deal. But revenue synergies are more difficult. It is hard to be sure how customers will react to the new situation (in financial services mergers, massive customer defection is quite common), whether customers will actually buy the new, expanded 'total systems capabilities' and how much of the company's declared cost savings they will demand in price concessions. Nevertheless, revenue synergies must be identified and delivered. The stock markets will be content with cost synergies for the first year after the deal, but thereafter they will want to see growth. Customer Relationship Management and Product Technology Management are the two core business processes that will enable the delivery of revenue.

2.7.2

Cost synergy A cost synergy results primarily from the existence of economies of scale. As the level of operation increases, the marginal cost falls and this will be manifested in greater operating margins for the combined entity. The resulting savings from economies of scale are normally estimated to be substantial.

2.7.3

Financial synergy Diversification Acquiring another firm as a way of reducing risk cannot create wealth for two publicly traded firms, with diversified stockholders, but it could create wealth for private firms or closely held publicly traded firms. A takeover, motivated only by diversification considerations, has no effect on the combined value of the two firms involved in the takeover. The value of the combined firms will always be the sum of the values of the independent firms. In the case of private firms or closely held firms, where the owners may not be diversified personally, there might be a potential value gain from diversification. Cash slack When a firm with significant excess cash acquires a firm with great projects but insufficient capital, the combination can create value. Managers may reject profitable investment opportunities if they have to raise new capital to finance them. It may therefore make sense for a company with excess cash and no investment opportunities to take over a cash-poor firm with good investment opportunities, or vice versa. The additional value of combining these two firms lies in the present value of the projects that would not have been taken if they had stayed apart, but can now be taken because of the availability of cash. Tax benefits The tax paid by two firms combined together may be lower than the taxes paid by them as individual firms. If one of the firms has tax deductions that it cannot use because it is losing money, while the other firm has income on which it pays significant taxes, the combining of the two firms can lead to tax benefits that can be shared by the two firms. The value of this synergy is the present value of the tax savings that accrue because of this merger. The assets of the firm being taken over can be written up to reflect new market value, in some forms of mergers, leading to higher tax savings from depreciation in future years. Debt capacity By combining two firms, each of which has little or no capacity to carry debt, it is possible to create a firm that may have the capacity to borrow money and create value. Diversification will lead to an increase in debt capacity and an increase in the value of the firm. It has to be weighed against the immediate transfer of wealth that occurs to existing bondholders in both firms from the shareholders.

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When two firms in different businesses merge, the combined firm will have less variable earnings and may be able to borrow more (have a higher debt ratio) than the individual firms.

2.7

Corporate reporting issues: business combinations

Acquisitions and mergers are subject to the requirements of IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements. These standards impose a number of significant requirements upon the parties involved that may influence their thinking.

2.8.1

Nature of acquisition Remember that IFRS 3 only applies to the acquisition of businesses.

Definition Business: An integrated set of activities and assets capable of being conducted and managed for the purpose of providing: (a) (b)

A return in the form of dividends; or Lower costs or other economic benefits directly to investors or other owners.

A business generally consists of inputs, processes applied to those inputs, and resulting outputs that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set is presumed to be a business. If it is just some assets, and perhaps liabilities, which are acquired, then the consideration is allocated according to other IFRS (eg IAS 16 in the case of property, plant or equipment) across what has been acquired; no goodwill should be recognised. IFRS 3 requires that one of the combining entities must be identified as the acquirer. Identifying the acquirer requires the assessment of all rights, powers, facts and circumstances. In a reverse acquisition, for example, the legal acquirer (the entity issuing the shares) may come under the control of the legal acquiree. Under IFRS 3 the legal acquiree will be treated as the acquirer.

2.8.2

Acquiring control IFRS 10 states that an investor controls an investee if and only if it has all of the following: (i) Power over the investee (see below) (ii) Exposure, or rights, to variable returns from its involvement with the investee (see below) (iii) The ability to use its power over the investee to affect the amount of the investor's returns (If there are changes to one or more of these three elements of control, then an investor should reassess whether it controls an investee.) Power is defined as existing rights that give the current ability to direct the relevant activities of the investee. Rights to variable returns may include rights to dividends, remuneration for servicing an investee's assets or liabilities or fees and exposure to loss from providing credit support.

2.8.3

Fair value requirements We discussed in the context of asset-based valuations above the basic requirement of IFRS 3 that the identifiable assets and liabilities acquired are measured at their acquisition-date fair value. We have seen that the requirement to account for a business combination using fair value measurement will also mean that the acquisition is subject to the requirements of IFRS 13 Fair Value Measurement.

2.8.4

Valuation of previously-held stake Sometimes an acquirer will make an acquisition, having previously held an equity interest in the company being acquired. If this happens, the previously held interest will be re-measured to fair value immediately before control is achieved and the gain or loss taken to profit or loss.

2.8.5

Valuation of non-controlling interest Definition Non-controlling interest: The equity in a subsidiary not attributable, directly or indirectly, to a parent. The figure for non-controlling interests in the statement of financial position will be the appropriate proportion of the translated share capital and reserves of the subsidiary plus, where the NCI is valued at fair value, its share of goodwill translated at the closing rate. In addition, it is necessary to show any dividend declared but not yet paid to the NCI at the reporting date as a liability. The dividend payable should be translated at the closing rate for this purpose.

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The non-controlling interest in profit or loss will be the appropriate proportion of profits available for distribution. If the functional currency of the subsidiary is the same as that of the parent, this profit will be arrived at after charging or crediting the exchange differences. The non-controlling interest in total comprehensive income includes the NCI proportion of the exchange gain or loss on translation of the subsidiary financial statements. It does not, however, include any of the exchange gain or loss arising on the retranslation of goodwill.

2.8.6

Fair value of consideration Part of the consideration for an acquisition may not pass to the acquiree's shareholders at the acquisition date but be deferred until a later date. Deferred consideration should be measured at its fair value at the acquisition date. The fair value depends on the form of the deferred consideration. Where the deferred consideration is in the form of equity shares: 

Its fair value should be measured at the acquisition date



The deferred amount should be recognised as part of equity, under a separate heading such as 'shares to be issued'

Where the deferred consideration is payable in cash: A liability should be recognised at the present value of the amount payable.

Definition Contingent consideration is an obligation of the acquirer to transfer additional consideration to the former owners of the acquiree if specified future events occur or conditions are met. The acquiree’s shareholders may have a different view from the acquirer as to the value of the acquiree. They may have different views about the likely future profitability of the acquiree’s business In such cases it is often agreed that additional consideration may become due, depending on how the future turns out. Such consideration is ‘contingent’ on those future events/conditions. Contingent consideration agreements result in the acquirer being under a legal obligation at the acquisition date to transfer additional consideration, should the future turn out in specified ways. IFRS 3 requires contingent consideration to be recognised as part of the consideration transferred and measured at its fair value at the acquisition date.

2.8.7

Goodwill on acquisition IFRS 3 requires goodwill acquired in a business combination (or a gain on a bargain purchase) to be measured as: £ Consideration transferred: Fair value of assets given, liabilities assumed and equity instruments issued, including contingent amounts Non-controlling interest at the acquisition date Less total fair value of net assets of acquiree Goodwill/(gain from a bargain purchase)

X X X (X) X/(X)

This calculation includes the non-controlling interest and is therefore calculated based on the whole net assets of the acquiree. Under IFRS 3 the acquirer is required to include a qualitative description of the factors that make up goodwill, such as expected synergies from combining operations or intangible assets that do not qualify for separate recognition.

2.8 2.9.1

Accounting policies and pensions

Accounting policies Accounting policies can have a significant impact on the valuation of acquisitions. They can either work to inflate or depress the share price. Optimistic accounting policies, valuing assets generously, bringing forward revenue recognition and delaying provisions may inflate the company position and share price. On the other hand, accelerating expenses or making very conservative estimates of future earnings may depress share prices. There may be agency issues with both approaches. Directors who wish to retain their own jobs may attempt to boost earnings, and hence share prices to deter takeovers. Alternatively, directors who feel they can benefit if a takeover occurs may be tempted to depress a company's market valuation, even though shareholders may lose out as a result.

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2.9.2

Pensions In Chapter 4 we raised the possibility that concerns over pension liabilities may impact upon strategic decisions, and this includes acting as a deterrent to takeover. A pension parachute is a type of 'poison pill', preventing the acquiring firm in a hostile takeover from using surplus cash in the pension fund to finance the takeover. The arrangement ensures that the fund's assets remain the property of its participants. A large deficit in a defined benefit pension fund can also be a deterrent in a merger or acquisition because of the risks involved. Under UK pension regulations, for example, employers operating schemes that have deficits must agree a plan with the scheme's trustees to pay off the deficit, generally by making extra payments. The aim normally was to clear the deficit within 10 years, although the UK pensions regulator has indicated that more flexibility will be allowed during the current recession. The requirement for three yearly full valuations of pension schemes, taking into account new actuarial assumptions, can cause companies to reappraise their plans. A study by Cocco and Volpin published in April 2012 did not find clear evidence of whether or not markets were able to correctly price companies with defined benefit pension plans. What was important was investor uncertainty about the value of liabilities, as the deficit in pension plans was difficult to determine, company insiders had better information than external investors and managers might also manipulate the assumptions used for the valuation of scheme assets and liabilities.

2.9

Due diligence Due diligence should be carried out in two stages. Preliminary due diligence should be conducted before an offer is made to acquire a target company. This will involve an investigation into the business on the basis of available information. An initial offer to acquire the target business will be made on the basis of this investigation. If the board of the target company indicate a willingness to accept the offer, the two parties should sign heads of agreement, setting out the main terms of the acquisition, such as: 

What the purchaser has agreed to buy



The purchase price and the form of the purchase consideration (for example cash or shares)



Preconditions that the buyer may insist on, such as a requirement that the target company’s next half-yearly or annual accounts will show at least a stated amount of profit



Any warranties or indemnities that the sellers will provide.

When heads of agreement have been signed, the purchaser should carry out a second stage of due diligence, which will be more detailed than the first. This may involve meeting with the target company’s main customers or suppliers, studying the company’s accounts for sales growth, profit margins and assets and liabilities. Due diligence may also include an employee audit, as well as legal due diligence (for example checking the legal ownership of certain assets, such as land and buildings and patents). We covered due diligence focus on the financial and tax aspects. Due diligence will attempt to achieve the following:     

Confirm the accuracy of the information and assumptions on which a bid is based Provide the bidder with an independent assessment and review of the target business Identify and quantify areas of commercial and financial risk Give assurance to providers of finance Place the bidder in a better position for determining the value of the target company

The precise aims will, however, depend upon the types of due diligence being carried out.

2.10.1

Financial due diligence Financial due diligence is a review of the target company's financial position, financial risk and projections. It differs from a statutory audit in a number of ways: 

Its nature, duties, powers, and responsibilities are normally determined by contract or financial regulation rather than by statute.



Its purposes are more specific to an individual transaction and to particular user groups.



There is normally a specific focus on risk and valuation.



Its nature and scope is more variable from transaction to transaction, as circumstances dictate, than

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a statutory audit. 

The information being reviewed is likely to be different and more future orientated.



The timescale available is likely to be much tighter than for most statutory audits.

The information which is subject to financial due diligence is likely to include the following:            

2.10.2

Financial statements Management accounts Projections Assumptions underlying projections Detailed operating data Working capital analysis Major contracts by product line Actual and potential liabilities Detailed asset registers with current sale value/replacement cost Debt/lease agreements Current/recent litigation Property and other capital commitments

Tax due diligence Information must be provided to allow the potential purchaser to form an assessment of the tax risks and benefits associated with the company to be acquired. Purchasers will wish to assess the robustness of tax assets, and gain comfort about the position in relation to potential liabilities (including a possible latent gain on disposal due to the low base cost).

2.10.3

Agreeing the final terms Following detailed due diligence, some of the terms of the offer may be changed, and any such changes will have to be negotiated and agreed.

3 Unquoted companies and start-ups 3.1

Why value unquoted shares?

Unquoted shares are valued for all sorts of purposes, for example:    

To sell the company As part of a divorce settlement For taxation purposes To raise capital from investors

The important thing to note is that as soon as you change the purpose of the valuation you will change the share price. Shares are valued on different bases for different purposes; there are many sources of information on which share values can be based.

3.2

How do we value unquoted shares?

The valuation of unquoted shares is not an exact science and there may be a range of possible values. When trying to value an unquoted company's shares, one of the most frequent errors is to assume that this exercise can be conducted without taking into account the value of the entire enterprise. Sole reliance on such measures as the P/E ratio for comparable quoted companies can result in valuable information being omitted from the valuation process, leading to potential under- or over-valuation. When unquoted shares are valued for tax purposes, the valuation method used tends to be – with a few exceptions the estimated price that the shares would achieve if sold on the open market. Various court decisions over the years have given guidance on how an imaginary market sale can be used to arrive at a value. For this purpose, the valuer should consider: 

The sustainable future reported earnings after tax



The company's performance as shown in its financial statements, and any other information normally available to its shareholders



The commercial and economic background at the valuation date

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

The company's dividend policy



Appropriate yields and price/earnings ratios



The value of the company's assets



Gearing levels



The existence of certain rights and obligations attached to preference shares, convertible bonds



Any other relevant factors

3.3

Valuing majority shareholdings

The valuation of a majority shareholding must reflect the extent to which a potential buyer of the shares can or cannot control – or influence – the company. There are many degrees of control which are usually determined by the voting power of a particular block of shares. These range from full control (including the power to liquidate the company) to a small or non-existent influence over the company's affairs. Unless there are exceptional circumstances, if the degree of control is less than complete, the value of the shares will be less than a pro-rata proportion of the overall value of the company. In order to value a majority shareholding, consider the following: 

The rights and prospects attached to the shareholding – for example, the right to appoint directors



Whether restrictions apply to, for example, sale of shares or receipt of dividend



Whether control is in excess of 75%, meaning that the articles of association can be changed by the holder. A 75% holding also gives the holder the right to wind up the company



Whether minority shareholders have contractual rights that would be expensive for majority shareholders to buy out



Whether the minority shareholdings are concentrated on one individual or dispersed

When a majority shareholding is valued, there is a control premium attached to it, meaning that the overall value will be in excess of the pro rata value to the value of the company as a whole. The extent of the premium depends on the answers to the above factors. As a crude guidance, the following table gives you a starting point for consideration: Shareholding

Discount on 100% company value

75% +

Nil to 5%

> 50% but < 75%

10 – 15%

50%

20 – 30% (but a much greater discount if another party holds the other 50%)

3.4

Valuation of minority shareholdings

While there are few differences between the value of a majority holding in a private company and that of a quoted company, there can be major differences between the values of minority holdings. This depends very much on the nature of the unquoted company. An article in Finance Week on 27 March 2007 entitled 'Valuing your unquoted company's shares' identified several factors that should be considered when valuing minority shareholdings in an unquoted company: 

Marketability – this may be the only difference between the quoted company being used for comparison purposes and the unquoted company.



Size – private companies are often much smaller than quoted companies. Any size adjustment to valuations depends very much on specific circumstances. Although the growth prospects of an unquoted company may not be as attractive as those of a quoted company, smaller organisations operating in a niche market may be more dynamic and therefore the adjustment in valuation may be positive rather than negative.



Expectations of cash returns – the marketability factor of unquoted companies is affected by the likelihood of minority shareholders receiving a future cash return, either in the form of dividends or due to the flotation of the company. Quoted companies' shareholders are more likely to receive

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cash returns by way of dividends or share buybacks. If there are little or no prospects of cash returns in the near future, there will be little or no value attached to minority shareholdings unless some significant influence can be exerted on the directors or other shareholders. Rather than using DCF analysis and market comparability models for valuation purposes, it is more appropriate to value minority shareholdings of unquoted companies using the present value of anticipated dividend streams. Consideration should also be given, however, to any contractual protection or rights pertaining to minority shareholdings (eg through the Articles of Association or service contracts). Similarly the question of which parties, and how many hold the majority shares may be a key issue in valuing any tranche of minority shares. These circumstances would need to be considered on a case by case basis.

3.5

Valuation of start-up businesses

Here we define a start-up business as an unquoted company that has not been in business for long. Startups may be attractive takeover propositions, not because of what they have achieved so far, but because of their future potential. The value of start-ups may lie in expectations of future revenue growth and profits, or in the value of some of the assets that it owns. The valuation of start-ups presents a number of challenges for the methods we have considered so far, due to their unique characteristics which are summarised below:

3.5.1



Most start-ups typically have little or no track record. Its revenues may be growing, but from a very small starting point.



Because it is earning relatively little revenue, it will probably be making losses and will also be cash flow negative.



It will not yet have established a strong customer base.



Its products may be insufficiently tested in the market. Its products may even still be under development, and not yet marketed at all. If so its likely market acceptance and the volume of sales demand for the product will be unknown.



Its management team may be inexperienced in business.



Little may be known about the nature of competition, if the product is new.

Projecting economic performance All valuation methods require reasonable projections to be made with regard to the key drivers of the business. The following steps should be undertaken with respect to the valuation of a high-growth start- up company. Identifying the drivers Any market-based approach or discounted cash flow analysis depends on the reasonableness of financial projections. Projections must be analysed in light of the market potential, resources of the business, the management team, financial characteristics of the guideline public companies, and other factors. Period of projection One characteristic of high growth start-ups is that in order to survive they need to grow very quickly. Startups that do grow quickly usually have operating expenses and investment needs in excess of their revenues in the first years and experience losses until the growth starts to slow down (and the resource needs begin to stabilise). This means that long-term projections, all the way out to the time when the business has sustainable positive operating margins and cash flows, need to be prepared. These projections will depend on the assumptions made about growth. However, rarely is the forecast period less than seven years. Forecasting growth For most high growth start-ups the proportion of profits retained will be high as the company needs to achieve a high growth rate through investing in research and development, expansion of distribution and manufacturing capacity, human resource development (to attract new talent), and development of new markets, products, or techniques.

3.5.2

Valuation methods Once growth rates have been estimated, the next step is to make a valuation. A number of different valuation methods may be used. Asset-based method

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The asset-based method may not be appropriate because the value of capital in terms of tangible assets may not be high. Most of the investment of a start-up is in people, marketing and/or intellectual rights that are treated as expenses rather than as capital. Market-based methods The market approach to valuation also presents special problems for start-ups. This valuation process involves finding other companies, usually sold through private transactions, that are at a similar stage of development and that focus on existing or proposed products similar to those of the company being valued. Complicating factors include comparability problems, differences in fair market value from value paid by strategic acquirers, lack of disclosed information, and the fact that there are usually no earnings with which to calculate price-to-earnings ratios. Instead of making a valuation using a P/E ratio multiple, it may be appropriate to value the company on a multiple of its current or expected annual sales revenue (a price-to-revenue ratio multiple). Discounted cash flows A discounted cash flow method of valuation might be used, but only if the start-up company is expected to achieve positive cash flows in the near future, and if these cash flows can be estimated with reasonable confidence in their probable accuracy. There is little point in making a DCF valuation when the cash flow estimates are uncertain and unreliable. Entry cost valuation method When an acquirer is seeking to enter a new sector of the market for the first time, it may consider that acquiring a start-up company will be a useful way of establishing its new business. Since a start-up has already occurred, it should be quicker to gain market entry by purchasing the start-up than by establishing a new business from scratch. In these circumstances, a useful method of valuation might be to consider what it would cost to enter the market and establish a new business, and value the target start-up business on the basis of this entry cost. The entry costs for the target start-up might include:  

Costs of raising the finance Cost of assets acquired

  

Cost of product development Costs of recruiting and training employees Costs of building up the customer base .

Having estimated this start-up cost, the acquirer should then consider any factors that would make it possible to establish a new business more cheaply, such as using better technology or locating operations in a less expensive area. The entry cost valuation should be then based on the estimates of these cheaper alternatives, i.e. the estimated entry costs incurred by the target start-up company should be reduced to allow for the costsaving alternatives of starting the business from scratch. First Chicago method The First Chicago method is a variation of an approach to the valuation of high-risk high-growth startups known as the Venture Capital Valuation Method. This method can be summarised as follows: 

A would-be investor in a high-growth start-up business produces three sets of estimated future cash flows and returns from the investment. The three sets of returns are based on a best case scenario, a worst case scenario and a ‘base case’ scenario.



For each scenario, estimates of investment returns are made for a given number of years, at the end of which the investor makes an assumption about the exit route for his investment, and the valuation of the investment at the exit date.



The cash flows for each scenario are discounted to a present value, using a risk-adjusted discount rate.



A probability estimate is made for the three scenarios, for example 40% worst case, 40% base case and 20% best case.



A valuation is obtained by calculating the expected value of the PVs of the three scenarios.



The resulting valuation is compared with other known information about business valuations, to assess the valuation for realism.

Standard industry methods of valuation

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In some industries, it may be standard practice to value companies on a basis other than profits. For example, an estate agency (realtor) business may be valued on a multiple of outlets. A larger company of estate agents may offer to purchase a small company with 10 outlets, but making no profits, at a price of £20,000 per outlet. The buyer will be able to incorporate the acquired outlets into its operations and online services, and make profits through savings/synergy. Similarly a larger company may offer to buy a smaller competitor that is making no profits on the basis of an amount per regular customer.

3.5.3

Probabilistic valuation methods In a probabilistic cash flow model, a number of scenarios are constructed for the drivers of value and derive a value under each scenario. The next step is to assign probabilities to each scenario and arrive at a weighted average value. The procedure to be followed is akin to the Monte Carlo methodology.

3.6

Bargain purchases Definition Bargain purchase. The purchase of a company for an amount that is less than the fair value of the net assets acquired. Occasionally a business may be acquired for a price that is less than the fair value of the net assets acquired. This could happen when the acquired company is in serious financial difficulties and is facing the risk of insolvency. It might be supposed that in such circumstances, the owners should seek to wind up their business and realise the business assets. However: 

The realisable value of the assets may be less than the fair value at which the assets would be valued in an ongoing business



It may be difficult to find willing buyers for the assets, especially within a short time.

In these circumstances the business owners may agree to accept an offer price that is lower than the fair value of the net assets of the business. IFRS 3 Business Combinations states that when a bargain purchase occurs, the acquirer should recognise the difference between the fair value of the acquisition and the actual purchase price as a gain in profit or loss on the acquisition date. However before recognising the gain the acquirer should reassess whether it has correctly identified:   

all the assets that have been acquired and the liabilities that have been assumed the non-controlling interest in the acquired business, if any the consideration transferred.

If this reassessment indicates the need to adjust any of these amounts, the gain on the bargain purchase should be adjusted accordingly.

4 Valuation of debt 4.1

Notes on debt calculations

(a)

Debt is usually quoted in £100 nominal units, or blocks (euro loans are usually quoted in €1,000 blocks); always use £100 nominal values as the basis to your calculations unless told otherwise.

(b)

Debt can be quoted in % or as a value, eg 97% or £97. Both mean that £100 nominal value of debt is worth £97 market value.

(c)

Interest on debt is stated as a percentage of nominal value. This is known as the coupon rate. It is not the same as the redemption yield on debt or the cost of debt.

(d)

Sometimes people quote an interest yield, defined as coupon/market price, but this is only a crude approximation unless the debt is irredeemable and there is no tax effect.

(e)

Always use ex-interest prices in any calculations, unless the debt is specifically described as cum interest.

4.2

Irredeemable debt

4.3

Redeemable debt

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4.4

Convertible debt

When convertible loan notes are traded on a stock market, the minimum market price will be the price of straight loan notes with the same coupon rate of interest. If the market value falls to this minimum, it follows that the market attaches no value to the conversion rights. The actual market price of convertible loan notes will depend on:    

The price of straight debt The current conversion value The length of time before conversion may take place The market's expectation as to future equity returns and the associated risk

If the conversion value rises above the straight debt value then the price of convertible loan notes will normally reflect this increase.

4.5

Floating rate debt With floating rate debt, the coupon rate is reset at each payment date (or possibly even more regularly) to prevailing interest rates. The implication of this is that at a reset date the bond will be valued at par. In addition, the cash value of the next coupon has now been set. Though all subsequent coupons will still be reset at the next reset date if interest rates move, the next coupon will not be. This resetting of the coupon at each payment date ensures that the price of floating rate debt is always close to par. Floating rate debt therefore safeguards the par value of the investment rather than showing great swings in value as interest rates fluctuate (as is demonstrated by normal bonds). Coupon rates tend to be reset by reference to money market rates. As a result, pricing follows money market conventions, applying simple rates over periods less than one year.

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Strategic Business Management Chapter-13 Financial instruments and financial markets 1 Equity Definition Equity represents the ordinary shares in the business. Equity shareholders are the owners of the business and through their voting rights exercise ultimate control. Equity shares have the rights to participate in the distribution of residual assets after any fixed claims from loan holders or preference shareholders have been satisfied.

1.1

Raising new equity There are broadly three methods of raising equity: In addition, new shares may be issued as all or part of a payment for an acquisition and some new shares are issued by companies that operate share option schemes for employees.

1.1.1 Retained earnings The cash generated from profits earned by a business can either be paid out to shareholders in the form of dividends or reinvested in the business. There is sometimes a misconception that because no new shares are being sold, using cash flows from retained earnings has no cost. There may be no issue costs but shareholders will still expect a return on the funds re-invested in the business. Such retentions represent a very easy and important source of finance, particularly for young growing businesses where there may be a continual need for funds but where it is impractical to keep raising them using rights/new issues (and debt).

1.1.2

Rights issues Definition A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings. Legally a rights issue must be offered to existing shareholders before a new issue to the public. Existing shareholders have rights of first refusal (pre-emption rights) on the new shares and can, by taking them up, maintain their existing percentage holding in the company. However, shareholders can, and often do, waive these rights by selling them to others. Shareholders can vote to rescind their pre-emption rights. Companies need to consider the following factors when making rights issues:

1.1.3



Issue costs – these have been estimated at around 4% on £2m raised but, as many of the costs are fixed, the percentage falls as the sum raised increases.



Shareholder reactions – shareholders may react badly to firms continually making rights issues as they are forced either to take up their rights or sell them (doing nothing decreases their wealth). They may sell their shares in the company, driving down the market price.



Control – unless large numbers of existing shareholders sell their rights to new shareholders there should be little impact in terms of control of the business by existing shareholders.



Unlisted companies – these often find rights issues difficult to use, because shareholders unable to raise sufficient funds to take up their rights may not have available the alternative of selling them if the firm's shares are not listed. This could mean that the firm is forced to use retentions or raise loans.

Issues in the market These account for around 10% of new equity finance. When they occur they are often large in terms of the amount raised. They are often used at the time a firm obtains a listing and a quotation on the Stock.

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1.2

Accounting: recognition of equity Definition

Equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. An instrument is an equity instrument if and only if: 1

1.2.1

The instrument includes no contractual obligation to: 

Deliver cash or another financial asset to an entity, or



Exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.

If the instrument will or may be settled in the issuer's own equity instruments, it is: 

A non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments.



A derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

Classification as equity Under IAS 32 whether a financial instrument is classified as an equity instrument should be in accordance with the substance of the contractual terms and not with factors outside the terms. Terms may include whether the instruments are redeemable, whether the returns are mandatory or discretionary and whether they contain features such as put or call options that require the issuer to settle the instrument in cash or other financial assets. The critical feature therefore in contractual terms is whether there is an obligation to deliver cash or another financial asset, or to exchange a financial asset or financial liability on potentially unfavourable terms. If the issuer does not have an unconditional right to avoid delivery of cash or other financial asset, then the instrument is a liability. The definition of residual interest is not confined to a proportionate interest ranking equally with all other interests, it may also be an interest in preference shares.

1.2.2

Interest, dividends, losses and gains Again this is a summary of what you've studied before. Interest, dividends, losses and gains arising in relation to a financial instrument that is classified as a financial liability should be recognised in profit or loss for the relevant period. Distributions, such as dividends, paid to holders of a financial instrument classified as equity should be charged directly against equity (as part of the movement on retained earnings in the statement of changes in equity). For compound instruments such as convertible bonds, the annual interest expense recognised in profit or loss should be calculated by reference to the interest rate used in the initial measurement of the liability component.

1.3

Cost of equity and portfolio theory This section provides a brief revision of portfolio theory and the cost of equity. The cost of equity is the size of returns that investors expect to receive on their equity shares, measured as an annual percentage amount on the value of their investment. Decisions by investors to buy or sell investments are based on an assessment of expected returns and risk. Risk is the possibility that actual returns could be higher or lower than expected, and risk can be measured statistically from historical data as the standard deviation of returns. A higher standard deviation around the mean expected return indicates higher volatility in returns and so greater investment risk. Risk can be divided into two categories:

(a)

Systematic risk: this is variability in returns that is caused by general market factors, such as changes in economic conditions. Systematic risk is a feature of the stock market as a whole; when the market as a whole suffers a fall in returns, the expected returns on all companies’ shares in the market also fall. Similarly, expected returns for all companies tend to rise when market returns as a whole increase.

(b)

Unsystematic risk or diversifiable risk is risk that is unique to individual companies. It represents variations in returns that are independent of market returns generally, for example due to changes in the perceived future profitability of a company.

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Portfolio theory is based on the view that investors with well-diversified portfolios can ignore diversifiable risk, because by holding shares in a fairly large number of different companies, the diversifiable risk with different companies will tend to cancel each other out. Some companies will provide unexpected high returns and others will disappoint with unexpected low returns, due to factors that are unique to those companies. Diversifiable risk can be ‘diversified away’ by having a sufficiently large portfolio of shares in different companies. If this is the case, systematic risk should be the only aspect of risk that concerns these investors. Investors should decide on the balance between risk and return that satisfies their investment preferences: do they want higher returns, by accepting higher risks; or lower returns and lower risks?

1.3.1

Risks and returns in a portfolio Investors in market securities (shares and corporate bonds) must accept that there will be some volatility in the returns they receive, due to systematic risk. If they invest in a portfolio of shares and other securities that represents the make-up of the stock market as a whole, they accept the average level of systematic risk in the market (the market risk). They could choose to invest in companies with higher systematic risk, or in companies with lower systematic risk. Whatever they choose to do, their expected returns (based on systematic risk only and ignoring diversifiable risk) will vary up or down with market returns, by a larger or smaller amount than returns for the market as a whole. Investors can also invest in risk-free securities. These are securities whose systematic risk is 0. The expected returns are predictable and do not change with changes in stock market returns. Risk-free returns can be defined as the return from government bonds (or other government securities) issued by a government with a high credit rating and in its domestic currency. An investor can therefore seek to create a portfolio that meets their requirement for risk and return by: (a)

creating an investment portfolio that has a suitable mix of shares representing the stock market as a whole and risk-free securities, or

(b)

creating a portfolio containing shares whose systematic risk is above or below the market average.

Investors will expect a return (ignoring diversifiable risk) that is the best obtainable for the amount of investment risk that they are prepared to accept.

1.3.2

Beta factors Systematic risk can be measured by beta factors. When average stock market returns change, up or down, the beta factor of an individual security (including risk-free securities) is a measure of the expected amount by which the expected returns on that security will change. (a)

The beta factor for the market as a whole is 1.0, meaning for example that if expected market returns go up by 1% (100 basis points) due to improving economic conditions, the change in expected market returns will be + 1% × 1.0 = 1%.

(b)

The beta factor for a risk-free security is 0, which means that if there is a change in the expected market returns, there will be no change in the expected returns from the risk-free security.

(c)

The systematic risk for a company’s shares may be higher than the systematic risk for the market as a whole, so that its beta factor is higher than 1.0. For example if a company’s shares have a beta factor of 1.5 and expected market returns rise by 1% (100 basis points), the expected returns from the company’s shares will increase by + 1% × 1.5 = 1.5%.

(d)

Similarly the systematic risk for a company’s shares may be lower than the systematic risk for the market as a whole, so that its beta factor is higher than 0 but lower than 1.0. For example if a company’s shares have a beta factor of 0.8 and expected market returns rise by 1% (100 basis points), the expected returns from the company’s shares will increase by + 1% × 0.8 = 0.8%.

2 Equity markets 2.1

London Stock Exchange The London Stock Exchange (LSE) is, above all else, a business. Its primary objective is to establish and run a market place in securities. In any economy there are savers and borrowers. The exchange acts as a place in which they can meet. Initially, the companies (the borrowers) issue shares to the investing public (the savers). This is known as the

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primary market. The main role of the LSE's primary market is to enable a company to issue shares. Investors would not be willing to invest their money unless they could see some way of releasing it in the future. Consequently, the exchange must also offer a secondary market trading in second-hand shares; this allows the investor to convert the shares into cash. Companies whose shares are traded on the London Stock Exchange (LSE) are generally known as quoted companies. Listed shares are those which have been admitted to the Official List by the UK Listing Authority (UKLA) (the title used by the Financial Conduct Authority in this area). Joining the Main Market of the LSE involves a two-stage process:

2.1.1

ď&#x201A;ˇ

The UKLA is responsible for the approval of prospectuses and the admission of companies to the Official List.

ď&#x201A;ˇ

The LSE is responsible for the admission to trading of companies to the Main Market.

Primary market The primary market is the market for the issue of new securities. It is important to ensure that the primary market is selective. A poor-quality primary market will undermine the liquidity of the secondary market. Companies wishing to issue shares often find it useful to hire the services of an issuing house or sponsor (usually these are services available from the investment banks) who will guide them through the process of preparing for the new issue and advertising the fact to potential new investors.

2.1.2

Secondary market The secondary market (markets in second-hand securities) exists to enable those investors who purchased investments to realise their investments into liquid cash. In order to ensure the stability of the secondary market, the exchange must establish strong controls over the companies that are allowed on to the market. Equally, the exchange must establish rules concerning the activities of brokers in the secondary market in order to preserve the reputation of the market. However, the LSE has itself a number of rules concerning the restriction on the investments in which a member firm can deal. These rules are designed to complement the UKLA rules. Most investors who buy or sell shares in a secondary market want a liquid market, in which there is always a number of other investors willing to buy or sell the shares. A liquid market should mean that a buyer or seller will always be able to get a fair price for the shares, and market prices will not be distorted by major share transactions (such as the sale of a large quantity of shares in a company by an investor) or by a temporary lack of willing buyers or sellers. Although secondary market trading is carried out on the stock exchange because it can provide a liquid market, a significant amount of trading in shares occurs elsewhere. Some institutional investors want to enjoy confidentiality about their share dealing and to avoid reporting requirements for large transactions on the stock exchange. Some banks therefore operate their own private share dealing services for off- market transactions.

2.1.3

Role of stock exchange member firms All member firms of an exchange are broker-dealers. Broker-dealers have dual capacity, giving them the choice to either act as agents on behalf of customers, or to deal for themselves as principals, dealing directly with customers.

2.1.4

Trading methods of the London Stock Exchange Different types of shares, with varying levels of liquidity, trade via a variety of market systems. On the London Stock Exchange, there are three trading systems, through which main market shares and AIM shares are traded: the Stock Exchange Electronic Trading Service (SETS), the Stock Exchange Electronic Trading Service â&#x20AC;&#x201C; quotes and crosses (SETSqx) and the Stock Exchange Automated Quotation System (SEAQ).

2.1.5

Order and quote-driven systems Where a market is order-driven, the relevant electronic trading system will match buyers and sellers automatically, provided that they are willing to trade at prices compatible with each other. This is essentially the function which SETS performs. Prices of securities which trade on SETS are, therefore, purely driven by the buyers and sellers in the market themselves: for example, buyers and sellers can specify limits to the prices they are prepared to pay or accept. A quote-driven market, such as SEAQ, requires certain market participants (market makers) to take responsibility for acting as buyers and sellers to the rest of the market so that there will always be a price at which a trade can be conducted. The market makers quote buying and selling prices for the securities in which they are prepared to trade. For such a market to operate efficiently, up-to-date prices at which

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market makers are willing to trade need to be made available to other market participants. This is the function performed by SEAQ. Unlike SETS, SEAQ does not provide a mechanism for trades to be executed automatically.

2.2

The criteria for listing The UKLA's rules for admission to listing are contained in the Listing Rules. These detail the requirements that a company must meet prior to being admitted to the Full List. The basic conditions are as follows: 

The expected market value of shares to be listed by the company must be at least £700,000. If the company is to issue debt, the expected market value of any such debt is to be at least £200,000.



All securities issued must be freely transferable.



The company must have a trading record of at least three years. Its main business activity must have been continuous over the whole three-year period. In addition, there should be three years of audited accounts. This requirement is waived for innovative high growth companies, investment companies and certain other situations.



The shares must be sufficiently marketable. A minimum of 25% of the company's share capital being made available for public purchase (known as the free float) is normally seen to satisfy this requirement. The lower the free float, the fewer shares are available in the market, potentially leading to higher share price volatility.

Applicants for listing must appoint a UKLA-approved sponsor whose role is to:    

Ensure the company and its directors are aware of their obligations. Ensure the company is suitable for listing and satisfy UKLA of this fact. Liaise with UKLA and submit documentation to them as required. Co-ordinate the listing process.

Companies must generally produce a prospectus containing information on the company's past and present activities and performance, directors, capital structure and future prospects.

2.2.1

'Premium' and 'Standard' listings UK entities are permitted to apply for a 'Primary' listing. 

The standard listing allows UK companies to qualify through the less stringent requirements and standards that were previously only open to non-UK entities. This now provides a level playing field for UK and overseas companies.



A premium listing is available for equity securities of UK and non-UK incorporated companies and investment entities. The issuer will have to meet the 'super-equivalent' standards.

Entities with a Premium listing are subject to more extensive continuing obligations, such as the publication of an annual financial report and other information. They also need to comply with the Disclosure and Transparency Rules (DTR). A Premium listing is a pre-requisite for admission to the FTSE UK index. Therefore, most larger companies are likely to continue to apply for Premium listing despite the additional compliance costs and continuing obligations. Many institutional shareholders have indicated that they will expect 'premium' listings.

2.2.2

Continuing obligations All applicants for membership agree to be bound by the continuing obligations of the Listing Rules which require the company to: 

Notify the LSE of any price-sensitive information.



Publish information about important transactions undertaken by the company under the Class Tests Rule.



Inform the LSE of any changes in the important registers of ownership of the shares, such as notifiable interests and directors' shareholdings.



Notify the LSE of dividends.



Issue reports.

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2.3

Alternative Investment Market (AIM) The LSE introduced the second-tier Alternative Investment Market (AIM) in 1995. This forum for trading a company's shares enables companies to have their shares traded through the LSE in a lightly regulated regime. Thus smaller, fast-growing companies may obtain access to the market at a lower cost and with less regulatory burden. An admission to trading on AIM used to be regarded as a stepping stone towards obtaining a full listing. Companies now choose to remain on AIM rather than progress to the Main Market. Recent years have seen an increase in traffic of companies transferring the other way – from the main market to AIM – attracted by the lighter touch regulation and also the tax advantages offered to investors. As at June 2014, there were about 1,100 companies listed on AIM. These are both companies with a UK base for their operations and foreign companies. The mean market capitalisation of AIM companies was £71 million but the median market capitalisation was only £23 million. This difference is explained by a small number of very large AIM companies.

2.3.1

Conditions for admission to AIM A summary of the main conditions that companies must meet in order to secure admission to AIM is as follows: 

All securities must be freely transferable.



AIM companies must have an LSE-approved Nominated Advisor (NOMAD) to advise the directors on their responsibilities and guide them through the AIM process.



AIM companies must also have a broker to support trading of the company's shares.



AIM companies must comply with ongoing obligations to publish price-sensitive information immediately and to disclose details of significant transactions. The NOMAD has a duty to ensure the AIM company meets its ongoing obligations.



Companies with a track record of less than two years must agree to a 'lock-in' whereby the directors, significant shareholders and employees with 0.5% or more of their capital agree not to sell their shares for a year following admission.

For AIM companies, there is no minimum level of free float (shares available for purchase by the public), no minimum market value for their securities and no minimum trading history. However, they must produce a prospectus, which is considerably less detailed than for a full listing and is known as an Admission Document.

2.3.2

Comparison of UKLA and AIM rules Full List

AIM

Trading record

Three years

None

Percentage in public hands

25%

None

Minimum market value

£700,000 for equity

None

£200,000 for debt

2.4

Free transferability

Yes

Requirement to produce a prospectus

Yes

Corporate governance requirements

Yes

Requirement to announce price sensitive information without delay

Yes

Applicable rules

UKLA

LSE

ISDX ICAP Securities and Derivatives Exchange (ISDX) is a Recognised Investment Exchange and may be described as London's third stock market after the LSE main market and AIM.

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The market is lightly regulated and was established to help smaller companies raise capital. However, it has struggled to attract listings, thanks in part to the success of AIM. The market had previously operated under the name PLUS, but due to financial difficulties it was acquired by ICAP in 2012. It targets smaller companies needing to raise between £2m and £3m. The average market value of companies on ISDX is about £10 million.

2.5 2.5.1

International stock exchanges USA The United States is home to the world's largest stock market with its constituent parts being the New York Stock Exchange, the American Stock Exchange, NASDAQ OMX, the Philadelphia Stock Exchange, the Boston Stock Exchange, the Chicago Stock Exchange, the Cincinnati Stock Exchange and the Pacific Exchange. The New York Stock Exchange was established in 1792 and is an order-driven floor dealing market. In 2007 the New York Stock Exchange merged with Euronext (itself an amalgamation of the Amsterdam, Brussels and Paris markets). Trading on the NYSE revolves around specialists who receive and match orders via a limit order book. Specialists will also act as market makers where an order cannot be matched via the order book to ensure continuous liquidity in a stock. The primary regulator of the US equities market is the Securities and Exchange Commission (SEC). Orders are processed through the Super Display Book System, the NYSE's primary order processing system since 2009. Exchange member firms input orders in a similar way to SETS and these reach specialists via the trading post, where the security is traded. The user, who may be an investor or a broker, receives a confirmation report of the transaction in real time as soon as the order is executed. The central clearing house is the Depository Trust Company (DTC) and settlement is T+3 (three business days). For overseas investors, a default 30% withholding tax is applied, which may be halved if a double taxation treaty is in force. NASDAQ OMX Group owns and operates the NASDAQ stock market, a screen-based, quote-driven market, and is monitored by the SEC. NASDAQ is the largest electronic screen-based securities trading market in the US, and is the second largest by capitalisation in the world. As the successor to over-the- counter trading of stocks and the world's first electronic stock market when it was set up in 1971, NASDAQ introduced new competition into the market and helped to lower spreads between bid and offer prices. It has specialised in providing a market for the more innovative companies and technology companies. To qualify for a NASDAQ listing, a company must be registered with the SEC, have at least three market makers in its securities, and meet minimum requirements for assets, capital, public shares and shareholders. Over-the-counter (OTC) trading generally involves trading of securities off the major exchanges. OTC trading of stocks is carried out by market makers who make markets in OTC Bulletin Board (OTCBB) and 'Pink Sheets' securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTCBB. Stocks quoted on the OTCBB must comply with US Securities and Exchange Commission (SEC) reporting requirements. Other OTC stocks, such as Pink Sheets securities, have no reporting requirements. Stocks categorised as OTCQX have met alternative disclosure guidelines through Pink OTC Markets.

2.5.2

Japan There are eight stock exchanges in Japan, the Tokyo Stock Exchange being by far the largest. The Tokyo Stock Exchange is order driven through the CORES dealing system. Settlement is on T3 by book entry transfer through the JSCC (Japanese Securities Clearing Corporation).

2.5.3

Hong Kong The Stock Exchange of Hong Kong Limited (SEHK) is a subsidiary of the Hong Kong Exchanges and Clearing Limited (HKEx). Trading is via AMS/3, an automated order matching system. The Central Clearing and Settlement System (CCASS) is the book-entry clearing and settlement system, operated by the depository, Hong Kong Securities Clearing Company Limited (HKSCC). CCASS's Continuous Net Settlement system (CNS) is used for inter-broker clearing of exchange trades on the Hong Kong Stock Exchange (SEHK).

2.5.4

France Trading on Euronext Paris is via the Nouveau Système de Cotation (NSC), the exchange's integrated electronic cash market trading platform. It is an order-driven market. Settlement is on T3 through the systems of Euroclear France, the central securities depository.

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2.5.5

Germany The Deutsche Börse is a fierce competitor with the LSE. Trading takes place through a computerised order book called XETRA. Settlement is on T2. Clearing, settlement and custody take place through Clearstream. The Deutsche Borse's Xetra US stars trading scheme allows for the trading of US shares in Europe outside the normal market hours.

2.5.6

Emerging markets There are various bond and equity markets in growing and emerging markets, each with its own unique characteristics. In many of these markets, bond and equity trading is OTC and is restricted to locally registered participants. Settlement systems in such markets tend to be run by central banks with no counterparty guarantees. In addition, non-electronic settlement systems and physical delivery are not uncommon. These characteristics make participation both difficult and risky for the UK investor. In an effort to achieve some international harmonisation, the larger (G30) economies have published recommendations of good practice including T+3 settlement for equities. Potential benefits from investing in emerging markets are as follows: 

Potential for high returns – in the long run, emerging markets may offer higher returns than developed markets. – –



There is a perception that foreign securities are mispriced, giving investment opportunities. Faster expanding developing market economies give higher profits growth for companies.

Potential for reduction in overall portfolio volatility – emerging markets have relatively low correlations with developed markets, giving diversification benefits.

Brazil, Russia, India and China are often referred to collectively as the BRIC countries. Brazil and Russia are rich in resources, particularly in oil. China is strong in manufacturing, while India has a welldeveloped information technology industry. Additional factors motivating investment in emerging markets are as follows: 

Liberalisation of foreign markets encouraged foreign investment. The demand caused by foreign investors caused prices to rise, attracting more investors. Note that this has a risk of becoming a speculative bubble, ending with the market crashing after excessive investment by foreign and local investors.



Deregulation (eg abolishing price controls, foreign exchange controls) made entry into emerging markets easier.



Privatisation of government industries gave a boost to emerging stock markets.



Improved trade, communication and transport links make investing easier.

Investability describes whether it is possible to invest in an emerging market or not. There are various restrictions on investability which will make an emerging market less attractive:

2.6



Limitation on foreign holdings in local stocks, either to a maximum percentage or to a particular class of share



Small free float of shares eg the government is still a substantial shareholder in a privatised industry



Restrictions on remittance of funds to overseas



Taxes on foreign investors



Dual currency system and other foreign currency controls



Investment may be only permitted by authorised foreign investors



Lack of liquidity with holdings being too small to be meaningful, giving rise to excessive transaction costs (market impact)



Emerging market indices are often based only on investable shares

Factors affecting share prices Share prices do not always react in the way that is expected of them. Investors buy ordinary shares mainly because they expect share values to increase. Over a long period, what causes share prices to rise is the increasing earning power of the companies and their ability to pay higher dividends out of these increasing

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earnings. However, in the short term, there are many other factors that can distort the picture.

2.6.1

Impact of information Share prices are observed to move when new information is received, and will fairly reflect that new information. Since new information must, by definition, be unpredictable and random (otherwise it would not be new information), it follows that share price movements will also be random. From these observations, the efficient markets hypothesis (EMH) (discussed below) was developed which hypothesised that, at any time, share prices are fairly valued on the basis of all existing known information.

2.6.2

Profit taking Surprising though it may seem, a company's share price will often fall when it announces good profits. This may happen because speculators buy before the profit announcement is actually made, and then sell their shares in order to take the profit.

2.6.3

Press recommendations If the press tips a particular share for whatever reason, the price of that share is likely to rise. It is worth noting, however, that this may be caused by buying or simply by the market makers pushing up the price in anticipation of likely buying.

2.6.4

Market makers' and speculators' manoeuvres Market makers depend on high levels of activity in terms of buying and selling in order to make their profits. Thus, in periods with little activity, they may well try to stimulate the market artificially by moving their quoted prices, and possibly sell shares that they do not own. Speculators may also employ this technique of selling shares they do not own if they anticipate that the share price will fall. However, if the market makers get wind of this activity, they may push up their quoted prices in order to force speculators to buy the shares, which they need to deliver, at a high price. These speculators who have traded in anticipation of a fall in the share price are known as bears.

2.6.5

Interest rate and currency movements An increase in interest rates may cause share prices to fall for two separate reasons: ď&#x201A;ˇ

The available alternative investments in, say, government stocks will become more attractive.

ď&#x201A;ˇ

The higher cost of borrowing is likely to damp down economic activity in general, thus having an adverse effect on company profits.

The effect of movements in sterling can also be fairly complicated. Although a fall in sterling may lead to a rise in interest rates, with its associated problems, it may also improve a country's competitive position relative to other countries and may thus give rise to greater profit potential.

2.6.6

New share issues If a company raises funds by issuing a large number of new shares, the share price may well fall, as at that time there may not be enough willing buyers to absorb the number of shares in issue.

2.6.7

Political and other sentiment In the run-up to an election, the anticipated result will often have an effect on share prices. It has been known in the past for share prices to be affected by the result of a cricket match and also by more logical factors such as economic statistics or the behaviour of other markets in the world.

2.6.8

Takeovers Rumours of a corporate action such as a major takeover tend to push up the share price of the company concerned and also quite possibly of the market as a whole.

2.6.9

Automated trading Automated forms of trading have sometimes been blamed for major movements in stock prices. ď&#x201A;ˇ

Program trading has been defined by the New York Stock Exchange as an order to buy or sell fifteen or more stocks valued at over US$1 million total. In practice, this means that computers are used to enter program trades. Such trades are often made to take advantage of arbitrage opportunities, which seek to exploit small price differences between related financial instruments, such as index futures contracts and the stocks underlying them.

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ď&#x201A;ˇ

2.7

Algorithmic trading is a form of trading in which orders are entered to an electronic trading platform based on an algorithm which sets criteria for making the trade based on aspects such as timing, price or quantity. Generally, orders will be executed without human intervention. A special type of algorithmic trading is high frequency trading (HFT) or 'flash' trading, which seeks to respond to information received electronically before other human traders are able to process the information and place trades. Studies have found that over half of equity trading volume on major exchanges results from algorithmic trading.

Market efficiency You covered the efficient market hypothesis in previous studies and we summarise it here. The 'random walk hypothesis' suggests that future share price movements cannot be predicted from details of historical movements. On the other hand, share prices are observed to move when new information is received, and will fairly reflect that new information. Since new information must, by definition, be unpredictable and random (otherwise it would not be new information), it follows that share price movements will also be random. From these observations, the efficient markets hypothesis (EMH) was developed which broadly stated that, at any time, share prices are fairly valued on the basis of all existing information. If securities are priced efficiently, their prices reflect forecasts of expected benefits from future cash flows capitalised at appropriate discount rates. Of course, individuals can disagree, and it is this disagreement which results in transactions. The aggregation and resolution of expectations in the transaction process produces an unbiased valuation in an efficient market. Broadly speaking, the evidence suggests that efficient markets can be divided into three forms that are classified according to the degree to which information is reflected in share prices and the availability of that information.

2.7.1

Weak form efficiency The weak form of the EMH states that all information that can be discovered from past price movements has already been incorporated into the current share price. This implies that it should not be possible to predict future price movements from past price movements or to produce superior returns on the basis of past information, since any such information available from past prices has already been taken account of in the current price.

2.7.2

Semi-strong form efficiency The semi-strong form of the EMH states that current share prices not only reflect the information referred to in the weak form, but also incorporate any information that has been published about a company (all publicly available information). For example, release of preliminary figures by the company constitutes new information and the share price will move to reflect this. This level of market efficiency has been investigated through a number of events studies investigating the reaction of the market to the release of new information. Observations in major markets have shown that prices do respond to the release of new information and, traditionally, many people have suggested that share markets tend to exhibit this level of efficiency.

2.7.3

Strong form efficiency The strong form of the EMH is based on the premise that share prices fully reflect all information, whether publicly available or private. If markets are strong-form efficient, then no investor will ever be able to make better than average returns, except through luck. It would be impossible for even the most corrupt investor to find out anything which the share price did not already reflect. The evidence on strong-form efficiency is not conclusive, but the seemingly widespread incidence of insider traders (until they are caught) suggests that knowledge of secret information does give the investor a way of predicting share price movements before they have happened. The strong form of market efficiency cannot, therefore, hold.

2.7.4

Alternative theories The global crisis of 2007â&#x20AC;&#x201C;2009 has brought renewed discussion of alternatives to the EMH, which include the following.

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Behavioural finance. This area of study postulates that markets are driven by traders who are not rational in the classical sense. Instead, they display behavioural and cognitive shortcomings which psychologists have identified. For example, market participants show a tendency to avoid losses at all costs. They also tend to act like a herd, which will make occasional extreme market crashes more probable. Adaptive evolution. Markets are complex 'ecosystems'. They may be in a stable equilibrium for extended periods of time. Occasionally, a disruptive event may upset the equilibrium, and new financial 'species' may emerge while others may become 'extinct'. Chaos theory. It is hypothesised that markets do not behave in a random fashion. Market movements may be modelled in a similar way to the modelling of 'chaotic' systems such as wind turbulence or weather patterns.

3 Fixed interest securities, bonds and leasing The term bonds describes various forms of long-term debt a company may issue. Bonds come in various forms, including redeemable, irredeemable, floating rate, zero coupon and convertible. The terminology should be familiar to you from your earlier studies but it is worthwhile to recap on it here.

Definitions Face (or par or nominal) value: The amount of money the bond holder will receive when the bond matures (provided it is not redeemable at a premium or a discount). This is not the market price of the bond. If the market price is above par value, the bond is said to be trading at a premium; if price is below par value, the bond is trading at a discount. Coupon rate: The amount the bond holder receives as interest payments based upon the par value. Maturity: The date at which the principal will be repaid. Maturities can range from one day to as long as 30 years (although it has been known for 100-year bonds to be issued). Issuer: The issuer's stability is the bond holder's main assurance for getting repaid. For example, the UK Government is much more secure than any company. Hence government-issued bonds are known as riskfree assets and will have lower returns than company-issued bonds. Fixed charge: The security given on the bond relates to a specific asset or group of assets, typically land and buildings. The company will be unable to dispose of the asset without providing a substitute asset or without the lender's consent. Floating charge: The charge is on certain assets of the company and the lender's security in the event of a default of payment is whatever assets of the appropriate class the company then owns. The company would be able to dispose of the assets as it chose until a default took place.

3.1

Bonds Unlike shares, debt is often issued at par, i.e. with ÂŁ100 payable per ÂŁ100 nominal value. Where the coupon rate is fixed at the time of issue, it will be set according to prevailing market conditions and the credit rating of the company issuing the debt. Subsequent changes in market (and company) conditions that change the yield that investors require on the bond will cause the market value of the bond to fluctuate, although the coupon will stay at the fixed percentage of the nominal value (the fixed coupon rate).

3.2

Terms of loan agreement Covenants within the loan agreement are conditions attached to a bond issue. Some examples of covenants are listed below. It is usual for bond issues to include a negative pledge, a cross-default clause and a number of restrictive financial position covenants.

3.2.1

Negative pledge A negative pledge clause is where the borrower undertakes to refrain from raising other finance on which it grants a better security.

3.2.2

Cross default clause A cross default clause is included in most loan agreements and states that if the borrower defaults on any one of its loans, then this will constitute a default of this borrowing as well. The important consequence of this is that the borrower may be allowed to default on one loan due to, perhaps, overly strenuous covenants which the lender is prepared to waive, but that will still constitute a default for any other borrowing which has a cross default clause in existence.

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3.2.3

Pari passu clause A pari passu clause ensures that any lender is granted the same level of security as given to any new lenders.

3.2.4

Restrictive financial position covenants It is possible to include within the loan documentation a number of key ratios, such as maximum gearing ratio, minimum interest cover and minimum business net worth which the borrower must meet. These financial covenants normally include some measure of the ability to pay interest and may state an express limit on the overall level of borrowing that can be undertaken.

3.2.5

Limitation on additional indebtedness There may be a restriction on the company that limits the ability to take on further indebtedness unless it meets certain conditions. These conditions are normally linked to key ratios such as interest cover.

3.2.6

Limitation on restricted payments This covenant limits the company's ability to pay dividends or repurchase its own capital. Once again, these limits are often linked to key ratio cut-off points, such as interest or asset cover.

3.2.7

Limitations on transactions with affiliates This limits the ability of the company to enter into transactions with an affiliate unless they are on normal commercial terms.

3.2.8

Limitation on dividend and other payment streams from subsidiaries This is a general covenant prohibiting any subsidiary from entering into an agreement which limits its ability to remit dividends up to the holding company.

3.2.9

Disposal proceeds of asset sales This ensures that the company cannot sell assets unless they receive a fair market value and unless a specified percentage of the consideration is received in cash. A further extension to this clause is often that the monies received are used to:   

3.2.10

Repay senior debt Reinvest within the business within one year Repay the debt

New owner clause A new owner clause (change of ownership clause) is included to allow the lender the right of repayment should the ownership of the corporate borrower change.

3.2.11

Nature of business This is linked to the new owner clause. Should the nature of the company's business change dramatically, this will again affect the rights of the holders of the bonds, and may give the right to request a redemption of the bond.

3.2.12

Financial information The company may be required to provide financial statements, interim accounts or quarterly or monthly management accounts to the lender (if a bank) or the lenders’ representatives.

3.2.13

Events of default A breach of the covenants or the failure to pay the coupon or principal on the due dates are events of default. Within the agreement there may be allowance for 'grace periods', during which time the borrower is able to remedy the breach. If the borrower remains in default, the loan is immediately repayable. In principle an event of default gives the lender/bondholders the right to demand immediate repayment of the debt. In practice a breach of covenant will lead to discussions between the borrower and the bondholders’ representatives about appropriate measures to be taken. Most bonds are constituted in such a way that there is a trustee who is responsible for ensuring the bondholder's interests are protected. Where there is no trustee, the bondholder is obliged to seek redress directly from the company.

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3.3 3.3.1

Bond coupons Predetermined coupons The majority of bonds have a fixed coupon rate. On these bonds, the gross annual coupon (i.e. the amount due to be paid in a one-year period, irrespective of the frequency of payment) is specified as a percentage of the nominal value of the bond. Sub-classes here include:

3.3.2



Straight/fixed coupon bonds – where the coupon is at a set level for the entire life of the bond.



Stepped coupon bonds – where the coupon increases in steps to pre-specified amounts as the bond moves through its life.



Zero-coupon bonds – bonds that carry no coupon and simply redeem at face value at maturity. Investors obtain a yield on these bonds because the bonds are issued at a discount to face value, and continue to trade at less than face value in the entire period up to maturity and redemption.

Variable coupons This category includes:

3.3.3



Floating rate bonds or notes – where the coupon varies as the yield on a benchmark interest rate varies. For example for sterling floating rate bonds that pay interest every six months, the benchmark rate is likely to be the six-month sterling Libor rate. Loan agreements specify the interest rate (called reference or index rate to be used) and also the quoted margin, the rate above the reference rate that must be paid. The quoted margin will reflect the borrower's credit rating and size of issue, along with market conditions. Arrangements may include a floor (the rate below which the rate paid cannot fall) and a ceiling or cap (the rate above which the rate paid cannot rise).



Index-linked bonds – where the coupon and redemption proceeds figures get scaled for the effects of inflation.

Coupon frequency The frequency of the payment of the coupons is predetermined before issue, normally following the local market conventions. As a result, all investors will (or should) be aware of these dates. Conventions regarding the frequency of payment differ between bond markets. Some markets have a convention of paying semi-annual coupons, as is the case in the UK and the US, whereas other markets, in particular the Eurobond market, France and Germany, pay coupons on an annual basis.

3.3.4

Zero coupon bonds Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them. The investor gains from the difference between the issue price and the redemption value. There is an implied interest rate in the amount of discount at which the bonds are issued (or subsequently re-sold on the market).

3.4



The advantage for borrowers is that zero coupon bonds can be used to raise cash immediately. There is no cash repayment until redemption date. The cost of redemption is known at the time of issue, and so the borrower can plan to have funds available to redeem the bonds at maturity.



The advantage for lenders is restricted, unless the rate of discount on the bonds offers a high yield. The only way of obtaining cash from the bonds before maturity is to sell them. Their market value will depend on the remaining term to maturity and current market interest rates.

Debentures Definition Debenture: A written acknowledgement of a debt by a company, usually given under its seal and normally containing provisions as to payment of interest and the terms of repayment of principal. A debenture is usually unsecured, which means that the investors rely on the creditworthiness of the borrower for repayment. In comparison, the term ‘bond’ is often used to mean a bond for which security has been given by the borrower.

3.5

Eurocurrency and Eurobonds Definitions Eurocurrency: Currency which is held by individuals and institutions outside the country of issue of that currency. Eurodollars: US dollars deposited with, or borrowed from, a bank outside the USA.

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Eurobond: A bond sold outside the jurisdiction of the country in whose currency the bond is denominated. The term ‘euro-‘ is still occasionally used, but the terms ‘currency deposits’, ‘currency loans’ and ‘international bonds’ are now more common usage.

3.5.1

Eurocurrency A UK company might borrow money from a bank or from the investing public in sterling. However it might also borrow in a foreign currency, especially if it trades abroad, or if it already has assets or liabilities abroad denominated in a foreign currency. When a company borrows in a foreign currency, the loan is known as a eurocurrency loan or more simply as a currency loan. The eurocurrency markets are money markets. They involve the depositing of funds with a bank outside the country of the currency in which the funds are denominated and re-lending these funds for a fairly short term, typically three months, normally at a floating rate of interest.

3.5.2

Eurobonds Eurobonds or international bonds are long-term loans raised by international companies or other institutions and sold to investors in several countries at the same time. Most Eurobonds are currently denominated in US dollars and, to a lesser extent, euros and yen. In recent years, a strong market has built up which allows very large companies to borrow in this way, long-term or short-term. The market is not subject to national regulations but there is a self-regulatory association of bond dealers, the International Capital Market Association (ICMA). Advantages of international bonds 

Most international bonds are 'bearer instruments', which means that there is no bond ownership register and the owner does not have to declare his identity.



Interest is paid gross and this has meant that in the past Eurobonds have been used by investors to avoid payments of tax.



International bonds can be used to create a liability in a foreign currency to match against a foreign currency asset.



They may be cheaper than a foreign currency bank loan because they can be sold on by the investor, who will therefore accept a lower yield in return for this greater liquidity.



They are typically issued by companies with excellent credit ratings and are normally unsecured, which makes it easier for companies to raise debt finance in the future. Companies with lower credit ratings that want to raise funds in the bond markets may do so through a national ‘junk bond’ market. There is a large junk bond market in the USA.



International bond issues are not normally advertised to the general investing public because they are placed with institutional investors and this reduces issue costs.

Disadvantages of international bonds

3.6



Like any form of debt finance there will be issue costs to consider (perhaps about 2% of funds raised) and there may also be problems if gearing levels are too high.



A borrower contemplating an international bond issue must consider the foreign exchange risk of a longterm foreign currency debt. If the money is to be used to purchase assets which will earn revenue in a currency different to that of the bond issue, the borrower will run the risk of exchange losses if the currency of the loan strengthens against the currency of the revenues out of which the bond (and interest) must be repaid.

Deep discount bonds Definition Deep discount bond: A bond offered at a large discount on the face value of the debt so that a significant proportion of the return to the investor comes by way of a capital gain on redemption, rather than through interest payment. Deep discount bonds will be redeemable at par (or above par) when they eventually mature. For example a company might issue £1,000,000 of bonds in 2014 at a price of £50 per £100, and redeemable at par in the year 2029. For a company with specific cash flow requirements, the low servicing costs during the currency of the bond may be an attraction, coupled with a high cost of redemption at maturity. Investors might be attracted by the large capital gain offered by the bonds, which is the difference between the issue price and the redemption value. However, deep discount bonds will carry a much lower rate of interest than other types of bonds. The only tax advantage is that the gain gets taxed in one lump on maturity or sale, not as amounts of interest each year.

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3.7

Redeemable and irredeemable bonds Bonds are usually redeemable. They are issued for a term of ten years or more, and sometimes for up to 25 or 30 years. At the end of this period, they will 'mature' and become redeemable (at par or possibly at a value above par).

Definition Redemption: Repayment of the principal amount (for example a bond) at the date of maturity. Some redeemable bonds have an earliest and a latest redemption date. For example, 12% Loan Notes 2015/17 are redeemable at any time between the earliest specified date (in 2015) and the latest date (in 2017). The issuing company can choose the date. The decision by a company when to redeem a debt will depend on how much cash is available to the company to repay the debt, and on the nominal rate of interest on the debt. Some bonds do not have a redemption date, and are 'irredeemable' or 'undated'. Undated bonds might be redeemed by a company that wishes to pay off the debt, but there is no obligation on the company to do so. Corporate bonds can have a variety of redemption terms.

3.7.1

Bullets Many bonds issued are bullet issues, with a single redemption date when the full amount borrowed becomes repayable. In practice a company that has to redeem a bond in a bullet payment may seek refinancing, and may issue a new bond to raise money to redeem the maturing bond.

3.7.2

Sinking funds The sinking fund or sinker is a process whereby a proportion of the bonds in issue are redeemed each year. The bonds to be redeemed in each year are selected by the process of 'drawing' the serial numbers. The serial numbers of the bonds drawn in this way are then published and the holders submit the bonds to the paying agent for redemption at par. The final repayment is normally larger than the others and is referred to as the balance or balloon repayment. Sinking funds tend to come into operation towards the end of the bond's life and rarely start to redeem from the first coupon date.

3.7.3

Purchase fund A purchase fund buys back the bonds in the secondary market and not at par. The obligation to repay is triggered by a condition specified in the offer document, normally the bond trading below par.

3.7.4

Serial notes A serial note is one where a proportion of the capital is repaid each year together with the interest.

3.7.5

Optional redemption The option to redeem a bond can be given to either side of the deal. A call right would give the issuer the right to seek an earlier redemption. An example would be the double-dated gilts in the UK market, where the government has the right to redeem from the earlier of the two dates, but must redeem by the later date.

3.7.6

Callable bonds Callable bonds are where the issuer has the right to redeem the bonds at an agreed price prior to its maturity. This price may be above the normal redemption price and the extra price paid is referred to as the call premium. The call provision is valuable to the issuer, but is a disadvantage to the investor, since the issuer will only exercise the call if it suits the issuer to do so. As a result, the price at which a callable bond can be issued will be lower than for a comparable straight bond, and the interest rate it will need to pay will consequently be higher. A call provision will reduce the expected time to maturity of the bond, since there is a possibility that the bond will be retired early as a result of the call provision being exercised. Call provisions will be exercised when the issuer can refinance the issue at a cheaper cost due to interest rates having fallen. For example, if a bond were issued when interest rates were 15% and interest rates have now fallen to 5%, the issuer could issue a new bond at the currently low rate and use the proceeds to call back the higher coupon bond.

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3.7.7

Puttable bonds This is where the investor has a put option on the bond, giving him the right to sell the bond back to the company at a specified price (the put price). The put price is typically around par, given that the bond was issued at par. The benefit to investors is that if interest rates rise after the bond is issued, they can sell the bond at a fixed price and reinvest the proceeds at a higher interest rate. As a result of the benefit to investors, puttable bonds are issued at higher prices or lower coupons than comparable non-puttable bonds.

3.8

Convertible bonds Definition Convertible debt: A liability that gives the holder the right to convert into another instrument, normally ordinary shares, at a pre-determined price/rate and time.

Conversion terms often vary over time. For example, the conversion terms of convertible bonds might be that on 1 April 20X6, £2 of bonds can be converted into one ordinary share, whereas on 1 April 20X7, the conversion price will be £2.20 of bonds for one ordinary share. Once converted, convertible securities cannot be converted back into the original fixed return security. The current market value of ordinary shares into which a unit of bonds may be converted is known as the conversion value. The conversion value will be below the value of the bonds at the date of issue, but will be expected to increase as the date for conversion approaches on the assumption that a company's shares ought to increase in market value over time. Most companies issuing convertible bonds expect them to be converted. They view the notes as delayed equity. They are often used either because the company's ordinary share price is considered to be particularly depressed at the time of issue or because the issue of equity shares would result in an immediate and significant drop in earnings per share. There is no certainty, however, that the security holders will exercise their option to convert. Therefore the bonds may run their full term and need to be redeemed.

3.8.1

Price, coupon rate and premium A company will aim to issue bonds with the greatest possible conversion premium so that, for the amount of capital raised, it will on conversion have to issue the lowest number of new ordinary shares. The premium that will be accepted by potential investors will depend on the company's growth potential and so on prospects for a sizeable increase in the share price. Convertible bonds issued at par normally have a lower coupon rate of interest than straight debt. This lower yield is the price the investor has to pay for the conversion rights. It is, of course, also one of the reasons why the issue of convertible bonds is attractive to a company, particularly one with tight cash flows around the time of issue, but an easier situation when the notes are due to be converted. When convertible bonds are traded on a stock market, their minimum market price or floor value will be the price of straight bonds with the same coupon rate of interest. If the market value falls to this minimum, it follows that the market attaches no value to the conversion rights. The actual market price of convertible bonds will depend on:

    3.8.2

The price of straight debt The current conversion value The length of time before conversion may take place The market's expectation as to future equity returns and the risk associated with these returns

Mandatory convertibles Sometimes the bondholder will be required to convert the nominal value into ordinary shares of the company at a set redemption date. These are known as mandatory convertibles. The use of mandatory convertibles in the UK has increased with the weak market for Initial Public Offerings since 2008. The appeal for the investor of 'mandatories' is that the company takes the risk of the share price volatility in the period between issuance and conversion. Mandatories are often issued in conjunction with equity in an IPO to attract investors who would not otherwise be interested in the IPO.

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3.8.3

Advantages and disadvantages of convertible bonds Advantages Compared to either a bond or share issue, convertibles offer the following advantages to the issuer:  

No immediate dilution of the current shareholders Lower cost than normal bonds due to a lower coupon

  

Less dilution of earnings per share than either a normal share or bond issue as a consequence Suitable for when assets are not available to secure straight finance Suitable for finance projects with long pay-back periods

Disadvantages The disadvantage to the issuer is that if the company fails to perform, it is obliged to make the coupon payments, and ultimately redeem the bond for cash if the holder chooses not to convert. Therefore, the firm cannot be sure that they are issuing deferred share capital when they issue a convertible.

3.9

Warrants Definition Warrant: A right given by a company to an investor, allowing him to subscribe for new shares at a future date at a fixed, pre-determined price (the exercise price). Warrants are usually issued as part of a package with unsecured bonds. An investor who buys bonds will also acquire a certain number of warrants. The purpose of warrants is to make the bonds more attractive. Once issued, warrants are detachable from the bonds and can be sold and bought separately before or during the 'exercise period' (the period during which the right to use the warrants to subscribe for shares is allowed). The market value of warrants will depend on expectations of actual share prices in the future.

3.9.1

3.9.2

3.10

Advantages of warrants 

Warrants themselves do not involve the payment of any interest or dividends. Furthermore, when they are initially attached to bonds, the interest rate on the bonds will be lower than for a comparable straight debt.



Warrants make a bond issue more attractive and may make an issue of unsecured bonds possible where adequate security is lacking.



Warrants provide a means of generating additional equity funds in the future without any immediate dilution in earnings per share. The cost will be the right that warrants holders have acquired to buy at the possibly reduced exercise price.

Disadvantages of warrants 

When exercised, they will result in the dilution of share capital.



Warrants may be exercised when a business does not need additional capital.



The company has less control over the exercise of warrants than it does over the exercise of share capital.

Exchangeable bonds Definition Exchangeable bonds: Bonds that are convertible into the ordinary shares of a subsidiary or associate company of the issuer. This is therefore a different company to the issuer of the bond. The use of exchangeable bonds can be to provide a way for a group to divest an unwanted investment. There is no dilution of control for the shareholders of the issuer.

3.11

Hybrid bonds Definition Hybrid bond: A security that combines characteristics of both debt and equity. Fixed rate hybrids pay a predictable return or dividend until a certain date, at which point the holder has a number of options, possibly including converting the securities into the underlying share. The most common examples of hybrids are convertible bonds and convertible preference shares.

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Though hybrids pay a fixed return like bonds, the payments are voluntary. A missed payment does not constitute a default and payments do not normally accumulate if deferred. Like equities, they tend to be irredeemable or very long dated and they rank behind other debt if the company becomes insolvent. The motives behind corporate hybrid issues include the following: 

Consolidating credit ratings by buying back senior debt.



Refinancing pension deficits by using the proceeds of the issue to increase the pension fund. This reduces the deficit and, if the hybrid is assessed as partly equity, replacing the pension liability debt will also have a positive impact on the company's credit rating.



Financing corporate activity such as mergers and acquisitions, share buybacks or LBOs (leverage buy-outs), providing non-dilutive capital and flexibility.

For bond investors, hybrids offer higher yields than conventional debt but are not without risk. For equity investors, hybrids provide a tax efficient, long-term source of finance to the company without either the diluting effect of an equity issue or the risk of extra gearing from a debt issue where the coupons cannot be deferred if circumstances dictate. Investors in the equity still enjoy the benefits associated with any improvement in company performance.

3.12

Commercial paper Definition Commercial paper: Short-term unsecured corporate debt with maturity up to 270 days (US dollar CP) or 364 days (euroCP). The typical term of this debt is about 30 days. As commercial paper is unsecured debt, it can only be issued by large organisations with good credit ratings, normally to fund short-term expenditure on operating expenses or current assets. The debt is issued at a discount that reflects the prevailing interest rates, but the rates on commercial paper are typically lower than bank rates. CP is issued within a longer-term programme, which is managed on an issuer’s behalf by a bank. For example within a five-year CP programme, a company may be able to issue CP up to a maximum amount at any time, with each separate CP issue having a maturity of 30 days. A bank managing the programme arranges for each issue, including the sale of the paper to investors. Typically investors hold the paper until maturity and there is no secondary market. Commercial paper is a cheaper alternative to bank credit, although the small difference in interest rates means that the saving on commercial paper is only significant if large sums are being raised. However, many businesses still maintain bank lines of credit even if they use commercial paper. The wide maturity gives greater flexibility, security does not have to be given and investors can trade their commercial paper, although the market is less liquid than for bonds. However issues are controlled, and banks that issue ordinary commercial paper see a reduction in their credit limits. A sub-sector of the commercial paper market – the asset-backed commercial paper market – is where the loans are backed by assets such as mortgages or credit card debt. The concern is that asset-backed commercial paper could be held off-balance sheet in special investment vehicles that use the funds raised to buy longer-term assets such as mortgage-based securities. As these vehicles are off-balance sheet, their activities do not affect the banks' ability to lend money for other reasons. However one of the uses made of the funds raised was to invest in sub-prime mortgage backed assets. When the credit crunch began, investors lost confidence and refused to continue the loans. As a result some of the special investment vehicles had to be bailed out by the banks that created them.

3.13

Medium Term Notes (MTNs) Medium Term Notes (MTNs) are not strictly a type of security. Instead, the term describes a facility enabling the issuer to issue a range of stock from one global facility. In the US, the facility can cover short-term, commercial paper out to 30-year debt. The issuer sets up a shelf programme. When the programme is initially set up, relevant documentation is prepared to enable the issuer to issue a wide variety of different instruments in terms of:  

Maturity (e.g. from one week to ten years) Currency (sterling, US dollars, euro)

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 

Coupon (coupon-paying or zero coupon) Instrument (commercial paper, long-term bonds)

The implication of this is that the costs of setting up the programme are relatively high compared to the cost of a large international bond issue. However, the benefit is that the programme offers greater flexibility and lower cost to the issuer in the long run. As a result, it is more suitable for issuers who need funding flexibility over a period of time. In contrast, a large issuer might find a one-off large international bond issue more suitable.

3.14

Repos Definition A repurchase agreement (repo): An agreement between two counterparties under which one counterparty agrees to sell a quantity of financial instruments to the other on an agreed date for an agreed price, and simultaneously agrees to buy back the instruments from the counterparty at a later date for an agreed higher price. A repo is a loan secured by a marketable instrument, usually a treasury bill or a bond. The typical term is 1 – 180 days. A repo is an attractive instrument because it can accommodate a wide spectrum of maturities. The flows in a repo are shown in the following diagram. A repo is in effect a cash transaction combined with a forward contract. Repos can be:   

Overnight (one-day maturity transactions) Term (specified end date) Open (no end date)

In effect a repo is a short-term loan secured by a quantity of financial instruments, such as short-dated bonds and money market instruments. By selling securities and agreeing to buy them back at a higher price, an organisation is borrowing money and repaying it with interest at maturity. A reverse repurchase agreement (reverse repo) is an agreement for the purchase of financial instruments with the simultaneous agreement to resell the instruments at an agreed future date and agreed price. In a reverse repo, the dealer purchases the securities initially and then sells them back at maturity. Because the two parties in a repo agreement act as a buyer and a seller of the security, a repo to one party is a reverse repo to the other.

3.14.1

Use of repos Repos give buyers the chance to invest cash for a limited period of time, on a transaction where they receive collateral as security. Market liquidity and rates are generally good. Traders use repos to cover their positions and benefit from lower funding costs. The repo market is an important component of the overnight market.

3.15

Islamic bonds Islamic bonds or Sukuk are bond issues that satisfy Islamic principles and have gained Sharia approval. Western style bonds do not satisfy certain Islamic principles, in particular the prohibition of speculation and the payment of interest or any charge simply related to time. Though Islam frowns on speculation, it does approve of partnerships and risk sharing. Sukuk are based on partnership risk sharing ideas. When investing in such bonds, the Sukuk holder is effectively becoming a part owner of the asset being financed, sharing in profits it generates or losses it incurs. The arrangement is achieved through a special purpose vehicle (SPV) which buys the asset to be financed with the funds raised and acts on behalf of all the Sukuk investors. In any partnership there are at least two parties involved who may contribute capital, skill and effort, or both. With Sukuk, the parties are:  

Rab al Mal – provides capital Mudarib – provides skill and effort

The main types of issue are: 

Mudaraba Sukuk – This is the primary type of Sukuk contract where the SPV is the Rab al Mal and company needing finance is the Mudarib. In such an arrangement, all profits are shared as defined in the Sukuk contract, and all losses are absorbed by the Rab al Mal. As part of the contract it is normal for the Mudarib to contract to buy the financed asset at maturity in order to redeem the Sukuk holders. The result of this arrangement can be very similar to that of Western asset-backed bonds depending on how the profit-sharing arrangements are structured.

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3.16



Musharaka Sukuk – Where all parties contribute both capital and effort. All profits are shared as defined in the Sukuk contract, and all losses are absorbed in proportion to capital introduced. This is very dissimilar to Western bonds, since Western bond-holders would not expect to contribute anything other than capital.



Salam Sukuk – Has a structure similar to a short term zero-coupon bond which is achieved through a combination of spot and deferred payment sales.



Istisn'a Sukuk – Used in construction contracts where the profits are generated from rents received and the ultimate sale of the property constructed.



Ijara Sukuk – Has a structure similar to a leasing arrangement. This is the most common form of sukuk structure.

Leasing Rather than buying an asset outright, using either available cash resources or borrowed funds, a business may lease an asset. This method of financing is extremely popular with airlines (who typically lease their aircraft) and companies with car pools: it has also been used extensively in the printing industry.

3.16.1

Operating leases An operating lease is a lease where the lessor retains most of the risks and rewards of ownership. 

The lessor supplies the equipment to the lessee.



The lessor is responsible for servicing and maintaining the leased equipment.



The period of the lease is fairly short, less than the economic life of the asset. At the end of one lease agreement, the lessor can either lease the same equipment to someone else and obtain a good rent for it, or sell the equipment second-hand.

Most of the growth in the UK leasing business has been in operating leases.

3.16.2

Finance leases A finance lease is a lease that transfers substantially all of the risks and rewards of ownership of an asset to the lessee. It is an agreement between the lessee and the lessor for most or all of the asset's expected useful life. There are other important characteristics of a finance lease.

3.16.3



The lessee is responsible for the upkeep, servicing and maintenance of the asset.



The lease has a primary period covering most or all of the useful economic life of the asset. At the end of this period, the lessor would not be able to lease the asset to someone else, because the asset would be worn out. The lessor must therefore ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment.



At the end of the primary period the lessee can normally continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent, sometimes called a 'peppercorn rent'. Alternatively, the lessee might be allowed to sell the asset on a lessor's behalf (since the lessor is the owner) and perhaps to keep most of the sale proceeds.

Sale and leaseback Sale and leaseback occurs when a business that owns an asset agrees to sell the asset to a financial institution and then lease it back on terms specified in a sale and leaseback agreement. The business retains use of the asset and has the funds from the sale, but as a consequence has to pay rent in the future. Sale and leaseback arrangements are particularly appropriate for highly specialised assets that may have a low realisable value and therefore would be poor security for a more traditional loan.

3.16.4

Attractions of leasing Attractions include the following.



The supplier of the equipment is paid in full at the beginning. The equipment is sold to the lessor, and, apart from any guarantees, the supplier has no further financial concern about the asset.



The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease payments from the lessee. The lessor will also get capital allowances on his purchase of the equipment.

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

Leasing may have advantages for the lessee: –

The lessee may not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it. If so the lessee has to rent the asset to obtain use of it at all.

–

Finance leasing may be cheaper than a bank loan.

–

The lessee may find the tax relief available advantageous.

Operating leases have further advantages. 

The leased equipment and the related obligation do not have to be shown in the lessee's published statement of financial position, so the lessee's statement of financial position shows no increase in its gearing ratio.



The equipment is leased for a shorter period than its expected useful life. In the case of hightechnology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keep on using it. The lessor will bear the risk of having to sell obsolete equipment second-hand.

A major growth area in operating leasing in the UK has been in computers and office equipment (such as photocopiers) where technology is continually improving.

3.16.5

Lease or buy? The decision whether to lease or buy an asset involves two steps. 

The acquisition decision: Is the asset worth having? Test by discounting project cash flows at a suitable cost of capital.



The financing decision: If the asset should be acquired, compare the cash flows of purchasing against those of leasing or hire purchase arrangements. The cash flows can be discounted at an after-tax cost of borrowing.

The traditional method is complicated by the need to choose a discount rate for each stage of the decision. In the case of a non-taxpaying organisation, the method is applied as follows.

Step 1 The cost of capital that should be applied to the cash flows for the acquisition decision is the cost of capital that the organisation would normally apply to its project evaluations.

Step 2 The cost of capital that should be applied to the (differential) cash flows for the financing decision is the cost of borrowing. 

We assume that if the organisation decided to purchase the equipment, it would finance the purchase by borrowing funds.



We therefore compare the cost of borrowing with the cost of leasing (or hire purchase) by applying this cost of borrowing to the financing cash flows.

In the case of a tax-paying organisation, taxation should be allowed for in the cash flows, so that the traditional method would recommend:

Step 1 Discount the cash flows of the acquisition decision at the firm's after-tax cost of capital.

Step 2 Discount the cash flows of the financing decision at the after-tax cost of borrowing.

3.16.6

Other issues Once a company has made the decision to acquire an asset, the comparison of lease vs buy only needs to include the costs that differ; the costs that are common to each option need not be included. A disadvantage of the traditional approach to making a lease or buy decision is that if there is a negative NPV when the operational cash flows of the project are discounted at the firm's cost of capital, the investment will be rejected out of hand. However, the costs of leasing might be so low that the project

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would be worthwhile provided the leasing option were selected. This suggests that an investment opportunity should not be rejected without first giving some thought to its financing costs. Other methods of making lease or buy decisions are as follows. 



Make the financing decision first. Compare the cost of leasing with the cost of purchase, and select the cheaper method of financing; then calculate the NPV of the project on the assumption that the cheaper method of financing is used. Combine the acquisition and financing decisions together into a single-stage decision. Calculate an NPV for the project if the machine is purchased, and secondly if the machine is leased. Select the method of financing which gives the higher NPV, provided that the project has a positive NPV.

4 Bond markets 4.1

Sterling domestic market The sterling domestic bond market is for UK companies and non-UK companies wishing to issue sterling denominated bonds in the UK market, for sale predominantly to UK investors. Progressively the UK domestic market declined in importance since the 1970s. The growth of the international bond undermined its issuer base. In the case of the domestic debt market, the issuance level was never strong given the 'cult of equity' that has dominated the UK markets since the 1950s and led to one of the largest equity markets in the world. However, as government bond markets have declined, corporate issuance has risen. In the UK, the size of the corporate bond market is now greater than the size of the government debt market. There are a number of reasons for this change: 

Banks have come under increasing regulation and consequently have been less able to lend from their own balance sheets. It therefore makes sense for them to arrange debt issuance.



Companies have become increasingly concerned about the efficiency of their capital structure. Many firms have historically restructured their balance sheets by reducing the equity and increasing their debt.



Mergers and acquisition activity is further fuelling this need for new debt capital.



As government bond markets contract, the investment opportunities shrink. Investors are therefore compelled to take an interest in corporate debt. This also fits into the demographic trends currently affecting the pension industry. As the population gets older, pension funds will tend to move towards safer investment categories such as debt.



Within the Euroland bloc, the advent of the single currency has removed an element of risk (forex risk arising from cross-border investment) and therefore reduced reward. Consequently, investors are seeking extra reward by moving down the credit curve.



Individual Savings Accounts (ISAs) allow the creation of tax-free collective investment vehicles offering the enhanced returns that bonds offer over bank accounts without the risks of equity.

These factors have all come together in order to stimulate an increase in issuance. The secondary market in corporate bonds involves the buying and selling of bonds after the initial offering. The corporate bond secondary market is almost entirely an over-the-counter (OTC) market. Most trades are conducted on closed, proprietary bond-trading systems or by telephone. The individual investor will normally only be able to participate through a broker. Trading on unregulated OTC markets carries risks. Liquidity may be low. There may be a price disadvantage due to unfavourable price spreads. Brokers' commission must be taken into account. Consequently, the market is not particularly structured, with relatively little involvement of market makers. In 2010, the Order Book for Retail Bonds (ORB) was launched. Rather than constituting a separate market, ORB is a trading platform for gilts and corporate bonds listed on the London Stock Exchange.

4.2

International market The international bond market is an international market in debt. Companies issuing debt in the market have their securities traded all around the world and are not limited to one domestic market place. The market only accepts highly-rated companies, since international bonds are unsecured debt.

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Primary market bond issuance is through the process of placing. A large borrower will have a relationship with a number of bond ‘houses’ (investment banks specialising in bonds). The decision to issue can come either from the borrower who perceives the need for finance or from the issuing house who perceives that there is an opportunity to issue a reasonably priced bond into the market. Once the decision has been taken to issue a new security into the market place, the borrower will embark upon a process of negotiating with a number of bond houses. Another key decision to be taken is whether or not to list the bond on one of the various exchanges. Almost inevitably a bond will be listed, normally on either the London or Luxembourg Exchange. The reason for this is that certain institutions and investors by their trust deeds are prohibited from investing in securities that are not listed on a formal exchange. Consequently, if bond issuers did not seek a listing, then they would be restricting a demand for their stocks. A second reason for listing is that it will provide the stock with a fall-back should the international bond markets fail, since as they are listed on a domestic exchange they will be able to trade in that domestic market. There is no formal market place for international bond trading. The market is telephone driven (or, increasingly, driven by electronic trading platform) and the main bond houses for international bonds are based in London. The market is regulated by the International Capital Markets Association (ICMA), which operates rules regulating the conduct of dealers in the market place. Settlement is conducted for the market by two independent clearing houses, Euroclear and Clearstream. These clearing houses immobilise the stocks in their vaults and then operate electronic registers of ownership. Settlement in the Eurobond market is based on a T+3 settlement system. Once again, the important feature about the registers maintained by the two clearing houses is that they are not normally available to any governmental authority, thereby preserving the bearer nature of the documents. With the long-term economic difficulties experienced throughout the world since the global financial crisis in 2007-2008, the monetary policies of central banks in Europe have involved maintaining government bond yields at a very low level. Since 2009 the UK Bank of England has operated a policy of Quantitative Easing (QE): this involves buying bonds (mainly UK government bonds) from institutional investors and banks, which has the effect of creating money (and so stimulating the economy). QE has had the effect of keeping government bond yields very low. In the Eurozone, the European Central Bank has also kept bond yields low through bond purchases (although it has not adopted a QE policy). An effect of low government bond yields appears to have been to make corporate bond yields more attractive for both issuers and investors. Issuers can benefit from the low interest rates in the bond markets, and investors are able to obtain a higher yield on corporate bonds than on government bonds.

4.3 4.3.1

Bond markets in other countries USA The US government bond market is the largest in the world having expanded rapidly in the 1980s. This size is evident in both the quantity of issuance in the primary market and volumes of activity in the secondary market. The US Treasury is responsible for the issuance of new securities. Issuance takes place on a regular calendar with weekly issues of three or six-month Treasury bills, monthly issues of one-year bills and two and five-year notes, and quarterly issues in set cycles of longer dated stocks. Central to the operation of the secondary market in government bonds are the primary dealers. These firms are the market makers. They are authorised to conduct trades by the Federal Reserve (the Fed) and are obliged to make markets in all issues. As with the UK, there are inter dealer brokers (IDBs) to facilitate the taking and unwinding of large positions. There are no money brokers, but there is a full repo market. While the stocks are listed on the New York Stock Exchange, the market is effectively an overthe-counter market. The market has deep liquidity across the maturity range. Federal agencies are quasi-governmental institutions established to fill gaps in the US financial markets. They are backed by the guarantee of the US government via the Fed and are therefore riskless. However, they may well trade at a slight premium to the equivalent US government securities principally due to lower liquidity. The main Federal agencies are:     

Federal National Mortgage Association (FNMA) ('Fannie Mae')* Government National Mortgage Association (GNMA) ('Ginnie Mae') Federal Home Loan Mortgage Corporation (FMLMC) ('Freddy Mac')* Federal Home Loan Bank System (FHLB) Federal Farm Credit Bank (FFCB)

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* Have been de-listed by the Federal Housing Finance Agency (FHFA) and are currently in conservatorship. Conservatorship is a US equivalent of receivership in the UK, where new managers try to rescue a business in financial difficulties. Unlike the UK, the US corporate sector has been able to borrow substantial sums via the issue of debt securities. In part, this has been forced upon them by the highly fragmented nature of the domestic banking market. Equally, however, investors are willing to hold corporate debt as part of their portfolios in a way UK investors are not. A Yankee is a dollar-denominated bond issued in the US by an overseas borrower. Given that international dollar-denominated bonds may not be sold into the US markets until they have seasoned (a period of 40 days), there is still a divide between the international bond market and the domestic US bond market. Apart from the access to a different investor base, the market also allows issuers to raise longer term finance, since the American domestic investors are prepared to accept longer maturities. The US corporate bond market is very large and there is an active market in bonds with a low credit rating (even a non-investment grade credit rating â&#x20AC;&#x201C; â&#x20AC;&#x2DC;junk bondsâ&#x20AC;&#x2122;). Investors are willing to accept the higher risk of default by borrowers in order to earn higher yields on their investment. In the US, corporates are allowed to issue bonds into the private placement market without seeking full SEC registration. This access to the market is available to both domestic and foreign issuers, though the market is dominated by US domestic issuers who have chosen not to enter the public market. The buy side of the market is restricted to certain institutional investors (primarily insurance companies) who are predominantly 'buy and hold' investors. Reflecting the nature of the market as in effect a one-to-one contract, new issue terms are negotiated between the issuer and the lender. This process can take up to eight weeks to complete. Equally, as a consequence, borrowers tend to have to pay a premium over the public market yields. However, they do not have the cost of seeking a credit rating, nor are they bound by the rules of the SEC.

4.3.2

Japan The bond market in Japan is dominated by Government bonds. This domination is not in terms of volume, where Japanese Government Bonds (JGBs) account for only half of the market, but in the secondary market where they account for over 80% of the secondary market trading. The issue process is complex with a monthly auction/syndicate issue. JGBs trade on both the Tokyo Stock Exchange (TSE) and the Broker-Broker (OTC) market. The market tends to focus on the 'benchmark' issues, with occasionally 90% of the volume taking place in that stock. However, any issues that are deliverable into the JGB future will possess a fair degree of liquidity. In Japan, there are a number of important issuers other than the government. In the form of 'quasigovernment' there are the agencies and municipal stocks. International borrowers are able to access the domestic pool of savings through the issue of Samurai (publicly issued yen bonds) and Shibosai (yen bonds issued via private placement).

4.3.3

France The French bond market has developed into one of the key international bond markets, mainly due to the economic transformation that took place since the introduction of the 'Franc fort' policy in 1985. The development of MATIF (the French financial futures market, now part of Euronext) and the trading of the 'Notional' future into the French long bond were also a vital component in the reform of the market. The French Government issues three types of bond, each with a different maturity. All French Government issues are now in book entry form with no physical delivery. Over half the market is made up of debt issues from the public corporations. These stocks are not, for the most part, guaranteed by the Government, but the corporations concerned do possess strong credit ratings. They have established their own market structure in order to facilitate trading in their stocks. All issues are by way of a placing through a syndicate of mainly local banks.

4.3.4

Germany The German bond market, including Government bonds, domestic bonds and international bonds, is the third largest in the world and one of the largest in Europe (the second largest after Italy). Unlike the UK, Germany has a strong corporate debt market and a relatively weak equity market. The bulk of finance for industry is still provided through the banks, either as lenders or shareholders, with debt securities (other than international bonds) being less significant. Within the context of debt issuance, banks issue bonds and then lend on the money to the corporate sector.

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The bulk of the banking sector bond issuance comes in the form of Pfandbriefe. These are effectively bonds collateralised against portfolios of loans. Offenliche Pfandbriefe are backed by loans to the public sector and Hypotheken Pfandbriefe are backed by mortgages.

4.4

Islamic bond markets Sukuk markets are relatively new and are not yet as developed and standardised as Western markets. They were originated by government entities, particularly that of Malaysia, and government entities still dominate the market, though corporate issues are gaining in importance. Issuance is achieved in a similar manner to corporate bond issues in the UK, with investment banks underwriting and managing the issues. Sukuk other than the short-term Salam Sukuk are traded by being listed on stock exchanges, though liquidity levels are currently quite low and many issues are held to maturity.

5 Bond valuation and yields 5.1

Bond pricing Bonds can be priced at par, at a premium or at a discount. Like shares, the price of a bond will depend on the market forces of supply and demand; the demand for bonds from investors depends on the yield that they require on the bond. The required yield will depend on factors such as the coupon rate on the bond, the credit rating of the bond issuer and the period to redemption (the maturity) of the bond.

5.1.1

Zero coupon bonds The pricing of zero coupon bonds is actually quite straightforward as there is no need to use the annuity formula. All you have to do is calculate the present value of the redemption value at maturity.

5.2 5.2.1

Flat yield Calculation of the flat yield The simplest measure of return in the bond market is the flat yield. This is also referred to as the running yield or the interest yield. It looks at the cash return generated by an investment over the cash price. In simple terms, what is the income that you generate on the money that you invest?

5.2.2

Limitations of the flat yield This measure is of some use, particularly in the short term, but it has important drawbacks for the investment markets. 

With all equities and some bonds (e.g. floating rate notes), the return in any one period will vary. If the coupon is not constant, then the measure is only of historical value unless the predicted return is used.



In addition to the coupon flows, bonds will have return in the form of the payment at maturity (the ‘redemption monies’). Where the bond has been purchased at a price away from par, this will give rise to potential gains or losses arising from the difference between the purchase price for the bond and its redemption value.



The calculation completely ignores the time value of money. If an investor were to be offered the choice between the receipt of £10 now or in two years' time, the logical choice would be to take the £10 now, since the money could then be invested to generate interest.

These limitations combine to make the flat yield of marginal use only.

5.3 5.3.1

Gross redemption yield (yield to maturity) Problems with the gross redemption yield We have noted that the yield that has been calculated so far is in effect the internal rate of return (IRR) of the flows generated by a bond. As a measure of predicted return, the yield is limited, since it assumes that any coupon receipts are reinvested at the same rate as the current yield. If the investor is only able to reinvest the coupon at a lower rate, then the overall return generated by the bond will be lower than the yield.

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5.4

The relationship between bond prices and interest rates One of the fundamental correlations in bond markets is that as the interest rate rises and bond yields go up, the price of a bond will fall. When interest rates and bond yields fall, bond prices will rise. There is an inverse relationship between yield and price. This can be demonstrated either through the flat or the gross redemption yield. Suppose the flat yield was calculated as: 10 ď&#x201A;´ 100 = 10.283% 97.25 If the market interest rate were to rise to 12% then the holders of the bond would be encouraged to sell the bond and invest their money into assets yielding 12%. The result of this would be that the supply of the bond would rise and the demand fall, leading to a fall in the price. As the price falls to ÂŁ83.33, the yield rises to 12% thereby removing the incentive to switch out of the bond:

10 = 12% 83.33

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5.5 5.5.1

The yield curve What is the yield curve? The yield curve (Figure 13.2) is a graphical representation of the term structure of interest rates, where the yield offered by bonds is plotted against maturity. It is often calculated by reference to the gross redemption yield.

5.5.2

The shape of the curve (a)

Liquidity preference If an investor's money is invested in longer-term (and therefore riskier) debt, then they will require a greater return – a risk premium. Short-term liquid debt carries a lower risk and therefore requires a lower return. This gives rise to the normal upward sloping yield curve.

(b) Expectations theory Expectations theory states that the yield curve is a reflection of the market's expectation of future interest rates. If the market believes that the yield at the long end of the yield curve is high and is likely to fall, then in order to profit from the increase in prices that this will create, investors will buy long-dated stocks. As a result, the demand for these stocks will rise. This demand pressure will force the price to rise. As a consequence, the yield will fall, reflecting the expectation of a fall. On the other hand, if the market believes that rates will have to rise, then the forces will work in the opposite direction and this will lead to a fall in the price and a rise in the yield. Here, short-term rates are unusually high, but the market anticipates that this cannot last for long. The longer end of the market has anticipated this change by forcing yields down. This can lead to the anomalous situation where the long-end of the market remains constant because it has anticipated change and the short end (which is technically the least volatile) exhibits all of the movement. Another key element of the market's expectations will be the expectation of inflation. If the market believes that inflation will rise in the future then the yields on the longer dated stocks will have to rise in order to compensate investors for the fall in the real value of their money. The expectation of inflation is much more of a problem with the long – rather than the short – end. (c)

Preferred habitat and market segmentation Certain maturity ranges are appropriate to particular types of investors. In the UK, the short-end of the market is dominated by the financial sector maintaining a proportion of their assets in liquid investments, whereas the long-end is dominated by institutional investors such as pension funds. In effect, this gives rise to two markets and may be reflected in a discontinuity, or hump, in the yield curve.

(d) Supply-side factors The availability of debt in certain maturity ranges may lead to either an excess or shortage of debt and consequently an anomalous yield on some debt.

5.5.3

Yield curve and interest rates The yield curve on a range of long-dated bonds provides the best means of inferring market estimates of future interest rates. The steepness of the yield curve reflects market expectations about the change in forward rates.

5.6

Composition of the yield The yield on any bond is made up of a number of elements. 

The real return – This is the real rate of return that the investment has to earn. Effectively, it represents the opportunity cost of saving over immediate consumption.



Inflation premium – As inflation rises then the yield on a bond will have to increase in order to compensate the holder. Inflation is basically negative interest, eroding the value of savings, whereas interest adds to them.

Together, the real return and the inflation premium form the yield on government bonds and are therefore said to approximate to the interest rate. In the case of non-government bonds, the required return is a yield in excess of the risk-free rate (the rate obtainable on government bonds) to compensate investors for the additional investment risks:

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5.7 5.7.1



Credit and default risk – This is the risk of the issuer defaulting on its obligations to pay coupons and repay the principal. The ratings issued by commercial rating companies can be used to help assess this risk.



Liquidity and marketability risk – This is the ease with which an issue can be sold in the market. Smaller issues are particularly subject to this risk. In certain markets the volume of trading tends to concentrate into the 'benchmark' stocks, thereby rendering most other issues illiquid. Other bonds become subject to 'seasoning' as the initial liquidity dries up and the bonds are purchased by investors who wish to hold them to maturity.



Even if an issuer has a triple A credit rating and is therefore perceived as being at least as secure as the government, it will still have to offer a yield above that offered by the government due to the smaller size (normally) and the thinner market in the stocks.



Issue specific risk – eg risk of call. If the company has the right to redeem the bond early, then it will only be logical for it to do this if it can refinance at a lower cost. What is good for the issuer will be bad for the investor and, thus, the yield will have to be higher.



Fiscal risk – The risk that withholding taxes will be increased. For foreign bonds, there would also be the risk of the imposition of capital controls locking your money into the market.

Sensitivity to yield Introduction All of the risks of holding a bond come together in the yield. As we have already seen, there is an inverse relationship between the price of a bond and its yield. It is possible to define this relationship mathematically and predict the way in which a selection of bonds will perform. This is sometimes referred to as the volatility of the bond. The sensitivity of any bond to movements in the yield/interest rate will be determined by a number of factors.

5.7.2

Sensitivity to maturity Longer-dated bonds will be more sensitive to changes in the interest rate than shorter dated stocks.

5.7.3

Sensitivity to coupon Lower coupon stocks demonstrate the greatest level of sensitivity to the yield. It should be noted that the relationship between yield and price is not symmetrical. This is a relationship that is known as convexity.

5.7.4

The impact of the yield If yields are particularly high, then the flows in the future are worth relatively little and the sensitivity is diminished. Conversely, if the yield is low then the value of flows in the future is enhanced and the bond is more sensitive to the changing GRY. While these simple maxims are good indicators of the likely sensitivity to fluctuations in the rate of interest, they do not allow for two bonds to be directly compared. For example, which of the following is likely to be the more sensitive to a rise in interest rates – a high-coupon, long-dated stock, or a low- coupon, short-dated stock? In order to enable two such bonds to be compared, a composite measure of risk known as the duration can be used.

5.8 5.8.1

Duration What is duration? This calculation gives each bond an overall risk weighting that allows two bonds to be compared. In simple terms, it is a composite measure of the risk expressed in years. Duration is the weighted average length of time to the receipt of a bond's benefits (coupon and redemption value), the weights being the present value of the benefits involved. Example A bond pays interest at 6% and has four years remaining to redemption. It will be redeemed at par at this time. Investors in this bond require a yield of 8%. The market price of the bond is calculated as follows. Year 1 2 3 4

Cash flow 6 6 6 106

Discount factor at 8% 0.926 0.857 0.794 0.735

PV 5.56 5.14 4.76 77.91 93.37

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931 933

The duration of the bond is calculated as follows: (1 5.56)  (2  5.14)  (3 4.76)  (4 77.91)

= 3.66 years. 93.37 In this example, modified duration is 3.66/1.08 = 3.39 years. In this example, if the bond yield increases by 0.2% to 8.2%, the change in the bond price will be: –3.39 × 93.37 × 0.0020 = –0.63. The bond price will fall from 93.37 to 92.74. (There is some rounding in these figures, so the calculation is not exact.)

5.8.2

Properties of duration The basic features of sensitivity to interest rate risk will all be reflected by its measure of duration. 

Longer-dated bonds will have longer durations.



Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero-coupon bond where the duration will be the maturity.



Lower yields will give longer durations. In this case, the present value of flows in the future will rise if the yield falls, extending the point of balance, therefore lengthening the duration.

The duration of a bond will shorten as the life span of the bond decays. However, the rate of decay will not be at the same rate. For example a five-year bond might have a duration of 4.157 years. In a year's time the bond might have a remaining life of four years and a duration based on the same GRY of 3.480 years. The life span has decayed by a full year, but the duration by only 0.677 of a year.

6 Credit risk 6.1

Credit (default) risk Definition Credit risk, also referred to as default risk, is the risk for a lender that the borrower will default either on interest payments or on the repayment of principal on the due date, or on both.

6.1.1

Credit risk aspects Credit risk arises from the inability of the borrower to fulfil its obligation under the terms of a contract. Creditors to companies such as corporate bondholders and banks are exposed to credit risk. The credit risk of an individual loan or bond is determined by the following two factors: (a)

The probability of default This is the probability that the borrower or counterparty will default on its contractual obligations to repay its debt.

(b) The recovery rate This is the fraction of the face value of an obligation that can be recovered once the borrower has defaulted. When a company defaults, bond holders do not necessarily lose their entire investment. Part of the investment may be recovered depending on the recovery rate.

Definition Loss given default (LGD) is the difference between the amount of money owed by the borrower and the amount of money recovered. For example, a bond has a face value of £100 and the recovery rate is 80%. The loss given default in this case is: Loss given default = £100 – £80 = £20

Definition Expected loss (EL) from credit risk shows the amount of money the lender should expect to lose from the investment in a bond or loan with credit risk.

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If the probability of default is, say, 10%, the expected loss from investing in the above bond is: EL  0.10  20  £2 per £100 nominal value of the bond. For all bonds, regardless of their credit rating, the probability of default increases with the future time period covered. For example, the probability of default for a bond may be a 0.05% probability of default within the next two months, a 1.2% probability of default within two years, a 2.0% probability of default within the next three years, and so on.

6.1.2

Credit risk measurement The measurement of credit risk is quite complex. All the approaches concentrate on the estimation of the default probability and the recovery rate. The oldest and most common approach is to assess the probability of default using financial and other information on the borrowers and assign a rating that reflects the expected loss from investing in the particular bond. This assignment of credit risk ratings is done by credit rating companies such as Standard & Poor's, Moody's Investor Services or Fitch. These ratings are widely accepted as indicators of the credit risk of a bond. The table below shows the credit rating used by the two largest credit rating agencies. Standard & Poor's Moody's

Description of category

AAA

Aaa

Highest quality, lowest default risk

High quality

Upper medium grade quality

BBB

Baa

Medium grade quality

Lower medium grade quality

Speculative

CCC

Caa

Poor quality (high default risk)

Highly speculative

Lowest grade quality

S&P also use + and – symbols to refine their credit ratings. For example the credit ratings below AAA are AAA- and then AA+, AA, AA-, A+ and so on. The lowest ‘investment grade’ credit rating is BBB-. Moody’s uses the numbers 1, 2 and 3 to refine their credit ratings, for example Aa1, Aa2 and Aa3. Both credit rating agencies estimate default probabilities from the empirical performance of issued corporate bonds of each category. It would be very difficult for any company without a credit rating to raise money in bond markets, and the market itself is confined to dealing with high credit-worthy stocks exclusively in the investment grade. A bond may be placed on credit watch as a prelude to a potential downgrade. If a bond is placed on credit watch then it is likely that its credit spread will widen with the consequence of a fall in price. This impact is less pronounced for the higher rated (investment grade) bonds but becomes quite significant for non-investment grade bonds or those falling from investment grade to non-investment grade. The more a bond gets downgraded, the fewer investors will find it to be of interest. There are specialist high yield funds. However, as a general rule the major investors prefer the higher rated bonds. One big step is when a bond falls from investment grade to non-investment grade, or high yield. At this stage there tends to be many forced sellers, and prices can be expected to decline dramatically.

6.1.3

Credit migration There is another aspect of credit risk which should be taken into account when investors are investing in corporate bonds, beyond the probability of default. A borrower may not default, but due to changing economic conditions or management actions the borrower may become more or less risky than at the time the bond was issued. As a result, the bond issuer will be assigned by the credit agency a different credit rating. This is called credit migration. The significance of credit migration lies in the fact that the assignment of lower credit rating will decrease the market value of the corporate bond.

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6.2

Credit spreads and the cost of debt capital Definition Credit spread is the premium required by an investor in a corporate bond to compensate for the credit risk of the bond. The yield to a government bondholder is the compensation to the investor for forgoing consumption today and saving. However, corporate bondholders should require compensation not only for forgoing consumption, but also for the credit risk to which they are exposed. Assuming that a government bond such as the ones issued by the US or UK governments is free of credit risk, the yield on a corporate bond will be:

6.2.1

The cost of debt capital The cost of debt capital for a company will therefore be determined by the following:    

Its credit rating The maturity of the debt The risk-free rate at the appropriate maturity The corporate tax rate

7 Derivatives Definition A financial derivative is a financial instrument or contract with the following characteristics: 

Its value is based on (is derived from) the value of an underlying asset, such as a quantity of shares, bonds or foreign currency, or a bank deposit.



Its value changes in response to the change in the price of the underlying item, such as a change in the share price, currency exchange rate or interest rate.



It is a contractual agreement involving an agreement to buy or sell the underlying item, or to exchange payments based on the price of the underlying item.



Acquiring a financial derivative requires no initial net investment, or only a small initial investment. Most of the eventual receipt or payment occurs at a future settlement date for the instrument.



It is settled at a future date, specified in the agreement or contract creating the derivative.

In addition to financial derivatives, there are widely-traded derivatives in commodities such as oil, wheat and precious metals. At the heart of derivative products is the concept of deferred delivery. The instruments allow you, albeit in slightly different ways, to agree today the price at which you will buy or sell an asset at some time in the future. This is unlike normal everyday transactions. When we go to a supermarket, we pay our money and take immediate delivery of our goods. Why would someone wish to agree today a price for delivery at some time in the future? The answer is certainty. Imagine a farmer growing a crop of wheat. To grow such a crop costs money for seed, labour, fertiliser and so on. All this expenditure takes place with no certainty that, when the crop is eventually harvested, the price at which the wheat is sold will cover these costs. This is obviously a risky thing to do and many farmers are unwilling to take on this burden. How can this uncertainty be avoided? By using derivatives, the farmer is able to agree today a price at which the crop will ultimately be sold, in maybe four or six months' time. This enables the farmer to achieve a minimum sale price for his crop. He is no longer subject to fluctuations in wheat prices. He knows what price his wheat will bring and can thus plan his business accordingly. Derivatives may either be: 

Exchange-traded – i.e. where there is an active secondary market accessible to participants.



Off-exchange – i.e. contracts entered directly between counterparties on the over-the-counter (OTC) market.

Derivatives can be used for one of two purposes: 

Speculation – speculation involves trading in derivatives for the purpose of attempting to make a gain from a favourable movement in the price of the underlying item. A speculator will seek to

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make a large gain from a relatively small initial investment in the derivative instruments. 

7.1

Hedging – hedging involves using derivatives to reduce the market risk in an investment position (i.e. the risk of an adverse movement in the price of the underlying item).

Forward contracts A forward contract is an agreement off-exchange between two parties to make or take delivery of an asset for an agreed price at a future date. Because this is an 'over-the-counter' transaction between two parties (a company and its bank), all terms of the contract can be tailored individually to meet the buyer's and seller's needs. The key advantage of forwards is that they allow much greater flexibility to suit particular circumstances. The main disadvantages are a lack of liquidity in comparison to exchange-traded futures and increased credit risk for both buyer and seller, as there is no clearing house to act as a central counterparty. This is known as counterparty risk. The most common type of forward contract is the forward exchange contract.

7.2

Forward rate agreement (FRA) A forward rate agreement or FRA is an over-the-counter (OTC) agreement between a company and its bank that fixes a future short-term interest rate. For example, a 3v9 FRA fixes an interest rate for a period beginning at the end of the third month from the date the FRA agreement is made and ending at the end of the ninth month. So it is an agreement that fixes a six-month interest rate for a period starting in three months’ time. Similarly a 2v5 FRA fixes a three-month interest for a period starting in two months’ time. Essentially, the two counterparties agree upfront to exchange a fixed rate of interest for a floating rate of interest on a predetermined notional deposit of cash, for a specific period of time in the future. One party to the FRA agrees to pay a fixed interest rate on the deposit and in return receive interest at a variable rate (a benchmark or reference rate that is specified in the FRA agreement). The other party agrees to receive the fixed interest rate on the deposit and in return pay interest at the variable rate. For example in a 3v9 FRA, the benchmark variable rate may be the six-month Libor rate. One party to the FRA is a bank, and the fixed rate in the FRA is determined by the bank. An FRA is essentially a contract for difference (or CFD). Rather than actually exchanging the interest payments at the variable and fixed rates, an FRA is settled by a payment of the net amount by one party to the other. For example if the fixed rate in an FRA is 5.5% and the floating benchmark rate at settlement is 6.0%, the payer of the floating rate in the FRA will make a net payment to the other party for the difference between the fixed rate of 5.5% and the floating rate of 6%. Because an FRA is settled immediately, at the beginning of the notional interest rate period, the amount payable/receivable is discounted from its end-of-interest-period value to a present value as at the settlement date. 

Buying an FRA. The buyer of an FRA agrees to pay the fixed interest rate and receive the floating rate. Buying an FRA can fix the rate of interest on a future short-term loan. The FRA buyer will receive compensation when interest rates rise above the fixed FRA contract rate.



Selling an FRA will provide compensation when interest rates fall below the FRA contract rate. It protects an implied lender.

Example A company has a variable rate loan of £10 million from its bank at Libor + 1% and the fixing date for the next interest period is in six months’ time. The company is concerned about the prospect of an increase in interest rates in the next six months and so buys a 6v12 FRA from its bank on notional principal of £10 million. The fixed rate in the FRA is 5%. This will fix the company’s effective borrowing cost at 6% (5% + 1%). At settlement date for the FRA, which coincides with the fixing date for the bank loan, the six-month Libor rate might have risen to 7%. The company will have to pay interest at 8% on its bank loan. However it will receive compensation under the terms of the FRA for the difference between the FRA fixed rate of 5% and the Libor rate of 7% – i.e. 2%. The net cost of borrowing will therefore be 8% – 2% = 6%. Suppose instead that at settlement date for the FRA, the six-month Libor rate has fallen to 3.5%. The company will pay interest at 4.5% on its bank loan. However it will pay compensation under the terms of the FRA for the difference between the FRA fixed rate of 5% and the Libor rate of 3.5% – i.e. 1.5%. The net cost of borrowing will therefore be 4.5% + 1.5% = 6%.

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7.3

Futures A future is an exchange-traded agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today. They can be described as exchange-traded standardised forward contracts. There are two parties to a futures contract – a buyer and a seller – whose obligations are as follows.  

The buyer of a future enters into an obligation to buy the specified asset on a specified date. The seller of a future is under an obligation to sell the specified asset on a future date.

Futures contracts are traded on an exchange with the contract terms clearly specified by the rules of the exchange. The first futures market was established in the nineteenth century in Chicago. Futures based on the prices of agricultural commodities allow farmers to be sure of the profit they will receive from the commodities months in advance of the commodities being produced. The main derivatives exchange in the UK is NYSE Liffe: although some exchanges trade the same or similar contracts, most futures contracts are unique to the exchange that trades them. Financial futures are traded in currencies, interest rates, bonds, shares and stock indices. There are also a large number of commodity futures. The contracts are of a standardised size with standardised delivery dates. This means that it may not be possible to match the exact exposure one requires over the exact period for which it is required. For example, a requirement to buy €950,000 in exchange for US dollars using a currency future must be dealt with by buying eight contracts, since the contract size is €125,000 (€950,000/€125,000 = 7.6, which is eight contracts to the nearest whole number). Futures are traded on margin, meaning that the trader only has to spend a small amount of money, far below the value of the underlying security, to be exposed to the price rise or fall of that security. Margin is an amount of money deposited with the clearing house of the futures exchange, to cover any foreseeable losses on the futures position. Both buyers and sellers of futures deposit initial margin with the exchange when they make their transaction, and may subsequently be required to pay additional variation margin if they incur a loss on their futures position. A futures contract has a fixed settlement date, typically in March, June, September or December each year. Most trading in futures is in contracts with settlement dates within the next six months. 

Someone who buys futures opens a long position in the contract, and will make a gain if the market value of the contract rises. This long position can be closed at any time before settlement date by selling an equal number of the same contracts.



Someone who sells futures opens a short position, and will make a gain from any fall in the futures price. This short position can be closed at any time before settlement date by buying an equal number of the same contracts.



Positions that are still open at the settlement date for the contract are settled by the futures exchange at a settlement price decided by the exchange. This will be the current spot price for the underlying item in the contract.

Example A company may wish to sell £740,000 in two months’ time in exchange for US dollars. It could do this by arranging a forward contract with a bank. Alternatively it could deal in British pound futures. Each futures contract is for £62,500, so to sell £740,000 it would need to sell 11.84 contracts – i.e. 12 contracts. It might sell the contracts at a rate of, say, $1.5200 = £1, creating a short position of 12 futures contracts. After two months it will close the position by purchasing 12 contracts. Suppose the price to buy the contracts is $1.5050 = £1. It will make a gain on the futures dealing of $0.0150 per £1, or ($0.0150 × 62,500 × 12 contracts) = $11,250 in total. It will sell the £740,000 in the spot FX market, at whatever the spot price happens to be, and will receive $11,250 in profit from the futures exchange (which takes on responsibility for the settlement of all futures contracts). Futures markets are wholesale markets in risk – markets in which risks are transferred from the cautious to those with more adventurous (or reckless) spirits. The users fall into one of three categories – the hedger, the speculator and the arbitrageur – whose motivations are as follows:   

Hedger – someone seeking to reduce risk. Speculator – a risk-taker seeking large profits. Arbitrageur – seeks riskless profits from exploiting market inefficiencies (mispricing).

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7.4

Options An option is a contract that gives its holder/buyer the right, but not the obligation, to buy or sell an underlying asset at a given price (the exercise price or strike price) on or before a given date (the expiry date for the option). If the rights under the option agreement are not exercised by a stated time on the expiry date, the option lapses and cannot be exercised. The right to buy the underlying item at the exercise price is known as a call option. The right to sell the underlying item at the exercise price is known as a put option. The rights to buy (call) or sell (put) are held by the person buying the option who is known as the holder. The person selling an option is known as a writer. The following diagram shows the relationship between the holder and the writer. The purchase cost of an option is known as its premium. It is paid by the holder to the writer: the amount of the premium will depend on the perceived value of the option rights that the option buyer is acquiring. The holder is obliged to pay the premium to acquire the option, and the premium is payable even if the holder does not subsequently exercise the option. Depending on the option specification, the premium may be paid on the purchase of the option (upfront) or on exercise or expiry of the option (on-close). In return for receiving the premium, the writer agrees to fulfil the terms of the contract, and sell the underlying item at the exercise price if a call option is exercised, and buy the underlying item at the exercise price when a put option is exercised. The holder has to pay a premium because the holder can take advantage of the upside risk without exposure to the downside risk. Options are available in a range of different exercise styles which are specified when the options are traded. There are a number of potential styles: 

American style options – In which the option can be exercised by the holder at any time after the option has been purchased.



European style options – When the option can only be exercised on its expiry date.



Asian style options – When the option is exercised at the average underlying price over a set period of time. Similar to these are TAPOs (Traded Average Price Options). These are fixed strike price, but are exercised against an average underlying price.

A person describing an option will specify its:  Underlying asset  Expiry date  Exercise price  Call/put For example, Cocoa (Underlying asset) May (Expiry date) 600 (Exercise price) Call (Call/Put)

7.4.1

Exercising options The holder of a call option will exercise the option at (or before) expiry only if the exercise price for the option is more favourable than the current market price of the underlying asset. When the exercise price is more favourable than the market price of the underlying item, the option is said to be ‘in-the-money’. When the exercise price is less favourable than the market price of the underlying item, the option is said to be ‘out-of-the-money’. An option will not be exercised if it is out-of-the-money.

7.5



A call option will be exercised if the exercise price is less than the current market price of the underlying asset, because the option holder can use the option to buy the asset for less than its current market value.



A put option will be exercised if the exercise price is higher than the current market price of the underlying asset, because the option holder can use the option to sell the asset for more than its current market value.

Factors affecting option value The option premium is the price paid to buy an option, but the value of an option changes over time between its creation and its expiry date. The value of a call option at any time up to expiry depends upon:

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7.5.1



Current asset price. If the market price of the underlying asset rises, the value of a call option will increase. For currency options, the relevant 'price' is the spot exchange rate.



Exercise price of the option. The higher the exercise price, the lower the value of a call option.



Asset price volatility or standard deviation of return on underlying share. The higher the volatility in the market price of the underlying asset (i.e. measured statistically as a standard deviation) the higher the value of a call option, because there is more likelihood that the asset price will rise above the option price.



Time to expiry of the option. The longer the period to expiry, the higher the value of a call option because there is more time for the asset price to rise above the option’s exercise price.



Risk-free rate of interest. The higher the risk-free rate of interest, the higher the value of a call option. As the exercise price will be paid in the future, its present value diminishes as interest rates rise. This reduces the cost of exercise and thus adds value to the option.

Share options The widespread use of derivatives involving options has resulted in much attention being paid to the valuation of options for financial reporting purposes and for measuring profits or gains. Exchange-traded share options (equity options) are a common form of option, giving the right but not the obligation to buy or to sell a quantity of a company's shares at a specified price within a specified period. The value of an equity option is made up of:  

'Intrinsic value' 'Time value'

The intrinsic value of an option depends on:  

Share price Exercise price

If the option is in-the-money and the current market price of the underlying shares is higher than the exercise price of a call option on the shares, the intrinsic value of the option is the difference between the market price and the exercise price. If the option is out-of-the-money and the exercise price is higher than the current market price of the underlying asset, the intrinsic value of a call option is zero. The time value of an option is based on the probability that the option is affected by:   

7.6

Time period to expiry Volatility of the underlying security General level of interest rates

The Black-Scholes formula The Black-Scholes formula for the valuation of European call options was developed in 1973. (European options are options that can only be exercised on the expiry date, as opposed to American options, which can be exercised on any date up till the expiry date.) The formula is based on the principle that the equivalent of an investment in a call option can be set up by combining an investment in shares with borrowing the present value of the option exercise price. The formula requires an estimate to be made of the volatility in return on the shares. One way of making such an estimate is to measure the volatility in the share price in the recent past and to make the assumption that this volatility will apply during the life of the option. The formula is part of the wider Black-Scholes-Merton model, which models a financial market containing derivative investment instruments.

7.6.1

Assumptions of the Black-Scholes formula In order to incorporate volatility and the probabilities of option prices into the formula, the following assumptions are needed:    

Returns are normally distributed. Share price changes are log-normally distributed. Potential price changes follow a random formula. Volatility is constant over the life of the option.

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The Black-Scholes formula is also based on the following other important assumptions:     

7.6.2

Traders can trade continuously. Financial markets are perfectly liquid. Borrowing is possible at the risk-free rate. There are no transaction costs. Investors are risk-neutral.

Value of American call options Although American options can be exercised any time during their lifetime it is never optimal to exercise an option earlier. The value of an American option will therefore be the same as the value of an equivalent European option and the Black-Scholes formula can be used to calculate its price.

7.6.3

Value of American put options Unfortunately, no exact analytic formula for the value of an American put option on a non-dividendpaying stock has been produced. Numerical procedures and analytic approximations for calculating American put values are used instead.

7.6.4

7.6.5

Limitations of Black-Scholes formula (a)

The formula is only designed for the valuation of European call options.

(b)

The basic formula is based on the assumption that shares pay no dividends.

(c)

The formula assumes that there will be no transaction costs.

(d)

The formula assumes knowledge of the risk-free rate of interest, and also assumes the risk-free rate will be constant throughout the option's life.

(e)

Likewise the formula also assumes accurate knowledge of the standard deviation of returns, which is assumed to be constant throughout the option's life.

Accounting requirements The pricing of options using Black-Scholes must be considered in the light of the requirements of IFRS 13 Fair Value Measurement. The Black-Scholes formula contains assumptions that correspond to different levels of the IFRS 13 hierarchies. This is most likely to be an issue for volatility. Historical volatility, volatility derived from historical prices, would be classed as a Level 3 input. Historical volatility generally does not represent current market participants' expectations about future volatility. It may be possible to gain stronger, Level 2, evidence, for example by observing prices for options with varying terms and extrapolating from those.

7.7

Monte Carlo simulation model The Monte Carlo simulation model is widely used in situations involving uncertainty. It is particularly useful for non-traded derivatives, where the Black-Scholes formula is not appropriate. The method amounts to adopting a particular probability distribution for the uncertain (random) variables that affect the option price and then using simulations to generate values of the random variables. To deal with uncertainty the Monte Carlo method assumes that the uncertain parameters or variables follow a specific probability distribution. The basic idea is to generate through simulation thousands of values for the parameters or variables of interest and use these variables to derive the option price for each possible simulated outcome. From the resulting values we can derive the distribution of the option price. The Monte Carlo simulation model is particularly relevant for IFRS 2 Share-based payment. This Standard requires that share-based transactions are recognised in the financial statements at their fair value at the grant date. One of the major challenges of this statement is measuring the value of the equity instruments (such as share options). The statement requires such instruments to be included in the financial statements at fair value, which should be based on market prices if available. If market prices are not available, the Monte Carlo simulation model is often used to estimate the fair value of the instruments.

7.8

Swaps A swap is an OTC contract that commits two counterparties to exchange, over an agreed period, two streams of cash or commodities. The contract defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of cash flows involves the future

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values of one or more market variables. Examples of swaps include:

7.9



Interest rate – where the two payments exchanged are calculated using different interest rates.



Currency – where two streams of interest payments in different currencies are exchanged.



Equity – where one cash flow is based on a reference interest rate such as LIBOR, the other is based on the performance of an equity, a basket of equities or an equity index.



Commodity – where one party offers at a fixed single price a series of cash-settled future contracts which the other party will buy or sell at an agreed date. Cash settlement is calculated on the difference between the fixed price and the price of an agreed index for a stated notional amount of the underlying asset.



Credit swaps – discussed below.

Credit derivatives Definition Credit derivative: A derivative whose value is derived from the credit risk associated with an asset. The market in credit derivatives has increased substantially in size over the past ten years or so, in spite of the global financial crisis in 2007-2008. The industry has centred around London, which has global market share in excess of 40%. Participants in the credit derivatives market include commercial banks, investment banks, insurance companies, hedge funds, pension funds and other corporate entities. In its simplest form, a credit derivative is very similar to an insurance policy on an amount of debt. The buyer of the derivative pays a fee (in a lump sum or in periodic payments) to the seller. In return the seller undertakes to make a compensation payment to the buyer and if there is a default on the underlying debt. For example, an investor may buy a credit derivative on £5 million nominal value of a fixed rate bond issued by ABC plc. If ABC plc defaults on a payment of the bond before the expiry date of the credit derivative, the seller of the derivative must pay an amount in compensation to the buyer. The credit derivative is therefore a way of buying protection against the risk of default on a debt. It is also a way of speculating that the borrower, in this case ABC plc will default. An investor does not need to have lent any money to ABC plc in order to buy a credit derivative and speculate on default. This makes credit derivatives different from a traditional insurance policy. Credit derivatives are divided into two main categories: those which are funded and those which are unfunded. The funded instruments include credit linked notes and collateralised debt obligations. They are unique because the purchaser of the derivative is buying 'protection' and the cash flows from the underlying security together. In an unfunded credit derivative only the protection is purchased. One of the most important aspects of credit derivatives is to define exactly what situations will result in the 'insurance' policy being triggered. These are known as 'default events'. The International Swaps and Derivatives Association (ISDA) has defined five 'default events' within its ISDA 2003 Credit Derivatives Definitions: 

Bankruptcy – Reference entity voluntarily or involuntarily files for bankruptcy or insolvency protection.



Failure to pay or default – Failure of the reference entity to make aggregate payments due (at least USD 1 million) following a grace period.



Restructuring – Reference entity agrees to, or announces, a change in terms of an obligation (minimum USD 10 million) as a result of deterioration in the financial condition of the reference entity.



Repudiation/Moratorium – Any change in the owner status or independence of the asset or company is considered a credit event, as is any significant change in the asset ownership structure.



Obligation default – A situation where one or more obligations have become capable of being declared due and payable before they would otherwise have been due and payable.

If a credit event does take place the seller of the 'protection' will be contractually obliged to settle the transaction by either taking 'physical delivery' of the underlying asset from the buyer or via cash settlement which is paid to the buyer. An independent valuer will then assess the residual value of the reference asset with the difference between that value and nominal value being paid to the protection buyer.

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Another important aspect of credit derivatives is the pricing mechanism and how it changes as the credit quality of the underlying security changes. Market participants have developed models that track the credit rating of the underlying corporate and adjust the value of the derivative accordingly. As credit ratings rise, credit derivative values fall and vice versa. These credit transitions are pivotal to the effective valuing of the underlying derivative.

7.9.1

Credit default swaps Credit default swaps (CDSs) are the most common form of credit derivative. They are mostly based on a single asset. Effectively a purchase of a credit derivative is buying an insurance policy against a credit event, such as bankruptcy, that will affect the value of the underlying security. The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract (like an insurance premium), expressed as a percentage of the notional amount. The more likely the risk of default, the larger the spread. For example, if the CDS spread of the reference entity is 50 basis points (or 0.5%) then an investor buying $10 million worth of protection from a bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or the reference entity defaults Unlike insurance, however, CDS are unregulated. This means that contracts can be traded â&#x20AC;&#x201C; or swapped â&#x20AC;&#x201C; from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. Credit default swaps are often used to manage the credit risk that arises from holding debt. For example, the holder of a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond. CDS markets By the end of 2007, the CDS market was valued at more than $45 trillion â&#x20AC;&#x201C; more than twice the size of the combined GDP of the US, Japan and the EU. An original CDS can go through as many as 15 to 20 trades. Therefore, when a default occurs, the so-called 'insured' party or hedged party does not know who is responsible for making up the default or indeed whether the end party has the funds to do so. When the economy is booming, CDSs can be seen as a means of making 'easy' money for banks. Corporate defaults in a booming economy are few, thus swaps were a low-risk way of collecting premiums and earning extra cash. The CDS market expanded into structured finance from its original confines of municipal bonds and corporate debt and then into the secondary market where speculative investors bought and sold the instruments without having any direct relationship with the underlying investment. Their behaviour was almost like betting on whether the investments would succeed or fail.

7.9.2

Total return swaps A total return swap (TRS) is a type of swap in which one counterparty agrees to pay a floating reference rate such as LIBOR and in exchange will receive the total return, interest and capital gains, generated by an underlying asset. This transaction is specifically designed to transfer the credit risk and the market risk of an underlying security to the counterparty and effectively enables the party to derive an economic benefit from an underlying asset without actually buying it. Note that if the equity markets actually fell in value, the receiver of the LIBOR payments would be paying a negative amount of money to its counterparty. Hence the investor would actually be receiving money. Bond markets also have two types of return associated with holding bonds: the price return and the coupon. TRS are also increasingly popular in the credit derivatives market where the holder of a bond can not only swap the price exposure of a bond (based on coupon and price), but also the credit exposure can be swapped into the deal.

7.9.3

Credit spread swaps A credit spread swap allows firms to trade smaller shifts in a borrower's credit rating short of outright default. One party makes payments based on the yield to maturity of a specific issuer's debt and the other makes payments based on the yield on a comparable sovereign bond plus a spread reflecting the difference in credit ratings between the bonds. If the above two flows are equal at inception of the swap, any change in credit rating of the specified bond relative to the benchmark will result in a payment being made from one party to the other.

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This, like the total return swap, allows an investor to lock in a specific spread above a benchmark yield. One of the prime causes of the spread is the difference in credit rating between the corporate bond and the government bond. Variations could see a swap between yields on a specific bond above a benchmark and the yield between two other bonds, or a swap on the spread on one security above a benchmark with a spread on another security above a benchmark.

7.10

Collateralised debt obligations (CDOs) The overall market for asset-backed securities (ABS) is known as the Collateralised Debt Obligation (CDO) market, where the ABS shifts credit risk on a pool of homogenous assets.

Definition Collateralised debt obligation is an investment-grade security that is backed or collateralised by a pool of actual bonds, loans or other assets. CDOs are a common form of funded credit derivative. From the viewpoint of the issuer, a CDO is designed to remove debt assets (e.g. mortgages, loans or credit card receivables), and their associated credit risk, from an originator's balance sheet in return for cash. The originator is typically a bank, seeking to remove assets from its balance sheet â&#x20AC;&#x201C; either to reduce its regulatory capital requirements or to obtain more cash to make more loans. To achieve this, the assets (loans) are sold by the originator to a special purpose vehicle (SPV) for cash, the cash having been raised by the SPV through the issue of bonds to investors. The interest on the SPVâ&#x20AC;&#x2122;s bonds will be paid out of the cash flows from the debts that it has purchased from the originator. Buyers of the SPVâ&#x20AC;&#x2122;s bonds are therefore investing directly in a portfolio of banking assets (loans), but are not investing in the bank itself. The value of the CDO should be directly linked to the value of the underlying securities that are used to collateralise it. Interest payments from the underlying securities will effectively be passed through to the CDO holders. Buyers of collateralised instruments can also participate in collateralised mortgage obligations (CMOs) and collateralised bond obligations (CBOs), where the underlying assets held by the SPV are mortgage loans or bonds. One of the most attractive aspects of investing in a CDO is that the issuer will normally issue a range of different classes of CDO for a single pool of assets. These classes are known as tranches and are split according to a credit rating. The higher the credit rating, the more senior the tranche. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche pays a periodic payment (the swap premium), with the junior tranches offering higher yields.

7.10.1

Synthetic collateralised debt obligations Definition Synthetic collateralised debt obligation: An issued security like a CDO but instead of being backed by a pool of actual underlying assets it is backed by a pool of credit default swaps. As discussed above, the value of a credit default swap is derived from the credit rating of the underlying asset and is therefore only a representation of that asset and not the asset itself. The CDO is therefore synthetic, as it is made up of a pool of these manufactured credit exposures. From the issuer's viewpoint, the synthetic CDO acts to remove credit risk on assets that the issuer cannot or does not wish to sell. There may be adverse tax consequences from selling certain assets or legal restrictions on their sale, especially on certain foreign debt. A bank may not wish to sell a particular loan as it wishes to maintain a relationship with the client. Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. A synthetic CDO issues various tranches of security to investors as with a normal CDO, but then invests any cash raised in a high quality bond portfolio paying a safe, but low, return with minimal credit risk. They then boost this income by selling credit default swaps, thereby taking on the credit risk of the issuer's asset portfolio. In a synthetic CDO, frequently some of the investors have an unfunded exposure to the risk of the credit default insurance provided, ie they face exposure to the risk of the loss on an asset but have not contributed the associated capital which they may need to if the credit event arises. Arguably, the unfunded nature of many synthetic CDO structures has exacerbated the impact of debt defaults in a

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manner that would not arise with a funded CDO structure, thereby exaggerating the effects of the credit crisis.

7.11

Limitations of using derivatives It might be assumed that derivatives should always be used to hedge interest rate and foreign exchange rate risk. However in many instances organisations could have perfectly legitimate reasons for not using derivatives or forward contracts.

7.11.1

Cost Many organisations will be deterred from using derivatives by the costs, including transaction costs and possibly brokerage fees. Companies may feel that the maximum losses if derivatives are not used are too small to justify incurring the costs of derivatives, either because the size of transactions at risk is not particularly large, or because the risks of large movements in interest or exchange rates is felt to be very small. Using natural hedging methods, such as matching receipts and payments in the same currency as far as possible, avoids the costs of derivatives. Matching may be particularly important for countries trading in Europe with countries that use the euro.

7.11.2

Attitudes to risk The desirability of hedging must also be seen in the wider context of the organisation's strategy and its appetite for taking risks. For example, directors may be reluctant to pass up the chance of making exchange gains through favourable exchange rate movements. They may therefore choose the riskier course of not hedging, rather than fixing the exchange rate through a forward contract and eliminating the possibility of profits through speculation. There will also be occasions when a company’s treasurer takes the view that exchange rates or interest rates will move favourably rather than adversely; or that they will remain stable for the foreseeable future. In these circumstances, a decision may be taken that hedging the risk is unnecessary, and the company should wait until it needs to make the transaction before dealing at the spot rate at that time.

7.11.3

Uncertainty over payments and receipts There may not only be uncertainties over movements in rates. Uncertainties may also affect the amount and timing of settlement of the transactions being hedged. Uncertainties over timing may be particularly significant if the hedging transaction has to be settled on a specific date, for example an exporter having to fulfil a forward contract with a bank even if its customer has not paid.

7.11.4

Lack of expertise If a business is making a lot of use of derivatives, or using complex derivatives, the potential losses from poor decision-making due to lack of expertise may be unacceptably high. These must be weighed against the costs of obtaining specialist external advice or maintaining an in-house treasury function, in order to reduce the risks of poor management of hedging. For smaller companies with only limited knowledge of the derivatives markets, the lack of expertise will also mean that the time and effort required to get involved in derivatives is not worth the potential benefits, because the risks involved are not excessive.

7.11.5

Accountancy and tax complications The accounting complications of using derivatives may be significant. We look in detail at these accounting issues later.

8 Derivative markets 8.1

Markets Derivative products have developed out of a desire of users in the underlying markets to manage their continuing price exposure in those markets. The main derivatives markets are:      

Foreign exchange (FX) Money markets (short-term interest rate, or STIR, markets) Fixed income markets (Government and non-Government) Equity markets Commodity markets (e.g. crude oil, metals and soft commodities) Credit markets

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8.1.1

Floor versus voice versus electronic For the Exchange Traded Derivatives Markets (the 'ETD' markets), trading takes place both electronically and via open outcry, on centralised physical trading floors. The trend is towards more electronic market places with the evolution of technology and the desire for banks and brokerage to utilise the most costeffective trading platforms. Some market places adopt both. The OTC derivatives market, by contrast, does not have centralised trading floors. It consists of a combination of telephone brokering and electronic trading. Just like the ETD markets, the shift is towards electronic broking and trading.

8.1.2

Quote driven versus order driven For derivatives markets, price discovery is generated though two different types of market systems. A quote-driven market is one where prices are determined by designated market makers or dealers. This is sometimes described as a 'price driven' market. An order driven market is one where the buy and sell orders placed in the trading system result in the best bid price and lowest offer price, resulting in a transaction taking place. The difference between these two market systems lies in what is displayed in the market in terms of orders and bid and ask prices. The order driven market displays all bids and asks, while the quote driven market focuses only on the bids and asks of market makers and other designated parties. For example, NYSE Liffe, which is an organised ETD market, is a centralised, order-driven market on which continuous trading is supported by brokers. OTC derivatives trade via a combination of quote driven and order systems.

8.1.3

Price taker versus price giver All quote driven transactions around the world involve one participant providing a two-way price on request (a price at which the market maker is willing to buy and a price at which he is willing to sell). Clearly his sell price is higher. A perfect day's trading for a market maker is one where he has simultaneously entered into buy and sell orders throughout the day with matching volumes. At the end of the day, he will have earned the difference between the buy price and the sell price on the volume that he has traded. The market maker is known as the 'price giver.' His counterparty to the deals is known as the 'price taker'. The price giver will always aim to make a profit that is equal to the difference between the buy price and the sell price that he is quoting. The price taker (known as the 'client') must accept that he will always pay the higher price quoted when he is buying and sell to the lower price quoted by the market maker when he is selling. Central banks, investment banks, brokerage houses and insurance companies tend to be the typical price givers. Asset managers, corporations and private clients tend to be the typical price takers.

8.2

OTC v exchange-traded markets As discussed above, derivatives may either be exchange-traded (where there is an active secondary market accessible to participants) or be contracts entered directly between counterparties (on the overthe-counter (OTC) market).

8.2.1

Features of exchange trading Futures and option contracts are traded on an organised exchange in a centralised location. These exchanges are also regulated by the local regulatory bodies in each country and are described as 'Recognised Investment Exchanges' or RIEs. They charge a membership fee and levies on contracts traded to cover the operational costs of the business.

8.2.2

Features of OTC markets The process of agreeing an OTC transaction is normally conducted over the phone directly with the counterparty or via an inter dealer broker. Once verbally agreed the contract terms will be sent to each counterparty for confirmation. Historically, OTC derivatives have been time consuming and therefore expensive to process because each trade would be unique with different terms and conditions and therefore had to be confirmed individually, then settled and finally cash flows reconciled. However, the advent of technology and the semi-commoditisation of certain portions of the OTC derivatives markets has facilitated the introduction of several trade processing systems which are being used in the OTC market. These include MarkitWire, SwapClear and DTCC Deriv/Serv. OTC products can present considerable counterparty risk exposure. To minimise this risk, participants normally undertake a lengthy due diligence investigation of their counterparty to avoid entering into

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contracts that may be subject to default. There is also a growing use of central counterparty clearing services provided by LCH Clearnet, which accepts certain OTC contracts as intermediary, protected by a margining system. Credit risks are also minimised through the netting of cash flows in products such as interest rate swaps and, more broadly, by favouring products that are settled on a difference rather than by delivering the physical underlying. Counterparties to an OTC product are at risk if either the paperwork does not operate as envisaged in the case of a default, or if one party is acting in a capacity for which it is not authorised. The documentary risk is less intense than before as the International Swaps & Derivatives Association (ISDA) has produced a standard master agreement to cover most bilateral OTC derivatives transactions. Valuing OTC positions can be difficult. While exchange-traded markets provide daily mark to markets against authoritative settlement prices, many OTC products are valued by the issuing bank. This may not provide the objectivity required by many trustees and custodians.

8.3

Participants in markets For markets to operate in the most efficient and effective way possible (which is what market users are looking for), some market places require additional market participants to help with access, execution and clearing services. These market participants include: 

Intermediaries – Interdealer brokers (IDBs). These participants are the lifeblood of the OTC derivatives markets. They provide price discovery services and quotation for the buyers and sellers.



Prime brokers – These are brokers who act as settlement agents, provide custody for assets, provide financing for leverage, and prepare daily account statements for its clients, who are money managers, hedge funds, market makers, arbitrageurs, specialists and other professional investors. They often also offer securities lending services for their hedge fund clients.



Futures commission merchants (FCMs) – This is mostly a generic US term for an exchange traded clearing and/or execution broker. They must be registered by the CFTC in the US.



Execution broker – This is a brokerage corporation or individual who executes client orders on a derivatives exchange. Note: the execution and clearing broker could be the same company or be a separate company.



Clearing broker – This is a brokerage/bank who is normally a member of an organised derivatives exchange. They offer clearing and settlement services internally and to clients who execute transactions on a derivatives exchange.

9 Financial reporting and financial instruments The three accounting standards that currently apply to financial instruments, including derivatives, are:   

IAS 32: Financial Instruments: Presentation IAS 39: Financial Instruments: Recognition and Measurement IFRS 7: Financial Instruments: Disclosure.

IAS 39 is to be replaced by IFRS 9 Financial Instruments, and will be mandatory for accounting periods beginning on or after 1 January 2018. At the moment, you are required to know the provisions of IAS 39, and not IFRS 9.

9.1

IAS 39 and recognition of financial instruments A financial asset or a financial liability should be recognised in the statement of financial position when the reporting entity becomes a party to the contractual provisions of the instrument. For example, if a company takes out a forward contract to buy/sell an amount of currency at a future date, the contract is a financial derivative and should be recognised immediately, instead of waiting until the settlement date of the contract to recognise it in the accounts. IAS 39 defines four classes of financial asset and two classes of financial liability and every financial asset or liability must be allocated to one of these classes on initial recognition.

9.1.1

Initial measurement A financial instrument should initially be measured at cost. This is the fair value of the consideration given or received. With a forward contract, there is usually no initial cost because nothing is paid to arrange the contract, and there is no gain or loss to either counterparty to the transaction when the deal is first made.

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9.1.2

Subsequent measurement: fair value measurement IAS 39 requires that the value of financial instruments should be re-assessed at each reporting date. The method of re-assessment depends on the category of financial instrument. When the carrying value of a financial instrument is re-assessed at fair value, there will be a difference between its previous carrying value and its new carrying value (new fair value). This difference is a gain or loss, which must be accounted for. The method of accounting for the gain or loss on re-assessment of the carrying value depends on the class to which the financial instrument belongs, as shown in the following table. A company purchases a financial investment for £25,000 on 1 May 20X5. At the end of its financial year, on 31 December 20X5, the fair value of the asset is re-measured as £31,000. The asset is subsequently sold on 16 March 20X6 for £35,500.

9.1.3

(a)

If the asset is classified as an asset at fair value through profit or loss, a profit of £6,000 is recorded at 31 December 20X5 and the asset is re-valued to £31,000. A further profit of £4,500 is recorded in the following year when the asset is sold.

(b)

If the asset is classified as an available-for-sale financial asset, it is revalued to £31,000 on 31 December 20X5, and a gain of £6,000 is reported in other comprehensive income and taken to an ‘available for sale’ equity reserve. When the asset is sold in March 20X6, a profit of £10,500 is recorded. The ‘available for sale’ equity reserve is reduced by £6,000 and there is also a debit of £6,000 in other comprehensive income for 20X6, to avoid a double counting of the gain/profit of £6,000 that would otherwise occur.

Subsequent measurement: amortised cost When financial assets or liabilities are subsequently measured at amortised cost, the asset or liability is revalued at the end of each accounting period as follows. Example A company issues a two year bond on the first day of its financial year. The bond has a coupon rate of interest of 4% and interest is payable annually. The bond is issued at a price of £96.00 and will be redeemed at par. The effective rate of interest on the bond is 6.1875%. Year 1 2 Redeemed

Opening balance £ 96.00 97.94

Interest charge at 6.1875% (P&L) £ 5.94 6.06

Interest paid £ (4.00) (4.00)

Closing balance £ 97.94 100.00 (100.00) 0

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9.1.4

Financial reporting of derivatives: disclosure and measurement The presumption is that when a derivative financial instrument gives one party a choice over how it is settled, it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument. If a derivative is a financial asset, then it should be classified as a financial asset at fair value through profit or loss, being treated as a financial asset held for the purpose of selling in the short-term. If it is a financial liability, it will also be treated at fair value through profit or loss. According to its classification, a derivative should be measured at fair value, with any changes in fair value being taken to profit or loss. This applies both to derivatives that are financial assets or financial liabilities. Fair value will be preferably the quoted market price or the price at which the latest transaction occurred. If there is no active market for a particular financial instrument, fair value should be determined using a valuation technique. Such techniques could include recent market transactions, transactions in other shares or securities that are substantially the same, discounted cash flow models and option pricing models. The inputs to such models should be market based and not entity specific, that is they should incorporate data which market participants would use but should not take account of factors which are only relevant to the owner of the asset (such as strategic importance to it). Establishing a fair value for non-traded derivatives may be problematic. Their value will be very dependent on the assumptions used, particularly those relating to the timing and size of future cash flows. (a)

Disclosures For derivatives that are financial liabilities, the entity should disclose: 

The amount of change, during the period and cumulatively, in the fair value of the financial liability that is attributable to changes in the credit risk of that liability.



The difference between the financial liability's carrying amount and the amount the entity would be contractually required to pay at maturity to the holder of the obligation.



The valuation techniques and inputs used to develop fair value measurements (under IFRS 13).

(b) Alternative method IFRS 7 allows the employment of an alternative method to calculate the amount of change in the fair value attributed to credit risk if the entity believes that such a method is more accurate. Accounting for derivatives where the derivatives are used for hedging.

9.2

Assurance over fair values When a firm is engaged to undertake an assurance engagement over fair values of financial instruments (or in reviewing fair value measurements as part of an audit) the general principles and approach to assurance should apply. The general approach to an assurance exercise in relation to the valuation of financial instruments should be to: 

Establish the method or model that has been used for the valuation of the financial instrument(s)



Consider whether this selected model is suitable for the purpose of the valuation, i.e. whether the criteria selected for the valuation are suitable.

If the model and its criteria are considered suitable, evidence should be gathered relating to the variables that are used in the model. Evidence should be gathered from independent and verifiable sources. Values for each variable that are considered appropriate should be compared with the values that have been used in the client’s valuation of the financial instrument. If the values that have been used for each of the variables in the model are considered suitable and appropriate, the financial instruments should be valued using the model to assess whether the model has been used correctly by the client. This valuation should be compared to the client’s valuation. Reasonable assurance can be provided if the valuation obtained in the assurance exercise conforms in all material respects with the client’s valuation.

9.3

Embedded derivatives Certain contracts that are not themselves derivatives (and may not be financial instruments) include derivative contracts that are 'embedded' within them. An embedded derivative is a derivative instrument

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that is included within a different type of contract, known as the ‘host’ contract. An embedded derivative may be identified if contracts contain: 

Rights or obligations to exchange at some time in the future.



Rights or obligations to buy or sell.



Provisions for adjusting the cash flows according to some interest rate, price index or specific time period.



Options which permit either party to do something not closely related to the contract.



Unusual pricing terms (e.g. a bond which pays interest at rates linked to the FTSE 100 yield contains an embedded swap).

A key characteristic of embedded derivatives is that the embedded derivative cannot be transferred to a third party independently of the instrument. For example, a bond with a detachable warrant, which gives the right to the owner to exercise the warrant and buy shares while retaining the bond, is not a hybrid or combined instrument. The warrant is a separate financial instrument, not an embedded derivative. Examples of host contracts Possible examples include:     

A lease A debt or equity instrument An insurance contract A sale or purchase contract A construction contract

Examples of embedded derivatives Examples include: (a)

A term in a lease that provides for rent increases in excess of local inflation:

(b)

A convertible debenture, where an equity option (the option to convert the bond into shares in the issuing company) is included within a bond instrument. The call option element of a convertible bond gives the holder of the bond the right to exchange the bond for shares in the company.

(c)

A bond which is redeemable in five years' time with part of the redemption price being based on the increase in the FTSE 100 index.

(c) A construction contract priced in a foreign currency. The construction contract is a non-derivative contract, but the change in foreign exchange rate is the embedded derivative. Accounting treatment of embedded derivatives The host contract is accounted for in accordance with the relevant accounting standard, separately from the derivative. The embedded derivative should be separated from its host contract and accounted for as a derivative. The purpose is to ensure that the embedded derivative is measured at fair value and changes in its fair value are recognised in profit or loss. But this separation should only be made when the following conditions are met: (a)

The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract.

(b)

A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.

(c)

The hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (if changes in the fair value of the total hybrid instrument are recognised in profit or loss, then the embedded derivative is already accounted for on this basis, so there is no benefit in separating it out).

Example A company issues a convertible bond with a coupon rate of 3.5%. The nominal value of the bond is £10 million. The bond is redeemable at par after five years, or convertible into shares of the company at a conversion rate of 20 shares per £100 of bonds (nominal value). When the bonds are issued at a price of 98.50, it may be established that (applying the effective interest rate to the cash flows on the straight bond) the value of the bond as a ‘straight bond

950

is, say £8.4 million. This means that the initial value of – £8.4 million = £1.45 million.

the equity option (the conversion option) is £9.85 million

The bond will be accounted for using the amortised cost method. The equity option is accounted for separately as a financial liability at fair value through profit or loss.

9.4

Derecognition When a derivative is derecognised, the difference between the carrying amount and any consideration received should be recognised in profit or loss. Any accumulated gains or losses that have been recognised in other comprehensive income should also be reclassified to profit or loss on derecognition of the asset. Where a financial asset such as a bond is sold with a simultaneous agreement to buy it back at some future date at a specified price, the substance of the transaction is that the risks and rewards of ownership have not been transferred. In effect the proceeds of the sale are collateralised borrowing. The asset should continue to be recognised and the amount received recognised as a financial liability. Similarly the asset should not be derecognised if it is sold but there is a total return swap transferring the market risk exposure back to the entity selling the asset. For securitisations, whether the securitised assets will be derecognised depends on whether the SPV (special purpose vehicle) has assumed all the risks and rewards of the ownership of the assets and whether the originator has ceded control of the assets to the SPV. If the SPV is a mere extension of the originator and it continues to be controlled by the originator, then the SPV should be consolidated and any securitised assets should continue to be recognised in the group accounts. Securitisation will not in this case lead to derecognition. Even when the SPV is not controlled by the originator, the risks and rewards of ownership will not have passed completely to the SPV if the lenders to the SPV require recourse to the originator to provide security for their debt, or if the originator retains the risk of bad debts. For total return swaps, the originator is prohibited from derecognising the asset that it has transferred.

9.5

Accounting for equity Accounting for equity (share capital and reserves) follows the requirements of company law and accounting standards, and IAS 32 and IAS 39 do not contain many rules with regard to equity (with the exception of equity derivatives such as options). It may be useful however to note the accounting treatment of treasury shares – buy-backs of its own shares by a company, in the market or from shareholders. For example a listed company may buy back 100,000 of its own shares in the market at a price of £4.80 per share. These treasury shares must be accounted for. The basic rule is that no gain or loss must be recognised on the purchase or subsequent disposal or cancellation of treasury shares. The consideration paid for the shares should be recognised directly in equity. In the above, if a listed company buys back 100,000 of its own shares in the market at a price of £4.80 per share, the accounting entry should be to credit cash £480,000 and debit a Treasury shares account. In the statement of financial position, the balance on this account should be deducted from equity, and not included within assets.

9.6 Reporting on leasing arrangements The requirements of IAS 17: Leases, which you have studied previously, are summarised below.

9.6.1

Lessor accounting and disclosures

9.6.2

Lessee accounting and disclosures

9.6.3

Leasing: current developments

The distinction between classifying a lease as an operating lease or a finance lease has a considerable impact on the financial statements, most notably on indebtedness, gearing ratios, ROCE and interest cover. It is argued that the current accounting treatment of operating leases is inconsistent with the definition of assets and liabilities in the IASB's Conceptual Framework. The different accounting treatment of finance and operating leases has been criticised for a number of reasons. (a)

Many users of financial statements believe that all lease contracts give rise to assets and liabilities that should be recognised in the financial statements of lessees. Therefore these users routinely adjust the recognised amounts in the statement of financial position in an attempt to

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assess the effect of the assets and liabilities resulting from operating lease contracts. (b)

The split between finance leases and operating leases can result in similar transactions being accounted for very differently, reducing comparability for users of financial statements.

(c)

The difference in the accounting treatment of finance leases and operating leases also provides opportunities to structure transactions so as to achieve a particular lease classification. It is also argued that the current accounting treatment of operating leases is inconsistent with the definition of assets and liabilities in the IASB's Conceptual Framework. An operating lease contract confers a valuable right to use a leased item. This right meets the Conceptual Framework's definition of an asset, and the liability of the lessee to pay rentals meets the Conceptual Framework's definition of a liability. However, the right and obligation are not recognised for operating leases. Lease accounting is scoped out of IAS 32, IAS 39 and IFRS 9, which means that there are considerable differences in the treatment of leases and other contractual arrangements.

There have therefore been calls for the capitalisation of non-cancellable operating leases in the statement of financial position on the grounds that if non-cancellable, they meet the definitions of assets and liabilities, giving similar rights and obligations as finance leases over the period of the lease. An exposure draft of the IASB's proposals was issued in August 2010 and the draft was re-exposed in May 2013, taking into account criticisms of the original draft. Significant changes to the current standard included the following:

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(a)

The current IAS 17 model of classification of leases would cease to exist.

(b)

Lessees would no longer be permitted to treat leases as 'off-balance sheet' financing, but instead would be required to recognise an asset and liability for all leases within the scope of the proposed standard.

(c)

For leases currently classified as operating leases, rent expense would be replaced with amortisation expense and interest expense. Total expense would be recognised earlier in the lease term.

(d)

The proposed standard has two accounting models for lessors: (i)

Performance obligation approach. This is used by lessors who retain exposure to significant risks or benefits associated with the underlying asset.

(ii)

Derecognition approach. This is used by lessors who do not retain exposure to significant risks or benefits associated with the underlying asset.

Strategic Business Management CHAPTER 14

Financial structure and financial reconstruction 1 Capital structure 1.1

Introduction Often the decision on the right capital structure will be a complex one. Remember businesses do not just decide what the best mix of equity and debt should be. They also consider, among other factors, the mix of long-term and short-term debt, the attractiveness of different lenders and the security they wish to offer. The mix of finance for a business can be assessed using the suitability, acceptability and feasibility framework you studied in the Business Strategy syllabus.

1.2 1.2.1

Suitability of capital structure Stability of company One determinant of the suitability of the gearing mix is the stability of the company. It may seem obvious, but it is worth stressing that debt financing will be more appropriate when:       

1.2.2

The company is in a healthy competitive position Cash flows and earnings are stable or rising Profit margins are reasonable The bulk of the company's assets are tangible The liquidity and cash flow position is strong The debt-equity ratio is low Share prices are low (unless share prices are low because the company already has high gearing)

Matching assets with funds As a general rule, assets which yield profits over a long period of time should be financed by long-term funds. In this way, the returns made by the asset should be sufficient to pay either the interest cost of the loans raised to buy it, or dividends on its equity funding. If, however, a long-term asset is financed by short-term funds, the company cannot be certain that when the loan becomes repayable, it will have enough cash (from profits) to repay it. A company would not normally finance all of its short-term assets with short-term liabilities, but instead finance short-term assets partly with short-term funding and partly with long-term funding.

1.2.3

Long-term capital requirements for replacement and growth A distinction can be made between long-term capital that is needed to finance the replacement of worn-out assets, and capital that is needed to finance growth.

1.2.4

Signalling Some investors may see the issue of debt capital as a sign that the directors are confident enough of the future cash flows of the business to be prepared to commit the company to making regular interest payments to lenders. However, this depends on the view that market efficiency is not very high. The argument would be that an efficient market would have sufficient information to be able to make its own mind up about the debt issue, without needing to take the directors' views into account.

1.2.5

Clientele effect When considering whether to change gearing significantly, directors may take into account changes in the profile of shareholders. If gearing does change significantly, the company may adjust to a new riskreturn trade-off that is unsuitable for many shareholders. These shareholders will look to sell their shares, while other investors, who are now attracted by the new gearing levels, will look to buy shares.

1.2.6

Domestic and international borrowing If the company is receiving income in a foreign currency or has a long-term investment overseas, it can

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try to limit the risk of adverse exchange rate movements by matching. It can take out a long-term loan and use the foreign currency receipts to repay the loan. Similarly, it can try to match its foreign assets (property, plant etc) by a long-term loan in the foreign currency. However, if the asset ultimately generates domestic currency receipts, there will be a long-term currency risk. In addition, foreign loans may carry a lower interest rate, but the principle of interest rate parity suggests that the foreign currency will ultimately strengthen, and hence loan repayments will become more expensive. Euromarket loans also generally require no security and it may be easier to raise large sums quickly on overseas markets.

1.2.7

Cost and flexibility Interest rates on longer-term debt may be higher than interest rates on shorter-term debt. However, issue costs or arrangement fees will be higher for shorter-term debt as it has to be renewed more frequently. A business may also find itself locked into longer-term debt, with adverse interest rates and large penalties if it repays the debt early. Both inflation and uncertainty about future interest rate changes are reasons why companies are unwilling to borrow long term at high rates of interest and investors are unwilling to lend long term when they think that interest yields might go even higher.

1.2.8

Optimal capital structure and the cost of capital When we consider the capital structure decision, the question arises of whether there is an optimal mix of equity and debt that minimises the cost of capital, which a company should, therefore, try to achieve. One view (the traditional view) is that there is an optimal capital mix at which the average cost of capital, weighted according to the different forms of capital employed, is minimised. As gearing rises, so the return demanded by the ordinary shareholders also begins to rise in order to compensate them for the risk resulting from an ever increasing share of profits going to the providers of debt. At very high levels of gearing the holders of debt will begin to require higher returns too as they become exposed to risk of inadequate profits. As you may remember, the alternative view of Modigliani and Miller is that the firm's overall weighted average cost of capital is not influenced by changes in its capital structure. Their argument is that the issue of debt causes the cost of equity to rise in such a way that the benefits of debt on returns are exactly offset. Investors themselves adjust their level of personal gearing and thus the level of corporate gearing becomes irrelevant. If tax is included in the model, then it is in the company's interests to use debt finance, because of the tax relief that can be obtained on interest which causes the weighted average cost to fall as gearing increases. A further issue is tax exhaustion, that at a certain level of gearing, companies will discover that they have no taxable income against which to offset interest charges, and they therefore lose the benefit of the tax relief on the interest.

1.3 1.3.1

Acceptability of capital structure Risk attitudes The choice of capital structure will not only depend on company circumstances, but the attitudes that directors and owners have towards the principal risks. This will include the risks that are specific to the business, more general economic risks, and also the risks of raising finance. It could, for example, adversely affect the company's reputation if it made a rights issue that was not fully subscribed. Owner-director attitudes to risk may also differ. Owners will be concerned about the combination of risk and return. Directors may be concerned with the risk to their income and job security, but, on the other hand, significant profit incentives in their remuneration packages may encourage them to take more risks than the owners deem desirable. At very high levels of gearing, the firm may face costs arising from the possibility, or fear, of bankruptcy. As firms take on higher levels of gearing, the chances of default on debt repayments, and hence liquidation ('bankruptcy'), increase. Investors will be concerned over this and sell their holdings, which will cause the value of the company's securities to fall, with a corresponding increase in its cost of funds. To optimise capital structure, financial managers must therefore not increase gearing beyond the point where the cost of investor worries over bankruptcy outweighs the benefits gained from the increased tax shield on debt.

1.3.2

Loss of control The directors and shareholders may be unwilling to accept the conditions and the loss of control that obtaining extra finance will mean. Control may be diminished whether equity or loan funding is sought.

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1.3.3

(a)

Issuing shares to outsiders may dilute the control of the existing shareholders and directors. The company will be subject to greater regulatory control if it obtains a stock market listing.

(b)

The price of additional debt finance may be security, restricting disposal of the assets secured and covenants that limit the company's rights to dispose of assets in general or to pay dividends.

Costs The directors may consider that the extra interest costs the company is committed to are too high. However, the effective cost of debt might be cheaper than the cost of equity, particularly if tax relief can be obtained. The differing costs of raising finance may also be important.

1.3.4

Commitments The interest and repayment schedules that the company is required to meet may be considered too severe. The collateral loan providers require may also be too much, particularly if the directors are themselves required to provide personal guarantees.

1.3.5

Present sources of finance Perhaps it's easy to find reasons why new sources of finance may not be desirable. Equally, however, they may be considered more acceptable than drawing on current sources. For example, shareholders may be unwilling to contribute further funds in a rights issue. The business may wish to improve its relations with its suppliers, and one condition may be lessening its reliance on trade credit.

1.4

Feasibility of capital structure Even if directors and shareholders are happy with the implications of obtaining significant extra finance, the company may not be able to obtain that finance.

1.4.1

Lenders' attitudes Whether lenders are prepared to lend the company any money will depend on the company's circumstances, particularly as they affect the company's ability to generate cash and security for the loan. Companies with substantial non-current assets may be able to borrow more.

1.4.2

Shareholder willingness to invest If the stock market is depressed, it may be difficult to raise cash through share issues, so major amounts will have to be borrowed.

1.4.3

Future trends Likely future trends of fund availability will be significant if a business is likely to require a number of injections of funds over the next few years.

1.4.4

Restrictions in loan agreements Restrictions written into agreements on current loans may prohibit a business from taking out further loans, or may require that its gearing does not exceed specified limits.

1.4.5

Maturity dates If a business already has significant debt repayable in a few years' time, because of cash flow restrictions it may not be able to take out further debt which is repayable around the same time.

1.5

Pecking order theory Pecking order describes the order in which businesses will use different sources of finance. It contrasts with the view that businesses will seek an optimal capital structure that minimises their weighted average cost of capital. The order of preference will be:     

Retained earnings* Straight debt Convertible debt Preference shares Equity shares (rights then new issues)

* Note: A common error in exams is to refer to retained earnings as a source of finance when there may be no liquid resources in the business. Where retained earnings are referred to as a source of finance it

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needs to be made clear that, in the context of using retained profits for new investment, this refers to operating cash flows retained in the business rather than paid out as dividends.

1.5.1

1.5.2

1.5.3

Reasons for following pecking order 

It is easier to use retained earnings than go to the trouble of obtaining external finance and comply with the demands of external finance providers.



There are no issue costs if retained earnings are used, and the issue costs of debt are lower than those of equity.



Investors prefer safer securities, particularly debt with its guaranteed income and priority on liquidation.



Some managers believe that debt issues have a better signalling effect than equity issues because the market believes that managers are better informed about shares' true worth than the market itself is. Their view is the market will interpret debt issues as a sign of confidence, that businesses are confident of making sufficient profits to fulfil their obligations on debt and that they believe that the shares are undervalued.



By contrast the market will interpret equity issues as a measure of last resort, that managers believe that equity is currently overvalued and hence are trying to achieve high proceeds while they can.



The main consequence in this situation will be reinforcing a preference for using retained earnings first. However, debt (particularly less risky, secured debt) will be the next source as the market feels more confident about valuing it than more risky debt or equity.

Consequences of pecking order theory 

Businesses will try to match investment opportunities with internal finance, provided this does not mean excessive changes in dividend payout ratios.



If it is not possible to match investment opportunities with internal finance, surplus internal funds will be invested. If there is a deficiency of internal funds, external finance will be issued in the pecking order, starting with straight debt.



Establishing an ideal debt-equity mix will be problematic, since internal equity funds will be the first source of finance that businesses choose, and external equity funds the last.

Limitations of pecking order theory 

It fails to take into account taxation, financial distress, agency costs or how the investment opportunities that are available may influence the choice of finance.



Pecking order theory is an explanation of what businesses actually do, rather than what they should do.

Studies suggest that the businesses that are most likely to follow pecking order theory are those that are operating profitably in markets where growth prospects are poor. There will thus be limited opportunities to invest funds. These businesses will be content to rely on retained earnings for the limited resources that they need.

1.5.4

Behavioural theories A number of studies have suggested that businesses pursue rules of thumb or behaviour patterns.

1.6



The herd theory states that businesses will stick closely to the industry average capital structure. Of course the average may hide wide variations that are acceptable to different companies. However, there is evidence to suggest that companies that are significantly more highly geared than the industry average will have difficulty obtaining further debt finance.



Benchmarking occurs where businesses identify a leader in their market and adopt a similar capital structure. However, the capital structure that is appropriate for the market leader with the investment opportunities that it faces may not be appropriate for the less successful businesses in that industry.



Past experience may be an important influence. The argument is that managers are aware of the advantages and disadvantages of both equity and debt, and choose the source of finance that experience suggests will cause them few or no problems.

Cost of capital The importance of cost of capital cannot be emphasised enough in the formulation of financial strategy. It is used for discounting cash flows of potential projects, determining the type(s) of finance that companies should be using for investment purposes and so on. If the incorrect cost of capital is used, then sub-optimal decisions will be made regarding the projects that are undertaken and the way in which capital is structured.

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1.6.1

Cost of equity The cost of equity (ke) of a company is the same as the returns required by investors and can be calculated in several different ways: the dividend valuation model (covered in Chapter 12); the Gordon growth model; and the Capital Asset Pricing Model (CAPM).

1.6.2

Cost of debt The cost of debt is the return an enterprise must pay to its lenders. For irredeemable debt, this is the (post-tax) interest as a percentage of the ex interest market value of the loan stock (or preference shares). (a)

Cost of convertible debt This calculation will depend on whether conversion is likely to happen or not. If conversion is not expected, then the conversion value is ignored and the bond is treated as redeemable debt. If conversion is expected, the IRR method for calculating the cost of redeemable debt is used, but the number of years to redemption is replaced by the number of years to conversion and the redemption value is replaced by the conversion value (that is, the market value of the shares into which the debt is to be converted).

1.6.3

Weighted average cost of capital (WACC) WACC is calculated by weighting the costs of the individual sources of finance according to their relative importance as sources of finance. Two methods of weighting could be used: market value or book value. The general rule is that market value should always be used if data is available, as the use of historical book values may result in WACC being understated.

1.6.4

Effective interest rates The effective interest rate is the rate on a loan that has been restated from the nominal interest rate to one with annual compound interest. It is used to make loans more comparable by converting interest rates of individual loans into equivalent annual rates.

1.6.5

Uses of different costs of capital It is important to use the appropriate cost of capital in the right calculation. The relationship between equity beta and asset beta can be used to establish a cost of equity when an investment involves a significant change in the level of gearing or in the business risk for the investing company. You should be familiar with this technique from Financial Management, but a brief description is given later in this section.

1.7 1.7.1

Portfolio theory and CAPM Portfolio theory Modern portfolio theory is based around the premise that an investor will want to minimise risk and follows the 'do not put all your eggs in one basket' theory. Rather than holding shares in just one company â&#x20AC;&#x201C; and thus being exposed to the risks associated with that company in particular and its industry in general â&#x20AC;&#x201C; investors should prefer to hold shares in a combination of different companies in various industries. In this way, if the investor has invested in companies whose shares move in different ways in response to economic factors, risk will be reduced. By holding a portfolio of shares, investors can reduce unsystematic risk (which applies to individual investments) through diversification. Investors cannot diversify away systematic risk, which is due to variations in market activity such as macroeconomic factors.

1.7.2

CAPM We mentioned the CAPM above in relation to calculating the cost of equity. With regard to portfolio theory, the CAPM is used to calculate the required rate of return for any particular investment and is based on the assumption that investors require a return in excess of the risk-free rate to compensate them for systematic risk. For a portfolio of shares, the beta value will be the weighted average of the beta factors of all the securities in the portfolio.

1.7.3

CAPM and cost of capital The CAPM can be used to produce a cost of capital for an investment project, based on the systematic risk of that investment.

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1.7.4

CAPM and the cost of equity when financial risk or business risk changes One approach to establishing the cost of equity for an investment, when there will be a significant change in gearing or business risk as a result of the investment, is to estimate a new equity beta for the investment and, from this, an appropriate cost of equity. Example A company is considering a new investment by diversifying into a new business area. It considers that a comparable company in this new business area has an equity beta of 1.25 and a debt: equity ratio of 1:2. The company has a debt: equity ratio of 2:3, which it intends to maintain. The taxation rate is 20%. In order to establish a cost of capital for DCF appraisal of the project, the company needs to estimate an appropriate cost of equity. The first step is to calculate an asset beta:  2  1(1 – 0.20)  1.25  β 



  2   1.25 = 1.4 ßa ßa = 0.893 The next step is to calculate an equity beta for the company and the new business area of investment.  3  1(1 – 0.20)  β  0.893 e   3   ße = 1.37. a

This equity beta can be used with the CAPM to calculate a cost of equity for the investment, and a weighted average cost of capital can then be obtained, given the cost of debt and the company’s debt: equity ratio of 2:3.

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1.7.5

Limitations of CAPM Problems that have been identified with the Capital Asset Pricing Model as a method of calculating a cost of equity (or a cost of non-risk-free debt) include the following. (a)

The need to determine the excess return. Forecast, rather than historical, returns should be used, although historical returns are normally used in practice.

(b)

The need to determine the risk-free rate. A risk-free investment might be a government security. However, interest rates vary with the term of the lending.

(c)

Errors in the statistical analysis used to calculate  values.

(d)

Beta factors based on historical data may be a poor basis for future decision-making. Evidence from a US study suggests that stocks with high or low betas tend to be fairly stable over time, but this may not always be so.

(e)

Beta values may change over time, for example, if luxury items produced by a company become regarded as necessities, or if the cost structure (eg the proportion of fixed costs) of a business changes.

(f)

The CAPM is also unable to forecast accurately returns for companies with low price/earnings ratios and to take account of seasonal 'month-of-the-year' or 'day-of-the-week' effects which appear to influence returns on shares. Beta factors measured over different timescales may differ.

(g)

Financial managers should preferably use betas for industrial sectors rather than individual company betas, as measurement errors will tend to cancel each other out.

(h)

The CAPM fails to take into account the ways in which returns are paid. Investors may have a preference for dividends or capital gains.

Some experts have argued that calculating betas by means of complicated statistical techniques often overestimates high betas, and underestimates low betas, particularly for small companies. Sometimes equations are used to adjust betas calculated statistically, such as: Adjusted  = 0.5 (statistically calculated ) + 0.5 This sort of equation increases betas that are less than 1 and lowers betas higher than one.

1.7.6

Arbitrage pricing theory The CAPM specifies that the only risk factor that should be taken into account is the market risk premium. Subsequent empirical research has shown that there may be other factors in addition to market risk premium that explain differences in asset returns, such as interest rates and industrial production. Factor analysis is used to ascertain the factors to which security returns are sensitive. Four key factors identified by researchers have been:    

Unanticipated inflation Changes in the expected level of industrial production Changes in the risk premium on bonds (debentures) Unanticipated changes in the term structure of interest rates

Momentum is the concept that a stock that has recently performed well will continue to perform well. The theory of momentum appears to be inconsistent with the efficient market hypothesis, that an increase in share prices should not of itself warrant further increases. The existence of momentum has been explained by the irrationality of investors who underreact to new information.

2 Dividend policy 2.1

Relevance of dividend policy You covered the different views on the relevance of dividend policy in your earlier studies. The traditional view is that £1 of dividend income received now is more certain than £1 of capital gain in the future. Therefore, greater value would be put on a firm paying a dividend (and issuing shares to finance new investments) rather than one using retentions (ie cutting dividends). In contrast to the traditional view, Modigliani and Miller (MM) proposed that in a tax-free world, shareholders are indifferent between dividends and capital gains, and the value of a company is determined solely by the 'earning power' of its assets and investments. MM argued that if a company with investment opportunities decides to pay a dividend, so that retained earnings are insufficient to finance all its investments, the shortfall in funds will be made up by obtaining additional funds

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from outside sources. There are strong arguments against MM's view that dividend policy is irrelevant as a means of affecting shareholder's wealth.

2.1.1

Clientele In theory, a company should choose between dividend payout and earnings retention so as to maximise the wealth of its shareholders. However, not all shareholders are likely to have the same tax situation and after-tax cost of capital. Hence there might not be an optimum policy which satisfies all shareholders. The clientele effect suggests that investors have a so-called 'preferred habitat', ie the company's shares may represent a home for investors with specific investment needs. Research conducted on the clientele effect generally supports its existence. In the USA, Pettit (1977) confirmed that investors with relatively high marginal personal tax rates preferred low dividend shares. Such investors tended to be younger investors and those who were less than averagely risk-averse. The management implications of the clientele effect are that it is important to understand the investment needs of the investors in the company. Failure to meet the needs of clientele groups may cause disappointment with the company and hence the company's share price might suffer.

2.1.2

Signalling Dividends can be used to convey good (or bad) information. A firm that increases its dividend payout ratio may be signalling that it expects future cash flows to increase as this ratio tends to remain steady over time. Bad firms can also increase dividends to try to convince the markets that they too are expecting increased future cash flows. However, this increase may be unsustainable if the promised increases do not occur and the inevitable reduction in dividend payout ratio will mean heavy penalties from the markets.

2.1.3

Agency Dividend payments can be an instrument to monitor managers. When firms pay dividends they subsequently often need to go to the capital markets to fund new projects. When firms go to the financial markets they will be scrutinised by different market participants. For instance, investors will require an analysis of the creditworthiness of the firm. Therefore, if shareholders force managers to keep dividends high, as already stated, managers will have to go to the capital markets to obtain funding for new investments and have to justify the use they will make of the funds raised.

2.1.4

Life cycle Under this theory, a company's dividend policy will vary depending on the stage of the company's life cycle. A young, growing company with numerous profitable investment opportunities is unlikely to pay dividends as its earnings will be used for investment purposes. Shareholders should therefore have low or no expectations of receiving a dividend. More mature companies may have built up a sufficient surplus of cash to allow them to pay dividends while still being able to fund investments.

2.1.5

Pecking order Again, this is based on the impact that the amount of surplus cash paid out as dividends has on finance available for investment. Managers have a difficult decision here; how much do they pay out to shareholders each year to keep them happy, and what level of funds do they retain in the business to invest in projects that will yield longterm income? In addition, funds available from retained profits may be needed if debt finance is likely to be unavailable, or if taking on more debt would expose the company to undesirable risks. Myers (2004) argued that dividend policy is linked to capital gearing and the costs of the various sources of finance. It suggests that dividend policy is really part of a bigger cost of capital issue. In effect, companies will try to ensure that investments are funded by the cheapest means possible. This leads to management setting up a 'pecking order' in which funding is implemented, as we have seen earlier. The implications of pecking order theory on dividend policy are that it will depress the level of dividend payments simply because retained earnings are the cheapest form of finance.

2.2 2.2.1

Other influences on dividend policy Dividend capacity In most circumstances, companies must not make a distribution except out of profits available for that purpose. The dividend capacity of a corporation determines how much of a company's income can be paid out as dividend.

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2.2.2

Other factors Current and historical levels of dividend payments may be seen by investors as a guide to what future dividends are likely to be in the future. (For example, the dividend growth model may make use of the assumption that past trends in dividend growth are a guide to expected future dividend growth.) If a company enjoys a successful year of profits, it may want to increase the dividend, but for one year only and without giving shareholders an expectation that there will be another high dividend payment next year. In this situation, the company could:

2.2.3



declare a ‘special’ dividend for the year, indicating that this will not be repeated next year, or



instead of paying a dividend, buy back shares in the stock market. This will give a cash return to shareholders willing to sell shares in the market: it will also reduce the number of shares remaining in issue, which should increase the EPS (and dividends per share) in the future.

Taxation The payment of dividends may be complicated by the existence of different corporate and personal taxes and different rates for income and capital gains tax. If taxes on dividend income are higher than taxes on capital gains, companies should not pay dividends because investors require a higher return to companies that pay dividends. If payments are to be made to shareholders, the company should opt for other alternatives, such as share repurchases. This is true if taxes on dividend income are higher than taxes on capital gains. However, different investors have different tax rates. High tax rate individuals will prefer that the firm invest more, whereas low tax individuals may prefer that the firm does not invest and instead pay dividends.

2.3

Approaches to dividend policy The Modigliani and Miller argument that dividend policy is irrelevant should have led to a random pattern of dividend payments. In practice, dividend payments tend to be smoothed over time. Various explanations have been offered for this.

2.3.1

Residual theory of dividends According to this theory, firms will only pay dividends if all the profitable investment opportunities have been funded. This theory assumes that internal funds are the cheapest source of financing, and the company will resort to external financing only if the available internal funds, current and retained earnings have been exhausted. The disadvantage with applying the residual theory each year is that it will give rise to unstable dividends each year, as the level of investment opportunities varies. As a result, it should be used to determine a long-run target payout ratio, rather than the payout in any one year. Investment opportunities are forecast through time, the target capital structure is established and an achievable target payout ratio is identified from this. Large stable firms, eg utilities, have few investment opportunities. Therefore, they should have higher payouts. New firms in high-growth industries will have more investment opportunities. Therefore, they should retain more of their earnings and have lower payout ratios. If a residual dividend policy is applied rigorously, it might lead to fluctuating payouts from year to year. This might not be viewed favourably by shareholders if the implications of the clientele effect and signalling effect are borne in mind. Any uncertainty caused is likely to raise shareholders' required return.

2.3.2

Target payout ratio According to the target payout theory, companies pay out as dividends a fixed proportion of their earnings. Firms have long-run target dividend payout ratios, which are designed to reduce uncertainty. The implications of a target payout are as follows. (a)

Mature companies with stable earnings are likely to have a higher dividend payout ratio than growth companies.

(b)

Managers focus more on dividend changes than in absolute amounts.

(c)

Transitory changes in earnings usually do not affect dividend payouts. If extra payments are made because earnings in one year are particularly good, then the dividends will be designated as special dividends and there is no guarantee that they will be repeated.

(d)

Only long-term shifts in earnings can be followed by permanent changes in dividends.

(e)

Managers are reluctant to change dividend payout ratios due to the potential signals that such changes may send to the markets.

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In practice, Bray et al suggest that many companies will adopt an approach that is designed to be a compromise between a number of conflicting objectives:     

Invest in projects with positive net present values Do not cut dividends Avoid raising new equity Maintain a target debt to equity ratio Sustain a target dividend payout ratio

For example, if earnings fluctuate, a constant dividend payout ratio will result in a changing debt to equity ratio, since the level of dividends will change each year and will not be linked to total investment levels including debt. As a result the dividend payout ratio will not be constant, with dividend growth lagging behind earnings growth. Therefore the actual dividend policy followed by a company is less important than communicating that policy to investors and adhering to it.

2.4

Reconstruction schemes Reconstruction schemes are undertaken when companies have got into difficulties or as part of a strategy to enhance the value of the firm for its owners.

2.4.1

Reconstruction schemes to prevent business failure Not all businesses are profitable. Some incur losses in one or more years, but eventually achieve profitability. Others remain unprofitable, or earn only very small and unsatisfactory profits. Other companies are profitable, but run out of cash. 

A poorly performing company which is unprofitable, but has enough cash to keep going, might eventually decide to go into liquidation, because it is not worth carrying on in business. Alternatively, it might become the target of a successful takeover bid.



A company which runs out of cash, even if it is profitable, might be forced into liquidation by unpaid creditors, who want payment and think that applying to the court to wind up the company is the best way of getting some or all of their money.

However, a company might be on the brink of going into liquidation, but hold out good promise of profits in the future. In such a situation, the company might be able to attract fresh capital and to persuade its creditors to accept some securities in the company as 'payment', and achieve a capital reconstruction which allows the company to carry on in business.

2.4.2

Reconstruction schemes for value creation Reconstruction schemes may also be undertaken by companies which are not in difficulties as part of a strategy to create value for the owners of the company. The management of a company can improve operations and increase the value of the company by:   

2.4.3

Reducing costs through the sale of a poorly performing division or subsidiary. Increasing revenue or reducing costs through an acquisition to exploit revenue or cost economies. Improving the financial structure of the company.

Types of reconstruction Depending on the actions that a company needs to take as part of its reconstruction plans, these schemes are usually classified in three categories:

2.4.4



Financial reconstruction which involves changing the capital structure of the firm.



Portfolio reconstruction, which involves making additions to, or disposals from, a company's businesses, eg through acquisitions or spin-offs.



Organisational restructuring, which involves changing the organisational structure of the firm.

Designing reconstructions You can use the following approach to designing reconstructions.

Step 1

Estimate the position of each party if liquidation is to go ahead. This will represent the minimum acceptable payment for each group.

Step 2

Assess additional sources of finance, for example selling assets, issuing shares, raising loans. The company will most likely need more finance to keep going.

Step 3

Design the reconstruction. Often the question will give you details of how to do it.

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Step 4

Calculate and assess the new position, and also how each group has fared, and compare with Step 1 position.

Step 5

Check that the company is financially viable after the reconstruction.

In addition, you should remember the following points when designing the reconstruction. ď&#x201A;ˇ

Anyone providing extra finance for an ailing company must be persuaded that the expected return from the extra finance is attractive. A profit forecast and a cash forecast or a funds flow forecast will be needed to provide reassurance about the company's future, to creditors and to any financial institution that is asked to introduce new capital into the company. The reconstruction must indicate that the company has a good chance of being financially viable.

2.5

ď&#x201A;ˇ

The actual reconstruction might involve the creation of new share capital of a different nominal value to existing share capital, or the cancellation of existing share capital. It can also involve the conversion of equity to debt, debt to equity, and debt of one type to debt of another.

ď&#x201A;ˇ

For a scheme of reconstruction to be acceptable it needs to treat all parties fairly (for example, preference shareholders must not be treated with disproportionate favour in comparison with equity shareholders), and it needs to offer creditors a better deal than if the company went into liquidation. If it did not, the creditors would most likely press for a winding-up of the company. A reconstruction might therefore include an arrangement to pay off the company's existing debts in full.

Financial reconstructions A financial reconstruction scheme is a scheme whereby a company reorganises its capital structure, including leveraged buyouts, leveraged recapitalisations and debt for equity swaps. There are many possible reasons why management would wish to restructure a company's finances, such as when a company is in danger of being put into liquidation, owing debts that it cannot repay, and so the creditors of the company agree to accept securities in the company, perhaps including equity shares, in settlement of their debts. On the other hand, a company may be willing to undergo some financial restructuring to better position itself for long-term success.

2.5.1

Leveraged capitalisations In leveraged recapitalisation a firm replaces the majority of its equity with a package of debt securities consisting of both senior and subordinated debt. Leveraged capitalisations are employed by firms as defence mechanisms to protect them from takeovers. A high level of debt in a company discourages corporate raiders who will not be able to borrow against the assets of the target firm in order to finance the acquisition. In order to avoid the possible financial distress arising from a high level of debt, companies that engage in leveraged capitalisation should be relatively debt free, have stable cash flows and should not require substantial ongoing capital expenditure in order to retain their competitive position.

2.5.2

Debt for equity swaps A second way in which a company may change its capital is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt-for-equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt-holders to participate in the swap. After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class. One possible reason that a company may engage in debt-for-equity swaps is because the company must meet certain contractual obligations, such as maintaining a debt/equity ratio below a certain number. Also a company in financial difficulty may persuade investors in its debt to accept equity in exchange for debt, as part of a financial reconstruction scheme: the company might otherwise default on interest payments due to lack of cash.

2.5.3

Other methods of refinancing Refinancing a loan or a series of loans might help companies to pay off high interest debt and replace it with lower interest debt. Alternatively, debt can be replaced with more flexible debt, having perhaps a longer term to maturity or fewer restrictive covenants. As well as reducing interest payments, companies may refinance to reduce the risk associated with an existing loan. For example, rather than having a variable rate loan, companies may switch to a fixed rate loan, which will eliminate the uncertainty of how much interest will have to be paid in any particular month.

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11 11

2.5.4

Dividend policy A company may change its dividend policy as part of financial restructuring and increase retained earnings and therefore its equity base.

2.6

Financial reconstruction and firm value The impact of a financial reconstruction scheme on the value of the firm can be assessed in terms of its effect on the growth rate of the company, its risk and its required rate of return.

2.7

Effect on growth rate The impact of changes in financial policy on the value of a firm can be assessed through the formula we used when assessing dividend policy.

2.8

Financial reconstruction and assurance When a company proposes a scheme of reconstruction, some investors in the company will usually be offered less attractive terms. Investors in the company’s debt may be asked to swap debt into equity, or to agree to deferral of the redemption date for the debt. Investors may be unwilling to agree to the reconstruction terms offered unless they have reasonable confidence in the ability of the company to survive and recover in its reconstructed form. The company’s management may therefore engage an accountancy firm to provide its investors with assurance about the financial forecasts that management have prepared. Assurance engagements on financial forecasts are discussed in relation to the going concern assumption and financial reporting.

2.9

Refinancing Definition Refinancing: The replacement of existing finance with new finance. Typically when existing debt matures and reaches its redemption date, new debt is issued and the proceeds from the new issue are used to redeem the maturing debt.

2.9.1

Refinancing to reduce interest payments Refinancing can be undertaken at relatively small levels – such as individuals refinancing a mortgage – or at a high level involving companies refinancing multi-million pound debts. Whatever the level, the aim is often to reduce costs, normally interest payments, by switching to a loan with a lower interest rate or by extending the period of the loan. The money saved might be used to pay off some of the principal of the loan, which can reduce payments even further.

2.9.2

Refinancing to reduce risk As well as reducing interest payments, companies may refinance to reduce the risk associated with an existing loan. For example, rather than having a variable rate loan, companies may switch to a fixed rate loan, which will eliminate the uncertainty of how much interest will have to be paid in any particular month. This might be particularly useful for small businesses that are just starting up as they face a great deal of risk anyway and any opportunities to reduce risk should be welcomed.

2.9.3

Refinancing to pay off debts Refinancing a loan or a series of loans might help companies to pay off high interest debt and replace it with lower interest debt. Alternatively, debt can be replaced with more flexible debt having perhaps a longer term to maturity or fewer restrictive covenants. Individuals are often urged to do this via advertisements urging them to consolidate their debts into one debt. Non-tax deductible debt might be replaced by tax-deductible debt, thus allowing the borrower to take advantage of tax deductions as well as potential reductions in interest payments.

2.9.4

Issues to be aware of when thinking about refinancing Although refinancing may appear to be an attractive option, there may be some problems. Some loans have penalty clauses that come into play if the loans are paid off early, whether partially or in full. In addition, there are usually closing and transaction fees associated with refinancing a loan. By the time penalty clauses and other fees are taken into consideration, they may actually outweigh the savings being made. Therefore, refinancing should only be considered as a source of finance if the short-term or long-term savings are likely to be substantial.

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Depending on the type of loan used to refinance existing debt, lower initial payments may give way to larger total interest costs over the life of the loan. The borrower might also be exposed to greater risks than the existing loan. It is therefore vital that any upfront, variable and ongoing refinancing costs are researched thoroughly before deciding whether to refinance existing debt.

2.10 Securitisation Securitisation is the process of converting illiquid assets or a future revenue stream into marketable securities. When a portfolio of assets is securitised, the newly-issued debt securities are called asset-backed securities (ABS). When a bank securitises a portfolio of mortgage loans, the new securities are called mortgage-backed securities (MBS). Securitisation started with banks converting their long-term loans (such as mortgages) into securities and selling them to institutional investors. One of the problems of banks as financial intermediaries is the fundamental mismatch between the maturities of assets and liabilities. Securitisation of loans and sale to investors reduces the mismatch problem and a bank's overall risk profile. Banks have also been subject to rules for maintaining a minimum amount of capital in relation to their risky assets: these are known as capital adequacy rules. By selling mortgages and other loans through securitisation, banks were able to reduce the amount of capital they were required to hold. Securitisation of bank loans was also attractive to investors who might prefer to invest in the loans themselves rather than in the shares of a bank. It is also possible to securitise a future income stream, such as the future revenues from an oil field (oil companies), or the future income from the sale of football season tickets (football clubs). In a typical ABS transaction, the first step is to identify the underlying asset pool or revenue stream that will serve as collateral for the new securities. The assets in this pool should be relatively homogeneous with respect to credit, maturity, and interest rate risks. Common examples of ABS, as well as mortgage loans and corporate loans, include credit card receivables, trade receivables, and car loans. Once a suitably large and homogenous asset pool is identified, the pooled assets are sold to a trust or other bankruptcy-remote, special purpose financing vehicle (SPV). 

The owner of the assets (or future revenue stream) sells the assets or future revenues to the SPV.



The SPV pays for the assets or revenue with money raised from issuing debt securities. (The SPV has minimal equity.) The debt securities are issued in different classes or ‘tranches’, each with a different maturity, interest rate and credit rating. The securities are purchased by investors, typically institutional investors.



The income from the assets or the revenue stream is then used to pay interest to the holders of the SPV securities, and to redeem these securities at maturity.



When a bank securitises a portfolio of assets, it may continue to collect the payments on the loans, as administrator for the SPV, and will remit the money to the SPV after deducting a fee for its services.

The development of securitisation has led to disintermediation and a reduction in the role of financial intermediaries as borrowers can reach lenders directly.

Definition Disintermediation describes a decline in the traditional deposit and lending relationship between banks and their customers and an increase in direct relationships between the ultimate suppliers and users of financing.

2.11 Legal consequences of financial distress You will recall from your law studies that directors have to be very careful if their company gets into financial difficulties. Carrying on trading for too long before taking action may mean that they are guilty of fraudulent or wrongful trading.

2.11.1 Fraudulent and wrongful trading The criminal offence of fraudulent trading occurs under the Companies Act 2006 where a company has traded with intent to defraud creditors or for any fraudulent purpose. Offenders are liable to imprisonment for up to ten years or a fine (s 993). There is also a civil offence of the same name under s 213 of the Insolvency Act 1986 but it only applies to companies which are in liquidation. Under this offence courts may declare that any persons who were knowingly parties to carrying on the business in this fashion shall be liable for the debts of the company.

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13 13

Various rules have been established to determine what is fraudulent trading. (a)

Only persons who take the decision to carry on the company's business in this way or play some active part are liable.

(b)

'Carrying on business' can include a single transaction and also the mere payment of debts as distinct from making trading contracts.

(c)

It relates not only to defrauding creditors, but also to carrying on a business for the purpose of any kind of fraud.

Directors will be liable for wrongful trading if the liquidator proves the following. (a)

The director(s) of the insolvent company knew, or should have known, that there was no reasonable prospect that the company could have avoided going into insolvent liquidation.

(b)

The director(s) did not take sufficient steps to minimise the potential loss to the creditors. Directors have an obligation in these circumstances to maximise creditors' interests.

The website www.companyrescue.com lists a number of tests for wrongful trading, including:     

Not filing accounts or annual returns at Companies House. Not operating tax schemes correctly, building up arrears with the taxation authorities. Taking excessive salaries when the company cannot afford them. Taking credit from suppliers when there is no realistic prospect of paying the creditor on time. Piling up debt.

The website also provides advice for companies that are in trouble:

2.12



Don't wait until legal actions have been taken against the company to ask for a time to pay deal.



Try to plan cashflows in advance, as directors have a legal obligation to meet cash flow requirements.



Don't be too ambitious in planning repayment.



Seek legal advice if worried about legal actions.



If cash flow projections say the repayment cannot be afforded that quickly, seek a means of continuing the company, such as a company voluntary arrangement in the UK.

Management of companies in financial distress We now look further at the arrangements for managing companies that apply under the most common procedures, administration and a company voluntary arrangement.

2.12.1

Administration In an administration the powers of management are subjugated to the authority of the administrator and managers can only act with his consent. The administrator will set out proposals for achieving the aim of administration or set out why it is not reasonable or practicable for the company to be rescued. If the company is to continue, the administrator may do anything necessarily expedient for the management of the affairs, business and property of the company. Administrators have the same powers as those granted to directors and the following specific powers to:     

2.12.2

Remove or appoint a director. Call a meeting of members or creditors. Apply to court for directions regarding the carrying out of his functions. Make payments to secured or preferential creditors. With the permission of the court, make payments to unsecured creditors.

Company voluntary arrangement (CVA) Under a CVA directors retain control of the company (albeit under supervision). A CVA allows the directors to continue to manage the company – they set out their terms in the proposal for the CVA that is put to creditors. An insolvency practitioner acting as nominee will decide whether the proposal is:    

Fit to be put to the creditors Fair Feasible, ie has a real prospect of implementation An acceptable alternative to liquidation or other formal insolvency processes

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The directors must establish that trading on will be viable and should be warned of the risks of wrongful trading. Consequently, they should take the following steps.

2.13



Ensure adequate funding available.



Prepare cash flow forecasts, a business plan and projections. They must show that both ongoing trading is viable and that dividends to creditors shown in the proposal are likely to be paid.



Obtain independent confirmation from the bank that it will support the proposal and continue to provide funding.



Consider other sources of funds.



Investigate whether the directors have the support of management, staff, key suppliers and customers.



Consider whether any major contracts with customers give the right to terminate if the company is in an insolvency procedure.

Corporate reporting consequences Going concern means that an entity is normally viewed as continuing in operation for the foreseeable future. Financial statements are prepared on the going concern basis unless management either intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. IAS 1 Presentation of Financial Statements makes the following points: 

In assessing whether the entity is a going concern management must look at least twelve months into the future measured from the end of the reporting period (not from the date the financial statements are approved).



Uncertainties that may cast significant doubt on the entity's ability to continue should be disclosed.



If the going concern assumption is not followed that fact must be disclosed together with: – –



The basis on which financial statements have been prepared The reasons why the entity is not considered to be a going concern

IFRSs do not prescribe the basis to be used if the going concern assumption is no longer considered appropriate. A liquidation or breakup basis may be appropriate, but the terms of the insolvency arrangement may also dictate the form of preparation.

When making the judgement of whether the going concern basis is not appropriate, the following indications taken from International Standard on Auditing, ISA 570 Going Concern may be significant: (a)

Financial indicators, e.g. recurring operating losses, net liability or net current liability position, negative cash flow from operating activities, adverse key financial ratios, inability to obtain financing for essential new product development or other essential investments, default on loan or similar agreements, arrears in dividends, denial of usual trade credit from suppliers, restructuring of debt, non-compliance with statutory capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets.

(b)

Operating matters, e.g. loss of key management without replacement, loss of a major market, key customers, licence, or principal suppliers, labour difficulties, shortages of important supplies or the emergence of a highly successful competitor.

(c)

Other matters, e.g. pending legal or regulatory proceedings against the entity, changes in law or regulations that may adversely affect the entity; or uninsured or underinsured catastrophe such as a drought, earthquake or flood.

In relation to going concern, IAS 10 Events After the Reporting Period states that, where operating results and the financial position have deteriorated after the reporting period, it may be necessary to reconsider whether the going concern assumption is appropriate in the preparation of the financial statements.

2.14

Assurance work and the going concern assumption You should be familiar with the requirements of ISA 570 Going Concern that auditors need to consider whether there are events or conditions that may cast significant doubt on the going concern assumption. The auditor should evaluate any management assessment of the company's ability to continue as a going concern. If there are doubts the auditor should evaluate plans for future actions and any cash flow forecasts. Additional procedures such as review of cash flow and profitability, loan and financial support terms, operating capability and possible legal action may be required.

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15 15

In addition, auditors may have to carry out assurance work to reassure interested parties that proposed financial reconstructions are likely to work. This is likely to include: 

Consideration of the commercial viability and financial assumptions made in any forecasts.



Consideration of whether the financial forecasts produced are consistent with the assumptions in amount and timing.



Assessment of whether the company is likely to meet any fresh commitments that it has assumed.



Risks that are likely to significantly affect whether the company achieves its objectives.



Consideration of whether the proposed reconstruction is in accordance with the wishes of all the parties involved.

Areas that may particularly concern the reporting accountant include the following: 

The reliability of forecasts. The fact that the company has been in trouble may have been linked to over-optimistic forecasts in the past or systems and information that provided an inadequate basis for previous projections.



Consistency of forecast accounting statements with historical financial statements, particularly consistency and appropriateness of accounting policies.



Projected evidence of income. The reporting accountant may need external evidence to support income projections, for example future orders, customer interest, market surveys. If income is expected to grow, certain costs (selling, distribution) would also be expected to increase (though perhaps not in direct correlation).



Changes in cost base. The forecasts may well include assertions that costs can be lowered, and the accountant will need to assess how successful cost control has been in the past, whether there is a programme for cost reduction, and whether this programme appears realistic and can be done without jeopardising attempts to increase income.



Sufficiency of finance. The accountant will need to assess whether the finance that is assumed to be available will be enough to sustain the changes in activities and operations required to make the reconstruction a success.



The form of report, particularly the caveats that need to be included about the achievability of the forecasts.

4 Demergers and disposals Unbundling can be either voluntary or it can be forced on a company. A company may voluntarily decide to divest part of its business for strategic, financial or organisational reasons. An involuntary unbundling, on the other hand, may take place for regulatory or financial reasons. The main forms of unbundling are: (a) (b) (c) (d) (e) (f) (g)

4.1

Divestments Demergers Sell-offs Spin-offs Carve-outs Going private/Leveraged buyouts Management buyouts

Divestments Definition Divestment: The partial or complete sale or disposal of physical and organisational assets, the shut- down of facilities and reduction in workforce in order to free funds for investment in other areas of strategic interest. In a divestment the company ceases the operation of a particular activity in order to concentrate on other processes. The rationale for divestment is normally to reduce costs or to increase return on assets. Divestments differ from the other forms of unbundling because they do not require the formation of a new company.

4.1.1

Reasons for divestment (a)

Divestments may take place as a corrective action in order to reverse unsuccessful previous acquisitions, especially when the acquisition has taken place for diversification purposes. A subsidiary that is unprofitable or incompatible with existing operations may be sold to allow the firm to concentrate on areas where it is more successful.

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4.2

(b)

Divestments may also take place as a response to a cyclical downturn in the activities of a particular unit or line of business.

(c)

Divestments may be proactive in the sense that a company may want to exit lines of business which have become obsolete or are too small, and redeploy resources to activities with a higher return on invested capital.

Demergers Definition Demerger: The opposite of a merger. It is the splitting up of a corporate body into two or more separate independent bodies. For example, the ABC Group plc might demerge by splitting into two independently operating companies AB plc and C plc. Existing shareholders are given a stake in each of the new separate companies. Demerging, in its strictest sense, stops short of selling out.

4.2.1

4.2.2

4.3

Advantages of demergers (a)

A demerger should ensure greater operational efficiency and greater opportunity to realise value. A two-division company with one loss-making division and one profit-making, fast-growing division may be better off splitting the two divisions. The profitable division may acquire a valuation well in excess of its contribution to the merged company.

(b)

A demerger should ensure that share prices reflect the true value of the underlying operations. In large diversified conglomerates, so many different businesses are combined into one organisation that it becomes difficult for analysts to understand them fully.

(c)

A demerger can correct a lack of focus, where senior management have to oversee and monitor a large number of businesses.

Disadvantages of demergers (a)

Economies of scale may be lost, where the demerged parts of the business had operations in common to which economies of scale applied.

(b)

The smaller companies which result from the demerger will have lower turnover, profits and status than the group before the demerger.

(c)

There may be higher overhead costs as a percentage of turnover, resulting from (b).

(d)

The ability to raise extra finance, especially debt finance, to support new investments and expansion may be reduced.

(e)

Vulnerability to takeover may be increased. The impact on a firm's risk may be significant when a substantial part of the company is spun off. The result may be a loss in shareholder value if a relatively low risk element is unbundled.

Sell-offs Definition Sell-off: A form of divestment, involving the sale of part of a company to a third party, usually another company. Generally cash will be received in exchange. The extreme form of a sell-off is where the entire business is sold off in a liquidation. In a voluntary dissolution, the shareholders might decide to close the whole business, sell-off all the assets and distribute net funds raised to shareholders.

4.3.1

Reasons for sell-off (a)

As part of its strategic planning, a company has decided to restructure, concentrating management effort on particular parts of the business. Control problems may be reduced if peripheral activities are sold off.

(b)

A company wishes to sell off a part of its business which makes losses, and so to improve the company's future reported consolidated profit performance. This may be in the form of a management buy-out (MBO) â&#x20AC;&#x201C; see below.

(c)

In order to protect the rest of the business from takeover, a company may choose to sell a part of the business which is particularly attractive to a buyer.

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17 17

(d)

The company may be short of cash.

(e)

A subsidiary with high risk in its operating cash flows could be sold, so as to reduce the business risk of the group as a whole.

(f)

A subsidiary could be sold at a profit. Some companies have specialised in taking over large groups of companies, and then selling off parts of the newly-acquired groups, so that the proceeds of sales more than pay for the original takeovers.

A sell-off may however disrupt the rest of the organisation, especially if key players within the organisation disappear as a result.

4.4

Spin-offs Definition Spin-off: The creation of a new company, where the shareholders of the original company own the shares. In a spin-off:

4.4.1

4.5

(a)

There is no change in the ownership of assets, as the shareholders own the same proportion of shares in the new company as they did in the old company.

(b)

Assets of the part of the business to be separated off are transferred into the new company, which will usually have different management from the old company.

(c)

In more complex cases, a spin-off may involve the original company being split into a number of separate companies.

Advantages of spin-offs (a)

The change may make a merger or takeover of some part of the business easier in the future, or may protect parts of the business from predators.

(b)

There may be improved efficiency and more streamlined management within the new structure.

(c)

It may be easier to see the value of the separated parts of the business now that they are no longer hidden within a conglomerate. Directors may believe that the individual parts of the business may be worth more than the whole.

(d)

The requirements of regulatory agencies might be met more easily within the new structure. For example, if the agency is able to exercise price control over a particular part of the business which was previously hidden within the conglomerate structure.

(e)

After the spin-off, shareholders have the opportunity to adjust the proportions of their holdings between the different companies created.

Carve-outs Definition Carve-out: The creation of a new company, by detaching parts of the original company and selling the shares of the new company to the public. Parent companies undertake carve-outs in order to raise funds in the capital markets. These funds can be used for the repayment of debt or creditors or the new cash can be retained within the firm to fund expansion. Carved out units tend to be highly valued.

4.6

Going private Definition Going private for a public company: When a small group of individuals, possibly including existing shareholders and/or managers and with or without support from a financial institution, buys all of a company's shares. This form of restructuring is relatively common in the USA and may involve the shares in the company ceasing to be listed on a stock exchange.

4.6.1

Advantages of going private (a)

The costs of meeting listing requirements can be saved.

(b)

The company is protected from volatility in share prices which financial problems may create.

(c)

The company will be less vulnerable to hostile takeover bids.

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4.6.2

(d)

Management can concentrate on the long-term needs of the business rather than the short-term expectations of shareholders.

(e)

Shareholders are likely to be closer to management in a private company, reducing costs arising from the separation of ownership and control (the 'agency problem').

Disadvantages of going private The main disadvantage of going private is that the company loses its ability to have its shares publicly traded. If a share cannot be traded it may lose some of its value. However, one reason for seeking private company status is that the company has had difficulties as a quoted company, and the prices of its shares may be low anyway.

4.6.3

Going private temporarily Sometimes a company goes private with the intention that it will go public once again. During this period, there may be a substantial reorganisation, in order to make significant profits.

4.7

Management buyouts (MBO) Definition Management buyout: The purchase of a business from its existing owners by members of the management team, generally in association with a financing institution. A management buyout is the purchase of all or part of a business from its owners by its managers. For example, the directors of a subsidiary company in a group might buy the company from the holding company, with the intention of running it as proprietors of a separate business entity. (a)

To the managers, the buyout would be a method of setting up in business for themselves.

(b)

To the group, the buyout would be a method of divestment, selling off the subsidiary as a going concern.

Management-owned companies seem to achieve better performance probably because of:     

A favourable buyout price having been achieved. Personal motivation and determination. Quicker decision-making and so more flexibility. Keener decisions and action on pricing and debt collection. Savings in overheads, e.g. in contributions to a large head office.

However, many management buyouts, once they occur, begin with some redundancies to cut running costs.

4.7.1

Reasons for a MBO The board of directors of a large organisation may agree to a management buyout of a subsidiary for any number of different reasons. (a)

The subsidiary may be peripheral to the group's mainstream activities, and no longer fit in with the group's overall strategy.

(b)

The group may wish to sell off a loss-making subsidiary. A management team may think that it can restore the subsidiary's fortunes.

(c)

The parent company may need to raise cash quickly.

(d)

The subsidiary may be part of a group that has just been taken over and the new parent company may wish to sell off parts of the group it has just acquired.

(e)

The best offer price might come from a small management group wanting to arrange a buyout.

(f)

When a group has taken the decision to sell a subsidiary, it will probably get better co-operation from the management and employees of the subsidiary if the sale is a management buyout.

A private company's shareholders might agree to sell out to a management team because they need cash, they want to retire, or the business is not profitable enough for them.

4.7.2

Parties to a MBO There are usually three parties to a management buyout. (a)

A management team wanting to make a buyout. This team ought to have the skills and ability to convince financial backers that it is worth supporting.

(b)

Directors of a group of companies.

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19 19

(c)

4.7.3

Financial backers of the buyout team, who will usually want an equity stake in the bought-out business, because of the venture capital risk they are taking. Often, several financial backers provide the venture capital for a single buyout.

Exit strategies Venture capitalists generally like to have a predetermined target exit date, the point at which they can recoup some or all of their investment in an MBO. At the outset, they will wish to establish various exit routes, the possibilities including:    

4.7.4

The sale of shares following a flotation on a recognised stock exchange. The sale of the company to another firm. The repurchase of the venture capitalist's shares by the company or its owners. The sales of the venture capitalist's shares to an institution such as an investment trust.

Appraisal of MBOs An institutional investor (such as a venture capitalist) should evaluate a buyout before deciding whether or not to finance. Aspects of any buyout that ought to be checked are as follows.

4.7.5

(a)

Does the management team have the full range of management skills that are needed (for example, a technical expert and a finance director)? Does it have the right blend of experience? Does it have the commitment?

(b)

Why is the company for sale? The possible reasons for buyouts have already been listed. If the reason is that the parent company wants to get rid of a loss-making subsidiary, what evidence is there to suggest that the company can be made profitable after a buyout?

(c)

What are the projected profits and cash flows of the business? The prospective returns must justify the risks involved.

(d)

What is being bought? The buyout team might be buying the shares of the company, or only selected assets of the company. Are the assets that are being acquired sufficient for the task? Will more assets have to be bought? When will the existing assets need replacing? How much extra finance would be needed for these asset purchases? Can the company be operated profitably?

(e)

What is the price? Is the price right or is it too high?

(f)

What financial contribution can be made by members of the management team themselves?

(g)

What are the exit routes and when might they be taken?

Problems with MBOs A common problem with management buyouts is that the managers may have little or no experience in financial management or financial accounting. Managers will also be required to take tough decisions. A good way of approaching the problem is scenario analysis, addressing the effect of taking a major decision in isolation. However, the results may be painful, including the ditching of long established products. Other problems are:

4.8

(a)

Tax and legal complications.

(b)

Difficulties in deciding on a fair price to be paid.

(c)

Convincing employees of the need to change working practices or to accept redundancy.

(d)

Inadequate resources to finance the maintenance and replacement of tangible non-current assets.

(e)

The maintenance of employees' employment or pension rights.

(f)

Accepting the board representation requirement that many providers of funds will insist upon.

(g)

The loss of key employees if the company moves geographically, or wage rates are decreased too far, or employment conditions are unacceptable in other ways.

(h)

Maintaining continuity of relationships with suppliers and customers.

(i)

Lack of time to make decisions.

Leveraged buyouts Definition Leveraged buyout is the purchase of another company using a very significant amount of debt (bonds or loans). Often the cash flows and assets of the company being purchased are used as collateral as well

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as the assets of the company making the acquisition. Typically, the company acquiring the equity in a leveraged buyout is a hedge fund. For example a hedge fund may want to acquire a target company, which could be either a private or a public company. It will negotiate with the board of the target company and agree acquisition terms that are then put to the shareholders and debt security holders in the target company for acceptance. The money to pay for the acquisition will come partly from the hedge fund (which will acquire the equity in the target company) and partly by issuing a large amount of new debt that will be put into the company. As a result of the LBO, the company will have a new capital structure, with equity owned by the hedge fund and large amounts of debt that will be paid off over time.

4.9

Purchase of own shares For a smaller company with few shareholders, the reason for buying back the company's own shares may be that there is no immediate willing purchaser at a time when a shareholder wishes to sell shares. For a public company, share repurchase could provide a way of withdrawing from the share market and 'going private'. There has also been extensive use of share buybacks in recent years by stock market companies with surplus cash. The companies buy their shares in the stock market, and the shares are either cancelled or become treasury shares. Treasury shares may be re-issued subsequently, for example to reward senior executives in an incentive scheme involving the granting of shares. When repurchased shares are cancelled, the expectation should be that by reducing the number of shares in issue, it should be possible to increase EPS and dividends per share.

4.9.1

4.9.2

4.10 4.10.1

Benefits of a share repurchase scheme (a)

Finding a use for surplus cash, which may be a 'dead asset'.

(b)

Increase in earnings per share through a reduction in the number of shares in issue. This should lead to a higher share price than would otherwise be the case, and the company should be able to increase dividend payments on the remaining shares in issue.

(c)

Increase in gearing. Repurchase of a company's own shares changes the relative proportion of debt to equity, so raising gearing. This will be of interest to a company wanting to increase its gearing without increasing its total long-term funding.

(d)

Readjustment of the company's equity base to more appropriate levels, for a company whose business is in decline.

(e)

Possibly preventing a takeover or enabling a quoted company to withdraw from the stock market.

(f)

Rewarding shareholders without having to increase dividends, which can give out unwanted signals to the market.

Issues with a share repurchase scheme (a)

It can be hard to arrive at a price that will be fair both to the vendors and to any shareholders who are not selling shares to the company.

(b)

A repurchase of shares could be seen as an admission that the company cannot make better use of the funds than the shareholders.

(c)

Some shareholders may suffer from being taxed on a capital gain following the purchase of their shares rather than receiving dividend income.

(d)

An increase in EPS might benefit directors if their bonus is aligned to this ratio.

Use of distributable profits Bonus issue A bonus/scrip/capitalisation issue is the capitalisation of the reserves of a company by the issue of additional shares to existing shareholders, in proportion to their holdings. Such shares are normally fully paid-up with no cash called for from the shareholders. By creating more shares in this way, a scrip issue does not raise new funds. It does though have the advantage of making shares cheaper and therefore (perhaps) more easily marketable on the Stock Exchange. For example, if a company's shares are priced at $6 on the Stock Exchange, and the

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21 21

company makes a one for two scrip issue, the share price should fall after the issue to $4 each. Shares at $4 each might be more easily marketable than shares at $6 each.

4.11

Valuation issues Unbundling will impact upon the value of a firm through its impact upon different factors in the valuation models.

4.11.1

Impact on growth rate When firms divest themselves of existing investments, they affect their expected return on assets, as good projects increase the return on assets (ROA), and bad projects reduce the return.

4.12

Valuation of divestments The techniques for business valuations that are described in Chapter 12 need to be applied carefully when considering an entity that has been divested. It may be difficult to forecast future cash flows or profits with any certainty and there will be uncertainties over business risk levels. Whether prices paid for individual assets fairly reflect their value to the new owners going forward may also be questionable.

4.12.1

Financial reporting issues in relation to demergers and disposals The main financial reporting standards that apply to demergers and disposals are IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and IFRS 8 Operating Segments.

4.13

Application of IFRS 5 Demergers and disposals can have significant impacts upon cash flows and profits in group financial statements, so the purpose of IFRS 5 is to help accounts' users make more accurate assessments about the businesses' prospects in the future, by being able to exclude these items.

4.13.1

Recognition of disposals Definitions Discontinued operation: A component of an entity that has either been disposed of, or is classified as held for sale, and: 

Represents a separate major line of business or geographical area of operations;



Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations; or



Is a subsidiary acquired exclusively with a view to resale.

Component of an entity: Operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. IFRS 5 also applies to groups of assets and associated liabilities which will be disposed of in a single transaction, described as a disposal group.

Definition Disposal group: A group of assets to be disposed of, by sale or otherwise, together as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. The group includes goodwill acquired in a business combination if the group is a cashgenerating unit to which goodwill has been allocated in accordance with the requirements of IAS 36 Impairment of Assets or if it is an operation within such a cash-generating unit. The definition includes, but is not limited to: 

A subsidiary which the parent is committed to selling.



A cash-generating unit of the entity, that is a group of assets which generates economic benefits that are largely independent of other activities of the entity.

The results of a disposal group should be presented as those of a discontinued operation if the group meets the definition of a component and is a separate major line of business. After a demerger is completed, the results may be shown as discontinued operations. However, assets and liabilities to be demerged would not meet the definition of assets and liabilities held for resale, since the demerger should be treated as an abandonment. Not all the disposals and divestments that a business makes will fulfil the recognition criteria of IFRS 5. They may not be sufficiently important to be regarded as a separate major line of business or geographical operation.

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If the disposal is a piecemeal disposal, where assets are sold separately or in small groups, and liabilities are settled individually, relevant standards, for example IAS 39 for financial assets and liabilities, apply. Where a spin-off takes place, the transactions are with the shareholders of a group and no gains or losses are recognised on disposals.

4.13.2

Held for sale assets Definition Held for sale: A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. A number of detailed criteria must be met. (a) (b)

The asset must be available for immediate sale in its present condition. Its sale must be highly probable (ie, significantly more likely than not).

For the sale to be highly probable, the following must apply. (a) (b) (c) (d) (e)

4.13.3

Management must be committed to a plan to sell the asset. There must be an active programme to locate a buyer. The asset must be marketed for sale at a price that is reasonable in relation to its current fair value. The sale should be expected to take place within one year from the date of classification. It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

Measurement issues A non-current asset (or disposal group) that is held for sale should be measured at the lower of its carrying amount and fair value less costs to sell (net realisable value). Non-current assets held for sale should not be depreciated, even if they are still being used by the entity. Fair value for cash-generating units should be determined in accordance with the requirements of IFRS 13 Fair Value Measurement, using the fair value hierarchy:

4.13.4



Level 1: Quoted prices for identical assets or liabilities in active markets.



Level 2: Valuation multiple (for example, a multiple of earnings or revenue or a similar performance measure) derived from observable market data, e.g. from prices in observed transactions involving comparable businesses.



Level 3: Financial forecast developed using the entity's own data.

Presentation and disclosure An entity should disclose a single amount in the statement of profit or loss and other comprehensive income comprising the total of: 

The post-tax profit or loss of discontinued operations; and



The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets constituting the discontinued operation.

An entity should also disclose an analysis of this single amount into: 

The revenue, expenses and pre-tax profit or loss of discontinued operations.



The related income tax expense.



The post-tax gain or loss recognised on measurement to fair value less costs to sell or on disposal of the assets constituting the discontinued operation.



The related income tax expense.

An asset classified as held for sale should be presented in the statement of financial position separately from other assets. Typically, a separate heading 'non-current assets held for sale' would be appropriate.

4.13.5

Impact on business Measurement and presentation of discontinued operations may have a significant impact on the business, depending on how accounts users view disclosures. Held-for-sale assets might be stripped out when assessing compliance with covenants. Separation of discontinued operations could also have quite a negative impact on the headline figures in the accounts.

4.14

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IFRS 8 only applies to entities whose equity or debt is traded in public markets.

4.14.1

Recognition of segments Even if the operations to be sold qualify as discontinued operations under IFRS 5, they may also qualify as an operating segment under IFRS 8 if they fulfil the IFRS 8 definition of an operating segment. The most important issues here will be that the component's results are still maintained and are still reviewed by the chief operating decision-maker. The segment may not meet any of the 10% disclosure thresholds of IFRS 8, but the entity should still apply the disclosure requirements if management believes that information about the segment would be useful to users of the financial statements.

4.14.2

Presentation and disclosure The entity will need to disclose: 

The factors used to identify reportable segments and the types of products and services from which each derives its revenues.



A measure of profit or loss for each segment, that is reported to the chief operating decision-maker.



Measures of total assets and liabilities if they are regularly provided to the chief operating decision- maker.

5 Small and medium-sized company financing Many small- to medium-sized enterprises (SMEs) have excellent business plans that require funding. The problem these enterprises have is lack of assets to provide as security for conventional loans. Without special sources of finance, many small businesses would not get off the ground, or their projects would have to be abandoned. There are numerous sources of finance available for SMEs. Due to the lack of available assets to offer as security, most funding will be equity funding rather than debt funding.

5.1

Characteristics of SMEs SMEs can be defined as having three characteristics: 

Firms are likely to be unquoted.



Ownership of the business is restricted to a few individuals, typically a family group.



They are not micro businesses that are normally regarded as those very small businesses that act as a medium for self-employment of the owners. (Laney)

The characteristics may alter over time, with the enterprise perhaps looking for a listing on a stock exchange geared to the needs of the smaller company, such as the UK Alternative Investment Market (AIM), as it expands. The SME sector accounts for between a third and a half of sales and employment in the UK. The sector is particularly associated with the service sector and serving niche markets. If market conditions change, small businesses may be more adaptable. There is, however, a significant failure rate amongst small firms.

5.1.1

Assurance work on SMEs One characteristic of SMEs in the UK is exemption from audit. SMEs qualify for an audit exemption if they meet at least two of the following criteria.   

Annual turnover of no more than £6.5 million. Assets with a carrying amount of no more than £3.26 million. 50 or fewer employees on average.

Nevertheless, SMEs may benefit from an audit or other assurance work being carried out on aspects of their business. (a)

Confidence to finance providers. This is probably the most important benefit as banks and other finance providers may be more inclined to support a business where assurance has been built in from the start. It may be easier to obtain finance more quickly if the business appears to be reliable. An assurance report may be required for the specific purpose of obtaining loan finance, particularly bank loan finance, and we look at this in more detail below.

(b)

Confidence in accounting. Assurance work can give the owners of SMEs confidence in the figures that their accounting records are producing. This means not only that the financial statements that the owners are legally responsible for are reasonable, but also that they can rely on their figures as the basis for making operational and finance decisions.

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5.2

(c)

Review of systems. Having external assurance providers involved from the start can help an SME in that they can provide advice on how systems should develop to cope with expanding operations.

(d)

Pre-empting audit requirements. If an SME expands sufficiently, it will need to have an audit. Having independent accountants involved from the start should avoid systems being disrupted when auditors do have to become involved.

(e)

Acceptability for tax. Tax authorities may be more inclined to rely on accounts that have been audited or had an assurance review carried out.

Sources of finance for SMEs Potential sources of funding for SMEs include:       

5.2.1

Owner financing Equity finance Business angel financing Venture capital Leasing Factoring Bank loans

Owner financing Finance from the owner(s)' personal resources or those of family connections is generally the initial source of finance. At this stage because many assets are intangible, external funding may be difficult to obtain.

5.2.2

Equity finance Other than investment by owners or business angels (see below), businesses with few tangible assets will probably have difficulty obtaining equity finance when they are formed (a problem known as the 'equity gap'). However, once small firms have become established, they do not necessarily need to seek a market listing to obtain equity financing. Shares can be placed privately. Letting external shareholders invest does not necessarily mean that the original owners have to cede control, particularly if the shares are held by a number of small investors. However, small companies may find it difficult to obtain large sums by this means. As noted above, owners will need to invest a certain amount of capital when the business starts up. However, owners can subsequently choose whether they withdraw profits from the business or reinvest them. A major problem with obtaining equity finance can be the inability of the small firm to offer an easy exit route for any investors who wish to sell their stake.

5.2.3



The firm can purchase its own shares back from the shareholders, but this involves the use of cash that could be better employed elsewhere.



The firm can obtain a market listing but not all small firms do.

Business angels Business angel financing can be an important initial source of business finance. Business angels are wealthy individuals or groups of individuals who invest directly in small businesses using their own money. They bring invaluable direct relevant experience, expertise and contacts in an advisory capacity. The main problem with business angel financing is that it is informal in terms of a market and can be difficult to set up. However, informality can be a strength. There may be less need to provide business angels with detailed information about the business due to the prior knowledge that they tend to have.

5.2.4

Venture capital Venture capital is risk capital, normally provided in return for an equity stake. Venture capital organisations, such as 3i have been operating for many years. The types of venture that the 3i group might invest in include the following. 

Business start-ups. When a business has been set up by someone who has already put time and money into getting it started, the group may be willing to provide finance to enable it to get off the ground.



Business development. The group may be willing to provide development capital for a company that wants to invest in new products or new markets or to make a business acquisition.



Management buyouts. A management buyout is the purchase of all or parts of a business from its owners by its managers.

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

Helping a company where one of its owners wants to realise all or part of their investment. The venture capital organisation may be prepared to buy some of the company's equity.

Venture capital organisations will take account of various factors in deciding whether or not to invest.

5.2.5



The nature of the product (viability of production and selling potential).



Expertise in production (technical ability to produce efficiently).



The market and competition (threat from rival producers or future new entrants).



Future profits (detailed business plan showing profit prospects that compensate for risks).



Board membership (to take account of the interests of the venture capital organisation and to ensure it has a say in future strategies).



Risk borne by existing owners.

Leasing Leasing is a popular source of finance for both large and smaller enterprises. A lease is a contract between a lessor and lessee for hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the asset. The lessee has possession and use of the asset on payment of specified rentals over a period of time. Many lessors are financial intermediaries such as banks and insurance companies. The range of assets leased is wide, including office equipment and computers, cars and commercial vehicles, aircraft, ships and buildings. When deciding whether to lease or buy an asset, the SME must make two decisions. 

The acquisition decision: is the asset worth having? Test by discounting project cash flows at a suitable cost of capital.



The financing decision: if the asset should be acquired, compare the cash flows of purchasing with those of leasing. The cash flows can be discounted at an after-tax cost of borrowing.

SMEs can also consider a sale and leaseback arrangement. If it owns its own premises, for example, the SME could sell the property to an insurance company or pension fund for immediate cash and rent it back, usually for at least 50 years with rent reviews every few years. While such an arrangement usually realises more cash than a mortgage would, the firm loses ownership of the asset which can reduce its overall borrowing capacity, as the asset can no longer be used as security for a loan.

5.2.6

Debt factoring SMEs can make use of debt factoring to release funds quickly. As with leasing, debt factoring was covered in detail in the Financial Management paper, therefore you should refresh your memory by revising your earlier notes. Factoring can release funds by 'selling' debts to a factoring organisation that will then chase the debts on the company's behalf for a fee. At the time of 'sale' the factor will advance a percentage of the debt in cash to the company, thus helping short-term liquidity. The main problem with this method of financing is that it could give out adverse signals about the firm's liquidity position.

5.2.7

Bank loans Bank loans are often used to finance short-term investment or as a 'bridge' to finance the purchase of, for example, new equipment. Short-term loans might be used to finance a temporary increase in inventory levels, for example to fulfil a special order. The sale of the goods then provides the finance to repay the loan. Longer-term loans are also available, say for five years. These are normally repaid in equal amounts over the period of the loan, although payments can be delayed until the reason for the loan is up and running – for example, until new machinery is operational and able to generate money-making stock. This is not often the case for small firms, however. Short-term loans are usually made at a fixed interest rate, while the rates quoted for longer-term loans tend to be linked to the general rate of interest, such as LIBOR.

5.2.8

Microfinance Microfinance involves the provision of financial services to very small business and entrepreneurs who lack access to banking services. Microfinance is provided by: 

Relationship-based banking for individual businesses.

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

Group-based models, where lots of entrepreneurs apply for finance and other services, such as insurance and money transfer, as a group.

As well as supporting economic growth, microfinance in certain countries is also seen as a means of poverty alleviation. One challenge in several countries has been providing smaller loans at an affordable cost, while allowing lenders sufficient margin to cover their expenses. Countries where microfinance has developed significantly include the United States, where microfinance institutions have served low income and marginalised communities. Credit unions have been important in Canada. In Bangladesh the focus has been on making unsecured loans to people living below the poverty line.

5.3

The problems of financing SMEs The money for investment that SMEs can obtain comes from the savings individuals make in the economy. Government policy will have a major influence on the level of funds available. 

Tax policy including concessions given to businesses to invest (capital allowances) and taxes on distributions (higher taxes on dividends mean less income for investors).



Interest rate policy with low interest rates working in different ways – borrowing for SMEs becomes cheaper, but the supply of funds is less as lower rates give less incentive to investors to save.

Definition Funding gap: The amount of money needed to fund the ongoing operations or future development of a business or project that is not currently provided by cash, equity or debt. The term 'funding gap' is most often used in the context of SMEs that are in the early stages of development, and need funds for research, product development and marketing. SMEs face competition for funds. Investors have opportunities to invest in all sizes of organisation, also overseas and in government debt. The main handicap that SMEs face in accessing funds is the problem of uncertainty. 

Whatever the details provided to potential investors, SMEs have neither the business history nor longer track record that larger organisations possess.



Larger enterprises are subject by law to more public scrutiny; their accounts have to contain more detail and be audited, they receive more press coverage and so on.



Because of the uncertainties involved, banks often use credit scoring systems to control exposure.

Because the information is not available in other ways, SMEs will have to provide it when they seek finance. They will need to supply a business plan, list of the firm's assets, details of the experience of directors and managers and show how they intend to provide security for sums advanced. Prospective lenders, often banks, will then make a decision based on the information provided. The terms of the loan (interest rate, term, security, repayment details) will depend on the risk involved, and the lender will also want to monitor its investment. A common problem is that banks are often unwilling to increase loan funding without an increase in security given (which the owners may be unwilling or unable to give), or an increase in equity funding (which may be difficult to obtain). A further problem for SMEs is the maturity gap. It is particularly difficult for SMEs to obtain mediumterm loans due to a mismatching of the maturity of assets and liabilities. Longer-term loans are easier to obtain than medium-term loans as longer loans can be secured with mortgages against property.

5.3.1

Impact of credit crunch on small businesses A survey by the Department of UK Business Innovation and Skills (BIS), published in April 2013, related that small businesses have found it more difficult to obtain credit finance since the global financial crisis began. Rejection rates for both overdrafts and term loans were significantly higher in the period from 2008 onwards. If a business had a higher credit risk rating, previous financial delinquency and falling sales levels, rejection was probable. Inevitably, the effects of the recession on sales, profitability and asset prices meant that a greater proportion of businesses were rated at above average risk. Older, more-established businesses were more likely to obtain finance. However, the survey found that banks appeared to view lending to safer small businesses as relatively more risky in the period after the financial crisis than they did before. Evidence also suggested a greater tightening on renewal of finance than for new loans.

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The BIS survey concluded there were greater restrictions on the availability of loan rather than overdraft finance. Some small businesses have thus been forced, or chosen, to rely on overdraft finance rather than loans. However, interest rates on overdrafts for smaller businesses rose between 2009 and 2011, despite the central bank rate remaining stable. Small businesses also faced higher additional charges. Some small businesses have been struggling to obtain even overdraft finance, with banks telling them that they must reduce their overdraft or threatening to withdraw their facilities. SMEs have also faced problems obtaining finance for assets, as a number of banks withdrew or wound down their asset finance market in the period since 2007. The survey suggested that key factors in restriction of finance were high levels of credit risk; the problems with lack of reliable information where the small businesses had limited reporting requirements; and insufficient or illiquid collateral. Margins on loans and overdrafts were also significantly higher, as cuts in the Bank of England base rate were not transferred to small businesses.

5.3.2

Funding for Lending The credit crunch for SMEs in the UK prompted the government to introduce initiatives to encourage more bank lending to small companies. One of these has been 'Funding for Lending', introduced by the UK Government in August 2012. The scheme allows banks to swap assets such as existing loans with the Bank of England for up to four years in exchange for gilts, which they can use to borrow money for their lending at an interest rate close to base rate. Banks can borrow up to 5% of existing lending stock. The fees that banks pay will depend on whether they grow or decrease their net lending. Fees will rise if lending is decreased, depending on how big the fall is. In April 2013, the Bank extended the scheme by a year to 2015 and gave lenders extra incentives to lend to small businesses.

5.4

Government aid for SMEs The UK Government has used a number of other assistance schemes to help businesses. Several of these are designed to encourage lenders and investors to make finance available to small and unquoted businesses.

5.4.1

Grants Grants to help with business development are available from a variety of sources, such as Regional Development Agencies, local authorities and some charitable organisations. These grants may be linked to business activity or a specific industry sector. Some grants are also linked to specific geographical areas, such as those in need of economic regeneration.

5.4.2

Enterprise capital funds Enterprise capital funds (ECFs) are designed to be commercial funds, established to invest a combination of private and public money in small high-growth businesses. Each ECF is able to make equity investments of up to ÂŁ2 million into eligible SMEs that have genuine growth potential but whose funding needs are currently not met, based on the evidence that such businesses struggle to obtain finance of up to ÂŁ2 million. ECFs are administered by the Department for Business, Innovation and Skills through the British Business Bank.

5.5

Assurance work on loan finance We revised briefly the elements of an assurance engagement in Chapter 8, including the work done on a financial forecast. In order to obtain loan finance, an SME may need to prepare and have assurance work done on prospective financial information. However unless the amount of the loan is quite large, it may be questioned whether the SME can afford to pay the cost of an assurance engagement sufficient to satisfy a lending bank. It is more likely that the bankâ&#x20AC;&#x2122;s own credit analysts will assess the financial forecasts of an SME asking for a loan. The checks that a bank will carry out on an applicant for a substantial loan will be similar to those carried out in an assurance engagement on a financial forecast.

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Strategic Business Management Chapter-15

Financial risk management 1 Financial risks 1.1 1.1.1

Financing and liquidity risks Financing risks There are various risks associated with sources of finance. 

Long-term sources of finance being unavailable or ceasing to be available.



Taking on commitments without proper authorisation.



Taking on excessive commitments to paying interest that the company is unable to fulfil.



Pledging assets to meet the demands of one finance provider, so that there will be insufficient collateral available to secure further funding.



Having to repay multiple sources of debt finance around the same time.



Being unable to fulfil other commitments associated with a loan.



Being stuck with the wrong sort of debt (floating rate debt in a period when interest rates are rising, fixed rate debt in a period when interest rates are falling).



Excessive use of short-term finance to support investments that will not yield returns until the long term.



Ceding of control to providers of finance (for example, banks demanding charges over assets or specifying gearing levels that the company must fulfil).

The attitudes to risk of the board and major finance providers will impact significantly on how risky the company's financial structure is.

1.1.2

Liquidity risks You have covered liquidity risks in your earlier studies and, hopefully, should remember the key indicators of liquidity problems (current and quick ratios and turnover periods for receivables, payables and inventory). To recap briefly, if a business suddenly finds that it is unable to cover or renew its short-term liabilities (for example, if the bank suspends its overdraft facilities), there will be a danger of insolvency if it cannot convert enough of its current assets into cash quickly. Current liabilities are often a cheap method of finance (trade payables do not usually carry an interest cost). Businesses may therefore consider that, in the interest of higher profits, it is worth accepting some risk of insolvency by increasing current liabilities, taking the maximum credit possible from suppliers.

1.1.3

Cash flow risks Cash flow risks relate to the volatility of a firm's day-to-day operating cash flows. A key risk is having insufficient cash available because cash inflows have been unexpectedly low, perhaps due to delayed receipts from customers. If, for example, a firm has had a very large order, and the customer fails to pay promptly, the firm may not be able to delay payment to its supplier in the same way.

1.2

Credit risk Definition Credit risk: Financial risks associated with the possibility of default by a counterparty. The most common form of credit risk for businesses is the risk of non-payment of a debt. The most common type of credit risk is when customers fail to pay for goods that they have been supplied with on credit, or (in the case of a bank or bond investor) when a borrower defaults on a loan or bond payment.

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A business can also be vulnerable to the credit risks of other firms with which it is heavily connected. A business may suffer losses as a result of a key supplier or partner in a joint venture having difficulty accessing credit to continue trading.

1.3

Market risk Definition Market risk: The financial risks of possible losses due to changes in market prices or rates. Types of market risk are: 

Interest rate risk: risk from unexpected future changes in a market rate of interest



Exchange rate risk: (foreign exchange risk, FX risk or currency risk): risk from unexpected future changes in an exchange rate



Commodity price risk: risk from unexpected future changes in the market price of a commodity



Equity price risk: risk from unexpected future changes in the price of a share or in the level of share prices generally in a stock market.

Unlike credit risk, market risk is a two-way risk in the sense that market prices may move unexpectedly in a favourable direction as well as in an adverse direction.

1.4

Foreign investment risks Risks here are linked to the strategies of setting up a presence in a foreign country or deciding to participate in global markets.

1.4.1

Economic risk Economic risk refers to the effect of exchange rate movements on the international competitiveness of a company. For example, a UK company might use raw materials which are priced in US dollars, but export its products mainly within the Eurozone area. Both a depreciation of sterling against the dollar and an appreciation of sterling against the euro would erode the competitiveness of the company.

1.5

Accounting risks There are various risks associated with the requirements to produce accounts that fairly reflect financial risks. These risks are particularly significant if the business has financial instruments that are accounted for in accordance with the requirements of IASs 32 and 39 and IFRS 7, and (in due course) IFRS 9. We have discussed the requirements of these standards already and later in Section 1 we look at the requirements that relate to the disclosure of risks. In Section 4 we discuss the hedging provisions in these standards.

1.5.1

Accounts risks The main risk is loss of reputation or financial penalties through being found to have produced accounts that are misleading. However, accounts that fully and fairly disclose risks may also be problematic, if investors react badly. This doesn't just apply to misreporting financial risks, it also includes misleading reporting in other areas, either in accounts or in other reports, for example environmental reporting.

1.5.2

Income risks Income may become increasingly volatile if fair value accounting for financial instruments is used. This may have an adverse impact on the ability of companies to pay dividends and on their share price and cost of capital, as accounts users find it difficult to determine what is causing the volatility. Investors may not be sure if low market valuations of financial assets are temporary or permanent.

1.5.3

Measurement risks Measurement of financial risks and value of financial instruments may be problematic. There may well be considerable uncertainty affecting assets valued at market prices when little or no market currently exists for those assets. The problem is enhanced for financial instruments which are not tradable and therefore have no market value. Arguably, also in slow markets use of market values underestimates long-term asset values.

1.5.4

Systems risks Accounting fairly for risks may require investment in new systems and there may be an increased risk of systems problems as systems have to cope with linking of assets with derivatives, accommodating changes in hedge allocations and measuring hedge effectiveness.

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1.6 1.6.1

Financial risk management Managing risks There are various ways of managing risks, including financial risks:

1.6.2



Accept the risk and do nothing: if a risk is not considered significant, or if future price movements are more likely to be favourable than adverse, it may be appropriate to accept the risk and remain exposed to it.



Avoid the risk entirely, usually by withdrawing from the business: businesses must accept some risks in order to make profit



Transfer the risk, wholly or partly, to someone else. Risk transfer is possible by means of arrangements such as insurance, credit default swaps, franchising arrangements and joint ventures.



Reduce the risk. Risk may be reduced to an acceptable level by means of arrangements such as diversification of operations or investments; internal control over financial, operational and compliance risks; and hedging with derivative instruments.

Diversification As we discussed in Chapter 7, risk diversification involves creating a portfolio of different risks based on a number of events, which, if some turn out well and others turn out badly, the average outcome will be neutral. Diversification can be used to manage financial risks in a variety of ways. 

Having a mix of equity and debt finance, of short and long-term debt, and of fixed and variable interest debt.



Diversification of trading interests or portfolio of investments.

International portfolio diversification can be very effective for the following reasons. (a)

Different countries are often at different stages of the trade cycle at any one time.

(b)

Monetary, fiscal and exchange rate policies differ internationally.

(c)

Different countries have different endowments of natural resources and different industrial bases. Potentially risky political events are likely to be localised within particular national or regional boundaries.

(d)

Securities markets in different countries differ considerably in the combination of risk and return that they offer.

However, there are a number of factors that may limit the potential for international diversification.

1.6.3

(a)

Legal restrictions exist in some markets, limiting ownership of securities by foreign investors.

(b)

Foreign exchange regulations may prohibit international investment or make it more expensive.

(c)

Double taxation of income from foreign investment may deter investors.

(d)

There are likely to be higher information and transaction costs associated with investing in foreign securities.

(e)

Some types of investor may have a parochial home bias for domestic investment.

Hedging Definition Hedging: Taking an action that will offset an exposure to a risk by incurring a new risk in the opposite direction. Hedging is perhaps most important in the area of currency or interest rate risk management, and we review the various hedging instruments in the next two sections. Generally speaking, these involve an organisation making a commitment to offset the risk of a transaction that will take place in the future. However, there will possibly be significant transaction costs from purchasing hedging products, including brokerage fees and transaction costs. Because of lack of expertise, senior management may be unable to monitor hedging activities effectively. There may also be tax and accounting complications.

1.6.4

Macro hedging Macro hedging, also known as portfolio hedging, is a technique where financial instruments with similar risks are grouped together and the risks of the portfolio are hedged together. Often this is done on a net

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basis with assets and liabilities included in the same portfolio. For example, instead of using interest rate swaps to hedge interest rate exposure on a loan-by-loan basis, banks hedge the risk of their entire loan book or specific portions of the loan book. In practice, however, macro hedging is difficult, as it may be hard to find an asset that offsets the risk of a broader portfolio. Example ABC Company is an international company with a large amount of debt finance. The debt of £600 million is mainly denominated in £ sterling and currently consists of 50% fixed interest debt and 50% floating rate debt. The treasury department is authorised by the board of directors to vary the proportions of fixed and floating rate debt, except that there must always be at least 25% of each in the company’s medium- and long-term debt structure. The company’s treasurer believes that in the near future, interest rates will rise by one or perhaps two percentage points (100 – 200 basis points). For simplicity of illustration, we shall assume that all the debt has the same remaining time to maturity. The treasurer could use macro hedging and arrange a swap on, say, £100 million of notional principal. In the swap ABC Company will pay a fixed rate and receive a floating rate of interest. The net effect of the swap will be to change the balance of debt from £300 million of fixed rate liabilities and £300 million of floating rate liabilities to a new balance of £400 million fixed rate and £200 million floating rate debt. This will provide some protection against the risk of a rise in interest rates. The hedge has been achieved with a single macro hedging instrument – the swap.

1.6.5

Transfer One method of transferring risk is securitisation, the conversion of financial or physical assets into tradable financial instruments. This creates the potential to increase the scale of business operations by converting relatively illiquid assets into liquid ones. For example if a South American oil company securitises its future oil revenues, it secures an amount of cash now and transfers the risk of future fluctuations in the oil price to the SPV that purchases the revenue rights (and its investors).

1.6.6

Internal strategies Internal strategies for managing financing and credit risks include working capital management and maintaining reserves of easily liquidated assets. Specific techniques businesses use include:     

1.7

Vetting prospective partners to assess credit limits. Position limits, ceilings on limits granted to counterparties. Monitoring credit risk exposure. Credit triggers terminating an arrangement if one party's credit level becomes critical. Credit enhancement, settling outstanding debts periodically, also margin and collateral payments.

Corporate reporting requirements We summarised the general requirements of the financial reporting standards relating to financial instruments in Chapter 13. In this section we focus on the disclosures relating to financial risks and the requirements of IFRS 7: Financial Instruments: Disclosures. After we have covered hedging for interest and foreign exchange risks, we summarise the requirements of the standards relating to hedge accounting in Section 4.

1.7.1

Qualitative disclosures For each type of risk arising from financial instruments, an entity must disclose:

1.7.2

(a)

The exposures to risk and how they arise.

(b)

Its objectives, policies and processes for managing the risk and the methods used to measure the risk.

(c)

Any changes in (a) or (b) from the previous period.

Quantitative disclosures For each financial instrument risk, summary quantitative data about risk exposure must be disclosed. This should be based on the information provided internally to key management personnel. More information should be provided if this is unrepresentative.

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Information about credit risk must be disclosed by class of financial instrument. (a)

Maximum exposure at the year end.

(b)

The amount by which related credit derivatives or similar instruments mitigate the maximum exposure to credit risk.

(c)

The amount of change during the period and cumulatively, in fair value that is attributable to changes in credit risk. This can be calculated as (Amount of change in fair value attributable to credit risk) = (Total amount of change in fair value) – (Amount of change in fair value attributable to market risk). E

(d)

Any collateral pledged as security.

(e)

In respect of the amount disclosed in (d), a description of collateral held as security and other credit enhancements.

(f)

Information about the credit quality of financial assets that are neither past their due dates nor are impaired.

(g)

Financial assets that are past their due dates or are impaired, giving an age analysis and a description of collateral held by the entity as security.

(h)

Collateral and other credit enhancements obtained, including the nature and carrying amount of the assets and policy for disposing of assets not readily convertible into cash.

C H

For liquidity risk entities must disclose: (a) (b)

A maturity analysis of financial liabilities. A description of the way risk is managed.

Disclosures required in connection with market risk are: (a)

Sensitivity analysis, showing the effects on profit or loss of changes in each market risk.

(b)

If the sensitivity analysis reflects interdependencies between risk variables, such as interest rates and exchange rates the method, assumptions and limitations must be disclosed.

There are two options in relation to disclosure of sensitivity analysis. Option 1 An entity should disclose: 

Sensitivity analysis for each type of market risk to which the entity is exposed at the reporting date, showing how profit or loss and equity would have been affected by changes in the relevant risk variables.



The methods and assumptions used in preparing the sensitivity analysis; and



Changes from the previous period in the methods and assumptions used, and the reasons for such changes.

Option 2 Alternatively, if an entity prepares a sensitivity analysis, such as value at risk, that reflects interdependencies between risk variables (eg interest rates and exchange rates) and uses it to manage financial risks, it may use that sensitivity analysis. In this case the entity should also disclose: 

An explanation of the method used in preparing such a sensitivity analysis, and of the main parameters and assumptions underlying the data provided; and



An explanation of the objective of the method used and of limitations that may result in the information not fully reflecting fair value.

2 Interest rate risk 2.1

Futures There are two types of interest rate future: bond futures and short-term interest rate futures. With a bond future, the underlying item is a quantity of notional bonds. With a short-term interest rate future, the underlying item is a notional (usually three-month) bank deposit of a given size. These futures can be used to hedge against the risk of changes in bond yields (and bond prices) or changes in money market interest rates. This section focuses mainly on short-term interest rate futures. Prices of short-term interest rate futures are quoted as 100 minus the interest rate for the contract period expressed in annual terms (the interest

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rate used is the rate for a benchmark such as three-month LIBOR). This means for example that if a futures contract is bought or sold at a price of 96.40, this means that the underlying notional bank deposit is being bought or sold with an interest rate of 3.60%. Futures contract prices move in 'ticks', with the tick size for interest rate futures usually being one basis point or 0.01% interest rate movement in the underlying market. If the underlying item for the contract is a notional three-month deposit of $1,000,000, the value of a movement in the futures price by one tick is $1,000,000 × 0.0001 × 3/12 = $25. A movement in price by ten ticks would therefore have a value (gain or loss) of $250, and so on. Futures contracts require an initial margin deposit when a position in the futures is opened, and also subsequent maintenance margin deposits (‘variation margin’ payments) if losses are incurred on the position. Futures contracts can be created and traded at any time up to the settlement date for the contract. Settlement dates on futures exchanges are typically in March, June, September and December each year. Most futures positions are closed before settlement date, with a resulting gain or loss on the trading. Hedging against the risk of an increase in short-term interest rates Borrowers wishing to hedge against the risk of an increase in short-term interest rates in the near future can do so by: 

selling short-term interest rate futures: this creates a short position in the contract, then



buying the same number of contracts at the required time to close out the position (or possibly to wait until settlement date for the contract, when the futures exchange will close the position and make settlement).

Closing the position results in a gain or loss on the futures trading, from the difference between the initial selling price and the subsequent buying price to close the position. Hedging against the risk of a fall in short-term interest rates Lenders or depositors wishing to hedge against the risk of a fall in short-term interest rates in the near future can do so by: 

buying short-term interest rate futures: this creates a long position in the contract, then



selling the same number of contracts at the required time to close out the position (or possibly to wait until settlement date for the contract, when the futures exchange will close the position and make settlement).

Closing the position results in a gain or loss on the futures trading, from the difference between the initial buying price and the subsequent selling price to close the position. Selling or buying short-term interest rate futures involves trading in a future short-term interest rate. The selling or A buying price for futures is usually different from the current spot market interest rate. For example if the spot market three-month LIBOR rate is 5.0% in February, March futures will usually be trading at a price above or below 95.00. The difference between the futures price and the spot market price is known as ‘basis’: basis will gradually reduce in size as the settlement date for the contract gets nearer, and at the settlement date, basis should be zero (i.e. the settlement price for the futures contract should be the same as the spot market LIBOR rate). Bond futures The price of bond futures reflects the price of the underlying notional bonds for the contract. For example, if the underlying bonds for a contract have a coupon rate of 10%, and the current price is 103.00, the implied yield on the bond is approximately 9.7% (= 100/103 × 10%). (The underlying bonds for a futures contract are notional bonds, because the price of a real bond changes as the bond approaches its redemption date and is typically 100 at the redemption date. Notional bonds avoid the problem of price changes due to a reducing time to maturity and redemption.)

2.1.1

H P T E R

Basis risk 'Basis risk' refers to the fact that the basis will usually result in an imperfect hedge using futures. The basis will be zero only at the maturity date of the contract. If a firm takes a position in the futures contract with a view to closing out the contract before its maturity, there is still likely to be basis. The firm can only estimate what effect this will have on the hedge.

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2.1.2

Advantages of interest rate futures (a)

Cost Costs of arranging interest rate futures are reasonably low and payments of margin to the futures exchange are low, unless a large loss builds up on the futures position.

(b) Amount hedged A company can therefore hedge relatively large exposures with a relatively small initial employment of cash.

2.1.3

Disadvantages of interest rate futures (a)

Inflexibility of terms Traded interest rate futures are for fixed deposit periods (usually three months) and there are standard settlement dates for contracts traded on the exchange, typically in March, June, September and December. Contracts are for fixed, large, amounts, so may not entirely match the amount being hedged.

(b)

Basis risk The company may be liable to the risk that the price of the futures contract may not move in the expected direction.

(c)

Daily settlement The company will have to settle daily profits or losses on the contract. When losses arise on a futures position, the futures exchange will demand additional payments of margin to cover the loss. (Margin ensures that when a futures position is closed, there is no credit risk because the futures exchange has already received cash for the settlement.)

2.2

C H A P T E R

Interest rate options Interest rate options can be purchased over-the-counter from a bank. Alternatively, they can be traded on a futures and options exchange, as options on interest rate futures. Over-the-counter interest rate options 

An over-the-counter interest rate call option gives its holder the right, but not the obligation, to borrow at the rate of interest in the exercise price for the option, on or before the expiry date for the option. The right to borrow is applied to a notional loan of a given length of time. A call option therefore fixes the maximum cost for borrowing the underlying amount for the given time period.



An over-the-counter interest rate put option gives its holder the right, but not the obligation, to lend or deposit at the rate of interest in the exercise price for the option, on or before the expiry date for the option. The right to lend is applied to a notional loan or deposit of a given length of time.

If the option is exercised, it is settled by a payment by the option writer (the bank) of an amount for the difference between the exercise rate for the option and the current spot interest rate for the benchmark rate specified in the option contract (e.g. three-month sterling LIBOR). Exchange-traded options on interest rate futures Exchange traded options are options on short-term interest rate futures or bond futures. 

A call option gives its holder the right but not the obligation to buy a quantity of short-term interest rate futures with a given settlement date (e.g. March futures). It therefore gives its holder the right to open a long position in the futures.



A put option gives its holder the right but not the obligation to sell a quantity of short-term interest rate futures with a given settlement date. It therefore gives its holder the right to open a short position in the futures.



If a company needs to hedge against the risk of an increase in short-term interest rates it could do so by purchasing put options to sell short-term interest rate futures.



Similarly, if a company wants to hedge against the risk of a fall in the short-term interest rate, it could do so by purchasing call options to buy short-term interest rate futures.

We shall revise the use of traded interest rate options by looking at a question

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2.2.1

2.2.2

Advantages of interest rate options (a)

Upside risk – the company has the choice not to exercise the option and will, therefore, be able to take advantage of favourable movements in interest rates.

(b)

Over-the-counter options – these are tailored to the specific needs of the company and are therefore more flexible than exchange-traded options for a more exact hedge.

(c)

Exchange-traded options are useful for uncertain transactions – for example, you may be unsure if a loan will actually be needed. If it becomes evident that the option is not required it can be sold.

Disadvantages of interest rate options (a)

Premium – the premium cost for options can make options relatively expensive compared with the costs of other hedging instruments. It is payable whatever the movement in interest rates and whether or not the option is exercised.

(b)

Expiry date – the expiry date for exchange-traded options is limited by the fact that futures contracts are traded with settlement dates of up to only one year or so in advance.

(c)

C H A P T E R

Traded options – if a company purchases exchange-traded options then the large fixed amounts of the available contracts may not match the amount to be hedged. The large amounts of the contracts will also prohibit organisations with smaller amounts to be hedged from using them.

Because of the potentially high cost of option premiums, the financial benefit from hedging with options is likely to be greatest when the market price of the underlying item is volatile, therefore the interest rate risk is high.

2.3

Caps, floors and collars Definitions Cap: A series of interest rate call options with different expiry dates, on the same underlying amount of principal and the same exercise rate for each of the options Floor: A series of interest rate put options with different expiry dates, on the same underlying amount of principal and the same exercise rate for each of the options Collar: A combination of purchasing an interest rate call option and selling a put option, or a combination of purchasing an interest rate put option and selling a call option. Like caps and floors, collars can be arranged for a series of call/put options with different exercise dates. The premium cost for a collar is much lower than for a cap or a floor alone.

2.4

Forward rate agreements (FRAs) A forward rate agreement (FRA) is a cash-settled forward contract on a notional short-term loan. FRAs are over-the-counter instruments whose terms can be set according to the end user's requirements, but tend to be illiquid as they can only be sold back to the issuing investment bank. FRAs, which were described in Chapter 13, can be used to fix an effective interest rate for a short-term loan starting at a future date. A 2 v 5 FRA, for example, is a two-month forward agreement on a threemonth loan. A company can buy a 2 v 5 FRA to fix the effective interest cost of borrowing for a threemonth period starting in two months’ time. Note that whereas a hedge against a rise in interest rate is achieved by selling futures, it is achieved by buying an FRA. There are several important dates when dealing with FRAs. 

The trade date is the date on which the FRA is dealt. The spot date is usually two business days after the traded date.



The fixing date is the date on which the reference rate used for the settlement is determined.



FRAs settle with a single cash payment made on the first day of the underlying loan – this date is the settlement date.



The date on which the notional loan or deposit expires is known as the maturity date.

FRAs are settled at the beginning of the notional loan period by a payment from one party to the other, depending on whether the FRA rate is above or below the benchmark interest rate (typically, LIBOR). For example if a company buys a 2 v 5 FRA on a notional principal amount of £5 million at a rate of 5.78% and if the three-month LIBOR rate at settlement is 6.00%, the company will receive from the FRA bank a payment for 0.22% on £5 million for three months, discounted to a present value because settlement is immediate and not at the end of the notional loan period.

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2.4.1

Advantages of forward rate agreements (a)

Protection provided An FRA protects the borrower from adverse interest rate movements above the rate negotiated.

(b) Flexibility FRAs are flexible. They can, in theory, be arranged for any amounts and any duration, although they are normally for amounts of over $1 million. (c)

Cost Forward rate agreements may well be free and will in any case cost little.

2.4.2

Disadvantages of forward rate agreements (a)

Rate available The rate the bank will set for the forward rate agreement will reflect expectations of future interest rate movements. If interest rates are expected to rise, the bank may set a higher rate than the rate currently available.

(b)

Falling interest rate

(c)

The borrower will not be able to take advantage if interest rates fall unexpectedly. Term of FRA The FRA will terminate on a fixed date.

(d) Binding agreement FRAs are binding agreements so are less easy to sell to other parties.

2.5

C H A T E R

Swaps An interest rate swap is a contract between two parties. The two parties agree to exchange a stream of payments at one interest rate for a stream of payments at a different rate, normally at regular intervals for a period of several years. The two parties to a swap agreement can come to an arrangement whereby both will reduce their costs of borrowing. Swaps are generally terminated by agreeing a settlement interest rate, generally the current market rate. There are two main types of interest rate swaps – coupon swaps and basis swaps. In a coupon swap, one party makes payments at a fixed rate of interest in exchange for receiving payments at a floating rate (which changes for each payment). The other party pays the floating rate and receives the fixed rate. In a basis swap, the parties exchange payments on one floating rate basis (for example at three-month LIBOR or at a six-month CD rate) for payments on another floating rate basis (for example at six-month LIBOR). Most interest rate swaps are coupon swaps. (a)

A company which has debt at a fixed rate of interest can make a swap so that it ends up paying interest at a variable rate.

(b)

A company which has debt at a variable rate of interest (floating rate debt) ends up paying a fixed rate of interest.

In this example, Company A can use a swap to change from paying interest at a floating rate of LIBOR + 1% to one of paying fixed interest of (8½% + 1%) = 9½%. A swap may be arranged with a bank, or a counterparty may be found through a bank or other financial intermediary. Fees will be payable if a bank is used. However a bank may be able to find a counterparty more easily, and may have access to more counterparties in more markets than if the company seeking the swap tried to find the counterparty itself.

2.5.1

Basis swaps Definitions Basis swap: A series of payments which vary over time (floating), exchanged for a series of payments which also vary over time (floating), according to a different method of calculation or different schedule of payments. For example, a company may agree to swap floating payments of 12-month USD LIBOR v 6-month USD LIBOR. This could be a trade based on the shape of the yield curve.

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There are many different types of basis swaps. Some include: 

Different tenors of the same index (for example three-month LIBOR v six-month LIBOR).



The same or different tenors of different indexes (three-month USD LIBOR v three-month US Treasury bill yield).



An index and its average (six-month LIBOR v the weekly average of six-month LIBOR over six months).

Basis swaps can also include swapping a stream of floating payments in one currency into a stream of floating payments in another currency. These are called cross-currency basis swaps.

2.5.2

Swaptions Definitions Swaptions: Options on swaps, giving the holder the right but not the obligation to enter into a swap with the seller. Payer swaption: Gives the holder the right to enter into the swap as the fixed rate payer (and the floating rate receiver). Receiver swaption: Gives the holder the right to enter into the swap as the fixed rate receiver (and the floating rate payer). Bermudan swaption: Allows the owner to enter the swap on multiple specified dates. European swaption: Allows the owner to enter the swap only on the maturity date. American swaption: Allows the owner to enter into the swap on any date that falls within a range of two dates. A swaption is a 'hybrid' hedging instrument that combines the features of different financial instruments. For example, A Ltd might buy a swaption from a bank, giving A Ltd the right, but not the obligation, to enter into an interest rate swap arrangement with the bank at or before a specified time in the future. Swaptions generate a worst case scenario for buyers and sellers. For example, an organisation that is going to issue floating rate debt can buy a payer swaption that offers the option to convert to being a fixed rate payer should interest rates increase.

2.5.3

Advantages of swaps (a)

Flexibility and costs Swaps are flexible, since they can be arranged in any size, and they can be reversed if necessary. Transaction costs are low, particularly if no intermediary is used, and are potentially much lower than the costs of terminating one loan and taking out another.

(b) Credit ratings Companies with different credit ratings can borrow in the market that offers each the best deal and then swap this benefit to reduce the mutual borrowing costs. This is an example of the principle of comparative advantage. (c)

Capital structure Swaps allow capital restructuring by changing the nature of interest commitments without renegotiating with lenders.

(d) Risk management Swaps can be used to manage interest rate risk by swapping floating for fixed rate debt if rates are expected to rise. Swaps can also be used to swap a variable rate for a fixed rate investment if interest rates are expected to fall. (e)

Convenience Swaps are relatively easy to arrange.

(f)

Predictability of cash flows If a company's future cash flows are uncertain, it can use a swap to ensure it has predictable fixed rate commitments.

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2.5.4

Disadvantages of swaps (a)

Additional risk The swap is subject to counterparty risk; the risk that the other party will default leaving the first company to bear its obligations. This risk can be avoided by using an intermediary.

(b) Movements in interest rates If a company takes on a floating rate commitment, it may be vulnerable to adverse movements in interest rates. If it takes on a fixed rate commitment, it won't be able to take advantage of favourable movements in rates. (c)

Lack of liquidity The lack of a secondary market in swaps makes it very difficult to liquidate a swap contract.

2.6

Devising an interest rate hedging strategy Different hedging instruments often offer alternative ways of managing risk in a specific situation. The choice of instrument or method of hedging should consider a number of factors, such as cost, flexibility, expectations and ability to benefit from favourable interest rate movements. In the following example, we consider the different ways in which a company can hedge interest rate risk.

3 Foreign exchange risk 3.1 3.1.1

Causes of exchange rate fluctuations Currency supply and demand The exchange rate between two currencies – that is the buying and selling rates, both 'spot' and forward – is determined primarily by supply and demand in the foreign exchange markets, which are influenced by such factors as the relative rates of inflation, relative interest rates, speculators and government policy. Try to keep clear the difference between a forward exchange rate in a forward FX contract and predictions of what the future spot exchange rate will be at a future date.

3.1.2



The difference between a spot rate of exchange for immediate settlement and a forward exchange rate for settlement at a future date is attributable entirely to differences in interest rates between the two currencies for the forward period. For example the difference between the spot exchange rate for US$/£ and the six-month forward rate is attributable to the difference between the sixmonth money market rates in the USA and the UK.



Companies may want to predict or forecast what the spot exchange rate will be at a future date, for example for the purpose of financial forecasting. Predicting what spot exchange rates will be in the future is difficult and predictions may well turn out to be wrong, especially when the exchange rate is volatile. However, two theories or models for making predictions of future spot rates are interest rate parity theory and purchasing power parity (PPP) theory.

Interest rate parity theory The difference between spot and forward rates reflects differences in interest rates. If this was not the case then investors holding the currency with the lower interest rates would switch to the other currency for (say) three months, ensuring that they would not lose on returning to the original currency by fixing the exchange rate in advance at the forward rate. If enough investors acted in this way (known as arbitrage), forces of supply and demand would lead to a change in the forward rate to prevent such risk-free profit making.

3.1.3

Purchasing power parity Purchasing power parity theory predicts that the exchange value of foreign currency depends on the relative purchasing power of each currency in its own country and that spot exchange rates will vary over time according to relative price changes. Countries with relatively high rates of inflation will generally have high nominal rates of interest, partly because high interest rates are a mechanism for reducing inflation, and partly because of the Fisher effect. Higher nominal interest rates serve to allow investors to obtain a high enough real rate of return where inflation is relatively high. According to the International Fisher effect, interest rate differentials between countries provide an unbiased predictor of future changes in spot exchange rates. The currency of countries with relatively high interest rates is expected to depreciate against currencies with lower interest rates, because the higher interest rates are considered necessary to compensate for the anticipated currency depreciation. Given free movement of capital internationally, this idea suggests that the real rate of return in different countries will equalise as a result of adjustments to spot exchange rates.

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3.2

Foreign exchange risk management Foreign exchange risk has three aspects: 

Transaction risk. This is the risk that an unexpected movement in an exchange rate could have an adverse effect on the value of a transaction (e.g. the transaction cost or income). Transaction risk can be managed in a number of different ways.



Translation risk. This is the risk of gains or losses that will be reported in the financial statements arising from movements in exchange rates.



Economic risk. This is a strategic risk, arising from the strategic effect of locating business operations in a country with a strong or a weak currency.

We shall begin by looking at the management of transaction risk. The implications of translation risk will be considered later. As with interest rate risk management, you should consider cost, flexibility, expectations and ability to benefit from favourable movements in rates when trying to determine how to hedge against foreign currency transaction risks. As well as using currency derivatives mentioned, it is possible to use internal hedging techniques to protect against foreign currency risk. These include matching receipts and payments, invoicing in your own currency and leading and lagging the times that cash is received and paid. These were covered in detail in the Application Level paper Financial Management and are reviewed briefly below.

3.3

Currency of invoice An exporting company can avoid currency risk by invoicing customers in its own home currency. An importing company can make arrangements to be invoiced in its own currency by overseas suppliers. This transfers all the currency risk to the other party. However, this is unlikely to continue in the long term as the overseas customers and suppliers are unlikely to be willing to bear the entire currency risk exposure burden.

3.4

Matching receipts and payments A company can reduce or eliminate its foreign exchange transaction exposure by matching receipts and payments. Wherever possible, a company that expects to make payments and have receipts in the same foreign currency should plan to offset its payments against its receipts in the currency. Since the company will be setting-off foreign currency receipts against foreign currency payments, it does not matter whether the currency strengthens or weakens against the company's 'domestic' currency because there will be no purchase or sale of the currency. C H

The process of matching is made simpler by having foreign currency accounts with a bank. Receipts of foreign currency can be credited to the account pending subsequent payments in the currency. (Alternatively, a company might invest its foreign currency income in the country of the currency – for example, it might have a bank deposit account abroad – and make payments with these overseas assets/deposits.)

3.5

A P T E R

Leading and lagging 15

Lead payments are payments made in advance, while lagged payments are those that are delayed. This tactic is often used to take advantage of movements in exchange rates.

3.6

Netting As the name suggests, netting involves setting-off intercompany balances before payment is arranged. This is common in multinational groups where a significant amount of intragroup trading takes place.

3.7

Forward contracts A forward contract is a contract that fixes the exchange rate for the purchase or sale of a quantity of one currency in exchange for another, for settlement at a future date. Companies can therefore arrange with a bank to buy or sell foreign currency at a future date, at a rate of exchange determined when the contract is made. Remember that it is a binding contract. A forward contract fixes the rate for a transaction, and these contracts must be settled regardless of whether or not the spot rate at the settlement date is more favourable than the agreed forward rate. The advantage of a forward contract is that it removes uncertainty in a future exchange rate by fixing the rate. The disadvantage is that it takes away the opportunity to gain from any favourable movement

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in the exchange rate in the forward period. You should remember from your earlier studies that a forward rate might be higher or lower than the spot rate. For example, if the spot rate for euros is €1.25/£1, the forward rate could be: Higher – €1.27 – the forward rate for the euro is said to be at a discount to the spot rate. Lower – €1.23 – the forward rate is said to be at a premium to the spot rate. A discount is therefore added to the spot rate, and a premium is subtracted from the spot rate. Premiums or discounts are attributable to interest rate differences between the two currencies. A company may arrange a forward contract with its bank and subsequently realise that the intended transaction will not take place, so that the sale or purchase of the currency is not required. In this situation, the bank will close out the original forward contract, in effect by arranging another forward contract for the same settlement date, to cancel out the original contract. The close-out is then settled with a cash payment by one party to the other, depending on the difference between the forward rates in the two contracts.

3.7.1

3.7.2

Advantages of forward exchange contracts 

They are transacted over the counter, and are not subject to the requirements of a trading exchange.



They can, in theory, be for any amount.



The length of the contract can be flexible, but contracts are generally for less than two years.

Disadvantages of forward exchange contracts   

3.7.3

The organisation doesn't have the protection that trading on an exchange brings. The contracts are difficult to cancel as they are contractual obligations (discussed below). There is a risk of default by the counterparty to the contract.

Synthetic foreign exchange agreements In order to reduce the volatility of their exchange rates, some governments have banned foreign currency trading. In such markets, synthetic foreign exchange agreements (SAFEs), also known as non-deliverable forwards, are used. These instruments resemble forward contracts but no currency is actually delivered. Instead the two counterparties settle the profit or loss (calculated as the difference between the agreed SAFE rate and the prevailing spot rate) on a notional amount of currency (the SAFE's face value). At no time is there any intention on the part of either party to exchange this notional amount. SAFEs can be used to create a foreign currency loan in a currency that is of no interest to the lender.

3.8

Money market hedge Money market hedges can be set up to cover future foreign currency payments or future foreign currency receipts. They can be used instead of forward contracts and have exactly the same effects.

3.8.1

Hedging payments Suppose a company needs to pay a foreign creditor in the foreign currency in three months' time. Instead of arranging a forward contract, the company could create a money market hedge. 

Borrow an appropriate amount in the home currency now, from the money market. This fixes the cost of buying the foreign currency after three months. The cost in domestic currency is the amount borrowed plus the interest on the loan.



Convert the home currency to foreign currency immediately, at the spot rate and put this money on deposit in the money market.



The amount placed on deposit should be sufficient, with accumulated interest, to make the foreign currency payment after three months.



When the time comes to pay the creditor: – –

Pay the creditor out of the foreign currency bank account. Repay the home country loan account.

The effect is exactly the same as using a forward contract, and will usually cost almost exactly the same amount. If the results from a money market hedge were very different from a forward hedge, speculators could make money without taking a risk. Therefore market forces ensure that the two hedges produce very similar results.

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3.8.2

Hedging future currency receipts with a money market hedge A similar technique can be used to cover a foreign currency receipt from a debtor. When a company is expecting to receive an amount of foreign currency at a future date, and wants to use money market hedging to hedge the risk, the aim should be to borrow in the foreign currency for the period up to the time that the foreign currency receipt will occur. The amount borrowed should be sufficient so that, with interest, the amount payable at maturity of the borrowing will be equal to the foreign currency receipt: the receipt is then used to repay the loan plus interest. To ‘manufacture’ a forward exchange rate with a money market hedge, follow the steps below. 

Borrow an appropriate amount in the foreign currency today.



Convert it immediately to home currency.



Place it on deposit in the home currency.



When the debtor's cash is received: – –

3.9

Repay the foreign currency loan with the foreign currency receipt. Take the cash from the home currency deposit account.

Currency futures A currency future is a contract to buy or sell a standard amount of one currency in exchange for another, for notional delivery at a set date in the future. For example, the Chicago Mercantile Exchange (CME) trades sterling futures contracts with a standard size of £62,500: these contracts are on the US dollar/sterling exchange rate. The foreign currency futures market provides an alternative to the forward market, but it also complements that market. Like the forward market, the currency futures market provides a mechanism whereby users can alter portfolio positions. It can be used on a highly geared basis for both hedging and speculation and thus facilitates the transfer of risk – from hedgers to speculators, or from speculators to other speculators.

3.9.1

Tackling futures questions

3.9.2

Basis risk Basis risk is the risk that the price of a futures contract will differ from the spot rate when the futures position is closed out. The difference between the spot rate and futures price (the 'basis') falls over time and should be zero at the settlement date for the futures contract. However, if a futures position is closed out before the settlement date, which is usual, there will be some basis. Basis does not decrease in a predictable way (which will create an imperfect hedge). There is no basis risk when a contract is held to maturity. In order to manage basis risk it is important to choose a currency future with the closest maturity date to the actual transaction. This reduces the unexpired basis when the transaction is closed out. The possible size of the basis when a futures position is closed can be estimated when the futures position is opened. An estimate of the likely basis can be made by measuring the basis when the position is opened (= difference between futures price and the spot exchange rate) and assuming that this will fall at a linear rate to zero by the settlement date for the contract. Estimating what the basis might be will enable a company to estimate how imperfect the hedge is likely to be because of basis risk.

3.9.3

Hedge efficiency Hedgers who need to buy or sell the underlying currency or commodity do not use the margin to trade more than they otherwise would. They can use the futures markets quite safely provided they understand how the system operates. The only risk to hedgers is that the futures market does not always provide a perfect hedge. This can result from two causes. (a) (b)

Amounts must be rounded to a whole number of contracts, causing inaccuracies. Basis risk – as discussed above. The actions of speculators may increase basis risk.

A measure of hedge efficiency compares the profit made on the futures market with the loss made on the cash or commodity market, or vice versa. (a) Transaction costs should be lower than for forward contracts. (b)

The exact date of receipt or payment of the currency does not have to be known, because the futures contract does not have to be closed out until the actual cash receipt or payment is made. In other words, the futures hedge gives the equivalent of an 'option forward' contract, limited only by the expiry date of the contract.

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(c)

3.9.6

3.10

Because future contracts are traded on exchange-regulated markets, counterparty risk should be reduced and buying and selling contracts should be easy.

Disadvantages of currency futures (a)

The contracts cannot be tailored to the user's exact requirements.

(b)

Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk.

(c)

Only certain currencies are the subject of futures contracts.

(d)

The procedure for converting between two currencies neither of which is the US dollar is twice as complex for futures as for a forward contract.

(e)

Using the market will involve various costs, including brokers' fees.

Currency options A currency option is an agreement involving a right, but not an obligation, to buy or sell a certain amount of currency at a stated rate of exchange (the exercise price) on or before some specified time in the future. Currency options involve the payment of a premium, which is the most the buyer of the option can lose. An option reduces the risk of losses due to currency movements but allows currency gains to be made. The premium cost means that if the currency movement is adverse, the option will be exercised, but the hedge will not normally be quite as good as that of the forward or futures contract. However, if the currency movement is favourable, the option will not be exercised, and the result will normally be better than that of the forward or futures contract. This is because the option allows the holder to profit from the improved exchange rate. The purpose of currency options is to reduce or eliminate exposure to currency risks, and they are particularly useful for companies in the following situations. (a)

Where there is uncertainty about foreign currency receipts or payments, either in timing or amount. Should the foreign exchange transaction not materialise, the option can be sold on the market (if it has any value) or exercised if this would make a profit.

(b)

To support the tender for an overseas contract, priced in a foreign currency.

(c)

To allow the publication of price lists for the company's goods in a foreign currency.

(d)

To protect the import or export of price-sensitive goods.

In both situations (b) and (c), the company would not know whether it had won any export sales or would have any foreign currency income at the time that it announces its selling prices. It cannot make a forward exchange contract to sell foreign currency without becoming exposed in the currency.

3.10.1

Types of currency options A business needs to decide which types of currency options it needs to purchase. With over-the-counter options there is usually no problem in making this decision. If, for example, a business needs to buy US dollars at some stage in the future, it can hedge by purchasing a US dollar call option. With traded options, however, only a limited number of currencies are available and there is no US dollar option as such. The company's requirements have to be rephrased.

3.10.3

(a)

A UK company wishing to sell US dollars in the future can hedge by purchasing £ sterling call options (ie options to buy sterling with dollars).

(b)

Similarly, a German company which needs to buy US dollars can hedge by purchasing euro put options.

Option premiums The level of currency option premiums depends upon the following factors:    

3.10.4

The exercise price The maturity of the option The volatility of exchange and interest rates Interest rate differentials, affecting how much banks charge

Advantages of currency options Foreign currency options have the advantage that while offering protection against adverse currency movements, they need not be exercised if movements are favourable. Thus the maximum cost is the option price, while there is no comparable limit on the potential gains.

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3.10.5

3.10.6

Disadvantages of currency options 

The cost depends on the expected volatility of the exchange rate: the premium cost for a currency option can be high.



Options must be paid for as soon as they are bought.



Tailor-made options lack negotiability.



Traded options are not available in every currency.

FX collars Interest rate collars have already been described. An FX collar is similar. It is a form of option that may be attractive because it reduces the net cost of the option. A collar is a derivative instrument that combines:  

buying a call and selling a put option with a lower exercise price, or buying a put and selling a call option with a higher exercise price.

The effect is to obtain an effective exchange rate for the underlying currency that is in the range between the exercise prices for the call and the put options. If the aim is to obtain a maximum buying price for a quantity of currency, a collar is created by:  

buying a call with an exercise price that is the maximum acceptable rate and selling a put with an exercise price that is the minimum rate that is acceptable.

If the aim is to obtain a minimum selling price for a quantity of currency, a collar is created by:  

buying a put with an exercise price that is the minimum acceptable rate and selling a call with an exercise price that sets a maximum acceptable rate.

As indicated above, the reason for arranging a collar is to acquire an option that ensures a ‘worst possible’ exchange rate, but that also limits the cost of the premium. The income from selling an option offsets the cost of buying the other option. For example suppose that a company wants to use an FX collar to fix a maximum buying price for a quantity of currency. The collar will consist of a purchased call option and the sale of a put option at a lower exchange rate. 

If the spot rate at expiry is above the exercise rate in the call option, the holder of the collar will exercise the call option and obtain the currency at the option strike rate.



However if the spot rate at expiry is below the strike rate for the put option, the put option will be exercised and the holder of the collar will have to buy the currency at the rate in the put option.



If the spot rate at expiry is between the exercise rate in the call option and the exercise rate in the put option, neither option will be exercised, and the collar holder will buy the currency in the spot market at the spot market rate.



So the exchange rate secured by the FX collar is a rate within the range of the exercise rates for the two options.

In some cases it may be possible to arrange a zero cost collar, where the cost of the purchased option is matched exactly by the income from the sale of the other option in the collar arrangement. However if a zero cost collar is possible, the range of exercise rates that will be created by the collar is likely to be within a very narrow range, and a forward FX contract might be a simpler arrangement. Example A UK company will need to buy US$2 million in three months’ time and due to the high volatility of the dollar-sterling exchange rate it wants to hedge its currency exposure on this transaction. There is a possibility that the dollar will increase in value, but there is also a possibility that it will fall in value. The company decides to hedge the risk with an FX collar. The collar consists of a call option with a strike rate of $1.4500 = £1 and a put option with a strike rate of $1.5000 = £1. (The put option has a ‘lower’ strike rate in the sense that the value of the dollar is lower at a rate of 1.5000 than at a rate of 1.4500.) 

If the spot exchange rate at expiry is $1.4000, the company will exercise the call option in the collar, and buy the $2 million at a rate of 1.4500.



If the spot exchange rate at expiry is $1.5500, the put option in the collar will be exercised, and the company will have to buy the $2 million at a rate of 1.5000.

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

3.11

If the spot exchange rate at expiry is $1.4700 – between the two strike rates – neither option will be exercised and the company will buy the dollars at the spot rate of 1.4700.

Currency swaps A currency swap (or cross-currency swap) is an interest rate swap with cash flows in different currencies. The parties to the swap exchange ‘interest payments’ on notional quantities of principal in two currencies. For example, one party may make payments on interest on £10 million and the other party may make payments of interest on a corresponding amount of another currency, say $15 million. Like interest rate swaps, currency swaps can be arranged for terms of several years. With a currency swap there are two (or possibly three) sets of cash flows. 

There is a regular exchange of ‘interest’ payments on the notional amounts of principal throughout the term of the swap.



At maturity of the swap, the parties exchange the actual amounts of principal. Each party must pay the amount of principal in the currency for which it has been paying ‘interest’ in the swap.

There may also be an exchange of principal amounts at the beginning of the swap (in the opposite direction to the exchange of principal amounts at the end of the swap, but this is unusual in practice. Swap arrangements are not usually linked with actual loan arrangements. Currency swaps are arranged over-the-counter with a bank.

3.11.1

Advantages of currency swaps The main benefit of currency swaps is that a company can use a swap to take on what in effect is a loan in a foreign currency. In the first example above, the UK company is effectively borrowing NZ$8 million for five years. Currency swaps may be possible to arrange in a foreign currency that is difficult to borrow in a direct loan. The swap can then be used as a hedge against FX risk over a long period of time. In the example of the NZ$-£ currency swap, the UK company may be planning an investment in New Zealand that will produce a stream of revenue over five years in NZ$. The revenue from the investment can be used to make the swap payments, thereby creating a match between revenue and payments that creates a hedged position. Other benefits of currency swaps can be stated briefly as follows. (a)

Flexibility Swaps are easy to arrange and are flexible since they can be arranged in any size and are reversible.

(b) Cost Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be paid. (c)

Market avoidance The parties can obtain the currency they require without subjecting themselves to the uncertainties of the foreign exchange markets.

(d) Access to finance The company can gain access to debt finance in another country and currency where it is little known, and consequently has a poorer credit rating, than in its home country. It can therefore take advantage of lower interest rates than it could obtain if it arranged the currency loan itself. (e)

Financial restructuring Currency swaps may be used to restructure the currency base of the company's liabilities. This may be important where the company is trading overseas and receiving revenues in foreign currencies, but its borrowings are denominated in the currency of its home country. Currency swaps thereby provide a means of reducing exchange rate exposure.

(f)

Conversion of debt type At the same time as exchanging currency, the company may also be able to convert fixed rate debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in addition to achieving the other purposes of a currency swap.

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(g)

Liquidity improvement A currency swap could be used to absorb excess liquidity in one currency which is not needed immediately, to create funds in another where there is a need.

3.11.2

Disadvantages of currency swaps (a)

Risk of default by the other party to the swap (counterparty risk) If one party became unable to meet its swap payment obligations, this could mean that the other party risked having to make them itself.

(b) Position or market risk A company whose main business lies outside the field of finance should not increase financial risk in order to make speculative gains. (c)

Sovereign risk There may be a risk of political disturbances or exchange controls in the country whose currency is being used for a swap.

(d) Arrangement fees Swaps have arrangement fees payable to third parties. Although these may appear to be inexpensive, this is because the intermediary accepts no liability for the swap. (The third party does however suffer some spread risk, as they warehouse one side of the swap until it is matched with the other, and then undertake a temporary hedge on the futures market.) Currency swaps are much less common than interest rate swaps.

3.12

Forex (FX) swaps An FX swap is a spot currency transaction coupled with an agreement that it will be reversed at a prespecified date by an offsetting forward transaction. Although the forex swap is arranged as a single transaction, it consists of two separate legs. The counterparties agree to exchange two currencies at a particular rate on one date and to reverse payments normally at a different rate on a specified future date. The two legs can therefore be seen as one spot transaction and one forward transaction going the opposite direction. A forex swap is called a buy/sell swap when the base currency, e.g. the dollar, is bought on the near date and sold on the far date, and is called a sell/buy swap when the base currency is sold on the near date and bought on the far date. A forex swap is useful for hedging because it allows companies to shift temporarily into or out of one currency in exchange for a second currency without incurring the exchange rate risk of holding an open position in the currency they temporarily hold. This avoids a change in currency exposure which is the role of the forward contract. Forex swaps are most commonly used by banks. For example two banks may arrange a forex swap to exchange an amount of currency spot and to make a reverse transaction (at a different rate) in, say, one or two daysâ&#x20AC;&#x2122; time.

3.13

Devising a foreign currency hedging strategy Given the wide range of financial instruments (both internal and external) available to companies that are exposed to foreign currency risk, how can an appropriate strategy be devised that will achieve the objective of reduced exposure while at the same time keeping costs at an acceptable level and not damaging the company's relationship with its customers and suppliers? There is no individual best way of devising a suitable hedging strategy â&#x20AC;&#x201C; each situation must be approached on its own merits. Unless you are told otherwise, it should be assumed that the company will be wanting to minimise its risk exposure â&#x20AC;&#x201C; it is up to you to come up with the most appropriate way of doing so. You should be prepared to justify your choice of strategy.

4 Hedge accounting Hedge accounting is the accounting process which reflects in financial statements the commercial substance of hedging activities. It results in the gains and losses on the linked items being recognised in the same accounting period and in the same section of the statement of comprehensive income, ie both in profit or loss, or both in other comprehensive income.

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Hedge accounting reduces or eliminates the volatility in profit or loss which would arise if changes in the value of derivatives had to be accounted for separately. Designation of hedging arrangements means that volatility in the values of the original derivatives is offset. Hedge accounting rules are particularly important for many companies, as companies will use derivatives for risk management and not speculative purposes.

4.1

Hedge accounting The main components of hedge accounting are: 

The hedged item: this is an asset, a liability, a firm commitment (such as a contract to acquire a new oil tanker in the future) or a forecast transaction (such as the issue in four months' time of fixed rate debt) which exposes the entity to risks of fair value/cash flow changes. The hedged item generates the risk which is being hedged.



The hedging instrument: this is a derivative or other financial instrument whose fair value/cash flow changes are expected to offset those of the hedged item. The hedging instrument reduces/eliminates the risk associated with the hedged item.



There is a designated relationship between the item and the instrument which is documented.



At inception the hedge must be expected to be highly effective and it must turn out to be highly effective over the life of the relationship (see below).



The effectiveness of the hedge, can be reliably assessed on an ongoing basis.



In respect of a cash flow hedge, a forecast transaction is highly probable.



To qualify for hedging, the changes in fair value/cash flows must have the potential to affect profit or loss.



There are two main types of hedge: –

The fair value hedge: the gain and loss on such a hedge are recognised in profit or loss.

–

The cash flow hedge: the gain and loss on such a hedge are initially recognised in other comprehensive income and subsequently reclassified to profit or loss.

Hedge effectiveness is the degree to which the changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. Hedge effectiveness should be tested on both a prospective and retrospective basis because hedge accounting should only be applied when: 

At the time of designation the hedge is expected to be highly effective; and



The hedge turns out to have been highly effective throughout the financial reporting periods for which it was designated.

The highly effective hurdle is achieved if the actual results of a hedge are within the range from 80% to 125%.

4.2

Hedged items Definitions A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that:  

Exposes the entity to risk of changes in fair value or future cash flows; and Is designated as being hedged.

A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates. A forecast transaction is an uncommitted but anticipated future transaction. Hedged items are exposed to a variety of risks that affect the value of their fair value or cash flows. For hedge accounting, these risks need to be identified and hedging instruments which modify the identified risks selected and designated. The risks for which the above items can be hedged are normally classified as: 

Market risk Which can be made up of: – –

Price risk Interest rate risk

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–  

Currency risk

Credit risk Liquidity risk

IAS 39 allows for a portion of the risks or cash flows of an asset or liability to be hedged. The hedged item may, for example, be: 

Oil inventory (which is priced in $) for a UK company, where the fair value of foreign currency risk is being hedged but not the risk of a change in $ market price of the oil.



A fixed rate liability, exposed to foreign currency risk, where only the interest rate and currency risk are hedged but the credit risk is not hedged.

P T E R

Other important aspects of the definition are: 



4.3

The hedged item can be: –

A single asset, liability, unrecognised firm commitment, highly probable forecast transaction or net investment in a foreign operation.

–

A group of assets, liabilities, firm commitments, highly probable forecast transactions or net investments in foreign operations with similar risk characteristics; or

–

A portion of a portfolio of financial assets or financial liabilities which share exposure to interest rate risk. In such a case the portion of the portfolio that is designated as a hedged item is a hedged item with regard to interest rate risk only.

Assets and liabilities designated as hedged items can be either financial or non-financial items. –

Financial items can be designated as hedged items for the risks associated with only a portion of their cash flows or fair values. So a fixed rate liability which is exposed to foreign currency risk can be hedged in respect of currency risk, leaving the credit risk not hedged.

–

But non-financial items such as inventories shall only be designated as hedged items for foreign currency risks or for all risks. The reason is that it is not possible to separate out the appropriate portions of the cash flow or fair value changes attributable to specific risks other than foreign currency risk.



Only assets, liabilities, firm commitments or highly probable transactions that involve a party external to the entity can be designated as hedged items.



As an exception, an intra-group monetary item qualifies as a hedged item in the consolidated financial statements if it results in an exposure to foreign exchange rate gains and losses that are not eliminated on consolidation.

Hedging instruments Definition A hedging instrument is a designated derivative or, for a hedge of the risk of changes in foreign currency exchange rates only, a designated non-derivative financial asset or non-derivative financial liability, whose fair values or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. The types of hedging instruments that can be designated in hedge accounting are: 

Derivatives, such as forward contracts, futures contracts, options and swaps; and



Non-derivative financial instruments, but only for the hedging of currency risk. This category includes foreign currency cash deposits, loans and receivables, available for sale monetary items and held-to-maturity instruments carried at amortised cost.

Any derivative financial instrument, with the exception of written options to which special rules apply, can be designated as a hedging instrument. Derivative instruments have the important property that their fair value is highly correlated with that of the underlying.

4.4

Fair value hedges A fair value hedge is a hedge of an entity's exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a part thereof, that is attributable to a particular risk and could affect profit or loss. Examples of fair value hedges include the hedge of exposures to changes in fair value of fixed rate debt using an interest rate swap and the use of an oil forward contract to hedge movements in the price of oil inventory.

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IAS 39 does not require that in order for a hedging relationship to qualify for hedge accounting, it should lead to a reduction in the overall risk of the entity. A hedging relationship that satisfies the conditions for hedge accounting may be designed to protect the value of a particular asset. If a fair value hedge meets the conditions for hedge accounting during the period, it should be accounted for as follows: 

The gain or loss from remeasuring the hedging instrument at fair value (for a derivative hedging instrument) or the foreign currency component of its carrying amount measured in accordance with IAS 21 (for a non-derivative hedging instrument) should be recognised in profit or loss; and



The gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognised in profit or loss.

If the fair value hedge is 100% effective, then the change in the fair value of the hedged item will be wholly offset by the change in the fair value of the hedging instrument and there will be no effect in profit or loss. Whenever the hedge is not perfect and the change in the fair value of the hedged item is not fully cancelled by change in the fair value of the hedging instrument, the resulting difference will be recognised in profit or loss. This difference is referred to as hedge ineffectiveness.

4.5

Cash flow hedges A cash flow hedge is a hedge of the variability in an entity's cash flows. The variability should be attributable to a particular risk associated with:  

A recognised asset or liability; or A highly probable forecast transaction

and could affect profit or loss. Examples of cash flow hedges include: 

The use of interest rate swaps to change floating rate debt into fixed rate debt. The entity is hedging the risk of variability in future interest payments which may arise for instance from changes in market interest rates. The fixed rate protects this cash flow variability (but with the consequence that the fair value of the instrument may now vary in response to market interest movements).



The use of a commodity forward contract for a highly probable sale of the commodity in future. The entity is hedging the risk of variability in the cash flows to be received on the sale, due to changes in the market price of the goods.

The hedge of foreign currency assets and liabilities using forward exchange contracts can be treated as either a fair value or a cash flow hedge. This is because movements in exchange rates change both the fair value of such assets and liabilities and ultimate cash flows arising from them. Similarly, a hedge of the foreign currency risk of a firm commitment may be designated as either a fair value or a cash flow hedge. A forecast transaction is an uncommitted but anticipated future transaction. To qualify for cash flow hedge accounting, the forecast transaction should be: 

Specifically identifiable as a single transaction or a group of individual transactions which share the same risk exposure for which they are designated as being hedged.



Highly probable.



With a party that is external to the entity.

If a cash flow hedge meets the qualifications for hedge accounting during the period it should be accounted for as follows: 

The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge should be recognised in other comprehensive income and held in a separate component in equity; and



The ineffective portion of the gain or loss on the hedging instrument should be recognised in profit or loss.

On a cumulative basis the effective portion can be calculated by adjusting the separate component of equity associated with the hedged item to the lesser of the following (in absolute amounts): 

The cumulative gain or loss on the hedging instrument from inception of the hedge.



The cumulative change in the fair value (present value) of the expected future cash flows on the hedged item from inception of the hedge.

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Any remaining gain or loss on the hedging instrument is the ineffective portion and should be recognised in profit or loss. The hedged item is not itself recognised in the financial statements.

4.6

Hedge accounting section of IFRS 9 The hedge accounting rules in IAS 39 have been criticised as being complex and not reflecting the entity's risk management activities, nor the extent to which they are successful. The IASB has addressed these issues in its revision of the current hedge accounting rules, IFRS 9. IFRS 9 does not come into force until 2015 at the earliest. You do not need to know this in detail for your Strategic Business Management exam, but you need to be aware that IFRS 9 remains a current issue in financial reporting, and that the standard will affect the rules for hedge accounting.

4.6.1

Hedge effectiveness Under the new rules the 80% â&#x20AC;&#x201C; 125% 'bright line' test of whether a hedging relationship qualifies for hedge accounting will be replaced by an objective-based assessment, ie that: (a)

There is an economic relationship between the hedged item and the hedging instrument, ie the hedging instrument and the hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk.

(b)

The effect of credit risk does not dominate the value changes that result from that economic relationship, ie the gain or loss from credit risk does not frustrate the effect of changes in the underlyings on the value of the hedging instrument or the hedged item, even if those changes were significant.

(c)

The hedge ratio of the hedging relationship (quantity of hedging instrument vs quantity of hedged item) is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. This allows genuine hedging relationships to be accounted for as such whereas the IAS 39 rules sometimes prevented management from accounting for an actual hedging transaction as a hedge.

4.6.2

Fair value hedges The IAS 39 treatment of recognising both changes in the fair value of the hedged item and changes in value of the hedging instrument in profit or loss will be retained. However, if the hedged item is an investment in an equity instrument held at fair value through other comprehensive income, the gains and losses on both the hedged investment and the hedging instrument will be recognised in other comprehensive income. This ensures that hedges of investments of equity instruments held at fair value through other comprehensive income can be accounted for as hedges.

4.6.3

Cash flow hedges These will continue to be accounted for as under IAS 39. Hedging gains and losses recognised in other comprehensive income will be recognised in a separate cash flow hedge reserve in equity.

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Strategic Business Management Chapter-16

International financial management 1 International trading The first three sections of this chapter cover general areas affecting multinational companies (MNCs), trading, establishing a business presence and finance. The last three sections cover more specific issues.

1.1

Trade risks Any company involved in international trade must assess and plan for the different risks it will face. As well as physical loss or damage to goods, there are also cash flow problems and the risk that the customer may not pay either on time or at all.

1.1.1

Loss or damage in transit The risks faced by international traders may be significant due to the distances and times involved. Businesses face the risk of goods being lost or stolen in transit, or the documents accompanying the goods going astray. Goods being exported should be insured from the time they leave the company till their arrival with the customer. Depending on the agreement, the exporter may bear the cost of insurance or responsibility for insurance may be passed onto the customer. The danger of leaving the customer to arrange insurance is that the exporter may not receive full payment from the customer if a problem arises and it is not adequately insured. If there is inadequate insurance and the goods are rejected, either at the port of entry or when they reach the customer's premises, the responsibility will be bounced back to the exporter.

1.1.2

Faults with products When supplying goods for export, companies must consider the risk that the product could cause damage to a third party, whether it is a person or property. Product liability insurance covers such risks. However, product liability insurance does not provide cover for claims against poor quality goods or services. Exporting companies must take responsibility for such risks themselves by sufficient quality control measures. By introducing such measures, companies may benefit from reduced insurance premiums.

1.2

Credit risks Regardless of whether goods are sold at home or abroad, there is always the risk that customers will either not pay in full or not pay at all. Where a company trades overseas, the risk of bad debts is potentially increased by the lack of direct contact with, and knowledge of, the business environment. Managing this credit risk is something that many companies overlook.

1.3

Financing trading When making decisions about financing international trade transactions, companies should consider:

1.3.1



The need for financing to make a sale, as favourable credit terms often make a product more competitive.



The length of time over which the product is being financed, which will determine how long the exporter will have to wait to get paid.



The cost of different methods of financing.



The risks associated with financing the transaction – the greater the risk, the more difficult and costly it will be to finance.



The need for pre-export finance and post-export working capital. This will be a particular issue if the order is especially large.

Pre-export finance Increased globalisation means that many companies rely heavily on export revenue. If large amounts of money have to be spent to allow the company to fulfil an export order, financing may be required to bridge the gap between fulfilling the order and being paid by the customer. For example, expensive 1

capital equipment may be required. Pre-export financing is often structured, meaning that banks will provide funding for the exporter but the funding will be tied to production and export activities. Export Credit Agencies (ECAs) can also provide finance to exporters. These agencies are government departments whose main function is to assist exporters by providing state insurance against political and commercial risks. While ECAs initially provided finance mainly to manufacturers, their role more recently has changed to providing assistance to companies exporting services as well as manufactured goods. ECA-covered finance is a suitable way of exceeding the natural limits of pre-export financing â&#x20AC;&#x201C; that is, the total value of proceeds under long-term export contracts.

1.3.2

Post-export finance This type of finance covers the period between the goods being shipped and payment being received. As overseas customers often negotiate lengthy credit periods, this can be a considerable period of time. Post-export finance protects against commercial and political risk. The cost of finance depends on various risk factors such as length of credit period, payment method and the country to which the export was made.

1.4

Foreign exchange risk management The following different types of foreign exchange risks may be significant.

1.5

Transaction risks Definition Transaction risk: The risk of adverse exchange rate movements occurring in the course of normal international trading transactions. This arises when export prices are fixed in foreign currency terms, or imports are invoiced in foreign currencies.

1.6

Economic risks Definition Economic risk: The risk that exchange rate movements might reduce the international competitiveness of a company. It is the risk that the present value of a company's future cash flows might be reduced by adverse exchange rate movements. Economic risk refers to the effect of exchange rate movements on the international competitiveness of a company. For example, a UK company might use raw materials which are priced in US dollars, but export its products mainly within the European Union. A depreciation of sterling against the dollar or an appreciation of sterling against other EU currencies will both erode the competitiveness of the company. Economic exposure is difficult to measure, but often it is determined by the impact of foreign exchange rate changes on costs and sales prices and the consequences for a business and for its competitors. It will therefore be influenced by the policies of suppliers (will they absorb price rises in raw materials themselves or pass the increase on to the business) and customers' reaction to price increases and differentials (whether there will be a significant adverse effect on demand). The impact of economic risk on financial statements may also be very difficult to assess. If a business's home currency strengthens, it may generate less revenue and profits from the export trade, but this may not be clearly disclosed in the financial statements.

1.6.1

Managing economic risk Various actions can reduce economic exposure, including: (a)

Matching assets and liabilities A foreign subsidiary can be financed, so far as possible, with a loan in the currency of the country in which the subsidiary operates. A depreciating currency results in reduced income but also reduced loan service costs.

(b) Diversifying the supplier and customer base For example, if the currency of one of the supplier countries strengthens, purchasing can be switched to a cheaper source. (c)

Diversifying operations worldwide On the principle that countries which confine themselves to one country suffer from economic exposure, international diversification of production and sales is a method of reducing economic exposure.

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(d) Change its prices How much scope a company has to change its prices in response to exchange movements will depend on its competitive position. If there are a lot of home and foreign competitors, an increase in prices may lead to a significant fall in demand.

1.7

Translation risks Definition Translation risk: The risk that the organisation will make exchange losses when the assets and liabilities of its foreign branches or subsidiaries are translated into the home currency. Following the requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates, at the year-end monetary assets and liabilities on the statement of financial position (cash, receivables, payables and loans) are retranslated at the closing rate on the accounting date. Non-monetary items (non-current assets, inventory and investments) are not retranslated. Translation losses can result, for example, from restating the book value of a foreign subsidiary's assets at the exchange rate on the date of the statement of financial position. However, such losses will not have an impact on the organisation's cash flow unless the assets are sold. In addition, a non-current asset purchase in a foreign currency may be financed by a loan but the loan will be retranslated every year whereas the non-current asset will not be and the two will no longer match. Apparent losses on translation could influence investors' and lenders' attitudes to the financial worth and creditworthiness of the company, even though they do not impact upon cash flows. Such risk can be reduced if monetary assets and liabilities, and non-monetary assets and liabilities, denominated in particular currencies can be held in balanced amounts. However, if managers believe that investors and lenders will not react adversely, they should not normally hedge translation risk.

2 Overseas investments Companies have a wide choice of strategies when it comes to setting up foreign operations so multinational companies (MNCs) wish to undertake investment in other countries. Each strategy fulfils a different purpose, depending on the type of presence that is required.

2.1

Takeover of, or merger with, established firms overseas If speed of entry into the overseas market is a high priority then acquisition may be preferable than starting from scratch. The main problem is that the better acquisitions may only be available at a premium.

2.1.1

2.1.2

2.2

Advantages of takeovers/mergers (a)

Merging with established firms abroad can be a means of purchasing market information, market share, distribution channels and reputation.

(b)

Other synergies include acquisition of management skills and knowledge, intangibles such as brands and trademarks, or additional cash and debt capacity.

(c)

Acquiring a subsidiary may be a means of removing trade barriers.

(d)

Acquisition can be a means of removing a competitor.

(e)

Start-up costs will not be incurred.

Disadvantages of takeovers/mergers (a)

Cultural issues may make it difficult to integrate the subsidiary into the Group.

(b)

Growing organically may be cheaper. In the long run it is more likely to be financed by retained cash flows than new sources with issue costs, and it will not involve paying a premium for a desirable subsidiary.

(c)

There may be duplication of resources/operations with the acquiring company.

Overseas subsidiaries The basic structure of many MNCs consists of a parent (holding) company with subsidiaries in several countries. The subsidiaries may be wholly- or partly-owned, and some may be owned through other subsidiaries.

2.2.1

Advantages of subsidiaries (a)

A local subsidiary may have a significant profile for sales and marketing purposes. 3

(b)

2.2.2

2.3

As a separate legal entity, a subsidiary should be able to claim legal privileges, reliefs and grants.

Disadvantages of subsidiaries (a)

As a separate entity, a subsidiary may be subject to significant legal and accounting formalities, including minimum capital requirements.

(b)

In some regimes, the activities of the subsidiary may be limited to the objects set out in its constitution and it may not be able to draft these objects too widely.

(c)

Dissolution of a subsidiary may be fairly complex.

Branches Firms that want to establish a presence in an overseas country may choose to establish a branch rather than a subsidiary.

2.3.1

2.3.2

Advantages of branches (a)

Establishment of a branch is likely to be simpler than a subsidiary.

(b)

In many countries, the remitted profits of a subsidiary will be taxed at a higher rate than those of a branch, as profits paid in the form of dividends are likely to be subject to a withholding tax. How much impact the withholding tax has however, is questionable, particularly as a double tax treaty can reduce its effect.

Disadvantages of branches (a)

The parent company is fully liable for the liabilities of the branch. A parent company may have to appoint an individual or company to, for example, represent it in dealing with the tax authorities and the individual or company chosen may be liable as well.

(b)

The obligations of the branch will be the same as those of the parent.

(c)

Banks and clients may prefer dealing with a local company rather than the branch of a foreign company.

(d)

The board of the parent company may need to ratify acts of the branch.

(e)

A branch may not be ideal for substantial projects because the parent company runs the entire risk.

In many instances a MNC will establish a branch and utilise its initial losses against other profits, and then turn the branch into a subsidiary when it starts making profits.

2.4

Joint ventures Definition Joint venture is the commitment, for more than a very short duration, of funds, facilities and services by two or more legally separate interests to an enterprise for their mutual benefit. A contractual joint venture is for a fixed period. The duties and responsibility of the parties are contractually defined. A joint-equity venture involves investment, is of no fixed duration and continually evolves. We discussed here joint ventures as a means of international expansion.

2.4.1 Advantages of international joint venture (a)

It gives relatively low cost access to markets in new countries.

(b)

Easier access to local capital markets may be available, possibly with accompanying tax incentives or grants.

(c)

The joint venture partner's existing local knowledge, cultural awareness, distribution network and marketing or other skills can be used.

(d)

Depending on government regulations, a joint venture may be the only means of access to a particular overseas market.

2.4.2 Disadvantages of international joint venture (a)

Managerial freedom may be restricted by the need to take account of the views of all the joint venture partners, particularly if cultural differences arise. The joint venture may be difficult to control or amend, especially if the investing company only has a limited presence in the country.

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2.5 2.5.1

(b)

There may be problems in agreeing on partners' percentage ownership, transfer prices, remittance arrangements, nationality of key personnel, remuneration and sourcing of raw materials and components.

(c)

Finding a reliable joint venture partner may take a long time, because of lack of local knowledge. Potential partners may not have the adequate skills.

Political and cultural risks Political risks As soon as a MNC decides to operate in another country, it is exposing itself to political risk. Host countries' governments, in an attempt to protect domestic industries or to protect their countries from exploitation, may impose such measures as quotas, tariffs or legal safety and quality standards, which can affect the efficient and effective operation of the MNC's activities. MNCs can assess the extent of political risk by considering such factors as government stability, level of import restrictions and economic stability in the country in which they propose to invest.

2.5.2

Cultural risks Businesses should take cultural risks into account when deciding the extent to which activities should be centralised, which will influence how overseas operations are established. The balance between local and expatriate staff must be managed. There are a number of influences.      

The availability of technical skills such as financial management The need for control The importance of product and company experience The need to provide promotion opportunities Costs associated with expatriates such as travel and higher salaries Cultural factors

For an international company, which has to think globally as well as act locally, there are a number of problems.   

2.6

Do you employ mainly expatriate staff to control local operations? Do you employ local managers, with the possible loss of central control? Is there such a thing as the global manager, equally at home in different cultures?

Accounting for foreign investments and IAS 21 The most significant requirements that relate to accounting for foreign investments are covered by IAS 21: The Effects of Changes in Foreign Exchange Rates. The main requirements of IAS 21 are summarised below.

2.6.1

Translation of foreign operations A reporting entity with foreign operations (such as a foreign subsidiary) needs to translate the financial statements of those operations into its own reporting currency before consolidation (or inclusion through the equity method). (a)

Statement of comprehensive income: translate using actual rates. An average for a period may be used, but not where there is significant fluctuation and the average is therefore unreliable.

(b)

Statement of financial position: translate all assets and liabilities (both monetary and non-monetary) using closing rates. This includes any purchased goodwill on the acquisition of a foreign operation. Any fair value adjustments to the carrying amounts of the assets and liabilities arising on the acquisition of the foreign operation should be treated as part of the assets and liabilities of the foreign operation.

(c)

Exchange differences are reported in other comprehensive income.

When a foreign operation is disposed of, the cumulative amount of exchange differences that have been reported in other comprehensive income and credited to an equity reserve account should be recognised in profit or loss for the period when the disposal occurs. (Any accumulated gains or losses in the equity reserve will therefore be reversed in other comprehensive income.)

2.6.2

Exchange differences Exchange differences comprise: 

Differences arising from the translation of the statement of comprehensive income at exchange rates at the transaction dates or at average rates, and the translation of assets and liabilities at the closing rate.



Differences arising on the opening net assets' retranslation at a closing rate that differs from the 5

previous closing rate. Resulting exchange differences are reported as other comprehensive income and classified as a separate component of equity, because such amounts have not resulted from exchange risks to which the entity is exposed through its trading operations, but purely through changing the currency in which the financial statements are presented.

2.6.3

Intragroup loans When a monetary item is part of the net investment in a foreign operation, ie there is an intragroup loan outstanding, then the following rules apply on consolidation.

2.6.4



If the loan is denominated in the functional currency of the parent entity the exchange difference will be recognised in the profit or loss of the foreign subsidiary.



If the loan is denominated in the functional currency of the subsidiary, exchange differences will be recognised in the profit or loss of the parent entity.



When the loan is denominated in the functional currency of either entity, on consolidation, the exchange difference will be removed from the consolidated profit or loss and it will be recognised as other comprehensive income and recorded in equity in the combined statement of financial position.



If, however, the loan is denominated in a third currency which is different from either entity's functional currency, then the translation difference should be recognised as part of profit or loss. For example, the parent may have a functional currency of US dollars, the foreign operation a functional currency of euros, and the loan made by the foreign operation may have been denominated in UK sterling. In this scenario, the exchange difference results in a cash flow difference and should be recognised as part of the profit or loss of the group.



A separate foreign currency reserve reported as part of equity may have a positive or negative carrying amount at the reporting date. Negative reserves are permitted under IFRS.



If the foreign operation is subsequently disposed of, the cumulative exchange differences previously reported as other comprehensive income and recognised in equity should be reclassified and included in the profit or loss on disposal recognised in profit or loss.

IAS 21 and foreign currency transactions Need to remember the rules in IAS 21 for reporting individual foreign currency transactions. Foreign currency transactions should be recorded and reported at the rate of exchange at the date of the transaction. At each subsequent reporting date: 

Foreign currency monetary amounts should be reported using the closing rate



Non-monetary items carried at historical cost should be reported using the exchange rate at the date of the transaction.



Non-monetary items carried at fair value should be reported at the rate in existence when the fair value was determined.

Exchange differences that arise when monetary amounts are settled or when monetary items are retranslated at a rate different from that when it was first recognised should be reported in profit or loss in the period. (An exception to this rule is when the exchange differences relate to monetary items that form part of a net investment in a foreign operation, when the rules described above will apply.)

3 Financing overseas investments MNCs fund their investments from cash flow generated from operations, from the issue of new equity and new debt. Equity and debt funding can be secured by accessing both domestic and overseas capital markets. Thus MNCs have to make decisions not only about their capital structure, as measured by the debt/equity ratio, but also about the source of funding, whether the funds should be drawn from the domestic or the international markets.

3.1

Factors affecting the capital structure of a MNC The source of funding for a MNC will be influenced by a number of factors.

3.1.1

Taxation Global taxation is an important factor in determining the capital structure of a MNC. Tax deductibility in any country in which it operates will be important, but because a MNC operates in several tax jurisdictions, it will have

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to consider other issues, such as double taxation, withholding taxes, and investment tax allowances. A MNC may choose the level of debt and the type of debt in a way that minimises its global tax liabilities. Tax-saving opportunities may also be maximised by structuring the Group and its subsidiaries in such a way as to take advantage of the different local tax systems.

3.1.2

Exchange rate risk Exchange rate risk may also influence the capital structure of a MNC. When a UK company wishes to finance operations overseas, there may be a currency (foreign exchange) risk arising from the method of financing used. For example, if a UK company decides on an investment in the US, to be financed with a sterling loan, the investment will provide returns in US dollars, while the investors (the lenders) will want returns paid in sterling. If the US dollar falls in value against sterling, the sterling value of the project's returns will also fall. To reduce or to eliminate the currency risk of an overseas investment, a company might finance it with funds in the same currency as the investment. The advantages of borrowing in the same currency as an investment are that:

3.1.3



Assets and liabilities in the same currency can be matched, thus avoiding exchange losses on conversion in the Group's annual accounts.



Revenues in the foreign currency can be used to repay borrowings in the same currency, thus eliminating losses due to fluctuating exchange rates.

Political risk Political risk to which companies may be exposed when investing overseas may also be reduced by the choice of an appropriate financing strategy. For example, a MNC may fund an international project by borrowing from banks in the country in which the project will be set up. In this way, the loss in the case of nationalisation will be borne by the local banks rather than by the parent company.

3.1.4

Business risk Business risk is also a determinant of capital structure. Business risk is normally proxied by the volatility of earnings. As multinational companies are able to diversify and reduce the volatility of earnings, they should be able to take on more borrowing.

3.1.5

Finance risk The choice of the source of funds will also depend on the local finance costs and any available subsidies. As subsidiaries may be operating with a guarantee from the parent company, different gearing structures may be possible. Thus a subsidiary may be able to operate with a higher level of debt than would be acceptable for the Group as a whole.

3.1.6

Other issues Parent companies should also consider the following factors.

3.2



Reduced systematic risk. There may be a small incremental reduction in systematic risk from investing overseas due to the segmentation of capital markets.



Access to capital. Obtaining capital from overseas markets may increase liquidity, reduce costs and make it easier to maintain optimal gearing.



Agency costs. These may be higher owing to political risk, market imperfections and complexity, which will lead to a higher cost of capital.

The advantages of borrowing internationally There are three main advantages to borrowing from international capital markets, as opposed to domestic capital markets.

3.3



Availability. Domestic financial markets, with the exception of the large countries and the Euro zone, lack the depth and liquidity to accommodate either large debt issues or issues with long maturities.



Lower cost of borrowing. In Eurobond markets interest rates are normally lower than borrowing rates in national markets.



Lower issue costs. The cost of issuing debt is normally lower than in domestic markets.

The risks of borrowing internationally A MNC has three options when financing an overseas project by borrowing in: 

The same currency as the inflows from the project. 7

3.4



A currency other than the currency of the inflows but with a hedge in place.



A currency other than the currency of the inflows but without hedging the currency risk. This exposes the company to exchange rate risk that can substantially change the profitability of a project.

Equity finance The issue of financing overseas subsidiaries using equity raises the following questions. 

How much equity capital should the parent put into the subsidiary?



Should the subsidiary be allowed to retain a large proportion of its profits to allow it to build up its own equity reserves or to finance further investment programmes, or will the majority of the profits be repatriated to the parent? What other issues may affect dividend policy? (We cover dividend policy in more detail in Section 5.)



Should the parent company hold 100% of the equity of the subsidiary or should it try to create a minority shareholding, perhaps by floating the subsidiary on the country's domestic stock exchange?



Should the subsidiary be encouraged to borrow as much long-term debt as it can? If so, should the debt be in the subsidiary's home currency or in a foreign currency?



Should the subsidiary be encouraged to minimise its working capital investment by relying heavily on trade credit?

The way in which a subsidiary is financed will give some indication of the nature and the length of time of the investment that the parent company is prepared to make. A sizeable equity investment (or long-term loans from the parent company to the subsidiary) would suggest a long-term investment by the parent.

3.5

Finance in developing markets Although companies in developed markets take the availability of a wide choice of finance options for granted, those operating in developing markets may not be quite so fortunate. Lack of regulation and a limited understanding of such markets make the funding of overseas acquisitions by, for example stock swaps (ie a share-for-share exchange), less likely. The target firms may be reluctant to accept payment in the form of risky equity. As a result companies in developing markets tend to finance overseas acquisitions using cash.

3.6

Hedging of net investment Definition Hedge of a net investment in a foreign operation: The hedged item is the amount of the reporting organisation's interest in the net assets of that operation. A non-derivative financial asset or liability can only be designated as a hedging instrument for hedges of foreign currency risk. So a foreign currency borrowing can be designated as a hedge of a net investment in a foreign operation, with the result that any translation gain or loss on the borrowing should be recognised in other comprehensive income to offset the translation loss or gain on the investment. (Normally gains or losses on such financial liabilities are recognised in profit or loss.) A net investment can be hedged with a derivative instrument such as a currency forward contract. In this case, however, it would be necessary to designate at inception that effectiveness can be measured by reference to changes in spot exchange rates or changes in forward exchange rates. The amount that an entity may designate as a hedge of a net investment may be all or a proportion of its net investment at the commencement of the reporting period. This is because the exchange rate differences reported in equity on consolidation, which form part of a hedging relationship, relate only to the retranslation of the opening net assets. Profits or losses arising during the period cannot be hedged in the current period. However, they can be hedged in the following periods, because they will then form part of the net assets which are subject to translation risk (discussed below).

3.6.1

Accounting for hedging of net investments Hedges of a net investment in a foreign operation should be accounted in a similar way to cash flow hedges, that is: 

The portion of gain or loss on the hedging instrument that is determined to be an effective hedge should be recognised in other comprehensive income; and



The ineffective portion should be recognised in profit or loss.

The gain or loss on the hedging instrument that has been recognised in other comprehensive income should be reclassified to profit or loss on disposal of the foreign operation. If only part of an interest in a foreign 8

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operation is disposed of, only the relevant proportion of this gain or loss should be reclassified to profit or loss.

3.7

Assurance work on overseas finance and investment risks The assurance adviser will be concerned with the issues of changing exchange and interest rates, where material, in the relevant accounting period, also issues over regulatory and tax compliance and whether there were any problems with remittance of income (covered later in this chapter). The assurance adviser will carry out the following work.

3.7.1



Examination of the loan capital terms and contractual liabilities of the company.



Checking the remittance of proceeds between the country of origin and the parent company by reference to bank and cash records.



Reviewing the movement of exchange and interest rates, and discussing their possible impact with the directors.



Obtaining details of any hedging transaction and ensuring that exchange rate movements on the finance has been offset.



Examining the financial statements to determine accurate disclosure of accounting policy and accounting treatment conforming to UK requirements.

Use of foreign auditors Some operations may be in countries which do not have accounting, auditing and assurance standards developed to the same extent as those in the UK. As a result, the work carried out on them by local practitioners may not conform to UK standards. In this situation the parent auditor may need to request:  

3.7.2

Adjustments to be made to the financial statements of the overseas investment. Additional audit and assurance procedures to be performed.

Transnational audits Definition Transnational audit means an audit of financial statements which are or may be relied upon outside the audited entity's home jurisdiction for purposes of significant lending, investment or regulatory decisions. This will include audits of all financial statements of companies with listed equity or debt and other public interest entities which attract particular public attention because of their size, products or services provided. The international networks linked to a number of major firms have set up an international grouping, the Forum of Firms (FoF). Membership is open to firms and networks that have transnational audit appointments or are interested in accepting such appointments. These firms have a voluntary agreement to meet certain requirements that are set out in their constitution. These relate mainly to:

3.8



Promoting the use of high quality audit practices worldwide, including the use of ISAs.



Maintaining quality control standards in accordance with International Standards on Quality Control issued by the IAASB, and conducting globally co-ordinated internal quality assurance reviews.

Global treasury management Important issues which the treasury department of a large company with significant international trading and operations will have to consider include:     

Management of cash flows from and to suppliers, customers and subsidiaries. Dealing with political constraints affecting the flow of funds. Compliance with multiple legal and taxation requirements. Dealing with foreign exchange exposure. Maintaining relations with banks in different countries.

4 Exchange controls 4.1

Introduction Exchange controls restrict the flow of foreign exchange into and out of a country, usually to defend the local currency or to protect reserves of foreign currencies. Exchange controls are generally more restrictive in developing and less developed countries, although some still exist in developed countries. 9

Controls may take the following forms.

4.2



Rationing the supply of foreign exchange. Anyone wishing to make payments abroad in a foreign currency will be restricted by the limited supply, which stops them from buying as much as they want from abroad.



Restricting the types of transaction for which payments abroad are allowed, for example by suspending or banning the payment of dividends to foreign shareholders, such as parent companies in multinationals, who will then have the problem of blocked funds.

Strategies for dealing with exchange control Multinational companies have used many different strategies to overcome exchange controls, the most common of which are listed below. 

Transfer pricing where the parent company sells goods or services to the subsidiary and obtains payment. The amount of this payment will depend on the volume of sales and also on the transfer price for the sales.



Royalty payments when a parent company grants a subsidiary the right to make goods protected by patents. The size of any royalty can be adjusted to suit the wishes of the parent company's management.



Loans by the parent company to the subsidiary. If the parent company makes a loan to a subsidiary, it can set the interest rate high or low, thus affecting the profits of both companies. A high rate of interest on a loan, for example, would improve the parent company's profits to the detriment of the subsidiary's profits.



Management charges may be levied by the parent company for costs incurred in the management of international operations.

5 Dividend management The choice of whether to repatriate earnings from a foreign subsidiary is one of the most important decisions in multinational financial management. Receipts from subsidiaries help parent companies meet their financing needs as larger dividends to external shareholders are associated with larger dividend payments inside the Group. Significant factors that shape dividend policy within the multinational firm are the interaction between the level of investment planned by the parent company and its financing, the payment of dividends to external shareholders, taxation issues and management control.

5.1

Investment and financing Dividends from foreign affiliates may offer an attractive source of finance for domestic investment expenditures, despite possible associated tax costs, especially when alternative forms of finance are costly. This applies to parent companies with profitable domestic investment opportunities that already maintain large amounts of external debt and do not wish to increase the level of borrowing even further. Another case is when companies need to expand fast into areas and home country profitability is not sufficient to finance the expansion.

5.2

Dividend policy Dividends from foreign affiliates may also offer an attractive source of finance for payments of dividends to home country shareholders, especially when the parent company prefers a smooth dividend payment pattern and domestic profitability is in decline. The dividend payments of a subsidiary may also be affected by the dividend policy of the parent company. For example, if the parent company operates a constant payout ratio policy, then the subsidiary will have to adopt a constant payout ratio policy too. Empirical evidence shows that dividend payments to parent companies tend to be regular. Multinational firms behave as though they select target payouts for their foreign affiliates, gradually adjusting payouts over time in response to changes in earnings.

5.3

Tax regime and dividend payments Tax considerations are thought to be the primary reason for the dividend policies of multinational firms. For example, the parent company may reduce its overall tax liability by, for example, receiving larger amounts of dividends from subsidiaries in countries where undistributed earnings are taxed.

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For subsidiaries of UK companies, all foreign profits, whether repatriated or not, are liable to UK corporation tax, with a credit for the tax that has already been paid to the host country. Similarly, the US government does not distinguish between income earned abroad and income earned at home and gives credit to MNCs headquartered in the US for the amount of tax paid to foreign governments. One of the strong implications of the US tax treatment of foreign income is that American multinational corporations should not simultaneously remit dividends from low-tax foreign locations and transfer equity funds into the same foreign locations. Doing so generates a home-country tax liability that could be easily avoided simply by reducing both dividends and equity transfers.

5.4

Managerial control Another influence on dividend policies is the need to control foreign managers. Regular dividend payments restrict the financial discretion of foreign managers and limit their ability to misallocate funds, thereby reducing associated agency problems. An MNC's central management can use financial flows within the firm to evaluate the financial prospects and needs of far-flung foreign affiliates.

5.5

Timing of dividend payments Timing of dividends may be equally important as the size of payments. For example, a subsidiary may adjust its dividend payments to a parent company in order to benefit from expected movements in exchange rates. A company would like to collect early (lead) payments from currencies vulnerable to depreciation and to collect late (lag) from currencies which are expected to appreciate. Also, given that tax liabilities are triggered by remittance of dividends, these tax liabilities can be deferred by reinvesting earnings abroad rather than remitting dividends to parent companies. The incentive to defer repatriation is much stronger for affiliates in low-tax countries, whose dividends trigger significant parent tax obligations, than they are for affiliates in high-tax countries â&#x20AC;&#x201C; particularly since taxpayers receive net credits for repatriations from affiliates in countries with tax rates that exceed the parent country tax rate.

6 Transfer pricing Definition Transfer price is the price at which goods or services are transferred from one process or department to another or from one member of a Group to another. Multinational corporations supply their affiliates with capital, technology, and managerial skills, for which the parent firm receives streams of dividend and interest payments, royalties, and licence fees. Significant intrafirm transfers of goods and services also occur. For example, one subsidiary may provide another with raw materials, whereas the parent company may provide both subsidiaries with final goods for distribution to consumers. For intrafirm trade, both the parent company and the subsidiaries need to charge prices. These prices for goods, technology, or services between wholly- or partly-owned affiliates of the multinational are called transfer prices.

6.1

Determining transfer prices The size of the transfer price will affect the costs of one profit centre and the revenues of another. Since profit centre managers are held accountable for their costs, revenues, and profits, they may dispute the size of transfer prices with each other, or disagree about whether one profit centre should do work for another or not. Transfer prices affect behaviour and decisions by profit centre managers. If managers of individual profit centres are tempted to take decisions that are harmful to other divisions and are not congruent with the goals of the organisation as a whole, the problem is likely to emerge in disputes about the transfer price. Disagreements about output levels tend to focus on the transfer price. There is presumably a profit-maximising level of output and sales for the organisation as a whole. However, unless each profit centre also maximises its own profit at the corresponding level of output, there will be interdivisional disagreements about output levels and the profit-maximising output will not be achieved.

6.2

Bases of transfer prices The extent to which costs and profit are covered by the transfer price is a matter of company policy. A transfer price may be based upon any of the following. ď&#x201A;ˇ

Standard cost 11

     

Marginal cost: at marginal cost or with a gross profit margin added Opportunity cost Full cost: at full cost, or at a full cost plus price Market price Market price less a discount Negotiated price, which could be based on any of the other bases

A transfer price based on cost might be at marginal cost or full cost, with no profit or contribution margin. However, in a profit centre system it is more likely to be a price based on marginal cost or full cost plus a margin for contribution or profit. This is to allow profit centres to make a profit on work they do for other profit centres, and so earn a reward for their effort and use of resources on the work.

6.3

Market value transfer prices Transfers based on market price might be any of the following.

6.3.1

(a)

The actual market price at which the transferred goods or services could be sold on an external market.

(b)

The actual external market price, minus an amount that reflects the savings in costs (for example, selling costs and bad debts) when goods are transferred internally.

(c)

The market prices of similar goods that are sold on an external market, although the transferred goods are not exactly the same and do not themselves have an external market.

(d)

A price sufficient to give an appropriate share of profit to each party.

Advantages of market value transfer prices Giving profit centre managers the freedom to negotiate prices with other profit centres as though they were independent companies will tend to result in market-based transfer prices. (a)

In most cases where the transfer price is at market price, internal transfers should be expected, because the buying division is likely to benefit from a better quality of service, greater flexibility, and dependability of supply.

(b) Both divisions may benefit from lower costs of administration, selling and transport. A market price as the transfer price would therefore result in decisions which would be in the best interests of the company or Group as a whole.

6.3.2

Disadvantages of market value transfer prices Market value as a transfer price does have certain disadvantages.

6.4

(a)

The market price may be temporary, induced by adverse economic conditions, or dumping, or the market price might depend on the volume of output supplied to the external market by the profit centre.

(b)

A transfer price at market value might, under some circumstances, act as a disincentive to use up spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.

(c)

Many products do not have an equivalent market price, so that the price of a similar product might be chosen. In such circumstances, the option to sell or buy on the open market does not exist.

(d)

There might be an imperfect external market for the transferred item, so that if the transferring division tried to sell more externally, it would have to reduce its selling price.

(e)

Internal transfers are often cheaper than external sales, with savings in selling costs, bad debt risks and possibly transport costs. The buying division should thus expect a discount on the external market price, and to negotiate for such a discount.

Factors affecting transfer pricing When deciding on their transfer pricing policies, multinational companies take into account many internal and external factors.

6.4.1

Performance evaluation When different affiliates within a multinational are treated as stand-alone profit centres, transfer prices are needed internally by the multinational to determine profitability of the individual divisions. Transfer prices which deviate too much from the actual prices will make it difficult to monitor properly the performance of an affiliated unit.

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6.4.2

Management incentives If transfer prices that are used for internal measures of performance by individual affiliates deviate from the true economic prices, and managers are evaluated and rewarded on the basis of the distorted profitability, then it may result in corporate managers behaving in an irresponsible way.

6.4.3 Cost allocation When units within the multinational are run as cost centres, subsidiaries are charged a share of the costs of providing the Group service function so that the service provider covers its costs plus a small mark-up. Lower or higher transfer prices may result in a subsidiary bearing less or more of the overheads.

6.4.4

Financing considerations Transfer pricing may be used in order to boost the profitability of a subsidiary, with the parent company undercharging the subsidiary. Such a boost in the profitability and its credit rating may be needed by the subsidiary in order to succeed in obtaining funds from the host country. Transfer pricing can also be used to disguise the profitability of the subsidiary in order to justify high prices for its products in the host country and to be able to resist demands for higher wages. Because multinationals operate in two or more jurisdictions, transfer prices must be assigned for intrafirm trade that crosses national borders.

6.4.5

Taxes MNCs use transfer pricing to channel profits out of high tax rate countries into lower ones. A parent company may sell goods at lower than normal prices to its subsidiaries in lower tax rate countries and buy from them at higher than normal prices. The resultant loss in the parent's high tax country adds significantly to the profits of the subsidiaries. A MNC will report most of its profits in a low tax country, even though the actual profits are earned in a high tax country.

6.4.6

Tariffs Border taxes such as tariffs and export taxes are often levied on cross-border trade. Where the tax is levied on an ad valorem basis, the higher the transfer price, the larger the tax paid per unit. Whether an MNC will follow high transfer price strategy or not may depend on its impact on the tax burden. When border taxes are levied on a per-unit basis (ie specific taxes), the transfer price is irrelevant for tax purposes.

6.4.7

Rule of origin Another external factor is the need to meet the rule of origin that applies to crossborder flows within a free trade area. Since border taxes are eliminated within the area, rules of origin must be used to determine eligibility for duty-free status. Over or under-invoicing inputs is one way to avoid customs duties levied on products that do not meet the rule of origin test.

6.4.8

Exchange control and quotas Transfer pricing can be used to avoid currency controls in the host country. For example, a constraint in profit repatriation could be avoided by the parent company charging higher prices for raw materials, or higher fees for services provided to the subsidiary. The parent company will have higher profits and a higher tax liability and the subsidiary will have lower profitability and a lower tax liability. When the host country restricts the amount of foreign exchange that can be used to import goods, then a lower transfer price allows a greater quantity of goods to be imported.

6.5

Transfer price manipulation Firms set prices on intrafirm transactions for a variety of perfectly legal and rational internal reasons. Even where pricing is not required for internal reasons, governments may require it in order to determine how much tax revenues and customs duties are owed by the multinational corporation. Transfer price manipulation on the other hand exists, when multinational companies use transfer prices to evade or avoid payment of taxes and tariffs, or other controls that the government of the host country has put in place. Overall MNC profits after taxes may be raised by either under- or overinvoicing the transfer price. Such manipulation for tax purposes, however, comes at the expense of distorting other goals of the firm, in particular, evaluating management performance.

6.6

Government action Governments are concerned about transfer price manipulation and try to take action against it.

Definition Arms-length standard: Intrafirm trade of multinationals should be priced as if they took place between unrelated parties acting at arm's length in competitive industries. The most common solution that tax authorities have adopted to reduce the probability of transfer price manipulation is to develop transfer pricing regulations as part of the corporate income tax code. These regulations are generally based on the concept of the arm's length standard, which says that all MNC intrafirm activities should be priced as if they took place between unrelated parties acting at arm's length in competitive markets. The 1979 OECD Report defines the arm's length standard as: 'Prices which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market'. (OECD 1979) The arm's length standard has two methods. The method used will depend on the available data. The main methods of establishing 'arm's length' transfer prices of tangible goods include:     

Comparable uncontrolled price (CUP) Resale price (RP) Cost plus (C+) Comparable profit method (CPM) Profit split (PS)

The first three are transactions-based approach, while the latter two are profit-based

6.6.1

The comparable uncontrolled price (CUP) method The CUP method looks for a comparable product to the transaction in question (known as a product comparable). Tax authorities prefer the CUP method over all other pricing methods for at least two reasons.

6.6.2



It incorporates more information about the specific transaction than does any other method; ie it is transaction and product specific.



CUP takes both the interests of the buyer and seller into account since it looks at the price as determined by the intersection of demand and supply.

The resale price method (RPM) Where a product comparable is not available, and the CUP method cannot be used, an alternative method is to focus on one side of the transaction, either the manufacturer or the distributor, and to estimate the transfer price using a functional approach. Under the resale price method, the tax auditor looks for firms at similar trade levels that perform similar distribution function. The RPM method is best used when the distributor adds relatively little value to the product, so that the value of its functions is easier to estimate. The assumption behind the RPM is that competition among distributors means that similar margins (returns) on sales are earned for similar functions. The resale price method backs into the transfer price by subtracting a profit margin, derived from margins earned by comparable distributors engaged in comparable functions, from the known retail price to determine the transfer price. As a result, the RPM evaluates the transaction only in terms of the buyer. The method ensures that the buyer receives an arm's length return consistent with returns earned by similar firms engaged in similar transactions. Thus the resale price method tends to overestimate the transfer price since it gives all unallocated profits on the transaction to the manufacturer.

6.6.3

The cost plus method The cost plus method starts with the costs of production, measured using recognised accounting principles, and then adds an appropriate mark-up over costs. The appropriate mark-up is estimated from those earned by similar manufacturers. The assumption is that in a competitive market the percentage mark-ups over cost that could be earned by other arm's length manufacturers would be roughly the same. The cost plus method works best when the producer is a simple manufacturer without complicated activities, so that its costs and returns can be easily estimated. In order to use the cost plus method, the tax authority or the MNC must know the accounting approach adopted by the unrelated parties.

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6.6.4



What costs are included in the cost base before the mark-up over costs is calculated? Are they actual costs or standard costs?



Are only manufacturing costs included or is the cost base the sum of manufacturing costs plus some portion of operating costs? The larger the cost base, the smaller should be the profit markup, or gross margin, over costs.

The comparable profit method (CPM) The comparable profits method is based on the premise that companies in similar industries will tend to have similar financial performance and characteristics. This similarity in performance will be indicated by the similarity in financial ratios. For instance, if the return on assets (ROA) is the profit level indicator, then knowledge of the rate of ROAs for comparable companies or for the industry coupled with knowledge of the assets of the company would determine the taxable profits of the company. The comparable profits method has the following shortcomings.

6.6.5



It is not a transactions-based method.



It does not take the contractual obligations of the parties into account.



It does not reflect the facts and circumstances of the case.



It could lead to substantial double taxation of income if other governments did not accept the method.

The profit split method (PSM) When there are no suitable product comparables (the CUP method) or functional comparables (the RPM and cost plus method), the most common alternative method is the profit split (PSM) method, whereby the profits on a transaction earned by two related parties are split between the parties. The profit split method allocates the consolidated profit from a transaction, or group of transactions, between the related parties. Where there are no comparables that can be used to estimate the transfer price, this method provides an alternative way to calculate or 'back into' the transfer price. The most commonly recommended ratio to split the profits on the transaction between the related parties is return on operating assets (the ratio of operating profits to operating assets). The profit split method ensures that both related parties earn the same return on assets.

Strategic Business Management Chapter-17 Investment appraisal 1 Investment appraisal 1.1.1

Taxation Tax writing-down allowances (WDA) are available on non-current assets which allows a company's tax bill to be reduced.

1.2

Adjusted present value The adjusted present value (APV) calculation starts with the valuation of a company without debt then, as debt is added to the firm, considers the net effect on firm value by looking at the benefits and costs of borrowing. The primary benefit of borrowing is assumed to be the tax benefit (interest is tax deductible) while the main cost of borrowing is the added risk of bankruptcy. The decision rule is to accept the project as long as its total worth is greater than the outlay required. The value of the firm is estimated in three steps. The first step is to estimate the value of the firm with no gearing. The present value of the interest tax savings generated by borrowing a given amount of money is then considered. Finally, an evaluation of the effect of borrowing the said amount on the probability of the firm going bankrupt is carried out, together with the expected cost of bankruptcy.

1.3

Modified internal rate of return One of the problems with the IRR is the assumption about the reinvestment rate. A way to resolve this problem is to allow the specification of the reinvestment rate. This modification is known as the modified internal rate of return (MIRR).

1.3.1

Advantages of MIRR There are two main technical advantages to the MIRR. First, it avoids any potential problems with multiple IRRs, and additionally, it will not provide decision-making advice concerning mutually exclusive projects that conflicts with the NPV decision. The second advantage arises as a result of the IRR decision being incorrectly based on the assumption that cash flows would be reinvested at the IRR. With MIRR, it is assumed that cash flows are reinvested at the project's opportunity cost of capital, which is consistent with NPV calculations. MIRR could be seen as being the best of both worlds, as it is underpinned by NPV, but at the same time presents results in the more understandable percentage format.

1.3.2

Disadvantages of MIRR However, MIRR, like all rate of return methods, suffers from the problem that it may lead an investor to reject a project which has a lower rate of return but, because of its size, generates a larger increase in wealth. In the same way, a high-return project with a short life may be preferred over a lower-return project with a longer life.

1.4 Investment appraisal and risk In general, risky projects are those whose future cash flows, and hence the project returns, are likely to be variable. The greater the variability is, the greater the risk. The problem of risk may be more acute with capital investment decisions than other decisions for the following reasons. ď&#x201A;ˇ

Estimates of capital expenditure might be for several years ahead, such as for major construction projects. Actual costs may escalate well above budget as the work progresses.

ď&#x201A;ˇ

Estimates of benefits will be for several years ahead sometimes 10, 15 or 20 years ahead or even longer, and such long-term estimates can at best be approximations.

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

An investment decision may be significant in scale compared to most operating decisions.



A major investment may be part of a new business strategy, or new venture, which may be more uncertain than operating decisions which are part of an ongoing strategy.

1.5 Sensitivity analysis Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used to calculate the NPV. One particular approach to sensitivity analysis – the certainty-equivalent approach – involves the conversion of the expected cash flows of the project to riskless equivalent amounts. The basic approach of sensitivity analysis in the context of an investment decision is to calculate the project's NPV under alternative assumptions to determine how sensitive it is to changing conditions. An indication is thus provided of those variables to which the NPV is most sensitive and the extent to which those variables would need to change before the investment results in a negative NPV. The NPV could depend on a number of uncertain independent variables.        

Selling price Sales volume Cost of capital Initial cost Operating costs Benefits Cost savings Residual value

Sensitivity analysis therefore provides an indication of why a project might fail. Management should review critical variables to assess whether or not there is a strong possibility of events occurring which will lead to a negative NPV. Management should also pay particular attention to controlling those variables to which the NPV is particularly sensitive, once the decision has been taken to accept the investment.

1.5.1

Weakness of this approach to sensitivity analysis These are: 

The method requires that changes in each key variable are isolated. However, management is more interested in the combination of the effects of changes in two or more key variables.



Looking at factors in isolation is unrealistic since they are often interdependent.



Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur.



Critical factors may be those over which managers have no control.



In itself it does not provide a decision rule. Parameters defining acceptability must be laid down by the managers.

1.6 Certainty-equivalent approach

2 International investment appraisal With international investment appraisal, multinational companies must take into account factors that affect the behaviour of the economies of those countries which have an impact on their projects. For example, in appraising a tourist development, a company may be making assumptions about the number of tourists from abroad who may be visiting. This will be affected by such factors as interest rates, tax rates and inflation in the countries from which tourists may visit. If interest and tax rates rise, potential tourists will have less money to spend and spending on such luxuries as foreign holidays may decline. Exchange rates will also have an impact on the number of foreign visitors – for example, there would be an increase in the number of UK visitors to the USA if the pound strengthened significantly against the US dollar.

2.1

DCF appraisal of foreign investment projects: the basic rules DCF appraisal of foreign investment projects is affected by several issues that do not apply to domestic investments in the home country:

1150



Exchange rate risk: future cash flows in the foreign currency, when converted into domestic currency, will be affected by changes in the exchange rate over time.



The cash flows for discounting: when DCF analysis is applied to cash flows in the investing

company’s own currency, assumptions should be made about the timing of remittances (cash returns) to the company. 

The net cash inflows from the project will be in the foreign currency of the investment, but some cash payments may be in the investing company’s own currency. For example the initial investment may be paid for in the company’s domestic currency, and there may be some tax payments too in the investing company’s own currency.

These issues could be re-stated in the following terms:

2.1.1



Which currency of cash flows should be discounted (and at what discount rate)?



How should foreign currency cash flows be converted into the investing company’s own currency? What is an appropriate rate of exchange?

Calculating NPV for international projects There are two alternative methods for calculating the NPV from an overseas project. For a UK company investing overseas, the two options are as follows. (a)

Method 1. Discount the expected cash flows that will occur in the investing company’s domestic currency. This approach is appropriate when the investing company will pay for the investment in its own currency and when additional tax payments, or other expenditures may occur in its own currency. It may be assumed that all the after-tax cash inflows from the foreign investment will be remitted to the investing company in the year that the cash inflows occur. With this assumption, the net cash inflows in each year should be translated into the domestic currency at a rate of exchange that will be expected at the end of that year. However, the amount of remittances each year can be adjusted to allow for any retentions of cash in the investment; for example if the foreign government imposes exchange controls over payments of dividends out of the country to foreign investors. These cash flows should then be discounted at an appropriate cost of capital. This may be the company’s weighted average cost of capital, but a different rate may be appropriate where the investment will significantly affect financial gearing or business risk for the investing company. A problem with this approach is the need to estimate what the exchange rate will be in each year. An estimated exchange rate can be calculated using Purchasing Power Parity (PPP) theory and estimates of rates of inflation in the two countries.

(b)

Method 2. Discount the cash flows in the host country's currency from the project at an adjusted discount rate for that currency, and then translate the resulting NPV at the spot exchange rate in Year 0. This approach is appropriate when the initial investment is made in the foreign currency of the project. For example, if a UK company borrows in euros to make an investment in the Eurozone, the project cash flows in euros can be discounted at an appropriate cost of capital to establish a value for the project in euros. This value can then be translated into a sterling equivalent at the spot rate of exchange.

Method 2 – discounting foreign cash flows at an adjusted discount rate When we use the second method we need to find the cost of capital for the project in the host country. If we are to keep the cash flows in euros, then they need to be discounted at a rate that takes account of both the UK discount rate (10%) and the rate at which the exchange rate is expected to decrease (5%). We can use the International Fisher effect to find the cost of capital in the host country that takes account of the UK discount rate and the rate at which the exchange rate is expected to decrease. We can then use this rate to discount the euro cash flows. Or 1.52 1 r   1.10  1.045 1.6

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Thus the euro discount rate is 4.5% and discounting the euro flows at this rate produces a NPV in euros of NPV = €1,238.78 million (as shown in the workings below). 0 1 2 3 4 5 6 Euro flows (€m) Capital -1,750 500 Net cash flows 800 800 800 800 800 Depreciation 250 250 250 250 250 Tax 220 220 220 220 220 Net cash flows -1,750 800 580 580 580 1,080 -220 Discount factor 1 0.957 0.916 0.876 0.839 0.802 0.768 PV -1,750.00 765.6 531.28 508.08 486.62 866.16 -168.96 NPV in euros 1,238.78m Translating this present value at the spot rate gives: NPV = €1,238.78m/1.6 = £774.24 million The difference between the figure above and the NPV of £774.37 million using the alternative method above is due to rounding.

2.1.2

The effect of exchange rates on NPV Now that we have created a framework for the analysis of the effects of exchange rate changes on the net present value from an overseas project we can calculate the impact of exchange rate changes on the sterling denominated NPV of a project. When there is a devaluation of sterling relative to a foreign currency, the sterling value of the cash flows increases and the NPV increases. The opposite happens when the domestic currency appreciates. In this case the sterling value of the cash flows declines and the NPV of the project in sterling declines. The relationship between NPV in sterling and the exchange rate is shown in the diagram below (where 'e' is the exchange rate):

2.2 2.2.1

Forecasting cash flows from overseas projects Effect on exports When a multinational company sets up a subsidiary in another country, to which it already exports, the relevant cash flows for the evaluation of the project should take into account the loss of export earnings in the particular country. The NPV of the project should take explicit account of this potential loss by deducting the loss of export earnings from the relevant net cash flows.

2.2.2

Taxes Taxes play an important role in the investment appraisal as they can affect the viability of a project. The main aspects of taxation in an international context are:     

Corporate taxes in the host country Investment allowances in the host country Withholding taxes in the host country Double taxation relief in the home country (discussed below) Foreign tax credits in the home country

The importance of taxation in corporate decision-making is demonstrated by the use of tax havens by some multinationals as a means of deferring tax on funds prior to their repatriation or reinvestment. A tax haven is likely to have the following characteristics.

2.2.3

(a)

Tax on foreign investment or sales income earned by resident companies, and withholding tax on dividends paid to the parent, should be low.

(b)

There should be a stable government and a stable currency.

(c)

There should be adequate financial services support facilities.

Subsidies Many countries offer concessionary loans to multinational companies in order to entice them to invest in the country. The benefit from such concessionary loans should be included in the NPV calculation. The benefit of a concessionary loan is the difference between the repayment when borrowing under market conditions and the repayment under the concessionary loan.

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2.2.4

Exchange restrictions In calculating the NPV of an overseas project, only the proportion of cash flows that are expected to be repatriated should be included in the calculation of the NPV.

2.2.5

Impact of transaction costs on NPV for international projects Transaction costs are incurred when companies invest abroad due to currency conversion or other administrative expenses. These should also be taken into account.

2.3

Double taxation relief Definition Double taxation agreement: An agreement between two countries intended to avoid the double taxation of income which would otherwise be subject to taxation in both. Typical provisions of double taxation agreements based on the OECD Model Agreement are as follows.

2.4

(a)

DTR is given to taxpayers in their country of residence by way of a credit for tax suffered in the country where income arises. This may be in the form of relief for withholding tax only or, given a holding of specified size in a foreign company, for the underlying tax on the profits out of which dividends are paid.

(b)

Total exemption from tax is given in the country where income arises in the hands of, for example, visiting diplomats, teachers on exchange programmes.

(c)

Preferential rates of withholding tax are applied to, for example, payments of rent, interest and dividends. The usual rate is frequently replaced by 15% or less.

(d)

There are exchange of information clauses so that tax evaders can be pursued internationally.

(e)

There are rules to determine a person's residence and to prevent dual residence (tie-breaker clauses).

(f)

There are clauses which render certain profits taxable in only one rather than both of the contracting states.

(g)

There is a non-discrimination clause so that a country does not tax foreigners more heavily than its own nationals.

Corporate reporting consequences We have discussed the impact of IAS 21 on how overseas investments are accounted for in earlier chapters. Assets and transactions associated with investments will be reported at the exchange rate at the date the transactions occurred or the assets were purchased. If assets are subsequently revalued they will be carried at the exchange rate at the date the revaluation took place.

3 Real options A real option is the right, but not the obligation, to undertake a business decision, such as capital investment – for example, the option to open a new branch is a real option. Unlike financial options, real options are not tradable – for example, the company cannot sell the right to open another branch to a third party. While the term 'real option' is relatively new, businesses have been making such decisions for a long time. This type of option is not a derivative instrument, in the same way as foreign currency and interest rate options. Real options pertain to physical or tangible options (that is, choice) – hence the name. For example, with research and development, firms have the option (choice) to expand, contract or abandon activities in a particular area in the future. Pharmaceutical companies such as GlaxoSmithKline are making such choices all the time. Real options can have a significant effect on the valuation of potential investments, but are typically ignored in standard discounted cash flow analysis, where a single expected NPV is computed. In this section we review the various options embedded in projects and provide examples.

3.1

Option to delay When a firm has exclusive rights to a project or product for a specific period, it can delay starting this project or product until a later date. A traditional investment analysis just answers the question of whether the project is a 'good' one if taken at a particular point in time, eg today. Thus, the fact that a project is not selected today either because its NPV is negative, or its IRR is less than the cost of capital, does not mean that the rights to this project are not valuable.

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Take a situation where a company is considering paying an amount C to acquire a licence to mine copper. The company needs to invest an extra amount I in order to start operations. The company has three years over which to develop the mine, otherwise it will lose the licence. Suppose that today copper prices are low and the NPV from developing the mine is negative. The company may decide not to start the operation today, but it has the option to start any time over the next three years provided that the NPV is positive. Thus the company has paid a premium C to acquire an American-style option on the present value of the cash flows from operation, with an exercise price equal to the additional investment (I). The value of the option to delay is therefore:

3.2

Option to expand The option to expand exists when firms invest in projects which allow them to make further investments in the future or to enter new markets. The initial NPV calculation may suggest that the project is not worth undertaking. However, when the option to expand is taken into account, the NPV may become positive and the project worthwhile. The initial investment may be seen as the premium required to acquire the option to expand. Expansion will normally require an additional investment, call it I. The extra investment will be undertaken only if the present value from the expansion will be higher than the additional investment, ie when PV > I. If PV < 1, the expansion will not take place. Thus the option to expand is again a call option of the present value of the firm with an exercise price equal to theCvalue of the additional investment.

3.3

Option to abandon Whereas traditional capital budgeting analysis assumes that a project will operate in each year of its lifetime, the firm may have the option to cease a project during its life. This option is known as an abandonment option. Abandonment options, which are the right to sell the cash flows over the remainder of the project's life for some salvage value, are like American put options. When the present value of the remaining cash flows (PV) falls below the liquidation value (L), the asset may be sold. Abandonment is effectively the exercising of a put option. These options are particularly important for large capital intensive projects such as nuclear plants, airlines, and railroads. They are also important for projects involving new products where their acceptance in the market is uncertain and companies would like to switch to more profitable alternative uses.

3.4

Option to redeploy The option to redeploy exists when the company can use its assets for activities other than the original one. The switch from one activity to another will happen if the PV of cash flows from the new activity exceeds the costs of switching. The option to abandon is a special case of an option to redeploy. These options are particularly important in agricultural settings. For example, a beef producer will value the option to switch between various feed sources, preferring to use the cheapest acceptable alternative. These options are also valuable in the utility industry. An electric utility, for example, may have the option to switch between various fuel sources to produce electricity. In particular, consider an electric utility that has the choice of building a coal-fired plant or a plant that burns either coal or gas. Naïve implementation of discounted cash flow analysis might suggest that the coal-fired plant be constructed since it is considerably cheaper. Whereas the dual plant costs more, it provides greater flexibility. Management has the ability to select which fuel to use and can switch back and forth depending on energy conditions and the relative prices of coal and gas. The value of this operating option should be taken into account.

3.5 Product options Examples of product options are patents and copyrights, and firms owning natural resources. Firms that have product options are often research- and technology-based. When a firm has a product option that is not currently generating cash flow, there is a risk that a discounted cash flow approach to valuation will not fully reflect the full value of the option. This is because a DCF approach may not incorporate all the possible future cash flows of the company.

3.6

Problems with traditional DCF techniques In the context of a product option, the DCF approach is not fully appropriate, for the following reasons. 

The options represent a current asset of the business, but are not generating any cash flows.



Any cash flows expected to be generated by the product could be outside of the detailed forecasting period.

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3.7

Possible solutions to the valuation problem There are three possible methods of valuing product options.

3.8 3.8.1



Value the option on the open market. This is only possible if there is a traded market in such options. If there is no active market or if the option is difficult to separate from the other operations of the firm, this approach is probably not feasible.



Use a traditional DCF framework and factor in a higher growth rate than would be justified given the existing assets of the firm. The problem with this is that any growth rate used will be subjective. In addition, it expresses contingent cash flows as expected cash flows.



Use an option-based approach to valuation. This is considered below.

Use of option pricing models Problems with using option pricing models to value product options The problems of using option pricing models, such as Black-Scholes, are:

3.8.2



They need the underlying asset to be traded. This is because the model is based on the principle of arbitrage, which means that the underlying asset must be easy to buy and sell. This is not a problem when valuing options on quoted shares. However, the underlying asset in the context of product options will not be traded, meaning that arbitrage is not possible.



They assume that the price of the underlying asset follows a continuous pattern. While this may be a reasonable approximation most of the time for quoted shares, it is clearly inappropriate in the context of product options. The impact of this is that the model will undervalue deeply out- ofthe-money options, since it will underestimate the probability of a sudden large increase in the value of the underlying asset.



They assume that the standard deviation of price of the underlying asset is known and does not vary over the life of the option. While this may be a reasonable assumption in the context of short-dated equity options, it is not appropriate for long-term product options.



They assume that exercise occurs at a precise point in time. In the case of product options, exercise may occur over a long period of time. For example, if a firm has the right to mine natural resources, it will take time to extract the resources. This will reduce the present value of the asset.

Using option pricing models to value product patents When valuing product patents as options, the key inputs for an option pricing model will need to be identified, being the underlying asset price, the strike price, the expected volatility of the underlying asset price and the time to expiry. The following approach could be adopted. 

Identify the value of the underlying asset. This will be based on the expected cash flows that the asset can generate. Given the uncertain nature of the cash flows and the distant time periods in which they may arise, it clearly will be difficult to value the underlying asset precisely.



Identify the standard deviation of the cash flows above. Again, this will be difficult to identify, owing to changes in the potential market for the product, changes in technology and so on. It would, however, be possible to use techniques such as scenario analysis. The higher the standard deviation, the more valuable the asset.



Identify the exercise price of the option. This is the cost of investing in the resources needed to produce the asset. It is typically assumed that this remains constant in present value terms, with any uncertainty being reflected in the cash flows of the asset.



Identify the expiry date of the option. This is when the patent expires. Any cash flows after this date are expected to have an NPV of zero, since there will be generic competition after patent protection ends.



Identify the cost of delay. If the product is not implemented immediately, this will reduce the value of the cash flows from the project as competing products will enter the market in future years.

A similar approach could be adapted to valuing other product options, such as natural resources. Where a company is investing in research and development, but has no patents developed, the same approach will apply, but the value of the option is clearly even more uncertain due to the greater uncertainty of the inputs.

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4 Externalities and social responsibilities There are a number of costs and other impacts resulting from the effects of investments on the environment that businesses should consider.

Definition Environmental management accounting: The generation and analysis of both financial and nonfinancial information in order to support internal environmental management processes. The United Nations Division for Sustainable Development (UNDSD) produced a similar definition of environmental management accounting as being the identification, collection, analysis and use of two types of information for internal decision-making: (a)

Physical information on the use, flows and destinies of energy, water and materials (including wastes).

(b)

Monetary information on environment-related costs, earnings and savings.

Environment related costs could be categorised into four groups. (a)

Environmental protection (prevention) costs – the costs of activities undertaken to prevent adverse environmental impacts such as the production of waste.

(b)

Environmental detection costs – costs incurred to ensure that the organisation complies with regulations and voluntary standards.

(c)

Environmental internal failure costs – costs incurred from performing activities that have produced contaminants and waste that have not been discharged into the environment.

(d)

Environmental external failure costs – costs incurred on performing activities after discharging waste into the environment.

Many conventional accounting systems are unable to apportion environmental costs to products, processes and services and so they are simply classed as general overheads. Environmental management accounting (EMA), on the other hand, attempts to make all relevant, significant costs visible so that they can be considered when making business decisions.

4.1

Other costs A 1998 IFAC report listed a large number of costs that a business might suffer. Direct or indirect environmental costs            

Waste management Remediation costs or expenses Compliance costs Permit fees Environmental training Environmentally driven research and development Environmentally related maintenance Legal costs and fines Environmental assurance bonds Environmental certification and labelling Natural resource inputs Record keeping and reporting

Contingent or intangible environmental costs        

Uncertain future remediation or compensation costs Risk posed by future regulatory changes Product quality Employee health and safety Environmental knowledge assets Sustainability of raw material inputs Risk of impaired assets Public/customer perception

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Clearly, some of the contingent costs will be very difficult to predict, both in terms of how much they will be and how likely they are to arise. Management's risk appetite, especially perhaps as regards threats to the company's reputation if environmental problems do arise, is likely to be very important. Companies that appear to be bearing significant environmental risks may also face increased cost of capital because investors and lenders demand a higher risk premium.

4.2

Externalities Definition Externality: The difference between the market and social costs, or benefits, of an activity. An externality is a cost or benefit that the market fails to take into account. One way in which businesses can help promote sustainability is to provide information about the external environmental effects – the externalities – of their investments and activities. This data can then be used in decision-making processes, both of government, and of other organisations, by internalising the costs of environmental effects. In addition, better costing of externalities will influence the price mechanism and hence the economic decisions that are taken. Examples of externalities could include:      

Depletion of natural resources Noise and aesthetic impacts Residual air and water emissions Long-term waste disposal (exacerbated by excessive product packaging) Uncompensated health effects Change in the local quality of life (through for example the impact of tourism)

With some of these impacts however, a business may be contributing negatively to the environment, but positively in other ways. An increase in tourism will provide jobs and other economic benefits to the community, but could lead to adverse effects on the environment as the roads become more crowded or because of infrastructure improvements. Ways of assessing the impact of inputs include the measurement of key environmental resources used such as energy, water, inventories or land. Measurement of the impact of outputs includes the proportion of product recyclability, tonnes of carbon or other gases produced by company activities, waste or pollution. A business may also be concerned with the efficiency of its processes, maybe carrying out a mass balance or yield calculation.

4.3 4.3.1

Corporate reporting issues Impact on accounts Accounting standards are relevant for the treatment of environmental issues. The consequences of making particular investments may include incurring of liabilities for waste disposal, pollution, decommissioning and restoration expenses. The company may therefore be obliged to make provisions under the terms of IAS 37 if it is probable that it will have to transfer economic benefits to settle its liabilities, and a reliable estimate will have to be made of the benefits that have to be transferred.

4.3.2

Business review The business review within the directors' report should include reporting on environmental issues, including reporting the impact of the company's business on the environment. Most of this information will be disclosed on an aggregate level, but possibly some individual investments might be material because of their size, financial or non-financial impacts or risks that details relating to them should be shown in the review.

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Strategic Business Management Chapter-18 Treasury and workingcapital management 1 Treasury management function 1.1

Treasury policy Definition Treasury management: 'the corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows, and the complex strategies, policies and procedures of corporate finance'. (The Association of Corporate Treasurers) Large companies rely heavily for both long- and short-term funds on the financial and currency markets. To manage cash (funds) and currency efficiently, many large companies have set up a separate treasury department.

1.2

The role of the treasurer The diagrams below are based on the Association of Corporate Treasurers' list of experience it requires from its student members before they are eligible for full membership of the Association. Required experience gives a good indication of the roles of treasury departments.

1.3

Advantages of a separate treasury department Advantages of having a treasury function which is separate from the financial control function are:

1.4



Centralised liquidity management avoids mixing cash surpluses and overdrafts in different localised bank accounts.



Bulk cash flows allow lower bank charges to be negotiated.



Larger volumes of cash can be invested, giving better short-term investment opportunities.



Borrowing can be agreed in bulk, probably at lower interest rates than for smaller borrowings.



Currency risk management should be improved, through matching of cash flows in different subsidiaries. There should be less need to use expensive hedging instruments such as option contracts.



A specialist department can employ staff with a greater level of expertise than would be possible in a local, more broadly based, finance department.



The company will be able to benefit from the use of specialised cash management software.



Access to treasury expertise should improve the quality of strategic planning and decision-making.

Outsourcing Because of the specialist nature of treasury management, a number of businesses outsource the function to specialist institutions. The company receives the benefit of the expertise of the specialist's staff, which may be able to fill resource or skills gaps otherwise absent from the internal team. Outsourcing operational functions may enable the internal team to concentrate on strategic functions. It may also give the organisation access to better systems solutions. The specialists can deal on a large scale and pass some of the benefit on in the form of fees that are lower than the cost of setting up an internal function would be. However, whether the same level of service could be guaranteed from the external institution as from an internal department is questionable. The external institution may not have as much knowledge of the needs of the business as an internal department. If treasury activities are to be outsourced, contract documentation needs to be clear and management and reporting procedures must be established. Other mechanisms may achieve the cost savings of outsourcing, but be more responsive to an organisation's needs. These include shared service centres (separate legal entities owned by the organisation and acting as independent service providers), which can be used to obtain economies of scale by concentrating dispersed units into one location. These may not necessarily be located near head office; in fact many are located where they can obtain tax advantages.

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1.5 1.5.1

Centralised or decentralised cash management? The centralisation decision A large company may have a number of subsidiaries and divisions. In the case of a multinational, these will be located in different countries. It will be necessary to decide whether the treasury function should be centralised. With centralised cash management, the central treasury department effectively acts as the bank to the Group. The central treasury has the job of ensuring that individual operating units have all the funds they need at the right time.

1.5.2

1.5.3

Advantages of a specialist centralised treasury department 

Centralised liquidity management avoids having a mix of cash surpluses and overdrafts in different local bank accounts and facilitates bulk cash flows, so that lower bank charges can be negotiated.



Larger volumes of cash are available to invest, giving better short-term investment opportunities (for example, money market deposits, high interest accounts and Certificates of Deposit).



Any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings, and perhaps on the eurocurrency or eurobond markets.



Foreign currency risk management is likely to be improved in a group of companies. A central treasury department can match foreign currency income earned by one subsidiary with expenditure in the same currency by another. In this way, the risk of losses on adverse exchange rate changes can be avoided without the expense of forward exchange contracts or other 'hedging' (risk-reducing) methods.



A specialist treasury department will employ experts with knowledge of dealing in futures, eurocurrency markets, taxation, transfer prices and so on. Localised departments would not have such expertise.



The centralised pool of funds required for precautionary purposes will be smaller than the sum of separate precautionary balances which would need to be held under decentralised treasury arrangements.



Through having a separate profit centre, attention will be focused on the contribution to Group profit performance that can be achieved by good cash, funding, investment and foreign currency management.



Centralisation provides a means of exercising better control through use of standardised procedures and risk monitoring. Standardised practices and performance measures can also create productivity benefits.

Possible advantages of decentralised cash management 

Sources of finance can be diversified and can be matched with local assets.



Greater autonomy can be given to subsidiaries and divisions because of the closer relationships they will have with the decentralised cash management function.



The decentralised treasury function may be able to be more responsive to the needs of individual operating units.

However, since cash balances will not be aggregated at Group level, there will be more limited opportunities to invest such balances on a short-term basis.

1.5.4

Centralised cash management in the multinational firm If cash management within a multinational firm is centralised, each subsidiary holds only the minimum cash balance required for transaction purposes. All excess funds will be remitted to the central treasury department. Funds held in the central pool of funds can be returned quickly to the local subsidiary by telegraphic transfer or by means of worldwide bank credit facilities. The firm's bank can instruct its branch office in the country in which the subsidiary is located to advance funds to the subsidiary.

1.6 1.6.1

The treasury department as a cost centre or profit centre Treasury department as a cost centre A treasury department might be managed either as a cost centre or as a profit centre. For a Group of companies, this decision may need to be made for treasury departments in separate subsidiaries as well as for the central corporate treasury department. In a cost centre, managers have an incentive only to keep the costs of the department within budgeted spending targets. The cost centre approach implies that the treasury is there to perform a service of a certain standard to other departments in the enterprise. The treasury is treated much like any other service department.

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1.6.2

Treasury department as a profit centre However, some companies (including BP, for example) are able to make significant profits from their treasury activities. Treating the treasury department as a profit centre recognises the fact that treasury activities such as speculation may earn revenues for the company, and as a result may make treasury staff more motivated. It also means that treasury departments have to operate with a greater degree of commercial awareness in, for example, the management of working capital.

1.7 1.7.1

Control of treasury function Statement of treasury policy All treasury departments should have a formal statement of treasury policy and detailed guidance on treasury procedures. A treasury policy should enable managers to establish direction, specify parameters and exercise control, and also provide a clear framework and guidelines for decisions. The guidance needs to cover the roles and responsibilities of the treasury function, the risks requiring management, authorisation and dealing limits. Guidance on risks should cover:    

Identification and assessment methodology. Criteria including tolerable and unacceptable levels of risk. Management guidelines, covering risk elimination, risk control, risk retention and risk transfer. Reporting guidelines.

The guidance must also include guidance on measurement of treasury performance. Measurement must cover both the management of risk and the financial contribution the department makes.

1.7.2

Planning and review As with other areas, there should be proper forecasts and contingency arrangements, with funds being made available by the bank when required. Because treasury activities have the potential to cost the organisation huge amounts of money, there ought to be a clear policy on tolerated risk and regular review of investments.

1.7.3

Controls over operations The following issues should be addressed. (a)

Competence of staff Local managers may not have sufficient expertise in the area of treasury management to carry out speculative treasury operations competently. Mistakes in this specialised field can be costly. It may only be appropriate to operate a larger centralised treasury function as a profit centre, and additional specialist staff may need to be recruited.

(b) Controls Adequate controls must be in place to prevent costly errors and overexposure to risks such as foreign exchange risks. It is possible to enter into a very large foreign exchange deal over the telephone. (c)

Information A treasury team that trades in futures and options or in currencies is competing with other traders employed by major financial institutions who may have better knowledge of the market because of the large number of customers they deal with. In order to compete effectively, the team needs to have detailed and up-to-date market information.

(d) Attitudes to risk The more aggressive approach to risk-taking which is characteristic of treasury professionals may be difficult to reconcile with a more measured approach to risk within the board of directors. The recognition of treasury operations as profit-making activities may not fit well with the main business operations of the company. (e)

Internal charges If the department is to be a true profit centre, then market prices should be charged for its services to other departments. It may be difficult to put realistic prices on some services, such as arrangement of finance or general financial advice.

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(f)

Performance evaluation Even with a profit centre approach, it may be difficult to measure the success of a treasury team for the reason that successful treasury activities sometimes involve avoiding incurring costs, for example when a currency devalues.

1.7.4

Audit of treasury function Auditors must ensure that the risk is managed in accordance with company procedures. They need to review forecasts and contingency arrangements for adequacy and examine investment reviews. The auditors also need to see evidence that the board is fully aware of the treasury activities that are being carried out.

1.8 1.8.1

Current developments in the treasury function The changing role of the treasury function A predictable consequence of the wide-ranging scope of the treasurer's role is that it is constantly evolving. Partly, this is in response to changes in the financial world such as the development of different types of capital instruments. It is also due to a changing emphasis on the relative importance of different aspects of the treasury role.

1.8.2

Risk prevention We have already stressed that risk control is an integral part of the treasury management function. More accurate forecasting techniques are being used to help other departments mitigate and avoid risks.

1.8.3

Working capital management Many businesses are placing increased emphasis on constant working capital improvement to minimise funding requirements. This means greater treasury involvement in supplier and inventory management.

1.8.4

Tax management Consequences of global developments such as European Union harmonisation need to be considered carefully. However in many businesses limitation of tax liabilities must be seen in the context of optimum liquidity management.

1.8.5

Information and technology management Careful management is needed of all the information sources that are relevant for the business including the internet and mass communication media. Optimum use of technology is a key part of information management and as well as choosing the right supplier, treasury departments need to monitor technological developments that could enhance their operations. Technology can also be used to provide a common information base that the service providers to the treasury function can use.

1.8.6

Relationship management The wider scope of treasury's role implies strengthening of relations with other functions, and cooperation in tasks such as establishment of terms and payment methods for customers.

1.8.7

Co-operation between treasuries Treasury functions of different organisations sometimes pass aspects of their operations to a single independent supplier. This enables the organisations to share processes, information and knowledge. Treasury functions also co-operate together in payment systems harmonisation, supplying information to rating agencies, and presenting a common front to suppliers and regulators.

2 Global treasury management 2.1

Issues affecting global treasury management Any company involved in international trade must assess and plan for the different risks it will face. As well as physical loss or damage to goods, there are also cash flow problems and the risk that the customer may not pay either on time or at all. The tasks that treasury departments have to undertake domestically, for example efficient cash and liquidity management, will also be relevant for international management. However, issues such as arranging funds to move cross-borders, may complicate these tasks. As also indicated above, the treasury function will be responsible for currency management. The following issues may be particularly significant for the treasury function.

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2.1.1

Cash flow issues The treasury department in a Multi-National Company (MNC) will be dealing with cash flows from customers, suppliers and Group companies based in perhaps many different countries. The treasury department will be dealing with a variety of different banking and payment systems. As mentioned above, the situation may also be complicated by many transactions crossing borders.

2.1.2

Legal issues The treasury department of an international company will need to be aware of the laws that affect financial transactions and assets, and the power of authorities in different jurisdictions to impose restrictions. A big risk area may be laws relating to bribery or money laundering, particularly the fact that behaviour that is legal (or at any rate not illegal) in some countries is prohibited in others. If the parent company is based in a jurisdiction where these activities are prohibited, it may be liable if its employees or agents breach these laws even if this take place in other jurisdictions.

2.1.3

Political issues An MNC's treasury department will have to deal with issues such as blocked funds or restrictions on ownership that some foreign governments may impose.

2.1.4

Tax issues Treasury departments will have to cope with a variety of tax laws and taxes. These are discussed further below.

2.2

Structure of treasury operations The question of the extent of centralisation may be particularly difficult for MNCs with extensive foreign operations.

2.2.1

Extent of centralisation For some MNCs, increasing globalisation may be an impetus towards centralisation and concentration on control frameworks, decision support and improved business performance. In some instances, the decision will follow how the MNC operates. If the MNC purely operates overseas sales offices, centralisation is more likely. If it operates subsidiaries that carry out full business operations, it is more likely to operate a decentralised structure with guidelines, a formal reporting system and assurance procedures. Many MNCs resolve the centralisation v decentralisation issue by operating treasury centres on a regional basis. This enables them to use staff who are well-informed about global requirements, but also sympathetic to local stipulations. A regional structure allows some decisions, for example the extent of outsourcing, to be taken region-by-region. The degree of centralisation is also important when the MNC is considering its banking as well as its treasury arrangements. Businesses will be concerned about whether their banks have the ability to provide global treasury services. However, the services of the global bank need to be matched with regional needs.

2.2.2

Shared service centre A shared service centre (SSC) may be the best method of achieving efficiencies and cost savings through some centralisation, while allowing overseas operations some autonomy in their treasury operations. The company can take a selective approach, centralising operations where there is no advantage in local management. An SSC may allow the company to operate global management systems and centralised databases, taking advantage of the most recent technology and standardised information management. Tax considerations and the availability of expert staff may be important determinants of where the SSC is based â&#x20AC;&#x201C; perhaps it will not be located in the same country as the parent company.

2.2.3

In-house banking The activities of a shared service treasury function may extend to providing in-house banking services. This means financial institutions have a single point of contact and should help the business obtain discounts by aggregating some transactions and undertaking some operations in bulk. An in-house banking arrangement would oversee netting and pooling arrangements (discussed below).

2.3 2.3.1

Treasury management Pooling Pooling means asking the bank to pool the amounts of all its subsidiaries when considering interest levels and overdraft limits. It requires all the Group companies to maintain accounts at the same bank. Banks normally require credit facilities to support debit balances in the Group. Pooling should reduce the interest payable, stop overdraft limits being breached and allow greater control by the treasury department. It also gives the company the potential to take advantage of

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better rates of interest on larger cash deposits.

2.3.2

Netting Definition Netting: A process in which credit balances are netted-off against debit balances so that only the reduced net amounts remain due to be paid by actual currency flows. Many multinational groups of companies engage in intragroup trading. Where related companies located in different countries trade with one another, there is likely to be inter-company indebtedness denominated in different currencies. In the case of bilateral netting, only two companies are involved. The lower balance is netted-off against the higher balance and the difference is the amount remaining to be paid. Multilateral netting occurs when several companies within the same Group interact with the central treasury department to net-off their transactions. The arrangement might be co-ordinated by the company's own central treasury or, alternatively, by the company's bankers. The process involves establishing a 'base' currency to record all intragroup transactions. All subsidiaries inform the central treasury department of their transactions with each other. Central treasury will then inform each subsidiary of the outstanding amount payable or receivable to settle the intragroup transactions. This procedure has the advantages of reducing the number of transactions and thus transaction costs, including foreign exchange purchase costs and money transmission costs. There will also be less loss of interest through having money in transit. However, it requires strict control procedures from central treasury. In addition, there are countries with severe restrictions on, or even prohibition of, netting because it is seen as a means of tax avoidance. There may also be other legal and tax issues to consider. Multi-currency accounts Treasury departments may also negotiate multicurrency account arrangements with banks. These arrangements allow customers to receive or make international payments in a range of currencies from one account of the company. Multicurrency arrangements generally specify:

2.3.3



The base currency of the account.



The currencies accepted.



The spread or margin over the spot rate when exchanging other currencies back to the base currency.



The value date for each transaction currency and type.

Other arrangements Treasury departments may also supervise arrangements designed to limit exposure to foreign exchange risk, including:

2.4



Leading and lagging – cross-border payments ahead of or behind the scheduled payment date, depending on how exchange rates are expected to move.



Reinvoicing – the reinvoicing centre purchases goods from an exporting subsidiary, which is selling the goods to an internal subsidiary. It improves foreign exchange rates available by allowing larger trades and improves liquidity management by allowing flexibility in intercompany payments.



Factoring – buying accounts receivable from exporting subsidiaries and collecting monies from importing business.

Taxation issues The treasury department may have to deal with complex global tax issues and also conflicting demands from different jurisdictions. In-house or external expertise will be needed to support treasury operations.

2.4.1

Capital tax Treasury functions will need to be alert for the different ways in which some jurisdictions levy capital taxes. The initial capital used and subsequent investments may be subject to tax. In other jurisdictions the tax point may be when the capital is repatriated at the conclusion of the investment.

2.4.2

Asset tax Even if an investment does not produce any profits, the assets used may be subject to an asset tax. The MNC may be subject to tax on the value of property or financial assets.

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2.4.3

Sales tax In many jurisdictions, an MNC will be subject to some form of turnover tax. It may simply be levied on sales of goods and services. Alternatively, it may be a value added tax, where the tax is charged at each stage of production or distribution on the increased value occurring at that stage.

2.4.4

Withholding tax As we have seen in investment appraisal, companies may be required to pay tax when moving any funds (not just capital) from a foreign country.

3 Working capital management 3.1

Working capital and value creation Working capital is technically the excess of current assets over current liabilities. In practice, it represents the resources required to run the daily operations of a business. You covered the techniques for managing working capital in detail in the Management Information syllabus, and may wish to refresh your memory of the most significant issues.         

Working capital ratios The cash operating cycle Overtrading Methods of managing inventory The Economic Order Quantity (EOQ) model Using trade credit Credit control finance and management Cash management (covered in further detail below) Cash budgets

This section provides an overview of some of the strategic issues. The effective management of a company's inventory, customer accounts, cash resources and suppliers' accounts are a source of competitive advantage and thus corporate and shareholder value. For example, good control over inventory can be important in ensuring that there are items on hand when customers want them and they are in good condition. Well handled supplier accounts are part of good supply chain management and help in the objective of ensuring costs and delivery times are minimised. Effective working capital management can also comprise a key element of the value chain. The management of inventories, supplier relationships and customer relationships are closely related to operations, supply chain and logistics management. A great deal of working capital management affects the customer interface and deserves a business manager's attention as it can be a significant source of customer satisfaction.

3.2

Aggressive and conservative working capital management The volume of working capital required will depend on the nature of the company's business. For example, a manufacturing company may require more inventories than a company in a service industry. As the volume of output by a company increases, the volume of current assets required will also increase. Even assuming efficient inventory holding, debt collection procedures and cash management, there is still a certain degree of choice in the total volume of current assets required to meet output requirements. Policies of low inventory-holding levels, tight credit and minimum cash holdings may be contrasted with policies of high inventory (to allow for safety or buffer inventory), easier credit and sizeable cash holdings (for precautionary reasons). Organisations have to decide what the most important risks are relating to working capital and, therefore, whether to adopt a conservative or aggressive approach.

3.2.1

Conservative working capital management A conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels of working capital. Customers are allowed generous payment terms to stimulate demand, finished goods inventories are high to ensure availability for customers, and raw materials and work-in-progress are high to minimise the risk of running out of inventory and consequent downtime in the manufacturing process. Suppliers are paid promptly to ensure their goodwill, again to minimise the chance of stock-outs.

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However, the cumulative effect of these policies can be that the firm carries a high burden of unproductive assets, resulting in a financing cost that can destroy profitability. A period of rapid expansion may also cause severe cash flow problems as working capital requirements outstrip available finance. Further problems may arise from inventory obsolescence and lack of flexibility to customer demands.

3.2.2

Aggressive working capital management An aggressive working capital investment policy aims to reduce this financing cost and increase profitability by cutting inventories, speeding up collections from customers, and delaying payments to suppliers. The potential disadvantage of this policy is an increase in the chances of system breakdown through running out of inventory or loss of goodwill with customers and suppliers. However, modern manufacturing techniques encourage inventory and work-in-progress reductions through just-in-time policies, flexible production facilities and improved quality management. Improved customer satisfaction through quality and effective response to customer demand can also mean that credit periods are shortened.

3.3

Working capital financing There are different ways in which the funding of the current and non-current assets of a business can be achieved by employing long- and short-term sources of funding. Short-term finance is usually cheaper than long-term finance (under a normal yield curve).

3.4

Other factors Overall working capital management will be complicated by the following factors.

3.4.1

Industry norms These are of particular importance for the management of receivables. It will be difficult to offer a much shorter payment period than competitors.

3.4.2

Products The production process, and hence the amount of work-in-progress, is obviously much greater for some products and in some industries.

3.4.3

Management issues How working capital is managed may have a significant impact upon the actual length of the working capital cycle, whatever the overall strategy might be. Factors to consider include the degree of centralisation (which may allow a more aggressive approach to be adopted, depending though on how efficient the centralised departments actually are). Differences in the nature of assets also need to be considered. Businesses adopting a more conservative strategy may well hold permanent safety inventory and cash balances, whereas there is no safety level of receivables balances.

3.5

Working capital management and the recession The current credit crunch is impacting upon the finance available to all companies. There are plenty of examples of well-established companies struggling with funding. The Financial Times reported in September 2008 that banks were limiting credit facilities, raising interest rates and pressuring businesses to switch from unsecured overdrafts to secured loans. Companies are having to draw on their own accumulated funds and look very carefully at their working capital levels. A significant difference between this recession and previous recessions is that the downturn this time has been driven by a shortage of liquidity.

3.5.1

Inventory levels Managing inventory has become even more of a balancing act between meeting the demands of customers and limiting inventory levels. Businesses are looking carefully at slow-moving or surplus items to see if certain lines can be discontinued. They are also examining reorder levels to see if just-in-time policies can be introduced.

3.5.2

Credit control This is another balancing act. Chasing customers too hard at a time when their liquidity is under pressure may risk customer goodwill. However, at some point the finance cost of the outstanding debt and the collection costs may mean slow payers become uneconomical.

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3.5.3

Supplier payments Using supplier finance to alleviate liquidity problems may be risky. Suppliers may come to regard the business as a poor credit risk and reduce permitted orders or stop offering credit. New sources of supply, that do not offer discounts for a long-established relationship, may be significantly more expensive. If the business is considering changing its supply arrangements, the cost of buying supplies from lower cost overseas sources will have to be weighed against the increased difficulty of introducing just-in-time arrangements.

3.5.4

Renegotiate loan finance Some companies have renegotiated their borrowing so that the loans are over a longer period and are ultimately more expensive, but have lower payments now. Adding more debt will have long-term consequences, but refinancing is worth doing if it means companies are able to reach the long term.

3.5.5

Cash hoarding Concerns about short-term finance have led some companies to hoard cash.

3.6

Working capital management and exporters One of the main problems facing exporters is cash flow. In order to win customers, exporters will normally have to offer credit facilities, but at the same time need liquid funds to finance investment. There are several finance options available for this purpose. Some of these – such as factoring and documentary credits – you will have met before, but we briefly mention them here.

3.6.1

Factoring Factoring involves passing debts to an external party (the factor) who will take on the responsibility for collecting the money due. The factor advances a proportion of the money it is due to collect, meaning that the exporter will always have sufficient funds to pay suppliers and finance growth. Sometimes the factor will also take on a percentage of the non-payment risk, which is known as 'non-recourse' factoring. This means that the factor will not come back to the exporter in the event of default on the part of the customer.

3.6.2

Documentary credits A documentary credit (or letter of credit) is a fixed assurance from the customer's bank in the customer's own country. This basically says that payment will be made for the goods or services provided the exporter complies with all the terms and conditions established by the credit contract. The exporter's own bank may be willing to advance a short-term loan for a percentage of the documentary credit prior to goods being shipped, to cover the temporary shortfall of cash. The bank will then collect the loan from the proceeds of the transaction.

3.6.3

Forfaiting Forfaiting – or medium-term capital goods financing – is used for larger projects and involves a bank buying 100% of the invoice value of an export transaction at a discount. The exporter is then free from the financial risk of not receiving payment and the resultant liquidity problems – the only responsibility the exporter has and is liable for is the quality of the goods or services being provided. Three elements make up the price of a forfaiting transaction. 

The discount rate – this is the interest element which is usually quoted as a margin over LIBOR.



Grace days, which are added to the actual number of days to maturity to cover the number of days' delay that usually occurs in the transfer of payment. The number of days depends on the customer's country.



Commitment fee, which is applied from the date the forfaiter assumes responsibility for the financing to the date of discounting.

Forfaiting enhances the competitive advantage of the exporter, who will be able to provide financing to customers, thus making the products or services more attractive. By having the assurance of knowing that they will receive the money owed to them, exporters will also be more willing to undertake business in countries whose risks would normally prohibit them from doing so.

3.6.4

Credit insurance Exporters may also make use of credit insurance facilities to ease liquidity problems. This involves assigning credit-insured invoices to banks who will offer up to 100% of the insured debt as a loan. These instruments may also carry the guarantee of the customer's home government.

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Strategic Business Management Chapter-19

Ethics 1 Ethics and ethical issues 1.1

Business ethics Ethics refer to notions of 'right' and 'wrong'. In a business context, the impact of a company's strategic decisions will have an ethical implication (eg child labour, pollution, wage rates, dealing openly and fairly with stakeholders, suppliers, customers etc). Business ethics can be defined as the expected standards of behaviour in the conduct of business. Business life is a fruitful source of ethical dilemmas because its whole purpose is material gain, and the making of profit. Moreover, success in business requires a constant search for potential advantage over others and business people are under pressure to do whatever yields such an advantage. However, they need to achieve this advantage without acting unethically. While acting ethically does not necessarily give an organisation a competitive advantage over its rivals, acting unethically is likely to damage an organisation's brand and reputation and could thereby damage its competitive position. As a result, organisations have become increasingly under pressure to act and to be seen to be acting ethically. In recent years many have demonstrated this by publishing ethical codes, setting out their values and responsibilities towards stakeholders. Similarly, there is increasing public demand for external assurance to support the fact that firms are acting ethically: for example, there is greater scrutiny of public competitions and telephone voting, and the draws for the National Lottery in the UK are supervised by 'an independent adjudicator'. The concept of 'corporate social responsibility' (CSR) which we considered earlier in Chapter 11 could also be relevant in relation to ethics, and the issues of ethics and CSR are often interlinked. However, some commentators note that the primary goal of CSR is to 'do good' whereas business ethics programmes focus more on 'preventing harm'. Point to note This chapter primarily considers ethics in business, and the ethical issues which could be faced by an accountant in business. We also consider ethics in an assurance context; in particular, considering the need for companies to assess (and gain assurance over) their ethical procedures.

Ethics and business decisions Ethics and business are inextricably linked, because management decisions can regularly involve a tradeoff between economic and social performance. For example, if a manager decides to recall a potentially dangerous product this might compromise profits in the short term, for the sake of consumer protection. By contrast, a manager who decides to delay the installation of pollution control equipment and its attendant costs could, at least in the short term, increase shareholder value. Even ethical managers face challenges trying to do the right thing in a complex business environment. Management faces intense pressure to produce consistently improving results. However, although lowering ethical operating standards could produce more favourable outcomes in the short term, these outcomes are not sustainable. We have already looked at the case example of BP & Deepwater horizon in Chapter 7 in the context of risk management. But the issues raised there are also relevant here â&#x20AC;&#x201C; in the context of the longer-term consequences of short-term decisions. This case example infers the importance of the distinction between the short- and long-term impacts of decision-making. This distinction is important in the context of ethics too, because, while acting ethically may sometimes reduce short-term profits, it should enhance longer-term shareholder value. Consequently, we could suggest that, in the long run, good business ethics is actually synonymous with good business overall.

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1 1

Conversely, unethical behaviour can damage reputations, in addition to bottom lines, as companies lose customers and employees and see their brands tarnished. All of these impacts destroy shareholder value, therefore companies need to appreciate the linkage between long-term, sustainable performance and the company's behaviour in relation to customers, employees, investors and the communities in which it does business. Ethics and marketing In relation to ethics and marketing, Schlegelmilch points out that: 'If customers did not trust a particular company, they might not buy its products, fearing that product claims would be untrue. The marketplace is built on trust between the company and the consumer. Any breakdown in this trust will have a detrimental effect on the company's sales.' For example, if a company makes a claim about its products, it must be able to substantiate the basis for any claim or any comparison with competitors' products. The rise and fall of the soft drink 'Sunny Delight' highlights the importance of not making false or misleading claims in advertising material.

1.2

Ethical stances of organisations Ethics can be defined as the moral principles that determine individual or business conduct, or behaviour that is deemed acceptable in the society or context. An organisation can adopt a range of ethical stances. 

Meet minimum legal obligations and concentrate on short-term shareholder interests.



Recognise that long-term shareholder wealth may be increased by well-managed relationships with other stakeholders.



Go beyond minimum legal and corporate governance obligations to include explicitly the interests of other stakeholders in setting mission, objectives and strategy. In this context, issues such as environmental protection, sustainability of resources, selling arms to tyrannical regimes, paying bribes to secure contracts, using child labour etc would be considered when evaluating strategic choices and implementing strategies.



In public sector organisations, charities, etc the interests of shareholders are not relevant (because there are no shareholders).

2 Resolving ethical dilemmas 2.1

Regulating ethical behaviour Ethical business regulation operates in two ways. 1

Forbidding or constraining certain types of conduct or decisions: eg most organisations have regulations forbidding ethically inappropriate use of their IT systems. Similarly, many will forbid the offering or taking of inducements in order to secure contracts.

Disclosure of certain facts or decisions: eg because the board sets its own pay it is disclosed, and sometimes the reasons behind the awards, to shareholders in the final accounts.

The following codes are potentially binding on you as a trainee Chartered Accountant.

The Auditing Practices Board (APB)

2.2



Ethical standards for Auditors – concerned with assuring their integrity and independence in the audit of financial statements and in how fees are levied. Thus the APB states 'Auditors shall conduct the audit of the financial statements of an entity with integrity, objectivity and independence'.



Ethical standards for Reporting Accountants – concerned with the integrity and independence of accountants involved in writing investment circulars.

The ICAEW Code of Ethics for members The Code of Ethics establishes the fundamental ethical principles for professional accountants and provides a conceptual framework that accountants should apply to: (a) (b)

Identify threats to compliance with the fundamental principles. Evaluate the significance of the threats identified.

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(c)

2.3

Apply safeguards, when necessary, to eliminate the threats or to reduce them to an acceptable level.

ICAEW Code of Ethics for professional accountants working in business Investors, suppliers, employers, the business community, government and the public may rely on the work of professional accountants in business in the context of:   

Preparation and reporting of financial and other information. Providing effective financial management. Competent advice on a variety of business-related matters.

The more senior the position held, the greater the ability and opportunity to influence events, practices and attitudes. A professional accountant in business is expected to encourage an ethics-based culture in an employing organisation, which emphasises the importance that senior management places on ethical behaviour.

2.3.1

Ethical issues and assurance engagements Throughout this Study Manual, we have identified a number of examples where assurance could be valuable in the context of strategic business management. For example, an accountant might be asked to undertake a financial due diligence engagement in relation to a possible acquisition. However, as with any professional engagement, an accountant should consider the ICAEW's Code of Ethics before accepting an assurance engagement. Independence – Stakeholders want credible information they can trust. An expert providing an independent opinion on the reliability of information helps to reinforce trust. Independence is an essential characteristic of assurance engagements. The accountant should consider any threats to independence before accepting an engagement. For example, providing assistance to a client in preparing a report may result in a self-review threat if the impact of the assistance on the matter being reported is material. Objectivity or confidentiality – The accountant must consider the threat to their objectivity and confidentiality requirements if they perform services whose interests are in conflict, or if the clients are in dispute with each other in relation to the matter in question. For example, if there is a dispute over the profit-sharing arrangements in a joint venture, the accountant should not act for both parties. In this respect, the accountant must ensure that they avoid any conflicts of interest. Professional competence – The accountant should only undertake an engagement for which they have the relevant skills and experience. In particular, the nature of some assurance engagements may demand specialist knowledge and skills to be available in the assurance team. For example, an engagement to provide assurance over the IT security and controls will require the presence of an IT specialist on the engagement team. Equally, in relation to a potential acquisition, there may be a need to consider the extent of a pension fund deficit in the company being acquired. The complexity of the estimates and assumptions relating to investment returns, mortality, wage inflation and future interests mean that this work should be referred to a qualified actuary, rather than being undertaken by the accountant.

2.4

Inducements and bribery In relation to the threat of ‘familiarity’ identified by ICAEW’s Code of Ethics, we noted that accepting a gift or preferential treatment could create a familiarity threat. In more extreme cases, accountants, or their immediate or close family, may be offered an inducement to support a particular course of action. Possible inducements include:    

Gifts Hospitality Preferential treatment Inappropriate appeals to friendship or loyalty

In addition to the ICAEW Code, accountants operating in businesses linked to the UK should be aware of the Bribery Act 2010. Bribery is an intention to encourage or induce improper performance by any person, in breach of a duty or expectation of trust or impartiality. Bribery may be an offence for the person making a bribe

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3 3

(‘active bribery’) and the person accepting a bribe (‘passive bribery’). Under the Bribery Act 2010, there are four categories of criminal bribery offences: 

Offering, promising or giving a bribe to another person (including officials)



Requesting, agreeing to receive or accepting a bribe from another person



Bribing a foreign official



Failing to prevent bribery (corporate offence). If companies fail to prevent bribes being paid on their behalf they have committed an offence, which is punishable by an unlimited fine.

A defence for a company will be having 'adequate procedures' in place for the prevention of bribery. If a bribery offence is committed by a company (or partnership) any director, manager or similar officer will also be guilty of the offence if they consented or were involved with the activity which took place. One particular point to note is that the Bribery Act has a very wide judicial reach: it applies to any persons with a 'close connection' to the UK. This is defined to include: 

British citizens



Individuals ordinarily resident in the UK



Businesses incorporated in the UK



Any business which conducts part of its business in the UK, even though it is not incorporated in the UK

Improper performance will be judged in accordance with what a reasonable person in the UK would expect. This applies even if no part of the activity took place in the UK and where local custom is very different. Note, however, that reasonable and proportionate hospitality is not prohibited under the Act.

3 Ethical safeguards 3.1

Safeguards To comply with the Code of Ethics, professional accountants are required to consider whether their actions or relationships might constitute threats to their adherence to the fundamental principles. Where these are significant, they must implement safeguards. These safeguards might be generic, created by the profession or regulation, or be developed in the working environment by the individual or their organisation. If effective safeguards are not possible, professional accountants are required to refrain from the action or relationship in question.

3.2

Action required in unethical circumstances In circumstances where a professional accountant in business believes that unethical behaviour or actions by others will continue to occur within the employing organisation, they should consider seeking legal advice. In extreme situations, where all available safeguards have been exhausted and it is not possible to reduce the threat to an acceptable level, a professional accountant in business may conclude that it is appropriate to disassociate from the task and/or resign from the employing organisation. Note, however, that resignation should be seen very much as a last resort.

3.2.1

Resolving ethical conflicts

The Code suggests that the following factors are relevant to resolving an ethical conflict.     

Establish the relevant facts, and the relevant parties affected by the conflict. Establish the ethical issues involved. Identify the fundamental principles related to the matter in question. Identify if there are any established internal procedures for dealing with the conflict. Evaluate the alternative courses of action available.

If a professional accountant is unable to resolve the conflict, they may wish to consult other appropriate people within their firm for help in obtaining a resolution.

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It is generally preferable for any ethical conflicts to be resolved within the employing organisation before consulting individuals outside the organisation. However, if such resolution cannot be reached, the accountant may consider obtaining professional advice from ICAEW or from legal advisors.

3.3

Ethics assurance On a number of occasions in this chapter so far we have referred to ICAEW's Code of Ethics, and we have also acknowledged that companies may have their own codes of ethics. (In Section 1.1 we also included an extract from Henkel's Code of Conduct as an illustration of this.) However, even if a company has a code of ethics, how can the board of that company be confident that the company (or more specifically, the staff) are adhering to the company's ethical values and commitments? In this context, boards would benefit from an ethical assurance programme giving them confidence that their company does act ethically, and as a result, the integrity, reputation and sustainability of the company can be safeguarded. However, there is no generally agreed framework for ethical assurance, so what would an ethics assurance programme actually mean in practice? A short article in Accountancy Magazine (April 2009; 'Woolf at the door'; see Case Study below) identifies four key challenges which were highlighted by ICAEW's ethics team. Defining assurance – a lack of understanding may create an expectation gap between providers and users of assurance services. Ethics assurance would be about adding credibility to an organisation's ethical behaviour; it is not ethics insurance, a source of recourse when something goes wrong with the business. Problems of measurement – providers of assurance (in particular, professional accountants) may be experienced in auditing quantitative information, but ethics is a more subjective area, so it may prove difficult to identify any suitable criteria and evidence on which to base an assurance opinion. As ICAEW's ethics manager points out: 'Even if controls and procedures can be verified and measured, this may not be enough. Ethics is ultimately about individual behaviour. Assessing and measuring individuals' ethical standards of behaviour as part of the assurance process is likely to be an onerous task.' Lack of agreed standards or frameworks for ethical assurance – ISAE 3000 is the internationally recognised standard on assurance engagements but it only includes high level principles in relation to ethical assurance. Therefore it will be left to individual practitioners to tailor the high level principles of the ISAE to suit the needs of individual clients. Reporting – how should information on ethical standards be reported, and to whom? Businesses must find a balance between providing a vast amount of information (because all of it is relevant to ethical assurance) and not producing enough to adequately address stakeholders' concerns. Equally, they must decide whether to report internally or externally. Demand for internal assurance, presented to the board or to a Corporate Responsibility Committee, is likely to develop before ethical assurance is published externally, because companies will want to assess their own ethical procedures internally before exposing them to wider (external) scrutiny. However, two possible forms that a publicly reported ethical assurance opinion could take have been suggested. 

The first is an assurance opinion as to whether the controls in place are appropriately structured to achieve the desired objectives.



In the second, the assurance provider attests not only to the existence of controls but also that they work in practice.

4 Ethics and strategy As well as presenting possible threats to a professional accountant, ethics and ethical issues can also have a role in strategy and business management more generally. For example, strong ethical policies – that go beyond simply upholding the law – can add value to a brand. Conversely, failing to act ethically can cause social, economic and environmental damage, and in doing so can undermine an organisation's long-term reputation and prospects. In this respect, a social and environmentally ethical approach can assist an organisation's ability to thrive in the long run. In this respect, ethical behaviour can help contribute to sustainable competitive advantage. The collapse of Enron (as a result of a massive fraud) clearly showed how unethical behaviour led to a

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failure to create a sustainable business model. It is also possible to argue that some other corporate failures – such as Lehman Brothers, Bear Stearns or Northern Rock – came about as a result of the organisations focussing too much on trying to pursue high short-term gains, and in doing so jeopardising their longer-term survival. These examples highlight the importance of organisations not only understanding the risks they are taking in their business, but also focussing on long-term sustainability as well as short-term profitability. Such considerations can be directly relevant in the context of strategic options. For example, how might a consideration of ethical behaviour affect an investment decision? In simple terms, if a project generates a positive net present value (NPV) it is likely to be accepted. If, however, the project involves exploiting cheap labour (or even child labour) it should not be accepted by an organisation; either on ethical grounds, or because of the potential risk to its reputation (and therefore future sales) if its labour practices became more widely known. Consequently, it is important that ethics are embedded in an organisation's business model, organisational strategy and decision-making processes. Moreover, ethical issues are particularly important when considered alongside aspects of sustainability.

4.1

Impact of ethics on strategy Ethics may impact upon strategy in various ways. 

In the formulation of strategic objectives, some firms will not consider certain lines of business for ethical reasons.



External appraisal will need to consider the ethical climate in which the firm operates. This will raise expectations of its behaviour.



Internal appraisal: management should consider whether present operations are 'sustainable', ie consistent with present and future ethical expectations.



Strategy selection: management should consider the ethical implications of proposed strategies before selecting and implementing them.

The Business Strategy Study Manual (at Professional Level) identified a range of contexts in which ethical issues could arise, and such contexts could equally be relevant to the scenarios in your exam. Marketing and the marketing mix: for example, there could be ethical issues relating to the products/services being sold, the price at which they are being sold, or the way in which they are being promoted. Manufacturing: for example, relating to pollution and environmental ethics, producing defective or inherently dangerous products (such as tobacco), the use of child labour, or product testing (eg testing on animals). Purchasing and procurement: for example, relating to human rights and working practices with supplier firms; or adopting fair contracting terms and conditions with suppliers (eg Fair Trade principles).

4.1.1

Ethical dilemmas and stakeholders

Often, the key issue facing organisations is not so much the number of different stakeholder groups per se, but the fact that these different groups have different interests which can come into conflict with each other. And the range of different stakeholders with interests in an organisation can create ethical issues for marketing managers in particular. As Schlegelmilch (in a text focusing on ethics and marketing) points out: 'This is due largely to the fact that their business function involves dealing with many different groups of people who have many, and sometimes conflicting, agendas. ............................ For example, a company might want to move its plant to a country where the cost of labour is lower. This decision would save on production costs and increase profits and, thus, be in the best interest of its shareholders. However, a relocation to another country might create negative publicity because it will lead to unemployment for many of its domestic workers.'

4.2

Ethics and sustainability We have already discussed issues around social responsibility and sustainability in Chapter 11, but it is worth acknowledging them again here because aspects of sustainability and ethics can be interrelated.

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In particular, it is important to remember that the concept of 'sustainability' does not only relate to 'environmental sustainability'. The 'economic sustainability' component of the triple bottom line could be equally important in encouraging organisations to act in a way which helps them grow and prosper as a result of developing sustainable business practices. In this respect, issues such as the health and safety of workers, or paying workers a fair wage are becoming increasingly important. For example, while Apple's iPhones and iPads are becoming 'musthave' consumer items in Western countries, a number of concerns have been raised about the working conditions of the employees in China who are making them; with allegations of excessive working hours, draconian workplace rules, and workers even being urged to sign an 'anti-suicide' pledge after a series of employee deaths in 2010. Although health and safety measures do not necessarily add value to a company on their own, they can help to protect a company against the cost of accidents which might otherwise occur. Moreover, if a company has poor health and safety controls this might result in, amongst other things, increased sick leave and possible compensation claims for any work-related injuries, as well as higher insurance costs to reflect the higher perceived risks within the company. Equally, the issue of social responsibility in relation to consumers has been highlighted in recent years. The tobacco industry and the food and drink industry have received criticism in relation to the potential harm their products may cause to consumers. Ultimately, if consumers cease to buy a product because they are concerned about the consequences of consuming it, that product will not be sustainable because it will not generate any sales. For example, concerns about the high level of sugar in the 'Sunny D' orange drink forced Procter & Gamble to withdraw the drink's original formulation from the market. Conversely, some companies do realise the importance of responding positively to environmental issues in order to protect and sustain their brand, and they can use sustainability issues to help maintain public trust in the brand. For example, Toyota responded to environmental trends by successfully launching the Prius hybrid car, which supplements normal fuel usage with an electric-powered engine. The battery-powered electric engine starts the car, and operates it at low speeds. At higher speeds, the car switches automatically to a conventional engine and fuel. However, this combination saves on fuel compared to conventional cars and causes less pollution. Similarly, environmental and social responsibility can provide marketing opportunities for companies, and companies can even achieve competitive advantage by addressing and accommodating their customers' ethical concerns. For example, Innocent Drinks has built its business on corporate social responsibility ideals. Given that firms are more likely to embrace sustainability if it brings them a financial benefit, it is important to note that introducing better environmental management systems can create 'win – win' situations. For example, if introducing environmental management systems can allow a company to continue to produce the same amount of product by using less resources, and generating less waste, this is both economically efficient, and also beneficial from an environmental and ecological perspective. In this context, the cost savings from more efficient resource usage and waste minimisation can be substantial.

4.2.1

Sustainability and strategy

The challenge sustainability presents for decision-makers comes in incorporating longer-term (sustainability) issues alongside short-term issues. If they focus too much on short-term issues at the expense of the longer term this undermines a company's long-term reputation and prospects. Although the challenges facing companies will vary according to their specific circumstances the following summarises some possible issues to consider in relation to social and economic aspects of sustainability and which could also overlap with ethical issues. Social dimension 

Being seen as an attractive employer (which in turn can affect: ability to recruit high quality staff, retain staff and staff know-how, and employee motivation).



Quality of working conditions (in own company, and across the supply chain).



Labour practices (labour/management relations, health and safety, training, diversity and opportunities, eg equal opportunities).

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

Data protection and privacy.



Risk of accidents (and subsequent litigation against the company).



Human rights (non-discrimination against minorities; use of child labour or forced labour; disciplinary practices, freedom for staff to belong to a union or other association).



Relations with society: contribution to local community.



Integrity and image: not being involved with bribery and corruption, or anti-competitive prices (eg price fixing).



Product responsibility: ensuring each product's health and safety for customers, honesty in advertising and communications with consumers.

Economic issues    

Business relations (security of business, relationship with banks and shareholders). Supplier and customer structure: quality of relationships with suppliers and customers. Brand name: risk to reputation and sales resulting from negative publicity. Market position.

Ethical consumerism – In relation to the sustainability of their sales, firms should also remember that, in most cases, consumers have a choice whether or not to buy their products. And individual consumers can make purchasing decisions based not only on personal interests but also the interests of society and the environment. For example, they may boycott companies whose products are made by sweatshops or child labour, choosing wherever possible fair trade products. Moreover, some customers are prepared to pay more for products that are environmentally or socially responsible (fair trade; organic etc) compared with cheaper, less responsibly sourced products. However, if firms are going to portray themselves as ethical or socially responsible, for this to have any meaningful benefit, they must be genuinely committed to ethical principles, rather than just treating them as an 'ethical veneer'. The focus on 'the longer term' can pose problems for the corporate decision-maker and accountants in business. Corporate reporting and performance measurement are often biased towards the short term. The fact that companies report their results on a yearly basis, and may be under pressure from shareholders and market analysts to deliver results, means they may be forced into measures or actions which boost profits in the short term, but which may create problems in the longer term and in doing so may threaten sustainability.

4.2.2

Corporate Responsibility Reviews

Increasingly, business executives are recognising that corporate responsibility is essential to their business, and that businesses have a duty to investors, employees, consumers, communities and the environment. These views reflect a trend that has seen an increasing number of companies producing corporate responsibility reviews in with they report publicly on their social and environmental performance. Earlier in the chapter, we noted BAE's response to the Woolf report in developing an ethics programme to support responsible behaviour. The ethics programme is part of BAE's wider corporate responsibility programme. As the Group's Corporate Responsibility Review notes: 'Creating a successful and sustainable business requires more than financial results. The Group places great importance not just on what we do, but how we do it. Responsible business is embedded within the Group's strategy.' The Group's Corporate Responsibility (CR) objectives support it in progressing towards leading positions in ethics and safety. The Group also has programmes in place to promote diversity and inclusion, and environmental sustainability. BAE has identified these four areas of ethics, safety, diversity and inclusion, and environmental sustainability as being priorities which are crucial to its long-term performance. 'The Group's CR agenda covers the issues that have been identified as having the most potential to affect the long-term sustainability of the Group, by directly impacting the Group's reputation or ability to operate.'

4.2.3

Sustainability assurance

We have already discussed corporate social responsibility; sustainability; and integrated (social, environmental and economic) reporting in Chapter 11 but it is worth noting again that an increasing

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number of businesses are producing information sustainability information in response to user needs and to meet regulatory requirements. Similarly, organisations choose to get assurance on their sustainability information, to support views expressed in the annual report as part of the narrative disclosures, or in relation to separately produced corporate responsibility reports. In some cases, firms may ask for assurance to enhance the credibility of their sustainability information more generally amongst external stakeholders.

4.2.4

Public interest

An important element of the role of a professional accountant is serving, and being seen to serve, the public interest. This may be particularly true for auditors, given the role which an audit plays in giving the public confidence in a set of financial statements, but all professional accountants have a duty to act in the public interest. However, determining what the public interest is may not always be as easy as it sounds. Legally, private sector companies exist to serve their shareholders, not any wider public interest, and this view could lead to potential conflict with the idea that companies should adopt a wider public interest perspective. For example, in the UK in 2013, global firms such as Starbucks, Google and Amazon have come under fire for avoiding paying tax on their British sales. The companies have argued, rightly, that everything they have done is legal, and the idea that firms would voluntarily pay more tax than they legally need does rather contradict the objective of maximising shareholder value. However, public opinion has increasingly turned against the tax avoidance schemes used by the firms, leading some people to boycott the brands in question; for example, buying coffee from Costa instead of Starbucks. For these customers, the issue is that they feel the firms are acting in a way which is morally, if not legally, inappropriate. Branding experts have pointed out that the reputational side of public opinion could be crucial to resolving these issues, because if a company with a strong brand damages that brand, it also damages its financial value. For example, following public pressure, Starbucks agreed to increase its tax payments in the UK. Nonetheless, the debate around the firms' tax avoidance schemes serves to highlight that investors' interests are not the same as the public's interests. In more general terms, the concept of public interest can also be difficult to determine because different sections of the public want different things. Consequently, there may be occasions when there may be no such thing as 'the' public interest. Equally, what the 'public' wants seems to fluctuate over time. For example, when a large supermarket moves into a small town, threatening the future of small, local businesses, people object, yet many of them still shop at the supermarket taking advantage of the lower prices on offer. So, in such a case, what is 'the public interest'?

4.2.5

Business sustainability

Our discussions of triple bottom line and corporate responsibility should have highlighted a key point about sustainability in a business context: that sustainability relates to the social, economic and environmental concerns of a business that aims to thrive in the long term. From a strategic perspective, there is little point in a business being profitable in the short term if it alienates customers, suppliers and/or staff in the process. By doing so, the business will weaken its chance of being profitable in the longer term. In this respect, the idea of business sustainability is central to business strategy. In Chapter 1 of this Study Manual we looked at the way organisations need to use their resources and capabilities to develop a sustainable competitive advantage. A company's ability to create and sustain a competitive advantage over its rivals is likely to be crucial to its long-term success. Equally, a sustainable business needs an understanding of the changing business landscape and external environment so that it can respond and adapt to the opportunities and threats presented by it. In this respect, the idea of sustainability should be seen as a strategic issue for almost every business â&#x20AC;&#x201C; for example, in relation to risk mitigation, strategic innovation and the development of new skills and capabilities. Crucially, however, the concept of sustainability should encourage an organisation to consider long- term orientation in business decisions, rather than purely focusing on short-term (financial) information and metrics. Short-term metrics may push managers towards making decisions that deliver short-term performance at the expense of long-term value creation. Equally, a focus on creating value for shareholders in the short term may result in a failure to make the necessary strategic investments to ensure future profitability.

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By contrast, an increased focus on business sustainability will support decisions aimed at attracting human capital, establishing more reliable supply chains, and engaging in product and process innovation, even if those decisions do not necessarily maximise short-term financial performance and profitability.

4.3

Potential conflicts between ethics and business One of the key sources of ethical issues facing accountants in business is the prospect of business strategies being proposed which could conflict (either in full, or in part) with ethical principles. Potential areas for conflict between ethics and business strategy include: 

Cultivating and benefiting from relationships with legislators and governments: Such relationships may lead politicians to ignore the national interest (eg of the people who elected them) to further their own personal interests. A related issue here could be managers bribing people to help their company win contracts or gain business.



Fairness of labour contracts: Firms can use their power to exploit workers, including child labour, and subject them to unethical treatment in areas where jobs are scarce.



Privacy of customers and employees: Modern databases enable tracking of spending for marketing purposes or discriminating between customers on the basis of their value. Staff can be subject to background checks and monitored through their use of email and the location of their mobile phones.



Terms of trade with suppliers: Large firms may pay poor prices or demand long credit periods and other payments from weak suppliers. This has been a particular criticism of large retail food stores in North America and Europe, who are blamed for the impoverishment of farmers at home and in developing countries.



Product and production problems: These include the environmental impacts of the production itself, product testing on animals or humans, the manufacture of products with adverse impacts on health and the impact on the environment when products are thrown away.



Supply chain: Remember that a company's reputation for ethical conduct isn't founded solely on its own internal activities. Increasingly, stakeholders are looking at the behaviour of other organisations a company interacts with – particularly in its supply chain. Continuing to use suppliers which are known to employ child labour, treat workers harshly, or pollute local environments can damage a company's reputation and brand.



Prices to customers: Powerful suppliers of scarce products such as energy, life saving drugs or petrol, are able to charge high prices that exclude poorer individuals or nations. Examples include anti-aids drugs to Africa or purified water to developing countries.



Managing cross cultural businesses: Different countries of operation or different ethnic groups within the domestic environment can present ethical issues affecting what products are made, how staff are treated, dress conventions, observance of religion and promotional methods.



Marketing: There is the basic argument that marketing persuades people to buy what they don't need. However this stance assumes superiority of judgement over the consumers who buy the products. A key issue is the ends to which marketing is put. Marketing can be used to promote ecologically responsible ways of life, but it can also be used to promote unhealthy products such as cigarettes, alcohol and fatty foods. Some promotion techniques have also been criticised for attempting to brainwash consumers, encouraging anti-social behaviour and upsetting observers. More generally, misleading statements made to consumers, for example, around the characteristics of benefits of products, can also create ethical issues.

Ethics and change Ethical issues can arise in change programmes, for example, whether staff are treated reasonably or fairly during the changes. It can often be difficult to monitor whether a company (or its staff) are acting ethically during periods of rapid change, so accountants may need to be particularly vigilant during such times. Companies which are looking to enter new businesses, markets or channels may make speed a priority – to be the first with the product, to capture new customers and markets, and to seize market share as sales and order fulfilment channel opportunities arise. Nonetheless, it is important that they do not let this need for speed become a justification for acting unethically.

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4.3.1

Ethical failings and audit firms

Although the focus of this chapter is predominantly on the ethical issues which could be faced by an accountant in business, the following case example highlights how potential conflicts between ethics and business strategy also affect accountants in practice. In particular, note the issues identified in the case which have been caused by a desire to cut costs in order to try to boost profitability.

4.4

Ethical issues in the exam Ethical issues have already been examined in the Professional Level papers. However, at the Advanced Level you will be faced with more complex situations. More emphasis will be placed on your ability to use your judgement in the light of the facts provided, rather than testing your knowledge of the ethical codes and standards in detail. In some instances, the correct action may be uncertain and it will be your ability to identify the range of possible outcomes which will be important rather than concluding on a single course of action. You should also be aware that the term 'ethics' will be used in a much broader sense than it has been in the earlier Assurance and Audit & Assurance papers. It is likely to be combined with financial reporting, business and tax issues where you may be required to assess the ethical judgements made by others including management. You may also be asked to consider the issue from the point of view of the accountant in practice and the accountant in business.

4.4.1

Ethical issues

Although the precise nature of the ethical issues you will be expected to consider in your exam will vary according to the context of the case study scenario, possible ethical problems that you may find in scenarios include: 

The impact of ethics on strategies and strategic choice.



Conflicts of interest amongst stakeholders.



Attempts to mislead key stakeholders (by disclosure or non-disclosure of information).



Issues in relationships with vendors, suppliers, contractors, joint venture partners or other third parties.



Mistreatment of staff (for example over pay, or in relation to dismissal/redundancy; equal employment opportunities or discrimination).



Doubtful accounting or commercial business practices.



Inappropriate pressure to achieve results.



Conflict between the accountant's professional obligations and the responsibilities to the organisation.



Lack of professional independence, eg personal financial interest in business proposals.



Actions contrary to law, regulation and/or technical and professional standards.



Unsafe or socially undesirable manufacturing processes.



Product quality and/or safety.



Corporate social responsibility and sustainability.



Corporate governance: the quality and behaviour of the board. Corporate governance issues could also involve issues like the integrity of the management accounting control system, the existence of internal controls and the integrity of management and staff.

Some of these issues may not be clear-cut. When assessing them, you need to develop a balanced argument, using appropriate ethical language and discussing relevant professional principles.

4.4.2

Recommended approach

The following is a suggested list of factors to consider when tackling questions involving ethical issues. 1

Is there a legal issue (criminal or civil law)?

Do any other codes or professional principles apply? (eg, is the individual with the ethical dilemma a professional accountant?)

Upon which stakeholders does the decision/action impact?

What are the implications in terms of:  

Transparency Effect

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ď&#x201A;ˇ

Fairness

If the proposed action/decision is not taken, what are the issues?

What are the alternative actions that could be taken and what are the consequences of each course of action?

Are there any sustainability issues?

4.4.3

Weaknesses to avoid

Key weaknesses in answering ethical questions include: 1

Failing to identify the ethical issue (eg transparency).

Failing to use ethical language.

Quoting chunks of the ICAEW's ethical code without applying it to the scenario.

Failing to identify appropriate safeguards.

Applying professional accountants' ethical codes to individuals in the scenario who are not accountants.

Failing to distinguish between the ethical responsibilities of the individual and those of the organisation.

Concluding by asserting an opinion that is not supported by clear justification on ethical grounds â&#x20AC;&#x201C; stating 'X should be done because it is right' is insufficient.

4.4.4

Distinguishing ethical and commercial issues

It is also important that you can distinguish between the ethical issues and the commercial issues which an organisation is facing in a case study scenario. Ethical issues can usually be described as issues under the following moral principles. Fairness: this means treating someone as they deserve to be treated or as you would wish to be treated if you were in their position. Therefore discrimination, poor pay, summary dismissal, or refusing reasonable requests for assistance are unfair. Deliberately distorting competition or taking advantage of a customer's ignorance or desperate position is unfair. Some of these are also illegal, and many would give rise to commercially-damaging publicity. However, these things happen. But society recognises the practices as ethically wrong and wants to stamp them out. Justice: this means going through a proper process, involving weighing up the evidence and arguments and coming to a balanced decision and a measured response. Therefore things like sacking someone without hearing what they have to say, or ignoring their side of the story, is unjust. So is punishing someone harshly for a minor wrong, even if the rules lay down that punishment. In such a case, the rules and the punishment are both unjust. Honesty and straightforwardness: this is as basic as telling the truth and not withholding important information, or trying to use loopholes to escape responsibilities. It also covers taking assets or value belonging to other people. This principle covers things like corruption, misrepresentation, deliberately misleading wording, and selling someone something unsuitable. Duty, responsibility and integrity: as a citizen you have duties â&#x20AC;&#x201C; such as to obey the law, report crime and so on. As an employee you take on other duties that flow from your job and you are paid to do them and put in a position of trust by your superiors or the people that appointed you into your role. Therefore you must put personal interest aside and act as the role requires you to do. Any attempt by you to make someone else forget their duty and responsibility, such as by making bribes or threats, is also an unethical action by you too.

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